Comparison Between India and China

June 2006
India and China: New Tigers of Asia, Part II
Chetan Ahya
JM Morgan Stanley Securities Private Limited
Chetan.Ahya@morganstanley.com
Andy Xie
Morgan Stanley Dean Witter Asia Limited
Andy.Xie@morganstanley.com
Stephen S. Roach
Morgan Stanley & Co. Incorporated
Stephen.Roach@morganstanley.com
Mihir Sheth
JM Morgan Stanley Securities Private Limited
Mihir.Sheth@morganstanley.com
Denise Yam
Morgan Stanley Dean Witter Asia Limited
Denise.Yam@morganstanley.com
June 2006
JM MORGAN STANLEY
MORGAN STANLEY RESEARCH
JM MORGAN STANLEY June 2006

India and China: New Tigers of Asia – Part II
Preface
This report is the second part of “India and China: New Tigers of Asia”. The first, published in July 2004, assessed the long-
term outlook for the two economies during a period of rapid globalization. We highlighted how the rise of India and China is
the most significant economic force in the world economy and their growing presence will continue to change the rules that
underpin the structure of global manufacturing and services output. In “New Tigers of Asia, Part II”, we focus on the
challenges the two economies now face to maintain their growth trajectories beyond the current boom.
Our longer term view on India and China has been reaffirmed over the past two years. The huge surplus in India’s and
China’s working-age populations has forced the world economy to recognize their roles in the global competitive dynamic.
Both markets are increasingly integral to the business strategies of multinational companies and are viewed as structural
drivers for global productivity and disinflation. By 2015, we forecast India’s GDP will cross the US$2 trillion mark while
China’s will surpass US$6 trillion, driven by the powerful combination of favorable demographics, structural reforms and
globalization. We expect the two economies to be the dominant secular growth stories for the next 30 years.
In the short to medium term, however, there will be challenges for both economies. Before these are addressed, we expect
some slowdown in the growth momentum. India and China are at a critical juncture where they need to reassess their
growth models and initiate difficult policy reforms for the current strong growth trend to be sustained. We see the greatest
challenge as the need to balance the economic contribution of investment and consumption. India requires an aggressive
investment and export thrust while cooling consumption; China needs to slow its investment and export drive in favor of
consumption.
Headwinds common to both economies include the need to reduce unemployment, poverty, and inequality and to improve
education. In addition, each country has a unique set of challenges: India has to strengthen its infrastructure, improve public
finances; reform its labor laws and augment its resources through higher FDI inflows and privatization. China needs to
revamp its financial system, move to a flexible currency regime, and reform its institutional framework.
Both countries require political reform to lift them to the next level of economic development. While policymakers are
increasingly aware of this need, they still have to demonstrate their willingness to tackle the issues head on. In this report,
we assess this willingness by analyzing the social and economic conditions in the two countries that form the backdrop to
the interplay of political will and economic need.
Chetan Ahya
Mumbai
June 2006
5

6

Contents
Preface ....................................................................................................................................................................5
A Tale of Two Asias ................................................................................................................................................8
Beyond the Cyclical Boom ....................................................................................................................................11
Why India and China Matter..................................................................................................................................14
Challenges Facing India and China - Some Are Similar.......................................................................................19

Transition in the Growth Model - India ..................................................................................................................20
Transition in the Growth Model - China.................................................................................................................24
Unemployment Scales New Heights.....................................................................................................................27
Poverty and Inequality...........................................................................................................................................30
Education Attainment Is Key .................................................................................................................................36
India’s Specific Challenges ...................................................................................................................................39

Infrastructure Deficiencies.....................................................................................................................................40
Weak Public Finances...........................................................................................................................................43
Outmoded Labor Laws ..........................................................................................................................................48
The Need to Encourage FDI Inflows……..............................................................................................................50
………and Privatization .........................................................................................................................................53
China’s Specific Challenges..................................................................................................................................55

Weak Banking Sector............................................................................................................................................56
Shifting to a New Currency Regime ......................................................................................................................60
The Need to Improve the Institutional Framework ................................................................................................63
Chart Scan ............................................................................................................................................................67

Growth Trends: China’s Fast Track vs. India’s Gradualism Model .......................................................................68
Consumption - Macro: China Spends Twice As Much As India............................................................................70
Consumption - Micro: Markets for Most Products in India Are a Third to a Tenth of China’s...............................72
Investments: China’s Total Capex Is More than Four Times India’s ....................................................................74
External Trade: China’s Share in Global Exports Is Six Times India’s .................................................................76
Appendices............................................................................................................................................................79
Appendix 1: Summary of Key Reforms in India and China...................................................................................80
Appendix 2: Fact Sheet .........................................................................................................................................85
Appendix 3: Key Economic Indicators – India.......................................................................................................88
Appendix 4: Key Economic Indicators – China .....................................................................................................89
Glossary ................................................................................................................................................................90
7

A Tale of Two Asias

Stephen S. Roach
At a Critical Juncture Exhibit 1
The China-India comparison is central to the Asia debate. It Two Asian Development Paths
is also of great importance to the rest of the world. In the end,
GDP per capita, US$
it may not be an either/or consideration. While the Chinese 1800
economy has outperformed India by a wide margin over the China
past 15 years, there are no guarantees that past performance 1400
is indicative of what lies ahead. Each of these dynamic
economies is now at a critical juncture in its development
1000
challenge – facing the choice of whether to stay the course or
alter the strategy. The outcome of these choices has
profound implications – not just for the 40% of the world’s 600
population residing in China and India but also for the future India
of Asia and the broader global economy. 200
2006E
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
As recently as 1991, China and India stood at similar levels of
economic development. Today, the Chinese standard of
living is over twice that of India’s, with China’s GDP per capita Source: IMF
hitting US$1,700 in 2005 versus a little over US$700 in India
Exhibit 2
(see Exhibit 1). The two nations have approached the The New Asia
development challenge in very different ways. China has
55
pursued a manufacturing-led growth strategy whereas India
has chosen a more services-based development model.
While each approach has its advantages and disadvantages, 50
China - % Share of
China’s outstanding performance in the development
Industry in GDP
sweepstakes over the past 15 years makes it a very tempting
45
model for the rest of Asia to emulate.
The contrast between the two approaches is dramatic. The

40
industry share of China’s GDP has risen from 42% to 47%
India - % Share of
over the past 15 years, maintaining a huge gap over India’s Services in GDP
generally stagnant 28% manufacturing portion over the same 35
period (see Exhibit 2). By contrast, the services share of
India’s GDP increased from 41% in 1990 to 54% in 2005 –
30
well in excess of the lagging performance in China’s services,
1961
1965
1969
1973
1977
1981
1985
1989
1993
1997
2001
2005
where the GDP share went from 31% in 1990 to 40% in 2005.
China’s macro character fits its manufacturing-led growth
Source: China National Bureau of Statistics, RBI, CSO, Morgan Stanley Research
dynamic to a tee. Benefiting from a high domestic saving
rate, huge inflows of foreign direct investment (FDI), and to a fragmented services sector as the sustenance of
major efforts on the infrastructure front, China’s economic economic growth. The labor-intensive character of services
growth has been increasingly fueled by exports and fixed has provided support to India’s newly emerging middle class
investment. Collectively, these two sectors now account for – a key building block for India’s consumption-led recovery.
over 75% of China’s GDP – and are still growing at close to a As a result, private consumption currently accounts for 61% of
30% rate today. India’s GDP, far outstripping the 40% share in China. The
India’s macro story is the mirror image of China’s in many key growth contribution of India’s export and investment sectors
respects. Constrained by a lower saving rate, limited inflows pales in comparison to that in China.
of FDI and a sorely neglected infrastructure, India has turned
8

Anything You Can Do, I Can Do What comes out of this debate is that both China and India
Interestingly enough, as both of developing Asia’s largest are at important inflection points in their development
economies look to the future, they do so with an eye toward experiences. They are focused on broadening out their bases
emulating the other. China is focused on a rebalancing of its of economic support. China wants to push more into services
growth dynamic – moving away from exports and investment and establish a consumption-based growth dynamic. India
and more toward an Indian-style consumer-led model. This is would like to enlarge its manufacturing footprint by putting
more by necessity than by choice. A continuation of the greater emphasis on infrastructure and FDI. In both cases,
export surge is a recipe for protectionism, while pushing an the growth objectives are focused on solving a difficult rural
already excessive investment binge risks capacity overhangs unemployment and poverty problem. For China, there is the
and deflation. added complication of its daunting ownership transition from a
state- to a privately owned economy.
At the same time, China aspires to match India’s progress on
reforms. India currently has over 25 world-class companies, Interplay of Politics and Economics
well-developed capital markets, a modern banking system, All this is not without rising political tensions. Reflecting
and a deeply entrenched rule of law. China is lacking in all of understandable concerns over social stability, the interplay of
those key respects, and wants to move in those directions. politics and economics is clearly having an important
China is also seeking to implement an Indian-style expansion influence on the execution of the respective “broadening out”
of labor-intensive services in an effort to provide job and strategies. There are equally profound questions for the rest
income support to its nascent consumer sector. However, of the world: If India is to services as China is to
given the high degree of precautionary saving sparked by manufacturing, what role does that leave for the high-cost
massive layoffs arising from state-owned enterprise reforms, developed world? If India also succeeds in pushing into
China may well encounter considerable difficulty in manufacturing while China makes successful forays into
establishing a broad-based consumer culture. services, the same question becomes all the more
challenging to the world’s major industrial economies.
Similarly, India aims to equal China’s effort on the
manufacturing front. India’s political leadership is convinced Protectionism is the biggest risk. IT-enabled globalization is
that manufacturing is the answer to high unemployment in pushing economic development into manufacturing and
impoverished rural areas. Whenever I go to India, I always services at a breakneck pace. Moreover, IT-enabled
have the same debate with its politicians and policymakers. I connectivity has increasingly transformed once non-tradable
take the side that the inherent labor-saving bias of capital- services into tradables – and has moved rapidly up the value
intensive global manufacturing platforms promises little hope chain and occupational hierarchy in doing so. The result is a
for Indian employment. I have seen this first-hand on my mounting sense of economic insecurity in the developed
visits to Indian manufacturing companies – factory floors more world that has become a lightning rod for political action,
heavily populated by robots than by human workers. which, unfortunately, has been manifested in the form of an
increasingly worrisome protectionist backlash.
India’s leaders have a different vision of manufacturing. They
have seen what China can do and hope to achieve a similar This is not the experience that orthodox economics
outcome. Earlier this year, at the World Economic Forum in understands. The win-win theory of globalization – workers in
Davos, I pressed senior Indian officials on the specifics of this poor countries getting rich through trade and then buying
strategy, asking them to identify the potential sources of products from rich countries – just isn’t working. Both the
manufacturing-led job creation. Their answer: food, textiles, speed and scope of an IT-enabled globalization have broken
and leather – potentially high-volume industries that could the mold of the classic theory of comparative advantage. In
well offer gainful employment opportunities to relatively poor, days of yore, it was fine – albeit painful – for rich countries to
under-educated, young rural workers. Unlike the Chinese, give up market share in tradable manufactured products.
the Indian leadership is not enamored of the job-creating Highly educated knowledge workers could seek refuge and
potential of labor-intensive services. In particular, they point shelter in non-tradable services. However, with non-tradables
out that IT-enabled services – the crown jewel of India’s “new becoming tradable and with educational attainment and skill
economy” – mainly offers employment to the elite graduates sets rising rapidly in the developing world, the security of the
of India’s prestigious institutions of higher education. old way no longer exists. Sadly, that provides both the
justification and the opening for protectionists.
9

Conclusion IT-enabled globalization has introduced an unexpected

China and India represent the future of Asia – and quite complication into the process – a time compression of
possibly the future for the global economy. Yet both economic development that has caught the rich industrial
economies now need to fine-tune their development world by surprise. The resulting heightened sense of
strategies by expanding their economic power bases. If these economic insecurity that has stoked an increasingly
mid-course corrections are well executed – and there is good dangerous protectionist backlash could well pose yet another
reason to believe that will be the case – China and India major challenge to China and India – learning how to live with
should play an increasingly powerful role in driving the global the consequences of their successes.
growth dynamic for years to come. With that role, however,
come equally important consequences.
10

Beyond the Cyclical Boom

Andy Xie
Retaining the Fruits of Globalization fixed investment by 27% in the same period, even though the
Annual GDP growth has averaged 10% in China in the past share of China’s fixed investment in GDP is one third higher
three years and 8% in India. During the same period, the than India’s.
global economy has enjoyed the biggest boom in decades,
averaging 4.5% growth a year. The unprecedented economic India’s growth model bears more resemblance to the Anglo-
expansion is due to rising productivity growth from Saxon than the East Asian model. Its external accounts have
globalization and information technology. China and India evolved in a similar fashion. Its current account balance
have been at the center of increasing global integration and deteriorated to a deficit equivalent to 1.7% of GDP in 2005
have done well in keeping the fruits of globalization at home from 1.5% of GDP in surplus in 2003. In contrast, China’s
to fuel their economies. current account surplus improved to 7.2% of GDP in 2005
from 2.8% in 2003.
The two economies have used different approaches to retain While China and India have different growth models, they
some of the globalization benefits. China has pursued the have both captured the opportunities from the current wave of
typical East Asian model of recycling export revenue into fixed globalization. Productivity gains have benefited from a low-
investment. As capacity expands in line with rapid export base effect. As the production chain becomes fully integrated
growth, the domestic economy does not suffer from high across the world in the coming years, the low-base effect will
inflation, merely floating upward with the global economy. disappear and the tailwinds from globalization for China and
Indeed, inflation in China is less than 2% despite 33% annual India will weaken. How to sustain fast productivity growth
growth in exports for the past three years. This reflects the beyond the current boom is a major challenge for both
excessive savings and investment bias of the political system. economies.
In addition to the traditional East Asian investment/export The Need to Clear Away the Thorns …
approach, China has taken advantage of its strong At present, the two countries appear to favor a muddling-
government and the country’s size to achieve unprecedented through approach, i.e., deal with an issue only if it appears to
economies of scale for productivity gains. In infrastructure, be an imminent threat to growth. Failure to heed long-term
for example, the economies of scale have cut capital costs in implications in crafting macro policy is a global phenomenon,
transportation, telecommunications, and electricity to below however. The best example is the lack of consideration for
those of any other economy. In the production and balance sheet problems by all major central banks even
distribution of consumer goods, the economies of scale that though economic history teaches us that the great economic
China has achieved are unmatched elsewhere in the global crises have all been due to overstretching the balance sheet.
economy. The increase in scale economies has also In that regard, China and India are just joining the crowd.
contributed to low inflation.
… in India
India has also achieved a breakthrough in trade. Exports The threat to India’s growth over the next two years is its poor
grew 25% a year in 2002-05 compared with 10.5% in the ten- infrastructure. To address the problem, India needs to
year period prior to this. However, India’s export base at mobilize capital more effectively and streamline the process
19.5% of GDP in 2005 is much lower than that for China for the implementation of infrastructure development,
(38%) and so its export success is not sufficient to drive the objectives that require strong government. Coalition politics,
economy’s strong growth. India has taken advantage of its as now prevailing in India, tend not to produce strong
flexible financial markets to attract foreign capital to fund its governments. Since India has been able to achieve high
growth. growth in the past three years even with a poor infrastructure,
the hope is for continuation of the same for the next two
Consumer credit, funded substantially by foreign capital years.
inflows into its capital markets, has given the Indian economy
a strong consumption anchor in this boom. India’s credit rose Another challenge to India’s growth is the potential bursting of
by 25% a year over 2002-05 versus 19% growth in fixed its asset bubble. India has experienced enormous growth in
investment. In contrast, China’s credit increased by 17% and its stock and property markets, mainly through price
11

appreciation in response to low real interest rates. In this low the formation of new cities – a must for India to accelerate
interest rate environment, the most important factors are an urbanization.)
increase in foreign capital inflow and a rise in import
competition, which have contributed to low inflation. 3) Sell state-owned assets to jump-start a 100 billion-dollar
However, both factors have limited lifespans. infrastructure program as the core of India’s modernization.
First, the foreign capital inflow is a component of the financial … and China
globalization that has kept risk appetite high and rising. The The challenges to China in sustaining its high growth are
increase in globalization has resulted in low inflation and quite different. The fundamental weakness of the economy is
strong liquidity – the backdrop for the current euphoria low consumption. Household consumption at 40% of GDP is
surrounding high-risk assets. As globalization matures, global exceptionally low by any standard. The excessive
liquidity conditions will normalize, and money can no longer dependence on investment and exports makes China
be expected to rush to India in the same quantities under the vulnerable to the global economic cycle. The dominant role of
same terms. the government in the economy, its bureaucratic bias towards
investment, and lack of organized forces in society to check
Second, increasing import competition forces local producers government excesses have led to macro vulnerabilities.
to accept lower prices. Low inflation in India, as in the rest of
the world, is due to globalization benefits from a low base. As Excessive liquidity due to low consumption and foreign
production responds to new prices, imports no longer are as speculation on a possible renminbi revaluation has resulted in
effective in keeping inflation low. rapid growth in the property market in terms of both
production and price. The rise in property prices has become
Buoyant asset markets have had a massive wealth effect on another deterrent to consumption, as Chinese households
consumption while the low cost of capital has encouraged hunker down to shelter from escalating living costs. This
more capital investment. This is probably the reason for further sustains the liquidity boom that feeds the property
India’s growth rate surpassing its historical trend. The sector. This sort of dynamic increases the imbalance in the
appropriate policy would be to raise interest rates economy.
aggressively to contain the cost when the bubble bursts.
However, as politics favor ‘keeping the party going for as long China’s cyclical risk and structural imbalance are one and the
as possible’, preemptive measures are not being taken. same. Unless China is able to rebalance its economy, it
could suffer from mounting appreciation pressure on its
Increasing scale economies is also a source of productivity currency and deflationary conditions at the same time. The
growth for India and should offset any waning in foreign required reforms in China would not be hard to implement.
capital inflows to sustain economic expansion. The China just needs to find ways to give money to households.
modernization of India’s consumer sector, in particular, could
accelerate productivity growth. To achieve this, India needs To rebalance the economy, China has to address the wealth,
to build a transportation system that supports modern logistics income, and security issues that have caused the household
and retool the regulatory infrastructure to support large-scale sector to shrink relative to the overall economy.
production.
1) On wealth, the government owns land, natural resources,
We see three steps India can take to accelerate growth and state monopolies. As these assets are not on the
beyond the current cyclical boom: household balance sheet, consumption remains below what
national wealth can support. Government wealth has to be
1) Introduce legislation that allows the implementation shifted to the household sector to balance the economy.
process for infrastructure projects to cut through the current
maze of regulations and to acquire land quickly. 2) On income, the labor surplus has kept the rise in wages
below that in labor productivity. This causes labor income to
2) Set up several special economic zones along the coast in contract relative to the economy and contributes to insufficient
areas without land title disputes. These SEZs could be cities consumption, excessive liquidity, and speculative mania.
with their own streamlined regulatory and bureaucratic Such imbalances occurred in the West during its
infrastructure. (The current SEZs are project-based tax industrialization, and the rise of labor unions eventually
breaks for export production, which will probably not lead to
12

helped wages to move up in line with labor productivity the negative aspects of both public and private systems – low
growth. quality and high cost – without the favorable aspects – low
price and high quality. More competition in government-
China’s surplus labor is likely to linger for another two dominated sectors could improve consumption, in my view.
decades. There is little chance that market forces will
address this imbalance. Local governments have been The resistance to reform lies in the massive bureaucratic
raising minimum wages and giving wage growth guidance to infrastructure that thrives on fixed investment. Further, the
enterprises. It is too early to tell if government persuasion will emergence of a private sector that profits from state-led
be sufficient to deal with this issue. investment projects, especially in property development, has
intensified resistance to balancing the economy.
Promoting collective bargaining between labor and business
could be more effective. China has one government- Doing the Right Thing Is Difficult
controlled labor union. It usually sides with business as the While we can argue about what China and India should or
government fears the effect of labor unions on job creation. should not do, the reality is that both are pursuing a muddling-
This view is not accurate, in my opinion. If wages rise in line through approach. This is the key for investors to understand
with productivity, the resulting consumption has a high how policies are likely to be formulated and asset markets will
multiplier effect on job creation, which more than offsets the probably behave in the short term.
direct and negative impact on job creation of higher wages.
Labor unions that are not independent tend to evolve into India is likely to try to keep interest rates as low as possible,
organizations that simply set wage standards. improve foreign access to its asset markets for funds to fund
the current account deficit that results from the low interest
3) The escalation of household expenditures on education, rate, and allow the currency to appreciate to contain the
healthcare, and housing and concern about future related inflationary pressure. In short, India will probably pursue
costs have led to precautionary savings and depressed policies that encourage the expansion of the asset bubble
consumption. Some issues in these three sectors are rather than contain it.
complex and take time to address. Others are easier to
resolve. We can expect China to crack down periodically on excessive
credit growth and property speculation. However, the
First, a public housing system should be re-introduced. As government will probably not do enough to curb either for long
the housing market has become entirely for profit, it has led to because such policies would not address the root cause of
rapid price inflation. As local governments control all the land, the surplus liquidity problem or cool either credit or property
they are effectively monopolies in the market. Local demand permanently. Continuation of these imbalances
governments want to maximize land sale revenue to fund could seriously weaken the economy. China’s approach is, in
rapid economic development; hence, a high property price is effect, to slow the speed at which the imbalances grow.
a development tax on local residents. However, it is a
regressive tax and can cause social instability. I believe In terms of the currency, China is likely to stick to a gradual
China should adopt a public housing program similar to that in appreciation path of 2-3% a year. The political system
Singapore. dislikes shock therapy – as a major currency move would be
viewed. The gradualist approach to currency reform is likely
Second, the Chinese government has ample financing to sustain speculation in the currency, keep liquidity artificially
capability and can issue bonds to fund basic healthcare and high, and spread speculation into property and local stock
education. The fear of debt has caused the government to be markets.
cautious in issuing bonds and eager to expand revenues. In
an economy with insufficient consumption, it makes good ‘Doing the right thing’ is difficult in the best of circumstances.
sense for fiscal debt to fund recurrent expenditures. It is much more difficult when the economies of China and
India are booming. Tough reforms usually happen in hard
Third, China should introduce competition into education and times. When the current cycle cools and growth in the two
healthcare beyond the basic level. Chinese healthcare and economies loses momentum, the governments may then
education establishments are government-owned monopolies embark on the required reforms.
that maximize revenues to benefit the staff. This system has
13

Why India and China Matter

Chetan Ahya
Increasing Global Productivity and Growth Exhibit 3
Participation in globalization is raising productivity and growth China and India: GDP Statistics
1990 2005
rates for India and China. The two economies together
India China India China
represent 40% of the global labor supply but their share in Nominal (US$ Bn) 313 388 773 2225
global output is only 6.7% in nominal dollar terms (21% in PPP Basis (US$ Bn) 1145 1633 3633 9412
PPP terms). The economic trend of globalization – that is, the Growth (CAGR for trailing 5 yrs)
cashing in of global labor arbitrage – is improving the --Nominal 7.5% 4.9% 11.0% 13.2%
utilization of their work forces. Indeed, their participation in --PPP Basis 9.6% 11.3% 8.5% 12.0%
Share in World GDP
the world economy as a result of globalization is redefining
--Nominal 1.4% 1.7% 1.7% 5.0%
the macro theory applied during the era of closed economies. --PPP 4.3% 6.1% 5.9% 15.4%
Share in World GDP Growth (trailing 5 yrs average)
The two countries will continue to boost global productivity as
--Nominal 0.6% 2.6% 2.5% 8.0%
long as the supply and stock of unemployed and ‘able’ --PPP 5.4% 8.8% 7.7% 25.6%
working-age population remain high. We define ‘able’ as the
Source: IMF, Morgan Stanley Research
part of the population that is not only skilled and capable of
competing in the global market place but that also has an Exhibit 4
enabling environment provided through the government’s China and India: Combined Share in World GDP
structural reforms, i.e., removal of obstacles and provision of 7.5%
21%
infrastructure/platforms. The world economy does not seem
to be close to the point where this labor arbitrage no longer 6.5%
18%
plays out in view of the current low levels of wages, large
stock of surplus labor and the expected additions to the labor 15%
5.5%
Com bined share on
pools in India and China.
PPP basis, LS
12% 4.5%
Combined share on
Interplay of Three Macro Factors
nominal US$ basis, RS
China and India are achieving high growth rates through the 9% 3.5%
powerful interplay of three key macro factors: demographics,
reforms and globalization – what we call DRG factors. First, 6% 2.5%
1980
1985
1990
1995
2000
2005
age dependency has fallen (the share of the working
population in the total has risen) in both countries since the
late 1970s with a much sharper drop in China than in India. Source: IMF, Morgan Stanley Research
Exhibit 5
Second, structural reforms have improved the utilization of China’s Share in World Goods Exports & India’s Share in
the working-age population, a key resource. A positive World Services Exports
demographic trend may be a necessary condition for strong 8.0%
growth but it is not a sufficient one. Favorable demographics
need to be converted into a virtuous cycle. A critical step in 6.4%
this process is the opening up of productive job opportunities
through reforms. The pace of such reforms has been 4.8%
aggressive in China and gradual but progressive in India. China
3.2%
Third, a backdrop of strong globalization has enabled growth
in these job opportunities to be accelerated. As India and 1.6%
India
China opted to be a part of this globalization trend, this
0.0%
1970
1975
1980
1985
1990
1995
2000
2005
Source: WTO, Morgan Stanley Research
14

proved to be a key trigger for their exports to GDP ratios to Exhibit 6
surge – in the late 1970s for China and the early 1990s for Asia’s Four Demographic Waves
India (Exhibit 7). This interplay of demographics, reforms and
Age Dependency Trend
globalization is crucial for the virtuous cycle of faster growth in 85% (Proportion of dependent to w orking age popn.)
productive job creation – income growth – savings –
investments – higher growth. 75%
Asia’s Third and Fourth Waves 65%

Positive demographic cycles have been a key component in
the strong growth trends for China and India. The ratio of 55%
non-working (elderly and children) to working-age (15-64
years) population has declined in both countries, i.e., the 45%
working population’s share in the total population is rising.
35%
Indeed, the benefit of favorable demographics has been a key
1945
1955
1965
1975
1985
1995
2005
2015
2025
factor in the emergence of Asia as an economic force in the
past 50 years following decades of development in western Source: UN, CEPD Taiwan, CEIC, Morgan Stanley Research
countries. Throughout the region, there has been a virtuous
Exhibit 7
cycle of falling age dependencies (rising share of the working-
India’s Export Trend Forecast (vs. Other Asian Countries)
age population), improving savings (and investment) to GDP
1200
and long phases of strong GDP growth. Japan was the first in Goods and Services Exports
Asia to experience a positive demographic wave, followed by US$ bn
1000
the former Tiger economies (i.e., Hong Kong, Singapore,
Taiwan and Korea) – and now China and, with a lag of a few 800
years, India (Exhibit 6).
600
Largest Suppliers to the World’s Labor Pool

400
China and India together account for almost 40% of the
world’s working-age population. The huge surplus in their 200
working populations is forcing recognition in the world
economy of their roles in global competition and output 0
1970
1975
1980
1985
1990
1995
2000
2005E
2010E
2015E
dynamics. United Nations’ data show that, by 2010, India and
China will contribute an additional 71 million and 44 million
people, respectively, to the global labor pool (Exhibit 8). In Source: WTO, CEIC, Morgan Stanley Research; E= Morgan Stanley Research Estimates
comparison, the US will provide 10 million while Europe’s Exhibit 8

working population will not increase in this time-frame and Growth in Global Working-Age Population (15-64)
Japan’s will decline by 3 million. Stock Addition to w orking age population by
Position 2005 2010
Similarly, the marginal supply of skilled manpower in the two World 4168 314
countries is large relative to that of the developed world. The India 691 71
potential for India and China to contribute significantly to the Africa* 500 64
world’s labor supply is evident from trends in the number of China 934 44
people with tertiary education in India and China compared South East Asia 362 33
with those in some major developed countries. For instance, Latin America 359 31
in 1990/91, the number of science and engineering graduates Western Asia 132 17
in India and China was lower than those in developed USA 200 10
countries; today, the reverse is true. While India and China Europe 497 0
are adding about 0.69 million and 0.53 million engineering Japan 85 -3 In Millions
plus science graduates, respectively, a year, comparable
numbers for Japan, the US and EC are 0.35 million, 0.42 * Note: Africa includes a group of 56 countries. Source: UN, Morgan Stanley Research
million and 0.47 million (Exhibit 9).
15

