Why China and India Need Each Other

Recent rumblings that the Indian government is making it difficult for Chinese companies to export telecom equipment to Indian operators (or may even issue an outright ban on security grounds) is just the latest development in a two-step-forward, one-step-back dance that China and India are trying to master, albeit awkwardly.

From a tiny base of $2.9 billion in 2000, bilateral trade between China and India has grown explosively over the past 10 years. It reached $52 billion in 2008, retreated somewhat in 2009 due to the global financial crisis, and will likely cross $60 billion in 2010. To put these numbers into perspective, China's bilateral trade with the entire Latin American region and the entire continent of Africa is about $110 billion in each case. Over the past decade, China-India trade has grown at a 40 percent annual rate, twice the pace of growth in either country's trade with the rest of the world. China is now India's largest trading partner. In turn, India is now China's 10th-largest trading partner.

Consider also some of the recent developments. Chinese companies are now the largest suppliers of equipment to India's power producers. In March 2010, a Chinese company shipped custom-built subway trains for use by Mumbai Metro. The same month, Kamal Nath, India's Minister of Road Transport and Highways, noted publicly that he would like to invite Chinese companies to play a role in developing India's high-speed rail networks, a statement that received a very positive response from Chinese officials.

India's exports to China consist largely of raw materials. After Australia and Brazil, India is the world's third-largest exporter of iron ore to China. Aside from trade, economic links between the two countries are growing along other dimensions, too. With its acquisition of Jaguar and Land Rover from Ford (F), Tata Motors (TTM) now derives nearly $1 billion in revenue from the China market. Another Tata company, Tata Consultancy Services (TCS:IN), has become the leading provider of core banking software to China's banking sector.

In turn, such Chinese companies as Lenovo (992:HK), Haier (1169:HK), and Alibaba (1688:HK) have a growing presence within India, and Shanghai Automotive (600104:CH) recently acquired a 50 percent stake in General Motors' Indian operations. Huawei Technologies, China's leading technology company, runs a 2,000-person software research-and-development center in Bangalore—its largest outside China—and has announced plans to expand it to 5,000 people over the next three to five years.

Aside from growing trade, investment, and technology links between companies, the Chinese and Indian governments have also begun to harmonize and coordinate their policies in a number of areas, such as global warming, global trade talks, and decision-making power in such multilateral institutions as the IMF and the World Bank.

Sources of Distrust

Notwithstanding these positive developments, two major issues continue to cause friction—India's trade deficit with China and the lingering distrust rooted in unsettled border disputes, coupled with China's enduring friendship with Pakistan. Even though political leaders on both sides have been explicit in charting a pragmatic course, the trust deficit occasionally rears its head, with negative side-effects on the economic front. Witness the recent rumblings regarding import of Chinese telecom equipment and the fact that India now leads the world in filing antidumping cases against China. In the context of this two-steps-forward, one-step-back dance, we put forward four recommendations.

First, the China-India economic relationship is of utmost importance to both sides. China is upgrading the structure of its exports from labor-intensive consumer goods to technology-intensive capital goods. As India's infrastructure and manufacturing revolution continues to gather momentum, it will offer by far the largest market opportunity for Chinese machinery manufacturers. Also, within 15 to 20 years, India will almost certainly become the world's third-largest economy. It will become increasingly difficult for Chinese companies to claim global championships in their respective industries without a sizable presence in India. The same logic applies to Indian companies with global ambitions. Thus it would behoove both countries' political leaders to stay pragmatic and level-headed and not become captive to the extremist rhetoric of nationalists on both sides.

Second, India should cast aside its misguided apprehension about the trade deficit with China. It is short-sighted for the Indian government to become captive to the concerns of domestic machinery suppliers, who in any case are unable to meet the rapidly growing domestic demand. Short of heavenly intervention, there is no way India can hope to become an economic power without aggressively building and upgrading the country's infrastructure. Lower-cost machinery from China can be a massive help to India in accelerating the infrastructure and manufacturing revolution. In fact, if China wants to give the machinery away for free, India should welcome it even more. As India's infrastructure begins to become world-class, it will easily start giving China a run for the money in the very sectors where China presently has the lead—manufactured goods. India's engineering capabilities are second-to-none, and its labor costs are less than half those of China.

The Appeal of Joint Ventures

Third, India should learn from China and push to deal with it in the same way that China deals with Western companies. The message should be: Our doors are open, you are welcome, but we would like you to set up joint ventures and invest in India. Such an approach will expand the scope of economic links between the two countries to dimensions other than trade. It will also enable the flow of Chinese infrastructure capabilities and capital to India. Importantly, investment ties and joint venture partnerships will also accelerate the pace at which entrepreneurs and managers on both sides learn about and become comfortable with each other.

Finally, reliable and trusted bridges must be built to enable Chinese capital (in the $100 billion range) to find its way into India. China is a mountain of capital looking for attractive investment targets. Over the coming decade, with a target of more thatn $1 trillion in needed investment, India's infrastructure projects may provide China with the largest such opportunity.

In short, aside from machinery, Chinese capital could also emerge as India's partner in accelerating the latter's infrastructure revolution. The gulf that needs to be bridged is one of lingering mistrust, but well-established mechanisms do exist to enable parties—who do not trust each other—to do business with each other. One such mechanism is for Chinese capital to go in as a "limited partner" in India-focused infrastructure funds managed by mutually trusted third parties. After all, if China and Japan can learn to engage in a close economic dance, why not China and India, two countries that have led a much more harmonious relationship for more than 2,000 years?