BusinessWeek Online
A New World Economy
Thursday August 18, 8:18 am ET
By Pete Engardio

Shanghai

It may not top the must-see list of many tourists. But to appreciate Shanghai's ambitious view of its future, there is no better place than the Urban Planning Exhibition Hall, a glass-and-metal structure across from People's Square. The highlight is a scale model bigger than a basketball court of the entire metropolis -- every skyscraper, house, lane, factory, dock, and patch of green space -- in the year 2020.

There are white plastic showpiece towers designed by architects such as I.M. Pei and Sir Norman Foster. There are immense new industrial parks for autos and petrochemicals, along with new subway lines, airport runways, ribbons of expressway, and an elaborate riverfront development, site of the 2010 World Expo. Nine futuristic planned communities for 800,000 residents each, with generous parks, retail districts, man-made lakes, and nearby college campuses, rise in the suburbs. The message is clear. Shanghai already is looking well past its industrial age to its expected emergence as a global mecca of knowledge workers. "In an information economy, it is very important to have urban space with a better natural and social environment," explains Architectural Society of Shanghai President Zheng Shiling, a key city adviser.

It is easy to dismiss such dreams as bubble-economy hubris -- until you take into account the audacious goals Shanghai already has achieved. Since 1990, when the city still seemed caught in a socialist time warp, Shanghai has erected enough high-rises to fill Manhattan. The once-rundown Pudong district boasts a space-age skyline, some of the world's biggest industrial zones, dozens of research centers, and a bullet train. This is the story of China, where an extraordinary ability to mobilize workers and capital has tripled per capita income in a generation, and has eased 300 million out of poverty. Leaders now are frenetically laying the groundwork for decades of new growth.

Invaluable Role

Now hop a plane to India. It is hard to tell this is the world's other emerging superpower. Jolting sights of extreme poverty abound even in the business capitals. A lack of subways and a dearth of expressways result in nightmarish traffic.

But visit the office towers and research and development centers sprouting everywhere, and you see the miracle. Here, Indians are playing invaluable roles in the global innovation chain. Motorola, (NYSE:MOT - News) Hewlett-Packard (NYSE:HPQ - News), Cisco Systems (NasdaqNM:CSCO - News), and other tech giants now rely on their Indian teams to devise software platforms and dazzling multimedia features for next-generation devices. Google (NasdaqNM:GOOG - News) principal scientist Krishna Bharat is setting up a Bangalore lab complete with colorful furniture, exercise balls, and a Yamaha organ -- like Google's Mountain View (Calif.) headquarters -- to work on core search-engine technology. Indian engineering houses use 3-D computer simulations to tweak designs of everything from car engines and forklifts to aircraft wings for such clients as General Motors Corp. (NYSE:GM - News) and Boeing Co (NYSE:BA - News). Financial and market-research experts at outfits like B2K, OfficeTiger, and Iris crunch the latest disclosures of blue-chip companies for Wall Street. By 2010 such outsourcing work is expected to quadruple, to $56 billion a year.

Even more exhilarating is the pace of innovation, as tech hubs like Bangalore spawn companies producing their own chip designs, software, and pharmaceuticals. "I find Bangalore to be one of the most exciting places in the world," says Dan Scheinman, Cisco Systems Inc.'s senior vice-president for corporate development. "It is Silicon Valley in 1999." Beyond Bangalore, Indian companies are showing a flair for producing high-quality goods and services at ridiculously low prices, from $50 air flights and crystal-clear 2 cents-a-minute cell-phone service to $2,200 cars and cardiac operations by top surgeons at a fraction of U.S. costs. Some analysts see the beginnings of hypercompetitive multinationals. "Once they learn to sell at Indian prices with world quality, they can compete anywhere," predicts University of Michigan management guru C.K. Prahalad. Adds A. T. Kearney high-tech consultant John Ciacchella: "I don't think U.S. companies realize India is building next-generation service companies."

Simultaneous Takeoffs: China and India.

Rarely has the economic ascent of two still relatively poor nations been watched with such a mixture of awe, opportunism, and trepidation. The postwar era witnessed economic miracles in Japan and South Korea. But neither was populous enough to power worldwide growth or change the game in a complete spectrum of industries. China and India, by contrast, possess the weight and dynamism to transform the 21st-century global economy. The closest parallel to their emergence is the saga of 19th-century America, a huge continental economy with a young, driven workforce that grabbed the lead in agriculture, apparel, and the high technologies of the era, such as steam engines, the telegraph, and electric lights.

