Saturday, May 21, 2005

A Tripolar World: India, USA and China

With the collapse of the Soviet Union in 1990, the World has become unipolar, with USA as the predominant power. Russia and France, along with rising powers such as China, have resisted this reality by pushing the concept of a multi polar world. Henry Kissenger had earlier written about the four powers, USA, EU, China and Russia and maybe a fifth India. Till about 9 months ago the US establishment was confident that the USA would remain the predominant world power and that China did not pose a serious threat to it during most of the 21st century. There was also a feeling that India could become a swing state in terms of the power balance in Asia in the second half of the century and therefore an improvement of India-US relations was desirable.
In a recent paper (ICRIER WP #160, March 2005) I have projected that within 25 years, China will become strong enough to challenge US power in Asia and India will become the third most powerful country in the World. This process will continue in the next 25 years so that by the middle of the century the World will become Tripolar. The USA, China and India will be the three great powers during most of the 21st century. A recognition of this fact will have a profound effect on the foreign and security policies of USA, India, EU and Japan. There is an important caveat: The projections for India depend on continuing reform of economic policy as well as reform of government institutions and political systems. Similarly we assume that single party (Chinese Communist Party) rule will remain in China and it will continue to introduce market reforms to correct the weakness of socialist policies. Though the European Union (EU) could be the fourth power if Germany, UK, France and Italy surrender their individual power to a EU “virtual” State, this appears unlikely (at present).
Though the size of a Nation’s economy has always been an important basis of its global power this will be more so in the 21st century. The size of a nation’s economy (GDP at ppp) is the multiple of its population and Per capita GDP (average income). If we compare each country’s share in World population and in World GDP we find four countries with the greatest imbalance. The USA and Japan’s share of world GDP is more than their respective shares of population by 16.5% & 5%, while China and India’s share of World GDP is less than their share of population by 11% and 9% respectively. Germany, France, UK, Italy also have significant positive and Indonesia a negative imbalance (there is no imbalance for Russia and Brazil). These imbalances will get reduced or eliminated during this century of globalization (free flow of technology). The reason for this are policy reform and catch-up growth by the three laggards, India and Indonesia, which are low income countries and China which is a lower middle income country: Since 1980, China, India and Indonesia have ranked 1st , 9th and 11th in terms of the average rate of growth of per capita GDP.
Over the next two decades, China and India will remain among the 5 fastest growing economies in the world and will therefore continue to close the per capita income gap with the USA. According to our mean scenario, in 2050, China and India’s per capita GDP ppp is projected to become 57% and 36% respectively of that of the USA. As China’s and India’s population would be 3.4 and 3.75 times that of the USA (respectively), their GDP at purchasing power parity will become about 1.9 and 1.3 times that of the USA in 2050. In contrast the GDP of the fourth largest country, Japan would be 1/5th that of the USA.
Though the size of the economy forms the basis of Global Power it may not be an adequate measure of power given that even in a Globalized world, each country has to develop its own strategic technology. We therefore measure the potential power of a country through a Power Potential Index (PPI) that gives additional weight to technological capabilities and national resources. The index shows that by 2050 China’s power is likely to be about 40% higher than that of the USA. China will therefore be able to challenge US power in Asia within 20 years, when its PPI will be about 70% of the USA. We also find that India’s potential power will be about 35% of USA in 2025 and 90% in 2050. If our projections come true, India will become a global power during the second quarter of this century and the World will become tripolar.
History shows that the risk of war rises when a new great power (now China) emerges to challenge an existing one (USA). In Asia, these risks are heightened by the imbalance between China and India. India’s economy will reach a low of 40% of China’s in the middle of the next decade, before starting to close the gap. However, even in 2050 the Indian economy is projected to be only 70% of China’s economy. Part of the reason for this gap is that the rich countries have denied India for 30 years the technology that they have allowed China to access. It is in the interest of the USA, EU, Japan and Russia to ensure that the technological and economic gap between India and China is closed as quickly as possible. They must lift the controls and restrictions on transfer of Dual use, nuclear and space technology to India, imposed after our first atomic test in 1974. The Bush administration seems to have recognized this imperative, as reflected in the statements of Secretary of State Condalezza Rice on her visit to India in March and the subsequent backgrounders by US spokesmen in Washington. India must use this opportunity to develop an ‘Indo-US partnership for peace’ that is mutually/equally beneficial to both. At the same time efforts to develop closer technological collaboration with Russia, Japan, France, UK and other countries must continue. We need to jettison the victim mindset engendered under the East India Company/British Raj and learn to act like a big power.
Normalization of relations between India and China will be critical to peace in the Tripolar World. We must enhance our economic ties through removal of bilateral impediments and development of inclusive structures such as an Asian Oil community and an (East) Asian Economic Community.

