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For those of you that have some spare time, this makes a \'highly\' interesting read. ...

For those of you that have some spare time, this makes a \'highly\' interesting read.
An in-depth coverage by BERR, of changing global momentum towards China and India and how UK business can adapt (rather then we wary) of this seismic shift.

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Berr China And India Outlook Berr China And India Outlook Document Transcript

  • BERR ECONOMICS PAPER NO. 5 China and India: Opportunities and Challenges for UK Business FEBRUARY 2009
  • BERR ECONOMICS PAPER NO. 5 China and India: Opportunities and Challenges for UK Business FEBRUARY 2009
  • The views within BERR Economics Papers are those of the authors and should not be treated as government policy. View slide
  • Contents Contents Lists of Figures, Boxes and Tables ii Acknowledgements iv Foreword v Executive Summary vi 1 Introduction 1 2 Opportunities for UK Business 3 2.1 The Growth of China and India 4 2.2 China and India’s Changing Consumer Market 14 2.3 UK Export Performance to China and India 25 2.4 Doing Business in China and India 36 3 Challenges for UK Business 45 3.1 The Growth of Chinese and Indian Exports 46 3.2 Education in India and China 53 3.3 Innovation in India and China 65 3.4 Chinese and Indian Businesses in the Global Economy 80 4 Conclusions 90 References 93 i View slide
  • List of Tables and Figures List of Figures Figure 2.1: Historical Share of World GDP 4 Figure 2.2: China and India’s GDP 5 Figure 2.3: Projected GDP 6 Figure 2.4: Projected GDP Per Capita 7 Figure 2.5: Distribution of Urban Households by Income Group 13 Figure 2.6: Forecasts of Chinese and Indian Urban Consumption 15 Figure 2.7: Patterns of Urban Consumer Expenditure 16 Figure 2.8: Chinese and Indian Merchandise Imports 26 Figure 2.9: Chinese and Indian Service Imports 28 Figure 2.10: UK Merchandise Trade with China and India 29 Figure 2.11: UK Services Trade with China and India 30 Figure 2.12: Shares of China and India’s Goods Imports 31 Figure 2.13: Contributions to Change in UK’s Exports to China 32 Figure 2.14: Contributions to Change in UK’s Exports to India 34 Figure 2.15: Shares of China and India’s Services Imports 35 Figure 2.16: China and India’s Stocks of Inward FDI 37 Figure 2.17: Problematic Factors for Doing Business in India and China 39 Figure 3.1: Chinese and Indian Goods Exports 46 Figure 3.2: Chinese and Indian Service Exports 48 Figure 3.3: Offshoring Location Preference by Function 49 Figure 3.4: China’s Processing and Non-Processing Exports 51 Figure 3.5: Chinese and Indian Enrolment in Higher Education 54 Figure 3.6: Chinese and Indian Higher Education by Subject 55 Figure 3.7: Comparison of Enrolment Rates in Tertiary Education 56 Figure 3.8: Supply of Skilled Professionals in Selected Countries 59 Figure 3.9: Skills Gaps in Chinese and Indian Workers 60 Figure 3.10: Comparison of Enrolment Rates 65 Figure 3.11: Current Foreign R&D Locations 67 Figure 3.12: Most Attractive Foreign R&D Locations 68 ii
  • Figure 3.13: R&D in Selected Countries, 2004 69 Figure 3.14: Patenting Trends in India and China 70 Figure 3.15: Regional Distribution of Selected Industries in China 84 Figure 3.16: Chinese and Indian Outward FDI Flows 87 List of Boxes Box 2.1: Changes in Chinese and Indian Government Policy 9 Box 2.2: What is a Middle Class Level of Income? 12 Box 2.3: Case Study - Marks and Spencer 18 Box 2.4: Brand Awareness In China and India 19 Box 2.5: Growth in Car Ownership 21 Box 2.6 China and India’s Regional Towns and Cities 25 Box 2.7: Case Study – JCB 38 Box 2.8: Lessons From Successful SME’s 42 Box 3.1: Vocational Training in China and India 57 Box 3.2: Case Study – Benoy 61 Box 3.3: British Education Institutions in China and India 63 Box 3.4: Case Study – Fiberweb Plc 71 Box 3.5: Case Study – AWI Group 82 Box 3.6: Infrastructure Congestion in Bangalore 86 List of Tables Table 2.1: Estimates of the Size of China and India’s Middle Class 10 Table 2.2: China and India’s Economic Classes 11 Table 2.3: Forecasts of Car Ownership 21 Table 2.4: Ownership of Consumer Durables 23 Table 2.5: Doing Business in India and China 44 Table 3.1: Domestic and Foreign Value-Added in Exports 52 Table 3.2: Estimates of Skilled and Unskilled Workers 56 Table 3.3: Innovation Output in Selected Countries 70 Table 3.4: Key Communication Metrics for Selected Countries 76 Table 3.5: Regional Distribution of Selected Industries in India 83 iii
  • Acknowledgements The following officials have contributed to this paper: Daniel Mawson, Carol Murray, James Watson, Jenna O’Byrne BERR is also grateful for comments, observations and discussion from a number of academics, businesses and organisations, in particular: Adam Cross Benoy British Chambers of Commerce Bob Lyall CBBC CBI Fiberweb JCB UKIBC iv
  • Foreword Globalisation has been good for the UK economy. It has created huge benefits, both in lower costing goods of improved variety and greater quality, and larger markets into which UK businesses can sell their goods and services. But as recent events have shown, globalisation also brings with it new challenges and uncertainties. The international financial crisis has demonstrated the need for greater international co-operation to strengthen the global financial system, alongside the shorter term measures we have undertaken in the UK to improve businesses access to finance. But in the longer term, it is the successful incorporation of emerging economies such as China and India which presents the greatest challenge for globalisation. Their rapid economic rise is leading to a re-balancing of economic power around the world, forging new economic linkages through trade and investment flows and changing how businesses see the global economy. The Manufacturing Strategy highlighted the longer run implications for UK business from the growth of these countries, both as potential markets and for the important role they play in global value chains. It emphasised the importance of UK firms investing in the skills and technologies needed to compete with them on quality rather than price. This report examines in more detail the potential opportunities from the rise of India and China, bringing together the latest data and research. Its findings reinforce the message that despite the recent slowdown these two countries represent a tremendous opportunity for UK business, one which successful British firms, both large and small, are already benefiting from. The report also highlights how protectionist fears about the competitive threat from these countries are often overdone. While China and India have continued to develop their skills and innovation capabilities, in many areas a substantial gap remains between them and the UK, which offers a substantial opportunity for UK firms wanting to expand their interactions with these countries. Vicky Pryce Chief Economic Adviser and Director General, Economics Department for Business, Enterprise and Regulatory Reform v
  • Executive Summary The rise of China and India as major economic powers has been central to the latest phase of globalisation, creating huge opportunities for UK business. However it has also created anxiety about the future of jobs and businesses in the UK. This report seeks to address this by looking at a number of key issues which arise from two broad questions; ●● What are the opportunities for UK business from the growth of China and India as a potential market? ●● What are the challenges for UK business from the rise of China and India as potential competitors? China and India are expected to continue their rapid growth Although they face a number of downside risks, the Chinese and Indian economies are still expected to continue their rapid growth over the next few decades. By 2050 they are forecast to be the first and third largest economies in the world respectively. (Section 2.1) Their rapidly growing middle classes are already a large consumer market in their own right and will account for the bulk of their four fold increase in real consumer spending over the next twenty years. These households aspire to developed country standards of living and demand world class goods and services. Cultural shifts, coupled with rising disposable incomes are driving a shift in the pattern of consumer spending. The share of spending on essentials such as food is declining while the importance of areas such as personal products, private education and healthcare is set to rise significantly. (Section 2.2) Which has helped drive up UK exports On the back of their strong economic growth Chinese and Indian imports of goods and services have risen rapidly. UK firms have been taking advantage of these new opportunities, since 2002 UK exports to India have grown by 14% a year, while exports to China have grown by 19%. The content of UK exports to these countries reflects our competitive advantage in higher skill manufactured goods, as well as financial and business services. However, while the UK has maintained or improved its market share of Chinese and Indian service imports, it has seen its share of their goods imports decline. Analysis of the latest trade data suggests that this has been driven by a decline in UK sector share, rather than a shift in Chinese and Indian import demand away from the types of goods and services we export. (Section 2.3) vi
  • But doing business in China and India remains challenging In order to take advantage of these opportunities, UK companies must navigate a challenging business environment. The World Bank ranks China and India as the 83rd and 122nd easiest places to do business in the world1, with corruption and bureaucracy still significant issues. Although they are starting to make inroads into the problem, protection of intellectual property rights remains a major issue for UK firms operating in China and India; with the state of enforcement measures lagging behind that of the law. Lessons from successful firms in China and India strongly point towards the importance of taking the long view of the market. Firms need to thoroughly research the market and invest in localising both their products and the people who deliver them. (Section 2.4) Meanwhile China and India’s exports have surged Over the last decade Chinese and Indian exports have risen by 20% a year. China is now the largest exporter of Information and Communication Technology products in the world, while India dominates the market for off-shoring of IT enabled business services. However these impressive trade figures overstate the extent to which China and India have moved up the value chain. For example, over half of China’s exports are from the processing trade, for which the value added of the domestically produced content tends to be small. Once appropriate adjustments are made, the average sophistication of domestically produced goods is found to be low. The data also suggests that Chinese firms are targeting further down the quality ladder than their competitors in the advanced economies. (Section 3.1) But improvements in education and innovation performance need to continue China and India have dramatically expanded their higher education systems which now produce millions of graduates a year, and their spending on R&D has also increased substantially. But in order to fulfil their long run potential both countries need to do more. In education this means building on their graduates technical skills, by ensuring they also develop the broader competencies needed to succeed in the global economy. Their rapid growth has created a huge demand for talent, which already outstrips supply. (Section 3.2) 1 World Bank: Ease of Doing Business Index (2008). For reference the UK is ranked 6th in this survey. vii
  • China and India: Opportunities and Challenges for UK Business On innovation, while China and India now rank among the top five locations for R&D related FDI, obstacles such as poor IPR protection and access to finance are constraining domestic innovation. (Section 3.3) And challenges to their future growth are emerging The motor behind China and India’s economic rise has been export orientated regional clusters specialising in particular activities. However this model of development is now coming under increasing pressure, particularly in the fastest growing regions. Shortages of skilled labour are generating double digit wage growth, while infrastructure often fails to keep pace with economic growth. Combined with exchange rate appreciation and higher transport costs, China and India’s low cost advantage is being eroded. Although they are optimistic about future prospects, Chinese and Indian businesses see a range of potential constraints on their future growth. This is driving more strategic overseas investments, mergers and acquisitions aimed at securing market access and improving their skills and innovation capabilities. (Section 3.4) Implications for Government policy These findings reinforce the importance of government’s approach to globalisation as both an opportunity and a challenge for the UK. Looking in particular at China and India the main policy lessons are; ●● To continue to resist calls for protectionist measures based on flawed comparisons with China and India. Although large, these countries are still developing and we should engage with them further to reduce the barriers to doing business. ●● Success in China and India requires taking a long term view, developing local connections and expertise. This requires tailored assistance from government to UK firms operating there, which helps mitigate the costs and risks associated with this approach. ●● We need a deeper understanding of China and India’s evolving role in global value chains, how their businesses activities can complement rather than compete with those of UK firms, and how best to use these synergies to compete in the global economy. viii
  • 1 Introduction “Do not despise the snake for having no horns, for who is to say it will not turn into a Dragon?” The Water Margin Globalisation2 is arguably the most important factor currently shaping the world economy. Although not a recent phenomenon (waves of globalisation can be traced back to the 1800s) the changes it is bringing about now occur far more rapidly, spread more widely and have a much deeper impact than previously was the case. The most recent wave of globalisation has witnessed substantial growth in international trade, capital flows and movements of people. It has been underpinned by three key developments: ●● The adoption of more open economic policies. ●● Technological progress (particularly in the areas of transportation and communication). ●● The integration of rapidly growing emerging economies into the global economic system. The rise of China and India has been central to this story. Spurred on by their own economic reforms, coupled with the increasing fragmentation of global supply chains, these countries have ridden the crest of the latest wave of globalisation. Their growth has helped lift millions out of poverty (an estimated 400m in China alone since 19903), and at the same time consumers in the developed world have benefited from a more diverse range of cheaper goods. However, China and India’s rise has also created considerable anxiety about the future of jobs and businesses in the UK. People see these countries’ huge pools of low cost, but increasingly more skilled labour, and fear that in time they will completely eclipse the UK’s competitive advantage in high skill, high value added products. In this paper we examine the foundations of these concerns in more detail. We look at their progress both in terms of increasing their skill levels and the innovation capabilities of their companies. Although we find evidence of substantial improvements in these areas, China and India still lag behind advanced economies such as the UK. More importantly, China and India also represent a tremendous opportunity for UK businesses as they are the fastest growing markets for the types of high value added goods and services we excel at. A large and rapidly growing middle class has developed in these countries; these households are increasingly 2 Here we define globalisation as “the process through which an increasingly free flow of ideas, people, goods, services and capital leading to the integration of economies and societies” (Köhler 2002). 3 World Bank (2006a). 1
  • China and India: Opportunities and Challenges for UK Business internationalised, aspire to developed country standards of education and health care, and demand world class goods and services. Structure of the Paper The focus of the paper is on answering two main questions; ●● What are the opportunities for UK business from the growth of China and India as a potential market? ●● What are the challenges for UK business from the rise of China and India as potential competitors? Chapter 2, on opportunities; considers China and India’s historical economic performance and how they are expected to grow in the future. In particular we examine the important role urban middle class consumers will play in shaping consumer demand. This is followed by an analysis of their import demand and the UK’s export performance to these markets. It then examines the challenges faced by firms operating in India and China and how successful UK firms have overcome them. Chapter 3, on challenges; provides a critical evaluation of the evidence on the technological sophistication of Chinese and Indian exports, as well as the extent to which they have improved their skills and innovation capacities. We discuss how the model of export orientated industrial clusters has helped them grow rapidly, but now presents challenges for the global ambitions of their firms in the longer term. Finally Chapter 4 concludes by considering the broader policy implications of this work. 2
  • 2 Opportunities for UK Business SuMMARy Over the next three decades China and India are projected to become the 1st and 3rd largest economies in the world respectively, but remain relatively poor in terms of per capita incomes. They will also exhibit significant variation in incomes between rural and urban areas, and between fast growing coastal regions and inland areas. Their rapidly growing middle classes are already a large consumer market in their own right and will account for the bulk of their four fold increase in real consumer spending over the next twenty years. These households aspire to developed country standards of living and demand world class goods and services. On the back of their impressive growth performance, China and India’s import demand has risen by an average of 18% a year since 1992. Over the same period UK exports to India have grown by more than 9% a year, while exports to China have grown nearly twice as fast again. The UK has increased its share of Chinese and Indian service imports, but seen its share of their goods imports decline. Investment in China and India has surged as overseas companies seek to take advantage of these huge opportunities. But while substantial reforms have been made, they remain challenging places to do business. Both countries continue to struggle with corruption and bureaucracy and enforcement of Intellectual Property Rights remains poor. Lessons from successful firms in China and India emphasise the importance of taking a long term view of the market; investing in building local connections and developing their people. The UK government has a range of policies in place to help companies seeking to do business in China and India. These range from top level discussions about reducing entry barriers through to more practical advice on how to do business. 3
  • China and India: Opportunities and Challenges for UK Business 2.1 The Growth of China and India “Poverty is not socialism. To be rich is glorious.” Deng Xiaoping ChINA ANd INdIA hAVE gROwN RAPIdly IN RECENt yEARS The rise of India and China over the last decade should in many respects be viewed as a return to the historical status quo rather than a recent phenomenon. When the ancient European civilisations of Greece and Rome were reaching their heights, the civilisations of China and India were already mature and prosperous. As Figure 2.1 below illustrates, for most of the last two millennia China and India accounted for over half of World GDP between them. However from the 1800s they went through a period of relative decline, with their share of world GDP completely eclipsed by that of the European nations by around 1850.4 Figure 2.1: Historical Share of World GDP 45% Europe China India Japan 40% 35% 30% 25% 20% 15% 10% 5% 0% 1 1000 1500 1600 1700 1820 1900 2003 Source: Maddison (2007) In part these shifts in economic power reflected advances in Europe and elsewhere, however they were also symptomatic of China and India’s disengagement from the world. Some economic historians have argued that having secured an early technological and cultural lead, both countries became complacent and failed to maintain it.5 Regardless, following a lengthy period of general economic stagnation and decline, the reforms initiated by Deng Xiaoping in China in the late 1970s, 4 Maddison (2007). 5 In the case of China for example this is often posed as Joseph Needham’s ‘Grand Question’, more recently India’s period of stagnation has been labelled by Deepak Lal as a ‘high level equilibrium trap’. 4
  • followed by Narasimha Rao and Manmohan Singh in India in the 1990s; are widely credited with laying the groundwork for them to become the major economic powers they are today. Figure 2.2: China and India’s GDP 2,500 China India 2,000 1,500 1,000 500 0 1980 1985 1990 1995 2000 2005 Source: IMF World Economic Outlook Figure 2.2 shows how China’s resulting growth spurt began in the 1990s, with real GDP growth averaging around 10% a year. Until 2003 India’s growth rate lagged behind, hovering around 6% a year; however since then it has started to pick up, reaching 9.7% in 2006, just short of the government’s goal of 10%. The impact of this on the world economy has been dramatic. Measured at PPP China and India now account for 10.8% and 4.6% of World GDP respectively, compared to 3.3% for the UK. More importantly, their rapid growth is increasingly shaping world demand; accounting for roughly 30% of the growth in world GDP since 2000.6 A key plank of both countries’ reform policies has been a move towards much greater openness to international trade and investment. Starting in the late 1970s, China’s trade with the rest of the world began to rise significantly, with India following suit from the early 1990s onwards.7 ●● Between them China and India accounted for over 10% of the growth in world trade since the 1990s. ●● China’s share of world trade has roughly doubled every ten years. 6 IMF (2008). 7 Source: WTO World Trade Figures. In order to avoid double counting, we consider Hong Kong as separate from mainland China. 5
  • China and India: Opportunities and Challenges for UK Business ●● India’s trade share remained relatively flat through the 1980s and 1990s, but has started to rise more rapidly over the last decade. ●● This is in the context of world trade growing by 9% a year over the same period. FORECAStS SuggESt thAt thIS gROwth wIll CONtINuE The recent growth of China and India is expected to be continued in the coming decades. Widely quoted work by Goldman Sachs (2003) predicts that China will become the second largest economy in the world by 2016 and go on to overtake the US as the world’s largest economy by 2041. India is not far behind, with its GDP overtaking Japan by 2032. Subsequent refinements to the BRICs model8 have seen these growth projections if anything revised upwards.9 Figure 2.3: Projected GDP GDP Projections ($bn 2003) 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 00 03 06 09 12 15 18 21 24 27 30 33 36 39 42 45 48 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 China India France Germany Italy Japan UK US Source: Goldman Sachs, Dreaming with the BRICS (2003) Although these countries will become significant in terms of economic size, their per capita incomes will still be low by the standards of the advanced economies10. As Figure 2.4 below illustrates, in 2050 China’s average per capita GDP is forecast to be only slightly higher than the current level in the US, with the figure for India less than half that. 8 BRICs – Brazil, Russia, India, China. 9 See for example Goldman Sachs (2003, 2007, 2008) and PWC (2008). 10 See for example World Bank (2007a, 2008b), PWC (2008). 6
  • Figure 2.4: Projected GDP Per Capita 100,000 GDP Per Capita ($US 2006) 90,000 2006 2050 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 China India France Germany Italy Japan UK US Source: Goldman Sachs, BRICs and Beyond (2007) These forecasts in part reflect the ambitious plans set out by the Chinese and Indian governments, some of the challenges for which are discussed in Box 2.1. Both countries see themselves as global economic and political players, and increasingly expect their level of recognition and influence in international institutions to reflect this. However, at the same time such projections are best seen as an indication of the potential for growth in India and China if ‘things go right’, rather than a prediction of the future. In practice there are a number of downside risks which need to be borne in mind. In the short term these include; ●● Both countries are being adversely affected by the global downturn brought about by the credit crunch; China in particular is overly reliant on external demand to fuel growth. ●● If the downturn were to lead to an increase in protectionism their export led growth model leaves them vulnerable. ●● They need to rebalance their economies; China towards domestic demand, while India cannot sustain its current rates of growth purely on the back of service sector exports.11 ●● A slowdown or reversal of their reforms would lead to business activity being choked off by factors such as bureaucracy, corruption and lack of access to finance. 11 For example see Panagariya (2007). 7
