India and China's Deepening Economic Engagement

Both India and China have seemingly emerged from the 2008 financial crisis with their high growth profiles largely intact. While there has been recent concern about domestic demand in China, and inflation and monetary tightening, the first quarter growth rate in China was 11.9 per cent.

Final quarter growth in India on an annual basis was 8.8%. The prospect remains for the global economy one of Asian led growth for the next several years. And it is one where, in relative terms given potentially negative growth in some European economies and flat to an anemic growth throughout the EU and only marginally better in North America, the gap between what were the low wage economies of Asia and the OECD narrows even more quickly than pre-crisis. Along with this growth differential will come major adjustments for the OECD economies as they seek to accommodate Asian growth in trade and outward FDI.

But not only is the Indo-Chinese-OECD gap narrowing, the economic closeness of India and China becomes ever more apparent. And this is despite the diplomatic distance which has characterized the relationship since the 1960s and even more recently. Following the Chinese military occupation of the plains of Assam at the time of the Cuban missile crisis and the Chinese break with the Soviet Union, relations deteriorated. In more recent decades this rift has been further complicated by Chinese closeness to Pakistan, reflecting in part the Chinese interest in deep-sea ports in Pakistan and the construction of roads through the Himalayas to Pakistan. Also, the suspicion in Indian circles of Chinese involvement in the development of Pakistan nuclear capability has been a further issue.

This diplomatic distance has in no way been eliminated overnight, but since the 1990s both India and China have each seemingly concluded that the overriding focus for all policy is the improvement of living standards broadly throughout the population, and this in turn implies achieving economic growth. Following the Cultural Revolution in 1976, Deng Xiao Peng had already begun the process of market-based reforms in agriculture with the adoption of the farmer incentive responsibility system as a departure from collectivization. In the early 1990s the adoption of a clear legal regime and incentives towards investment, manufacturing growth began to build and with it rapidly escalating inward foreign investment. GDP growth reached figures of 10 per cent annual growth year after year; export growth in some years touched 30 per cent, and between 1976 and 2008 real GDP/capita increased by a factor of eight.

India's growth story is a little different. Inheriting a regime of regulation and control from the British after the war, this regime grew and ossified to the point that up to the 1980s growth rates were poor. GDP growth sometimes touched 3 per cent, but GDP/capita growth remained stuck in a range of 1 to 1.5 per cent. Change was eventually to come in the late 1980s following a major balance of payments crisis. The government of the day embraced IMF conditionality, and extensive removal of regulation, privatization, and trade liberalization all followed swiftly. Growth slowly began to accelerate, albeit with some dips in the 1990s. Much of the growth occurred in service industries, accompanied by extensive outsourcing of labor intensive activities, such as teleconferencing from the OECD. Growth was driven heavily by the domestic market. Unlike in China, trade growth remained at around 10 per cent/year, and FDI inflows were small (they have recently turned up).

As a result, these economies have progressively integrated into the global economy, in both cases to the point that each is now viewed as an engine of sustained growth that can help the global recovery from the 2008 financial crisis. The extent of that integration in the Chinese case is little short of breathtaking. China's trade has increased by a factor of seven between 1995 and 2007, and FDI inflows to China now account for around 50% of all OECD FDI outflows.

But behind these data are even more remarkable figures on the depth of bilateral integration. India-China trade has grown by a factor of 33 between 1995 and 2007. And this has been at an accelerating rate. In the year before the financial crisis, Indian exports to China were growing at well over 40 per cent. China has now become India's largest country export market, although the whole of the EU still exceeds China. And China has become the fourth largest market for India. And at precrisis rates and growing rapidly, by around 2025, China-India trade will account for over 50 per cent of each other's trade if these rates continue. The financial crisis of 2008 impacted India-China trade negatively, as it did most trade, but this has since recovered.

And on the policy coordination front things are now moving apace. Both India and China have concluded bilateral trade pacts with ASEAN, which some believe could provide the basis for a trilateralized trade pact, and effectively a bilateral trade arrangement between India and China. Direct discussions of an India-China Free Trade Agreement are also underway. In international fora, such as the WTO, India and China now coordinate and support each other's positions. And in Copenhagen last fall in negotiations on the post-2012 post-Kyoto climate regime india and China agreed common positions in a five-year pact, and were jointly instrumental in achieving the outcome in the form of the Copenhagen Accords.

Economic closeness of an accelerating form thus now seems to be driving the India-China relationship, and it will be central to the global economy in the decades ahead.

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