Master Thesis

The economic development of India and China in a globalizing world

Author: M.M.A. Restiau, BSc. Supervisor: Dr. A.J.W. van de Gevel Date September 2007 Number of words: 22.447 (introduction, table of contents, appendix and literature list excluded, footnoted and references included) Table of contents

Word of thanks...... 2 Introduction...... 3

Chapter 1 ...... 5

1.1. The anti-globalists ...... 5

1.1.1. Rising inequality ...... 6 1.1.2. The ‘pauper labour’ and ‘de-industrialization’ arguments ...... 8 1.1.3. The race to the bottom and increased vulnerability ...... 9

1.2. The Pro-globalists ...... 11

1.2.1. Rising inequality? ...... 11 1.2.2. Can we speak of pauper labour and/or de-industrialization ...... 12 1.2.3. Wages in labour-intensive manufacturing and labour standards...... 13

1.3. Conclusion ...... 15

Chapter 2 ...... 17

2.1. India ...... 17

2.1.1. The globalization and liberalization process in India ...... 17 2.1.2. India’s role in the world economy ...... 20 2.1.3. Consequences of globalization on India’s economy...... 24 2.1.4. To conclude the section on India ...... 31

2.2. China ...... 32

2.1.1. Policy reforms and institutional changes ...... 32 2.1.2. China’s role in the world economy ...... 33 2.1.3. Consequences of globalization on China’s economy...... 38 2.1.4. To conclude the section on China...... 41

Chapter 3 ...... 43

3.1. India’s future ...... 43

3.1.1. Why is it that India remains behind China? ...... 43 3.1.2. What needs to be done to stimulate industrialization? ...... 45 3.1.3. Keeping the IT-sector up-to-date...... 46 3.1.4. Conclusion...... 47

3.2. China’s future...... 48

3.2.1. The future of capital formation in China...... 48 3.2.2. Human Capital ...... 51 3.2.3. Exports ...... 52 3.2.4. Conclusion...... 54

Conclusion...... 55 Appendix ...... 58 Literature ...... 61

1 Word of thanks

I would like to thank Dr. van de Gevel for supervising my Master Thesis, reading it, and providing me with useful advice.

2 Introduction

For the largest part of my study, I have been particularly interested in the economic development of developing countries. The globalization of the world economy brings about opportunities as well as threats for these kinds of countries. Especially the development of India and China has attracted my attention, because China has profited from the opportunities and advantages a globalizing world brought to them. India, however, seems not to have profited as much as China.

In my Master Thesis, I would like to discuss which choices the governments of these two giant countries have made, and which reforms they have carried out in their countries. Second, I want to show that these past choices have had a major influence on the economic development of both India and China, and that these choices have had enormous consequences that are still in effect today.

The main question I want to find an answer to in my thesis is the following:

“India and China have responded in different ways to the globalization process. How are these different choices responsible for the fact that India lags behind China, and will India ever be able to bridge the gap?”

To be able to answer this question, however, I have to answer several sub-questions, which will be formulated at the beginning of the sub-sections that are supposed to answer those questions.

Before I start to discuss the situations of India and China, I am going to present the views of the groups in favor and against globalization in the first chapter . The reason why I am going to do this, is because one of the reasons that China is such a large country today, is because it has chosen to open up to the world market already in the early 1980’s. India has only shifted its orientation from the internal market to the international market in the early 1990’s. This is a major cause of India lagging behind China. This means that globalization plays a large role in the development of countries all over the world. This does, however, not mean that globalization only has advantages. Anti- globalists show that there are many disadvantages connected to globalization, which could also apply to India and/or China.

In the second chapter , I am going to apply the arguments against globalization to China and India, and enquire whether there are arguments against globalization that apply to China and/or India. Moreover, I will also talk about the recent developments in the economies of the two countries.

3 In the third chapter , the final step toward answering the main question will be taken by talking about why India is lagging behind China, and whether it is possible and likely that India will ever bridge this gap with China. The main question will then be answered in the main conclusion .

4 Chapter 1 Globalization

In this first chapter I will show that there are two main parties regarding the subject ‘globalization’, namely those in favor of globalization (hereafter: pro-globalists), and those against globalization (hereafter: anti-globalists). I will discuss their views by answering the sub-question of this chapter, namely:

“What are the main arguments used by the different parties to support their views?”

1.1. The anti-globalists

Before I start to discuss the different views concerning globalization , I will give a definition of what I mean when I use the term ‘globalization’. When I talk about globalization, I refer to ‘economic globalization’. Bhagwati describes economic globalization as follows:

….[economic globalization is the] integration of national economies into the international economy through trade, direct foreign investment (by corporations and multinationals), short-term capital flows, international flows of workers and humanity generally, and flows of technology. Bhagwati (2004, p.440)

Economic globalization is subject to a lot of criticism. According to Wolf (2004) there are two main groups of critics regarding economic globalization. One group broadly consists of old-fashioned economic interests , while the other group consists of single-issue non- governmental organizations. The group of the economic interests consists of several sub- groups, such as trade unions, which are concerned with the jobs in the home countries of their members, as well as with labour standards abroad. Other sub-groups can be farm lobbies and other producer groups that want to protect their position in the world economy. These groups provide an economic rationale for their views and they can be very influential. Apart from the fact that they try to protect their position in the world economy, they also state that globalization leads to increased poverty in developing countries and to deterioration of the environment worldwide. But even though these groups can still be very influential, they are no longer the most dominant group that fights against liberalization.

The other group of anti-globalists consists of the more idealistic sub-groups. They include conservative groups, environmentalists, lobbies for development, consumer groups, human right groups and church groups. A large proportion of these groups consist of non-governmental organizations. This anti-globalization movement is divided in many different groups which all have very different ideas. The only thing they have in common

5 is that they are against ‘neo-liberal globalization. By this they mean liberal internationalism. So one cannot define this second group as a homogeneous group. They all use different arguments, and have different reasons for why they fight against globalization

Wolf (2004) sums up the main charges critics make against economic globalization: First, it can deteriorate the ability of countries to regulate their own national economies by raising taxes, or by spending more or less on public goods. Second, in the process from autarky to globalization, democracy can be undermined, because of the increase of bureaucracy. Third, globalization can make countries to hand over power from democratic governments to private corporations. Fourth, globalization is increasing inequality within and between countries. Fifth, it is destroying the employment of peasant farmers. Sixth, it is lowering wages and labour standards while it increases economic insecurity everywhere, because countries with an open economy are more vulnerable to external economic shocks. Seventh, it is destroying the environment world wide. Eight, it is causing a global race to the bottom, with low taxes, low regulatory standards and low wages in every country, Ninth, a global financial market can generate crises that impose heavy costs, particularly on developing countries. And finally, it is destroying the variety of human cultures.

1.1.1. Rising inequality

Anti-globalists mainly focus on the inequality issue that globalization brings about. Wolf (2004, p. 139) states their main statements regarding this issue are the following:

- Global inequality among individuals has increased - The number of people living in extreme poverty has risen - The ratio of average incomes in the richest countries to those in the poorest countries continues to rise - The proportion of people in extreme poverty in the world’s total populations has also increased. - Income inequality has risen in every country and particularly in countries most exposed to international economic integration.

The above statements are hard to reconcile with the classical Heckscher-Ohlin trade model . This model contains two countries, two products and two production factors (skilled and unskilled labour , or labour and capital ). Under the simplest form of the model, free trade should benefit the poor in the poor countries, and thus decrease inequality within the poor countries. The line of reasoning goes as follows: suppose that there are two countries, North and South. The North has a high ratio of skilled to unskilled workers, while the South has a high ratio of unskilled to skilled workers. Under autarky the wage of skilled workers will be relatively low in the skill-abundant North and relatively high in the South, where skilled labour is scarce. When the two countries would

6 engage in international trade, the wages in both countries should equalize. So, the wages of skilled workers in the North will rise, while they will fall in the South. This means that inequality in the rich country will increase, while it decreases in the poorer country. The statements of the anti-globalists mainly rest on two failures the Heckscher-Ohlin model brings about. First, the model predicts that the gains from international trade will be largest when the two production factors differ most. But empirically there is little or no trade between extremely rich countries such as the US, and extremely poor countries such as Chad. A second failure of the model is that evidence from examination of specific developing countries following trade liberalization and from cross-country studies does not suggest that trade liberalization generally reduces inequality in poor countries and in fact frequently suggests that trade liberalization can increase inequality 1.

The same paper by Kremer and Maskin (2004, pp. 3-5) contains a small study on Mexico, which reveals the second failure of the Heckscher-Ohlin model. It shows that after Mexico joined the GATT in 1985, white-collar 2 real hourly wages increased 13.4 percent while blue-collar 3 wages decreased 14.0 percent. Before 1995 wage inequality had been decreasing, so the membership of the GATT, and thus increasing globalization, had a negative impact on this favourable trend. The biggest rise in inequality was observed in firms active in export industries. The rising wage inequality in Mexico was linked to capital inflows from abroad. An increase in outsourcing by northern multinationals shifted production in Mexico towards skill-intensive goods thereby increasing the relative demand for skilled labour. That globalization has favoured skill-intensive production in Mexico is further supported by the fact that employees of multinational firms and international joint ventures receive higher wages.

Another criticism to the classical theory is that an expansion of international trade and openness will mostly benefit rich people within a country. These people are mostly able to benefit from foreign cultures and technologies. This would indicate an increase in inequality in poor countries. This is the opposite of what is predicted by the Heckscher- Ohlin model. Research by Barro (2000) supports this view. He finds a positive relationship between the degree of openness and inequality within a country. This is in line with the main criticism of anti-globalists: the higher the openness to trade in a country, the larger inequality. This positive relation between the degree of openness and inequality is mostly apparent in poor countries. Barro finds that the estimated relation weakens as countries become richer, and that it disappears when a country reached a per capita GDP of around US $13,000. So for the US and most OECD countries the relation between openness to trade and inequality is negative. This again reaffirms the arguments of the anti-globalists, stating that inequality between rich and poor countries increases when the degree of globalization increases.

1 Kremer and Maskin (2004) Globalization and Inequality (pp. 2-4) 2 White-collar jobs are jobs free of hard physical labour, like office jobs. 3 Blue-collar is used to describe relatively unskilled jobs

7 The so called ‘inequality argument’ is not the only argument critics have against globalization. There are some more arguments, which will be discussed briefly in the next sub-section.

1.1.2. The ‘pauper labour’ and ‘de-industrialization’ arguments

Another argument frequently used by anti-globalists is the so called ‘pauper labour’ argument. This argument elaborates on the previous mentioned Heckscher-Ohlin model. Mishan (2005) describes the pauper labour argument as follows: again, there are two countries: the North and the South. In the North, wages are relatively higher because of the higher amount of capital per worker there. If, in an extreme case, all barriers to migration are to be removed by the North, an extreme amount of labour would migrate from the South to the North, and the ratio of capital to labour in the North would heavily decrease. This, therefore, leads to a decrease in the real wages in the North. If migration would be entirely costless, the stream of migration would stop only when relative wages in the North and the South are equalized. This is a big problem when the poor country (the South) has a much larger population than the rich country (the North); the equilibrium wage will then be much closer to that of the South than to that of the North. So in this case international trade has decreased real wages in the North, and because of the declining capital to labour ratio (and thus a declining productivity), it has also led to a declining per capita real income. The same line of reasoning holds when there is a large movement of capital from the North to the South, which is more likely to happen than a massive stream of migrating workers, but then this argument only holds when the movement of capital from the North to the South reduces the North’s capital stock . This can be the case when corporations move their production from rich countries with relatively high wages to poorer countries with lower wages, such as China. This can cause the wages in rich countries to decline heavily towards Chinese standards.

There is not only the fear of decreasing wages when capital moves from one country to the other, but also the fear of job losses . Proponents of free trade state that high- productivity and high-wage jobs will replace the loss of low-productivity and low-wage jobs. Unfortunately, in many countries unemployment rates are high, and those who lose their low-productivity job cannot easily change over to high-productivity and high-wage jobs. It is more plausible that they will end up unemployed. This threat especially applies to developing countries, because as these countries liberalize, the private sector cannot afford to invest enough to create new jobs.

Developing countries are not the only countries which suffer from these kinds of job losses. It can also easily happen in developed countries. People who lose their jobs often cannot find new jobs immediately. There can be vast periods of unemployment in these countries. Low-skilled workers are the most likely workers to suffer from this phenomenon, because it is mostly these jobs that move from developed, relatively high- wage countries, to less developed, relatively low-wage countries like China. This is one of

8 the main reasons why developed industrialized countries oppose against losing manufacturing jobs to countries like China, and service sector jobs (especially in the IT sector) to India . As Stiglitz states:

... Even if trade liberalization may make the country as a whole better off, it results in some groups being worse off. And it suggests that, at least in the advanced industrial countries, it is those at the bottom –unskilled workers- who will be hurt the most. Stiglitz (2006, p. 68)

Another argument against globalization is the ‘de-industrialization argument’ , which elaborates on the pauper labour argument. The critics of globalization state that international trade can lead to de-industrialization within the richer countries because of unrestricted imports from cheaper, poorer countries. Wolf shows that:

... Between 1970 and 2000 the US lost 2.5 million jobs in manufacturing, while the share of manufacturing in total employment fell from 26.4 percent to 14.7 percent. In the UK, the reduction in employment in manufacturing was 3.5 million between 1970 and 1998, while the share of manufacturing in employment fell from 34.7 percent to 18.6 percent. The UK was extreme. But similar patterns can be seen elsewhere: 39.5 percent of West Germany’s workers were in manufacturing in 1970, an extraordinary high share. By 1999, this had fallen to 24.1 percent. Wolf (2004, p. 178)

1.1.3. The race to the bottom and increased vulnerability

Opponents of free trade also frequently use the argument of the race to the bottom and increased vulnerability of liberalized countries. Open economies are subject to shocks. One example of these kinds of shocks could be the worsened competitive position of a domestic firm on the world market when imports increase because of a devaluation of a foreign currency. The devaluation of a currency makes the products from that country cheaper, which stimulates imports, and harms domestic producers of the same product. Another example could be the worsened position on the world market of farmers that feel the increased competition from developing countries, especially in years when the farmers in those developing countries have a good crop. In those years, western farmers need protection like import quota and tariffs , while they will be harmed heavily by free trade. The vulnerability to external (economic) shocks is not limited to certain firms and their workers. When domestic firms go bankrupt because of cheaper imports, not only their workers are affected, but also the firms’ suppliers suffer from it. Birdsall (2002) cites a study by Easterly, Islam and Stiglitz (2000) which shows that the ratio of trade to GDP and of the standard deviation of capital flows to GDP are correlated with volatility in growth rates. Their regressions show that openness to trade leads to increased volatility. According to their study, this is especially the case in developing countries, while the effect is almost entirely diminished in developed countries.