  • China and India: Opportunities and Challenges for UK Business The risks in the medium to longer term revolve more around the need for them to move to more sustainable modes of production; ●● They have a shortage of natural resources; China’s per capita stocks of water, arable land and minerals are well below the world average, India is also highly dependent on imports of raw materials, in particular petroleum and related products.12 ●● China’s production methods are environmentally unsustainable, with a high energy intensity of GDP and pollution discharges per unit of output13. India performs better in this regard, but its manufacturing sector is only now entering a high growth phase.14 ●● Their advantage as low cost production centres is being eroded by rising wage costs due to shortages of skilled labour in fast growing regions. (See Chapter 3). ●● In order to prevent social unrest their governments need to spread the benefits of growth more widely. (See Box 2.1) 12 Kai, M (2004). 13 See Junko Z. et al (2005). 14 For example India’s Energy Intensity of GDP is estimated to have been 142.4 tonnes of oil equivalent per $m (real 2000), compared to 195.1 in China. 8
  • BOx 2.1: ChANgES IN ChINESE ANd INdIAN gOVERNMENt POlICy The first wave of economic reforms in China and India were focused on fostering enterprise and export led growth. Current policies aim to build on this, while delivering more balanced economic development through: ●● Continued reform of the state sector. ●● Protection for vulnerable groups. ●● Reduction of regional income disparities. In China this is driven by the need to address the negative consequences of its breakneck economic growth. The policies of the last thirty years which encouraged un-restrained growth, widening income disparities and environmental degradation; are now regarded as unsustainable. Under the banner of ‘creation of harmonious society’ the government is now trying to tackle these problems, while also attempting to spread the benefits of growth more widely. Through a combination of infrastructure investment and incentives for firms to relocate, the government hopes to stimulate more economic activity in China’s inland regions. In India the Common Minimum Programme (CMP) is intended to address a wide range of development issues; whilst also reconciling the competing demands of the electorate and strong cultural opposition to market reforms such as the privatization programme.15 The government has also announced its intention to develop a stronger, more labour intensive export-orientated manufacturing base. To this end FDI will be encouraged in infrastructure, technology intensive manufacturing and export orientated production. Especially where ‘local assets and employment are created on a significant scale’. In terms of international policy, both countries aspire to regional economic leadership. China has committed to signing free trade agreements with the ASEAN countries by 2015, while India has attempted to position itself as a leader of developing nations in multilateral forums such as the WTO. 15 15 The government aims to privatise the state run sector within ten years, with some official estimates suggesting that 60% – 70% of the programme will be complete by 2013. Foreign investors are permitted to bid for these assets and in principle enjoy equal treatment in matters such as business licensing. 9
  • China and India: Opportunities and Challenges for UK Business Leading to a rapidly growing urban middle class Although per capita incomes will remain relatively low in China and India, this masks huge variation between different regions as well as rural and urban areas. Cities in their fastest growing regions already have a large population of more affluent middle class households. A number of studies have attempted to forecast the size of the global middle class, but few break down their estimates by country. A summary of the findings of the small number of studies which do so for China and India is given in Table 2.1 below. Table 2.1: Estimates of the Size of China and India’s Middle Class China and India’s Middle Class Population China India Source Estimate (year) Source Estimate (year) goldman Sachs ~1bn (2030) goldman Sachs ~1½bn (2040) McKinsey 612m (2025) McKinsey 384m (2025) uBS 20m-70m (2007) world Bank 56m (2000)-361m (2030) world Bank up to 57m (2030) Source: Bussolo et al (2007), Goldman Sachs (2008), McKinsey (2006, 2007), UBS (2007) The World Bank estimate that the proportion of the world’s population who are middle class will roughly double between 2000 and 2030 (from 7.6% to 16.1%). High rates of growth in developing countries means that they are expected to make the biggest contribution to this shift.16 Thus by 2030 an estimated 1.2bn people in developing countries (15% of the world population) will be middle class17. China and India dominate this trend, by 2030 they could account for as much as 44% of the global middle class; ●● Chinese citizens accounted for 13.5% of the global middle class (in 2000, by 2030 this is expected to increase to 38%. ●● By 2030 India’s share of the global middle class population is forecast to rise to 6%.18 ●● China’s income distribution is expected to shift with middle income cohorts making up a larger share of the population.19 16 Population growth rates of households within the middle class are 18% compared to a world average of 32%. All other things being equal this implies that more households are moving into the middle class group, rather than households within this group growing in size. 17 These are taken from Bussolo et al (2007), who use Milanovic and Yizhaki’s values for middle class income. 18 Bussolo et al (2007) where unable to estimate the current size of the Indian middle class due to limitations in the Indian Household Survey. 19 Although India will experience growth rates in per capita incomes above world average, the differential is not large enough to make this country significantly move along the global income distribution. 10
  • Studies by McKinsey (2006, 2007) and Goldman Sachs (2008) are substantially more optimistic. The latter forecast that by 2030 the size of the global middle class could reach 2bn people. By 2020 they expect 70% of the Chinese population to be middle class and similarly by 2040 the vast majority of Indians will be in this group. In part this is because the definitions of middle class income used in these studies can vary significantly (See Box 2.2). For our purposes we make use of the income bands used by McKinsey (2006, 2007). These are based on values employed in surveys of household expenditure in India and China, such as that carried out by NCAER (2004, 2008). These are then converted into $US equivalents at a fixed exchange rate.20 Table 2.2: China and India’s Economic Classes China and India’s Economic Classes (Real Annual household Incomes) China India Renminbi $uS Rupees $uS global >200,000 >24,155 global >1,00,000 >21,882 Affluent 100,000-200,000 12,077-24,155 Strivers 500,000-1,00,000 10,941-21,882 upper Aspirants 40,000-100,000 4,831-12,077 Seekers 200,000-500,000 4,376-10,491 lower Aspirants 25,000-40,000 3,019-4,831 Aspirers 90,000-200,000 1,969-4,376 Poor <25,000 <3,019 deprived <90,000 1,969 ‘Middle Class’ 25,000-100,000 3,019-12,077 ‘Middle Class’ 200,000-1,000,000 4,376-10,491 Source: McKinsey (2006, 2007) – All prices are in real 2000 terms On the face of it an annual household income of between $4,000 and $20,000 would not provide a particularly affluent lifestyle in most developed countries. However such measures do not adjust for differences in purchasing power. Converted at PPP our middle class income band in China becomes $13,500 – $53,000 whilst the equivalent figures for India are $23,000 – $118,000; which purchases a more recognisably middle-class lifestyle. Although defensible in terms of thinking about standards of living, definitions based on PPP values carry with them an important caveat. Whilst a household in China or India which earns $50,000 a year measured on a PPP basis might aspire to a developed country standard of living; from the perspective of overseas firm trying to sell into these markets, what matters is their purchasing power measured at market exchange rates, which is much lower.21 20 McKinsey use the prevailing exchange rates in 2000. These are 8.28 RMB to the Dollar at market rates/1.85 TMB to the Dollar at PPP for China and 45.7 Rupees to the Dollar at market rates/8.5 Rupees to the Dollar at PPP for India. 21 A counterpoint to this is of course that given domestically produced goods and services may be much cheaper, this could leave more disposable income available for more expensive international brands. Also by shifting production into these countries companies will also be able to reduce their costs. 11
  • China and India: Opportunities and Challenges for UK Business BOx 2.2: whAt IS A MIddlE ClASS lEVEl OF INCOME? A number of attempts have been made to define what constitutes a middle class level of income. Early studies often made use of relative measures, linking it to some function of the income distribution22. However when thinking about consumer demand such definitions are less useful as they do not allow easy comparison across countries. Milanovic and Yitzhaki (2002) proposed disaggregating the world population into three categories; poor, middle class and rich. The average real per-capita incomes of Italy and Brazil in 2000 measured at purchasing power parity (PPP) were used as the upper and lower bounds respectively for the middle class group. Using these figures, a middle class per capita income would lie between $4,000 and $17,000 implying an annual household income of between $16,800 and $72,000. On this basis many people in the OECD countries would be classified as rich, whilst the ‘relatively rich’ in many developing countries would be considered middle class. The advantage of this approach however is that these bounds are defined in terms of real purchasing power and hence do not need to be revised in line with rising incomes over time.23 Goldman Sachs (2008) proposed a lower range of $6,000-$30,000 per capita measured at PPP. An even lower bound was used by Duflo and Banerjee (2007) who defined the middle class as those earning $2 – $10 per day measured at PPP (roughly $800-$3,600 a year). An alternative approach employed by UBS (2007) is to define the middle class on the basis of a level of income which is high enough to sustain above average spending on luxury items. Or by Chinese standards. “...a decent flat, a car, nice appliances and an entertainment budget”. Drawing on cost of living data they estimate that an urban household in China would need to be earning in excess of $10,000 – $18,000 a year ($3,300 – $6,000 per capita) to sustain a middle class or better lifestyle. Given these income bands McKinsey provide a breakdown of their forecasts of China and India’s urban middle classes by income group. Although the brackets they use are not identical, they are sufficiently comparable in Dollar terms to draw broad conclusions about the balance rich, middle class and poor households.2223 From Figure 2.5 we can see that in 2005 the urban populations of India and China were predominantly from lower income groups. China in particular has a much higher proportion of households living on poor/deprived levels of income. By 2025 these will have largely been supplanted by upper-aspirant/seeker households who will account for over half the urban population. 22 For example, see Easterly (2001) or Birdsall, Graham and Pettinato (2000). 23 World Bank (2007a) Global Economic Prospects. 12
  • Figure 2.5: Distribution of Urban Households by Income Group China India 100% 100% 90% 90% 80% 80% 70% 70% 60% 60% 50% 50% 40% 40% 30% 30% 20% 20% 10% 10% 0% 0% 2005 2025 2005 2025 Global Global Affluent Strivers Upper-Aspirant Seekers Lower-Aspirant Aspirers Poor Deprived Source: McKinsey (2006, 2007) However, whereas in China the top two income groups are expected to account for less than 10% of the urban population in 2025, in India they will be nearly a third. By 2025 while China may have a much larger urban middle class than India overall, the latter could have more highly affluent households, both in absolute and relative terms.24 Underlying all of these forecasts is a story of large scale rural-urban migration coupled with urban incomes growing more rapidly than the economy as a whole. The consequence of this is that although they account for less than half of China and India’s populations, expenditure by urban households will dominate consumer spending. We now turn to the implications of this in more detail in Section 2.2 below. 24 In terms of the very highest income group, Merrill Lynch, Cap Gemini (2007) estimated that there were 100,000 High Net Worth Individuals (HNWI) in India in 2006, compared to 345,000 in China, but that this group has been growing more rapidly in India than in China. By comparison there were 485,000 HNWI’s in the UK in 2006. 13
  • China and India: Opportunities and Challenges for UK Business 2.2 China and India’s Changing Consumer Market “When the Goddess of Wealth comes to give you a blessing, you should not go to wash your face” Indian Proverb uRBAN CONSuMPtION IS FORECASt tO RISE SIgNIFICANtly China and India’s (predominantly urban) middle class populations are expected to expand significantly. The combination of rising incomes and expanding urban populations will lead to a dramatic increase in their spending power over the next twenty years. However, whether this will translate into a similarly large increase in consumption is dependent on factors such as savings behaviour and levels of social protection. Limited state provision of health and pensions and undeveloped financial markets has historically led to high savings rates in China and India. In 2005 China’s national savings have been estimated to be over half of GDP, whilst India’s were nearly a third (compared with a quarter in Japan and an eighth in the US). For China, the generation born just prior to the introduction of the ‘one child’ policy in 1979 is now at prime working age, helping to push up average household incomes. However, over the next 20 years China’s demographics will start to work against it.25 ●● Population growth to slow to zero by 2030 and thereafter become negative. ●● The share of the population aged 65 and over will more than double from 7.7% in 2005, to 16.2% over the same period. ●● With birth rates relatively stable, this will lead to a rising dependency ratio.26 India’s demographics are much more favourable. Falling birth rates and changes in life expectancy mean that the share of the population aged 15-65 is expected to rise until 2040, falling slightly thereafter. ●● Population growth to slow to below 1% by 2020, but remain positive for the foreseeable future. ●● The share of the population aged 65 and over will increase to 10% by 2035. ●● The growing adult population will help drive down the dependency ratio.27 In India the falling dependency ratio will reduce the pressure to save for old age, freeing up more income for consumption amongst its youthful population. China’s increasing life expectancy will initially drive up savings rates, but as 25 These forecasts are drawn from UN population database. 26 The dependency ratio is defined as the proportion of the population who are too old (aged above 64) or too young (aged under 15) to work. 27 India’s old age dependency will rise slowly, but this is more than offset by a falling child dependency ratio. 14
  • its population ages this should help to reduce savings as they run down their savings during retirement.28 Coupled with improvements in their financial sectors, these trends mean that changes in savings behaviour are expected to have a positive or at least neutral effect on spending. McKinsey forecast aggregate consumption to more than quadruple in real terms by 2025 – to $3,265bn in China and $1,521bn in India29. If realised, China and India will become the third and fifth largest consumer markets in the world respectively. In China the majority (64%) of urban consumption will come from the upper- aspirant group, roughly in line with their share of households. In India, despite accounting for only a third of urban households, the top two income groups (globals and strivers) will be responsible for 59% of spending. As we can also see from Figure 2.6, India’s rapid expansion in consumer spending is expected to lag China’s by up to a decade. Figure 2.6: Forecasts of Chinese and Indian Urban Consumption China India Real Urban Consumption Real Urban Consumption Expenditure (bn Renminbi, 2000) Expenditure (bn Rupees, 2000) 25,000 50,000 20,000 40,000 15,000 30,000 10,000 20,000 5,000 10,000 0 0 2005 2015 2025 2005 2015 2025 Global Global Affluent Strivers Upper-Aspirant Seekers Lower-Aspirant Aspirers Poor Deprived Source: McKinsey (2006, 2007) 28 Life-cycle models of saving predict that savings rates are higher in the working age population as they build up savings for retirement and then fall in old age as the retired population starts to run down their savings. 29 Both figures are in constant 2000 US Dollars converted at market exchange rates. 15
  • China and India: Opportunities and Challenges for UK Business To some extent these forecasts understate the purchasing power of Chinese and Indian consumers. If we were to convert these figures into Dollar terms using PPP exchange rates this would imply aggregate real consumption expenditure in India and China of $9.2trn and $14.6trn respectively (larger than the US today at $7.8trn).30 PAttERNS OF hOuSEhOld ExPENdItuRE wIll ChANgE Although detailed analysis of consumption trends for the whole of China and India’s populations are not generally available, a number of studies have focused on the key group of urban consumers. Figure 2.7 below provides an illustration of how the breakdown of urban household expenditure in China and India is expected to change. Figure 2.7: Patterns of Urban Consumer Expenditure China India Breakdown of Consumer Spending Breakdown of Consumer Spending 100% 100% 90% 90% 80% 80% 70% 70% 60% 60% 50% 50% 40% 40% 30% 30% 20% 20% 10% 10% 0% 0% 2005 2025 2005 2025 Housing and Utilities Transportation Education Services and Personal Items Communication Health Care Household Items Food and Apparel Source: McKinsey (2006, 2007), Authors Calculations The main driver behind these shifts in spending is that incomes have risen above the threshold level needed for essentials such as food, basic clothing etc. This leaves them free to increase spending on discretionary items such as luxuries, improved health care and education. Cultural and demographic factors have also played their part; the current generation of consumers in China and India are more likely to have a philosophy 30 Although the earlier caveat about conversions using PPP versus market exchange rates still applies. 16
  • of ‘enjoy life today’ as opposed to their parent’s mentality of ‘save for the future’. We now provide a brief overview of some of the trends driving expenditure in each of the broad product categories: Essentials (Food and Apparel) Although it will decline as a share of household expenditure, spending on essentials will still grow significantly in real terms. Within this we would expect to see; ●● A shift in household spending towards a richer more westernised diet, with increased consumption of meat and dairy products.31 ●● Greater consumption of luxury items such as alcohol and tobacco as well as designer apparel. ●● The impact on world food prices to be moderated by their agricultural policies which are geared towards self sufficiency.32 Services and Personal Items In common with spending on household items, demand for recreational services as well as personal products is forecast to grow more rapidly than overall consumption. ●● In China a shift in attitudes coupled with deliberate government policies (such as the ‘Golden Week’ holidays) all point towards a broad based increase in this category of spending.33 ●● Growth will be even more rapid in India, which already has a large market for personal/household services and a historically large demand for jewellery.34 ●● Although spending on entertainment in India will more than triple by 2025, it does so from a low base and so will remain a small component of the overall total. 31 These trends are already apparent in official figures, for example Chinese urban households doubled their per capita consumption of milk and poultry between 1999 and 2006 (China Statistics Yearbook 2000, 2007). 32 As a result of deliberate government policies China and India are largely self sufficient in staple food products (China’s official target for grain self sufficiency is 95%). However these policies and related price controls are likely to come under increasing pressure as demand rises. 33 ‘Golden Week’ is the name given to a pair of week long national holidays, however due to the disruption they have caused the Chinese government is planning to re-organise them to better distribute them and reduce the pressure on transport infrastructure etc. 34 Jewellery is commonly used as a vehicle for personal savings in India. 17
  • China and India: Opportunities and Challenges for UK Business BOx 2.3: CASE Study – MARKS ANd SPENCER35 In 2008 Marks and Spencer announced a Joint Venture (JV) with Reliance Retail to open fifty full scale stores in India over the next five years. Although they already had franchise operations there, when the company reviewed the potential scale of the market opportunity in India, it decided to invest more directly. In looking for a JV partner M&S were highly conscious of the need to access capability in three key areas; property, logistics/supply chain and experience of operating in India. A key driver behind their selection of Reliance was the company’s drive and ambition. Management of their Indian operations is shared between the two companies, with functions such as HR and marketing being locally recruited. This was critical to retaining the core values of the brand whilst also being able to personalise their offering to the local market. Although their experience of operating in India has generally been positive, M&S perceive a number of challenges: Lowering pricing whilst maintaining quality is vital to attracting the Indian consumer, infrastructure remains an issue and the time between decision making and delivery is longer than in the UK. M&S is also seeking to expand into the Chinese market, recently opening its first store on the mainland in Shanghai’s premier shopping district. As with its Indian operations the strategy is to build on their reputation for quality and localise the brand without compromising its core values. Household Items35 Changing lifestyles and more leisure time is already leading to increased demand for recreational items such as DVD players, game consoles and satellite TV, in addition; ●● Demographic trends in China will encourage spending growth on items such as furniture and appliances as Chinese households tend to spend more on these products in later life.36 ●● Low product penetration for appliances and entertainment items in India is likely to persist, due to factors such as a lack of infrastructure and relatively low spending on entertainment. ●● This is changing in India’s urban areas, but slower growth in rural areas will hold down overall spending growth in this area.37 35 Source: UKIBC. 36 Young Chinese couples commonly live with their parents whilst they save up enough to allow them to move out into their own home, at which point their spending on such items significantly increases. 37 For example see McKinsey (2008c). 18
  • BOx 2.4: BRANd AwARENESS IN ChINA ANd INdIA Chinese and Indian consumers are increasingly brand conscious. A walk through the major shopping districts in cities such as Bangalore or Shanghai reveals a huge range of shops dedicated to international brands, particularly luxury products. Although the top global brands can rely on instant recognition thanks to their international reputation, awareness of smaller and more niche brands is much less widespread. These companies have to build up a reputation for quality through word of mouth recommendations, which remain one of the most important marketing mediums. Surveys such as McKinsey (2008c) suggest that achieving this recognition can be extremely important as Chinese and Indian consumers are not only willing to pay a premium for quality (when they recognise it), but also exhibit high levels of brand loyalty. Companies operating in India and China have found that increasing national pride has bolstered the perception of some domestic brands, particularly in regional cities where consumers may not quite have the disposable income to afford a major global brand. Perhaps surprisingly, these same consumers are not always aware of the foreign nature of their favourite products. When surveyed, 67% of Chinese consumers mistook consumer beverages such as Coca-Cola, Pepsi and Sprite to be domestic rather than foreign brands. Although these brands do not hide their foreign origins, their name, packaging and marketing have all been given a specific Chinese identity. Education Education is regarded as a priority by both Chinese and Indian households and already accounts for a relatively large proportion of household expenditure38, however; ●● As China’s population ages and the number of children declines, spending on education will fall as a proportion of household spending even while spending per child is likely to increase. ●● India’s booming youth population will make this one of the fastest growing categories of household expenditure, doubling its share. 38 At 4% and 6% in India and China respectively, education accounts for a much higher proportion of private expenditure than in most advanced economies, which typically spend less than 4% due to their much larger public education systems. BERR (2008) Public Services Industry Review. 19
