Employment Generation versus Employment Guarantee

Over three decades ago PM Indira Gandhi introduced the policy of “poverty alleviation.” The rationale bears repetition as it has remained unchanged for decades and underlies the EGS. It was argued that, “Economic growth does not lift all boats equally. As poverty is pervasive, all these people cannot be left to suffer while we wait for poverty to be eliminated by economic growth. We therefore need targeted programs for the poor to give them relief till such time as poverty is eliminated.” During that period of Indian socialism, the rate of growth of per capita income was 1.3% per annum and poverty was on an uptrend. Dozens of poverty alleviation programs have been introduced by successive governments. We may recall that “those who ignore history are condemned to repeat it.” My fear is that unless the EGS is seen in an overall context of policy and institutional reform it will become just another poverty alleviation program to be supplanted by new ones by the next government. Then, ten-fifteen years from now a new set of brilliant young academics will be agitating for another revolutionary new program to alleviate the suffering of the poor.
Most people would agree with the contents of a 1988 Planning Commission paper “Efficient Labour Intensive Growth: Key to Accelerated Poverty Reduction.” Among other things it suggested a change in labour policy that is discouraging organised manufacturing industry from hiring unskilled labour and making it impossible for India to compete with other countries in mass (unskilled) labour intensive manufacturing. If the poor are to participate in the modern manufacturing or service sectors they must also have Basic/Primary education and information about job opportunities suitable for them across the country. However, even if these and other reforms for accelerating labour intensive growth eliminate poverty in fifteen years, there will be geographical (remote areas), seasonal (between sowing and harvesting) and cyclical (drought years) pockets of unemployment. Therefore in a 1999 Finance Ministry paper, “From Poverty to Prosperity: Reforms for Accelerating Growth,” I recommended an Employment Guarantee Scheme and a Right to Information Act along with other reforms for accelerating (employment) growth.
There are four elements of a successful EGS. First it must replace the dozens of poverty alleviation schemes in existence today. This can be done by amalgamating and integrating these schemes into the EGS, with a minimum 75% of EGS funds coming from these dissolved schemes. To ensure that the employment builds infrastructure assets that have a long term benefit to the local population, all local infrastructure building programs (village/block roads, water harvesting, irrigation & drainage, sewage & sanitation systems, school/PHC building & maintenance) should be within its purview. The concerned schemes departments must be required to provide their expert advise and assistance (consultancy) to the EGS scheme so that it builds productive assets.
Second, the EGS wage rate should be less than or at most equal to the local off-season market wage. If the former is raised above the latter, Rents rise and so does the incentive for corruption, with less chance of the poor getting any employment. In addition with a higher wage, even employed people will be drawn away from productive private jobs to the “sarkari jobs” where shirking is a birthright and accountability is low. The uniform minimum wage of Rs. 60 (about 3/4th of daily per capita GDP) may prove to be too high for high poverty districts making EGS as ineffective as earlier schemes (15% to poor).
Third, full disclosure must be built into the EGS rules. Thus the names of every person employed in the EGS, the hours worked and wages paid and the assets built, must be posted in a public place and be available for cross-checking by NGO’s subsequently.
Fourth, incentive compatibility must be ensured between the funding and the implementing agencies. A 90:10 Center:State funding ratio provides little incentive for the State government machinery to ensure that funds are spent efficiently. These could be corrected by merging the local area development programs of the State government into the EGS.
If these four elements can be ensured the scheme could be a very successful one. If not, a few years of good performance are likely to be followed by a sharp fall in effectiveness, as happened in the Maharashtra EGS. A mere law, even the Supreme Court, cannot ensure that every person in every remote village gets employment.

Next Steps in Strategic Relations: Completing The Triangle

A recent research paper forecast that the World will become bipolar in 25 years and Tripolar by the middle of the 21st century and that this possibility would lead to greater technological cooperation between the USA and India. In this context, the two recent US-India framework agreements (defense & nuclear) are just the beginning of a far reaching transformation of the global order. Realization of potential into reality requires work not only on India-US relations, but more importantly on India-China relations over the next 12-18 months, to reap the benefits.
First we should turn our attention back to the second pole China by implementing the agreements reached earlier this year between Dr. Man Mohan Singh and PM Wen Jibao. One was an agreement to enhance economic cooperation and double the volume of bilateral trade. The India-China study group (of which I was a member) had identified several constraints and barriers to trade in goods and services. India and China must work together to ensure that the route map outlined for addressing these issues is followed and the full potential of trade in goods in services is realized expeditiously.
The second was a framework agreement on defining the India-China border. Its importance can be gauged from the fact that since PM Rajiv Gandhi’s pioneering visit to China, two decades of meetings on the border issue had failed even to define the line of control between the two countries. As India is quite used to the concept of ‘LOC’ (a la J&K), some Chinese objective or fear must have prevented this from happening. The framework agreement therefore reflects a change in China’s approach to India and this must be followed up to a successful conclusion. The key to an India-China border settlement and lasting peace is secure and defensible borders, not how much territory is exchanged. A fair, just and equitable settlement of the border that reduces the risks & enhances the security of both is in the long term interests of both countries.
The third is to carry forward the strategic dialogue. We could perhaps propose a bilateral agreement on non-proliferation of WMD’s and nuclear/space technology to each others neighbors (e.g. Pakistan, Bangladesh; Vietnam, Taiwan). To avoid any ambiguity such an agreement should have an explicit, detailed list attached. Such an agreement would reduce suspicion and enhance mutual trust.
Our communist parties, the CPI and the CPM, can play a vital role in this process by convincing their fraternal party the Communist Party of China of the fundamental need for better India-China relations.
The successful completion of these three steps would set the stage for a comprehensive co-operation agreement (/FTA) covering goods, services, FDI and skilled personnel, between the two countries. An India-China joint study group for the same could be set up by the end of 2006-7. This could lay the foundation for the formation of an (East) Asian Economic Community.
There is also a lot of work to be done on the Indo-US front. Indian business, including US MNCs in India, must work with the NRI/PIO community in the USA to persuade the US Congress to change US laws and rules to provide India full access to Civilian Nuclear and all ‘Dual Use’ technology. At home transparent rules and regulation for private investment (including FDI) in nuclear power must be put in place. A Commercial Nuclear Power Corporation could be set up with 49.9% govt. equity and 50.1% private equity (investors, Indian companies and FDI). Some government re-insurance (for major catastrophe) as well as risk cover for loans and/or central purchase of nuclear power may be necessary initially (for the first few private nuclear power plants). The great advantage of such plants is that they can be subject to international rules and safeguards without affecting our existing nuclear establishment in anyway. Logically we can be “no worse off” than before, if we keep our current facilities as non-commercial ones for the time being. Subsequently we can declare one or more (Tarapur, RAPP) as commercial ones, if and only if it makes us “better off.” The choice is ours (nuclear experts), not that of the US or another country.
We must also activate our diplomatic machinery to free up the flow of civilian nuclear technology from Japan, Russia, UK, France, Germany and other EU members. If this can be done by the time the US Congress approves the promised changes, India will reap the maximum benefit of competition among them to supply materials, equipment and power plants to India. We could similarly promote greater competition in defense technology transfer and co-production by signing appropriate agreements with Japan and others where they are needed to lubricate flows of defense technology or equipment.
Though media reports suggest that F16/F18 deals are imminent, considerable staff work has to be done to give substance to the Indo-US defense agreement, so that the benefits begin to flow to both countries. We should also expand the discussion from air to naval equipment and components, without which a ‘minimum nuclear deterrent’ and ‘No first use,’ nuclear policy is not credible to any recognized nuclear power.
If these and related issues are pursued with seriousness and determination, the Indo-US strategic partnership will help accelerate the transformation of the World from a uni-polar one into a stable tri-polar one, with the USA, China and India as the three poles. President Bush and Dr. Man Mohan Singh must be congratulated for taking bold decisions that may well determine their place in history.

Historic Transformation of US-India Relations and India’s Role in Asia?

