Transcript

Washington, D.C., Thursday, December 14, 2006

Moderator:

Wanda S. Tseng, Deputy Director, Asia and Pacific Department, International Monetary Fund

Panel Presentations:

T.N. Srinivasan, Yale University (Presentation)
Minxin Pet, Senior Associate and Director, China Program, Carnegie Endowment for International Peace
Jahangir Aziz, Head, China Division, Asia and Pacific Department, International Monetary Fund (Presentation)

MS. TSENG: First, let me welcome you to the IMF's Book Forum on the launching of our two books to look at China and India and their expanding role in the global economy. As you all know, China and India have captured the world's attention recently, and these two economies are becoming major players in our increasingly globalized world. Indeed, it is really unprecedented that such two large economies accounting for more than half of the world's population have grown so rapidly in such a short period of time. This is already having a lot of impact in the world economy, be it in the demand for energy and natural resources, be it as a source for manufactured goods and business services, or as the sources and destinations for capital flows, so it is really a very exciting time for us to be working on India and China.

The books we are presenting today and which are available outside are, first, "China and India Learning from Each Other," and "India Goes Global." These two books represent the IMF's interest and work on these two very important economies.

Shortly after I took over as the head of the IMF's work on India after having worked in China for a number of years, we organized our first conference on India and China. In November 2003, in Delhi, we organized a conference and it stimulated really a lively discussion on the growth and reform experience of China and India, what they can learn from each other, and what lessons they offer for other countries. I think many of you joined us for the launching our first book, "China and India: The Recent Experience in Reforms."

Because of the intense interest, we took the China/India Conference to Nairobi, Kenya, in November 2004, where we shared a different model for growth and poverty reduction with many African countries. With so many interesting issues emerging, we followed this up with another India/China Conference in Beijing last October. And Mr. Dunaway who is here in the audience was instrumental in organizing that conference with the China Society for Finance and Banking, and the Stanford Center for International Development.

Selected papers from that conference formed one of the books that we are present in the China and India book. What is unique about this particular book is that many of the pieces written in this book are from policymakers and practitioners who have hands-on experience in advancing the forms in these two countries. I draw your attention in particular to the piece by Governor Zhou Xiaochuan of the People's Bank of China, China's Central Bank, where he spells out clearly the challenges facing China today on the excessive investment growth and the slow pace of consumption, the heavy reliance on manufacturing and the slow development of services, and the inequality of income distribution and its deterioration on recent years. And he also talks about what China needs to do to sustain its economic expansion and to achieve what the government calls a more harmonious society.

The second book, "India Goes Global," is the product of the most recent work by the IMF's staff team on India, and Catriona Purfield, one of the editors of that book, is in the audience so you can meet her later. It represents the close dialogue that we have had with the Indian authorities, with various think tanks there, and also with market participants. It also looks at the challenges that India faces to achieve rapid sustained growth and what the government there calls a more inclusive growth. In particular, we look at the divergent growth experience across India's states, trade and financial liberalization, banking reforms, fiscal consolidation and reforms, among other topics.

I think both books have a heavy emphasis on the IMF's current work agenda, focusing on financial sector issues and capital market developments, and on the regional and global implications of the emergence of these two great economies.

We are very honored to have with us two eminent guest speakers who both have deep expertise on India and China. Let me just say a few words about our guest speakers, who really need no introduction. First is Professor Srinivasan. He is the Samuel C. Park Jr. Professor of Economics at Yale University, and a Nonresident Senior Fellow at the Stanford Center for International Development. Many of you know that he has written extensively on economic reforms in India, international trade development, agricultural economics, and microeconomic theory.

We have also Dr. Pei Minxin. He is a Senior Associate and Director of the China Program at the Carnegie Endowment for International Peace. He has taught politics at Princeton University, and has written extensively on U.S./China relations, a very topical issue with Secretary Paulson's visit to China this week, and the development of democratic systems in China and Chinese speaker.

Our third speaker is my colleague, Dr. Jahangir Aziz. He is head of the China Division in the IMF's Asia and Pacific Department. He is also heading the IMF's work on Hong Kong SAR, and he has previously headed the work on Sri Lanka. Dr. Aziz has written extensively on many topics including in particular the determinants and dynamics of growth, and he is the editor of our China/India book, so you can also speak to him after this meeting.

Without further ado, let me proceed with our presentations. Professor Srinivasan will go first, followed by Dr. Pei, and then Mr. Aziz. I would like to ask the speakers to keep your presentations to 20 each, and this will allow us for some discussion of 15 to 20 minutes. Let's welcome Professor Srinivasan.

(Applause)

MR. SRINIVASAN: Thank you very much for inviting me to this book review forum. As you all know, India and China have been the flavors of the year for the last couple of years or so, and so this is one of the many India/China presentations at which I have had an opportunity to be present (View the presentation).

Given the limited amount of time, I am going to quickly go over a few issues but not all the relevant issues that a comparison of India with China and the sustainability of India's recent growth would warrant. As Wanda just mentioned, the emergence of China and India's rapidly growing economy since the 1980s has attracted attention all over the world from academics, policymakers, and the multilateral agencies. This is given, again, as Wanda mentioned, India and China not only have 50 percent of the world's population, but even a larger proportion of the world's poor, and the growth in my perspective is the sure and effective way of addressing poverty. So it is important that we understand what generated this growth and how it can be sustained.

The IMF alone has sponsored three conferences, there are more dealing with India and China. Those three volumes have been published this year, two that are being released today, and the third one on a sustainable fiscal policy in India which was a joint IMF effort and was published earlier this year. Those volumes cover the relevant issues comprehensively and exhaustively, so without attempting to deal with each one of them, I will focus on a few that I consider need urgent attention. I will engage in some comparison with China, for it is very instructive in highlighting the challenges facing India.

In thinking about Indian performance, we should not focus only on the recent years, but we should also have a much longer-term perspective in assessing what kind of a changes in the Indian economic and policy environments currently represent compared to the past. As most of you know, India had a number of state-controlled, state-directed, inward-oriented development strategy for nearly 30 years, from 1950 to 1980. In the 1980s the process of reform started, but the 1980s were characterized by piecemeal reforms trying to remove what were deemed to be irksome aspects of some of the controls, rather than rethink the whole economic management arrangement. So it was not systemic reforms of any kind, it was a piecemeal reform, removing microeconomic distortions somewhat, and a little bit of opening with respect to the external sector, but no major reforms.