  • China and India: Opportunities and Challenges for UK Business Health Care Limited health care infrastructure and greater health awareness has encouraged a large increase in private provision, which will continue as health insurance becomes more prevalent. ●● Private spending on health related goods and services in China and India is expected to reach 13%-14% of household consumption by 2025, substantially higher than in most advanced economies.39 ●● China’s ageing population, coupled with increases in ailments associated with pollution, urbanisation and a richer diet, will combine to make this the fastest growing category of household expenditure. ●● India’s demographics are more favourable, but health spending will grow almost as rapidly. Transportation Affluent Chinese and Indian households are shifting their preferences away from public to private transport (See Box 2.5), as well as more overseas travel.40 ●● Transport already accounts for 17% of Indian household expenditure, but infrastructure bottlenecks will keep growth below its potential. ●● Such constraints are less binding in China, allowing for more rapid growth in spending, although it will remain a less important category of spending than in India. ●● It is unclear though how factors such as rising fuel prices will act as a constraint on spending, as they remain subsidised by government.41 39 Outside of the US, private expenditure on health care is typically around 4% of consumption in the advanced economies. BERR (2008) Public Services Industry Review. 40 National Statistics (2008) estimate that from 2002 the number of visits from Chinese and Indian citizens to the UK grew by 8.5% and 15.7% a year respectively, reaching over half a million visits in 2006. On average these visitors also stayed for longer and spent more while they were here. 41 Due to the widening gap between the world price of crude oil and China’s officially set domestic fuel prices its refineries have been making substantial losses (Sinopec the largest refiner lost £1.5bn in the first quarter of 2008 alone). The government raised its official prices in June 08 by between 17% and 25% the largest increase for four years, but still well below what was needed to close the gap. 20
  • BOx 2.5: gROwth IN CAR OwNERShIP There is a well documented relationship between car ownership and aggregate per capita incomes. At levels of per capita income below $5,000 car ownership tends to be low, but once this threshold is reached it starts to increase rapidly (with only limited evidence of demand beginning to be satiated at higher income levels). Based on this relationship Chamon et al (2008) predict that car ownership in China will overtake that in the uS by 2030, with India following suit by 2050. As a result their combined share of world car ownership will increase from 4.3% in 2005 to 32.4% in 2050 (though per capita car ownership in the US will still remain substantially higher). Table 2.3: Forecasts of Car Ownership Car Ownership (millions, % world total in brackets) USA India China Advanced Rest of World World Total Economies 2005 153 (24%) 7 (1%) 21 (3%) 304 (47%) 161 (25%) 646 2010 171 (23%) 9 (1%) 51 (7%) 332 (44%) 197 (26%) 760 2020 211 (20%) 19 (2%) 134 (13%) 390 (27%) 292 (28%) 1046 2030 253 (17%) 55 (4%) 255 (17%) 442 (30%) 468 (32%) 1473 2040 295 (14%) 163 (8%) 415 (20%) 490 (23%) 732 (25%) 2095 2050 337 (12%) 367 (13%) 573 (20%) 532 (18%) 1098 (38%) 2907 Source: Chamon et al (2008) Note: Advanced Economies excludes the USA Such a massive increase in car usage will inevitably have an impact on world oil prices which are already under pressure from rapid growth in Chinese and Indian demand. More broadly it will also create major challenges for these countries in terms of managing congestion and pollution, as well as having implications in terms of climate change. 21
  • China and India: Opportunities and Challenges for UK Business Communication Reforms made in the 1990s have led to a massive expansion of telecommunications in China and it is now the largest mobile phone market in the world. India’s reforms came later; as a result the market is only now entering into a similar rapid growth phase. ●● Telecommunications already account for 8% of Chinese household expenditure, but are still expected to grow faster than overall consumption. ●● Although it only accounts for 2% of Indian household expenditure, the huge potential for expansion means that this will be the fastest growing category of spending, tripling its share by 2025. Housing and Utilities42 Modelling spending on housing and utilities is complicated by a number of methodological problems and the impact of government policies towards housing. That said; ●● The recent privatisation of the housing stock in China has created a huge housing market and ignited demand for home improvements. ●● India’s large rural population and slowing rate of urbanisation means that spending on housing will grow slowly. ●● As a result, while the proportion of spending will shrink in India, it will grow to become the second largest category in China. But the regional dimension should not be overlooked While China and India’s fast growing regions are already attractive consumer markets, they are also becoming intensely competitive. It has been argued that some areas are now oversaturated with domestic and foreign brands and that a wave of consolidation is imminent.43 In response to this international firms are now increasingly looking further afield in China and India; but in doing so they find that they are far from homogenous markets. As we can see from Table 2.4 below, although consumer durables are common in urban households, ownership rates drop off dramatically in rural areas (which make up 60% – 70% of China and India’s population44). 42 In terms of methodology there is the question as how to determine imputed rents on owner occupied property and what the implications are of rising house prices. On the policy side both the Chinese and Indian governments subsidise utilities and housing to some degree or other. 43 See for example Gustavsson (2008). 44 There is considerable debate about official figures for China and India’s rural populations. It has been argued though these figures overstate India’s rural population as they do not fully account for people who live on the periphery of larger urban agglomerations, while China’s population statistics may understate its rural population. For example see McKinsey (2007), Anderson (2006), UBS (2007). 22
  • Amongst these households, lower disposable incomes and a lack of necessary infrastructure (such as reliable electricity supplies), have so far constrained demand for these types of products. Rural households also face tighter budget constraints which limits their ability to make certain types of routine expenditures. For example, Hindustan Unilever found that rural consumers struggled to afford the relatively large containers of personal products commonly sold in countries like the UK. But, by creating a reusable sachet which could be refilled locally, they created a sales format which allowed consumers to break their purchases down into more affordable lumps, as well as significantly reduce the cost of the product. Table 2.4: Ownership of Consumer Durables durable Consumer goods per 100 households (2006, or most recent year available) China India urban Rural urban Rural total Automobiles 4.3 .. 4 0.7 1.7 Bicycles 117.6 98.4 51.9 57.2 55.7 Cameras 48 3.7 0 0 0 Computers 47.2 0 0 0 .. Microwave Ovens 50.6 .. .. .. .. Motorcycles 20.4 44.6 28.3 7.9 13.6 Refrigerators 91.8 22.5 30.8 4.8 12.1 telephones 93.3 64.1 .. .. .. telephones: Mobile 152.9 62.1 .. .. .. televisions 137.4 89.4 70.4 27.5 39.5 Video disc players 70.2 .. 8.2 1.7 3.6 washing machines 96.8 43 12.5 0.9 4.1 Source: Chamon et al (2008) However, whilst the term ‘rural India and China’ might conjure up visions of small villages dominated by subsistence farming, with poor infrastructure and limited connectivity to the rest of the world, the reality can be quite different. For example, approximately a third of the rural Indian population lives in close proximity to an urban area or in a rural economic centre. These communities have relatively good access to basic infrastructure such as roads and electricity supplies.45 45 CII/McKinsey (2007). 23
  • China and India: Opportunities and Challenges for UK Business Furthermore, as was discussed in Box 2.1, both the Chinese and Indian governments have recently placed increased emphasis on ensuring that the wealth from their economic growth is spread more widely. This is being driven by a range of policies such as; ●● The recent agricultural land reform in China to encourage more commercial farming and improve rural incomes. ●● China’s ‘Go West’ and ‘Revitalise North-Eastern China’ initiatives to encourage firms to relocate inland from the coastal regions. ●● India’s Bharat Nirman plan which injects billions of dollars of infrastructure investment into the rural economy. The effects of these changes are already apparent at the lower level of the income distribution, with the proportion of rural Indian households in the lowest income group falling by a third to 65% since 1985, while the number of rural Chinese households in extreme poverty has more than halved over a similar period. This trend is set to continue with lower middle class households becoming the largest rural income group.46 Pockets of more wealthy rural consumers are already present in certain regions, such as India’s more prosperous south-west, and will probably emerge as the early leaders in terms of rural consumer markets. These will tend to be clustered around China and India’s regional cities who are leading a ‘second wave’ of fast growing areas (See Box 2.6). The huge geographic dispersion of these regional cities, rural towns and villages poses a major obstacle to firms seeking to supply these markets. Establishing a regional presence supported by an effective distribution network is a real challenge. Often the only way to achieve this is through some form of partnership or joint venture with local businesses. In trying to reach these markets international companies also face stiff competition from domestic brands, many of whom have their foundations in strong regional operations. A case in point is Wahaha, China’s largest beverage producer. While Coca-Cola and Pepsi were building market share in China’s urban markets, through a combination of aggressive marketing and exploiting its large distribution network Wahaha has come to dominate the rural market. 46 McKinsey (2006, 2007). 24
  • BOx 2.6 ChINA ANd INdIA’S REgIONAl tOwNS ANd CItIES Although China and India have a number of ‘mega-cities’ such as Beijing, Shanghai, Delhi and Mumbai, the majority of their urban populations live in smaller urban areas. In China these tend to be regional cities with populations of 1m – 5m, whilst India has a large network of smaller cities and towns.47 A recent UKTI study examined the potential opportunities offered by a shortlist of 35 of the most promising Chinese regional cities; between them they accounted for 16% of China’s population and 36% of its GDP. Although average per capita incomes are still lower than in the major cities, they have been growing much more rapidly in regional cities, by an average of 15% a year or more.48 India has just over a third as many regional cities as China49, but while some multinationals already operate in these markets, most confine their activities to the major cities. One of the reasons for this is that unlike China, India’s regional cities taken together have not yet taken off as a consumer market, accounting for 23% of disposable income in 2004, compared to 39% for the eight major cities.50 Though major urban centres are expected to dominate spending, India’s smaller cities (those with a population between 0.5m – 1m) have almost as many rich and middle class households as the regional cities and in some cases have higher levels of disposable income. By 2025 around half of India’s middle class will live in these cities and smaller towns. 2.3 UK Export Performance to China and India “Don’t bargain for fish which are still in the water” Indian Proverb China and India’s rapid economic growth, rising urban incomes and increased openness are already driving dramatic increases in their imports of goods and services. As Figure 2.8 below illustrates, imports of goods to both countries have surged over the last five years, although India imports about a fifth as much as China.47484950 47 Estimates of the number of regional cities in China and India can vary significantly. For example the China Statistics Yearbook (2003) states that the country had 174 cities with a population over one million, while a recent UKTI study found 274 cities with a population in excess of 1m. Here we quote figures from UN (2007). 48 McKinsey (2006). 49 India has 37 cities with a population of 1 m – 5m, compared to 91 in China. 50 McKinsey (2007). 25
  • China and India: Opportunities and Challenges for UK Business Figure 2.8: Chinese and Indian Merchandise Imports China India Merchandise Imports ($bn) Merchandise Imports ($bn) 900,000 200,000 800,000 180,000 160,000 700,000 140,000 600,000 120,000 500,000 100,000 400,000 80,000 300,000 60,000 200,000 40,000 100,000 20,000 0 0 19 2 19 3 19 4 19 5 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 20 5 06 19 2 19 3 19 4 19 5 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 20 5 06 9 9 9 9 9 9 9 9 0 0 0 0 0 0 9 9 9 9 9 9 9 9 0 0 0 0 0 0 19 19 Other Machinery and Equipment Manufacturers Chemicals Fuels and Raw Materials Food and Animal Products Source: UN Comtrade Manufactures, specifically machinery, equipment and related parts now account for the bulk of Chinese merchandise imports (at around 45% of the total). Within this: ●● Imports of electronic goods and related parts expanded rapidly, from 10% of the total in 1992 to around 30% by 2006.51 ●● Of this roughly three quarters was in the form of components rather than finished products.52 51 China is now the second largest importer of ICT products in the world after the USA. UNCTAD (2008b). 52 This reflects the importance of the processing trade to China’s economy (the assembly of finished products from imported components for re-export). We return to this issue in more detail in Chapter 3. 26
  • As China has built up its own manufacturing capabilities it has become less reliant on imported heavy machinery, but increased its imports of more sophisticated equipment and raw materials. ●● The share of imports accounted for by heavy industrial machinery has halved since 1992, to 10%. ●● Imports of scientific equipment have grown by 44% a year since 2000, increasing their import share to around 6%.53 ●● Petroleum imports have grown by 26% a year since 1992, since 2000 imports of metals have grown by 28% a year. India’s merchandise imports are, if anything, even more dominated by raw materials and other primary commodities. ●● Petroleum and related products is the largest category with an import share of 30%. ●● Imports of metals are the second largest at around 9%. ●● India is a major market for jewels and precious metals (accounting for a fifth of world demand for gold).54 The trends in India’s imports of machinery and equipment reflect its less developed manufacturing base and the importance of ICT enabled services to the economy, for example; ●● Imports of heavy industrial machinery have been growing by 31% a year since 2000 (but are still below China’s in absolute terms). ●● Over the same period imports of telecommunications equipment have grown by 49% a year. Lack of data makes a similarly detailed breakdown of India and China’s service imports impossible; however top level data does allow us to observe a number of broad trends. From Figure 2.9 below we can see that China imports nearly twice as much in terms of services as India, although more recently the latter has been growing more rapidly. 53 China’s exports under this category have also increased, which is also indicative of processing trade. 54 Kannan (2008). 27
  • China and India: Opportunities and Challenges for UK Business Figure 2.9: Chinese and Indian Service Imports China India Service Imports ($bn) Service Imports ($bn) 120 60 100 50 80 40 60 30 40 20 20 10 0 0 19 2 19 3 19 4 19 5 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 20 5 06 19 2 19 3 19 4 19 5 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 05 9 9 9 9 9 9 9 9 0 0 0 0 0 0 9 9 9 9 9 9 9 9 0 0 0 0 0 19 19 Other Business Services Computer and Information Financial and Insurance Travel Transport Source: UNCTAD Both countries’ service imports are dominated by the transport, travel55 and other business services categories. But since 2000 it is imports of Computer & Information, and Financial services which have been growing the most quickly (by 45% and 37% a year respectively)56. Over the same period Indian imports of Communication and Construction services have surged (by 45% and 39% a year respectively). One interesting contrast between the two countries is in terms of their payments overseas relating to royalties and license fees. These account for less than 2% of India’s service imports, but over 6% of China’s (and have been rising much more rapidly in the latter). According to one academic we spoke with, as much as one third of some Chinese manufacturer’s costs consists of license fee payments overseas. thE uK’S ExPORtS tO ChINA ANd INdIA ARE dOMINAtEd By hIgh SKIll MANuFACtuRES ANd SERVICES UK exports to China and India have increased significantly over the last fifteen years. Since 1992 exports to China have grown by an average of 16% a year, while growth in exports to India has accelerated from an average of 10% a year 55 Travel primarily covers all purchases of goods and services of short run visitors (business and holidaymakers) to that country, it also includes travel for health or education related reasons. 56 Albeit from a very low base. 28
  • in the 1990s, to 14% a year since 2002. In common with many other developed countries, at present the UK trades substantially more with China than India. Figure 2.10: UK Merchandise Trade with China and India China – UK India – UK Merchandise Trade Merchandise Trade ($bn, 2005) ($bn, 2005) 30,000 6,000 25,000 5,000 20,000 4,000 15,000 3,000 10,000 2,000 5,000 1,000 0 0 Exports to UK Imports from UK Exports to UK Imports from UK Other Electronic Components Electronics High Skill Manufactures Medium Skill Manufactures Low Skill Manufactures Labour Intensive Manufactures Primary Commodities Source: UN COMTRADE Figure 2.10 provides a breakdown of the UK’s trade in goods with China and India using a product classification57 which distinguishes manufactured goods by skill intensity rather than by product. As one would expect the UK’s merchandise exports to these countries are dominated by higher skill manufactured products, while our imports are concentrated in labour intensive and low skilled manufactures. There are two obvious anomalies in this data which deserve comment. Firstly, the UK appears to export a large amount of labour intensive manufactures to India. This is caused by our exports of precious stones and metals, which is largely on a re-export basis and hence does not reflect domestic production. Secondly, the UK imports a large amount of electronic goods and components from China (see section 3.1). 57 UNCTAD (2007) Trade and Development Report p116 – This uses 3 digit SITC Rev 3 COMMTRADE data. 29
  • China and India: Opportunities and Challenges for UK Business Figure 2.11: UK Services Trade with China and India China – UK India – UK Services Trade Services Trade ($bn, 2006) ($bn, 2006) 1600 1600 1400 1400 1200 1200 1000 1000 800 800 600 600 400 400 200 200 0 0 Exports to UK Imports from UK Exports to UK Imports from UK Other Business Services Computers and Information Financial and Insurance Travel Transport Source: UNCTAD Figure 2.11 above provides a breakdown of the UK’s trade with China and India on the services side. India’s service imports from the UK reflect our world leading position in terms of finance and business related services; however these form a smaller proportion of our exports to China. 30
  • dESPItE thE StRONg gROwth IN gOOdS ExPORtS tO ChINA ANd INdIA thE uK hAS SEEN ItS ShARE OF thE tOtAl dEClINE. Figure 2.12: Shares of China and India’s Goods Imports China India Import Share Import Share 20% 10% 18% 9% 16% 8% 14% 7% 12% 6% 10% 5% 8% 4% 6% 3% 4% 2% 2% 1% 0% 0% UK USA Japan Germany France UK USA Japan Germany France 1992 2000 2006 Source: UN COMTRADE The UK has seen strong growth in its merchandise exports to China and India over the last two decades, even while its share of the total has declined. However, the rapid growth in trade with China and India means that the UK has also seen its share of their goods imports decline relative to that of our major competitors. Using detailed trade data it is possible to break down the changes in the UK’s share of Chinese and Indian goods imports into the contribution from two main components: ●● Changes in the product structure of Chinese and Indian import demand. ●● Changes in the sector share, that is, how much the UK sold within those product categories it exports to China and India. Thus for example if China’s import demand had shifted away from the types of products the UK exports we would expect to see this reflected in the contribution of the former, while a reduction in the UK’s share in particular sectors would be picked up by the latter. 31
  • China and India: Opportunities and Challenges for UK Business The results of these calculations are illustrated in Figures 2.13/2.14 below, which provide the results for overall imports as well as the specific contributions to the total from certain key sectors. The darker bands indicate the change in UK market share over the period 1992-2000, while the lighter bands the change during the period 2000-2007. Figure 2.13: Contributions to Change in UK’s Exports to China 0.4% Competitiveness Product structure 0.2% 0.0% -0.2% -0.4% Specialist Telecoms/Sound Electrical Industiral Equipment Machinery & Parts Machinery -0.6% Total excl Telecoms & Electrical Machinery -0.8% Total -1.0% 0 7 0 7 0 7 0 7 0 7 00 00 00 00 00 00 00 00 00 00 -2 -2 -2 -2 -2 -2 -2 -2 -2 -2 92 00 92 00 92 00 92 00 92 00 19 20 19 20 19 20 19 20 19 20 Source: BERR Calculations from UN COMTRADE As is clear from Figure 2.13, the increase in the UK’s share of Chinese imports during the 1990’s and subsequent decline after 2000 were primarily driven by changes in the UK’s sector share. Although changes in the product structure of Chinese demand reinforced these shifts, they tended to have a smaller impact. Central to this story were the telecommunications equipment and electronics sectors which were a major success story for the UK during the 1990’s. Between them they accounted for virtually all of the improvement in UK share once gains and losses in other sectors are netted out. However after 2000 the telecommunications and electronics sectors became two of the largest contributors to the decline in the UK’s share58. This was part of a wider trend with the US and Europe losing market share in these sectors to Asian economies such as Korea, whose combined market share in 2005 had grown to over 80%59. 58 The sectors with the largest negative impact were telecommunications equipment, petroleum and related products, power generating machines and electrical equipment. 59 One explanation for this trend is that US and European telecommunications companies offshore the production of this type of equipment to China, thus reducing our direct exports under this heading. 32
  • These results are in line with research commissioned by UKTI (2007a) on the UK’s export performance to emerging markets. This suggested that the primary driver in the decline in the UK’s share of imports was a decline in sector share, rather than a change in product structure. In addition the report noted that: ●● The UK exported a similarly broad range of products to China as its major competitors, but sold comparatively less of them. ●● The main cause of this appears to have been a drop in the quantities sold (the intensive margin60), although price per unit also declined slightly. ●● There was also a poor correlation between the types of products the UK exports, and the overall pattern of China’s import demand.61 Figure 2.14 provides a similar analysis for the changes in the UK’s share of India’s merchandise imports over the same period. The picture for India is complicated by the impact of its large imports of more ‘erratic’ items such as coinage and precious metals and stones . These constitute a large proportion of the UK’s exports to India, but are primarily re-exports rather than domestically produced products. Between 1992 and 2000 these categories contributed over one percentage point to the increase in the UK’s recorded share of Indian imports, almost completely offsetting falls in other product groups; leading to a relatively small overall decline in the UK’s share . Conversely they account for the majority of the decline in the UK’s share of India’s imports after 2000. To put these figures into context, the change in the UK share of India’s imports of specialist industrial machinery is reported alongside. This category saw the largest fall of any sector under the heading of imports of machinery and equipment, yet is still dwarfed by the impact of the more erratic product categories. To gain a clearer picture of how the UK’s share of India’s imports has changed, we repeated the analysis excluding these erratic sectors, the results from this are detailed in the far right pair of columns in Figure 2.14. From this we see that prior to 2000 the UK appears to have suffered from both an unfavourable shift in the pattern of Indian product demand and a decline in its sector share. After 2000, although UK sector share continued to decline, the pattern of Indian import demand became more favourable. 60 The extensive margin refers to the range of products sold, whilst the intensive margin refers to how much a country sells in these product areas. The available data on the latter was more limited, covering approximately 70% of total merchandise trade. 61 As China and India become richer however, this is expected to improve. 33