US President Nixon transformed US relations with China, with his breakthrough trip to China. This led after a decade or so to a transformation of China’s role in Asia. President Regan transformed US relations with the USSR, contributing to the disintegration of the Soviet empire. Will President Bush similarly transform the US relationship with India leading to a transformation of India’s role in Asia? A change in objective conditions, presented in several of our papers (WP #160, March 2005 and WP# 150, December 2004), suggests that this is likely. There are however obstacles on the US side that will have to be overcome before this can happen.
President Clinton, after his statement about China and USA being strategic partners and jointly deploring India’s 1998 nuclear tests, repaired relations by condemning Pakistani aggression in Kargil and supporting the Strobe Talbot – Jaswant Singh talks. These talks along with candidate Bush’s advisory group ‘Vulcans’ (that included Profs Condolezza Rice of Stanford and Prof Robert Blackwill of Harvard) laid the foundations for a changed approach of USA towards India. President Bush envisaged a much bigger role for India in Global affairs than his predecessors. PM Vajpayee reciprocated by calling India and USA “Natural Allies.” This resulted in the initiative labeled “Next Steps in Strategic & Technological Partnership (NSSTP).” The process was however side tracked by 9/11 as the US focus shifted to Afghanistan & Iraq and Pakistan made itself indispensable to the US.
The transformation had therefore to await President Bush’s second term and the visit of Secretary Rice to India in March 2005 (followed by the background briefing recognizing India’s potential power). A major landmark will be the visit of PM Dr Manmohan Singh to Washington starting on July 16th 2005. A key test will be US support for a permanent (veto bearing) UNSC seat. A possible deliverable is the formation of an India-US study group for a CECA. The transformation will likely (with 75% probability) be in place by the time President Bush visits India at the end of 2005-6, with the key test being an effective agreement to free the flow of nuclear plants, equipment and materials from the USA to India.
As shown in the author’s ICRIER working papers #150 (December 2004) and #160 (March 2005), the global economy is undergoing a dramatic transformation. Over the next 35 years both Chinese and Indian economies will become larger than the US economy in size (measured in PPP). In the case of China this will happen in a decade while in the case of India it will take an additional 25 years. At the same time Japan’s economy will decline gradually and Russia’s rise slowly (relative to the US) as the population of both declines by 25% over the next 50 years. The large economies of Europe will see varying population declines that will reduce their GDP relative to the USA.
The impact on the Global balance of power will be equally dramatic. This is shown by our ‘Index of Power Potential’ based on the economic projections. Currently the USA is the strongest power in the World by a wide margin and the World is correctly described as being Uni polar (the constraint imposed by terrorists, Jehadis and rogue states notwithstanding). With the rise of China and India the World will first become Bi polar (by 2025) and then Tripolar by 2050. This poses a serious challenge to the global order in general and to the USA in particular. Historically, the rise of a new power has invariably led to conflict with the established power. This suggests that China will very likely challenge US power in Asia during the next 20 years and conflict between the two on Taiwan cannot be ruled out. If the USA withdraws from Asia then the imbalance of power will put great pressure on the freedom and independence of China’s neighbors’ in Asia.
There is one exception to the generalization of inevitable conflict between the incumbent and the challenger. The declining colonial power Britain gradually ceded power to the rising USA in the late 19th and early 20th century. There are several differences between that situation and the one today. Firstly, both the USA and UK were English speaking democracies with a large cultural and philosophical overlap. This is not true of Marxist-Leninist (Communist) Party ruled China and the USA. Second China considers Taiwan, parts of N. India, the South China Sea and other areas as wrongfully taken from it. It has historical grievances against Japan that persist to this day. Unless these issues are resolved peacefully they retain the potential for igniting conflict. Third, the degree of globalization and economic interdependence is now much higher (Exports, FDI, investments). Fourth is the existence of nuclear weapons and their deterrent effect. The first two factors suggest that US-China conflict is more likely and the next two that it is less likely than in the US-UK case.
In either case the balance of power in Asia will be critical to peace in Asia and India’s power potential will be greater than Japan’s and Russia’s by 2025. A natural balance of power, in which India and China (with equal population in 2030) have similar levels of per capita GDP will make peaceful evolution of global relations more likely. This requires an expeditious closing of the technological and economic gap between India and China. The recognition of this fact by President Bush and his advisors is the key factor underlying the transformation of US-India relations. The fact that the USA and India share fundamental human and democratic values provides a basis for mutual trust.
From India’s perspective the key to a US-India partnership is technology transfer and technological co-operation. This requires a complete exemption of India from the denial regime set up by the USA and its allies after India’s 1974 atomic test, which played a role in the opening of the China-India GDP gap. In particular India must get civilian nuclear technology on conditions no more stringent than China. President Bush’s past actions suggest that he has the guts to change a dis-functional regime that has allowed NPT members to transfer weapons designs and/or technology to Pakistan, Libya, N Korea and Iran while stopping the supply of nuclear fuel to India’s power stations.
The Indian public seems to sense this possibility. That is why global polls show Indians giving the USA and its president the highest positive ratings among all countries. Indian’s are well aware of the US blind eye towards Pakistan military/ISI’s sheltering of Taliban & Al Qaeda leaders and training & financing of anti-India terrorists. But they hope that, despite the large current asymmetry in GDP and power, President Bush can transform India-USA relations to one that bring equal benefits to both.

A Tripolar World: India, USA and China

With the collapse of the Soviet Union in 1990, the World has become unipolar, with USA as the predominant power. Russia and France, along with rising powers such as China, have resisted this reality by pushing the concept of a multi polar world. Henry Kissenger had earlier written about the four powers, USA, EU, China and Russia and maybe a fifth India. Till about 9 months ago the US establishment was confident that the USA would remain the predominant world power and that China did not pose a serious threat to it during most of the 21st century. There was also a feeling that India could become a swing state in terms of the power balance in Asia in the second half of the century and therefore an improvement of India-US relations was desirable.
In a recent paper (ICRIER WP #160, March 2005) I have projected that within 25 years, China will become strong enough to challenge US power in Asia and India will become the third most powerful country in the World. This process will continue in the next 25 years so that by the middle of the century the World will become Tripolar. The USA, China and India will be the three great powers during most of the 21st century. A recognition of this fact will have a profound effect on the foreign and security policies of USA, India, EU and Japan. There is an important caveat: The projections for India depend on continuing reform of economic policy as well as reform of government institutions and political systems. Similarly we assume that single party (Chinese Communist Party) rule will remain in China and it will continue to introduce market reforms to correct the weakness of socialist policies. Though the European Union (EU) could be the fourth power if Germany, UK, France and Italy surrender their individual power to a EU “virtual” State, this appears unlikely (at present).
Though the size of a Nation’s economy has always been an important basis of its global power this will be more so in the 21st century. The size of a nation’s economy (GDP at ppp) is the multiple of its population and Per capita GDP (average income). If we compare each country’s share in World population and in World GDP we find four countries with the greatest imbalance. The USA and Japan’s share of world GDP is more than their respective shares of population by 16.5% & 5%, while China and India’s share of World GDP is less than their share of population by 11% and 9% respectively. Germany, France, UK, Italy also have significant positive and Indonesia a negative imbalance (there is no imbalance for Russia and Brazil). These imbalances will get reduced or eliminated during this century of globalization (free flow of technology). The reason for this are policy reform and catch-up growth by the three laggards, India and Indonesia, which are low income countries and China which is a lower middle income country: Since 1980, China, India and Indonesia have ranked 1st , 9th and 11th in terms of the average rate of growth of per capita GDP.
Over the next two decades, China and India will remain among the 5 fastest growing economies in the world and will therefore continue to close the per capita income gap with the USA. According to our mean scenario, in 2050, China and India’s per capita GDP ppp is projected to become 57% and 36% respectively of that of the USA. As China’s and India’s population would be 3.4 and 3.75 times that of the USA (respectively), their GDP at purchasing power parity will become about 1.9 and 1.3 times that of the USA in 2050. In contrast the GDP of the fourth largest country, Japan would be 1/5th that of the USA.
Though the size of the economy forms the basis of Global Power it may not be an adequate measure of power given that even in a Globalized world, each country has to develop its own strategic technology. We therefore measure the potential power of a country through a Power Potential Index (PPI) that gives additional weight to technological capabilities and national resources. The index shows that by 2050 China’s power is likely to be about 40% higher than that of the USA. China will therefore be able to challenge US power in Asia within 20 years, when its PPI will be about 70% of the USA. We also find that India’s potential power will be about 35% of USA in 2025 and 90% in 2050. If our projections come true, India will become a global power during the second quarter of this century and the World will become tripolar.
History shows that the risk of war rises when a new great power (now China) emerges to challenge an existing one (USA). In Asia, these risks are heightened by the imbalance between China and India. India’s economy will reach a low of 40% of China’s in the middle of the next decade, before starting to close the gap. However, even in 2050 the Indian economy is projected to be only 70% of China’s economy. Part of the reason for this gap is that the rich countries have denied India for 30 years the technology that they have allowed China to access. It is in the interest of the USA, EU, Japan and Russia to ensure that the technological and economic gap between India and China is closed as quickly as possible. They must lift the controls and restrictions on transfer of Dual use, nuclear and space technology to India, imposed after our first atomic test in 1974. The Bush administration seems to have recognized this imperative, as reflected in the statements of Secretary of State Condalezza Rice on her visit to India in March and the subsequent backgrounders by US spokesmen in Washington. India must use this opportunity to develop an ‘Indo-US partnership for peace’ that is mutually/equally beneficial to both. At the same time efforts to develop closer technological collaboration with Russia, Japan, France, UK and other countries must continue. We need to jettison the victim mindset engendered under the East India Company/British Raj and learn to act like a big power.
Normalization of relations between India and China will be critical to peace in the Tripolar World. We must enhance our economic ties through removal of bilateral impediments and development of inclusive structures such as an Asian Oil community and an (East) Asian Economic Community.

Can Oil Prices motivate Radical Energy Policy Reform?

