China vs.

India: a microeconomic look at comparative macroeconomic

performance

Taye Mengistae, Lixin Colin Xu, Bernard Yeung

May 2006

Abstract

In comparable random samples of manufacturing businesses drawn from the two countries,
Chinese establishments are found to have higher total factor productivity on the average than
their Indian counterparts. Controlling for initial size, age, and line of industry, the average
employment growth rate is higher for Indian establishments. Chinese plants grow faster in
value added terms, nonetheless. This is mainly because the average net investment rate in
fixed assets is higher in Chinese businesses. To a lesser extent, it is also because productivity
grows faster on the average in Chinese plants. Partly because of this, the aggregate
productivity growth rate that we compute industry by industry is larger for the Chinese
sample. A second reason why the aggregate productivity growth rate is higher for the China
sample is that allocative efficiency gains are larger in Chinese industry. By this we mean that
market shares are reallocated from less productive plants to the more productive more rapidly
(or steeply) in the Chinese sample. This is consistent with another finding: catch up effects
and life cycle effects in productivity and growth, are stronger in the Chinese sample than in
the Indian sample. Lastly, such key elements of the business climate as labor market
flexibility and access to finance are major sources of the productivity and growth gaps
between Chinese and Indian plants. If nothing else mattered, the average Chinese businesses
would be more productive and would grow faster than its Indian counterparts on account of
business climate differences between the two countries. This is not so much because business
climate indicators are better in China than in India as because the marginal return to
improvements in indicators is higher in China.

1
 If [by the time China’s saving rates start to fall] India has completed the second generation reforms, built up its
infrastructure and fully integrated itself into the world economy, we might find that the tortoise overtakes the
hare… This race between the two Asian giants is set to be the most dramatic event of this century. (Deepak Lal in
Business Standard, March 15, 2005)

1. Introduction

China’s and India’s are among the largest economies in the world today. They have
also been among the fastest growing over the last two decades and a half. They both
entered the 1980s at comparable levels of per capita income following three decades
of growth-China at an average rate of 4.4 percent per annum, and India at a rate of
3.75 percent (Srinivasan, 2003). 1 Since then China’s economy has taken off to a state
of unprecedented growth that averaged 10.1 percent per annum in the 1980s, 10.3
per cent per annum in the 1990s, and has yet to show any sign of slowing down.
India’s GDP growth has also picked up to an averaged 5.6 per cent a year in the
1980s, 6 percent per annum in the 1990s’, and even higher since. Although India’s
growth rate has been remarkably high by any standard, the sustained growth gap
between the two countries has intrigued observers, especially given what seemed to
be significant similarities in their initial conditions. According to Srinivasan (2003),
India’s GDP per capita stood at 853 in 1990 international dollars in 1973 as
compared to China’ 839. The divergence in growth rates since then has created a
widening income gap in China’s favor, which stood at 3,117 dollars versus 1746
dollars by 1998 (Srinivansan, 2003). Figure 1 shows the evolution of the gap in
Purchasing Power Parity terms computed from data in the World Bank’s World
Development Indicators.

In this paper we analyze data from comparable samples of manufacturing businesses

drawn from the two countries in order to help shade light on two complementary
questions: Why is per capita income so much higher today in China than in India?
And why is China’s GDP growing so much faster? One hypothesis is that China’s
better performance on both scores reflects differences in the quality of institutions or
in the immediate policy environment in which businesses operate. Another is that the
contrast is partly a consequence of China’s earlier investments in superior physical
infrastructure paying off. These are no doubt macro economic issues in the
investigation of which the analysis of available national aggregate data has yet to be
brought to bear. At the same time a key limitation of aggregate analysis has to be
recognized in this particular context. This is that, at this stage, available time series
are bound to be too short on key variables for problems of econometric identification
to be resolved satisfactorily based solely on the observation of cross-country
differences in national or sector aggregates. To this should be added what seems to be
widespread skepticism about the comparability of China’s national account
aggregates with India’s.2

1
The growth rate figures reported in the following lines are also from Table 3 of the same paper by
Srinivasan.
2
Although there is solid consensus that China’s economy has grown much faster than India’s since the
early eighties, many suspect that China’s growth rates might have been significantly overstated relative to
India’s due to discrepancies in national accounting conventions. See , for example, Srinivasan (2003) and
Young (2003).
2
 Part of the remedy to this should be the exploitation of sub national variation in
economic performance and its determinants as an additional means of identification.
An obvious instance or component of such a strategy of is the analysis of firm level
data, which are regularly generated in both countries by a variety of agencies. The
data on the analysis of which we report in this paper come from business surveys that
the World Bank sponsored in the two countries in 2003. The India survey covered
1860 manufacturing establishments sampled from the country’s top 40 industrial
cities and its major exporting industries. The China survey covered 2400 enterprises
sampled from 18 cities and 5 regions, and a wider set of industries including most of
those covered by the India survey. Both surveys include production, employment and
investment data on each business on annual basis for the three years leading to the
year of survey. This is in addition to data on the local business and policy
environment of each establishment as of the survey year, including indicators of the
quality of the financial, regulatory, infrastructural, and labor market settings in which
it operated at the time of the survey.

What does information of this kind have to do with the (macro economic) questions
of growth and development we just raised? Per capita income is probably used far
more often as indicator of wellbeing than anything else, but one obvious
interpretation of it is also as an index aggregate labor productivity, as is the case in,
for example, Hall and Jones (1999). Thus the fact that it is presently twice in China of
what it is India means that China’s labor productivity is at least higher than India’s. In
general this should mean that output per worker is greater in the average Chinese firm
than it is in its Indian counterpart, either because production is more capital intensive
in the Chinese firm, or because total factor productivity is higher, or both. Likewise,
China’s higher GDP growth rates should be reflected in faster growth of the average
Chinese firm or faster allocative productivity gains in China’s industries.3 Like its
aggregate analogue, growth at the firm level can only originate in one of two sources,
namely, growth in factor inputs, and growth in their productivity. If the average
Chinese firm is indeed growing faster than the average Indian firm, then it must be
investing at a higher rate in physical or human capital, or its net job creation rate must
be higher, or it must have greater total factor productivity growth.

Our analysis is focused on two issues. The first concerns whether or not the
performances of Chinese and Indian firms differ significantly in terms of productivity
and growth, as should be expected from the macro-economic performance contrast
between the two countries. Secondly, assuming that such differences do exist, how far
can they be attributed to differences in “business environment”? The first issue can be
broken down into a series of subsidiary questions the answers to which describe the
linkages between business climate and firm level determinants of aggregate
productivity and growth. These include, first, whether or not there is significant
productivity gap between Chinese and Indian firms as the per capita income gap
between the two countries suggests. Secondly, do Chinese firms grow faster as should
be expected from China’s better GDP growth performance? Third, assuming they do,

3
This is strictly true if the structure of production is the same in the two countries and the number of firms
is fixed within each industry in each country, or the equilibrium size distribution of firms within each
industry does not vary across countries. We are abstracting here from the aggregation problems that arise
due to the failure of these assumptions in practice.
3
what are the proximate sources of their faster growth: is it that they invest at a higher
rate, or that they are getting more efficient in factor use more quickly, or some
combination of both?

Since the data we analyze here are entirely on manufacturing firms, our answers to
these questions are most pertinent to the comparative performance of the
manufacturing sectors of the two economies. However, given the weight of
manufacturing in each economy, and given that China has done particularly well in
this sector compared to India, knowledge of the factors behind the contrast between
the performance of Chinese manufacturers and their Indian counterparts should help
us better understand of the relative performance of the broader national economies. In
the context of manufacturing, the projection of the performance indicators of the
average firm to its aggregate analogues would be strictly valid only on two
assumptions. One is that the structure of manufacturing production is the same
between the two countries. The second is that the equilibrium size distribution of
plants within individual industries is the same for both countries. Since we are
working with samples of observations from the selected industries rather than census
data on all sectors, we have no way of testing either of these assumptions. We have
nonetheless sought to make our conclusion robust to the possible failure of the first
assumption by confining our comparison of businesses to industries that are common
to both countries.

The actual size distribution of businesses could vary between the two countries in
any of the industries from which our data are drawn as result of policy induced
distortions, or as a consequence of differences in the stages of industry evolution
observed at the time of the surveys. This in turn should drive a wedge between the
(sample) average firm’s performance we observe and the aggregate performance we
ultimately care about-that is, between (sample) average firm level productivity and
(aggregate) industry productivity, on the one hand, and between the average firm
growth rate and the industry growth rate, on the other. In order to eliminate this
distortion we compute mean firm level performance indicators conditional on firm
size and firm age. By helping us to control for differences in catch up and life cycle
effects stemming from differences in the stages of industry evolution between the two
countries, this should help us get at true industry effects in performance gaps. In
addition we computed market share weighted (sample) mean levels and growth rates
of productivity in order to separate the dynamics of firm level productivity from intra-
industry reallocation effects on aggregate productivity, which, together with the
relative strength of catch up and life cycle effects, provide a picture of the
comparative dynamism of industry in the two countries.