  • China and India: Opportunities and Challenges for UK Business Figure 2.14: Contributions to Change in UK’s Exports to India 2% Competitiveness Product structure 1% 0% -1% -2% Specialist Total excl Industrial Precious Metals Machinery & Stones -3% Precious Metals Non-Precious -4% and Stones Metals Total -5% 0 7 0 7 0 7 0 7 0 7 00 00 00 00 00 00 00 00 00 00 -2 -2 -2 -2 -2 -2 -2 -2 -2 -2 92 00 92 00 92 00 92 00 92 00 19 20 19 20 19 20 19 20 19 20 Source: UN COMTRADE Care should be taken when attempting to interpret the causes of changes in the UK’s sector share as it only captures direct trade in goods. For example, if a UK firm were to offshore the physical production of its product but retained its core design and development activities onshore, this would be reflected as a fall in import share in that particular category of goods (even if as a result the firm’s market share increased). whIlSt It hAS IMPROVEd ItS POSItION IN tERMS OF SERVICE ExPORtS Sufficiently long detailed time series data are not available for trade in services to carry out a similarly detailed analysis of the UK’s share of service imports. The data do allow a more limited comparison of the UK against its major competitors, which is given in Figure 2.15 below. Analysis commissioned by UKTI (2007b) looked at the UK’s comparative advantage in services vis-à-vis its major competitors and how this translated into market penetration in emerging markets. It found that in general the UK has a significant comparative advantage in a number of high skill sectors, with the lead being particularly large in finance, insurance and information services.62 62 Strictly speaking Sea Passenger Transport Services were the strongest sector, but this primarily reflects the importance of ferry services for the UK as an island nation. 34
  • Figure 2.15: Shares of China and India’s Services Imports China India Import Share Import Share 16% 70% 14% 60% 12% 50% 10% 40% 8% 30% 6% 20% 4% 2% 10% 0% 0% UK USA Japan Germany France UK USA Japan Germany France 2001 2005 Source: OECD, WTO In terms of translating this into market penetration, the report found the UK has a strong position in the Indian service sector and is holding its ground in China. However this position is potentially under threat from Japan, whose performance across a range of Asian markets in terms of service exports has improved significantly. Although a useful indicator of the overall shifts in terms of the UK’s direct trade with India and China63, the results from this type of analysis should still be treated with a degree of caution. Moreover, as these markets have grown in importance business strategies have moved away from an export driven model, towards locally based production funded through outward direct investment. We now turn to this issue and the challenges of doing business in China and India in Section 2.4 below. 63 Due to the problems with regard to double counting as a result of goods passing though Hong Kong on their way to the mainland, we deliberately excluded Hong Kong from of our definition of China for the purposes of this analysis. However, a brief examination of trade with China and Hong Kong combined suggested that it would not materially alter our overall findings with regard to the changes in the UK’s share of China’s imports of goods and services. 35
  • China and India: Opportunities and Challenges for UK Business 2.4 Doing Business in China and India “If you do not go into the tiger’s cave, how can you expect to catch its cub?” Chinese Proverb FOREIgN INVEStMENt INtO ChINA ANd INdIA hAS SuRgEd Trade with China and India is only one aspect of their economic linkages with the rest of the world. As they have opened up their economies to foreign firms, more and more businesses have chosen to invest there directly. This trend has been driven by a number of factors, including; ●● The increased off-shoring of production activities in order to take advantage of lower labour costs. ●● China and India’s importance as regional hubs for exporting to neighbouring countries. ●● The need to establish a visible presence in these markets, building contacts with local businesses and government. One consequence of this is that the pattern of trade between China and India, and the advanced economies has changed. Whereas historically the latter may have exported sophisticated items such as electronics to these countries, today their companies’ production activities for these goods are located there. Thus remitted profits and exports of services have been substituted for exports of the physical product. As a result of this, FDI into China and India has surged. At the start of the 1980s their FDI stocks were minimal, with estimates of their combined value putting it at just over $1.8bn. By the 1990s FDI flows into China had started to increase rapidly, with India following suit around ten years later. Since 2000, new FDI flows into China and India have averaged around $70bn a year, with China commanding the lion’s share of this. Despite this, FDI flows into China and India remains well below the levels for advanced economies. For example, in 2006 the UK stock of inward FDI is estimated to have been $1,347bn, with an average of $102bn added to this each year since 2000.64 Data on the breakdown of FDI into China and India by source country do not completely align. Figure 2.16 reports OECD data on FDI into China and India from selected countries. Although the UK appears to lag behind in terms of FDI into China, due to our historical connections our level of investment in India is second only to that of the US. 64 Source: UNCTAD (2006, 2008), UNCTAD FDI Database. 36
  • Figure 2.16: China and India’s Stocks of Inward FDI FDI into China and India China and India’s Inward FDI Stocks ($bn) (Selected Countries, $bn) 350 35 300 30 250 25 200 20 150 15 100 10 50 5 0 0 1981 1987 1991 1997 2001 2007 UK USA France Germany Japan China India Source: UNCTAD, OECDStat This contrasts with data reported by the Chinese Ministry of Finance and Commerce (MOFCOM) which suggests that the UK is the 9th most important investor in China and the single largest EU investor (just ahead of Germany). Indian Ministry of Finance data puts the UK as the fourth largest investor after Mauritius, Singapore and the US.65 UK FDI into China and India is dominated by the food and extraction sectors who between them account for around half of the total. This is driven by substantial oil related investments in China and the large presence of UK food companies in India. Traditional areas of investment such as financial services are much less important however. By contrast, UK FDI into Hong Kong was worth an estimated £17bn in 2006 (with this being dominated by financial investments).66 Information on the sectoral breakdown of overall inward FDI into China and India is limited. Indian official statistics put services and computer hardware/ software as the two most important sectors, accounting for a third of all FDI. Chinese official statistics do not provide as detailed a breakdown, but do show that manufacturing dominates the figures, at nearly two thirds of the total.67 65 Mauritius accounts for 43% of FDI into India, however this is widely thought to be for tax planning reasons. 66 Source: UK National Statistics. Note, even ignoring the financial services sector, UK FDI into Hong Kong is almost twice that for China or India. 67 Indian FDI data breaks the figures down into over 60 sectors; however these do not neatly align into internationally comparable definitions. For example ‘telecommunications’ appears to include both components of both goods and services. 37
  • China and India: Opportunities and Challenges for UK Business What is clear from official data is that there are large regional differences in FDI flows into China and India, with fast growing states attracting the majority of foreign investment. According to the IMF, India’s richest states receive over half of FDI approvals68, while in China 85% of FDI has gone to special development zones in the eastern coastal regions. BOx 2.7: CASE Study – JCB JCB has a long history in India, having entered into the market in 1979 through a joint venture, before becoming the sole owner of JCB India Limited in 2003. It is the fastest growing company in the Indian earthmoving and construction equipment industry; with one in every two pieces of construction equipment sold in India one of its products. JCB has two manufacturing sites in India, one in Ballabgarh and the other in Pune (strategically close to the port facilities in Mumbai). These produce complete machines for the domestic market as well as components for export. The operation is positioned as a regional hub to supply the rest of the South- East Asia market and the Middle-East. Although the company runs its Indian business to the same high standards as the rest of its global operation, it has drawn on its long experience of the market to tailor its products to the needs of its Indian customers. JCB India’s design centre works to ensure that their machines are fully tailored to the Indian environment and working conditions. For example in 2008 it launched the ‘JCB Liftall’, a heavy duty crane designed specially for the Indian market. The company attributes its success in India to taking a long term view and building a strong reputation for high standards of product quality and customer service. It has also invested heavily in its people, allowing them to localise the entire operation from shop floor to senior management. This gives them a key advantage in terms of having people on the ground that have a real understanding of the Indian market, as well as stronger links into the local supply chain. These are lessons it has taken to heart when expanding elsewhere abroad, including more recently when it opened its first Chinese factory in Pudong, Shanghai. JCB’s overseas operations have allowed it to develop a global presence, with a foothold in key emerging markets. Historically these investments have primarily been through Joint Ventures (JVs). More recently though, as ownership restrictions have started to be lifted Wholly Owned Foreign Enterprises (WOFEs)69 have become much more common. In 68 Purfield (2006). The Reserve Bank of India tracks FDI via its regional offices, of which 6 account for nearly 73% of all inward FDI. 69 These are also referred to as Wholly Foreign Owned Enterprises (WFOEs). 38
  • 2006 over half of all FDI projects in China were some form of JV, but WOFEs accounted for over two thirds of new projects by number and value.70 This is because for businesses seeking to do business in China or India the decision as to pursue the JV or WOFE approach is increasingly strategic. JVs can be a useful route into markets where they lack the necessary expertise or local contacts, but also bring with them the burden on managing the relationship with the local partner. As a result, more experienced firms generally prefer the greater freedom offered by investing through a WOFE. But ChINA ANd INdIA REMAIN ChAllENgINg PlACES tO dO BuSINESS Despite substantial progress, China and India are still not easy places to do business, and for British based companies this is further compounded by the geographic and cultural distance between them and the UK. Whilst Britain is ranked the 6th easiest place to do business in the world, India and China lag far behind at 122nd and 83rd respectively.71 Figure 2.17 details responses to the latest World Economic Forum survey of executives with operations in China and India, who were asked to list the five most problematic factors for doing business there. Although not a direct measure of the relative impact of these factors, it does provide a useful ordering of top level business concerns. Figure 2.17: Problematic Factors for Doing Business in India and China China India Inadequate Infrastructure Government Bureaucracy Corruption Access to Financing Policy Instability Restrictive Labour Requirements Tax Regulations Tax Rates Inadequate Education Poor Work Ethic Foreign Currency Regulation Inflation Government Instability/Coups Crime and Theft 0 5 10 15 20 25 30 Source: World Economic Forum Global Competitiveness Report (2007-08) 70 Source: MOFCOM. 71 World Bank: Ease of Doing Business Index (2008). For reference the related indices/data for these two countries alongside the UK are reported in Table 2.5 at the end of this section. 39
  • China and India: Opportunities and Challenges for UK Business Working through them in turn; corruption and government bureaucracy remain a significant issue in both China and India. Basic commercial activities such as starting a business can take two to three times longer in compared to the UK, while the administrative cost can as much as ten times higher (relative to per capita incomes).72 Within this, issues around the rapid and effective enforcement of intellectual property rights are a particular concern for UK firms. As we discuss in Chapter 3, enforcement of IPR lags well behind the state of the law in China and India. Court procedures are cumbersome and non-transparent, sometimes taking years to reach resolution. Businesses also raise concerns about the impartiality of the Chinese legal system.73 Infrastructure shortfalls are overwhelmingly the biggest problem reported by businesses operating in India. Major issues include the unreliability and high cost of electricity supplies, which have led to three fifths of manufacturers having their own on site generator (with the figure even higher in industrial centres such as Delhi and Bangalore)74. By comparison, infrastructure ranks 5th in the list of business concerns for China (although there is substantial geographical variation). On the employment side, India’s labour laws are regarded as substantially more burdensome than China’s (in particular regulations governing the firing of workers). Whilst in China authorities must be notified when a company wishes to make one or more employees redundant, in India their authorisation is required to do so. Despite the huge size of its financial and banking sector, the dominance of directed lending to state owned enterprises in China is crowding out private sector investment. As a result, business access to finance in China is severely constrained. While India suffers similar problems with the influence of state directed investment, its lively and comparatively well regulated finance markets appear to compensate for this.75 The government’s all pervasive role in the economy means that policy uncertainty is a real challenge for businesses operating in China. Keeping on top of the constant updates to regulations or their interpretation by local officials requires substantial amounts of effort. Conversely, despite having to balance the myriad concerns of a large and highly diverse democracy, uncertainty about government policy was not ranked as a significant issue for India. 72 World Bank Ease of Doing Business Index (2008). 73 In China the courts are subordinate to government. By contrast although viewed as slow and bureaucratic, India’s courts are generally regarded as being impartial arbiters. 74 World Bank (2006b). 75 The World Economic Forum Financial Development Report (2008) survey of executives ranked China last in terms of access to finance, scoring poorly across a wide range of indicators. 40
  • The experience of successful firms in China and India highlights a number of key lessons for UK businesses seeking to enter these markets, these include: ●● The importance of taking a long view of the market and building a presence there for the future. ●● Existing products cannot be simply transplanted into these markets; they need to be suitably localized.76 ●● To do this, attracting and developing local talent, with better links to customers and suppliers is vital. ●● While at the same time leveraging the benefits of their domestic and other international operations. In general companies regard the heavy investment in time and resources needed to China and India as a necessary step to establishing a presence there. In some cases loss leading activities are undertaken into order to build the brand or protect it from domestic competition. For example, many firms pursued IPR cases not to secure appropriate compensation, but to discourage wholesale abuse in the future. Where IP had to be brought into China and India, firms would employ a variety of non-legal strategies to limit the scope for infringement.77 Choice of location was also considered to be highly important. For example, in order to make an impact in China, consumer brands are commonly launched in Shanghai or Hong Kong. The latter is often used as a launch pad for selling into China by companies wishing to benefit from its lower cultural and legal barriers to doing business.78 British businesses generally found the cultural barriers to doing business in India less of an issue, but cautioned about taking this for granted. The huge geographical and cultural diversity of both countries makes prior research of the market and local business environment essential. 76 A recent survey for the UKTI by the EIU (2008) found that the vast majority of firms reported having to engage in some degree of product localisation. 77 These included splitting up production amongst multiple locations, retaining firm control of the tooling necessary for production and using local connections to create an environment which discouraged IPR abuse. 78 However firms were also clear that relying entirely on a Hong Kong based operation would not be successful due to China’s huge regional diversity. 41
  • China and India: Opportunities and Challenges for UK Business BOx 2.8: lESSONS FROM SuCCESSFul SME’S SME’s face particular difficulties when entering into the Chinese and Indian markets. They lack the resources to make the necessary upfront investment in building a local presence and absorbing the early losses associated with doing so. That said, discussions with various businesses operating in China and India identified a number of strategies which have been successfully used to mitigate these issues. ●● tailgating into the market on the back of a contract with an existing customer. ●● Exploiting the clustering of industrial activities to target their efforts on a geographically concentrated market. ●● Making use of web based business to business services and contacts made at trade fairs. These approaches all reduce the risks associated with entering into the market by making more effective use of SME’s limited resources and reducing the level of up-front investment required. Securing contracts with multinational companies already operating there was found to be particularly effective. These not only provide a reliable income stream to support further expansion, but also a prominent showcase for their products. This approach need not be confined to looking at opportunities in major cities. Regional cities often lack the supporting services demanded by multinational companies and are eager to help foreign firms with the necessary expertise to provide them. None of these approaches take away from the broader lessons identified above. In our discussions we also encountered numerous examples of SME’s who had struggled because they had not done their homework on the market, developed a long term business strategy or identified a sufficiently profitable business opportunity. whAt gOVERNMENt IS dOINg tO hElP BuSINESSES The growing importance of China and India not just as investment locations but also as important new markets is reflected in a range of policy initiatives across government. At the multilateral level government works with its EU partners to negotiate fair market access agreements via the WTO. It also engages at the bilateral level with the Indian and Chinese governments in technical discussions to help improve business and trade linkages between our countries. 42
  • In addition UKTI in conjunction with the China Britain Business Council (CBBC) and the UK India Business Council (UKIBC) also provide a range of more practical services and advice to firms seeking to business in these countries, including; ●● Overseas Market Introduction Service (OMIS): A chargeable service tailored to the requirements of the client, to access market and industry information, identify potential contacts, schedule visits in market, or assist in planning events such as product launches and networking receptions. ●● Passport to export: An assessment and skills-based programme that provides new and inexperienced exporters with the training, planning and ongoing support they need to succeed overseas. ●● Missions: Outward missions to China and India allow UK companies the opportunity to be supported in visiting the market, including organised visits and meetings. Inward missions allow UK companies to meet with their Chinese and Indian counterparts, both as potential business partners or as investors to the UK. ●● Market information and sector reports: Identifying business opportunities and trends in these markets. ●● Export Communications Review: An assessment of companies’ export communications followed by practical recommendations for improvement (managed by British Chambers of Commerce). ●● Export Marketing Research Scheme: A facility to collect systematic and objective market research to assist in the development of a market entry strategy (managed by British Chambers of Commerce). ●● Practical support: Assistance in setting up operations in China and India such as translation services, interpreters, meeting arrangements and logistical advice. The Manufacturing Strategy (BERR 2008) highlighted the important role played by China and India in global value chains. As a result additional resource is to be directed by UKTI towards identifying manufacturing value chain opportunities in these countries. Greater prominence will be also given to IPO advice to help UK firms protect and exploit intellectual property in these types of emerging markets. 43
  • China and India: Opportunities and Challenges for UK Business Table 2.5: Doing Business in India and China Activity China India uK Activity China India uK Starting a Business 135 111 6 Protecting Investors 83 33 9 Procedures (number) 13 13 6 Disclosure Index 10 7 10 Time (days) 35 33 13 Director Liability Index 1 4 7 Cost (% of income per 8.4 74.6 0.8 Shareholder Suits Index 4 7 7 capita) Investor Protection Index 5 6 8 Min. capital (% of income 190.2 0 0 per capita) Paying taxes 168 165 12 Payments (number) 35 60 8 dealing with licences 175 134 54 Time (hours) 872 271 105 Procedures (number) 37 20 19 Profit tax (%) 19.9 19.6 21.3 Time (days) 336 224 144 Labour tax and 46 18.4 11.3 Cost (% of income per 840.2 519.4 64.6 contributions (%) capita) Other taxes (%) 8 32.5 3.2 Total tax rate (% profit) 73.9 70.6 35.7 Employing workers 86 85 21 Difficulty of Hiring Index 11 0 11 trading Across Borders 42 79 27 Rigidity of Hours Index 20 20 0 Documents for export 7 8 4 Difficulty of Firing Index 40 70 10 (number) Rigidity of Employment 24 30 7 Time for export (days) 21 18 13 Index Cost to export (US$ per 390 820 940 Non-wage labour cost (% 44 17 11 container) of salary) Documents for import 6 9 4 Firing costs (weeks of 91 56 22 (number) wages) Time for import (days) 24 21 13 Cost to import (US$ per 430 910 1267 Registering Property 29 112 19 container) Procedures (number) 4 6 2 Time (days) 29 62 21 Enforcing Contracts 20 177 24 Cost (% of property value) 3.6 7.7 4.1 Procedures (number) 35 46 30 Time (days) 406 1420 404 getting Credit 84 36 6 Cost (% of debt) 8.8 39.6 23.4 Legal Rights Index 3 6 6 Credit Information Index 4 4 6 Closing a Business 57 137 10 Public registry coverage 49.2 0 13 Time (years) 1.7 10 1 (% adults) Cost (% of estate) 22 9 6 Private bureau coverage 0 10.8 0.8 (% adults) Recovery rate (cents on 35.9 11.6 84.6 the dollar) Source: World Bank Ease of Doing Business Database 44
  • 3 Challenges for UK Business SuMMARy Whilst the rapid growth of China and India’s economies has created huge opportunities for UK firms it also brings with it a number of challenges. The emergence of China as a major exporter of sophisticated manufactures and India as a centre for IT enabled services, has led to concerns that they will soon be competing with businesses in the advanced economies in high-skill goods and services. Detailed analysis of trade data indicates that these fears are premature. While China has dramatically increased its exports of products in potentially sophisticated sectors such as electronics, the domestically produced content of these exports is low. Discussions with organisations operating in China and India paint a similar picture of the skill content of activities such as R&D which has been off-shored to these countries. China and India have made tremendous progress in improving their education and innovation systems, but there still remains a significant gap between them and advanced economies such as the UK. Whilst centres of excellence do exist, primarily around their major economic clusters, education and innovation performance across the country as a whole tends to be much lower. Consequently their economies will remain dominated by relatively low skill activities for some time. More generally, as they become richer India and China’s advantage in terms of low cost production is starting to erode due to the appreciation in their exchange rate, coupled with rising wages and non-labour costs. Bottlenecks in physical and human infrastructure are also starting to act as constraints on the global ambitions of Chinese and Indian firms. In response to these challenges Chinese and Indian businesses are making more strategic overseas investments, mergers and acquisitions. These are aimed at securing market access, improving their skills and innovation capabilities and enhancing their global competitiveness. 45
