1. EconomicLetter
vol. 3, no. 8
aUGUsT 2008
Insights from the
Federal reserve Bank oF dall as
China and India: Two Paths to Economic Power
by W. Michael Cox and Richard Alm
The two Asian giants have For decades, China and India plodded along under ideologies that fa-
achieved rapid and vored the visible hand of government over the invisible hand of markets. Their
sustained growth— economic systems stifled growth and left both countries poor. In 1980, real per
China by focusing capita income stood at $556 in China and $917 in India.
on goods, India by To jump-start their economies, China and India shifted strategies, let-
tilting toward services. ting private enterprise flourish and opening markets to trade and investment. The
new policies have led to rapid economic development. China’s real per capita in-
come has grown an average of 8.4 percent a year since 1995, climbing to $4,766.
India’s 5 percent average annual growth has raised per capita income to $2,534.1
Both China and India have unleashed pent-up economic energy, but
they’re not traveling the same development path. China has followed the tra-
ditional route, becoming a center for low-wage manufacturing and exporting

2. clothing, toys, electronics and other
goods. India has emphasized services, Table 1
using its large English-speaking labor
force for call centers, data-processing China’s Goods Output Soars
operations and the like.
Growth rates give China’s goods- 1978 1990 2006 Units (millions)
dominated strategy the better track Chemical fiber .3 1.7 20.7 tons
record so far. But India’s approach Cloth 11,030.0 18,880.0 59,855.0 meters
may pay off better longer term. A Paper 4.4 13.7 68.6 tons
look at per capita incomes around the Plastics .7 2.3 26.0 tons
world shows that the wealth of nations Electricity 256.6 621.2 2,865.7 1,000 kwh
Coal 618.0 1,080.0 2,373.0 tons
eventually depends more on services
Pig iron 34.8 62.4 412.5 tons
than industry. Steel 31.8 66.4 419.1 tons
Steel products 22.1 51.5 468.9 tons
On Different Paths Cement 65.2 209.7 1,236.8 tons
China’s strides in industrial pro- Plate glass 17.8 80.7 465.7 weight cases
duction have been phenomenal. Since Refrigerators 0 4.6 35.3 units
1978, when early reforms began loos- Room ACs 0 .2 68.5 units
Washing machines 0 6.6 35.6 units
ening communism’s yoke, the country
Color TVs 0 10.3 83.8 units
has made great leaps forward in pro- Motor vehicles .1 .5 7.3 units
ducing such inputs as cloth, electric- Microcomputers 0 .1 93.4 units
ity, steel and cement (Table 1). Gains Integrated circuits 30.4 108.4 33,575.0 units
have been just as impressive in such Mobile phones 0 0 480.1 units
finished products as air conditioners,
NOTE: In 1978, China produced 28,000 refrigerators, 200 ACs, 400 washing machines and 3,800 color TVs.
color televisions, microcomputers and
SOURCE: China Statistical Yearbook 2007.
mobile phones. The bulk of the pro-
duction increases have occurred since
1990, suggesting the Chinese economy
performed better as reforms took root
and spread.
This development path forged an
economy skewed toward producing Chart 1
goods, a broad category that encom- China Above Average in Goods,
passes manufacturing, construction India Above Average in Services
and agriculture. China’s goods output
as a share of gross domestic product
exceeds the average for nations at its GDP Percentage of GDP in goods
per capita 100 90 80 70 60 50 40 30 20 10 0
per capita income level by about 12 50,000
percentage points (Chart 1). 45,000 United States
The country lags the worldwide 40,000
Ireland
average in services as a share of GDP 35,000
Above average France
by the same amount. Other global cen- 30,000 in goods Greece
Above average
ters for low-wage manufacturing — for 25,000
South Korea in services
example, Malaysia and Thailand — also Portugal
20,000
depend heavily on goods. Some Chile
15,000
wealthier countries, among them South Malaysia
10,000 Panama
Korea and Ireland, are above average Thailand
China
5,000
in goods production as well. India
0
India hasn’t matched China’s 0 10 20 30 40 50 60 70 80 90 100
breakneck industrial buildup. For its Percentage of GDP in services
per capita income level, India lags the NOTES: Data for Australia, Iceland, Ireland, Japan, Nigeria, Serbia, Switzerland and the U.S. are for 2005. Data for the
global average of goods output as a remaining countries are for 2006. GDP per capita is in 2007 U.S. dollars, adjusted for purchasing power parity.
