China and India: Strategies for sustainable growth
This post is a guest contribution by Chetan Ahya, Derrick Kam and Jenny Zheng of of Morgan Stanley.
Backdrop: Have Both Nations Been Living on Borrowed Growth for Too Long?
Following the credit crisis, both China and India relied on aggressive tactical measures to revive growth quickly. Given the pace at which the external environment was deteriorating then, policy-makers in both China and India had to act quickly and decisively to boost domestic demand.
• Specifically, in China, the key driver of domestic demand was an aggressive credit expansion – close to a 30pp rise in the ratio of bank loans to GDP (excluding non-bank loan lending by banks), in addition to some support from the expansion in the government’s budget deficit. Bank loans to GDP has been maintained at these high levels of close to 130% until recently.
• In India, the biggest driver was the doubling of the national fiscal deficit – from 4.8% of GDP in the year ending March 2008 to 10% in the year ending March 2009. By our estimates, the national deficit is likely to be 9.2% for the year ended March 2012 – implying that the government has now maintained this expansionary fiscal policy for four years in a row.
China’s Fetish for Investment, India’s for Consumption
As growth began to slip immediately after the credit crisis, China focused on supporting investment with the large rise in the ratio of bank loans to GDP. India focused on supporting strong consumption (particularly rural consumption) growth with its major fiscal stimulus. These stimulus measures were largely instrumental in helping China and India to recover quickly from the global recession. Indeed, this counter-cyclical response – a rise in bank loans in China and fiscal expansion in India, respectively – had also been employed during the 2001 US recession and global growth slowdown.
Macro Stability Risks – Only Symptoms of Low Productivity Dynamic
The stimulus measures helped to boost growth quickly – but they also brought macro stability risks. A major rise in property prices, inflation pressures and banking sector asset quality issues – symptoms which surfaced in China and India over the course of 2010-11 – are only a reflection of the low productivity dynamic of growth driven by tactical stimulus, in our view.
We believe that the aggressive policy stimulus was not based on what was truly needed for achieving a sustained growth trend in these countries. Rather, the stimulus measures were based on what both governments could do best in that short period in response to the sudden growth shock on account of the credit crisis. Given the sharp and rapid pace of the deterioration in growth conditions, we believe one can hardly question this move at the time the credit crisis was unfolding.
However, persistent reliance on tactical measures for such a long period (September 2008 to late 2010) was at the heart of the emergence of these symptoms of macro stability risks.
Deleveraging in DM – A Reminder to China and India
Following the 2001-02 global slowdown, low real interest rates and the rise in leverage in the US and Europe had supported strong growth in their domestic demand and overall GDP growth.
• The expansion in US/European domestic demand meant that China benefited from strong growth in exports… In China, net exports contributed an average of 1.9pp to overall GDP growth of 12.1% between 2004-07. Strong growth in investment aimed at building capacity to feed exports demand was the other key anchor of GDP growth.
• …while the low real interest rate environment meant that India (along with many other emerging markets) gained from a major rise in capital inflows. For India, the sharp rise in capital inflows over F2005-08 meant that real interest rates declined to average just 2.1% even as GDP growth averaged 9.0%, led by strong growth in private investment.
We believe that this extremely favourable global environment, apart from structural domestic factors in both countries, played a big role during the 2003-07 period in lifting growth rates for China and India.
However, the credit crisis and the subsequent deleveraging in US and Europe have disrupted this benign global environment that had benefited China and India. We saw a short period of revival in exports and capital inflows into the region over the course of 2010-11, but the emergence of sovereign concerns in the developed world has again reminded us about the sustainability of these two drivers. Considering the major structural challenges that the developed world now faces, the external environment will likely be less benign than in 2004-07 – suggesting that policy-makers in China and India will have to seek sustainable sources for domestic demand engines of growth for their respective economies.
Growth Is Slowing Again
After recovering strongly from the credit crisis, growth in China and India is slowing again. The emergence of macro stability risks forced policy-makers to tighten monetary and fiscal policy to control domestic demand.
• In China, tighter monetary conditions and the gradual withdrawal of fiscal incentives have curtailed domestic demand.