But what was notable about the 1980s was fiscal profligacy. India for the first 30 years ago had macroeconomic policy stability which I used to characterize as stability of the graveyard. It kept inflation low, but it kept the growth rate low as well, so you had stability, but no growth of a significant kind. In the 1980s this fiscal -- was thrown to the winds and the government began expanding its fiscal deficits, not only for capital expenditure as one would expect, but even for current expenditures. In the Indian quaint terminology this is called a revenue deficit of the government. This is excess of current expenditures over current revenues, and that began occurring in the 1980s and began growing in the 1980s. This was financed by borrowing at home and abroad. External debt nearly quadrupled, and debt to private creditors between 1980 and 1990 grew elevenfold. What happened was that you had a classic Latin style debt led growth with fiscal profligacy, borrowing from aboard, but it delivered growth, I will come back to the numbers in the moment, growth accelerated, and of course, poverty as a consequence of growth acceleration went down as well. But this was not sustainable given as it was based borrowing at home and abroad.

So when the First Gulf War broke out and the oil prices hit the roof, the crisis came. The systemic reforms after the 1991 crisis went beyond the mere cosmetic reforms to satisfy the institutions from whom we had to borrow money, the IMF and the World Bank, and then after a while go back to business as usual. This is what India had done in a previous crisis in 1966, it liberalized the economy for a year or so, and at that time the World Bank reneged on his commitment to provide nonproject assistance to India. But anyway, that reform process did not last.

This time the reform was systemic and was not reversed. Why? There are two reasons, in my view. One, of course, is China. China had opened up the economy in 1978, the Chinese rapid growth after the opening was evident to Indians as well as anybody else. And India having fought and lost a war with China in 1962, being left behind by China forever is not a prospect that any Indian could visualize in a calm way, so it had to come.

The other is India's model for economic development, namely, the Soviet Union had collapsed ignominiously in 1991, so going back to business as usual was not longer an option for India and so reforms have to take place, and did. So the reform agenda had poverty alleviation and employment growth, fiscal consolidation and tax reform, industrial and financial sector reform, foreign trade and investment liberalization, including market determination of interest rates, subject of course to the heavy hand of intervention by the Reserve Bank of India, and the reform of infrastructure. So that is the background.

A quick comparison, China in PPP terms is the second-largest economy in the world, India is the fourth largest, and the share of world GDP and PPP, China, one-seventh, India, one-sixteenth, and so on. The per capita income in PPP terms in China is about twice as much as India.

From a longer-term perspective, this is very interesting, looking at Angus Maddison's work who is a brave economic historian who calculates PPP/GDP from year 0 on for every country in the world, but let's focus on China and India. In the first wave of globalization in the late-19th Century, India benefited and China did not. The Chinese economy grew very slowly between 1870 and 1913, whereas India's economy grew rapidly during that period. If you run the clock forward, in 1950 when India began planning for development and in China the communists had taken over, India had an advantage of 25 percent GDP per capita over China. The entire area Mao area until Deng Xioping and later was spent essentially in catching up with India. So all the divergence between India and China is post China's opening and not before. And of course, now China is far ahead.

Going back to the growth, the next table tells you that until the opening of the two economies, there was not that much difference in the growth rate between the two economies, and that growth rate was not particularly high. The infamous rate of growth for the 30 years is 3.75 percent, and China, 4.4, but that again is some overestimation that may be there. So all you change you see is in the post-opening period in the two economies.

The interesting thing is the last column. In the first half this fiscal year, India has been growing at 9.2 percent, compared to about 10.4 percent in China. This is important because if you take the last 3 or 4 years, India has been growing at the rate of 8 percent, China is about 10 percent, a 2 percent growth difference. China invests twice as India, so this indicates to you that Chinese investment is grossly inefficient compared to India's investment.

As growth began to pick up in India, poverty began to decline. Prior to that there was on decline in poverty. If you will start from the 1980s on until now, the poverty has been halved in India. This is for millions of people, and the same in China. So this is a major, major achievement.

In terms of global integration, again, China has gone much further. India merchandise export as a share of global exports is only .8 percent, and it is thirtieth, whereas China is number 3 at 6-1/2 percent, and India is going in the wrong direction. In services India does better, but still it has a long way to go, so for India this is a challenge. India is still is one of the most protected economies in the developing world, so you can see what its effects are from this table. As to long-term shares, also India has assiduously brought it down from 2.2 to .5 percent through the inventory-oriented development phase and it has slowly begun increasing.

The share of goods and GDP, in China, 64 percent, whereas India is only 28 percent now. Foreign capital flows, we know of the tariff barriers, as I mentioned, which tells you that 91 percent of the Indian tariff lines are higher than international peaks, so this gives you an idea of opening now.

Now I am going to talk about a number of challenges. Table 4 I will come to in a moment, given the problems I have going to and back. Fiscal diversity is a major challenge. India's fiscal diversity with the 1991 crisis was of the order of 9.4 percent of GDP. For the first 5 years after the reforms were initiated, there was some fiscal consolidated and the fiscal deficit came down, but after that, it has all gone haywire and it reached even higher than at the pre-crisis level in between. Now recently there has been a decline in the fiscal deficit, but even with the decline currently budgeted for this fiscal area is about 6-1/2 percent of GDP which is very high, and I will come back to that in a moment.

Education and health are major challenges in the Indian case, even though in terms of gross indicators like infant mortality which has come down one-third of the level that it was in 1950 and life expectancy doubled compared to 1950, those indicators are reasonably good. But if you think in terms of education concerning what proportion of the workers have a primary education, let alone a secondary education, that leaves a lot to be desired. So there is an attempt in the so-called inclusive growth that is being talked about in India to expand expenditure in education and health. But expenditure is only one-tenth of the story in my view.

