INDIA CAN OVERTAKE CHINA

Yasheng Haung is associate professor, MIT Sloan School of Management, and author of Selling China, a book on FDI during the reforms era
Tarun Khanna is professor at Harvard Business School

Walk into any Wal-Mart and you won't be surprised to see the shelves sagging with Chinese-made goods - everything from shoes and garments to toys and electronics. But the ubiquitous 'Made in China' label obscures an important point: few of these products are made by indigenous Chinese companies. That is because China's export-led manufacturing boom is largely a creation of foreign direct investment (FDI), which serves as a substitute for domestic entrepreneurship. 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.

India has not attracted anywhere near the amount of FDI that China has. That's partly because China has a large and wealthy diaspora that has long helped the motherland while the Indian diaspora was, until recently, resented for its success and much less willing to invest back home. Delhi instead provided a more nurturing environment for domestic entrepreneurs. India has spawned a number of companies that now compete internationally with the best that Europe and the US have to offer. Moreover, many of these firms are in the most cutting-edge, knowledge-based industries - like Infosys and Wipro in software and Ranbaxy and Dr. Reddy's Labs in pharmaceuticals and biotechnology. 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.

When it comes to gross domestic product (GDP) figures and other headline numbers, India is still no match for China. At the micro level, though, India displays every bit as much dynamism. By relying mainly 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. "Can India surpass China?" is no longer a silly question. If it turns out that India has indeed made the wiser bet, the implications - for China's future growth and for how experts think about economic development - could be enormous.

The fact that India is building from the ground up while China is pursuing a top-down approach reflects their contrasting political systems: India is a democracy and China is not.
China has been far bolder with external reforms but has imposed substantial legal and regulatory constraints on indigenous, private firms. These restrictions were designed not to protect Chinese entrepreneurs from foreigners but to prevent private domestic businesses from challenging China's state-owned enterprises (SOEs).

Foreign investors have been among the biggest beneficiaries of such constraints. In 1992, the income accruing to foreign investors with equity stakes in Chinese firms was only $5.3 billion; today, it's more than $22 billion. (This money does not necessarily leave the country; it is often reinvested.)

The Mogul As Hero
During the last decade, Delhi has backed away from micromanaging the economy. True, privatisation is proceeding at a glacial pace, but the government has trimmed bureaucracy a bit and a number of industries have been opened to private investment, including investment from abroad.

As a result, entrepreneurship and free enterprise are flourishing. In a recent survey of leading Asian companies by the Far Eastern Economic Review, India registered a higher average score in leadership performance than any other country in the region, including China (the survey polled over 2,500 executives and professionals in a dozen countries). Only two Chinese firms had scores high enough to qualify for India's Top 10 list. All of the Indian firms were private initiatives; most of the Chinese ones had significant state involvement.

Indeed, entrepreneurs in India have become folk heroes. For instance, Narayana Murthy, the 56-year-old founder of Infosys, is often compared to Microsoft's Bill Gates and has become a revered figure. These success stories would never have happened if India lacked the infrastructure needed to support Murthy and other would-be moguls. But democracy, a tradition of entrepreneurship, and a decent legal system have given India the underpinnings necessary for free enterprise to flourish. Property rights are not fully secure, but the protection of private ownership is certainly far stronger than in China.

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. In a World Bank study published last year, only 52% of the Indian firms surveyed reported problems obtaining capital, versus 80% of the Chinese companies polled. Corporate governance has also improved dramatically. In a survey of 25 emerging market economies conducted in 2000 by Credit Lyonnais Securities Asia, India ranked sixth in corporate governance, China 19th.

Dollars And Diasporas
If India has so clearly surpassed China at the grassroots level, why isn't its superiority reflected in the numbers? It is worth recalling that India's economic reforms only began in earnest in 1991, more than a decade after China. In addition, India has had to make do with a national savings rate half that of China's and 90% less FDI. Moreover, India is a sprawling, messy democracy riven by ethnic and religious tensions as well as a volatile dispute with Pakistan over Kashmir. China, on the other hand, has enjoyed two decades of relative tranquility; apart from Tiananmen Square, it has been able to focus almost exclusively on economic development.

That India's annual growth rate is only 20% lower than China's is then a remarkable achievement. And, of course, whether the data for China are accurate is an open question. The speed with which India is catching up is due to its efficient deployment of capital and China's inefficiency - much of the money has been frittered away on SOEs.

In the early 1990s, when China was registering double-digit growth rates, Beijing invested massively in the state sector. Most of the investments were not commercially viable, leaving banks with non-performing loans of about 50% of bank assets. At some point, the capitalisation costs of these loans will have to be absorbed, either through write-downs (depositors will bear the cost) or recapitalisation of the banks by the government, which diverts money from other, more productive uses. This could limit China's future growth trajectory. India's banks may not be models of financial probity, but they have not made mistakes on nearly the same scale.

The real issue, of course, isn't where China and India are today but where they will be tomorrow. The answer will be determined, greatly, by how well they utilise their resources. Here, India is doing a superior job. Is it pursuing a better road to development than China? We won't know the answer for years. However, India may soon have the best of both worlds: it is poised to reap significantly more FDI in the coming years. After decades of keeping the Indian diaspora at arm's length, Delhi is now embracing it. Earlier this year, the government held a conference on the diaspora that many prominent non-resident Indians (NRIs) attended.

During the 1990s, more than half of China's FDI came from overseas Chinese sources. The billions of dollars that came from Hong Kong, Macao and Taiwan may have inadvertently helped Beijing postpone politically difficult internal reforms. For instance, because foreign investors were acquiring assets from loss-making SOEs, the government dragged its feet on privatisation.

Until now, the Indian diaspora has accounted for less than 10% of the foreign money flowing to India. With the welcome mat laid out, direct investment from NRIs may increase. And while Indians abroad cannot match the Chinese diaspora as far as 'hard' capital goes, they have a lot of intellectual capital to contribute.

The Indian diaspora has made a name for itself in knowledge-based industries, especially in Silicon Valley. With the help of its diaspora, China has won the race to be the world's factory. With the help of its diaspora, India could become the world's technology lab.

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 may enable it to catch up with and, perhaps, even overtake China. If that's the case, it will not only demonstrate the importance of homegrown entrepreneurship to long-term development, but it will also show the limits of China's FDI-dependent approach.