share of GDP by about 8 percentage SOURCES: World Bank, World Development Indicators database; Central Intelligence Agency, The World Factbook 2007.
points. It tilts toward services by an
EconomicLetter 2 F edera l re serve Bank oF dall as

3. equal amount. India shares an above-
average reliance on services with
dozens of wealthier nations. Panama, Chart 2
with its namesake canal, has carved Two Paths to the Same Goal—Economic Growth
out footholds in international trade
and banking. France, Greece and other
economies with thriving tourism indus- A. China Exports More of Its Goods…
tries — and the U.S., with its globalized Share of goods production exported (percent)
business services — also lean toward 70
services.
All told, 20 percentage points sep- 60 China
arate goods and services as a share of
GDP in the Chinese and Indian econ- 50
omies — a gap that confirms the two
40
countries are on different development
India
paths. Goods production includes
30
agriculture, a backward sector in both
China and India. Narrowing the focus 20
to manufacturing, however, reveals a
similar dichotomy, with factory output 10
accounting for 48 percent of GDP in
China but just 28 percent in India. 0
1982 1985 1988 1991 1994 1997 2000 2003 2006
Today’s rapid globalization has
been vital to the countries’ climb up
the income ladder. As they opened B. …While India Exports More of Its Services
their economies and began to grow, Share of services production exported (percent)
both saw trade boom and became 18
magnets for foreign investment.
China’s surging goods production laid 16
India
the foundation for a rapidly expanding 14
export sector, while India built up its
12
niche in the global services market.
China sold more than 60 percent 10
China
of its goods abroad in 2006, up from 8
just 12 percent in the early 1980s.
Its exports of goods relative to total 6
production are nearly double India’s 4
(Chart 2A). India passed China a
2
decade ago in the share of services
going overseas and in 2006 exported 0
1982 1985 1988 1991 1994 1997 2000 2003 2006
nearly 17 percent of its services, dou-
ble China’s share (Chart 2B). SOURCE: World Bank, World Development Indicators database.
Production and trade data tell a
consistent story: China tends to make
goods; India tends to sell services. Of percent export growth rate, compared South Korea, whose rapid ascent
course, the split isn’t clear-cut. with India’s 23.7 percent. began in the 1960s. Following some
As its economy took off, India Despite their different develop- variation of a free enterprise model,
made strides in goods production and ment paths, both countries have these countries prospered and nar-
trade. Its goods exports, for example, reaped the same reward: rapid and rowed their income gaps with the U.S.
grew 11.4 percent a year from 1996 sustained economic growth. Their (Chart 3).
to 2006—strong but less than China’s rapid progress evokes comparison to Today, sheer size gives greater
17.8 percent. At the same time, China Germany and Japan, which became weight to the economic miracles tak-
made headway selling services on economic miracles with their quick ing place in China and India. The two
global markets, posting a healthy 13.6 recoveries after World War II, and nations’ combined population of nearly
F ederal reserve Bank oF dall as 3 EconomicLetter

4. needs of foreign multinationals, Indian
Chart 3 companies offer services that include
computer programming, tax return
Fast Growing Economies Gain Ground processing, back-office numbers-
(GDP per capita) crunching, debt collection and cross-
border tutoring. One database of the
business-processing segment of India’s
2007 U.S. dollars
46,000 $45,123
offshoring industry lists more than 900
United States
$33,171 companies employing almost 575,000
32,000
$32,786
workers.4
$23,592 In addition to the homegrown
16,000 services companies, multinationals like
Germany Japan
Dell and IBM have established their
8,000 own operations in India. The coun-
South Korea
try’s major offshoring firms, for their
4,000
$4,766 part, have gone global, even setting
China up operations in China and the U.S.
