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The Dynamic of Economic Growth

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Today China has many of the benefits of the possible Asian common market achieved through its open door reforms in 1980s, and its close economic relationship with Hong Kong and Japan, as well as its growing contacts with Taiwan and Korea. If these benefits can be maintained without the changes that might be required to join Asian market-changes which could be politically costly – there would be little incentive for China to join an Asian market in the short run. This could however change sharply if such a market became in fact established and China, not being a member, was excluded. That would be economically very costly for China, possibly forcing it to reconsider and to adopt the policies to become a member.

India possesses a distinct identity in its geography, culture, people, history, and language as well as in its natural ecosystem. It is blessed with a wide variety of climates and soil types which permits the growing of many unique earthy roots, precious woods, aromatic spices, exotic flowers, balsamic resins and scented grasses. India’s botanical treasures have many fascinating worlds to discover throughout the country. A new spirit of economic freedom is now inspiring the country, bringing comprehensive change to its economy. A sequence of determined economic improvement aimed at deregulating the country and stimulating foreign investment has moved India firmly into a position of the rapidly growing Asia Pacific region and set free the hidden strengths of a complex and fast changing nation.

Structural and Policy Indicators in Economic Growth in China

Recent resurgence of interest in economic growth has led to a blossoming literature.  Among the many approaches proposed, cross-country growth regressions have been widely applied to examine the role of various structural and policy indicators in economic growth. The findings in this large and growing literature are often conflicting and yet to be sorted out. For example, Levine and Renelt (1992) carried out a sensitivity analysis of the determinants of the average annual growth rate of GDP per capita for a sample of 101 countries during the period 1960-89. According to their extreme bounds analysis, among many only three variables (i.e., investment, international trade and initial income) are found to possess fairly robust predictive power. Recently, Sala-i-Martin (1997) presented a more optimistic study showing that a substantial number of variables are strongly related to growth. This finding is further evaluated by Snowdown, Brian in 2006.

One common feature of the existing studies is their reliance on cross-section statistics. The main drawback associated with cross-country analyses is the presence of heterogeneity in data aggregation, economic structure and institutional framework among the countries considered.

Determinants of China’s Regional Growth

Given the aforementioned data, the empirical analysis begins with a baseline model which is employed to investigate the impact of physical capital accumulation and the initial income on regional growth. For the purpose of comparison, the empirical analyses focus on two periods, i.e., 1982-90 and 1991-97. The point of division is largely dictated by the availability of statistics. For example, many Chinese regions began receiving FDI in 1982, and population censuses were conducted in 1982 and 1990, respectively. 5 In addition, it is interesting to compare regional growth in the 1980s and 1990s.

Capital Accumulation and Initial Conditions

Capital accumulation has often played a key role in economic growth (Blackman, 1999). It is expected to be positively correlated with the rate of economic growth. The initial income is regarded as an important factor underlying growth. It is argued that less developed economies may be able to take advantage of backwardness and hence enjoy faster growth (Dodgson, 2000). The initial income variable in the empirical models takes the value of GDP per capita in the first year of the time period considered and its coefficient is expected to have a negative sign.

As expected, the growth of physical capital stock (domestic) has made a significant contribution to economic growth over the periods considered. The initial level of income is found to be negatively related to economic growth. This relationship is significant at a given level of significance. Thus, it may be concluded that there is evidence of conditional convergence among the Chinese regions during the past two decades. The rate of convergence is about 1.5 per cent per annum according to the baseline regressions. The coefficients of the two regional dummies have shown that the western regions grew relatively fast in the 1980s but lagged behind both the coastal and central regions in the 1990s. Thus, the estimated convergence as indicated by the sign of the initial income took place mainly within the regions. This finding is consistent with observations from regional disparity studies (Wu, 2000).

Other factors such as infrastructure, labor productivity conditions, foreign capital, economic reform, openness and human capital have also played important roles in China’s growth over time. However, these variables cannot enter the regressions simultaneously due to the existence of multicollinearity. For example, the coefficient of correlation between the variables representing infrastructure and economic reform and that between foreign capital and openness is relatively high. As a result, various alternative models are estimated. The interpretation of the results from selected models is presented in the following sections.

Infrastructure and Labor Productivity

The level of infrastructure development can be proxied by several indicators such as the length of roads and number of telephones.  However, the use of the length of roads is likely to be biased against regions where railway is the dominant means of transportation. Due to the fact that the large and relatively more developed regions always have more telephones, the growth rate of the number of telephones per head is used to reflect the change in infrastructure among the regions. The use of growth rate rather than level is also consistent with other variables. The regions led by Guangdong and Fujian achieved substantial growth in infrastructure during 1982-97. This growth should have contributed positively to the regions’ economic performance.  Infrastructure development is positively correlated with economic growth in the Chinese regions. Improvement in labor productivity is expected to make a positive contribution to growth. Impact of economic reform and openness

It is argued that economic reform has contributed significantly to China’s growth in the past two decades. This claim is supported by empirical studies of the agricultural sector (Demurger, 2000). In particular, one of the key reform initiatives was to open China to the world. As a result, China’s economic takeoff over the past decades has been accompanied by rapid expansion of international trade. How have domestic reforms and external trade affected growth performance among the regions? To answer this question, reform and openness indicators are developed and incorporated into the growth regressions.

In the growth literature, the ratio of the total value of exports and imports (or the value of exports) over GDP is employed as an indicator of openness. In the case of the Chinese provinces, it is found that the ratio of the total value of exports and imports over GDP is highly correlated with the ratio of the value of exports. Thus, either ratio can be used as the indicator of openness. In the final estimation, the ratio of the value of exports over GDP is used to represent openness.  Guangdong and Shanghai have the most open economies in China.

To reflect the progress of economic reform among the regions, the role and development of the non-state sector is examined. The non-state sector includes all but the state sectors. Three indicators can be used to assess the development of the non-state sector: the shares of the non-state sector over urban employment, industrial output and total retail sales in the Chinese regions. In general, these three shares have been rising over time, implying the deepening of China’s economic reform. In the empirical models, after preliminary checking, the mean output shares of the non-state sector between 1985 and 1990 and between 1990 and 1997 are used to proxy the degree of economic reform during the two periods. Coincidentally, the value of the output share is bound by the value of the employment and sales shares. China’s reform and openness have contributed positively to economic growth in the past decades.

The Role of Human Capital

China conducted population censuses in 1982 and 1990. A sample survey was also carried out in 1997. The census and survey data have now been published in various sources. Statistics on the level of schooling of the population are available for 1982, 1990 and 1997. To justify the use of the 1982 census data, the two sets of data for 1990 and 1997 are compared. It is found that these data sets are highly correlated, with a coefficient of correlation greater than 0.99. Due to this close relationship, the average level of education of the population is used to derive the level and growth rate of human capital stock among the regions.

The average rates of growth of human capital stock during 1982-90 and 1990-97 are employed in the regressions. It turns out that the coefficient of this variable is either negative or insignificant. Other authors have reported the same problem with the human capital stock variable (Khan, 1998). This may be due to measurement errors and technical constraints in deriving human capital stock data (Li, Jingwen, 1995). To overcome this problem, an alternative proxy for human capital may be employed, that is, the proportion of population aged six and over with at least six years of schooling (i.e., the completion of primary school education). The average growth rate of this figure is used in the final estimation. Shanghai and Beijing have the most educated populations in China. It is also found that Anhui and Jiangxi, two central regions, have achieved the highest growth in human capital during 1982-97.

FDI as an Engine of Growth

According to new growth theory, FDI has been an important factor propelling economic growth. 11 China’s FDI increased significantly in the 1990s but the amount of investment varies considerably across the regions. In particular, some regions experienced hyper growth in certain years only due to the launch of a few large projects. As a result, regional growth rates of FDI vary a lot over time and the outliers in the data sample are problematic. To overcome this problem, the proportion of foreign stock over the total capital stock is employed in the empirical estimations. Foreign capital still plays a minor role in many regions, in particular in central and western China. The contribution of FDI to China’s growth in both the 1980s and 1990s was significant.

Cross-country studies on economic growth have been criticized for overlooking heterogeneity among the world economies. Studies focusing on a single country, instead, may suffer less from this problem.

