Serious Money: Three hundred years ago, China and India were the largest economies on earth, accounting for more than 45 per cent of world gross domestic product.
Subsequent events, such as the opium wars in China and British colonisation in India, ensured that the two most populous countries on the planet endured an almost continuous decline in their share of global income - until recently. Times have changed and both countries are set to restore their former roles as leading players in the world economy.
Indeed, the two economies combined look set to surpass the US as the world's largest in just 25 years. Based on realistic projections, China and India should rank second and third respectively by 2030 and, 10 years later, the former should reach number one. But does outsized growth lead to outsized returns?
Investors are always looking for the next big thing and none comes bigger than the rise of China and India. The stock markets of both countries have performed well this year. Chinese stocks have returned almost 30 per cent so far this year, while Indian stocks have generated returns of almost 20 per cent.
The leading corporations in both countries are becoming household names, from Sinopec, PetroChina and Lenovo in China to Infosys and Dr Reddy's in India. Even Warren Buffett, the world's greatest investor, has caught the bug and owns shares in PetroChina.
The world has looked on in awe as China's economy has increased more than sixfold since reforms were introduced in the late 1970s. India introduced reforms more than a decade later in the early 1990s and has recently enjoyed impressive growth rates of 6 to 7 per cent.
Nevertheless, India's income per capita is less than half China's level, and it is desperately trying to catch up. The gap shows little sign of narrowing. Athletic prowess correlates well with income per capita, so it is no surprise that India won just one medal at the last Olympics against China's tally of 63.
China and India have pursued radically different approaches to economic development. The Chinese have followed a traditional path in transitioning their economy from agriculture to industry. The country has invested heavily in its physical infrastructure, which has helped make it an attractive destination for foreign investment. It is considered to be the manufacturing workshop of the world and commands a 7 per cent share of global merchandise trade.
The extraordinary success it has enjoyed has seen the percentage of the population earning less than $1 (€0.80) a day drop from 64 per cent in 1981 to just 16 per cent today.
In sharp contrast to China, India is attempting to move its economy away from agriculture towards knowledge-based services. Although the economy has doubled in size over the past 10 years, its focus on information technology has provided few linkages to the rest of the economy, while its poor infrastructure has deterred foreign investment. Almost 35 per cent of the population earn less than $1 a day.
Despite this, India's private sector is far more profitable than China's, which has allowed for better stock market performance in recent years.
Both countries face serious challenges that could thwart their economic development. China's one-child policy means that its population will age relatively quickly and, by mid-century, its most populous age group will be 55 to 65. Its banking system, though extraordinarily liquid, is technically insolvent, with non-performing loans twice the value of equity.
India requires $125 billion in investment over the next 10 years to upgrade its crumbling infrastructure. Substantial investment is also needed in the agricultural sector, which still accounts for 60 per cent of total employment. Additionally, its relatively high level of public debt needs to be monitored.
Investment in either country involves a significant level of geopolitical risk. China views Taiwan as a breakaway province that can never become independent. Tensions between the two countries stem from the 1949 revolution - the communists claimed control of the mainland, while the nationalists withdrew to Taiwan. Tensions intensified last year when China passed a law which states that it can use force if Taiwan moves towards achieving independence.
India and Pakistan have been bitter rivals for 60 years and have fought several times since the two countries were partitioned and gained independence in 1947. The countries first went to war in October 1947 and again in 1965 and 1971. They were on the brink of war as recently as 2001.
There is no doubt that the economies of China and India will increase significantly in the years ahead. Nevertheless, investors would do well to note that long-range forecasts are fraught with uncertainties. As the 20th century dawned, economists forecast that Argentina's economy, then the world's eighth largest, would outpace the US. Similar pronouncements were made with regard to the Soviet Union in the 1960s and Japan in the 1980s.
A similar fate would not appear to await China and India as there is still considerable room to grow the stock of labour and capital, while improving the productivity of both.
But investors need to be aware that higher rates of long-term economic growth do not necessarily translate into higher earnings growth and hence, higher stock market returns.
Higher rates of economic growth require higher investment rates. This can be achieved by reinvesting a greater proportion of earnings or through the issue of new shares. Aggregate earnings should increase as a result of increased investment but they are traded off for lower dividends today or they accrue to the holders of newly issued shares. This is often overlooked by investors who bid prices up to unsustainable levels.
This appears to be true today in the case of India, which trades at more than four times book value. China looks a more reasonable bet at two times book, though its exposure to the commodity cycle cannot be overlooked at this time.
•Charlie Fell is an independent consultant and lectures in finance and investment at UCD and the Institute of Bankers in Ireland.