Oil Prices touched $50 a barrel last year while the International Energy agency confidently forecast that prices could go below $25 a barrel. This year oil prices touched $57 a barrel. Though prices are currently down below $48 don’t be surprised if they again shoot up in the next six months. Will we passively watch these developments or take action to reduce our dependence on oil? If the latter, what can we do? The most important action is to reform our coal, electricity and oil policies. Otherwise we will continue to remain at the mercy of the oil cartel.
India is among the ten largest oil importers in the World. A rise in global oil prices is a tax on the nation paid to the oil cartel. So far we have tried to absorb this tax within the budget, either directly by lowering import duties or by reducing government owned oil company profits and consequently their dividends to the exchequer. This means that these revenues are no longer available to build infrastructure or carry out the social expenditures enumerated in the CMP. Further as the prices paid by consumers of Kerosine, LPG, Diesel and Petrol do not rise there is no incentive to be careful in their use. It is a known economic fact that short term price elasticity of demand for oil products is much lower than the long term elasticity. If oil price increases are not reflected in consumer prices the demand response and the technical change that it induces will be delayed even further. Thus oil dependence will continue to grow and so will the tax that citizen’s pay to the oil cartel.
The solution is to, (a) Allow complete and automatic pass through of international oil prices to domestic users. (b) Set all oil related import tariffs at the peak rate (now 15%) (c) Put a resource rent tax on domestic oil producers that applies above a base oil price (set in the exploration contract) and varies with the international price of oil. The revenues from this tax can be earmarked for development and introduction of energy conservation technology and alternative energy resources. (d) Replace differential pricing of Kerosene, whose adulteration of diesel is destroying Bharat III engines, by a direct subsidy to BPL house holds.
The nationalization of coking (non-coaking) coal mines in 1971 (1973) was justified (among other reasons) by the need to use our abundant coal reserves optimally for the good of future generations (50-100 years). The talk now, thirty years after nationalization, is about how coal imports are needed because the coal is of poor quality and how it will not last very long in any case. What happened? Nationalization created a monopoly, that along with the Ministry of Coal and the regulators appointed by it constituted itself into a monolith that has destroyed this great national resource. Greedy politicians (from coal mine areas or coal ministers), the coal mafia and the public coal monopoly have milked this national resource in the name of the people. A former vigilance head of Coal India confirmed to me that the stories one had heard and read about the ‘Coal Mafia” (which controls the labor force in the mines) are indeed true. Is it any wonder that the Coal Mine Nationalization Amendment Bill had been stuck in parliament since 2000 and was allowed to lapse, without re-introduction, in 2004!
The solution, (a) Amend the Coal Nationalization Act to allow private entry into coal mining. This will end the State monopoly and introduce true competition into the coal mining industry. It will allow specialized companies to come in, reduce demand risk through diversification of buyers, exploit economies of scale, make long gestation investments in mining & processing of high ash coal and in R&D for more effective use of available (quality/type) coal. (b) Sell 49.9% of the shares of public coal mining companies to the public/people. This does not disturb the government’s management control (mafia control?), but will provide an incentive to the people and the financial media to shed light on the worms operating under the stones. Hopefully the performance of the State companies will improve to the point they can compete with imports. (c) Reform and strengthen the coal regulatory system by making it independent and professional.
The electricity Act (2003) is an important step in the direction of electricity reform. But large private investments will not flow unless three critical problems are addressed and policy and regulatory risk is reduced. The most fundamental problem is electricity Theft. With 50% T&D losses Delhi electricity privatization will eventually loose support unless this problem is tackled. The Theft and Dacoity carried out by the electricity mafia is legendry. Several years ago, a central electricity minister, who had himself been a DESU union leader, had no hesitation in confirming this fact. This problem is not unique to Delhi but perhaps Delhi can show the way by taking on and destroying the electricity mafia and thus reducing the cost to honest users by about 40%. Full success would eliminate the need for cross-subsidies and allow a uniform price for all electricity users.
The second issue is that of the cross-tax subsidy to be paid by independent power producers for open access to the existing controlled government distribution system. Unless the methodology is clearly specified and is reasonable and limited by some upper bounds, the risk of arbitrary imposts will remain and deter investment. The third issue is the setting up of an independent and professional regulatory system. This requires regulatory law(s) ensuring sufficient delegation in all matters related to standards, norms, interconnection, pricing and quality of service and clear rules and procedures for financing of regulators, selection of chairman & members and adequate professional staff. State Governments and politicians are loath to loose control of the levers of power and pelf and the setting up of this system in the major states is going to be a long and painful process. Unless all this is done the regulatory and policy risks will remain.
With the best of intentions, these reforms will take about 10 years to fructify. In the meanwhile a radical solution is required. The government should declare a 10 year regulatory holiday for all new private generation, distribution and transmission companies (starting from date of first completed project). Producers/distributors would be free to supply electricity to any buyer at mutually agreed prices, terms and conditions. On completion of the regulatory holiday, normal regulatory systems, which by then will be fully in place across the country, would become applicable. By then the power shortage would be eliminated.

Economic Reforms During The Past 12 Months

Soon after the UPA Government took office, the stock market crashed because investors expected a sharp slow-down in reform, given the UPA’s dependence on left parties. At that time, I had written that in areas in which markets were expecting a halt in reform namely labor laws and PSU privatization, there had not been little actual policy action in the previous 2-3 years. So even if there were no labor policy reform this would not amount to a slow down. Further, though privatization was ruled out, disinvestment of shares was still possible. These unjustified apprehensions were dispelled after the first budget and the market recovered and exceeded expectations in the subsequent six months.
Taking stock of the entire one-year period, the pace of reform has been in line with the average pace seen since 1992-93. Once the crisis driven spurt in 1991-92 was over, the pace of reform has been modest under every government. This slow and steady pace has continued under the UPA government. For instance, the SSI reservation list has been gradually reduced with the removal of remaining labor intensive textiles and other exportables. Similarly peak non-agricultural tariff reductions have continued with a reduction to 15% in the last budget.
There have also been sporadic policy reform initiatives from other ministries. Thus the FDI limit in domestic airlines was raised to 49% and in Telecom to 74%. In Telecom indirect channels of foreign investment were simultaneously closed thus increasing transparency. The permission given to private Indian airlines to fly on foreign routes and the open skies agreement with the USA could transform foreign air travel over the next few years. One hopes that private investment in upgrading major airports will finally get underway after 5 years of policy circumlocution. The SEZ law could similarly have resulted in a revolution in labor intensive exports, but the dropping of the labor clause has made this a little uncertain.
The performance on tax reform has been mixed. In CENVAT the reduction in rates on polyester etc. has been offset by a move away from genuine CENVAT in textiles. Income tax reform has been a mixture of simplification (saving exemptions) and new complexity (securities transaction tax, fringe benefit tax). The latter will have to be reformed 5 years later. The harmonization of States’ sales tax rates that passes under the name of VAT has finally got under way, a great political achievement. From the economics perspective however, a genuine equitable State VAT that simplifies the system by replacing all indirect taxes requires a uniform 10% rate on all goods and local services except food, drugs and medical equipment/ services. This has to be complemented with a handful of sales taxes on final consumer goods (e.g. entertainment, petrol, cars) as argued in Planning Commission Working Paper No 4/2002-pc.
One of the predictions that I made at the start of PM Manmohan Singh’s Government is that given his depth of understanding and commitment he would be a Prime Minister who would pay greater attention to long term and difficult issues like governance reform. This process has indeed been initiated and a few things like the ‘Right to information Act’ already passed. But there is still a long way to go and I expect that in the remaining four years further action will in fact be taken.
Most new governments take at least a year to find their feet and get going on policy reforms. As this was the first year of the Government and given the novel political arrangements in which the leader of the major government party is not the Prime Minister, it was perhaps inevitable that the Government would take a little time to settle down. It is hoped and expected that the pace of reforms will gradually accelerate over the next couple of years.

China and India in a Globalised World

India has been a trading nation for centuries, as has China. China has, however, been much more successful since 1980 in exploiting the opportunities provided by a globalised world to enhance its own growth. Its trade, led by exports, has increased much more rapidly to seven times ours. Free, fair and open trade with any and every country in the World is in the interests of India. ICRIER studies have shown that in 2000 the potential for trade between India and China was about 2.5 times the actual trade. The India-China study group (of which I was a member) has identified constraints and barriers that impede the attainment of this objective and recommended solutions. If these are sincerely and speedily implemented, there will be a mutually beneficial increase in trade.
Should better trade relations be contingent on and hostage to building of trust? Do we need to trust the Chinese to trade with them? I don’t think so! The essence of modern markets is impersonality. The systems of laws and rules that constitute the market as an institution allow strangers to trade with each other. If we only traded with our friends and relatives, the modern industrial economy could not exist. Impersonal trade can however, lead to greater information flows and knowledge and therefore help remove misperceptions. If trade is good then is isn’t more trade, engineered through a Free trade agreement, even better? This is false logic: More trade based on removal of distortions (e.g. a general reduction of our very high tariffs) is good for the Indian public, more trade based on creation of new distortions (e.g. selective reduction in tariffs for China) is bad both for industry and the public.
International trade in services is much more important to India than it is for China. An FTA would benefit China more than India, but can’t we balance this by better access for our Service exporters? Possible, but unlikely during the next 3 years. Service trade is heavily dependent on domestic rules, regulations and procedures. Partly because of the language barrier and partly because China is still a Socialist nation run on the principle of the “Dictatorship of the proletariat” such rules and regulations can be extremely non-transparent to Indian exporters and subject to individualistic application and change. It would be serious mistake to assume that if we reduce our goods tariffs to zero (the essence of a Free Trade Agreement) China will allow India free access to its service exports and the associated movement of skilled personnel. This will require a clear understanding of our national interest, hard bargaining, clear and explicit agreements and forceful implementation. It cannot be based on trust. In the next five years China will open its economy to service exports in line with its accession agreement with WTO. This will open opportunities for Indian service exports and will also indicate how open China’s service market will truly be. During the same period, the gap between India’s and China’s general tariff rates will be narrowed perhaps even eliminated. The scope for a mutually beneficial bilateral agreement will be much greater and we can and should revisit the issue in about three years.
Trust is critically important in a broader ‘partnership’ in economic, technological or strategic areas. Larger trade volumes cannot act as a substitute for rebuilding trust where it has been destroyed. The basic source of mistrust is the undefined border and the supply of nuclear technology (e.g. atomic bomb designs, in violation of NPT) and material to countries/regimes hostile to us. Other issues impinging on ‘trust’ include, (a) Opposition to the entry of India into pan-Asian economic organisations such as East Asian economic organisation and ASEAN+3. (b) Implicit (through Pakistan) opposition to permanent membership of India in the UN Security Council. The fact that India supported replacement of Taiwan, China by China, PRC in the Security Council decades ago is merely proof of India’s soft and sentimental approach in contrast to China’s hard realistic approach. Trust can only be re-established by addressing these issues. The willingness, after a long time, of China’s leadership to realistically address the border issue gives hope. On the other hand, the supply of nuclear and strategic technology to hostile countries/regimes is not conducive to building trust. Trust cannot be compartmentalised. It can only be rebuilt by addressing the broad range of issues in a sustained way.