But in a way, even America's rise falls short in comparison to what's happening now. Never has the world seen the simultaneous, sustained takeoffs of two nations that together account for one-third of the planet's population. For the past two decades, China has been growing at an astounding 9.5% a year, and India by 6%. Given their young populations, high savings, and the sheer amount of catching up they still have to do, most economists figure China and India possess the fundamentals to keep growing in the 7%-to-8% range for decades.

Barring cataclysm, within three decades India should have vaulted over Germany as the world's third-biggest economy. By mid-century, China should have overtaken the U.S. as No. 1. By then, China and India could account for half of global output. Indeed, the troika of China, India, and the U.S. -- the only industrialized nation with significant population growth -- by most projections will dwarf every other economy.

What makes the two giants especially powerful is that they complement each other's strengths. An accelerating trend is that technical and managerial skills in both China and India are becoming more important than cheap assembly labor. China will stay dominant in mass manufacturing, and is one of the few nations building multibillion-dollar electronics and heavy industrial plants. India is a rising power in software, design, services, and precision industry. This raises a provocative question: What if the two nations merge into one giant "Chindia?" Rival political and economic ambitions make that unlikely. But if their industries truly collaborate, "they would take over the world tech industry," predicts Forrester Research Inc (NasdaqNM:FORR - News). analyst Navi Radjou.

In a practical sense, the yin and yang of these immense workforces already are converging. True, annual trade between the two economies is just $14 billion. But thanks to the Internet and plunging telecom costs, multinationals are having their goods built in China with software and circuitry designed in India. As interactive design technology makes it easier to perfect virtual 3-D prototypes of everything from telecom routers to turbine generators on PCs, the distance between India's low-cost laboratories and China's low-cost factories shrinks by the month. Managers in the vanguard of globalization's new wave say the impact will be nothing less than explosive. "In a few years you'll see most companies unleashing this massive productivity surge," predicts Infosys Technologies (NasdaqNM:INFY - News) CEO Nandan M. Nilekani.

To globalization's skeptics, however, what's good for Corporate America translates into layoffs and lower pay for workers. Little wonder the West is suffering from future shock. Each new Chinese corporate takeover bid or revelation of a major Indian outsourcing deal elicits howls of protest by U.S. politicians. Washington think tanks are publishing thick white papers charting China's rapid progress in microelectronics, nanotech, and aerospace -- and painting dark scenarios about what it means for America's global leadership.

Such alarmism is understandable. But the U.S. and other established powers will have to learn to make room for China and India. For in almost every dimension -- as consumer markets, investors, producers, and users of energy and commodities -- they will be 21st-century heavyweights. The growing economic might will carry into geopolitics as well. China and India are more assertively pressing their interests in the Middle East and Africa, and China's military will likely challenge U.S. dominance in the Pacific.

One implication is that the balance of power in many technologies will likely move from West to East. An obvious reason is that China and India graduate a combined half a million engineers and scientists a year, vs. 60,000 in the U.S. In life sciences, projects the McKinsey Global Institute, the total number of young researchers in both nations will rise by 35%, to 1.6 million by 2008. The U.S. supply will drop by 11%, to 760,000. As most Western scientists will tell you, China and India already are making important contributions in medicine and materials that will help everyone. Because these nations can throw more brains at technical problems at a fraction of the cost, their contributions to innovation will grow.

Consumers Rising
American business isn't just shifting research work because Indian and Chinese brains are young, cheap, and plentiful. In many cases, these engineers combine skills -- mastery of the latest software tools, a knack for complex mathematical algorithms, and fluency in new multimedia technologies -- that often surpass those of their American counterparts. As Cisco's Scheinman puts it: "We came to India for the costs, we stayed for the quality, and we're now investing for the innovation."

A rising consumer class also will drive innovation. This year, China's passenger car market is expected to reach 3 million, No. 3 in the world. China already has the world's biggest base of cell-phone subscribers -- 350 million -- and that is expected to near 600 million by 2009. In two years, China should overtake the U.S. in homes connected to broadband. Less noticed is that India's consumer market is on the same explosive trajectory as China five years ago. Since 2000, the number of cellular subscribers has rocketed from 5.6 million to 55 million.