The basic problem is changing the efficiency of delivery of health and education services, this is still in a disastrous setup for the primary and secondary education and primary health. If you take higher education, there was a recent ranking of the world's universities by "Times of London," and if you take the first 100 top universities in the world, I think there is one Indian university, one of the IITs, that feature in this and nothing else. If you go to the next 200, then there becomes three.

As to higher education, given India's disproportionate spending on higher education compared to primary education, the quality of delivery in terms of innovation, research and development, and training the engineers, half a million engineering students enter the engineering colleges as of now, but out of the graduates who turn out, not even 20 percent would be deemed by the software companies as fit to have the right skills to participate in that growing sector. So higher education is another major challenge of the Indian case.

As to structural transformation of the economy, here I want to mention two points. One is with both China and India, there is a demographic change. India's share of the population in the working age group is going to increase slightly over the next five decades, and the dependency ratio is going to come down. With China it is the other way. The working age population is going to do down and the dependency ratio is going to go up, with a prima facie potential demographic dividend which can sustain economic growth.

The other point is that with India and China to some extent, a significant proportion of the workforce, in India in the case of nearly two-thirds, is stuck in low-productivity, primary activities. The right policy framework would bring structural transformation of the economy, shifting of these workers away from low-productivity primary activity to high-productivity activity elsewhere in the secondary and tertiary sectors and would give additional movement. So in the Chinese case also, this part of it is quite significant even though the demographic part of it is not as favorable as India. India's demographic and this shift are both favorable, so these are the potential challenges in doing that.

If you look at in terms of industrial share in GDP, and the manufacturing share in GDP, in India it is very low and growing very slowly. Any dreams of using the growing service sector as a way of skipping manufacturing and shifting the massive number of workers in agriculture into high-productive activities is a pipedream. So India's challenge is the structural transformation of transforming the sector. As to the external sector, I have already mentioned the problems, India is one of the most closed economies in the developing world, and even in foreign investment we have sectoral caps and the mindset as not completely changed. The full convertibility of the rupee in 5 years has been recommended by the Tarapore Committee. I am for committing to the full convertibility of the rupee in 5 years as a credible, and these reforms are needed to make the convertibility successful. Otherwise, if you do not commit yourselves you will never do the reforms at the pace that is needed to do in the financial sector.

As for infrastructure, electricity is a disaster still, and it will take a whole session to describe what it is all about.

The emerging disparities in growth and distribution of food and so forth, there is all this talk about inclusive growth. India has always been talking about that. Since 1962, India's Planning Commission at that time under the leadership of the late Chandra Pant put together a program of 15 years development of minimum standards that are being provided to all the Indian population. The idea was that growth was not trickle-down, it was a pull-strategy, faster growth will pull people who are outside of the economic mainstream into the mainstream and enable them to climb out of poverty. That was the strategy. But the growth was not delivered and so that opportunity did not take place.

Now there is this nonsense about we are thinking about redistributing, and it is just nonsense. The only way to frontally address poverty is to raise the growth to double-digits and sustain them for a couple or three more decades. So distribution of growth, this again is natural. Imagine when you open up a closed economy, there are some people, some regions, some individuals, some households, some firms, who are capable or who are positioned in a way to take advantage of the opportunities and they will get ahead. So if the disparities did not widen, I would say reform is a failure rather than anything else, so the success is reform is seen in the fact that some regions and some individuals who saw the opportunity have taken hold of it and have gotten ahead. The question I have to ask is there an institutional mechanism to bring those who are lagging behind to catch up. That is the question that you should ask, not wring your hands about the increasing disparities. And that increase of wringing of hands in these institutions in Washington also goes on too much in my view about distribution rather than focusing on the real issues.

The other thing is rethinking of economic management. After all, the Indian Constitution was passed in 1950 and India's Planning Commission was instituted, this is an extraconstitutional body by resolution of the Cabinet in 1950. Planning has gone everywhere else into the dust bin of history. Even China does not call its program anywhere Eleventh Five-Year Plan, but India still continues with this nonsense. So a rethinking of the whole system of economic management from fiscal federalism to what I have proposed, to abolish the Planning Commission, to be reconstituted as the Fund for Public Investment, because that is what it is. It is focusing on doing the public investment more efficiently, and financing it more effectively. That is what they should be doing. So that is necessary.

As to the last point in this challenge story, Ken Rogoff who was the chief economist of this institution has been writing recently pointing out that the 1980s and 1990s globally had been a benign era. Imagine just after 2000 the shocks you had, you had the dot-com bubble, you had 9/11, you had the Iraq way, you have the U.S. recession and global recession, all these have been absorbed with the global economy with not as much as a ripple, so to speak, compared to what these shocks would have done. So you had a global economic chain, and interests in particular were low, inflation rates were low.

Was India's benefiting basically in recent growth, quite a large part of it is luck. This is like if Greenspan was very efficient or intelligent, or is it that he just was lucky? The same type of story, as India succeeded and China to some extent in the 1980s and 1990s, to what extent the benign global environment had to do with it. But the obvious side of the question is if it is not a major structural change in the global environment, it is a purely cyclical phenomenon, though the cycle has been for 20 years or so, if it rises, then the consequences would be serious. If it is a structural change that forever now that interest rates are going to be low forever and inflation rates are going to be low, that is one story. But if it was only temporarily low and it is going to reverse, India's luck will run out. So that is the major challenge, is India poised in a way to absorb a possible shift in the global environment adversely. I will not give you the table on fiscal deficits. It is a dismal story.

India is catching up with China on growth, India is a vibrant representative democracy unlike China. Whether China will be able to transform as successfully its polity has been successful in transforming its economy, away from the centralized state-directed economy is a very open question. India's judiciary is well functioning though slow, and the legal system is there and the laws are there. The financial system has improved rapidly. The transactions costs on the National Stock Exchange in Delhi is lower than the New York Stock Exchange, so equity markets have improved deeper, but there are no corporate bond markets. So there are major things to do in the financial sector area.

Indian enterprises are becoming global every day. You read in the newspaper of an Indian company trying to acquire a company somewhere else around the world, and this is again a strength. So India's open system, a free press, a vibrant democracy, both of which are absent in China, a legal system which for all its slow-cranking way is still an entrenched legal system independent of the executive, and so on. These are the strengths of India.