To highlight our main results, we find that output per worker is higher for the China
sample than for India sample. This is in part because the average Chinese plant is
more capital intensive. It is partly because total factor productivity is higher in for the
China sample. The average Chinese establishment is also about the same age as its
Indian counterpart, but much larger by all three measures of scale, that is , sales
revenue, fixed assets and employment. This is consistent with a second set of results,
namely, that output and fixed assets growth rates are higher for the Chinese sample
than for the Indian sample, while employment growth rates are higher for the Indian
4
 sample.4 Third, of the two sources of the growth advantage of Chinese sample,
higher rate of investment is by far the more important. It accounts for more than four
times the growth advantage explained by faster TFP growth. China’s faster
productivity growth at the firm level has meant that the growth rate of aggregate (or
industry level) productivity has been higher for Chinese sample. This effect of on the
growth rate of aggregate productivity has been reinforced by allocative efficiency
being higher in the China sample. Consistent with this catch up and life cycle effects
are found to be stronger in the Chinese sample.

To investigate how far differences in business environment could explain the first
three sets of results we estimate various firm performance equations. The main
business climate influences in the TFP gap between Chinese and Indian firms are
differences labor market flexibility, in access to finance, and in levels of skill and
technology. Differences in access to finance and in skills and technology are also
powerful influences in the growth performance gap between the two groups. This
finding is consistent with results of other cross-country firm level studies based on the
World Bank’s investment climate surveys including Dollar et al. (2005), Eifert et al.
(2005)…. A novelty of our estimation strategy compared to existing work is that we
allow for the possibility that the marginal effects of individual elements of business
climate could vary between the two countries even if all business climate indicators
had assumed the same values in both countries. . It turns out that while the better
performance of Chinese firms in our sample is partly on account of “better business
environment”, this less because China’s business climate indicators are better than
India’s than because the marginal effect of a better business climate on firm
productivity or on firm growth is higher in China.

The rest of the paper is organized as follows. We lay out the empirical framework of
our analysis in the next section. We discuss our data in Section 3 along with the
econometric issues arising from them. Our findings are reported in detail in Section
4. We conclude in Section 5.

2. Empirical Framework

In order to address the questions we have posed we have carried out three distinct
analytic tasks. The first of these concerns the measurement of relative performance of
Chinese and Indian firms. The second involves accounting for observed performance
gaps between the two groups of firms, in terms of their proximate causes (or
components). The third task is one of explaining the gaps in the sense of identifying
their ultimate causes, of which one set, we hypothesize, is business environment.

Measuring and accounting for performance gaps

Our basic measures of performance are plant level productivity and the plant level
rate of output growth. The reason we have chosen these particular indicators is that
they are the micro-economic analogues of the two main indicators of aggregate
4
If the growth pattern observed across the two underlying populations has been going on for some time, it
is plausible that the World Bank surveys capture cross-sections in which the average Chinese firm is larger
and more capital intensive.
5
 performance, namely, per capita income and the rate of GDP growth. Knowledge o
the factors behind the relative productivity and growth performance Chinese and
Indian producers should help us understand as to why per capita income and the GDP
growth rate are higher in China than in India.

Our approach to accounting for performance gaps is also strictly analogues to

established practices in aggregate growth accounting and accounting for cross-
country aggregate productivity gaps. Although the latter is relatively uncommon, it is
levels analogue of growth accounting and, as shown in Hall and Jones (1999), no less
illuminating a tool of analysis of international inequality. In adapting it to our setting,
a natural plant level analogue for per capita income is output per worker. The problem
with this particular productivity measure is that it is a function of factor proportions,
which, depending on relative factor prices could vary between Chinese firms and
Indian firms even when they produce an identical product. As a rule output per
worker should be higher where capital input per worker is also higher. Since there is
nothing inherently good or bad about greater capital intensity from the point of view
of efficiency in resource use at the firm level, however, a meaningful comparison of
labor productivity between groups of firms should make allowances for possible
differences in factor proportions. For this reason we use as our productivity measure
total factor productivity (TFP), rather than output per worker.

As already pointed out, the fact that Chinese firms are growing faster on the average
than Indian firms in our dataset poses the question of whether this is because they are
investing at a higher rate, or because they are getting ever more productive. This was
the very question that Young (1994, 1995) raised in the context of the exceptional
growth performance of what were then known as the “Newly Industrialized
Countries” of Hong Kong, Singapore, South Korea, and Taiwan. The answer Young
provided then was that, contrary to what then seemed to be the conventional wisdom,
faster accumulation and “static neoclassical gains from sectoral reallocation”, rather
than rapid TFP growth accounted for “the lion’s share of the East Asian growth
miracle.” Young (2003) draws more or less the same conclusion about the growth
performance of the Chinese economy over the period 1978-1998: in China too, TFP
growth was a far less important source of GDP growth than accumulation and gains
from the reallocation of manpower and capital between sectors. Our results basically
confirm this latter finding based on firm level data in as far as investment in fixed
assets turns out to be far more important than TFP growth as a source of the growth
advantage of Chinese firms over Indian firms in our sample.5

Firm level productivity, allocative efficiency gains, and aggregate productivity

growth

That said higher productivity growth remains to be one source of the growth
advantage of Chinese firms over their Indian counterparts. And while we lack the
data to test Young’s other hypothesis that inter-sector reallocation of manpower and

5
The view that China’s faster growth rate largely reflects its higher investment rates more than anything
else appears to command consensus. See, for example, Srinivasan (2003) and Martin and Manole (2004).
The only contested point here seems to be whether or not productivity growth has played a significant role
in the growth gap between the two countries (Srinivasan, 2003).
6
 capital has been a significant source of China’s GDP growth, we do find that intra
industry allocation of market share from less productive firms to the more productive
has been a more important source of productivity growth in the China sample than in
the India sample our dataset. We draw this conclusion based on an Olley-Pakes cross-
sectional decomposition of industry level productivity growth for each sample.6 The
decomposition expresses the average productivity, Pt , of a given industry in year t
as the weighted mean of establishment level productivities, p it , with establishment
market share, sit , as weights where i indexes establishments. The decomposition
can alternatively be written as
Nt
(1) Pt  pt   ( s it  s t )( pit  pt ) , where
i 1

letters with upper bars represent unweighted industry means of variables. In other words
the industry-level average productivity is the sum of the (unweighted) average of
establishment level productivity and the sample covariance between establishment
productivity and market share. A positive covariance term implies that more productive
firms have higher market shares. Considering changes over time, this means that it is not
necessary that p t increases for average industry productivity to grow. Pt can increase
even in the absence of significant changes in p t as a result of the reallocation of market
share in favor of more productive firms, which measures of industry deregulation or
market liberalization are often found to lead to. In practice actual change in industry
productivity is often a result of a bit of both, and one objective of our analysis has been to
assess the relative weight of the two elements as potential sources of the productivity
growth gaps we observed between our China and India samples.

Explaining performance gaps: the role of business climate

Output per worker is higher in the average Chinese firm than in its Indian counterpart for
two reasons. One is because Chinese plants have more capital per worker. The other is
because their total factor productivity is higher. Likewise Chinese firms grow faster on
the average in terms of output partly because they invest at a higher rate and partly
because of their faster TFP growth. But why are TFP and its rate of growth higher for the
average Chinese plant? And why do Chinese firms invest at higher rates? A popular
hypothesis is that part of the answer lies in China’s allegedly superior physical
infrastructure. A second common hypothesis is that other aspects of the business
environment significantly differ between the two countries, and have on balance
influenced economic outcomes in China’s favor. Differences seem to be particularly
pronounced between the two sets of firms in terms of access to finance, labor market
flexibility, the predictability of the regulatory environment and the level of skills and
technology. In order to test these hypotheses we have estimated performance equation on
each country dataset whereby the performance, y i , of firm i , is assumed to depend on
a vector of business climate variables, X i , a vector of firm level controls and industry