The contribution of productivity to economic growth in China has been of particular concern on the East Asian newly industrialized countries (NICs) by Krugman (1994). He quoted work. Rapid growth in the East Asian NICs has been driven mainly by massive injection of factor inputs rather than innovation and that growth in these countries would not be sustainable. By employing a growth accounting method, Borensztein and Ostry (1996) and Hu and Khan (1997) found a significant contribution of total factor productivity to growth in China during the reform period. Fleisher and Chen (1997) investigated the impact of human capital and foreign investment on regional variations in productivity. China has largely followed an extensive growth model with little technological progress.

Productivity growth is decomposed into two components, i.e., efficiency change and technological progress. The former refers to catching up to the production frontier and the latter to outward shifts in the production frontier. This decomposition allows the identification of productivity growth due to either improvement in efficiency (i.e., catch-up) or technological progress (i.e., innovation). In particular, this technique can be applied to estimate the impact of economic reforms on China’s growth. Economic reforms can boost productivity growth in two conceptually different ways. One way is by increasing the efficiency with which the existing resources are utilized in production.

For well-known reasons, centrally planned economies like the Chinese economy produce well below their best-practice outputs. Economic reform aims to raise production close to the frontier (i.e., improvement in technical efficiency). Another way to boost productivity growth is by stimulating innovation, i.e., technological progress. Centrally planned economies have recorded low levels of technological progress according to international standards (Zhao, 1999). An investigation of China’s productivity performance, in particular the two components of productivity growth, can provide valuable insight into the understanding of that country’s spectacular growth over the last two decades.

China’s regional growth is positively affected by capital formation, infrastructure, productivity, human capital, foreign investment, economic reform and openness. These factors together with initial conditions accounted for 70-90 per cent of China’s total growth. There is also evidence of conditional convergence among the regions. This trend of convergence was particularly strong in the 1980s. It is also found that convergence mainly occurred within China’s three geographical regions, i.e., the western, central and coastal regions. There is little convergence between the three regions.

Regional disparity in China has recently become the focus of academic research and policy-making. It is found that researchers do not agree with each other on the conditions of regional disparity in China. Their work is constrained due to data limitations and inconsistent goals. Several indices of regional disparity are estimated and the results are compared to previous studies. A major distinction in this study is its separation of the three municipal cities, namely Beijing, Shanghai and Tianjin, from the provincial regions. It is found that, in the absence of the three cities, regional disparity in China has changed little during the reform period. Previous measures of regional disparity mainly picked up the gap between largest cities and the provinces. The latter are less urbanized than the cities. With the exclusion of the three cities, China’s regional disparity is internationally compatible.

The southern China economic region has emerged as a major economic centre in Asia in the 1980s and 1990s. It is found that the two mainland regions, Guangdong and Fujian have shown rapid catch-up with their affluent neighbors, Hong Kong and Taiwan. As a result, the gap between the four economies has been narrowing over time. This has become the driving force for economic integration in the region. With mainland China and Taiwan becoming official WTO members in late 2001, economic integration will be accelerated in the near future.

The telecommunications industry has far outpaced the growth of the Chinese economy. Several factors have contributed to this growth. They include burgeoning demand for services, changes in government policy and deregulation in telecommunications. In particular, deregulation has become the main driving force for the growth in China’s telecommunications. Since the early 1990s, the Chinese telecommunications sector has been transformed from state monopoly to a privately owned and operated system. Several independent large companies together with small providers compete for services in the market. Foreign traders and investors are also allowed to play a role in various forms though there are still restrictions. As China complies with WTO regulations, foreign participation will gradually increase in the near future. China is now the world’s largest mobile phone as well as fixed line market in terms of numbers. However, China’s teledensity is still a long way from matching the level in advanced economies such as the USA and Japan. There are also huge differences between the coastal and inland regions and between rural and urban areas. These factors imply that China’s telecommunications sector will maintain high growth in the coming years.

The energy sector used to be the bottleneck of the economy. This was due to poor efficiency in domestic production and the pursuit of energy self-sufficiency. After two decades of reform, China has shifted to rely on diverse sources of energy supply. In 2001, about a third of China’s crude oil comes from offshore sources. As a result, China is now an important trader in the international oil market. China has also signed a 25 year contract to purchase LNG from Australia. Domestically, dramatic changes have taken place in coal, oil, gas and electricity sectors. In all sectors, production and trade have moved away from state monopoly to multiple players. The coal sector is most deregulated. It is followed by the petroleum sector. A major reform package for the electricity sector was announced in late 2002. More changes and deregulation initiatives are expected in the future. In the meantime, burgeoning demand and rising consumption will maintain the trend of growth in this sector.

Growth Outlook

China’s GDP is expected to achieve a rate of growth of 7.9 per cent in 2002. This rate is impressive given the economic performance in the USA and Japan during the same period. In the same year, China overtook the USA to become the largest recipient of foreign direct investment. With China being a WTO member for just a year, more foreign capital is expected to flow to the Chinese economy. The Chinese government is also injecting massive investment in the western part of the country. All these signs point to the direction of continuing growth at the current level in China.

There are however potential uncertainties associated with China’s growth in the near future. First of all is raising unemployment. According to official statistics, unemployment was around 4 per cent. The actual figure is much higher. As more foreign firms and products enter the Chinese economy, the situation is likely to become worse in the short run. Coupled with unemployment is the lack of a nation-wide social security network. Most unemployed are left alone and are receiving no financial assistance. This could be a threat to social stability in a society with a billion urban workers and farmers.

While telecommunications and energy industries have moved ahead to embrace the market and economic openness, China’s banking and financial sectors are yet to be reformed. These sectors are still dominated by state ownership and often closely linked with the inefficient state-owned enterprises (SOEs). The latter are the main debtors of the former and can still borrow more from the former under its current system. Many SOEs are inefficient but politically sensitive to the risk of bankruptcy. Thus, the banking and financial sectors could hamper long-term growth prospects of the Chinese economy.

Tax Laws and FDI in China

Introducing foreign investment is regarded as the most effective instrument for obtaining capital, new technology and managerial knowledge. However, most host countries, especially developing countries, are concerned about the potential negative effects of foreign investment. Similarly, China has a great need for foreign investment and recognizes the benefits of foreign investment, but at the same time is concerned over its potential negative effects. Therefore, for China there is often a dilemma of regulating conduct against the national interest yet not discouraging foreign investment. The considerations of government policy towards foreign investment are different in each country. Much depends on the host country’s perception of what types of investment are beneficial or harmful to the interests of the state. However, one thing does seem clear – , that is, the attitude and policies of countries depend very much on whether they feel that they are in control of their own destiny.

For China, considerations from different perspectives may well be in flux as long as the debate over benefits and negative effects of foreign investment continues. The unresolved controversial issues will continue to affect the outlook of Chinese leadership towards foreign investment. This means that China’s foreign investment laws and regulations can be expected to be subject to constant changes in such a context.

Efforts to harmonize foreign direct investment with the objectives and economic development programs of China necessitate a fairly detailed framework of policies and regulations regarding foreign investment. The prevailing philosophy is that foreign investment could be beneficial to China, if such investment were properly harnessed to China’s economic development. It is for this reason that there is an apparent inconsistency within China’s foreign investment laws. On the one hand, the laws provide many tax incentives and different preferential treatment in order to entice foreign investors. They also provide protection for management autonomy and contractual rights in a planned economy context, and guarantees relating to the repatriation of profits and against nationalization of the property of foreign investors without payment of compensation. But, on the other hand, the laws contain requirements of government approval for establishment and provide different restrictions such as prohibition of certain activities. Thus controls, restrictions, incentives and protections are mixed up and form a complex regulatory regime.

China does not have a foreign investment code, although there are suggestions from some Chinese scholars that China should enact a systematic code governing FDI. (Miyake, 2005) Instead, the legal framework for FDI in China consists of laws, regulations, measures and policies of both the national and local governments. The basis of the framework is founded on three laws passed by the Chinese National People’s Congress, which are (a) the Law on Chinese-Foreign Equity Joint Ventures; (b) the Law on Chinese-Foreign Co-operative Joint Ventures; and (c) the Law on Wholly Foreign-Owned Enterprises. On the basis of the three laws, a great number of national and local regulations, measures and policies have been enacted. In addition, a number of national laws, which have been passed for other purposes are sometimes relevant to foreign investment. The legal framework for foreign investment consists of the following four groups of laws, regulations and policies.