A Tripolar Century: The USA, CHINA And INDIA

Introduction
The fast growth of Japan till the mid-eighties, gave birth to several books about the Pacific Century and the Asia-Pacific Century. This talk gradually disappeared after the bursting of the Japanese bubble. The talk revived with the phenomenal growth of the NIEs or Asian Tigers but was soon overcome by the Asian Crises. Virmani (1999) showed that India (the elephant) was among the ten fastest growing economies of the World since 1980 and projected that in the next decade its growth rate would accelerate above that of the Tigers and reach the top three. Though China’s past growth had been overestimated by about 2% it (the dragon) would remain the fastest growing economy in the World during the first decade of the 21st century.
Krauthammer had heralded the arrival of “The Unipolar Moment” and set of a debate on its many ramifications. The reality of the unipolar world returned to center stage after the Asian crisis even some have asserted that the unipolar moment had passed. Since 9/11 the USA has asserted its primacy and the Unipolar nature of the World has been re-asserted. There is, however, a variety of views on how long the unipolar world will last. The current paper argues that the global economy is evolving in a direction that will result in a tripolar World by the middle of the 21st century. Thus the 21st century will be a ‘Tripolar Century’ with two of the poles in Asia and one on the other side of the Pacific. So ironically it could end up as partly a Pacific, partly an Asia-Pacific and partly an Asian century.
Economic Basis of Global Power
The globalised world of the 21st century will be driven by economic growth. This is based largely on an economic view of power a la Paul Kennedy. The relative power of nation states will depend on the relative size of national economies. This in turn means that within the set of growing economies the rate of catch-up growth and relative population size, indicate the shape of the likely future.
Developed economies with relatively high per capita income are at the frontiers of technology (knowledge) and grow relatively slowly. Growth varies among them based largely on technological innovation. Low and middle income countries lie well within the technology frontier and their growth rate depends on the transfer of technology (knowledge) from the developed countries, and its adaptation, application and diffusion. Such knowledge flows take place through multiple channels, such as machinery import and investment, FDI, foreign trade, internet, media and travel. The globalisation of the World economy during the 20th century has removed many of the constraints on such movement and reduced the cost of such flows. The low and middle-income economies can in principle grow much faster than the advanced economies as long as their income is well below that of the advanced countries. The Asian tigers were the first to take full advantage of the benefits of globalisation. Other Asian countries have followed in their footsteps. Between 1980 and 2003, 8 of the 10 fastest growing economies in the world in terms of average per capita GDP (the measure of catch-up growth) were in Asia.
If catch-up growth is sustained over several decades, as it has in Singapore, Hong Kong the economy will eventually reach the technology/income frontier . The growth rate of an economy is likely to slow as it comes closer to the frontier and the scope for catch-up growth is exhausted and more of the growth must come from its own technological innovation. With per capita incomes/GDP almost identical, the relative size of the population is the primary determinant of relative economic size. Therefore over the medium-long term relative population is an important determinant of size. The economic size and therefore the relative power of large relatively fast growing economies will therefore rise over time. The two most heavily populated countries in the World are China and India. They are among the 10 fastest growing economies in the world and are projected to remain among the 3 to 5 fastest growing economies. Their relative power will therefore inevitably rise. The question is only about the speed with which this will happen and the level that will be reached.
Index of Power Potential
We define an index of relative power potential that is parameterised by a technological weighting factor ‘a’ that can range upwards from 0. It can be shown that, (i) When the technology weight is zero the power potential is captured by the relative size of GDP measured at purchasing power parity. (ii) When the technology weight is 0.4 the power potential is approximately equal to the relative size of the economy at current market exchange rate. The power potential index for country i (PPIi) is calculated as:
PPIi = (GDPi/GDPu)*(PCgdpi/PCgdpu)a ,