What's more, Chinese and Indian consumers and companies now demand the latest technologies and features. Studies show the attitudes and aspirations of today's young Chinese and Indians resemble those of Americans a few decades ago. Surveys of thousands of young adults in both nations by marketing firm Grey Global Group found they are overwhelmingly optimistic about the future, believe success is in their hands, and view products as status symbols. In China, it's fashionable for the upwardly mobile to switch high-end cell phones every three months, says Josh Li, managing director of Grey's Beijing office, because an old model suggests "you are not getting ahead and updated." That means these nations will be huge proving grounds for next-generation multimedia gizmos, networking equipment, and wireless Web services, and will play a greater role in setting global standards. In consumer electronics, "we will see China in a few years going from being a follower to a leader in defining consumer-electronics trends," predicts Philips Semiconductors (NYSE:PHG - News) Executive Vice-President Leon Husson.

For all the huge advantages they now enjoy, India and China cannot assume their role as new superpowers is assured. Today, China and India account for a mere 6% of global gross domestic product -- half that of Japan. They must keep growing rapidly just to provide jobs for tens of millions entering the workforce annually, and to keep many millions more from crashing back into poverty. Both nations must confront ecological degradation that's as obvious as the smog shrouding Shanghai and Bombay, and face real risks of social strife, war, and financial crisis.

Increasingly, such problems will be the world's problems. Also, with wages rising fast, especially in many skilled areas, the cheap labor edge won't last forever. Both nations will go through many boom and harrowing bust cycles. And neither country is yet producing companies like Samsung, Nokia (NYSE:NOK - News), or Toyota (NYSE:TM - News) that put it all together, developing, making, and marketing world-beating products.

Both countries, however, have survived earlier crises and possess immense untapped potential. In China, serious development only now is reaching the 800 million people in rural areas, where per capita annual income is just $354. In areas outside major cities, wages are as little as 45 cents an hour. "This is why China can have another 20 years of high-speed growth," contends Beijing University economist Hai Wen.

Very impressive. But India's long-term potential may be even higher. Due to its one-child policy, China's working-age population will peak at 1 billion in 2015 and then shrink steadily. China then will have to provide for a graying population that has limited retirement benefits. India has nearly 500 million people under age 19 and higher fertility rates. By mid-century, India is expected to have 1.6 billion people -- and 220 million more workers than China. That could be a source for instability, but a great advantage for growth if the government can provide education and opportunity for India's masses. New Delhi just now is pushing to open its power, telecom, commercial real estate and retail sectors to foreigners. These industries could lure big capital inflows. "The pace of institutional changes and industries being liberalized is phenomenal," says Chief Economist William T. Wilson of consultancy Keystone Business Intelligence India. "I believe India has a better model than China, and over time will surpass it in growth."

For its part, China has yet to prove it can go beyond forced-march industrialization. China directs massive investment into public works and factories, a wildly successful formula for rapid growth and job creation. But considering its massive manufacturing output, China is surprisingly weak in innovation. A full 57% of exports are from foreign-invested factories, and China underachieves in software, even with 35 software colleges and plans to graduate 200,000 software engineers a year. It's not for lack of genius. Microsoft Corp.'s (NasdaqNM:MSFT - News) 180-engineer R&D lab in Beijing, for example, is one of the world's most productive sources of innovation in computer graphics and language simulation.

While China's big state-run R&D institutes are close to the cutting edge at the theoretical level, they have yet to yield many commercial breakthroughs. "China has a lot of capability," says Microsoft Chief Technology Officer Craig Mundie. "But when you look under the covers, there is not a lot of collaboration with industry." The lack of intellectual property protection, and Beijing's heavy role in building up its own tech companies, make many other multinationals leery of doing serious R&D in China.

China also is hugely wasteful. Its 9.5% growth rate in 2004 is less impressive when you consider that $850 billion -- half of GDP -- was plowed into already-glutted sectors like crude steel, vehicles, and office buildings. Its factories burn fuel five times less efficiently than in the West, and more than 20% of bank loans are bad. Two-thirds of China's 1,300 listed companies don't earn back their true cost of capital, estimates Beijing National Accounting Institute President Chen Xiaoyue. "We build the roads and industrial parks, but we sacrifice a lot," Chen says.

