China: Tariff war, Debt bubble, Over investment & Growth.

Q1: The IMF has downgraded China's economic growth by 0.2 percentage points to 6.2% for the (calendar) year 2019. Meanwhile, you have predicted China's growth could slip to below 5%. When do you expect this to happen?

A1: All official forecasts, including IMF, World Bank, ADB, relate to official country data. My forecast of a decline in China's GDP growth rate to 4.5% to 5.5% , relates to the real (underlying)GDP growth rates. The gap between official & real rates in China is likely to rise sharply next year and then close slowly. This official data may only reflect the full extent of real growth slowdown in about 3 years i.e. 2021!

Q2: How will China's growth slowdown impact the rest of the world? What will be the impact on the Indian economy?

A2: We must distinguish the immediate short term (ST) impact from the medium & long term one (MLT). The ST effect will be to slow China’s export growth and Imports linked to it i.e. natural resources from developing countries, capital goods from developed countries & intermediate inputs from Asian supply chains. Therefore, GDP growth in these countries may be adversely affected in short term. In MLT a slowing of Chinese growth and investment in manufacturing & other tradable goods will reduce excess global capacity in tradable goods. This will increase profitability in manufacturing, investment & GDP growth in India and other competing countries.

Q3: You have pointed out that China's growth will be impacted by the tariff war and domestic credit bubble. Can you quantify the impact of these two factors?

A3: The USA is the largest market for China’s exports. A rise in US tariffs on imports from China has both a direct effect on its exports and an indirect effect on FDI investment in supply chains located in China. Together these could reduce China’s growth by 0.75% to 1.25%, if higher US tariffs are maintained. Exit from the debt-credit bubble would reduce growth by 0.5% to 1%. These supply chains will relocate out of China over next year or two, increasing FDI & investment in competing countries in Asia, and increase exports from & GDP of these countries.

Q4: Tariff war is largely being pushed by President Trump. If the restrictions do not escalate into a war, is the Chinese economy still at risk?

A4: The effect of an additional (above rates for others) 25% US import tariff on all imports from China, if sustained for 3 to 5 years will result in a deceleration of China's GDP growth. The measures directed at preventing forced transfer of technology and theft of technology from US companies will continue in parallel and ensure that, reverse engineered US R&D cannot be passed off as innovation.

Q5: How bad is the domestic credit bubble in China? Can the country manage a soft landing?

A5: The Chinese economy has seen among the largest increase in debt among the systemically important economies (US, Euro Area, Japan, UK, India), since the Global Financial crises(40% of total global debt increase). An earlier debt-credit bubble burst in 2015 & a new one was initiated in 2016, but channeled a little more through the fisc and combined with a tightening of capital controls on residents/citizens. Increased external & internal controls make it easier to ensure a financial soft landing. They do not ensure a soft landing in terms of real Economic growth.

Q6: How can China maintain its growth momentum in a de-globalized world

A6: The massive increase in World Trade ended with the Global Financial Crisis. China which benefited hugely from this globalization, has avoided the severe consequences of this reversal of globalization by increasing its share of global import and by pumping credit into its economy. These measures have kept its growth from falling below 6.5%. The US tariffs on China mean that countries which have lost because of the mercantilist growth model followed by the communist party of China are no longer willing to accept these costs. Similarly credit fueled growth cannot be sustained indefinitely. Thus, a decline in China's GDP growth rate is inevitable. The only question is when and how smoothly? China can smoothen the adjustment to a lower growth rate by allowing wages to rise to level consistent with its Per Capita GDP & eliminating directed lending to unprofitable SOEs, Exporters, Party capitalists and high risk, low return investments.

Q7: You have talked about the opportunities for India from the US-China tariff war. What are they?

A7: From the start of the US-China tariff war, late last year-early this year I have emphasized the huge opportunity for India to attract supply chains located in China to India. The new US approach to China's communist party run non-market, non-transparent economy creates great uncertainty for export-oriented supply chains located in China. Given India's free market, open democratic system the Indian economy provides a stable long-term location for such investment. This is particularly so for labour intensive products & processes and where cyber security is a concern as in electronics, telecom & electrical control systems. However, we need to get our own policies and institutions in order. The EoDB external indicator is still very poor. Complaints of tax terrorism are still heard from foreign companies. We need to drastically simplify bureaucratic procedures for FDI & other Export production.

Q8: There is talk of decoupling or disentangling of the US and Chinese economy, what are your views?

