Indian Economic Growth: Post GFC

Introduction

    Indian GDP data seems to have become a constantly evolving puzzle.  In February 2015, Ruchir Sharma, Managing Director and Head of Emerging Market Strategy, Morgan Stanly Investment Management, wrote, “the dramatic upward revision of the GDP growth rate is a bad joke, smashing India’s credibility and making its statistics bureau a laughing stock in global financial circles” and “Nobody really believes that the Indian economy grew at anywhere close to 7% last year, and shockingly no one is willing to put an end to this nonsense.”[i] I disagree strongly.[ii]

   In my view, more than 90% of World renowned analysts have failed to understand the Global Financial Crisis (GFC) and its Impact on the World Economy. The GFC is a once in a ¾ century event, the most significant since the “Great Depression” and not just another post-war recession, or “great recession.” It has changed the nature of many effects and correlations, at least temporarily.  Non-recognition of this fact has led to inadequate or wrong policies that have delayed the global recovery. This note focuses on the Indian economy, and the change in  co-relations between the Indian Corporate sector and the overall economy.

Economic Growth

         Since 2013-4 Indian GDP growth has been on a gradually rising trend : From about 6.9% to about 7.3% over  9 quarters. The latest data for the first Quarter of 2015-16 at 7% (y-o-y) is below this two year trend. But two demand side drivers of sustained recovery were above their trend lines in the first quarter:  Private Consumption growth has trended from about 6.0% to about 6.7% and was at 7.4% in the first quarter, significantly above the trend.  Fixed investment growth which has been virtually flat at 4%, grew at 4.9% (y-o-y), significantly higher than in last eight quarters.  These two factors give confidence that  GDP will remain on trend for the rest of the year, giving us a growth rate between 7.5% to 8% for the year 2015-16.  Foreign trade is an area of concern as export growth has been negative for the past four quarters and the reduction in imports due to falling commodity prices may be exhausted by the end of the year. Thus declining net exports could act as a drag on the economy.  As I had warned in IE (June 6^th, 2015), the external environment remains a drag on corporate investment and growth recovery.[iii]

Corporate Decoupling

   The opening of the Indian economy in the 1990s forced the Indian corporate to compete and become stronger by building World scale plants and quality products. Corporate investment and growth therefore led the India growth story in the 2000s and was highly co-related with it.  The GFC has disturbed this co-relation, aided by misplaced notions of fiscal austerity and “moral hazard” in Developed countries, by reducing global demand dramatically. Non-market economy China, given its export-investment growth model with 45%+ investment rates, continued to build new capacity in tradable goods, unmindful of declining profitability. The consequent excess capacity put increased pressure on the profits and reinvestment of the globalized Indian corporate sector, once fiscal-monetary-ECB bubble of 2010-11 was pricked and profit enhancing efficiency improvements were exhausted around 2012-13. Thus the cyclical investment recovery that most analysts expected by 2013-14, has been delayed further.[iv]

Policy Options

   Though recovery of the globalized part of the corporate sector during 2015-16 is likely to depend  on the strength of the US economic recovery, other parts of the sector are more intimately related to domestic policy. The shift in fiscal policy from consumption & transfers to infrastructure investment will increase the fiscal multiplier and raise demand for both infrastructure companies and consumer durable companies. The acceleration of fixed investment growth in the first quarter and the above trend growth of 6.9% of the construction sector are suggestive.  Falling inflation has raised the real interest rates and thus tightened monetary policy. Restoring the real interest rate to a level that accounts for a projected end year CPI inflation of less than 5.5% will remove the policy constraints on growth of interest-sensitive sectors like automobiles and real estate thus stimulating durables investment and growth.[v]  The efforts to reduce “tax terrorism” have smacked of two steps forward one step backward undermining the credibility of government. The increase in paperwork linked to the black money bill or the misuse of its draconian powers, could erode credibility further.  Government, Central and State,  must ensure that both on the tax front and on “Ease of Doing Business” the changes reach down to the ground level where the vast majority of  business (tiny, small and medium) operate.  This will give greater confidence to all business, including corporate and Foreign Direct investors to accelerate investment plans.

