China and India: Strategies for sustainable growth

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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.

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India – cutting growth estimates again

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This post is a guest contribution by Chetan Ahya of Morgan Stanley.

Over the past few months, India’s growth outlook has been affected by adverse macro developments. The two key factors that are making us nervous on the growth outlook are inflation persistently staying above policy-makers’ comfort zone and the weak investment growth trend. In this context, we believe that the recent spike in commodity prices and consequent impact on inflation and cost of capital has increased the downside risks to growth. We now expect domestic demand growth to be more constrained than estimated earlier. We cut our F2012 GDP (YE Mar-12) growth forecast to 8.2% from 8.7% in January 2011 (see India EcoView, Clouds Emerging over Growth Outlook, January 25, 2011). We are now cutting it further to 7.7%. On a calendar-year basis, we expect GDP growth for 2011 at 7.7% compared with 8.2% earlier. We have also trimmed our 2012 GDP growth forecast to 8.7% from 9%.

Inflation Pressures Remain High

High inflation expectations have already pushed the cost of capital higher than expected. With global commodity prices continuing to rise and surprising on the upside, the cost of capital is likely to remain high for longer than we had expected, adversely affecting growth. The high inflation expectations have meant a slow rise in bank deposit growth of 16.9%Y as of February 11, 2011, compared to the recent peak of 23.2%Y as of July 2009, whereas credit growth remained high at 23.9%Y as of February 11, 2011. With the central bank continuing to be slow to hike policy rates, banks delayed deposit rate hikes. However, given persistent tightness in interbank liquidity, banks began to resort to aggressive deposit rate hikes from December 6, 2010. The State Bank of India, the largest bank, has increased its deposit rates for the one to two-year period by 175bp to 9.25% currently over the last three months. Some banks are offering 9.5-9.75% deposit rates for the same tenure. We believe that the central bank may continue to follow its gradual pace of lifting rates. We expect another 75bp hike in the repo rate for the rest of 2011. However, we now track the bank deposit rate as a better measure of tightening of monetary conditions instead of the policy rates.

Until recently, we were expecting a quick improvement in interbank liquidity due to the acceleration in deposit growth. For instance, we thought that the deposit rate hikes were aggressive and had expected deposit growth to respond much faster, resulting in banks beginning to cut deposit rates by 25-50bp. However, with the persistent rise in crude oil and other commodity prices, we believe that inflation expectations will remain sticky and interbank liquidity may remain tighter for longer. Currently, overall loan-deposit ratio is extremely tight at 75%, which is a multiple-year high. Considering that the banks are required to invest 24% of deposits in government securities (SLR) and park 6% of deposits with the central bank in the form of cash reserve ratio (CRR), the current credit-deposit (C/D) ratio indicates the stretch in the banking system to fund strong credit growth. Moreover, unlike in 2006-07, when the banking system had excess liquidity as reflected in the form of market stabilisation scheme (MSS) bonds or reverse repo balances, currently the RBI has been injecting liquidity to prevent pressure on interbank rates. We believe that banks are likely to have to slow credit growth with more hikes in lending rates even as deposit growth accelerates, unless deposit growth accelerates all the way up to 22-24% in the near term, which appears unlikely, in our view.

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Roubini: Reevaluating “Chindia”: The story of the elephant and the dragon

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The report below comes courtesy of Nouriel Roubini’s team of analysts at RGE.

The emerging market powerhouse known as “Chindia” is becoming a focal point of global attention as China and India show themselves to be growth dynamos of the coming Asian Century. But examining these countries’ intrinsic differences, is more illustrative than listing their similarities—and the two countries are likely to be on a divergent path over the next five years in the areas of growth, economic policy and politics.

China and India both entered the 20th century with large chunks of their populations in subsistence farming with medieval living conditions. Large numbers of people are leapfrogging generations of economic growth and development to join a modern services and manufacturing economy in the 21st century. Both societies are changing quickly, with different sectors and elites in the vanguard not just at home, but also in the international sphere. But the similarities between the two countries conceal underlying differences, such as India’s democratic, capitalist English common law vs. China’s authoritarian, state-led models of development. As fault lines in China’s export-led growth model emerge, bigger bets are being placed on India’s enormous potential.