6
This is set out in Olley and Pakes (1996), and is discussed in Foster, Haltiwanger, and Krizan (2001) in
the context of the wider literature on productivity decomposition.
7
characteristics, Z i , and an iid random error term, summing up a set of unobservable
influences assumed to be orthogonal to firm characteristics and business environment.
The performance equations we have estimated are of the form
(2) y i   counry  X i'  country  Z i' country   icountry

where country indexes China or India,  China ,  India ,  China ,  India ,  China ,  India are
constants, and  icountry is random error terms assumed to be iid and orthogonal to X i
and Z i . It is possible, but not necessarily the case that the coefficients of the two
versions of equation (2) are identical. In particular, it could be that  China   India ,
meaning that the various elements of business environment we just listed would have the
same marginal effect in China as India, or improvements in business climate would have
the same marginal “rate of return” in both countries. In that case the average performance
gap between the two countries on account of differences in business climate would
simply be the differences in business climate indicators scaled up by the common
marginal rate of return. However, it is also possible that marginal rates of return are
different for the two countries. We have therefore chosen to treat the equality of  China
and  India as a testable proposition rather than an assumption of our analysis. Because
we find that the two sets of coefficients are in fact different, we conclude that there
would always be performance gaps between Chinese and Indian firms for business
climate reasons even if even if all business climate indictors assumed identical values in
the two countries. Let Ey | X k be the amount by which the mean performance of
indicator of Chinese firms exceeds that of Indian firms on account of differences with
respect of business environment indicator X k . Then we have

(3) Ey | X k   k ,China ( X k ,China  X k , India )  X k , India (  k ,China   k , India ) ,

where  k ,country is the coefficient of the kth business climate indicator in the
performance equation and X k ,country is the mean value of X k in the indicated country.
This is an Oaxaca-Blinder decomposition of the performance gap Ey | X k into the
“endowment effect” of the fact that X k has different values in China and India, and the
“rate of return effect” of the fact that the marginal effect of X k would be different in
China from what it is in India even when the indicator assumes the same values in the
two counties.7

The effects of firm and industry characteristics on the performance gaps can likewise be
decomposed into “endowment” and “rate of return” effects.8
7
The Oaxaca-Blinder decomposition was introduced to the literature by Oaxaca (1973) and Blinder (1973)
in the early 1970’s as technique for accounting for wage gaps between labor market groups and sectors. As
a purely statistical technique it clearly has a much wider relevance than the analysis of labor market
earnings.
Let   ( ,  ,  ) and Wi  (1, X i , Z i ) , so that we can write the performance equation (2) as
8 ' ' ' ' '

y i  Wi '   icountry . The Oaxaca –Blinder decomposition of the total gap between the mean
performance indicator of Chinese firms and Indian firms would be given by
Ey   China (WChina  W India )  W India ( China   India ) .

8
3. Data and econometric issues

Survey data sources

Although the World Bank Surveys from which our data are drawn were quite similar in
sample design and survey instrument, they were planned and executed independently and
had significant differences in both respects. The India survey covered 1860
manufacturing establishments, sampled from the top 40 industrial cities in the country.
The forty cities were selected from 12 of the largest 15 states by picking the largest 3 or 4
industrial centers from each state. These 12 states were Andhra Pradesh, Delhi, Gujarat,
Karnataka, Kerala, Haryana, Maharashtra, Madhya Pradesh, Punjab, Tamil Nadu, Uttar
Pradesh, and West Bengal. Between them the 12 states account for well over 90 percent
of India’s industrial GDP. The 3 or 4 cities covered in each state also accounted for the
bulk of manufacturing outputs of their respective states. In each city, samples were drawn
from the main exporting or import competing manufacturing industries, namely: food
processing, textiles, garments and leather goods, chemicals and pharmaceuticals,
household electronics, electrical equipment and parts, auto and parts, metallurgical
products and tools. The total sample was allocated between states in proportion to state’s
share in the national employment total of the eight industries. Each state’s allocation was
then drawn by systematic sampling from a consolidated list of registered firms employing
at least 10 workers and belonging to one of the eight industries. The list was restricted to
the selected 3 to 4 industrial cities within each state and sorted by ascending employment
size. The systematic sampling rule set an establishment’s probability of selection
proportional to the establishment’s number of employees.

In the China survey enterprises were sampled from 18 cities considered to be representative
of five regions. The cities were: (1) Benxi, Dalian, Changchun, and Haerbin, from the
Northeast Region; (2) Hangzhou, Wenzhou, Shenzhen, and Jiangmen, from the Coastal
Region; (3) Nanchang, Zhenzhou, Wuhan, and Changsha, from the Central Region; (4)
Nanning, Guiyang, Chongqing, and Kunming from the Southwest Region; and (5) Xi’an
and Langzhou.from the Northwest Region. Each of these cities was allotted a sample size
of either 100 or 150 firms. These were randomly drawn from an electronic database of
firms according to several criteria. Unlike the India survey, the China survey covered firms
from manufacturing as well as service industries. As in the India survey, the sampling frame
in China was also restricted to businesses the employment size of which was above a
minimum cut off point. In the Chinese case the cut off employment level was set at 20
workers for manufacturing industries and 15 employees for service industries.

Firm characteristics: industry, size, and age profiles

To ensure comparability, our analysis is confined to manufacturing firms drawn from

industries that were covered both by the India survey and the China survey. As a result we
have excluded textiles producers from the India sample and all service sector establishments
and producers of transport equipment from the China sample. The businesses on which we
actually analyze data are consequently 1565 firms from China and 1735 firms in India. The
distribution of these by industry is shown in Table 1. Summary statistics of the variable used
in our analysis are given in Table 2.

9
The average business age is about 16 years in both samples. However, the median age is
significantly lower for the China sample. The average Chinese business is also several times
larger than its Indian counterpart by all three measures, namely, number of employees, book
value of fixed assets, and annual value added. Both surveys provide information on all these
and other financial indicators for a period of 2 or 3 years for most establishments. We have
therefore been able to measure the growth performance of most businesses in the dataset in
terms of all three measures of size. We have also been able to estimate for most businesses
total factor productivity in levels as well as its annual growth for a period of up to two years.

Measuring growth and productivity

As one of our two primary performance indicators, the rate of growth of output is
measured here as the log difference in annual value added. Likewise the employment
growth rate is the log difference in the annual average number of employees. The rate of
growth of capital stock is the log difference between the book value of fixed assets at the
end of a fiscal year from that at the beginning of the year. We define the growth rate of
productivity as the annual log difference in total factor productivity.

We measure total factor productivity itself as the amount by which the actual output of a
plant or establishment exceeds or falls short of a counterfactual output on a reference
technology given its actual inputs. We estimate this technology for each of the seven
industries listed in Table 1 using our sample observations based on the assumption that, in
each industry, output is Cobb-Douglas in capital services and labor input. We define output as
annual value added, Vit in constant US dollars. We proxy capital services by the constant
dollar book value of fixed assets at the end of the fiscal year, K it . Labor input is measured
by the average number of employees during a fiscal year, Lit . We define the reference
technology as

(4) ln Vit  ait  b1 ln K it  b2 ln Lit

where a it is the TFP term, and b1 and b2 are constant factor share parameters. We have
estimated (log) TFP as aˆ it  ln Vit  bˆ1 ln K it  bˆ2 ln Lit , where b̂1 and b̂2 are estimates of
b1 and b2 obtained by fitting (4) to our data. A major concern, in obtaining the estimates
b̂1 and b̂2 is that a it is a state variable that influences input choices: inherently more
productive firms could employ more resources. Consistent estimates of the factor share
parameters cannot therefore be obtained by applying OLS to (4).9 To address this problem
we have used the Levinsohn- Petrin estimator (Levinsohn and Petrin, 2003), which is in
fact the only feasible solution to the problem of input endogeneity given our data. This is
essentially a two step procedure in the fist step of which we use material inputs as proxy
for exogenous variation in productivity to consistently estimate the share of labor (as the
non-state input). The estimate so obtained is then used to consistently estimate the share
of capital by minimizing the excess of capital over the share of all other inputs at the
mean productivity predicted in the first step.10

9
The main references on this problem and proposed solutions are Olley and Pakes (1996), Blundell and
Bond (2000), and Levinsohn and Petrin (2003). See also Ackerberg and Caves (2003) for a critique of the
Levinsohn –Petrin estimator we have used here, and Wooldridge (2005), for its interpretation in a system
equation framework.
10
One drawback of our using the Levinsohn-Petrin estimator to address the endogeneity
problem is that we have to use value added as our output measure since material inputs is the
only non-state input that we can use to control for unobservables. 11 The problem with using
value added as our measure of output is that it is a computed variable rather than one that is
reported in company records. As it turns out, reported sales and purchase figures imply
negative value added in many cases. It seems that the natural thing to do is not to consider
these as valid entries. This could lead to bias in our estimates of China-India performance
gaps since it would seem that we would have to drop more Indian firms than Chinese firms
from the survey samples. In order to avoid the bias this would lead to in our estimates of the
China-India performance gaps we have decided to drop 8 percent of firms on the lowest
end of the distribution of value added per employees from each country sample in
estimating the production function.12

Gauging business climate

There have been two primary considerations behind our selection of the business climate
variables used as regressors in our performance equations. One is the list of factors that
the policy literature identifies to be significant determinants of economic performance in
the institutional setting of business operations in either country. The second is the
availability of comparable indicators at the micro level in both countries. The quality of
physical infrastructure, access to finance, labor market flexibility, predictability of
government regulation, and levels of technology or workforce skills are all considered to
be important influences in economic performance either in China or in India. We also
happen to have at least one common proxy in both the China and the India samples of our
data.