On a stock basis, the numbers for India and China are Exhibit 9
staggering when compared with those for developed Delta in Global Supply of Science & Engineering
countries. The combined strength of the population educated Students Graduating in a Year* ('000s)
to secondary level and above in India and China is almost 800
In '000s 1990/1991 2002/2004
twice that of the US, major European countries and Japan
combined (see Exhibit 10). Over the past five years, India 600
and China would have added about 16 million and 24 million
of secondary-level and above educated people to the 400
working-age population compared with 14 million in the US.
200
China Overshadows India Today….
China has managed to convert its advantage of a growing
0
working population into a virtuous loop of creating productive
Japan US European China India***
jobs for its expanding work force and translating this into Community
higher savings, investment and growth. China’s age
dependency (share of non-working to working population) * Includes people with first university degree in science and engineering; *** Note: India data
do not include engineering diploma holders; the data are for the latest year available, i.e. the
peaked in 1965 at 80%. Since then, its working population current data for different countries range over various years from 2002 to 2004; Source:
National Science Foundation, NASSCOM, Morgan Stanley Research.
has been rising sharply. Its age-dependency ratio fell to 67%
in 1980 and further to 46% in 2000 and 41% in 2005. Exhibit 10
Educational Attainment Levels (total population
At the same time, the government has been able to increase breakdown)
productive employment opportunities and, in turn, generate Illiterate Secondary
higher savings. China’s savings rate increased from about
(2003)
China
25% in the mid-1960s to 35% in 1980 and further to 50% in 258 70 315 578 71
2005, providing the financing for the acceleration in the Below 15 Prim ary and below Tertiary
(2001)
India
growth of physical capital accumulation and GDP. 386 255 163 183 42
28 110
Real GDP growth in China averaged 9.5% a year over the
(2000) Countries* (2004)
Japan European USA
61 81
past 25 years compared with 5.8% in India. During this 14
period, China’s GDP grew 7.5 times to US$2.2 trillion
Major
whereas that for India expanded 4.5 times to US$800 billion. 131 40
36
China’s exports (including services) surged 41 times over this
49
period to US$840 billion while India’s exports increased 13 35
In Millions
times to about US$150 billion.
0 200 400 600 800 1000 1200
The lag in India’s performance, in our view, was due to the
lower level of support from demographic, reform and * Includes United Kingdom, Germany, France and Italy for latest available year (1999-2004).
Source: China Statistical Yearbook, CEIC, Census of India, DFES (UK), France Census
globalization factors. India’s demographic cycle is trailing data, Eurostat, ISTAT, Population Division - U.S. Census Bureau, Morgan Stanley Research
China’s. Although the two had similar age-dependency ratios
Exhibit 11
in the late 1970s, China has far outpaced India in the past 20
China and India: Savings and Age-Dependency
years (Exhibit 11).
Trends
1960s 1970s 1980s 1990s 2000-05
China was also well ahead of India in initiating structural India
reforms, introducing them in the 1980s versus the 1990s in Age Dependency1 77.8% 76.8% 71.7% 67.0% 61.8%
India. The depth of the reforms also varies. In the context of Savings2 13.0% 18.0% 19.9% 23.8% 26.3%
structural reform, we believe that there are two major roles for Investments3 15.1% 18.1% 21.8% 25.2% 26.0%
China
the government of an emerging economy. First, the
Age Dependency1 79.0% 74.8% 57.4% 48.1% 43.6%
government needs to reduce its interference in the real Savings2 25.6% 34.7% 35.4% 38.5% 39.8%
economy, allowing factors of production to operate more Investments3 26.1% 34.8% 34.8% 40.6% 42.2%
freely (i.e. deregulation of economic activities). Second,
1. Ratio of non-working to working population. 2. Gross national savings rate. 3. Gross
capital formation. Source: UN, CIEC, CSO, Morgan Stanley Research
16

the government is required to play an active role as a Exhibit 12

productive public sector in certain areas to enable factors of India’s Demographics vs. G7 and China
production to operate more effectively. For instance, the 85%
Age dependency (Prop. of non-
government is best positioned to invest in building public
75% w orking to w orking population)
infrastructure and providing basic services such as education
and healthcare for the rural poor. While the Indian
65%
government has been reasonably successful in the first role,
its performance is significantly lacking compared to that of 55%
China’s government in the second role.
45%
India was also late in deciding to participate in globalization
35%
as reflected in the import tariff trend (Exhibit 13). India’s
1950
1960
1970
1980
1990
2000
2010
2020
2030
2040
2050
integration with the global economy started to accelerate in
the early 1990s while China’s integration began in the early China India G7
1980s. Indeed, we can see from Exhibit 14 that India is
following the same path as China when we compare their Source: UN
exports to GDP ratios, keeping the starting points for both as Exhibit 13
the years in which they initiated the liberalization that allowed China and India: Customs Duty Collections as % of
their resources to interact with those of the rest of the world. Imports
But India Has the Potential to Catch Up

60%
Over the next 10 years, as China’s growth rate moderates
from a high base, India’s economic growth has the potential to
45%
accelerate to a sustained 8%-plus rate, breaking out of its
average growth band of 6-6.5% for the past 10 years. We India
calculate nominal GDP will cross the US$2 trillion mark by 30%
2015, up from an estimated US$773 billion in 2005. We
believe that the path to a higher level of growth will be 15%
supported by further improvement in demographics, structural China
reforms and globalization.
0%
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
India is following the East Asian economic model but with
some differences. The East Asian high-growth model is Source: CEIC, RBI, Morgan Stanley Research
driven by a virtuous link of improving demographics, strong
Exhibit 14
growth in high-saving-potential export income, an increase in
Exports to GDP: India vs. China since Start of Reforms
the savings-to-GDP ratio to above 35-40% for a sustained
period and a matching rise in investments. While India is 35%
Exports as % of GDP
following a similar virtuous link, peak growth rates for India For India year 0 = 1991; For China year 0 = 1978
may be lower than those achieved by East Asian countries as 29%
India’s age-dependency ratio bottoms out at higher levels

than in East Asian economies. However, at the same time, 23%
India could have the advantage of maintaining its high-growth India
phase for longer than in East Asia as UN data show that its 17%
age dependency will continue to decline (i.e., the share of the China
working-age population will continue to rise) until 2035. 11%
Indeed, United Nations’ projections show that India will be the
only large country still enjoying favorable demographics after 5%
2010 (Exhibit 12). Japan, Europe and the US (in that order) 0 2 4 6 8 10 12 14 16 18 20 22 24 26
will witness a significant rise in their ageing populations. Number of years since liberalization
17

China will also reach an inflexion point in its age-dependency Political pressure for protectionism can be expected to
ratio by 2010, with a sharp rise thereafter. This is reflected in increase. However, it will be difficult for protectionism to take
the median age in China, which by 2015 will reach 37 hold in view of the high costs that every major economy has
compared with 27 for India. The economic impact of India’s sunk in the current system.
demographic trends should improve further as the age-
dependency ratio falls to 55% by 2010 and to 52% by 2015 Exhibit 15
from an estimated 60% currently. Steady implementation of India: Investment-Growth Relationship

(%) F1992-96 F1997-05 Required
structural reforms and the rising supply of educated/skilled
Avg ICOR 4.7 4.4 4.2
labor should support acceleration in growth over this period.
Avg GDP Growth 5.4 5.9 8.0
In addition, continued integration with the global economy will
Avg Investments 25.1 25.5 33.6
increase the productive job opportunities for its skilled labor
force. We estimate that, by 2010, India’s exports will total ICOR = Incremental Capital Output Ratio
Source: CSO, RBI, Morgan Stanley Research
US$300 billion, up from US$155 billion in 2005 (Exhibit 7).
Internal Challenges to Sustained Strong Growth Story
The combined effect of more favorable demographics and
The two countries’ ability to achieve their long-term potential
increased productive job opportunities should boost India’s
also depends on how they handle internal challenges. Both
private savings level and push aggregate savings to over 33-
need to implement political reform to move to the next level of
35% of GDP over the next five to seven years from the past
economic development. They need to restructure their
three years’ average of 28.6%. This increase in savings and,
growth models: for India, exports and investments have to
correspondingly, the investment-to-GDP ratio to above 35%
increase while China’s export-led investments have to slow to
should ensure a shift in India’s growth to a sustained growth
shift the focus to consumption. Common challenges for India
rate of 8%-plus in this period.
and China include the need to reduce unemployment,
poverty, and inequality and improve education.
External Challenge to India/China Story: Protectionism
Globalization has been key to the acceleration in Asia’s
At the same time, the two countries have pressures that are
growth cycle. However, as this trend continues, political
unique to them. India’s major headwinds include the need to
pressure is mounting. Not only is the trade in goods scaling
strengthen the infrastructure, improve public finances, reform
up but also the share of the tradable portion of the services
labor laws, and augment resources through higher FDI
sector is rising. As India and China continue to add their work
inflows and privatization. China’s main challenges include the
forces to the global labor supply chain, this has implications
strengthening of the banking system, moving to a flexible
for the real wage growth of middle-income groups of the
currency regime, and improving the institutional framework.
developed world and raises the risk of protectionism.
We discuss the internal challenges in greater detail later in
this report.
In this context, Surjit Bhalla’s study (“Imagine There’s No
Country: Poverty, Inequality and Growth in the Era of
Growth to Moderate Near Term, then Revert to
Globalization”1) adds an interesting perspective to the debate
Acceleration Path
on the implications of globalization. The study claims that the
We expect growth in China and India to moderate in the near
single biggest group likely to suffer as a result of globalization
term as they brace for internal challenges. At the opening of
is the middle-income category of the developed world. As the
the National People's Congress (March 2006), China’s
elite (educated and skilled workers) of the developing world,
Premier, Wen Jiabao, indicated that the government is
especially in Asia, attempts to compete with this group, they
targeting annual growth of 7.5% for the next five years, down
put pressure on their real wage growth.
from 9.2% over the past five years. This slowdown
expectation reflects the government’s recognition of internal
We believe that, with the marginal supply of the skilled work
as well as external challenges to the current growth model.
forces in India and China increasing, globalization could
Similarly, India needs to initiate some politically difficult
further undermine this middle-income group’s real wage
reforms to remain on a sustained 8%-plus growth path.
growth.
Economic growth could dip below 7% in India and decelerate
to less than 8% in China over the next couple of years before
the longer term paths of stronger economic growth are
1
Bhalla, Surjit: ”Imagine There’s No Country: Poverty, Inequality and Growth in the Era of resumed.
Globalization,” published by the Institute for International Economics, 2002
18

Challenges Facing India and China - Some Are Similar
19

Transition in the Growth Model - India
India Needs a Stronger Supply Response

Summary Exhibit 16
While China’s growth model is driven by supply (investment), India: GDP Growth (Trailing 4-Quarter Average)
India’s is underpinned by demand (consumption). In the 9.5%
GDP Growth (% YoY)
current economic cycle, a sharp fall in real interest rates 8.5%
driven by high global liquidity has boosted consumption more
7.5% Average=5.4%
than investment in India. There are many challenges
emerging from this consumption-driven growth, posing risks 6.5%
Average =
to macro stability. We believe a commensurate rise in the 5.5% 8.0%
supply side is critical for ensuring a sustained acceleration in
4.5%
the growth cycle. The government needs to implement
measures to stimulate the supply-side response by investing 3.5%
Jun-98
Dec-00
Mar-02
Jun-03
Dec-05
Sep-99
Sep-04
in infrastructure, implementing labor reforms, improving the
management of government finances and strengthening the
administrative framework. Source: CSO, Morgan Stanley Research
Exhibit 17
Growth Acceleration Due More to Cyclical Drivers
Over the past three years, India’s GDP growth was an
India: Aggregate Debt to GDP1
average 8% a year, up from the 5.4% annual average for the 126%
preceding five years. A key factor in this acceleration in
growth has been the sharp rise in capital flows in response to 112%
an increase in the global risk appetite. The global liquidity
spillover into India has allowed the government to pursue 98%
relatively loose monetary and fiscal policies. Over the past
five years, households and government have lapped up this 84%
liquidity, increasing India’s debt-to-GDP ratio by 26 Sharp increase in govt
and household debt
percentage points, which has supported the acceleration in 70%
F1982
F1984
F1986
F1988
F1990
F1992
F1994
F1996
F1998
F2000
F2002
F2004
F2006E
GDP growth. This compares with increases in the debt-to-
GDP ratios of 25 percentage points for the US and 8 for
China during this period. A large part of the borrowing by the
Source: RBI, Morgan Stanley Research 1. Note debt stock figures are understated as they
Indian government and households has been used to boost do not include external borrowings by corporates and lending by non-banking financial
entities; E= Morgan Stanley Research Estimates
consumption rather than increase productive investments.
Exhibit 18
Low Global Real Rates a Major Supporting Factor Public, Retail and Corporate Debt* (As % of GDP)
Low real interest rates globally and the consequent rise in risk 100%
appetite have resulted in a disproportionate increase in capital Corporate debt (manfacturing plus services) * (RS) 31%
90%
inflows into India. Cumulatively, over the past three years 28%
India has received capital flows of US$72 billion versus 80% 25%
Public debt plus retail debt (LS)
US$28 billion in the preceding three years. A bulk of the rise 70% 22%
in capital flows has been from less stable non-FDI sources. 19%
60%
We believe that the unusually high appetite for risk has been 16%
a key factor pushing real rates in India down to unsustainably 50%
Corporate debt (Manufacturing)* (RS) 13%
low levels. In mid-2004, the real yield on Indian government
40% 10%
bonds was lower than that in the US, implying that US
F1991
F1993
F1995
F1997
F1999
F2001
F2003
F2005
government bonds carry greater risk than their Indian

counterparts.
Source: CSO, RBI, CMIE, Morgan Stanley Research
*Based on data for over 3,800 manufacturing and 1,200 services companies
20

Exhibit 19
Although Indian interest rates have corrected significantly Indian Corporate Sector’s Risk Aversion to Capex
over the past 12 months, the real 10-year government F1995 F1996 F2000 F2003 F2005 F2006E
securities yield is still at levels similar to those in the US, MS Research Coverage Universe
(80 companies, accounting for 47% of total market cap.)
indicating that global risk appetite remains high.
Capex to Depn 4.3 2.8 2.4 2.3 2.0 2.4
Cash to Book Value 12.9% 13.0% 17.1% 17.5% 28.0% 26.2%
India’s Supply-Side Response Tends to Be Weak Debt to Equity 0.60 0.55 0.42 0.42 0.32 0.27
India’s relatively modernized financial system is able to ROE 16.5% 17.4% 16.6% 19.1% 22.3% 20.0%
stimulate a strong demand-side response. Ideally, the sharp
Top 200 Listed Companies (accounting for 57% of total market cap.)
fall in real interest rates should have generated a stronger
Capex to Depn 4.6 4.5 1.9 1.2 2.0 na
investment response from the corporate sector. However, Cash to Book Value 10.6% 9.6% 12.7% 17.8% 26.1% na
over the past five years, corporates have been reducing their Debt to Equity 0.9 0.8 0.7 0.6 0.4 na
debt-to-equity ratios and their capex-to-depreciation ratios ROE 16.2% 16.3% 11.7% 18.2% 22.7% na
have been falling despite the rising return on equity. The fall Source: Capitaline, Morgan Stanley Research; E= Morgan Stanley Research Estimates
in US interest rates from the beginning of 2001 has evoked a
Exhibit 20
sharp acceleration in capex (supply response) in China; in Trailing 4Q Current Account Balance (As % of GDP)
contrast, in India it ushered in a new paradigm in household
10.0% India
consumption spending (demand response) through China
Emerging Asia (Ex-India & China)-1
leveraging. The government has also continued with its 7.5% LatAm-2
relatively loose fiscal policy, biased towards current Emerging Europe-3
consumption. There has also been some risk aversion within 5.0%
the corporate sector, which can be seen in the balance sheet
2.5%
trends of Indian companies under our coverage and the top
200 companies (Exhibit 19). Over the past five years, these 0.0%
companies have lowered their debt-to-equity ratio and kept
-2.5%
capex low despite a rising return on equity.
-5.0%
But Why Is Growth Mix Tilted Towards Consumption?
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
The skewed trend is due to the unsatisfactory performance of
the public sector. We believe the government has two key
roles in a liberalization program in an emerging economy. Note: Based on MSCI Emerging Market universe filtered by countries with nominal GDP
greater than US$100 bn. 1. Includes Korea, Taiwan, Indonesia, Thailand and Malaysia. 2.
The first is allowing the operation of free-market dynamics Includes Argentina, Brazil, Mexico and Venezuela. 3. Includes Russia, Turkey, South Africa,
Israel, Czech Republic. Source: CEIC, Central Bank websites, Morgan Stanley Research
whereby the government reduces its interference through
deregulation. The second is active intervention by the Initially, the growth in consumption, supported by government
government in select areas, with the most important being the and household borrowing, was not necessarily a negative
creation of a physical infrastructure/provision of a platform to development as it helped improve domestic capacity
enable the work force to participate in productive activities. utilization. We believe that, since early 2004, a rising
proportion of this consumption is being met through imports.
While the Indian government seems to have been fairly In other words, incrementally every rupee of consumption
successful in fulfilling the first role, progress in its second boosted by borrowing is not generating the same positive
function has fallen short of expectations. For instance, India’s impact on domestic output. This trend is also posing
infrastructure spending is still low even after the recent significant challenges (a point that the central bank has
pickup. The corporate sector is not pursuing a full-blown highlighted), including deterioration in credit quality, asset
capex cycle as the government is slow to implement bubbles (especially property prices), a decline in household
investments in infrastructure and initiate other long-awaited financial savings and a widening current account gap. More
structural reforms. On an aggregate basis, foreign liquidity importantly, implementation of aggressive capex schedules
flows continue to boost government consumption and now could cause interest rates to rise sharply – especially in a
household spending more than corporate or infrastructure tightening global environment – as the financial capacity in
investments. However, incrementally, excesses are building the system has already been used to boost consumption
in the system as a result of this trend. (Exhibit 21).
21

Need for Greater Investments in Infrastructure Exhibit 21
The government’s attitude toward infrastructure is changing India: Bank Credit Deposit Ratio (3MMA)#
with spending in this area finally beginning to rise. We 75%
estimate that India’s infrastructure spending will increase to
70%
4.9% (US$50 billion) of GDP in F2009 from 3.6% (US$28
billion) currently. However, this is only a modest rise 65%
compared with India’s needs and considering the steady
60%
decline in spending over the past few years prior to the recent
improvement. This spending also pales when compared with 55%
China’s outlays on infrastructure – 9% of GDP (US$201
50%
billion) in 2005.
45%
Mar-81
Mar-84
Mar-87
Mar-90
Mar-93
Mar-96
Mar-99
Mar-02
Mar-05
We believe that, with government debt to GDP at 82%, large
divestments of government stakes in public sector enterprises
(PSEs) to mobilize resources of US$15 to 20 billion a year
Source: RBI, Morgan Stanley Research # Currently banks can have maximum credit deposit
would serve to kick-start substantial growth in infrastructure ratio of 75%. Minimum 25% is required to be invested in government securities.
spending. This would form a much-needed supply response,
Exhibit 22
generating more productive job opportunities for the growing
India: Net Financial Savings (As % of GDP)
work force and increasing the savings rate. In this way, India
11.8%
could be moved onto a higher sustained virtuous growth
cycle.
11.0%
Bias Should Shift toward Investment

We think India needs to take a “total return” approach in 10.3%
economic decisions relating to the utilization of resources

such as capital, labor, land and natural resources. Current 9.5%
macro policies leave a large part of the resources pool,
especially the working-age population, underutilized. There is 8.8%
clearly a need for a large increase in investment. The sense
of urgency in this respect is due to the large surplus being 8.0%
F2006E
F1999
F2000
F2001
F2002
F2003
F2004
F2005
added to the country’s work force each year. About 71 million
people are likely to join the working-age population (15 to 64
years) over the next five years. This is even higher than the
Source: RBI, Morgan Stanley Research; E= Morgan Stanley Research Estimates
44 million people being added in China during this period.
spending, lifting overall investment and creating new
In addition, the high unemployment level in India shows that productive jobs at a rapid pace, India is using its public
the country cannot afford a weak investment environment and finances to increase revenue expenses to pursue populist
low job creation. About 20% of the population (220 million) policies for supporting lower income groups, the efficiency of
lives below the poverty line (according to government which is questionable.
estimates), indicating the magnitude of the challenge that the
huge numbers of unemployed represent. In addition to the One could argue that China’s investment obsession has
implications for social stability, underutilization of the working- attendant costs in the form of non-performing assets (NPA) in
age population will check India’s ability to raise its per capita the banking system. However, even if we add these non-
income to East Asian levels. performing assets to its public debt, the public debt-to-GDP
ratio would be 47% at the end of 2005 (including recent NPA
Work force expansion and related unemployment concerns transfers by the government) compared with 84% (public debt
are common challenges to both China and India. However, of 82% and NPA of 2% of GDP) for India. If the Indian
the issue has so far evoked different responses from the two government were to increase its capital and development
governments, particularly in the context of the management of expenditure instead of running up unsustainably high revenue
public finances. While China is focused on infrastructure expenditure, the dependence on cyclical consumption drivers
would be reduced.
22

Greater Focus on Manufacturing Is Inevitable in services is the same as manufacturing. In other words, 1.0
Relatively low savings and the lack of infrastructure percentage point of growth in both segments brings about the
investment and FDI are limiting India’s ability to compete in same change in employment growth.
the manufactured export market. Although the strong growth
in services outsourcing is a positive development, we believe Third, global trade opportunities are significantly higher in
that an increased focus on manufacturing (especially SMEs) manufacturing. In 2005, global exports of goods amounted to
and infrastructure is inevitable for India. an estimated US$10.4 trillion compared with US$2.4 trillion in
services. More importantly, the global market in IT and IT-
First, this shift in focus will be necessary for creating more enabled services outsourcing, which is more relevant for
productive employment opportunities for the large proportion India, is even smaller although rising.
of the relatively less educated section of the work force.
According to a study on employment by the Indian Planning However, a greater presence in manufacturing would require
Commission, 44.0% of workers in 1999-2000 were illiterate higher savings for India to be able to invest in the much-
and a further 22.7% had schooling only up to primary level. needed development of its physical infrastructure. The capital
Only about 33.2% of the labor force had achieved schooling intensity of manufacturing is significantly higher than that for
up to middle level (eight years of education) and above. Even services. We believe that India should over the medium term
if we assume that all new additions to the work force since benefit from an improvement in its gross savings due to the
1999-2000 were educated to the middle level or above, the rising proportion of the working population. However, the rate
ratio would rise to only 39%. at which savings rise depends on the pace of structural
reforms by the government. For instance, the government
Second, employment elasticity within the industrial sector is can accelerate the virtuous cycle of a rising work force –
not much lower than that for services even though the capital productive job opportunities/higher income/higher
efficiency of the two sectors is different. Indeed, our analysis savings/higher investments – by undertaking large-scale
of past trends shows that the employment elasticity of growth privatization for investment takeoff and job creation.
23

Transition in the Growth Model - China
China Needs a Stronger Demand Response

Summary Exhibit 23
We believe the main component in China’s unprecedented China: Working Age Popn (As % of Total Popn)
and sustained economic success over the past 25 years is
the political will to enlarge the pie rapidly with a continuous 71%
focus on removing growth bottlenecks. This approach was in
some sense inevitable for China considering the sharp and 67%
sudden change in the demographic cycle with the share of its
working-age population having risen steeply since the late
63%
1970s (Exhibit 23). Although this bureaucratic entrepreneurial China began reform process at
thrust certainly helped accelerate growth in the initial phases the most opportune time
of reforms, we believe the model is now facing major 59%
challenges incrementally.
55%
China Needs to Move to More Balanced Growth Model 1950 1960 1970 1980 1990 2000 2010
While policymakers in India have difficulty initiating a much-

Source: UN, Morgan Stanley Research
needed aggressive investment drive, the government in China
is experiencing problems trying to slow the capex cycle. Exhibit 24
China’s underlying political and financial structure provides Exports to GDP: China vs. Rest of the World
incentives to over-invest. Local governments influence most 40%
of China’s investments regardless of the final owners. They
also have significant influence on the financial system. China
32%
Political power still plays a decisive role in China’s capital
allocation. We believe inadequate pricing of risk has resulted
in over-investment. Since 1998, China has pursued an 24%
Rest of the World
aggressive capex cycle, taking its fixed investment-to-GDP
ratio to the unsustainably high level of 49% in 2005. The 16%
strong GDP growth in the past few years has been achieved
at the cost of capital efficiency. 8%
Cheap Money and Globalization Support Investment and

0%
Export Booms
1980
1985
1990
1995
2000
2005
China’s economy experienced a significant upturn between
2001 and 2005. In this period, exports surged by 185%, fixed
investment by 170%, M2 by 89%, and retail sales by 79%. Source: WTO, Morgan Stanley Research
This boom is similar in size to the last one, between 1991 and Exhibit 25
1995. Adjusting for inflation, mostly caused by currency China: Fixed Investment and Export Trends
depreciation between 1991 and 1995, the growth rates are 1980 1990 1995 2000 2005
similar between the two periods across different sectors. US$ bn
Cheap money triggered both booms. The US Federal funds Fixed Investment 61 94 240 398 1082
rate was cut drastically in 1991 to deal with the savings and Exports 21 68 167 279 843
% of GDP
loans crisis and even more dramatically in 2001 in response
Fixed Investment 20% 24% 33% 33% 49%
to the bursting of the tech bubble and the 9/11 incident. Exports 7% 17% 23% 23% 38%
Source: CEIC, WTO, Morgan Stanley Research
24

The ample global liquidity has influenced China’s growth cycle Exhibit 26
in two ways. First, China has experienced an export boom Fed Funds Rate vs. China’s Capex Growth
on the strong global demand supported by the low Fed funds 40% 0
rate. Second, capital flows into China have increased, which
has helped to accelerate investment and exports. 30% 2
Disproportionate Share of Trade and Fixed Investment 20% 4

The value of exports to GDP increased to 38% in 2005 from
23% in 2001. In the same period, fixed investment to GDP 10% 6
rose to 49% from 34% whereas the share of consumption

dropped further from 60% to 50%. China’s economy is far 0% 8
more dependent on trade and fixed investment than the

average for the rest of the world. So far China’s growth -10% 10
1990
1992
1994
1996
1998
2000
2002
2004
2006
model has faced little resistance because of the low base
factor. With China having become the third largest trading Investments (Nominal, % YoY, 3 Yr MA, LS)
economy in the world and its fixed investment approaching Fed Funds Rate (RS, Reverse Scale, pushed forward one year)
half of GDP, the current model increasingly runs into
Source: CEIC, WTO, Morgan Stanley Research
diminishing returns and is unlikely to be able to sustain high
growth over the long term. Second, state-directed investment is the primary policy
instrument for spreading economic development inland. The
China Enters Uncharted Territory trade sector is concentrated along the coast. The five coastal
Trade and investment usually lead China’s booms. Each provinces (Guangdong, Fujian, Zhejiang, Shanghai, and
boom has enlarged the trade and investment share relative to Jiangsu) account for 75% of the country’s exports but only
the economy. In the early 1990s boom, exports plus fixed 21% of the population. State-directed investment channels
investment rose to 60% of GDP in 1994 from 45% in 1991. In financial capital that the coastal provinces create through
the latest boom, the share rose to about 87% in 2005 from trade into inland provinces to increase their capital base and,
57% in 2001. In this cycle, both fixed investment and exports hence, labor productivity.
have entered uncharted territory. Fixed investment
accounted for about half of the economy in 2005, Third, state-led investment has become the primary
unprecedented for a large economy. This is significantly instrument for the central government to supervise local
higher than that for Japan at the peak of its investment cycle. government achievements. China’s political incentives
Exports reached an estimated 38% of GDP in 2005, also function on awards for development success or punishment
unprecedented among large economies. for development failure. A commonly used metric is GDP at
the city or province level. Local governments boost GDP
Why Is China Investment Prone? through increases in fixed investment. In addition, popular
China’s development model is based on (1) creating opinion is that physical transformation is the most important
incentives for foreign capital to boost exports to increase benchmark for the success of a government; hence, political
savings, and (2) a state-controlled financial system incentives are heavily biased toward fixed investment.
monopolizing financial capital for investment planned by the
central or local governments. This state-directed investment Bias Against Consumption
has been driven by multiple objectives: China’s development model is positively biased toward
investment and implicitly biased against consumption. As the
First, it complements foreign capital in sustaining China’s investment/GDP ratio rises, the role of the government in the
competitiveness. When the foreign-capital dominated export economy increases. This tends to result in income
sector grows, state-directed investment ensures that the concentration. Those with access to power enjoy a
supporting infrastructure expands in tandem. This is the most disproportionate share in national income growth. The rising
constructive aspect of China’s state-driven investment income inequality is unfavorable for consumption
machine. development. The low share of household income in GDP is
another important factor in relatively weak consumption.
25

Currency Appreciation Is Not the Answer Third, return assets to the people. The government owns
China is taking tentative steps towards reforming its exchange land, natural resources, and numerous state-owned
rate. Many analysts have argued that China should revalue enterprises. Households, therefore, have a lower share of the
its currency to boost consumption. We believe that reforming country’s wealth. The return of assets to the people could
the currency is not a sufficient condition. Currency provide support for household consumption growth. We
appreciation can help boost consumption in a completely believe that reforming the role of the government in the
market-oriented economy. China is not yet a full-fledged economy would also be necessary for better income
market economy. Unless changes are made to the political distribution.
economy, a strong currency would cause growth to slow.
Fourth, reform the healthcare and education sectors to
The Hard Road to Balanced Growth reduce households’ cost concerns. Healthcare and
We believe that China needs to undertake five fundamental education, in theory, are still under government control;
reforms to achieve balanced growth. however, these sectors usually raise funds from students and
patients through a range of unofficial levies and charges.
First, decrease the role of government in the economy. Adequate funds are not provided to local authorities for
The government has controlled a large proportion of running these social programs. China does not enjoy either
economic resources and directed them in a way that ensures the benefits of efficient private ownership or the low costs of
strong economic growth. This has helped China in the initial public ownership. In addition, the high cost of health and
stages to take a “total return” approach in economic decision- education adversely influences household behavior toward
making to improve utilization of all resources, i.e., capital, consumption.
labor, land and natural resources. However, incrementally
this model may pose systemic challenges. Although, China Fifth, boost supply of affordable housing. Property is the
has initiated major deregulatory measures, the government’s most important expenditure item for a typical family. High
control and influence over economic resources remain high. property prices are a secular force against consumption.
China should reduce the dominance of government Some cities have witnessed a significant rise in property
ownership to improve market discipline. prices. Many analysts argue that rising property prices are
good for consumption. This is true in the short term only and
Second, improve the institutional framework and at the expense of long-term consumption. A rise in property
corporate governance. Agency costs associated with prices in a country where home ownership is still low can
excessive local government influence on economic activities cause social tension and make people save more from a
are high. China needs to focus on improving the institutional sense of insecurity.
framework to provide a structure that encourages the efficient
allocation of capital to lay the foundation for sustaining the Conclusion
current strong growth trend. Financial sector reforms are an The path to balanced development is challenging but the
important part of these overall reforms aimed at reducing the government appears to be initiating steps towards this
government role. Under the current structure, state-owned corrective path. The recent announcements by the Premier
banks are not able to effectively discharge their role of that the government will target development of the
ensuring corporate governance. countryside, reduce inequality and improve the share of
consumption in GDP are moves in that direction. However,
executing the plan will likely remain a challenge.
26

Unemployment Scales New Heights
Large Work Forces – A Demographic Boon or Threat?

