Economic Development in China and East Asia: Lessons for India

A few months ago, I came across a very interesting talk (via Rajesh), comparing and contrasting India and China, delivered by Professor Leslie Young, Executive Director of the Asia-Pacific Institute of Business and Professor of Finance at the Chinese University of Hong Kong. The full transcript of the talk is available online.

It was an extremely thought provoking talk which raised many questions in my mind. The talk covered the history and philosophy of the two nations and attempted to connect that to the long-term economic progress of the two countries and also discussed the state of capital markets and corporate organisations in both the countries.

Definitely worth reading!

Update: The link provided above to the transcript of the speech seems to be dead now. Fortunately I had a copy of the speech saved on my local hard disk. So here is the entire text.

Economic Development in China and East Asia -- Lessons for India

Professor Leslie Young.

Chetan Parikh: On behalf of Capitalideasonline and Oxford Bookstore I would like to welcome all of you to a talk on "Economic Development in China and East Asia -- Lessons for India". This is to be given by the distinguished speaker, who has taken time out to be with us -- Professor Leslie Young.

The geographies and histories of China and India have left them facing modernization with very different ethnic structures, cultures, institutions and overseas populations. This talk will analyze these differences to explain the contrasting parts of economic development and modernization.

Let me introduce Professor Leslie Young. Professor Leslie Young was born in Guangzhou, China and holds the B. Sc. and M. Sc. degrees from Victoria University of Wellington, New Zealand and the D. Phil. in Mathematics from Oxford University. This was completed at age twenty and won the Senior Mathematics Prize for the best dissertation of his year.

He is currently Executive Director of the Asia-Pacific Institute of Business and Professor of Finance at the Chinese University of Hong Kong, where he teaches courses in Money and Capital Markets and in Options and Futures.

In 1983-1992, he served as V.F. Neuhaus Professor of Finance and Professor of Economics at the University of Texas at Austin. His previous positions include a Fellowship in Economics at Lincoln College, Oxford and Senior Lecturership in Economics at the University of Canterbury, New Zealand. He has also held Visiting Professorships at the Indian School of Business, Australian National University, M.I.T. and the University of California at Berkeley.

Professor Young's fields are International Trade, Political Economy International Finance and Financial Economics. Twelve Ph.D. dissertations in these areas have been completed under his chairmanship. His book Black Hole Tariffs and Endogenous Redistribution Theory was published by Cambridge University Press with commendations by two Nobel Prizewinners, James Buchanan and George Stigler, and by the Chairman of the Nobel Committee, Assar Lindbeck. He co-edited The Hong Kong Securities Industry (the official manual for the Hong Kong Broker's Examination published jointly with the Stock Exchange of Hong Kong Ltd.) and China's Financial Markets. He has also published over forty academic articles in top international professional journals in areas such as international trade under uncertainty, international investment, the economics of export-processing zones, asset pricing under inflation, futures markets, the political economy of trade, the economics of corruption and the ownership and control of corporations. On the Editorial Board of the American Economic Review, the leading academic journal in economics, he was the longest-serving member, completing an unprecedented four terms.

Professor Young has served as consultant for the Governments of Mexico, Trinidad and Tobago and New Zealand and taught in Executive Training Programs for leading business schools such as those of Stanford, Wharton and Duke Universities. His research has been cited in the International Herald Tribune, the Economist and Wall Street Journal.

A survey on the Asian business by The Economist is being in distributed in which professor Young has made some observations.

Before I give the floor to professor Young I would like to thank Mehul Bhat who made this happen. And also Tanya and Renuka at the Oxford Bookstore for the unstinting support.

Ladies and gentlemen, Professor Leslie Young.

Prof. Young: Thank you.

Good evening. This talk will have two parts. I know that many of you are interested in capital markets and investments. Therefore about half the talk is oriented towards you, that is to say, I will discuss the corporate organization, corporate groups and the consequences for business performance in East Asia. So that will be the second half of my talk.

The first half of my talk will be a long term perspective comparison of India and China, because I know that just turning on the television I can see that India is very interested and feeling very challenged by the performance of China and based on my experience at the Indian School of Business in Hyderabad I know that Indian people in general like to take a broad perspective and are very interested in talking about history and philosophy. So I will talk to you about history and philosophy too, connecting it to the long-term economic progress of India vs. China. So this part is what I will begin with and the second half will be about capital markets and corporate organizations.

These facts and figures are basically known to you. These figures are from the year 2001. This year I think China's GDP is exactly twice that of India -- 1057 vs. 500 and something. So it is exactly twice and I think you are all aware that say 15 years ago the GDP per head was essentially the same. So I think this is why people from India are very interested and intrigued and challenged by what's happening in China and my aim is to tell the story of what happened in China.