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As developing countries are the countries who suffer most from globalization, they are also the ones least possible of enjoying the benefits (like increased exports) that occur from globalization. This is because the infrastructure in developing countries often is inferior, so there is no possibility of increased exports. A second problem that these countries have to cope with is the problem of highly imperfect capital markets . The interest rates in developing countries are often much higher than those in developed countries. This makes some export opportunities financially impossible.

Although the vulnerability of countries with an open economy has increased, their governments have limited power to intervene. Liberalization has removed tariffs, but also requires a race to the bottom in terms of taxes to keep attracting economic activity, and remain competitive on the world market. But decreased taxes lead to lower public spending on infrastructure, education and the welfare state. Another form of this so called ‘race to the bottom’ is the possible worsening labour standards in rich countries in order to be able to compete with poor countries which in some cases have extremely low labour standards. Anti-globalists are afraid that with the threat of employers leaving rich countries for countries where the labour standards are lower, employers will lobby to induce governments to lower labour (and possibly environmental) standards.

To conclude this section, I give a citation of Stiglitz, who expresses the overall opinion of anti-globalists as follows:

... The world of Adam Smith and the free trade advocates, in which free trade will make everyone better off, is not only a mythical world of perfectly working markets with no unemployment, it is also a world in which risk does not matter because there are perfect insurance markets to which risk can be shifted, and where competition is always perfect, with no Microsofts or Intels dominating the field. In such a world, workers would not worry about losing their jobs because of trade liberalization: they would move seamlessly to other jobs. (...) Even in the best-functioning market economies, this kind of insurance cannot be bought: while in developed countries the government provides some unemployment insurance, in most developing countries workers are left to fight for themselves. Stiglitz (2006, p. 68)

The arguments discussed in the previous three sub-sections are the arguments most frequently used by the opponents of free trade. In the next section, I will discuss the most commonly used arguments of proponents of economic globalization, as well as some refutations of some opponents’ arguments.

10 1.2. The Pro-globalists

As can be read in the section above, economic globalization is a target of many opponents of globalization. They have several arguments that are heard often in the discussion on globalization. In this section I will discuss some arguments of the proponents of the liberalization of world trade.

1.2.1. Rising inequality?

Most proponents of economic globalization admit that absolute and proportional gaps in living standards between the world’s richest and poorest countries have increased. They also admit that inequality is rising in the world’s largest countries. 4 But global inequality is falling . This is due to rapid economic growth in poor countries which have half the world’s population. Economic growth in these countries has powerful effects on the inequality among individuals. The same effect holds for poverty in the world. The growth of Asia has powerful positive effects on the world economy.

In his book, Wolf (2004, pp. 143-143) discusses an analysis of globalization executed by the World Bank in 2002. In this study the World Bank divided 73 developing countries, with aggregate population, in 1997, of 4 billion people (80 percent of all people in developing countries), into two groups. The first group was one third of these 73 countries, which had the largest increasing ratios of trade to GDP since 1980. The second group consisted of the two-thirds of the remaining countries of the study, which were less globalized. The first group, with total population of 2.9 billion people, faced a total increase of 104 percent in the ratio of trade to GDP. Over the same period, the increase in the trade ratio of the high-income countries was 71 percent, while the remaining two- thirds ‘less-globalized’ countries in the sample of developing countries faced a decrease in their trade ratios.

The World Bank’s analysis showed that the average income per capita in these 24 globalizing countries rose by 67 percent between 1980 and 1997. In contrast, the other forty-nine countries managed a rise of only 10 percent in income per head over this period. Although China and India contain 75 percent of the group’s combined population, the standpoint that globalization makes the rich richer and the poor poorer is not true. One has to make some distinction between different countries and situations. There are several countries, like most countries in (South-) East Asia, which integrated more in the world economy, and flourished dramatically. These countries have in common that they moved towards a market economy, with private property rights and competition.

4 Taken from: Wolf (2004) Why globalization works (p. 142) New Haven: Yale University Press

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Sala-i-Martin has devoted several studies on the inequality subject. The results of his studies have one thing in common: they all report a decline in poverty and inequality during the globalization process. The main results of his 2002 research paper are as follows: first, the whole world is becoming richer. Second, the density functions he estimated all showed that although in 1970 the world income distribution had a large mode close to the poverty line, since then this mode has become smaller, which created a large middle-class. Sala-i-Martin used the same estimated functions to calculate poverty rates and poverty headcounts. The poverty headcount decreased with 400 million people between the 1970’s and 1998. The one-dollar-a-day poverty rate fell from 20 percent in 1970 to 5 percent in 1998. The two-dollar rate fell from 44 percent to 8 percent. Sala-i-Martin used seven measures of income inequality, namely the Gini- coefficient, the variance of log-income, two Atkinson’s Indexes, three Generalized Entropy Indexes 5 (which include the Mean Logarithmic Deviation, the Theil Index and the squared coefficient of variation), which all show a decreasing income inequality over the last two decades. 6 Basu (2005) confirms that the population-weighted Gini coefficient has been decreasing ever since the late 1960’s.

1.2.2. Can we speak of pauper labour and/or de-industrialization?

It is indeed true that workers in developing countries work on average for lower wages than workers in more advanced countries. This, however, does not mean that wages of these advanced countries will be pushed down to developing countries-levels. This is merely due to the fact that labour in these developing countries is cheap but it is also very unproductive . According to the World Development Indicators 2006 of the World Bank, the value added in manufacturing per worker was US $79,616 per year in Germany, US $81,353 per year in the United States, US $55,060 per year in the United Kingdom, but only US $2,885 per year in China, US $1,711 per year in Bangladesh and US $3,118 per year in India, measured over the period between 1995 and 1999.

The fact that labour in developed countries is more productive than in less developed countries can be partly explained by the differences in the amounts of capital workers in those different countries have at their disposal. Another possible explanation for the differences in productivity can be the differences in education between developed and developing countries. This makes is not very difficult for developed countries to compete with these cheap, less developed countries. When wages and productivity increase in the same line (and the real exchange rates remain the same), the unit labour cost remains constant. Opponents of globalization will argue that workers in less developed countries, especially Asian countries, will gain efficiency rapidly, and that their productivity will increase steadily as well. This might be true, but does not necessarily mean that these

5 See Appendix for formulas 6 Sala-i-Martin (2002) The Disturbing “Rise” of Global Income Inequality (pp. 38-39)

12 countries will become far more competitive than the developed countries, because wages will increase there as well.

As could be read in the previous section, between 1970 and 2000, the US, the UK and Germany have lost many jobs in manufacturing. Wolf (2004) says this can be explained by the fact that labour productivity has increased more than output did. The result of this is that employment in the manufacturing sector must decrease. When developed countries engage in trade with developing countries, labour productivity in the manufacturing sector in the developed countries will increase, because labour-intensive manufacturing will move towards the developing countries. However, capital-intensive manufacturing in the developed countries will increase. This increases labour-productivity and can potentially increase GDP. However, this requires a labour market which is able to reallocate workers.

In conclusion, there is no reason to believe that trade liberalization leads to pauper labour or de-industrialization. This is because wages and productivity increase in the same line, so developed countries keep being able to compete with relatively cheaper, less developed countries. The fact that the absolute number of jobs in the manufacturing sector in developed countries has decreased in the past years is because of increasing productivity, not because of globalization.

1.2.3. Wages in labour-intensive manufacturing and labour standards

Anti-globalists fear that wages in developed countries will decrease to underdeveloped countries’ standards, and that labour standards both in developed as well as less developed countries will worsen, in order for countries to remain competitive and keep attracting economic activity. The pressure resting on liberalized countries can lead to a race to the bottom. These fears seam plausible, but are, however, not supported empirically.

In his book, Bhagwati (2004) argues that international trade has improved wages in developed countries, in the sense that it has reduced the decrease in wages that would have occurred especially by labour-saving technological change in Western countries.

If the prices of labour-intensive products fall, wages of workers in this sector tend to fall as well. Prices fall when supply (especially from poor countries) increases. If production of these good increases faster than consumption within the country of production, exports will increase. Increased exports lead to decreased world prices of the respective labour-intensive products. Capital accumulation and technological change in growing poor countries (for example the NICs in Asia), give extra incentives to producers of capital- intensive products, which attracts resources formerly used in the production of labour- intensive products.

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This attacks the argument often used by anti-globalists: namely that exports of labour- intensive goods from all liberalized poor countries will accumulate and flood rich countries , thereby depressing relative prices and real wages. Instead, countries that are economically growing and developing, like the NICs in Asia, move towards the production of capital-intensive goods, thereby offsetting the downward pressure on relative prices of labour-intensive products imposed by new developing countries on the international market. The fastly growing developing countries become net importers of labour- intensive products, and net-exporters of capital-intensive products (with China, for now, as a notable exception). Therefore, the net exports of labour-intensive manufactures to rich countries grow not nearly as fast as the pessimists would like the world to believe.

Bhagwati (2004) cites a study by Feenstra and Hanson (1997) who examined the effect on real wages of unskilled American workers as a result of outsourcing to foreign suppliers of labour-intensive components in U.S. manufacturing in the period 1972-90. This study concluded that the effect of such imports of labour-intensive goods for producers (rather than as goods for consumers, such as textiles and shoes), much of it also from poor countries, actually raised the real wages of the workers. The ratio of the relative wages of skilled to unskilled labour rose in that period, but the effect on the absolute real wages of the unskilled workers showed an increase. The relative fall came from a disproportionate increase in the real wage of skilled workers.

In one of his articles, Bhagwati (2007) cites a remark from Samuelson, who states that external changes, such as the growth of China and India, could diminish the gains from trade and hence be harmful. Samuelson argues that when gains from trade diminish because of exogenous changes abroad, the policy response must be to abandon free trade and to embrace protection . According to Bhagwati, this is not true. When developing countries grow, and adopt more and more capital and capital-intensive ways of production, rich and poor countries get more similar in their factor endowments and the gains from trade will decrease because the prices of the rich countries’ exports fall. So when countries get similar, trade in similar goods will increase. In other words, intra- industry trade will increase. To support his theory, Bhagwati cites empirical work by Feenstra and Weinstein, who have demonstrated these gains from similar products are huge today.

Another fear of anti-globalists is the fear of worsening labour standards in rich countries in order to remain competitive on the world market . This phenomenon would trigger a race to the bottom in rich countries. This fear, however, is also not supported empirically. Institutions in developed countries are too strong to indulge to lobbies by employers who want to decrease labour standards there. There is no race to the bottom with respect to labour standards. Moreover, we cannot even speak of a race to the top with respect to labour standards in the world. This is because many rich countries demand raising labour standards from exporting developing countries. This can be seen as a form of protectionism, but can, however, be helpful in increasing labour standards worldwide.

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1.3. Conclusion

To conclude this chapter, I first want to make a few remarks on the arguments used. First, as hopefully has become clear from the previous two sections, it is possible to find a lot of arguments for both sides of the story. There are many theories, all supporting different views. Second, one can find a lot of data and different statistical methods to support both the pro-globalists as well as the anti-globalists. I believe that there is no real choice to be made. Both the pro-globalists and the anti-globalists have convincing arguments, and one cannot choose sides without looking at empirics for a specific country.

Second, I will summarize the answer to the first sub-question:

“What are the main arguments used by the different parties to support their views?”

The main arguments used by the anti-globalists are the arguments of rising inequality, pauper labour, de-industrialization, race to the bottom and increased vulnerability: They state that increased integration into the world economy leads to increased inequality within the respective country. Second, they argue that increased globalization and decreasing migration barriers can lead to the migration of labour from labour abundant to labour scarce countries (the pauper labour argument). The same holds for capital: it will move from capital abundant to capital scarce countries. This will cause job losses and unemployment in the emigration country. A third frequently heard argument against globalization is the de-industrialization argument. This implies that international trade can lead to de-industrialization within the richer countries because of unrestricted imports from cheaper, poorer countries. Forth, globalization could lead to a race to the bottom with respect to taxes, social security and public goods because the country wants to be as competitive as possible. And last but not least, increasing world trade makes a country more vulnerable for international economic shocks, since all countries depend on each other.

Pro-globalists, on the other hand, deny that globalization will leas to such disastrous outcomes. They state that during the globalization process, inequality and poverty in all countries were decreasing. Sala-i-Martin is an economist who has performed several researches on the matter, and he has been the one who has come up with this result. There are, however, also economists who state the opposite. Second, pro-globalists also deny that there is something like the pauper labour argument. They argue that although wages in developing countries are lower than in developed countries, globalization will never cause wages in developed countries to fall towards wages in developing countries, simply because productivity is much higher in developed countries. This makes it easier for developed countries to keep competing with low-wage developing countries. Third,

15 according to the pro-globalists, the de-industrialization argument of the ant-globalists does not hold, either. They state that the fact that the number of jobs in the manufacturing sector in developed countries are decreasing because of the higher productivity in these countries, not because all firms move their activities towards developing countries.

These are the main arguments used the two parties which argue over the globalization matter. As said before, there are numerous of arguments to be found for both views, as well as different researches that support arguments of one of the two parties.

In the next chapter, I will look at China and India, and their role in the world economy. I will especially look at the reforms both countries have gone through, the different choices the two countries have made in the past, and the results that came out of these choices. I will also make a small link to the first chapter by looking at the inequality, productivity and other economic data for both countries.

16 Chapter 2 India and China

China and India have enjoyed rapid economic growth over the past two decades. The emergence of these two gigantic economies has significant influences on the world economy, especially on the market for tradable goods and services. In this chapter I will discuss the role of China and India in the world economy, including the past reforms both countries have carried out. I will also look at the consequences opening up to the world market has had for China and India.

2.1. India

In 1956, India was still under a highly interventionist state, and it launched an import substitution industrialization (ISI) program. This model was inspired on the Soviet model. The politicians in India liked this model because it gave them economic independence as well as politic independence. The economic planners in India wanted to install a regime of economic autarky, and wanted to isolate the national economy from the world economy.