Exhibit 27
India India and China: Working Population (age 15-64*; mn)
1200
Working-age Population Rising Faster in India than China India overtakes China
India and China have working-age populations (15-64 years)
of 691 million and 934 million, respectively. The UN 1000
estimates that by 2015 the working-age population in India India China

will have risen by 138 million and in China by 67 million. As a 800
result, by that time the combined share in the global working-

age population for India and China would be 1,830 million 600
(about 39% of the world’s working-age population).
400
Although the rise in the working population will provide huge
opportunities for growth, it will also present challenges in view 200
1950
1960
1970
1980
1990
2000
2010
2020
2030
2040
2050
of the size of the populations. In that sense, incrementally
India faces a bigger problem than China. While favorable
demographic trends are necessary for the creation of a strong * People who could potentially be economically active.
Source: UN
and sustained economic growth cycle, they are not a
sufficient condition. What is needed is the ability to empower Exhibit 28
the working-age population to participate in productive Slow Investment Has Impaired Job Creation in India
activities and to initiate reforms that would generate 18.0%
productive job opportunities for this population. Public and
1.5%
Private Capex
(As % of GDP, 16.5%
Unemployment Remains High
3 Yr MA, RS)
Over the past few years in India, job growth has been trailing
0.5%
the rise in working-age population. A study on employment 15.0%
conditions by the Planning Commission of India shows that
unemployment is likely to have risen to 9.1% in F2005 (36 -0.5%
13.5%
million) from 7.3% (27 million) in F2000. Organised Sector Em ploym ent
(3 Yr MA % YoY, LS)
We believe official estimates understate effective -1.5% 12.0%
F1987
F1989
F1991
F1993
F1995
F1997
F1999
F2001
F2003
F2005
unemployment. The government estimates the poverty level
at 20% for F2005 based. (Poverty incidence is defined by the
number of people who are not able to earn a minimum
Source: CSO, Economic Survey of India, Morgan Stanley Research
income to buy the cheapest food that would provide the daily
requirement of more than 2000 calories.) Slow Investment Growth Is Key Issue
The overall investment trend in India has been weak in the
Therefore, even if we assume that actual employment is as past few years. We believe that the combined trend for
high as that indicated by official estimates, not all is corporate and public capex (excluding household sector
meaningful employment, as reflected in the poverty rates. If investments) to GDP is a good indicator of productive job-
we adjust official estimates for quality of employment, we creating investment. Although the investment trend improved
calculate that the overall number of unemployed could be in the past three years, it still seems to be lower than the
more than 80 million (about 20% of the total official work force required level. We estimate that to achieve the desired GDP
estimate) in F2005. growth rate of 8-9% on a sustained basis, the combined
public plus private corporate investment to GDP ratio would
need to rise to 19-22% from 15.6% currently and overall
investments should increase from an estimated 28% currently
27

to 33-37% of GDP (assuming an average capital output ratio Exhibit 29
of 4.2 compared with an average of 4.4 since F1997). India: Employment Trends
Unit F2000 F2002 F2005
Population Mn 1015 1051 1097
Intensity of Employment Growth Diminishing
Growth p.a. % 3.3 1.8 1.4
The unemployment problem is compounded by the decline in Labor Force Mn 363 378 399
the elasticity of employment growth observed in recent years. Employed Mn 337 345 363
This stems from modernization and a greater focus on Unemployed Mn 27 34 36
efficiency. Employment elasticity fell to 0.16 (i.e., for every Unemployment rate % 7.3 8.9 9.1
Poverty Rate # % 36 na na
1% increase in GDP, employment rises by 0.16%) in F1994-
2000 from 0.52 in F1983-1994. According to the study on Source: Planning Commission of India, Morgan Stanley Research # International poverty line
= Population living below US$1 PPP per day. na = not available
employment by the Planning Commission of India, this trend
Exhibit 30
is unlikely to change significantly as there is still scope for
improving efficiency in some of the traditional large sectors China: Employment Trends
Unit 1999 2001 2004
such as electricity, mining, agriculture and government
Population Mn 1258 1276 1300
services. Growth p.a. % 0.8 0.7 0.6
Labor Force Mn 728 744 768
Strong Macro Plan Needed Employed Mn 714 730 752
Unless India initiates a well-planned program to increase Unemployed Mn 14 14 16
GDP growth to 8-9% on a sustained basis, we believe that the Unemployment rate % 1.9 1.9 2.1
Poverty Rate # % 17.8 16.6 na
expanding work force could become an increasing threat to
social stability. We think such a program should entail a Source: CEIC, World Bank, Morgan Stanley Research; # International poverty line =
Population living below US$1 PPP per day. na = not available
sharp rise in investment, especially in infrastructure. A
Exhibit 31
second issue requiring government attention is labor
flexibility. India’s labor laws are outmoded and do not
China Urban Employment: Changing Mix of SOE vs.
encourage employee flexibility. Indeed, labor legislation is an
Private Sector
area where India’s performance during the past 15 years of 200
In Millions
liberalization has been especially unsatisfactory.
160
Under current legislation, all employers of more than 100 Private Sector
people must seek approval from the government through a 120
complex process before retrenching employees. In practice,
these laws have been a deterrent to employers, forcing them 80
to choose capital-intensive methods of production, even if SOEs and
they would have otherwise preferred labor-intensive options. Collective Units
40
The laws that have been introduced to protect labor are in
practice working against it. We discuss this issue in greater
0
detail in the section titled, “Some Challenges Are Unique to
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
India: Outmoded Labor Laws”.

Source: CEIC, Morgan Stanley Research
China
934 million in 2005 from 596 million in 1980. Despite strong
China Suffers from Similar Pressures economic growth of an average 9.7% in the 1980s and 10%
China’s demographic shift has meant unparalleled changes in in the 1990s, China’s unemployment problem remains
global working-age population growth. In 2005, China challenging. Its official urban unemployment rate at the end
accounted for an estimated 22% of the global working-age of 2005 was an estimated 4.2% (8.4 million). The
population. Its age-dependency (ratio of non-working-age to government does not disclose official statistics on rural
working-age population) peaked in 1965 at 80%. Since then, unemployment. According to the Organization for Economic
the working population has increased sharply. The age- Cooperation and Development (OECD) (2002), the rural
dependency ratio fell to 67% in 1980 and further to 46% in hidden unemployment level in China could be as high as 150-
2000. Its working-age population (15–64 years) increased to 275 million.
28

Substantial Job Creation in Urban Areas but Not Enough Exhibit 32
Official data indicate that overall annual employment growth China: Changing Employment Growth Mix
(CAGR) 1990-1996 1996-2004 1990-2004
between 1990 and 2005 was 1.1%. Most of the job creation
GDP Growth
was in urban areas. Rural employment grew at an average
Primary 4.3% 3.3% 3.8%
0.2% a year in this period compared with 3.2% in the urban Secondary 16.5% 9.9% 12.7%
sector. Breaking down employment trends in two distinct Tertiary 10.6% 9.8% 10.1%
phases during 1990-2004 provides a perspective on the Overall 11.9% 8.8% 10.1%
government’s efforts to manage the employment growth mix.
Employment Growth
Primary -1.8% 0.2% -0.8%
During the period 1990–96, the government’s focus was to Secondary 2.6% 0.5% 1.5%
ease the pressure on the agriculture sector. In this period, Tertiary 7.0% 3.2% 5.1%
China achieved strong GDP expansion of 12%. Robust Overall 1.1% 1.1% 1.1%
growth in manufacturing (secondary) and services (tertiary)
Rural 0.5% -0.1% 0.2%
helped offset the decline in employment in the agriculture
Urban 2.6% 3.6% 3.2%
(primary) sector. Pressure from job losses due to the reform -- SOE 0.4% -7.6% -4.2%
of state-owned enterprises (SOE) was limited. While -- Non SOE 10.3% 16.2% 13.7%
employment in the private sector increased, the SOE sector
continued to carry surplus labor.
Slower Growth in Working Population Should Ease
Between 1996 and 2004, the focus was to shift the Pressure
responsibility of job creation to the private sector. During this The UN estimates China’s working population growth will
period, average GDP growth slowed to 9% and, at the same decelerate sharply over the next 10 years from an average
time, the government accelerated the process of reforming 1.4% a year in the five-year period ended 2005 to 0.7% over
SOEs and collectives. In this period, total secondary sector the 10 years ending 2015. However, the problem of the stock
employment grew only 0.5% a year. The stock of people of surplus labor, particularly in the rural sector, will continue to
employed in SOEs and collectives declined by 67 million be a macro challenge. As of 2005, official data showed that
during 1996-2004. Non-SOE sector job creation, however, 490 million people (65% of the total) were employed in the
was strong enough to ease the burden of job losses in the rural sector.
SOE sector.
Conclusion
We believe that unless the two countries – India in particular –
initiate a well-planned program to create adequate
employment, the rising work force may increase the risks of
social instability.
29

Poverty and Inequality
Globalization Success Stories but Human Development Lags

Slow Progress in Broad Human Development Measures Exhibit 33
While India and China have been major beneficiaries of India and China: Human Development Index
globalization in terms of acceleration in GDP growth, their 0.80
track records in improving human development have been China
less impressive. We believe that, while both countries are 0.72
likely to remain on the globalization path, their governments

need to intervene constructively in the economy to empower 0.64
India
lower income groups.
0.56
The Poverty Challenge

0.48
What Is Poverty?
Poverty has been defined in many ways. The Indian
0.40
government defines the poverty ratio as that proportion of the
1975
1980
1985
1990
1995
2000
2003
population that is unable to purchase the minimum amount
required to meet the daily food need of 2,000 calories. The Source: UN’s Human Development Report, Morgan Stanley Research
World Bank defines the international poverty ratio as the
Exhibit 34
percentage of the population living on less than US$1 a day
Poverty Rate (% of population living below US$1
at 1993 international prices. We believe a more appropriate
PPP per day)
measure would be one that is broader by definition. For
instance, the UN looks at income as well as non-income 60%
1985 - 1995 -
factors (human development index), which include rankings 381 Mn
1990-91 -
472 Mn
on education and health parameters. Nobel laureate Amartya 357 Mn India

45%
Sen has also argued that poverty is not just about low income
but deprivation of basic capabilities.
1999 -
30% 359 Mn
1990-91 -
Elaborating on this point, the United Nations Committee on 375 Mn
1985 - China
Economic, Social and Cultural Rights has similarly defined 254 Mn
1995 -
15% 290 Mn
poverty as "a human condition characterized by the sustained 2001 -
212 Mn
or chronic deprivation of the resources, capabilities, choices,
security and power necessary for the enjoyment of an 0%
adequate standard of living and other civil, cultural, economic,
1985
1986
1987
1988
1989
1990-91
1992
1993
1994
1995
1996
1997
1998
1999
2001
political and social rights." The challenges facing the two
nations would be even more serious if this broader definition
of poverty were to be considered. Source: World Bank, Morgan Stanley Research
lower their poverty levels, particularly in China. According to

Significant Reduction of Income Poverty but Not Enough
World Bank data, in China the poverty rate declined to 17%
Both India and China have been able to cut income poverty
(212 million people) in 2001 from 33% (375 million) in 1990.
rates (share of population living below US$1/day in PPP
Similarly, the poverty rate in India dropped to 36% (359
terms) at a reasonable pace over the past 15 years. The
million) in 1999 from 42% (357 million) in 1990.
World Bank estimates the two countries have witnessed
significant declines in income poverty rates over the past 10-
Despite this reduction, India and China together accounted for
15 years. A reduction in poverty is dependent on income
about 55% of the world’s poor in 2001. An improvement in
growth in a country and the extent to which that income
the poverty rate should have continued even after 2001 but
growth is distributed to the poor. Acceleration in growth has
the absolute size of the population below the poverty line in
been the key factor that has allowed the two countries to
both countries is likely still to be huge (in the range of 250 to
30

300 million, 23%-27% for India and 125 to 150 million, 9%- Exhibit 35
11% for China). Child Mortality Rate (per 1,000 live births)
250
India
China’s Record Less than Desirable But Better Than
China
India’s 200
Bangladesh
India faces a considerable challenge in managing child Vietnam
150
survival and health. About 47% of the children in India suffer
from malnutrition compared with 8% in China. India accounts 100
for 2.4 million (20%) of the 10.8 million global deaths among
children under five years of age. This is the highest for any 50
single nation. Of every 12 children, one dies in the first five
years of life. In comparison, China experiences 0.5 million 0
1960
1970
1980
1990
1995
2000
2004
deaths among children under five years, implying 1 in every
32 children dies in the first five years of life.
Source: UNICEF, Morgan Stanley Research
The poor record in this area for the two nations, especially Exhibit 36
India, cannot be entirely blamed on the low levels of per GDP Growth Rates
capita income as improvement in this area is possible through 1980s 1990s 2000-2005
lost-cost intervention using simple technology. The annual Vietnam 5.9% 7.6% 7.3%
reduction in child mortality rate in India slowed to 0.25% from China 9.3% 9.9% 9.2%
0.4% a year over 1970-1990. Similarly, in China it declined to
India 5.6% 5.6% 6.7%
0.25% from 0.36% a year in 1970-1990. This drop is
Bangladesh 3.6% 4.9% 5.4%
surprising in the context of both countries’ track record on
economic growth. Source: IMF, CEIC, Morgan Stanley Research
Success in addressing the challenge of human development

According to the UN’s Human Development Report (2005), at will be a key factor in determining the positions of India and
lower levels of income and economic growth rates, Vietnam China in the global economy. It will also be critical for
has performed better than China in improving the child empowering larger sections of their populations to participate
mortality rate. Similarly, Bangladesh has achieved better in productive economic activities.
results than India in this respect (Exhibits 35 and 36). China
and India have been relatively less successful than their
The Inequality Challenge
neighbors in transferring increases in wealth and income to
human development. Inequality Widened in Post Reform Period
The trend in income inequality following the introduction of
Improving Public Institution Capabilities Is Crucial reforms in China is more worrying than that in India.
The gap in economic growth and health development trends
reflects the inability of the respective governments to Does Inequality Matter?
implement effective strategies to help weak and poor sections From a pareto efficiency (optimality) perspective, acceleration
of the population. There is a need to shift to outcome-based in the incomes of some sections of the population without the
investment allocations by the governments. Although in India rest of the population being worse off would be welfare
the central government and planning commission are making enhancing. However, as Amartya Sen argues, “a society can
an effort to move to outcome-based budget allocations, the be pareto optimal but still be perfectly disgusting”. Apart from
impact of this approach is yet to be seen. We believe that this social justice and morality argument, there are a number
India also needs gradually to decentralize implementation of of research papers arguing that in the long run a high level of
welfare schemes with greater responsibility and authority inequality can hurt growth on account of socio-political
transferred to local institutions after installing the right checks tensions. More importantly, as the United Nations
for following the outcome-based approach. Development Program (UNDP) points out, the reduction in
absolute poverty also tends to be significantly influenced by
the inequality of income, health and education.
31

Exhibit 37
Summary of Social Indicators
India China
Units Year Value Year Value
Population
Population Mn 2004 1097 2004 1300
Births Mn 2004 26 2004 19
Deaths Mn 2004 9 2004 10
Poverty & Inequality
Poverty Rate (below US$1 per day) % 1999-2000 34.7 2001 16.6
Poverty Rate (below US$1-2 per day) % 1999-2000 45.2 2001 30.1
Gini Index % 1999 32.5 2001 44.7
Gender Inequality
Life Expectancy at birth
Female yrs 2003 65.0 2003 73.5
Male yrs 2003 61.8 2003 69.9
Overall yrs 2003 63.0 2003 71.0
Adult Literacy Rate (% ages 15 and over)
Female % 2000 45.4 2000 86.5
Male % 2000 68.4 2000 95.1
Overall % 2000 57.2 2000 90.9
Access to an Improved Water Source
Total % of popn 2002 86 2002 77
Rural % of popn 2002 82 2002 68
Urban % of popn 2002 96 2002 92
Access to Improved Sanitation Facilities
Total % of popn 2002 30 2002 44
Rural % of popn 2002 18 2002 29
Urban % of popn 2002 58 2002 69
Child Mortality
Under Five Mortality Rate Per 1000 2004 85 2004 31
Under Five Mortality Rate Mn 2004 2.2 2004 0.5
Overall Mortality
Probability at birth of surviving to age 65, Male % of cohort 2003 62 2003 73
Probability at birth of surviving to age 65, Female % of cohort 2003 65 2003 79
Adult mortality rate, Male* Per 1000 2002-04 241 2002-04 145
Adult mortality rate, Female* Per 1000 2002-04 161 2002-04 91
Health
Incidence of tuberculosis Per 100,000 2003 168 2003 102
Prevalence of HIV (population ages 15-49) Mn 2003 5.0 2003 0.7
Prevalence of HIV (% of population ages 15-49) % 2003 0.9% 2003 0.1%
Malnutrition
Prevalence of undernourishment % of popn 2001-2003 20 2001-2003 12
Prevalence of child malnutrition % of children < 5 1999 47 2002 8
Source: UN’s Human Development Report, World Bank, WHO, UNICEF, Morgan Stanley Research
* Adult mortality rate is the probability of dying between the ages of 15 and 60.
32

Widening Inequality in China since Mid-1980s Exhibit 38
The first phase of reforms (1978 to 1984) in China, which Comparison of Inequality across Emerging Markets
focused on the rural sector, helped reduce income inequality, (Gini Index)
as measured by the Gini Index. (The Gini Index measures Russia (2002)
Korea (1998)
the extent to which the distribution of income or consumption
India (1999)
expenditure among individuals or households within an Indonesia (2002)
economy deviates from a perfectly equal distribution.) Turkey (2000)
Thailand (2000)
China (2001)
However, income inequality has widened significantly since
Malaysia (1997)
1984 when the government initiated major reforms to enable Argentina (2001)
participation in globalization, as a report on China’s inequality Mexico (2000)
by the United Nations University-WIDER 2 highlights. From South Africa (2000)

Brazil (2001)
the mid-1980s, China decentralized (with a gradual shift in
15 25 35 45 55
power to the provinces) to integrate with the global market
Rising Inequality
and increase its foreign trade and attract FDI inflows.
Source: UN’s Human Development Report, Morgan Stanley Research
The reforms initiated from 1984 allowed the coastal zone to
Exhibit 39
become integrated in the global market, increasing rural-
urban income disparities. Indeed, the ratio of urban to rural China: Rising Disparity (Per Capita Disposable
per capita income increased to 3.2 in 2005 from 2.2 in 1990. Income, US$)
At the same time, greater delegation of power to provincial
governments for resource mobilization and spending (Exhibit 1,200
40) meant that the central government’s capacity to intervene Urban
for equity diminished.
900
India’s Track Record Better on Inequality

600
Inequality as measured by the Gini coefficient has increased
only marginally since 1991 when India initiated reforms. Rural
300
However, the pace of reforms and integration in the global
market (as measured by foreign trade to GDP) was also
relatively slower than that of China in this period (Exhibit 41). 0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
The slower pace of reforms in India has, however, also meant
slower aggregate income growth and this has impaired India’s
Source: CEIC, China Statistical Yearbook, Morgan Stanley Research
capability to lower the numbers below the poverty line even if
the trend in income inequality has been less worrying. Exhibit 40
Share of Local Government in Total Public
China’s rural human development index at 0.67 is higher than Expenditure
India’s total population human development index of 0.60. 75%
Even though overall population inequality has widened only
marginally, India does suffer from a high degree of regional 68%
disparity. The ratio of per capita income in the top five states
China
and the bottom five states has increased to 2.8 from 2.2 in 61%
F1994 (Exhibit 42).
54%
47%
India
40%
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2
Kanbur, Ravi and Zhang Xiaobo, “Fifty Years of Regional Inequality in China,” published by
the United Nations University-World Institute for Development Economics Research
Source: RBI, CEIC, Morgan Stanley Research
(WIDER), 2004
33

Exhibit 41
How Are the Governments Addressing
Total Foreign Trade (As % of GDP)
Poverty and Inequality?
70%
Relatively low public spending on social development has
resulted in large gaps in the standards of living between the 58%
urban and rural populations. For instance, in both China and
India the public health spending ratios are low compared with 46%
other major emerging markets whereas private spending is China

34%
comparable (Exhibit 43).
22%
Interestingly, over the past one to two years, both India
10%
governments have responded to some of the major social
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
issues. In the case of India, the outcome of the last general
elections in May 2004 was read by politicians as a vote for
Source: WTO, CEIC, Morgan Stanley Research
change – a mandate that is demanding a response from
politicians in addressing the needs of the poor. Similarly, Exhibit 42
growing social concerns in China have prompted the India: Divergence between Rich and Poor States
government to shift its focus to building “a new socialist 800 2.8
Ratio of Top 5 to Bottom 5, RS
countryside”.
660
Top 5 States (US$ per capita income, LS) 2.6
Recent Measures
520
Indian government spending on the social sector (education,
2.4
health, social security and housing) has remained largely Bottom 5 States (US$
380
constant over the past 20 years despite being low by global per capita incom e, LS)
standards. Indeed, over the past five years spending has 2.2
240
decreased to 5.7% of GDP from 6.2% of GDP in F2001. India
faces two major challenges in this respect. First, the fiscal 100 2.0
F1994
F1995
F1996
F1997
F1998
F1999
F2000
F2001
F2002
F2003
F2004
F2005
stress in the central and states’ budgets limits their social
spending capability. Second, the efficacy of even the limited
spending is affected by poor governance.
Source: CSO, CEIC, Morgan Stanley Research
Exhibit 43
For the first time since coalition government structures have
emerged, there is some hope that social development
Health Expenditure for Select Emerging Markets
expenditure will increase and governance will improve. The As % of GDP, 2002 Low Public
4.5 Expenditure...
government formed in May 2004 has initiated efforts to
3.0
increase social development expenditure.
1.5
0.0
Key measures are as follows:
Pakistan
Russian Fed.
Turkey
Thailand
Mexico
Malaysia
China
India
Indonesia
Brazil
Korea
Argentina
South Africa
National health renewal mission: In April 2005, the

government initiated a program for improving access to And…
healthcare for the rural population, especially the 4.5 High Private Expenditure
disadvantaged groups, including women and children. This 3.0
program essentially aims to integrate ongoing programs for 1.5
health and family welfare. Its objective is to enhance 0.0
Russian Fed.
Pakistan
Turkey
India
China
Mexico
Indonesia
Malaysia
Thailand
Brazil
Korea
Argentina
South Africa
healthcare service by improving access, enabling community

ownership and demand for services, strengthening public
health systems and promoting decentralization. Although
total spending has not been boosted significantly, there
Note: Data relate to emerging markets with nominal US$ GDP greater than US$100 bn and
per capita income less than US$10,000 and for which data are available. Source: World
Bank, Morgan Stanley Research
34

appears to be a greater focus on improving the outcomes China’s New Plan Focuses on Rural Economy
from current outlays. China has also initiated several measures to reduce inequality
and rural poverty. The government has decided to increase
Unemployment program: In view of the rise in rural its rural spending plan. In March 2006, Premier Wen Jiabao
unemployment, the government introduced the National Rural announced that the government would make a concerted
Employment Guarantee Act (NREGA), which promises wage effort to build “a new socialist countryside” over the next five
employment to every rural household where adult members years. The government’s objective is to improve living
volunteer to do unskilled manual work. The minimum daily standards and enhance productivity levels. The government
wage provided under this Act is the minimum wage fixed by announced a 14% increase in its 2006 rural budget to
the respective state government for agricultural laborers Rmb340 billion (US$42 billion, 1.7% of GDP). Some of the
(about US$1.5-2 per day) and the job is provided for a measures announced recently for rural development are as
minimum of 100 days in a year. follows:
In the first stage, the government aims to cover 200 districts Rural infrastructure spending: The government intends to
(about 30-35% of the total population). The program is increase rural infrastructure spending. About US$148 billion
expected to cost Rs400 billion (US$9 billion, 1.1% of GDP). (average per annum spending of US$29.6 billion, 1.3% of
However, not all of this spending will be fresh allocations by 2005 GDP) will be spent on rural roads during the five-year
the government for the purpose. The government will close period ending 2010. Increased spending on irrigation is also
several existing employment schemes, releasing funds for planned.
NREGA; hence, the additional cost of implementing NREGA
is likely to be about Rs150 billion (US$3.3 billion). Removal of agriculture tax: The government has rescinded
the agriculture tax nationwide, which will save the country's
Increased allocation for education: The central government farmers a total of Rmb125 billion (US$15.5 billion, 0.7% of
has increased the spending on education over the past two GDP).
years. The government has levied a special cess for
augmenting revenues for funding education, especially Increase in rural education spending: Rural education has
primary. Central government spending on education is significantly lagged that in the urban areas in recent years.
estimated to rise to 0.6% of GDP in F2007 from 0.5% in This has been the most important constraint on the upward
F2006 and 0.4% in F2005. mobility of rural youth. During 2006-2010, the China’s central
and local governments will spend Rmb218.2 billion (US$ 27.1
Indeed, the central government’s spending has doubled from billion) for rural education over and above the existing spend.
0.3% of GDP in F2000. However, the concern is that
spending by state governments, which accounts for over 80% Healthcare: Most villages do not have modern healthcare
of total spending, has been declining, to 2.3% in F2006 from services. They tend to be too expensive and of poor quality.
2.4% in F2005 and 2.9% in F2000. This unsatisfactory The government plans to develop and consolidate rural
performance by state governments is offsetting the positive cooperative medicare systems over the next three years. The
effort by the central government, leaving overall education central government has budgeted Rmb4.7 billion for 2006 or
spending almost stagnant. seven times that in the previous year to finance rural medical
cooperatives.
In summary, we believe that while the central government is
beginning to make a fresh attempt to increase social As in India, China’s efforts to execute a plan for improving
development expenditure and improve governance, the living standards of the rural population will be challenged by
effective execution of this plan remains a challenge. the lack of an effective institutional framework although, on an
Moreover, a significant part of the execution responsibility is overall basis, China’s track record is better than India’s. We
with the state governments and, hence, we believe that there believe that reforms to improve governance at local levels are
is a need for the central government to build in incentive urgently needed in both countries to ensure governments get
systems for ensuring effective participation by local-level the “best bang for their buck” in terms of social development
institutions. spending.
35

Education Attainment Is Key
Education Is Crucial for Breaking Vicious Cycle of Poverty and Inequality

China’s Track Record in Basic Education Is Better Exhibit 44
China implemented free nine-year compulsory education (six Adult Illiteracy Rate
years of primary and three years of junior high school) in 70%
1986. This rule was passed to ensure that rural areas, which China India
had only four to six years of compulsory schooling, were 56%
brought in line with their urban counterparts. This enabled a

dramatic increase in literacy levels in the country, especially 42%
in rural areas. However, in India literacy has lagged because

the government has put relatively less emphasis on primary 28%
education until recently. This is evident from historical trends