Also I think it is interesting for you to look at the comparison between China and Russia. And that's because both China and Russia are of course former communist countries that decided to liberalize their economies but the consequences for the two countries were vastly different. And so in understanding what happened to China another useful benchmark is what happened in Russia.

So we just go down to this line, we see that - see Russia is a developed country -- literacy is just an indicator of the state of economic development. So China has basically looked after the bottom half better than India and that shows up in higher literacy rate. This is a dramatic figure where China has consistently over a period of decade of the '90s has grown at almost twice the rate of India. But India's growth rate is very strong. It's still a very good growth rate by almost any standards except that of China and East Asia.

When we look at these figures bear in mind that they are an average over 10 years. So when a country goes down on average 6 percent a year for 10 years than it becomes impoverished. And both India and China of course have shown much improvements. Here this is a really an indicator of competence in economic management truly. If you look at the levels of inflation every year for 10 years than what I mean is the entire middle-class has been destroyed. All their savings have gone.

And so both India and China have been competently managed over these years. This figure I put up as a benchmark so you see that what I was saying that the basic health of the population in China has been taken care of and it shows up in the difference in female life expectancy. But here is a dramatic figure you may not be aware of. You look at the life expectancy of Russia is actually less than that of India for the males. So this is a stunning kind of a figure. And it's an indicator of a total social collapse and this is reinforced by the next figure -- you may be unaware that China has a one-child policy and that is enforced with some effectiveness. And that shows -- India is almost twice that but a stunning figures is where it is one-third that of India. And so this is below replacement value. So what's happening is that the collapse of the Russian economy and society in the transition from socialism to capitalism has been so great that Russians simply are choosing not to have children. They don't want to inflict life on children.

And look at the death rates. In Russia it is double that of India and China. So these are people who are drinking themselves to death basically. So it's a terrible statistic to contemplate because these two things together mean that Russia is getting smaller in population and within about 20 years Russia will have a fewer people than Vietnam or Taiwan. So it is a stunning outcome for a superpower.

I will refer again to Russia -- I will focus on the comparison between China and India. What I want to convey to you is that the difference in the economic performance is very deeply rooted. So the previous slide was just a fact but there is a very long story behind the facts. China's success wasn't an accident. But it's part of a very long story, which is what I want to tell you -- the story that I want to tell you.

So I will try to, all the way, make a comparison, draw a parallel and the first big story that I tell is the difference between having a population as very homogeneous and a closer culture of unity vs. what I understand you have in India which is that you have a very diverse population and a much weaker tradition of cultural unity and this difference constrains the behavior of governments -- it limits the options that are available to governments. And where does this difference come from? It comes from 5000 years of history. So it is actually interesting -- I thought to draw some parallels between what you may call the geographies of India and China.

I am sure you know that India was repeatedly exposed to invasion and conquest from Afghanistan in Central Asia and there was a key difference however -- the militarily more skilled people from Central Asia, from Afghanistan were different. They were simply racially and culturally different from the people who lived in India.

By contrast the conquerors, as it were, in China were only in the Northwest. So the basic fact is a looked that the same. They were racially very very similar. And what I meant was that the conquest from the Northwest did not create a diverse population, nor a stratified population. It left the people homogenous and the culture unified. So their first conquest was the north of China which is the valley of the Yellow River. And this is where the early Chinese dynasties were.

Then the Yellow River in turn was geopolitically -- just think of the amount of the agricultural resources that could be organized around the Yellow River. This was very large relative to the rest of China. In other words Northwest China took over North China. North China was strong enough essentially to dominate the whole of China and this meant that China remained a unity.

By contrast my understanding is that the Ganges Valley, which is a kind of a counterpart to the Yellow River Valley, is not strong enough to dominate South India. Of course there were attempts to conquer South India and sometimes they were successful and sometimes they weren't but you didn't have anything like the ongoing easy success of dominance. So you did not have a unified culture, nor did you have a tradition of unity where the norm was one China was to my understanding of India.

So this is as I say something that constrains what a government can do.

There is another very interesting difference between the foundations of the two nations. Which is this. That if you look at the major rivers then the Ganges has a very rich area very suited for agriculture, much better suited in fact than the Yellow River Valley and it has many tributaries, they all come down from the Himalayas. So river control of course is good but the difference was -- in China it is something very different. That the Yellow River also comes from Tibet, comes from the Highlands, but it has no tributaries halfway down its course. Beyond halfway down its course it has no tributaries and moreover because of a huge amount of silt, that's why it's called the Yellow River Valley -- because of yellow silt, when it comes on to the plains it dumps it. And what that means is that the bed of the river rises and what that means is that the river overflows unless you build dikes. But even if you build dikes, the bed of the River keeps on rising and so the dikes have to get higher and higher.