The Foreign Economic Contract Law (FECL) is important to foreign investors when they plan to establish a joint venture with Chinese enterprises. It is formulated with a view to protecting the lawful rights and interests of the parties to Chinese-foreign economic contracts and promoting the development of China’s foreign economic relations, as stated in the beginning of the law. One main reason for a separate contract law for foreign economic relations is that the Economic Contract Law (ECL) that governs domestic contracts reflects the influence of the state economic plan. Thus, the FECL is enacted to grant parties to a contract more autonomy, thus giving foreign investors more legal certainty. At the same time, improvements were introduced to meet the concerns of foreign investors, for example, ‚Äúthe 22 Articles‚ÄĚ – Provisions for the Encouragement of Foreign Investment.

Since then, the legal framework governing FDI has been continuously supplemented by implementation rules and specific pieces of legislation regulating various areas of the operation of FDI: registration procedures, labor matters, banking and loans, foreign exchange transactions, regulations governing the use of land, tax laws and arbitration. (Harpole, 1998) Other laws and regulations of general application that can affect FDI are such statutes as the General Principles of Civil Law (GPCL), Trademark Law, Patent Law, Company Law and Administrative Litigation Law. These laws helped to bring the Chinese legal structure more in line with that of the West, though the content was not always the same as that existing in developed countries.

Local Laws and Regulations on Foreign Investment

Local legislation had played an important role in regulating foreign direct investment. As discussed above, theoretically, regulations made by local governments must be consistent with the laws and regulations of the NPC and the central government. However, in practice, they supplement and specify the national laws and regulations which are meant to be general and broad principles. Due to the continual interpretation and specification of law at different levels of administrative organs, ambiguity and inconsistency become a serious problem. Due to the need to experiment with new policy on foreign investment, in some Special Economic Zones, local regulations also fill the vacuum left temporarily by the national law. The company laws in Shenzhen and Shanghai, which were superseded by the national Company Law of 1993, are such examples. The Shenzhen Special Economic Zone, in particular, became a centre for legislative experiments. For example, the regulations governing contracts between foreign and Chinese companies in Shenzhen and those relating to foreign technology import contracts were precursors of similar regulations adopted for other localities and for the national counterpart legislation. (Feng, 1999)

Foreign investment policies of both national and local governments

The policy on FDI also affects the operation of FDI. It is an important part of the legal framework for FDI in China. The policy is usually not as transparent as the law and regulations. A foreign investor should pay attention to the policy which may affect a particular investment project from time to time.

Thus China, whose policy and legal framework on FDI could have been described in 1979 as virtually non-existent in the sense of the modern world, has now constructed a policy and legal framework on FDI within a very short time. The establishment of a legal framework considered to be an essential element in China’s open policy has had a positive impact on the flow of foreign direct investment. For example, in the early 1980s, the amount of foreign investment grew very slowly. The legal environment for joint ventures was clarified by implementing a series of regulations in 1983. This was followed by a foreign investment boom which peaked in 1985. When, dissatisfaction caused a slowdown in 1986, the 22 Articles which added new incentives and reduced past uncertainties, resulted in another increase of foreign investment flow.

However, despite the achievements in law development, many problems remain. To understand the features and problems in relation to foreign investment law, this section will further analyze China’s foreign investment law from four perspectives, namely, legal controls on foreign investment, legal incentives to foreign investment, legal protection of foreign investors’ management autonomy, and protection of foreign investors’ contractual rights.

Special financial regulations often apply not only to the establishment of a direct foreign investment but also, and even more commonly, to the continuing operations of foreign-invested enterprises. The financial transactions most frequently subject to regulation are reinvestment of profits, repatriation of capital and profits, and borrowing by foreign enterprises. For instance, reinvestment of profits is regulated either through the establishment of a reinvestment quota or by means of differential tax treatment of remitted profits and reinvested earnings.

Countries that suffer constantly from balance of payment and foreign exchange problems usually place great value on the limited foreign exchange available for all their overseas transactions. Various restrictions directly affecting the operations of private foreign-owned enterprises are imposed for reasons of monetary and foreign exchange policies. Thus local or foreign borrowing may require prior authorization. Limits may be imposed on the granting of credit to an investor by national or foreign financial institutions, not only in respect of the amount of borrowings but also concerning the currency of payment.   (Duffy, 1996)

Foreign investors may also be required to deposit certain amounts in convertible currencies with the host country’s central bank. (Dicks, 2004) Repatriation may require exchange control authorization. Profit repatriation ceilings in terms of a fixed percentage of the registered capital are sometimes established by some laws in developing countries. In some cases, such laws not only restrict the remittance of earned profits or the repatriation of capital but also create multiple exchange rates.

Many countries turn to foreign direct investment simply because local savings are inadequate to support increased investment. Governments also expect foreign investors to provide technology, management skills and access to markets – in short, they are interested in the package of tangible and intangible assets embodied in foreign direct investment. The less developed a country is, the more severe are the domestic resource and capability constraints, and usually the greater are the expectations from foreign investment to alleviate them. (UN, World Investment Report 1995)

However, foreign investors are not attracted to locations with few advantages. Therefore, host countries adopt different measures in order to attract foreign investments. Among different measures such as providing a better built-up infrastructure, different incentives are frequently used by host countries. Therefore incentive measures also constitute one part of the national regulations in encouraging FDI. Thus by providing incentives, (OECD, 1983) the host country can attract more foreign investment and direct foreign investment into desired areas and industries.

Competition among countries to attract and keep foreign investment through incentives is strong and pervasive. Generally the most common incentive is the offer of tax holidays, for periods of five or more years, to new industrial undertakings. Sometimes investment incentives take the form of initial allowances or accelerated depreciation of the cost of buildings, plant and machinery for tax purposes. Moreover, any part of this allowance which cannot be deducted from profits or income of the year of assessment may be carried forward to subsequent years. Fiscal relief can also be given by fully or partially exempting building materials, plant and machinery and raw materials for new industries from customs duties.

Most developing countries provide tax holidays and other incentives to foreign investors in order to attract them to invest in their countries. While a reduction of the standard corporate income tax rate is the most frequently used type of fiscal incentive for foreign investors in most countries, the levels of reduction vary considerably, even within the same country. Tax holidays are more common in China, for up to five years after an investment, but they could be extended to ten years or even more. The incentives are usually available only to investors who fall into specified categories, such as those who bring in high technology or who invest in particular industries or who locate in certain regions. As a result, incentives have been increasingly functioning as instruments for regulating investments and for channeling them towards particular economic sectors.

One of the differences between developed and developing countries is that financial incentives such as grants and low-interest loans are frequently used in developed countries, while in many developing countries it is not so easy for foreign investors to get loans, let alone grants.

In China, many tax and other incentives are available to foreign investors. They can be categorized into two main types. One of them is site-specific. It ties eligibility to location in different types of special zones designated by the government for foreign investment. The other type of incentives is offered nationwide to companies that are either export-oriented or technologically advanced.