14%
in public expenditure on education. Per capita expenditure
was higher in India (in US dollar terms) than in China in the
0%
early 1990s, but China has since left India well behind.
1970 1980 1990 1995 2000-2001
Illiteracy Levels in India Still Relatively High Source: World Banks’ Education Statistics Database
The increased expenditure on education enabled the Exhibit 45
reduction in illiteracy rates in China from almost 33% in 1980 China and India: Education Data Comparison
to just 9% in 2000 (Exhibit 44). While India has also reduced As of China India
the illiteracy level, from 59% in 1980 to 39% in 2000, it is still Primary Schooling
significantly higher than that in China. This is despite the Gross Enrollment Ratio (%) 2004 118 116
more rigorous definition of literacy in China. In India, a Drop-Outs (%) 2003 1 21
Pupil/Teacher Ratio 2004 21 40
person is literate if he or she can write his/her name, while in
China such a person must also be able to read. Secondary Schooling
Gross Enrollment Ratio (%) 2004 73 54
Superior Support for Primary and Secondary Education Pupil/Teacher Ratio 2004 19 32
in China Source: UNESCO, Morgan Stanley Research
China ranks higher on all parameters for primary education in
a comparison with India. While both countries have a gross In India, 200 million children were in the 6- to 14-year age
primary school enrolment ratio of 100%, India ranks poorly on group in 2000 but about 42 million of this total were not at
completion ratios. The condition of primary education school although the government has recently introduced
facilities is also inferior in India when compared with China. measures to improve primary education. The government
The pupil-teacher ratio (number of students per teacher) for initiated a drive to bring school-age children not attending
primary education in China is 21 compared with 40 in India. school back to school. As a result, school-age children not in
school fell to 9.5 million in 2005 of about 210 million children
Similarly, India does not rank well on secondary schooling in that age bracket.
parameters. UNESCO estimates for 2004 that the secondary
school (entrance age of 10 years) enrolment ratio (percentage However, the effectiveness of this effort is still less than
of relevant age group receiving full-time education) was lower desirable. A recent survey led by Pratham, a non-
in India at 54% versus 73% in China. The pupil-teacher ratio government organization, indicated that, while net enrolment
for secondary schooling in India is 32 compared with 19 in has increased, the quality of education (outcome of the
China. We believe that the government should provide new government effort) is not yet satisfactory. The survey
initiatives to train this large part of the population who will indicated that the percentage of children in the 7- to 14-year
otherwise enter the work force without adequate education. age group that cannot read a small paragraph and conduct
mathematical operations is 35% (over 60 million children) and
41% (over 70 million), respectively. The survey indicated
36

that, on average, about 25% of the teachers were also absent Exhibit 46
from the sampled schools. Availability of Skilled Labor in World’s Most

Populous Nations*
India’s Has Performed Relatively Better in Tertiary Score out of 10
Education 0 2 4 6 8 10
The absolute size of the tertiary-educated population in China
Philippines (2nd)
is higher than that in India, reflecting the gap in the size of the
India (7th)
young populations between the two countries. In 2003, 15.2
million students were enrolled in tertiary education in China USA (9th)
compared with 11.3 million in India (Exhibit 47). Germany (14th)
Japan (18th)
India adds about 2.7 million bachelor-degree graduates (12 Russia (28th)
years of schooling plus three to four years of college) Brazil (44th)

compared with 3.1 million in China (12 years of schooling plus Mexico (47th)
four years of college). However, India is ahead in terms of China (55nd)
Figures in brackets indicate
the proportion of its population having attained tertiary Indonesia (58th) rank out of 60 nations
education. According to the IMD World Competitiveness Year
Book (IMD), in 2002 about 8% of the population in India Source: IMD Competitiveness Year Book 2005
* Data are for the top 15 most populous nations which have been ranked by the IMD.
between the ages of 25 and 34 years had obtained some Pakistan, Bangladesh, Nigeria, Vietnam and Ethiopia have not been included in IMD’s
survey.
tertiary education compared with 5% in China.
Exhibit 47
Another edge for India is that the majority of tertiary programs Trends in Tertiary Education Enrollment
use English as the main medium of instruction. In terms of 18 (Figures in brackets indicate gross tertiary (83%)
the extent that the university education system meets the
Millions
enrollment rate)
competitive needs of the economy, IMD ranks India eleventh 15
among 60 nations with a score of 6.2 out of 10 (the higher the (81%)
better) compared with a ranking of 53 for China with a score (15.4%)
12
of 3.2 out of 10. India has a large pool of skilled labor,
especially engineers, relative to its economy’s needs. IMD 9 (11.5%)
ranks India seventh among 60 nations in terms of availability (55%)
(6.6%)
of skilled labor. In fact, it gives India top ranking for 6
availability of qualified engineers while China is in fifty- (5.3%)
(5%)
seventh place. 3
(1.7%)
Conclusion 0
1970
1975
1980
1985
1990
1994
1995
2000
2001
2002
Both countries need to continue to boost measures to ensure 2003
their young populations have access to education. While
China India US
India in particular should put greater emphasis on basic
education, China needs to work on its tertiary education Source: World Bank, Morgan Stanley Research
efforts.
37

38

India’s Specific Challenges
39

Infrastructure Deficiencies
Infrastructure Is Key to a Strong Growth Cycle

India’s Infrastructure Spending Is One-Seventh of China’s Exhibit 48
We believe that the single most important macro constraint on Infrastructure Investment
(As of 2005/F2006) India China
the Indian economy, limiting its average growth rate, is the
US$ bn % of GDP US$ bn % of GDP
low spending on infrastructure. We estimate India is currently Transport 10.9 1.4% 95.7 4.3%
spending a miniscule amount compared to its needs. Our -- Railways 3.5 0.4% 15.2 0.7%
analysis reveals that China is spending seven times as much -- Roads 5.8 0.7% 67.1 3.0%
as India on infrastructure (excluding real estate) in absolute -- Ports 1.2 0.2% 9.7 0.4%
terms. In 2005, total capital spending on electricity, railways, -- Airports 0.4 0.1% 3.7 0.2%
Communication 8.1 1.0% 19.0 0.9%
roads, airports, seaports and telecoms was US$201 billion in
Electricity 8.4 1.1% 80.1 3.6%
China (9.0% of GDP) compared with US$28 billion in India Urban Infrastructure 1.0 0.1% 6.4 0.3%
(3.6% of GDP). We believe that India needs a national plan Total 28.4 3.6% 201.2 9.0%
to increase infrastructure spending to 7-8% of GDP, from an Source: CEIC, Morgan Stanley Research
estimated 3.6% of GDP in 2005, to push the economy onto a
Exhibit 49
sustained growth path of 8-9% a year.
Major Emerging Markets:
Share in World Goods Exports, 2005
Glaring Deficiencies in Infrastructure
Share in Share in
Except for telecoms, the cost of most infrastructure services is Country Rank World Exports Country Rank World Exports
50-100% higher in India than in China. For instance, average China 3 7.3% Malaysia 19 1.4%
electricity costs for manufacturing in India are roughly double Korea 12 2.7% Brazil 23 1.1%
those in China. Railway transport costs in India are three Russia 13 2.4% Thailand 25 1.1%
Mexico 15 2.1% India 29 0.9%
times those in China! Similarly, the average cost of freight
Taiwan 16 1.9% Indonesia 31 0.8%
payments as a percentage of imports is about 10% in India
versus around 5% in developed countries and an overall
global average of 6%. High costs aside, the lack of basic However, the manufacturing sector is constrained by
infrastructure facilities is impeding the efficiency of production. relatively inefficient and high-cost infrastructure. We believe
The gap is evident in almost all areas of infrastructure: roads, that the lack of adequate infrastructure is limiting inter-state
airports, seaports, railways, electricity and industrial as well as global trade. This is evident in India’s share of
clusters/estates (SEZs). global goods exports, at just 0.9% in 2005, compared with
China’s 7.3% (Exhibit 49). With the exception of a select few,
Infrastructure Is Key for Job Creation Indian companies that have globally competitive cost
India’s strengths of a huge skilled and semi-skilled work force, structures are not able to scale up their operations. Low
entrepreneurial expertise and natural resources are currently government spending on infrastructure hurts high-
being inadequately utilized because of lack of infrastructure. employment-generating, labor-intensive small enterprises the
The UN estimates that India will be the largest contributor to most.
the additional working-age population globally over the next
five years, accounting for 23% of the worldwide increase. We While large companies can draw on their own resources for
think infrastructure is, in many ways, the key to unlocking basic infrastructure services, such as a captive electricity
underutilized manpower. Efficient and low-cost infrastructure plant or a diesel generator set, small enterprises suffer when
is the key facilitator of globalization and labor arbitrage. India public infrastructure support is lacking. In many cases, it is
has been able to make major inroads into software services not cost per se but the sheer lack of infrastructure that holds
IT-enabled business process outsourcing exports (ITES) back small enterprises. In addition to attracting domestic
because of the availability of high-quality telecom facilities, investors for aggressive capex, improved infrastructure
the infrastructure backbone for these exports, at a reasonable should pull in foreign direct investment in manufacturing and
cost. augment a sustainable recovery in the investment cycle and
growth.
40

Many Challenges to Big Infrastructure Push …. After several years of hiatus, infrastructure investment is
The complexity around infrastructure development is unlikely picking up – albeit at a gradual pace. The government is
to be resolved quickly. The biggest hurdle is the political introducing a set of measures for different sectors to
environment. This is evident from the trend in government accelerate infrastructure spending growth. We expect
capital expenditure, which has been cut significantly since the infrastructure investment to increase to US$50 billion (4.9% of
emergence of coalition government in the mid-1990s. The GDP) by F2009 from US$28 billion (3.6% of GDP) currently.
pulls and pushes of government coalitions have inhibited a
change in spending mix. Lack of political will to work toward Some of the major areas receiving government attention are
infrastructure spending that is oriented to longer payback roads, airports, SEZs, railways and urban infrastructure. The
periods is an overriding generic worry. largest increase in investments is planned for the roads
sector. The government is implementing a seven-phase
In addition to this systemic concern, there are several program, which is likely to be around Rs1,750 billion
challenges to achieving the required steep increase in (approximately US$38 billion), and it is scheduled for
infrastructure. First, we believe that the current state of the completion in 2012. The government recently privatized
government balance sheet allows little scope for a major rise Mumbai and Delhi airports, which should help increase
in infrastructure spending from public resources. Public debt investments in these two major airports.
to GDP is at 82% and the annual consolidated fiscal deficit
(including off-budget subsidies) is close to 10% of GDP. The government has recently cleared the new SEZ Act, which
aims to attract private sector investments in SEZs. The
Second, over the years, the ability of the government government also plans to initiate a US$5 billion greenfield
administrative machinery to handle large infrastructure railway network dedicated to freight traffic (Freight Corridor)
projects efficiently has weakened. through funding from a Japanese government-owned financial
institution. In December 2005, the government launched the
Third, political interference has resulted in a large gap Jawaharlal Nehru National Urban Renewal Mission
between user charges and the costs of operating infrastructure (JNNURM) aimed at improving urban infrastructure and urban
utilities. Often the government covers the subsidy gap by basic services in over 60 cities. The plan envisages a
overburdening the paying customer – mostly industrial users. cumulative investment of US$22 billion over the next seven
In many cases, the gap in collection is due not just to years (US$3.1 billion a year). As part of this plan, the
legitimate subsidization but also to widespread theft. This is a government has already initiated work on metro rail projects
critical problem, considering that a substantial proportion of in three cities.
infrastructure utilities is owned by the government or
government-owned entities. … And New Execution Styles Are Evolving
The government is working to provide some impetus to
Fourth, poor private participation is also a hurdle to improving infrastructure by bringing in new styles of execution. It is
efficiency. We believe that, for many infrastructure sectors pushing the public/private partnership route in various sectors
(such as electricity); the only way to ensure significant including roads, airports and electricity. We believe that the
improvements in service is privatization. The electricity road development program by the National Highway Authority
distribution network is currently owned more than 90% by the of India (NHAI) to build the golden quadrilateral (GQ) road
government or government-owned entities. However, network connecting four major metros is a good example.
extensive privatization of public utilities is likely to be difficult
to achieve. Execution of this project has involved the private sector,
whereby contracts have been awarded to private players at
… But the Government Is Making a Fresh Effort agreed terms. The NHAI operates largely as an independent
Infrastructure has continued to be one of the most important supervisory authority. Although the NHAI is facing hurdles in
issues to attract the attention of policymakers over the past ensuring completion of these projects on time because of
two years. The Planning Commission of India, which is delays in land acquisition, removal of encroachments and
becoming a powerful institution for key economic policy environmental issues, overall progress under this structure
decisions, appears to be determined to push public has been much better than that achieved in the traditional
infrastructure investment. There seems to be a consensus style.
among policymakers that the infrastructure issue needs
immediate focus.
41

A Need to Accelerate the Pace Further greater participation by the private sector, raise public
We believe that slow growth in infrastructure spending is a resources by initiating the privatization of public sector
key constraint to achieving sustained economic growth of 8- companies and reducing the revenue deficit.
9% a year. The biggest hurdle to a vigorous capex cycle in
the private sector seems to be the lack of support from the Exhibit 50
physical infrastructure. Although infrastructure spend is finally India and China: Spending on Road Development
picking up as a percentage of GDP, as just mentioned, the 72
US$ bn
pace needs to be more rapid.
60
Even the planned increase is miniscule compared with what

48
China is spending currently. For instance, the maximum China
increase in investment over the next few years in India is 36
expected in the road sector. The current plan is to spend
US$38 billion by 2012 on highways. China has spent more 24
than that in just one year (Exhibit 50). In 2005, its total India
12
spending on highways was US$67 billion. We believe that,
for India’s GDP growth to accelerate to over 8-9% a year on a 0
sustainable basis, infrastructure spending would have to rise
1998
1999
2000
2001
2002
2003
2004
2005
to around 7 to 8%, versus the forecast of 4.9% by F2009
based on current spending plans. Source: CEIC, World Bank, Economic Survey (India), Morgan Stanley Research
To boost this spending, the government needs, in turn, to

improve the infrastructure investment environment to ensure
42

Weak Public Finances
The Largest Fiscal Deficit among World’s Major Economies

Fiscal Deficit Close to All-time High Exhibit 51
Since the late 1990s, India’s fiscal management has India’s Consolidated Fiscal Deficit
(As % of GDP) F2004 F2005 F2006E F2007E
deteriorated steadily. The headline combined fiscal deficit
Central Fiscal Deficit 4.5% 4.0% 4.2% 4.2%
(central plus state governments’ deficit) is estimated at 7.8%
State Fiscal Deficit 4.5% 4.0% 3.7% 3.6%
of GDP for F2006 (Exhibit 51). Including off-budget items like Sub-total 8.9% 8.0% 7.9% 7.8%
oil subsidies and state electricity board losses totaling about Inter-government adjustments -0.5% -0.2% -0.2% -0.2%
1.9% of GDP, the deficit estimate rises to 9.6% of GDP for Combined Headline Deficit 8.4% 7.8% 7.8% 7.6%
F2006. India’s deficit is the highest among those in major Major Off-budget items
---Oil Subsidy 0.2% 0.6% 1.2% 1.2%*
emerging markets (Exhibit 52) and about two to three times
---Electricity Subsidy 0.8% 0.8% 0.7% 0.7%
those of major developed economies on a percentage to GDP Overall Fiscal Deficit 9.4% 9.2% 9.6% 9.5%
basis. Although there has been some improvement in the
* Assuming oil (WTI) @ US$ 65/bbl; E= Morgan Stanley Research Estimates; Source: RBI,
fiscal deficit trend at the margin, there is little evidence that Budget Documents, Economic Survey of India, Morgan Stanley Research;
the government is implementing any major structural reforms
Exhibit 52
to reduce revenue expenditure, which we believe is critical to
Select Emerging Markets: Budget Deficit (As % of
achieve a sustainable reduction in the deficit.
GDP, 2005)
State Governments More Profligate in the Past Few Years
7.5%
Although the central government has been less profligate in
this period, poor management of state finances has been the 3.5%
key reason for the recent sharp rise in the combined deficit.
The states’ deficit was an estimated 4% of GDP in F2005. -0.5%
The states’ share in the combined headline deficit was an -4.5%
estimated 50% for F2005, up from 40% in F1996. While the
state governments’ revenue collections increased by 0.8 -8.5%
Pakistan *
Colombia
Turkey
Malaysia
Russia
Chile
Thailand
Mexico
China
Poland
India
Brazil
Argentina
Venezuela
S. Africa
percentage points of GDP over this period, aggregate

expenditure rose to 16.3% of GDP, from 14.0%. This
increase in expenditure was largely due to higher non-
development expenditure on items such as interest, pension Note: Data relate to emerging markets with nominal US$ GDP greater than US$100 bn and
and administrative services, to 6.2% of GDP in F2005 from per capita income less than US$10,000. Data for Iran & Algeria are unavailable. * Pakistan
data are for fiscal year ended F2005.
4.6% in F1996 and 3.9% in F1991. Source: CEIC, Central Bank Websites, Morgan Stanley Research
Exhibit 53
Cyclical Improvement in Central Finances Reconciling Reduction in Central Government’s
On the surface, fiscal management by the central government Deficit over Past Four Years (as % of GDP)
seems to be improving. The government has been able to cut I] Fiscal Deficit (F2002) 6.2%
its fiscal deficit from a peak of 6.2% in F2002 to 4.2% in
F2006 (Exhibit 53). However, a large part of the reduction Increase in Tax Collections 1.7%
was due to a higher ratio of tax to GDP. The rest of the Decline in Non-Tax Receipts -0.9%
Decline in Capital Receipts (Privatization and recoveries of loans) -0.5%
decline is explained largely by a decrease in interest cost,
2] Change in Total Receipts 0.3%
largely due to a fall in interest rates (debt burden has not
declined). We believe the improvement in tax to GDP is Decline in Capital Expenditure -0.7%
largely cyclical (Exhibit 54), reflecting a leveraged, Decline in Interest payments -1.1%
consumption-driven growth cycle supported by global liquidity Increase in non-interest revenue expenditure 0.2%
3] Change in Total Expenditure -1.6%
and low real interest rates. Indeed, most of the increase in
tax to GDP is due to higher corporation taxes because of 4] Fiscal Deficit (F2006E) [1-2+3] 4.2%
higher profits. For a structural decline in the deficit, we
Source: Budget Documents, RBI, Morgan Stanley Research; E= Morgan Stanley Research
Estimates
43

believe that the government would have to initiate expenditure Exhibit 54
reforms but there is no sign of such a move yet. Indeed, Cyclical Improvement in Central Government Tax
since F2002, non-interest revenue expenditure has risen by Collections
0.2 percentage point of GDP. 11.0%
7.5% IIP (RS, % YoY 3MMA,
pushed fw d six 8.8%
Internal Debt Burden Remains High
7.1% m onths)
The size of the deficit is reflected in the rise in the public debt
6.6%
to GDP ratio to 82% as of March 2006 from 65% in March 6.7%
2000 and 59% in March 1997. Since 1997, internal debt has 4.4%
6.3%
grown at a compound annual growth rate of 15% compared
with 11% growth in nominal GDP. The main driver of this 5.9% 2.2%
Trailing 12M Tax Revenues
steep rise in internal debt has been the more rapid (As % of GDP, LS)
deterioration in state governments’ finances, with their internal 5.5% 0.0%
Jun-98
Jun-99
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
debt having grown at 17% in the period compared with growth
of 14% for the central government. This high level of debt-to-
GDP stock has resulted in a large preemption of revenues for
Source: Ministry of Finance, Morgan Stanley Research
payment of interest. The combined (central plus state
government) interest payments increased to an estimated 6% Exhibit 55
of GDP in F2006 from 5.1% in F1997 and 4.3% in F1991. India Public Debt (External + Internal), as % of GDP
Rising Off-budget Burden 80%
The off-budget burden for both the central and state

72%
governments has also been rising significantly over the past
few years. Although no aggregate data are published by the 64%
government, anecdotal evidence suggests a rapid rise. Some
56%
of the major areas where the off-budget burden is increasing
are pension dues for government employees, debt of state 48%
electricity boards, oil subsidies and special-purpose vehicles
for investment in infrastructure created by the government. In 40%
F2006E
F1981
F1986
F1991
F1996
F2001
addition to these off-budget liabilities, both central and state
governments have built up contingent liabilities, amounting to
10.6% of GDP in the form of government guarantees.
Source: RBI, CSO, Morgan Stanley Research; E= Morgan Stanley Research Estimates
Reasons for the Large Deficit Exhibit 56

We believe that this deterioration in public finances reflects Coalition Politics Had Adverse Effect on
three key factors. Development Expenditure in the Past
• Weaker political environment – The declining share for

19.0% 74%
the single largest political party (due to the emergence of Share of the single-largest
policital party in seats of the
smaller regional parties) has been reflected in the fall in Low er House of Parliam ent (RS)
development expenditure. The central government has 17.0% 56%
not been able to enforce strict fiscal discipline on state

governments. This has resulted in a gradual decline in
15.0% 38%
development expenditure, especially by state
Government's development
governments. Total development expenditure dropped expenditure (As % of GDP, LS)
to an estimated 14.2% of GDP in F2006 from 17.1% in 13.0% 20%
F2006BE
F1982
F1985
F1988
F1991
F1994
F1997
F2000
F2003
F1991.
BE= Government Budget estimates

Source: Election Commission of India, RBI, Morgan Stanley Research
44

• Unabated rise in non-development expenditure - Exhibit 57
Combined non-development expenditure rose to 13.5%

India: Mix of Public Expenditure Needs to Improve
of GDP in F2005 from 11.4% in F1991. The major areas 20.0%
As % of GDP
where non-development expenditure has risen are
interest costs, explicit subsidies and pension expenses. 17.0%
Development Expenditure
• Continued weak tax compliance - Although there has 14.0%
been some improvement in this area over the past few
years, overall compliance is still not satisfactory. Of the 11.0%
total employed workforce of 363 million, as of March Non-Development
Expenditure
2005, only 30.9 million (8.5% of total) submit annual 8.0%
F1981
F1986
F1991
F1996
F2001
F2006BE
income tax returns. The actual number of taxpayers is
even lower.
How Has the Economy Sustained Such a Large Deficit?

Source: RBI, Morgan Stanley Research; BE= Government Budget Estimates
We believe that two key factors have allowed such a large
Exhibit 58
deficit to be sustained without a major shock to the economy.
First, until recently the government has maintained strict
India: Consolidated Government Interest Cost to
control over the capital account, ensuring adequate domestic
GDP
savings for funding the government deficit. Second, India's 6.5%
deficit has been largely funded through domestic debt as

opposed to external debt. In fact, the ratio of external debt to 5.5%
India’s total public debt was only 7% as of December 2005.

4.5%
Does the Fiscal Deficit Matter?

3.5%
Although we do not expect a blow-out, we believe that the
large fiscal deficit is having a negative effect on the economy.
2.5%
First, the natural corollary of a high revenue deficit is lower
government savings. This, in turn, is constraining fixed
1.5%
investments and vitiating the growth outlook. Second, to curb
F1981
F1983
F1985
F1987
F1989
F1991
F1993
F1995
F1997
F1999
F2001
F2003
F2005
the rise in the deficit, the government has been steadily
cutting expenditure on productive areas such as education,
health and welfare, which in turn influences the long-term Source: RBI, Morgan Stanley Research
growth potential. This reduction in productive expenditure is

China is ahead of India on most social indicators and physical
seen in the fall in the combined (central plus states)
infrastructure facilities. Some of the key areas where India’s
development expenditure to 14% of GDP in F2006 from 17%
expenditure to GDP ratio has been higher than China’s are
at the commencement of the liberalization process in F1991.
defense, subsidies, pensions and interest costs.
Third, the government has been forced to maintain a higher
level of indirect taxes to cover rising non-development
So What Is the Solution for India?
expenditure. The high level of indirect taxes adversely affects
India needs not only to stop accruing debt for funding less
the competitiveness of the manufacturing sector.
efficient current consumption expenditure but also to reduce
its debt stock to GDP to lower its interest cost burden.
Fiscal Management Is Better in China than India
Interest costs currently form about one-third of revenues and
China’s tax to GDP ratio has been lower than India’s on
one-fifth of total expenditure. Indeed, they have been
average in the past 10 years. However, its fiscal deficit has
consistently higher than capital expenditure since the mid-
also been lower, averaging 1.8% of GDP in the past 10 years
1990s. To stabilize its debt-to-GDP ratio, the government
compared with 8.5% in India (Exhibit 59). The key difference
needs to address the primary deficit (revenues less non-
in China has been in expenditure management. China has
interest expense). However, possible solutions to the
maintained significantly lower expenditure to GDP. Despite
problem would likely be difficult to execute from a political
having a lower expenditure to GDP ratio than India for years,
perspective.
45

First, the government could initiate major expenditure reforms December 2000 after taking into consideration the
and move effectively to outcome-based expenditure recommendations of the committee. After receiving the
management from the current outlay-based system to cut assent of the President, it became an Act in August 2003.
non-interest revenue expenditure. We believe that a The Act, along with the rules, was notified in July 2004. Note
sustainable reduction in the primary deficit would require that this legislation is only applicable to management of
expenditure reforms. We do not think the recent improvement central government finances.
in the primary deficit is sustainable as this has been achieved
through a cyclical improvement in the corporate tax to GDP While on paper the Act is expected to improve fiscal balances
ratio and an understating of the oil subsidy burden over the significantly, implementation has been inadequate. Although
past three years. the reduction in the headline deficit of the central government
appears to be line with that targeted by the FRBM Act, we do
Second, the government could reduce the debt burden in a not think it is a structural reduction in the deficit. There has
short period by stripping out its assets in the form of large been very little action on expenditure reforms. As discussed
public sector entities (PSEs). The government could sell earlier, the government has benefited from a cyclical rise in
stakes in PSEs worth, say, US$15 to 20 billion a year in the the tax-to-GDP ratio, and there has also been an understating
next five years to invest in infrastructure, which in turn would of the subsidy burden on oil products, reducing headline
help accelerate GDP growth and the tax to GDP ratio on a revenue and the fiscal deficit.
sustainable basis and, thereby, reduce the primary deficit as
well as debt to GDP. Conclusion: No Easy Solution
Over the past five years, the government has paid little
Fiscal Responsibility Act – Will It Help? attention to stabilizing the debt-to-GDP ratio. We believe that
After a long period of debate, the government passed a heavy fiscal deficit burden is one of the major hurdles to the
legislation to improve fiscal management. In 2000, the government achieving its GDP growth target of 8-10% on a
government set up a committee to recommend draft sustainable basis. A sustainable reduction in the
legislation for fiscal responsibility. It introduced the Fiscal government’s deficit would have to entail difficult and
Responsibility and Budget Management (FRBM) Bill in politically sensitive measures, in our view.
46

Exhibit 59
India and China - Comparison of Government Finances
(As % of GDP) 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
China
Total Receipts 11.6% 10.8% 10.9% 11.4% 12.1% 13.1% 13.8% 15.2% 15.9% 16.2% 16.6%
Tax Receipts 10.6% 9.9% 9.7% 10.4% 11.0% 11.9% 12.7% 14.0% 14.7% 14.7% 15.1%
--Direct Taxes 2.1% 2.1% 2.2% 2.0% 2.0% 2.3% 2.8% 3.7% 4.2% 3.8% 4.1%
Corporate Profits 1.5% 1.4% 1.4% 1.2% 1.1% 1.4% 1.7% 2.4% 2.6% 2.1% 2.5%
Personal Incomes (including agriculture) 0.6% 0.7% 0.8% 0.8% 0.9% 0.9% 1.1% 1.3% 1.6% 1.7% 1.7%
-- Indirect Taxes 7.8% 7.1% 6.9% 7.1% 7.5% 8.9% 9.6% 9.9% 10.2% 11.0% 11.8%
Domestic Production 5.8% 5.2% 5.0% 5.0% 5.3% 6.4% 7.0% 7.2% 7.6% 8.3% 8.9%
Customs 0.6% 0.5% 0.4% 0.4% 0.4% 0.6% 0.8% 0.8% 0.6% 0.7% 0.7%
Services 1.4% 1.4% 1.5% 1.7% 1.9% 1.9% 1.9% 1.9% 2.0% 2.1% 2.2%
-- Other Taxes 0.8% 0.7% 0.6% 1.3% 1.5% 0.8% 0.3% 0.3% 0.3% -0.1% -0.8%
Non-Tax Receipts 0.9% 0.8% 1.1% 1.0% 1.1% 1.2% 1.1% 1.3% 1.3% 1.4% 1.5%
Total Expenditure 12.8% 11.8% 11.6% 12.2% 13.2% 15.0% 16.3% 17.5% 18.5% 18.3% 18.0%
Of Which:
- Defense 1.1% 1.0% 1.0% 1.0% 1.1% 1.2% 1.2% 1.3% 1.4% 1.4% 1.4%
- Culture, education, public health,
science & broadcasting 2.7% 2.4% 2.4% 2.4% 2.6% 2.7% 2.8% 3.1% 3.3% 3.3% 3.2%
- Agriculture 0.8% 0.7% 0.7% 0.7% 0.7% 0.8% 0.8% 0.8% 0.9% 0.8% 1.1%
- Social welfare relief 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.3% 0.4% 0.4%
- Subsidies 1.4% 1.1% 1.1% 1.2% 1.2% 1.1% 1.3% 0.9% 0.8% 0.6% 0.6%
Fiscal Balance -1.2% -1.0% -0.7% -0.7% -1.1% -1.9% -2.5% -2.3% -2.6% -2.2% -1.3%
India*
Total Receipts 19.6% 18.8% 18.5% 18.3% 17.4% 18.2% 18.6% 18.3% 19.2% 20.5% 21.2%
Tax Receipts 14.5% 14.6% 14.5% 14.1% 13.3% 14.1% 14.5% 13.8% 14.7% 15.0% 15.8%
--Direct Taxes 3.3% 3.5% 3.4% 3.6% 3.3% 3.6% 3.8% 3.7% 4.1% 4.6% 5.0%
Corporate Profits 1.4% 1.4% 1.4% 1.3% 1.4% 1.6% 1.7% 1.6% 1.9% 2.3% 2.6%
Personal Incomes (including agriculture) 1.3% 1.4% 1.4% 1.2% 1.2% 1.4% 1.6% 1.5% 1.6% 1.6% 1.7%
Others 0.7% 0.7% 0.6% 1.0% 0.6% 0.6% 0.5% 0.6% 0.7% 0.7% 0.7%
-- Indirect Taxes 11.1% 11.1% 11.0% 10.6% 10.0% 10.5% 10.7% 10.1% 10.5% 10.4% 10.8%
Domestic Production 7.7% 7.1% 7.0% 6.9% 6.7% 6.9% 7.4% 7.3% 7.6% 7.5% 7.6%
Customs 2.6% 3.0% 3.1% 2.6% 2.3% 2.5% 2.3% 1.8% 1.8% 1.8% 1.8%
Services 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.2% 0.3% 0.5% 0.5%
Others 0.7% 0.9% 0.8% 0.9% 0.9% 1.0% 0.8% 0.9% 0.8% 0.7% 0.8%
Non-Tax and Capital Receipts 5.0% 4.1% 4.0% 4.0% 3.9% 3.9% 4.1% 4.6% 4.6% 5.4% 5.1%
Total Expenditure 26.6% 25.3% 24.8% 25.5% 26.3% 27.6% 28.1% 28.3% 28.8% 28.9% 29.0%
Of Which:
- Defense 2.3% 2.2% 2.1% 2.3% 2.3% 2.4% 2.4% 2.4% 2.3% 2.2% 2.5%
- Culture, education, public health,
science & broadcasting 2.7% 2.7% 2.7% 2.7% 3.0% 3.2% 3.2% 3.0% 3.0% 2.7% 2.9%
- Agriculture 1.9% 1.8% 1.7% 1.7% 1.8% 1.9% 1.8% 2.0% 2.0% 1.9% 2.0%
- Social welfare relief 1.2% 1.3% 1.4% 1.5% 1.8% 2.2% 2.2% 2.2% 2.1% 2.0% 2.1%
- Subsidies 1.2% 1.1% 1.1% 1.2% 1.3% 1.3% 1.3% 1.4% 1.8% 1.6% 1.5%
Fiscal Balance -7.0% -6.5% -6.3% -7.2% -8.9% -9.4% -9.5% -9.9% -9.6% -8.4% -7.8%
Source: RBI, Indian Government Budget Documents, CEIC, IMF, Morgan Stanley Research. * Data for India pertain to corresponding fiscal year ended March 31.
47