So river management is a big problem for governance in China. In fact it's a kind of a meter of governmental performance because to maintain these tall dikes you have to collect resources from a big area and then you have to use them. But of course they get stolen. But the corruption cannot be too great, because if it is too great then the dykes break and moreover remember the bottom of the river is above the top of the plain. So once the Dykes breaks the river cannot go back into the old course. It has to go somewhere else. And this disrupts entirely the irrigation system, the entire agriculture of China. So people starve by millions. So here is a very clear signal of bad governance, of corruption. There is no way of hiding the fact. Because we have a total destruction of the economy and mass starvation. So this is important for understanding the behavior of modern governance in China. Because they were always subjected to this kind of meter for corruption, that if the corruption was above this critical level, then they were visibly failing to do their job. And they would lose their legitimacy.

So this is important to understanding how China in modern times switched over to taking responsibilities for people's livelihoods.

So another thing was that when the -- when there was a big time change of government in India it was basically by conquest. That was some guy came in from Central Asia, Afghanistan and started a new dynasty. There was a Delhi Sultanate and there was Mughals and there were these guys, you know about that, but in China the big changes in governance were by internal revolt when the government had purely failed to do its basic job of keeping the dikes strong. So then the new rulers had to justify -- they looked just the same as the old ones but -- they were also Chinese you see -- the guys coming in from Afghanistan said we are stronger than you -- you do what we tell you, we are stronger than you -- but in China you had to say, well, why are you justified in taking over government and the justification had to be that you offered better government and this became the expectation of the Chinese population and it was called the Mandate of Heaven. When you rule well, you have the Mandate of Heaven. And so the governance is justified by performance. And you lose legitimacy by poor performance. So this is a very deep part of the political tradition of China, which again is very relevant to modern times.

Next thing I want to talk about which has an impact on modern governance is the religion, the philosophy and we can trace the differences -- I am sure you have some deep knowledge of Indian religion and philosophy and you have some knowledge that China is very different. And I say firstly that we can understand this difference and we ought to look at its impact on modern China.

First of all it seems to me that what happened in India was that you had a 1000 years in which you had a period of old culture -- the Vedic period in which you developed a certain kind of philosophy which was -basically it said that there was inside your self was the whole universe. So this was a deep philosophy which then had to deal with another issue which arose when you started writing and writing kind of separates you from the world.. And so you had a tension between two philosophies.

I mention this because in the very long term had an impact on China and on Japan.
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But by contrast in China what you had is the following. You had a different writing system, which was a pictorial and videographic writing system that mixed up pictures with abstract symbols and therefore Chinese philosophy developed in quite a different path. What it did was to view the world not in transcendental terms, that is in terms of there is some abstract world up there and there is a real world down here, but the Chinese view is that the real world is all that there is but it has an internal structure and this view of the world meant that on one hand you had Taoism which was looking for the structure of the world and this inside the world itself not above it and this led to ideas like free markets, spontaneous order of society. The view was that society orders itself. It wasn't a God given order -- it was a society that ordered itself. This is the first viewpoint.

The second point was Confucianism, which basically took the family as a metaphor for government. So it used -- the metaphor for politics was an extended family you might say.

And the last thing, the least positive aspect of it is something that you probably even haven't heard of, called legalism. Which was a very tough minded ruthless philosophy of control. That a large state was held together by very tight government and these three philosophies kind of supported each other. The legalism was too tough and the first empire that tried it, the Qin empire, which gave China its name lasted only two emperors, then got kicked out. It was too harsh an area and then the next dynasty, the Han dynasty learned from that and installed Confucianism to come and soften it. To impose obligations on the rulers, to make the emperor, the father of the people to soften harshness of legalism.

And the third that point is that Taoism then lead to the notion that the classic experiment is you should rule an empire like you cook a small fish. That is you leave at alone. You leave it alone. So the notion was that the administrators, the rulers of China should really let the market work and stand back. So this I emphasize is an idea that originated in China and one can find in Chinese history and text that spoke the idea of invisible hand 2000 years ago.

So these three things if you see complemented each other. The notion of a tough harsh government, top down government, nevertheless which took responsibility for the people -- and took responsibility, but left them alone as much as possible. So these three things balanced each other.

From also a unique Chinese intervention was the use of examinations to sort people by ability and to induct into ruling elite. So anybody could enter by passing enough exams. And this is of course why Chinese are so keen on education and so relentless in study. It was because of this tradition.