• India is seeing a broad-based slowdown in domestic demand. Persistently high inflation has eroded purchasing power and has forced the government to slow down its expenditure growth, the major driver of rural consumption.
Just as domestic demand had begun to slow, external demand conditions turned less supportive as the sovereign debt situation in Europe intensified during the summer of 2011. Export growth for the region weakened; sequential growth (seasonally adjusted) had averaged close to zero since March 2011.
Moreover, the risks to the growth outlook for both China and India are skewed to the downside, in line with our global team’s view on Europe and the US. Barring a quick recovery in the developed world, the external environment could again be a drag on the region’s growth outlook.
Aggressive Tactical Easing Is Not an Option
We believe that there is growing recognition among policy-makers that the low productivity dynamic of growth driven by tactical stimulus had resulted in the emergence of macro stability risks. As such, if economic conditions evolve in line with our base case outlook, we do not expect policy-makers to engage the same old aggressive policy response, as it would quickly revive the macro stability risks. We do expect some policy easing in China and India, but the policy response would likely be less aggressive than in 2008-09.
In China, we expect policy-makers to proceed with further policy easing to cushion the moderation in growth. We believe that the PBoC will favour quantitative adjustment through RRR cuts, open market operations (OMO) and window guidance, while keeping the policy rate unchanged for now.
In India, we expect the RBI to initiate policy rate cuts by March-April 2012 when inflationary pressures start softening, delivering a cumulative 100bp cut in policy rates in 2012. The RBI would also likely continue to inject liquidity via open market operations and/or via a reduction in CRR to prevent a sharp rise in inter-bank rates.
What Would Help Revive it on a Sustainable Basis?
Investors remain focused on the next round of tactical responses – but we believe it is essential to watch the efforts from policy-makers in China and India to revive domestic demand in a sustainable manner through strategic policy responses. We would also highlight that the source of domestic demand growth matters as well.
In this context, we believe that China should tilt the balance towards boosting consumption growth – while India needs to focus on lifting investment.
China Needs to Move Towards Higher-Value-Added Economic Activities, Boost Private Consumption
In China, a number of structural impediments have held back private consumption growth:
1) Surplus labour in preceding years, as reflected in relatively low wage growth, has meant that a larger incremental share of income has been allocated to corporates rather than households. Hence, the growth in private consumption was held back by the relatively weaker growth in disposable incomes.
2) There has been a lack of a comprehensive social security system and access to public healthcare, housing and education, particularly for migrant residents. This has fostered a strong desire to hold a high level of precautionary household savings.
3) Until the late 1990s, China had several restrictions on ownership of private property. As a result, a large proportion of lower- and middle-income households were not able to tap the private housing market and thus experienced a lack of security on that front.
Hence, to address these impediments, we believe that China needs to initiate structural reforms: The ultimate goals: to transition towards higher value-added economic activities, to accelerate fiscal transfers towards social security, and to boost private consumption.
First, a sustainable rise in household disposable incomes (wages) would help to support consumption growth.
In this context, the government has been addressing this issue by steadily raising minimum wages. Indeed, in 2011, minimum wages have risen by an average of 22.0% in 22 of China’s 31 provincial-level regions. Some provinces have already announced further plans to hike minimum wages in 2012. The government, in its 12th Five-Year Plan, has also set out to lift household disposable incomes (wages) at a pace that at least matches the nominal GDP growth.
We believe that demographic changes will mean that market forces will also warrant this rise in wage growth. According to UN projections, 18 million people will be added to China’s working age population over the next decade, one-sixth of what it was in the last decade.
• These significant demographic changes indicate that the social objectives (economic welfare) are changing from aggressive employment creation (creating enough jobs to absorb the rise in working age population) …
• …to employment enhancement (moving employed workers up the value chain, thereby giving them the opportunity to earn higher wages).
Moreover, the CAGR in number of new graduates has been 21% over 2001-10, rising from 2.0 million in 2001 to 7.7 million in 2010. The rising number of graduates from higher education institutes will mean that the economy will need to generate higher value-added jobs to ensure that their skill sets will be fully utilised.