$2,534 Although the tentacles of India’s service
2,000
providers stretch around the globe, the
India
chief export destinations are the U.S.,
1,000 Britain and the Middle East.
1950 1960 1970 1980 1990 2000
Industry experts extol India’s edge
NOTE: GDP per capita is adjusted for purchasing power parity and displayed in a log base 2 format. in delivering global services. Business
SOURCE: World Bank, World Development Indicators database. consultant A.T. Kearney put India at
the top of its 2007 Global Services
Location Index, based on such factors
2.5 billion is 10 times the 260 million many of them college graduates avail- as cost, worker skills and information
total of Germany, Japan and South able at a fraction of what they could technology infrastructure. Jones Lang
Korea. Never before has the world earn in the U.S. and other advanced LaSalle, another consultant, included
seen an economic development story economies. China’s labor force in- the Indian cities of Bangalore, Delhi
of such epic proportions. cludes larger numbers of educated and Chennai on its list of the 10 low-
workers, but the country has a ways to est-cost offshoring destinations.5
The Services Strategy go before matching India’s advantages India’s fastest-growing services
Japan and South Korea launched in language, cultural compatibility and exports are linked to offshoring. Busi-
their economic transformations by communications technology.2 ness services, which make up a quarter
using abundant, low-wage labor to India also had the blessing of of the country’s services exports, shot
establish manufacturing-for-export good timing. Services trade has surged up 107 percent in 2006 and 138 percent
industries. China has followed a similar in recent decades, providing new in 2007. Software services, two-fifths
path, becoming the world’s low-cost opportunities in the global market- of the services exports, rose about 33
producer of goods and a daunting place. Two factors are at work. First, percent each of the past two years.
competitor for global market share. the Internet and other technologies Financial services exports may be rela-
Japan and South Korea provided have made international communica- tively small, but they grew roughly 140
a road map for China, but India knew tions faster and cheaper, lowering percent in both 2006 and 2007.
it couldn’t go toe-to-toe with China in barriers to marketing and delivering These recent gains build on earlier
manufacturing. It had a better chance services over vast distances. Second, ones. In the past decade, India’s ser-
with services exports, which are often rising incomes have shifted consum- vices sales have risen from 18 percent
an afterthought in the early stages of ers’ spending from goods, boosting to 38 percent of all exports, topping
economic development. demand for services and making it an the 30 percent of the U.S., the largest
India possesses advantages that engine for economic growth.3 seller of services in the global mar-
bolster a services strategy. Two are Globalizing companies exploit ketplace (Chart 4).6 At the same time,
legacies of British rule: large numbers new technologies by moving services China’s services sales have fallen from
of English-speaking workers and famil- work to low-wage economies — an 13 percent to 8 percent of all exports,
iarity with the West. India also offers extension of domestic outsourcing confirming that sales have risen faster
an ample supply of educated workers, known as offshoring. To meet the for its goods than its services.
EconomicLetter 4 F edera l re serve Bank oF dall as

5. Chart 4
India’s Services Exports Up Sharply
Share of total exports (percent)
40
India
35
30
25
20
Japan and South Korea
15
China
provided a road map
10
5
for China, but India
0 knew it couldn’t go
1982 1985 1988 1991 1994 1997 2000 2003 2006
SOURCE: World Bank, World Development Indicators database. toe-to-toe with China
in manufacturing. It
India expects even greater suc- around the office, store and house.
cess selling its services in the future. In developing economies, many of had a better chance
The Federation of Indian Chambers of these domestic services involve low-
Commerce and Industry, the country’s productivity work, and they’re rarely with services exports.
largest business group, estimates ser- exported. By contrast, globally traded
vices exports will more than triple in services tend to be knowledge-inten-
the next five years, growing much fast- sive, requiring more-educated and
er than goods shipments and reaching productive workers.