China is reported to have invested far more than India in physical infrastructure almost
since the 1980s. The share of investment in this particular sector is believed to have
averaged 15 to 20 percent of GDP since the mid 1990s as compared to India’s less than 7
percent of GDP, which China’s investment at about 8 times India’s in absolute terms
(Ahya and Xie, 2004). At the same time, infrastructure is often cited as one of the key
bottlenecks to growth in India. 13 Within the category of infrastructure, the blame has
particularly been focused on the problem of expensive and unreliability of power supply
to industry (World Bank, 2004). We therefore use as our proxy for the quality of
infrastructure the proportion of annual sales that businesses report in surveys to have lost
due to power outages. On the average firms in the Indian sample report about 9 percent in
lost sales due to power outages, against 2 percent of loss in sales as the average for the
China sample (Table 2).

10
Alternative approaches to the problem of endogeneity of inputs are proposed in Olley and Pakes (1996)
and Blundell and Bond (2000). Neither of these is feasible with our data, though.
11
We also estimated a production function with gross output as the dependent variable and capital, labor
and materials as three distinct inputs. With this approach we cannot deal with the problem of endogeneity
of input choices since material input is used as regressors. TFP on this approach is simply estimated as the
fixed effects residual (including the fixed effects). The correlation between the Levinsohn-Petrin TFP and
the fixed effects TFP is nonetheless quite high, with a correlation coefficient of 0.66.
12
The 8 % city cut off point ensures that all Indian firms with positive value added are included, but means
that some Chinese firms had to be dropped even when they had positive value added.
13
See, for example, Pinto, Zahir and Pang (2006).
11
The literature suggests that access to finance might be more of a growth bottleneck in
China than in India. Although China’s higher investment rate is claimed to have been
facilitated by low interest bank loans in the 1980s and the 1990’s, the financial system
has been plagued recently by extremely high rates of non-performing loans and very
low rates of return on bank assets compared to the Indian banking system (Ahya and Xie,
2004).14 Possibly because the credit restraining measures that Chinese authorities are
reported to have taken in response are taking effect, our indicators suggest that Chinese
firms have poorer access to finance than their Indian counterparts. One of these
indicators is whether or not a business has an active bank overdraft facility. Since firms
could substitute trade credit when faced with tight bank credit, we use this along side a
second indicator, which is the proportion of inputs purchased on credit. The proportion of
firms that have bank overdraft facility in China is 29% as compared to 56% in India
(Table 2). Only 12 percent of input purchases are also on credit in China, as opposed to
66 % in India.

Deepak Lal’s reference to ‘second generation reforms’ in the opening quote almost
certainly includes making India’s labor market more flexible than it is today. Although
there are outstanding labor market reform issues in China as well, reforms that took place
in the mid 1980s and mid 1990s are believed by many to have made the Chinese labor
market more flexible than India’s in terms of the ease with which firms can adjust staffing
levels to product market and technological developments. (Ahya and Xie, 2004). In India
one of the key provisions of the existing labor code requires businesses employing more
than 100 workers to seek the permission of the state government for closure or the
retrenchment of workers, which permission, critics point out, is rarely granted (Sachs et
al., 1999). This is believed to have added significantly to duration of insolvency
procedures in the country. It is also claimed to force firms to maintain suboptimal scale of
operation. Related items of the labor law include the ‘service-rules’ provisions of the
Industrial Employment Act of 1946 and the provisions of the Contract Labor (Abolition
and Regulation) Act of 1970. The Industrial Employment Act provides for the definition
of job content, employee status and area of work by state law or by collective agreement,
after which changes would not be made without getting the consent of all workers.15
Zagha (1999) points out that this has always made it difficult for businesses ‘to shift
workers not only between plants and locations, but also between different jobs in the
same plant.’ As a way out of such restrictions businesses may resort to contract workers,
as per the provision of yet another law, namely, the Contract Labor Act. This law gives
state governments the right to abolish contract labor in any industry in any part of the
state. In states where recourse to contract labor has been more restricted as a result,
keeping employment below the threshold level of 100 employees or contracting out jobs
has been the only way of maintaining flexibility in the allocation of manpower.

The immediate consequence of China’s labor market reforms of the mid 1980s and mid
1990’s has been to increase the proportion of workers on temporary contracts (Ahya and
Xie, 2005). As well, variations in the strictness of the enforcement of the labor law in
India seem to be highly correlated with the same proportion. We therefore use the

14
See also Deutsche Bank Research (2005).
15
This too applies to establishments with more than 100 employees, but Zagha (1999) notes that some
states have made the provisions mandatory to firms with 50 or more workers while other states have
abolished the employment size limit altogether.
12
proportion of non-permanent employees in the workforce as one of our indicators of
labor market flexibility. A complementary indicator on which we have observations on
both the China and the India samples is the overstaffing ratio reported by managers at the
time of the survey. This is the proportion of current employees that managers could lay
off without reducing output. While overstaffing of this kind could be a result of voluntary
labor hoarding, the India survey gives indications that restrictive labor laws are part of
the list of reasons behind the phenomenon. The values of both indicators in Table 2 are
consistent with the Chinese labor market being more flexible. Although the difference
between the mean proportions of non-permanent workers is not statistically significant,
the median proportion in China is more than twice that of India. Both the mean and
median overstaffing ratios are also significantly larger in the Indian sample.

In both countries recent growth has benefited from rapid expansion of exports. Martin
and Manole (2004) note that in both countries exports have progressively shifted to more
skill intensive and more high tech manufactures, this being more so in China, where the
growth rate of exports has also been a great deal faster. As they point out this suggests
that there must have been significant increase in the availability or utilization of skills and
technology. However, the question of how far difference in this respect explains the
performance gap between the two economies has yet to be addressed explicitly. The
picture that emerges from a comparison of conventional indicators of availability between
the two countries is rather mixed. China clearly has the advantage on adult literacy and
school enrollment rates (including those for tertiary education), but India is also believed
to have more qualified engineers and other categories (Deutsche Bank Research, 2005).16
The indicator of firm level skill levels that we use in our performance equations is the
proportion of workers that regularly use computers on their jobs. On this measure
Chinese firms appear to have a slight edge over their Indian counterparts. On the average
22 percent of workers in a Chinese business use computers regularly on the job as
compared to 17 percent in an Indian establishment (Table 2).

Our last indicator of business climate relates to the predictability of government

regulation of industry to maintain environmental, safety, health, and labor standards.
Many of these standards are enforced through inspection visits by government officials.
While the standards are probably not much different from what is enforced routinely in
developed economies, individual government officers seem to have far more discretion in
enforcement in the developing world. In many cases inspection visits are arbitrary or too
frequent, and are viewed by business people as a form of veiled demand for bribes, as the
price of avoiding future visits. The price is sometimes worth paying to avoid disruption to
production plans or save valuable staff time, including that of senior management. Our
proxy for the predictability of regulation is the local coefficient of variation in the
reported frequency of inspection visits per year. Both the mean and the median of this
indicator are not statistically different between the China and the India samples (Table 2).

Endogeneity of business climate indicators to firm performance

Unlike our measures of performance on which we typically have 2 to 3 annual

observations for each firm, all seven of our indicators of business environment are
16
India’s adult literacy rate stood at 68% against 95% for China in 2003 (Deutsche Bank Research, 2005).
The tertiary enrollment rates for the same year were 11% and 13% for India and China respectively.
13
observed only for the year of the survey. We have therefore estimated equation (2) on a
cross-section by pooling the performance indicators over time and assuming that the
business environment indicators are constant over the three year period leading up to the
survey. This means that business environment indicators included in the equation would
very likely be correlated with the error term if these are measured at the firm level. This
is because the error term will probably include unobservables that drive both the
performance of a firm and the business environment indicators it reports. It is possible,
for example, that inherently more productive firms cope better with frequent power
outages through the use of more flexible processes and production schedules. They could
consequently lose less in potential output than other firms. Similarly, our indicators of
labor market flexibility could be correlated with business growth or productivity if, for
example, labor regulation is a more binding constraint on more innovative firms, which
may have less scope for manipulating the share of non-permanent employees in their
labor force. Likewise with the other indicators: inherently high growth firms could be
more attractive to potential lenders; or could rely more on information technology; or
better control the behavior of government inspectors; and so on.