India's financial system is far stronger than China's, but there my concern is the public sector owns 75 percent of the assets of the banking system. This in my view is too large to have any credible way of market controlling the behavior of the banks, and so there I would urge more disinvestment of public assets in the banking system. But even given that, India's financial system is strong.

High fiscal deficits did not create a crisis in my view largely because of this global benign environment I talked about, the low interest rates, et cetera, that masked the otherwise pernicious effect of high fiscal deficits. I will stop there. Thank you.

(Applause)

MR. PEI: First I want to thank Wanda for inviting me to this session today. Before I start my presentation, I just want to make one observation about my own profession, and that is, I have been in this business for 15 years, and how well you do as a professional depends not on how good your personal qualifications are, but it really depends on how popular the subject you study is. So I am all for the popularity of China and India, because it increases my job security.

(Laughter)

MR. PEI: Because of the extensive and intensive interest in China and India, I have had the opportunity to visit India for the first time, so let me make some very brief comments on how I see these two countries in the next decade.

The two countries are very different, even though we often lump them together. The two countries have two different risk profiles. One country's problems are not necessarily those of the other country. The two countries face very different challenges in the decade ahead, but if I have to pick and choose, I would pick India as the country that is most likely to outperform China in the next decade or so, probably even longer, for the reasons I am going to outline today.

But this does not mean that China does not have great opportunities ahead. China still has very strong economic momentum for the short- to medium-term, and that means a 5- to 10-year timeframe. That is, its savings rate continues to be very high and will continue to drive investment growth, and China is reaping handsomely dividends from globalization. China, as the previous speaker has said, is far more deeply integrated into the global trading system than India. China is also gaining a lot more from the profusion of knowledge from the West. And so again for the next 10 years or so, China's demographic trend will remain quite favorable and the rural-urban migration will continue to provide abundant labor and drive domestic demand for consumption.

Then the last thing is this intangible, psychological effect on the Chinese people at large, because China and India according to recent surveys are among the most optimistic people surveyed by Pew. That is why if I think if you talk to the people in China, even ordinary people who are not necessarily sharing adequately the wealth of growth, they feel that China's moment in the sun has come and that if other countries can do it, China can do it. This optimism is a huge asset for the government. Of course, it can sometimes have the unintended effect of giving the government too much room to make bad mistakes.

Let me talk about the more unfavorable obstacles and why as a political scientist who is inclined to see politics as constraints on economic growth and good economic policy, I think that in India the political obstacles to good economic policy -- but compared to China, the obstacles in China are far more difficult.

I think that if you look at what the popular press is saying about China or scholars and experts are saying about China, one word jumps out, and that is imbalances. China is an economy and a society that is suffering from huge and growing imbalances. The first imbalance, obviously, is investment versus consumption. Within China if you look at the chart, investment is 42 percent of GDP, private consumption is below 40 percent. That kind of economy is not a health economy and of course, the Chinese government has recognized this problem. So the domestic demand growth and export growth are not equal. Export growth is much faster than demand growth, and that means there is a huge imbalance there. On this score, you are already seeing the international political response to this imbalance and that is why Secretary Paulson is in China today, because that means domestic imbalances in China are having global effects. China's trade tensions with its major partners are rising, and of course, given China's resource-intense growth model, China's demand for resources will also increase not just prices, but more importantly, geopolitical concerns around the world.

The third imbalance is one that is much less talked about, and that is what I call the growth in institutional reform imbalance. The China story is known primarily as a growth story, success in maintaining high-speed economic growth for three decades, but it is not really known as a success story for promoting and implementing institutional reforms.

The Chinese economic system may be dynamic only in the sense of producing good growth, but it is not a system that has commonly held up as a system that has very robust, effective institutions. Of course, the lagging institutional reforms have a very serious economic effect. If you measure inefficiency of the Chinese economy as a whole, the explanation is a relatively slow speed in institutional reforms, so the Chinese economy if it wants to move up to the next level of growth which is what I call quality-based growth, not speed-based growth, it has to tackle the deep institutional obstacles to growth.

Finally, a major imbalance in China today is the social imbalance, or what I call the social deficits in China. Very rapid growth in China has been achieved at enormous social cost to the environment, inequality, but I think is around the provision of public goods, in health and education. Some data are very shocking. For example, in China today you see a systematic desocialization of risks. Individuals are bearing more and more risks for their retirement, for their health, for their unemployment, and the state is focusing too much attention on building infrastructure, hardware, but underinvesting in health and education. That is why when you go to China you are always impressed by the buildings, the highways, and the airports. Of course, these things are needed, but as I will explain later on, the Chinese system is very good at delivering visible evidence of accomplishments, it is much less good at delivering less-visible accomplishments of good governance. What causes these imbalances? Obviously, misguided public policies are to blame. If you look at the fiscal policy in China, if you look at the health policy, the education policy, the environment policy, these policies are at least questionable judging by the results we have seen.

But I would look at the institutions because the theme of my presentation is this gap between growth and institutional reform. In particular, the governance system in China rewards short-term results, and as I said, favors evidence of what I call tangible accomplishments. Put yourselves in the position of a local mayor. What does he have to worry about? His time horizon is at most 3 to 4 years, because in year 5, he is up or out. In that kind of environment, you must make sure that you deliver evidence of your managerial ability within 3 years. You cannot expect to achieve visible success in 3 to 4 years if you invest in education and health, but you can have a really good shot at building impressive highways, office parks, and industrial parks, because when your superiors come down to inspect your work, you are going to take them to these places, and voila, that is your ticket to the next level. You are not going to chart out 1,500 well-fed, well-taken-care-of, well-educated kids for those officials to inspect. That kind of mentality and mindset and incentive structure really lies behind the underinvestment in public policy.

Another cause of social imbalance in China is the imbalance in political power distribution, because in order to make policymakers really accountable for the results of their policy, you have to make them pay for their mistakes. What is interesting is in China is that local officials essentially make a one-way bet. There are studies that show that they get promoted for promoting growth, but they do not get punished for making disastrous infrastructure mistakes. If you look at the official Chinese press, it is really amazing to see that local officials are punished for being corrupt, but they are not punished for making wrong-headed investment decisions. So the accountability system is not functioning well.