A8: There is very high likelihood of a decoupling of the US and Chinese economies over the next 10 years. This will affect significant effects on Geo-economics and Geopolitics. We must be prepared to grab the opportunities this will throw up while remaining alert to the dangers.

To read more,

 "Effect of China Slowdown on India", Policy Paper No. WsPP 1/2017, April 2017, ChinaIndia17feb20Apr.docx .

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A version of this Q&A appeared in digital Financial Express at, https://www.financialexpress.com/economy/avind-virmani-exclusive-china-gdp-growth-could-crash-to-just-5-and-it-is-profitable-for-india/1345357/ and at https://www.financialexpress.com/economy/china-gdp-growth-could-fall-below-5-former-cea-arvind-virmani-tells-when-and-why-it-will-happen/1343910/

Growth Prospects: Deceleration, Demonetization, GST

Introduction

   The advance and revised estimates for the year 2016-17 gave as some indication of the effects of demonetization on GDP growth. However, there were doubts and disagreement between analysts about whether the negative effects would be limited to Q4 of 2016-17. With the CSO releasing data on Q1 of 2017-18, we are in a better position to provide a quantitative impact of demonetization on GDP, as the effects of demonetization can be separated from the earlier deceleration of growth from its quarterly peak in mid 2015-16. We are also in a position to take stock of earlier forecasts of GDP for FY 2017-18.

Demonetization

  From the GDP data now available, we estimate that Demonetization reduced GDP growth by ~1.2% point in first half of 2017 or by ~0.6% point in 12 post-Demonetization. This is at the mid-point of my forecast range of -0.2% to -1% on 12 month basis[i]. The methodology, though far from perfect, accounts for /adjusts for the decelerating trend in quarterly GDP growth since the middle of 2015-16. 

Deceleration in GDP growth

         GDP growth decelerated from 7.9% in July-Sept 2015(Q22015-16) to 5.7% in April-June 2017(Q1 2017-18), while GVA decelerated from peak of 8.2% to 5.6% over the same period.  Our analysis suggests that the GDP growth deceleration since mid-2015-16 is due to the following factors:

(a) Monetary policy has not only been tight for last two years, but has tightened over last 18 months because of sharply falling inflation. The real repo rate has been on an uptrend from the beginning of 2014, rising from a neutral 0.3% in January 2014 to 6.3% in august 2017. The direct negative effect of rising real interest rates has been strongest on manufacturing and construction, Another consequence of high real rates relative to global rates, is excessive capital inflows into debt (and carry trade, which gives free money to foreigners). This results in appreciation of the real effective exchange rate of the Rupee (REER 36), which has appreciated from 104.7 to ~120 over the same period. Since February 2015 it has however moved progressively above the gradually appreciating trendline & appreciated by 6.6% till July 2017. This in turn resulted in loss of competitiveness & worsening of net exports of goods (Exports-Imports: X-M), which are almost 62% of its absolute value in Q2 2015-16 and 48% of its absolute value in Q1 2015-16.

 (b) A return of the Indian economy from deflation to inflation in manufacturing & other internationally tradable goods. Inflation measured by the deflator for manufacturing, which was negative from Q1 of 2015-16 to Q1 2016-17 turned positive in Q2 of 2016-17 and has risen progressively since then. Similarly inflation as measured by mining deflator turned positive i Q3 2016-17 for the first time since Q2 of 2014-15. The deflation results in leads and lags in input & output prices that result in overestimation of value added in manufacturing & other goods, while the return to normal inflation reverses these effects on inputs & outputs so that average growth measures values which would have prevailed in absence of deflation episode.

(c) Public Sector bank(PSB) NPAs were incurred largely in 2009-13, after the Global Financial Crisis(GFC) in 2008, partly because of the unjustified euphoria generated by quick recovery in 2009 due to appropriate fiscal monetary policies. The recovery led to abandoning of fiscal sobriety in 2010 & lending pressure by government on Public sector banks. However, the increasing NPAs were more hidden or in speculative domain. Tighter regulations on NPAs since 2014 and their disclosure to public forced Banks,  companies and capital markets to see & evaluate the risks more carefully and clearly, worsening Credit/Investment in 2015 & 2016.

Reforms for Growth

With uncertainties and risks from introduction of GST still hanging over the economy, the key question at this point is what specific policy changes can help revive growth: The following reforms, in order of feasibility and impact, should be accelerated by government:

(1) Government must refocus on subsidy reform and put the savings from reduction in corruption and administrative efficiency, into public goods infrastructure investment. This will be an important driver of grwoth as long as private corporate investment remains weak.