This system indeed succeeded in setting up a complex industrial system, but India was also stuck with economic stagnation with an annual growth rate of around 3.5 percent. This growth rate was called the ‘Hindu growth rate’. Also its share in world trade declined heavily. This was not what the Indian leaders wanted, so they launched another strategy to stimulate economic liberalization and increase integration into the world economy.

India still is in the ongoing process of increased integration into the world economy. One can mark 1975 as the ‘starting point’ of the reintegration process of India. Such a process “(…) proceeds from the recognition of the transformative impact on the integration of the world economy, of the collapse in 1971 of the Bretton Woods regime and the earthshaking OPEC oil price shock in 1973.” (Nayar 2006, p. 9) The period before 1975 can be referred to as the pre-globalization period.

2.1.1. The globalization and liberalization process in India

The year 1991 is the year mostly referred to as the starting point of economic liberalization in India. There are also some analysts who put the starting point of the economic liberalization in 1980, because of India’s strong economic performance in the 1980’s. However, there is no evidence for any reforms which took place in 1980. They only witnessed a change in Indira Ghandi’s attitude toward businesses, which cannot be called a reform in the attitude toward the world economy. There are also analysts who claim that the reforms already began in 1974. What they saw were the first steps in an

17 incomplete process of economic liberalization, taken under the pressure of enormous economic crises.

Nayar (2006) describes the period between 1969 and 1973 as a period of radicalization of economic policy through nationalization of banking and industry. There were also many restrictions put on the private sector in that period. This policy, as well as some fierce external shocks like the immense increase in oil prices, led to a deterioration of the national economy, which in turn fed social and political agitation. This stimulated the government to change its economic system.

In order to stimulate exports, the government, by the end of 1974, allowed fifteen export-oriented engineering industries to increase production capacity by 25 percent over five years. Moreover, the government also stopped with the severe restrictions on the private sector, adopted a deflationary package to decrease prices, and introduced deregulation and export promotion. To facilitate the expansion of exports , the government allowed automatic licensing for importation of raw materials which were used by export-industries. It also allowed more imports for specific industries, while it made the access to financial means for the export sector easier at reasonable interest rates. By giving entrepreneurs more room to breath, economic growth was stimulated. This is the reason why the year 1975 is marked as the starting point of India’s reintegration into the world economy. After this turning point in 1975, other economic reforms followed.

In 1980, the so called ‘Industrial Policy Statement’ was implemented, which was meant as an adjustment of the 1956 ISI to the new economical circumstances. This statement contained the permission for a large number of industries to increase production capacity by 25 percent over five years. The government also adopted an even more liberal standpoint towards the import of raw materials and technology. All of these reforms were included in the so called ‘Sixth Five Year Plan’.

In 1982, the government took a next step in the globalization process. Again, the production capacities of several industries were allowed to increase. Second, the government picked some ‘core’ industries which were opened up to foreign companies and large (international) firms. The government also allowed the private sector to engage in new industrial activities.

When Rajiv Ghandi became prime minister after his mother Indira Ghandi, he accelerated economic liberalization. The program was soon stopped because of a very strong opposition. However, Ghandi was able to undertake various measures that have stimulated economic liberalization.

The reforms carried out in the period between 1975 and 1982 were reforms that, although extremely important, slowly stimulated liberalization, but the main part of the economy remained inward-oriented. Singh (2006) cites an evaluation of the Indian

18 economy in the 1980’s and 1990’s by Panagariya. He stated that between 1987 and 1990, annual growth in India averaged 7.6 percent. These three years were the years that caused India’s average growth in the 1980’s to be relatively high. Without these booming years, growth in the 1980’s would have been only marginally better than that of the previous decades. In 1991, there was finally the shift in orientation, with a government openly seeking integration with the world economy, especially with the NICs. There was a strong devaluation, a gradual unification of exchange rates and the national currency was made convertible on the current account. The government removed tariffs, the restrictions on foreign trade were gradually removed, and taxes were cut down. The Indian government also undertook liberalization of foreign direct investment in that period.

In table 2.1 an overview of important data can be found. The economic crises that hit India will be discussed in sub-section 2.1.3.2.

Table 2.1 Important years for the development of India Year Crisis / reform 1956 • Highly interventionist state • Introduction of ISI program 1969-1973 • Radicalization of the nationalization of banking and industry 1973 • Economic crisis due to first OPEC oil price shock 1974-1975 First reforms toward liberalization: • Increase of production capacity of 15 export-oriented industries • Restrictions on the private sector less severe • Deflationary package to decrease prices • Deregulation and export promotion • More imports were allowed 1979 • Second OPEC oil price shock (negative impact on Indian economy) • Extremely high inflation rates 1980 • Introduction of the Industrial Policy Statement, which allowed an increase in the production capacity of a large number of industries 1982 • Production capacity of a number of industries was again allowed to increase • Government picked ‘core industries’ that were allowed to open up to foreign companies • Private sector was allowed to engage in new industrial activities 1987-1990 • Economic growth of, on average, 7.6% per year 1990-1991 • Economic crisis due to Gulf War • Oil prices increased • India had almost no foreign exchange reserves, so it was unable to pay for its imports • Non-resident Indians were withdrawing their capital from Indian bank accounts • Banks were unwilling to provide loans 1991 • Orientation shift: • Strong devaluation • National currency now convertible on the current account

19 1991 (continued) • Tariffs were removed • Taxes were cut down • Liberalization of FDI

2.1.2. India’s role in the world economy

Naturally, the fact that the Indian government has carried out so many economic reforms to increase economic integration, has had an enormous impact on India’s role in the world economy. In this sub-section I will find an answer to the question:

“What are the most important sectors in the Indian economy?”

2.1.2.1. Trade in goods and services

According to Nayar (2006), India’s trade (imports plus exports) as a proportion of its GDP was around 10 percent in 1974. In 2002 this proportion had increased to around 31 percent. According to the World Development Indicators 2006 from the World Bank, India’s trade as a proportion of its GDP in 2005 was already around 45 percent (with imports as a proportion of GDP around 24 percent, and exports as a proportion of GDP around 21 percent). To make a comparison to other countries: trade 7 as a proportion of GDP in the United States was 24 percent in 2002, and 25 percent in 2005. This means that India is now more integrated into the world market with respect to trade, than the United States! But still, with these percentages, India belongs only to the medium category, and has great potential to grow even more. But nonetheless, it has made great progression, especially since it has little experience with globalization, and the liberalization process has started only about 30 years ago.

A very strong feature of India’s economy is its service sector . Between 1981 and 2000, growth of the service sector in India accelerated, with an average growth of 7.5 percent per year. 8 Between 2000 and 2004, the average growth of the service sector per annum was 8.2 percent, according to the World Development Indicators 2006 of the World Bank. In 2004, the service sector determined 52 percent of India’s GDP. For agriculture, this was only 21 percent in 2004 and industry determined 27 percent of India’s GDP in 2004.

In table 2.2 the structure of India’s service export in 1990 and 2004 can be found. The commercial service export in US $ millions increased dramatically between 1990 and 2004. As can be seen in the table, the exports of transport and travel services declined at the expense of the export of insurance and financial services and especially the export of computer, information, communications and other commercial services, which determined 66.4 percent of India’s total commercial service export in 2004.

7 Trade is defined as: imports + exports 8 Gordon and Gupta (2003) Understanding India’s services revolution (p. 2)

20 Table 2.2 Structure of India’s service export Commercial Transport Travel Insurance Computer, Service Export and information, Financial communications services and other commercial services

$ millions % of commercial % of % of % of commercial services commercial commercial services services services 1990 2004 1990 2004 1990 2004 1990 2004 1990 2004 4,610 39,638 20.8 13.3 33.8 16.8 2.7 3.5 42.7 66.4 Source: the World Bank’s World Development Indicators 2006, table 4.6

India’s growth has been characterized with a decline in the share of agriculture in GDP and an increase in the share of industry and (especially) services. Between 1951 and 2004, the share of agriculture in GDP declined from 58 percent to 21 percent, while the shares of industry and services in GDP increased from 15 to 27 percent and from 27 to 52 percent, respectively. 9

According to Gordon and Gupta (2003), while the development in India has caused a shift from agriculture to services in terms of shares in GDP, the same is not true for employment shares. There has been little decline in the share of employment in agriculture, and the employment share of services declined by about one percentage point during the 1990’s. This points out that India experienced a relatively jobless service sector growth and that labour productivity has increased. The share of the service sector in capital formation has declined from 46.1 percent between 1965 and 1966 to 39.6 percent between 1999 and 2000. This means that the increase in labour productivity is not due to an increase in the relative capital intensity. A possible explanation of the increase in labour productivity could be that the largest part of the service sector growth is concentrated in areas which are highly dependent on skilled labour instead of unskilled labour or capital. Other explanations could be improvements in technological efficiency or benefits resulting from liberalization in India.

Information Technology (IT) enabled services are a vastly upcoming phenomenon all over the world. IT services are important inputs used by other sectors. Nowadays it is possible to exchange information with people and businesses all over the world in very little time and at low costs. India has picked up on this trend, and is very successful in exporting all kinds of services related to the IT sector . The increase in exports has been most dramatic in custom software and other business services, like outsourcing . Outsourcing means that companies delegate certain parts of the production process to

9 Gordon and Gupta (2003) Understanding India’s services revolution (p. 3), The World Bank’s World Development Indicators 2006, table 4.2

21 other firms all over the world. The fact that trade barriers in the world are disappearing has made outsourcing even more attractive. When an activity is outsourced to another country (regardless whether it remains within the same company or not), this is called ‘offshoring’ . The share of offshoring and especially Business Process Outsourcing in India’s service sector is increasing heavily, soon to be dominating the sector. Business Process Outsourcing is the outsourcing of a certain business task to a third party. Since India is specialized in IT-enabled services, Business Process Outsourcing activities also play a large part in India’s outsourcing activities. Examples of BPO services are call centres, human resources, accounting, and the outsourcing of payrolls. It were the United States that started the outsourcing and offshoring trend in the IT-sector, soon to be followed by Western European countries. Today, India is the major recipient of these offshored IT-services. However, India is now starting to offshore the activities offshored to them to China . This is being done by opening facilities in China, because wages in the IT-sector in China are much lower than in India. A huge local market is now emerging in China. The Indian government is still promoting offshoring in India through improvements in education and health of the population, but also by the fast growth in communication- and financial services. The liberalization of telecommunications has been of vital importance for the development of the Indian service sector.

2.1.2.2. Capital flows

For long, India has been restrictive toward foreign investment . The Indian government forced foreign companies in the 1970’s to “dilute the foreign equity in their subsidiaries in India to 40 percent or to withdraw from India (Nayar 2006, p. 19).” 1977 was the all- time low for foreign direct investment in India: the previously mentioned policy had caused IBM and Coca Cola to leave India in 1977, and foreign direct investments reached a negative US $36.10 million. Foreign investment in India was extremely regulated. Every proposal for investment in India had to be evaluated by the Indian government. As a result, foreign investment in India was very low, never reaching even US $100 million in a year. 10

Gradually, however, foreign direct investment was deregulated, and FDI inflows into India have risen significantly. In 1985 foreign direct investment crossed the US $100 million border, with FDI reaching US $106.10 million. As from then, foreign direct investment into India expanded quickly. In 1995, FDI reached US $2,026.44 million.11 In 2001, FDI into India was US $5,471.95 million, increasing up to US $6,598.00 in 2005. 12 Panagariya states that:

10 Nayar (2006) India’s globalization: evaluating the economic consequences (p. 19) 11 Nayar (2006) India’s globalization: evaluating the economic consequences (p. 21) 12 The World Bank’s World Development Indicators 2006

22 ... the top six recipients of foreign direct investment between 1991 and 2005 have been electrical equipment including computer software and electronics (16.5 percent); transportation industry (10 percent); services sector (10 percent); telecommunications (10 percent); power and oil refinery (8 percent) and chemicals (6 percent). (Panagariya 2006, p. 27)

India was also relatively late in allowing Portfolio Foreign Investment (PFI). The Indian government only allowed portfolio foreign investment as from 1992, by permitting foreigners to invest in securities traded on India’s stock markets. But still, these investments were highly regulated by the government.

It is very important for India to further deregulate foreign direct investment. It is now creating Special Economic Zones (SEZs) in which regulations that hold nation wide in India do not apply, in order to attract foreign direct investment. However, there are still limits to foreign ownership in different sectors, and also restrictive labour laws continue to be in effect.

Whether we look at trade in goods and services or at capital flows, India is undoubtedly more integrated into the world economy than it was a decade ago. The reforms carried out by the successive Indian governments have paid off insofar that India now plays a significant role in the world economy, especially in the field of IT enabled services and Business Process Outsourcing.

Foreign Direct Investment and Portfolio Foreign Investment into India have increased dramatically, although some improvements can be made here, for example by further deregulating FDI and PFI, and by creating attractive economic zones.

23 2.1.3. Consequences of globalization on India’s economy

In this sub-section I will discuss the (economic) consequences of globalization on India’s economy. In chapter 1 I discussed the possible downsides and advantages of globalization for the domestic economy. Now I will look at the situation in India, and answer the question:

“Regarding the Indian economy, which arguments of the opponents of globalization hold?”

2.1.3.1. Inequality within the country

Growth in India’s Southern and Western states has exceeded that in the Northern and Eastern states. Research by Schaffer and Mitra (2005) for Deutsche Bank Research has pointed out that in Gujarat, which is the fastest growing Indian state, the State Gross Domestic Product more than doubled between 1993 and 2003 and that per capita product increased by 73 percent over that period. In Uttar Pradesh the increase in per capita product was only 13 percent over the same period. In India’s poorest state, Bihar, the increase was 22 percent. According to Schaffer and Mitra (2005) who cite the economic Survey of the Indian Ministry of Finance from 2005, in fiscal year 2001/2002, per capita product in Gujarat was 3.8 times that in Bihar.

It is noteworthy to mention that even before the orientation shift of 1991, the states in India experienced different growth rates. The question is now whether the states that had increased growth rates after 1991 were more open to globalization than states that lagged behind even after 1991.