To alleviate the bias that these instances of endogeneity would lead to in the estimation of
performance equations by OLS we measure all business climate indicators as city
averages of firm level observations. This would be equivalent to the use of city dummies
as instruments for the indicators, and should remove the bias, if we can assume that the
location decision of firms is exogenous to performance. This would be a reasonable
assumption if either location decisions are irreversible once made, or that there are no
unobservables that influence both the performance of firms and their choice of location.
Otherwise the estimation of the performance equation would be biased. Because the vast
majority of firms are small and medium sized we think the assumption of irreversible
location is a reasonable one. Just in case it is not we have run a robustness check by
running the regression on the subset of small firms in each country sample, for which the
scope for cross-city mobility would seem to be far more limited.17 [[We need to do the
robustness check]]

4. Estimation Results

Comparing performance

Summary statistics of the two primary measures of performance, namely total factor
productivity (in log) and annual value added growth are given in Table 2. Also reported in
the same table are summary statistics of the rates of the three sources of value added
growth, namely, employment growth, capital stock growth and growth of total factor
productivity. The most noticeable element of the summary is probably the huge TFP
premium of the China sample. The log difference in mean TFP is 1.23 in favor of the
China sample, meaning that the average TFP for the China sample is more than three
times that of the India sample. This together with the higher capital intensity of Chinese
firms that we read the employment and capital stock rows of the table makes value added
per worker larger in the China sample than it is for Indian firms.
17
This is the approach used in Dollar et al. (2005).
14
 Chinese firms also grow much faster in terms of output, the average growth rate in value
added being 12 per cent per annum in their case as compared to 5 percent per annum for
the India sample. This is in spite of the fact that the average employment growth rate is
significantly higher for the Indian firms at an average of 4 percent per annum as
compared to 2 percent per annum for the Chinese sample. This, however, is more than
made up for by the higher growth rate both of capital stock and total factor productivity
in the China sample to result in the higher growth rate of output of Chinese firms. Of
these two, growth in capital stock is by far the more important reason why the output
growth rate is so much higher. The average rate of growth of net fixed assets for Chinese
firms is 11 per cent per annum against a rate of -1.0 percent per annum for the India
sample. On the other hand rates of TFP growth are comparable between the two samples
at 3 percent per annum and 4 percent per annum for the India and China respectively.
To facilitate computation of the relative weight of these gaps in the growth rate of output,
we have regressed the growth rate of value added on the rates of growth of employment,
fixed assets and total factor productivity for each country in Table 3. Given that the
underlying specification is in fact an accounting identity, nothing should be read into the
goodness of fit of the regression or the fact that the coefficient estimates are almost
identical across the two country samples. The regression nonetheless shows that
differences in factor growth account for at least 74 per cent of the gap in the rate of
growth of output between Chinese and Indian firm. TFP growth accounts for at most 26
percent of the same gap. This means that Chinese firms are growing faster than Indian
firms mainly because they are investing in plant and equipment at higher rate. However,
the 26 percent contribution of TFP growth for the gap in output growth is fairly large.
Since we are talking about a 7 percentage point gap in output growth rate, this means that
Chinese firms are probably growing by 1.8 percentage points a year faster than their
Indian counterparts on account of their higher rate of TFP growth.

In order to see how the firm level TFP growth rate gap itself translate to industry terms
we have computed the Olley-Pakes decomposition of industry level TFP for two
consecutive years. The results are reported in Table 4. We see right at the end of the table
that aggregate industry productivity increased by 3.1 percentage point for the Chinese
sample over the two year period as compared to 2.2 percentage points of growth for the
India sample. This is a substantial albeit not very large gap, and reflects mainly the
greater allocative efficiency gains in the Chinese sample. While firm level TFP growth
has been a more important source of growth in aggregate productivity than allocative
efficiency gains in both the China and the India samples, allocative efficiency gains led to
productivity growth by a full percentage point in the China sample, while aggregate
productivity in fact fell by half a percentage point in the India sample due to allocative
efficiency losses.

Estimated performance equations

Our estimation results of performance equations are reported in Table 5. The performance
measure for the equation estimated in the first column is the log of total factor
productivity. In column 2 we estimate an output growth equation with the rate of growth
of annual value added as the dependent variable. The other columns refer to the
employment growth, the fixed assets growth and the TFP growth equations in that order.
15
Obviously the key columns are the first two, columns 3 to 5 being in a sense extensions
of the output growth regression of the second column. While column 1 and 2 relate to
productivity and output growth as distinct measures of performance, the performance
indicators of columns 3 through to 5 relate to the constituent elements of output growth.
In view of the fact that the average firm in the Chinese sample is much larger than its
Indian counterpart, we include employment size among our firm level controls all five
equations. We also include firm age and sector dummies to control for lifecycle effect in
performance. While age, size and line of industry should be no less outcomes of business
environment than productivity or growth, our focus here is on effects conditional on the
existing industry, size and age distribution of firms.

There are two striking patterns in Table 5. One is that, on the whole, the marginal effects
of business climate seem to be stronger in the China sample. Secondly age and size
effects also tend to be larger for the China sample. In column1, for example, total factor
productivity increases rapidly with a businesses scale of operations in both samples, but
the effect is stronger in the China sample by as much 15 percent. Perhaps more
importantly, there is no evidence of age or lifecycle effects in the India sample, while
there is a strong and inverse effect in the China sample. In the China sample younger
firms tend to be more productive. This is important since age can proxy for entry cohort
effects. Age could also capture passive learning effects such as learning by doing. To the
extent there is passive learning, older firms should be more productive, at least up to a
point in the life cycle. If younger firms are nonetheless more productive as is the case in
the China sample, new entry cohorts must be more productive than incumbents to a point
that more than makes up for their relative “inexperience”. This in itself would be a source
of growth in aggregate (industry) productivity, which we are setting aside by including
age among the controls in the productivity equation.

A measure of the contrast in the marginal effects on productivity of business climate

between the two samples is that labor market flexibility is the only statistically significant
influence in the Indian sample, while skills and access to finance are what matter in the
Chinese sample. The only business climate indicator that has statistically significant
coefficient in the India equation is the proportion of non-permanent workers. This,
however, is not among the statistically significant indicators for the China sample, which
are the proportion of computer users, the share of inputs purchased on credit, and the
proportion of businesses with bank overdraft facilities. Total factor productivity is higher
in India where the proportion of non-permanent workers is higher, which we interpret as
evidence of positive association between labor market flexibility and productivity. For the
China sample, the coefficients of the proportion of computer users is positive and
statistically significant as are the coefficients of both indicators of access to finance. We
interpret the first as evidence that total factor productivity is higher where skill or
technology levels are higher. Productivity is also higher where access to finance is
greater.18

Turning to the value added growth equation of column 2 (of Table 5), we see that,
although life cycle effects seem to be similar across the two samples, the effects of
18
The positive association between productivity and the proportion of inputs purchased on credit is
consistently with the observation about the substitution of informal financing for formal financing in
making Chinese firms functioning (Allen, Qian and Qian, 2005).
16
business environment again differ sharply. In both samples, younger firms grow faster in
revenue terms, as should be expected. The business climate variables with statistically
significant influences are also the same in the two samples, these being skills and access
to finance. Of these two access to finance has a positive and statistically significant effect
on output growth in as far as it is captured by access to bank overdraft facilities. The
contrast is in two ways. First, the coefficient of this indicator is substantially larger in the
China sample. Secondly, the coefficient of our skills and technology indicator is negative
in the growth equation for China. Our interpretation of this is that relatively high-tech or
more skill intensive firms grow faster than low tech businesses in India, while the reverse
is the case in China. This in turn suggests that, conditional on the current structure of
industry, skills and technology are a constraint to growth in India, but not so in China.
This reverses the pattern observed in connection with the effect of skills and technology
on productivity, whereby total factor productivity is higher on the average in high-tech or
more skills intensive firms in China but not so in India.

