CPA ISSUES FORUM MEMO:

India and China: An Advanced Technology Race and How the United States Should Respond 

                                                                                           prepared by Carolyn Avery, IASG Ltd., June 2, 2008

Speaker:

                   Earnest Preeg, Manufacturers Alliance/MAPI

The United States faces great challenges as technologically driven globalization with China and India is changing the global economic order. Yet we cannot devise an effective response unless we first understand the context, nature and likely evolution of these challenges.

I.     The Big Picture

    -    Both India and China have over 1 billion-strong populations.

    -    Both countries have annual growth rates of 8 to 11% for GDP and 25% for exports, mostly in manufactured goods and business services.

    -   Since 2000, R&D expenditures have increased by 19% per year in China and 11% in India, compared to 4% in the U.S., EU and Japan.

    -   China and India are actively engaged in military modernization, driven by deepening  integration between defense and high-tech civil industries.

    -    China is currently 5 to 10 years ahead of India in most respects, but India has the lead in some areas, and is closing the gap quickly in others, increasing competition for foreign direct investment and export markets in business services and manufacturing. Even though India has only attracted half the levels of foreign direct investment as China, indigenous multinational corporations have energized India's leap ahead of China in the pharmaceutical, automotive, and steel sectors (in terms of industry globalization). In the military arena, India is building its first aircraft  carrier, while China is still at the planning stage.

    -    In broader international terms, fundamental changes in the world economy and political order will be driven by China and India's entry into the ranks of the world's advanced technology superpowers. In terms of purchasing power parity GDP, China's economy in 2007 was half the size of the US economy, and the two countries are set to reach parity in 10 years. Meanwhile, last year India surpassed Germany, the world's fourth largest economy, and is on track to pass Japan--number three--in five to seven years.

    -    The world is no longer divided into East versus West and North versus South, but rather into four hegemons versus the rest of the world. The four advanced technology regions are North America, Western Europe, East Asia, and South Asia. Together they account for 70% of the global population, 80% of global GDP and exports, 90% of global military expenditures, and 95% of R&D. All of these figures are likely to increase even further in the next decade. 

    -    These changes present major challenges for the U.S. The immediate one is to restore U.S. export competitiveness, especially in the manufacturing sector. Another is to maintain U.S. leadership in technological innovation. A broader economic challenge is to reform the international finance and trading system and its institutions, starting with the now dysfunctional International Monetary Fund. There is also a growing threat to the U.S. military position in Asia as the region's three "blue-water" fleets increasingly interact. Finally the most important foreign policy challenge is to bridge the great political divide between the world's two largest democracies and the largest authoritarian state. There is no simple silver bullet policy response to any of these challenges.

II.     Two Central Questions

        1. What is the likely economic course ahead for India and China over the next two to five years?

    -    India and China have taken very different paths to high economic growth. India's growth has been balanced with healthy private sector involvement, while China has pursued excessively export-oriented growth with a much larger government role.

   -   The Indian government is moving slowly, unevenly, and with limited financial reserves. Private investment has bolstered India's growth, representing 33% of GDP last year. It is easy to underestimate progress, however, because the Indian government often moves forward by stealth more than by public proclamation. For example, in February 2006, the Indian government quietly passed legislation liberalizing its treatment of special economic zones (SEZs). Six months later, 400 applications had been submitted and 200 were approved. Opposition mobilized, protesters demonstrated, and the government responded by enacting a few changes, but the momentum continues.  In 2007, forty SEZs were in production with $10 billion in exports, and up to $25 billion in exports projected for this year. Another example is the deepening competition between the states to attract job-creating investment. On paper, the regulatory framework is not changing, but behind closed doors state governments negotiate with companies to make the application of regulations more investor-friendly.

    -    China provides much higher financial incentives to attract investment from high technology industries. However, two threatening clouds have emerged over the past couple of years, casting doubt over the results and direction of China's strategy. The first is the extraordinary surge in China's current account surplus. The second cloud is the new Chinese economic strategy of independent or "indigenous innovation" launched in January 2006 and intended to give a strong preference to Chinese firms over foreign invested ones for science and technology R&D investments. Such economic nationalism is a reversal of earlier policies that gave preference to foreign firms. It is unclear how fast and far the Chinese government will pursue this new policy, but foreign investors are already concerned and the USTR made several references to this change in its December 2007 annual report to the Congress. As a result, new investors looking at China might have doubts and look to set up their R&D operations elsewhere, such as India.

    -    IMPORTANT RECENT TRADE DEVELOPMENTS:

        1. China has surpassed the U.S. as the number one exporter of manufactured goods. In 2000, U.S. exports totaled $690 billion and were three times larger than those of China ($224 billion). Last year, China surged ahead to almost $1.2 trillion, versus $982 billion for the U.S.

        2. Meanwhile, China's trade surplus with the U.S. increased tenfold from $45 to $444 billion. The U.S. trade deficit in manufactures jumped from $324 billion in 2000, to $500 billion last year. A majority of China's growth and export sectors are now in advanced technology goods.

       3. China and India are intensely competing in business service exports, where India has tripled its share in three years, from roughly $20 billion in 2003 to $60 billion in 2006. China started with a slightly higher base, but has captured a lower share of the market--about $35 billion in 2006. India's trade balance in business services has surged to $27 billion, while China has a $5 billion deficit.

