This graph shows that while in the 1980s China’s and India’s economies started out at roughly the same size, China soon left India in the dust, becoming roughly 5x its size. However, now, with China’s economy slowing down, and Western companies seeking to move their factories elsewhere,
could it be that it’s now India’s turn to replicate China’s growth miracle?
That is the question that has been keeping up both India and the world. However, to avoid cliché answers like, it needs to reduce corruption, liberalize its economy more, or increase education and infrastructure, in this video, I’ve turned to two of India’s most eminent economists: ex-central bank president professor Raghuran Rajan, and Johns Hopkins professor Devesh Kapur, and summarized their vast bodies of research into key insights about exactly: (1) why China’s economy took off after the liberal reforms of the 1980s and 1990s, while India’s did not; (2) why China’s growth path will never work for India, and finally, (3) whether or not India will soon be able to pull off its own growth miracle.
And, I’m happy to report that, in their research, I found some really surprising insights about how India’s real problem is not that it didn’t know what to do. But, rather that it failed to properly implement China’s strategy due to its unique political structure in which understaffed local governments often cater to local interests rather than to the public. A structure that means that while there are other growth models for India to follow, the country could not and still can never grow like China.
But, to see why that is the case, we first need to answer:
Why China outgrew India in the first place
In other words, what caused this massive divergence between India and China in the 1990s, and early 2000s? **
To answer that question, I first turned to the work of professor Raghuran Rajan, who has highlighted that, already in the late 1970s Chinese workers had a better level of basic education than their Indian counterparts. A better level of basic education enabled two key elements of how China transitioned from an agricultural society to the manufacturing powerhouse that it is today. The first element is that to supercharge economic growth, China started attracting a lot of foreign factories in the 1980s, and 90s. Factories that typically required at least a basic education from their workers so that they could follow simple instructions. The second element is that a basic education, especially in accounting, enabled a lot of these workers to then later start their own companies, which propelled China’s economy to the next level in the 2000s. But, given that there were plenty of countries with a better level of basic education than China in the late 1970s, better education alone cannot explain why China was able to attract foreign factories, and enable its workers to start their own, while India was not.
Indeed, as I discussed in my video about China’s economic miracle, besides being able to attract foreign factories to learn from them, there are two other key ingredients that allowed China to transform its economy into the manufacturing superpower that it is today. The first, and most often discussed, ingredient is that in the 1980s communist China liberalized it’s economy, both by allowing private entrepreneurs to start companies and by allowing foreign firms to come in.
In my opinion, this was indeed a necessary condition for the Chinese economic miracle to happen. But, given that there are plenty of more liberalized economies, it can not explain China’s rapid growth by itself. India is a prime example of that. Following China, India also carefully liberalized its socialist economy in the 1980s. This was then followed by more radical liberalization in the 1990s. But, while India’s economy certainly grew faster after these reforms, it never quite reached China’s double digit growth numbers.
Of course, you could then argue that India just didn’t liberalize enough. And that maybe true. But, China is also still a highly restrictive place to do business, scoring very similar points to India when we compare the two countries using the index for economic freedom.
Therefore, to explain this massive divergence between the two countries, we need to talk about the second and third ingredients of the Chinese growth miracle. Ingredients that India was never able to reproduce, despite the best intentions.
Okay, the second key ingredient of the Chinese growth miracle is that it followed what Peking University’s professor Michael Pettis calls the investment led-growth model. This is the growth model that was at the heart of miracle growth in countries like the United States, Germany, Japan, and then later adopted by China. Essentially, the idea of investment led growth is that poor countries, like China, and India, in the 1980s, have a huge underinvestment problem. While they have a population that could potentially be very productive, they are held back by a lack of infrastructure, knowledge and productive assets such as machinery. So, to grow at miracle level speed, a poor country simply needs to invest very, very rapidly in infrastructure and other productive assets.
But, where does that money come from in a poor country? Perhaps surprisingly for non-economists, a lack of money in even the poorest country is never the real problem. After all, in a fiat money system, local money is infinitely available since the central bank can just print as much as it likes and use that money to spur unemployed workers into action. However, because the central government of these massive countries alone cannot hope to spend all that money productively to prevent inflation, they have essentially outsourced most money creation to commercial banks, who create money as debt. Debt money that will not produce inflation and will not increase debt to GDP, as long as its used to grow the economy. So, to make sure that China’s banks invested in productive infrastructure and factories, China ordered its local and state owned banks to direct credit mostly to infrastructure & manufacturing, at low interest rates.
And, while these state interventions can now explain why China has too much infrastructure, and even too much factory capacity, it worked extremely well when China was still a very underdeveloped country.
But what about India? Why didn’t India try to follow the investment led growth model and supercharge investments in factories and infrastructure? Well, actually, it did. While it liberalized its corporate sector, it kept its banking system largely in the hands of the state, just like China. And, just like China, that banking system then went on a lending spree to well connected business tycoons. However, unlike China’s successful entrepreneurs, India’s well connected tycoons did not spend the money productively, which meant that around 2013, while China’s corporates increasingly conquered the world, India’s corporates were failing and heavily indebted to a state banking system that was close to collapse.
