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India's Economy May No Longer Be the Achilles' Heel in Relationship with U.S.

India Report by John E. Carbaugh, Jr.
July 16, 2003

Although India’s economy had been widely seen as the Achilles’ heel in the evolving relationship with the U.S., there is some optimism that this could change for the better.

U.S.-India economic ties are often described as lagging compared to other areas in the rapidly improving bilateral relationship. However, there is more hope of late that India’s economy is on the rise -- helping economic ties with the U.S. catch up with the deepening bilateral relationship on other fronts.

WIDER CONSEQUENCES OF PROBLEMATIC ECONOMY

The U.S. has seen India’s problematic economy not only in terms of impeding bilateral trade and investment, but also as a wider strategic concern. India’s economy is holding back the South Asian power from fulfilling its potential as a major player on the international stage, Washington argues.

"America’s strategic interests would be significantly served if India -- through a new wave of economic reforms -- climbs firmly aboard the globalizing train," outgoing U.S. Ambassador to India Robert Blackwill said earlier this year. "Put simply, the United States has major strategic stakes in India’s economic success. An India that takes full advantage of its extraordinary human capital to boost its economy would be a more effective strategic partner of the U.S. over the next decades, including in promoting peace, stability and freedom in Asia. An India that enters into a full fledged series of second generation domestic economic reforms would inevitably play an increasingly influential role in international affairs across the board, and that too would be beneficial for the United States."

MORE OPTIMISM OVER INDIA’S ECONOMY

However, there is a growing opinion that such concerns are overblown. Bruce Gilley of Princeton University contends that India has already transformed itself into a modern economy that can match its foreign policy ambitions.

"Almost unnoticed by the outside world, India over the past two decades has witnessed an economic transformation of staggering proportions," Gilley said. "It is a transformation that has cut poverty to 20 percent of the population today from something like 40 percent a few decades earlier (estimates vary), while adding nine years to the life of the average Indian. Low inflation, strong foreign-exchange reserves and healthy agriculture and services sectors underlie the changes. The information technology sector continues to boom despite the global IT bust, now accounting for 3 percent of GDP and 15 percent of exports."

WEAKEST LINK

In the last few years economic ties have certainly been viewed as the weakest link in the deepening U.S.-India relationship. "This modernization of U.S.-India economic interaction based on Indian economic reform is the missing piece in our transforming bilateral relationship," Blackwill said.

The U.S. has especially complained that India is dragging its feet over carrying out economic reforms -- with comparisons to reform in China often unfavorable.

COMPARISONS TO CHINA

China’s GDP has increased at about 10 percent a year, compared with India’s 6 percent growth rate in the last decade or so. A decade ago, India and China had close to the same per-capita income. Today China’s per-capita income is about $900, roughly twice that of India. Cellular phone penetration in India is less than one percent of the population, compared to over 11 percent in China.

In 1991, India and China started off from about the same base, with less than one computer for every thousand individuals. By 2000 China’s rate was three times India’s, with more than 15 computers for every thousand persons, compared to 4.5 in India.

In 1990, manufacturing in China was about 37 percent of the economy; today that relative weight has increased to about 45 percent. In contrast, in the last 12 years, manufacturing as a percentage of the Indian economy has decreased, falling to about 24 percent of the economy from 30 percent.

This contrasting performance is certainly reflected in foreign investment figures. Since 1980, China has welcomed over $336 billion in foreign investment; India, in contrast, has received only $18 billion. Last year alone, China attracted $47 billion in direct foreign investment (FDI) -- capturing 21 percent of the world’s foreign investment going to developing countries. India’s FDI figure, however, was a lowly $4 billion -- less than 2 percent.

STRATEGIC COMPLICATIONS

There are also U.S. worries over the strategic, not just the economic consequences of U.S. investment being put off by India’s foot-dragging on economic reforms, and going to China instead. "Of particular concern to me, as an American policymaker, is the fact that the rate of U.S. foreign investment in China is several times that of U.S. investment in India," said Sen. Sam Brownback, a Kansas Republican and supporter of India on Capitol Hill. "It makes little sense for long-term U.S. national security to see U.S. foreign investment go so unevenly divided in the region."