India’s growth surge is occurring despite the government, China’s largely because of it. China’s economic miracle is a state-led, industrial revolution catch-up story, reflecting the efficiency of a strong, relatively centralized state in control. The main players are parastatals or foreign firms, which this communist country has protected from labor unrest. The ostensible results are superb: gleaming infrastructure, unprecedented for a country at China’s per capita income levels, with bullet trains, airports, roads, urban and increasingly extra-urban infrastructure, as well as productive capacity far exceeding current needs.

In contrast, India’s economic renaissance is led by a private sector struggling under the tethers of the “License Raj”—a mixed-economy hodgepodge of central planning and private capitalism with multiparty coalition governments that make U.S. gridlock politics look lightning fast. Businesses are thriving amid rising entrepreneurship, foreign investment, global competition and innovation but are facing bottlenecks of all kinds—whether overloaded transport infrastructure or petty corruption along transit routes that drives up transport costs. Much of the growth has come from entirely new sectors like information technology or internationally traded services that capitalize on India’s comparative advantages with a very large, cheap pool of English speakers, many with a very strong education and technical skills.

Looking ahead, China’s demographics are less than favorable for growth, but should support rebalancing. In 2011 China’s dependency ratio will bottom out, and its 15-29-year-old population will peak. The total working-age population will begin to decline in 2015, but labor supply constraints are already looking acute. In contrast, India is will see a demographic dividend, but structural factors will likely keep the country from fully capitalizing on it. India’s population and labor force will continue to expand through 2050, and the 25-39 cohort will not peak until 2030. The bulk of the increase in labor force will occur during this decade, with the median age rising to 28 by 2020. However, concerns about the poor quality of social services, low affordability of private sector services and a shortage of high- and low-end labor skills suggest that skill shortages will keep up the wage-price spiral.

China’s trend GDP growth will decline from about 10% in 2010 to 8% or so by 2015. Consumption will narrowly outpace GDP growth by 2012 or 2013, but structural factors will bring down the savings rate. Rising capital costs and nonperforming loans will constrain investment, which will begin to decrease as a share of GDP. By 2015, services’ share of GDP will rise while that of manufacturing and agriculture will decline slightly. India’s trend growth rate will rise above 9% in 2011-15 and will outpace Chinese growth starting in 2014. The rising services’ share of GDP will be offset by a declining agricultural share of GDP, while industry’s share is unlikely to increase. The saving-to-GDP ratio will exceed 40% by 2015, reducing consumption’s share of GDP and pushing investment’s share of GDP above 40% by 2014.

Nobody could accuse Chinese policy makers of being ignorant of their economy’s weaknesses, but they have not done much to address them either. The current Five-Year Plan looks much like the previous, and will sound the right notes for reform. The problem, as always, will be in the follow-through. The main constraint is China’s political economy, in which provincial leaders are rewarded for delivering strong growth and state-owned banks are hardwired to push out as many loans as hamstrung regulators will bear. The coming political transition in 2012-13 will make policy makers risk averse in the near term, but we are hopeful for change after 2013. On the political side, greater institutionalization within the Chinese Communist Party (CCP) and government should shift the country gently toward a rule-of-law system and away from the current rule-by-law model, where might makes right. There are signs that China is already heading down this path, with groups outside of the CCP having greater influence on policy making, but the process is likely to accelerate after the 18th Party Congress in late 2012.

India’s reforms in the 1990s and early 2000s laid the groundwork for the economy’s stellar performance, but the second phase of structural reforms has moved at a snail’s pace. Spending on populist social programs doubled between 2003 and 2009, yet did not enhance rural sustainability or the quality of services due to corruption and cost and implementation inefficiencies. The share of health care and education spending in total government expenditure has barely increased, while spending on ill-targeted subsidies has risen. With the government failing to provide key services, private sector investment in health care, education, labor training, utilities, infrastructure, R&D, agriculture and rural credit—sectors considered critical to increasing trickle-down effects, reducing structural inflation and benefiting from demographics and migration—will rise. Political aspirations to sustain 9-10% GDP growth will keep the economy vulnerable to overheating and asset bubbles, which would force policy makers to suppress private demand via tight monetary policies until supply-side bottlenecks ease over time. This, along with an unfavorable current account deficit financing structure, poses the biggest risk to India’s growth story.