Where GDPi and GDPu are GDP measured at purchasing power parity of country i and the USA respectively and PCgdpi and PCgdpu are the per capita GDP at purchasing power parity of country i and the USA respectively. The second term in PPI therefore represents a technology factor that is applied to economic size.
The technology weighting parameter a gives extra weight to a country’s inherent technological capability. The reasoning is as follows. As a result of globalisation knowledge/ technology, capital and human skills can flow freely across countries given appropriate policies. If all technological flows were unconstrained by national restrictions then a weight of 0 would best represent market conditions as all technology can be freely purchased. Each country’s command over resources including technology is given by its GDP at purchasing power parity.
The flow of Defence, Strategic and ‘Dual use technologies’ are however constrained by national polices and technology denial regimes and cannot be bought on the market. In this situation a nations inherent technological capability is still important for the development of such technologies. Such inherent technological capability is most simply and effectively captured by per capita GDP measured at purchasing power parity.
The parameter a provides the extra weight on this (technology) variable. In our view a=0 captures the economic potential and a=0.4 the power potential of nations adequately and the latter will be the focus of our analysis. For those who think that military power and consequently strategic technological capability play a greater role than economic power, a would be set at 0.6 or 0.8. The main difference is that the USA’s predominance over other countries is heightened if the technology weight is increased. In addition the relative position of the poorer countries worsens much more than that of the richer ones. Currently China is a lower-middle income country while India is a low-income country and their ranking deteriorates if we use higher values of a. The position of Russia an upper-middle income country also worsens. However its power potential remains less than that of China, though it becomes higher than that of India.
Actual power can vary from the level indicated by the power potential index because of (a) Differing national objectives (the will to power). For instance the will to power of post-war Japan was very low, while that of the USSR was and of China since 1980 is, very high. (b) Different allocation of national revenues to military and strategic R&D and equipment relative to that on other public goods and services (e.g. environment). Thus Russia continues to benefit from the high investment of the USSR in strategic technology. (c) Alliances that transfer restricted technology and equipment and thus effectively supplement national technological resources. For instance in the past China used its alliance with the USSR to develop its strategic technology and also benefited from its informal partnership with the USA (President Clinton called China a strategic partner). Many countries including Israel have benefited in the past from their formal or informal alliance with the USA.
Sophisticated models of global power, such as those of Tellis et al (2000) have incorporated both economic and strategic technology dimensions of national power. The Index of Power Potential is designed to capture most of the economic factors analysed in such sophisticated models, in the simplest possible way (Principle of Ocam’s Razor).
Current Unipolarity
The USA is clearly the predominant power today. Japan the second ranked power has less than 30% of the power potential of the USA in 2002. China the third ranked power is just behind it with 1/4th the power potential of the USA. Germany with less than 1/5th of US power potential is next with France, UK and Italy occupying the next three positions with a power potential of little over 1/10th of the US. India according to this measure is next, followed by Canada and Spain. Neither Brazil nor Russia are in the top ten.
There are many foreign policy experts who question the importance of economic factors in national power by citing the cases of Japan and Germany. According to the Power Potential Index their relative power is less than 30% and 20% of the USA’s respectively. In 1975 the relative power of Japan was 31% in 1975. Germany was divided so its (W Germany’s) power was fragmented. This was not sufficient for either of them to have challenged US power even if they wanted to, given the fear and resentment that it would have aroused in their neighbours. It can also be argued that the victors of World War II the USA, France and UK ensured that the losers, Japan and Germany did not develop great power ambitions, by imposing a pacifist constitution and tying them into the EU/NATO and US-Japan alliances.
In complete contrast many observers continue to talk about Russia as a future great power as Russia’s actual power appears to be much greater than its power potential. Its power potential as per the Index is currently about 6% of that of the USA. It was however as high as 19% in 1981-1982 but has declined steadily since then. The economy of the Soviet empire (including former USSR and E European satellite States), which constituted a unified ‘virtual State’ ruled from the Kremlin/Moscow, was much larger than the Russia of 1982. Therefore the power potential of the USSR, whose data is not available, would have had a much higher PPI. This allowed the USSR to devote much more resources to the development of strategic technology and equipment, a legacy from which current day Russia benefits greatly.
A Tripolar Future
Based on our projection of growth of per capita income and the population projections of the United Nations, we conclude that the World will become tripolar by the middle of the 21st century. There is nothing sacrosanct about the precise numerical projections. What is important is the trends and the direction they are leading the world. During the first half of this century India’s population will increase from 3.6 times to 3.75 times that of the USA, while China’s population will decline from 4.5 to 3.4 times that of the USA. Population growth is not therefore the primary driver of the change from a unipolar to a tripolar world, even though it places these two countries in a much more favourable long term position relative to all other countries (e.g. Japan, Russia) and associations (EU, ASEAN). Over these 50 years China will become a high income country with its per capita GDP increasing from 11% of the USA’s to 57%. Similarly, India will become a higher middle-income country with its per capita GDP increasing from 7% to 36% of USA. The global economy will be transformed by this convergence of incomes, because for the first time in history it affects the two most populous countries in the World.
Figures 1 and 2 show the evolution of power potential of the most powerful countries when the technology parameter is set at 0 and 0.4 respectively. The latter can be taken as the mean scenario in terms of power potential and also captures the direct effect of the concerned economy on other countries and the World economy. Figure 2 shows that China’s power potential will equal that of USA by the end of the first quarter of the 21st century, while the power potential of India will equal that of the USA by the end of the 2nd quarter (1st half) of this century. Thus the World will become bi-polar within 25 years and tripolar within 50 years. By the middle of this century China could be the strongest pole of a tripolar world in which the combined power of the USA and India would be only a little greater than that of China. This has important implications for economic and technological co-operation between the USA and India.
Figure 2 also shows that Japan has passed the peak of its potential power and will be on a declining trend over this century. Its power potential has already fallen below that of China and will fall below that of India within the next 20 years. The gap between Japan and the European powers of the 20th century will close steadily over this century. It will however remain a significant power during the first quarter of this century, if it changes its pacifist approach and develops a more muscular foreign and national security policy. Recent statements of the Japanese Prime minister and joint statements with the USA in the context of the US-Japan security treaty give a hint of this change. If Japan indeed becomes a “normal nation” it can play a critical role in securing peace in Asia in co-operation with other democratic countries of Asia during the first quarter of this century. This process of change may however be too slow and incremental (given the strong resistance and the nature of consensual decision making) to significantly affect the balance of power in Asia.
According to our mean forecast the power potential of Russia will rise slowly to exceed that of Germany by the middle of the century. It will however remain less than that of Japan, reaching about 80% of that of Japan by mid-century. If these scenarios turn out to be correct, both Japan and Russia would be classed as regional powers at that point.
Will it matter if the best parameter for measuring power is 0.8 rather than 0.4? Not really, as the only affect would be to increase the time it would take for the world to become bipolar and tripolar! Even if the technological weight is increased to 0.8 China will clearly emerge as the second pole by the middle of the century as its power potential will be 65% of the USA by 2030 and equal it by 2040. In any case it is not necessary for a country’s power to exactly equal that of the strongest power to emerge as a second pole. A power potential of 50% to 66% (with a=0.8) would make a country an alternative pole. By the end of the first quarter of this century, China will therefore be in a position to challenge the US power in Asia. Whether and how it chooses to do so will depend on many factors including the Balance of Power in Asia and its level of Strategic technology.
Similarly in the case of India, even with a technology parameter of 0.8, India’s power potential will exceed that of Japan by 2030. By the middle of the century it will be about 60% of that of the USA. Thus it will emerge as a third pole in a tripolar world. By way of comparison, second ranked Japan’s power potential at the height of its potential power in the early 1980s was less than one third of the USA. It has declined to one fourth of the US by 2000. France, Russia and other countries had a fraction of this power potential and were therefore in no position to challenge the USA. In the case of the rich countries the power potential does not vary much with the technology parameter.
From our current vantage point it appears very likely that India will be the weakest pole in the tripolar world of the 21st century. As India and the USA share fundamental human, social, institutional and democratic values, it may be in the interest of the USA to ensure that the economic and technological gap between India and China is closed as rapidly as possible so that India can act as a stronger pole in Asia. This will also help expand the freedom of action of other countries in West Asia, Central Asia and of the members of ASEAN.
India the Third Pole!
Few observers have taken the possibility of India’s emergence as a global power seriously. As our projections for India and China differ significantly from those by earlier authors it is necessary to provide a rationale. In our mean forecast we expect China’s growth rate to fall gradually to more normal levels rather than collapsing abruptly as many earlier authors assume. The IMF has shown that China’s growth so far is on a trajectory similar that of Japan and the NIEs in a similar period of their development, though it is faster than that of the ASEAN-4. Many earlier forecasts (including those by the ADB, World Bank and IMF) that projected a sharp slow down of China’s economy in the near future have been proved wrong. This does not however mean that the possibility of sharp slow down can be ruled out, only that the timing is very difficult to predict. As long as China remains dependent on FDI-export led growth and subsidised supply of capital and intermediates to exporters (disguised as non-performing Assets of banks) the risk remains. The second factor is the overestimation of economic growth in the 1980s and 1990s by about 2% points. We expect this overestimation of 2% to be gradually eliminated from the published data and an allowance has accordingly been made for this in our forecast.
In contrast to China we assume a steady rise in the rate of growth of the Indian economy. Our analysis suggests that the extensive reforms undertaken in India in the early 1990s have so far increased growth rate by only about half a percent point because the negative effects of lower protection appear immediately while the positive effects appear gradually. The former reduces capacity utilisation of outdated capital while new more productive capital is built up gradually through investment and diffusion of best practice takes time. The underlying GDP growth rate will therefore rise over the next five years to 6.5%.
It will rise further to 7% thereafter, with continuing reform and the following factors. Firstly the fast growing (25% per year) Information technology and IT enabled services export sector will start contributing significantly to GDP growth. Though this sector is already a major contributor to exports, its share in GDP was minuscule. It is now becoming large enough for its continuing rapid growth to have a measurable impact on total GDP growth rate. Second, the un-exploited potential of FDI is likely to be utilised more fully in the next few decades. In contrast to China and ASEAN, India’s growth has been driven by domestic entrepreneurship while FDI has played a negligible role. A likely increase in FDI levels from $3-4 bi. in the past to $8-$10 billion in future will give a substantial boost to productivity and growth. The proven capability of Indian middle skills along with the availability of low wage unskilled labour and a new Special Economic Zone (SEZ) law, will attract increased FDI. Finally India is in the midst of its demographic transition and poised to exploit the demographic dividend. It will have the youngest labour force in the world. It will therefore become the primary source for goods and services that depend on such labour. For instance in many disciplines (e.g. physics), the most innovative ideas are developed by experts under 30 or 35.
An important common factor underlying the projected increase in India’s growth is the fuller use of the large under-utilised pool (20mi to 100mi) of independent minded, democratically confident, high IQ population. Another factor is the high level of social capital accumulated over centuries and the relatively high quality of its institutions (despite some deterioration over the past thirty years). It has been estimated that India’s current economic growth rate is about 2% points lower than that predicted by the quality of its institutions. Growth will therefore gradually rise to the predicted level with the correction of wrong policies.
Russia’s growth is also assumed to be much higher than it has been in the past. Even though the oil price rise has led to an acceleration of growth this push will end after oil prices have stabilised. Russia has the advantage of a relatively educated/skilled work force and vast natural resources. How effectively it will be utilised is however still uncertain.
European Union: Another pole?
Whether or not the European Union can emerge as another pole in a multi-polar world depends on its evolution into a “virtual state,’ that is a super-national body with elements of a nation state, such as the power to tax and to use the tax revenues for security (defence and offence). Its global power can in principle lie anywhere between that of its strongest member and that of the aggregate of all members depending on how much of it they surrender. For instance surrender of half the power by each country could mean that the EU virtual state’s power is up to half the total aggregate power of members (who would be left with only half their original power). The economy of Europe and Central Asia (taken as approximating the future EU) is projected to decline from a little over 125% of the US economy to a little over 100% of the US economy. Half of this would mean about 50% of the USA’s power potential. According to current indications this amount of power accumulation by EU (surrender by member states) is unlikely. This is reflected in the increased resistance to surrender of financial power by joining the EMU, the strong push by Germany to become a permanent member of the security council and the move to include Asian Turkey into the European Union so as to strengthen multi-culturalism and diversity in the EU.
Though there have been periods in which the EU appeared to be moving in the direction of becoming a ‘virtual state’ its current direction appears to be towards an umbrella organisation with increasing soft power. The EU constitution, if passed will certainly make the EU administration another player on the global scene, though individual countries of the EU (Germany, UK, France, Italy) will continue to play an important role in the global economy. Even a surrender of a 1/4th of each members’ power to the EU will not, however, make the EU into the fourth pole of a multi-polar world. We are therefore sceptical at this time that the EU per se will aggregate enough power under it to become another pole in a multi-polar world.
Partnership For Peace
Within a decade China’s economy will become larger than the US economy and may be almost twice as large by the middle of the century (in terms of GDP at purchasing power parity). Its power potential will therefore equal that of the USA sometime during the second quarter of this century. The World will become bipolar much before that happens, probably towards the end of the first quarter. China will almost certainly challenge USA’s economic power in Asia and across the globe and likely be much more unabashed in asserting its economic claims in the South China Sea and its economic interests in Asia, Africa and Latin America.
In parallel, India’s economy will overtake Japan’s within five years to become the third largest in the world and likely equal the US economy in size by 2040. The world will therefore become tripolar by the middle of the century. The size and power of China relative to India is projected to peak within a decade (at 2.3 times and 3.1 times respectively). The absolute gap will however continue to grow till the middle of the century. India will consequently be the weakest pole in this tripolar world of the 21st century. As the USA and India share fundamental human and democratic values and have no conflicts of interest, it will be in their mutual interest to develop a strong partnership for economic and technological development. The USA as the predominant power today should strengthen India’s economic and technological capabilities so as to benefit in future from its young labour force and large potential supply of knowledge workers.
The partnership between the USA and India needs to be balanced by the development of co-operative and inclusive economic structures in Asia, based on the lessons of European history and the European Union. We must build an Asian Economic Community that includes all the major powers of Asia (China, India, Japan) as well as S. Korea and the ASEAN countries. The Indian Prime Minister, Mr Man Mohan Singh has endorsed this concept. By analogy with the European coal and steel community the Asian (petroleum) oil community proposed by India’s Petroleum Minister, Mr Mani Shankar Aiyer, could act as a precursor to the Asian Economic Community. The possible inclusion of West Asian and Central Asian countries can also be considered at some stage. The USA and the European Union should support this endeavour.