more than 50 percent of total exports What India sells doesn’t match
in 2012. the sophisticated services exports of
A key insight by Eli Heckscher the U.S. and other advanced econo-
and Berlin Ohlin helps explain China’s mies. However, India’s exports are
relative strength in goods and India’s more likely to be at the top end of
in services. In the 1930s, the two its services hierarchy. In fact, export
economists refined David Ricardo’s success has allowed India to achieve
theory of comparative advantage and a high level of services productivity
showed that nations tend to export for a nation at its stage of economic
goods and services that intensely use development.
their abundant factors of production. A typical Indian services worker
China’s abundant factor has been generates over $25,000 a year in out-
low-wage workers, many of whom put — significantly more than Russia,
become factory hands. India’s abun- a country with four times the per
dant factor has been the relatively capita income (Chart 5). India more
well-educated, English-speaking labor than doubles the services productivity
that provides a low-cost gateway to of Indonesia, a country with similar
global services. per capita income. Average income is
The largest chunk of any coun- four times higher in Turkey and more
try’s services output meets its con- than twice as high in Mexico, two
sumers’ demand for such things as countries that eclipse India in services
transportation, recreation, and help productivity.
F ederal reserve Bank oF dall as 5 EconomicLetter

6. on the size of the government sector,
a measure that tracks public spending,
Chart 5
subsidies and tax rates (6C). China has
India Stands Out in Services Productivity greatly improved its rating on sound
money, a measure of the ability to
control inflation and access to foreign
Highest
Russia currency (6D).
Mexico
China and India still lag in some
Iran
Brazil areas. China has done little to reduce
Turkey the size of its government sector (6C).
Thailand
Colombia India has encountered difficulty ensur-
Ukraine ing access to sound money (6D).
GDP per capita
Egypt
China
Because both countries remain heav-
Indonesia ily bureaucratized, their governments
Philippines
India
impose heavy regulatory burdens on
Vietnam business and labor (6E).8 They’ve
Pakistan
Nigeria
failed to sustain progress toward
Bangladesh improving their legal systems and
Ethiopia guaranteeing property rights (6F).
Lowest 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000
Fraser isn’t alone in identifying
Output per worker
deficiencies in the Chinese and Indian
NOTES: Data are for 2007. Output is in U.S. dollars, adjusted for purchasing power parity. All the nations have per capita
income below $15,000. systems. The World Bank’s Doing
SOURCES: World Bank, World Development Indicators database; Central Intelligence Agency, The World Factbook 2007. Business survey shows substantial bur-
dens on starting a business—in time,
red tape and initial costs. Starting a
business, for example, takes 35 days
The Road Ahead provide an environment for the private in China and 33 days India, more than
China and India have taken dif- sector to conduct business efficiently, five times the United States’ six days.
ferent development paths, but each effectively and profitably.7 Compared with the U.S., the cost
moved ahead with a strategy that Fraser documents a strong posi- of start-up procedures is 106 times
made sense given its economic funda- tive relationship between economic higher in India and 12 times higher
mentals. China probably wouldn’t have freedom and per capita income. The in China, according to the Doing
grown as fast had it sought to become “most free” nations grow more rapidly Business survey. Enforcing contracts
a services powerhouse. It would have and achieve higher levels of per capita is particularly difficult in India, where
stumbled on language and cultural income. For China and India, the rapid the process typically takes three years.
barriers. Similarly, emphasizing goods growth of recent years has come as China and India rank in the
probably wouldn’t have worked well both countries have made significant bottom 10th of the 60 countries on
in India, especially if it meant compet- gains in economic freedom, reflect- the A.T. Kearney/Foreign Policy
ing with China for export markets. ing the broad shift away from closed, Globalization Index, suggesting
For both countries, the chal- state-dominated systems (Chart 6A). they still have a ways to go in inte-
lenge now centers on pushing the In addition to an overall score, grating into the world economy. The
development process further along Fraser ranks countries on five mea- two countries also fare badly on
and moving up to more sophisticated sures — freedom to trade internation- Transparency International’s assess-
goods and services, the domain of ally; size of government; access to ment of corruption.
the world’s richer nations. Competing sound money; legal structure and secu- It may seem petty to fault the two
in cutting-edge industries will require rity of property rights; and regulation major economic success stories of our
China and India to further improve of business and labor. time. More sophisticated economies,
business climates that in many ways When it comes to the freedom however, demand strengths that aren’t
aren’t up to the standards of the U.S. to trade, China has pulled even with critical to the catch-up phase of devel-
and other nations. the U.S. and India has narrowed the opment. These include higher levels
A useful gauge of business cli- gap (6B). Opening markets, of course, of innovation, entrepreneurship and
mates is the Fraser Institute’s Economic has been a key facet of the two Asian education.
