China and India, the world's two most populous countries, used to be described as giant ships passing in the night, such was the paucity of economic and other ties between the two neighbours. But they are starting to sound the foghorns as they draw closer.

Perhaps the most important shift in perception has been from the fast- growing, increasingly powerful Chinese side, which long dismissed India as being backward in contrast. Huang Jinxin, of the University of Wisconsin-Madison, recalls that standard Chinese school textbooks compared India unfavourably with China on key indicators. "Based on India's comparative experience, the Chinese concluded that development and democracy were a trade-off," she says.

But India's economic performance in the last few years has prompted a re- assessment by Beijing. The emergence of a world-class Indian software outsourcing industry has been the most important factor in changing China's mindset. This is increasingly translating into trade and investment.

More than 25,000 Chinese software students have already passed through the doors of NIIT, India's largest software training company, which has 106 "education centres" in China - up from just two in 2001. "China is our number one overseas market and growing rapidly," says Vijay Thadani, chief executive of NIIT, from his offices in New Delhi. "China's thirst for Indian software skills is remarkable."

Meanwhile in Bangalore, Liu Hongqi, India head of TCL, the Chinese consumer electronics enterprise, talks of the growing purchasing power of India's middle classes. TCL recently set aside $150m to build an Indian factory and market its televisions, DVD players and air conditioners to Indian consumers. "India is not only a new market for us but [is becoming] a strategic market as well," says Mr Liu.

The two countries are held up as having contrasting models of development and economic records, with the Chinese hare outstripping the Indian tortoise. But this is to overlook the growing interaction between the two neighbours, borne out by the experiences of companies such as Mr Liu's and Mr Thadani's.

From only $1.8bn in 2001, bilateral trade will hit $14bn during India's current financial year, which ends next month. By Chinese standards the numbers are still small - its exports are more than $300bn. But in the next two years China is set to overtake the European Union to become India's largest trading partner, having been its ninth largest in 2001. Until 2002 there were no direct flights between India and China: now there are five a week with the number set to rise in the next year.

India and China are even exploring ways of joining forces to find cheaper sources of supply and boost their competitiveness. There is increasing awareness - especially in India - that, far from competing in a zero sum game, both countries are growing at such a speed that there is enough room for each to accommodate greater productive capacity.

"People used to say it was China and not India, then it was China against India - but if you look at any number of sectors the real story is more likely to be China and India," says N. Srinivasan, head of the Confederation of Indian Industry.

To some extent China and India's strengths are complementary rather than clashing. Whereas China has become the world's workshop for manufactured goods, India is developing a highly competitive services sector.

From only a handful in 2000, there are now 90 Indian companies with offices in China. They have a presence in sectors ranging from pharmaceutical production to automotive components but are mostly software and information technology companies. Infosys and Tata Consultancy Services, two of India's largest software companies, have technology and development centres in Shanghai and other cities.

Each company has hired some 150 to 200 locally trained engineers, comparable in cost to skilled workers in India but much cheaper than IT professionals in the US and Europe. Their immediate target is the market for customised software for multinationals in China. "That's where we are aiming to go - we want to replicate our model [in China]," says R. Narayanan, the financial manager of Infosys Technologies in Shanghai. "In the past two to three years especially, all the major Indian software companies have looked at China in a big way."

Likewise, Chinese manufacturers are starting to target India's growing purchasing power. Shenzhen-based Huawei Technologies, the telecommunications equipment maker, is one of a number prospering in India. Huawei spent $100m to establish a research and development centre in India in 1999 and will expand its workforce from 800 to 2,000 in the next three years.

"The size of the Indian market and the low costs are not the most important reasons for being here - it's essential to our strategy of being a genuinely international corporation," says James Yuan, the chief operating officer of Huawei in Bangalore.

Yet bilateral trade and investment ties are not simply about India selling software to China and China selling hardware to India. The division of labour is not so clear cut.

A few years ago there was deep fear in New Delhi about the prospect of cheap Chinese imports flooding into India. Yet India actually has a modest trade surplus with China, driven largely by the export of Indian raw materials such as cement and iron ore, but also by exports of manufactured goods including plastics and steel.

Executives at Tata Steel, India's most competitive steel producer which last week sealed a $300m acquisition of NatSteel, a Singaporean steel company, describe an almost unquenchable thirst for steel in China, India and beyond.

Tata Steel plans to double its production within two years. To improve delivery times for its exports for China and elsewhere Tata is constructing a port from scratch in the Indian state of Orissa and building a $3bn steel mill nearby.

Tata estimates India is roughly 10 to 15 years behind China's steel production, which, at more than 250m tonnes a year, is well ahead of India's 40m tonnes. But India's output is set to double in the next four years.

"The issue is not competition between India and China - there is no way production can keep up with demand in either country," says a senior executive at Tata. "The real question is how quickly what remains of global production will move to China, India and Brazil."

Foreign direct investors, who have long shunned India in favour of China, are seeing the advantages of having large-scale manufacturing operations in India as well. Last week Posco, the Korean steel company, said it would set up an $8bn steel plant in Orissa to produce steel for export and India's domestic market.

In textiles, too, the two countries look to be able to compete side by side. China is far ahead of India, with about five times the volume of textile exports. But India is second only to China in reaping the benefits of last month's abolition of the global Multi-Fibre Arrangement, which had imposed quotas on developing country textile exports to the developed world. Last month India's overall exports were 33 per cent up on the previous January, driven mostly by Indian garment makers making the most of the abolition of quota ceilings.

Executives say that India's textiles exports would be much greater if they enjoyed the same conditions as Chinese manufacturers. Dinesh Hinduja, chief executive of Gokal Das Exports, one of India's largest clothing exporters and a supplier to Wal-Mart, Marks and Spencer, Gap and other western retailers, says he can only envy the advantages of his Chinese counterparts.