As for corruption, increasing participation in civil society, use of technology in government projects, freedom of press and expansion of an educated middle class will gradually increase transparency and bring about institutional changes in administration and the judiciary. But this will happen from a very low base and will be a drawn-out process, given India’s centralized system, the immense disparities between states and the government-elite class nexus.

Source: RGE Monitor, February 23, 2011.

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Ruminations on China and India

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In the short piece below Arjun Divecha, Director of GMO’s Emerging Markets Division, shares some of his thoughts on China and India.

China: If you build it, they will come …

India: You’re not going to build it, but they’ll come anyway …

It occurred to me that this is a good metaphor for China and India and the resulting implications for growth and investment return.

Last month I had a long chat with one of the people in China whose views I most respect. He is extremely plugged in with the financial elite and serves on a number of government advisory boards. He told a very convincing story about how things were going to play out in China over the next few years, and which sectors would benefit. However, at the end of the discussion, it occurred to me that the entirety of his story depended on government policy and actions.

In my travels around India over the last couple of weeks, I had multiple discussions with business and financial leaders about what is likely to happen in India over the next few years. None of their thoughts depended on government action. If anything, their main fear was that government intervention/inaction was the thing most likely to slow down or kill the huge growth momentum that exists today.

That, in a nutshell, is the relative case for China vs. India. China succeeds if the government gets it right; India succeeds if the government gets out of the way. Both could happen. Or neither. In both cases, long-term return to investors will depend not so much on the success or failure of the country in GDP terms, but on the ability of companies to deliver high return on capital. So, what drives return on capital?

One of my colleagues at GMO has written about the problems of overcapacity in China (see “China’s Red Flags” by Edward Chancellor) so I won’t spend time on it, but one thing is clear to me: building overcapacity is generally good for the consumer and bad for the producer. Thus, building multiple high-speed rail lines in China almost certainly improves the quality of life for the average Chinese, but it is inconceivable that the return on capital on those rail lines will be high, in pure financial terms. If it were, the U.S. would surely have built plenty of high-speed rail lines by now.

After all, the ability of the U.S. consumer to pay for transportation is considerably higher than that of the Chinese consumer. The fact that no high-speed rail lines exist in the U.S. tells you something about the potential return on capital on high-speed rail in expansive continental geographies.

In short, overcapacity may lead to high social return, but almost certainly leads to low return on invested capital.

Click here for the full report (registration is required).

Source: GMO, January 2011.

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India: Taking stock of macro stability risks

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This post is a guest contribution by Chetan Ahya of Morgan Stanley.

What Really Caused Stretch Marks Early in the Current Recovery Cycle?
We believe the ideal outcome would have been to manage GDP growth closer to potential of 7.5-8% for the first 12 months immediately following the credit crisis – and then to gradually push growth higher as investment growth accelerated, lifting potential growth.

However, since the credit crisis unfolded, India’s policy-makers have been aggressively pushing growth back to pre-crisis levels as fast as possible. Unusually low real interest rates, loose fiscal policy and faster-than-expected global recovery have brought growth in India back close to pre-crisis levels. The credit crisis had a significant impact on investment in India. India’s investment trends tend to be highly influenced by the capital market environment. As the global credit crisis impaired capital markets, private corporate capex declined from 16.1% of GDP in F2008 to 12.7% in F2009 and further to 12.6% (our estimate) in F2010. On the other hand, the quick recovery in domestic demand from April 2009, driven by the government’s aggressive fiscal and monetary policy as well as an improvement in global and local sentiment, resulted in a capacity stretch much earlier in the cycle than was normal.

