Under the volcano

China is having a significant impact on how India sees itself and its relations with the outside world. For the time being the results are almost entirely positive. Longer term, however, there are some deep-rooted rivalries and differences of perception. Perhaps it is as well that such a high Himalayan barrier remains between Asia's two giants.

India's economic reform program, induced by its 1991 foreign exchange crisis, was always predicated on a gradual opening to the outside world, the removal of state controls, lowering of tariffs and access of foreign investment to hitherto closed sectors. But it was more coincidence than design that China, from a very different starting point, was already embarked on such a course.

Until quite recently, China's success in developing foreign trade and investment was as much feared as admired in India. Industry had something of an inferiority complex, and worried that trade liberalization could lead to Chinese goods flooding Indian markets. China was assumed to enjoy bigger economies of scale, more flexible labor markets, lower cost and better infrastructure, and easy access to low-cost capital from state banks which had scant worry about non-performing loans.

Spinning wheels
China's advantages in terms of port and road infrastructure, ease of entry for foreign capital, promiscuous bank funding are all still there and India's slow moving bureaucracy and its democratic political institutions at state and central levels mean that liberalization tends to be a two steps forward-one step back process. Nonetheless, there has been a fundamental shift in Indian attitudes. First, there is recognition that it must follow China's path if the gap between the two is not to grow even wider and condemn India to a very second-class status within Asia.

Secondly, Indian self-confidence has risen dramatically. The spearhead has been IT software, now world renowned, and the pharmaceutical industry. But with a combination of fast expanding domestic markets and some inflow of foreign technology and investment, other industries such as auto parts and even low-cost autos are finding they have little need to worry about Chinese or indeed any other foreign competition. For sure there are still areas of friction, keen competition and resort to anti-dumping actions. But India's mindset has shifted.

This is reflected too in an approximate communality of interest with China – and countries such as Brazil – at the WTO. India, like China, now favors more than fears reform of farm trade. They share a common interest in ensuring that there is no backsliding from the end of the quota system in international trade in textiles and garments. India is expected to be the second biggest beneficiary after China.

India has realized too that it cannot afford to let China do all the running in relations with Southeast Asia which historically has been at least as close to India as to China. India shares borders with three ASEAN countries, Indonesia, Thailand and Myanmar, and has long had close diplomatic ties with Hanoi. Though India has yet to be able to follow China, Japan and South Korea in opening talks on a free trade areas with the ASEAN, it is striking bilateral deals with Thailand and Singapore. Most recently new Prime Minister Manmohan Singh underlined this commitment at the Vientiane summit of East Asian leaders, where he had warm exchanges with Wen Jiabao and others. In other words, though in practice it is miles behind – 12- 15 years perhaps in terms both of economic development and trade – the need to compete internationally with China is helping drive India's liberalization process.

At the practical level, trade between the two has been growing rapidly, albeit from a low base. Two-way trade grew 80% in the first 10 months of 2004, according to Chinese data, and surpassed US$10bn for the first time. For the full year it is expected to hit US$12bn or four times its level in 2000. There is active two-way trade in items such as yarn, metal products, chemicals and pharmaceuticals, but the biggest reason for the jump in 2004 was the value of iron ore, India's largest export to China. India is third after Australia and Brazil as supplier of iron ore and as a result now enjoys that rarity – a substantial trade surplus with the Mainland. Its exports to October were $6.2bn compared with imports of $4.6bn.

Indian firms have, however, been quicker to invest in China than vice versa, particularly in IT. The major Indian software houses have operations there. Some Indian manufacturers have even set up in China to serve third country markets because of lower-cost raw material and intermediate inputs.

In India, Haier has a strong presence in appliances and communications technology leader Huawei has set up in Bangalore. But more rapid growth of two-way investment, especially from China into India, is now expected. A Hong Kong private equity firm is setting up a fund to spur two-way investment. Tourism also looks to have big potential given the rise in disposable incomes in China and the prospects of airline liberalization into and within India greatly reducing travel costs.

Potential friction
However, while both nations focus on economic development and modernization, areas of strategic friction remain in the background. India is at least as dependent as China on imported hydrocarbons and its needs are also growing very fast. It is conscious that China has made much more progress in combining investment, diplomacy and military spending to try to ensure future supplies. It appears somewhat envious of China's rapid development of close ties with Iran – as evidenced by its huge gas supply deal and Chinese participation in major Iranian infrastructure projects, such as the Tehran underground railway. India finds itself with less leverage because its trade is so much smaller and other strategic considerations mean it must also foster good relations with the US.

It is also concerned about the extent of Chinese influence in Myanmar, once closer to India, and China's potential to project its naval and surveillance presence into the Bay of Bengal and the Andaman Sea. Likewise, it knows it is far behind in relations with Southeast Asia generally.

On the plus side, a new border trade post is being opened and both nations share an interest in the suppression of Islamic fundamentalism and separatism in Central Asia. Old border issues between India and China remain merely in abeyance and no nearer resolution than before. And the closer integration of Tibet through the building of the railway to Lhasa is, in Indian eyes, reducing the buffer zone role of the Himalayan/high plateau region.

All in all, relations are at their best since the late 1950s days of anti-colonial brotherhood. Common economic interests should ensure this continues over the next few years. But healthy competition can also lead to enhanced strategic rivalry between the two unequal Asian giants – and new alignments, for example with the likes of Japan and Indonesia – as Asia witnesses the rise of China's might and the relative decline of US power.