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| Source - Economic Times |
India and China are the 2 largest economies of Asia today. While China is the largest economy of the world in terms of PPP terms, whereas India has consistently remained the world's fastest growing economy over the past half a decade, this is huge in the context as both of the countries have also been impacted by various geopolitical shocks namely - Galwan clash of 2020, political instability in South Asia, return of pre Abrahamic accord conflicts in West Asia, Russia - Ukraine war and the biggest economic disruptor the coronavirus pandemic. Despite these shocks, both India & China have recorded decent growth rates, except for 1 financial year where China's growth rate plumetted it has otherwise, maintained a very steady annual growth figures.
The same can be said even about India, which has recorded impressive growth rates by following a different mix of supply side economics in 2021 & 2022, where government's capital expenditure helped the economy in a massive manner. Since, 2023 Q3, its a well known factor that, India has grown on the back of consumption expenditure, which is also seen in the fourth graph.
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| GDP annual growth (% of GDP) - Graph 1 (WDI, World Bank) |
The 2 countries have achieved these consistent economic numbers despite not having anywhere near to normal political relations from the past half a decade, which shows that there are some inherent structural strengths in the economies of both the countries. The 2 countries, over the past few months have also shown signs of re-starting & normalizing the relations between them with steps like - resuming direct flight services and the much publicized RIC meeting. While on the outset, it may seem as a political realignment, due to the pressure of Donald Trump via his tariffs or is this realignment a case built due to international open economics is what this article tries to explore.
The FDI conundrum-
While trade is undoubtedly the most critical factor that single handedly determines the direction of open economy & monetary policy, another important factor that determines the direction is the financial & capital accounts of the countries. One of the most important components of the financial account for emerging economies like India is the Foreign Direct Investment. Now, foreign direct investment is categorized as a long term control with greater than 10% ownership, while FDIs are shown in the debits section of a central bank's balance sheet, but its a known fact, that it translates into economic benefits like - higher investments, higher growth and access to foreign capital. Both India and China, have also reported higher growth rates since their post reforms era which has primarily been due to the foreign capital influence in these 2 countries.
This makes, FDI inflows as a critical component for the GDP of these 2 countries, the graph below shows the FDI inflows as a net% of GDP, it can be seen, that, since 2022 onwards due to sluggish economic growth across the globe, the net inflows as a % of GDP has fallen to less than 1% GDP in FY 2024 in India & China. This trend is not healthy for either of the countries, which has a good number of established foreign firms in their respective countries, stagnation of FDI in these countries can stagnate long term FDI inflows in both the countries, which is not a good sign as it leads to something called as consumption smoothing and possibly stagflation, if this trend continues. It may be possible, that to arrest the decline of FDI inflows as net% of GDP was a major reason, why India & China are pushing for a normalization of ties.
Furthermore, it is interesting to see from which countries do both the Asian giants recieve their FDIs. The second infographic provides interesting insights, now while China is a big investor in different countries courtesy the CPEC & OBOR initiative, it still needs access to global capital markets. In case of India, the countries making the FDI investments are diversified, which are mainly coming from Singapore (27%), Mauritius (17%), USA (10%), Netherlands(8%), UK(6%), UAE (7%) & Japan (5%).
On the other hand, China recieves its FDI investments, mainly from the financial center countries. For the unintiated, financial center countries are defined as those, which serve as critical hubs for international banking, investment and other allied fiscal sectors. China has its, FDI majorly coming in from these countries namely - Hong Kong & Virgina Islands, contributing to 75% of total FDI inflows.
Now on the outset, investments from financial centers is what many countries desire for, as they work with little to no legal regulation, but these investments also have their own drawbacks such as - high capital mobility which is volatile in nature. Using simple, IS-LM-BP model, what technically happens from investments from the financial centers is that, it causes short term output fluctuations and it ends up making capital flows dominate the exchange rate market dynamics, which is very risky for an emerging economy.
Furthermore, since the financial centers work with almost little to no regulation from the monetary policy banks of their respective countries, it makes them suspectible to interest hikes from the central banks of other economies. This also can have profound impacts on the emerging economies like China - a hike in interest rates from USA's fed, increases the cost of capital outflow from the financial center (say Hong Kong), which in turn pushes the Chinese central bank to rise the interest rates in order to keep inflation under check, as the financial center ends up investing more in a country which has lower interest rates as compared to that of a bigger economy.
This can lead to exchange rate appreciation in the short run, but it ends up impacting the competitiveness of a country's exports. Furthermore, since financial centers dont have a strong regulatory authority, the reactions of capital management in these countries are highly procyclical meaning, that during global downturns these countries struggle in making/recieving investments. This phenomenon at least explains as to why the net FDI inflows of both countries have fallen massively post pandemic.