Now one thing you should emphasize is of course is that this is only possible if you have a very homogenous population. If everyone looks the same then it kind of makes sense that you should have the brightest people ruling. If people look different, then it's more likely that those persons who look the same ones they are in power make sure they stay in power. So this is an advantage that China got from its homogeneity.

One another thing -- this shows Chinese leadership were strangely enough, you must think of them as liberal arts graduates, they specialized in the essay writing, in poetry, in calligraphy -- these were the rulers of China. However this was balanced by the duty -- the books that they studied were the Confucian classics and they imposed on the social leaders, the elite, the duty to look after everyone else. And this meant -- and this is something that I noticed when I come to India that it seems to me that the elite of India don't feel the duty to provide practical leadership. They have the duty to provide theoretical leadership but not practical leadership. I will give you an example.
In the campus of the Indian School of Business there are lots of women who sweep the streets, sweep the roads, sweep the paths and they have a little broom made of twigs and the broom is this long. And they spend their lives sweeping the path. Now why can't somebody tell them to put a stick in the middle and then they could stand up and sweep the path. Then their lives will be transformed if only somebody would take the trouble to do that. Once you put the stick in the middle -- you can find a stick anywhere -- right? And this to me is amazing.

Now contrast that with the invention that you know about. The Chinese -- it was the Chinese who invented the wheelbarrow. I don't see wheelbarrows in India. People carry baskets of dirt on their heads. So this is - now anyone in this room is capable of inventing a wheelbarrow -- there is no question of that -- right? But no one has done it for these guys moving dirt around.

So that's what I mean by a duty to provide practical leadership which seems to me that the leaders in India provide intellectual, philosophical, religious, something leadership but they don't feel the duty to provide practical leadership.

And there are whole provinces in China that were made fertile because some engineer came and designed an irrigation system and he was a scholar. He started out as a scholar but being put in charge of a province he said why don't I fix this problem. So this is I think one of these historical traditions that are very important for explaining, for understanding what's happening in China today.

The last point I want to about starting from religion philosophical framework is this. That India ironically made a very long-term historical contribution to East Asian modernization. Because from the tension that I described between oral and written cultures came the Buddhist concept of enlightenment, which was an attempt to resolve that tension. This was transported to China through Central Asia. So Buddhism came to China. But the Chinese as I previously explained to you were not interested in the transcendental world. So they reinterpreted Buddhism, Buddhist enlightenment as a breakthrough to understanding the structure in the real world. And this was then transported to Japan and so the Japanese kind of embraced this notion and they adapted that and to my interpretation this embrace of Zen Buddhism is what underpinned the Japanese success in modernization. They were the first non-Western people to modernize and they were able to do it because they had a conceptual intellectual framework that kind of bridged East and West. They had a transcendental framework and at the same time as they had a concept of structure that's internal to the real world. You can see that in how creative the Japanese were in the depth in which the institutions to their own societies and in particular over the famous Japanese organizational innovations, the managerial innovations, you have the Just In Time managements and things like that. This is a very great burst of creativity, which was critical for the next phase of development, which was to spread the Japanese ideas into East Asia.

Now before I go on to that I will just emphasize a difference between the institutions of India and China that I have already mentioned that the scholars also were the administrators. They were often recruited -- anybody who was bright enough could join and they saw their responsibility to serve as social critics. So amongst the most honored people in Chinese history are scholars bureaucrats who stood up to the emperor and pointed it -- stuck a finger in his face and said what you are doing is wrong. So this is a very honorable tradition in Chinese history. Scholar bureaucrats who kind of exposed themselves and often they suffered terribly while they were castrated for example for standing up to the Emperor. But they thought it their duty to do that.

It seems to me that in India there is no such counterpart. It seems to me that the elite, they validated power but to my rather limited knowledge of Indian history, we don't have examples of Brahmins saying you shouldn't do this. So there is no ideology to unify the empire as it was, as Confucianism providing a unifying ideology for China. And also because the governance structure evolved over so many dynasties and errors were picked up and corrected by the following dynasty that ultimately Chinese governance became rather efficient. So that for example there was this structure where every five years the governors had to move on. They could only rule a province for five years and then they had to move on and move to our different province. What this did was to break up power bases. So you couldn't have the governor then deciding, well, unless I start myself off as a separate country. It seems to me this is what happened and tended to happen in India. I am sure there are many examples like the Nizam in Hyderabad, he was originally a viceroy of a Mughal and then when the moguls kind of got weaker, he just split off. That was anticipated in China -- and he ruled the state as a Nizam for more than five years.. So these governance structures, this experience is brought into Chinese political traditions and you see it even today where the governors of provinces are moved around every five years. So they don't get the opportunity to build up corrupt power bases.