The good news is that GDP growth in F2011 could potentially be even higher than our forecast of 8.5%. However, this approach by policy-makers to maximize the growth opportunity came at the cost of rise in macro stability risks in the form of higher inflation, a wider current account deficit and tighter interbank liquidity – we have been highlighting this for some time now (see India EcoView: Inflation Risks Rising Fast, March 15, 2010 and India EcoView: Policy Support Maximizing Growth Opportunity but Macro Stability Risks Emerge, June 16, 2010). Moreover, a major crop failure due to drought in summer 2009 only added to the inflation management challenge.

Worst of the Macro Stability Risks May Be Behind
We see three key factors supporting this gradual improvement in some of the macro stability risks:

1) A steady rise in private corporate capex: Private sector capex has been accelerating over the last 10 months. We believe that it will soon begin to reflect in the form of commissioned capacity. The revival in capital markets as well as capital inflows and increased corporate confidence have fueled a significant pick-up in capex. For instance, as per the RBI data, aggregate resources raised by the commercial sector had risen by 47%Y as of September 2010. In this context, the key risk to our view of a continued steady rise in investments is potential risk-aversion among public sector banks due to recent corruption-related investigations. Similarly, we see the risk that contract awards for infrastructure and commodity-related projects might slow because of similar issues and a delay in mining approvals.

2) The tightening of short-term interest rates: We expect that this should start checking aggregate demand growth, reducing the non-food inflation pressures.

3) Recovery in G3 domestic demand and consequent rise in India’s exports: This is helping to reduce the trade and current account deficits.

Note, the risk to our view that the worst may be behind us is that oil prices quickly shoot up above US$100/bbl on a sustained basis and/or capital inflows into EM and India decline sharply. Under either of these conditions, the short-term cost of capital will spike up – hurting growth.

Tracking the Macro Stability Risks

1) Trade and Current Account Deficit Narrowing for Now
After widening for a sustained period from 2H09 when the recovery began, the trade deficit has shown a clear trend of moderating over the last three months. The monthly trade deficit stood at US$8.9 billion (7.1% of GDP annualized) in November. This is down from the peak deficit of US$13 billion (10.8% of GDP annualized) in August 2010. On a three-month trailing basis, the trade deficit narrowed to 7.3% of GDP, annualized as of November 2010, from 8.6% in October and the peak of 10.1% in August 2010. The improvement in the deficit has been supported by a faster rise in exports while imports have been steady. Over the last six months, seasonally adjusted exports have risen by 26.1%, whereas imports have increased by only 4.8%. We expect the trade and current account deficits to narrow over the next six months as rising investments help to build capacity and a steady reversal in monetary and fiscal policy contains demand growth. The key risk to our view would be a sustained rise in crude oil prices above US$100/bbl.

2) Aggressive Deposit Rate Hikes Should Help to Improve Interbank Liquidity
The persistent lag in policy rate hikes had meant that real deposit rates were unattractive. While bank loan growth is accelerating, deposit growth is decelerating. The gap between credit growth (23.7%Y as of the fortnight ending December 17, 2010) and deposit growth (14.7%Y during the same period) has remained high. Currently, the banking system loan-deposit ratio is already high at 75.8% as of as of the fortnight ending December 17, 2010. Similarly, the 12-month trailing banking system loan-deposit ratio is already tracking above 100%. Considering that the statutory liquidity ratio is 24% and the cash reserve ratio is 6%, we believe that there is a need to significantly accelerate deposit growth so that the system has adequate liquidity to support this rising credit demand.

There was a lag (relative to strength of growth and inflation) in deposit rate hikes as the RBI was slow in moving policy rates up – but the banks have finally moved deposit rates now. The State Bank of India (SBI, India’s largest public sector bank) recently raised deposit rates by 50-150bp across maturities. In the 1-2 year bucket (using the 555-day deposit rate as benchmark), SBI increased rates by 150bp to 9%. Indeed, over the last 12 months, short-term rates have moved up significantly. 91-day T-bill yields have risen by close to 310bp to 7.1% over the last eight months. The three-month commercial paper rate has risen by 480bp during the same period to 9.5% currently. We believe that these hikes in deposit rates should start improving deposit growth and reduce tightness in interbank liquidity over the next 2-3 months if the inflation rate does not spike up again.