This overdependence by China more specifically on the financial centers for FDIs can also be considered as a amjor reason, of why China and India are pushing for some degree of normalisation in the bilateral relations, as both India & China have relatively strong central banks.
Hence, when said from the perspective of FDI & financial account flows, it can be said that, in the face of the latest tariffs, the dance between elephant & dragon is imperative, at least for some years. Now, since FDI is also a part of investment component for the country, it is even more imperative that the foreign capital flows are more or less stable, which can keep the production linked economy stable.
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| The FDI sources for India - Diagram 1 (PHDCCI) |
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| FDI sources for China - Diagram 2 |
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| FDI Inflows (net % of GDP) - Graph 2 (WDI Indicators, World Bank) |
The second big international open economy concept that may influence the behaviour of both the countries can actually be the trade related consumption smoothing, which is very normal in international open macroeconomic settings.
Now in both countries, trade is a very critical component of GDP in the past 5 years, India's trade stats as percentage of GDP has remained around 40%, while India is an import dependent nation courtesy petroleum imports amongst others, whereas for China it has remained around 37% which is also super impressive.
Contrary to popular belief, Indian exports & Chinese exports contribute roughly the equal amount as relative to the GDP, though in terms of absolute value, China trumps India by a large margin. Now from graph 3 and graph 4, it can be seen that, for both India & China is exceptionally important while contributing to its economy.
However, its the graph 5 which may have nudged India & China to relook the hardened economic stances against one another, as that graph pertains to consumption which is one of the most critical components of GDP growth. While for India, final consumption expenditure growth has remained constant around 70% over past 4 years, mainly driven by government investment, China's FCE has taken a hit due to the pandemic.
China's FCE has remained constant at around 50% and has shown signs of recovery only since the FY 2023, which means that China intends to continue to push its people to consume more so that using simple basic Keynesian economics, the growth rates can be kept intact.
For India, consumption expenditure tends to be historically high in terms of open macroeconomics as its a majorly import dependent country having a very young population, whereas China is sort of a old country with more importance over exports.
This can be a prime reason, why, China has restarted direct flights to India which can have a positive impact on the final consumption expenditure. This is even more important now, as due to the Trump tariffs and the constant interest rate cuts by different countries in order to prevent consumption smoothing which can push the growth rates down.
For the unstarted, consumption smoothing is a process opted by countries to maintain stable consumption patterns in the macroeconomic structure, so that the living standards in the country dont drop drastically during the depression phases or dont rise exponentially during . Now, on the backdrop of Trump tariffs and other geopolitical shocks as covered in the first paragraph, it is quite possible, that the recent reforms in India like the IT rate cuts, GST slab rate changes are done in order to keep the consumption patterns stable, which otherwise can run the risk of getting volatile, which is not a good news for any emerging economies. Not managing consumption properly can also have devastating affects on the exchange rates, which both India & China wont like to risk at a time when they can actually ending up as winners due to the various trade regulations coming up.
Also given, that both countries are highly tariffed at this time by the USA, which has an impact on the exchange rates & the resulting consumption smoothing phenomenon, it is very important for both of them to increase their trade with BRICS+ nations and with the ASEAN bloc, which can help them smooth the consumption dynamics till a new equilibrium is found with the Trumpian tariffs and the upcoming CBAM regulations.
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| Trade as % of GDP - Graph 3 (WDI Indicators, World Bank) |
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| Exports of goods & services(as % of GDP) - Graph 4 (WDI indicators, World Bank) |
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| Final Consumption Expenditure (as % of GDP) - Graph 5 (WDI indicators, World Bank) |
Way Forward -
This is a new & sort of a unfamiliar geoeconomic territory for both the countries. Both India & China, had huge trade & FDI relations, from 2000-2017 years which was primarily due to multiple reasons like no border clashes, India's MSME sector was very weak in this timeframe which made India a net importer of cheap manufactured goods and the geoeconomic scenario of the world was much more stable with the only major events in this decade being of the 2008 financial crisis which both countries were able to manage well.
But, now, the scenarios are very different, Indian economy is more stronger which can be seen in various indicators like the innovation index, trade volumes & a much stronger MSME, heavy & sunrise sectors which makes the ball game very different. India & China are also now major competitors in various sectors, while are also collaborating in various other areas. Also, geopolitically India is much stronger in today's time and the world is a more unstable place due to the various factors as listed in the first paragraph.
Since, the timeframes are drastically different now, it makes sense for both India & China to start economically cooperating in certain areas which can be of great help to the Asian continent. But, it is imperative for India to make sure that the reforms related to economy dont stop and that this time the cooperation with China doesnt end up compromising India's national economic interest which happened due to RCEP for many years. The way is not certainly easy but it can change the power dynamics if both of these asian giants collaborate and take the other smaller countries of the world together in a non-confrontational manner.
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