In order to move up the value chain, the government would need to reorient manufacturing investment towards higher value-added manufacturing. In its 12th Five-Year Plan, the government plans to raise the strategic emerging industries’ share of GDP from 4% in 2010 to 8% in 2015. These industries include high-end equipment manufacturing, next-generation information technology, biotechnology and environmental protection (including alternative energy).
Moreover, the production structure of the Chinese economy is likely to shift gradually towards the services (tertiary) sector as the economy continues to mature in its developmental stage.
This process of industrial upgrading and movement towards the tertiary sector will likely bring with it more job opportunities which will be higher value-added in nature – thereby allowing for a virtuous cycle of sustainable growth in disposable incomes and therefore consumption growth.
Second, to address the issue of improving social security, the government could push for affordable social housing.
This would boost investment in the near term but would ultimately boost consumption, as households feel more secure. The government has announced plans to construct 36 million units of social housing from 2011-15. We believe that the government will likely accelerate its efforts to ensure that the construction of social housing projects proceeds smoothly and is completed as scheduled. The government has announced measures to ease the financial constraints of the local government financing vehicles, thereby indirectly supporting the construction of social housing.
Third, we believe that the government will work to extend the provision of social services such as public education, healthcare and housing for more residents.
This, we believe, will be the key to improving social security and will also free up disposable income for consumption of other goods and services. In this context, one of the possible measures that the government could consider is allowing the registration of migrant urban residents in a phased manner. According to the National Bureau of Statistics of China, as of 2011, 230 million residents are not registered under the hukou system in the city where they are currently residing. Registration of these residents would give them access to the above-mentioned social services of public education, healthcare and housing.
We believe that the goal of boosting household incomes to raise consumption will serve as a strategic complement to accelerate growth in the services sector, thereby raising the opportunity for higher value-added jobs.
We believe that fiscal policy is likely to play an important role in supporting this transition towards domestic demand. Indeed, China’s government balance sheet is in a strong position to provide this support. The government’s fiscal position, as measured both in terms of its fiscal deficit and public debt to GDP trend, has more than adequate room to play this constructive role. The government could thus increase its social spending and initiate tax reforms to lower the tax burden of households to boost consumption.
India: Revival in Investment Is the Key to Recovery in Growth
In India, structural measures are needed to help boost private investment. India will continue to have strong support from favourable demographic trends, as the age dependency ratio (proportion of non-working age population to working age population) will continue improving until 2040, according to UN projections.
This warrants a rise in investment to GDP, which would help to generate productive capacity, and is crucial to kick-start a virtuous cycle of faster growth in productive job creation – income growth – savings – investments – higher growth, without a rise in inflation challenges.
Unfortunately, investment sentiment in corporate India has remained weak… Currently, from an entrepreneur’s perspective, several factors are adversely affecting corporate confidence:
1) The slowdown in domestic demand growth;
2) Weak global economy and slowing export growth;
3) Weak global capital markets;
4) Relatively high global commodity prices in rupee terms hurting margins;
5) Slowing pace of execution by government machinery;
6) Corruption-related investigations.
…and the government has little fiscal room for manoeuvre: Moreover, the already high starting point of the fiscal deficit (9.2% of GDP) implies that the government has very little room to pursue an expansionary fiscal policy to boost public investment.
Credit policy isn’t enough on its own: We expect the RBI to start cutting policy rates from Mar-April 2012 onwards and cumulatively cut policy rates by 100bp during 2012 to 7.5%. Still, interest rate cuts are unlikely to be a sufficient driver to kick-start the investment cycle, in our view. Indeed, private investment has slowed even though real interest rates remain negative. As inflation moderates, real interest rates will need to be high for some time to ensure that India lifts savings enough to fund the eventual rise in investment.
We acknowledge that reviving capex in a counter-cyclical manner will not be easy: A typical capex recovery cycle involves cyclical policy stimulus reviving domestic demand (particularly consumption) and growth confidence. This is then followed by a gradual pick-up in private investment. However, with limited scope for cyclical policy stimulus this time and an otherwise adverse macro environment, we believe that reviving the investment cycle quickly will be challenging.
