Economist explains why India can never grow like China

This chart shows that while in the 1980s, the economies of China and India started out as roughly the same size. China soon left India behind, becoming approximately five times its size. However, now the Chinese economy is slowing and Western companies are looking to move their factories elsewhere. Could it be that it is now India's turn to replicate China's

grow

th miracle? That is the question that has been haunting both India and the world lately. However, to avoid cliché answers like that it needs to reduce corruption, further liberalize its economy or increase education and infrastructure. In this video, I turned to two of India's most eminent

economist

s, its central bank chief Professor Raghuram Rajan and Professor Davesh Kapur of Johns Hopkins University, and distilled their vast bodies of research into key insights on exactly one of the reasons why China's economy took off after the liberal reforms of the 1980s and 1990s.

While India did not. Why China's

grow

th path will

never

work for India. And finally, whether or not India can soon achieve its own growth miracle. And I'm happy to report that in your 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 own unique political structure, in which understaffed local governments often serve local interests rather than those of the public, a structure that means that while there are other growth models that India can follow, the country could not and

never

will grow like China.

But to see why this is the case, we must first answer why China overtook 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 turned first to the work of Professor Raghuram Rajan, who highlighted that as early as the late 1970s, Chinese workers had a better level of basic education than their Indian counterparts; A better level of basic education allows for two key elements. how China went from an agricultural society to the manufacturing powerhouse it is today. The first element is that, to boost economic growth, China began attracting many foreign factories in the 1980s and 1990s, factories that typically required at least a basic education of their workers so that they could follow simple instructions.

The second element is that a basic education, especially in accounting, allowed many of these workers to start their own companies, which propelled China's economy to the next level in the 2000s. But since in the late 1970s there were many countries with a better level of basic education in China, better education alone cannot explain why China was able to attract foreign factories and allow its workers to start their own factories. Well, India wasn't. In fact, as I mentioned in my video about China's economic miracle. In addition to being able to attract foreign factories to learn from, there are two other key ingredients that allowed China to transform its economy into the manufacturing superpower it is today.

The first, and most discussed, ingredient is that in the 1980s communist China liberalized its economy by allowing private entrepreneurs to found companies and allowing foreign companies to enter China. In my opinion, this was indeed a necessary condition for the Chinese economic miracle to occur. But since there are many more, liberalized economies alone cannot explain China's rapid growth. India is an excellent example of this. After China, India also carefully liberalized its socialist economy in the 1990s, and a more radical liberalization followed in 2000. But while India's economy certainly grew faster after these reforms, it never reached the numbers of China's double-digit growth.

Of course, then you could argue that India simply didn't liberalize enough, and that may be true, but China also remains a very restrictive place to do business today, scoring very similar points to India when we compare the two countries. , For example. For example, using the Index of Economic Freedom. Therefore, to explain this huge divergence between the two countries, I think we must talk about the second and third ingredients of the Chinese growth miracle that India could never replicate despite its best intentions. Well, the second key ingredient to China's growth miracle is that it followed what Peking University professor Michael Pettis calls the investment-led growth model.

This is the growth model that was at the center of miraculous growth in countries like the United States, Germany and Japan and was later adopted by China. Essentially, the idea of ​​investment-led growth is that in poor countries like China and India in the 1980s, they have a huge underinvestment problem while having 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 miraculous speed, a poor country simply needs to invest at miraculous speed in infrastructure and other productive assets. But where does that money come from?

You know, in a poor country, perhaps surprisingly to someone who is not an

economist

, lack of money, even in the poorest countries, is never the real problem. After all, in a fiat money system, local money is infinitely available, since a central bank can simply print whatever it wants and use that money to stimulate unemployed workers to act. However, because the central government of these huge countries alone cannot really hope to spend all that money productively to prevent inflation, they have essentially outsourced most of the money creation to commercial banks that create money like debt, that money that will not produce inflation and will not increase debt relative to GDP as long as it is used to grow the economy.

So, to ensure that Chinese banks invest in productive infrastructure and factories, China ordered its local and state banks to direct credit primarily to infrastructure and manufacturing. Other low interest rates. And while these state interventions may now explain why China has too much infrastructure and even too much manufacturing capacity, they worked extremely well when China was still a developing country. But what about India? Why didn't India try to follow the investment-led growth model and boost investments in factories and infrastructure? Well, it actually went well. It liberalized its business sector. It kept its banking system largely in state hands, like China and like China.

That banking system then launched into lending to well-connected business magnates. However, unlike China's successful businessmen, India's well-connected tycoons did not spend money productively, which meant that around 2013, as Chinese companies increasingly took over the world, Indian companies India were failing and heavily indebted to the banking system of a state that was on the brink of collapse. . Although I must say that since then India's investment has improved a lot. A recovery that was partially made possible by Professor Rajan himself, who, as head of India's central bank, helped clean up many of these bad debts. Much of the credit also goes to Modi, who since he came to power in 2014 has made many new investments in India's infrastructure.

