fp india-china june2003

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74 Foreign Policy

Whats the fastest route to economic development? Welcome foreign directinvestment (FDI), says China, and most policy experts agree. But a comparison

with long-time laggard India suggests that FDI is not the only path to pros-

perity. Indeed, Indias homegrown entrepreneurs may give it a long-term

advantage over a China hamstrung by inefficient banks and capital markets.

By Yasheng Huang and Tarun KhannaAPWIDEWORLD

Overtake China?Can IndiaOvertake China?Can India


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July | August 2003 75

Walk into any Wal-Mart and you

wont be surprised to see the shelvessagging with Chinese-made goodseverything from shoes and garments

to toys and electronics. But the ubiquitous Made inChina label obscures an important point: Few ofthese products are made by indigenous Chinese com-panies. In fact, you would be hard-pressed to find asingle homegrown Chinese firm that operates on aglobal scale and markets its own products abroad.

Yasheng Huang is an associate professor at the Sloan School

of Management at the Massachusetts Institute of Technology.

Tarun Khanna is a professor at Harvard Business School.

That is because Chinas export-led manufactur-ing boom is largely a creation of foreign directinvestment (fdi), which effectively serves as a sub-stitute for domestic entrepreneurship. During thelast 20 years, the Chinese economy has taken off, butfew local firms have followed, leaving the countrys

private sector with no world-class companies torival the big multinationals.

India has not attracted anywhere near the amountoffdi that China has. In part, this disparity reflectsthe confidence international investors have in Chinasprospects and their skepticism about Indias commit-ment to free-market reforms. But the fdi gap is alsoa tale of two diasporas. China has a large and wealthydiaspora that has long been eager to help the moth-erland, and its money has been warmly received. Bycontrast, the Indian diaspora was, at least until recent-

ly, resented for its success and much less willing toinvest back home. New Delhi took a dim view ofIndians who had gone abroad, and of foreign invest-ment generally, and instead provided a more nurtur-ing environment for domestic entrepreneurs.

In the process, India has managed to spawn anumber of companies that now compete interna-tionally with the best that Europe and the UnitedStates have to offer. Moreover, many of these firms arein the most cutting-edge, knowledge-based indus-triessoftware giants Infosys and Wipro and phar-

maceutical and biotechnology powerhouses Ranbaxyand Dr. Reddys Labs, to name just a few. Last year,the Forbes 200, an annual ranking of the worldsbest small companies, included 13 Indian firms butjust four from mainland China.

India has also developed much stronger infra-structure to support private enterprise. Its capital mar-kets operate with greater efficiency and transparencythan do Chinas. Its legal system, while not withoutsubstantial flaws, is considerably more advanced.

China and India are the worlds next major pow-

ers. They also offer competing models of develop-ment. It has long been an article of faith that Chinais on the faster track, and the economic data bear thisout. The Hindu rate of growtha pejorativephrase referring to Indias inability to match its eco-nomic growth with its population growthmay bea thing of the past, but when it comes to grossdomestic product (gdp) figures and other headlinenumbers, India is still no match for China.

However, the statistics tell only part of thestorythe macroeconomic story. At the micro level,things look quite different. There, India displays

every bit as much dynamism as China. Indeed, by

Stitching the future: A weaver

at a privately owned textile

mill in Muradnagar, India,

near New Delhi


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relying primarily on organic growth, India is mak-

ing fuller use of its resources and has chosen a paththat may well deliver more sustainable progressthan Chinas fdi-driven approach. Can India sur-pass China? is no longer a silly question, and, if itturns out that India has indeed made the wiser bet,the implicationsfor Chinas future growth andfor how policy experts think about economic devel-opment generallycould be enormous.

T H E S T I F L I N G S T AT E

The fact that India is increasingly building from theground up while China is still pursuing a top-downapproach reflects their contrasting political systems:India is a democracy, and China is not. But the dif-ferent strategies are also a function of history. ChinasCommunist Party came to power in 1949 intent oneradicating private ownership, which it quickly did.Although the country is now in its third decade of free-market reforms, it continues to struggle with the legacyof that periodwitness the controversy surround-ing the recent decision to officially allow capitalists to

join the Communist Party.India, on the other hand, developed a softer brandof socialism, Fabian socialism, which aimed not to

destroy capitalism but merely to mitigate the social illsit caused. It was considered essential that the publicsector occupy the economys commanding heights,to use a phrase coined by Russian revolutionaryVladimir Lenin but popularized by Indias first primeminister, Jawaharlal Nehru. However, that did not pre-

vent entrepreneurship from flourishing where thelong arm of the state could not reach.

