Sunday, 30 July 2006

Time to stop obsessing with China and FDI

MIT professor says potential for disruption of reforms is high


New Delhi

Is China vulnerable to an East Asian kind of crisis? It could, given the combination of high financial inefficiency and declining productivity. That was the combination in East Asia, right before the financial crisis, says Yasheng Huang, professor at the MITs Sloan Institute of Management.

Huang, who co-authored the definitive paper "Can India overtake China" along with Harvard Business Schools Tarun Khanna, was in India to deliver lectures on "Policy framework and development strategies: India and China" organised by the Confederation of Indian Industry.

Improvement in Chinas financial sector has been very modest compared with the Indian reforms in the 1990s. "The potential for disruption is and remains high. Though whether or not there will be an actual crisis will depend on other things we cant foresee," he warned, speaking to DNA Money.

Huang, who has been a trenchant critic of the development model followed by China in the 1990s, had one message for India: dont be obsessed with China or foreign direct investment (FDI). Ascribing Chinas success to its world-class infrastructure or its huge FDI inflows is an incorrect, misleading and harmful way of understanding the Chinese phenomenon, was Huangs simple point. "India is achieving 8% growth with 50% of Chinas investments and 10% of its FDI. To me this is a picture of more sustainable growth.

Chinas FDI inflows, Huang argues, reflect the systemic weaknesses in the economy. The financial system heavily supported the state-owned enterprises (SOEs) and actively discriminated against domestic private sector firms, which, then had no choice but to turn to foreign investors for equity capital.

A vibrant domestic private sector, Huang argues, can pull in high quality, technologically intensive FDI. Suppressing it, he warns, will bring in only low quality FDI, as it is in China. Huang questions the popular notion in India that FDI is needed to bring in technology. Korean firms, he points out, obtained technology by getting technical designs and information from the companies they supplied to, as also by exporting capital and acquiring firms in Silicon Valley and elsewhere. Much of Indian investments abroad too, he notes, are for acquiring technology, mentioning Ranbaxy as just one example.

Provinces like Zhejiang following an Indian growth model tend to get more technologically intensive FDI. They may have poor infrastructure but fairly liberal financial policies that support the domestic private sector. Zhejiang is home to a lot of the Indian IT firms. "India has the best of both worlds because it can get FDI as well as the benefits of domestic private sector growth."

Nor has Chinas growth to do with its huge infrastructure build up. The huge investments happened in the 1990s, his presentation showed, while the growth preceded it. China, in fact, may have over-invested in infrastructure, since the actual usage of expressways and some other hard infrastructure is very low. Not for him arguments that usage volumes will increase ten years down the line. "

Why? The volume is a function of growth and the growth is a function of education, health." Putting huge amounts of capital in physical infrastructure, will pull away resources from the health and education systems, which are equally, if not more, important for growth. Most business analysts underestimated India because they only looked at the lack of airports and hotels, he rued, ignoring its soft infrastructure. "Economic growth is a function of soft infrastructure, property rights and a relatively efficient financial system."

Though China is on a course correction of sorts, this, says Huang, is yet to show up in increased domestic consumption, another factor that economists like Morgan Stanleys Stephen Roach have identified as a factor behind Indias more sustainable growth. The government has started waiving rural education fees, reducing rural taxation. All this, Huang believes, will increase the consumption to GDP ratio over time.

Though attempts are being made to address the problem of lack of local entrepreneurship (which Huang and Khanna had identified as a major weakness in the Chinese growth model), Huang isnt sure the government is going about it in the right way.

"They think the lack of innovation is because of too much FDI. Its not because you have very liberal FDI policy. It is because you have very illiberal domestic investment policies." The government is beginning to look into the domestic business environment but not as drastically as Huang thinks they should.