Although, I have to say that since then, India’s investment has gotten much better. A recovery that was partially made possible by professor Rajan himself, who, as head of India’s central bank, helped clean up a lot of these bad debts. A lot of credit also goes to Modi, who has, since coming to power in 2014, made a lot of new investments in India’s infrastructure. But, while Indian investment, and growth has not been bad, it has not been as miraculous as that of China.
Therefore, we need to revisit the third key ingredient of China’s growth miracle, attracting foreign factories, which is also known as attracting foreign direct investment, or FDI for short, which gets its name from that fact that if you build a factory somewhere you are directly investing there. When it comes to FDI, while China became the factory of the world, India simply failed to attract anywhere close to the same amount of FDI.
But, why is attracting FDI so important? And, why was China able to do it, while India failed?
To answer these questions, let’s go back to India and China in the 1980s. They were not just lacking infrastructure and machines. They were also lacking the knowledge about how efficient factories operate. Knowledge that you cannot learn in school. Knowledge that you instead accumulate by working in efficient factories. This is why attracting foreign factories to turbo charge local knowledge was the third key ingredient for China’s growth miracle. On top of that, while local money is in theory infinite, as it can be created by local banks and the central bank, foreign money, US Dollars, is needed for crucial imports, such as, in China’s case, German machines.
So, attracting FDI is a key ingredient of most growth miracles because it can be used to supercharge local knowledge and to obtain the US Dollars needed for crucial imports.
And, as we’ve discussed China’s basic education really helped create the right environment for FDI. But, according to professor Rajan there is actually a deeper difference between China and India, and that is how well their local governments function. You see, because both the Chinese and Indian economies are decentralized systems on a massive, I mean massive scale, it is really important to note that getting education, investment, and FDI right, is really is not something that is determined at the top. You need governments at the local level to actually implement these changes. And, for that they need the right incentives.
And, if we zoom into how China’s local governments work, we can see they had the right incentives to stimulate both local investment and FDI. First of all, local governors were all part of the Chinese Communist Party, and they would be promoted or demoted, not based on how well liked they were by the local population, or how loyal they were to the boss, but rather by how much they were able to grow their local economy. On top of that, a large part of local government revenue was to be generated through land sales. And, given that the value of land appreciates when the right infrastructure is built, if local governors wanted to further their career in the party, one of their best options was to build infrastructure, such that they could get more revenue, and increase the GDP of their province, or city, and, okay, maybe also skim some of the top in the process. Importantly these incentives meant that local Chinese governors were really keen to make things as easy as possible for foreigners that wanted to invest in their city.
For example, as professor Rajan describes in his book, when an Indian businessman wanted to invested in a middle sized city in China, he was met at the airport by the deputy major, taken to visit a possible site on the same day, and then immediately taken to the majors office where all the necessary paperwork had already been filled out and any problems he raised could be dealt with by the local government. Similarly, when Elon Musk came to China, he was able to have his Shanghai factory up and running in record time because local Shanghai government officials cleared all legal obstacles.
Contrast this to India, where while the central government assured citizens that it was a great destination for FDI, it’s local governments often actively frustrated the arrival of foreign firms by strictly upholding India’s difficult regulations and making it time-consuming to get around them.
In summary, following the insights from professor Rajan, China was able to outgrow India initially because it had a better level of education. And, while both countries liberalized their economies, only China was able to successfully invest on a colossal scale, and attract enough foreign direct investment to supercharge its economic growth. Finally, it’s not that India’s central government was not aware that it needed to invest more and attract FDI. No, the deeper reason why India was not able to keep up with China, is that it’s local governments did not play along, whereas in China local governors had the right incentives to promote both local investment and FDI.
And, sadly, if we next turn to the work of professor Davesh Kapur, I’m afraid it will become clear that, not only did dysfunctional local governments hold India back in the past, they also mean that, even today,
India can never grow like China
Okay, to understand why India’s local governments are failing to unleash a China style miracle, let’s now turn to professor Kapur, who has identified the three most plausible explanations.
The first explanation is really straightforward, India’s local governments are terribly understaffed, especially when compared to China, which greatly increased its local government capacity during its growth miracle.
Indeed, if we look at this graph, we can see that the structure of India’s government employee count is basically the opposite of that of China and the US. Whereas in the US and China, by far most government employees work at the local level, and only some at the state and federal level, in India it is the other way around. Most of India’s government employees work at the state and to a lesser extend federal level, whereas only a few work at the local level.
This can explain why India’s local governments were not able to invest or help foreign investors around the rules on the same scale as their Chinese counterparts did.
But, if just local capacity was the only problem, then it could simply be solved by giving the local governments more money to hire more people, right? Well, sadly, that will likely not completely fix the problem.
You see, there is something really strange going on with India’s local governments. Despite high unemployment, many local governments have thousands of unfilled open positions. Even worse, some of India’s poorest local governments do not even spend all the money that they get from the Federal government.
So, what else is going on?
Well, this brings us to Kapur’s second explanation of why India’s local governments are not living up to their potential: India’s infamous caste system, which divides people into a hierarchy of social categories based on their birth.