An important element of the open policy is that it inevitably reversed the previous bias against the coastal areas. (Pomfret, 1991) Since 1979, China has established in coastal areas many special investment areas which offer a variety of investment incentives to foreign investors. (Pomfret, 1991)

By mid-1992, the concept of open areas had reached virtually every part of China, leading to the creation of ‚Äúhigh-technology‚ÄĚ and other types of areas of increasing specialization, variously designated as ‚Äúnew areas‚ÄĚ, ‚Äúindustrial zones‚ÄĚ, ‚Äúdevelopment zones‚ÄĚ, ‚Äúindustrial parks‚ÄĚ and other similar-sounding names. Even the remote inland border cities have designated ‚Äúborder zones‚ÄĚ as special investment zones to facilitate trade with neighboring countries. This trend culminated in 1992 with the creation of ‚Äúbonded zones‚ÄĚ in some cities and a ‚Äúnew technology development experimental zone‚ÄĚ in Beijing. (Tretiak, 1993)

With the opening of different types of special zone, the main regulations concerning tax incentives in each type of special zone were also enacted. Different special privileges which are characteristic of China are also offered to foreign investors in different zones. SEZs, one of the earliest outcomes of the open door policy were established to attract foreign capital, technology and expertise. They aimed at developing external economic cooperation, fostering technical exchange and promoting the socialist modernization program by the provision of tax reductions, trade opportunities, low land utilities costs, competitive wage rates and abundant labor supply.  (Tretiak, 1993)

Another special privilege of SEZs is that the provincial governments where these zones are located are awarded special authority in economic affairs to minimize bureaucratic ‚Äúred tape‚ÄĚ and lengthy negotiations. Furthermore, in 1992 Shenzhen became the first zone authorized to enact its own regulations. One main feature of SEZs is that they are under less control of the planned economy and act as experimental laboratories for more liberal treatment of foreign investors. This experiment with a specific reform is supposed to be limited within certain regions in the beginning but can spread to the whole country if successful. Thus SEZs had the opportunity to develop first by experimenting with the market economy. For example, the enterprises established in SEZs are not regulated by the state plan with respect to decisions on their types of purchases for producing exportable goods.

In addition, they are permitted to set sale prices in accordance with international market conditions. The SEZs were the first to permit the establishment of foreign bank branches and in 1985 foreign financial institutions were allowed to engage in Renminbi dealings or services, something which was not permissible in Shanghai even in 1990. The SEZs were also the first to allow foreign investment in real-estate development, retail operations and other service and tertiary industries. Following SEZs, fourteen areas were designated as Open Coastal Port Cities in 1984. While the SEZs were established in industrially barren areas, especially in Shenzhen, to develop new economic centers, the Open Coastal Port Cities offer similar incentives to revitalize existing industrial regions. Local governments in these areas are granted more autonomy to approve foreign investment.

Each Open Coastal Port City was further permitted to set up Economic and Technological Development Zones (ETDZs) as sub-zones within its region, a focus that could offer incentives rivaling those available in the SEZs. Companies can generally be sure of superior infrastructure and access to utilities such as water supply, and other necessary services, because these zones aim to be developed specifically to support industry and foreign investment. Furthermore, ETDZ authorities tend to be more knowledgeable about business principles in a free market economy and are generally more willing to satisfy the specific needs of foreign investors.

In the late 1980s, five areas were designated Open Coastal Economic Zones (OCEZs). Not all of the cities and counties in these five areas were declared ‚Äúopen‚ÄĚ. In 1988, the Ministry of Finance promulgated Interim Provisions Concerning the Reduction of and Exemption from Enterprise Income Tax and Consolidated Industrial and Commercial Tax for the Encouragement of Foreign Investment in the Open Coastal Economic Zones.

The New Tax Law

From the very beginning of the open door policy, China’s central tax officials have worked to create a tax system and a set of incentives that would be attractive to the foreign investors. The accomplishments in just a few years have been truly impressive. The Income Tax Law Concerning Chinese-Foreign Equity Joint Ventures was enacted in 1980 and detailed regulations were made under the legislation. Another major law was the Income Tax Law Concerning Foreign Enterprises, enacted in 1981. Correspondingly, detailed regulations were also made under that legislation.

To make foreign investment in China more attractive, the National People’s Congress finally passed the long-awaited new ‚ÄúIncome Tax Law of the PRC for Enterprises with Foreign Investment and Foreign Enterprises‚ÄĚ in 1991 (‚ÄúNew Tax Law‚ÄĚ) to replace the previous two tax laws on equity joint ventures and foreign enterprises.

First, the New Tax Law applies to all ‚Äúenterprises with foreign investment‚ÄĚ in China and all ‚Äúforeign enterprises‚ÄĚ as defined under the New Tax Law. Second, all kinds of enterprises mentioned above, which are engaged in production and business operations, will be paying income tax at the effective rate of 33 percent. This is because the national tax rate is 30 percent, and in addition a local income tax is also payable on the same taxable income at the rate of 3 percent. Therefore, the old progressive tax rate of 30-50 percent under the provisions of foreign enterprise tax law has now been eliminated, and all foreign investment enterprises, regardless of their form, will now pay income tax at the unified tax rate of 33 percent.

An important aspect that should be pointed out is the non-retrospective application of the New Tax Law. Under Article 27 the old relevant laws and the provisions of the State Council that were in force will continue to apply for the rest of the approved term for those foreign investment enterprises which were set up before the promulgation of the New Tax Law, in cases where the New Tax Law would otherwise increase their income tax rate or prejudice any exemption or reduction currently being enjoyed by them under the old tax regime. For any foreign investment enterprises without a fixed operational term, the old relevant laws and provisions of the State Council shall apply within the period stipulated by the State Council. Specific measures related thereto shall be provided by the State Council.

Under the old tax regime, the tax holidays enjoyed by equity joint ventures and the other types of foreign investment were quite different.  Under Article 8 of the unified New Tax Law, all foreign investment enterprises are entitled to enjoy tax exemptions for two years and 50 percent tax reductions for the subsequent three years, but they will have to be production-oriented with operation periods of ten years or more.

Paragraph 2 of Article 8 in the New Tax Law further provides that, if the duration of preferential treatment regarding exemptions and reductions of income tax granted to energy, communication, harbor, wharf and other major production-oriented or non-production-oriented but important projects under regulations promulgated by the State Council before the execution of the new law are longer than those provided in the first paragraph of Article 8, they shall continue to be in effect after the implementation of this law. However, this may be subject to Article 27 of this new law, which provides that old privileges will only continue to apply for the remainder of the approved operational terms of the enterprises and, if without a fixed term, for a period to be stipulated by the State Council.

Detailed Regulations on the Implementation of the Income Tax Law for Enterprises with foreign investment and foreign enterprises enacted by the State Council on 30 June 1991 set out detailed provisions for explaining and implementing the New Tax Law. Article 75 of ‚ÄúRegulations on Implementing Tax Law‚ÄĚ gives an explanation of the second paragraph of Article 8 in the New Tax Law. It lists some of the major tax reduction and exemption regulations previously promulgated by the State Council, regulations which will continue to apply even after the promulgation of the New Tax Law. The list is not exhaustive as paragraph 9 of Article 75 includes ‚Äúother‚ÄĚ regulations for tax reduction and exemption that were promulgated by or with the approval of the State Council.

Furthermore, the competent tax authorities of the State Council are entitled to grant a reduction of 15-30 percent for a further ten-year period after the expiration of the initial period for exemption and reduction to enterprises engaged in agriculture, forestry and animal husbandry or established in a remote and economically underdeveloped area.

Article 7 of the New Tax Law mentions some incentives concerning some special zones, which are mostly equivalent to the rules in ‚Äúthe 1984 provisions‚ÄĚ with a little difference.¬† Article 73 of ‚ÄúRegulations on Implementing Tax Law‚ÄĚ also sets out a detailed list of the types of enterprises in different locations which will qualify for a tax reduction of 15 percent. It is important to note that the people’s governments of provinces, autonomous regions or municipalities directly under the central government, may decide on the exemption or reduction of local income tax in the light of actual circumstances for an enterprise engaged in industries or projects encouraged by the state.

Provisions for the encouragement of foreign investment

In 1986, foreign investment slowed down in China due to many problems. Thus China reacted with further legislative revisions favorable to foreign investors. One important legislation is the Provisions for the Encouragement of Foreign Investment (‚Äúthe 22 Articles‚ÄĚ) enacted in October 1986 and followed by a series of implementing regulations announced over the next year, The new rules addressed some of the problems and improved the investment climate both by adding new incentives and by reducing past uncertainties.

Unlike the early incentives in the old national tax law, granted on the basis of the form of the investment, incentives granted in SEZs are essentially the same regardless of the form taken by the foreign-invested venture. ‚ÄúThe 22 Articles‚ÄĚ incentives are not only regardless of the form of the venture but also irrespective of its location. The 1991 national New Tax Law adopts the principles of these ‚Äúgovernment provisions‚ÄĚ. However, ‚Äúthe 22 Articles‚ÄĚ provide different incentives (both tax incentives and other benefits) to ‚Äúproductive enterprises‚ÄĚ that is either export-oriented or technologically advanced (hereafter referred to as ‚Äútwo categories of enterprises‚ÄĚ).¬† These are the enterprises that meet the Chinese objectives of earning foreign exchange and gaining advanced technology. Other enterprises with foreign investment are allowed to enjoy only some of the benefits listed. Ventures in the service sector, such as hotels, receive even fewer benefits in practice. Other preferences for enterprises in these ‚Äútwo categories of enterprises‚ÄĚ include:

  1. exemption from payment of all state subsidies that enterprises have to pay to workers and staff;
  2. reduced land-use fees or exemption from them;
  3. priority in obtaining water, electricity and transportation services, and communication facilities at the same rates as local state enterprises;
  4. Priority in receiving loans for short-term revolving funds as well as other needed credit.

Benefits available to all kinds of foreign-invested enterprises include permission to adjust their foreign exchange surpluses and deficiencies amongst each other; exemption from the consolidated Industrial and Commercial tax on most export products; the privilege to export their products directly or through agents; exemption from the requirement for import licenses for machinery parts or raw materials needed to fulfill export contracts. The 22 Articles also try to solve some problems generally faced by foreign-invested enterprises. The provisions call for local authorities and relevant departments in charge to minimize bureaucratic controls and assure foreign investors of management autonomy such as the right to determine production and operation plans, freedom to hire and fire and the freedom to determine wage and bonus systems.

Customs duty relief constitutes an important part of incentives to foreign investors in China.

Imported capital goods intended for approved foreign-invested enterprises were usually exempted fully or partially from customs duties. However, from April 1996, China abolished this preferential tariff treatment for foreign investors. At the same time, China also announced a tariff cut from 35.9 percent to 23 percent. China hopes that by moving towards a uniform investment regime for domestic and foreign firms it will increase its chances of gaining admittance to the World Trade Organization. However, China had ruled that some big projects approved before 1 April would be entitled to exemptions. Regarding SEZs and Pudong, transitional regulations would be applied.

Round-tripping is therefore a form of ‚Äúsystem escape‚ÄĚ, whereby Chinese investors avoid the regulatory regime governing domestic investment by channeling capital through foreign affiliates and thereby bringing this capital under the more favorable regime governing foreign investment. One estimate suggested that round-tripping inward FDI accounted for 25 per cent of China’s FDI inflows in 1992. (Harrold, 1993)

Policy reform aimed at equalizing the treatment of domestic and foreign capital has substantially reduced the incentive for round-tripping, in particular the ongoing reduction of tax incentives for FDI and, more generally, the gradual movement towards a national treatment-based regulatory regime governing investment. Furthermore, most provinces and cities are no longer allowed to provide their own incentives or preferential treatment to foreign investors. As a result, round-tripping has become less common. (Zhan, 1995)

Originally, round-tripping was one of the examples of how weak or distorting regulatory regimes governing FDI can give rise to efficiency losses and a sub-optimal contribution of FDI to the development process. It highlights factors that have served to distort data on FDI flows in and out of China, as well as FDI data for countries used as round-tripping bases. Thus, figures on foreign direct investment need seriously to be reassessed in light of round-tripping.

Yet from here we can also see that Chinese domestic enterprises feel that foreign enterprises generally are better treated than domestic enterprises despite those restrictions on foreign enterprises. If the principle of national treatment were adopted, foreign-invested enterprises would not be able to benefit from the present tax incentives and various special privileges such as better infrastructure and services, guarantee of energy and water supply, and trade opportunities; or such privileges and special treatment would apply to both domestic and foreign-invested enterprises alike.

Thus, at least in respect to tax, Chinese law is not discriminating against foreign-invested enterprises. On the contrary it discriminates against domestic enterprises. What constitutes deterrence to foreign investment here lies in the difficulty of implementing incentives policy due to the uncertainty and the ambiguity of some rules. (Potter, 1995) Investors who attempted to rely on the stipulations of the 1984 Provisions regarding old urban districts found it difficult to ascertain where these districts were located. (Paul, 1996)  The situation was further confused by the fact that a large number of cities and regions that were neither SEZs nor coastal port cities began to formulate their own packages of tax incentives similar to those offered by the 1984 Provisions.

Obstacles to receipt of information have extended to Chinese government departments, many of which, particularly at lower levels, are not fully or accurately apprised of changing government policies and regulations. For example, the implementing regulations that followed ‚Äúthe 22 Articles‚ÄĚ were often not communicated effectively to provincial and county-level foreign investment commissions and bureaux, to the detriment of foreign investors who tried to use these provisions at the local level. 35 Thus, ‚Äúthe 22 Articles‚ÄĚ were presented as effectively addressing the concerns of foreign investors, whereas in fact they merely identified some of the problems and were largely ineffective in resolving them. (Potter, 1995)

Moreover, under ‚Äúthe 22 Articles‚ÄĚ, foreign investors were required to meet specific criteria for classification as either ‚Äúadvanced technology‚ÄĚ or ‚Äúexport-oriented‚ÄĚ firms in order to avail themselves of most of the tax reductions. Despite the issuance of regulations on this classification, the process and standards for achieving these classifications remained murky. (Potter, 1995)

In practice, it is also difficult for foreign investors to find out whether some local regulations are made within the authority of the local governments. Economic reform is a difficult process. Thus, the government set up some areas as experiments for its new reform policy. The first type is SEZs. Other types are open coastal cities, open economic zones, Shanghai’s Pudong project, high and new technology industrial development zones, and the number of these is constantly increasing. Each type came out in a different period. They are empowered to make their own regulations concerning foreign investment and some other economic areas. To attract more foreign capital, some cities try to provide more preferential treatment in terms of taxation, land-use fees, and so on. Sometimes foreign investors were ‚Äúfrightened‚ÄĚ and then ‚Äúescaped‚ÄĚ when they were told about ‚Äútoo preferential‚ÄĚ treatment such as exemption from taxes for three years and reduction of taxes for another three years, free land use for twenty years, etc. (Potter, 1995) Foreign investors feel that they would rather be treated according to the law than accept the non-guaranteed preferential treatment.

The 1986 Encouragement Provisions were also followed by a spate of national and local implementing rules that further refined the incentives available and allowed local governments to tailor offerings to their own particular priorities and needs. To some extent, the guidelines spurred inter-provincial competition to attract foreign investment. Some provinces have gone beyond the central guidelines to offer very attractive terms. The situation may become better now the central government is trying to forbid the local governments from offering their own incentives package. However, how it is going to be implemented in reality is another question. According to the regulations, which are still valid, some cities still have such autonomy.

Foreign investors have also reported that in the context of slower growth in Asia, Chinese central and local government officials are eager to boost foreign direct investment and reverse capital outflows. Thus, they are more flexible than usual in approving traditionally ‚Äúhard-to-get‚ÄĚ investment such as wholly foreign-owned subsidiaries. As part of industrial reform, the government is eager to shed loss-making state-owned enterprises or merge them with their more successful competitors. Economic and tax incentives are supposedly available to investors willing to take on state-owned assets. But due diligence can reveal significant discrepancies between the willingness and ability of local authorities to offer tax and other incentives to foreign investors. (Helsell, 1999)

In many cases, foreign-invested enterprises outside of the main coastal cities, if they are in China’s encouraged industries or work with powerful local partners, are more likely to be granted special incentives. However, attractive incentives can be misleading. For instance, investment zones that are not approved by the State Council are not legally authorized to offer a 15 percent income tax rate, though in practice many do. If the central government decided to crack down on these practices, foreign investors in these unsanctioned zones might be forced to pay the standard 33 percent rate – more than double the tax rate originally factored into these ventures’ business plans. As approval rules may also vary according to locality, investors must check which approvals are necessary, and from which authority. Several foreign companies have been penalized for not having the correct approval from the appropriate level of authority. (Helsell, 1999)

To solve the problems discussed above, it is important to gradually implement an incentive system for both domestic and foreign investors on an equal basis and only sometimes specifically for foreign investors in certain areas, as is commonly practiced in developed countries. Also the categories of incentives, especially site-specific ones, can be simplified. Certain performance requirements can be reduced. Local incentives which only worsen the confusing situation can be abolished. It is not in the public interest that the cost of incentives granted exceeds the value of the benefits to the public. However, as local governments compete to attract foreign investment, they may be tempted to offer more and larger incentives than would be justified, sometimes under pressure of being criticized by the central government for not having attracted enough foreign investment.

Abolishing local incentives will not only avoid unnecessary projects but also avoid the costs for foreign investors when their project is declared invalid because the local government have offered unlawful incentives. Sometimes a certain industry area is over-invested simply because local governments compete with each other to attract more foreign investments, resulting in the central government nullifying the related project. To be effective, the design of incentive programs aimed at attracting foreign investment with specific characteristics not only must involve careful specifications of those elements that are thought to be desirable but, in addition, policy coordination at various levels of government is necessary to ensure that implementation of the incentives does not cause unwanted side effects.

The development of a legal system was also viewed by the Chinese leadership as a necessary support in modernizing the economy at a time when the policies of economic reform and opening up to the outside world were introduced. (Deschandol, 1998) Thus, in theory, law was regarded as the most efficient and institutionalized means to safeguard people’s democracy, to prevent sudden social changes brought about by the whims of leaders and to maintain the sustained economic development of the country.

Despite the recognition of the importance of the law in modernizing the economy, a number of issues concerning what the new legal system should be like or how to build it were not clear. The ideological justification for the integration of Western legal concepts and the subsequent development of this new legal system are no less complex than the effective implementation of this new law throughout the country. Even today debates on many theoretical issues are still going on.

With the debate continuing, (Potter, 1994) the Chinese leadership adopted the attitude that a number of political and legal concepts common to Western countries were endemic to rapid industrialization and were not merely incidental organizational features of Western society. Thus, the legislative practice has accepted the idea of legal transplant and borrowed extensively from many foreign jurisdictions.

The essence of capitalist investment is the ability of individuals and companies to plan ahead assume and rely upon contractually formulated commitments in a legal, fiscal, institutional and regulatory environment that is as predictable and stable as possible. (Waelde, 1994) Thus, legal reforms initially aimed at promoting foreign investment by providing foreign investors with a degree of security and confidence in China. These reforms often distinguished between foreign business involvement and domestic activities, with reforms usually aimed first at the foreign business dealings, commonly in the form of ‚Äúprovisional‚ÄĚ regulations. Many of these regulations contain rules with regard to decentralizing control, permitting more profits and incentives, and increasing managerial autonomy.

When foreign enterprises found themselves at the whim of the government bureaucracy, they began to demand legal guarantees from the government that their ventures could proceed as negotiated. Contract law is one of the crucial components of capitalist market-oriented law. (Waelde, 1994)  It is precisely what the foreign capitalist firms began insisting upon, as opposed to Party decrees or official rules and regulations, which could not be counted upon to establish the atmosphere of rational business interaction required by profit-oriented production process. Thus FECL was promulgated in 1986, which also includes provision of international arbitration, a private settlement technique familiar to foreign investors.

Gradually the laws were also developed for domestic economic activities. To be maximally effective, a liberal foreign investment regime needs to be embedded in an overall institutional framework conducive to foreign and domestic investment. The liberalization of China’s foreign investment framework has therefore exerted constant pressure in the direction of introducing other market mechanisms. Numerous laws and regulations governing both international and domestic economic activities were prompted – in some cases to a large extent – by the legal framework specifically pertaining to foreign investment. As a result, China has in place a considerable proportion of a market-oriented regulatory framework. (Chow, 2003) This is remarkable given that almost no commercial laws existed before the reform and that the legal framework had to be redesigned from scratch.

Thus, China has some aspects of a dual legal system in that certain laws apply to foreign business involvement and some apply to purely domestic activities. For instance, the Economic Contract Law (ECL) is domestic, and the FECL is for foreign activities. There are also different tax laws that apply to foreign and domestic enterprises respectively. Some laws, however, apply to both foreign and domestic affairs, such as the patent law and the trademark law.

New laws with Western legal concepts and principles are being applied in China, but their implementation requires large-scale appointment of well-trained judges, administrators, prosecutors and lawyers. Any effort at mere legislative reform will fail if it does not cover the challenges of helping to build up the organizations required and the institutional environment within which a legal culture can emerge and flourish. ((Waelde, 1994) Thus, along with these legislative reforms came the rebuilding of a legal infrastructure to make the new laws work. The law-making organizations have been reactivated, courts have been rejuvenated, and the legal profession has been restored. New emphasis was given to the education of the lawyers and judges needed to make the laws and courts work. Academic and professional training institutions have been revived, and law journals and law books are flourishing.

The accomplishments of the legal reform are considerable when measured against the pre-reform state of Chinese law. (Lubman, 1996)Yet, this does not mean that Chinese law is perfect. On the contrary, both the contents of the law and its application are still limited by the existing social, cultural and legal foundation on which the new legal system is built.

There is also another group of international instruments on FDI, particularly at the multilateral levels, which consists of guidelines, recommendations, etc. Those are voluntary in nature and are not directly enforceable in a court of law by either the governments involved or their nationals. Voluntary instruments, however, can produce some legal effects under certain circumstances; indeed, inasmuch as they reflect the opinion juris of the community of countries, they may become sources of international law.

To help states in their national and international law-making on investment, the World Bank issued a set of guidelines on foreign investment, the World Bank Guidelines on the Treatment of Foreign Direct Investment. The guidelines are intended to contribute to the evolution of emerging principles of international law and reflect the need for compromise between contending views on the area of foreign investment protection through international law. (World Bank, 1992)

The most comprehensive and universal voluntary instrument on FDI is the draft of the United Nations Code of Conduct on Transnational Corporations. However, despite the impressive progress in the elaboration of specific standards bearing on the operations of foreign investors, the negotiations on a global framework for the activities and treatment of transnational corporations (TNCs) – undertaken under the auspices of the United Nations Economic and Social Council by the Commission on Transnational Corporations and aimed at concluding a Code of Conduct on Transnational Corporations – did not come to a successful conclusion.

The Organization of Economic Cooperation and Development (OECD) has also been actively engaged in the drafting of codes of conduct on multinational corporations. Under the OECD Declaration on International Investment and Multinational Enterprises, OECD member countries ‚Äúrecommend to multinational enterprises operating in their territories the observance of the OECD Guidelines‚ÄĚ. The guidelines lay down standards for the activities of multinational firms.

In 1995, OECD Ministers launched negotiations on a multilateral agreement on investment (MAI) with high standards of liberalization and investment protection, with effective dispute settlement procedures, and open to non-Members. Five non-Members – Argentina, Brazil, Chile, Hong Kong, and the Slovak Republic – participated fully as Observers to the Negotiating Group. The fact that this initiative did not succeed reflected the technical complexity and political sensitivity of the issues under consideration. (Nolan, 1996) The draft Agreement developed during the OECD negotiations between 1995 and 1998, however, will undoubtedly make a significant contribution to future work.

With respect to bilateral treaties, there are two main types, namely, bilateral treaties for the promotion and protection of foreign investment and bilateral treaties for the avoidance of double taxation. The former deal exclusively with investment issues and prescribes general standards of treatment, including fair and equitable treatment, as well as national and most-favored-nation treatment. The latter deal was carried out with a very significant aspect of foreign investment management, namely, the harmonization of tax rules on income and capital distribution between home and host countries and territories. (Png, 2002)

The endeavors of governments and different world organizations may eventually result in a coherent body of international law on foreign investment, though its principles are mired in controversy at the moment. No other area involves so much conflict of interests between states as foreign investment. This is also one of the main reasons why there is not yet a comprehensive multilateral legal framework on international investment. In the absence of such a multilateral framework as GATT that regulates world trade; foreign direct investment continues to be regulated by host country legislation. International law would only be relevant where there were applicable treaty obligations.

Manpower Labor Force in India

According to Chong et al (1991), Labor is regarded as the most important factor of production from many points of view. It is both a productive factor and a consumptive factor. Labor as a factor of production involves direct human activity. India’s large population has provided India with large reservoirs of labors.

India’s Ninth Five-Year Plan projects generation of 54 million new jobs during the Plan period (1997-2002). But the actual performance has always fallen short of their objectives in the past, but they believe that the current Plan will be able to meet its target. India’s labor force is growing at a rate of 2.5 per cent annually, but employment is growing at only 2.3 per cent. Thus, the country is faced with the challenge of not only absorbing new entrants to the job market (estimated at seven million people every year), but also clearing the backlog. More than 90 per cent of the labor force is employed in the “unorganized sector”, i.e. sectors which don’t provide with the social security and other benefits of employment in the “organized sector.” In the rural areas, agricultural workers form the bulk of the unorganized sector. In urban India, contract and sub-contract as well as migratory agricultural laborers make up most of the unorganized labor force.

Macroeconomic Analysis of Indian Economy

Chong et al (1991) described that in macroeconomics, we examine the general economic factors that determine income, production, general price level, saving and investment, agricultural growth from the standpoint of the whole economy.

India’s total GDP composition by sector in 2000 can be classified into:

Agriculture         :         30%

Industry              :         28%

Services              :         42%

Nearly 400 million of India’s labor force, which accounts to about 67%, works in agriculture, which contributes 30% of the country’s GDP. Many of the country’s fundamentals – including savings rates (26% of GDP) and reserves (now about $24 billion) – are healthy. Inflation eased to 7% in 1997, and interest rates dropped to between 10% and 13%. Export growth from 1996 to 1997 faced a slow growth of 1% averaging only about 4% to 5%–a large drop from the more than 20% increases it was experiencing over the prior three years–mainly because of the fall in Asian currencies relative to the rupee.


Total value         :         $33.9 billion

Commodities:         gems and jewelry, clothing, engineering goods, chemicals, leather         manufactures, cotton yarn, and fabric

Partners:                  US, Hong Kong, UK, Germany


Total Value         :         $39.7 billion (c.i.f., 1997)

Commodities:         crude oil and petroleum products, machinery, gems, fertilizer, chemicals

Partners:         US, Belgium, Germany, Kuwait, Saudi Arabia, UK, Japan

India’s annual wholesale price inflation rate rose for the second straight week to a fresh three-and-a-half-year high of 8.33 percent in the year to Aug. 28 as a nationwide truckers’ strike impacted prices. The rise exceeded the median forecast of a Reuter‚Äôs poll, which had estimated the rate would have risen to 8.22 percent, compared with 8.17 percent a week before. Inflation was at 3.88 percent in the year ended Aug. 30, 2003. The government also revised up the annual inflation figure for July 3, 2004, to 7.08 percent from 6.16 percent earlier.

The Profile of Economic Policy of India

Monetary Policy

According to Mishkin (2003), monetary policy is the management of money supply and interest rates. It helps to promote national economic goals, by influencing the availability and cost of money and credit. Monetary policy affects people everywhere making economic and financial decisions. It influences the performance of economies, as reflected in factors such as inflation, employment or unemployment, and economic output. It affects demand across the economy, influencing how a person chooses to spend money on goods and services.

In India, managing overall growth targets to setting interest rates to meet these growth targets, managing exchange rates and managing money supply in order to keep a check on inflation and maintaining price stability is done by the Reserve Bank of India (RBI). The Reserve Bank of India (RBI) is India’s central banking institution. It was established in 1935 and was nationalized in 1949. From this point on, the RBI has operated as a state-owned and state-managed central bank of India. It acts a banker to central and state governments, commercial banks, state cooperative banks, and other financial institutions The RBI’s functions include: formulating, implementing, and monitoring monetary policy; regulating the issue of bank notes, managing India’s foreign and exchange reserves; facilitates external trade; and develop India’s financial structure in line with national policies and objectives.

India’s banking system is one of the largest in the world. The Reserve Bank lays downs restrictions on bank lending and other activities with large companies. It is the sole authority for issuing bank notes and supervises all banking operations in India. The RBI acts as banker to central and state governments, commercial banks, state cooperative banks, and other financial institutions. The RBI manages overall growth targets by setting interest rates to meet these growth targets, managing exchange rates and managing money supply in order to keep a check on inflation and maintaining price stability.

To understand the working of the economy from a macro angle, a new concept of potential output has also been introduced. The second portion, `Stance of Monetary Policy for 2000-2001′, corresponds to the usual pattern of previous years. In 1999-2000, narrow money, on a point-to-point basis, rose by 10 per cent and, on a monthly-average basis, by 14.6 per cent. Reserve money is increased by 8.1 per cent and 11.9 per cent respectively, and broad money by 13.6 per cent and by 16.9 per cent.

What do these figures indicate? On a monthly-average basis, the increase is higher by 3.3 percentage points for M3 and by 4.6 percentage points for M1. The RBI has kept the indicative target of about 15 per cent for broad money, probably on a point-to-point basis. This target is higher than the actual rate of increase by 1.4 percentage points or more by about 1/10. The rate of increase in prices on a point-to-point basis was 4.16 per cent. On a monthly-average basis, the rise was 2.9 per cent.

How realistic are these projections? The rate of price rise would depend on the increases in the rates of commodity supplies and M1, assuming velocity to be unchanged. In an open economy, supplies of commodities can be higher than the growth rate of production. This is because imports can be resorted to _ provided, of course, the stocks of exchange reserves are abundant enough. Hence, a mandated target of inflation can be achieved if the rate of increase in M1 can be moderated; this would depend on making the fiscal system borrow less than what it can given, that is, the inability of the RBI directly/indirectly to say no to the government beyond a point and its measure of freedom to allow the interest rates to move up if the government does not listen.

At present, these options are limited. A sanction from Parliament that the Finance Ministry and the RBI can use all their powers to see that the inflation rate is kept within a certain bound or range will be required. Alternatively, Parliament may stipulate that the RBI is fully empowered to use all its instruments to see that the inflation rate is within limits. In fact, it may even specify that the RBI should keep the rate of price level increase within a range. Sufficient margin to use all its instruments is acknowledged to RBI in order to achieve the above objective.

Fiscal Policy

Chong et al (1991) stated fiscal policy is related to public finance and it’s concerned with the means of increasing or decreasing public expenditure, taxation or public debt to achieve certain economic objectives. Heyne (2003) states “fiscal policy is the means of using the government’s budget to bring about desired levels of total spending”. Fiscal Policy is the direction government uses in determining how much money to collect in taxes, what services it will provide and what economic initiatives it intends to support. In recessionary times, the fiscal policy may attempt to expand the economy with increased government spending or lower taxes to increase consumer spending. The main element of the Government budget is taxation. Taxation takes capital away from income earners, investors and companies and returns services, infrastructure and hopefully better business climates.

India’s fiscal situation is precarious. The state expenditure, which is increasing, is financed by higher domestic borrowing. However, the rise in state spending is not financing public programs to support social and capital expenditure. Instead the high level of state expenditure is subsidizing loss-making public enterprises and paying the state’s wage bill. The public sector losses put a heavy burden on India’s fiscal condition. The fiscal crisis of the government is due to the fiscal problem of the public sector. The fall in national savings is caused by dwindling public savings. Higher fiscal deficits not only have a negative effect on savings but also contribute to inflationary pressure.

India’s large public sector is clearly not advancing the interest of the poor. Subsidy for the public sector exceeds the expenditure for education. The loss and the poor performance of public enterprises, public financial institutions, public insurance companies, and unproductive public spending are detrimental to economic growth. The authorities shall need to reduce the liabilities and the financial pressure on the state. The authorities may overcome the problem of poor performance of public enterprise by privatization. India’s divestiture and privatization programs should be fair and transparent. Prior to privatization sectors should be deregulated to eliminate the scope for monopoly rents. Public enterprises should be sold through open competitive bidding rather than negotiated sale. Recent developments in the telecommunication sector reveal the need for public scrutiny and surveillance to avoid corruption and fiasco that derails the creation of a competitive business environment. Otherwise privatization and private sector entry will exclusively benefit the privileged. The present public sector losses imply that there are private beneficiaries, who form a vested lobby for continued subsidization.

Price Policy

India has adopted a uniform pricing policy for all buyers and not tried to not charge a premium from developing countries in Asia. What India needs is a uniform official selling price and significant spot trading to increase liquidity and establish a genuine and representative indicator for the fast growing Asian market? Other than that, India exercises the rationale of the twin policy of minimum support and a procurement price to be easily explicable. To implement this two part pricing policy, the agricultural prices commission was set up and it was assigned the task of announcing the minimum support and procurement prices for the main agricultural crops, including food grains.