Freedom of the World index, which giants’ development strategies. India Economic freedom enhances all
rates 141 countries on how well they now compares favorably with the U.S. three. An effective legal system pro-
EconomicLetter 6 F edera l re serve Bank oF dall as

7. tects the rewards for developing new
products and technologies. Start-up Chart 6
firms are often innovators, and high
cost and red tape hinder their forma- How China, India Rate on Economic Freedom
tion. Excess regulation saps incentives
to expand operations and create new A. Overall Index B. Freedom to Trade Internationally
and better jobs. These new employ- Most Most
ment opportunities motivate the next free
10
free
10
generation of workers to become bet- 9 9
ter educated.9 8
U.S.
8
U.S.
7 7
Works in Progress India
6 6
Economies advance as they shift China China India
5 5
from low-productivity agriculture to
4 4
higher-valued productive resources in
3 3
industry and services. China and India
2 2
are building viable alternatives to farm-
1 1
ing in low-end goods and services pro-
0 0
duction. But both maintain agriculture Least ’80 ’85 ’90 ’95 ’00 ’02 ’04 ’06 Least ’80 ’85 ’90 ’95 ’00 ’02 ’04 ’06
sectors that are larger than other coun- free free
tries with similar per capita incomes, a
sign they still have far to go. C. Size of Government D. Sound Money
About 45 percent of China’s work- Most Most
free free
force remains in the countryside; 30 10 10 U.S.
percent is in services and 25 percent 9 9
China
in industry. Seventy percent of India’s 8 U.S. 8
workers are still on the farm, leav- 7 7
ing services at 20 percent of the labor 6 India 6 India
force and industry at 10 percent. 5 5
Labor migrating from rural areas 4 China 4
can usually go to work doing the rote 3 3
tasks of factories, so industry often 2 2
takes the lead in economic develop- 1 1
ment. This may provide a growth 0 0
spurt, but research shows industry Least ’80 ’85 ’90 ’95 ’00 ’02 ’04 ’06 Least ’80 ’85 ’90 ’95 ’00 ’02 ’04 ’06
free free
eventually bumps up against a ceiling
at about 30 percent of the labor force
and a per capita income of $20,000. E. Regulation of Business, Labor F. Legal System, Property Rights
Beyond these levels, further Most Most
free free
expansion of goods production doesn’t 10 10
U.S.
raise income, and economic prog- 9 9
U.S.
ress comes from increasing services’ 8 8
share of the economy. Countries with 7 7
the highest per capita income tend India India
6 6
to concentrate employment and pro- 5 5
China
duction in services. Four-fifths of the 4 China 4
U.S. economy, for example, is in this 3 3
sprawling sector. 2 2
This broad view of economic 1 1
progress provides a framework for 0 0
assessing the development strategies of Least ’80 ’85 ’90 ’95 ’00 ’02 ’04 ’06 Least ’80 ’85 ’90 ’95 ’00 ’02 ’04 ’06
free free
China and India. With its tilt towards
goods, China grew faster over the past SOURCE: Fraser Institute, forthcoming.
two decades, using its cheap labor to
F ederal reserve Bank oF dall as 7 EconomicLetter

8. EconomicLetter is published monthly
by the Federal Reserve Bank of Dallas. The views
expressed are those of the authors and should not be
attributed to the Federal Reserve Bank of Dallas or the
good effect in developing industry. Notes Federal Reserve System.