Developments at the microeconomic level inChina reflect these historical and ideological differ-ences. China has been far bolder with externalreforms but has imposed substantial legal and reg-ulatory constraints on indigenous, private firms. Infact, only four years ago, domestic companies werefinally granted the same constitutional protectionsthat foreign businesses have enjoyed since the early1980s. As of the late 1990s, according to the Inter-

national Finance Corporation, more than two dozenindustries, including some of the most important andlucrative sectors of the economybanking, telecom-munications, highways, and railroadswere stilloff-limits to private local companies.

These restrictions were designed not to keep Chi-nese entrepreneurs from competing with foreigners butto prevent private domestic businesses from chal-lenging Chinas state-owned enterprises (soes). Someprogress has been made in reforming the bloated,inefficient soes during the last 20 years, but Beijing

is still not willing to relinquish its control over thelargest ones, such as China Telecom.

Instead, the government has ferociously pro-tected them from competition. In the 1990s, numer-ous Chinese entrepreneurs tried, and failed, to cir-cumvent the restrictions placed on their activities.Some registered their firms as nominal soes (all thecapital came from private sources, and the compa-nies were privately managed), only to find themselvesensnared in title disputes when financially strappedgovernment agencies sought to seize their assets.

More than a few promising businesses have beendestroyed this way.This bias against homegrown firms is widely

76 Foreign Policy

[ Can India Overtake China? ]

CompetingGiantsSources: CIA World Factbook 2002 (Washington: CentralIntelligence Agency, 2002); The Economist Pocket World

in Figures (London: Profile Books, 2002); World Development

Indicators CD-ROM (Washington: World Bank, 2002);

Financial Times

China

India

Population(2002)

1.28 billion

1.05 billion

PopulationGrowth Rate

(2002)

0.87 percent

1.51 percent

InfantMortality

(2002)

27(per 1,000 live births)

61(per 1,000 live births)

Average Annual RealGDP Growth Rate

(19902000)

9.6 percent

5.5 percent

Foreign DirectInvestment

(2001)

$44.2 billion

$3.4 billion

Yes, chairman: Workers at a government-owned shoe factory in Beijing

GOHCHAIH

IN/AFP


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acknowledged. Areport issued in2000 by the ChineseAcademy of SocialSciences concludedthat, Because of

long-standing preju-dices and mistakenbeliefs, private andindividual enterpris-es have a lowerpolitical status andare discriminatedagainst in numerouspolicies and regula-tions. The legal, pol-icy, and market envi-

ronment is unfairand inconsistent.

Foreign investorshave been among the biggest beneficiaries of the con-straints placed on local private businesses. One indi-cation of the large payoff they have reaped on the backof Chinas phenomenal growth: In 1992, the incomeaccruing to foreign investors with equity stakes in Chi-nese firms was only $5.3 billion; today it totals morethan $22 billion. (This money does not necessarilyleave the country; it is often reinvested in China.)

T H E M O G U L A S H E R O

For democratic, postcolonial India, allowing for-eign investors huge profits at the expense of indige-nous firms is simply unfeasible. Recall, for instance,the controversy that erupted a decade ago when theEnron Corporation made a deal with the state ofMaharashtra to build a $2.9 billion power plantthere. The project proceeded, but only after severalyears of acrimonious debate over foreign invest-

ment and its role in Indias development.While China has created obstacles for its entre-preneurs, India has been making life easier for local

businesses. During the last decade, New Delhi hasbacked away from micromanaging the economy. True,privatization is proceeding at a glacial pace, but the

government has ceded its monopoly over long-dis-tance phone service; some tariffs have been cut; bureau-cracy has been trimmed a bit; and a number of indus-tries have been opened to private investment, includinginvestment from abroad.

As a consequence, entrepreneurship and freeenterprise are flourishing. A measure of the progress:In a recent survey of leading Asian companies by theFar Eastern Economic Review (FEER), India regis-tered a higher average score than any other countryin the region, including China (the survey polled

over 2,500 executives and professionals in a dozencountries; respondents were asked to rate companieson a scale of one to seven for overall leadership per-formance). Indeed, only two Chinese firms had scoreshigh enough to qualify for Indias top 10 list. Telling-ly, all of the Indian firms were wholly private initia-tives, while most of the Chinese companies had sig-nificant state involvement.

