The biggest risk facing investors in China and India
Financial commentators often ask which economy holds the best long-term prospects for investors - China or India? But it's not that simple, says Morgan Stanley's Stephen Roach. China wants to strengthen its services sector, while India believes a stronger manufacturing sector is the solution to rural poverty. But what will be left for the developed world if the Asian powerhouses succeed?
The China-India comparison is central to the Asia debate. It is also of great importance to the rest of the world. In the end, it may not be either / or.
While China has outperformed India by a wide margin over the past 15 years, there are no guarantees that past performance is indicative of what lies ahead. Each of these dynamic economies is now at a critical juncture in its development challenge - facing the choice of whether to stay the course or alter the strategy. The outcome of these choices has profound implications - not just for the 40% of the world's population residing in China and India, but also for future of Asia and the broader global economy.
As recently as 1991, China and India stood at similar levels of economic development. Today, the Chinese standard of living is over twice that of India's, with China's GDP per capita hitting US$1,700 in 2005 versus a little over $700 in India.
The two nations have approached the development challenge in very different ways. For China, it's been a manufacturing-led growth strategy, whereas for India, it has been much more of a services-based development model. While each approach has its advantages and disadvantages, China's outstanding performance in the development sweepstakes over the past 15 years makes it a very tempting model for the rest of Asia to emulate.
The contrast between the two approaches is dramatic. The industry share of Chinese GDP has gone from 42% to 47% over the past 15 years - maintaining a huge gap over India's generally stagnant 28% manufacturing share over the same period. By contrast, the services share of Indian GDP has risen from 41% in 1990 to 54% in 2005 - well in excess of the lagging performance in Chinese services, which has gone from 31% of GDP in 1990 to 40% in 2005.
China's macro character fits its manufacturing-led growth dynamic to a tee. Benefiting from a high domestic saving rate, huge inflows of foreign direct investment (FDI), and major efforts on the infrastructure front, Chinese economic growth has been increasingly fueled by exports and fixed investment. Collectively, these two sectors now account for over 75% of China's GDP - and are still growing at close to a 30% rate today.
India's macro story is the mirror image of China's in many key respects. Constrained by a lower saving rate, limited inflows of FDI, and a sorely neglected infrastructure, India has turned to a fragmented services sector as the sustenance of economic growth. The labour-intensive character of services has provided support to India's newly emerging middle class - a key building block for India's consumption-led recovery. As a result, private consumption currently accounts for 61% of Indian GDP - far outstripping the 40% share in China. The growth contribution of India's export and investment sectors pales in comparison to that in China.
Interestingly enough, as both of developing Asia's largest economies look to the future, they do so with an eye toward emulating the other. China is now very focused on a rebalancing of its growth dynamic - moving away from exports and investment more toward an Indian-style consumer-led model. This is more by necessity than choice. A continuation of the export surge is a recipe for protectionism, while pushing an already excessive investment binge risks capacity overhangs and deflation.
At the same time, China also aspires to match India's progress on reforms. India currently has over 25 world-class companies, well-developed capital markets, a modern banking system, and a deeply entrenched rule of law. China is lacking in all of those key respects, and very much wants to move in those directions. China is also seeking to implement an Indian-style expansion of labour-intensive services in an effort to provide the job and income support to its nascent consumer sector. However, given the high degree of precautionary saving sparked by the massive layoffs arising from state-owned enterprise reforms, China may well encounter considerable difficulty in establishing a broad-based consumer culture.
At the same time, India very much aspires to match China's progress on the manufacturing front. India's political leadership is convinced that manufacturing is the answer to high unemployment in impoverished rural areas. Whenever I go to India, I always have the same debate with its politicians and policy makers. I take the side that the inherent labour-saving bias of capital-intensive global manufacturing platforms promises little hope for Indian employment. But the Indians don't buy it. They have seen what China can do and genuinely hope to achieve a similar outcome.
Earlier this year, at the World Economic Forum in Davos, I pressed senior Indian officials on the specifics of this strategy - asking them to identify the potential sources of manufacturing-led job creation. Their answer - food, textiles, and leather - potentially high-volume industries that offer gainful employment opportunities to relatively poor, under-educated, young rural workers.
By contrast, unlike the Chinese, the Indian leadership is not all that enamoured of the job-creating potential of labour-intensive services. In particular, they point out that IT-enabled services - the crown jewel of India's "new economy" - mainly offers employment to the elite graduates of India's prestigious institutions of higher education.
What comes out of this debate is that both China and India are at important inflection points in their development experiences. They both are very focused on broadening out their bases of economic support. China wants to push more into services and a consumption-based growth dynamic. India wants to enlarge its manufacturing footprint by putting greater emphasis on infrastructure and FDI. In both cases, the growth objectives are focused on solving a very difficult rural unemployment and poverty problem. And in both China and India, the interplay between politics and economics is clearly having an important influence on the execution of their respective "broadening out" strategies.
All this raises a profound question for the rest of the world: if India is to services as China is to manufacturing, what role does that leave for the high-cost developed world? Down the road, if India also succeeds in pushing into manufacturing while China makes successful forays into services, the same question becomes all the more threatening to the world's major industrial economies.
Protectionism is the biggest risk in all this. IT-enabled globalisation is pushing economic development into manufacturing and services at a breakneck pace. Moreover, IT-enabled connectivity has increasingly transformed once non-tradable services into tradables - and has moved rapidly up the value chain and occupational hierarchy in doing so. The result is a mounting sense of economic insecurity in the developed world that has become a lightning rod for political action that, unfortunately, has unleashed an increasingly worrisome protectionist backlash.
This is not the experience that orthodox economics understands. The win-win theory of globalisation - workers in poor countries get rich through trade but then turn around and buy things made by rich countries - just isn't working. That's because both the speed and scope of an IT-enabled globalisation has broken the mould of the classic theory of comparative advantage.
In days of yore, it was fine - albeit painful - for rich countries to give up market share in tradable manufactured products. That's because highly-educated knowledge workers could seek refuge and shelter in nontradable services. However, with nontradables becoming tradable and with educational attainment and skillsets rising rapidly in the developing world, the security of the old way has all but vanished. Sadly, that provides both the justification and the opening for protectionists.
China and India represent the future of Asia - and quite possibly the future for the global economy. Yet both economies now need to fine-tune their development strategies by expanding their economic power bases. If these mid-course corrections are well executed - and there is good reason to believe that will be the case - China and India should play an increasingly powerful role in driving the global growth dynamic for years to come.
With that role, however, comes equally important consequences. IT-enabled globalisation has introduced an unexpected complication into the process - a time compression of economic development that has caught the rich industrial world by surprise. Out of that surprise comes a heightened sense of economic security that has stoked an increasingly dangerous protectionist backlash. This could well pose yet another major challenge to China and India - learning how to live with the consequences of their successes.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum