Finally, Lane (2006) records that both Chinese and Indian shares in global external debt liabilities have sharply declined in recent years – by 2004, only 0.65 percent and 0.35 percent, respectively. The decline is especially noteworthy for India, which was a much more important international debtor (in relative terms) in the early 1990s.

Turning to the future, continued domestic financial reform and external liberalization should produce some evolution in the level and composition of China’s and India’s external liabilities. As a benchmark, an increasing share of these countries in world GDP and world financial market capitalization should naturally prompt increasing capital inflows to these countries. In addition, we may expect to see some rebalancing in the composition of external liabilities. For China, reform of the domestic banking system and the development of its equity and bond markets may reduce its heavy reliance on FDI inflows as alternative options become more viable. A reduction in the relative importance of FDI also may be supported by moves to limit the generosity of the current incentives offered to foreign direct investors, which would attenuate FDI directly and through its attendant impact on round-tripping activity.<sup>27</sup> Finally, the expansion of domestic capital markets and reform of the banking system also would allow foreign-owned firms to draw on domestic funding sources.

With regard to India, recent moves to further liberalize the FDI regime may increase the relative importance of FDI inflows. India’s ability to attract FDI also depends on more widespread institutional reforms that improve the investment environment for foreign investors and encourage them to channel FDI into the country. The major barrier regarding the liberalization of debt inflows could be that opening up the capital account may threaten the government’s ability to finance its large fiscal deficits at a low interest cost. Under these conditions, further liberalization may be delayed until the domestic fiscal situation is reformed.

# **IV.b. How Important Are China and India as International Investors?**

As shown in Table 2a, China and India are much less important as external investors in equity assets than as holders of equity liabilities. This is especially the case for portfolio equity assets, which by 2004 were only 0.3 percent and 0.1 percent of GDP for China and India respectively. Relative to portfolio equity assets, FDI assets in 2004 were much larger – but remain small at 1.9 percent and 1.3 percent of GDP respectively. In terms of non-reserve foreign debt assets, China had a much larger position in 2004 than did India (13.3 percent versus 2.6 percent of GDP). Nevertheless, even the China position is small in global terms, representing just 0.6 percent of global non-reserve foreign debt assets in 2004, as shown in Lane (2006) and Figure 6.

> 27 While current policy is strongly pro-FDI, one reason to believe that FDI incentives could be scaled back is provided by the increasing political concerns about excessive FDI inflows. At one level, this relates to the demands of farmers whose land has been appropriated to provide industrial sites for direct investors and others (mainly local real estate developers). At another level, domestic firms that compete with foreign direct investors complain about the favorable treatment accorded to the external investors.

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