India, by contrast, has had to develop with scarcity. It gets scant foreign investment, and has no room to waste fuel and materials like China. India also has Western legal institutions, a modern stock market, and private banks and corporations. As a result, it is far more capital-efficient. A BusinessWeek analysis of Standard & Poor's (NYSE:MHP - News) Compustat data on 346 top listed companies in both nations shows Indian corporations have achieved higher returns on equity and invested capital in the past five years in industries from autos to food products. The average Indian company posted a 16.7% return on capital in 2004, vs. 12.8% in China.

Small-Batch Expertise
The burning question is whether India can replicate China's mass manufacturing achievement. India's info-tech services industry, successful as it is, employs fewer than 1 million people. But 200 million Indians subsist on $1 a day or less. Export manufacturing is one of India's best hopes of generating millions of new jobs.

India has sophisticated manufacturing knowhow. Tata Steel is among the world's most-efficient producers. The country boasts several top precision auto parts companies, such as Bharat Forge Ltd. The world's biggest supplier of chassis parts to major auto makers, it employs 1,200 engineers at its heavily automated Pune plant. India's forte is small-batch production of high-value goods requiring lots of engineering, such as power generators for Cummins Inc. (NYSE:CMI - News) and core components for General Electric Co. (NYSE:GE - News) CAT scanners.

What holds India back are bureaucratic red tape, rigid labor laws, and its inability to build infrastructure fast enough. There are hopeful signs. Nokia Corp. is building a major campus to make cell phones in Madras, and South Korea's Pohang Iron & Steel Co. plans a $12 billion complex by 2016 in Orissa state. But it will take India many years to build the highways, power plants, and airports needed to rival China in mass manufacturing. With Beijing now pushing software and pledging intellectual property rights protection, some Indians fret design work will shift to China to be closer to factories. "The question is whether China can move from manufacturing to services faster than we can solve our infrastructure bottlenecks," says President Aravind Melligeri of Bangalore-based QuEST, whose 700 engineers design gas turbines, aircraft engines, and medical gear for GE and other clients.

However the race plays out, Corporate America has little choice but to be engaged -- heavily. Motorola illustrates the value of leveraging both nations to lower costs and speed up development. Most of its hardware is assembled and partly designed in China. Its R&D center in Bangalore devises about 40% of the software in its new phones. The Bangalore team developed the multimedia software and user interfaces in the hot Razr cell phone. Now, they are working on phones that display and send live video, stream movies from the Web, or route incoming calls to voicemail when you are shifting gears in a car. "This is a very, very critical, state-of-the-art resource for Motorola," says Motorola South Asia President Amit Sharma.

Companies like Motorola realize they must succeed in China and India at many levels simultaneously to stay competitive. That requires strategies for winning consumers, recruiting and managing R&D and professional talent, and skillfully sourcing from factories. "Over the next few years, you will see a dramatic gap opening between companies," predicts Jim Hemerling, who runs Boston Consulting Group's Shanghai practice. "It will be between those who get it and are fully mobilized in China and India, and those that are still pondering."

In the coming decades, China and India will disrupt workforces, industries, companies, and markets in ways that we can barely begin to imagine. The upheaval will test America's commitment to the global trade system, and shake its confidence. In the 19th century, Europe went through a similar trauma when it realized a new giant -- the U.S. -- had arrived. "It is up to America to manage its own expectation of China and India as either a threat or opportunity," says corporate strategist Kenichi Ohmae. "America should be as open-minded as Europe was 100 years ago." How these Asian giants integrate with the rest of the world will largely shape the 21st-century global economy.

CHINA AND INDIA -- THE LEAP AHEAD

Scrambling Up The Development Ladder
By leveraging software wizardry and low-cost talent, India is eyeing the next level: Tech innovation

Congenia, a two-year-old Italian drug company, can't match the cash of Big Pharma. So when it needed help in developing medicines to combat the diseases of aging, it turned to an unlikely source -- India. Congenia in June tapped Tata Consultancy Services Ltd. for drug-discovery software and a team of programmers and life scientists in Hyderabad. The software, Bio-Suite, simulates the interactions of molecules with proteins, whittling down the universe of potential drug candidates from millions to thousands in about half the normal time. That also halves research costs.