Brownback stressed that U.S. foreign policy goals would be much better served if more U.S. trade and investment went to India instead of China. "Especially in light of the incident with our downed plane and the difficulties we experienced with the Chinese military, we cannot forget that while China is opening up -- and should be encouraged to continue -- they are still a nation that does not share many of the values and principles of a free and democratic society," he said. "India is a much better ideological fit. But we will not see an increase in investment or trade with India until India decides it is willing to reform its highly bureaucratic red tape, recognize the sanctity of contracts, protect intellectual property, and bring down the high trade tariffs."

Aside from narrow commercial considerations, it is in India’s security interest to undergo economic reform, according to Brownback.

"American businesses will invest in the countries where such reforms are made. Without these steps, American businesses will not invest in India," Brownback said. "If China continues its pace of reforms and keeps on opening up its economy, American business will move in there. This in turn will only help building up the Chinese military -- a danger to both U.S. and India. It is a matter of not only money but also regional insecurity. It is India who will lose the benefit of a stronger economy, more jobs and increased trade -- not American businesses who can just easily locate other parts of the world."

"If American investment and trade ties do not improve, there will be more repercussions for India, than for the U.S. American strategic interests may be damaged by a stronger China," he added. "However, the U.S. will always be able to defend itself against a potentially aggressive China."

IS INDIA, NOT CHINA, RISING?

However, business professors Yasheng Huang and Tarun Khanna dispute the contention that India is dropping well behind China economically, and actually predict that India, not China, is the rising economic power to watch.

"India’s homegrown entrepreneurs may give it a long-term advantage over a China hamstrung by inefficient banks and capital markets," Huang and Khanna write in the current edition of noted U.S. journal Foreign Policy. "China and India have pursued radically different development strategies. India is not outperforming China overall, but it is doing better in certain key areas. That success may enable it to catch up with and perhaps even overtake China. Should that prove to be the case, it will not only demonstrate the importance of homegrown entrepreneurship to long-term economic development; it will also show the limits of the FDI-dependent approach China is pursuing."

STATISTICS ONLY TELL HALF THE STORY

Huang, an associate professor at the Sloan School of Management at the Massachusetts Institute of Technology, and Khanna, a professor at Harvard Business School, acknowledge that statistically, China’s figures look more impressive than India’s. However, they contend that statistics only tell half the truth.

"It has long been an article of faith that China is on the faster track, and the economic data bear this out," Huang and Khanna note. "The ‘Hindu rate of growth’ -- a pejorative phrase referring to India’s inability to match its economic growth with its population growth -- may be a thing of the past, but when it comes to gross domestic product (GDP) figures and other headline numbers, India is still no match for China.

"However, the statistics tell only part of the story -- the macroeconomic story," they add. "At the micro level, things look quite different. There, India displays every bit as much dynamism as China. Indeed, by relying primarily on organic growth, India is making fuller use of its resources and has chosen a path that may well deliver more sustainable progress than China’s FDI-driven approach."

ENTREPRENEURIAL CONTRASTS

China’s economic growth has depended heavily on foreign direct investment (FDI). However, the downside of this is that such FDI has discouraged local entrepreneurship and innovation -- in contrast to India, argue Huang and Khanna. "During the last 20 years, the Chinese economy has taken off, but few local firms have followed, leaving the country’s private sector with no world-class companies to rival the big multinationals." In contrast, "India has managed to spawn a number of companies that now compete internationally with the best that Europe and the United States have to offer."

Moreover, many of these Indian firms are in the most cutting-edge, knowledge-based industries, such as software giants Infosys and Wipro, and pharmaceutical and biotechnology powerhouses Ranbaxy and Dr. Reddy’s Labs. Last year, the Forbes 200, an annual ranking of the world’s best small companies, included 13 Indian firms but just four from mainland China.

INFRASTRUCTURE SUPPORT

Huang and Khanna point out that India has also developed much stronger infrastructure to support private enterprise. "Its capital markets operate with greater efficiency and transparency than do China’s. Its legal system, while not without substantial flaws, is considerably more advanced."

Although India’s courts are notoriously inefficient, they at least comprise a functioning independent judiciary, in contrast to China. Property rights are also not fully secure in India, but the protection of private ownership is certainly far stronger than in China. The rule of law, Huang and Khanna note, generally prevails in India.