The real political challenge for China, and I here have to say that the Chinese government as a whole recognizes these imbalances, and Governor Zhou Xiaochuan's chapter in the book really spells out very clearly the challenges China faces. But my question as a political scientist is how can these imbalances be addressed really effectively without reforming the underlying governance structure that is the cause, again in my judgment, of these imbalances? Because today I do not believe that the Chinese government does not have the technical expertise for addressing these public policy issues. But the question again is, without reforming the underlying incentive structure and the accountability system, are you going to simply throw good money after bad money? And here I will make one final observation about what a good governance system ought to be.

Any governance systems has two subsystems. One is what I call a discounting mechanism where all government operates on discounts, good intentions from the top can be discounted to such an extent that at the bottom, at the grassroots level, it is nothing. In China today I think the discount rate is a good public policy, but once it goes through this bureaucracy it becomes severely diluted, so you have to lower down the discount rate.

Another subsystem is the amplification system, how bad policies made at the top will progressively be contained as they move down the implementation chain. Unfortunately, in China the with the amplification system, it goes in the opposite direction, bad policies tend to get very much amplified as they move down the system. So without lowering the discount rate and constraining the amplification of bad decisions, it is very hard for China to move ahead.

How does China really address these imbalances? I would say, based on my own observation, that these kinds of imbalances because they are accumulating quite slowly, they have to reach a so-called tipping point or they have to precipitate shock to the system. Shocks to the system in China have produced reforms in the past, and I believe that for the next round for the Chinese government to seriously deal with its imbalances, it must have a crisis on its hand because crisis focuses your mind, forces you to see into a very dangerous future, and it breaks up an otherwise stifling, stagnant political equilibrium. Thank you.

(Applause)

MR. AZIZ: Thank you, Wanda. Thank you, panelists. I will assign my welcome to Wanda's welcome for all of you to come for the session. (View the presentation)

I am going to talk about something that Professor Srinivasan talked about in the case of India and Dr. Pei touched upon the political angles of in the case of China, the big question, can China's rapid growth be sustained?

Let me begin by very quickly giving a brief summary of what happened in the last 20 years as far as China is concerned. China added about $2 trillion to the global GDP, it added 120 million people in new employment, and pulled around 300 million people out of poverty. These numbers have the usual margin of error, but regardless of that, these are very large numbers. To just give you a context of what these numbers mean, it is like adding a country the size of Portugal every year to the world economy, creating as many new jobs each year as Australia's total labor force, and eradicating poverty from Ethiopia, Nigeria, Tanzania, and Zambia combined. So the question is, can this expansion be sustained? I am going to touch upon three issues regarding that. One, what is driving recent growth? Are there any weaknesses in this growth process? And if there are, what needs to be done?

In recent years, growth in China has been above 10 percent, as Professor Srinivasan pointed out, and much of this growth is driven by very rapid investment and trade surpluses. As a share of GDP, which is the red line, investment has gone from around 37 percent to around 45 percent. The orange line, which is the net exports, has gone from around 3 percent to 6 percent. And against that, the blue line, which is consumption as a share of GDP, has fallen, as has the green line which is the share of government consumption of GDP. The argument that I am going to take over here is that the red line, the orange line, and blue line are somehow all connected.

In the absence of sufficiently fast consumption growth, and let me pause for a second over here and clarify something, that in absolute terms, consumption in China has been growing very rapidly. If you look at retail sales numbers, they have been growing over 10 percent since 2002. The problem is it has not been sufficiently fast to keep pace with the growth of GDP. In any other country, if retail growth was growing at around 10 percent in real terms for about 6 years, this would give sleepless nights to many central bankers. Instead, as Wanda pointed out, Governor Zhou is worried about the weakness in consumption.

The reason is clear, because investment has been at least 15 percentage points higher than the growth rate in consumption. Why should that be a problem? The problem is that the capacity that is created by investment in the absence of sufficient domestic demand through consumption is being absorbed by net exports which is the reason why the orange line which is the trade surplus is going up, past investment creates capacity, and the absence of sufficiently fast consumption growth leads to higher net exports.

To look at this problem in slightly more detail, let's pick a few industries where China exports a lot: steel. The blue line is the index of production. The blue line suggests that from 2000 to 2006, Chinese steel production tripled. China was a major net importer of steel until about 2003, and China turned into a net exporter of steel. In the electronics industry in China, there is a caricature of the electronics industry in China which is also used for caricaturing China's development process, and that is that China is essentially a very large assembly-line production. It imports raw materials, it imports parts from other countries, and uses its cheap labor to produce final goods. That probably was true in 2000 when the domestic content of electronics exports was around 50 percent. Today the domestic content is up to 75 percent. It is the same story with chemical fiber, and the same story with plastics.

Looking at the picture differently, this is a breakdown of China's trade surplus along different industry lines. Accept for the blue line which is the primary commodities, mostly oil, and the light-blue line which is machinery, all the other bars show a positive trade surplus from 2002 onwards, right up to October 2006. Importantly, the red line which was the basic materials where China was a net importer, in the last 1 year has turned into a net exporter.

The question is, why should one be worried about this growth process? It would not have been a problem if China were a small open economy. For a small open economy, they could have carried on for quite some time doing this. The problem is that China is no longer a small open economy. Today China is an economy in many markets where it is a price setter and where what it does makes a difference to the prices of these commodities.

What is the concern? The concern is that this process could be disrupted either due to falling prices in the overcapacity sectors, or there might be a limit to the export market growth. Professor Srinivasan talked about the benign external environment. China has had a very favorable external environment, as the world economy had been growing very fast over the last few years. The world economy is likely to slow down. The question is, can China keep on expanding its export markets without seeing a rise in protectionist pressures or more stiffer price competition from its competitors in a world economy which is not growing as fast as it used to be in the past few years?