Nayar (2006) shows in his study that disparities between states widened between 1990 and 2000. There were even states that had even lower growth rates after the orientation shift of 1991 than they had before (for example Bihar and Uttar Pradesh). The disparities between states can partly be explained by differences in FDI inflows, which can cause differences in economic growth. FDI in India is concentrated in a small number of states, with four states alone accounting for 43.74 percent of FDI. All of these four states experienced high growth rates in the post-liberalization period. 13 But there are more states that had high growth rates in the period after 1991. What is the relation of FDI to the other states that experienced high growth rates? According to Nayar (2006) the answer lays in the FDI per capita figures for these other states. Almost all high-growth states are also states that had the highest FDI per capita.

13 Nayar (2006) India’s globalization: evaluating the economic consequences (pp. 30-31)

24

The fact that growth was geographically uneven means that the fight against poverty has been uneven, too. Some states see their poverty rates falling very quickly, while others still have to cope with high poverty rates. So the growth in India has not been pro-poor. Growth occurred in states that already did relatively well before the country opened up to international trade, not in the states which were already relatively poor before India engaged more in world trade.

Growth in India was not only geographically uneven, as well as sectorally uneven . Growth rates in the agricultural sector have declined compared to those in the manufacturing and service sector. According to Chaudhuri and Ravallion (2006), urban incomes and expenditures have increased faster than rural incomes since 1975 in India. This can be seen from the increasing ratio of urban to rural mean real consumption: this ratio has risen from about 1.4 in 1983 to about 1.7 in 2000. Sectorally uneven growth in India (growth rates in the agricultural sector lagging far behind growth rates in the manufacturing and service sectors, and rural incomes growing more slowly than urban incomes) has led to dramatically less reduction in poverty rates than would have been possible if growth had been more evenly spread across the country.

Openness to foreign trade and foreign direct investment leads to higher growth rates . Globalization does not affect all states evenly. It is highly dependent on initial conditions and political situations in the different states. Growth rates have been significantly higher in rural states, and also sectors are not equally influenced by growth, either. When the Indian government would try to stimulate growth to be more pro-poor (so more directed towards the agricultural sector), inequality would decrease, and growth rates could become even bigger.

2.1.3.2. Industrialization and vulnerability

Opening up to international trade is always an enormous challenge for a country: competition increases because of an expanded market, more imports because of decreased tariffs and the entry of large multinational firms on the national market. According to anti-globalists, this can lead to de-industrialization of the national market, but pro-globalists state that increased competition on the national- and international market can increase efficiency and effectiveness of the home market, leading to more industrialization on the home market.

In table 2.2 one can find growth rates for the manufacturing sector in India over a long period, namely from 1951-52 to 2004-05. Manufacturing is the largest part of the industry sector in India. Over the entire period of globalization and liberalization, the period between 1975-76 and 2004-05, the manufacturing sector grew on average 6.4 percent. This is a much higher growth rate than the average growth rate of manufacturing in the period before globalization and liberalization, the period 1951-52 to

25 1974-75, which was 5.2 percent. However, the manufacturing growth rate in the period of globalization did vary over different years, as can be seen in the table.

In table 2.3 the entire period between the introduction of the ISI program in 1956 and the present (2004-05), has been divided in three periods in India’s globalization history. In this table, different years are compared to each other. At the beginning, the ISI program seemed to be a success, since the manufacturing growth rate between 1956-57 and 1964-65 was 7.1 percent. This was however a brief revival in the growth rates, because between 1965-66 and 1974-75, the growth rate fell back to 3.5 percent.

In the transition to liberalization period, the manufacturing growth rates recovered to an average of 6.4 percent over the entire period, with a maximum of 7.5 percent from 1985-86 to 1990-91. These high growth rates could be maintained after the orientation shift in 1991, with an average growth rate of no less than 6.2 percent over the period 1991-92 to 2004-05. When one leaves out the year 1991-92, the year of a national economic crisis, the manufacturing growth rate is even higher: 7.0 percent. The booming year for the manufacturing sector was the year 1995-96, with a growth rate of about 15 percent. This was due to an investment boom and optimistic expectations after the orientation shift of 1991. Unfortunately, the demand lagged behind the supply, causing growth rates to fall back to lower numbers up to 2000. Other factors causing the slowdown were the counter inflation contractionary policies carried out in 1997. In the new millennium, however, demand boomed, caused by increased export, improved infrastructure, and easier loan finance.

One cannot state that globalization has led to de-industrialization of the Indian market. After the orientation shift of 1991, manufacturing growth rates increased , with an average of 7.0 percent over the period 1992-93 to 2004-05. It is also not right to state that India has experienced rapid industrialization after 1991, but the de-industrialization argument of the anti-globalists certainly does not hold for the Indian case. Pessimists could argue that manufacturing growth rates tell nothing about the health of the manufacturing sector, since it might be the case that capital formation is low, and thus that capital is hollowed out. However, when one takes a look at data from the World Bank’s World Development Indicators 2006, it is obvious that this is not the case here. In 2001, gross capital formation as a percentage of GDP was 24 percent. In 2002 this percentage was 26 percent, growing to 27 percent, 31 percent and 33 percent for the years 2003, 2004 and 2005, respectively.

Another point to look at in the Indian economy is the possible increased vulnerability of the economy after the increased openness to foreign trade. A real risk arising from globalization is that an international (economic) crisis can lead to a national crisis since markets are more related and integrated into each other. However, these kinds of international relationships can never be completely avoided, since a minimum level of international integration is unavoidable. Before 1975, India was an almost completely insulated economy, but still, the oil price shocks in 1973 and 1979 had an enormous

26 negative impact on the Indian national economy. It is, therefore, better to state that globalization leads to relatively increased vulnerability, since even an insulated economy has to cope with international economic shocks.

On the other hand, groups that are optimistic about the effects of globalization on the national economy state that increased integration into the world economy leads to more efficient institutions 14 , a higher per capita income and more economic activities, so that international shocks will be absorbed better by the national economy. This especially holds for developing countries, which on average have bad quality institutions and one- sided economic activities. Improved integration into the world economy will improve the economic and institutional efficiency in those countries, so that the countries that need it most are more capable of handling international shocks. It is important to improve the quality of institutions in developing countries, since institutions play an important part in the development of a country. For example, when institutions in a certain country ensure property rights of investors, people are more likely to invest in this country than if there would not be such insurance. In their paper Acemoglu, Johnson and Robinson (2001) refer to their earlier study in which they found that 75 percent of the income gap between the top and the bottom of the world income distribution may be due to differences in their institutions.

Between the introduction if the ISI program in 1956 and the orientation shift in 1991, several economic crises have hit the Indian economy. These crises often resulted in high inflation rates. According to Nayar (2006), the shortage of foreign exchange resources was critical in each of these crises. The foreign exchange constraint suppressed India’s economic development, which led to economic stagnation in the country.

In his paper, Nayar (2006) discusses several crises that hit the Indian economy in the past (with the period between 1956-57 and 2004-05 divided into three sub-periods). The first crisis occurred right after the introduction of the ISI program in 1956. The enormous expenditures on this ISI program triggered this first crisis, because the foreign exchange resources of India were exhausted, causing people to no longer trust the plans of the government. The second crisis lasted for the largest part of the 1960’s. The economy was still inward- oriented, and there were interstate conflicts , droughts and withdrawals of aid donors during that period. Within this crisis, a ‘sub-crisis’ occurred in 1963, which was caused by a shortage in resources, enormous population growth and stagnation in agriculture. A third crisis occurred in the period between 1971 and 1974, when preceding droughts, a war with Pakistan, the OPEC oil price shock of 1973, strikes and a political movement which caused the downfall of the government resulted in extremely high inflation rates. It was this crisis that forced the government to take its first steps toward liberalization and international trade. These three major crisis show that almost the entire first period between 1956-57 and 1974-75 was one large crisis with only a few exceptional years.

14 Institutions are defined as the political and economic organization of a country

27

The second period, from 1975-76 to 1990-91, faced two major crises according to Nayar (2006). The first one was triggered by a severe drought in 1979, which slowed down agricultural production, and was spurred by the second OPEC oil price shock of 1979. Inflation rates exploded. The government was able to overcome this crisis, and the rest of the 1980’s did not see any economic crisis anymore. The second crisis of this second period was the crisis of 1990-91, with an unacceptable high fiscal deficit. 15 In the meanwhile, aid donors were still withdrawing from the country, and the government turned to short-term external commercial borrowing, bringing India even closer to a major financial crisis. During the 1990-91 Gulf War crisis , oil prices again increased. Because India had almost no foreign exchange reserves, they were unable to pay for their imports. Additionally, non-resident Indians were withdrawing their capital from their Indian bank accounts and creditors were unwilling to provide any more loans. Taken al together, India was heading for disaster. This was the point at which the government realised that this could not go on forever. Their orientation shifted toward the international market.

Since this orientation shift, there has not been any economic crisis in India. Foreign exchange reserves started accumulating in 1993, exports expanded, non-resident Indian started putting their capital on Indian bank accounts again, and foreign direct investment increased. The foreign debt decreased, inflation remained low and India did not have to borrow any more funds from the IMF.

So the argument of increased vulnerability does not hold in the Indian case. Since the increased integration into the international market, India has not experienced any economic crisis. This, however, does not mean that there will never be an economic crisis again. A Possible source that could lead to an economic crisis in India could be the fiscal deficit, which will be discussed in chapter 3.

2.1.3.3. Economic growth in India

Opening up to international trade and the reforms related to this have highly accelerated economic growth in India. In table 2.3 the data on growth rates in GDP and manufacturing are summarized. As can be seen, the period before opening up to international trade (the period between 1951-52 and 1974-75) experienced much lower average growth rates than the period after liberalization (the period between 1975-76 and 2004-05).

15 The fiscal deficit (FD) of a country is the excess of government expenditures over revenues. This excess has to be borrowed, which in turn increases the public debt of a country.

28 Table 2.3 GDP and Manufacturing growth rates, 1951-52 to 2004-05 Year GDP % Mf. growth % Year GDP % Mf. growth %

1951-52 2.3 3.2 1975-76 9.0 2.1 1952-53 2.8 3.5 1976-77 1.2 8.8 1953-54 6.1 6.9 1977-78 7.5 602 1954-55 4.2 7.8 1978-79 5.5 12.4 1955-56 2.6 7.8 1979-80 -5.2 -3.2 Average 3.6 5.8 Average 3.6 5.3 1956-57 5.7 7.5 1980-81 7.2 0.2 1957-58 -1.2 3.9 1981-82 6.0 8.0 1958-59 7.6 4.9 1982-83 3.1 6.6 1959-60 2.2 6.8 1983-84 7.7 10.1 4-year average 3.6 5.8 1984-85 4.3 6.6

1960-61 7.1 8.3 Average 5.7 6.3 1961-62 3.1 8.5 1985-86 4.5 3.9 1962-63 2.1 7.3 1986-87 4.3 6.9 1963-64 5.1 9.5 1987-88 3.8 7.3 1964-65 7.6 6.9 1988-89 10.5 8.8 Average 5.0 8.1 1989-90 6.7 11.8 1965-66 -3.7 0.9 Average 6.0 7.8 1966-67 1.0 0.8 1990-91 5.6 6.1 1967-68 8.1 0.4 1991-92 1.3 -3.7 1968-69 2.6 5.5 1992-93 5.1 4.1 1969-70 6.5 10.7 1993-94 5.9 8.5 Average 2.9 3.7 1994-95 7.3 11.9 1970-71 5.0 2.4 Average 5.0 5.4 1971-72 1.0 3.3 1995-96 7.3 14.9 1972-73 -0.3 3.9 1996-97 7.8 9.7 1973-74 4.6 4.5 1997-98 4.8 1.5 1974-75 1.2 2.9 1998-99 6.5 2.7 Average 2.3 3.4 1999-00 6.1 3.9 Average 6.5 6.6 2000-01 4.4 7.4 2001-02 5.8 3.6 2002-03 4.0 6.3 2003-04 8.5 6.9 2004-05 6.9 9.2 Average 5.9 6.7

1956-57/1974-75 1975-76/2004-05 Average 3.5 5.2 Average 5.5 6.4 Source: Nayar (2006) India’s globalization: evaluating the economic consequences (pp. 25-26)

29 To be fully able to compare the period before globalization to the period after globalization, one can also make a table which compares three different periods, already briefly discussed in the first section of this chapter. This has been done by Nayar (2006) in table 2.4. In this table it can be seen, for example, that between 1965-66 and 1974- 75 GDP growth was only 2.6 percent for an entire decade. If you consider the fact that the Indian population grew fast, this meant economic stagnation. This was the decade that triggered the reforms executed by the government as from 1975.

The fact that this was a sensible decision can also be seen in table 2.3: between 1975-76 and 1990-91, GDP growth accelerated to 5.1 percent. The reason why this period is split up in several smaller periods in table 2.3 is because of the variations in growth rates during this rather long period.

Table 2.4 Growth rates in various combinations of years Period GDP (%) Manufacturing (%) Autarky and command economy 1 1956-57 to 1974-75 3.4 5.2 1956-57 to 1964-65 4.4 7.1 1965-66 to 1974-75 2.6 3.5 Transition to Liberalization 2 1975-76 to 1990-91 5.1 6.4 1975-76 to 1978-79 5.8 7.4 1975-76 to 1979-80 3.6 5.3 1975-76 to 1984-85 4.7 5.8 1980-81 to 1984-85 5.7 6.3 1985-86 to 1990-91 5.9 7.5 Orientation shift 3 1991-92 to 2004-05 5.8 6.2 1992-93 to 2004-05 6.2 7.0 Extended Liberalization 2 and 3 1975-76 to 2004-05 5.5 6.4 Source: Nayar (2006) India’s globalization: evaluating the economic consequences (pp. 27)

Given the data in the previous two tables, one can state that globalization has accelerated India’s economic growth. The period before the start of the liberalization process was characterized by economic stagnation, and the fact that the Indian government chose to integrate more into the world economy has caused India’s GDP to grow at very high levels.

30 2.1.4. To conclude the section on India

In the period between 1956 and 2005, India has gone through some major reforms and crises . After years of almost complete insulation from the world economy, India has only now started to recover from this major backlog on the rest of the world. Although it still has a long road ahead, major steps have been taken over the past four decades, and major steps still have to be taken to try to catch up with the rest of the developed world.

