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US-India Economic Ties Remain Uneven as Recent Optimism is Clouded by Trade Spat

India Report by John E. Carbaugh, Jr.
September 30, 2003

U.S.-India economic ties remain uneven, with recent signs of progress being tempered by U.S. bitterness over India’s role in the recent breakdown of global trade talks.

Tepid commercial ties between the U.S. and India have been viewed as an albatross in the bilateral relationship. Continued deep-seated problems in India’s economy have acted as a disincentive to U.S. trade and investment, with India often being unfavorably compared to another emerging economy -- China -- as a nation to do business with.

However, in the last year there has been evidence of an improvement in U.S.-India economic ties, sparked by optimism that India is more committed to freeing itself from the remaining shackles of its past socialist economy, and evidence that in the longer-run India, not China, will be a better place for U.S. trade and investment. There has even been chatter of a possible U.S.-India free trade agreement.

Nevertheless, this optimism has been somewhat clouded in recent weeks in the wake of the collapse of the World Trade Organization (WTO) trade liberalization talks in Cancun, Mexico, which saw the U.S. and India square off over a number of contentious trade issues. There is now a belief among U.S. policy players that the collapse of the world trade talks damaged the prospects for further economic reforms in India, and likewise for deeper U.S.-India commercial ties.

ECONOMIC TIES HAVE LAGGED

In general, India’s economy has been widely seen as the Achilles’ heel in the evolving relationship with the U.S. -- with economic ties lagging compared to other areas in the rapidly improving bilateral friendship in the last few years.

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.

CHINA ENVY

“Indians suffer from a national inferiority complex when it comes to China. It is not hard to see why,” noted the Center for Strategic and International Studies in Washington. “In 1980, living standards and other social and economic indicators in the two countries were roughly the same. But by 2001, China, fuelled by 22 years of dynamic economic reforms, had overtaken India in almost all major development indicators. Economic reforms in India began only in the early 1990s and have moved forward fitfully, beset by political and bureaucratic inertia.”

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.

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.

WIDER STRATEGIC CONCERNS OVER ECONOMY

The U.S. views 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.

U.S. policymakers have also aired strategic concerns over U.S. investment going to China instead of India. “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 prominent ‘Friend 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. “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 earlier this year. “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.”

INDIA’S ECONOMIC PROBLEMS EXAGGERATED

However, there is a growing school of thought that believes concerns over India’s economy are overblown, with recent positive economic developments there not being given enough credit by the U.S.

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, 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. 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.

“India’s reforms are not just an economic issue,” Gilley notes. “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.”

NEW SIGNS OF OPTIMISM

Indeed, growth estimates for India have been raised recently, with New Delhi now predicting that inflation-adjusted growth for the current fiscal year, which ends March 31, may “significantly exceed” the earlier forecast of 6 percent and instead touch 8 percent.

“With economies in the U.S., Europe and Latin America still wobbly, India’s emergence could be one of the world’s most important economic-trend stories over the next two decades,” the Wall Street Journal recently said. “More immediately, the growth explosions in India and China, the world’s two most populous nations, signal an inevitable changing of the guard in Asia. East Asia’s traditional tiger economics, in countries such as South Korea, have seen their export-driven models challenged by sluggish global trade. Indians increasingly feel that their country has chosen the right balance of growing its domestic economy and its export economy at the same time. And no country, many Indians feel, is better positioned to profit from the global boom in information-technology services than their own.”

This optimism has been reflected in the surge of foreign capital heading to India of late.

It is estimated that international portfolio investors have poured $3.65 billion into Indian equities so far this year -- up from $763 million for all of 2002.

The Indian Venture Capital Association also says that foreign private-equity firms, mainly from the U.S. and Europe, have injected up to $500 million into Indian companies since the beginning of the year. “In our opinion, the frontline Indian companies have never been in better shape since liberalization began in 1991,” said a report on the India economy by U.S. financial firm Smith Barney this month.