In our view, two key factors can help support the investment and therefore GDP growth recovery:
(a) Global capital markets: Global capital markets weigh on capital inflows into India and also tend to influence the risk appetite in the domestic markets. This factor is particularly important for India, because its corporate sector’s investment funding is more dependent on capital markets compared to bank credit. Moreover, businesses of many of the companies are now linked to the global economy and their investment decisions are dependent on the global economic outlook.
Considering that the developed world is facing major structural challenges, support from the global economy and capital markets may not be forthcoming. Hence, to support investment growth, the government needs to focus on policy reforms to get the productive dynamic back, in our view.
(b) Government policy action: If global support is less forthcoming, we believe that the only way to revive investment will be a ‘campaign-style’ effort from the government which should include major policy reforms and a focused approach to speed up the execution machinery of the government.
Thus, the government could use a two-pronged strategy – first, speed up implementation of major policy reforms…
•· Strengthen institutional capacity to allocate critical national resources (land, minerals) to the private corporate sector in a transparent manner for rapid industrialisation.
•· Enact the Goods and Services Tax Act (GST; value-added tax).
•· Strengthen institutional capacity to manage the awarding of major infrastructure projects through the public-private route, which should increase transparency.
•· Build a comprehensive plan for energy security along with a systematic programme for energy pricing reform.
•· Initiate aggressive fiscal consolidation which aims to reduce the national government deficit and improve the mix of its expenditure towards development spending.
•· Take meaningful steps towards divestment of the government’s stakes in SOEs.
•· Accelerate infrastructure spending, particularly for power: The government needs to systematically address institutional capacity to sustain a steady rise in infrastructure spending.
…second, identify 25-30 core infrastructure and industrial projects – and fast-track them: The government could either take up projects already underway or encourage new ones that can be taken up for execution quickly to ensure that investment is revived in a more timely fashion. These projects could be those with limited call on land/mineral resources.
We believe that the government should focus in particular on infrastructure investment, which can be taken up in a counter-cyclical manner, because weak global sentiment could weigh on manufacturing investment. For instance, many Indian cities need a jump-start in critical urban infrastructure facilities. The central government could provide a capital grant of about US$10 billion to initiate projects worth US$40-50 billion. We understand that in many cases the plans for such infrastructure projects are ready – but need a determined push from the central government.
We believe that such measures could also give a strong boost to foreign investor sentiment and would help to revive capital inflows as investors look for strong growth opportunities in an otherwise gloomy global environment. Among the large economies in the world, India’s structural growth story remains the most compelling, in our view. However, policy support would help to keep faith in this growth opportunity intact.
Macro Imperatives Will Likely Force the Much-Needed Transition, Pace Is an Issue
We believe that policy-makers in both China and India have indeed embraced the view that aggressive tactical easing will bring the same old macro stability risks. This is also reflected in their calibrated approach towards monetary easing thus far in this cycle. Encouragingly, policy-makers have been indicating that structural measures are needed to support domestic demand on a sustainable basis. Indeed, according to press reports (China Daily), Vice Premier Li Keqiang had emphasised that “more priorities should be given to the areas related to improving people’s livelihood, so as to boost the domestic demand and consumption” and stressed that “more expenditures should be made in areas such as social security, education and healthcare”.
Similarly in India, Prime Minister Manmohan Singh admitted that the government had taken “a conscious decision to allow a larger fiscal deficit in 2009-10 in order to tackle the global slowdown”. He stressed, however, that “like other countries that resorted to this strategy, we have run out of space and must once again begin the process of fiscal consolidation”. Finance Minister Pranab Mukherjee has also indicated that, in the context of reviving investment and growth, policy-makers will “have to be alert to shape the required policy responses, reform systems, improve the regulatory framework of our institutions to make the most of the opportunities coming our ways”.
We believe that policy-makers in China could surprise with more meaningful strategic measures in 2012.
In India, we believe that a window of opportunity for acceleration in policy measures could arise after the state elections in March 2012.
Source: Chetan Ahya, Derrick Kam and Jenny Zheng, Morgan Stanley, January 20, 2012.
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