By Prieur du Plessis, on January 23rd, 2012 posted in: China, Economy, India Leave your comment

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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.

Continue reading China and India: Strategies for sustainable growth