Figure 1: Projected Power Potential of the Major Powers

Figure 2: Projected Power Potential of The Major Powers

The New Tripolar World

The Dragon has emerged from the dungeons of Maoist communism to grab the benefits of globalisation whether its foreign direct investment, exports, education or skills without singeing it with its fiery breath. It has successfully combined communist party ownership & control with elements of a globalized market economy. The vegetarian elephant has similarly emerged from the Indian version of Socialism to experiment with market reforms in its usual slow and steady but plodding democratic way. Though both started the transition in 1980 the dragon has attained a lead over the elephant that may take three quarters of a century to be completely eliminated.
A 1999 paper, “Potential Growth Stars of the 21st Century: India, China and The Asian Century,” (Occasional Paper, Chintan, October 1999, www.icrier.org/avpapers. html) forecast that India would be one of the three fastest growing economies in the World. So far the forecast has not come true. Un-deterred, a new paper, “A Tripolar Century: USA, China and India,” (Working Paper No. 160, ICRIER, March, 2005) forecasts that India will, by the middle of the century, become one of three global powers constituting the global trinity. What is the basis for this forecast of a Tripolar World?
If we compare the distribution of World GDP at Purchasing Power Parity (PPP) and the distribution of World population between the US, China and India, the results are striking. USA has only 5 per cent of the world's population but accounts for 21 per cent of the World GDP. China in contrast has 21 per cent of the world's citizens but thanks to its phenomenal economic growth rates since 1980 now has 12 per cent of the world's GDP share. India has 17 per cent of the world's population but because of slower growth rates its GDP share is only six per cent of the total. However, the discrepancy between these three countries is expected to be closed during the 21st century.
Why will a centuries old gap be closed in half a century? Because the past two decades has seen the two most populous countries change their economic policies and play catch-up in growth rates. Consequently, they were among the 10 fastest growing economies since 1980 and will remain among the 3-5 fastest growing in the next several decades. As a result the income gap between the two and the USA will close gradually. Given their much larger population, China's and India's GDP at PPP will equal that of the USA by around 2016 and 2039 respectively, though average income will be much lower (ICRIER WP 160). Within the next five years India's economy will overtake that of Japan to become the third largest in PPP terms. A few years later India will become a lower-middle income country (currently low-income). In a recent paper I have forecast that India will, by the middle of the century, become one of three global powers constituting the global trinity. It also presents an index of power potential that shows that, (a) China's potential power will exceed that of the USA by the second quarter of the century, and (b) India's power potential will exceed that of Japan by 2025. In 2035, India's power potential will be half that of the USA. Fourth ranked Japan's power potential will be 1/5th that of the USA and 50% that of India. India's power potential will be almost 80% of the USA by 2050. By way of comparison it should be noted that at its peak in the 1970-1980s (3rd ranked) Japan's power potential was only about 1/3rd that of the USA. The world will therefore become tripolar sometime during the second quarter of the 21st century.
India's GDP at PPP and its power potential will decline relative to that of China during the current decade, stabilise during the next and start to rise during the third. According to our forecast the gap between the two will be closed in the third quarter of the 21st century. History shows that the rise and fall of great powers leads to wars. The globalised world of the 21st century provides an opportunity to break the jinx of history, by building a system of co-operative relations between the three great powers of the 21st century. As India will be the weakest pole of this tripolar world, the USA must help close the technology gap between India and China, that was partly created by discriminatory Western sanctions against India. This requires a translation of recent announcements by Secretary of State Condoleezza Rice into concrete changes in laws, rules and procedures. India and USA must build a partnership for peace.
China and India must also improve their bilateral relations. As China is the larger power it must recognise and respect India's role in Asia and the World. This requires a fair an equitable settlement of the border issue and a decision by China not to proliferate nuclear technology to countries hostile to India. Barriers to trade must be removed so that the trade potential is fully exploited. Drawing on the lessons of European history, India must pursue the idea of an Asian oil community and an Asian economic community with India, China, Japan and ASEAN at its core.

China’s Socialist Market Economy and Hindi - Chini Bhai-Bhai!

The media the press, everybody is talking about an India-China Free Trade Agreement (FTA)! The discussion, however, reflects a confusion between the need for increasing India-China trade and improving economic relations and the usefulness of an FTA. In WTO parlance an FTA means zero duties on all goods (with few exceptions). Further an FTA does not include Services, FDI or the movement of persons, issues of vital interest to India that would normally be covered in a CECA.
An ICRIER working paper (No. 151) has shown that the highest un-exploited potential of India’s trade with any/all countries is with China. Her study shows that trade could be more than doubled. I am sure most scholars would agree with this assessment, even though precise estimates may differ. Normalisation of Trade between the two countries is highly desirable and perhaps even necessary.
To ensure that this potential is realised two countries must jointly identify the constraints and barriers to trade and take steps to remove them. These include rules and procedures and their application, transparency, information-language barrier. All other trade facilitation measures must be taken to make sure that the gap between potential and reality is closed. This does not require an FTA.
Prime facie the economic benefits of a bilateral FTA between India and any other country are not obvious. India till two years ago had the highest non-agricultural tariffs in the world. With the reduction of the peak rate to 15% we now have rates that may be in the top 1/5th or 1/4th . Tariffs on agricultural goods are much higher with few as high as 100%. Reduction of these rates to zero under an FTA could result in substantial Trade diversion and welfare loss. Thus as long as our tariff rates remain high the a priori presumption must be that an FTA with any country with lower tariffs is likely to result in economic losses not gains. Only hard evidence to the contrary should overcome this basic scepticism.
Building mutually beneficial economic relations between India and China requires a clear understanding of the Chinese economy. There is a tendency for people involved in China to find economic similarities even when they do not exist. Definitions are adapted to make it appear similar to a normal market economy. This is reflected for instance in the definition of “Private sector’ “non-state sector” State owned enterprises (SOE), Collective enterprises, Town & Village enterprises (TVE), listed companies, joint venture companies etc. The standard international definitions in which ownership (majority, minority, largest share etc), management control (e.g. power to appoint CEOs) are not used/ applied in defining the “private” and “public” sector. This obscures the true nature of the economy and of the development strategy.
A recent Working paper (No. 160, ICRIER, March 2005: www.icrier.org/wp160.pdf ) has given a stylised model of China’s economy. China’s basic Goal is National power through Growth maximisation. Employment generation, individual income growth and public welfare act as constraints (rather than secondary objectives) to the growth maximisation objective. The CPC network, a mix of centralised and decentralised systems, implements these objectives. Like most other developing countries, quality of governance in China is gradually deteriorating. This involuntary lack of control (e.g. on corruption) should not be confused with deliberate policy change by the State/CPC.
The strategy adopted to achieve the growth objectives has four important elements. The FDI-export policy is the most important and critical means for achieving this goal. China is now a part of the global supply chain for labour-intensive exports, and these are highly competitive. The reason is not however the productivity of Chinese labour in terms of output per man-hour. A critical subsidiary element of the FDI-export strategy was the abolition/suspension of minimum wage conditions, upper limits on working hours and rules against firing workers. Control of labour market (labour responsibility system) ensured the supply of workers who worked 100 hours a week, 52 weeks a year. Thus high productivity per person-year is due to more hours worked per week compared to normal market economies (35 to 48).
The second element is the social ownership of capital assets (100% till 1980) . The returns from these assets are used to raise national investment rates to very high levels, without creating disincentives and distortions through high tax rates. High infrastructure investment since 1997 is a manifestation of this. The third pillar is normal markets for most goods and services where the forces of demand and supply operate to set prices. This removes the worst feature of the Soviet system that played an important role in its collapse.
The fourth pillar is the control over banks and capital markets, which allows subsidisation of capital-intensive and skill intensive exports as well as FDI investment in hi-tech industry, indirectly through banks (govt department). The modus operandi is to give loans to State/CPC owned/controlled enterprises that supply inputs to the target companies. These loans are not expected to be repaid and therefore the use of the word NPA is a misnomer.
The result: Incredible rates of growth of 9.5% per annum for 25 years. Even if there is overestimation of 2% (scholars estimate 1% to 3%), 7.5% per annum is the highest in the world during this period (30% higher than India’s).
The Asian crises showed that some of the elements of this strategy are risky. The strategy is a bit like peddling furiously on a bicycle to keep from tipping over. Expectations of foreigners play a key role in FDI. Euphoria about China’s growth keeps FDI flowing. That in turn ensures very high growth of production. Given the low share of private income and consumption in GDP, excess capacity is created in many industries. This can only be utilised by pushing exports. Either unit values fall (e.g. textiles) or implicit subsidies have to be provided.
This picture of the Chinese economy suggests that the arguments for an FTA with China and the according of “Market economy” status to it are very weak. We should focus on normalisation of economic relations, settlement of the border issue and collaboration in areas where there are clear identity of interests (e.g. oil purchases) rather than jump from one extreme to the other. It is said that India-China Bhai-Bhai, became India-China Bye Bye, which in turn has become India-China Buy-Buy (over the last five years). Let us not restart the cycle by getting euphoric over words like “strategic partnership.” It is much better for both countries, as well as for the rest of Asia, if we jointly build a normal, realistic and well-rounded relationship that will last through the 21st century.