For the sake of completeness, I will summarize the answers to the different sub- questions of this section.

The first question to be answered is the following:

“What are the most important sectors in the Indian economy?”

A very strong feature of India’s economy is its service sector. Between 1981 and 2000, growth of the service sector in India accelerated, with an average growth of 7.5 percent per year. Between 2000 and 2004, the average growth of the service sector per annum was 8.2 percent. In 2004, the service sector determined 52 percent of India’s GDP. For agriculture, this was only 21 percent in 2004 and industry determined 27 percent of India’s GDP in 2004. The strongest part of India’s service sector is its IT-sector. India is specialized in the development of software, as well as in IT-enables services. India is the largest recipient of offshoring activities in the world.

Foreign Direct Investment and Portfolio Foreign Investment into India have also gained in importance, although some improvements can be made here, for example by further deregulating FDI and PFI, and by creating attractive economic zones.

“Regarding the Indian economy, which arguments of the opponents of globalization hold?”

As is extensively discussed in this section, the only argument of the anti-globalists that seems to hold is the argument of increased inequality within the country. Benefits of globalization were both geographically as well as sectorally uneven. Other arguments of anti-globalists fail to hold for India: instead of stagnation, India has seen accelerating growth rates, both in GDP and the manufacturing sector. Moreover, there has not been a single economic crisis after the orientation shift of 1991, while the period before 1991, and especially the period of insulation, can be seen as one major, enduring crisis. This means that India has not been increasingly vulnerable to international shocks, as predicted by anti-globalists. One can also not speak of de-industrialization in India. Although its manufacturing sector has never been a booming one, it is now growing at higher rates than before the globalization process.

31 2.2. China

China is well known for its rapid economic development over the past 2 decades, which is often referred to as the Chinese ‘miracle’. China is considered an economic threat by several countries in the world, because of its huge growth rates, especially in the manufacturing sector.

In this section, I will discuss some major policy and institutional changes China has gone through in the past years. I will also discuss China’s role in the world economy, and the internal economic situation, like inequality, industrialization and growth rates.

2.1.1. Policy reforms and institutional changes

Just like India, China has followed the autarchic growth model for several years. In the late 1970’s, reforms started with local reorganization in the agricultural sector. These reorganizations meant that farmers and workers on the farm now had greater autonomy. In 1978-79, the Household Responsibility System was developed, and these reforms were included in the system. At the beginning of the 1980’s, collective farms were replaced by family farms.

The reforms did not stop here. In the early 1980’s, reforms in industry were carried out, with the creation of Township and Village Enterprises, which were collective industrial firms in rural areas. These TVE’s were initiated by local political leaders, and grew out from Commune Brigade Enterprises, which were developed during the Cultural Revolution. These CBE’s were originally formed to take over industrial production from agricultural communes. The purpose of TVE’s was to employ farmers in the industrial- or service sector at a location which was not far from their homes in rural areas. This allowed the Chinese rural areas to grow and develop, without massive migration toward urban areas. It turned out that it was a smart decision to create these Township and Village Enterprises, since they became the most important part of the Chinese manufacturing sector until the 1990’s. Other economic reforms in the industrial sector contained the increasing autonomy of state-owned enterprises , which was the result of the Contract Responsibility System created in the mid-1980’s.

These were the major reforms that constituted the beginning of major changes in the Chinese economy. Numerous state-owned enterprises were privatized, and both domestic and foreign private firms were now allowed to enter the market. The Chinese government created Special Economic Zones, in which economic activities were stimulated by not applying regulations that do hold in the rest of China. Also international trade was being liberalized, and China was getting more and more integrated into the world economy. By the mid-1990’s, privatization was getting more important, and most TVE’s were now basically private firms, and many international companies present in China were labelled a TVE.

32 The privatization of state-owned enterprises in the industrial sector did not go as fast as in the agricultural sector, because the government feared job losses and mass unemployment. This could have led to social tensions. According to Lindbeck (2006), another reason for slowing down industrial privatization was the fact the government simply could not leave their socialistic point of view of controlling some large production firms. Moreover, the Chinese government had the ambitious plan of creating a number of large oligopolistic players on the world market. A fourth reason why privatization did not go very fast, was because most private agents were hesitant to buy (former) state- owned enterprises, because of their weak financial position and possible inefficiencies in their production processes. Although all of these ‘problems’ slowed down the privatization of state-owned enterprises, nowadays almost all production processes in China take place in private firms, with occasional government intervention, especially in large firms. The autonomy of publicly owned firms is also not always what it seems, since managers are appointed by political authorities.

The fact that China has internationalized its trade makes its industry far more efficient and therefore competitive. China has also profited from capital mobility, since foreign direct investment in China is very high. To tighten their bands with the international market even more, China has entered the WTO in 2001. China was allowed to enter the WTO after it agreed to reduce tariffs and regulations in the manufacturing sector, terminate subsidies to most state-owned enterprises, eliminate export and production subsidies in the agricultural sector and open up the market for banking, insurance and telecom. 16 Also construction services and the Chinese media had to be liberalized. China had to implement these reforms between 2002 and 2007.

2.1.2. China’s role in the world economy

As already mentioned in the introduction to this chapter, China is considered a threat by a lot of large economies in the world, because of their large manufacturing sector, labour market and relatively low wages.

In this sub-section I will give an answer to the question:

“Does China play a large role in the world economy, and which sectors are the most important?”

2.1.2.1. Manufacturing and FDI

In 1979 foreign direct investment was authorized in China. Since then, China has been the largest recipient of FDI. Within China, the manufacturing sector has been the most important and the largest recipient of foreign direct investment. According to the World Bank (2006), by the end of 2004 China had attracted a total foreign direct investment of

16 Whalley (2006) China in the world trading system . CESifo Economic studies, Vol. 52, no. 2, April (p. 218)

33 US $562.1 billion since the beginning of the 1980’s. There are several reasons why the FDI inflow in China was this large. First, the fact that China was liberalizing its sate- owned enterprises, created a more stable investment climate. Second, China’s high growth rates over the past years have attracted foreign investors. The same holds for China’s integration into the world economy: this attracts investors from all over the world.

The huge FDI inflows permitted China to develop, by increasing exports and creating jobs. Official data show that in 2002, 83 million people worked in the manufacturing sector. These data do not contain migrants working in the manufacturing sector, nor people working at the TVE’s. Actual employment numbers are thus likely to be much higher. Of the 83 million manufacturing workers, 45 million are called rural, and 38 million are urban. 17

China has been very selective toward foreign direct investment. This included tariff exemptions and lower tax liabilities in areas were foreign direct investment had to be promoted. These areas were mainly the export oriented sectors and sectors that were subject to the import substitution policies of the Chinese government. In other sectors, foreign direct investment was not stimulated or even limited.

In China’s FDI ‘history’, one can distinguish three periods. According to Lemoine (2000) the first period was the entire 80’s decade, in which FDI inflows increased moderately. In the second period, between 1992 and 1997, FDI inflows accelerated. This was due to an international trend, which implied that dramatically large flows of FDI were directed toward developing countries in the 1990’s. Lemoine (2000) shows that between 1992 and 1998 the total amount of FDI received by China reached the amount of US $250 billion, which is 30 percent of all FDI directed toward developing countries and 50 percent of all FDI directed toward Asia. It was in 1993 that FDI directed toward the manufacturing sector boomed, and since the mid-1990’s, multinational firms have important positions in the Chinese manufacturing sector. During the third period, after 1998, FDI inflows were significantly smaller than in the second period. This was due to less dramatic GDP growth rates in China during that period. This was reinforced by the Asian economic crisis in 1997, which made investors more careful. According to World Bank 2006 data, FDI inflows in China are increasing again since 2003-04.

During the privatization process of the state-owned enterprises, employment in de manufacturing sector declined, because of increased efficiency and increasing labour productivity. Result was that the privatized manufacturing firms are far more efficient and productive than the old state-owned enterprises. This highly improved the position of Chinese manufacturers on the international market. After this temporary slowdown in employment, employment in manufacturing started to grow again after 2000, partly because the manufacturing sector in China is such a big recipient of FDI.

17 Banister (2005) manufacturing employment and compensation in China (12)

34 In the 1980’s and the largest part of the 1990’s, China’s major strength lied in jobs that are labour intensive , like for example clothing, shoes, toys and sport goods. Its weakness in that time was the production of products that require a lot of technology and those which are capital intensive, like machinery, engines, and plastics. In the late 1990’s, China’s specialization grew more widespread into the area of consumer electronics, consumer equipment, household electrical appliances, miscellaneous hardware and manufacturing articles, leather, and electrical apparatus. This increase in specialization was due to a very quick increase in exports of these goods. 18 China had chosen to diversify its export sector toward products and manufactures that were rapidly gaining importance in the word economy, such as computer equipment, telecommunications and electric apparatus. China succeeded in this diversification of its exports, as can be seen in the empirical data: its market shares in leather, consumer electronics, miscellaneous manufactured products and domestic electrical appliances rose on average by 9.63 percentage points between 1990 and 1997, with leather as the leader in the race: China’s market share in leather as a percentage of world exports rose from about 8 percent in 1990 to about 22.3 percent in 1997. 19 It is obvious that China is moving more toward capital intensive production processes when one looks at China’s rate of capital formation over the last 1.5 decades. Between 1990 and 2004 China’s gross capital formation experienced a growth of on average 11.2 percent per year. Between 2000 and 2004 this growth accelerated to an average of 15.0 percent per year.

Areas in which China’s specialization declined were those of clothing, carpets, crude oil and knitwear. According to the Word Development Indicators 2006 of the World Bank, machinery and transport equipment was 32 percent of China’s total value added in manufacturing in 2002, while this was 24 percent in 1990. Textiles and clothing lost some of their importance between 1990 and 2002: their value added reduced from 15 percent of the total value added in manufacturing in 1990 to 12 percent in 2002. This can easily be explained, because it is well known that countries move more and more toward capital intensive products and production processes as they develop and as wages increase.

In 2004, manufactures covered 91 percent of China’s total merchandise exports, while this was ‘only’ 72 percent in 1990. According to Nikomborirak (2006) who cites the World Bank’s Quarterly Update of February 2006, the average annual growth rate of the manufacturing sector in China has been 17 percent between 1978 and 2005. This indicates China’s heavily increasing importance in the world economy, especially in the manufacturing sector.

18 Taken from: Lemoine (2000) FDI and the opening up of China’s economy, figure 15 (pp. 56 - 57) 19 Taken from: Lemoine (2000) FDI and the opening up of China’s economy, figure 17 (p. 58)

35 2.1.2.2. Emergence of the service sector in China

Although India is famous for its service sector, one should be careful not to wipe out China’s service sector. China’s commercial service exports have increased from US $5,748 million in 1990 to US $62,056 million in 2004. This means that China’s service exports were 11 times larger in 2004 than in 1990! Over the period between 1990 and 2000 the average annual growth of the service sector was 10.2 percent. Over the period between 2000 and 2004, this was 9.8 percent. 20 Services trade is still by far not the most important role in the development of China’s economy. Over the period between 1995 and 2002, services trade as a share of GDP only rose marginally: from 6.33 percent to 6.81 percent. 21 This points out that trade in services is still less important than trade in manufactures for China.

The base of the service sectors of China and India are different. As discussed in the section on India, the country almost immediately went from agriculture to services, without mass industrialization. This is, however, not the case in China. China did experience mass industrialization, so the step toward services is more obvious . The role of the service sector in China was mainly to facilitate national production and (inter)national trade in goods. This is not the only difference between these two countries with respect to their service sectors. A second difference is the scope of their service sectors. India is specialized in Information Technology-enabled services and software. According to Nikomborirak (2006), China’s service sector is much broader than that of India, with specializations on the areas of export of tourism, business services and transport services . On the other hand, China imports a lot of services to support its manufacturing sector, like transportation, insurance and license fees. China also imports tourism, because Chinese people tend to travel more as their income levels rise. Because China’s imports of services are larger than its exports of services, China has a deficit in services. This can imply a comparative disadvantage in services for China.

The service sector as a whole (so not only trade in services) is increasing in importance very fast in China. In 1990 services accounted for 31 percent of China’s GDP. This had grown to about 41 percent of GDP in 2004. 22 These numbers can also be found in figure 2.1. This figure shows that the service sector has been gaining importance in China ever since the 1990’s. This growth has been mainly at the expense of agriculture, which has been the subject of declining importance since the 1990’s. Another sector which is somewhat declining in importance is the industry sector. In percentages of GDP it is still the largest sector in China, but the service sector is threatening to pass the industry sector in the coming years. As noted before, it is a natural process for a country to move from agriculture to industry to services, so China is simply developing in a natural way.

20 Numbers taken from: The World Bank’s World Development Indicators 2006 21 Numbers taken from: Nikomborirak (2006), A comparative study of the role of the service sector in the economic development of China and India (p.18) 22 Numbers taken from: The World Bank’s World Development Indicators 2006

36 Figure 2.1 Percentage of GDP per sector in China 1995-2004

Taken from: Nikomborirak (2006) A comparative study of the role of the service sector in the economic development of China and India. Table 1.2 (p. 7) Source: World Bank Office, Bejing (2006), Quarterly Update: February 2006

As could also be read in the first sub-section on China, not only manufacturing firms in China have liberalized since the 1980’s. Also a number of service markets were liberalized by the Chinese government. For example the financial sector: in 2001, the Chinese government promised full access for foreign banks within five years. These foreign banks will be allowed to make local currency loans also to foreign enterprises. 23 Also the insurance -, telecommunications - and distribution sectors have undergone many transformations since the beginning of the 21 st century. China’s insurance market has opened up for foreign companies. According to Nikomborirak (2006), China’s telecommunications sector still lags behind that of India because the Chinese telecommunications sector remains relatively more closed than that of India. China’s distribution services are almost completely liberalized. China has also opened up the entire logistical chain for foreign companies.

23 Nikomborirak (2006), A comparative study of the role of the service sector in the economic development of China and India (p.34)

37 Because China has dramatically liberalized its service sector over the past years (according to the commitments it made when it became a WTO member), it will be likely that this sector will increase in importance for the Chinese economy in the upcoming years. Foreign investments in the Chinese service sector are likely to accelerate, since the sector is opening up more and more to foreign investors and companies. Furthermore, China has a solid and stable industrial base for its service sector. This means that any industrial expansion will automatically lead to expansion of the service sector. This is reinforced by increasing wages in China.