Outmoded Labor Laws
India’s Young Work Force Needs Flexibility

Youngest Work Force among Large Economies Exhibit 60
The median age of the Indian population is currently 24.3 Major Countries: Median Age (years)
2005 2010 2015 2020
years, the lowest among large nations (Exhibit 60). India will
India 24.3 25.6 27.1 28.7
add 71 million to its working-age population of 691 million by
China 32.6 34.9 36.5 37.9
2010, according to estimates by the United Nations. India USA 36.1 36.6 37.0 37.6
has to convert the advantage of having a growing working United Kingdom 39.0 40.3 40.9 41.2
population into a virtuous loop, creating productive jobs for Western Europe 40.7 42.4 44.0 44.9
the expanding work force, which, in turn, should translate into Japan 42.9 44.4 46.1 48.0
higher savings, investment and economic growth. In our Source: United Nations
view, reducing labor rigidity through labor reforms is crucial
Not surprisingly, the World Economic Forum’s global
for creating this virtuous cycle.
competitiveness report (2005) ranks India one hundred and
eleventh out of 117 countries on hiring and firing policies
Labor Laws Are Archaic
compared with a twenty-sixth ranking for China.
More than 40 labor-related laws have been enacted by the
central government on such issues as compensation,
Narrow Focus of Indian Labor Laws
retrenchment, industrial disputes and trade unions. In
Indian laws are working only for the protection of labor
addition, state governments have several pieces of labor
employed in the organized sector, which accounts for only 7%
legislation. Most laws are outmoded and are not in sync with
of the total work force. In fact, to avoid these restrictive laws,
the practical realities of a highly competitive globalized world.
a large majority of factories use ‘casual’ labor. Moreover,
Currently, any employer of more than 100 people needs to go
employers end up choosing capital-intensive methods of
through a rigorous approval-seeking process not only for
production, even if they would have otherwise preferred labor-
closing down the business but also for laying off employees.
intensive options. The labor laws are adversely affecting the
In this respect, the labor laws are more restrictive than they
employment elasticity of growth (i.e., increase in employment
were before 1976.
for every unit change in GDP growth). The legislation to
protect labor is in practice working against the overall welfare
Prior to 1976, the law allowed employers to retrench labor if
of labor.
this was warranted provided they followed the last-in/first-out
rule, giving one month of notice or pay in lieu of notice and
Labor Laws in China Are More Accommodative
half a month of wages for each year of service and informed
China has pursued major reforms in its labor market since it
the government. However, in 1976 this regulation was
initiated its liberalization program in the late 1970s. Over the
amended, making it mandatory for employers with more than
years, it has adopted greater flexibility in labor, in terms of
300 employees to seek approval from the government before
hiring as well as firing. While initially this policy was
retrenching or closing a part of the enterprise. This was
applicable to the private sector, in the 1990s China
further amended in 1982 with employers of more than 100
implemented a lay-off program for state-owned enterprises.
workers now needing prior government approval for
Since 1996, the SOE and collective workforce has declined
retrenching.
by 67 million to 76 million currently.
Apart from the laws per se, an added challenge comes from
Labor Productivity Is Lower in India than in China
the painfully slow and complex nature of the legal
On an aggregate basis, China’s productivity is ahead of
proceedings, which increases labor costs. Over the period
India’s, which is reflected in higher compensation in China.
since 1976, some of the court judgments have effectively
According to IMD, in 2004 China’s labor productivity
added to the rigidity of the labor laws. For instance, if an
(measured in terms of PPP-based GDP/ employed person/
employer does not renew a contract at the end of the contract
hour) was also higher at US$4.8 compared with India’s
period this is effectively tantamount to retrenchment.
US$3.1. In select industries in the organized sector, this gap
Similarly, termination of employment at the end of a probation
is even bigger. Based on a study by the Confederation of
period has been treated as retrenchment.
Indian Industries (CII), labor productivity in China’s organized
48

sector is about 10 to 300% higher than in India for certain Exhibit 61
large industries. Labor Productivity: GDP (PPP) Per Person

Employed Per Hour, US$
Political Will in India Is Still Lacking USA 43.2
Even though the current labor laws are hurting the welfare of Germany 36.2
the overall work force, politicians are finding it difficult to Japan 31.0
introduce reforms. In 2002, the National Commission on Singapore 26.5
Labor appointed by the Parliament recommended a Hong Kong 25.4
comprehensive revamp of the legislation. One of the major
Taiw an 24.6
recommendations was consolidation of various pieces of
Korea 17.6
labor legislation into a single piece called “Labor Management
Mexico 10.2
Relations Laws”.
China 4.8
Indonesia 3.7
On retrenchment, the recommendation was for higher
compensation to the retrenched employees and an automatic India 3.1
time-bound approval for closure of units employing 300 or

Source: IMD Competitiveness Year Book, 2005
more workers (compared with 100 or more workers currently).
There have been a number of consultations among the Exhibit 62
government, employers and trade unions on these Labor Reforms in China
recommendations. However, no reforms have been initiated Freedom of
In 1980, urban job seekers were allowed to find
so far. choice
work in SOEs, collectives or the private sector.
Enterprises were given more autonomy in hiring
Although there was an attempt by the Ministry of Industry to decisions. Instead of unilaterally allocating
workers to manufacturing units, labor bureaus
initiate labor reforms in a phased manner by first relaxing the
began introducing workers to units.
laws for Special Economic Zones, this idea was rejected by
the coalition members of the government. We believe that Wages
Firms were allowed to give bonuses to
reforming labor laws will be needed as a catalyst for employees. The employer’s discretion on wages
promoting labor-intensive small and medium-scale was increased in 1994.
manufacturing. Contract labor
In the mid-1980s, a labor contracting system was
introduced, a step change from the earlier life-
time employment system. There were further
reforms in 1994, which enabled the share of
contract labor to increase.
Retrenchment
In the mid-1990s, state enterprises were allowed
to retrench labor but had to establish re-
employment centers (RECs) to provide retraining,
job search assistance and unemployment benefits
to these laid-off workers for three years. The
government has already initiated the process to
phase out RECs.
Source: IMF, Morgan Stanley Research
49

The Need to Encourage FDI Inflows……
India’s FDI Inflows Improving but Still Low

FDI and Privatization Can Augment Resource Exhibit 63
Mobilization FDI Flows into India

A key reason for India’s below-potential economic growth rates is 7.0 1.0%
FDI Inflow s (US$ bn, LS)
the government’s relatively weak resource mobilization effort. FDI inflow s as % of GDP, RS
FDI and privatization are the key funding sources that can help 5.6 0.8%
augment the resource availability. India has received an average
of about US$4.4 billion a year from privatization and FDI over the 4.2 0.6%
past ten years compared with US$53 billion a year in China. In
2005, India’s FDI flows were estimated at US$6.6 billion (0.9% of 2.8 0.4%
GDP) compared with US$60 billion in China (2.7% of GDP).
Even if we exclude an estimate of US$15 billion for round-tripping 1.4 0.2%
in China, total adjusted FDI would be about US$45 billion, seven
times that of India’s FDI. Although FDI inflows for India should 0.0 0.0%
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
rise modestly over the next three years, we think an aggressive
thrust is necessary to augment resource mobilization
meaningfully. Source: UNCTAD, Morgan Stanley Research
Exhibit 64
India’s Share in Global FDI is Improving But Still Low
India & China: Rank in World FDI Inflows
India’s share in global FDI flows improved to an estimated 0.7%
0
in 2005 from close to zero in 1991 when the government initiated
China
liberalization in FDI-related regulations. Its ranking in terms of 15
the value of gross FDI inflows has also steadily improved to
twenty-first in 2004 from forty-eighth in 1992 (Exhibit 64). 30
However, we believe that FDI inflows are still significantly below

45
potential. FDI inflows in India are at 0.85% of GDP (in 2005) India
compared with the average of 4% of GDP (in 2004) for 60
developing countries. India’s inflow at US$6.6 billion in 2005 was

75
significantly lower than that for other major emerging markets like
China (at US$60.3 billion), Mexico (US$17.8 billion), Brazil 90
1980
1983
1986
1989
1992
1995
1998
2001
2004
(US$15 billion) and Russia (US$ 14.6 billion) (Exhibit 65). If India
were to receive FDI inflow of 4% of GDP, in line with the
developing countries’ average, economic growth would be 0.7 Source: UNCTAD, Morgan Stanley Research
ppts higher (assuming the current trend-line average capital Exhibit 65

output ratio of 4.4%). FDI Inflows into Key Markets (US$ bn)
65
FDI Inflows Should Pick Up Moderately India
Gradual reforms should ensure a moderate pickup in FDI inflows China
52
although these are still likely to be less than desired levels. First, Brazil
Mexico
India is continuing to expand as a major destination for services 39 Russian Federation
sector outsourcing. While FDI inflows for services tend to be
relatively small as this sector is not very capital intensive, its 26
contribution is rising. Second, we expect an increase in FDI in

13
mining and metals manufacturing (exports and domestic
markets) because of India’s strength in natural resources, 0
including iron ore, bauxite and thermal coal. Third, there should
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
be a steady increase in FDI focused on growing domestic market

Source: UNCTAD, Morgan Stanley Research
opportunities, especially in consumer goods.
50

Exhibit 66
Hurdles to FDI Flows to India
Comments
Laws in general rather than those specific to FDI are in many cases a major hurdle to investments. For instance, laws
Regulations and Laws relating to food processing are complex, making it difficult for investors, domestic as well as foreign, to invest large
amounts in this area.
Except for telecoms, the cost of most infrastructure services is 50-100% higher in India than in China. For instance,
average electricity costs for manufacturing in India are roughly double those in China. Railway transport costs in India
Infrastructure
are three times those in China! High costs aside, the simple lack of basic infrastructure facilities are impeding efficiency
of production.
More than 40 labor-related laws have been enacted by the central government. In addition, state governments have
introduced several pieces of labor legislation. Most laws are outmoded and are not in sync with the practical realities of
Labor Laws
a highly competitive globalized world. Currently, any factory employing more than 100 people needs to undergo a
rigorous approval-seeking process not only for closing down but also for laying off employees.
Approval for investment proposals and clearance requires long lead times. Although the government is steadily taking
Procedures
steps to reduce the time required, it is still much longer than is desired.
Although the rule of law is a big attraction with respect to India, the effectiveness of this sound legal environment is
Legal Proceedings
hampered by the long delays in legal proceedings. There are currently 28-29 million legal cases pending for the courts.
The high indirect tax rate for the organized sector in India is a key contributor to the higher manufactured product prices
compared with those in China. In addition, the Indian tax system suffers from a multiplicity of rates and surcharges
Tax Structure
compared with one single rate in most other emerging markets, including China. The government, is in the process of
reforming the indirect tax laws but it could be another three years for these changes to be fully implemented.
Source: Morgan Stanley Research
Exhibit 67
POSCO’s US$12 Billion Investment Plan - Timeline
July - August 2004 POSCO and BHP Billiton jointly approach the Orissa government to set up an integrated steel plant.
August 2004 - March 2005 The POSCO team makes multiple visits to India; evaluates various site locations and fine-tunes details of the project.
The signing of an MOU cancelled following disagreement between the government and POSCO on the export of iron ore by the
April 2005
venture from India.
May 2005 BHP Billiton opts out of project, citing differences due to constraints imposed by the state government.
POSCO submits a revised proposal to the Orissa government; scaling down the quantum of iron ore it wishes to export.
Finance Minister calls for a meeting to finalize details regarding the project.
June 2005 MoU for setting up a US$12 billion plant signed on June 22 after further negotiations & settlement of the iron ore issue.
July 2005 POSCO decides to set up a captive port in Orissa; finds existing facilities at the government-owned port inadequate
August 2005 Company indicates detailed feasibility report likely to be delayed.
Orissa government asks POSCO to partner with an Indian company for the mining project in place of BHP Billiton; clause not part
October 2005
of MoU; POSCO in talks with 7-8 companies
POSCO revises implementation schedule; project to be set up in three phases of 4 million tonnes each, first phase to be
December 2005
completed by December 2010.
Central government warns that POSCO's captive port plans could lead to environmental problems. Orissa government asked to
conduct detailed feasibility study.
POSCO insists on setting up captive port, re-asserting that existing facilities are inadequate
January 2006 Protests in Orissa against displacement of families on account of project. Ministerial committee set up to formulate package for
displaced families.
February 2006 POSCO indicates that it is undertaking studies to gauge impact of its proposed captive port.
March 2006 POSCO scales down demand for land to reduce the number of families that have to be rehabilitated.
POSCO submits proposal to Orissa government for captive port; reiterates need for separate facility
Present Status Captive port issue remains unresolved, detailed feasibility report also delayed; government has announced rehabilitation policy for
displaced families but locals continue opposition.
Source: Press Reports, Company Data, Morgan Stanley Research
51

Fourth, recent liberalization measures implemented by the encouraged a lot of round-tripping. Even if we exclude such
government should result in a gradual rise in FDI in the real investments, China’s net inflows at US$45 billion in 2005
estate sector. We expect FDI investments to rise from would still make it the largest recipient of FDI among
US$6.6 billion currently to US$10 billion (1% of GDP) by developing countries. Another popular argument in India is
2008. that, unlike China, India’s FDI figures have not in the past
included reinvested earnings as per the International Finance
Why FDI Flows Are Relatively Low Corporation (IFC) norm. However, the Reserve Bank of India
We do not think the disappointing response of FDI investors (RBI) has now started releasing FDI figures for India,
to India is necessarily due to the constraint of foreign including reinvested earnings. In this report, we include
investment limits. Many of the hurdles faced by foreign reinvested earnings in India’s FDI figures.
investors are the same as those suffered by domestic
entrepreneurs. Significant coverage has been given in the FDI Outflows Are Rising
foreign media to delays in increasing foreign investment limits Relaxation of capital controls by the government has induced
in some of the politically sensitive sectors such as insurance Indian companies to invest abroad. In 2003, the RBI further
and banking. In our view, regulations in India on foreign liberalized the regulations on FDI investment by Indian
investment limits on an overall basis are not rigorous companies in other countries. FDI outflows from India rose to
compared with those in some other emerging markets that US$2.0 billion in 2004 from US$0.5 billion in 2000. This is in
have higher shares than India of total FDI flows to developing line with the trend for other major developing markets
countries. For instance, the foreign investment limit in India generally. Aggregate outflows from developing countries rose
for most manufacturing sectors has been 100% for the past to US$40 billion in 2004 from US$16 billion in 2002.
few years.
Low Net FDI Inflows Result in India Relying More on
We think FDI in India is deterred by the general business Relatively Less Stable Flows
environment rather than specific FDI regulations. The main Capital flows into India have risen sharply since 2003, at
obstacles are inadequate infrastructure facilities throughout US$65 billion compared with US$30 billion in the preceding
the country, rigid labor laws, bureaucratic controls and three years. However, net FDI flows totaled only about
procedures and long delays in legal proceedings (Exhibit 66). US$11 billion in this period. Most of the improvement in total
For instance, although POSCO has shown keen interest in capital inflows has been due to higher non-FDI flows.
setting up a steel plant in the state of Orissa, translating that Cumulatively, for the past three years non-FDI flows
intent into investments is taking an unusually long time accounted for about 83% of total capital flows in India
(Exhibit 67). POSCO initially faced hurdles in identifying compared with 32% for the top emerging markets (Exhibit 68).
mines and negotiating the terms with the government for One of the most important non-FDI sources for India has
accessing those mines. Later it encountered problems in been portfolio investment. Of the total capital flows of US$65
acquiring land for the plant and ports. POSCO first billion received over the past three years, US$29 billion were
announced its investment plan in July 2004 but it appears that in the form of portfolio inflows. Indeed, in 2005 portfolio flows
meaningful investment will start flowing only from 2007. accounted for about 45% of the total capital flows in India.
India has been one of the most favored markets over the past
Similarly, the government has liberalized FDI rules in real three years, representing an estimated 20%-25% of total
estate recently but the domestic regulations relating to the portfolio flows into developing markets.
Urban Land Ceiling Regulation Acts (ULCRA) and other laws
and procedures remain impediments to rapid expansion in Exhibit 68
construction investment by foreign companies. Many large Composition of Capital Flows for Top 10 Emerging
states have yet to repeal the ULCRA. Such obstacles prevail Markets1
EM Basket
in many sectors and, unless the general investment (Data for 2003-2005) (Ex-India) India
environment improves, there is likely to be only a gradual Total Net FDI Flows* (US$ bn) 250 11
increase in FDI investment. Total Capital Flows (US$ bn) 366 65
% Share of FDI Flows 68% 17%
Are China’s FDI Figures Overstated vs. India’s? % Share of Non-FDI Flows 32% 83%
It has been argued that FDI inflows into China are overstated 1. Includes Russia, Mexico, India, Turkey, Indonesia, South Africa, China, Korea, Brazil and
Taiwan; * FDI inflows less outflows; Source: IMF, Central Bank Websites, CEIC, Morgan
compared with those in India. The most common argument is Stanley Research
that favorable tax laws for foreign investors in China have
52

………and Privatization
India’s Privatization Policy Misses the Big Picture

India’s Privatization Process Has Been Abysmally Slow the private sector, the current government appears to be
Since India first initiated the privatization of public sector against this option.
enterprises (PSEs) in 1991-92, the process has been very
slow. The total amount collected through privatization is just The present government’s common minimum program (CMP)
US$12.8 billion over 15 years – US$850 million a year – and allows privatization only of units with chronic losses and
an annual average of just 0.2% of GDP (Exhibit 69). permits profit-making companies to raise funds for expansion.
Privatization remains a highly debated and politicized topic However, the Finance Minister, who is in favor of reforms, has
although the previous government appeared to be moving in managed to push through the sale of some government
the right direction. The key argument presented by politicians stakes in the secondary market without the transfer of
against privatization is that it results in job losses, adding to government control. Given the political pressures, the
social pressure. In our view, however, the appropriate government is unlikely to collect a substantial amount of funds
application of funds raised from privatization could help create through this route.
jobs and alleviate social pressures.
Exhibit 69
The Extent of India’s Assets in PSEs Privatization Proceeds (US$ bn)

Our very broad estimate indicates that the total market value 4.0
of government companies (including unlisted companies) is
3.2
US$200 to 225 billion. Government-owned listed companies
are currently valued by the market at US$140 billion. Note 2.4
that our estimates are derived from a secondary market-
based valuation measure. We think the government could 1.6
realize a much higher amount if it opted for strategic stake 0.8

sales with the transfer of management control to the private
sector. The basket of unlisted companies is also large. 0.0
F2007BE
F1992
F1993
F1994
F1995
F1996
F1997
F1998
F1999
F2000
F2001
F2002
F2003
F2004
F2005
F2006
Some of the large profit-making unlisted PSEs include Life
Insurance Corporation of India (the largest life insurance
company in India with an asset base of approximately Source: RBI, Government Budget Documents, Morgan Stanley Research; BE= Government
Budget Estimates
US$110 billion), Bharat Sanchar Nigam (the biggest telecom
company in India with a subscriber base of 54.6 million), Coal Will Privatization Impair Labor Welfare?
India (the largest coal company in India with an annual coal Politicians who oppose privatization claim that the policy hurts
output of 324 million tons) and Nuclear Power Corporation the welfare of the labor force. The common concern is that
(capacity of 3,310 megawatts). Our overall estimate excludes privatization will result in job losses in the public sector units
the government’s non-corporatized assets, which include that are privatized. In our view, this argument misses the big
infrastructure facilities (such as Indian Railways, large picture and focuses on a very narrow section of the
electricity generation and distribution capacity, seaports, population. The total work force employed in public sector
airports) and a large land bank. undertakings of the central government (excluding those
directly working in administrative machinery) amounts to six
Lackluster Privatization Record million, just 1.6% of the total work force; hence, only a very
Privatization in India has so far been on a slow track. small part of the total work force is being protected.
Moreover, 80% of privatization receipts are from divestments
of stakes in the secondary market without transferring Moreover, while the government continues to own these
management to the private sector. Although the previous entities, market forces are, nevertheless, forcing it to pursue
BJP-led coalition government did start the sale of strategic labor rationalization. Many entities resisting market forces
stakes in public sector units by way of transferring control to have become unviable, questioning the sustainability of this
protective policy.
53

Right Application of Privatization Funds Is Critical which we believe are critical for accelerating growth and
The government has so far not been able to demonstrate any would, we believe, help create jobs for the semi-skilled, less-
visible gain from privatization, in our view. The small amounts educated sections of the work force. We believe that
that have been collected from privatization have been used to potential job creation from investments in infrastructure could
fund the deficit. Indeed, over the past 15 years, the more than offset job losses due to privatization.
government has cut development expenditure as a
percentage of GDP to 13.9% (in F2006) from 17.1% (in Although key policymakers clearly appreciate the urgent need
F1991). for investments in infrastructure but are short of funds with the
current national fiscal deficit (including off-budget items) being
We think the government should direct funds collected from close to 10% of GDP. Funding constraints are currently
privatization to productive areas through special-purpose limiting the government’s annual spending on infrastructure to
vehicles in a transparent manner, clearly demonstrating the US$28 billion. We estimate the government could increase
benefits of privatization. The government should allocate infrastructure spending by at least US$15 to 20 billion (1.5%
these funds directly to fresh investments in rural and urban to 2% of GDP) a year for the next three to four years through
infrastructure and/or other development expenditure, both of privatization.
54

China’s Specific Challenges
55

Weak Banking Sector
Strengthening China’s Banking System Is Key to Sustainable Growth

China’s Banking System 8.5 Times Larger Than India’s Exhibit 70
Although, China’s GDP is about three times India’s, its India and China: Banks – A Snapshot
(As of end-2005, US$ bn) China India
banking system (in terms of loan assets) is 8.5 times larger.
Deposits 3706 436
India’s credit to GDP ratio at 39% is significantly lower than
--As % of GDP 165% 57%
China’s 113% (Exhibit 70). Although one of the key Credit 2554 304
differences between the two economies that explain the huge --As % of GDP 113% 39%
variation in the sizes of the banking systems is their savings Credit-Deposit Ratio 69% 70%
to GDP ratios, we believe that China’s credit growth has run --Consumer Credit 271 81
--As % of GDP 12% 11%
ahead of the sustainable trend. China’s credit-to-GDP ratio is
Investments na 159
far higher relative to its per capita income when compared --As % of GDP na 21%
with other Asia/Pacific markets (Exhibit 71). Gross NPL Ratio* 8.9% 5.2%
--As % of GDP* 6.7% 1.9%
Issues Facing the Chinese Banking System Source: CEIC, CBRC, RBI, Morgan Stanley Research
Improving the efficiency of the banking system is critical for * Data for India as of March 2005, due to unavailability of latest data. Data for China are as
published by CBRC and do not include all banks
China as total savings stock in the form of bank deposits is
large at 165% of GDP. The institutional framework of the Exhibit 71
Asia: Credit Penetration vs. Per Capita Income
Chinese banking system is in a formative stage when
compared with international standards. The following are
140%
Loan to GDP
Hong Kong
some of the key challenges it faces: Taiwan
110% Australia
China Malaysia
Government’s excessive influence on resource allocation
Korea Singapore
and weak governance: China’s growth model has provided 80% Thailand
incentives to local governments as major owners with strong
influence over the banking system and companies within their 50%
provinces. The four large banks, which account for about India
Indonesia (As of 2005)
54% of the total assets of the banking system, have been 20%
traditionally operating under the strong influence of 0 5000 10000 15000 20000 25000 30000 35000
GDP Per Capita (US$)
government bureaucracy and mandates, including credit
allocation decisions. This has resulted in multiple and mixed
business goals for banks. Large banks’ ownership structure
and corporate governance have adversely affected their Exhibit 72
ability to evolve a self-managing risk-assessment system. Credit Growth (% YoY, 3MMA)

Even after SOE managers have been granted increased
autonomy, the incentive system is aligned in a way that 30%
India
encourages them to over-invest. The high level of NPAs in
the banking system is to a very large extent a reflection of this 25%
incentive structure.
20%
Weak credit appraisal systems: The system of internal
assessment and credit rating mechanisms in Chinese banks
15%
is not robust. There is a lack of adequate data collection with
regard to borrowers and facilities, which serve as a basis for a China
quantitative approach to measure and to manage credit risk. 10%
Mar-98
Mar-99
Mar-00
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06
The Chinese banks are gradually trying to overhaul their

credit appraisal processes to bring them in line with
international best practices.
Source: CEIC, RBI, Morgan Stanley Research
56

High credit penetration: China’s high savings rate, coupled Exhibit 73
with low real interest rates, has resulted in substantial capital China and India: Banks – Market Share of Loans
(As of 2004/F2005) China India
expenditure expansion over the past few years. Indeed,
SOE Banks 84.1% 73.2%
banks have been relied on too much for funding business
---Top 4 53.7% 34.3%
capex. We believe this has resulted in a macroeconomic Private banks (Other joint stock commercial banks) 14.9% 19.9%
imbalance, as reflected in the country’s banking credit-to-GDP Foreign Banks 1.0% 6.8%
ratio of 113%. Indeed, if we include the credit disbursed by Source: CEIC, CBRC, RBI, Morgan Stanley Research
non-banking entities, the credit-to-GDP ratio is even higher at
136%. The government has recognized this as a problem certain banks with a large number of overseas branches will
and has initiated measures to slow credit growth to unwind adopt Basel II norms from 2010 to 2012.
the excesses. As a result, the credit (excluding that from non-
banking) to GDP ratio has started to ease, having peaked at Aggressive Effort by China to Improve Banking Sector
126% in April 2004. The Chinese government has recognized the weaknesses in
its banking system. It has initiated several reforms to
Weak asset quality: The lack of an adequate risk- inculcate a more market-oriented culture for the banking
assessment system has resulted in large balances of non- system. The China Banking Regulatory Commission (CBRC),
performing loans (NPLs) in the banking system. At the end of established as the regulator of the banking industry in 2003,
2003, NPLs represented 17.8% of loan assets (18% of GDP), formulates rules and regulations and has been a key player in
according to China’s five-category loan classification system. promoting banking reform. It has pushed the banks to
However, NPLs had declined to 8.9% of loan assets by the improve risk-control systems, address the NPL situation,
end of 2005 (6.7% of GDP). This decline was driven by NPL tighten capital adequacy restrictions, and intensify
disposals as part of the restructuring for some of the large inspections. The government has been working on reforming
banks like Bank of China, Bank of Communications and China state-owned banks to convert them to modern banks through
Construction Bank. This of course is not as healthy as reforms of their ownership structure and corporate
correcting NPLs gradually by such measures as better credit governance. Some of the key reforms implemented over the
management, the means by which Indian banks have cut their last few years are as follows:
NPL levels.
Ownership reform: China allows foreign banks to acquire
Limited competition structure: The People’s Bank of China stakes in state-owned banks. About 20 banks in China now
(PBOC) was the key bank in China until the early 1980s. The have foreign strategic stakes. The cumulative investment
government then created four new SOE banks and moved the from foreign investors in Chinese banks totals more than
responsibility of regulation to PBOC. Until the late 1990s, US$20 billion. India lags China in this respect. The Indian
there were no other commercial banks operating in China. government has allowed a strategic stake acquisition by a
Even though a few joint-stock banks have now been formed foreign bank in only one local bank.
and foreign banks have been allowed a limited presence, the
top four SOE banks still have 54% of the market (all SOEs Efficiency reform: Over the past few years, the government
together account for 84% of loans). has focused on improving efficiency by reducing the number
of branches and the employee base. Over the four years
Relatively low capitalization: Only eight of the total of ended 2004, the number of branches declined by 25% and
around 115 banks in China had a capital adequacy ratio the employee base contracted by 10%.
(CAR) over the Basel I requirement of 8% as of 2003.
However, the situation has improved over the past two years Balance sheet reform: Over the past three years, China has
with the number of banks with a CAR over 8% increasing to reduced the NPLs in the banking system by using its strong
53 as of 2005. The Chinese government also improved the fiscal position. The government has disposed of the NPLs on
CAR of the two large banks (Bank of China and China banks’ balance sheets, bringing the level down to a more
Construction Bank) by injecting US$45 billion in January acceptable 8.9% in 2005.
2004. In addition, the two banks raised over US$19 billion via
equity issuances. In India, most banks already comply with Pricing reform: The government has gradually granted
the stricter norm of 9% and will move to meeting Basel II banks greater freedom in pricing loans, which in turn is
requirements by March 2007. China has announced that helping to improve margins.
57