Friday, May 20, 2005

Can Oil Prices motivate Radical Energy Policy Reform?

Oil Prices touched $50 a barrel last year while the International Energy agency confidently forecast that prices could go below $25 a barrel. This year oil prices touched $57 a barrel. Though prices are currently down below $48 don’t be surprised if they again shoot up in the next six months. Will we passively watch these developments or take action to reduce our dependence on oil? If the latter, what can we do? The most important action is to reform our coal, electricity and oil policies. Otherwise we will continue to remain at the mercy of the oil cartel.
India is among the ten largest oil importers in the World. A rise in global oil prices is a tax on the nation paid to the oil cartel. So far we have tried to absorb this tax within the budget, either directly by lowering import duties or by reducing government owned oil company profits and consequently their dividends to the exchequer. This means that these revenues are no longer available to build infrastructure or carry out the social expenditures enumerated in the CMP. Further as the prices paid by consumers of Kerosine, LPG, Diesel and Petrol do not rise there is no incentive to be careful in their use. It is a known economic fact that short term price elasticity of demand for oil products is much lower than the long term elasticity. If oil price increases are not reflected in consumer prices the demand response and the technical change that it induces will be delayed even further. Thus oil dependence will continue to grow and so will the tax that citizen’s pay to the oil cartel.
The solution is to, (a) Allow complete and automatic pass through of international oil prices to domestic users. (b) Set all oil related import tariffs at the peak rate (now 15%) (c) Put a resource rent tax on domestic oil producers that applies above a base oil price (set in the exploration contract) and varies with the international price of oil. The revenues from this tax can be earmarked for development and introduction of energy conservation technology and alternative energy resources. (d) Replace differential pricing of Kerosene, whose adulteration of diesel is destroying Bharat III engines, by a direct subsidy to BPL house holds.
The nationalization of coking (non-coaking) coal mines in 1971 (1973) was justified (among other reasons) by the need to use our abundant coal reserves optimally for the good of future generations (50-100 years). The talk now, thirty years after nationalization, is about how coal imports are needed because the coal is of poor quality and how it will not last very long in any case. What happened? Nationalization created a monopoly, that along with the Ministry of Coal and the regulators appointed by it constituted itself into a monolith that has destroyed this great national resource. Greedy politicians (from coal mine areas or coal ministers), the coal mafia and the public coal monopoly have milked this national resource in the name of the people. A former vigilance head of Coal India confirmed to me that the stories one had heard and read about the ‘Coal Mafia” (which controls the labor force in the mines) are indeed true. Is it any wonder that the Coal Mine Nationalization Amendment Bill had been stuck in parliament since 2000 and was allowed to lapse, without re-introduction, in 2004!
The solution, (a) Amend the Coal Nationalization Act to allow private entry into coal mining. This will end the State monopoly and introduce true competition into the coal mining industry. It will allow specialized companies to come in, reduce demand risk through diversification of buyers, exploit economies of scale, make long gestation investments in mining & processing of high ash coal and in R&D for more effective use of available (quality/type) coal. (b) Sell 49.9% of the shares of public coal mining companies to the public/people. This does not disturb the government’s management control (mafia control?), but will provide an incentive to the people and the financial media to shed light on the worms operating under the stones. Hopefully the performance of the State companies will improve to the point they can compete with imports. (c) Reform and strengthen the coal regulatory system by making it independent and professional.
The electricity Act (2003) is an important step in the direction of electricity reform. But large private investments will not flow unless three critical problems are addressed and policy and regulatory risk is reduced. The most fundamental problem is electricity Theft. With 50% T&D losses Delhi electricity privatization will eventually loose support unless this problem is tackled. The Theft and Dacoity carried out by the electricity mafia is legendry. Several years ago, a central electricity minister, who had himself been a DESU union leader, had no hesitation in confirming this fact. This problem is not unique to Delhi but perhaps Delhi can show the way by taking on and destroying the electricity mafia and thus reducing the cost to honest users by about 40%. Full success would eliminate the need for cross-subsidies and allow a uniform price for all electricity users.
The second issue is that of the cross-tax subsidy to be paid by independent power producers for open access to the existing controlled government distribution system. Unless the methodology is clearly specified and is reasonable and limited by some upper bounds, the risk of arbitrary imposts will remain and deter investment. The third issue is the setting up of an independent and professional regulatory system. This requires regulatory law(s) ensuring sufficient delegation in all matters related to standards, norms, interconnection, pricing and quality of service and clear rules and procedures for financing of regulators, selection of chairman & members and adequate professional staff. State Governments and politicians are loath to loose control of the levers of power and pelf and the setting up of this system in the major states is going to be a long and painful process. Unless all this is done the regulatory and policy risks will remain.
With the best of intentions, these reforms will take about 10 years to fructify. In the meanwhile a radical solution is required. The government should declare a 10 year regulatory holiday for all new private generation, distribution and transmission companies (starting from date of first completed project). Producers/distributors would be free to supply electricity to any buyer at mutually agreed prices, terms and conditions. On completion of the regulatory holiday, normal regulatory systems, which by then will be fully in place across the country, would become applicable. By then the power shortage would be eliminated.