2.1.3. Consequences of globalization on China’s economy

Naturally, the increasing integration of China into the world economy has not been without any consequences for the Chinese national economy. In this section, I will discuss the consequences of China’s liberalization and globalization for its economy, with respect to GDP growth and national inequality, and answer the question:

“Regarding the Chinese economy, which arguments of the opponents of globalization hold?”

2.1.3.1. GDP and national inequality

Over the period between 1980 and 1990, China’s GDP grew at the dazzling rate of an average of 10.3 percent per annum 24 . Over the period between 1990 and 2000, this rate reached an average of 10.6 percent per year. The average annual GDP growth rate was 9.4 percent over the period between 2000 and 2004. 25 The most recent number is the GDP growth rate of 2005, which equaled 9.9 percent. Per capita income in China has also grown substantially, and according to Dollar (2006) the poverty rate in China fell from 64 percent at the beginning of the reform period, to 10 percent in 2004.

One can conclude from the previous data that China has not at all suffered from deteriorations in its GDP growth after globalizing. GDP growth has been very high every year since the 1980’s. One can therefore not state that globalization has been bad for the Chinese economy in terms of GDP growth. But what about inequality within China? Have all Chinese people profited from these extremely high growth rates, or have the advantages of globalization profited only certain groups within the China?

Although virtually every household in China has profited from the reforms the Chinese government carried out (recall that the poverty rate in China dropped from 64 percent at the beginning of the reform period, to 10 percent in 2004), income inequality within China has increased significantly since 1985. This can be explained mainly by the increasing wage-gap between rural and urban areas. Inequalities within the urban areas are caused by the fact that there is a selected group of people who are highly educated

24 Numbers taken from: Srinivasan (2005) China, India and the world economy (p. 1) 25 Numbers taken from: The World Bank’s World Development Indicators 2006

38 and rich , while other people who live in urban areas are within the simple urban working class, with significantly lower wages. The accelerated GDP growth rates of the past two decades have especially favored urban areas and rich people. Rises in inequality would have been inevitable since China introduced a market system, but is has been exacerbated because of some political decisions. There were restrictions on rural-urban migration . It was also not allowed for people in rural areas to sell or mortgage land. Furthermore, the Chinese government made local governments responsible for the provision of basic education and health care. The local governments of poor states in rural areas could not afford to supply education and heath care, so most people in rural areas are not highly educated. A possible solution to the inequality between rural and urban areas could be the promotion of urban areas and the stimulation of migration from rural to urban areas. However, it is questionable whether the cities can absorb such huge streams of migrants. It is therefore not likely that this kind of inequalities between urban and rural areas will diminish any time soon.

A second explanation of why inequality in China has increased after the reforms of the early 1980’s is the so-called rising return to education : In the period before the reforms in China took place, there was little difference in the salaries of educated and non- educated workers. The economic reforms created a market in which education led to higher wages. This caused the wages of educated people to rise dramatically in the period after the reforms. According to Dollar (2007), in the period between 1988 and 2003 the wage returns to an additional year of education rose from 4 percent to 11 percent. This in turn led to higher inequality, since the initial stock of educated people was small and the people who were educated already lived in the highest classes of society. When one combines this phenomenon with the fact that poor rural areas are to provide education themselves (which they cannot afford), it is obvious that inequality in China is rising. However, this is a phenomenon that could be reversed when the government would stimulate education, and makes is accessible to everyone.

The migration system of the Chinese government is a system which has been only slowly changing over the past 2.5 decades. Before the reforms were carried out, migration within China was completely restricted. Each person has a registration in a rural area or an urban area, and he cannot change this registration without the permission of the jurisdiction in which the migrant wants to live. In practice, the only people who were given this permission were (highly) educated workers. Dollar (2007) cites a study by Sicular (2007), who finds that the gap in per capita income between rural and urban areas widened during the reform period, reaching a ratio of three to one. Also, in the past years manufacturing wages have risen dramatically. These wage increases are of course good for the incumbent manufacturing workers in China, but these workers already live at the top of the Chinese society. This means that such wage increases worsen the income inequality in China. It is unlikely that these dramatic wage increases in the manufacturing sector would have happened when there would have been no, or less severe, restrictions on labour migration.

39 In short, the reforms carried out in China, and therefore globalization, have increased inequality. This was inevitable, because China turned from fully controlled economy to a market economy. However, these increases in inequality have been exaggerated by some policies that are still in effect in China, like restrictions on migration and limited access to proper education. When the Chinese government would abolish these policies, and stimulate education also in rural areas (in other words: make the growth more pro- poor), inequality will reduce.

2.1.3.2. Economic crisis in China?

Although it’s not the purpose of this thesis to analyze the financial crisis that hit Asia in the late 1990’s, it is virtually impossible to ignore it when one wants to discuss the economy of China. Another reason why I want to discuss part of this major crisis is because I would like to show that China was able to survive this crisis without major damage partly because it was so heavily integrated into the world economy. As will be shown later, it were these favorable external fundamentals which protected China from a major economic crisis, since the internal fundamentals were not that stable at the time of the crisis hitting Asia.

In 1997 and 1998, a major financial crisis hit Asia. China, however, remained largely undamaged. According to Fernald and Babson (1999) China’s GDP growth rate was 7.8 percent in 1998, which was the lowest rate since the beginning of the 1990’s. This was, however, an admirable achievement, since most Asian countries experienced negative growth rates that year. This performance seems even more admirable if one knows that China’s internal fundamentals were not too favorable. China had a weak banking system which was also poorly regulated and offered bad loans to powerful state-owned enterprises. All banks could continue to operate, even with severe balance-sheet weaknesses, because of government support. Institutions were weak , and unable to adjust rapidly. When one should only look at the internal fundamentals of China, it seems unclear how China was able to escape the Asian financial crisis unharmed, because the Chinese internal factors were almost as bad as the internal factors of other Asian countries which did not survive the crisis unharmed. Fernald and Babson, however, state that China’s external accounts looked very favorable. It ran current account surpluses from 1996 to 1998, and its (sizeable) total debt relative to its reserves was still much lower than in other Asian countries at the time. It were also the capital controls by the Chinese government that helped prevent the crisis from hitting China, because these controls prevented Chinese financial institutions from borrowing excessively abroad, which kept the external fundamentals strong. China had very large foreign exchange reserves, which China’s central bank had been accumulating to offset pressure for a nominal appreciation. Another reason why China was able to insulate from the worst effects of the Asian crisis was the fact that it had a very strong currency. The exchange rate vis-à-vis the Dollar was virtually stable.

40 It is obvious that part of the reason why China was not harmed severely by the Asian financial crisis is because it was already more integrated into the world economy than other Asian economies in the late 1990’s. When this would not have been the case, China’s economy would have suffered a lot from the crisis, because the internal factors were not favorable. The banking system and institutions were weak, badly organized and mainly uncontrolled. It were the external factors, such as a current account surplus, large foreign exchange reserves and a strong currency that protected China from a major financial crisis. It is therefore obvious that globalization did not make China more vulnerable to crises, but in fact protected the country from them.

2.1.4. To conclude the section on China

China has been one of the first Asian countries starting to open up to the world economy. Up to now, China has only profited from it. After the economic reforms of the 1970’s, economy has started to grow at immense growth rates. The Chinese manufacturing sector is booming and has a very important and strong position in the world market. In the 1980’s and the largest part of the 1990’s, China’s major strength lied in jobs that are labour intensive, like for example clothing, shoes, toys and sport goods. Its weakness in that time was the production of products that require a lot of technology and those which are capital intensive, like machinery, engines, plastics, etceteras. In the late 1990’s, China’s specialization grew more widespread into the area of consumer electronics, consumer equipment, household electrical appliances, miscellaneous hardware and manufacturing articles, leather, and electrical apparatus. It had chosen to diversify its export sector toward products and manufactures that were rapidly gaining importance in the word economy, such as computer equipment, telecommunications and electric apparatus. In 2004, manufactures covered 91 percent of China’s total merchandise exports. China was partly able to develop because of the large FDI inflows which have permitted the country to make favourable investments and create employment.

It is a natural development for an economy to move from mass industrialization towards the development of a large service sector. This is precisely what China is experiencing today. China’s service sector is much broader than that of India, with specializations on the areas of export of tourism, business services and transport services. On the other hand, China imports a lot of services to support its manufacturing sector, like transportation, insurance and license fees. Because China has dramatically liberalized its service sector over the past years (according to the commitments it made when it became a WTO member), it will be likely that this sector will increase in importance for the Chinese economy in the upcoming years. Foreign investments in the Chinese service sector are likely to accelerate, since the sector is opening up more and more to foreign investors and companies.

41 This leads me to the following answer to the question:

“Does China play a large role in the world economy, and which sectors are the most important?”

The role China plays in the world economy is very large. China is the largest recipient of FDI in the world. The country is heavily integrated into the world economy, and on the demand side, China relies almost completely on exports and imports. The most important sector in China still is the manufacturing sector, but the service sector is also starting to emerge.

As has been said before, globalization has speeded GDP growth rates in China. Inequality in China, however, has also become larger when China got more integrated into the world economy. It is partly obvious that this would happen, because the economy moved to a market economy, which will almost always tends to increase inequality in a country. It was however not globalization, but some political decisions which caused a major increase in inequality in China. When these decisions would be revised, inequality could improve.

It is also obvious that globalization did not make China more vulnerable to economic crises. It actually protected China from being hit by the Asian financial crisis in the late 1990’s, and there has not been another crisis in China ever since.

Knowing this, I can give an answer to the question:

“Regarding the Chinese economy, which arguments of the opponents of globalization hold?” by stating that, as was the case with India, the only argument that holds for China is the argument of increased inequality. And even here this is questionable, because there are several possible explanations for the increased inequality in China, like the transition to a market economy, and some inefficient political choices. Therefore, it is not necessarily globalization that brought about the increase in inequality.

42 Chapter 3 The future of India and China

In the previous chapter I discussed some past economic reforms of both India and China. Also the historical and current economic situations of both countries were discussed. In this chapter I will discuss the future prospects of India and China.

3.1. India’s future

As has been discussed in previous chapters, China and India went through different developments and are economically different. But even though India is considered a success in the world economy, it stays far behind the immense success of the Chinese economy. China experienced much higher growth rates which caused the Chinese per capita income to be US $1272.14 in 2004 as opposed to India, which had a per capita income of US $640.79 in that year 26 . This means that the per capita income of China was almost twice that of India in 2004. It is obvious that India lags far behind China. What is not so obvious, however, is why this is the case. Therefore, in this section I will give an answer to the question:

“Why is it that India lags behind China, and what needs to be done for India to catch up with China?”

3.1.1. Why is it that India remains behind China?

Naturally, India would like to achieve growth rates comparable to that of China. In a paper written for the Deutsche Bank Research, Schaffer and Mitra (2005) state that India needs to sustain at least 8 percent growth over a long period of time, to be able to catch up with China, which had a GDP growth rate of 9.9 percent in 2005 . To be able to reach those kinds of growth rates, one has to identify why it is the case that India still lags behind China. One large difference between the Indian economy and the Chinese economy is the fact that India never experienced mass industrialization . According to numerous economists, like Panagariya (2007), this is the reason why India performs much less than China. Traditionally, India has focused primarily on the service sector, but services tend to be far less tradable than industrial products. This means that an economy which does not produce many industrial products will experience a much lower trade-to-GDP ratio and slower growth. Another reason why industrialised economies tend to have larger growth rates is because countries which are labour abundant tend to attract foreign direct investment towards their manufacturing sector because of low wages. This means that less industrialization translates into less foreign direct investment and therefore into less growth. However, India was able to attract some foreign direct investment and increase the trade-to-GDP ratio somewhat by specializing in software and IT-enabled services , which tend to be tradable. But these services make

26 Own calculations, based on the World Bank’s World Development Indicators 2006 .

43 up only a small share in India’s GDP, fast growth in this sector only has a limited impact on GDP.

Critics of Panagariya’s theory state that India need not develop in the traditional way. That is, moving from agriculture to industry to services. This would be the case because India has a large stock of skilled labour and is a leader in the IT sector. Panagariya (2007), however, says that this it not necessarily true. Software and IT-enabled services make out only a small share of the Indian service sector and therefore of the Indian economy. Much of the growth in the service sector comes from informal services in which wages and productivity tend to be low. In his article, Chandrasekhar (2005) shows that gross revenues from IT services accounted for 3.3 percent of GDP in India in 2004-05. Although the importance of software and IT-enabled services is increasing, the minimal contribution it made to GDP in the previous decade explains mainly why India has lagged behind China. Even if IT would have a large share in India’s GDP, it is highly questionable whether a country can move from agriculture directly towards services. Panagariya cites a part from the 2001 Census, which states that 77 percent of the total Indian workforce still lived in the rural areas in 2001, with 58.5 percent of them working in the agricultural sector. It is reasonable to assume that policies can direct a part of these people toward the cities into manufacturing activities, but it is doubtful whether this would succeed if people are directed from agriculture toward jobs in the formal service sector, like banking, insurances, communications and IT-enabled services. This is the case because manufacturing jobs often do not require a lot of education, while people who work in the formal service sector often need to be highly educated . When India decides that it wants its economy to rely mainly on services, it has to start educating the children still living in the rural areas. This strategy would not do much for the adults now living in the rural areas, so it will take several years before the current children are ready for the labour market and modernization can take off. This policy will only succeed when the government has enough resources to facilitate education for everyone. According to Panagariya (2007) only 10 to 12 percent of young men and women aged 18 to 24 go to college in India. It is uncertain whether the government is able to raise this proportion significantly in the near future. Moreover, the universities in India are too ill-equipped to provide high quality education to a lot of people.

Because of the reasons mentioned in the previous paragraph, it is nearly impossible for India to modernize the economy and catch up with China in the near future without experiencing the industrialization stage, first. It is certainly not necessary for India to leave the IT sector, especially since it is increasing in importance for the Indian economy. It will be very good for the economy of India to both industrialize and operate in the IT- enabled services sector in the future.

44 3.1.2. What needs to be done to stimulate industrialization?

As has been mentioned in the section on India in chapter 2, there have been several reforms in the past to stimulate industrialization in India. Despite these reforms, major industrialization has never really taken off. As I discussed in previous paragraphs in this section, there needs to be industrialization in India in order for the economy to catch up with China. Other reforms will be needed for industrialization to develop and expand, and some structural problems in the economy need to be addressed.