Moving to the determinants of the constituent elements of output growth in columns 3

through 5 of Table 5, we note again that the broad pattern where both life cycle effects
and the effects of businesses climate differs between the two countries applies here as
well. For example, we see in column 3 that larger firms have lower job growth rates in
both countries, but the same effects is three times as strong in China as it is in India,
suggesting that small firms are more important in creating jobs in China than in India.
Employment growth is also slower in older firms in both countries. This pattern too is
more pronounced in China than in India, again suggesting a stronger creative destruction
process in China. A case of the contrasting effects of business climate between the two
countries in the context employment growth is that the effect of skills and technology
seems to be much more pronounced in India than in China. On the other hand labor
market flexibility, while being important in both, is a stronger influence on employment
growth in China than in India. In both samples the employment growth rate is higher
where the proportion of non-permanent workers is higher, but the estimated coefficient is
several times larger for the China sample. A third case of contrast in the effect of business
climate between the two samples is that employment growth is faster where there is more
access to bank finance or trade credit, but again the effect is stronger in China. This is not
surprising since Chinese banks are well-known in lending to favor large and state-owned
enterprises (Cull and Xu, 2000, 2003; Huang, 2003; Brandt and Li, 2003), while job
creation rates are faster in small firms.19 Fourth, while there is no association between
our indicator of the predictability of regulation and employment growth rates in the
Indian sample, greater unpredictability seems to reduce the job creation rate in the China
sample.

In column 4 of Table 5 we see the contrast in the patterns of growth in capital stock
between the two samples. First, in the India sample, net investment rates are higher in
larger (in employment terms) and more skill intensive or high tech firms, suggesting that
capital formation is probably driven more by firms in the upper ends of the size
distribution and technology spectrum. This, however, does not seem to be the case in the
China sample, where net investment rate is (randomly) uniform across the size spectrum.
The rate is also actually lower for more high tech or more skill intensive firms. Secondly,
19
Interestingly, there is evidence that informal finance (i.e., trade credit) does help job creation, but the
association is not statistically significant (t=1.50)
17
while there are no age effects in capital growth in the India sample, net investment rates
are higher in younger firms in the China sample. Third, the effect of business
environment on capital growth rates is sharply different between the two samples. One
aspect of this is the difference in the association between skills or technology and
investment rates that we already refered to. A second is that greater access to finance is
associated with greater assets growth in the China sample while there is no such
association in the India sample. A third aspect is that net investment rates is highly
correlated with both of our indicators of labor market flexibility in the China sample,
while there is no such correlation in the India sample. In the China sample the rate of
capital growth decreases both with the overstaffing rate and with the proportion of non-
permanent workers.

The pattern of TFP growth we see in column 6 is far more similar across the two samples
than is the case with the growth patterns in employment and capital stock. For example in
both country samples, productivity growth is faster in younger firms. Access to finance is
also positively associated with TFP growth in both samples. However, even here there is
an important difference in that higher skill and technology levels are associated with
faster productivity growth in the India sample while this is not the case for Chinese firms.

Our discussion of the results of Table 5 so far has been intended to identify the major
influences on firm performance in the two country samples. We now move to the
question of how far these influences explain the performance gaps observed between the
samples. In order to address this question, we present in Table 6 the Oaxaca-Blinder
decomposition of the effect of business climate variables on productivity and output
growth, but confining ourselves to influences that are statistically significant in at least
one of the two country samples. Apart from enabling us to disentangle “endowment
effects” from “rate of return effects”, this will help us assess the weight of each aspect of
business climate relative to other covariates of performance. We present in Table 7 the
full decomposition for the entire range of regressors (including firm level controls) and
covering effects on employment growth and assets growth as well.

To give a sense of how powerful an influence business climate is on the observed

performance differential between the two samples, the log TFP gap between them would
be 1.39 if productivity depended solely on business environment as captured by our
indicators (Table 6). This is greater than the raw (actual) sample mean difference of 1.23.
As our discussion of column 1 of Table 5 showed, this is the combined effect of four
element of business climate, namely, skills and technology, labor market flexibility,
access to bank finance and access to trade credit. The mean indicators of skills and
technology and labor market flexibility are both higher for the Chinese sample,
suggesting that the Chinese business environment is better on those counts. On the other
hand, the means of the finance indicators are both higher for the Indian sample,
suggesting the Indian firms have better access to finance than their counterparts. The
combined effect of the four indicators on productivity is nonetheless in favor of higher
productivity of the Chinese sample. This is not because skills and labor market flexibility
are more powerful influences on productivity than access to finance.20 The first two
20
On the contrary, access to finance is the more powerful influence in each country sample than skills and
technology and labor market flexibility combined.
18
columns of Table 6 show that it is rather because that the marginal effect of each of the
four elements is stronger in China than in India. Although Indian firms are more
productive than their Chinese counterparts because of the “endowment effect” of their
better access to finance, the “rate of return” effect of better access finance is higher in
China to a degree that makes the overall productivity effect of access to finance higher
for Chinese firms.

We see from the third and fourth columns of Table 6 that labor market flexibility does not
account for much of the (output) growth gap between the average Chinese firm and the
average Indian firm in our sample. A possible reason for this is the fact that its effects on
physical capital formation tend to cancel out the effects on employment growth. On the
other hand differences in access to finance and levels of skills and technology together
would generate an annual out growth gap of 9.5% in favor of the average Chinese firm, if
they were the only sources of variation in value added growth. This is higher than the raw
average growth gap of 7% we observe in the data, and goes to show how powerful an
influence business environment is in growth performance as well. However, this time too
the aggregate business climate impact masks two patterns. One is that the growth rate of
Indian firms is actually higher on account of one of the two aspects of business climate
that matter here, which is skills and technology. The overall outcome is consequently due
to growth being faster on account of the other business climate element, that is, access
finance. The second is that the Indian average growth rate is smaller on account of the
aspect of business climate the mean indicator of which is actually higher for the Indian
sample, which is access to finance. Ditto with the average Chinese growth rate, which is
smaller on account of the business climate element which is better for the Chinese
sample, which is level of skills and technology. The reason for this is that the
“endowment effect” of China’s better indicator of skills and technology is undermined by
a negative “rate of return effect”-that is by the fact that, unlike the case with India
relatively higher skills and technology in China are associated smaller growth swamped
by the higher rate of return of better access to finance to China. On the other hand, the
positive “endowment effect” of India’s better access to finance is swamped by the higher
“rate of return” to better access to finance in China.

The relative importance of firm level controls can likewise be read from the full
decomposition given in Table 7. For example we see from the TFP panel of the
decomposition (Panel A) that the fact that Chinese firms are larger than their Indian
counterparts accounts for 59 percent of the explained component of the TFP gap between
the two samples, the unexplained part being the component due to unobserved country
effects. Panel C also shows that the fact that Chinese firms are much larger on the
average in employment terms is the single most important factor explaining why their
employment growth rate is smaller than that of the Indian sample, dwarfing all other
influences including elements of business environment. Panel D shows that unobserved
country effects account for the higher net investment rate of Chinese firms far more than
do all our explanatory variables combined.

5. Conclusion

This paper has analyzed data on samples of manufacturing plants drawn from China and
India with the aim of shading light on the reasons why the Chinese economy has done so
19
much better in terms of per capita income and GDP growth. Consistent with the gap in
per capita income, the average Chinese plant in our sample has significantly higher labor
productivity, in part because it is more capital intensive and in part because its total factor
productivity is higher than that of its Indian counterpart. Chinese plants are also larger.
This is partly because Chinese firms grow a great deal faster on the average in terms of
revenue and fixed assets. Higher rates of investment in physical capital are the main
reason for the higher growth rate of output in Chinese firms. A less important, but
significant source of their growth advantage has also been their faster rate of TFP growth.
Faster firm level productivity growth has in turn helped make aggregate industry
productivity growth rates higher for the Chinese sample than for the India sample. There
is also a second source of the greater industry level productivity growth of Chinese firms,
which are the greater allocative efficiency gains of the Chinese sample.

The finding that allocative efficiency gains are greater in the Chinese sample is consistent
with a second result: that catch up (or inverse size) effects and life cycle (or age) effects
are generally stronger in the Chinese sample than in the Indian sample. In particular it is
worth noting that there is no evidence of age effects in firm level productivity in the India
sample, while younger firms are more productive in the Chinese sample. Employment
growth rates are higher in smaller and younger firms in the two samples, but again both
these effects happen to be stronger for the China sample. Also, while there are no age
effects in the rate of net investment in the India sample, the rate is higher for younger
firms in the China sample.

Together size and age effects account for a large proportion of the performance gaps
between the Chinese sample and the India sample. Since the age and size distribution of
firms very much depends on the institutional and policy environment in which firms
function, an assessment of the role of what we have collectively termed business climate
here, should probably involve the modeling the determination of both distributions. Our
analysis shows that, even setting aside its effects on firm age and firm size, business
climate accounts for a large part of the performance gap that we observe between the
China and India samples. Labor market flexibility, access to finance, and the availability
of skills and technology are the main element of business climate contributing to the TFP
gap between the two groups of firms. Differences in access to finance and skill and
technology levels also account for a large proportion of the growth gap. On the whole, we
can say that business climate differences are one of the factors behind the performance
gaps we have documented to exist between Chinese firms and Indian firms. It is
important to note that this is not so much because business climate indicators are better in
China on the average as because the marginal effect of improvement in business climate
is larger than in India. To put it another way, even if China and India had an identical set
of values for our indices of business climate, the average Chinese firm would have better
performance indicators than its Indian counterpart because of the influence of business
environment on performance.