China Uncertainty

    Recent developments in China, were a shock to those who believed that China’s CCP led economy is a market economy like any of a 100 others. It was not a surprise to those analysts who have been predicting a growth slowdown based on long term trends and/or knew the medium term dangers of creating a credit fueled, investment bubble.  However, even those who have been watching for signs of economic slowdown (excess capacity in manufacturing & real estate) below the officially revealed growth rate of 7%, were surprised by the quality of economic management displayed in the creation & pricking of the China stock market bubble.  This loss of invincibility will have more lasting impact than any short-term turmoil and uncertainty created by it and the subsequent Yuan devaluation.

  In the short term we need to watch out for dumping by stressed Chinese firms, ensure that our real effective exchange rate doesn’t appreciate and stick to our Revenue deficit targets to minimize vulnerability to shifts in capital inflow-outflows. In the longer term a decline in China’s growth and investment will reduce excess capacity in manufacturing and benefit India, and we will benefit only if we pursue our reforms more effectively.

Conclusion 

 The Indian economy seems to be on a trend line of slow, gradual recovery to a level of 7.5% growth. Attaining the potential growth of 8.5% is only possible if Corporate profitability, internal resource generation and investment growth revive.  This requires an implementation of the reforms announced in the last two budgets, along with the macro-economic re-balancing measures outlined above.   It appears unlikely that the economy can reach and sustain 8.5% growth without the Corporate sector recovering its role as driver of fixed investment and productivity growth.[vi]

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A version of this article appeared in the Indian Express, Editorial page on September 7, 2015 under the banner, “Some Home economics”. http://indianexpress.com/article/opinion/columns/some-home-economics/  .

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[i]  http://blogs.timesofindia.indiatimes.com/toi-edit-page/6-9-growth-world-laughing-at-this-bad-joke/

[ii]  Indian Growth Puzzle, Policy Paper No. WsPP 3/2015, New Delhi, April 2015.  https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnxkcmFydmluZHZpcm1hbml8Z3g6NDg5YTE1ZDM5ZTU2MWNiMQ

[iii]    http://indianexpress.com/article/opinion/columns/inside-outside-4/  

[iv] http://dravirmani.blogspot.in/2015/06/external-enviornment-favourable-or.html

[v]  http://dravirmani.blogspot.in/2015/04/inflation-monetary-policy-2015-16.html & http://dravirmani.blogspot.in/2015/06/real-gdp-real-interest-rates-real.html

[vi]  “The J curve of Productivity and Growth: Indian Manufacturing Post-Liberalization,” (with Danish Hashim) IMF Working Paper, No WP/11/263.  July, 2011. http://www.imf.org/external/pubs/cat/longres.aspx?sk=25029.0 .

Chinese Economy: Post GFC

Introduction

   A series of recent developments in China have exposed the extent of growth slowdown in China, previously hidden by the careful control that the CCP exercises over information.  This means that in the short term the external environment will become more uncertain as markets understand and absorb this new information. The effect on the real economy however depends on how much of the growth slowdown has already occurred and has been transmitted to commodity markets and China’s supply chain. As with the growth slowdown that has already occurred (from 10% to 6-7%), further deceleration will have both a positive effect through lower oil & other commodity prices, and a negative one from Chinese excess capacity in tradable goods.  However, in the medium term a decline in the growth rate of the Chinese economy will be co-related with a decline in investment in manufacturing and other tradable goods, reducing the over-capacity created by past Chinese investment.  This will benefit the Indian economy.

Trends & Bubble

     The Chinese economy has long stood out as an economy that has been able to maintain very fast growth for several decades.[i] Right up to and including the Global Financial crises it had averaged a GDP growth rate of 9.9 per cent per annum for three decades. However a study of such fast growing economies also showed that such high growth rates cannot be maintained indefinitely.[ii]  Some of us had predicted at the end of the 1990s, that the growth slowdown would occur around the middle of the current decade.[iii] The advent of the Global financial Crisis in 2008, increased greatly the probability of this growth slowdown occurring during the 2010s. I had also suggested that the degree of slowdown could be minimized if and only if the basic model of Chinese growth was changed from a “net export-investment” led one to a to neutral one with respect to wages & profits, consumption & investment, manufacturing & services and exports & imports.[iv]  This did not happen.