But while India's investment and growth have not been bad, they have not been as miraculous as China's. Therefore, I think the time has come to review the third key ingredient of China's growth miracle: attracting foreign factories, also known as attracting foreign direct investment, or FDI for short. FDI gets its name from the fact that if you build a factory somewhere, you are investing directly there. As far as FDI is concerned, while China became the factory of the world, India simply failed to attract even the same amount of FDI. But why is it so important to attract FDI and why was China able to do it while India failed miserably?

To answer these questions, let's go back to India and China in the 1980s. They weren't just infrastructure and machines. They also lacked knowledge about the efficiency of factory operations. Knowledge that cannot be learned at school. Knowledge that, on the other hand, is accumulated by working in efficient factories. This is why attracting foreign factories to boost local knowledge was the third key ingredient for China's growth. Miracle. On top of that, while local money is theoretically infinite, as it can be created by local banks and central banks, foreign money, US dollars, is needed for crucial imports, such as, in China's case, machines.

German. Attracting foreign direct investment is therefore a key ingredient of most growth miracles, because it can be used to boost local knowledge and 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. He will see, because both the Chinese and Indian economies are decentralized systems on a large scale, I mean massive. It's really important to note that getting education, investment and FDI right is not really something that is determined from the top.

Local government needs to actually implement these changes, and to do so they need the right incentives. And if we look at how China's local governments work, we can see that they had the right incentives to stimulate both local investment and foreign direct investment. Firstly, the local governments were all part of the Chinese Communist Party, and would be promoted or demoted, not based on how similar they were to the local population or how loyal they were to the boss, but rather on how much they were able to grow their economy. local. Additionally, a large portion of local government revenue would be generated through land sales.

And since the value of land is appreciated when the appropriate infrastructure is built. If local governors wanted to advance their career in the party, one of their best options was to build infrastructure that would allow them to obtain more revenue and increase the GDP of their province or city. And that's okay, maybe we'll take off the top a little bit in the process too. Importantly, these incentives meant that local Chinese governors were really interested in making things as easy as possible for foreigners who wanted to invest in their city. For example, as Professor Rajan describes in this book, when an Indian businessman wanted to invest in a medium-sized city in China, the vice mayor met him at the airport, took him to visit a potential site that same day, and then immediately He was taken to the Mayor's office, where all the necessary paperwork had already been completed and any issues he raised could be dealt with by the local government.

Similarly, when Elon Musk came to China, he was able to get his Shanghai factory up and running in record time because local Shanghai government officials removed all legal obstacles for him. Compare this to India, where while the central government assured citizens that it was now a great destination for FDI, its local government often actively thwarted the arrival of foreign companies by strictly adhering to India's difficult regulations and making it pass. a lot of time sorting through them. In short, following Professor Rajan's ideas, China was able to initially surpass India 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 fuel its economic growth. Finally, it is not that India's central government was not aware that it needed to invest more and attract FDI. No, the deeper reason why India could not keep pace with China is that its local governments did not play along. While 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 fear it will become clear that dysfunctional local governments not only held India back in the past, but also mean that even today, India will never be able to grow as China. .

Well. To understand why India's local governments fail to unleash a Chinese-style miracle, let's turn nowto Professor Kapoor, who has identified the three most plausible explanations. The first explanation is really simple. Local governments in India are terribly understaffed, especially compared to China, which greatly increased its local government capacity during its growth. Miracle. In fact, if we look at this graph, we can see that the structure of India's government employee headcount is basically the opposite of that of China and the United States. While in the United States and China, the vast majority of government employees work at the local level and only a few at the state or federal level.

In India it is the other way around. Most Indian government employees work at the state level and, to a lesser extent, the federal level, while only a few work at the local level. This may explain why Indian local governments were unable to invest or assist foreign investors around regulations on the same scale as their Chinese counterparts did. But if the only problem was local capacity, then it could be solved by simply giving local governments more money to hire more people, right? Well, unfortunately, that probably won't completely fix the problem. You see, something really strange is happening with local governments in India despite high unemployment.

Many local governments have thousands of vacant positions open. Worse still, some of India's poorest local governments don't even spend all the money they receive from the central government. So what else is going on? Well, this brings us to Kapur's second explanation for why local governments are not living up to their potential here. India's infamous caste system, which divides people into a hierarchy of social categories based on their birth. But before we get into how we must point out that the caste system has effectively been banned. Yet despite that, in many parts of the country it remains largely a political reality.