India must invest in basic education'

Yasheng Huang says in the long run, the Indian growth story is far more sustainable than China's

India's economic growth has prompted many to suggest that it will eventually compete with the other Asian economic giant, China. The numbers of course tell another story. On most counts, foreign investment, infrastructure and sheer economic strength, China is way ahead. Yet, there are sceptics about China. One of them is Yasheng Huang, MIT Sloan Institute of Management professor, whose paper, Can India Overtake China, co-authored with Tarun Khanna, has become a must read on the India-China race. He thinks India's economic model has several positive aspects that Indians themselves tend to dismiss. In an interview, Huang tells Seetha where he thinks China has gone wrong and why India is a better bet.

The Indian development model is seen as more sustainable than the Chinese one. But India is now pursuing the Chinese pattern of export-led, FDI-driven growth.

Indians are enamoured of China when the Chinese themselves increasingly recognise the shortcomings of their development model. I am not criticising the Chinese model as a whole. I am criticising the 1990s model, which is more investment driven. The current central leadership is more concerned about the aftermath of the huge investment programmes, about social issues, of the crowding out effect of FDI. They are increasing investments in agriculture and rural areas. But they cannot change policies drastically, because a lot of them have strong local support base. Besides, it will take some time for the changes to filter through the system.

You have argued that it is not FDI that propels growth but growth that pulls in FDI.

Over the last decade in India, FDI increased but only very moderately, but the growth pick-up was substantial. It's incorrect to say that China's economic miracle was created by FDI. It was created in the 1980s by rural entrepreneurs and economic liberalisation. Worldwide, FDI has played a relatively insignificant role in economic development. Why do we expect large countries like China and India, with huge entrepreneurial bases and domestic markets, to depend so heavily on FDI as a way to grow? I'm not against FDI; I'm FDI neutral. I am also not for protectionism. But the obsession with FDI in China has created huge distortions in the economy, with foreign investors being favoured and domestic ones being discriminated against.

The conmon argument is that FDI provides technology. That is just patently not true. In China we are talking about FDI in textile factories, shoe factories, garment factories. India has the best of both worlds. It can get FDI as well as the benefits of domestic private sector growth. This is what makes the Indian growth story superior and far more sustainable.

You argue that China's infrastructure hasn't been responsible for its growth. But can a country grow if it has an infrastructure deficit?

I didn't say infrastructure is not important for growth. My point is that poor countries struggle without infrastructure and they do something else right that promoted growth. Once you have the growth, you have the resources to invest in infrastructure. A lot of the Indian obsession with China is with Shanghai, with high rises and skyscrapers. That is wrong. I distinguish between business necessary infrastructure like power and roads and business unnecessary infrastructure, like government buildings. Much of the perception of China in India is shaped by business unnecessary infrastructure.

You identify China's lack of democracy as a weakness. But India's democratic advantage is seen as being overestimated.

High quality democracy should not slow down decision-making excessively. If there are problems with political interest groups in the Indian system, the first thing to look at is the quality of democracy. I think democracy is used in India very often as an excuse for not getting things done. It could be a reflection of poor leadership. In a democracy you need leadership, management. Rather than saying it is the problem of democracy, let's ask: do we have the necessary leadership?

Indians lament that our politicians have only a five year vision, while China's policy makers have a longer term vision.

What if that long-term vision is wrong? There is no free lunch. In a democracy, just as in a one party system, you come with certain liabilities. But they are of different kinds. Indians must make up their minds about what kind of liabilities they like and don't like. Land seizures, corruption are big problems in China. And it's all because China doesn't have democracy.

Wage costs in are rising faster in China than in India while productivity is rising slower. Could that be another reason why India will overtake China?

That's a big factor. Whether India is actually going to overtake China or not depends on what China is going to do. They need to reform their financial system, their legal system.

And what does India need to do?

For India to transform itself from a poor struggling developing country into a middle income prosperous one, it needs to have broad success in the manufacturing industry - labour-intensive low-end industries. For that, it has to invest massively in basic education. It should do everything possible not to divert resources that would have gone to the social sector. Indians are so creative, they can think of clever ways of managing this trade-off between physical and social infrastructure. We should never lose sight of the fact that basic education should take priority over all these things.