We should close with a serious qualifier to these conclusions. This is that they are based
on purely cross-sectional variation in business climate indicators. It should be clear from
our discussion of the identification problems this poses, and from our robustness checks,
that our results are unlikely to be driven entirely by reverse causation-that is by the
possible tendency of inherently more productive or faster growing firms self-selecting
20
into localities where the business climate happens to be better. This of course is no
substitute for formal selectivity bias correction techniques that would be possible with
better data. However, at this stage the data we have analyzed in the paper seem to be the
best available set of observations yet of co-variation between micro-economic
performance and business environment.

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22
 Table 1: Industry distribution of firms to which the data refer

China India

Number % Number %
Garments and leather products 352.0 22.5 357.0 20.6
Household electronics 63.0 4.0 137.0 7.9
Electrical equipment and parts 461.0 29.5 163.0 9.4
Auto and parts 358.0 22.9 265.0 15.3
Food processing 71.0 4.5 216.0 12.5
Chemicals and pharmaceuticals 102.0 6.5 421.0 24.3
Metallurgical products and tools 158.0 10.1 176.0 10.1
Total 1565.0 100.0 1735.0 100.0

23
 Table 2. Summary Statistics.
India China China-India
mean median S.D. mean median S.D. mean dif median dif
china 0.00 0.00 0.00 1.00 1.00 0.00
age 15.80 12.00 16.56 15.74 9.00 14.13 -0.06 -3
V (in mil) 1.01 0.05 7.57 6.87 0.76 36.30 5.86 0.71
K (in mil) 1.04 0.04 17.10 10.20 0.86 48.90 9.16 0.82
L 86.98 18.00 285.70 456.95 146.00 1066.30 369.97 128
tfpLP_W -0.63 -0.57 1.43 0.60 0.58 1.46 1.23 1.15
tfpLPG_W 0.03 0.01 0.50 0.04 0.05 0.51 0.01 0.04
Vgrow_W 0.05 0.01 0.54 0.12 0.08 1.08 0.07 0.07
Kgrow_W -0.01 -0.03 0.27 0.11 0.03 0.33 0.12 0.06
Lgrow_W 0.04 0.00 0.14 0.02 0.00 0.25 -0.02 0
Mlossppower 0.09 0.09 0.05 0.02 0.02 0.01 -0.07 -0.07
MsL_computer 0.17 0.18 0.05 0.22 0.21 0.09 0.05 0.03
MsL_nperm 0.43 0.20 0.84 0.44 0.43 0.13 0.01 0.23
Moverman 0.11 0.10 0.06 0.06 0.05 0.04 -0.05 -0.05
Moverdraftt 0.56 0.58 0.20 0.29 0.26 0.10 -0.27 -0.32
MtradecreditS 0.66 0.67 0.08 0.12 0.11 0.07 -0.54 -0.56
CVinspectt 1.56 1.49 0.72 1.52 1.48 0.27 -0.04 -0.01

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Table 2A. Correlation Matrix of Key Variables
Mlosspowe Moverdraf

Vgrow_W Kgrow_W Lgrow_W tfpLPG_W tfpLP_W lnL1 lnage r MsL_computer MsL_nPerm Moverman t MtradecreditS
Vgrow_W 1
Kgrow_W 0.0673 1
Lgrow_W 0.2053 0.1209 1
tfpLPG_W 0.9574 -0.1347 0.0806 1
tfpLP_W 0.2049 0.0933 0.0385 0.1866 1
lnL1 0.035 0.1309 -0.1619 0.0316 0.6402 1
lnage -0.0881 -0.0682 -0.1987 -0.0611 0.0442 0.1976 1
Mlosspower -0.0205 -0.1568 0.0166 0.0061 -0.2881 -0.4499 -0.0013 1
MsL_computer 0.07 0.0967 0.0426 0.0503 0.1785 0.272 -0.1086 -0.1988 1
MsL_nperm 0.0109 0.0199 0.0207 0.0065 0.0915 0.1263 -0.011 -0.0753 0.0244 1
Moverman -0.053 -0.0595 -0.0208 -0.038 -0.1893 -0.2238 0.0839 0.1362 -0.37 -0.1144 1
Moverdraft 0.0191 -0.0954 0.0604 0.031 -0.1564 -0.2189 0.104 0.4273 -0.1467 0.2273 0.3019 1
MtradecreditS -0.0219 -0.1966 0.0447 0.0089 -0.3665 -0.553 0.0243 0.641 -0.2798 -0.0429 0.3163 0.602 1
CVinspect -0.0275 0.0021 -0.0125 -0.0287 -0.0044 0.0102 0.0816 0.0381 -0.1283 0.1556 -0.0901 0.1363 -0.0369

25
Table 2B. Correlation Matrix of Key Variables: India and China
Mlosspowe Moverdraf
India Vgrow_W Kgrow_W Lgrow_W tfpLPG_W tfpLP_W lnL1 lnage r MsL_computer MsL_nperm Moverman t MtradecreditS
Kgrow_W 0.0202 1
Lgrow_W 0.179 0.1306 1
tfpLPG_W 0.9684 -0.1701 0.0843 1
tfpLP_W 0.1194 0.009 -0.0537 0.1172 1
lnL1 -0.004 0.0662 -0.1401 -0.0037 0.541 1
lnage -0.0842 0.0459 -0.1411 -0.0784 0.1833 0.2885 1
Mlosspower 0.0117 -0.032 -0.0312 0.0198 -0.0048 -0.0984 -0.0706 1
MsL_computer 0.1073 0.0371 0.12 0.0944 -0.1117 -0.1064 -0.098 0.175 1
MsL_nperm 0.01 0.0313 0.0143 0.0061 0.1189 0.2133 -0.005 -0.1085 0.0021 1
Moverman -0.0248 0.0384 0.0199 -0.0287 0.0529 0.0618 0.0387 -0.266 -0.2331 -0.0861 1
Moverdraft 0.0434 0.0224 0.0369 0.04 0.1232 0.247 0.1564 -0.0144 -0.0743 0.2978 0.1469 1
MtradecreditS 0.0389 -0.0028 0.074 0.0383 -0.034 -0.0395 -0.0607 -0.1529 0.1285 -0.1843 -0.1803 0.0654 1
CVinspect -0.0349 0.0157 -0.0129 -0.038 0.05 0.0727 0.0831 -0.0002 -0.0607 0.1585 -0.1495 0.1661 -0.2002
China: Vgrow_W Kgrow_W Lgrow_W tfpLPG_W tfpLP_W lnL1 lnage Mlossp~r MsL_co~r MsL_np~m Moverman Moverd~t Mtrade~S
Kgrow_W 0.0928 1
Lgrow_W 0.2327 0.1332 1
tfpLPG_W 0.9479 -0.115 0.0833 1
tfpLP_W 0.2908 0.0158 0.1222 0.2834 1
lnL1 0.0327 -0.0275 -0.2014 0.0714 0.5542 1
lnage -0.0887 -0.1438 -0.2439 -0.0441 -0.0434 0.2682 1
Mlosspower 0.0039 0.0042 0.0352 -0.0047 -0.1059 -0.023 0.022 1
MsL_computer 0.0372 0.023 0.0375 0.0302 0.1392 0.195 -0.1047 -0.1345 1
MsL_nperm 0.034 -0.003 0.1044 0.0203 0.1312 0.0788 -0.0657 0.2458 0.17 1
Moverman -0.0656 0.0046 -0.0881 -0.0549 -0.1766 -0.0714 0.1202 0.1336 -0.3521 -0.5805 1
Moverdraft 0.0795 0.0665 0.0876 0.0539 0.107 0.1749 -0.0048 0.3779 0.3024 0.3676 -0.0378 1
MtradecreditS 0.0811 0.0203 0.0336 0.0683 0.2008 0.2019 -0.0914 -0.4859 0.3323 -0.0316 -0.3134 0.237 1
CVinspect -0.0164 -0.0111 -0.0254 -0.0143 -0.1265 -0.079 0.1116 0.568 -0.3579 0.1529 0.0456 0.0983 -0.3589