India’s Banking System – On a Better Footing too, official gross NPLs are just 1.9%. This turnaround has
In comparison, the Indian banks are in a much better position been brought about by the better credit-appraisal methods
in terms of risk-assessment systems, NPLs, capital base and adopted by the Indian banks and an improvement in the
effective central bank supervision. business cycle, which has resulted in older NPLs turning into
performing assets. However, we believe that the underlying
Relatively better risk-assessment systems: In India, the levels of NPAs could be rising again in view of recent strong
risk-appraisal system has improved significantly over the past credit growth. Even if NPAs are higher than official levels,
few years. This is especially the case with the private sector they are likely to be manageable for the banking system.
and foreign banks, which have implemented IT solutions,
enabling a centralized credit-appraisal system. For public Competition: In the mid-1990s, the RBI allowed the private
sector banks, risk-assessment systems are relatively inferior sector to open new banks, which increased the level of
to those at private and foreign banks but are improving at the competition. In fact, in F2005 the share of SOE banks in
margin. system loans was 73% compared with almost 85% in F1996.
The increased competition has also created a need for SOE
Adequate capitalization: The RBI has implemented a much banks to implement technology solutions as they have lost
stricter capital requirement norm, with the minimum CAR of market share in deposits, fees and advances to private sector
9% for Indian banks versus the Basel requirement of 8%. banks because of inadequate infrastructure in the form of
This has resulted in a relatively strong capital base in India, ATMs and networked branches. Competition from foreign
with the average CAR at 12.8% as of end-March 2005. The banks has also increased over the past few years.
Indian banks, especially the state-owned banks, were helped
in this regard in 2002 to 2004 by the continued decline in Indian Banks’ Own Set of Challenges
interest rates, which resulted in higher treasury earnings on Although on an overall measure Indian banks are much better
large government bond portfolios. placed than the Chinese, we believe the former also face
some structural challenges. The first and biggest risk to the
Stricter supervision by the central bank: The RBI has been Indian banking system, in our view, is its high level of
at the forefront in terms of laying out strict norms to ensure exposure to long-tenure government bonds. On average,
stability of the Indian banking system. Some of the key about 30% of their total assets are in government bonds.
regulations, apart from the higher CAR requirement, are as Indian public-sector banks, which account for almost three-
follows: fourths of total deposits, chose to increase the average
maturity of their government securities investment portfolios
• Setting an investment fluctuation reserve of 5%, which all even as interest rates dropped below sustainable levels.
banks had to maintain by March 2006. This helps the Although the average maturity of Indian banks’ bond portfolio is
banks in the event of adverse movements in interest not available, we believe it has increased significantly. The
rates. government raised the average maturity of its debt to 9.6
years in F2006 from 6.3 years in F1999. We believe that, if
• Changing the NPL recognition norm to 90 days in March there is a sudden and sharp rise in interest rates to the extent
2004 from 180 days previously, to ensure continuing of 250-300 bps in 10-year paper, it would pose a big threat to
sound asset quality at banks. the health of the Indian banking system.
• Ensuring that only banks with a strong capital base and The second problem for Indian banks is in respect of the
good asset quality are allowed to pay dividends. mandatory lending to priority sectors. Banks have to lend
40% of their overall loans to agriculture, small-scale industries
• Banks are required to comply with Basel II norms by and other weaker sections of society. Such lending has
March 2007, which requires adoption of more stringent historically increased the NPLs in the banking system and
risk management. Under the new regime, banks will be reduces banks’ operational freedom.
required to set aside capital for operational risk.
The third problem is restricted access to foreign capital,
Manageable level of NPAs: The asset quality of Indian which is capped at 20% for SOE banks and 74% for private
banks has strengthened significantly over the past few years, banks. Until 2009, foreign banks cannot take a strategic
with the official gross NPL ratio improving to 5.2% in March stake in excess of 5% unless the domestic bank is
2005 from 15.7% in March 1997. As a percentage of GDP, categorized as ‘weak’. This restricted access to foreign
58

capital in India, especially for SOE banks, which form a large Conclusion
part of the system, is constraining the availability of growth A strong banking sector is one of the key ingredients for faster
capital. China is much more liberal in this respect. China’s and stable economic growth for transition economies. An
total foreign ownership cap on a strategic basis (excluding efficient financial sector can promote savings and enable the
shares listed overseas for portfolio/individual investors) is flow of a larger share of savings into productive investments.
25% with maximum ownership of one single entity limited to The efficiency of the banking sector will be important for the
20%. stability of the financial system. Indeed, a weak banking
sector was the genesis of many of the financial crises in
The fourth problem is the low capability of the government’s transition economies in the 1980s and 1990s. While China’s
balance sheet to absorb banking system losses, if these real economy has moved far ahead of India’s, its banking
occur. In India, public debt to GDP is already high, at 82%, system lags that of India’s. Recent efforts by the Chinese
compared with around 27% in China. This restricts the government are encouraging but the path to a truly market-
government’s ability to bear the burden of any significant oriented stable financial system is long and challenging.
write-offs of banking sector bad debts or inject capital; hence,
maintaining strict controls on the banking system is imperative
for the government.
59

Shifting to a New Currency Regime
Open Economy but Relatively Inflexible Exchange Rate Structure

India Has Led China in Exchange Rate System Reform sharp increase in capital flows pushed its foreign exchange
India has had a greater focus than China on building soft reserves to US$875 billion in March 2006 from US$3 billion in
infrastructure (institutional framework). The government 1985. However, its exchange rate policy reforms have lagged
initiated calibrated reforms in both the banking sector and the overall progress in the economy.
exchange rate regime from the early 1990s. These reforms
were to a large extent an outcome of the 1991 balance of Traditionally, the government has determined the exchange
payments crisis, which brought to the fore the risks of rate based on a composite set of factors, including an
continuing with controlled systems that eventually cause international consumer price comparison, the weighted
shocks. The exchange rate and banking sector reforms were average values of a basket of major currencies, and foreign
a part of the broader liberalization program whereby India exchange settlement for overseas Chinese remittances,
adopted an open-economy model. tourist expenses, transportation and other non-trade
transactions.3 Prior to 1979, China imposed strict controls on
India made its first move to the transition from a fixed to a exchange transactions. Although exchange controls have
managed floating exchange rate regime in 1992. Prior to that, been relaxed gradually since then, the government still has
it had followed a de facto peg against the US dollar, which significant capital account controls and its exchange regime
was adjusted periodically. The first step was to have a dual remains fairly inflexible.
exchange rate along with other broader macro economic
reforms. Under the dual exchange rate system, the Slow Transition to Flexible Exchange Rate Regime
government accepted the existence of two exchange rates – Although the fixed exchange rate regime and capital controls
the official exchange rate, which was controlled, and the proved to be a source of strength for China during the Asian
market rate, which was allowed to fluctuate with prevailing crisis, the government is increasingly facing pressure from the
market conditions. Only 60% of export earnings could be external world, especially the US, to implement a flexible
realized at the market rate and the balance of 40% had to be exchange rate regime. Several issues are being debated,
surrendered at the official exchange rate. including whether the renminbi is overvalued and should
China opt for a one-time adjustment in its currency.
At the second stage, the government took the most important
step towards full convertibility on the current account by There are several entities in the camp that argues that the
unifying the two exchange rates. However, the central bank renminbi is undervalued and that China should allow greater
intervened actively in the foreign exchange market. Over the flexibility in its exchange rate. The argument is based on
years, India has continued to strengthen the banking sector China’s large trade surplus and its rising bank of foreign
and financial markets in general. The flexible exchange rate exchange reserves. A statement by G7 finance ministers and
regime has survived three distinct periods of volatility: 1995- central bank governors emphasized that “Greater exchange
1996, post the Mexican crisis; 1997-1999, a period of major rate flexibility is desirable in emerging economies with large
disturbing events such as the Asian crisis and nuclear tests current account surpluses, especially China, for necessary
by India; and 2001 after the 9/11 incident in the United States. adjustments to occur”.
The central bank now follows a clearly specified policy of
intervening to check volatility but has been less aggressive in The Chinese government, however, has always been
influencing the direction of the exchange rate. cautious about changing its exchange rate regime in view of
the position of its financial system, the potential threat of
China Lagging in Reforming Exchange Rate Regime destabilization and, more importantly, the implications for
Over the past 20 years, China has witnessed massive employment growth. However, international pressure is
transformation from a centrally planned economy to a market- continuing for China to move faster on its currency regime.
oriented economy. The progress in foreign trade and
improvement in the external balance sheet is the most
impressive. Foreign trade expanded from US$75 billion (24%
of GDP) in 1985 to US$1.6 trillion (72% of GDP) in 2005. The 3
Lin, Guijun. “On the Exchange Rate of the RMB;” University of International Business and
Economics Press, China, 1997
60

Exhibit 74 Exhibit 75
History of the Chinese Renminbi History of the Indian Rupee
Renminbi per US$ Rupee per US$
0 1 2 3 4 5 6 7 8 9 10 0 10 20 30 40 50
1948 1948 -People's Bank of China (PBC) established, 1948 1948 -India becomes independent. Reserve Bank of India
PBC begins issuance of RMB. (RBI) is nationalized and becomes the central bank.
1949 - People's Republic of China established,
1951 RMB becomes sole unified legal currency 1951
1950 - Trade embargo established against China by
1948-1975 -Fixed exchange rate regime w ith rupee
United States, other countries
pegged to pound sterling on account of historic links w ith
1954 1954 Britain.
1950s - China adopts centrally planned economy
model; strict foreign exchange control system
adopted
1957 1957
1960's - 1970's - RMB stable in inflation terms

1960 w ith government setting prices/w age in 1960
centrally planned economy, foreign trade largely
done via public sector enterprises allow ing
1963 China to maintain over-valued currency 1963
1966 - India faces severe problems funding trade/budget

1966 1966 deficit follow ing w ithdraw al of foreign aid (party due to
w ar w ith Pakistan). Rupee devalued by 36.5%.
1969 1969
1971 - China resumes its seat at United Nations
1972 onw ards - RMB revalued gradually, rate set
1972 1972
after considering several factors such as international
1975 - Indian rupee delinked from the pound sterling
consumer price comparison, w eighted average values
follow ing the declining share of UK in trade & breakdow n
against currency basket and other factors; trade
1975 embargoes against China lifted
1975 of Bretton Woods system; exchange rate officially
determined by the RBI w ithin a nominal band of +/- 5% of
1978-79 - China initiates economic reforms and open door
the w eighted basket of currencies of India's major trading
policy; China's foreign trade decentralized; more banking
1978 1978 partners
institutions to engage in forex transactions
1980 - China introduces "internal" settlement rate

1981 for goods trade at RMB 2.8/US$; China starts 1981
foreign exchange sw ap market allow ing exporters
to sell their retained foreign exchange.
1984 1985 - China abolishes dual exchange rate 1984
system follow ing protests; official rate
converges w ith "internal rate"
1987 1991 -Country faces severe Balance of
1987 1986 - Exchange rate determined by sw ap
Payments crisis caused by a large fiscal and
market diverges to RMB 6.5/US$
current account deficit, a sharp dow ngrade of
1990 rating, high inflation and increasing internal
1990
1993 -Sw ap market rate rises 1992-1993 - RBI transitions to internal and external debt. Economic
to RMB 8.7/US$; official rate market determined rate via a reforms process initiated in
sees continued adjustments. 1993 dual currency regime w hich July 1991. Rupee is
1993 1994 - Major reform in exchange rate system; w as eventually unified in 1993. devalued by 19%.
official exchange rate and sw ap rate merged The rupee w as made fully
completely; China starts inter-bank forex market. 1996 convertible on trade account.
1996
1996-97 - China adopts current account 1995-1999 - Rupee remains under pressure on
convertibility; Asian crises hits in 1997, immense account Mexican crisis, economic sanctions
pressure on China to devalue but status quo 1999 follow ing nuclear tests, Asian crisis, Russian crisis,
1999
maintained political conflict w ith Pakistan and sharp rise in oil prices.
RBI ensures orderly correction in rupee.
2001 - China joins World Trade Organization
2002 Current Policy - Central Bank continues to follow clearly
2002 2002 - USA initiates debate on valuation/convertibility
specified policy of intervening to check volatility but has
July 2005 - China revalued its currency first time in 11 been less aggressive in influencing the direction of the
2005 exchange rate.
2005 years by 2.1% to RMB 8.11/US$.
Source: IMF, GW Center for the Study of Globalization, Morgan Stanley Research Source: IMF, RBI, Morgan Stanley Research
61

Why China Needs a Flexible Exchange Rate index. Therefore, the PBoC does not need to strictly adhere
Our global currency economist, Stephen L. Jen, lists the to the index though the USD/RMB rate is likely to move in the
arguments in favor of greater flexibility for an economy like same direction as the underlying index. Second, while the
China. First, a flexible exchange rate regime would allow market is more focused on the nominal bilateral exchange
China to have a more independent monetary policy. With the rate of USD/RMB, in real effective exchange rate (REER)
capital account in the process of being liberalized, China’s terms, the renminbi has already appreciated significantly. For
monetary policy will move more closely in line with the Fed’s instance, in 2005 while the renminbi appreciated against the
actions if the renminbi remains linked to the US dollar. As the US dollar by 3%, its REER appreciated by 9.7%. Third, and
economy matures in the coming years and the domestic more importantly, China’s monetary system is not yet in a
sector almost certainly becomes more important relative to state where a complete shift away from the exchange rate-
the external sector, China will need its own monetary policy. based policy platform is possible. The financial system needs
For instance, continued intervention and inadequate to build matching flexibility and risk-management capabilities
sterilization have resulted in an excessive investment before the transition to a flexible exchange rate is fully
problem. The Principle of the Impossible Trinity stipulates operative.
that central banks cannot have all three of the following: (1)
an independent monetary policy, (2) an open capital account Need to Develop an Interest Rate Market
free of controls, and (3) a target on the exchange rate. What China needs now is to further develop and refine the
Essentially, China is replacing (3) with (1) and (2). interest rate market. The yield curve in China has to be a
meaningful reflection of the underlying supply and demand
Second, with gradual liberalization of the capital account and conditions. It also has to be a good indicator of investors’
greater integration with the global economy, a more flexible expectations of China’s future growth and inflation paths. In
exchange rate regime would be better able to handle the general, the PBoC will need to bring the monetary system to a
powerful ebbs and flows of global capital that will inevitably point where the monetary transmission mechanism in China
impinge on the economy. A more flexible exchange rate allows the PBoC to start to conduct monetary policy in an
could help the economy cope with real external shocks, orthodox manner. China’s monetary system is built on
without exerting so much pressure on wages and prices for administrative directives and not one where the price of
adjustment. liquidity/credit (i.e., interest rates) is endogenously determined
by supply and demand. To move to a market-based
If China has to shift towards a market-oriented financial monetary system, much work needs to be done. Until then,
system, then moving to a more flexible exchange rate would the USD/RMB rate will remain relatively more stable than
be essential. most think, in our view.
First Step to Change in Currency Regime Complementary Reforms Will Be Necessary

On July 21, 2005, China decided to change its currency In addition to further capital account liberalization and banking
regime. The renminbi was revalued by 2.1% and from that sector reforms, it is important that the onshore forward market
day fluctuations of 0.3% have been allowed on either side of and derivatives instruments are developed to provide
the central rate, announced by the central bank on the currency hedging for local firms. Currency flexibility
previous day (i.e., the currency is able to crawl by 0.3% a day necessarily leads to uncertainty and risk. Chinese firms will
at a maximum). The central bank refers to a basket of need to master management of risk, but the hedging
currencies to manage the currency. The renminbi has instruments and hedging markets will have to be developed in
appreciated by a further 1.1% since July 21, 2005. While this tandem. At the same time, both policymakers and the private
move, in our view, is relatively modest, it was intended to sector will need to learn to treat changing exchange rates not
counter international pressure on China and lay the as an irritant but as a critical source of information about the
foundation for improving monetary policy over time. state of the Chinese and global economy.
Why Has the Renminbi Not Moved Much So far? (Part of this section draws from research by our global
First, technically, China does not have a basket peg; it has a currency economics team.)
managed float regime guided by a basket currency reference
62

The Need to Improve the Institutional Framework
Slow Progress in China in Building Modern Institutions

Summary Exhibit 76
After liberalizing the economic resources in the system to China and India: World Competitiveness (Ranked
operate in a more market-oriented structure, China needs to Out of 117 Countries, Lower Is Better), 2005
China India
focus on improving the institutional framework within which
Freedom of Press 114 18
this structure encourages efficient allocation of capital. In this
Judicial Independence 65 23
way it would be laying the foundation for sustaining the strong Property Rights 71 32
growth trend that has been achieved for the past 25 years. Public Trust of Politicians 29 69
Favoritism in Decisions of Govt. Officials 59 53
India has developed a much stronger public institutional and Source: World Economic Forum
regulatory infrastructure, having made significant progress in
Exhibit 77
this area over the past 15 years of liberalization. It has
China’s Preference for Bank Lending vs. India’s
already undertaken the hard work involved in building several
Preference for Market-Oriented Capital Funding
economic and political institutions – a stable democratic
China India
polity, parliamentary bureaucracy, independence of the press, As of: US$bn % of GDP US$bn % of GDP
a well-managed banking system under the active supervision Listed Equity Mar-06 449* 20.2% 677 84.9%
of the central bank, reasonable rule of law, a vibrant capital Listed Debt Dec-05 182 8.2% 328 41.2%
market and the protection of property rights. -- Corporate Debt Dec-05 17 0.8% 9 1.1%
-- Government Debt Dec-05 165 7.4% 319 40.1%
Total 631 28% 1005 126.1%
The following is a review of the key areas of the institutional
framework in India and China. Bank Credit Dec-05 2553 115% 303 38%
* Includes only A&B shares since H-Shares and Red Chips are listed in Hong Kong. If we
Building vibrant capital markets: China’s capital market include the same, market capitalization increases to US$ 919 bn (41% of GDP).
history is short, with the first stock exchange opened in Sources: CEIC, Wind Information, World Federation of Exchanges, National Stock Exchange
Shanghai in December 1990 and the second in Shenzhen in of India, Morgan Stanley Research
February 1991. In contrast, the Indian stock market has a Exhibit 78

130-year history. Its capital markets operate with greater China and India: Average Daily Turnover
efficiency and transparency than China’s. This is mainly due (US$ bn, 2005) China India
to the earlier deregulation of the capital markets. Equity
---- Cash 1.5* 1.9
---- Derivatives na 3.5
India has been strengthening the regulatory and institutional
Debt
framework of its equity capital markets since 1991. In 1992, ---- Government 0.1 0.7
the government abolished control over the pricing of new --- Corporate 0.1 0.0
equity issuances by private companies, leading to free market Forex Market
pricing. Subsequently, the Securities and Exchange Board of ---- Spot na 7.8
---- Forward/Swap na 7.3
India (SEBI) gained importance as the independent statutory
Commodities
authority for regulating stock exchanges and supervising ---- Forward/Swap 6.6 1.5
various market intermediaries.
* Includes only A&B shares.
Sources: Various Stock Exchanges, CEIC, Wind Information, Economic Survey of India,
The National Stock Exchange (NSE) was established by the Reserve Bank of India, Morgan Stanley Research
government in 1994 as a “demutualized” exchange. The NSE
initiated various reforms including introduction of an electronic
order-matching system, establishment of the clearing
corporation as a central counter-party and paperless
(dematerialized) settlement. In 1999, the government
undertook the necessary regulatory measures to allow trading
63

in derivative securities. Both cash and derivative turnover transparent manner to improve overall efficiency. The
levels have increased sharply over the past few years. Cash government has initiated several measures over the past few
turnover rose twofold to US$473 billion in 2005 from US$249 years to strengthen corporate governance, making changes in
billion in 2001 while derivative turnover surged over 100-fold the laws to protect public investors’ interest, in company laws
to US$887 billion in 2005 from US$8 billion. In contrast, the (such as requiring the appointment of independent directors
Chinese equity markets are relatively underdeveloped and and the imposition of the legal responsibility of directors), in
lack depth. Cash turnover, currently at US$383 billion, has accounting policies and disclosure norms.
been largely stagnant since 2001 while the derivative market
is virtually non-existent. However, we believe that for corporate governance-related
laws to be effective, ownership reforms to reduce government
China has used the Hong Kong stock exchange as a near- influence on companies are needed. Unless there is a
term solution with mainland companies accounting for credible threat of market failure such as bankruptcy or a
US$470 billion of the market capitalization (as of March 2006) hostile takeover, the overall corporate governance
listed on that exchange. However, this is clearly not the environment is unlikely to be effective as the corporate sector
optimal solution for China since its own retail and institutional has no incentive to be disciplined.
investors are restricted from buying shares in these
companies. China is initiating more measures to improve the Judiciary systems: Although the Chinese legal system has
breadth, depth and efficiency of its equity, government debt, developed substantially in the past two decades (for instance,
corporate debt and foreign exchange market. with the number of lawyers in China increasing from just
5,500 in 1981 to around 142,500 in 2003), its overall progress
Flexibility in financial markets: The government also needs in this regard remains far behind that of India. The World
to improve the availability of risk management instruments Economic Forum ranks China sixty-fifth out of a total of 117
and trading efficiency in financial markets, particularly countries surveyed on judicial independence.
corporate, government bonds, and foreign exchange.
Similarly, effective hedging instruments are not operative in India is ranked twenty-third. India has strong legal remedies
most of its markets. Although this is also an issue in India, although there are some questions on the efficacy of the legal
the latter has been ahead in initiating changes to address it. system. In India, court cases take unduly long to be resolved,
With a well-established cash foreign exchange market, the resulting in a large number of pending cases. For instance, in
central bank has been steadily encouraging an improvement 2004 around 3.2 million cases were pending in the high
in the depth of the forward exchange market. Cash trading in courts.
government securities markets has improved already. The
RBI recently allowed intra-day short selling in government IPR protection: China has been slow to initiate measures to
bonds. protect intellectual property rights. The Office of the US
Trade Representative placed China on a priority watch list in
The government is now focusing on developing the corporate April 2005. According to the USTR report, the efforts by
bond market. In December 2005, a government-appointed China have not been sufficient and the administration would
committee submitted its recommendations. Key among them use WTO instruments “whenever appropriate”.
were the revamping of the stamp duty structure for corporate
bonds, providing incentives to market makers, developing an Presence of the media: A relatively independent media is
efficient secondary market, allowing repos in corporate bonds important for transparency and the monitoring of the
(to improve liquidity) and simplifying various other norms for performance of public institutions. India is already witnessing
listing. In February 2006, the Finance Minister announced benefits of an active and independent media, exposing poor
that the government had accepted the recommendations and performance of public institutions. Both India and China were
it would now take steps to create a single, unified exchange- closed to the foreign media until the beginning of the 1990s.
traded market for corporate bonds. However, since then, India has made rapid strides in opening
up the sector, while China continues to lag.
Corporate governance: The establishing of non-
governmental civil organizations does not seem to have been The Indian government allowed satellite television in India in
given priority by the Chinese government. The pace of 1990-91, and, since then, there has been a rapid proliferation
reforms needs to be accelerated to create institutional of television media. It permits foreign channels to transmit
mechanisms that influence corporate behavior in a different genres of content, including news. With regard to
64

print media, the government allowed facsimile (exact replicas) Conclusion

of foreign newspapers to be published and circulated in the Although one could argue that the efficacy of many of the
country in 2005. public institutions in India is less than satisfactory, the
country’s progress in developing the required infrastructure is
In China, there are stringent regulations governing the media still commendable. While India has been slow to develop the
sector. The government also actively blocks access to certain physical infrastructure, it has steadily accelerated the pace of
websites. An example of the government’s restrictive establishing the soft infrastructure of the institutional
measures is its recent effort to control the access of Google framework. While China’s government has initiated a number
search. Google.com has agreed to censor certain of measures to improve this soft infrastructure, we believe it is
websites/keywords on its search services for Chinese users one of the major challenges for the country in the near to
after pressure from the government. medium term.
65

66

Chart Scan
67

Growth Trends: China’s Fast Track vs. India’s Gradualism Model

¾ Acceleration in growth in the post-reform period: China’s economic growth has averaged 9.4% a year since 1978. Taking
advantage of a sharp rise in the working population ratio in the early 1970s, the government initiated major structural reforms in
1978, which allowed the virtuous interplay of labor and capital. India’s economic growth underwent a structural shift at the start
of the 1980s. Over the decade, the government made an attitude shift in favor of the private sector. Economic growth
averaged 5.7% a year in the 1980s versus 3.5% in the prior three decades. Since 1991 the government has initiated major
liberalization measures, adopting the open-economy model. India has achieved average growth of 6% a year since 1991 and
in the past five years, growth has averaged a higher rate of 6.7%.
¾ The emphasis for China remains manufacturing and for India, services: In terms of segment growth mix, China has
followed a model similar to that of other Asian countries, relying on manufactured exports as a key anchor for sustainable
acceleration in growth and integration with the global market place. As a result, China’s manufacturing sector has recorded
real growth of 11.5% a year since 1978. Growth in services and agriculture averaged 10.6% and 4.6%, respectively, over the
period. India’s growth mix, however, has been significantly different from that of China. Over the past 15 years (since the start
of India’s reforms), India’s services sector growth has averaged 7.9% a year compared with 6.0% for manufacturing and 2.5%
for agriculture. In comparison, China’s manufacturing growth has been about 12.6% a year over this period versus 10.1% for
services and 3.8% for agriculture.
¾ Differing focus on exports and fixed investments as growth drivers: China has been over-reliant on exports for
stimulating growth compared with India. Its export (goods plus services) to GDP ratio has increased to 38% from 7% in 1980.
India’s exports to GDP ratio has risen to 19% from 6% in 1980. Similarly, China’s investment-to-GDP ratio has increased to
49% from 20% in 1980 compared with a rise in India’s investment share of GDP to 30% from 21% in 1980.
¾ Accounting for growth differences: A simplistic way to account for growth in a country would be to consider the contributions
from the three basic drivers: (1) labor force inputs, (2) capital inputs and (3) total factor productivity. Total factor productivity
(TFP) is that part of non-factor inputs that enables higher growth with less application of factor inputs. It encompasses the
contribution of technology and managerial aspects to the growth of real output. The two major areas where India’s growth
suffers compared with that of China are capital accumulation and lower productivity growth (Exhibit 84). In the past 10 years,
on average, more than 4.5 percentage points of China’s GDP growth was accounted for by capital accumulation, which was
supported by its high national savings rate. In comparison, capital accumulation in India, contributed only about 2.1
percentage points of GDP growth. For India, a large proportion of its growth is accounted for by total factor productivity
although it was lower than that for China on average in the past ten years.
68

S-Curve for Income Growth GDP Growth Trends
40000
35000 10%
PPP-Adjusted Per Capita GDP, US$
Hong Kong
30000 Japan 8%
Singapore
25000 Taiw an
6%
20000
Korea
15000 4%
Malaysia
10000 China
2%
Thailand
5000
Philippines
India
0%
0
0 10 20 30 40 50 60 1960s 1970s 1980s 1990s 2000s
Years from Beginning of Economic Progress
China India
Source: IMF, World Bank Research Source: CEIC, CSO, Morgan Stanley Research
Segment Growth Rates Sector Breakdown of GDP
(Real % YoY) 1960s 1970s 1980s 1990s 2000-2005 1960 1970 1980 1990 2005
China India
Agriculture 2.8% 2.9% 5.3% 4.3% 3.7% Agriculture 53% 47% 40% 33% 20%
Industry 2.1% 10.9% 10.6% 12.9% 10.5% Industry 18% 21% 23% 26% 26%
Services 1.1% 6.1% 12.6% 9.4% 9.9% Services 29% 33% 37% 41% 54%
India China
Agriculture 2.3% 1.0% 4.3% 3.0% 1.9% Agriculture 23% 35% 30% 27% 12%
Industry 6.5% 3.5% 6.7% 5.7% 6.9% Industry 44% 40% 49% 42% 47%
Services 4.9% 4.4% 6.6% 7.6% 8.0% Services 32% 24% 21% 31% 40%
Source: RBI, CEIC, CSO, Morgan Stanley Research Source: RBI, CEIC, CSO, Morgan Stanley Research
Nominal US$ GDP (US$ billions) Accounting for GDP Growth Differences (1995-2005)
2,500 9.0%
Labor Input Capital Input
TFP*
2,000 7.5%
China
1,500 6.0%
4.5%
1,000
India 3.0%
500
1.5%
0
1970
1975
1980
1985
1990
1995
2000
2005
0.0%
China India
Source: CEIC, RBI, CSO, Morgan Stanley Research
*TFP = Total factor productivity; Source: CEIC, UN, Morgan Stanley Research
69