Muqtedar Khan, a visiting fellow at the Brookings Institute in Washington, believes India is “poised to break away its low-income status and become a middle-income, industrializing and globalizing nation.” India, Khan added, has “a large diaspora that can help bring in foreign direct investment, technology and international business.”

INDIA, NOT CHINA, IS THE ONE TO WATCH

The contention that India is dropping well behind China economically is also being increasingly challenged, with growing predictions that India, not China, is actually the rising economic power to watch.

“My bet is that India will begin to outperform China within the next five years,” said Rajiv Lall of U.S. investment house Warburg Pincus.

Business professors Yasheng Huang and Tarun Khanna recently published their findings on why India has better long-term economic policy prospects than China.

“India’s homegrown entrepreneurs may give it a long-term advantage over a China hamstrung by inefficient banks and capital markets,” they wrote in 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.”

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 much more impressive than India’s. “However, the statistics tell only part of the story -- the macroeconomic story,” they note. “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 very heavily on 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 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.”

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.”

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.”

INDIAN FIRMS MORE GLOBALLY COMPETITIVE

Some economists contend that India’s economy is being propelled by Indian 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 survey of leading Asian companies by the Far Eastern Economic Review (FEER) earlier this year, 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 reflects their contrasting political systems: India is a democracy, and China is not.

Overall, 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.

U.S.-INDIA TRADE TIES

Such increased optimism over India’s economy has even produced some consideration in U.S. policy circles of a possible free trade agreement with India.

Brownback suggested that the possibility of a free trade accord should be used as a carrot to help prompt India to carry out much-needed economic reforms. “This will help America tap into a large new market as well as providing greater national security for our country. The two countries should start discussing a free trade agreement, which could form the basis of jump starting their economic relationship,” he said.

Already last year bilateral trade grew substantially. Indian exports to the U.S. rose by 21.4 percent in 2002 to $11.82 billion, the highest in past decade, while American exports to Indian grew by 9.1 percent.

Of particular note, trade ties in the high-technology, defense, and other sensitive areas are progressing following the Bush Administration’s move to lift most of the nuclear test sanctions on India.

TRADE TALKS FAILURE CLOUDS OPTIMISM

However, the increased hope for better U.S.-India commercial ties was significantly tempered this month when the two nations clashed over the Doha Round of global trade negotiations in Cancun.

The Bush Administration is upset with India over its role in the collapse of the trade liberalization talks, with India taking an aggressive lead in opposing the U.S., emerging as the leader of poorer countries in a stand-off with richer nations over trade barriers.

U.S. trade officials have hinted that they could punish India and other nations that stood against Washington in Cancun by pursuing deepening trade ties with more accommodating countries -- certainly dealing the prospects for a U.S.-India free trade agreement a major blow.

“We will find countries that want to open up markets with the United States,” U.S. Trade Representative Robert Zoellick said.

New Delhi’s stance in Cancun merely reinforces an American perception that India is still a protectionist economy with too many barriers to trade and investment, some observers warn.

India already maintains among the highest average tariff rates in the developing world, the Wall Street Journal notes, while caps on foreign investment in sectors such as retailing and the media have denied India a potentially large inflow of new funds.

The International Monetary Fund and the World Bank also recently cautioned India will struggle to meet its 8 percent annual growth target, set out in the government’s current Five-Year Plan, without deeper reforms.

‘MAKE OR BREAK’ TIME

In conclusion, it appears to be ‘make or break’ time for India’s economy. One U.S. analyst describes India’s economy as schizophrenic, with both evidence that it could become a dynamic model of growth, but also signs that expectations will not be met as stubborn problems remain.

“Among South Asian states, only the economy of India could be in any way labeled as advanced -- though even that economy has both developed and developing aspects,” he said. “India has made strides in the information technology sector: It is known for software research and development, and its large number of English-speaking citizens has aided its service industry as well, making it home to a large number of call centers. These new industry sectors are currently among the most profitable. However, India also has one of the world’s most corrupt bureaucracies, and many fear this machinery will begin to cause a drain on growth in these areas. At best, what we might see are islands of growth and development within a sea of economic stagnation.”