Unleashing China and India’s growth potential (2): institutional quality

In Erken et al (2017), we have seen that technological development, increased human capital and innovation boost productivity. We now turn to institutional quality, another important determinant for economic growth. In line with Bruinshoofd (2016), Coe et al. (2009) and Acemoglu and Robertson (2013), we build on the notion that institutional development is an indicator for structural development and long-term welfare creation for a nation. Institutions provide the environment for economic convergence and development, and institutional quality allows countries to achieve long-term income convergence. In this Economic Report, we compare China and India based on their performance in terms of institutional quality.

China and India differ widely in terms of institutional development, though they do have some historical comparisons. Both countries started as sovereign nations during the second half of the 1940s, and initially based their economic policies on the planned economy of the Soviet Union. For different reasons, both countries followed a protectionist approach in terms of international trade for a long period of time. China followed this strategy mainly due to international political tensions (between the Eastern and Western world), and India due to its historical background as a British colony. India and China’s political systems were, and still are, totally different. China has been ruled by the Chinese Communist party under a one-party political system, while India chose the path of democracy and elects its central and local government leaders by a so-called popular vote (Motohashi, 2015).

In China, President Deng Xiaoping took office in 1978 and began to open up the country economically by policy reforms in order to attract foreign companies and investment, thereby generating benefits in terms of economic growth and employment. The reform of State Owned Enterprises (SOEs) focused on integrating competition via market mechanisms instead of a planned economy. India was ruled as a British colony until 1947. After its independence, the country’s first Prime Minister Nehru focused on controlling domestic industries through different regulations, both for foreign transactions and domestic operations. States itself had an independent economic system and barriers were related to investments by labour laws, registrations for businesses and tax issues. Also the lack of quality or absence of infrastructure, such as roads and railways, were on the negative side.

Institutions should be viewed as a basic requirement for economic success and long-term progress. Institutional quality consists of a broad range of factors, which often are hard to measure. For the sake of objectivity, transparency and replication, we used conventional sources of the World Bank’s six World Governance Indicators (WGIs) and the Ease of Doing Business Indicator (EDB). This last indicator captures the quality of the processes and administrative work, over and above the WGIs regulatory quality. In total, seven indicators have been selected for comparing China and India on an institutional basis:

Looking at World Governance Indicators (WGIs)[1], India outperforms China in 2015, reaching an average score of 45.5 compared to China’s 39.7. It is, however, noteworthy that China ranks better on almost every variable, but due to a significantly lower score on voice & accountability, India takes the final lead on average (figure 1). The same picture holds for the average over 2008-2015, where India is better positioned than China in terms of voice & accountability and rule of law (figure 2).

China’s weakness on the indicator voice & accountability is directly related to its political system, as Chinese citizens are unable to participate in the selection of government officials. This is, of course, a major difference with India’s democratic environment. On the other hand, the Chinese government is more effective than the Indian, as China’s direct state-led way of policy making outpaces India’s democratic methods with a reliance on independent state policies. In terms of rule of law, India has several business regulations, which need to be adhered to strictly. China, simply stated, makes the dealing of several business procedures simple (Motohashi, 2015).

Over the years, institutional quality in both countries has improved markedly due to a better control of corruption and enhanced government effectiveness. In 2012, China’s President Xi Jinping even put his anti-corruption campaign at the top of his agenda. India is also attempting to address the problem of corruption. The most recent example was the replacement of high value Rupee notes, so called demonetization[2], to wash the stock of counterfeit money out of the economy, which has allegedly been used to fund criminal activities, such as terrorism and drug trafficking.

[1] World Governance Indicators (WGIs) are presented in a percentile rank varying from 0 to 100 (best).

[2] On 9 November 2016, Prime Minister Modi announced that the INR 500 and INR 1,000 currency notes ceased to be legal tender, and that people had the opportunity to exchange these old notes for newly-developed INR 500 and INR 2,000 INR notes until the end of the year. All incidences of extraordinary deposit growth were to be subject to a tax investigation by the authorities. With this so-called demonetization plan 86% of the currency in circulation was replaced.

The Ease of Doing Business (EDB) index ranks countries from 1–190 (1=highest, 190=lowest) and a higher EDB ranking indicates that the regulatory environment is more conducive for starting and operating a local business. If we look at the EDB of China and India, we see a clear difference on the categorical side between the two countries (figure 3). First, China has a higher overall EDB ranking than India (78 vs. 130). China outpaces India on the areas of starting a business, registering property, paying taxes, trading across borders and resolving insolvency. But the main driver behind the better score of the Chinese economy is the way contracts are enforced. China is even ranked 5th worldwide on this topic.

Over the years, both countries have introduced several measures to improve different areas of EDB. China has reduced requirements on capital and its verification by audit firms, and has introduced simpler ways to obtain licenses and tax registration. Moreover, its credit information system has been improved by the introduction of industry regulations and a new corporate income tax law. India has established an online VAT registration system, has lowered registration fees and has reduced capital requirements. Furthermore, India has reduced the administrative burden of paying taxes and introduced electronic taxation, implemented an Insolvency and Bankruptcy Code and created the National Companies Law Tribunal (NCLT), which will specifically take over all corporate law cases from the courts.

Of special importance has been the passage of the landmark Goods and Services Tax (GST), which brings uniformity in India’s complicated and inefficient tax scheme and reduces the cascading effect in the old system. The implementation is most likely due in July 2017, and will result in lower prices of goods and services, enhances free movement of goods, creates economies of scale and will result higher investment and tax revenues.

An international comparison shows that India and China score below the global average on almost all indicators. China’s low score on voice & accountability, as well as its high score on effectiveness of the government are noteworthy (figure 5[3]). Based on comparisons of global average figures China outperforms India on all sub-indicators, except on the area of voice and accountability, where for India political stability is regarded as the worst performing area. This relatively low score is related to tensions with Pakistan over the Kashmir border dispute, as well as some violent outbursts in the past. On the other hand, India has a better score on voice & accountability compared to the international average, although the difference is small (figure 6).

[3] As a technical note, the Ease of Doing Business Indicator is transformed into a z-score using its absolute distance to frontier component. Subsequently, we compute the simple average of this normalized Ease of Doing Business Indicator and the six WGIs (which are already expressed as normalized values). The institutional quality indicator thus must be interpreted as a relative score; it expresses institutional quality relative to the global average, normalized by the global variation around this average.

Given their highly dynamic economies and large potential markets, international investors and companies are keen to grasp investment and business opportunities in China and India. It is crucial to keep pace of institutional quality in relation to economic development, as they can reap substantial economic gains from institutional progress. The countries differ widely in terms of institutional developments, though they share some comparisons when looking at historical developments.

After India’s economic reforms of 1991, Capelli et al. (2010) already found that government organizations became more supportive of business activities. As such, there is a bottom-up approach of doing business: private companies conduct business, and might need support in doing so by (local) government. In China, there is a clear top-down approach, since the government organizations themselves are the primary business players. Put differently, the major difference from a structural point of view is that, especially in terms of doing business, various government relationships in China are most important, while those in India are mostly private-owned companies participating in the middle of market mechanisms.

Looking at seven institutional indicators for measuring differences across both countries, one can state in a simple manner that India only outpaces China on areas of world governance because of a substantially higher score on voice and accountability. On the ease of doing business index China performs better on every aspect. Most of the differences on institutional quality can be clarified via differences in political systems, as China’s communistic government does directly influence its own effectiveness, while India, on the contrary, has developed to a democratic system, which results in a higher score on voice & accountability.