(2) It should expeditiously complete already launched reforms in Bankruptcy law, rules & procedures and the cleanup of the NPAs in PSBs. 

(3) To get the full benefits of GST and minimize the costs, the GST council must undertake drastic simplification of the GST (to 3 slab System with one base rate, basic food, health, education as exempt sectors & surcharges on 6-12 carefully selected indutries+services).[ii]

(4) Reform Export-Import (EXIM) policy (Agriculture, Textile), and unify customs (import) duty into a uniform 10% duty on all manufactures & minerals (GST is seperate).(a) Suspend the IT-electronics agreement for 3-5years (if possible).  Either through EPZs or FTZ or other temporary mechanisms (5-10years) provide an opportunity to Labor intensive industries & Export Supply Chains to shift base from China to India.[iii]

(5)  Two consecutive normal monsoons provide an opportunity to eliminate all export controls & QRs  on agricultural commodities and reduce export duties to zero immediately. If government wants to help farmers on a permanent & longer term basis, it should also repeal ECA & APMC, approve all GM seeds recommended by the GEAC & induce hold-out States to join the National e-market for all agricultural products. Remaining impediments to FDI in food retailing of agricultural & related products should also be removed.

(6) Education is one of the remaining heavily controlled sectors of the Indian economy. Central Govt. can make a start by replacing controls on higher education with modern, rational regulation (based on asymmetric information & moral hazard problems faced by users).

(7) Reform of the two most distorted markets, labor & land, are not 0-1 processes. They have multiple dimensions, each one badly riddled with controls, distortions and corruption. So a phased program of labor & land reform can be drawn up and implemented step by step over next five years as political opportunity permits.

Outlook

    In my judgment the negative effects of demonetization on GDP are largely over. Because of fears of getting shortchanged on input credit from GST, there was an inventory draw down in June, and a possible slowdown in production even before that. Both these will be offset in August and Q2 of 2017-18. On balance I expect the economy to bottom out in July, but the speed of recovery will depend on the reforms & Monetary policy. 2017-18 GDP Growth is likely to be below my mean forecast of 7.5%, but within the range of 6.75% to 8.25% that I had forecast at the beginning of the financial year.[iv]

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A version of this article appeared in Economic Times on 8/9/2017 under the banner, " Post-demonetisation economy: Exorcising DeMo’s demons" at https://blogs.economictimes.indiatimes.com/et-commentary/post-demonetisation-economy-exorcising-demos-demons/

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[i]  http://dravirmani.blogspot.in/2016/11/demonetization-economics_16.html

[ii] https://www.facebook.com/arvindvirmani2/posts/780808875419702

[iii] Further details in tax reform chapter of forthcomng book: India at 70 years, Modi at 3 years

[iv] http://dravirmani.blogspot.in/2017/03/gdp-2016-17-and-2017-18-forecasts-cso.html , http://dravirmani.blogspot.in/2017/02/monetary-policy-8217.html
(a)  AV, "Towards a Competitive Economy: VAT and Customs Duty Reform," Planning Commission Working Paper No. 4/2002-PC, April 2002.  http://www.planningcommission.nic.in/reports/wrkpapers/wp_vat.pdf ; Arvind Virmani, "Customs Tariff Reform," Economic and Political Weekly, Vol. XL No. 11, March 12-18, 2005, pp. 1006-1008

Indian Economy at Mid-year 2015-16: Some Observations

Economic Growth

Q1:  The Mid-year analysis of the CEA, lowered economic  growth projections  sharply from 8.1-8.5 per cent for 2015-16. Don't you think  it  is  too  pessimistic a  projection since  the  UPA had left  growth at  7.9 per cent  for 2013-14? Even  upper band  is a tad  higher than 7.3 per cent recorded last  year.

A1:  At the end of 2014-15, most macro-forecasters(public & private) had predicted a GDP growth rate of over 8% for 2015-16 with a steady growth in the first half and a stronger pick up in the second half of the year.  Since then they have reduced their forecasts of GDP growth in 2015-16 to below 7.5%.

     I retain my post-budget forecast of a 0.25% to 0.75% acceleration in GDP growth in 2015-16 over previous year. Given that GDP growth rate was 7.3% in 2014-15, my  expectation remains of a growth rate between 7.5% and 8%, though current data suggests it will be on the lower side. On the positive side is the recovery of IIP manufacturing growth from negative growth at end 2013-14 to a growth rate of 4.5% to 5.5% at present. This is underpinned by a strong recovery in both capital goods and consumer durable goods production.  The two back to back droughts in 20014-5 and 2015-6 have however taken a greater than anticipated toll on demand for consumer durables produced by the organized sector represented in the IIP. A decent Rabi crop should help revive rural incomes and demand for non-durables consumer goods. This will, however, need to be re-evaluated as more data comes in January.