With so much riding on its ability to discover new drugs, why would Congenia rely heavily on a company like TCS, which is mainly known as a low-cost supplier of computer services? Congenia Chief Executive Paolo Fundaro acknowledges he is taking a risk, but he's confident of TCS' skills. "There's no reason Indian companies shouldn't be on the front edge of tech in every field," he says.

This is a message Indian companies like TCS hope will spread far and wide. Over the past five years they've burst onto the world scene in software development, tech support, generic drugs, and back-office services. These businesses are nothing to sniff at. But in many cases they simply involve following orders from overseas clients or reverse-engineering.

Now, India is gearing up to reach the next level -- technology innovation. By leveraging their software wizardry and cheap engineering and software talent, Indian companies are starting to develop their own products. Software companies such as i-flex Solutions Ltd., with its banking programs, are selling globally. "We have to build products that can be sold again and again, like Microsoft does. We have to continually go up the value chain," says Chairman Rajesh Hukku. On Aug. 2, in an affirmation of Indian software, U.S. software giant Oracle Corp. (ORCL ) said it will pay $900 million for a controlling interest in i-flex -- but leave the current executives in charge.

Hukku isn't alone. Pharmaceutical companies such as Nicholas Piramal India, Ranbaxy Laboratories, and Biocon are making strides in drug discovery and patenting their own compounds. This creative ferment could push Indian pharma output from $5 billion last year to $25 billion by 2010, predicts consultant McKinsey & Co. And a Nasscom/KPMG study predicts that Indian IT industry revenues -- which swelled 32% last year, to $22 billion -- could reach $148 billion by 2012. Industry leaders figure they have the chance to design and even make advanced products of all kinds. "The big opportunity for India is when it all comes together in manufacturing," says Ravi Gopinath, TCS' vice-president for engineering and industrial services. The Indians, in fact, hope to change the global game in industries from vehicles and machine tools to medical systems.

India, a manufacturing powerhouse? Still sounds off. Last year, India exported $1.7 billion in electronics goods. That could reach $12.5 billion in 2010, projects Evalueserve Inc.

But India would still be a manufacturing minnow compared with China, which expects to export $175 billion worth of electronics this year. Besides, highways, ports, air terminals, and other infrastructure aren't yet adequate to support an export boom.

Yet India produces hundreds of thousands of industrial and software engineers yearly. And as more functions for cars, consumer electronics, and complex tools are packed onto semiconductors, the need for embedded software -- an Indian expertise -- is expanding fast. "That means India is well positioned to be a development hub in all kinds of industries," says A. T. Kearney high-tech consultant John Ciacchella.

STILL GROWING UP
Internet connections and advances in interactive design software, meanwhile, make it increasingly possible to design, test, and reassemble industrial prototypes of highly complex products on computers. Using 3-D computer simulations of a virtual prototype, mechanical engineers and fluid dynamics specialists at Onward Technologies Ltd. in Pune are helping to design virtually every piece of a three-cylinder tractor engine due out in 2007 from a major farm-equipment company. Says Onward Chairman Harish S. Mehta: "This industry is in its infancy, but in two years you will see this really take off." Indian product engineering revenues rose 30%, to $2.7 billion, last year.

A handful of Indian outfits are rapidly moving along the path to hardware innovation. Wipro (WIT ), Ittiam, HCL Technologies, and others are bringing together chips, circuit boards, embedded software, and industrial design -- the whole stack of skills and technology needed to create a finished product. That can shave months and even years off product development, a godsend for Western companies under great pressure to cut costs.

India's industrial engineering firms are also moving beyond limited contract jobs for clients like Ford (F ), General Electric (GE ), and Airbus and starting to cook up original prototypes for everything from machine tools to power generators. Bangalore's HCL designed a backup navigation system for the Airbus A340 and A320 jetliners in just 18 months. HCL clients often provide a mere two- or three-sentence description of the desired product and price target, and Indian engineers do the rest. "India will be very important for the world in hardware product development," predicts HCL Chief Executive Shiv Nadar.

The model for some Indian design houses is Taiwan. Big Taiwanese electronics companies like Quanta, Compal, and BenQ design and manufacture notebook PCs, cell phones, digital cameras, and other electronics for such brands as Dell (DELL ), Hewlett-Packard (HPQ ), and Apple (AAPL ). Instead of mass-produced consumer items, though, India's niche could be industrial goods involving smaller production runs but high engineering content.