First, there need to be made some large investments in the infrastructure . When a country wants to expand and develop its industry sector, it needs to have high quality roads, airports and ports. If there is too much congestion in ports , on the roads and on the airports , the position of the country on the world market can deteriorate and major industrialization will never happen. In his paper, Panagariya (2007) talks about some reforms the government is already carrying out with respect to the roads in India. In the recent past, the government launched the National Highway Development Project which has as a goal to renovate and modernize existing roads. In order to be able to take full advantage of these roads, the government must liberalize the access and exit of transportation companies to the market, and must lift any restraints on the size and operations of these transportation companies. This will greatly enhance efficiency. Another part of infrastructure which is of great importance for the industry sector is power . When the supply of power is not good taken care of, there can never be mass industrialization. The supply has occurred at reasonable costs, and the supply must always be secured, or large companies will never enter the Indian market.

Second, the problem of the sizeable fiscal deficit needs to be solved. This fiscal deficit requires a huge amount of interest payments every year, which is not desirable. Moreover, a high fiscal deficit could lead to a fiscal crisis : high interest payments can force the Indian government toward inflationary finance, which can damage the credibility of the country, and raise interest rates. This means that the problem of the fiscal deficit needs to be attained, because it can deteriorate growth. When the government keeps postponing solving this problem, interest payments keep increasing and the debt can become unmanageable. The government has to attain this problem carefully. It is not only of vital importance that the problem itself is solved, but also the way in which it is solved is fairly important. If the government increases taxes to reduce the fiscal deficit, private savings will decrease, which is not at all desirable, because this in turn reduces investments. A possible solution to the deficit problem is the government bringing its expenditures down. This can easily be done by no longer providing unproductive subsidies to inefficient firms and banks.

45 Third, large reforms on the labour market have to be carried out. In 1976, Prime Minister Ghandi obligated firms which employed over 300 people to ask permission to the state government when they wanted to retrench workers. The government would never give permission to do this, so retrenchments were impossible. In 1982, this law was expanded by obligating firms employing over a 100 people to ask for the same permission when they wanted to retrench workers. Obviously, this is a large deteriorating factor in the Indian economy. It withholds firms from entering the market. This especially holds for the industry sector, because the law introduced by Prime Minister Ghandi only holds for low-skilled workers. This causes entrepreneurs to concentrate their activities in sectors such as pharmaceuticals, chemicals, the IT-sector and for example the production of automobile parts. These often are activities that require high(er) education, and therefore are not part of the deteriorating law. When this law will not be amended, industrialization in India will never happen, because firms are too hesitant to enter the market. Exports of manufactures will remain low, and India will not be able to catch up with China. However, when the government carries out these needed reforms, foreign direct investments will increase, international firms will enter the market, and growth rates in India will accelerate. The government needs thus needs to look at these positive sides of reforming the labour market and allowing the retrenchments of workers. This means that the orientation shift of 1991 needs to be broadened, and that the government needs to keep modernizing its country. This will obviously not happen overnight.

3.1.3. Keeping the IT-sector up-to-date

As said in the first sub-section, it is not only important for India to start industrializing, but it also has to stay ahead in the IT-sector. This, however, will not be easy. China’s IT- sector is growing, and if India is not careful, it will be crowded out by China. India has always had an advantage in the English language over China. This advantage is disappearing, because Chinese students studying abroad are bridging the gap there is between them and the Indian people regarding the English language, although Chinese people are on average still lagging far behind Indian people on this area. Also the technical education in China is becoming better and better, and will soon catch up with that of India. These factors cause the Chinese IT-sector to keep getting closer to that of India. Another potential threat to the Indian IT-sector lies at the supply side. The demand for outsourcing activities is increasing, which means that employment in this sector is increasing. These jobs require college education, which is not affordable for everyone. Moreover, the Indian universities lack the resources to be able to educate enough people for the IT-sector to be able to handle all demand. India is forced to do something about these restraints, or the IT-sector will be surpassed by China. This is reinforced by the fact that India is already offshoring IT-activities to China, because India simply cannot handle all demand for IT related services. India is thus giving China the opportunity to develop its IT-sector.

46 Panagariya (2007) offers some solutions to the Indian education problem. First, India should allow the entry of private universities . The government simply does not have the resources available to provide enough education. The only solution is the entry of private universities. Also, universities and colleges should be given more autonomy . They should be able to decide upon matters like research, college fees and courses themselves. This could be the fundamental of a modern educational system. It is also necessary for India to raise the tuition fees . Up to today, tuition fees are almost negligible in India. There must be funds for scholarships and loans for the poor who want to attain university, but there is no need to burden Indian residents who do not attain college or university with the expenses that need to be made for those who do want to attain university or college. Since the largest part of education benefits is private, it is only fair that those who get educated pay for it.

3.1.4. Conclusion

I will now answer the question:

“Why is it that India lags behind China, and what needs to be done for India to catch up with China?”

The main reason why India still lags behind China is the fact that there has never been mass industrialization in India. The country has never developed in the traditional way, by moving from agriculture to industry to services. Instead, it skipped industrialization, and moved almost directly to the service sector. This has never been a really big problem, but it certainly can bring about some serious difficulties for the Indian economy: there are still many people working in the agricultural sector. These people are mostly not, or poorly educated. However, for the Indian economy to keep growing will relying on the IT-sector, educated people are necessary. If the government would start stimulating education today, it will take years before today’s children are ready for the labour market. India, therefore, needs some intermediate state, in which also poorly educated farmers can find work. This can be done by starting to industrialize the country. For most jobs in this sector, no high education is needed, and there is much on-the-job training.

Obviously, there is no need for India to abolish its IT-sector, since it has a great advantage over other countries here. It is, however, really important for India to remain a leader in this sector. This will be very hard, because China is also starting to develop its service sector. To make sure that the economy will not stagnate in the near future, the IT-sector needs to be kept up-to-date by reforming the educational system, so that supply of IT-professionals can keep meeting the international demand for IT-services. Only then will it be possible for India to catch up with China.

47 3.2. China’s future

China has always been superior to India with respect to GDP growth rates. China also had very high rates of investment and capital formation since the beginning of the reform period in 1978. It is useful to know whether China will be able to keep the GDP growth rate at its current level. The main question of this section on China’s future will be:

“Is it likely that China will be able to maintain very high GDP growth rates in the future?”

To be able to answer this question, I will first give an answer to the question:

“What needs to be changed in the Chinese economy to be able to maintain high GDP growth rates?”

A large part of the Chinese capital formations were possible because of high domestic savings. If these savings would suddenly drop, capital formation and GDP growth rates could decrease. It is therefore important for the Chinese government to know how the domestic savings rate will develop in the future.

3.2.1. The future of capital formation in China

According to Perkins, the largest part of Chinese investment is being financed by domestic savings :

... A 39-40% gross capital formation rate in the first years of the twenty-first century translated into a total investment of well over US $500 billion per year even at the undervalued exchange rate then prevailing. [inward] FDI, large as it was in comparison with other developing and even with developed countries, was still ‘only’ US $60.6 billion (in 2004). Perkins (2006, p. 18)

Perkins states that the reason why domestic savings in China are so high is very straight forward: with the introduction of a market economy, the citizens had to take care for themselves. This meant that they had to save for their pensions, housing, education, etceteras.

As is well known in economics, savings tend to follow as so called lifecycle model . This means that people save close to nothing when they are young and have children, save during their working years, and again save less to nothing when they are retired. The amount of domestic savings then depends on the ratio of the number of economically unproductive members of society (the young and the old) to the number of economically productive people (those of working age), which is also known as the dependency ratio. In most high-income countries, the group of working age is between 15 and 64 years old. This is also becoming the case for China.

48

Since the 1960’s, the dependency ratio has been falling in China, due to a population boom beginning in the 1950’s. In the 1970’s, the government implemented the one-child policy , because the Chinese population was growing explosively. This resulted in a very small group of people being younger than 15 years. The portion of retired people was also not very large, because the people in this group were all born in a period in which child mortality was still high. This caused the dependency ratio to fall.

In the future, however, this situation is going to change dramatically. The group of retired people will grow rapidly because of increased life expectations and because of the fact that the children born during the baby boom period of the 1950’s, will retire in the near future. At the same time, the group of working people today is large. The children born under the one-child policy are now between 15 and 30, and thus fall in the group of working people. The much larger group of children born slightly before the one-child policy, aged between 30, 35 and above, also falls in the group of working people. The fact that there are much less children being born, and that there are many Chinese people that will retire now and in the future (the very large group of children born slightly before the one-child policy was implemented will also start to retire in about 20 years), will cause China’s dependency ratio to increase over the next two decades. According to Perkins (2006), the dependency ratio will be quite high by 2025, but the rise will start from a low base, and then accelerate. The Chinese government could opt for extending the retirement age, but this will only solve part of the problem. Moreover, this will be offset by the fact that people go to school longer, so the age of working people will only change from 15-64 to, for example, 22-70. This will not change the dependency ratio.

Obviously, this increasing dependency ratio leads to lower domestic savings . This is because the group that saves most will become smaller over time, while the groups that save least become bigger. Of course, household savings are not the only savings that determine investments in China. Savings by non-financial enterprises are also important, as well as government savings. It is, however, difficult to forecast what will happen with these two savings in the future, especially in a developing country. Investments from non-financial firms mostly come from firms in the mineral sector. Since it is impossible to predict what will happen to, for example, oil and gas prices, it is also impossible to predict how much the profits and the investments of these firms will be.

To increase the probability of maintaining high growth rates in the future, China should not only depend on domestic savings. Foreign direct investments are also of great importance to the Chinese economy. FDI has always been high in China, but it is important for the Chinese government to keep opening up their financial market . According to Perkins (2006), the government still had controls over the capital movements across its borders by 2005. Although these controls are getting less restrictive over time, the goal of the government should be to abolish these controls in the near future. In this way, China will no longer be fully dependent on domestic savings to maintain high investment rates.

49

To maintain high growth rates, it is not only important to keep high investment rates, but also to make useful investments. State investments, which have been quite high over the past decades (see table 3.1) seem to be declining over the years, but this is not entirely true. The category ‘other’ includes shareholding enterprises, which are mainly controlled by the state. This causes the share of state investments in fixed assets to remain high. These state investments, however, have not always been efficient. For starters, the rate of return to investments of state-owned enterprises has always lagged behind that of private firms and the collective sector. Perkins (2006) comes up with an example of investments made by the government in infrastructure. A major road-building program was implemented, which included building roads and airports in developing areas, in which demand was low. Making such immense investments, way ahead of demand, leads to low rates of return for the society. Perkins even states that part of this road-building program was implemented in the 1990’s to keep aggregate demand high, and in this way artificially keep the GDP growth rate above 7 percent.

Table 3.1 Investments in fixed assets by ownership in China Year State (%) Collective (%) Individual and other (%) 1980 82.8 5.1 13.2 1985 66.1 12.9 21 1990 66.1 11.7 22.2 1995 54.4 16.4 29.1 2000 49.8 14.6 35.3 2003 39 14.4 46.6 Taken from: Perkins (2006) China’s Recent Economic Performance and Future Prospects (p.21) Source: National Statistical Office (2001) China Statistical Yearbook , 2001 (p.188)

Perkins gives two possibilities for China to keep its growth rate high in the future. The government either has to reach higher rates of return to its investments, or the country should reduce state control , and move investments to the more efficient private sector. The government should keep investing in infrastructure , since the need for that is large in China. It is not very useful to privatize the provision of infrastructure, since this is a public good. In other areas, such as telecommunications, the government has to privatize investments to be able to reach high rates of return and maintain high GDP growth.

50 3.2.2. Human Capital

In table 3.2 one can find the stock of educated people in China from 1964 to 2000. As can be seen from this table, the stock of educated people has expanded fast over time, while the number of illiterate people is declining. Obviously, there is much room for expansion of these numbers, especially at university level. According to Perkins, the percentage of the population with some university education is less than 4 percent of the total population and enrolment is only 15 percent of all people who are currently of university age.

Table 3.2 Stock of educated people in China (in 1000s) Level of education 1964 1982 1990 2000

Primary School 196.775 355.252 420.108 451.914 Junior Secondary 32.506 180.384 264.646 429.889 Senior Secondary 9.162 68.345 91.137 141.089 Junior college and 2.889 6.200 16.110 45.709 above Illiterate 233.270 229.960 180.030 85.070 Total 474.602 840.141 972.031 1.153.671 Source: Perkins (2006) China’s Recent Economic Performance and Future Prospects (p.24)

It is very important for China (actually, for every country) to expand its stock of human capital. To see this, one must first recognize the effect human capital has on productivity . The first way in which human capital affects productivity is obvious: education raises the skills of those who attained it. Heckman (2005) cites Nelson and Phelps (1966) and Schultz (1975), who found that skilled workers are able to allocate resources more efficiently across tasks and response better to new opportunities and environments. These advantages that stem from human capital are still highly relevant today: the world economy is changing fast. Moreover, skilled workers can be moved across firms, industries, departments and regions when necessary. This increases productivity and efficiency. As Heckman states it:

... A more educated workforce is a more flexible workforce. More educated people are better able to absorb new ideas, adopt foreign technologies, improve local technologies, and understand and apply knowledge from outside China to local situations. Heckman (2005, p. 54)

51 The more China gets integrated into the world economy, the more new and improved technologies come at their disposal. This means that the demand for educated and skilled workers will increase over time. By standards of developed countries, China’s stock of educated people is still low. However, the benefits to education are not entirely private. The ability of educated workers to work with the latest technologies and to be able to allocate resources efficiently are spillovers that benefit the entire economy. These spillovers are not internalized in the decision of an individual to attain university or not. Here lies a responsibility for the government: to stimulate education.

Skilled and educated workers are also able to educate other, non-educated workers on the job. This causes the effect of human capital on productivity to be even larger. Skilled workers and unskilled workers complement each other. The same holds for capital and skilled workers. Investments in fixed assets and new technologies may be sky-high, they are only useful when there are skilled and educated workers in the country who can use these technologies and work with them. The government should thus balance the investments in fixed assets and human capital. Over- or underinvestment in one of the two will not maximize efficiency and productivity.