Today, production costs are rising, The authors thank Robert Lawson of Auburn Articles may be reprinted on the condition that
with wages jumping 18 percent the University for providing the latest data on the source is credited and a copy is provided to the
first half of this year. Other countries— Research Department of the Federal Reserve Bank of
economic freedom indicators. Lawson is
Dallas.
Vietnam, for example—can feed coauthor of the Fraser Institute’s Economic Economic Letter is available free of charge
foreign markets more cheaply. At the Freedom of the World reports. by writing the Public Affairs Department, Federal
same time, high oil prices are pushing 1
Per capita income is in 2007 dollars, adjusted Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX
up shipping rates, which may crimp for purchasing power parity.
75265-5906; by fax at 214-922-5268; or by telephone
China’s exports as U.S. companies at 214-922-5254. This publication is available on the
2
India’s 3.3 percent of college graduates as Dallas Fed website, www.dallasfed.org.
shorten their supply lines. a share of the population exceeds China’s 2.3
India’s service industries have
percent. Both are well below the 30.3 percent of
offered few opportunities for poorly
the U.S. The size of their populations, however,
educated peasants, slowing the devel-
give China and India large numbers of college
opment process. Like China, India faces
graduates. Management consultants generally
rising costs that erode competitiveness.
rate the quality of India’s college graduates above
Wages are increasing particularly fast
China’s.
for well-educated workers, the lifeblood
of the offshoring industry. Indeed, a
3
See “Opportunity Knocks: Selling Our Service to
shortage of educated workers is one of the World,” by W. Michael Cox and Richard Alm,
the economy’s biggest problems. Federal Reserve Bank of Dallas Annual Report,
Over time, though, India’s strategy 2007.
may be more sustainable than China’s. 4
See www.bpoindia.org.
Exporting will help India raise its per 5
See A.T. Kearney at www.atkearney.com/
capita income as it develops world- shared_res/pdf/GSLI_2007.pdf and Jones Lang
class service providers, fosters a skilled LaSalle at www.joneslanglasalle.co.id/en-GB/
workforce and provides incentives for news/2004/160904OffshoringIndex.htm. Richard W. Fisher
President and Chief Executive Officer
education. India may fare better in a 6
U.S. services exports totaled $497 billion in
world of high transport costs because 2007, followed by Britain at $275.5 billion and Helen E. Holcomb
moving information on the Internet Germany at $210 billion. First Vice President and Chief Operating Officer
will remain cheap. 7
See Economic Freedom of the World: 2008
Harvey Rosenblum
China and India made great eco- Annual Report, forthcoming at www.freetheworld. Executive Vice President and Director of Research
nomic strides because low labor costs com/release.html.
improved their competitiveness on 8
The new Chinese employment contract law took W. Michael Cox
world markets. Today’s rising wages Senior Vice President and Chief Economist
effect in January 2008. Among its provisions are
and prices undermine their cost advan- 30-day notice of layoffs, new limits on dismissing Robert D. Hankins
tages, suggesting they can’t forever be Senior Vice President, Banking Supervision
long-term workers and mandatory severance pay.
the world’s low-cost producers. Nor
These recent changes aren’t captured in Fraser’s
should they want to be. Executive Editor
assessment of regulation of business and labor, W. Michael Cox
Both countries will remain
which applies to 2006.
relatively poor unless they shift their Editor
9
For more on the connection between economic
economies toward producing the Richard Alm
freedom and education, see “What D’Ya Know?
more sophisticated goods and services
associated with higher incomes. The Lifetime Learning in Pursuit of the American Associate Editor
Dream,” by W. Michael Cox and Richard Alm, Monica Reeves
assessments from Fraser, the World
Bank and others show that China and Federal Reserve Bank of Dallas Annual Report,
Graphic Designer
India remain works in progress, with 2004, Exhibit 3, p. 12. Ellah Piña
systems that would reap big rewards
from pressing forward on economic
freedom and globalization.
Cox is senior vice president and chief economist
of the Federal Reserve Bank of Dallas and Alm is Federal reserve Bank oF dallas
senior economics writer in the Bank’s Research 2200 n. Pearl st.
Department. dallas, tX 75201