These two things point to one thing that might happen, which is that they could lead to a potentially large number of new loan defaults on nonperforming loans. Apart from the fact that it is going to create an adverse banking sector, it also comes at a very unfortunate time. China has just completed or is almost to complete a very large recapitalization of the banking system. If this banking system is now faced with another spate of new nonperforming loans, then that is going to push back the reforms that took place over the last few years. This is where the concern is, and this also is the concern that is, for example, shared by Governor Zhou of People's Bank in his preface.

What needs to be done? The answer is that it needs to rebalance growth from investment and exports to consumption, but the issue is that this is much easier said than done. To see this, let's ask the question why is consumption low. Consumption is not only low, it has fallen, as you saw from the blue line in the previous charts. If you compare China's consumption to the consumption of other countries, something interesting comes out. Let's look at the first two columns, labor income and disposable income. If you look at labor income, China is not very low compared to the other countries, it is about 56 percent of GDP in its labor income. However, if you look at the other countries, the difference between labor income and disposable income is pretty large. Countries like the U.S. add almost about 17 percentage points to its labor income, and that is income coming from other sources. In China, that amount is only 4 percentage points of GDP, i.e., in China's households, almost all of its income comes from labor income and very little from investment income or other forms of transfers from the government.

In the other columns, what is interesting is to look at the last column. A lot of consumption goods, for example, health, education, et cetera, are provided by the government. In the case of the U.S., almost 10 percentage points of GDP is government provision of essentially private goods which is health and education, but in the case of China, it is only 3 percentage points. This is something that Dr. Pei was alluding, the fact that public provisioning has fallen in China. So even if one adjusts consumption for the publicly provided private goods, it is very, very low compared to the other countries.

The question is, why did consumption fall? One way to look at it is to ask the question why did household savings rise. Household savings rose between 1990 and 2005. As you can see from the chart, the savings rate of the head of the household which was around 15 to 20 percent across the board in 1990, has suddenly shot up to around 30 percent in 2005, and this as Mr. Dunaway would call it is the breaking of the rice bowl. The story is something which Dr. Pei alluded to, which is that until about the mid-1990s, much of public provision of health, education, and pensions, was being provided by the state-owned enterprises, and state-owned enterprises were therefore running at a loss. In the mid-1990s, China embarked on a large-scale reform of its SVs. The thing that was done was to remove these social responsibilities away from the SVs, and place them in the hands of the local governors. SVs got a very clean balance sheet, whose effect we will talk about a little later, but what it meant was that the local governments will have to provide for these resources. However, local governments were not provided with adequate resources, and, consequently, there is, as Dr. Pei again mentioned, the desocialization of risks. Individuals have started to take this risk on themselves, or, in other words, self-insure against uncertainties of pensions, health, and education. As we all know, once we start self-insuring, the amount of savings individuals do is always larger than if you pool risks socially. That is one aspect as to why consumption has fallen in China.

The other aspect, which is less discussed, is that household income at the same time has declined. Household income was around 70 percent not so far back in 1996, and now it is around 56 or 57 percent. If you look at the bars over there, a big drop takes place in the yellow bar which is investment income, the point I was trying to make earlier, that the gap between wage income and disposable income in other countries is much larger, and in China it is very small, and in addition, it has become even smaller. Previously, almost 6 to 7 percentage points of GDP, households would earn from investment income, now they earn barely anything, the reason being that investment income in the form of either interest rate or dividends that Chinese households would get from their equity holdings have fallen.

Let me move on to why we think that investment is high. One of the reasons investment is high is because profits are very high. In addition, retail profits are very high. Retail profits are high because very little, as we pointed out, is getting passed on to households. Consequently, and in addition to all of those things, input prices are low in China, input prices running the gamut of land prices, utility prices, water prices, et cetera, but particularly it is the cost of capital, and here I am measuring the cost of capital just by a 3-year effective real interest rate, and there are much better measures of costs of capital, but just to give you an indication, has been at least 6 to 7 percentage points below, so to speak, the average return one would get from investment which is the real GDP growth. Consequently, there is a fundamental reason as to why investment is taking place: it is very, very profitable.

What needs to be done? As we talked about, growth needs to be rebalanced, and as Dr. Pei pointed out, this is a central part of the government's reform agenda right now. But if we go back to the reasons which we have talked about as to why consumption is low and why investment is high, et cetera, the reform agenda is very large. First of all, one needs to reform the pension, education, and health care systems, one needs to reform banks and develop capital markets, shift public spending to social areas, get state-owned enterprises who do not pay dividends to the budget to pay dividends which actually could be used to finance additional spending on pension reforms or education and health care reforms. But all of these are time-consuming and very difficult reforms that require a lot of consensus to be built in.

There is also a need for pricing utilities and land, et cetera, to reflect market conditions. In that connection, we also think that increasing the price of capital is an important thing. Increasing the price of capital essentially would imply raising interest rates, for example, but the problem with raising interest rates in this environment is that if you raise interest rates, foreign capital is going to flow in which will require another round of increasing interest rates again. So the way out of this, and this brings us back to what we do for a living with the IMF, China needs a more rapid exchange rate appreciation. A more rapid exchange rate appreciation in the short-run would allow People's Bank, which is the Central Bank of China, that space required to raise the cost of capital, raise benchmarks and interest rates, raise the RISA (?) requirement, without fearing a massive inflow of capital. In the medium-run, a higher or a more appreciated exchange rate could provide, for lack of a better term, better price signals to investment. A lot of investment is taking place in the -- sector, both in the export sector, as well as in the -- solution sector, based on a view that the exchange rate may not appreciate very fast in the next few years. Providing -- singles will probably help to curb investment in these areas, and at the same time a more appreciated exchange rate will help to raise household purchasing power and therefore help imports.

In this connection, China did make a very important step in July last year by moving from a pegged exchange rate to a managed floating exchange rate. Since then, the Chinese renminbi has appreciated significantly, or quite a bit, against the dollar. However, with the dollar's weakness in real or -- effective terms, it is still quite low. So from our perspective, in the very short-run, this is an area that China would need to address in order to curb both its rapid investment growth and to rebalance its economy. Thank you.

(Applause)

MS. TSENG: Let me thank our three speakers for three really very interesting presentations. I would like to open this discussion up to the floor for any questions. I think we can take questions hopefully for 15 minutes or so. So please raise your hand, and when you ask a question, please identify yourselves, your affiliation, and please speak into the microphone.