It is obvious that education in China should be stimulated. The only question now remaining is how this should be done. One possibility is the government subsidizing education, but this would heavily increase government expenditures which is not desirable. Another, more feasible, possibility is to free up labour markets for human capital. Heckman (2005) states that a free labour market creates the same private incentives as those on the capital and product markets in China. If persons receive a large return on their investment in education, they would be willing to pay the costs of schooling. Moreover, if educated workers earn substantially more than non-educated workers, not only will the number of educated people increase, but also the private savings are likely to increase, which is in turn positive for the capital formation in China. This could partly offset the problem of the increasing dependency ratio in China I have discussed in sub-section 3.2.1.

3.2.3. Exports

A large part of China’s immense growth over the past decades stems from its huge amounts of exports . According to Perkins (2006), China’s exports exceeded a total of US $100 billion for the first time in 1994 (total exports equalled US $121 billion that year), and ten years later total exports reached a total of US $593 billion, which means an average annual increase of 17 percent a year. In 2005, the growth rate of exports has been even larger, with exports rising by more than US $100 billion per year. China’s rapid GDP growth can be explained for a large part by this very large expansion in exports.

52 It does not seem likely that China can sustain these kinds of growth rates in the export sector for many more years to come. In his article, Perkins (2006) shows that an export growth rate of 17 percent per year would lead to an increase in exports of on average US $200 billion per year. China is thus a large competitive power on the world market, and it seems likely that other countries integrated in the world economy will soon come up with protectionist measures to stop China from flooding the world market with their products. China should therefore not keep relying on export demand to maintain its high GDP growth rate. Perkins states that it is likely that China’s currency, the Renminbi, will revaluate 27 within the coming two decades when it is allowed to float. According to him, this is almost inevitable, since this is also what happened in China’s neighbouring countries after they went through almost the same industrialization- and reform process as China is experiencing today. When the Renminbi revaluates, exports will slow down, and imports will increase. This could slow down aggregate demand, and at the same time, GDP growth. For the revaluation of a currency to have a negative impact on the trade balance of a country, the Marshall Lerner condition has to be met. This conditions says that a currency devaluation , which is a decrease in the value of a currency in relation to another currency, only has a positive impact on the trade balance of a country when the sum of the import elasticity and the export elasticity, in absolute terms, is greater than one. For a revaluation, the opposite holds. The above events will thus only happen when the sum of the import- and export elasticities, in absolute terms, is smaller than one. Empirically, it has been found that the Marshall Lerner condition only holds in the long term, because it takes time for consumers to change their consuming patterns.

It is not possible for the government to fill this entire gap in aggregate demand, because the government deficit would increase heavily. A possible way to fill this potential aggregate demand gap is by expanding private consumption . Since the savings rate is high in China, consumption should be promoted, for example through expanding consumer credit. Another way to fill the potential aggregate demand gap when exports slow down is an increase in private investments. China therefore has to create attractive investment opportunities and a stable financial system.

27 A revaluation of a currency means that the value of a currency rises in relation to another currency in a fixed exchange rate.

53 3.2.4. Conclusion

“What needs to be changed in the Chinese economy to be able to maintain high GDP growth rates?”

China has been regarded as the Asian miracle for two decades. In the past, the most important factor in explaining the high growth rates in China has been the large rates of capital formation, mainly made possible by large domestic savings. Also the stock of human capital has been increasing since the 1950’s.

Even though the stock of educated people has been growing in China, education still needs to be stimulated, because the number of educated people in China is still relatively small compared to developed countries’ standards. China needs more educated workers, since the spillover effects are large for the entire economy. If China wants to keep developing and get even more integrated into the world economy, it needs more highly educated workers that are able to use the technologies that will become available to China.

Domestic savings are declining due to an increasing dependency ratio, which will only accelerate in the future. This means that capital formation could slow down in the next decade. To prevent this from happening, investments that are being made should be efficiently, in order to keep capital formation at its current level, create high rates of return, and to be able to maintain high GDP growth rates in the future. The least efficient investments that are being made in China are state investments. This means that the government should privatize most investments. Moreover, a stable financial market should be created in order to create attractive investment opportunities. This is especially necessary since China cannot only rely on its export sector in the upcoming decades.

“Is it likely that China will be able to maintain very high GDP growth rates in the future?”

As may be obvious from this section on China, it is uncertain whether China will be able to maintain extremely high GDP growth rates in the upcoming decades. There are a lot of insecurities in China’s future, such as the savings rate, its dependency on its export sector, the relatively low number of educated people and the inefficient investments made by the relatively inefficient government. The Chinese government has to reform many aspects of its economy in order for China to keep reaching the same GDP growth rates as it has reached in the past. It remains questionable whether the Chinese government is ready to make these numerous changes in the near future.

54 Conclusion

As has become clear to me while reading books and articles regarding India and China, I have chosen two countries which both have not developed in a traditional way. India has almost completely skipped a stage in the traditional development process, namely industrialization. China can be regarded a miracle, incomparable to other countries. China has experienced extremely high growth rates for over two decades, and is highly integrated into the world economy with its GDP growth rates on the demand side almost completely relying on exports and imports, instead of domestic demand.

I found it very interesting to take a look into the history of both countries and to find out that the different economic and political choices they have made in the past still have large effects today. Moreover, these different choices could be regarded as the reason why India is still lagging behind China. The fact that China has so early decided to open up its economy has caused China to take the lead in economic development. While China already started to reform and get more integrated into the world economy in 1978, it took India until 1991 to finally shift its orientation towards the world economy. This meant that India had to catch up on a backlog of almost 15 years, which is still by far not completed today.

In the section on India’s future I have discussed some of the steps that have to be taken by the government to make sure that India is at least able to catch up with China in the future. The most important measure that has to be taken is the start of the industrialization process. While China has gone through this process a long time ago, and is now naturally ready for the next step; the development of its service sector, India has to start the entire process! This does not mean that India will never be able to catch up with China, because India has a major advantage in the service sector: their IT-sector is one of the best developed IT-sectors in the world, and India is the largest recipient of offshoring activities in the world. This brings us to the next step that has to be taken by the Indian government: it has to make sure that India will not lose its advantage in the IT-sector to China. This means that the Indian government has to keep reforming the educational system, while promoting and stimulating education with its citizens. When the Indian government is aware of the measures to be taken, and takes advantage of the latest technologies available today to develop its industrial sector, India will be able to reach high GDP growth rates and catch up with China eventually.

Naturally, to be able to start the industrialization process, many investments have to be made. For example, India desperately needs better infrastructure. There are, however, not only investments to be made in India, but there also need to be carried out some reforms in. First, the labour law should be changed. The fact that any firm that employs over 100 people needs to ask permission before it lays off workers, is not only inefficient, but it also imposes a large threshold for any firm that wants to enter the Indian market. Second, the sizeable fiscal deficit in India should be eliminated, because it virtually

55 absorbs all financially intermediated savings. Foreign savings are able to fill part of the gap, but this creates a large current account deficit, which implies macroeconomic instability. It is therefore necessary to bring down the fiscal deficit, since this is the only way in which savings can be invested in the industrial sector.

While there are numerous measures that have to be taken by the Indian government to accelerate GDP growth, the Chinese government has to take some measures to be able to maintain its GDP growth rate at the high level that it reached over the past years. This will, however, not be simple, if possible at all. As may be clear by now, GDP growth has been extremely high in China, and it remains questionable whether the country can keep growing at this pace for many more years to come. The steps that undoubtedly have to be taken by the Chinese government are, among other things, the stimulation of human capital, by freeing up the labour market to make sure that those who attain university benefit from it in the form of higher wages. Second, the government should privatize investments, because state investments have proven to have much lower rate of returns than private investments. Third, since the dependency ratio will increase in the future, and therefore domestic savings will decrease, the government should no longer rely on domestic savings for capital formation. Instead, the Chinese financial market should be opened up, and all state control should be abolished in order to attract even more foreign capital. Fourth, the Chinese economy should stop relying mainly on its exports when it wants to remain GDP growth high. It is questionable whether Chinese exports will keep growing at the same high pace as they are doing today, without any protectionist measures taken by other countries. The government should therefore stimulate domestic consumption, for example by expanding consumer credit.

All in all, the future of India and China remains uncertain. Obviously, this holds for all globalized economies in the world, but I believe this is especially the case for China and India, where so many measures have to be taken to make sure that their economies will not stagnate.

This conclusion answers the main question I formulated in the introduction:

“India and China have responded in different ways to the globalization process. How are these different choices responsible for the fact that India lags behind China, and will India ever be able to bridge the gap?”

It is obvious that the different choices from the past have mainly caused China to be the leader in economic development. China opened up to the world very early, while India only started this process in 1991. Moreover, when India finally opened up, it chose not to industrialize, but to specialize in services, especially IT. Since the contribution of the IT- sector to GDP is moderate, this specialization has not caused India’s GDP growth to boom.

56 Whether India will ever be able to bridge the gap between them and China remains uncertain. To be able to start the process of closing the gap, the Indian government has to recognize that the country has to industrialize to reach higher growth rates. Moreover, the educational system of India needs to be modernized and reformed. This takes a lot of effort and investments, and again an orientation shift of the government. Whether this will happen in the near future has to be seen.

57 Appendix

Explanations and formulas of the seven measures of income inequality mentioned in section 1.2.1. in chapter 1. These explanations and formulas are taken from Sala-i-Martin (2002) The Disturbing “Rise” of Global Income Inequality . I want to stress that I have not re-calculated these formulas myself. I only add them for the sake of completeness.

1. The variance of log-incomes

If we have a set of m countries, the variance of the log of individual income is given by:

m Nit 2 ∑∑ (ln yijt − µt ) i=1j = 1 var(ln yijt ) = Nt

Where yijt is the level of income for a person j in country i at time t, and N t is the world population (equal to the sum of country populations, N it ).

Sala-i-Martin uses survey data to estimate income shares, which are denoted by σ ikt . The index k stand for the individual quintile, the index i stands for each individual country and the index t stand for each year. With these income shares, he approximates the within country distribution by dividing each country’s population in five groups and assigning them a different level of income. Let N it be the population in country i at time t, and let

yit be the income per capita for country i at time t. He now assigns to each fifth of the N population it the income level 5σ y . This means that within each quintile, the 5 ikt it population is assumed to have the same level of income. With these income shares, the world variance of individual log-income can be calculated:

2 m 5  m 5  N it 2 N it var(ln yit ) = ∑ ∑[]ln( 5σ ikt yit ) −  ∑ ∑ ln( 5σ ikt yit ) i=1 5N t k =1 i = 1 5N t k =1 

58 2. The Atkinson Index

Atkinson created an inequality measure which relates the ‘equally distributed equivalent level of income’ to the actual mean income. The Atkinson measure depends on society’s degree of ‘inequality aversion’.

1 1  1−ε 1−ε  1−ε 1−ε M Nit   m 5    1  yijt    1 Nit  5σ ikt yit   Aε = 1− ∑∑ = 1− ∑ ∑  N  −    N 5  −   t i=1j = 1 y t i=1 k =1 y   t     t  

− m Nit m 1 Nit Where y t = ∑∑yijt = ∑ yit is the world average per capita income and ε is Nt i=1j = 1i = 1 N t the coefficient of relative inequality aversion.

3. The Generalized Entropy Indexes

I already discussed two inequality measures that are included in Sala-i-Martin’s 2002 research paper. In this paper, he suggests that there are some principles that are desirable for a good inequality measure. He cites four principles introduced by Cowell (1995).

The first principle is the ‘Pigou-Dalton Transfer Principle’ by Dalton (1920) and Pigou (1952), cited in Sala-i-Martin 2004, pp. 22. This principle states that a qualified inequality measure should rise in response to a redistribution from a poor to a rich person whenever the mean remains the same. The most popular inequality measures, like Gini, Generalized Entropy Class and the Atkinson class satisfy this principle. However, the variance of logarithms does not satisfy this first principle.

The second principle that has to be satisfied is the ‘Income Scale Independence Principle’ . This principle states that a qualified measure of inequality should be homogeneous of degree zero. That is, if all incomes in the world would be scaled by the same number, the chosen measure of inequality should not change. Most measures satisfy this principle.

The third principle is the ‘Principle of Population’. The intuition behind this principle is that the distribution of income in a country does not depend on the size of the population. As Dalton (1920) puts it: “if we measure inequality in an economy with N people and then

59 merge it with another identical economy, inequality in the larger economy should be the same.” (Cited in Sala-i-Martin 2004, p. 23.)

The final principle is the ‘Principle of Decomposability’. An ideal inequality measure should be able to decompose total inequality as the sum of inequality within groups and inequality across groups. The inequality within groups should be expressed as the average of the inequality of each individual group within a certain country.

Bourguignon (1979) as well as Shorrocks (1980) and Cowell (1995) show that the only inequality indexes that satisfy all the above principles are the Generalized Entropy Indexes (cited in Sala-i-Martin 2004, pp. 23-24).

 θ   θ  m Nij   m 5   1  1  yijt   1  1  5σ ikt yit   GEI (θ )t = ∑∑ −1 = ∑∑ −1 2  N  −   2  N  −   θ −θ t i=1j = 1 y θ −θ t i=1 k =1 y   t     t  

Where θ is a constant parameter. There are three special cases of GEI (θ) t namely when θ approaches 0,1 or 2. When θ 0,

 −  m Nit − m 5 1  yt  1 Nit GEI )0( t = ∑∑ln = ln y − ∑ ∑ ln( 5σ ikt yit ) N  y  t N 5 t i=1j = 1 ijt  t i = 1 k =1 This is the Mean Logarithmic Deviation (MLD),

When θ 1,

  m Nit m 5 − 1 yijt  yijt  N σ y GEI it ikt it y y )1( t = ∑∑ − ln  −  = ∑∑ − ln( 5σ ikt it ) − ln( t ) Nt i=1j = 1   i=1 k =1 N t yt  yt  y t This is Theil’s Index (T)

When θ 2,

2 2  m Nit −   m N 5 −  1 2 1 1  1 2  1 1  1 it 2  GEI )2( t = CV = ∑∑ yijt − y t = ∑ ∑ 5( σ ikt yit ) − y t − 2   − 2   2 2  N t i=1j = 1  2  N t i=1 5 k =1  y t y t This is equal to one-half times the square of the coefficient of variation.

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