  • China and India: Opportunities and Challenges for UK Business 3.1 The Growth of Chinese and Indian Exports “Do not blame God for having created the tiger, but thank him for not having given it wings.” Indian Proverb The story of China and India’s economic rise has been dominated by the massive growth of Chinese manufactured exports and Indian exports of IT enabled business services. China in particular has opened up to international trade, having recently overtaken the US to become the world’s second largest exporter. Looking first at exports of goods, although both countries’ exports started to accelerate after 2000, China currently exports eight times as much goods as India by value.79 Figure 3.1: Chinese and Indian Goods Exports China India Merchandise Exports ($bn) Merchandise Exports ($bn) 1,200 140 120 1,000 100 800 80 600 60 400 40 200 20 0 0 19 2 19 3 19 4 19 5 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 20 5 06 19 2 19 3 19 4 19 5 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 20 5 06 9 9 9 9 9 9 9 9 0 0 0 0 0 0 9 9 9 9 9 9 9 9 0 0 0 0 0 0 19 19 Other Machinery and Equipment Manufactures Chemicals Fuels and Raw Materials Food and Animal Products Source: UN COMTRADE China’s exports are dominated by machinery and equipment which now account for 47% of the total. In 2005 China overtook the US to become the largest supplier of Information and Communications Technology (ICT) products to the 79 Roughly 50%-60% of China’s goods trade (imports and exports) is with the OECD countries, while the figure for India is slightly lower at 40%-50%. 46
  • world, with this sector accounting for 30% of Chinese exports80. In addition we have seen; ●● Exports of basic manufactures such as refined metals and plastics have consistently outstripped overall export growth.81 ●● Traditional export industries such as textiles and clothing have grown tenfold since 1992, but their share of the total still halved. ●● Primary commodities such as crude materials, fuel and food have also seen their export share fall to 5%, down from 20% in 1992. By contrast the importance of primary commodities to India’s exports has increased, to around a third of the total. Despite its dependence on imported fuel and related products, India’s exports of these products have actually risen. This reflects a combination of improvements in domestic refinery capacity and rising world fuel prices, which have made exporting more profitable than sales to the domestic market82. However; ●● Chemicals and non-machinery manufactures83 have made the largest overall contribution to India’s export growth. ●● Within this, metals have grown strongly, nearly doubling their share of India’s exports to 11%. ●● More traditional Indian export industries such as textiles and clothing have seen their share of exports nearly halve to 16%. Turning to services, although much of the commentary on China’s trade has focused on the massive growth of its merchandise trade; Chinese service exports are actually greater than India’s in absolute terms and have maintained their share of overall exports at around 10%. 80 UNCTAD (2008a). 81 Since 2000 they have grown at 40% a year. 82 Fuel prices in India are subject to a wide array of price controls. 83 For example steel, textiles and plastics. 47
  • China and India: Opportunities and Challenges for UK Business Figure 3.2: Chinese and Indian Service Exports Chinese Indian Service Exports ($bn) Service Exports ($bn) 100 60 90 50 80 70 40 60 50 30 40 20 30 20 10 10 0 0 19 2 19 3 19 4 19 5 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 20 5 06 19 2 19 3 19 4 19 5 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 05 9 9 9 9 9 9 9 9 0 0 0 0 0 0 9 9 9 9 9 9 9 9 0 0 0 0 0 19 19 Other Business Services Computer and Information Financial and Insurance Travel Transport Source: UNCTAD Outside of the catch-all ‘travel’ category China’s service exports are concentrated in transport and other business services which have grown steadily over the last fifteen years. Since 1997 Computer and Information related services have been the fastest expanding sector with average annual growth of 49%; however this was from a very low base and they remain a small proportion of the total. India’s service sector has progressively increased its share of the country’s overall exports from 20% in the early 1990s to 37% by 2007. Computer and Information related services have been at the heart of this transformation and have been the primary force behind the impressive 35% year on year growth since 2002. This has resulted in India running a surplus on services since 2004.84 In 2005 India overtook Italy and Luxembourg to become the 8th largest exporter of ICT enabled services in the world85, well ahead of China which was ranked 17th. A NASSCOM-McKinsey (2005) study found that India accounted for 65% of the global market in ICT off-shoring and 46% of Business Process Outsourcing (BPO). Although China has made inroads (notably in procurement and product development), India remains the global off shoring location of choice. A Booz 84 WTO (2007) Analysis of India’s balance of payments data indicates that the surplus was largely due to software related services with imports under other headings largely cancelling out. 85 UNCTAD (2008a) It should be noted that there are minor discrepancies in the service trade statistics, particularly for India. 48
  • Allen Hamiliton/Duke University (2006) survey of executives indicated that it is countries such as the Phillippines and Latin America rather than China which are emerging as more serious competitors to Indian dominance of this sector.86 Figure 3.3: Offshoring Location Preference by Function Back Office Contact Centre IT Canada 3% 8% 3% Mexico 3% 4% 4% China 7% 3% 7% Eastern Europe 7% 6% 9% Other Asia 7% 6% 6% Western Europe 7% 6% 6% Latin America 9% 14% 9% Philippines 12% 19% 6% India 45% 31% 49% Procurement Product Dev. Canada 0% 2% Mexico 5% 2% China 29% 19% Eastern Europe 7% 8% Other Asia 2% 5% Western Europe 5% 6% Latin America 12% 9% Philippines 10% 2% India 27% 41% Source: Booz Allen Hamilton (2006) China Exports a Surprisingly large Array of high tech Products Classical trade theory would predict that a relatively capital poor, labour rich economy such as China would tend to export labour intensive products and import high skill, high technology products. However, China’s goods exports appear to be concentrated in sophisticated product areas such as electronics and communications. Schott (2008) constructed an export similarity index87 for China and found that the structure of its exports is surprisingly similar to that of the OECD countries. Even more striking was how the overlap in its exports with OECD countries has increased. In 1972 the calculated index for China was 0.05, ranking it alongside countries such as India and Hungary, by 2005 it had jumped to 0.21 putting it just behind Taiwan and well ahead of most other emerging economies. 86 NASSCOM/Booz Allen Hamilton (2006) also identified significant potential for further growth in India’s offshoring activities into areas such as engineering services. 87 Schott uses Finger and Kreinin’s (1979) Export Similarity Index (ESI) which compares the overlap in terms of commodity structure of two countries’ manufacturing exports to the US in a particular year. 49
  • China and India: Opportunities and Challenges for UK Business Looking at China’s market share of US manufacturing imports he found that it increased from virtually zero in 1972 to 19% in 2005; the fastest gain for any of the US’s major trading partners. In terms of product penetration, that is the range of product categories in which China exported to the US, this had increased from 9% in 1972, to 85% in 2005; close to the levels exhibited by OECD countries. The massive growth in the range of products exported by China can in part be explained by new trade theory which emphasises consumer’s preference for variety88. This leads larger economies to produce a wider range of products than smaller ones. Although poorly endowed (in relative terms) with capital and skilled labour, China’s economy is large. This suggests that all else being equal, it will produce a greater variety of products than smaller economies at the same level of development. This leaves open the issue of the apparent increase in the sophistication of China’s manufacturing exports. Rodrik (2006) and Hausmann et al (2007) find that the composition of goods exported by China is similar (in terms of sophistication) to those of countries with a per capita income three times higher than that of China. however the Aggregate trade Figures Paint a Misleading Picture Assche et al (2008) argue that China’s trade statistics are distorted by the impact of the processing trade, that is, the final assembly of products from imported components. They note that trade figures are normally reported as gross flows and as such do not give an indication of where the value added in a particular product was actually created. Using Chinese customs statistics they calculate that the processing trade accounted for 55% of China’s exports in 2005. Within this, barely a third of the value added was created domestically within China, the remainder being accounted for by imported inputs. Adjusting China’s exports to exclude imported components they conclude that only 60% – 70% of the value of China’s total exports is produced domestically. 88 For example see Krugman (1980), Hummels and Klenow (2005). 50
  • Figure 3.4: China’s Processing and Non-Processing Exports Breakdown of China’s Exports ($bn) 1,200 Processing Trade Ordinary Exports 1,000 800 600 400 200 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: Koopman et al (2008), UNCOMTRADE Looking at the share of the processing trade in China’s exports by their technological level89, Assche et al find that it ranges from 30% for low tech products, through 40% to 50% for medium tech products, to 90% for high tech products. While the share of the processing trade in China’s low and medium tech exports declined between 1992 and 2004, its share in high tech exports remained more or less constant. Using a more sophisticated variant of the methodology developed by Hummels et al (2001), Koopman et al (2008) reach a similar conclusion. They found that the average share of foreign content in China’s exports is not only significant but has remained relatively constant over time, at around 50%. This was driven by the high share of foreign value added in processing exports as can be seen in Table 3.1 below. They also found that a fifth of China’s manufacturing sectors have a domestic value added content of less than 50%, yet between them account for 44% of manufacturing exports. These were sectors such as computers, electronic devices and telecommunications equipment which would traditionally be considered to be sophisticated industries. A common feature of these industries was that processing exports account for over two-thirds of their exports. They also tended to have a large proportion of foreign invested firms, for which the share of domestic value added is on average 89 Assche et al (2008) use the OECD’s classification of manufacturing into: high technology industries, medium – high technology industries, low – medium technology industries and low technology industries. 51
  • China and India: Opportunities and Challenges for UK Business less than a third. In light of this evidence they conclude that “...the appearance of a sophisticated export structure by China is largely a statistical mirage.”90 Table 3.1: Domestic and Foreign Value-Added in Exports Normal Exports Processing Exports 1997 2002 2006* 1997 2002 2006* All Merchandise Foreign Value-Added 5.3% 10.8% 11.3% 81.9% 74.4% 81.7% Domestic Value-Added 94.8% 89.2% 88.7% 18.1% 25.6% 18.3% Manufacturing goods Foreign Value-Added 5.7% 11.6% 11.7% 82.4% 74.9% 82.0% Domestic Value-Added 94.3% 88.4% 88.3% 17.6% 25.1% 18.0% Source: Koopman et al (2008) *Indicates Preliminary Estimate A FINdINg whICh IS BACKEd uP By PROduCt lEVEl dAtA The implication of this is that using aggregate trade data to make inferences about China’s comparative advantage in certain sectors can be highly misleading. One way of circumventing this problem is to use more detailed data at the product level, which includes information on both the level and type of production activities within each country. Using data from the Reed Electronics Production Data Set (REP) Assche and Gangnes (2007) use the methodology applied by Rodrik (2006) and Hausmann et al. (2007) to construct an index of technological sophistication for the electronics industry. They find no empirical evidence to suggest that China is a positive outlier in terms of the sophistication of its domestically produced electronics; rather they find that it is exactly where one would predict given its level of development. Ferrantino et al (2007) examine the classification of trade in advanced technology products between China and the US. Using micro level data they find that the processing trade has accounted for virtually all of the increase in China’s trade surplus with the US in these products since the 1990s. They also note that although China exports high tech products under similar product headings as the US, they generally command a lower price than equivalent US products. This is consistent with the results of analysis carried out by Schott (2008) who examined data on relative export prices by industry for a range of countries. He observed that China’s exports trade at a significant discount relative to those of OECD countries in the same product classification and that this discount appeared to be increasing over time. 90 Koopman et al (2008). 52
  • Schott concluded that competition between China and the developed economies may be less direct than the product mix of their exports implies. He speculated that this is due to developed countries responding to competition from China by moving up the quality ladder into more sophisticated products within the same general category. He did caveat his analysis however, noting that his conclusions depended on the assumption that the premium commanded by OECD exports was down entirely to differences in product quality. In reality it may also reflect differences in production costs, the effects of exchange rate movements etc. However Schott argues that the latter are unlikely to be the dominant factor, as we would expect to see China driving all competition out of the market if it were the case. Chinese policy towards the processing trade is currently somewhat ambivalent. On the one hand it is a highly successful sector which generates a large number of jobs, on the other hand, as this section has shown relatively little of the value added goes to the domestic economy. In the longer term, both India and China aspire to move into the design, development and production of more sophisticated products. Whether they will be able to do so is crucially dependent on the performance of their education and innovation systems, which we now turn to in the following sections. 3.2 Education in India and China “A book is worth a house of gold.” Chinese Proverb Chinese and Indian higher Education has Expanded Both China and India have historically had a strong cultural emphasis on education, both at the private and government level. Since the 1990s government spending on education has been growing at 12% a year in India and 16% a year in China, of which roughly a fifth goes towards higher education. China and India’s higher education systems now rank alongside that of the United States in terms of scale. However, as a share of GDP total education spending is still lower than in most developed countries. ●● India spends 4.9% of its GDP on education, while China spends 4.5% of GDP. ●● The average in OECD countries is 5.7%. ●● Non-government spending on education is a relatively high proportion of the total at 40% in China and 25% in India.91 91 Chinese Statistical Yearbook (2007), World Bank (2008a), UNESCO (2007). 53
  • China and India: Opportunities and Challenges for UK Business Figure 3.5: Chinese and Indian Enrolment in Higher Education Enrollment in Higher Education Institutions 20,000,000 India China 18,000,000 16,000,000 14,000,000 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0 1980 1990 2000 2006/07 Source: MHRD Annual Report 2007-08, China Statistical Yearbook 2007 Prior to independence, higher education in India was available only to an elite few, with the country having less than a million students enrolled in 500 colleges and 20 universities across the country. Subsequent reforms led to a huge expansion in higher education. Today there are over 12m students enrolled in 416 universities and 20,677 colleges.92 The expansion in China’s higher education system began in the mid to late 1990s; with a series of policy initiatives aimed at expanding both the numbers of institutions and enrolment rates. The latter in particular has increased dramatically, from roughly 1m at the beginning of the 1980s, to over 17m by 2006/07 (overtaking India in 2004). Roughly 20% of students in both countries study commerce, economics or management related courses. China’s main focus however is on engineering and technical courses, which cover 36% of all enrolments. In India it is arts subjects which account for the largest proportion of enrolments, at 45% of the total, followed by sciences at 20%. 92 Indian Ministry of Human Resources and Development (2008), Annual Report 2007-08. 54
  • Figure 3.6: Chinese and Indian Higher Education by Subject India (2004/05) China (2006) Science Law Others Commerce Economics Science Medicine Engineering/ Technical Education Medicine Law Literature Education Others Engineering Arts Mmgt Source: Statistical Abstract India (2007), China Statistics Yearbook (2007) Time series data on the breakdown of Chinese and Indian student enrolment by field of study is limited. What is available suggests that in general these proportions have not changed dramatically over the last ten years. The exception being the study of sciences in China, whose share of enrolments declined from 11% in 1994 to 6% in 2006. A number of researchers have challenged the figures for Chinese and Indian graduate numbers in specialist areas such as engineering, suggesting that official statistics are not comparable. Gereffi et al (2008) argue that once differences in the definitions are taken into account, the gap between the number of engineers produced in the United States versus those in India and China is smaller than commonly reported. Regardless, the numbers of students in higher education in China and India reflect their huge populations; rather than a high level of engagement in tertiary education. As Figure 3.7 below shows, when calculated as a proportion of the relevant age group, tertiary enrolment rates in China and India are less than half those in the advanced economies such as the UK. 55
  • China and India: Opportunities and Challenges for UK Business Figure 3.7: Comparison of Enrolment Rates in Tertiary Education 90 1992 1997 2002 2006 80 70 60 50 40 30 20 10 0 China India East South UK US France Germany Japan Asia Asia Source: World Bank EdStats Database. Data were not available on higher education in Germany. Thus while their graduate populations are large in terms of absolute numbers, for the foreseeable future China and India’s economies will remain dominated by low skilled labour. The World Bank forecasts that by 2030 the share of skilled labour in the working population will be just 8.3% for China and 6.2% for India. This is compared to a figure of 14% for the world as a whole and 40% in the high income countries. Table 3.2: Estimates of Skilled and Unskilled Workers Supply of Skilled and unskilled workers (millions) unskilled Skilled total 2001 2030 2001 2030 2001 2030 world 2674 3545 403 598 3077 4144 high-Income Countries 327 276 154 183 481 459 developing Countries 2347 3269 249 415 2596 3684 East Asia & the Pacific 988 1163 71 117 1060 1279 of which China... 740 816 33 54 773 870 South Asia 589 925 42 81 632 1005 of which India... 441 653 32 59 473 712 Europe & Central Asia 195 192 41 41 236 233 Middle East & North Africa 87 144 32 61 119 205 Sub – Saharan Africa 293 573 20 44 313 617 Latin America & the Caribbean 194 273 42 72 236 345 Source: World Bank Global Economic Prospects (2007a) 56
  • This creates a challenge for China and India in that while they aspire to move up the value chain, the majority of job creation over the next thirty years needs to be in low skill activities. As a result a number of analysts argue that China (for example) should focus on strengthening its processing trade to make it more competitive, rather than trying to shift into more sophisticated sectors. BOx 3.1: VOCAtIONAl tRAININg IN ChINA ANd INdIA93 The vocational education system has been expanding in China in terms of graduate numbers even while the number of schools and staff has decreased. In 2005 there were 2,855 technical schools with 20,400 staff in China, down from 4,521 schools and 33,700 staff in 1995. However over the same period the numbers of graduates increased from 68,000 to 69,000 and new enrolments rose from 74,000 to 118,400. These results reflect the lower priority given to vocational education in China as well as the transformation of many professional schools and colleges into normal universities in recent years. The Indian vocational training system is highly fragmented and even though it has limited capacity it is still underutilised, with approximately 6800 schools serving around 400,000 students. The government plans to place 25% of Indian secondary students in vocational education, although this target has not yet been met. In part this is due to the preference of employers for workers with strong basic academic skills rather than vocational qualifications and the desire by students to go on to higher education rather than entering into the workforce. But thE QuAlIty OF EduCAtION NEEdS tO IMPROVE In terms of raw numbers China and India may dominate the world’s supply of graduates. However, once differences in the quality of graduates between countries are taken into account, in particular their suitability for employment, a different picture emerges. Figure 3.8 below details the findings of McKinsey’s (2005b) widely used survey of HR professionals in multinational companies, which asked “Of 100 graduates with the correct degree, how many could you employ if you had demand for all?” From these results they then imputed the potential supply of ‘suitable’ professionals for a range of countries. 93 Source: OECD (2008b), World Bank (2008c). 57
  • China and India: Opportunities and Challenges for UK Business Although to some extent skewed by the requirements of multinational firms, these results provide strong evidence to support the conclusion that despite the expansion in graduate numbers; China and India’s supply of high skill professions is actually quite low. The main barriers to employability highlighted by the survey included: ●● Poor language proficiency, primarily in terms of English skills. ●● Overly narrow education, such as too much emphasis on theory and not enough on broader skills. ●● Cultural barriers, which hinder integration into multinational firms. In general these problems were more prevalent for Chinese applicants than Indian ones. This is reflected in the proportionately higher employability of the latter. 58
  • Figure 3.8: Supply of Skilled Professionals in Selected Countries Engineers Analysts Germany 80% Germany 80% Japan 20% Japan 16% UK 80% UK 80% US 81% US 80% India 25% India 15% China 10% China 10% 0 500 1,000 1,500 2,000 0 500 1,000 1,500 2,000 2,500 3,000 Finance/Accounting Generalists Germany 80% Germany 58% Japan 10% Japan 5% UK 80% UK 70% US 81% US 60% India 15% India 10% China 15% China 3% 0 500 1,000 1,500 2,000 2,500 0 2,000 4,000 6,000 8,000 10,000 Life Sciences Support Staff Germany 81% Germany 60% Japan 21% Japan 5% UK 80% UK 80% US 81% US 60% India 15% India 5% China 10% China 5% 0 200 400 600 800 1,000 0 20,000 40,000 60,000 80,000 100,000 Suitable Unsuitable Source: McKinsey Global Institute (2005b). Figures in percentages are the proportion of total supply in that occupation deemed ‘suitable for employment’. 59