So what we are seeing is that China has this long powerful tradition of unity and effective governance. Of course in modern times it was poorly governed. But there is a memory of 2000 years of very effective unified governance.

The next players in the story are of course the overseas Chinese and I want to draw a contrast between them and the overseas Indians. I think you call them call them what -- nonresident Indians -- right? And so both China and India were of course massive cultures and they exported those cultures to the neighboring countries, but there was a difference. That the export -- there was a huge surge of migration out of two coastal provinces of China into Southeast Asia, into Malaysia, into Indonesia and the Philippines in the 19th century. And the numbers were big enough that essentially they took over the economies of Southeast Asia. They didn't take over the politics but they took over all the business.

It seems to me that there is no counterpart to that. Of course Indian immigrants were very successful businessmen but at no point did they come to dominate any particular economy and so after the World War II these small East Asian economies, which were dominated by overseas Chinese, were, under their leadership, able to grow very fast. So what that did was to provide China with a benchmark. All these neighboring economies dominated by Chinese who kept on going back to China. And they kept on going back to China with things for their relatives. And so this was a constant challenge to the mainland -- a challenge which it seems to me, there is no counterpart in India.

So if we make a comparison now not between China and India but between the smaller economies of Taiwan, Malaysia and Singapore, Hong Kong, South Korean, we see that the West has a model of modernization in democracy, law and the markets. East Asia, the small East Asian economies modernized very fast because they had counterparts, substitutes for these institutions. They didn't have democracy, but what they had was the Chinese tradition that rules had to own the right to rule. So even though they were dictators like in Taiwan and South Korea and Singapore and Hong Kong for that matter, they thought it their duty to earn the right to rule by delivering fast economic growth. So in that sense not being democratic was helpful for growth ironically. By contrast in India you always had democracy since liberation and therefore that legitimized the government. So there wasn't the pressure to deliver economic growth as well. We said we got voted in. In East Asia these guys never got voted in so they had to justify themselves and within Chinese political traditions it was by delivering economic growth.

Also there wasn't rule of law, there was the Chinese tradition of a strong meritocratic bureaucracy and so all these countries had strong non corrupt and capable civil servants that were bright people. Like in the cabinet in Taiwan and South Korea typically had half their members with Ph.D.s that were obtained in the United States. So these were bright people. And they had inherited a sense of responsibility of leadership.

And of course India has its bureaucracy as well it and there are lots of bright people there as well but what they did not have is it seems to me the same ambition that they would become the leaders and drive economic growth. That's because on top of them there was some politicians as well. So in place of the law of contract, we basically didn't have the effective rule of law in countries like say the Philippines or Indonesia or even in Taiwan and South Korea, but instead you had business networks, extended families and you could do business within a business network of people who spoke the same language and came from the same village.

And that was also true I think amongst people in India and also I think overseas Indians but in India itself of course law became an impediment to business. Because lawsuits kept on going on and on and they kind of flows property out of use. So I think having British laws probably a bad idea so far as India was concerned. Any decision was better than getting involved in a court case.

The last point is about the ideal of the market economy. This ideal was picked up in an interesting way in East Asia. There was no inhibition about interfering with the market in fact but its just as the persons interfered with it was smart and they didn't commit to one particular interference when that interference didn't work in fact East Asia started also with import substitution. But they saw it wasn't working in the '50s and they just -- they simply stopped it and they switched over to export led growth. This was possible because of authoritarian governments because what happened in India was that import substitution created its own constituency. Right? People just got rent from being protected and they were able to use their profits from that artificial scarcity essentially to buy government as is possible within a democracy.

But always was not available to be bought in countries which were led by authoritarians who didn't have to get elected. They didn't need your money. So that's why there was a switch towards export led growth that did not have to have a political base. So whole industries were simply shut down. Japan for example in the '60s simply shut down the steel industry, shut down the ship building industry and those moved to Korea. And this would not have been possible in a democracy because all those guys who were in those industries would have lobbied and paid up the politicians and given them money to get themselves reelected.

So this was an important part of the story of the success of the small East Asian countries.

So the result then spread by example to the mainland in that China had meantime been doing something like different. It had been engaged in Marxism and what happened in Marxism was quite fascinating. Essentially Marxism destroyed itself, destroyed its own credibility because Mao said, well, we will have a great leap forward and that killed 30 million people, then we have got to have a Cultural Revolution that killed another 30 million people and many of those people killed were Communists. In other words the true believers in Communists simply self-destructed and so what was left by the end of the cultural Revolution were opportunists, not Communists but opportunists who happened to be in the Communist Party. They were not believers in communism. So at this stage -- of course by this time the overseas Chinese were very visibly successful -- so there was a crisis of legitimacy and the party leader saw that after two upheavals the party had no legitimacy and they had to deliver something to maintain his right to rule China. And the only thing he could deliver was economic growth. So that's what he is delivered.