Rule of Law or of Law Breakers?

What are the most important problems facing India and what are the most urgent reforms needed? The answer varies with the knowledge and interests of the person asked. The list includes, Infrastructure, Electricity, roads, railways, Agriculture, irrigation, Poverty, Inequality, Education, Health, Water shortage, Urban development /slums, high fiscal/revenue deficit, low tax-gdp ratio, low expenditures on social sectors/infrastructure, land policy/rules.
Perhaps one can focus the question a little: If you were made dictator of India with the authority to address a few issues what would they be? My answer: The most difficult thing for a democracy to reform. That which affects those who make the laws (members of parliament and state assemblies) and are supposed to be the guardians of these laws (judiciary, police). The greatest danger to the nation and the greatest long-term threat to India’s continuing development is the breaking of the law by the law makers. Like the proverbial rotting head of a fish it affects everything else.
The deterioration in governance, that has taken place over the decades is broad based & universal: Civic amenities, publicly provided utilities, public education and health law & order and justice have deteriorated, in some places beyond belief. What one had heard about law & order in Bihar for several decades and began hearing about UP during the last decade, can strike even in the capital and its suburbs. Kidnapping in Ghaziabad, police extortion in the heart of Delhi (a beat constable asking a small scale factory owner for ‘hafta,’ backed by the threat of overnight theft of materials lying in his premises). Some years ago, the secretary (food) of one State govt. admitted in a meeting with IAS peers that they were not competent to procure excess production or deliver food to the starving. Hearing this from an inheritor of the ‘steel frame of India,’ was a shock. Similarly, the chief minister of one notorious State confessed that the existing State machinery could not spend money productively and that it would be very happy if development activities could be carried out by anyone else, including the provider of the funds.
The lack of interest and motivation to fulfil the basic functions of government is the fundamental cause. The underlying problem is distorted incentives and the corruption of power. Power corrupts and absolute power corrupts absolutely. As the systems of governance deteriorate under rent seeking and rent creation, the power to do good falls relative to the power to harm. The result is that today, the latter is much greater than the former, so that the rare employee wanting to do good has the dice loaded against him/her. There is an urgent need to strengthen the checks and balances in the political system. Though the framers of our constitution paid a lot of attention to the potential for corruption in the bureaucracy, they made the fatal mistake of assuming that all future elected representatives would be incorruptible and selfless like those who fought for independence. They could not imagine that the judiciary could also be corrupted.
There is an urgent need for electoral reform to reduce the currently overwhelming incentive for political corruption. If the Neta-criminal nexus is not broken a time will come in the not too distant future when it will become virtually impossible to stop the criminalisation of the entire police force. Possible elements of a solution include, (a) State funding of elections through a matching funds approach. (b) Transparent accounting and mandatory auditing of the accounts of political parties that receive State or company funds. (c) Mandatory bar to running for (or holding) any political office by any one against whom criminal charges have been legally framed, (d) Special courts to try politicians/potential candidates against whom such charges have been framed so that those who are the object of motivated/false charges can be tried and cleared quickly. Penalties could also be prescribed against those who wilfully make false charges.
The police force has over time become an important instrument of political power and manipulation. The police are therefore no longer an independent instrument for enforcing and upholding the rule of law and for providing personal security to all its citizens. The misuse of police by the political masters for personal ends as well as the use by the police of state power vested in them, for their own personal ends, is not merely a theoretical possibility but a frightening reality. This enormous power of the police to do harm must be checked before it becomes uncontrollable.
A number of commissions from the Dharam Vira commission to the Law Commission have suggested the creation of a buffer between the political bosses and the day-to-day operation of the police. One approach is to set up an autonomous police commission in each state along with open and transparent process for appointing the senior officers of the commission. There is also need for an independent public prosecutor whose job is to take cognisance of, oversee investigation of and prosecute major crimes (e.g. murder, armed robbery/dacoity, kidnapping, rape, police crimes). To ensure accountability to the public, which has become the object of police harassment, each police commission & public prosecutor would be accountable to an oversight committee of representatives from all walks of life (including the administration & judiciary). This would ensure that the police themselves obey the law and the law-breakers among them are given exemplary punishment.
Reform of the judiciary could similarly involve a National Legal commission to provide oversight over the legal system and ensure the neutrality and probity of judges at different levels.
We cannot afford to keep waiting for a consensus among all political parties (including those with 20% criminals). Let not the best be the enemy of the good. The two national parties and their non-criminal allies should come to an agreement and start the process of reforms.

A Reform Budget: Promised Reform have Fructified

The PM and the FM had promised extensive tax reforms in the budget for 2005-6. This transparency raised the possibility of over-expectations and disappointment. The budget has however met the expectations. The surprise element, that could perhaps have transformed this budget from a very good one to an outstanding one, was however lost. There is clearly a trade-off between transparency and pleasant surprises that characterised the two outstanding budgets (current account convertibility and income tax rate reductions).
In the Pre-Budget meeting that the Finance Minister had with economists I had suggested three areas of economic reforms for the 2005-6 budget. These were tax reforms, FDI policy and Infrastructure reforms. As all three areas have been emphasised by the government. it is interesting to see where the budget has fallen short or exceeded these implicit expectations. Taking FDI first, the presentation had emphasised the importance of FDI in raising the growth rate from the 6 to 6.5% level to the 7 to 7.5% level. Research done at ICRIER has shown that FDI has a positive impact on exports, efficiency and productivity of modern sectors where it enters. In contrast to the Interim budget last year this years budget merely talks of a committee to look at FDI in sectors such as mining and distribution. The completion of the FDI reforms promised in the previous budget with respect to Aviation and Telocom and the announcement of considerable liberalisation of FDI in Real Estate (construction development) is however quite encouraging. A paper and a project report by two different ICRIER scholars respectively, have recommended allowing FDI in the retail sector. I expect FDI in the retail sector to be allowed during the next 6 –9 months.
In Infrastructure, the presentation had emphasised the quality of infrastructure investment versus the quantity. The best way to improve infrastructure was to divide it into three different categories that required different emphasis, namely public goods (roads, town & village infrastructure, R&D, knowledge dissemination), quasi-public goods (rural infrastructure) and private goods (urban electricity, airports, ports, railway services). It was recommended that limited government revenues must focus on the first two categories while improving the productivity of these expenditures through institutional reform and innovation. In addition private-public partnerships, subsidy auctions and other innovative mechanisms can play a vital role. Though the budget has still not adopted this three-fold classification, in implementing the agricultural development and rural poverty alleviation objectives of the CMP higher expenditure allocations have sought to be made more effective by channelling them through new and or improved institutional mechanisms. In the case of private goods (infrastructure) the presentation had emphasised the importance of the policy and regulatory framework so as to minimise policy risk. The budget does not spell out these things in detail but one expects the planning commission and the infrastructure committee to do so in the next 3 months.
Tax reform is of course the core of this budget. The income tax and customs duty reforms have met or exceeded expectations, while excise duty reforms have fallen short. The presentation had emphasised the integration of goods and services in a comprehensive CENVAT with a uniform rate of 15-16% and exemptions for food products, medical goods and services and education services. Though the grand design has not been implemented, this can probably be justified the need for caution at the time at which the State Vat is coming into operation. There has also been progress in reducing the excise on PFY & tyres and in exempting some food products. A further rise in the SSI in the SSI exemption from 3 crore to 4 crore is however a retrograde.
On customs duty the presentation had suggested reduction of the peak customs duty to 15% this year and 10% next year along the lines of the Inter-ministerial Group report (Virmani, November 2001). The peak rate reduction will enhance the efficiency and competitiveness of the industrial sector. No steps have been taken to start reducing the very high import duties on some agriculture products and this will act as a drag on the agro-processing sector. Selective reduction of import duties on capital goods to 10% can also be justified in the interest of faster productivity growth.
Income tax reform has three key elements. The elimination of the standard deduction and other exemptions and the consolidation of the saving exemption into one integrated exemption of Rs 1 lakh. The extension of the 10%, 20% and 30% brackets to 1lakh, 1.5 lakh and 2.5 lakh respectively. Our presentation had emphasised the simplification of the system from the perspective of the honest taxpayer and the reform has met this expectation. The long-standing recommendation to bring the corporate tax rate to 30% has also been met, but it has been offset by the imposition of a surcharge and the reduction of the depreciation rate. Along with the MAT credit the effective tax rate is only marginally different.
The SSI reserved list has been further pruned by the removel of 108 items of which 30 are from the textile sector.
The finance minister has successfully balanced tax reform with the need for raising more tax revenue. He has also been reasonable successful in balancing social, agriculture and infrastructure expenditure requirement of the common minimum program against the requirements of fiscal balance imposed by the Fiscal reform and budget management act, even though he has had to suspend the revenue deficit reduction targets for next year. Thus he has neatly balance the political imperatives against the demands of economic rationality and reform.

Indian Budget 2005-6

There was one expectation and one fear before this budget. The budget fully met the expectation of solid tax reform and belied fears of a politically driven increase in expenditures that would be largely wasted without achieving any social or economic objectives. Given the reputation of the PM and FM as tax reformers and their own statements to this effect tax reform was expected in Customs, Excise and Income tax. This has indeed happened in all three years. The reduction in the peak customs duty rate to 15%, reduction of the excise on PSF and tyres to the general rate of 16%, simplification of the personal income tax and the 30% rate on corporate tax are among the positive features. This does not mean that there are no negative elements in the tax changes only that they are within reasonable bound expected of any government and not so large as to dilute the overall positive impact of the reforms. The reform thrust has been reinforced by removal of another 108 items from the list of SSI reserved items and the reforms of the financial sector.
On the expenditure side, promised increases in expenditure on social sectors (education, health), agricu;lture, rural infrastructure and employment have gone hand in hand with efforts to reduce wastage and improve their effectiveness. This includes efforts to find alternative institutions for channelling these expenditures, improving monitoring and evaluation of the effect of these expenditures and exploration of private-public partnerships.