  • China and India: Opportunities and Challenges for UK Business These findings are consistent with a more recent survey of global manufacturers carried out by Deloitte (2007). This found that whilst their technical and mathematical skills were often adequate; Chinese and Indian workers perform poorly in terms of general skills such as leadership and team working. The survey also highlighted the relative strength of Indian workers compared to their Chinese counterparts, with fewer difficulties reported in six out of the eight skill areas. Figure 3.9: Skills Gaps in Chinese and Indian Workers China India Leadership Team Work English Problem Solving Managerial Reliability Technical Mathematical 0% 10% 20% 30% 40% 50% Source: Deloitte: Innovation in Global Markets, Annual Study 2007 The top level figures mask significant variation in the quality of graduates from Chinese and Indian institutions. The Indian Institutes of Technology (IIT) have earned a world class reputation, but produce only a few thousand graduates each year, compared to over 200,000 from the second tier Indian institutions94. A recent survey of multinational engineering firms in China found that they targeted the same top tier institutions, outside of which the quality of graduate engineers produced was considered to drop off dramatically.95 Gereffi et al (2008) argue that these results are illustrative of a trade off in that the rapid expansion of higher education in India and China appears to have come at the expense of average quality. In India for example, two thirds of the increase in enrolments in the period 2000-2006 were provided by private-unaided institutions; which are subject to much lower levels of regulatory oversight than public ones.96 An alternative approach to thinking about the supply of skilled labour in China and India would be to look at how many of their graduates go on to obtain 94 World Bank (2008a) quoting Puliyenthuruthel, J. (2005). 95 Gereffi et al (2008). 96 Figures based on World Bank (2008a) Country Summary of Higher Education – Table 4. 60
  • Masters or PhD level qualifications. This provides an indication of how effective they have been at translating the expansion in their graduate numbers into highly skilled innovators and professionals. BOx 3.2: CASE Study – BENOy Benoy is an UK originated firm providing architectural, planning and design services, with a team of nearly 400 people working in offices in the UK, Hong Kong, Shanghai, Singapore and Abu Dhabi. The company entered into the Chinese market in 2001 on the back of a contract in Hong Kong, which required staff on the ground to support the client. This became a springboard for further expansion into China and the rest of the region. Their introduction to India was less conventional, arising from business contacts built up by its Chairman during a series of lecture tours. This helped raise the company’s profile amongst industry executives in India, without requiring a substantial commitment of resources. Like many businesses operating in China and India, Benoy has found that people with apparently sound technical qualifications often lack the required skills. It combats this with extensive training and support, not just for its own staff but also those in the companies it works with. Although this has made their employee’s attractive recruitment targets for other firms, the Hong Kong office has relatively low staff turnover. Benoy attributes this to a business culture which is much more open and less hierarchical than their local competitors, with greater opportunities to participate across the whole range of the business (both locally and internationally). The company’s growth in China and India has allowed it to build on its experience in the UK and expand its product offering. Innovations developed for the more experimental type of projects favoured in China and India, are fed back into work in the UK. More importantly they have helped it establish itself as a global brand, with a strong reputation for quality. On the back of this Benoy is now seeing a flow back of business opportunities to its UK operations. In India, of the 2.6m people who graduated from higher education institutions in 2003, roughly a fifth (540,658) were awarded a masters level qualification. By contrast while 3.8m people graduated from Chinese higher education institutions in 2006, only 6% (219,655) obtained a masters or equivalent.97 97 The picture is reversed at the Doctorate level with China awarding 36,247 (1%) PhDs in that year, compared to 17,898 (0.7%) in India in 2004/05. Chinese Statistical Yearbook, Indian University Grants Commission Annual Report 2005-2006, Selected Education Statistics India 2004-05. 61
  • China and India: Opportunities and Challenges for UK Business As with their undergraduate output numbers, these figures need to be put into the context of China and India’s huge populations. Of the 446,195 UK residents who graduated in 2006/07 roughly a quarter (119,355) were awarded a masters or equivalent. Put another way, the uK’s per capita output of masters’ level graduates is six times that of India and China.98 thE dEMANd FOR tAlENt IS StIll gROwINg Despite the rapid growth in graduate numbers, businesses operating in China and India increasingly report shortages of key talent as a major barrier to their future growth. These shortages are most acute at the managerial level, with middle managers who understand both global markets and the domestic markets in extremely short supply. In their recent survey of business executives, McKinsey (2008a) found that a lack of managerial talent was the biggest barrier to Chinese based companies’ ability to expand into global markets; 44% of executives citing this as a problem, well ahead of the next biggest barrier capital constraints (at 25%). In their survey of manufacturers Deloitte (2007) found that roughly a quarter of executives described hiring qualified workers in China and India as ‘very difficult’. Even more problematic however was keeping hold of such workers, with 30%-40% of executives reporting serious difficulties in terms of employee retention.99 Interestingly the EIU (2008) found that 57% of respondents in India felt it would be ‘significantly harder’ to recruit and retain talent over the next three years. Pressures in China were viewed as less severe with 33% of respondents expressing similar views, mainly due to the recent huge increase in the numbers of graduates entering the market. This contrasts with the Deloitte survey in which China was generally viewed as a more difficult environment for recruitment and retention than India. A common thread to these studies is that competitive compensation packages coupled with clear opportunities for advancement are critical to retaining staff. Young Chinese and Indian graduates are highly ambitious and well aware of their potential value in the market place. Intense competition for these workers has created a lively market, in which they are happy to regularly move from job to job in search of better pay and career opportunities.100 98 HESA Statistics 2006/07; in addition 3% (13,655) were awarded a Doctorate level qualification. 99 In general these problems were less pronounced for skilled production workers and engineers compared to those involved in managerial, R&D and sales/marketing activities. 100 There is some evidence that the recent slowing of the Chinese and Indian economies is starting offset this trend however. 62
  • BOx 3.3: BRItISh EduCAtION INStItutIONS IN ChINA ANd INdIA101 Increasing numbers of Chinese and Indian students are choosing to study abroad, with UK Institutions receiving 9,853 applications from prospective students in these countries in 2007. At the same time leading UK Universities are building on their strong reputation for academic excellence to set up campuses and courses abroad. For example in 2006 the University of Nottingham officially opened an overseas campus in Ningbo, near Shanghai (the university was first established and taking students in 2004). The University of Nottingham Ningbo was the first Sino-Foreign university in China with approval from the Chinese Ministry of Education (MoE). The campus is now home to almost 4,000 undergraduate and postgraduate students and more than 250 teaching and administrative staff. Before the Ningbo campus was set up the University of Nottingham entered into a number of student exchange agreements and joint research projects with Chinese universities. This meant that when Chinese law changed to allow foreign universities into China, Nottingham was well placed to rapidly enter into the market. The other British University which has entered into China is Liverpool, who in 2006 set up a campus in Suzhou in partnership with Xi’an Jiaotong University. Initially focusing on courses in computer science, electronics and IT, the graduate intake quadruped to 800 in only two years. The project was the result of over two years of careful negotiation with potential partners and the MoE, and also provides employment and research links to Suzhou industrial park. Both universities take the long view about these investments, having put in substantial effort in terms of building up a network of contacts from which they could draw advice and support. These ventures are being closely watched by the Chinese government which has closed the door on future projects until it has had time to assess their success. ANd CONStRAINtS ExISt ON SuPPly While China and India have made great strides in expanding their higher education systems, they still face a number of challenges in the longer term. This is both in terms of effectively utilising their existing supply of talent, as well as increasing it sufficiently to meet the demands of their rapidly growing economies. In the short term there is a geographic mismatch between the demand for skilled labour in India and China, and its supply. The bulk of the demand for 101 Source: Agora (2007). 63
  • China and India: Opportunities and Challenges for UK Business skilled labour is in fast growing regions such as Guangdong or Bangalore, but graduates themselves are more dispersed. In China for example roughly 60% of its 3.7m graduates in 2006 were produced outside its top ten university cities/regions102. Using proximity to international hubs as a proxy for availability to the global labour market, McKinsey (2005b) found that only a quarter of Chinese graduates lived in a city or region with an international airport. Of the remainder 34% were willing to move for a job, suggesting that half of Chinese graduates were ‘accessible’ to multinational companies in China. Indian graduates on the other hand were found to be more concentrated around international hubs, with 47% living in close proximity to an international airport, and of the remainder 68% were willing to move for a job. As a result three fifths of Indian graduates were ‘accessible’ to multinational companies in India. Anecdotally there is also evidence of a trend amongst young Chinese graduates choosing to remain in their home city or region, rather than move eastwards to the fast growing costal regions. From their perspective there is a lack of sufficiently well paid jobs in these areas to compensate for the higher costs of living and worse lifestyles. Thus while China may have overtaken India in terms of graduate numbers, the greater mobility the latter means that India may end up with a larger share of the effective global supply of skilled labour. That said, both face competition from countries such as Poland, the Philippines and Czech Republic, who although smaller in terms of population have much higher graduate suitability rates. In the medium term, shortfalls in China and India’s schooling systems may constrain the flow of students into higher education. Although enrolment in primary education is near universal in both countries, this has yet to translate into a comparable performance for secondary education, for which enrolment rates drop of significantly. (Figure 3.10) One cause of this is the rural-urban educational divide in China and India. For example in India the literacy rate amongst the urban population was 82% in 2004, but the comparable figure for rural areas was just 61%.103 World Bank analysis of net enrolment rates by level of education indicates the gap at primary education is relatively small, but starts to widen significantly thereafter. Given that 60%-70% of their populations live in rural areas, this suggests a significant proportion of China and India’s huge pool of human capital is not reaching its potential. 102 Chinese Statistical Yearbook. Here we take the top ten cities/regions as Beijing, Chong-qing, Guangdong, Hubei, Henan, Hunan, Jiangsu, Nanjing, Shanghai, Shaanxi and Tianjin. 103 Surveys such as Pratham (2007) also find significant deficiencies in basic skills. See also UNESCO (2004, 2007). 64
  • Figure 3.10: Comparison of Enrolment Rates 120 Primary Secondary Tertiary 100 80 60 40 20 0 China India UK US France Germany Japan Source: World Bank EdStats Database. Data were not available on higher education in Germany. A further constraint more specific to India is its gender gap in education. Literacy rates amongst Indian women are some 25 percentage points lower than for men, compared to an eight percentage point gap in China. Looking at enrolment rates by level of education, the gap in India is largest for secondary education during which absence rates for girls rise much more quickly than for boys. In part this reflects cultural factors constraining female participation in education, however analysis104 of the returns to education in India suggests that they are lower for women than men; this further reduces the incentives to invest in schooling and participate in the labour force. The implication of all of this is that China and India are likely to find that their ability to continually expand their skilled workforces will be constrained in the longer term. As we now discuss in Section 3.3 below, this has important implications for their ambitions to become innovation orientated economies. 3.3 Innovation in India and China “An idea that is developed and put into action is more important than an idea that exists only as an idea.” Siddhartha Gautama ¯ Innovation is a critical driver behind long term economic growth and has been identified as a key priority by the Chinese and Indian governments. As part of 104 See Kingdon G (1998). 65
  • China and India: Opportunities and Challenges for UK Business their aspirations to move up the value chain, their goal is to become originators rather than deliverers or assemblers of sophisticated goods and services. Here we define innovation to include both the creation and commercialization of state-of-the-art knowledge as well as diffusion and absorption of existing knowledge. For China and India the second form of innovation is particularly important, as in many areas they are well behind the global frontier of knowledge creation (and hence have more to gain from absorption of new ideas). It is also important to note that innovative activities are not restricted to new products – they also include innovations in processes (production, design, marketing, distribution, and financing) as well as innovations in business and organizational models. thE glOBAlISAtION OF R&d Until recently, the technological capabilities of businesses were far less globalised than other activities such as marketing and production. However firms now increasingly offshore R&D activities to other countries, with large multinational enterprises (MNEs) the main drivers of this process. Traditionally, cross-border R&D has largely involved adapting products to the needs of host countries through exposure to local conditions close to ‘lead users’. R&D activities were also undertaken abroad in order to support MNEs’ local manufacturing operations. Today, MNEs seek not only to exploit knowledge generated at home, but also to source technology internationally and tap into worldwide centres of knowledge. Intensifying global competition has forced companies to innovate and develop commercially viable products faster. At the same time the knowledge required to do so has become increasingly multidisciplinary and more broadly located; making innovation both more expensive and riskier. Innovation strategies therefore now depend on global sourcing to sense new market and technology trends. This has become a major reason for locating R&D overseas.105 This process has been developing over recent years. A European Commission survey of companies that had recently off-shored R&D found that nearly 70% had increased their R&D off-shoring over the last five years106 and almost 75% intended to do so in the next five years. While some companies perceived internationalised R&D as complementary to domestic R&D, in other cases it came at the expense of R&D at home. The main benefits of R&D off-shoring were found to be: ●● Increased cost efficiency in the innovation process. ●● Improved learning about R&D conducted by other companies/institutions. ●● More rapid commercialisation and a positive impact on the firm’s innovation capacity. 105 MNEs’ geographic dispersion is also increasingly viewed as a basis of knowledge creation. 106 LTT-Tutkimus Oy (2007). The base year for the study was 2004. 66
  • Figure 3.11: Current Foreign R&D Locations 70% OECD Country non-OECD Country 60% 50% 40% 30% 20% 10% 0% nd e n st d Fi ralia Fe or d et ra y rla n Ire nds in P and Ta d st i Is ia Th ore l ai a ng es Ch m an a I n G na a Si rm a ap y e ly Sp zil lg in Sw Sw ium Au ipe K e Ja e N de wa Fr in Ca ndi e d ng an e an itz ede Au rlan n N lan he tio pa or r Ita ra Be a c a do Ki at la Br l es ol n d St te d ni e U nit Ch U ia ss Ru Source: OECD (2006), Drawing on UNCTAD (2005) Figure 3.11 above reports data from UNCTAD’s survey of the largest worldwide R&D spenders. It shows that the majority of overseas R&D investments go to major OECD countries, although non-OECD countries are becoming increasingly important – with China and India ranked third and sixth respectively. However, surveys also indicate that emerging economies such as China and India are now considered highly attractive locations for future R&D related investments. According to official statistics, some 750 foreign R&D centres had been established in China by 2004, most of them after 2001. Over the same period over a 100 multinationals established R&D facilities in India. Their attractiveness is driven by; ●● Large and rapidly growing markets. ●● Large pools of qualified workers (measured in absolute terms). ●● Relatively low (though rising) labour costs. This shift towards emerging countries is expected to continue as demonstrated by the findings on future R&D investments in UNCTAD’s survey. Figure 3.12 below reports the results for a range of countries – China was most often mentioned location followed by the United States with India in third place, well ahead of Japan and the UK. 67
  • China and India: Opportunities and Challenges for UK Business Figure 3.12: Most Attractive Foreign R&D Locations 70% OECD Country non-OECD Country 60% 50% 40% 30% 20% 10% 0% China United States India Japan United Kingdom Russian Federation France Germany Netherlands Canada Singapore Chinese Taipei Belgium Italy Malaysia Korea Thailand Australia Brazil Czech republic Ireland Israel Mexico Morocco Norway Poland Romania South Africa Spain Sweden Tunisia Turkey Vietnam Source: OECD (2006), Drawing on UNCTAD (2005) This is confirmed by a more recent study by the Economist Intelligence Unit (2007) of more than 300 senior executives. This identified India (26% of respondents), the United States (22%) and China (14%) as the most attractive overseas locations for R&D. The Asia-Pacific region in particular is expected to attract more offshore R&D over the next three years (30% of respondents planned a substantial increase in their investment there). whERE dO ChINA ANd INdIA CuRRENtly StANd ON INNOVAtION? Both China and India have increased their R&D expenditure significantly in recent years. According to the OECD, by 2005 China was the largest spender on R&D (measured at PPP) amongst the non-OECD countries, and ranked worldwide only behind the US and Japan107. On the same basis, although lower than in OECD economies, India’s R&D expenditure was higher than comparable countries such as Russia and Brazil. However while their R&D activity is large in absolute terms, China and India’s R&d intensity is low. As Figure 3.13 below shows, R&D spending as a percentage of GDP and the numbers of researchers per million of population are well below those found in the advanced economies. 107 When measured at market exchange rates China’s R&D spending is the sixth largest worldwide. 68
  • This is backed up by industry level data. According to Chinese official statistics the R&D intensity of its manufacturing sector relative to value added is just 3.2%, compared to 7.2% in the UK and 8.5% in the US. For high tech sectors the gap is even larger, with China’s R&D intensity of 5.6% less than a fifth of that found in the UK (27.6%) and US (29%).108 Figure 3.13: R&D in Selected Countries, 2004 (total gross domestic expenditure on R&D in purchasing power parity dollars) 5,800 4,800 researchers per million population United States Japan 3,800 Russian Fed. France Korea, Rep. of 2,800 Germany United Kingdom 1,800 China 800 Brazil India –200 0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 R&D expenditure as a percentage of GDP Source: World Bank (2007b) – Calculated from R&D as percentage of GDP and GDP in purchasing power parity (PPP) terms, data from World Bank (2006d). Note: The size of the bubbles represents the gross amount spent on R&D in 2004 in PPP terms. Looking at the outputs from the innovation process, applications to the Chinese Patent Office have increased significantly since the late 1990s, with India’s starting to pick up over the last few years. While in China both residents and non-residents have been driving this trend, in India it is the latter who have been behind the recent increase (Figure 3.14). 108 Source: Chinese Statistics on High Tech Industries. 69
  • China and India: Opportunities and Challenges for UK Business Figure 3.14: Patenting Trends in India and China Chinese and Indian Patent Applications 100,000 90,000 China Residents China Non Residents 80,000 India Residents 70,000 India Non Residents 60,000 50,000 40,000 30,000 20,000 10,000 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source: WIPO Patent Statistics database However as Table 3.3 shows, when benchmarked against their populations China and India’s innovation output is low. This is not just relative to the OECD economies, but also to comparator countries such as the Russian Federation and Brazil.109 Table 3.3: Innovation Output in Selected Countries Country Scientific Articles per million triadic patent families per population million population China 22.6 0.3 India 12 0.1 Brazil 47.9 0.3 Russian Federation 109.3 0.3 uS 725.6 55.2 uK 810.8 26.4 Japan 470.3 119.3 OECd Av. 440.5 43.9 Source: OECD Science Technology and Industry Scoreboard 2007, World Bank (2007b) 109 An important caveat to this is that in countries with poor IPR protection we might expect to see fewer patents filed, because companies would be concerned that their innovations would be expropriated. 70
  • Anecdotal evidence also suggests that R&D activity carried out in China and India tends to be process based rather than cutting edge research. In its survey of global R&D trends, the OECD (2008a) noted that much of the R&D related FDI into emerging economies such as China and India, has been driven by the need to adapt existing innovations to the local market, rather than developing new innovations.110 Thursby and Thursby (2006) examined the factors influencing multinational’s R&D location decisions. They found that 45% of efforts undertaken in ‘home locations’ were for new science, compared to 22% of those carried out in emerging economies. Concerns over the ability to protect IPR were highlighted as a key factor in multinationals reluctance to carry out ‘new’ research in these countries. BOx 3.4: CASE Study – FIBERwEB PlC Fiberweb is a UK listed company which produces high performance speciality non-woven fabrics. Its materials are used in a host of products, ranging from everyday items such as baby diapers and hygiene products through to specialist industrial items like protective clothing and filters. In 1999 it added to its range of European and North American production facilities with a factory in Tianjin, which started commercial production in 2001. Although low production costs were a factor behind the move, the company predominantly had an eye on China’s rapidly-growing market, as well as the need to be near their major customers (who were also setting up production there). In order to meet growing demand, in 2007 Fiberweb invested in a second production line in Tianjin. In contrast to the first facility, which was imported from a European supplier, this was manufactured and installed by a Chinese airlaid specialist. The decision to utilize a Chinese supplier was based on significantly lower investment costs, the opportunity to explore the use of Chinese technology suppliers and speed of response. Fiberweb’s experience is that Chinese firms are excellent at mastering fairly basic technologies (this capability was only partially present in China when they first set up there), but they also find that Chinese firms still only partially enjoy the capabilities to design and manufacture reliable, sophisticated technologies. In part this is due to a business culture which excels at speed of production and lowering costs, but has had less experience and demand for highly complex products, or especially for the reliability and robustness expected in Europe and North America. 110 The former is referred to as ‘home base exploiting’ R&D while the latter is ‘home base augmenting’ R&D. 71