Chinese textile companies import manufacturing equipment at zero duty, compared with 25 per cent in India. China has impressively modern ports, highways and power supply compared with India's rusting infrastructure. Most importantly, China has more liberal labour regulations: Mr Hinduja's Chinese counterparts can hire at whatever pace they like without fear of being stuck with a huge payroll in a downturn. In India, by contrast, downsizing is expensive and difficult. Mr Hinduja is unable under India's labour laws to sack even a chronically absentee employee.

Yet somehow India manages to compete. Gokal Das's exports are rising sharply - from $140m last year to an expected $200m in the next 12 months. "When I visit China I am in awe of the benefits that government makes available to its textile manufacturers," says Mr Hinduja. "But we have skills where the Chinese are weak: high quality design and software, the ability to interract with western customers in English and a managerial talent pool which has a very flexible and cosmopolitan mindset."

All this makes Indians believe that they can continue to compete even on turf where China seems to have the advantages. At any one time Gokal Das Exports is producing 200 different clothing items for 26 separate western labels. Mr Hinduja points to the £88 price tag on an item produced for Marks and Spencer. "This would be several hundred pounds if it had been made in England," he says. "It is uneconomic to manufacture these in the west any more. Once one company outsources to China or India, all its competitors have to."

Mr Hinduja's observation would serve for almost any sector, whether in services or manufacturing, call centres or car components, in China or India. "All that will be left to the west is personalised tailoring," he predicts.

The much higher quality of China's infrastructure and India's continuing inability to move rapidly ahead with micro-economic reform make it more likely that China will continue to outstrip its democratic neighbour - albeit with the gap narrowing over time.

But China can also learn much from its neighbour, something that policymakers in Beijing and elsewhere have begun to recognise. India's success in software, although by no means yet comparable in dollar earnings to China's manufacturing performance, has sparked Chinese envy. Beijing and Shanghai now compete aggressively for Indian IT investment. "This is really hot right now," says Zhu Peifen, head of the Hi-Tech Industry Development Division for the Beijing city government. "The Indian software sector can be a good teacher for us."

The two countries are also tentatively exploring areas of co-operation, for example as partners for joint purchases in markets such as energy and commercial aircraft. Such a prospect - which Boeing or Airbus would not welcome - is so far not much more than talk. Nevertheless there is a determination in both capitals to consider the unmatchable economies of scale that would be available to them as joint buyers of some of the materials and technology that both countries lack.

That would help to ensure the 21st century would belong both to China and India - regardless of which of the two neighbours posts the best growth figures over the next few years.

Sources for charts: Thomson Datastream; Morgan Stanley

Strategic parity prompts a neighbourly respect

The low point in the recent history of Sino-Indian ties - the moment when, in 1998, New Delhi exploded its first nuclear bomb - was in retrospect also the starting point for the increasingly vigorous bilateral relationship of today. While earning it short-term opprobrium, the bomb gave India strategic parity with its hitherto mostly disdainful neighbour.

Chinese scholars say Beijing helped spur India’s nuclear programme by pointedly refusing a request from New Delhi in the early 1990s for a guarantee of no first strike. Without a bomb of its own, India did not merit such a promise, Beijing reasoned. “China did not respect India,” says a Chinese academic, “and it did everything possible to show that China was a great nation and that India was not. This was a big mistake.”

Symbolic in rectifying that will be a trip to New Delhi - perhaps as early as next month - by Wen Jiabao, the Chinese premier. The summit he is to hold with Manmohan Singh, Indian prime minister, follows a 2003 visit to Beijing by Atal Bihari Vajpayee, Mr Singh’s predecessor.

Disagreements include a border dispute remaining from China’s humiliation of India in their 1962 war and India’s harbouring of Tibetan exiles. But they are learning how to agree to disagree. Such has been the progress in relations that New Delhi points to the negotiating framework on the border issue as a model for resolving its differences with Pakistan over Kashmir. The border dispute “may never be resolved, but the two sides will still maintain peace and tranquillity along the (lines) of actual control,” says Shen Dingli of Fudan University in Shanghai.

Still, India and China this month took their relations to a new level when they inaugurated what they said would be regular talks about issues of “mutual strategic concern”, such as terrorism, energy co-operation and United Nations reform.

“The model is to put all the bilateral differences to one side and allow economics to drive the relationship,” says Raja Mohan, a leading Indian analyst. “This doesn’t mean that the disputes will necessarily be resolved, but it does raise the cost of not resolving them.”

India’s success in the software industry, and its emergence in the last few years as a potential regional economic superpower, has also helped transform its image in China. Cheng Ruisheng, a former Chinese ambassador to New Delhi, says: “We both need a peaceful environment to develop our economies.”

There is talk of opening negotiations to establish a bilateral trade agreement - but such a project is probably still some way off. Indeed, many in both countries maintain a deep distrust about the motives of the other.

“There is very little goodwill on the Chinese side,” says an Indian academic who has had extensive contacts with China. “They are very clear that they see us as a dangerous long-term competitor - and they are simply looking for a way in which we can be neutralised.”

India’s economic emergence is openly encouraged by the 10-member Association of South East Asian Nations, which has become increasingly concerned about the growing preponderance of China. In much the same way as the US hopes India will become a geopolitical counterweight to China over the next decades, Asean hopes India will become an economic counterweight.

That may be premature. India, with its sensitivity about sovereignty, bristles at being asked to play roles on behalf of other countries. But economic ties between India and China will continue to grow and a convergence of the two giants’ broader interests at the World Trade Organisation and elsewhere will help bring them closer together.