Some of the leading Indian firms are true start-ups,notably Infosys, which topped FEERs survey. Oth-ers are offshoots of old-line companies. SundaramMotors, for instance, a leading manufacturer of auto-

motive components and a principal supplier to Gen-

Infosys conquers: Clockwise from top,

Infosys founder Narayana Murthy and

Microsofts Bill Gates; an Infosys

engineer in the server room of the

companys Bangalore, India, campus;

Infosys Technologies campus,Bangalore

Size ofDiaspora

55 million

20 million

Fixed Lines andMobile Phones

(2001)

247.7(per 1000 people)

43.8(per 1000 people)

LaborForce(1999)

706 million

406 million

Populationin Poverty

(2002)

10 percent

25 percent

TOPLEFT:P

ALLAVABAGLA/CORBIS-SYGMA;TOPANDBOTTOM

RIGHT:PAWELK

OPCZYNSKI/REUTERS


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78 Foreign Policy


of an investor class, coupled with the fact thatcapital providers, such as development banks, arethemselves increasingly subject to market forces,has only bolstered the efficiency and credibility ofIndias markets. Apart from providing the regula-tory framework, the Indian government has taken

a back seat to the private sector.In China, by contrast, bureaucrats remain the

gatekeepers, tightly controlling capital allocationand severely restricting the ability of private com-panies to obtain stock market listings and access themoney they need to grow. Indeed, Beijing has used

the financial markets mainly as away of keeping the soes afloat.These policies have produced enor-mous distortions while preventingChinas markets from gaining depth

and maturity. (It is widely claimedthat Chinas stock markets have atotal capitalization in excess of$400 billion, but factoring out non-tradeable shares owned by the gov-

ernment or by government-owned companiesreduces the valuation to just around $150 billion.)Compounding the problem are poor corporate gov-ernance and the absence of an independent judiciary.

D O L L A R S A N D D I A S P O R A S

If India has so clearly surpassed China at the grass-roots level, why isnt Indias superiority reflectedin the numbers? Why is the gap in gdp and otherbenchmarks still so wide? It is worth recallingthat Indias economic reforms only began inearnest in 1991, more than a decade after Chinabegan liberalizing. In addition to the late start,India has had to make do with a national savingsrate half that of Chinas and 90 percent less fdi.Moreover, India is a sprawling, messy democracy

riven by ethnic and religious tensions, and it hasalso had a longstanding, volatile dispute with Pak-istan over Kashmir. China, on the other hand, hasenjoyed two decades of relative tranquility; apartfrom Tiananmen Square, it has been able to focusalmost exclusively on economic development.

That Indias annual growth rate is only around 20percent lower than Chinas is, then, a remarkableachievement. And, of course, whether the data forChina are accurate is an open question. The speedwith which India is catching up is due to its own effi-cient deployment of capital and Chinas inefficiency,

symbolized by all the money that has been frittered

eral Motors, is part of the T.V. Sundaram group, a cen-tury-old south Indian business group.

Not only is entrepreneurship thriving in India;entrepreneurs there have become folk heroes. Nehruwould surely be appalled at the adulation theIndian public now showers on captains of industry.

For instance, Narayana Murthy, the 56-year-oldfounder of Infosys, is often compared to MicrosoftsBill Gates and has become a revered figure.

These success stories never would have hap-pened if India lacked the infrastructure needed tosupport Murthy and other would-be moguls. But

democracy, a tradition of entrepreneurship, and adecent legal system have given India the under-pinnings necessary for free enterprise to flourish.Although Indias courts are notoriously inefficient,they at least comprise a functioning independentjudiciary. Property rights are not fully secure, but

the protection of private ownership is certainly farstronger than in China. The rule of law, a legacy ofBritish rule, generally prevails.

These traditions and institutions have provedan excellent springboard for the emergence andevolution of Indias capital markets. Distortions arestill commonplace, but the stock and bond marketsgenerally allow firms with solid prospects andreputations to obtain the capital they need togrow. In a World Bank study published last year,only 52 percent of the Indian firms surveyed

reported problems obtaining capital, versus 80percent of the Chinese companies polled. As aresult, the Indian firms relied much less on inter-nally generated finances: Only 27 percent of theirfunding came through operating profits, versus57 percent for the Chinese firms.

Corporate governance has improved dramati-cally, thanks in no small part to Murthy, who hasmade Infosys a paragon of honest accounting andan example for other firms. In a survey of 25emerging market economies conducted in 2000 byCredit Lyonnais Securities Asia, India ranked sixth

in corporate governance, China 19th. The advent

With the help of its diaspora, China has won the race

to be the worlds factory. With the help of its diaspora,India could become the worlds technology lab.


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away on soes. And Chinas misallocation ofresources is likely to become a big drag on the econ-omy in the years ahead.