So this is what happened. That communism destroyed itself and its created a path -- all the Communists killed each other and we only had opportunists and these were just the right people you needed to get rich. You had a country run by opportunists.

But another thing about China success was that they knew what they didn't know. In another words they didn't try an overnight transition as the Russians tried. They tried it slowly. They started off with four special economic zones around the coasts and that worked out because as the Overseas Chinese came in and provided the capital and the entrepreneurship and they were highly experienced at the buying of politicians from their experience in the Philippines and Indonesia when you had to pay up people. And so they just paid off the local Communists who often were their second cousins anyway, so they would go back to the old villages. And so the special economic zones and the coastal provinces were a massive overnight success. And this kind of success fed on itself.

By contrast there was no such mechanism it seems to me in India. The only overseas Indians I know about were in Mauritius and just as small. And there was some experimentation among states like in Andhra Pradesh we got guys trying to do things differently. So there was some experimentation among states, but there was there was no overseas, convincing overseas example to challenge what was being done in India. China kind of promised the overseas Chinese, come and do business here and life will be simple, clean and you will get rich. It seems to me that there are probably a lot of nonresident Indians interested to do business in India but life for them was not been made simple.

And the last point is that in China the success in creating economic growth actually due to this political clout -- so in a sense the most obvious way to get economic growth is to reward people for it. It is to reward the political leadership and that's exactly what China did.

So specifically what happened was that if you were the governor or the party secretary of a province, of a district, of a town that was successful, then you got promoted. That was that. So there was a system for rewarding bureaucrats which was very realistic. It went like this. There was a five tiers of government in China and the rule was that half the tax you collect, you keep at that level. The other half you pass up to the next level.

This contrast with the rule where all the taxes that you collect gets pumped up to the center and then the center decides how much they give back to you. So this gave every bureaucrat an incentive to grow the economy under his control. Because with a larger economy you collect more taxes and you get to keep half of it. And keeping half of it you can spend some of it obviously you spread it around but some of it stays with you.

So in this way essentially all these communist opportunists were kind of brought in, brought on board, so that they received a personal reward or if not a personal than a political reward for creating economic growth. So it didn't happen by accident. These guys could have messed everything up. They could have sat on the overseas Chinese and ripped them up to such a huge extent that they wouldn't come back. That they were given incentives not to do that.

So to contrast that with what happened in Russia where the guys from the Harvard Institute they kind of researched and said oh, you guys should do this. And the Russians said alright lets do it. They didn't have any better idea and what they tried to do was to Xerox a Western system and implement it overnight but without supporting institutions like accountants, an accountancy profession or regulatory profession or legal profession -- none of those supporting institutions were available, so the whole state was essentially stolen.

By contrast in China there was very large-scale corruption, but two things prevented it from getting out of hand. Firstly the capital account was kept closed. So you could steal the money but you couldn't get it out of the country. So that limited the damage and the second thing was the way that Chinese bureaucracy works. There are two key elements in it. Firstly it is a system of factionalism. So you can't help but join the faction. Because there are heavyweights at the top who look after their boys, who look after their boys, who look after their boys and so you have competing factions. Now what's the best way to undermine one of the guys at the top is to accuse and convict one of his boys for corruption. So the accusation of corruption and the proof of corruption becomes a weapon in factional infighting and the thing about it is that it can be fatal that is to say the Chinese justice system is pretty arbitrary. You don't have any rights to due process, you don't have any rights to lawyers. So if the political whim shifts against you, you get accused of corruption, you got no defense. You're going to be executed tomorrow.

So here is a situation that a typical Chinese manager finds himself in. He has to belong to a faction. That's how he got appointed to a managerial position. Therefore he becomes a pawn in factional infighting. If he does corrupt things, he exposes himself to the possibility that he will be caught up one day in the factional infighting, get accused and be executed the following morning. Of course some people want money so much that they still do it. But some people don't. What I am trying to explain is why some Chinese aren't corrupt. Right? So in other words there was a large residual set of honest managers running China -- not because Chinese are intrinsically honest but because of the mechanism I described. So this limited corruption. Whereas by contrast in Russia there were laws but there wasn't any effective system of enforcement. So that people weren't scared to be corrupt. And half the Chinese were scared and about half -- that was a critical mass of honest officials are still there in China, not because they have beautiful ethics, but because they are scared.

