Written by Karolina Wysoczanska.

Over the last few decades, China and India have made substantial improvements in the structural transformation of their economies by allowing foreign firms to compete  in markets from which they were previously barred. At the outset of reforms, the conditions of both economies were similar, and both were under the influence of the Soviet model, pursuing similar development strategies involving central planning and rapid industrialization. Both leaderships considered the state to be the engine of growth and suspected foreign sector development. In China, foreign investments were prohibited and the mechanism for foreign trade was monopolized by the Ministry of Foreign Trade. In India, the Foreign Exchange Regulatory Act (1974) reduced foreign equity participation from 51 to 40 percent which led to the exit of companies like IBM, Shell and Coca-Cola. Since that time, both governments have significantly liberalized their FDI regimes, however, China has been able to attract a much higher level of foreign investment. Of course, Beijing initiated the reform process much earlier than New Delhi and both countries are far more “FDI-led” than other developing countries have been in the past. Nonetheless, the experience of these two large, but strikingly different countries underlies the importance of political economy for growth and development.

The divergence of attitudes toward FDI can be easily explained by the two countries’ different political systems. China has an authoritarian regime where policy-making is generally regarded as a top-down process, and where the government is able to be flexible in its decision-making. Additionally, the Chinese leadership has a clear focus on economic growth. In contrast, the formation of policy in democratic India is much slower. Short-term political calculations dominate as there are frequent elections conducted at different levels- national, state, municipal or village. Interest groups are important constituencies for Indian parties since they have the ability to provide campaign finances and influence voting behavior. That is why for democratic, post-colonial India, allowing foreign investors to earn huge profits at the expense of domestic firms is unthinkable. Moreover, the nationalist devotion of India’s leaders translated into a suspicion of an open economy and often discouraged foreign investors. Even the Indian diaspora was perceived as hostile by New Delhi, whereas in China more than half of FDI comes from overseas Chinese.

A further part of the answer  lies in the political economy of the local state. In China, decentralization of economic responsibility and establishment of special economic zones (SEZs) was a key feature in foreign sector reform. Local authorities, responsible for the economic growth of their province, undertook many initiatives to ensure that SEZs would attract foreign investors. In India, decentralization was less ‘economic’ and more ‘political’. It began in the early 1990s only because central government lacked sufficient political power and was not able to create an efficient coalition without depending on the state governments support. Thus, local officials have no direct incentives to promote FDI and state governments heavily rely on centrally-led strategies. Hitec City- a special economic zone in Hyderabad, designed to attract investments in the IT sector, is a case in point. Every significant aspect of the project, from negotiations with investors to the design of the regulatory framework was conducted centrally with no local participation. Seen broadly, local bureaucracy in India- epitomized in this case by the license-quota-permit raj- do not perceive themselves as independent actors in terms of economic reform and oblige central government to be responsible for the implementation of development programs.

Such dependence on central government also has an impact on infrastructure. In China local governments have far greater control over local revenues than in India. Under the new fiscal system that resulted from economic decentralization, Chinese provinces entered into negotiated revenue sharing contracts with the central government. This means that local governments are allowed to keep a share of revenue that they collected before handing over a negotiated amount to the central government. The ability to extract these revenues provides them with the financial resources to build a strong infrastructural base to foreign investors and maintaining a reputation for the rapid completion of infrastructure projects. Unlike in China, the tax assignment system in India is imbalanced: most broad-based taxes have been assigned to the center, while taxes narrow in scope are assigned to the states. The impact is that central government has a greater income and less expenditure whereas state governments are collecting less and spending more. This deficit in local state budgets needs to be balanced by central funds, which in turn means greater central control of the allocation of financial resources to state governments while simultaneously laying responsibility for infrastructure development on them. Since the central government itself is running on the deficit, transfers to state governments must take second place to central consideration. This has resulted in their decline in recent years, throttling state-level infrastructure investments. State governments are not able to quickly and effectively implement these projects, thus decreasing its appeal to FDI.

Local states have a little impact on macro-policy issues but they can provide the base that is crucial for attracting foreign enterprises. And indeed, local political economy and the coherence of institutional aims provide a partial answer for the promotion of FDI in China. In India, local policy was one of change ‘within institutions’ rather than change ‘of institutions’. Existing bureaucracy had to adapt to a new circumstances within old institutional arrangements instead of following incentives created by newly established institutions.

Karolina Wysoczanska is a PhD student in the School of Contemporary Chinese Studies, University of Nottingham.