August 28, 2014 12:00 am JST

Prachi Priya: What the Sino-Indian nexus means for the region

A July meeting between Indian Prime Minister Narendra Modi and Chinese President Xi Jinping on the sidelines of the BRICS summit in Brazil reinforced an increasingly positive tone in the Asian nations' relationship.

     During their 80-minute discussion -- the fourth high-level Sino-Indian engagement since India's new government took charge in May -- Xi invited Modi to attend the Asia-Pacific Economic Cooperation summit in Beijing in November. Modi, meanwhile, has invited Xi to visit India in September.

     India and China together account for 21% of global gross domestic product on a purchasing power parity basis, as well as 37% of the world's population. They have a lot to offer each other. The two leaders' optimism and fresh approaches are likely to energize otherwise low-key Sino-Indian ties, as could a recent agreement by the BRICS countries -- Brazil, Russia, India, China and South Africa -- to create a new development bank.

     Modi has declared relations with China "a priority." Previously, during his tenure as the chief minister of Gujarat, he courted Chinese investment in the state. Now he has the daunting task of reviving India's economic growth. This requires a new stance toward commerce, trade and foreign policy.

     So far, trade has been among the most important pillars of Sino-Indian economic engagement. It is revealing to assess the prospects for trade in the context of the broader relationship, and consider the implications for the region.

Trade asymmetry

China has replaced the United Arab Emirates as India's largest trading partner. Bilateral trade has increased more than twentyfold in the past decade, from a mere $3 billion to a total of $65 billion in 2013.

     China is India's largest source of merchandise imports and also the third-largest market for India's exports. However, India's trade deficit with China rose from $600 million in the fiscal year through March 2001 to a peak of nearly $40 billion in the year through March 2013, before dipping slightly to $36 billion last fiscal year. The rate of growth in China's exports to India over the last decade, a 37% year-on-year average, has consistently exceeded growth in India's exports to China, a 30% average. This has created a major trade imbalance in favor of China.

     China accounts for a fifth of India's total trade deficit, and a startling half of India's total non-oil trade deficit. The composition of bilateral trade flows is even more lopsided. Raw materials such as copper, ores and cotton constitute almost 60% of India's exports to China. On the other hand, India mostly imports capital goods from China. About 50% of Chinese shipments to the country consist of electrical machinery, telecom equipment, nuclear reactors and boilers, machinery and project goods.

     Overall, India's exports have diversified over the last 10 years, both in terms of product range and destinations. India's top exports now feature high-value items like engineering goods, automobiles, car parts and refined petroleum products. The percentage of traditional products like textiles and finished garments has declined significantly, from 26% to 9%. But China has yet to emerge as an important destination for these high-value-added products.

     India's exports to the rest of the world are better diversified than those to China.

     Why has the trade deficit widened?

     First, India's massive infrastructure requirements have resulted in the rise of capital imports from China into India. Domestic manufacturers have not been able to compete with the Chinese imports in terms of both quantity and price.

     Second, an undervalued yuan, or renminbi, makes it difficult for Indian exporters to compete with lower-priced Chinese imports.

     Third, Beijing's imposition of nontariff barriers makes it difficult to export to China. Anti-dumping duties, technical trade barriers, sanitary and phytosanitary issues, operations of state-owned enterprises, customs processes, export restrictions and intellectual property protections are examples of such barriers.

     Notably, the higher price elasticity of China's imports into India compared to that of India's exports to China possibly explains why the current trade balance is so heavily skewed in favor of China. Price elasticity captures the responsiveness of the quantity demanded of a particular good to change in its price.

     Last and most important, India's export competitiveness, especially in the manufacturing sector, lags far behind that of China. In fact, a study by the Institute of South Asian Studies shows that despite India being globally competitive in 21 product groups that it exports to China, it is not as competitive in these categories as the so-called Asean-4 -- Indonesia, Malaysia, the Philippines and Thailand.

Don't fuss over the trade deficit

Economic talks between India and China have emphasized the need to address the trade asymmetry. However, we need to question if the trade deficit is really a concern. At this stage of development, India needs low-cost capital goods from China. China was in a similar position in the 1980s, as it imported capital goods from Japan and Germany to strengthen its manufacturing sector and infrastructure. Today, China is a net exporter of capital goods.

     Thus, the deficit should not necessarily be perceived as a negative. Seen differently, cheap intermediate and capital goods imports from China are helping India build its infrastructure.

     Even though India and China are two of the world's most attractive investment destinations, bilateral investment flows between the countries are very low. Chinese investment accounts for around 0.2% of total foreign direct investment in India, even with China's outbound FDI on the rise. Indian investment in China is even smaller, accounting for 0.05% of China's inbound total.

     It is well-known that Indian policymakers still closely scrutinize Chinese investment proposals. In contrast, India is increasingly comfortable with Japan -- now its fourth-largest investor, accounting for 8% of FDI inflows in the fiscal year through March. The Japanese have been quick to take advantage of India's massive infrastructure opportunities, investing in projects including the Delhi Metro and the Delhi-Mumbai Industrial Corridor. The Japanese government also invests in various noncommercial projects through the Japan International Cooperation Agency and commercial projects through the Japan Bank for International Cooperation.

     According to a McKinsey study, poor logistics infrastructure costs India around 4.3% of gross domestic product. The study notes that "rail and coastal shipping costs in India are approximately 70% higher than those in the U.S. Likewise, road costs in India are higher by about 30%."

     China, like Japan, has the perfect opportunity to invest in India's infrastructure and manufacturing sector. The BRICS development bank could add a new dimension to India-China relations by acting as a funding platform. This could be a win-win strategy for both countries.

     Moreover, India Inc. should not get nervous about doing business with China. Given India's comparative advantage in services and huge need for capital, it requires a trade strategy involving comprehensive pacts that cover goods, services and bilateral investments. Engagement with China should not be restricted only to trade, so trade asymmetry need not be a major impediment for future bilateral and multilateral talks involving the two countries.

     That said, China's use of nontariff measures and circumvention of rules of origin need serious review, particularly in negotiations on the proposed Regional Comprehensive Economic Partnership -- a loose grouping that comprises the 10 Association of Southeast Asian Nations members, Australia, New Zealand, India, China, South Korea and Japan.

     As the U.S. pushes for a pair of major pacts that exclude India and China -- the Trans-Pacific Partnership and the Transatlantic Trade and Investment Partnership -- the two Asian giants could redefine the global trade architecture in Asia's favor by leading deeper economic engagement within the region.

     Ultimately, with the recent changing of the guard in New Delhi, it is high time to overcome the "trust deficit" with Beijing. The question is whether Xi and Modi are ready to walk that tightrope together.

Prachi Priya is a corporate economist based in Mumbai. She previously worked at an investment bank in Singapore.