But, before getting into how, we should note that the caste system has effectively been outlawed. However, despite that, in many parts of the country it is still very much a political reality.
The caste system can explain India’s dysfunctional local governments in three different ways. Firstly, realizing that the caste system was still strong at the local government level, India’s founders, on purpose, made sure that local governments were not too powerful, which can explain why this graph, looks the way that it does. Secondly, even if a local government has adequate capacity, they might not have the right incentives, meaning that they may frustrate the implementation of well-meant central policies because it is not in line with the caste system. As an example, professor Kapur mentions that quite a few Federal education programs, where schools were built to improve the education of girls, failed on the local level because
“what happens within the classroom is affected by (local) caste and gender norms.”
Thirdly, in some extreme cases, the caste system even leads to government vacancies intentionally being left open, because they only have candidates from higher castes. For example, in their book the Narrow Corridor, professors Acemoglu and Robinson describe how in one of India’s poorer states, Bihar, the state had thousands of vacancies for engineers that were not filled, despite high unemployment. Why not? Well, because those qualified to be engineers are typically from higher castes. But, because the province’s reigning governor, Lalu Prasad Yadav was from a lower caste he refused to fill these positions. Of course, as a consequence, everyone suffered because the government of Bahir was so severely understaffed that it could not even spend all the money it got allocated from the central government to upgrade local infrastructure.
But, okay that is an extreme case, which may not be applicable to all states. What is applicable to all of India though is the third reason why it’s local governors are not enabling businesses like their Chinese counterparts and that India is a democracy.
Now, I want to stress that, in itself, this is not problem. Sure, in China the incentive of a promotion in the party meant that local governors could override local concerns to build infrastructure and go out of their way to attract foreign firms. However, in well functioning democracies, this does not need to be a problem since there the democratic process itself could give local governors the incentive to invest in their cities and to attract foreign firms. After all, this grows an economy and a growing economy in turn would make it more likely that the local governor would be re-elected. Indeed, democracy has produced the vast majority of growth miracles ranging from West Germany, to Italy, to Japan, and the United States.
However, unlike these countries, professor Kapur claims that India is a so-called precocious democracy, meaning that the country became democratic, before it was perhaps ready for it. Again, professor Kapur discusses three reasons why this is holding India’s local governments back. The first is that a precocious democracy can get into a vicious cycle in which it delivers poor public services like schools and healthcare at the time that it is established. As a consequence, wealthier people exit the public system and start using private schools and hospitals instead. Therefore, they are now less willing to pay taxes, making local government services even more dysfunctional. Indeed, as professor Kapur notes, local governments in India in particular are very hesitant to raise the taxes they need to improve their cities.
But sadly, there’s more. The second reason why being a precocious democracy is holding India back is that, because India is so divided, local government officials, that were elected by their specific caste, or religious group, tend to prefer rewarding their voters by giving them subsidies or other specific benefits, rather than to invest in public services that can be enjoyed by all.
Finally, in precocious democracies, politicians will tend to emphasize public goods that are highly visible and relatively easy to provide. For example, they may prefer to invest in hypermodern metros, rather than in investing in improving the education system, of which the results will only be seen after a few years.
So, on the surface, India did not grow as fast as China because it lacked basic education, didn’t invest as much, and didn’t attract as much FDI.
But, the deeper reason is that India’s local governments did not have the capacity nor the right incentives to improve education, invest a lot and attract as much FDI due to lack of personal, and wrong incentives provided by the caste system, and India being a precocious democracy.
And sadly, despite a lot of good intentions by the Modi government, all of these causes of India’s local government disfunction are still in place.
This is why I am confident to say that India can never grow like China, especially not now that Modi, who became increasingly autocratic in recent years, lost his majority in parliament. So, does that mean there is no hope for India to ever catch up to China? No. I am actually quite optimistic because there are still a few
Reasons to be optimistic about India’s economy
First of all, if we compare India to the place it was in the 1980s, we will see that while it may not have gone through miracle growth, people are now better educated and its infrastructure has received a major upgrade, especially on the digital and financial side. And, given that foreign companies are increasingly looking for an alternative to China, India is in theory really well positioned to attract a lot of foreign direct investment now.
Of course, FDI in India has not yet been anything to write home about due to the fact that the local governments do not have the capacity and incentives to help foreign firms navigate its complicated rules. However, now that India elected a more democratic coalition government, some have argued that this could mean that Modi now has to work more closely together with local governments to push through reforms. Closer cooperation in a divided nation will never put India on the path of China. But, it could put it on the path of the United States, a big divided nation that went through a slow, messy, but, what in the end, turned out to be the most successful growth miracle of all time.
Finally, perhaps more importantly, as professor Kapur notes, a successful implementation of various programs such as opening bank accounts, gas connections, and toilets that connect to the sewage system demonstrates that slowly but surely local government capabilities are improving.
But, yeah, don’t expect a China style miracle any time soon. But, I am still quite optimistic about India’s potential to grow in the upcoming decades. But, yeah, that is my take, do you agree with me that India can never grow like China. But, that it is now actually well positioned for its own unique, messy, slower, but perhaps ultimately more successful growth miracle? Let me know in the comments.
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