In the early 1990s, when China was registeringdouble-digit growth rates, Beijing invested massivelyin the state sector. Most of the investments were not

APW

IDEWORLD

commercially viable, leaving the banking sector witha huge number of nonperforming loanspossiblytotaling as much as 50 percent of bank assets. Atsome point, the capitalization costs of these loans willhave to be absorbed, either through write-downs(which means depositors bear the cost) or recapital-

By V.S. Arunachalam

It was an ambitious task forsomeone who has livedalmost exclusively in apartmentsand government bungalows.About a year ago, I decided to

rebuild and modernize myancestral home in Bangalorewithout the help of a contractor.I hired the laborers, bought allthe parts, rented the necessaryaccessories, and supervised therenovations. My inexperienceshowed: The project ran wellbehind schedule and over budg-et. And, of course, now that it isdone, I dont have anyone to

blame for the few blemishes Inotice in my living room.

But it was ultimately arewarding undertaking, and notjust because it restored a lovelyhouse. I was afforded a glimpseof the changes occurring at theworking-class level in India, andthey are deeply impressive.

The average worker is nowmore professional, technologi-

cally savvy, and conscious of timeframes and schedules than in thepast. Machines are fast replacingmuscle power. One builderrefused to accept my offer of acontract unless I guaranteed elec-tric supply for his drills. Thanks

to the ubiquitous cell phone, Iwas able to contact him and hiscolleagues at any time. For them,cell phones are too empoweringto be switched off.

More impressive than the

gadgetry was the diversity. Thelaborers I employed came fromall over the country. They spoke

different languages and prac-ticed different religions, but theyworked well together. They hada common goal: In rebuilding

my house, they were buildingbetter lives for themselves. Thisgoal had brought them to Ban-galore, Indias Silicon Valley. Itsemergence as an informationtechnology hub has made it amagnet for young professionalsfrom across India, and for work-ers eager to cater to the citysnewly affluent. Indeed, Indiasworking class is displayingunprecedented mobility and

enjoying its first real taste ofprosperity. While polishing themosaic floor, a worker fromBihar told me he moved to Ban-galore because people in his vil-lage had talked of the boom

in the south. He found plenti-ful work and an absence ofxenophobia. His family hadjoined him, and he spoke proud-ly of his wifes mastery of thelocal language, Kannada.

Of course, Bangalore ishardly representative of the restof India, and it will take manymore such miracles to spreadthe wealth to other parts of the

country. Neither is Bangalorescontinued success by any meansassured. The city is choking oncongestion and could well gothe way of chaotic, dysfunc-tional Bombay. Corruptionremains rampant in Indian pol-itics and thwarts economic andsocial progress. The judicial sys-tem is burdened with frivolouslawsuits that hamper develop-

ment projects.But Bangalore is a robustand organic phenomenon thatdraws its strength from enter-prises large and small. It is a phe-nomenon based on knowledge,education, ambition, and a will-ingness to travel far in pursuitof opportunityintangibleassets, to be sure, but preciousand elevating resources that Indiashould be proud to possess.

Home Improvement: An Indian Tale

V.S. Arunachalam is a professor at

Carnegie Mellon University and was

a scientific advisor to Indias defense

minister from 1989 to 1992.

A nation rising: Construction workers at a

building site in Bangalore, India


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80 Foreign Policy


ironically, comes from within China itself.Consider the contrasting strategies of Jiangsu

and Zhejiang, two coastal provinces that were atsimilar levels of economic development when Chinasreforms began. Jiangsu has relied largely on fdi tofuel its growth. Zhejiang, by contrast, has placed

heavier emphasis on indigenous entrepreneurs andorganic development. During the last two decades,Zhejiangs economy has grown at an annual rate ofabout 1 percent faster than Jiangsus. Twenty yearsago, Zhejiang was the poorer of the two provinces;now it is unquestionably more prosperous.

India may soon have the best of both worlds: Itlooks poised to reap significantly more fdi in thecoming years than it has attracted to date. Afterdecades of keeping the Indian diaspora at armslength, New Delhi is now embracing it. In some

circles, it used to be jokingly said that nri, anacronym applied to members of the diaspora, stood

for not required Indians. Now,the term is back to meaning justnonresident Indian. The changein attitude was officially signaledearlier this year when the govern-ment held a conference on the dias-pora that a number of prominentnris attended.