   The massive credit policy response of the Chinese government, which cannot be distinguished from fiscal-monetary policy, given that the Chinese banking system was practically a department of its Finance Ministry, masked the, degree to which the global slowdown in GDP and Trade growth had affected the Chinese economy. At that time I had warned in the IMF that this credit fueled growth could be maintained for a maximum of three to five years, before growth would slow down. The credit boom raised the formal debt:GDP ratio of the economy increased from 121% of GDP in 2008 to 163% of GDP by 2013. The debt routed through the unregulated shadow banking sector has been estimated by private analysts to have increased by a 100% of GDP. The effects of the debt fueled bubble were felt not just in manufacturing excess capacity but also in the real estate sector. We know from the history of such debt fueled bubbles, as analysts began to warn in 2014, that  substantial proportion of bring down the rowth rate sharply (hard landing) when they burst.  

    A number of reports have appeared over the past few years about empty apartment complexes and even empty cities in China. This and other indicators such as growth in electricity consumption, led several analysts (including us) to conclude that China’s actual growth was likely a per cent point below the officials numbers released by the Government i.e. around 6%. Recent developments suggest that the growth is trending down further by about 1 to 2%, below the 6% that is likely already happened, i.e. it may be trending towards a 4-5% level.  Thus growth rates of 4% or lower, representing a hard landing for the Chinese economy,  are no longer unimaginable for the Chinese economy, if fundamental structural reforms to shift from an export-investment led economy to a domestic consumption led economy do not take place. 

Market Developments & Devaluation

       The panic reaction revealed by the use of draconian control methods to prop up the stock market in June and the shock devaluation in August suggest that the Communist Party (CCP) may have lost its ability to manage the economy and maintain a growth rate of around 6% (a much wanted soft landing). Consequently the probability of a decline in Chinese growth rate to 4% (feared hard landing) has now increased to 30%, from less than 10% a year ago and about 1% about three years ago.  

Monetary Policy

    China's monetary policy actions on August 24, 2015, fall into two categories: A conventional reduction in Banks reserve ratio combined with a cut in the benchmark lending rate. These will have little or no effect on China's growth rate, which is on a clear declining trend and is currently around 6% even though official data suggest it is close to 7%. Over the past year or so China's capital account has moved from a net inflow to a net outflow situation. Before the devaluation these outflows were likely met from foreign exchange reserve draw down. This would reduce the monetary base and lead to a tightening of monetary policy. Thus the monetary policy action may also be seen as a move to counter this tightening.  

     Looking forward, expectation of further devaluation could accelerate the capital outflow. Thus the authorities are confronted by a dillema. If the exchange rate is genuinely freed it could set off a spiral of capital outflows and further devaluations. The other option is to hold the exchange rate, meet all outflows from the ample foreign exchange reserves and offset the consequent monetary tightening by further reductions in the bank reserve ratios and (controlled) interest rates. The authorities are likely to lean towards the latter option, perhaps interspersed with small devaluations of the Yuan, linked to visible changes in the external environment for China.

   The second part of the monetary actions consisted of increasing financing for banks and financial institutions that operate in rural areas and provide consumer credit for consumer durable (automobile) purchase. Though such lending has long term potential it is probably too little and too late to have an impact in 2015.

   Though the monetary actions will have little effect on China's real growth rate, they have helped correct the over-reaction in several global markets, starting with European markets and to a lesser extent in the US and Indian market.