MR. ABBAS: There is the perception that the growth in China is driven essentially by the process of imitation, imitating stuff that other countries produced and then producing it at lower cost, whereas the growth in India is driven more by innovation, the software industry and India's service sectors are very vibrant, and a more educated class. Is that pattern still there, and what is it looking like going forward?

MS. TSENG: Would you please identify your affiliation?

MR. ABBAS: Abbas, Africa Department, IMF.

MR. SVINIVASAN: To some extent, the perception that the Indian software industry is driven by innovation is exaggerated. Until recently, the Indian software growth came from expansion of the low-quality end of the spectrum. Only recently the really innovative aspects of the information technology is entering the Indian software scene. So I do not think if you take a longer-term perspective, a decade or more, you would call Indian growth driven by innovation.

In any case, the service sector, even though it has been growing very fast, is not the high-end modern component of the service sector per se that has been growing fast. The low end, so to speak, service sector trade, hotels and restaurants, if you go to the Indian GDP calculation, that has been growing at the rate of 13 percent or so. You might say that some of the Indian hotels now transformed from low compared to what they were 20 years ago, but that is imitation or that is adaptation of what was innovated elsewhere. So I would not call Indian growth that much as yet as innovation driven.

MR. AZIZ: Let me just add to what Professor Srinivasan said. A lot of these perceptions are also driven by very bad data. In 2005, China went and revised its GDP. If you take the situation just before 2005 and look at the share of manufacturing services, services was just about 20 percent of GDP, which is one of the reasons why this perception of India being the service center of the world and China being the factory of the world is sort of --

Just after one round of better, I will not say more comprehensive, but better surveys of what is happening to the economy, the services sector share rose by about 9 percentage points. So it is a perception, I think as Professor Srinivasan said, that both economies do as much R&D as the other person and they are both in their different stages of development, and as their development stage advances, more innovative- and R&D-based growth will be forthcoming.

QUESTION: I am a former staff here and I am teaching at SAIS University at Johns Hopkins. I want to ask the question with regard to one of the causes or factors that could stop the growth in China. Dr. Pei mentioned vaguely about the environmental issue, so I am wondering how much the environmental issue will impact on growth in the future.

MS. TSENG: Dr. Pei?

MR. PEI: I want to identify the mechanisms through which environmental decay actually affects economic growth. There are several costs you can clearly identify. One is that the cost of shortage of water in China. China is in the middle of a drought in Northern China, and then that will clearly push the prices up and that would mean divergence of some capital, and of course it will require money to treat. So you bring down the money otherwise you are developing investment in other projects.

But the health costs, and also you look at the potential impact on stability, because in some areas environmental degradation can precipitate political violence, riots, and so forth.

MR. SVINIVASAN: In the Indian case, it is a bit more complicated than that. At one level, the immediate or short-term growth could be compromised in some areas, the water degradation, water quality, local environmental pollution could be a problem. But the major environmental insult will have their deleterious effect coming up decades from now, so if you do a proper growth accounting and proper investment accounting that in the future, environmental costs would be counted in, but the way national accounts are put together all around the world, very few do very careful green accounting, so to speak, and so you do not see it immediately in the measured growth rates and also immediately as a threat to sustaining the growth rate. So we are borrowing from the future but not paying for it or not providing for paying for it by way of current activities and that is going to be significant in both countries.

Another way of thinking about it is are we substituting the nonenvironmental capital, physical capital, human capital, et cetera, to substitute for the borrowed investment capital, so that the investment in education, investment in physical capital is high enough, you may be able to substitute from the borrowing from the natural capital. That depends on how high the investment rate has to be.

Professor Kenneth Arrow at Stanford and his co-authors, including Partha Dasgupta, have precisely asked that question, is China's growth sustainable if you do a proper accounting of the environmental costs? Their answer is, given the current high rates of investment, assuming that they are correctly calculated, probably is, but India is a dicey question.

MR. WOOD: Barry Wood, Voice of America. Professor Pei, in the case of crises, you say that a crisis is required to address these imbalances, what do you think the most likely crisis is? And in the context of your statement that you thought India has a better shot over a longer period, that suggests a very rapid diminution of the Chinese growth rate to what?

MR. PEI: Let me address the second question first. I do not see rapid diminution of the Chinese growth rate. I think that the momentum is still strong enough to keep the growth rate going at least 7 to 8 percent. But China's problem is that maybe 10 years from now these accumulated risks will force it to grow at a lower rate, even lower than 7 percent. Of course, that is long-term forecasting nobody can trust.

As for crises, I would say the most likely is the one that my colleague identified, that this round of overinvestment in China will lead to overcapacity, and then when the business cycle experiences a downturn, you are going to have a massive problem of nonperforming loans and that triggers financial panic in China, and that can affect all kinds of people in China. So what will that do? Because China has already spent half a trillion dollars, depending how you count, recapitalizing its banks, and it has now a trillion dollars in foreign exchange reserve. The next round of banking crises if it takes place given the massive explosion of credit in China in the last 5 years probably will not be much smaller than a trillion dollars, so China probably is going to see its foreign exchange reserve, the largest in the world today, evaporate in the next round of banking crises. So that is one. I see that if reforms are not taken, it is just a matter of time.

The others, somebody who has a kidney problem but also heart disease and smokes and drinks all the time, and that kind of person, you just say, God knows what will happen.

(Laughter)

MR. SVINIVASAN: If I may add a word or two to what Professor Pei said, I am not a political scientist so you have to discount what I am saying somewhat, but it is not immediately obvious that the response of the political system to an emerging crisis would necessarily be in the way of addressing the deeper process of the crisis which Professor Pei mentioned. It could just as well become a more repressive regime than it is now. The kind of opening that China has in the political sphere that it has engaged in at the local level, introducing capitalist -- into the party and that kind of opening of the political system, one may response may be a clamp down. And also external adventurism, the probability of that could increase as well, and that could be response to a crisis rather than a response that will address the fundamental problems of generating the crisis. Not being a political scientist, I do not want to wager which is more likely in the Chinese case. But one thing I will say, with no free press, with no democracy, the safety valve India has in preventing a repressive political response of the sort that I am describing, China does not have. So to that extent, the repressive is more -- the reason that I am saying this, I ask this question about how the political system would respond, one of my good friends from China -- Linn (?) his response was that the government has enough means to address any riots or incipient responses of the system. That to me is the response of the old Anseear (?) regime, and so the Anseear regime may come back with full force.