A different important aspect of the transition in China was that they did not go from state ownership to private ownership. In fact most property in China is owned by a collective, meaning a set of people which could be a township. So a township is the owner of a set of factories. So we know that if you have one billion people owning everything, then no one is responsible, no one takes the trouble. But if 50,000 people owned something, a factory, then there is still an incentive problem but it is not as severe. So 50,000 people can see who is corrupt and they can do something about it. Because the guys who are corrupt live in the same town. So they can break his windows, burn his house, beat up his children, slash his tires. They can solve the principal - agent problem to a limited extent. Of course this is not a perfect solution. The perfect solution is private ownership. But private ownership creates its own problems in the transition. Because the question is that terms on which state owned goods are converted to privately owned goods is something that could be manipulated and in the course of that conversion most of that can be stolen. And that is what happened in Russia.

So the collective ownership in China, that is still present in China, is an imperfect and partial solution but it doesn't mean state property isn't simply stolen. And it was the heavy theft of state property, the total theft of state property that led to the terrible statistics that I give you regarding Russia. It was essentially for those ten years people were participating in the market economy not in order to do what you and I do in an economy but to steal. In other words every transaction was oriented towards theft. And that's how the Russian economy degenerated and that's why the Chinese economy did not. There is still plenty of corruption in China but didn't proceed to that point.

Now just as an indication of how it works, we have essentially every political unit in China spun off its own corporation and these corporations did business with each other. And the political mechanism was in that sense a substitute for the rule of law, for the rule of contract, because you could enforce the contract politically, but you could not legally. And here is a specific indicator of this.

Here is the ownership structure of Chinese companies. It is in the two stock changes. Essentially one-third is owned by the state, one-third is owned privately and one-third is owned by this mysterious category of legal persons. And what that means basically is that these shares are owned by the front companies of Chinese political units and the consequences are very interesting.

You can look at the return on equity, return on capital, usual measures of economic performance and what you find is that the more private ownership there is in a company, the lower the rate of return on equity. And also the more the state ownership, the lower will be the return on equity. But the more legal person ownership, the higher the return on equity. So these are statistically significant results that you do with regressions and stuff. And so the reason is that private shareholders have no clout. That are no shareholders rights. So if you are a private shareholders then there is nothing you can do if the management is stealing the company. You can't do anything about it.

But the state is interested in -- basically it is still a communist country, so the state supports the workers. And of course it results in higher wages, better benefits for the workers and lowers the rate of return. So you can understand why we have these results.

Lets think about what going on when you have more ownership by legal persons. Essentially you say you might have a state oil company and big block of shares will be owned by outfits like the front company of a province or the front company of a city. So civil cities, from the front company of civil cities could be owning big block of shares. Now these front companies have access to the political power, these are communist heavyweights. So they want you to earn a return so they give some. But they want the money for their own boys back home. And unlike the private shareholders these are not people that you can brush off. These are communist heavyweights who can make your life miserable. So the more as it were diverse communist heavyweights are in a position, the more they have an incentive to force you to generate returns, the higher the returns will be. So this is an interesting and specific example of how China made the transition. It brought the existing power structure on board economic growth and used them to supervise economic growth. So you are using one set of Communists as it were to supervise another set of Communists to make sure that they didn't steal anything.

So that completes my story of China in contrast to India. I have a different story which I will tell in a minute but this might be a good moment to open the floor to questions for only five or ten minutes before I move on to the other story. Anyone wants to raise questions? Yes.

Q: Is the conclusion of the first part that it will the very difficult for India to even catch up with China, given the history and the way it works, over a period of time?

A: The question is the implication of what I said is that it will be very difficult for India to catch up with China. I think the short answer is yes. You can see that the success of China has very deep roots. And I think it's a bad idea for India in any sense to try to imitate China. See, India has had its own long-term political traditions, it has a very very different society and Chinese society and its governance and institutions are so different that although I will mention some lessons I think on the whole there is no possibility of a wholesale transfer of ideas. Since you raised the question, let me just put down some -- what I think are the lessons.

It seems to me that there is no real possibility of transplanting the bigger ideas because you have a different kind of a regime. There are some warnings, some lessons like privatization can result in massive thefts so that overnight privatization is probably a bad idea.

There are probably lots of overseas Indians you could attract if you could create some zones where they could be guaranteed that they are not going to be messed around with lots of bureaucracy. So if you could create special economic zones, that's probably an idea that would work.

Another idea that might work is that you have to find a way to bring the bureaucracy on board. It seems to me as the most likely at the moment that bureaucracy is a problem. It gets in the way of just about everything. But the bureaucracy is not going to go away. You still need it to run the country. So you have to find a way to give them an incentive to grow the economy. I don't know much about the specific structure of India to really have a specific suggestion, but I think the notion of converting bureaucrats into leaders by rewarding them appropriately I think is probably a very useful one.