Consumption - Macro: China Spends Twice As Much As India

¾ India’s consumption-to-GDP ratio is higher than China’s: Although in nominal US dollar terms India’s GDP is 35% of
China’s size, India’s consumption spending is about 45% of China’s. India’s overall consumption-to-GDP ratio was 72% in
2004 compared with 54% for China. Not all the difference in consumption-to-GDP ratio is explained by the demographic
position (as defined by the age-dependency ratio) of the two countries. Indeed, China’s consumption ratio was lower than
India’s even while its demographic position was similar to India’s in 1975 (Exhibit 88). India’s active consumerism culture,
populist attitude of the government and the larger share of household income in GDP are the key reasons for consumption’s
relatively higher share of GDP.
¾ China’s consumption growth rate is higher than India’s: Although China’s share of consumption in GDP is lower than
India’s, its absolute spending on consumption was US$1,074 billion in 2004 compared with India’s US$498 billion. China’s
consumption growth has also been higher at 7.6% over the past 10 years (compared with India’s 5.8%), driven by its higher per
capita income.
¾ Both India and China are witnessing a shift in the consumption mix: In India and China, rising per capita income,
changing demographics (rising young population), rapidly emerging modern retail format and increased access to financing are
bringing about a change in the consumption basket. The share of organized sector products is increasing while that of primary
products is declining. The Indian consumption basket is still relatively primitive currently and biased towards such products as
food, beverages and tobacco. An average Indian spends about 49% of his/her expenditure on products other than food,
beverages and tobacco compared with the average for China of 67% (Exhibit 87).
¾ Reforming the retail distribution network: China has already built a modern retail distribution system to a large extent while
India has just initiated such a network. The new retail format is beginning to drive a change on the supply side in India. This is
a reverse of the process in China where the supply chain was relatively modernized for exports before the shift was initiated in
retail distribution. We believe this change in the retail sector could lead to a significant transformation in India’s small &
medium manufacturing as well as farming segments. This, in turn, could provide India with the opportunity to participate in the
global export market for low-ticket manufactured goods.
70

Consumption: Basic Facts Share of Consumption in GDP Tracking Demographics
(As of 2004/F2005) China India 90%
GDP (Nominal US$bn) 1979 694
82%
Consumption as % of GDP
Consumption (Nominal US$bn) 1074 498
India
---Private consumption 788 420
---Government consumption 286 78 74%
Consumption (as % of GDP) 54.3% 71.8%

66%
---Private consumption 39.8% 60.6%
---Government consumption 14.5% 11.3% China
58%
Consumption per capita (US$) 826 457
---Private consumption 606 385 50%
---Government consumption 220 72 80% 75% 70% 65% 60% 55% 50% 45% 40%
Age Dependency
Source: UN, CEIC, CSO, Morgan Stanley Research
Real Total Consumption Growth Trends Consumption per Capita Trends (Nominal US$)
12% 900
% YoY, 3Yr MA
10% 740
China
8% 580
China
India
6% 420
India
4% 260
2% 100
1987
1990
1993
1996
1999
2002
2005
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
Source: CEIC, Morgan Stanley Research Source: CEIC, Morgan Stanley Research
Consumption Basket Components India and China: Share in World Nominal US$
As of 2004 China India
Consumption
Food, beverages and tobacco 33% 51%
Transport & Communications 18% 15% 5.0%
Housing 10% 12%
Leisure and education 12% 4%
4.5%
Clothing and footwear 8% 5%
Household goods and services 7% 3%
4.0%
Health 6% 9%
Hotels and catering 5% 2%
3.5%
Miscellaneous goods and services 7% 9%
Source: Euromonitor, Morgan Stanley Research 3.0%
2.5%
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
Source: CEIC, CSO, Morgan Stanley Research
71

Consumption - Micro: Markets for Most Products in India Are a Third to a Tenth of China’s
¾ Consumer product penetration rates higher in China: Penetration rates and per capita consumption are higher in China
than in India for most broad-based manufactured consumption items because China’s per capita income is 2.4 times that of
India. In fact, real per capita private consumption expenditure in China has increased by an average of 7.3% a year over the
past 10 years compared with 5.3% in India.
¾ China’s consumer product market is significantly larger than India’s: Not only is China well ahead of India in terms of
exports, its domestic market for consumer products is also much bigger. For consumer non-durables as well as durables
China’s market (annual sales) is about three to ten times that of India. Among durables, annual sales in China for products like
cell phones are about double those in India whereas at the other extreme are items such as televisions where annual sales in
China are about seven times those in India (Exhibit 94).For non-durables, India’s market is of similar size to China’s in basic
products like soaps but lags in products such as detergents, skin care products and bottled water (Exhibit 91).
¾ India lags China in per capita consumption of key items by a range of 4 to 11 years, depending on the product: Even if
it manages a big shift in growth rates and follows China’s trend, India is likely to remain 4 to 11 years behind China across
different products. To approximate the amount of time the market size for the various consumer products in India will take to
reach China’s current market size, we performed a regression analysis with China’s and India’s per capita consumption of
various products being dependent on their respective per capita income levels. Based on this regression analysis, we arrived
at India’s and China’s respective per capita consumption to income slope levels, which explain the penetration trend to per
capita trend relationship, as shown in Exhibits 92 and 95. These slopes help explain the relationship between past growth in
per capita consumption and the increase in per capita income levels. We have projected per capita consumption and, in turn,
the market size in India based on two scenarios: 1) India will continue to follow its own past slope i.e., it follows its past
penetration to per capita income trend; we call this Type I; and 2) India will shift to China’s slope i.e., it follows China’s
penetration to per capita income trend; we call this Type II. We have also provided alternative calculations, assuming two real
GDP growth scenarios, 7% and 8% a year. We have forecast the number of years India will take to reach China’s market size
under these growth scenarios and under the two slope functions – one using India’s past trend and the other using a shift to
China’s past trend. Our nominal GDP growth forecasts for India assume constant real GDP growth of 7-8% a year. For per
capita calculations, we have used the population growth projections of the United Nations.
72

Penetration Rates for Non-Durable Products Penetration Rates for Durable Products
(As of 2004) Unit China India Penetration Rate Market Size
Skin care US$ spending per person 2.3 0.3 (As of 2005) (Per 1000 people) (Annual Sales, mn)
China India China India
Detergents US$ spending per person 3.4 1.4
Shampoo US$ spending per person 0.2 0.3 Passenger Cars 14 10 3.2 1.1
Toothpaste US$ spending per person 0.5 0.4 Motorcycles 59 39 10.5 5.8
Soft Drinks litres per person 4.3 1.3 Cellular Subscribers 301 69 59 28
Bottled Water litres per person 7.5 1.2 Internet
Accounts/Subscribers 85 6 17 1.1
Source: Euromonitor, Morgan Stanley Research Televisions 416 104 87 12
Source: Euromonitor, Morgan Stanley Research
Years Needed for India to Reach China’s Current Years Needed for India to Reach China’s Current
Market Size If It Follows Trend of Current Market Size If It Follows China's Consumption to
Consumption to Per Capita Income Slope (Type I) Per Capita Income Slope (Type II)
No of Years Implied Growth No of Years Implied Growth
Trailing Trailing
Assumed GDP Growth 3 Yrs Assumed GDP Growth 3 Yrs
Rate of: 7% 8% Growth 7% 8% Rate of: 7% 8% Growth 7% 8%
Cars 5 4 13% 16% 28% Cars 7 6 13% 5% 9%
Televisions 11 10 4% 21% 24% Televisions 11 10 4% 21% 24%
Telephone 11 10 37% 7% 9% Telephone 9 8 37% 12% 16%
Motor-cycles 5 5 22% 21% 17% Motor-cycles 5 5 22% 17% 17%
Source: Morgan Stanley Research Source: Morgan Stanley Research
Real Private Consumption Growth Modern Retail Trade as % of Total
12% 90%
% YoY, 3Yr MA
10% 72%
China 54%
8%
36%
6%
18%
India
4%
0%
Malaysia
Vietnam
Hong Kong
Korea
Australia
Thailand
China
India
Philippines
2%
1987
1990
1993
1996
1999
2002
2005
Source: CEIC, Morgan Stanley Research Source: AC Nielsen
73

Investments: China’s Total Capex Is More than Four Times India’s

¾ China’s investment-to-GDP ratio is 1.6 times that of India: In 2005, China’s investment was 49% of GDP (US$1,082 billion)
while India’s was an estimated 30% of GDP (US$240 billion). The key driver for China’s high investment rate is a higher
domestic savings rate. FDI accounts for about 5.5% of total investment in China versus 2.7% for India. Indeed, China’s capex
to GDP is now 2.7 times that of the US and it accounts for about 11% of global investment.
¾ Rising share in global capex: While the world investment to GDP ratio has been constant over the past 10 years, the ratios
for India and China have increased; hence, the combined share for the two in global investment rose significantly to 13.4% in
2005 from 7.2% in 2000 and 3.0% in 1990.
¾ China’s huge infrastructure bias: One of the major areas of difference in the capex of the two countries is in investment for
infrastructure. In 2005, China infrastructure investments were an estimated US$201 billion (9.0% of GDP) compared with
US$28 billion (3.6%) for India. Another key variation is in investment in property. In 2005, China’s investment in housing
construction was US$224 billion (10.1% of GDP) versus an estimated US$33 billion (4.1%) in India.
¾ Manufacturing, services and agriculture mix: Not surprisingly, while China’s investments are biased towards manufacturing,
India’s investments are evenly spread between manufacturing and services. Both countries have cut the share of agriculture in
total investment.
¾ India’s poor penetration in fixed investment-dependent products: Steel and cement demand reflects the differences in
spending on capex. China’s steel and cement demand is about 10.5 and 7.5 times that for India, respectively. However, the
growth in demand for these products in India should accelerate as its investment-to-GDP ratio rises further, reflecting an
improvement in savings to GDP.
74


Investments: Basic Facts Investment Trends (Total Nominal Dollar)
(As of 2004/F2005) China India
GDP (Nominal US$bn) 1979 694 1,000
China
Capex (Nominal US$bn) 851 209 800
---Private capex 429 148
---Government capex 423 50 600
Capex (as % of GDP) 43% 30% 400

---Private capex 22% 21% India
---Government capex 21% 7% 200
0
Capex per capita 655 191
2005E
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
---Private capex 330 135
---Government capex 325 46
Source: CEIC, CSO, Morgan Stanley Research Source: CEIC, CSO, Morgan Stanley Research, E= Morgan Stanley Research Estimates

Investment Trends (Per Capita Nominal Dollar) Investments Trends (As % of GDP)
50%
600
China 43%
China
480
36%
360
29%
240
India 22%
120 India
15%
0
2005E
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
Source: CEIC, CSO, Morgan Stanley Research Source: CEIC, CSO, Morgan Stanley Research; E= Morgan Stanley Research Estimates

India and China: Combined Share in World Investment India: Estimated Market Size of Cement and Steel
and GDP (Nominal US$ Terms) Absolute (mn tonnes) Implied Growth
Cement Steel Cement Steel
2005 139 36 9% 8%
13%
2015 - If India follows its own historical slope1

11%
7% GDP Growth 396 94 11% 10%
% Share in World Investment
8% GDP Growth 432 102 12% 11%
9%
2015 - If India follows China's historical slope1

7%
7% GDP Growth 721 326 18% 25%
5% 8% GDP Growth 805 368 19% 26%
% Share in World GDP 1. Slope of product penetration to per capita income.
3% Source: CEIC, Morgan Stanley Research
2005E
1984
1987
1990
1993
1996
1999
2002
Source: CEIC, CSO, IMF, Morgan Stanley Research; E= Morgan Stanley Research
Estimates
75

External Trade: China’s Share in Global Exports Is Six Times India’s

¾ India lags China substantially despite an improvement in the trend over the past few years: While India had a 2.2%
share of global goods exports in 1948, this position has been steadily eroded, reaching a low of 0.4% in 1981 and around 0.9%
currently. Even if we consider services, India’s combined share in goods and services was 1.1% in 2005 versus 0.4% in 1990
and 1980. In contrast, China’s combined share in goods and services rose sharply to 6.6% in 2005 from 1.6% in 1990 and
0.9% in 1980.
¾ India takes the lead in high-end commercial services: On an aggregate basis, China’s share in world commercial services
exports is 3.3% versus India’s 2.3%. However, this includes tourism and transport revenues. China’s total services exports
are about US$81 billion compared with US$57 billion for India. The mix, however, is very different. India has a bias toward
scaleable IT software services and IT-enabled business process services (IT and ITES). IT and ITES currently account for
37% of India’s total services exports. We expect IT and ITES exports to rise to US$60 billion by 2010 from US$21 billion in
2005. Due to strong growth in IT and ITES, India’s commercial services exports have grown 29% a year in the past five years
compared with 21% for China. We believe that India’s aggregate share in the global commercial services trade will start to
outpace China’s share in the next five to six years.
¾ Relatively less supportive business environment constrains India’s manufacturing: China’s success in manufacturing is
well demonstrated by its 7.3% share of global goods exports compared with 0.9% for India in 2005. China’s goods exports
recorded a CAGR of 18% from 1990 to 2005 versus India’s 11%. We believe that India needs a further overhaul of its
manufacturing business environment to follow China’s lead in manufacturing. The key factors constraining manufacturing so
far are lack of world-class infrastructure, rigid labor laws, inefficient tax laws and government interference.
¾ With gradual implementation of reforms and a rise in its savings rate, India is beginning to make inroads into
manufactured exports. India’s top ten exports are currently biased towards products that are high in labor intensity and
natural resources (Quadrant I in Exhibit 108). However, incrementally, India’s exports will move towards high
capital/infrastructure intensity sectors (Quadrant II and III in Exhibit 108). India is already beginning to compete well in complex
manufacturing such as chemicals, engineering goods and machinery, automobiles and auto components.
76


Share in World Goods and Services Exports Trend in Exports and Market Share
China India
1990 2005 CAGR 1990 2005 CAGR
6.0% Goods Exports (US$ bn) 62 762 18% 18 90 11%
Share in World Exp. 1.8% 7.3% 0.5% 0.9%
4.8%
Services Exports* (US$ bn) 6 81 19% 5 57 18%
3.6% Share in World Exp. 0.7% 3.3% 0.6% 2.4%
China
Total Exports (US$ bn) 68 843 18% 23 147 13%
2.4%
Share in World Exp. 1.6% 6.6% 0.5% 1.1%
1.2% Note: Total world good and services exports have grown to US$12,899 bn in 2005 from
India US$4,230 bn in 1990 a CAGR of 7.7%.
* Services include travel, transportation and other comm. services
0.0% Source: IMF, CEIC, Morgan Stanley Research
1980
1985
1990
1995
2000
2005
Source: IMF, CEIC, Morgan Stanley Research

Constraints to India’s Manufacturing Sector Exports China and India: Drivers of Price Manufacturing Products’
Differential
Unfavourable 100 14-16
Tax Structure
3-4 2-3 0-2 2-3 4-6 0-1
67-72
Unfavorable Poor
Labor Laws Manufacturing Infrastructure
Chinese Retail
Indirect Taxes
Indian retail
Retailing
Capital
Cost of
Manufacturing
productivity
Labour costs
productivity
margins
Capital
Labour
margins
price
Interfering
Price
Administrative
Environment
Source: Morgan Stanley Research Source: CII Mckinsey Analysis

China Has Done Well in Almost All Manufacturing India Has Done Well In Exports of Labor-Intensive
Sectors (China’s Current Top 10 Exports) Products (India’s Current Top 10 Exports)
IV Plastic I
High
High
Services
IV I
Garments Machinery Agri goods
Mechanical Leather goods
Engg Goods
Labour Intensity
Instruments
Labour Intensity
Garments Gems
Metal Prod. Auto Comp.
Footw ear
Textiles Transport Pharma Textiles
Equip.
Electronic
Goods
Computer &
Telecom Chemicals
Low
Low
III II III II
Low Capital Intensity High Low High
Capital Intensity
Source: WTO, Morgan Stanley Research Source: WTO, Morgan Stanley Research
77

Exhibit 109
China and India: Competitiveness in Exports
Share in global
2004 Total Exports Exports Outlook for Next Five Years for India
China times
US$bn World China India India China India
Merchandise Exports
All Merch. products 8,634 592 75 7.9 6.9% 0.9%
There have been virtually no reforms in this
sector in the past 20 years or so. However, India
should do better over the next five years with the
government beginning to initiate reforms in this
Agricultural Products 783 24 9 2.8 3.1% 1.1% area, albeit gradually.
India should do well in these sectors as it has
greater availability of resources such as iron ore,
Fuels & Mining Products 1,281 26 9 2.9 2.0% 0.7% bauxite and thermal coal.
Manufactures 6,570 542 58 9.4 8.3% 0.9%
India has performed relatively well in iron and
steel exports, but these could be bigger if the
Iron and Steel 266 14 4 3.3 5.2% 1.6% infrastructure availability improves.
Within this segment, we see greater potential in
Chemicals 976 26 9 3.1 2.7% 0.9% pharmaceuticals and specialty chemicals.
Exports of automotive products have increased in
India in the past three to four years. We expect
India’s share to improve, especially through
higher exports of two-wheelers and auto
Automotive Products 847 6 2 2.9 0.7% 0.3% components.
Office Machines & India is likely to be a laggard in this segment in
Telecom Equipment 1,134 172 1 172.3 15.2% 0.1% the near term.
Textiles 195 33 7 4.9 17.2% 3.5% Removal of quotas has already resulted in strong
growth for India’s exports in these two segments.
We expect India to do much better over the next
five years in these segments as Indian producers
implement modernization and infrastructure
Ready-Made Garments 258 62 6 9.7 24.0% 2.5% services improve further.
Other Manf. Products 2,895 229 28 8.1 7.9% 1.0%
Services Exports
All Commercial Services 2,180 62 38 1.6 2.8% 1.8%
There may be some increase in this share as the
number of tourists rises. In addition, a gradual
increase in the share of global trade should bring
Travel & Transportation 1,140 38 10 3.9 3.3% 0.9% about an improvement.
Other Commercial Services 1,040 24 29 0.8 2.3% 2.7%
Grand Total 10,814 654 113 5.8 6.1% 1.0%
Memo Items:
This will remain a growth driver for the country as
more corporates from across the world outsource
IT Services & IT Enabled Services 634* na** 17*** na na 2.7% their needs, both IT and non IT, to India.
* Potential outsourcing market according to IDC estimates. ** We believe that China’s exports in this segment are negligible. *** For comparability, we have excluded software product and hardware
exports totaling US$ 1.4 billion. Source: WTO, NASSCOM, Morgan Stanley Research
78

Appendices
79

Appendix 1: Summary of Key Reforms in India and China

India China
How did the reform process begin?
The reform process in India was triggered by a major The Third Plenum (of the 11th Party Congress Central
macroeconomic crisis in early 1991. This was caused by a large Committee) held in 1978 is widely regarded as the starting point
fiscal and current account deficit, high inflation, increasing of China's reform process. The government initiated market-
internal and external debt, three changes of government in a oriented reforms with the gradual experimentation approach in
span of two years and socio-political upheaval. In June 1991, the rural sector and later followed it up in the industrial sector.
the new government (led by Mr. PV Narsimha Rao from the On the rural front, China initiated a massive de-collectivization
Congress Party, with Dr. Manmohan Singh as the Finance program whereby the land was distributed or contracted out to
Minister) immediately made a commitment to structural reform. households. This program was accompanied by a sharp
The rupee was devalued by 19% against the US dollar in two increase in agricultural procurement prices and a decrease in
quick moves in July 1991. agricultural input prices.
Various external as well as internal reform measures have been The government later initiated a “big bang” industrialization plan
implemented subsequently. The government cut tariffs on with gradual liberalization of product pricing, the setting up of
imports, reduced quantitative restrictions on trade, liberalized the new systems that rewarded local government for promoting
foreign investment policy and encouraged exports through tax development, allowing greater autonomy of management to
exemptions. On the internal front, licensing requirements were SOEs, encouraging external trade through deregulation,
removed for most major sectors, undue control on trade & implementing labor reforms, setting up special economic zones,
business was reduced, banking reforms were initiated and the attracting FDI, establishing township & village enterprises and
process of fiscal consolidation was initiated. transferring commercial banking operations from just one bank
(People's Bank of China) to four banks.
External Sector Reforms
Trade Reforms
Exchange Rate The macro economic reforms commenced with the devaluation China implemented current account convertibility of the renminbi
of the rupee by 19% to Rs26:US$1 from Rs21 in July 1991. The (RMB) in 1996 but it followed a fixed exchange rate regime until
rupee was subsequently floated on the current account. Over recently. On July 21, 2005, China decided to change its
the years, the Reserve Bank of India has allowed market- currency regime. The renminbi was revalued by 2.1% against
oriented movements in the currency. Its interventions have the US dollar and from that day fluctuations of 0.3% have been
usually been with the aim of checking volatility rather than setting allowed on either side of the central rate, announced by the
the direction. central bank on the previous day (i.e., the currency is able to
crawl by 0.3% a day against the US dollar at a maximum
although, in practice, the government still does not allow a 0.3%
movement in a day).
Tariffs India lowered its weighted average import tariff rate from 87% in China has lowered import tariffs dramatically. Weighted
F1991 to 47% in F1994 to around 15-17% currently. The peak average import tariffs were well over 50% in the early 1980s, but
rate on non-agricultural products was reduced from 355% in have been reduced to just 9.9% currently – close to honoring
F1992 to 35% in F2001 and 12.5% in F2006. the WTO commitment to reduce tariffs to 9.8% by 2010.
80

India China
Capital Account Reforms
FDI India initiated the liberalization of its FDI policy in 1991. It allows In 1979, the Chinese government granted legal status to foreign
100% FDI in most of its manufacturing sectors, except those investment. The establishment of SEZs in 1980 also improved
pertaining to defense equipment. 100% FDI is allowed in the climate for FDI flows. In 1986, new provisions were passed,
infrastructure sectors except atomic energy. In services, 100% which included reducing fees for labor and land use;
FDI is allowed for many sectors other than civil aviation, retail establishing a limited foreign currency market for joint ventures;
trade, satellite TV/FM broadcasting, banking, insurance and and extending the maximum duration of a joint-venture
professional services. Despite a relatively liberal FDI regime, the agreement beyond 50 years. The FDI climate further improved
FDI inflow into India has been poor due to bureaucracy, in 1990, when a number of provisions were adopted to make
inadequate infrastructure, rigid labor laws and an unfavorable tax China an attractive destination for FDI (e.g., protection from
structure. However, gradual implementation of reforms should nationalization). Hong Kong played an instrumental role in the
improve FDI inflows into India. takeoff in FDI in the mid-1980s to early 1990s amid the
migration of the manufacturing base and the subsequent
expansion. Overseas Chinese and Hong Kong enterprises had
already established robust track records in China before WTO
accession in 2002, which has further helped increase FDI
inflows into the country.
Portfolio In September 1992, the government allowed FIIs to invest in The Shanghai and Shenzhen stock exchanges were established
Investments Indian capital markets. A single FII is allowed to invest up to in 1990. China allowed FIIs to invest in B shares.
10% in a company. Initially, the government limited the Subsequently, China allowed Qualified FIIs (QFIIs) to invest in
investment by FIIs to a ceiling of 24% of paid-up capital; the A share market. The investment limit for any stock is 10%
however, this has since been liberalized and FIIs are now of the total share capital for each QFII, with a 20% maximum for
allowed to invest in Indian companies with no limits (subject to all QFIIs combined. Restrictions on outbound portfolio
certain sector caps). In 2003, domestic mutual funds/resident investment are gradually being relaxed. Formal announcement
individuals were allowed to invest in companies abroad that have was made in mid-April 2006 for the QDII (qualified domestic
a reciprocal 10% holding in a listed Indian company (subject to institutional investor) scheme. Under this scheme, Chinese
specified conditions). The reciprocity condition for domestic institutional investors are allowed to invest abroad. Domestic
mutual funds was relaxed in 2006. banks, insurers and fund management companies will be the
first institutions to do so.
Internal Sector Reforms
Agricultural After independence India initiated some land reforms by dividing The first sets of reforms in China were in the agriculture sector.
Reforms land among the tenants and introduced the green revolution, China collectivized agriculture in the 1950s, with the
which increased agricultural output in the 1960s. There have not establishment of the commune system. However, in the late
been any major reforms in agriculture since the broader macro 1970s a household responsibility system was developed, under
reform process began in 1991. The government’s spending on which the communes’ land was divided among households.
infrastructure for agriculture has been very low. Total public This gave a big impetus to the rural economy, with incomes
spending on agriculture dropped to 0.4% of GDP in F2004 from increasing by up to 50% over 1978-84. Recently, the
0.6% in F1991. Only about 40% of the land is irrigated, leaving government has decided to increase its rural spending plan. In
farmers exposed to the vagaries of monsoons. Over the past March 2006, Premier Wen Jiabao announced that the
few years, the government has launched some initiatives to government would make a concerted effort to build “a new
accelerate agriculture growth, including allowing exchange- socialist countryside” over the next five years. The government
trading of commodities; encouraging states to reform laws to announced a 14% increase in its 2006 rural budget to Rmb340
liberalize marketing of agricultural produce; and encouraging billion (US$42 billion, 1.7% of GDP). It also abolished the tax
banks to increase lending to the agriculture sector. on agricultural income and plans to invest US$148 billion on
rural roads over the next five years.
81

India China
Industrial Key industrial reforms implemented in India are: Key industrial reforms implemented in China are:
Reforms
Removal of licensing regime: The government abolished Reforming SOEs: In 1979 the government allowed state-owned
licensing requirements for setting up all but 18 industries in 1991. enterprises to retain profits. Gradually, the government is trying
In 1998-99, further de-licensing took place and now licenses are to build professional management within SOEs. It has also
required only in industries such as alcohol, tobacco products and adopted SOE labor reforms, such as the contracting of labor,
those pertaining to defense equipment. retrenchment and performance-linked pay. The reform process
picked up in 1995 when the central government adopted the
Removal of undue control of trade and business: In 1991, the idea of ‘grasping the large and letting go the small’, wherein it
government abolished the Monopolies and Restrictive Trade intended to keep about 1,000 enterprises as state-owned and
Practices Act, which constrained corporate acquisitions and privatize the rest.
over-regulated business practices.
Deregulation of product prices: Initially, China adopted a dual-
Deregulation of product prices: The prices of various goods, such track approach to price liberalization wherein price
as steel, cement, paper and pulp, have been deregulated since determination was through both planned and market forces. By
the reform process began. Now most manufactured product the mid-1990s, prices of most products in China were
prices are determined by market forces except for a select few liberalized.
products like oil & coal.
SME reforms: Since 1978, the importance of Township and
Reduction of protection to SME sector: The government has over Village Enterprises (TVEs) in China has increased manifold.
the years been reducing reservations for small-scale industries The TVEs are hybrid institutions – alliances between TVE
(SSI). The number of items reserved was reduced from a peak entrepreneurs and local government officials (acting in the
of 873 in 1984 to 506 in 2005. capacity of ‘owners’). TVEs have emerged as one of the key
Privatization of SOEs: In India, the disinvestment process initially growth drivers of industrial output in China.
focused on the transfer of minority rights to public and financial Encouraging private and joint sectors: The government has
institutions. However, no controlling right was sold to the private allowed non-state-owned enterprises to operate in China and
sector. In 2003-04, the government privatized a few public they have proven to be a primary driver of economic growth
sector enterprises, where it passed the controlling interest to since the 1980s. Non-state-owned enterprises accounted for
strategic investors. However, the sale of controlling stakes is 61% of total value-added industrial output in 2005, up from 43%
unlikely to take place in India in the near term, with a clear in 1998.
change in government policy in this area. The public sector
accounts for about 20% of industrial output. Privatization of SOEs: China has pursued a limited form of
privatization by way of the sale of stakes in state-owned
Labor reforms: India still lags on labor reforms. Current companies to public and foreign institutional shareholders. The
regulations require enterprises employing more than 100 people government has used this as an opportunity to strengthen state-
to undergo a complex approval process before retrenching owned enterprises. The amount collected in China from the
employees. sale of stakes in SOEs is many times that in India.
Labor reforms: China has been successful in introducing a

flexible labor system. China has over the years shifted to a
more flexible policy on labor in terms of both hiring and firing.
Geographical mobility of labor is still limited, nevertheless.
Unfavorable conditions for migrant workers in urban areas have
limited the pace of migration; hence, the apparent labor
shortage in recent years in the coastal cities.
82