"Democracy, a tradition of entrepreneurship, and a decent legal system have given India the underpinnings necessary for free enterprise to flourish," Huang and Khanna write. "These traditions and institutions have proved an excellent springboard for the emergence and evolution of India’s capital markets. Distortions are still commonplace, but the stock and bond markets generally allow firms with solid prospects and reputations to obtain the capital they need to grow."

Indeed, in a World Bank study published last year, only 52 percent of the Indian firms surveyed reported problems obtaining capital, versus 80 percent of the Chinese companies polled. As a result, the Indian firms relied much less on internally generated finances: Only 27 percent of their funding came through operating profits, versus 57 percent for the Chinese firms.

Corporate governance has improved dramatically in India compared to China. In a survey of 25 emerging market economies conducted by Credit Lyonnais Securities Asia, India ranked sixth in corporate governance, China only 19th.

"The advent of an investor class, coupled with the fact that capital providers, such as development banks, are themselves increasingly subject to market forces, has only bolstered the efficiency and credibility of India’s markets" Huang and Khanna write. "Apart from providing the regulatory framework, the Indian Government has taken a back seat to the private sector. "In China, by contrast, bureaucrats remain the gatekeepers, tightly controlling capital allocation and severely restricting the ability of private companies to obtain stock market listings and access the money they need to grow."

GOVERNMENT ROLE

Huang and Khanna note that during the last decade, New Delhi has backed away from micromanaging the economy. "True, privatization is proceeding at a glacial pace, but the government has ceded its monopoly over long-distance phone service; some tariffs have been cut; bureaucracy has been trimmed a bit; and a number of industries have been opened to private investment, including investment from abroad. As a consequence, entrepreneurship and free enterprise are flourishing."

India is actually on track to be the second-fastest-growing economy in the world after China this year. For the first time since the late 1990s, India is on target to post at least 6 percent growth in gross domestic product.

Some observers contend this projected growth is in spite of an expanding fiscal deficit and the slow pace of economic reform. The Indian Government is unlikely to accelerate its privatization program, move to carry out tough reforms of the rigid labor market, or slow spending to restrain the deficit before elections next year.

INDIAN FIRMS GLOBALLY COMPETITIVE

Nevertheless, India’s economy is being propelled by companies’ growing competitiveness which helped increase merchandise exports by almost 20 percent last year despite the downturn in the global economy, with exports expected to grow similarly this year.

"Large parts of corporate India are slowly but surely becoming globally competitive," said Suditpto Mundle, chief economist for India at the Asian Development Bank. "How else can you explain strong export growth when the Indian rupee is appreciating and when global demand is dead?"

In a recent survey of leading Asian companies by the Far Eastern Economic Review (FEER), India actually registered a higher average score than any other country in the region, including China. Indeed, only two Chinese firms had scores high enough to qualify for India’s top 10 list. "Tellingly, all of the Indian firms were wholly private initiatives, while most of the Chinese companies had significant state involvement," Huang and Khanna point out.

POLITICAL CONTRASTS IMPACT ECONOMIC CHANGES

They also note that the fact that India is increasingly building from the ground up while China is still pursuing a top-down approach, reflecting their contrasting political systems: India is a democracy, and China is not.

Gilley makes a similar point. "The economic transformation has been achieved through open processes of reaching a fair and consensual policy, which in the lexicon of the dissatisfied is now being disparaged as ‘politics,’" he said. "The democratic nature of India’s economic miracle, as frustrating as it is to those who like the stroke-of-a-pen changes of authoritarian countries like China, has ensured that reforms are more just and therefore more enduring. Inequality has remained moderate while opportunities have expanded for all. There is no vast underclass of disaffected farmers and workers threatening to overturn the reforms, or even the political system, as there is in China. Indeed, the BJP-led coalition includes many of the parties that represent those groups. India’s reforms are not just an economic issue. The country is forging a proudly democratic model of economic reforms. It is the kind of model that many developing countries, despairing that they do not have the dictatorship of China to force through difficult reforms, can hope to emulate."

FUTURE LIES WITH INDIA

Overall, observers like Gilley, Huang, and Khanna predict that India will surpass China’s as an emerging economic powerhouse. "The real issue, of course, isn’t where China and India are today but where they will be tomorrow," Huang and Khanna stress.