Deconstructing China’s and India’s growth: the role of financial policies

Economic theory considers a country's financial policies, that match investors with savers, to be an essential driver of growth. The specific contribution of the financial sector to economic development has been less easy to measure empirically owing to data inadequacies. In this context, a new paper brought out by the Indian Council for Research on International Economic Relations adopts an alternative approach to looking at the role of the financial sector in the growth processes of China and India to find that the connection appears to be more complex than it has been considered to be so far.

Since 1990, growth in both China and India has been driven by investment. By 2005, China’s gross investment-to-GDP ratio had reached 43 percent, while that of India’s was an estimated 30 percent. In contrast, private consumption’s share in GDP in China had fallen to 38 percent, one of the lowest in the world, while that in India was around 58 percent.

The paper uses a standard one-sector neoclassical growth model to identify China- and India-specific market distortions that have constrained an optimal balance between growth, investment and consumption to find that distortions to the cost of capital appear to be an important factor in both countries. In particular, while the cost of capital has been persistently lower than what it would have been under optimal conditions in China, the cost of capital has been persistently higher than this optimal level in India.

This appears to explain why China’s growth has been largely driven by investment, while growth in India has become relatively less investment-driven over time. In the case of China, the suppression of the cost of capital below its optimal level is a reflection of continued financial repression that has implied a large implicit tax on household’s investment income. In contrast, while financial repression persists in India, it is now less than it was prior to the economic reforms of the 1980s and 1990s.

The paper concludes that reducing financial distortions in both countries will be important for sustainable growth. Specifically, banking sector reforms, strengthened financial markets and financial sector liberalisation in China and India is likely to ensure: 

• less export-driven growth, particularly in the context of the current financial crisis
• increased household income and consumption
• the greater availability of low-cost private capital – particularly to meet infrastructure constraints