India China
Fiscal Reforms Tax Structure: India initiated major tax reforms in the early Tax Structure: China has implemented major changes in its tax
1990s. It has reduced the marginal rate of personal tax from structure over the past 20 years. It has already cut its import
56% in F1992 to 30% currently, lowered the corporate tax rate tariff such that the total import tariff as a proportion of the value
from 50% in F1992 to 30%, and cut the peak excise and non- of imports is less than 2.5%, compared with 10% in India.
agriculture import tariff from over 100% and 150% in F1992 to China adopted the value-added tax system in the mid-1990s,
24% and 12.5%, respectively. Since the mid-1990s, the which further improved the efficiency of the tax system. Tax
government has expanded the tax net by levying taxes on incentives have been widely used to attract foreign capital, but
services. In 2005-06, the government replaced the multiple-rate the upcoming reform on unifying tax rates on local vs. foreign
sales tax (ST) system, which was independently managed by enterprises will be a landmark change towards a more level
various states, with a synchronized single-rate system. The new playing-field in China.
system leaves the central tax collection system independent.
The government has since announced its intentions to shift to a Fiscal Prudence: China has initiated several measures for
country-wide common goods and services tax (GST) by 2010-11. better management of government finances. Previously, all
government revenue and expenditure had to go through the
Fiscal Prudence: India pursued some public finance reforms central government. However, in the 1980s, the process was
from the early 1990s to the mid-1990s by reining in expenditure decentralized, with the local government transferring a
and augmenting revenues. This helped reduce the consolidated negotiated amount to the central government and keeping the
fiscal deficit to 6.4% of GDP in F1997 from 9.4% in F1991. rest. This gave increased incentives to the local governments to
However, the emergence of coalition government at the center improve revenue collection and tax efficiency. Government
resulted in major slippage in government finances and pushed accounts in China are relatively well placed. The aggregate
the fiscal deficit to a new high of 9.9% of GDP in F2002. fiscal deficit in China has remained under 3% of GDP over the
Although the headline fiscal deficit has since dropped to 7.8% of past 10 years.
GDP in F2006, the off-budget oil and electricity subsidy burden
remains high at 1.9%. We believe the government needs to
initiate major expenditure reforms and move effectively to
outcome-based expenditure management from the current
outlay-based system to cut non-interest revenue expenditure.
Banking sector India has steadily strengthened its banking system, improving Although China has initiated reforms for the banking sector, its
reforms the regulatory framework, imposing strict prudential norms and progress pales when compared with India. Until 1980, there
encouraging greater competition. The government has allowed was hardly any competition. The government then created four
private sector entry since the mid-1990s. Private players have large banks. Subsequently, joint stock banks were formed and
already built a 27% share of loan assets in the banking system. foreign banks were also allowed to open branches. By 2007,
The prudential norms in terms of capital adequacy requirements foreign banks will receive national treatment in China under the
have gradually tightened, and currently banks are required to WTO agreement. Of a total of around 115 banks in China, 53
maintain a CAR of 9%. Most banks already comply with the norm do not yet comply with the Basel I requirement of capital
of 9% CAR and will move to meeting Basel II requirements by adequacy ratio of 8%. However, over the past few years the
March 2007. In 2002, the government enacted the Foreclosure government has taken steps to reduce NPLs and has
Act, which gave lenders powers to forfeit assets of defaulting recapitalized the weaker banks. China has also announced that
borrowers, enabling quick recovery of NPAs. One area where the certain banks with a large number of overseas branches will
Indian banking system lags is in the relatively restricted access adopt Basel II norms from 2010 to 2012. On balance, China
to foreign capital, which is capped at 20% for the SOE banks and lags India in banking sector reforms.
74% for private banks.
83

India China
Infrastructure Except for telecoms, overall progress in infrastructure has While the overall regulatory system in China is still fairly weak,
Reforms historically been slow in India. However, over the past two the government has undertaken major initiatives to encourage
years, infrastructure has gained the attention of policymakers. adequate investments in infrastructure.
Roads: Investments in this long-gestation sector have been low, Roads: China has largely relied on government investments in
averaging just US$ 2.5-3 billion over the past 10 years. The this area. Investments have averaged US$34 billion p.a. over
government has now initiated a US$38 billion seven-phase the past 10 years. Indeed, in 2005 China spent US$67 billion
national highway development, covering 65,000 kms of national on road development. The government plans a major push on
highways to increase road spending. building rural roads over the next the few years.
Seaports: Over the past few years, the government has Seaports: China has built world-class port infrastructure. A
introduced several measures to augment private investment in large part of this is owned and developed by the government.
the sector. The average turnaround time at Indian ports Hong Kong enterprises have played a big role in the
improved to about 3.4 days in F2005 from 8.5 days in F1996. development of China’s ports, but they have also done so in
Although a good beginning has been made, progress is still slow, partnership with local governments.
leaving the overall cost-efficiency at Indian ports relatively low
compared with world averages. Telecoms: Prior to 1994, the Ministry of Post and
Telecommunications (MPT) was the regulator as well as the
Telecom: The government opened up services like cellular, radio biggest player in the Chinese market through its arm, China
paging, and data services to the private sector in F1993 and Telecom. Subsequently, the entity was split into two parts: the
followed it up with the opening up of basic telephony to private Ministry of Information Industry (MII), the operational arm, and
participation and foreign equity (up to 49%) in F1995. It also China Telecom. Later China Telecom was further divided on
fixed a 49% foreign investment limit for cellular telephony, which the basis of geography and business. In recent years, China's
has recently been increased to 74%. The favorable policy telecom sector has become more open to foreign investment.
environment has encouraged the private sector to participate The government has encouraged foreign companies to
aggressively, and private investment has contributed significantly establish telecom companies by acquiring domestic companies
to growth in the sector. Significant technological change has and has also allowed established joint ventures to apply to
resulted in a 90% decline in the cost of accessing telecom operate telecom services. Over the last ten years, China’s
services over the past seven years. Overall progress in this telecom subscriber base has increased 17-fold to 744 million
sector is commendable with the subscriber base having risen to from 44 million.
130 million as of 2005 from 12 million over the past 10 years.
Airports: Over the past 15 years, China has spent approximately
Airports: After neglecting airport infrastructure for years, over the US$14.8 billion on upgrading its airport infrastructure. Recently,
past three years, the government has initiated a number of policy the Civil Aviation Administration of China (CAAC) announced
measures to attract the private sector and improve efficiency. plans to invest a further US$17.4 billon over the next five years
Some of the major initiatives taken by the government in this
on airport infrastructure.
context are an open-skies policy for passenger traffic,
restructuring and privatization of Mumbai and Delhi airports, Electricity: The Electricity Law was promulgated in 1995 and
announcing construction of greenfield airports in select cities and was the first comprehensive legislation for the electricity sector.
undertaking the modernization of other domestic airports. In 1997, the State Power Corporation (SPC) was formed. In
2002-2003, the government split the SPC into 11 separate
Electricity: The electricity sector is one area in need of serious
companies, which included two grid corporations, five power
and immediate overhaul. Measures to attract private investment
generating groups and five other companies. The government
in power generation were introduced in F1993 but investors’
response has been lackluster. The most important investment also established the State Electricity Regulatory Commission
deterrent in the power sector is the poor financial condition of the (SERC) to be responsible for supervising and regulating market
state electricity boards (which own more than 90% of the competition in the electricity industry. However, the SERC
distribution in the country). The electricity operations of the shares power with regards to pricing and electricity sector
public sector incur annual losses of US$4-5 billion due to the investments and as a result the government continues to control
large burden of subsidies and theft in electricity distribution. the sector. Despite this, the operations are far more efficient
While the government has initiated several measures over the than those in India. The government has taken the lead in
past few years, the effective implementation of reforms in this boosting investments in the sector. China has increased its
area is far slower than required. This constrains investments in electricity generation capacity to 508 GW currently from 217
the sector with peak electricity shortages at 12%. GW in 1995.
SEZs: The government initiated the first major change in April SEZs: In 1980 China created four Special Economic Zones,
2000 for the establishment of Special Economic Zones. which enjoyed special policy benefits like lower tax rates in
However, the response from investors has been poor. In May addition to good infrastructure facilities. The success of these
2005, the government approved a new SEZ legislation which is SEZs led to the creation of more such zones, and this has been
more comprehensive and provides for a larger tax incentive a cornerstone of China’s reform success.
package. Since the new legislation was passed, various private
investors have announced their intentions to set-up SEZs.
However, the response from the private sector is largely for
investing in small SEZs where tax benefits are a key attraction.
Source: IMF, World Bank, RBI, US Department of State, Morgan Stanley Research
84

Appendix 2: Fact Sheet

Equity Markets Trends in Urbanization
India China Urban Population Avg annual increase
(mn) in urban popn (mn) % of Total Popn.
Key Statistics (as of Mar. 2006) India China India China India China
Market Capitalization (US$ bn) 677 449 1970 110 145 3 4 20% 17%
MSCI Weight (Asia Pacific) 6.5 8.5 1980 159 196 5 5 23% 20%
Average Daily Volumes (US$ bn) 1990 217 317 6 12 26% 27%
-- Cash 3.4 2.2 2000 282 456 7 14 28% 36%
-- Derivatives 7.5 na 2005 317 533 7 16 29% 41%
Total Domestic Mutual Fund Assets (US$ mn) 52.1 63.7 2010E 358 612 8 16 30% 45%
FII Ownership (% of Market Cap) 22.7% 4.1% 2020E 463 763 10 15 35% 54%
Source: United Nations (UN); E= UN estimates
Key Valuation Metrics* (as of Mar. 2006)

Trailing P/E 22.7 14.6
Trailing P/BV 4.8 2.5 Infrastructure
ROE (%) 21.1% 17.1% Comparison of Infrastructure Spending
For China, market capitalization and average daily turnover data pertain to A, B shares; If we India China
include H-Shares and red chips (shares of Chinese companies listed in Hong Kong) market
capitalization increases to US$919 billion (As of 2005) US$bn % of GDP US$bn % of GDP
* Data for MSCI India & China respectively; Source: CEIC, Wind Information, AMFI, BSE,
Transport 11 1.4% 96 4.3%
MSCI, Morgan Stanley Research
-- Railways 3 0.4% 15 0.7%
-- Roads 6 0.7% 67 3.0%
Economy -- Ports 1 0.2% 10 0.4%
India China -- Airports 0.4 0.1% 4 0.2%
Communication 8 1.0% 19 0.9%
National Income Statistics
Electricity 8 1.1% 80 3.6%
Nominal GDP (2005, US$ bn) 773 2225
Urban Infrastructure 1 0.1% 6 0.3%
Real GDP Growth
Total 28 3.6% 201 9.0%
-- 1980-1990 5.7% 9.3%
-- 1991-2000 5.7% 10.4%
Cost of Infrastructure
-- 2001-2005 6.3% 9.5%
India China
Per Capita GDP (2005, US$) 700 1702
GDP Per Capita Growth Railways, PPP US C/TKM^, 2002 7.9 2.6
(Nominal US$ terms %, 1991-2005) 6.7% 12.5% Electricity Costs for Industrial Clients,
0.08 0.03
US$ per kwh, 2004
Composition of GDP (As of 2005) Telecom - Average cost per minute (US$, 2004)
Agriculture 20% 12% -- Wireless 0.08 0.04
Industry 26% 47% -- Fixed 0.05 0.04
^ US Cents per Ton Kilometer
Services 54% 40% Source: IMD, CSO, CEIC, TISCO, Morgan Stanley Research
Note: For India, except for national income statistics, the corresponding financial year-end
numbers have been stated. Source: IMF, CEIC, Morgan Stanley Research
Agriculture: Some Facts
Agriculture
Demographics
---Share in GDP (2005) 20% 12%
India China
---Real growth in agriculture GDP
Population (mn, 2005) 1105 1308 (average in 2001-2005) 2.3% 3.9%
Population Growth (% YoY, 2005) 1.6% 0.6% ---Share in Employment (2000) 59.8% 46.8%
Age Dependency Ratio* (2005) 60% 41% -- Production of Rice (mn tonnes, 2004) 85 179
Median Age (2005) 24.3 32.6 -- Production of Wheat (mn tonnes, 2004) 72 92
Note: For India, the corresponding financial year-end numbers have been stated.
Crude Birth Rate (2005-2010, per 1000 ppl) 22.5 13.2 Source: CSO, CEIC, Statistical Outline of India 2005-06, Morgan Stanley Research,
Crude Death Rate (2005-2010, per 1000 ppl) 8.3 7.1
Urban Population (% of total, 2005) 29% 41%
Female Population (% of total, 2005) 49% 48%
* Ratio of non-working to working population.
Source: United Nations, Morgan Stanley Research
85

Trade Monetary Aggregates

Trade Data (% of GDP), 2005

Goods Exports 11.6 34.3 GDP (US$ bn, 2005) 773 2225
Goods Imports 17.0 28.3 M3/GDP (for China M2/GDP, 2005) 74% 164%
Trade Balance -5.4 6.0 M1/GDP (2005) 21% 59%
Current Account Balance -1.7% 6.3 Bank Credit/GDP (2005) 39% 113%
Bank Deposit/GDP (2005) 57% 165%
Main Goods Export Destinations (% share in total exports), 2005 Bank PLR (end-2005) 10% 5.6%
Asian Countries (Ex-Japan) 26.0 32.5 1 Yr Deposit Rate (end-2005) 5.5% 2.3%
USA 15.5 21.4 Inflation, CPI (avg for 2005) 4.2% 1.8%
Japan 2.3 11.0 Forex Reserves (US$ bn, March 2006) 152 875
Source: CEIC, RBI, Morgan Stanley Research
EU 20.9 18.9
Main Goods Import Origins (% share in total imports)#, 2005

Public Finances
Asian Countries (Ex-Japan) 18.8 37.8
India China
USA 5.0 7.4
Aggregate Fiscal Deficit (2005, US$ bn) 63* 22
Japan 2.3 15.2
EU 15.3 11.1 Aggregate Fiscal Deficit (2005, % of GDP) 7.8%* 1.5%
Public Debt (2005, % of GDP) 82%* 27%
Share of World Goods Exports
1950s 1.4% 1.5% Sovereign ratings India China
Foreign Local Foreign Local
1960s 0.9% 1.3% Ccy Ccy Ccy Ccy
1970s 0.5% 0.8%
S&P BB+ BB+ A- A-
1980s 0.5% 1.3%
Fitch BB+ BB+ A A+
1990s 0.6% 2.7%
Moody's Baa2 Ba2 A2 NR
2005 0.9% 7.3% *Excluding off-balance sheet subsidies. Note: For India, the corresponding financial year-end
numbers have been stated. Source: Bloomberg, RBI, CEIC, Morgan Stanley Research
Share of World Services Exports

1980s 0.7% 0.7%*
1990s 0.6% 1.4% Consumption of Key Products
2005 2.3% 3.3% (As of 2005) Per Capita Consumption Annual Sales/Consumption
# For India, the imports number does not include the share of petroleum and crude products Units India China Units India China
since a breakdown by country for this is unavailable. * Data for China are available from
1982; hence, the average for the 1980s has been computed using the period 1982-1989. Cars Per 000 Ppl 10 14 mn 1.1 2.8
Source: World Trade Organisation, CEIC, RBI, Morgan Stanley Research
Motorcycles Per 000 Ppl 59 39 mn 10.5 5.8
TVs Per 000 Ppl 104 416 mn 12 87
Telephone
Lines Per 000 Ppl 123 570 mn 37 85
External Debt Tonnes Per mn
As of 2005 India China
Cement 000 Ppl 126 804 tonnes 139 1051
Tonnes Per mn
External Debt (US$ bn) 119 280 Steel 000 Ppl 32 288 tonnes 36 376
External Debt (% of GDP) 15% 13% Tonnes Per 000
Short Term Debt/Total (%) 8% 56% Aluminium 000 Ppl 0.7 5.5 tonnes 808 7156
Source: RBI, CEIC, Morgan Stanley Research KWH per
Electricity person 556 1885 bn KWH 614 2469
Source: Industry Sources, Morgan Stanley Research
86

Employment Percentage Share of Income/Consumption*

Total Labor Force (mn, 2004) 399 768 Lowest 20% 8.8 4.7
Female (% of total, 2003) 33%^ 45%^ Second 20% 12.1 9.0
Agricultural Workforce (% of total, 2000) 60% 47% Third 20% 15.7 14.2
Unemployment (% of total workforce, 2004) 9.1 na Fourth 20% 20.8 22.1
na = not available
Source: CSO, Planning Commission of India, CEIC, China Statistical Yearbook, Statistical Highest 20% 42.6 50
Outline of India, Morgan Stanley Research
Gini Index 32.5 44.7

* Survey Year for India: 1999-2000, Survey Year for China: 2001
Source: World Bank, Morgan Stanley Research
Education
India China
Gross Enrollment Ratio (%)
Health
-- Primary Schools, 2004 116 118
India China
-- Secondary Schools, 2004 54 73
-- Tertiary Education, 2003 15 12 Physicians (per 1,000 people), 2004 0.5 1.6
Adult Literacy (%, 2000) Health Expenditure (% of GDP), 2002 6.1 5.8
-- Total 57 91 -- Public 1.3 2.0
-- Male 68 95 -- Private 4.8 3.8
-- Female 45 87 Health Expenditure per Capita (US$), 2002 29 66
Source: World Development Indicators
Total Public Expenditure on Education
(% of GDP, 2004) 2.9 2.5
Source: World Bank, CEIC, CMIE, UNESCO, Morgan Stanley Research
87

Appendix 3: Key Economic Indicators – India

Years Ending March 31 F2000 F2001 F2002 F2003 F2004 F2005 F2006E F2007E F2008E
National Income
GDP (at current mkt prices) Rs bn 19588 21077 22813 24497 27602 31214 35292 39533 44127
GDP (US$bn) 451 460 478 506 601 694 797 912 1063
Growth rates
Gross domestic product 6.2 4.4 5.8 3.8 8.5 7.5 8.1 6.6 6.8
Agriculture and Allied activities (incl. mining) 0.6 0.2 5.8 -5.6 9.6 1.2 2.1 3.2 3.3
Manufacturing, Constn, Electricity 5.1 6.7 2.8 6.8 7.9 8.9 9.8 6.8 7.2
Services 10.2 5.6 7.1 7.3 8.2 9.9 9.8 8.1 8.0
Money and Banking
Money Supply (M3) growth (avg) 18.9 17.4 15.7 12.9 12.6 14.3 15.4 15.5 15.0
Non-food bank credit (avg y-y increase) 15.3 19.3 11.8 16.3 16.2 25.0 30.8 27.0 22.0
Interest rates
91-Day T-Bill Yield (year-end) 9.9 8.9 6.2 5.8 4.3 5.2 6.1 6.8 6.8
Bank Rate (year-end) 7.0 7.0 6.5 6.3 6.0 6.0 6.0 6.3 6.3
Prices
Wholesale price index (avg y-y increase) 3.3 7.0 3.6 3.1 5.3 6.4 4.4 5.0 4.8
Consumer price index (avg y-y increase) 3.5 4.1 4.3 4.0 3.9 3.8 4.4 4.5 4.3
External sector
Current account
Exports (US$ bn) 38 45 45 54 66 82 102 117 131
Imports (US$ bn) 55 59 56 64 80 119 159 179 203
Trade balance (US$ bn) -18 -14 -12 -11 -14 -37 -57 -63 -72
Invisibles, net (US$ bn) 13 11 15 17 28 31 39 46 52
Current account balance (US$ bn) -5 -4 3 6 14 -5 -17 -17 -20
Current account Balance as a % of GDP -1.0 -0.8 0.7 1.3 2.3 -0.8 -2.2 -1.9 -1.8
Capital account
Foreign investment (US$bn) 5 7 8 6 16 14 17 16 17
Total capital -net (US$bn) 10 9 9 11 17 31 33 31 27
Capital inflow as a % of GDP 2.3 2.0 1.8 2.1 2.8 4.5 4.1 3.4 2.5
Reserves
Foreign currency reserves (US$bn) 38 42 54 75 112 140 152 169 175
Foreign currency reserves as no. of months imports 7.6 8.0 10.9 13.2 15.9 14.1 11.5 11.3 10.4
Exchange rate
Average exchange rate (Rs/US$) 43.4 45.8 47.7 48.4 45.9 45.0 44.3 43.3 41.5
Year end exchange rate (Rs/US$) 43.6 46.6 48.7 47.6 45.0 43.7 44.5 42.0 42.0
External debt
External debt (US$bn) 98 101 99 105 112 123 128 140 149
External debt as a percentage of GDP 21.9 22.4 21.1 20.4 18.2 17.3 16.0 14.8 14.2
Short term debt as a proportion of total 4.0 3.5 2.8 4.4 4.0 6.1 7.8 7.8 8.3
Public Finance
Fiscal deficit (Rs bn)#
-----Central government 1047 1188 1410 1451 1233 1252 1497 1661 1809
-----State government 915 895 960 1021 1231 1236 1333 1424 1544
-----Consolidated Deficit ** 1848 1999 2264 2350 2319 2441 2776 3024 3286
Fiscal deficit (As % of GDP)#
-----Central government 5.3 5.6 6.2 5.9 4.5 4.0 4.2 4.2 4.1
-----State government 4.7 4.2 4.2 4.2 4.5 4.0 3.7 3.6 3.5
-----Consolidated Deficit ** 9.4 9.5 9.9 9.6 8.4 7.8 7.8 7.6 7.4
** Individual Central and State deficits may not aggregate to consolidated deficit due to adjustments relating to inter-government transfers. # Does not include off-balance sheet burden of oil &
electricity subsidy. Source: CSO, RBI, CEIC, Morgan Stanley Research; E= Morgan Stanley Research Estimates
88

Appendix 4: Key Economic Indicators – China

Years Ending March 31 1999 2000 2001 2002 2003 2004 2005E 2006E 2007E
National Income
GDP (at current mkt prices) RMB bn 8968 9922 10966 12033 13582 15988 18232 20400 22237
GDP (US$bn) 1083 1198 1325 1453 1640 1931 2225 2610 3070
Growth rates
Gross domestic product 7.6 8.4 8.3 9.1 10.0 10.1 9.9 9.5 7.5
Agriculture and Allied activities (incl. mining) 2.8 2.4 2.8 2.9 2.5 6.3 5.2 NA NA
Manufacturing, Constn, Electricity 8.1 9.4 8.4 9.8 12.7 11.1 11.4 NA NA
Services 9.3 9.7 10.2 10.4 9.5 10 9.6 NA NA
Money and Banking
Money Supply (M2) growth (avg) 16.1 14.4 14.1 15.0 20.0 16.2 16.0 NA NA
Bank credit (avg y-y increase) 8.3 6.0 11.6 15.8 21.1 14.5 13.0 NA NA
Interest rates
3M Time Deposit Rate (year-end) 1.98 1.98 1.98 1.71 1.71 1.71 1.71 1.71 1.71
1 Yr Working Capital Lending Rate (year-end) 5.85 5.85 5.85 5.31 5.31 5.58 5.58 5.85 5.85
Prices
Producer price index (avg y-y increase) -2.9 2.7 -1.3 -2.3 2.3 6.1 4.9 NA NA
Consumer price index (avg y-y increase) -1.4 0.4 0.7 -0.8 1.2 3.9 1.8 2.5 1.5
External sector
Current account
Exports (US$bn) 195 249 266 326 438 593 762 877 995
Imports (US$bn) 159 215 232 281 394 534 628 735 831
Trade balance (US$bn) 36 34 34 44 45 59 134 142 165
Invisibles, net (US$bn) -8 -6 -6 -7 -9 -10 -9 -8 -8
Current account balance (US$bn) 16 21 17 35 46 69 161 164 187
Current account Balance as a % of GDP 1.4 1.7 1.3 2.4 2.8 3.6 7.2 6.3 6.1
Capital account
Foreign investment (US$bn) 40 41 47 53 54 61 60 60 60
Total capital -net (US$bn) 5 2 35 32 53 111 63 NA NA
Capital inflow as a % of GDP 0.5 0.2 2.6 2.2 3.2 5.7 2.8 NA NA
Reserves
Foreign currency reserves (US$bn) 155 166 212 286 403 610 819 NA NA
Foreign currency reserves as no. of months imports 12 9 11 12 12 14 16 NA NA
Exchange rate
Average exchange rate (RMB/US$) 8.28 8.28 8.28 8.28 8.28 8.28 8.19 7.82 7.24
Year end exchange rate (RMB/US$) 8.28 8.28 8.28 8.28 8.28 8.28 8.07 7.50 7.00
External debt
External debt (US$bn) 152 146 170 169 194 229 281 NA NA
External debt as a percentage of GDP 14.0 12.2 12.8 11.6 11.8 11.8 12.6 NA NA
Short term debt as a proportion of total 10.0 9.0 29.7 31.4 39.8 45.6 55.6 NA NA
Public Finance
Fiscal deficit (RMB bn)
-----Central government 170 147 341 362 445 661 NA NA NA
-----State government -344 -396 -593 -677 -738 -870 NA NA NA
-----Consolidated Deficit -174 -249 -252 -315 -293 -209 -181 -306 -334
Fiscal deficit (As % of GDP)
-----Central government 1.9 1.5 3.1 3.0 3.3 4.1 NA NA NA
-----State government -3.8 -4.0 -5.4 -5.6 -5.4 -5.4 NA NA NA
-----Consolidated Deficit -1.9 -2.5 -2.3 -2.6 -2.2 -1.3 -1.0 -1.5 -1.5
Source: CEIC, Morgan Stanley Research; E= Morgan Stanley Research Estimates
89

Glossary
Working-age Population: Population in the 15- to 64-year age group.
Age Dependency Ratio: Ratio of dependents (people younger than 15 and older than 64) to the working-age population (those
between the ages of 15 and 64).
Revenue Deficit: Refers to the excess of revenue (current consumption) expenditure less revenue receipts (tax plus non-tax).
Fiscal Deficit: Fiscal deficit includes revenue deficit plus capital deficit (gap for funding capital expenditure). This indicates the
total borrowing requirements of the government from all sources.
Total Factor Productivity (TFP): The part of non-factor inputs that enables higher growth with lesser application of factor inputs. In
other words, TFP implies enhanced output per unit of input. TFP broadly encompasses the contribution of technology and
managerial aspects to the growth of real output.
Incremental Capital Output Ratio (ICOR): The amount of capital required to produce one additional unit of output. The lower the
ICOR, the higher the output for a given level of capital formation. Usually this ratio is calculated by dividing the sum of investment
in a specific period by the incremental output during that period. For example, if a country’s investment to GDP is 25% and GDP
growth is 6%, its capital output ratio would be 4.2 (i.e., 25% divided by 6%).
Public Saving: Represents savings from government administrative operations and non-departmental enterprises (including those
engaged in the production of goods for commercial purposes).
90

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June 2006

India and China: New Tigers of Asia, Part II

JM MORGAN STANLEY June 2006

JM MORGAN STANLEY June 2006

JM MORGAN STANLEY June 2006

Challenges Facing India and China - Some Are Similar.......................................................................................19

India’s Specific Challenges ...................................................................................................................................39

China’s Specific Challenges..................................................................................................................................55

Chart Scan ............................................................................................................................................................67

JM MORGAN STANLEY June 2006

A Tale of Two Asias

At a Critical Juncture Exhibit 1

The contrast between the two approaches is dramatic. The

JM MORGAN STANLEY June 2006

JM MORGAN STANLEY June 2006

Conclusion IT-enabled globalization has introduced an unexpected

JM MORGAN STANLEY June 2006

Beyond the Cyclical Boom

JM MORGAN STANLEY June 2006

JM MORGAN STANLEY June 2006

JM MORGAN STANLEY June 2006

Why India and China Matter

Increasing Global Productivity and Growth Exhibit 3

Source: WTO, Morgan Stanley Research

JM MORGAN STANLEY June 2006

proved to be a key trigger for their exports to GDP ratios to Exhibit 6

Asia’s Third and Fourth Waves 65%

Largest Suppliers to the World’s Labor Pool

comparison, the US will provide 10 million while Europe’s Exhibit 8

JM MORGAN STANLEY June 2006

JM MORGAN STANLEY June 2006

the government is required to play an active role as a Exhibit 12

But India Has the Potential to Catch Up

India’s age-dependency ratio bottoms out at higher levels

India could have the advantage of maintaining its high-growth India

Source: WTO, Morgan Stanley Research

JM MORGAN STANLEY June 2006

from an estimated 60% currently. Steady implementation of India: Investment-Growth Relationship

JM MORGAN STANLEY June 2006

Challenges Facing India and China - Some Are Similar

JM MORGAN STANLEY June 2006

Transition in the Growth Model - India

India Needs a Stronger Supply Response

government bonds carry greater risk than their Indian

JM MORGAN STANLEY June 2006

JM MORGAN STANLEY June 2006

Need for Greater Investments in Infrastructure Exhibit 21

Bias Should Shift toward Investment

economic decisions relating to the utilization of resources

JM MORGAN STANLEY June 2006

JM MORGAN STANLEY June 2006

Transition in the Growth Model - China

China Needs a Stronger Demand Response

While policymakers in India have difficulty initiating a much-

Cheap Money and Globalization Support Investment and

JM MORGAN STANLEY June 2006

Disproportionate Share of Trade and Fixed Investment 20% 4

rose to 49% from 34% whereas the share of consumption

more dependent on trade and fixed investment than the

JM MORGAN STANLEY June 2006

JM MORGAN STANLEY June 2006

Unemployment Scales New Heights

Large Work Forces – A Demographic Boon or Threat?