Economic Policy

India advocates market-oriented economic policies to stimulate growth and development. India must broaden and deepen the scope of its market-oriented reforms. Researches emphasize the need to accelerate the rate of economic growth. Increasing the growth rate will reduce and eventually eradicate mass poverty, improve the standard of living for the majority of Indians, and develop the country’s infrastructure, forces of production, agriculture, industry, and services. Although market-oriented economic policies are necessary for economic development, there ought to be limitations of the market.

Economic growth will reduce poverty because it will create employment opportunities for the poor and raise their income. India believes that the execution of market-oriented economic policies should go hand-in-hand with measures that strengthen the social sector to overcome poverty, illiteracy, malnutrition, and ill health. In reforming state policies the authorities must pay attention to the employment consequences. The state’s ability to finance social expenditure designed to offset the turpitude and discordance of the market is contingent on higher economic growth.

The Analysis

¬†¬†¬†¬†¬†¬†¬† As we can be familiar with that India is one of the major developing countries. But not every developing country is certain to have a comparable situation. Based on my analysis, India has an economy that is slowly beginning to reform. Therefore, it might be concluded that the most suitable theory to apply to India’s current economy is the theory of Structural – Change Model. According to Todaro (2000), the structural – change model focuses on the mechanism by which underdeveloped economies transform their domestic economic structures from a heavy emphasis on traditional subsistence agriculture to a modern, more urbanized, and more industrially diverse manufacturing and service economy.

Perspective & Prospect of the India Economy

The Eight Five Year Plan (1992-97) had recognized human resource development as a key to development and outlined various steps in this direction. This focus is also retained. In the Ninth Five Year Plan Human resource development encompasses not only the economic opportunities available to the people but also their ability to take advantages of the opportunities and existence of healthy and productive life. It also attempts to analyses the nature of relationship among HDI, CPM and demographic parameters. The main objectives of determining human resource are to assess the variability in human progress among the major states of India, to examine the lack of capabilities among the major states using Capability Poverty Measure; and to examine the linkage among human development index, capability poverty measure and demographic parameters in the major states of India.

India’s Economy in the Global Context

India’s declining influence as a leader of developing countries may reflect not only national and international political economy forces, but also the way in which its representatives handle the process of negotiations. There was a time when India’s standing in the international community of nations was very high. This is not just due to the size of the population and of the economy and the country’s geopolitical significance in Asia. It also reflected the respect India commanded among other developing countries, by virtue of strong and principled stands on a number of international issues as well as what was widely perceived as a genuine desire to build unity among developing nations as a group. India thus became an important voice for the desires of developing countries in general, and a major spokesman in international forums.

This perception was probably strongest during the early days of the Non-Aligned Movement, which reflected the dreams of some remarkable men and women as much as those of the governments they led. But even in the 1970s and much of the 1980s, when the political leadership did not display much in terms of an inspiring vision domestically, the foreign policy remained a source of some pride to many Indians and a source of much hope to many in the developing world.

This attribute was perhaps already beginning to work loose by the late 1980s, but in the 1990s it seems to have disappeared altogether. The collapse of the Eastern community may have turn into non-alignment meaningless, but it is still difficult to understand why it should also have put paid to attempts by India to create a common position with other developing countries to protect at least some of their own interests, and made it so completely determined to favor the Western powers. Even so, there is still a sense of surprise at the Indian government’s reluctance to raise issues at international forums and multilateral negotiations, and also its inability to lobby and gain international support for itself on the rare occasions when it does choose to raise any such issues.


India’s economy can be considered to be still in an agriculture sector. Despite the obstacles India faces in its reformation process, like the balance of payment crisis in 1991, India still thrive to achieve an impressive GDP growth, which has increased from 4% in 2003 to 8.2% in 2004. Their agriculture sector is still considered healthier compared to their industrial sector.

But India in on its way, yet still a long way, to develop and become and industrialized country like Japan. It may be concluded that this is because India has one of the world’s biggest pools of highly trained IT labor, an excellent technical higher education system and a reputation for quality work, which is considered an advantage for India. Besides this, the increase in their income per capita is another reason that prepares them to an industrialized economy. Also, the Indian government has plans of making credit available to large industries, contributed both to high profits and low capital cost. This opens opportunities to build more industries.

However, the importance of the agricultural sector in India’s economy is obvious. It will remain a key sector because it is the employer of a very large proportion of the labor force, a supplier of food for a very large and growing population, a source of industrial raw materials and a market for India’s industrial products. India is experiencing a structural – change model but focuses primarily on the Lewis theory of development. This is due to India’s underdeveloped economy, which is overpopulated that leads to a surplus labor. India focuses on the transfer of labor from agriculture, where there is surplus labor, to a modern industrial sector where employment and productivity are expected to rise. All the steps taken have proven India to have the potential towards building a self-sustaining country achieving high economic performance, although there is still a lot to be improved.

China has undertaken great efforts in designing different incentive packages to attract foreign investment. At the beginning of the open door policy incentives were only granted to a few special economic zones. Concern about negative effects was partly the reason of this zoning policy which had the attraction of imposing geographical limits on activities involving foreign investment. The impressive performance of the SEZs, in terms of attracting investment, stimulating trade, allowing policy experimentation, and fostering economic growth led to a changing perception by the government of foreign investment. Since 1984, the number of locations in which such incentives are available has expanded and the various zones and open areas have been established.

Apart from site-specific incentives, China also offers nationwide incentives aimed at foreign-invested enterprises that are either export-oriented or technologically advanced. Preference for joint ventures in the 1980s means that wholly foreign-owned enterprises not only received more control but also enjoyed less preferential tax concessions than equity joint ventures. The unified new tax law in 1991 changed this situation as a result of the changing attitude to foreign investment.

China also offers foreign investors various special privileges such as better infrastructure and services, guarantee of energy and water supply, trade opportunities, less bureaucratic ‚Äúred tape‚ÄĚ and more managerial autonomy. The reason that they are stipulated in law as incentives is that, in reality, they constitute serious problems for most Chinese domestic enterprises. For most developed countries, they cannot be regarded as incentives. However, in China – a developing country – the electricity and water supply being suddenly cut off is a very common thing for most enterprises. Most domestic enterprises have no right to import or export. Therefore, guarantees of energy and water supply and trade opportunities are regarded as special privileges.

In China, incentives are intended only for foreign investors, while incentives in most developed market economies, whether with regional objectives, industrial promotion objectives or with other objectives, are in most instances directed primarily at domestic enterprises or at domestic and foreign-controlled enterprises on an equal basis and only sometimes specifically to foreign investors.

Because of this special treatment of foreign investors, Chinese domestic enterprises even go around the law through a process called round-tripping in order to be treated as foreign investors. Round-tripping involves the circular flow of capital out of China (in most cases to foreign affiliates of Chinese transnational corporations) and the subsequent ‚Äúre-investment‚ÄĚ of this foreign capital in China for the purpose of benefiting from fiscal entitlements accorded to foreign investors.

The Indian economy has grown rapidly over the past decade, with real GDP growth averaging some 6% annually. Social indicators, such as poverty and infant mortality also have been improved during the last ten years. Considering the improvement in poverty itself is not enough. The Indian government should try to control India’s overpopulation. The citizens of India can act become India’s labor that will help boost economic growth but the overpopulation of India might slow down their economic growth or may even suspend the development of their economy. So my recommendation is that the government should control the birth rates and impose limits on how many children a family can have.

Despite that, we can view the economy of India is on the edge for growth and is on the road to prosperity, with no doubt. How high the rate of growth will be, depends on all of us governance, people and proper exploitation of resources. Given political stability and peace it should not be difficult to achieve higher economic performance in the next decade. The imperative now is not to pine but try fine tune the economy think and implement vigorously an effective plan for the development of the country – Statesmen should think and act that they are trustees for the future not merely for the present or for themselves. The key to India’s success lies in implementing hard policies and a strong government to make India’s economy one of the economic superpowers in the near future.


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