One another point, lessons I draw is that is probably people like yourselves are very strong advocates of opening the capital account. But the combination of privatization, liberalization and opening the capital accounts is quite a dangerous one as the Russian example shows. China has not opened the capital account and if it did, the first thing would happen is all these corrupt guys would get their money out. Which would destabilize the economy. So keeping the capital account closed against the advice of the IMF is an important ingredient of China's success. Essentially what happened was that it kind of locked all the corruptly appropriated funds in China, so the people who stole the money still had to reinvest that within China rather than shipping it out. And this was I think an important policy. So I think it is a kind of a useful lesson. Probably the most useful lessons coming out of China is simply that it is possible to transform a country, but a specific part of the transformation is likely to be very different.

Q: Is there any illegal flow of money?

A: Very much so. Let me tell you some stories about the illegal flow of money. It's very subtle and I will give you a statistic. Hong Kong's ports are very efficient. They are among the world's most efficient ports. But the port charges are very high. They are amongst the world's most expensive. The figures are possibly something like this. That Hong Kong's ports are twice as efficient as those in China but cost four times as much. So why do the Chinese use Hong Kong ports to shift stuff in and out? It doesn't make sense economically. The answer is this. In Hong Kong there are a whole lot of corporations which are subsidiaries of corporations which belong to the same group as it were as corporations in China. So the corporation in China, what it does is that it ships goods through Hong Kong and as it does so -- there is a T shirt that costs $1 to make in China, it is sold to the Hong Kong subsidiary at $1.10 and the Hong Kong subsidiary sells that T shirt to the U.S. for $7. So all the profits are booked in Hong Kong. Because the tax rate is lower in Hong Kong than in China and moreover the Hong Kong dollar is convertible. So that once you've got your profits in Hong Kong you can ship them anyway you like, whereas if you left the profits in China you could never get it out.

In fact this is the most probably likely explanation for why Hong Kong is still there. It's not because the Chinese leadership in wedded to international agreements and loves democracy and rule of law. It's that the Chinese leadership, they are the guys with the profits. And they are parking them in Hong Kong.

So that answers your question. Yes, there is a lot of money being stolen and is being shipped and Hong Kong is the kind of a laundry for Chinese money.

And another mechanism is IPOs. So if you're shell company is listed in Hong Kong and you inject some Chinese assets into the shell company and in the meantime your friends and your cousins have been given big allocations of these shares and the Hong Kong investors get all excited at the news of the injection of Chinese assets and so these shares appreciate and now you have got a big capital gain in Hong Kong. So you sell the shares and you get legitimately loads of money into Hong Kong.

Q: One of the things that we have learned about China from our little reading of history is the China was always the leader in technology.. We kept hearing that China -- I mean we have read that China discovered paper first. Why is it -- what happened in history that has transformed China to becoming a mass producer rather than a technology vendor? Why is it the image that goes around the world today of a giant mass production...?

A: I think the question is a contrast between a historical success in technological innovation and a modern economic model which does not rely on innovation. The historical technological innovation were practical innovations. They were not based on theory. They were based on practice. They were not based on theory because Chinese didn't actually have any theory. Remember I drew a contrast between a philosophy of looking for structure within the world, not above the world. Now a structure above the world is what science is about -- right? You have a mathematical model of a physical system and then with that mathematical model you test it against the real world and in that way science and technology advances. That approach to technological advance was not available to China. China did not develop a theory based technological advance. It only developed practical innovations by smart responsible people who said oh, we can put a wheel under a bin and then we got a wheelbarrow. But that is not theory based. It can only take you so far. So that is why the leadership in technological innovation passed over to the rest. So if you contrast that with India, my image at least of India was that you that think in transcendental terms. And so all your minds were very well attuned to stuff like software to abstract manipulation -- this is what software is all about. So it seems to me that you have an advantage there and you have an intellectual advantage over Chinese. You have a practical disadvantage.

Comments

[Rajesh Desai]

Some thoughts on a remarkably incisive lecture.

The mystery of how Hong Kong survived post British colonialism has been rather satisfactorily explained. The big boys in mainland China have simply incentivised themselves adequately to profit from HK's free trade regime.

Govt built institutions (as opposed to social institutions) are essentially time based. Our bureaucracy based on supposed personal integrity, worked effectively only for a very short time after independance (remember, our 1st five year plan was successful). Equally, a Chinese type institution, based on personal or political enrichment may not survive forever. In fact according to some observers, it looks quite ready to implode in the not too distant future. So perhaps, long term comparisions may be made only with due caution.

Personally, I believe the race for superior economic status between India & China is still quite open. The best possible solution may well be economic cooperation. But there I think the good professor may be right. We in India may not be 'practical' enough for such experiments yet.