MR. AZIZ: Let me add something to it. Someone once remarked that economists are pessimists because we predicted eight of the last three crises.

(Laughter)

MR. AZIZ: There is one factor which we are not giving enough credence to. The government actually is aware of these issues, they are actually taking reforms, and even though as economists you are always pessimists about these things, these reforms might actually work and China just may not have another crisis. I am -- that China will have a crisis.

MS. TSENG: Another question, please?

QUESTION: My question is on India. What is the risk that India's strong growth rate will cause complacency among India's policymakers with regard to further reforms? I am particularly interested in the financial sector particularly reforms there I think have stalled.

MR. SVINIVASAN: That underlies the last sentence of yours, that I agree that the financial sector reforms if not stalled are not progressing as fast as they should be. It is not due to complacency in a major way. It seems to me a misperception of why India was able to "escape" the financial crisis that the East Asian economies experience, the Indian common widespread belief is India had capital controls, India had the restrictions on capital movement, and that is what made India escape the crisis. This is a fundamental misunderstanding of what the Indian was.

What does that mean? That means the resistance to anything that will force the government to do the financial sector reforms in a faster way, namely, capital account convertibility. So if you announce or if you try to do capital account convertibility tomorrow without doing the financial sector reform, you will be in deep doo-doo. If you believe the capital controls -- which prevented you from escaping the crisis, this reinforces the notion that any attempt to open up the capital account should be delayed as far as possible or even prevented. So this mindset is not just in the lay public, it is held by some economists and academics as well in India, including some distinguished Indian economists in the United States, Jagdish Bhagwati, for example, has argued for a slowdown in the capital account convertibility. Though I have written lots of things with him, I have never understood why he took that view. So anyway, I agree with you.

MS. TSENG: I think I will take two more questions.

MR. CHOUDHURY: -- Choudhury, Elizabethtown College, Pennsylvania, if you do not know where it is. To Professor Srinivasan and also to maybe Dr. Aziz.

Professor Srinivasan, at one point in your slides you mentioned increasing disparity, if I understood you correctly or not, is a good sign or signal that the economy is making progress, and as a result of that, poverty has been diminished, but income inequality has increased. My point is that regional disparities or thinking in terms of employment or sectoral distribution of employment, could you please give me some data if you have that total employment creation -- sector significantly rising, but could it absorb some people taking out of agriculture or from manufacturing?

Second, I think I will just mention on one of his slides that China, the way it is growing, it is the size of Australia? Or it was a different context. You gave it some number, but then China also, regional disparity if you think the coast of China where the growth has been significant and rapid for the last 20 to 25 years, in terms of employment creation and regional disparities, could you shed some light on that, that is, implications in the short-term or the long-run in terms of sustaining the growth and spreading the fruits of growth?

MR. SVINIVASAN: It is difficult to put a very precise notion of what one means by employment creation. If you go by the statistics on unemployment rates in India, for example, if you take the national sample survey and they have various concepts of unemployment, the longer-term notion, the usual status notion, if you take the employment rate, it is at less than 3 percent, and it has been like that for decades. So if you measure simply the rising unemployment rate as an indicator for failure to create employment, that would show there has been no such failure.

The other way of looking at it is the way I tried to emphasize with my presentation. Are we shifting the work force in terms of concentration in low-productivity activities to high-productivity activities? That is the way I would like to see the employment question posed. There the answer is unmistakably that the development strategy until 1980 did not do that and now the recent development strategy including opening to the rest of the world has contributed toward this, but it has not done its full potential for two reasons. One, if you look at the labor-intensive manufactured exports of China and India, take textiles and apparel, even before the phase-out of the MFA on January 1, 2005, when it happened from 1995 in a phased way, China was able to move into the apparel items that moved out of the quota and capture markets both in the U.S. and Europe, India did not do so.

And if you go to any local supermarket you see small manufactured items from China, from brass locks, to small hammers, any number of items, toys, et cetera, all those sectors lags behind. Why? My own prejudice, if you will, is both the small-scale industries reservation and India's draconian labor laws. Those who claim that the labor laws have not had any effect, and there are some studies to that effect, they do not at all take into account that entry and exit of firms to an industry was very much dependent upon whether the labor regime is liberal or not. If you cannot get out easily, then you will fear to enter. So the dynamics of growth is vastly tilted in the wrong way by the Indian regime. So for this reason I think India has to go along with, one, in the direction of opening up substantially, get rid of all these small-scale industry's reservations, remove draconian labor laws. Again, China is instructive. When they opened up the Special Economic Zones, they said Special Economic Zones, 100 percent foreign investment is okay, firing and hiring of labor is okay, and so on, and provided a good infrastructure for the zones. We are opening up Special Economic Zones now without thinking through what do you need to do in these matters. The labor laws have been left to the states whether they want to do, may be more flexible, et cetera. So I think the entire framework for generating productive employment, increasing productivity and employment, is just not there yet in India.

MR. AZIZ: The regional disparity in China is pretty big and pretty wide, but the one thing that happens when you have very fast growing coastal regions, for example, is that input costs, labor costs, et cetera, starts rising there, and then what you see is a natural shift of industries away from the very congested costal regions into the interior regions. That is more or less what is taking place in China right now. So in the 1980s and the 1990s when Europe and the U.S. people were arguing about deindustrialization, Shanghai and Guangdong, et cetera, in the next few years will also say that they are being deindustralized. So that is a natural process in which development takes place, and I think as Professor Srinivasan mentioned, what is also true in China's case is that what you need is proper rules over institutions and infrastructure to allow this process to happen.

MS. TSENG: Since we are running out of time, may I suggest that we close now? We have some light refreshments outside, and if you have additional questions, perhaps you can try to ask them later. Let me ask you to thank our three speakers for their very interesting presentations.