26
Table 5. Firm characteristics, business environment, and firm performance
(1) (2) (3) (4) (5)
tfpLP_W Vgrow_W Lgrow_W Kgrow_W tfpLPG_W
china dummy 0.558 0.422 0.390 0.453 0.111
(0.88) (1.19) (3.79)*** (3.98)*** (0.45)
lnL1 0.632 0.009 -0.011 0.016 0.007
(28.73)*** (0.79) (3.31)*** (2.21)** (0.62)
lnage 0.048 -0.073 -0.031 0.007 -0.054
(0.95) (2.44)** (3.52)*** (0.64) (2.39)**
Mlosspower 0.873 -0.174 -0.111 -0.046 -0.157
(0.57) (0.55) (1.43) (0.41) (0.53)
MsL_computer -0.914 1.133 0.321 0.293 0.993
(1.07) (3.55)*** (2.98)*** (2.12)** (3.74)***
MsL_nperm 0.048 -0.010 0.007 0.006 -0.008
(1.71)* (1.09) (2.13)** (1.50) (1.06)
Moverman 0.815 0.151 0.108 0.218 -0.220
(0.96) (0.69) (0.98) (1.49) (1.03)
Moverdraft -0.035 0.194 0.054 -0.022 0.173
(0.12) (2.81)*** (2.24)** (0.87) (2.87)***
MtradecreditS -0.416 -0.091 0.122 -0.009 -0.020
(0.86) (0.41) (1.50) (0.10) (0.10)
CVinspect 0.002 -0.011 0.007 0.007 -0.026
(0.03) (0.68) (1.59) (0.93) (1.51)
C_Mlosspower 6.512 6.186 1.779 -1.732 -0.046
(1.25) (1.20) (1.58) (1.35) (0.02)
C_MsL_computer 2.756 -1.474 -0.359 -0.330 -1.226
(3.03)*** (2.56)** (2.60)** (1.91)* (3.70)***
C_MsL_nperm 0.373 -0.504 0.082 -0.193 -0.149
(1.66) (1.37) (1.51) (2.57)** (1.10)
C_Moverman -1.878 -1.283 -0.483 -0.515 -0.665
(1.15) (1.46) (1.75)* (1.85)* (1.42)
C_Moverdraft 0.664 0.378 0.226 0.370 0.118
(1.58) (1.57) (2.44)** (3.31)*** (0.65)
C_MtradecreditS 1.965 0.027 -0.027 -0.181 0.099
(2.91)*** (0.05) (0.19) (1.09) (0.33)
C_CVinspect -0.168 0.113 -0.073 0.015 0.017
(1.08) (0.87) (2.31)** (0.42) (0.25)
C_lnL1 -0.092 -0.004 -0.036 -0.015 0.019
(2.24)** (0.13) (3.46)*** (1.75)* (1.10)
C_lnage -0.442 -0.089 -0.024 -0.077 0.014
(6.35)*** (1.50) (2.00)** (5.62)*** (0.51)
Observations 2821 2887 3114 3014 2668
R-squared 0.57 0.02 0.13 0.06 0.02
Note. We control for industry dummies. We allow for clustering at the city-level to account for within-city
correlation of the error term.

27
Table 3. How well do capital, labor and TFP growth explain value added growth?
(1) China (2) India
Vgrow_W Vgrow_W
Lgrow_W 0.293 0.288
(11.63)*** (11.88)***
Kgrow_W 0.320 0.367
(20.70)*** (15.91)***
tfpLPG_W 1.025 1.033
(84.51)*** (103.99)***
Constant -0.003 -0.001
(1.30) (0.46)
Observations 2634 2221
R-squared 0.95 0.97
remarkably similar in terms of elasticity

Table XX. The relative importance of factor growth

 india *[
E ( X China ) E ( X China )  E ( X india ) ]
 india  china  E ( X india ) E ( X china ) + (  china -  india )* E ( X china ) %explained
constant -0.003 -0.001 0.002 4.423
Lgrow 0.288 0.293 -0.02 0.02 -0.006 -12.517
Kgrow 0.367 0.32 0.12 0.11 0.039 85.958
Pgrow 1.033 1.025 0.01 0.04 0.010 22.136
 0.045 100

28
 Table 7. Accounting for India-China differences
Panel A. E (TFPchina )  E (TFPindia )  1.232 , Panel B. E (Vgrowchina )  E (Vgrowindia )  0.073 ,
of which, total being accounted for our explanatory variables: 1.217 of which, total being accounted for our explanatory variables: 0.048
(1) :  common (1) :  common
( EX china  EX India ) (2) :  China EX china (1)+(2) ( EX china  EX India ) (2) :  China EX china (1)+(2)
Cby_china 45.9 45.9 875.9 875.9
Mlosspower -4.7 10.9 6.2 23.8 262.2 286
MsL_computer -3.7 49 45.3 114.5 -661.3 -546.8
MsL_nperm 0.1 13.6 13.7 -0.3 -463.4 -463.7
Moverman -3.1 -9.4 -12.5 -14.3 -162 -176.3
Moverdraft 0.8 16.1 16.9 -108.5 230.8 122.3
MtradecreditS 18.4 19.3 37.7 101.9 6.6 108.5
CVinspect 0 -21.1 -21.1 0.9 358.8 359.7
lnL1 97.3 -38.3 59 33.4 -39.9 -6.5
lnage -0.1 -90.9 -91 4 -463.1 -459.1
100 100

Panel C. E ( Lgrow china )  E ( Lgrow india )  0.016 , Panel D. E ( Kgrow china )  E ( Kgrow india )  0.116 ,
of which, total being accounted for our explanatory variables: -0.016 of which, total being accounted for our explanatory variables: 0.119
(1) :  common (1)+(2) (1) :  common (1)+(2)
( EX china  EX India ) (2) :  China EX china ( EX china  EX India ) (2) :  China EX china
Cby_china -2484.9 -2484.9 380.5 380.5
Mlosspower -46.7 -231.2 -277.9 2.6 -29.7 -27.1
MsL_computer -99.4 493.8 394.4 12 -59.9 -47.9
MsL_nperm -0.6 -230.4 -231 0.1 -71.9 -71.8
Moverman 31.3 187.1 218.4 -8.4 -26.3 -34.7
Moverdraft 93.1 -423.8 -330.7 4.9 91.5 96.4
MtradecreditS 419 20.8 439.8 4.2 -18.2 -14
CVinspect 1.8 704.8 706.6 -0.2 18.9 18.7
lnL1 135.1 1155.6 1290.7 24.9 -63.5 -38.6
lnage -5.3 379.8 374.5 -0.1 -161.3 -161.4
99.9 100.1

29
 Table 4. Aggregate Productivity Decomposition

India China

Year Industry Pt
simple
avg  s p
i i i Pt
simple
avg  s p
i i i
"garments & leather
2001 prod." 7.87 7.718 0.152 8.7 8.582 0.118
"garments & leather
2002 prod." 8.204 7.818 0.385 8.754 8.616 0.138
2001 "electrical eqp./prts" 6.715 6.617 0.098 8.224 8.102 0.122
2002 "electrical eqp./prts" 6.741 6.65 0.091 8.409 8.128 0.281
2001 "Hhd. electronics" 7.962 7.678 0.284 9.798 9.397 0.401
2002 "Hhd. electronics" 7.691 7.661 0.030 9.431 9.369 0.062
2001 "auto & parts" 7.532 7.51 0.023 9.302 9.231 0.071
2002 "auto & parts" 7.544 7.528 0.016 9.451 9.348 0.104
2001 "Food processing" 7.664 7.596 0.069 8.72 8.639 0.081
2002 "Food processing" 7.885 7.602 0.283 8.774 8.704 0.071
2001 "Chem. & pharma" 7.129 6.809 0.320 7.913 7.798 0.115
2002 "Chem. & pharma" 6.894 6.84 0.053 8.192 7.795 0.397
"metallergical products
2001 & tools" 8.642 8.637 0.006 9.88 9.689 0.191
"metallergical products
2002 and tools" 8.71 8.652 0.058 9.744 9.628 0.116

aggregating across industries:

2001 Annual Aggregate 7.645 7.509 0.136 8.934 8.777 0.157
2002 Annual Aggregate 7.667 7.536 0.131 8.965 8.798 0.167

Table 6 : Oaxaca-Blinder Decomposition of the effect of business climate on TFP and output growth
Based on cols. 1 and 2 of
Table 5

Effect on total factor productivity Effect on growth rate of annual value added
Gap at china' Gap at china' India's at coeff.
coeff India's at coeff. Diff coeff Diff
("Endowment ("Rate of return ("Endowment
gap") gap") gap") ("Rate of return gap")
Skills/technology:
proportion of of computer users 0.09 0.47 0.04 -0.06
Labor mart flexibility:
prop of temporary workers 0.00 0.16
overstaffing ratio
Access to Finance:
proportion with bank overdraft
facility -0.17 0.37 -0.21 0.32
ratio inputs on credit -0.84 1.30
Total -0.91 2.30 -0.17 0.26
Total of the two components 1.39 0.10

30
31