  • China and India: Opportunities and Challenges for UK Business A Booze Allan Hamilton/INSEAD (2007) survey of international R&D investments found similar results. R&D facilities in home markets tended to have the complete range of innovation activities, whilst those abroad focus on development as opposed to core technology research. Access to the low cost skills base was found to be an important driver for future R&D investments in both China and India. While market access was a key driver for R&D investment into China, access to qualified workers was the next most important factor for India. In developed countries such as the UK a combination of market access and technology clusters were the main motivators. The authors argue that this is indicative of companies focusing lower down the innovation chain in China compared to India or the advanced economies. thE CONStRAINtS ON ChINA ANd INdIA’S INNOVAtION PERFORMANCE Given the determination of the Chinese and Indian governments to improve their country’s innovation performance, it is likely that they will continue to devote significant resources to increasing their R&D and innovation activity. Whether these efforts will be successful is dependent upon a number of broader structural and institutional factors, including; ●● Access to Finance ●● Public Procurement ●● Technology Standards ●● Information Infrastructure ●● Competition between firms ●● Education and skills ●● Property rights Working though each of these in turn – Access to Finance Finance is vital to allow firms to adopt and develop new technologies and business practices. However even in developed markets accessing financing for innovation is a challenge, particularly in the case of smaller enterprises, start- ups and innovative grassroots projects. As we highlighted in Chapter 2, business access to finance is a serious problem in China. In particular: ●● The financial system is dominated by state owned banks whose main business consists of loans to other state owned enterprises. 72
  • ●● Capital markets are undeveloped and lack the necessary expertise and regulations to support an adequate venture capital system. Although it has a well-developed public and private equity market, India faces similar difficulties in terms of funding seed and early stage projects.111 ●● In 2005, early stage funding accounted for just 13% of the deals by the venture capital and private equity industry112. In Dollar terms early stage deals accounted for just 4%-6% of investment by the venture capital and private equity industry. ●● Indian firms also rely disproportionately on internal funding for new investments, with 54% of new enterprise investments financed internally (compared to 15% in China). ●● India’s large number of small businesses, particularly in the textiles sector, tends to rely on internal or informal funding. Larger Indian businesses in more advanced sectors like electronics make greater use of commercial bank lending. Both China and India have initiatives underway which aim to improve business access to finance. In China, the Medium to Long-Term Strategic Plan for the Development of Science and Technology proposes to introduce several new funding mechanisms for ‘policy banks’ and commercial banks. Initiatives have also been introduced to increase access to funding for small high-technology SMEs and start-ups. In India schemes such as the Credit Linked Capital Subsidy scheme for upgrading technology in small-scale industries are also underway. However, government schemes such as the domestic venture capital firms set up in China are unlikely to provide a significant boost to innovation. These tend to be run by government officials who do not always have the necessary managerial, commercial and technical skills. Public Procurement Government can have a role to play in terms of using public procurement to stimulate innovation. In the EU economies, around 16% of GDP is spent on public procurement and it is increasingly recognised as a source of innovation dynamics at the European and national levels. Although the size of government is smaller than that in other emerging or developed economies public procurement is set to increase rapidly in India and 111 After the US India has the second highest number of publicly listed firms. Although the shares of many of these firms are not actively traded on the stock exchanges, their liquidity has improved considerably in recent years. Data in bullets is drawn from World Bank (2007b). 112 Note that early-stage finance includes seed capital as well as initial finance required for start-up operations to commercialize an innovation. Although there is no clear definition, early-stage finance is usually classified by amount (say, less than $3 million), the life of the firm (say, less than five years), or the sequence of external funding available to the firm (say, first two rounds of external finance). 73
  • China and India: Opportunities and Challenges for UK Business China113. In China the aforementioned National Medium and Long-term S&T Plan has explicitly targeted the use of procurement to stimulate innovation. In India, the government plans to expand the scope of programmes such as SPREAD (Sponsored Research and Development Programme) to a wider range of activities and build on the lessons it has learned from its space programme. However; ●● The public sector is overly dominant in domestic R&D, accounting for 70-80% of the total compared to less than 25% in China. ●● These programmes are also dominated by sectors such as defence, with less than 20% going towards civil research.114 The challenge for China and India is to ensure that they move away from overly directive policies for stimulating R&d. Development and implementation of an innovation-oriented procurement policy requires significant expertise and co-ordination across government. Innovation through public procurement cannot be ‘ordered’; rather, it has to be the result of a sophisticated articulation of demand for innovative products or services and a transparent competitive process. Equally, to be successful these policies must not close off China and India’s public procurement to foreign firms. Neither China nor India has yet joined the WTO Government Procurement Agreement (GPA)115. Integration into the GTA would not only allow China and India to benefit from the expertise of foreign firms and stimulate competition, but also open up opportunities for their firms in overseas markets. However their governments will need to absorb best practice policy from overseas, as well as ensure that they adapt their processes to fit local needs.116 Technology Standards The impact of the use of technology standards depends on the relationship with competition. ●● They have frequently been used to protect domestic industries from foreign competition. ●● But have also enhanced competition, by making possible economies of scale and promoting inter-changeability, compatibility and co-ordination. Technological standards have been gradually embedded in Chinese policy. They were initially seen as part of the industrial development strategy and were integrated in major R&D programmes. But when China became a member of the 113 For example public procurement is just 2% of GDP in China, compared to 10% in developed countries and 16% in the EU. 114 World Bank (2007b). 115 Although China has announced it will start negotiations. 116 See the Public Services Industry Review (BERR 2008) for a discussion of these issues. 74
  • WTO they increased in importance. The recent policy priority given to indigenous innovation has nurtured the idea of using technological standards to enhance China’s domestic technological capabilities. The importance of technology and security to the ICT and BPO117 sectors has meant that standards have rapidly become embedded into Indian business practices. The government has also been actively involved through legislation such as the 2000 IT Act. A similar pattern can be observed in other sectors such as biotechnology and pharmaceuticals where quality assurance is highly important. Both countries are striving to promote their own technology standards and to transform domestic standards into international standards. This is a goal that requires improving the ability of Chinese and Indian actors to take part in international standard-setting processes. Their size, the dynamism of their domestic markets and their rapidly developing technological capabilities give them a unique position in this regard. The challenge for China and India is to develop standards regimes that are in line with WTO regulations and do not eventually lead to distortions of national and international competition and thus stifle innovation. Information Infrastructure Obtaining and applying new ideas lies at the heart of the innovation process. Thus, the supply of information is a key driver of firms’ ability to create and absorb new innovations; this in turn is strongly influenced by: ●● Its availability. ●● The cost of obtaining it. ●● The ease with which it can be shared between collaborators. Electronic communication systems are at the centre of the information transfer process. International evidence shows a clear link between investment in ICT and productivity and profitability at the firm level. For example, the World Bank recently concluded “enterprises that use ICT more intensively are more productive, grow faster, invest more, and are more profitable”.118 The table below includes some key metrics which highlight the extent of the penetration of communication infrastructure in selected economies. It is clear from this that China and India’s information infrastructure still lags behind other economies. A key driver behind this is the sharp drop off in penetration for rural areas. 117 Business Process Outsourcing. 118 Qiang et al (2006). 75
  • China and India: Opportunities and Challenges for UK Business Table 3.4: Key Communication Metrics for Selected Countries Per 100 people China India uK Russian Korea Brazil Fed Mobile penetration 35.1 15 115 83.8 83 52.8 Broadband penetration 3.88 0.21 21.46 2.04 29 3.13 Internet users 10.4 5.5 55.4 18 70.5 22.5 Personal Computers 4.3 1.6 75.8 12.2 53.2 16.1 Source: World Bank Data and Statistics But as technology improves and more of their populations become connected through basic communication infrastructure, the opportunities for innovation and development in China and India, particularly at the micro and SME level, are significant. Education and Skills A critical enabling capability for innovation is education and skills, in particular human resources for science and technology (HRST) as; ●● Highly skilled people contribute to economic growth directly through their role in the creation and diffusion of innovations. ●● Those with science and engineering (S&E) skills contribute indirectly, by maintaining society’s store of knowledge and by transmitting it to future generations. Research has suggested strong social returns to education and close links between formal education and innovation capabilities. Even though innovation requires many non-research and non-technological skills, the tertiary education system plays a critical role in developing innovation capabilities and encouraging knowledge diffusion. As we discussed in the previous section; although China and India’s higher education systems produce millions of graduates a year, these numbers are small in comparison to their populations. Moreover these graduates often lack the necessary broader skills needed to become innovators. As a result China and India both face bottlenecks in their supply of HRST which will constrain their ability to increase innovation. In India, the focus has been on training science graduates, whereas in China the emphasis has been directed towards engineering. Lazonick (2007) argues that this has benefited China’s economic development. Indeed, because of this difference, he suggests that “China was much better positioned than India in the 1990s to absorb technology from the advanced nations and adapt it to indigenous industrial uses”. 76
  • Increasing formal education alone will not drive innovation. Innovating firms do not necessarily engage in the development of radical, new-to-the-world goods, services or processes. They may reproduce products already on the market, perhaps using off-the-shelf technology inputs, or they may make incremental improvements to existing products. This is not an easy or costless process because it requires learning and adaptation within the firm. In fact, innovation involves a range of activities such as tooling up, design work, developing prototypes and testing. These are a key function of vocationally trained personnel.119 Businesses have indicated that Chinese and Indian trained engineers lack important skills. A visit from members of the North American Chinese Semiconductor Association to China highlights some of these issues. While the group was impressed by the technical expertise of Chinese scientists and engineers, they noticed a lack of managerial, production and marketing skills. Indeed, “...the private technology enterprises in Zhongguancun and Zhangjiang science parks are typically started by graduates of China’s elite universities or employees of research institutes. These entrepreneurs may be technically talented, but they rarely have the knowledge of markets or the connections to customers needed to commercialize their products.” That said, similar criticisms are often made in many OECD countries (Arundel and Bordoy, 2006; Dosi et. al., 2005). In China and India, the reasons may have as much to do with the shortcomings of the higher and vocational education systems, as with skill mismatches in the job market for specific types of skilled labour. Competition between Firms The relationship between competition and innovation is complex. Product market competition encourages enterprises to innovate because the market rewards genuine creativity with extra-ordinary returns. This can then turn innovators into powerful incumbents, whose competitors have an incentive to supplant them by producing a superior alternative – thereby creating the next generation of products.120 Openness of the economy to external market forces through trade is also important for stimulating competition and hence innovation. As countries integrate more into global markets there is increased pressure on domestic firms to develop new innovations, while inward investment can also bring new ideas and business processes. 119 See Toner (2007), Tether et al. (2005). 120 The classic characterization of innovation dates to Joseph Schumpeter’s (1975 [1942]) notion of ‘creative destruction’. 77
  • China and India: Opportunities and Challenges for UK Business Intense or distorted competition can also suppress innovation. If a firm expects its innovations to be rapidly imitated by competitors, either through their own R&D or IPR infringement then their incentives to innovate are reduced. Equally, if labour and business regulations impede the setting up or closing down of enterprises this reduces competition and reduces the resources available to successful firms.121 While China and India have significantly opened up their economies and are working to reform their business and labour laws, surveys of the business environment such as those detailed in Chapter 2 indicate there is still much more that can be done. In particular as we note below, they lack a solid framework for protection of property rights to encourage healthy competition through innovation. Property Rights The discussion above relates to the various supporting institutions and resources needed to foster and promote innovation. However if an innovator expects their fruits of their work to be expropriated, their incentives to innovate are severely eroded. As a result, China and India’s poor performance on Intellectual Property Rights (IPR) is the most serious obstacle to them becoming innovation orientated economies. This lack of IPR protection in China and India impacts on their ability to innovate in four main ways; ●● Foreign firms hesitate to transfer technology to these countries; the threat of IPR infringement may even limit their willingness to produce in, or even export goods to them. ●● Concerns about IPR protection have reportedly reduced Chinese and Indian inventors’ propensity to commercialise the results of their R&D. ●● IPR infringements combined with low standards of quality, can also affect the national and international reputation of Chinese and Indian firms (notably when poor quality affects the health and safety of consumers). ●● It impedes the transfer of research results from public research organisations to business enterprises and from foreign firms to the Chinese and Indian economies. At the national level this issue has been recognised by the Chinese and Indian governments. When China joined the WTO in 2001 it became a signatory to TRIPS122 and brought its patent system in line with international standards and conventions. India’s legal framework has been in line with TRIPS since 2005. 121 For a more detailed discussion of the relationship between competition and innovation see OFT (2007). 122 Agreement on Trade Related Intellectual Property Rights. 78
  • Despite this, problems with IPR protection are one of the most commonly cited business concerns with regard to India and China. In its surveys of the Chinese and Indian IPR systems the UKIPO (2008a) highlights that it is enforcement rather than the laws themselves that are the problem, for example in China they find; ‘There is a difference between having adequate laws and achieving their effective enforcement; in other words, it is a question of theory and practice. Few people doing business in China would deny the extent of China’s IPR enforcement shortcomings; but at the same time most believe the Chinese authorities are in earnest in trying to improve matters and some experts are convinced that real progress is being made.’ India faces similar problems and although progress is being made, issues around implementation remain. The challenge is that IPR infringement in China and India is characterised by a large number of small players, making enforcement costly and difficult for those affected. Indeed, one IPR protection expert we spoke to voiced the opinion that infringement has become so widespread that their governments will never be able to stamp it out. These problems are compounded by non-transparent, bureaucratic court procedures which can take years to reach resolution. In China concerns are voiced about the lack of independence of the legal system (particularly at the regional level) which is subordinate to government. By contrast the Indian judicial system is regarded as relatively balanced and impartial in its judgements of IPR cases. Piracy over the internet of films, music, books and software is also particularly severe. According to the Business Software Alliance’s Global Software Piracy Study for 2006 (published in May 2007) India’s software piracy rate was 71 per cent, compared with the Asia Pacific average of 55 per cent. Although there are heavy penalties for software copyright infringement, the UKIPO (2008b) notes that: 123 ‘...public education lags considerably behind the law: it is believed that the vast majority of illegal copiers are ignorant of their offence or wholly apathetic to it because they are unlikely to be caught.’ However, as these two economies become increasingly innovation orientated the situation with regard to IP enforcement is likely to improve. Both public bodies and businesses in China and India are increasingly aware of the detrimental effects of IP infringement on their growth prospects. For example it has been estimated that 95% of IPR cases in China are now brought by Chinese businesses.124 123 ‘Intellectual Property Rights Primer for India: A guide for UK companies’ produced by Hunter Rodwell Consulting in partnership with Rouse & Co. International and sponsored by UKTI and UKIPO. 124 ‘Intellectual Property Rights Primer for China: A guide for UK companies’ produced by Hunter Rodwell Consulting in partnership with Rouse & Co. International and sponsored by UKTI and UKIPO. 79
  • China and India: Opportunities and Challenges for UK Business This trend is being reinforced by the fact that as they have become more global in their outlook, the exposure of Chinese and Indian businessmen to international business norms has increased. As a result they have become steadily more vocal in demanding government action to address the problems in China and India’s fast growing regions. 3.4 Chinese and Indian Businesses in the Global Economy “Do the difficult things while they are easy and do the great things while they are small. The journey of a thousand miles must begin with a single step.” Lao Tzu A striking feature of many Chinese and Indian businesses is the degree to which they are international in their outlook. Policies aimed at encouraging export led growth and inward investment from foreign corporations, have exposed both small and large firms to the intensely competitive demands of the international market. ExPORt ORIENtAtEd REgIONAl CluStERS hAVE BEEN CENtRAl tO ChINA ANd INdIA’S dEVElOPMENt A key driver behind China and India’s rapid growth has been their creation of export orientated regional clusters specialising in particular products or activities. Although the development of industrial clusters is hardly a new phenomenon125, they have been critical in allowing these countries to build globally competitive industries. Clusters are commonly defined as a geographically co-located group of interconnected companies associated with a particular field126. They can take a number of forms ranging from a ‘hub and spoke’ type form in which a giant manufacturer develops a halo of supporting businesses, through to a proliferation of small and medium sized enterprises in the same region who produce the same type of products127, for example; ●● India’s largest car manufacturer Maruti Sazuke128, has deliberately fostered an extensive local supply chain around its Delhi factory; roughly 60% of its first tier suppliers are based in the National Capital Region (NCR). ●● In Zhejiang province China, clusters of SMEs in towns like Datang and Zhilli specialise down to the level of producing particular types of garments such as socks or children’s clothing.129 Clusters can arise for a number of reasons; Marshall’s (1920) seminal work identified the key role played by factors such as a shared labour pool and 125 For example Jingdezhen in China has been a centre for pottery production for over a thousand years. 126 This can extend vertically down the supply chain from end product manufacturers through to component manufacturers, as well as laterally to suppliers of complimentary products or supporting services. 127 See Porter (1998). 128 Formerly Maruti Udyog. 129 Okada (2007), Lifang et al (2006). 80
  • knowledge spillovers, as well as more practical concerns relating to availability of raw materials, good transport links and proximity to a large group of customers. More recent work has also highlighted the importance of other factors such as FDI flows, local entrepreneurial culture and the presence of educational and research institutions in encouraging cluster formation.130 National and local government policies have played an important part in promoting particular clusters of industries or types of economic activity in China and India. This can be through policies such as: ●● Preferential tax treatment. ●● Favourable regulatory environment. ●● Improvements in infrastructure. For example, prior to its emergence as an IT centre Bangalore already had a long history in science and engineering; with the Indian Institute of Science established there in 1911, as well as being home to the largest number of engineering colleges in the country. In 1978 an industrial park called Electronics City was founded in the southern suburbs, with the dream of building on the city’s emerging reputation as an electronics centre and establishing Bangalore as the ‘Silicon Valley’ of India. However it was the construction of the city’s first earth station by STPI131 which provided the critical impetus to the city’s development as a hub for IT enabled services. This gave international companies reliable high speed connectivity between their operations in Bangalore and the rest of the world, allowing them to easily access the region’s large pool of relatively low cost skilled labour. Alongside international companies with operations there, Indian firms such as WIPRO and Infosys grew into large operations in their own right. As a result, today Bangalore accounts for roughly a third of India’s software related exports. In China, reforms of the household ‘Hukou’ system and relaxation of the rules governing migration between rural and urban areas in the 1970s and 80s, freed up a large number of rural workers to move into its coastal regions; which were developing into manufacturing hubs.132 These regions benefited from a range of deliberate government policies including the establishment of special economic development zones133. Within these, foreign investment receives preferential treatment and firms benefit from various incentive schemes. 130 For a useful survey of this literature see Okada (2007). 131 Software Technology Parks of India (STPI) is an autonomous society which was set up by the Indian Ministry of Information Technology with the purpose of promoting software exports. 132 See Wang et al (2008). 133 The original Special Economic Zones (SEZs) were designated as Zhuhai and Shantou in Guangdong Province, Xiamen in Fujian Province and the entire province of Hainan. 81