Sunday, May 15, 2005

Economic Reforms During The Past 12 Months

Soon after the UPA Government took office, the stock market crashed because investors expected a sharp slow-down in reform, given the UPA’s dependence on left parties. At that time, I had written that in areas in which markets were expecting a halt in reform namely labor laws and PSU privatization, there had not been little actual policy action in the previous 2-3 years. So even if there were no labor policy reform this would not amount to a slow down. Further, though privatization was ruled out, disinvestment of shares was still possible. These unjustified apprehensions were dispelled after the first budget and the market recovered and exceeded expectations in the subsequent six months.
Taking stock of the entire one-year period, the pace of reform has been in line with the average pace seen since 1992-93. Once the crisis driven spurt in 1991-92 was over, the pace of reform has been modest under every government. This slow and steady pace has continued under the UPA government. For instance, the SSI reservation list has been gradually reduced with the removal of remaining labor intensive textiles and other exportables. Similarly peak non-agricultural tariff reductions have continued with a reduction to 15% in the last budget.
There have also been sporadic policy reform initiatives from other ministries. Thus the FDI limit in domestic airlines was raised to 49% and in Telecom to 74%. In Telecom indirect channels of foreign investment were simultaneously closed thus increasing transparency. The permission given to private Indian airlines to fly on foreign routes and the open skies agreement with the USA could transform foreign air travel over the next few years. One hopes that private investment in upgrading major airports will finally get underway after 5 years of policy circumlocution. The SEZ law could similarly have resulted in a revolution in labor intensive exports, but the dropping of the labor clause has made this a little uncertain.
The performance on tax reform has been mixed. In CENVAT the reduction in rates on polyester etc. has been offset by a move away from genuine CENVAT in textiles. Income tax reform has been a mixture of simplification (saving exemptions) and new complexity (securities transaction tax, fringe benefit tax). The latter will have to be reformed 5 years later. The harmonization of States’ sales tax rates that passes under the name of VAT has finally got under way, a great political achievement. From the economics perspective however, a genuine equitable State VAT that simplifies the system by replacing all indirect taxes requires a uniform 10% rate on all goods and local services except food, drugs and medical equipment/ services. This has to be complemented with a handful of sales taxes on final consumer goods (e.g. entertainment, petrol, cars) as argued in Planning Commission Working Paper No 4/2002-pc.
One of the predictions that I made at the start of PM Manmohan Singh’s Government is that given his depth of understanding and commitment he would be a Prime Minister who would pay greater attention to long term and difficult issues like governance reform. This process has indeed been initiated and a few things like the ‘Right to information Act’ already passed. But there is still a long way to go and I expect that in the remaining four years further action will in fact be taken.
Most new governments take at least a year to find their feet and get going on policy reforms. As this was the first year of the Government and given the novel political arrangements in which the leader of the major government party is not the Prime Minister, it was perhaps inevitable that the Government would take a little time to settle down. It is hoped and expected that the pace of reforms will gradually accelerate over the next couple of years.