3) Inflation Stays Too High for Policy-Makers’ Comfort
Headline inflation has moderated to 7.5%Y in November 2010 from the peak of 11%Y in April 2010, primarily due to high base effect in food prices. While non-food inflation remains high at 7.9%Y in November 2010 (versus the peak of 8.9%Y in April 2010), food inflation (primary and manufactured) has moderated to 6.6%Y in November from the peak of 19.2%Y in February 2010. We were earlier expecting the headline and food inflation (WPI) rates to moderate further to 6-6.5%Y and 5.5-6%Y by March 2011 – but we now raise our headline and food inflation forecast to 7%Y and 7.3%Y, respectively.

Key reasons for raising our food inflation estimates are:
(a) Unseasonal rains damaged the onion crop, pushing up prices of other vegetables: The onion crop in Maharashtra and Gujarat has been significantly damaged by unseasonal rains. These two states combined contribute about 40% of the country’s onion output. The sharp rise in onion prices has also had an impact on other vegetable prices. During the week ended December 18, 2010, higher vegetable prices pushed headline primary food inflation further upwards to 14.4%Y from 12.1%Y and 9.5%Y in the previous two weeks. Indeed, the weekly primary food articles index has risen by 3.5% over the last three weeks cumulatively. Typically, the primary food index declines MoM in December. However, the recent rise in vegetable prices is likely to push December primary food inflation index over the November number. We believe that vegetable prices could moderate when the next onion crop arrives in February-March 2011.

(b) Rise in edible oil and other soft commodity prices: Over the last three months, international prices of crude palm oil and other edible oils have jumped by 30%. Domestic edible oil prices are highly influenced by international prices as India is a big importer of edible oils. Edible oils have a weighting of 3% in the WPI. Edible oil prices as reflected in WPI always tend to lag the international prices. We believe that over the next three months the WPI edible oil component inflation will likely spike up. Similarly, other soft commodity prices have also been rising. For products where India is self-sufficient, the international prices don’t reflect one-to-one – but some pass-through is inevitable.

Rise in Oil Prices Could Compound the Inflation Problem
We currently expect non-food inflation (WPI) at 6.8% by March 2011, assuming that oil prices remain close to US$100/bbl. Hence, any upside surprise in G3 domestic demand could push crude oil prices to increase to US$110-120/bbl.

In this context, the recent announcement in the US of a potentially large fiscal stimulus in 2011 has increased the probability of such an outcome. If crude oil prices reach US$110-120/bbl for a sustained period of six months or more, we believe that headline inflation (WPI) could spike to 8-9%. This would increase the risk of disruptive policy actions to manage inflation pressures and thus would eventually hurt growth. Indeed, this could remind us of the macro environment in mid-2008.

Fiscal Deficit Reduction in F2012 Will Be Key
We believe that fiscal policy has to lift most of the burden of tightening. While short-term interest rates have moved up aggressively over the last 12 months, the government has delayed reduction in the core deficit (excluding one-off receipts like divestments and 3G license fees), supporting strong aggregate demand growth. The government is currently indicating its determination to cut the central fiscal deficit to 4.8% of GDP in F2012 from 5.5% in F2011 (7% excluding 3G revenues). We believe that this is a difficult target to achieve but, in order to manage the inflation risks, we think it will be critical that the government abides by this earlier stated target.

Source: Chetan Ahya, Morgan Stanley, January 5, 2010.

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India price hikes loom up inflation

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Rising fuel and food prices in India are reviving inflation fears in India. During the past year, the nation’s food price index rose 12.13%. High food inflation has dislodged state governments in the past. India’s Congress party that leads the ruling coalition has to come up with a solution before the partial state elections later this year.

Source: YouTube, January 2, 2010 (hat tip: Financial Doom Blog).

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