  • China and India: Opportunities and Challenges for UK Business The effect of these policies has been a steady rise in the share of China’s exports originating from these areas. In 1995 they accounted for less than 6% of exports, by 2005 this had risen to 25%. Over time, the number and types these zones has proliferated. In some cases smaller enclaves within larger zones receive differential treatment in order to promote particular high tech sectors or industrial activities. As a result they also dominate China’s production of Advanced Technology Products.134 India also has a number of designated special economic zones; however they are less important to the national economy. Official statistics state that Indian SEZ’s generated 666bn Rupees worth of exports in 2007-08, equivalent to roughly 10% of total merchandise exports. In terms of their sectoral composition they are dominated by exports of electronics hardware and software, which account for roughly a third of the total.135 BOx 3.5: CASE Study – AwI gROuP136 AWI Group is a UK originated SME specialising in steelwork and steel-framed buildings. It first began exporting to China in 1994, particularly marketing to foreign companies setting up operations there. Following an early foray into Beijing and Shanghai via an agent, the company readjusted its strategy and concentrated its efforts on Shanghai – first through a representative office and later a Wholly Owned Foreign Enterprise (WOFE). This allowed them to focus on the business opportunities around Shanghai and build up local contacts. Over time the business model evolved from exporting to China to include local production, with the company setting up a manufacturing base in Ningbo, Zhejiang province. This was selected for its facilities, lower manufacturing costs and access to export destinations. In addition they benefited from the fact that the Zhejiang is ‘twinned’ with Yorkshire & Humber, where their UK operations are based – this helped facilitate building business and government relationships. The early lesson they drew from this experience is that “...China cannot be considered as a single market. As an SME, we have to concentrate our resources and stay focused.” They also note that the constant updates to regulations (or their interpretation) in China can present serious operational barriers for firms. 134 Ferrantino et al (2008) estimated that in 2006 they accounted for 65% of China’s exports to the United States under this heading. 135 Indian Ministry of Commerce (2008) – Strictly speaking gems and jewellery are the largest category, however as we discussed above these are a highly erratic component in India’s trade. 136 Source: UKTI (2008) Opportunities for UK Business in China’s Regional Cities. 82
  • As a result of these factors the distribution of industrial clusters in China and India is highly uneven. As Table 3.5 and Figure 3.15 below illustrate, they are commonly found in China’s eastern coastal regions and India’s National Capital Region and south-western states. These are typically states with regional governments who were receptive to foreign investment and made early investments in education and infrastructure. From the perspective of UK business, the development of clusters in China and India is primarily important in terms of business to business transactions, rather than selling directly to consumers. Clusters act as hubs in global value chains which make it easier for firms to locate potential customers or suppliers of particular products. Nowhere is this more evident than in China’s huge wholesale markets, such as YiWu’s International Trade City; this is marketed as the world’s largest supermarket for trade buyers, with over 50,000 ‘selling booths’ operating in purpose built facilities; including international logistics companies on hand to facilitate delivery. Table 3.5: Regional Distribution of Selected Industries in India Region drugs Electronics Consumer Electronics Output (%) Employ. (%) Output (%) Employ. (%) Output (%) Employ. (%) North 17.33 15.76 28.97 27.9 38.63 34.66 …of which NCR 3.04 4 21.76 17.31 31.64 26.24 East 4.502 6.12 1.44 2.8 6.67 7.29 west 48.15 34.56 23.51 22.49 34.83 39.52 ...of which Gujarat 15.13 15.43 12.17 6.49 4.84 8.88 Maharashtra 25.92 16.47 9.3 15.38 26.98 27.14 South 30 43.66 40.98 43.09 18.47 17.48 …of which AP 9.86 9.04 8.88 10.1 1.7 2.57 Karnataka 4.25 4.89 15.46 20.04 9.67 6.44 Tamil Nadu 6.25 25.49 2.47 6.07 5.87 6.2 Source: Okada (2007) 83
  • China and India: Opportunities and Challenges for UK Business Figure 3.15: Regional Distribution of Selected Industries in China Source: Li and Fung Research Centre (2006) 84
  • But PROBlEMS FOR thIS MOdEl hAVE StARtEd tO EMERgE The model of using export orientated regional clusters to drive economic development has served China and India well; helping them build successful industries on the back of their huge supplies of low cost labour. However as they have developed further a number of serious challenges to this approach have emerged, including; ●● Exchange rate appreciation. ●● Rising Wages. ●● Rising non-labour costs. ●● Infrastructure congestion. At the macro-economic level, as countries become richer and more productive this generally leads to an appreciation in their real exchange rate. As a result, the gap between China and India’s labour costs relative to those in developed countries is expected to narrow.137 Rising costs of living and the shortages of key workers in faster growing regions are already pushing up wage demands from these workers; this in turn is having a trickle down effect on wages further down the skills spectrum. According to official statistics wage growth in China has averaged in the region of 14% – 15% over the last few years; once the appreciation in the Yuan is taken into account, this means that wages have been growing by roughly 18% a year in Dollar terms. A further threat to China and India’s role as a source of low cost manufactured goods has been the explosive rise in transport prices, which is itself partly a result of their own increasing demand for oil. It has been argued that when added to the effect of rising wages and other hidden costs, China’s low cost advantage in certain types of bulkier manufactured goods is almost completely eliminated.138 India’s exports of software and other IT enabled services are less susceptible to rising transport costs as they can largely be delivered through telecommunications. However they are also more skill intensive and so place greater demands on India’s supply of skilled labour. More broadly, the same factors which are impacting on China’s low cost exporters are a threat to the recent growth in Indian manufacturing over the last five years. These issues are most intense in China and India’s ‘first wave’ of regional clusters. These are already facing problems in that improvements in physical infrastructure cannot keep pace with the demands from rapidly growing 137 This is known as the Harrod-Balassa-Samuelson effect. 138 In 2000 the average cost of shipping a standard 40ft container from China to the US was roughly $3000, by early 2008 this had leapt to $8000 and when oil prices hit $150 per barrel the figure reached $10,000. CIBC World Markets (2008), McKinsey (2008b). 85
  • China and India: Opportunities and Challenges for UK Business companies. This has encouraged domestic and international firms to look further afield within India and China when making their location decisions. A recent survey of international companies commissioned by UKTI (2008) found evidence of a broad based relocation of manufacturing away from Shanghai and Beijing to China’s north-eastern and western interior regions. A similar pattern of behaviour can also be seen in India: ●● While 75% of manufacturers surveyed currently had operations near Shanghai, this was expected to fall to 21% within ten years. ●● Over the same period the number who expected to have operations in north- eastern China would double from 22% to 44%. ●● In India, 40% of manufacturers expected to have operations in Rajasthan within ten years even though none of them were currently active there. BOx 3.6: INFRAStRuCtuRE CONgEStION IN BANgAlORE Bangalore’s emergence as a hub for IT enabled services has seen the city grow dramatically, but has also put tremendous pressure on the city’s infrastructure, which has never managed to keep up with its breakneck economic growth. Power outages, water shortages, and traffic congestions are now commonplace, with firms increasingly having to rely on their own infrastructure; setting up power generators, employee bus services and even running their own hotels. While this is hardly a new problem (concerns about Bangalore’s infrastructure were already being raised in 1996), companies have become increasingly concerned about the constraints it places on their future growth. In 2004 and 2005, local executives threatened to boycott a government run technology fair in protest, citing evidence that the number of new companies setting up operations in the city had dropped 40% since 2003 due to its reduced attractiveness as a business location. Since then major employers such as Infosys and Wipro have chosen to pursue expansion elsewhere in India, while cities such as Chennai and Hyderabad are increasingly attracting technology investors looking for good supplies of skilled labour and better infrastructure139. As a result smaller cities are expected to increase their share of sectors such as IT-BPO to around a third over the next ten years.140 139 For example see Navi Jadjou, Harvard Business Publishing http://discussionleader.hbsp.com/radjou/2008/09/ bangalore-in-2025-global-innov.html. 140 NASSCOM/AT-Kearney (2008). 86
  • whIlE ChINESE ANd INdIAN FIRMS ARE INCREASINgly glOBAl IN thEIR OutlOOK Thanks to policies encouraging increased openness to trade and foreign investment, China and India have benefited from growing inward FDI flows. However as they have become more global in their outlook Chinese and Indian businesses are now increasingly a source of outward investment flows.141 As Figure 3.16 shows, this is a relatively recent phenomenon, with the growth in China and India’s stocks of FDI starting to accelerate over the last six to seven years; with the US being the most favoured destination amongst the advanced economies (although thanks to our historical links there is a substantial amount of Indian investment into the UK). Figure 3.16: Chinese and Indian Outward FDI Flows Chinese and Indian Stocks Chinese and Indian FDI Stocks of Outward FDI ($m) in Selected Countries ($m) 120000 1,600 China India 1,400 100000 China India 1,200 80000 1,000 60000 800 600 40000 400 20000 200 0 0 1981 1986 1991 1996 2001 2006 UK USA France Germany Japan Source: UNCTAD, OECD A significant proportion of China and India’s FDI activity has also been directed towards developing and transition economies, for example; ●● Investment flows from China into Africa increased sevenfold in the period 2003-2006. ●● Russia accounted for half of India’s outward FDI during 2001-2005. ●● Both countries also invested substantial amounts in tax friendly locations such as Mauritius and the Cayman Islands.142 Much of this relates to state directed investment to secure access to energy and raw materials; the ten largest Chinese multinational enterprises by FDI stock are 141 Given our focus on business behaviour we do not consider the role of sovereign wealth funds in this section. 142 Sources: UNCTAD, MOFCOM, Indian Ministry of Finance. 87
  • China and India: Opportunities and Challenges for UK Business all state owned enterprises, of which more than half are in the resources sector. India’s investment in Russia is dominated by a 20% stake in the Sakhalin oil and gas field by the Oil and Natural Gas Commission (ONGC).143 While resource seeking is an important driver, the motivations behind a large proportion of other Chinese and Indian overseas investments instead reflect their global ambitions, including; ●● Improving market access. ●● Creating a global brand. ●● Enhance own capabilities. ●● Access to technology and R&D. ●● Improve global competitiveness. Surveys suggest that after securing supplies of key resources, the most important driver of Chinese and Indian outward FDI is to improve market access144. Particularly when entering into more mature markets in developed countries, Chinese and Indian firms it easier to secure market share through acquisitions. A related motivation is the desire by Chinese and Indian businesses to forge global brands. A classic example of this strategy is Levono’s acquisition of IBM’s personal computer operations. This lifted the company from the position of being barely known outside of China to the world’s third largest PC manufacturer. In order to do this, these firms are highly conscious of the need to enhance their capabilities; particularly with regard to securing access to specific skills and modern methods of production145. In other cases firms have sought to expand their portfolio of products through acquisition of patent rights or complementary service capabilities.146 Similarly a number of acquisitions have been aimed at securing access to advanced technology and R&d. This is cited as an important motivation behind the Shanghai Automotive Industry Corporation and Nanjing Automotive bids for various parts of Rover.147 Finally, intense domestic and foreign competition is driving efforts by Chinese and Indian firms to improve their global competitiveness. Arguably this was a key driver behind the scale enhancing merger of Arcelor and Mittal Steel which in turn prompted the decision by Tata Steel to acquire Corus. 143 OECD (2008c), UNCTAD (2004). 144 See for example McKinsey (2005, 2008), Accenture (2005, 2006), UNCTAD (2006a, 2006b), Kumar (2007) 145 For example when Tata Motors acquired the Daewoo Commercial Vehicle Company it did so for the Korean firm’s state of the art production facilities. 146 This is particularly true of sectors such as pharmaceuticals where these firms may have the ability to produce particular products but need to acquire the legal rights to do so. 147 Nanjing Automotive has stated it plans to shift the bulk of production to China, but retain the Rover R&D facilities in the UK. Shanghai Automotive created its Roewe brand based on Rover technology. 88
  • It should be noted though, that while many of these investments have attracted a high media profile, China and India are currently still relatively small players in global FDI terms. ●● Between them they accounted for just 1.4% of world outward FDI flows in the period 2000-2007. ●● This is compared to over 16.8% for the US and 11.3% for the UK. ●● In 2007 their share of world outward FDI stocks was just 0.8% of the total.148 In the longer term this will change, particularly as more and more Chinese and Indian businesses seek to break out of their domestic markets. The challenge for these globalising firms will be to acquire the skills and expertise needed to facilitate international acquisitions and manage a global business. Discussions with businesses and trade organisations suggest that this is currently an area of weakness for Chinese and Indian entrepreneurs. For example, the reliance of Chinese businessmen on personal relationships or Guanxi, often leaves them poorly prepared for working in the more formal, rules based international business environment. As a result surveys suggest that the performance of Chinese and Indian outward FDI is mixed. A lack of experience can lead to overpayment for assets, or insufficient focus on key areas such as cost savings from supply chain opportunities and operational synergies.149 A key factor underlying all of these trends is the paradox that while many people in the developed world see China and India’s rapid economic growth as a threat; Chinese and Indian companies themselves see serious barriers to their future growth looming on the horizon. Factors such as infrastructure which struggles to keep pace with economic growth, shortages of skilled labour and a lack of technological expertise in key areas are all seen as significant problems. Ultimately how China and India respond to these challenges will determine how and when they manage to make the transition into advanced economies. 148 UNCTAD (2008). 149 See for example, Accenture (2005, 2006), McKinsey (2008). 89
  • 4 Conclusions China and India are populous, increasingly wealthy economies whose re-emergence into the world economy is both a tremendous challenge and opportunity for the UK. Although they will remain relatively poor in per capita income terms for some time, their huge size and dynamic markets mean that UK businesses cannot afford to ignore them. With this in mind there are three broad observations we can draw from this work. SIzE ISN’t EVERythINg (But StIll COuNtS FOR A lOt) It is easy to be seduced by the sheer scale of China and India and lose sight of the overall picture. Many of the myths perpetuated about them result from the improper use of aggregate data, rather than figures appropriately benchmarked against population or GDP. For example, while China and India produce millions of graduates each year, this is only a small fraction of their population. In practice, due to the long lead times involved in raising average levels of education, China and India will remain dominated by low skill activities for some time. However, their huge size does mean that small changes in the pattern of economic activity in China and India can have major implications for the world economy. In the words of one academic we spoke with “when China lifts its finger, the world takes notice.” thERE IS hugE VARIAtION BEtwEEN REgIONS ANd SECtORS A second factor which is often overlooked is that China and India are far from homogenous. There is huge regional variation in patterns of industrial activity and consumer demand, which means in many ways they should each be thought of as a collection of markets. The huge differences between rural and urban consumers, means that business strategies targeting one group are unlikely to succeed with the other. When bringing a product to market firms need a clear focus on a particular market segment, or to sufficiently localise their product offering by region. On the supply side, regional clusters specialising in particular activities make it easier to access supporting infrastructure and resources, but also suffer from intense competition for these resources. As a result firms doing business in China and India face significant tradeoffs when making decisions about where and with whom to do business. 90
  • thEy SPECIAlISE IN ACtIVItIES NOt SECtORS The latest phase of globalisation has been characterised by the increasing fragmentation of global value chains. Firms now source inputs into their production process on a global basis and base different activities within the value chain in geographically dispersed locations. Having emerged into the world economy in this environment, the pattern of industrial activity in China and India has been strongly influenced by this trend. For example China has emerged as the leading location for manufacturing processing trade, while India has developed a strong position in off-shored IT enabled services. The implication of this is that to think about the competitive challenge from China and India in terms of industries can be misleading. In practice they will (in general) continue to specialise in activities which take advantage of their low cost skills base. These complement rather than compete with the high skill activities carried out in advanced economies such as the UK. thE IMPlICAtIONS FOR gOVERNMENt POlICy The government’s central economic objective is to achieve high and stable rates of economic growth and employment. Trade openness and globalisation have an important role to play in this as the evidence shows that they;150 ●● Strengthen the drivers of productivity growth. ●● Benefit consumers through increased choice and lower costs of goods and services. ●● Generate supply side benefits by allowing firms to specialise in particular parts of the supply chain. However, while globalisation creates substantial opportunities for the UK, it also creates a number of challenges. Globalisation puts UK firms in competition with those from across the globe, reinforcing the need for them to continue to innovate and offer high quality goods and services. Against this backdrop the government’s policy response to globalisation can be seen as threefold: ●● Recognising the benefits from openness, government is committed to reducing international barriers to trade; while also ensuring that global institutions are equipped to handle the challenges of an increasingly interconnected world. ●● To ensure the UK is best placed to compete in global markets, government has put in place policies to raise productivity. This is through a combination of delivering macro economic stability and strengthening the five drivers of productivity (competition, investment, innovation, enterprise and skills). 150 BERR (2008). 91
  • China and India: Opportunities and Challenges for UK Business ●● Acknowledging the social dimension of globalisation, government is working to spread its benefits as widely as possible – Through policies which help the UK adapt to its changing role in the world economy, reduce regional income disparities and protect vulnerable workers via targeted interventions. The analysis in this report provides further evidence to support this approach and reaffirms the central message that a retreat into protectionism is not the answer. Looking in particular at China and India the main policy lessons are; ●● To continue to resist calls for protectionist measures based on flawed comparisons with China and India. Although large, these countries are still developing and we should engage with them further to reduce the barriers to doing business. ●● Success in China and India requires taking a long term view, developing local connections and expertise. This requires tailored assistance from government to UK firms operating there, which helps mitigate the costs and risks associated with this approach. ●● We need a deeper understanding of China and India’s evolving role in global value chains, how their businesses activities can complement rather than compete with those of UK firms, and how best to use these synergies to compete in the global economy. Finally, while this paper has shown that the UK will remain ahead of China and India in terms of specialisation for some time, this does not leave room for complacency. In order to exploit the huge opportunities offered by these two economies, it is essential that the UK responds by continuing to raise its productivity and competitiveness. 92
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  • BERR Economics Papers BERR places analysis at the heart of policy-making. As part of this process the Department has decided to make its analysis and evidence base more publicly available through the publication of a series of BERR Main Economics Papers that set out the thinking underpinning policy development. The BERR Main Economics Papers Series is a continuation of the series of Main Economics Papers, produced by the Department of Trade and Industry which analysed issues central to business and industry. The Main Economics Papers Series is complemented by a series of shorter Occasional Papers including literature reviews, appraisal and evaluation guidance, technical papers, economic essays and think pieces. These are listed below: BERR Main Economics Series 4. Regulation and Innovation: Evidence and Policy Implications, December 2008 3 high growth Firms in the uK: lessons from an analysis of comparative uK Performance, November 2008 2. Five dynamics of Change in global Manufacturing, September 2008 1. BERR’s Role in Raising Productivity: New Evidence, February 2008 DTI Main Economics Series 19. Business Services and globalisation, January 2007 18. International trade and Investment – the Economic Rationale for government Support, July 2006 17. uK Productivity and Competitiveness Indicators 2006, March 2006 16. Science, Engineering and technology Skills in the uK, March 2006 15. Creativity, design and Business Performance, November 2005 14. Public Policy: using Market-Based Approaches, October 2005 13. Corporate governance, human Resource Management and Firm Performance, August 2005 12. the Empirical Economics of Standards, May 2005 11. R&d Intensive Businesses in the uK, March 2005 99
  • China and India: Opportunities and Challenges for UK Business BERR Occasional Papers Series 3. Impact of Regulation on Productivity, September 2008 2. Evaluation of Regional Selective Assistance (RSA) and its successor, Selective Finance for Investment in England (SFIE), March 2008 1. Cross-Country Productivity Performance at Sector level: the uK compared with the uS, France and germany, February 2008 DTI Occasional Papers Series 7. the Impact of Regulation: A Pilot Study of the Incremental Costs and Benefits of Consumer and Competition Regulations, November 2006 6. Innovation in the uK: Indicators and Insights, July 2006 5. Energy efficiency and productivity of uK businesses: Evidence from a new matched database, April 2006 4. Making linked Employer-Employee data Relevant to Policy, March 2006 3. Review of the literature on the Statistical Properties of linked datasets, February 2006 Copies of these papers can be obtained from the BERR publications order line at http://www.berr.gov.uk/publications/reports/index.html or telephone 0845 015 0010. These papers are also available electronically on the BERR Economics website at http://www.berr.gov.uk/publications/economicsstatistics/economics-directorate/ page14632.html. Further information on economic research in the BERR can be found at: http://www.berr.gov.uk/publications/economicsstatistics/economics-directorate/ page21921.html . This site includes links to the various specialist research areas within the Department. Evaluation reports are available on the BERR evaluation website at http://www. berr.gov.uk/publications/economicsstatistics/economics-directorate/page21979. html. The views expressed within BERR Economics Papers are those of the authors and should not be treated as Government policy. We welcome feedback on the issues raised by the BERR Economics Papers, and comments should be sent to berr.economics@berr.gsi.gov.uk 100
  • Printed in the UK on recycled paper containing a minimum of 75% post consumer waste. Department for Business, Enterprise and Regulatory Reform. www.berr.gov.uk First published February 2009. © Crown copyright. BERR/Pub 8809/0.5k/09/08/NP. URN 09/553