Chinas success in attracting

fdi is partly a historical acci-dentit has a wealthy diaspora.During the 1990s, more than halfof Chinas fdi came from overseasChinese sources. The moneyappears to have had at least oneunintended consequence: The bil-lions of dollars that came fromHong Kong, Macao, and Taiwanmay have inadvertently helped Bei-jing postpone politically difficult

internal reforms. For instance,because foreign investors wereacquiring assets from loss-makingsoes, the government was able todrag its feet on privatization.

Until now, the Indian diaspo-ra has accounted for less than 10percent of the foreign moneyflowing to India. With the wel-come mat now laid out, direct

ization of the banks by the government, which divertsmoney from other, more productive uses. This couldwell limit Chinas future growth trajectory.

Indias banks may not be models of financialprobity, but they have not made mistakes on near-ly the same scale. According to a recent study by

the management consulting firm Ernst & Young,about 15 percent of banking assets in India werenonperforming as of 2001. Indias economy is thusanchored on more solid footing.

The real issue, of course, isnt where China andIndia are today but where they will be tomorrow.The answer will be determined in large measure byhow well both countries utilize their resources, andon this score, India is doing a superior job. Is itpursuing a better road to development than China?We wont know the answer for many years. How-

ever, some evidence indicates that Indias ground-upapproach may indeed be wiserand the evidence,

Detroits slice of Shanghai: An auto worker at a

General Motors plant in Shanghai, China LIUJIN/AFP


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open their wallets. With the help of its diaspora,China has won the race to be the worlds factory.With the help of its diaspora, India could becomethe worlds technology lab.

China and India have pursued radically differentdevelopment strategies. India is not outperforming

China overall, but it is doing better in certain keyareas. That success may enable it to catch up with andperhaps even overtake China. Should that prove to bethe case, it will not only demonstrate the importanceof homegrown entrepreneurship to long-term eco-nomic development; it will also show the limits of thefdi-dependent approach China is pursuing.

investment from nonresident Indians is likely toincrease. And while the Indian diaspora may notbe able to match the Chinese diaspora as hardcapital goes, Indians abroad have substantiallymore intellectual capital to contribute, which couldprove even more valuable.

The Indian diaspora has famously distinguisheditself in knowledge-based industries, nowhere moreso than in Silicon Valley. Now, Indias brighteningprospects, as well as the changing attitude vis--visthose who have gone abroad, are luring many non-resident Indian engineers and scientists home andare enticing many expatriate business people to

Speculating about Asias economic prospects has long been a favorite parlor game for policy wonks andjournalists. Two of the best recent attempts are Jim RohwersAsia Rising(New York: Simon and Schus-ter, 1995) and Nicholas Kristof and Sheryl WuDunns Thunder From the East: Portrait of a Rising Asia(New York: Alfred A. Knopf, 2000).

The role of democracy and individual rights in promoting or hindering growth is one of themost vexing questions confronting economists. Economist Hernando de Soto has produced not onebut two seminal works on the subject: The Other Path: The Invisible Revolution in the Third World(New York: Harper & Row, 1989) and The Mystery of Capital: Why Capitalism Triumphs in theWest and Fails Everywhere Else (New York: Basic Books, 2000). Nobel-winning economistAmartya Sen has also made a career of studying the relationship between freedom and growth. His

most recent book, which includes much material on both India and China, isDevelopment as Free-dom (New York: Alfred A. Knopf, 1999).

For a closer look at India, see Gurcharan DassIndia Unbound(New York: Viking, 2000) and StephenCohensIndia: Emerging Power(Washington: Brookings Institution Press, 2001).

Chinas reform process is an inexhaustible topic. See Yasheng Huangs Selling China: ForeignDirect Investment During the Reform Era (New York: Cambridge University Press, 2003), as well ashis article Why China Will Not Collapse (Foreign Policy, Summer 1995). Other noteworthy workson Chinas economy include Stephen Greens Chinas Stock Market: The Players, Institutions and the

Future (London: Profile Books, 2003) and Chinas Emerging Private Enterprises: Prospects for the New

Century (Washington: International Finance Corporation, 2000). For a look at how reform is playingin China, check out Minxin Peis Cracked China (Foreign Policy, September/October 2001), areview of the 2001 Social Blue Book.

To read more about how homegrown companies in emerging markets become global players, con-sult two papers by Tarun Khanna, both cowritten with Krishna Palepu: Is Group Affiliation Profitablein Emerging Markets? An Analysis of Diversified Indian Business Groups (Journal of Finance, April2000) and Emerging Giants: Building World-Class Companies From Emerging Markets (Boston: Har-vard Business School Publishing, 2002).

For links to relevant Web sites, access to the FP Archive, and a comprehensive index of relatedForeign Policy articles, go to www.foreignpolicy.com.

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