      4. Bilateral U.S. trade with India and China in the advanced technology products with the highest R&D content is growing. The U.S. has a $66.7 billion deficit with China in this category and a $7.4 billion surplus with India.

Answer to Question 1:

 It is highly likely that India will continue its 8 to 10 percent annual growth, while China is equally likely to experience a "hard landing" adjustment to more domestically oriented growth, including slower growth for at least a couple of years.

    -    The key assumption behind this first conclusion is that sometime over next few years China will have take strong action to revalue its currency in order to level off its current account surplus and centralbank purchases of foreign currency. Macroeconomic trends show that China’s current strategy iunsustainable:

      1. China’s current account balance amounted to 4% of Chinese GDP in 2002, rose to 9% in 2006, and reached 12% last year. No major trading nation has ever accumulated anything close to such surplus-to-GDP ratios in the history of the IMF. In contrast, India has a current account deficit equal to 2-3% of GDP that is more than offset by inflows of long-term investment.

       2. Domestic investment as a share of GDP grew from 25 to 34% in India from 2002 to 2007, versus 35% to 45% in China. The excessive Chinese figure suggests that investment is not leading to productivity-enhancing growth.

       3. India’s domestic savings represent around 30% of GDP, while China’s are approaching 60%. China’s high savings rate is a result of high investment. Last year, the Chinese central bank compoundedthe rate by investing 14% of Chinese savings abroad.

       4. Personal consumption as a share of GDP is 60% in India, versus 37% in China. The low Chinese figureis a reflection of the high savings rate. It will be difficult for China to transition to domestically oriented growth with such a small base. Per capita personal consumption in India is 80% that of China, despite the fact that the Chinese economy is more than twice as large as India’s.

    - The principal roadblocks to India’s development are poor infrastructure and education. China has an advantage over India in these two areas. However, India can address these issues and continue togrow incrementally, whereas China will have to undergo deep restructuring to overcome its problems: a dysfunctional banking system, lack of rule of law and property rights, environmental pollution, andcorruption, particularly at the provincial and local levels. The Chinese government’s major politicalproblem is that restructuring will have a disproportionately adverse impact on the manufacturing sectorin the coastal areas, where the country’s money and political power are concentrated. Unlike itspredecessors, the current Chinese administration is highly risk adverse and might not be willing to takethe bold steps that are needed to restructure without too great of an adverse impact on China’s upward growth trend.

2. What should be the U.S. Policy Response?

Answer to Question 2:

The response needs to be forceful and comprehensive. In the short to medium term, economic policy issues will dominate, including exchange rate policy, international trade and investment policies, and a corresponding domestic economic policy agenda. Over the longer term, foreign policy and national security issues will become more important, within fundamentally changed international political and economic orders.

- In the economic area, the U.S. should seek to reap the large and mutual gains from trade and crossborder investment in new technology applications. At the same time, the U.S. should balance thisobjective with the recognition that the economic policy framework in recent years has put U.S. exporters at a competitive disadvantage. The U.S. government needs to simultaneously move the trading system towards market-based, rather than government-manipulated, competition.

            1. Exchange rate policy is the most important issue that the U.S. government needs to resolve now. The IMF proscribes currency manipulation to gain an unfair competitive advantage, particularly through the protracted large-scale purchase of foreign exchange by central banks. China and other Asian countries are violating this rule and India is emerging as a potential currency manipulator. The U.S., EU, and Canada should press China and others to take definitive action to end this practice through a progressive reduction in the level of central bank purchases. If their request is met with resistance, the U.S. and other affected countries should bring their case to the WTO under article 15.

            2. Trade policy is currently mired in the Doha impasse and the proliferation of bilateral trade agreements. The U.S. should pursue a two-staged multilateral free trade agreement in nonagricultural goods. First, the U.S. should forge agreements across the Pacific with Japan and India before East Asian countries form a preferential agreement regional block that leaves out the U.S. Next, the U.S. should integrate its bilateral agreements into a multilateral trade agreement after concluding a free trade agreement with China.

            3. International investment policy faces the new issue of sovereign wealth funds (SWFs), which are a vehicle for the public sector to compete with the private sector. China is still a relatively small sovereign investor, but is likely to be number 1 within a few years. This year, Chinese foreign exchange holdings will reach $2 trillion; they are on track to pass $3 trillion by 2010. China is most likely to use SWFs for strategic rather than financial purposes. For example, a Chinese SWF could focus on acquiring high-tech companies. The U.S. should push for transparency as a first step. Substantive issues may require greater regulations.

            4. The domestic policy agenda should relate more closely to international trade competitiveness. In recent years our trading partners have taken many big steps to make their economies more investment friendly, meaning that the U.S. economy has become relatively less appealing. The main domestic issues the U.S. should focus on are education, public support for basic R&D in science and technology, corporate taxation, energy, and tort reform.

    -     The U.S. needs a greater sense of national purpose in responding to both the opportunities and challenges of this new brave advanced technology world. India and China believe that they are historically destined to build technologically advanced, internationally competitive, information-based economies. Their governments invoke this sense to justify difficult, controversial, and financially costly decisions. Meanwhile, neither political party in the U.S. has successfully articulated an American strategy and - decisions to strengthen our competitiveness languish. We need…change…in the way we formulate our national purpose.