The Economics and Politics of the Budget

When Dr Manmohan Singh became Prime Minister, the middle class by and large was very happy that an educated professional had become the Prime Minister of India. Still many among his supporters and well wishers wondered whether he had the political savy to be effective in the dog-eat-dog world of politics. The way in which the ‘dream team’ and the finance minister (who has been in politics the longest) have balanced economic rationality against political imperatives has been quite masterful. There are three sets of issues that have been balanced: (a) Tax reform (revenue neutral) and raising tax revenue (tax GDP ratio). (b) Fiscal prudence & revenue deficit reduction and new expenditures mandated by the Common Minimum Program of the government. (c) Broader economic reforms and narrow budget issues (taxes, expenditures) within the purview of the finance ministry. Let us start with the last one first.
Since 1991 most finance ministers have used part A of their speech to send a broader reform message by announcing reforms that do not fall strictly within the purview of the finance ministry. These reforms have often been left unimplemented for many years. For instance three years ago the budget speech promised labour policy reforms, but they could not be implemented by the government in the remaining two years of its tenure. The 2005-6 budget has minimized the announcement of specific non-fiscal/financial reforms that would require action by other ministries. Even in the case of FDI, though the possibility of raising FDI caps has been indicated, there is no specific announcement in contrast to the previous budget. Criticism of the budget by the left has therefore been minimized, while FDI actions including liberalization of FDI in ‘Real Estate’ were announced the previous week and liberalization of FDI in retail is likely to follow after the budget has been passed. Relatively non-controversial financial sector reforms have been carried forward. The SSI reserved list has been rightly pruned further so as to take on the challenge of labour intensive Chinese exports in global markets.
The second set of balances is that between tax reform and raising the tax-GDP ratio so as to finance new expenditures or bring down the revenue/fiscal deficit. Reforms have been carried out in all three areas though to different degrees. The most radical reform is in personal income tax followed by Customs duties and Corporate tax and Excise. The so-called ‘Peak rate’ that applies to all manufacturing and mining has been reduced from 20% to 15%. Though there was scope for reducing the very high agricultural tariffs these have not been touched for political reasons. Duties on capital goods imports have been reduced to 10% in the expectation of greater productivity boost from machinery investment. Excise tax reforms are modest but significant in that PFY duty has finally been brought down to the basic rate along with that on tyres and ACs. The reduction in customs and excise rates on oil products can be justified as a temporary response to high oil prices, though in the long term they should not be given special consideration and must have uniform ad valorem rates. Personal income tax reform has been the most radical with the raising of tax brackets, elimination of the very complex standard deduction and the unification of the savings deductions into a single integrated one of Rs 1 lakh. Corporate tax changes are a mixed bag with a reduction in the rate from 35% to 30%, the imposition of a surcharge of 10% and the reduction in the depreciation rate.
The third set of balances has been that between the social imperatives of the CMP and the requirement of Fiscal Responsibility and Budget Management Act. The CMP asserted the need for raising expenditures on education, employment, health, agriculture/rural and infrastructure sectors. As some of us have pointed, out throwing more public money at these problems will not solve them unless the effectiveness of these expenditures in achieving their objectives is enhanced. Thus higher allocation for the social sectors and rural infrastructure have been balanced by a search for innovative ways of making these expenditures more effective in reaching those who are in greatest need. An output based approach to monitoring and evaluation is promised, in place of the current input/expenditure based approach. Though the FRBM targets have been largely met during the year, they will be held in abeyance during 2005-6. In my view this is better than the alternative of raising effective tax rates under the guise of tax reforms (what I have earlier referred to as ART)
Overall the finance Minister has produced a Very good budget by minimising the opportunity for political criticism while introducing substantial reforms in taxation.

What Should The SEZ Law Do?

China’s success in attracting export related FDI and its success in labour intensive exports contrasts sharply with that of India. Many of the policy reforms that are politically difficult in India were equally difficult in China. China however was able to introduce these reforms on an experimental basis in their Special Export Zones and then use the demonstrated success of these reforms to make them deeper and wider. This is an example worth emulating.
A number of surveys have shown that the key problems with respect to FDI are Bureaucratic red tape, Labour laws, rules & procedures and Private infrastructure policy and regulatory systems (“Foreign Direct Investment Reform,” Arvind Virmani, Occasional Policy Paper, ICRIER, April 2004; http://www.icrier.org/FDIsgpc03.pdf). Though the first best solution would be to improve these across the country, this could take decades. The Central and State SEZ laws should cover industrial, labour, environmental, infrastructure and administrative issues, with a view to simplifying and promoting investment and production in the SEZs. Though tax neutrality is an objective, the purpose is not to give sops and incentives that distort the system and are not sustainable .
Though it will take a decade or more to improve infrastructure services across the country, infrastructure availability and quality can be brought to global standards in the Special Economic Zones (SEZs) within a couple of years. The effect of a weak highway and railway system can be minimised by locating SEZs in the coastal regions as was done by China and many other countries in S. E. Asia. Among the measures needed for accelerated development of Infrastructure in and exports from SEZs are;
a. Power generation and distribution for the SEZ needs to be isolated from the crumbling SEBs to the extent possible. As size limitations make electricity generation for the SEZ (alone) non-optimal, the private electricity generator for the SEZ should be allowed to sell excess power to parties outside the SEZ subject to transparent wheeling charges and cross tax-subsidy arrangement.
b. There should be free entry and exit of Telecom service providers into the SEZ without any service or USO charges, subject only to the condition that the spectrum would be auctioned if and only if it ceases to be a “free good” within the SEZ. Inter-connectivity with other countries (ILD) should be free and unrestricted (subject only to the condition that this cannot be used as a conduit for provision of unregulated telecom services into the DTA). Automatic 100 per cent FDI should be allowed.
c. Private parties would also be free to set up a private airport or port to service the SEZs with automatic 100% FDI. If an unused harbour is not available nearby, the requisite number of berths in the closest port should be made available to private parties for the purpose of servicing the SEZ. These parties (or another developer) should be given the authority to set up toll highway connecting the port to the SEZ.
d. A law should be passed by the State governments under which 100% privately owned townships can be set and run by private developers as private municipalities. Private SEZs should be designated as private municipalities under this law and road, electricity transmission & other linkages provided by State/Central govt.

A number of other legal and bureaucratic changes can also be introduced much more quickly in the SEZs than is possible in the country in general. The applicable laws, rules, regulations and procedures in the SEZs should be made as attractive as in China’s coastal regions & other competing destinations. This requires,
a. Elimination of all price controls & distribution controls (e.g. on Power, Rents),
b. Removal of all investment restrictions (e.g. SSI reservation, foreign equity limits & bans, public sector reservation) for production and supply within the zone or for export. This would include removal of State & local restrictions (eg. Urban land ceiling, retail trade, real estate).
c. Removal of all capital account restrictions/controls/prior permissions for businesses operating within the SEZ (reporting requirements and regulations relating to inflow of Foreign exchange debt etc. into DTZ would remain).
d. International standard financial regulations for financial institutions operating within the zone with our unique Indian “controls” eliminated. Thus the FDI limits on Banking, Insurance, NBFCs would not apply, directed credit & SLR would be eliminated and CRR brought down to internationally comparable levels.
e. Customs, Excise & Service tax laws to be modified so that all transactions within the SEZ are exempt and transaction of DTA with the SEZ can be treated as if with a foreign country. Normal excise (& customs) rules would no longer apply for transactions within the SEZs. Customs and Additional duty (equal to CENVAT/Excise) would apply to all sales to DTA. SAD should not apply as state sales and other taxes would apply on DTA sale. State sales tax law should also be modified, so that within the SEZ only sales to resident consumers (not producers/traders) are taxed. No excise/CST/ST/Octroi would be charged for sales from DTA to SEZs.
f. Normal personal and corporate income taxes would apply, but not the surcharges, cesses, MAT or any other temporary/special imposts. The depreciation rate should be globally competitive.
g. A new labour law incorporating a work ethic. Abolition of Contract Labour restrictions. Freedom for multiple and night shift for workers of both sexes. Designation of Development Commissioner as Labour Commissioner.
h. An integrated unified industrial regulator (i.e. only one inspector for all continuing industrial regulations including pollution, labour safety).
i. Designation of the Development Commissioner as the Commissioner under all the relevant laws (industrial, environmental etc.) within the SEZ.
j. A modernised judicial sub-structure for SEZs that deals with cases in a time bound manner.
In fact we should experiment with an even bolder model of a market economy with no controls and restrictions complemented by a modern regulatory system based on trust that punishes violators quickly and effectively like the traffic light approach. For some regulations, self-certification may be adequate while for others outside (private) certification eg. by an accredited professional or certification agency) may be required.
A special marketing effort is needed for export oriented FDI. For instance, Taiwanese and other exporters in East and S.E. Asia can be targeted for this purpose. Our missions in OECD and other FDI source countries should be fully briefed on the comparative advantages of SEZs in India and distribute the required literature.