China Growth Projection

    Real economic growth is therefore likely to slip towards the 4-5% level unless more fundamental reforms of China's growth model takes place. This includes a complete halt in lending to State, provincial and Party inked companies for investment in sectors with excess capacity and the diversion of this lending to the service sector and small & medium consumers. Further there is need for complete decontrol of wages, so household income income and consumption can rise & drive the Chinese economy. The political economy of China's Communist Party suggests, however, that the CCP will not undertake any reform that appears to undermine its unchallenged control of the economy and risks building alternative center of politico-economic power eg a genuine large scale domestic private sector.

  Chinese economic growth has likely already slowed to 6%. A further slow down to 4% would imply that 2/3rd of the growth slowdown has already occurred while 1/3rd is still to take place. Correspondingly, 2/3rd of the real impact of the China slowdown on natural resource prices and producers, on prices & producers of metals and other commodities and supply chains into its manufacturing machine have already occured. Only another third remains to be actualized. 

Implication for India

      Indian policy can minimize the adverse short term direct effects of Chinese hard landing by ensuring that the “Real effective exchange rate (36 country)” of the rupee does not appreciate (repeat not).  This is critical to maintaining medium term competitiveness, given the negative growth of Indian goods exports for the last seven months and the worsening of the balance on goods and services (in GDP) during the last three quarters.  Temporary measures to control any potential dumping by Chinese firms during the next year or so would also be justified, but these must be withdrawn once the immediate threat has passed.  India can minimize the negative effect of a Chinese hard landing by accelerating the reforms that are already on the Government's menu, such as the GST, bankruptcy law and other measures proposed in the last two budgets, plus the "Ease of Doing Business" and "Skilling India."

    In the medium-long term the reduction in profitability of investment, beginning to be revealed in the worsening profitability of foreign (FDI) firms operating in China, will also become visible in State and party controlled enterprises. With lower investible surpluses these State & party controlled firms will be forced to cut down their investment, and stop creating capacity that adds to global excess capacity in traded goods, particularly manufacturing.  Over time this will help reduce excess capacity globally and benefit India and other countries suffering from an imbalance between effective global demand and subsidized capacity creation by China.  In particular the globalized Indian corporate sector, producing standardize products such as metals and basic chemicals will benefit in the medium term.

   As a Chinese hard landing will put pressure on the global economic recovery, to really benefit from a Chinese hard landing, India may have to expand the menu of policy to other areas such as private entry into government monopoly controlled infrastructure, more competitive Banking sector, a reform of the EXIM policy through elimination of "specific duties" on textiles and a thorough overhaul of the QR-tariff regime for agriculture and Education policy & regulatory reform (including Health education) to enhance “Educate in India”. Sustained movement on institutional reforms (Police, legal & judicial reforms) is also important for long term growth sustainability.

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[i] Arvind Virmani,”Potential Growth Stars of the 21^st Century: India, China and The Asian Century,” Occasional Paper, Chintan, October 1999, www.icrier.org/avpapers.html and Arvind Virmani, “Star Performers of the 20^th (21^st) Century: Asian Tigers, Dragons or Elephants, Occasional Paper, Chintan, September 1999, www.icrier.org/avpapers.html .

[ii] Arvind Virmani, ““Accelerating And Sustaining Growth:  Economic and Political Lessons,” IMF Working Paper No.  WP/12/185, July 2012

http://www.imf.org/external/pubs/cat/wp1_sp.aspx?s_year=2012&e_year=2012&brtype=default.

[iii] China-India GDP growth Projections:Summary extracts from 2004 to 2014 (with references to originals).  IndiaChinaGrProjs04to14.docx .

[iv]  Arvind Virmani, “Global Crisis: Impact on China and India,” Keynote Address at a CII-CPR seminar, “Debating Inclusive Futures: Prosperity And Inequality In India and China,” March 19, 2009, New Delhi. http://www.cprindia.org/semiid.php?s=82  and Arvind Virmani, “Global Crisis: Impact on Growth Strategies”, Co-lead Presentation at the, Development Debate on Export Competitiveness, Korea Development Institute-WBI, Seoul Korea, March 10, 2010. http://info.worldbank.org/etools/docs/WBIvideos/avirmani/avirmani.html .