The caste system can explain India's dysfunctional local governments in three different ways. First, realizing that the caste system was still strong at the local government level, India's founders deliberately made sure that local governments were not too powerful, which may explain why this graph has the appearance it has. Second, even if a local government has adequate capacity, it may not have the right incentives, meaning it may frustrate the implementation of well-intentioned central government policies because they are not in line with a caste system. As an example, Professor Kapoor mentions that quite a few federal educational programs in which schools were built to improve girls' education failed at the local level because, and I quote, what happens inside the classroom is affected by caste and gender norms. .

Third, in some extreme cases, the caste system even leads to government vacancies potentially being left open because they only have higher-cost candidates. For example, in their book The Narrow Order, Professor Acemoglu and Robinson describe how in Bihar, one of the poorest states in India, the state had thousands of vacancies for engineers that were not filled despite high unemployment. Why not? Well, because those qualified to be engineers tend to have higher costs. But since the reigning governor of the province, Lalu Prasad Yadav, belonged to a lower caste, he refused to take up these posts. Of course, as a consequence, everyone suffered because the government here was so severely understaffed that it couldn't even spend all the money allocated to it by the central government to improve the local infrastructure.

But okay, that's an extreme case that may not apply to all states, but it does apply to all, although it is the third reason why their local governments are not allowing business like their Chinese counterparts, and that is that India is a democracy. Now I want to emphasize that this in itself is not a problem. Sure, in China, the incentives of a rise in the party meant that local governments could ignore local concerns to build infrastructure and do everything they could to attract foreign companies. However, in well-functioning democracies, this need not be a problem, since there the democratic process itself could give local governors the incentive to invest in their cities and attract foreign companies.

After all, if you, as a local governor, grow your economy, then you will have a better chance of being re-elected again as a local governor. In fact, democracy has produced the vast majority of growth miracles, from West Germany to Italy, Japan and the United States. However, unlike these countries, Professor Kapur claims that India is a so-called early democracy, meaning that a country became democratic before it was perhaps ready to become so again. Professor Kapur discusses three reasons why this is holding back local governments in India. The first is that an early democracy can enter a vicious cycle in which it provides poor public services, such as schools and health care, at the same time.

But it is established as a consequence. The richest people will leave the public system and start using private schools and hospitals. And therefore, they are now less willing to pay taxes, making local government services even more dysfunctional. In fact, as Professor Kapur points out, local governments in India in particular seem very reluctant to raise their taxes, the taxes they need to improve their cities. But unfortunately there is more. The second reason why being an early democracy is holding India back is because India's very divided local government officials who were elected by their specific caste or religious group or, you know, any other interest group, tend to prefer to reward their voters by giving them subsidies. or other specific benefits, rather than investing in public services that can be enjoyed by all.

Finally, in early 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 hyper-modern subways rather than investing in improving the education system, the results of which will only be seen after a few years. Of course, this happens in any democracy, but even more so in early democracies, is what Professor Kapoor maintains. So on the surface, India did not grow as fast as China because it lacked basic education. They did not invest as much or attract as much FDI. But the deeper reason is that the local government in India did not have the capacity and adequate incentives to improve education, invest heavily and attract FDI due to lack of personnel and the wrong incentives provided by the caste system and being India an early democracy. necessarily.

Despite the many good intentions of the Modi government, all these causes of India's local government dysfunction remain and that is why I am confident in saying that India will never be able to grow like China, especially now that Modi, who became increasingly autocratic, In recent years, it lost its majority in parliament. So does that mean there is no hope of India ever catching up with China? No. I'm actually quite optimistic because there are still some reasons to be optimistic about the Indian economy. First, if we compare India to where it was in the 1980s, we will see that it may not have experienced miraculous growth.

People are now better educated and their infrastructure has received a major upgrade, especially digitally and financially. And as foreign companies increasingly look for an alternative to China, India is, in theory, very 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 local governments do not have the capacity or incentives to help foreign companies navigate its complicated rules. However, now that India has elected a more democratic coalition government, some have argued that this could mean Modi will now have to work more closely with local governments to push through reforms.

Closer cooperation in a divided nation will never put it in China's path, but it could put it in America's path. A large and divided nation that went through a slow and disorderly period. But what in the end turned out to be the most successful growth miracle of all time. Finally, perhaps most importantly, as Professor Kapur points out, is the successful implementation of various programs such as the opening of bank accounts, gas connections and toilets that connect to the sewage system. This shows that slowly but surely local government capabilities are improving. But yes, I don't expect a Chinese-style miracle anytime soon, but I remain optimistic about India's growth potential in the coming decades.

But yes, that is my opinion. Do you agree with me that India can never grow like China, but is now really well positioned for its own unique, messy, slower, but perhaps ultimately more successful growth miracle? Let me know below in the comments. Finally, given that primary education is typically the responsibility of local governments and that this capacity has increased recently, this could mean that this is where improvements will be felt and then, which could be huge, because having a basic level of education widely shared will provide More Indians access an unprecedented wealth of online materials, such as the unique lessons provided by today's sponsor video.

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