The breadth of research and development at TCS evinces the new vision for Indian tech prowess. Working from digital prototypes, its 850-engineer center in Bangalore is helping a U.S. auto maker design the drive train, outer body, and interior layout of a future passenger car. For a leading U.S. developer of orthopedic implants, TCS engineers analyze CAT scans and custom-design replacement hips, knees, and wrist bones to fit patients awaiting surgery in American hospitals. For other U.S. clients, TCS has helped develop a forklift, a small earthmover, a golf cart, and high-security locks. For the Indian air force, it has even designed a test jet. Over the next half-decade, TCS plans to create a hybrid business model with 40% of revenues coming from licensing its technology and selling its own products, such as BioSuite.

SMATTERING OF STARTUPS
The Indians are starting to come up with original consumer electronics designs, too. Ittiam Systems Ltd. of Bangalore specializes in integrating multimedia into low-cost devices. It licenses core designs to makers of in-flight entertainment systems, digital cameras, and video cell phones. Ittiam is preparing to release designs for portable iPod-like devices to play video downloaded from the Web.

A smattering of startups have taken the next step. They're both designing and selling their own cutting-edge hardware. Four-year-old Tejas Networks India Ltd., for instance, has become one of the leading sellers of optical networking gear in the rapidly growing Indian market. It has also begun selling its machines globally through Western networking suppliers. "The vision is to become one of the next Ciscos (CSCO ) or Nortels (NT ) of the world," says Chief Executive Sanjay Nayak.

What could delay India as it strives to innovate and build its own global brands? "It's a capital-starved country," says Sanjay Anandaram, a partner in JumpStartUp Fund Advisors Ltd., a Bangalore venture-capital firm. Startups with one foot in Silicon Valley have the edge. HelloSoft, a leading supplier of signal-processing technology for voice-over-Internet communications, raised $16 million from U.S. VCs on June 30. It was started by Indian entrepreneurs but its headquarters are in San Jose, Calif.

Indian startups don't have such ready access to cash. A recent scene inside the tiny conference room of JumpStartUp, located across from a crumbling Hindu temple, illustrates the problem. Weary from a red-eye flight from overseas, Sanjay Shah, CEO of three-year-old Skelta Software Ltd., a maker of corporate workflow programs, was making a presentation. JumpStartUp's partners, although sympathetic, peppered him with questions about how Skelta would gain credibility in the West and compete with Microsoft. Shah only wants to raise $1.5 million but sounded discouraged after the meeting. "I don't know how many VCs will be interested in funding me, and I don't see that changing fast," he says. "Without venture capital, India won't become powerful globally in software products."

But players like Shah don't need much money to make a difference. Engineering salaries are so low in India -- even now, after rising 5% to 10% per year -- that Skelta can afford to employ 30 engineers even though it only expects $2 million in revenues this year. This gives it an advantage over its main rival, SourceCode Technology Holdings Inc. of Redmond, Wash., which does much of its programming in the U.S.

Where there's hype, there's hope. Oracle's acquisition of i-flex shines a spotlight on India's nascent software products industry. And that could stimulate a flowering of new ideas and companies. "We're convinced that a good portion of the next generation of software companies will be emerging from India," says Oracle President Charles E. Phillips Jr.

I-flex Chairman Hukku urges his comrades to concentrate on developing software products tailored to particular industries.

That won't be the only path to software innovation, however. Trying something brand new is another option. Ramco Systems Ltd., for instance, which stumbled in its attempt to compete against Oracle and other leading corporate software makers, is being reborn with a new business model that could knock some of the established players off balance. Instead of selling packaged applications for accounting and manufacturing, which often don't fit a particular business, it builds software components that can be mixed and matched for a more custom fit. "They have been laboring away quietly," says University of Michigan management professor C.K. Prahalad. "This is going to surprise a lot of people throughout the world."

Indians know it's now or never. The advantages of low costs will last perhaps another 15 years, and competition from the likes of China, Brazil, and Ukraine is intensifying. "We are at a point in this country where if you don't innovate, you just won't exist," says S. Sadagopan, director of the Indian Institute of Information Technology in Bangalore. The Indians don't just want to exist: They want to flourish.