Q2: It said private investment may remain weak next financial year as well. What is your view?

A2: Assuming that all the financial sector reform measures outlined in the budget (eg bankruptcy law) and elsewhere, are implemented I expect a steady but slow recovery of corporate demand, investment and growth during 2016-17. This would be stronger if the right choice is made in the fiscal-monetary balance as suggested above. There is nothing in the data so far to suggest a very sharp pick up in private investment in 2016-17.

World Economy

Q3: What is the effect of the Global economy on India?

A3: Many analysts are just beginning to understand that we are living in a near-deflationary World economy and many still don't understand that the Global financial crisis (2008) was more akin to the Great Depression than the worst post-war recession.[i] This was masked to a large extent by US QE till 2011 and in the oil/energy market till 2013, by the Chinese debt bubble.  What this means is that the standard effects of monetary and fiscal and economic co-relations that analysts have got used to in the inflationary post-war world have been disrupted and often yield wrong answers.

      Though low aggregate demand in developed countries was important in triggering deflationary trends, it is has been underpinned by excess supply from continued production and investment in China unmindful of the near zero or negative returns. The largest effect of Chinese over-supply is on "un-differentiated tradable goods", which in earlier analysis of Indian economy I have termed  "Globalised (part of the) Corporate sector". 

   Coming specifically to the Indian economy, both the decline in oil prices, from which India benefits and the collapse of nominal sales, revenues and profits in the "Globalised corporate sector"(which surprised analysts) are the direct results of the demand supply imbalances in  "undifferentiated tradable goods." As any improvement in this sector depends on US-EU actions on fiscal policy and Chinese actions in abandoning its investment-export growth model, not much relief can be expected in the next few years. Consequently India has to focus on reforming policies that either constrain or could drive the growth of the non-globalised parts of the economy. This includes Infrastructure, Agriculture, Education, Real Estate and Construction, Defense and substantial segments of the Manufacturing sector

Fiscal Deficit & Monetary Policy

Q4: The analysis said meeting fiscal deficit target at 3.9 per cent in the current financial year would be challenging due to decline in nominal gdp growth, though the target would be met. Next year, the fiscal deficit target could be relooked at but no decision has been taken as yet as gains from declining prices would not be much, seventh pay commission is there and OROP is there. Your take?

A4: As I said after pay commission report, I Expect the current year's fiscal deficit target to be met. The greater challenge is from the equity sale targets, given the decline in the stock market since the budget. 

     For 2016-17, I believe there is a clear choice between (a) Sticking to announced fiscal target & loosening monetary policy in line with the decline in CPI inflation, which requires a repo rate cut of another 75 bps, or (b) holding monetary policy tight (much tighter in real terms than it was 18months ago) and letting fiscal targets slip by raisin govt investment in infrastructure. In my view the former choice is a better one for revival of corporate investment & growth, given other complementary policies.

Q5: How much of a repo cut do you think is still required.

A5: Inflation as measured by both the CPI and the GDP Private consumption deflator PFCE) have fallen dramatically in the past two years. The PFCE deflator has fallen from peak inflation rate of 11.3% in the 3rd quarter of 2013-14 (ie Oct-Dec 2013) to 1.4% in the 2nd quarter of 2015-16 (ie jul-Sept 2015). Similarly CPI inflation has declined from a peak of 11.7% Novemebr 2013 to 5.4% in November 2015 (ie -6.3% ). Over the same period the repo rate has been reduced by 1% (or 1.25% if taken from the subsequent peak). Therefore the real repo has risen dramatically resulting in a sharp tightening of monetary policy over the last year despite a reduction in the fiscal deficit. This is true even if we use the core CPI inflation rate which declined by 3.4%. Based on this decline I have repeatedly said that a 2% reduction in the repo rate can safely be undertaken.  However RBI has reduced the repo rate by only 1.25% points leaving scope for a further reduction of 75 bps.

   Now that the uncertainty over the US Feds rate hike is over, I would recommend an immediate Repo rate cut of 25 bps. If this does not take place now, then I would recommend a 50bps rate cut at the next Monetary policy statement.

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[i] As I pointed out at the IMF from 2010 to 2012, the use of policies that worked in post-war recessions would likely extend this cycle by at least 2 years (ie 5-7 years) in the US and last at least 10years in the Euro area/EU(ie + UK).