CHINA…….a slowing dragon?

The Western economies, tottering from the financial crisis, have been depending on China and other emerging markets to drive economic growth. Increasingly, machinery exporters, energy suppliers and metals producers across the globe look to China and other fast-growing emerging economies for business growth.

Never has been so much riding on China's success as now - Foreign direct investments, global trade, the energy, metals and mining sectors dependence on continue demand from China, property and currency speculators, macro hedge funds and above all the lives of more than a billion people.  The growing influence of China has in both the global scene and the Asian region has been palpable.

However, what’s interesting is how different sets of prognosis are being made by economists based on the same set of facts. Well that's what makes a market. Of course you could also dismiss it as economists are six of one and half a dozen of the other!  On one side of the spectrum we have some who argue about China’s bright future and declare that it’s a forgone conclusion for it to emerge as the largest economy in the world by the turn of this decade.  On the other end, some see a looming disaster on the horizon and a collapse of the Chinese economic miracle by 2015. In The Coming Collapse of China, Gordon Chang forcefully argues the pessimist's case. So which side should we believe?

…..current economic outlook

Chinese officials have warned that their economy is poised to slow. In late February, Premier Wen Jiabao announced that the target for annual GDP growth over the next five years is 7%. This represents a significant decline from the 11% rate averaged over the five years through 2010.

That blistering growth was achieved despite the global financial crisis as they aggressively pushed up bank lending in 2008.  It is hard to fault the Chinese policy as it had ensured country’s robust growth in tough economic times, nothing short of a miracle.  So should we believe China’s forecasts as they have always under-promised and over-delivered? 

Or is it a response to foreign and domestic pressure against currency revaluation. China will have to rebalance its economy, placing less weight on manufacturing and exports and more on services and domestic consumption.  China appears to be absolutely no closer to the hallowed goal of rebalancing with currency being the focal point of any US and China talks.

Inflationary pressures are growing with high commodity prices and increasing wage pressures.  Chinese workers have started demanding higher wages and better working conditions which could lead to more consumption as well as reduced wage arbitrage resulting in slowing exports and lesser investment.  All of this implies could imply slower growth.

So what is at issue is not whether Chinese growth will slow, but when.

…..increasing wage pressures

Wages in China have been rising fast in the past couple of years and workers have demanded better pay and conditions.  Foxconn came into spotlight last year due to increasing workers’ suicides arising from stress and poor wages. Thus the wage arbitrage is eroding fast and it seems then that manufacturers are going to raise their prices on account of increase in commodities prices and increase in wages. This could further fuel inflation across the consumer goods.  There is already significant social unrest in many markets over increase in food prices.

Herein lies the conundrum: Producers cannot pass higher costs to consumers which will lead to the exit of high cost producers.  It follows that this will mean an increased number of liquidations with concurrent increases in the unemployment rate in the short term till demand/supply imbalance is restored.

While wages in China are still a fraction of what U.S. workers earn but that difference is expected to narrow, with the weakening US Dollar, increasing Chinese wages and factoring the transportation costs and the risk of Intellectual Property rights violations.

In the US, high unemployment is already driving state incentives to attract factories, while unions are becoming increasingly flexible.  The next few years could see a wave of reinvestment by U.S. multinational manufacturers in their home base, as rising wages and a strong yuan currency make China a less attractive proposition according to BCG. There is some evidence of this trend emerging with the likes of Caterpillar and NCR moving some of their units back to United States.

…..abundant labour supply?

China has been able to grow so rapidly by shifting large numbers of underemployed workers from agriculture to manufacturing. It has an extraordinarily high investment rate, about 45% of GDP. And it has stimulated export demand by maintaining what is, by any measure, an undervalued currency and has even been branded by a section of lawmakers in the US as a “currency manipulator”.

China has about 250 million rural residents who work off the farm, and about 150 million of them are migrants.  Nationwide, rural incomes in China rose 10.9 percent in 2010, outpacing a 7.8 percent rise in urban incomes, reflecting rising wages for the hundreds of millions of migrant workers. The proportion of Chinese aged 14 or younger was 16.6%, a fall of 6.3% from the 2000 census. Those aged >60 increased to 13.3% of the population, up 2.9%.

The converging consequences of a disappearing labor surplus and the transition to an older population with more non-working retirees dependent on their families and welfare will be an "enormous challenge" for China, per Ba Shusong, a senior economic advisor to the Government.

…..reaching Lewis’s turning point

China's census results show the world's second-biggest economy is nearing a demographic watershed that will auger wage rises, higher inflation and relatively lower growth.  The current data show that China has already crossed the Lewis turning point and the window of the demographic dividend will soon close.

Nobel-prize winning economist Arthur Lewis' theory contended that as a developing country modernizes, workers' wages begin to rise quickly once surplus rural labor shrinks to the point that labor shortages emerge.

The shortages of rural migrant workers since 2004 have been no passing blip, but it is now signaling a major turning point -- a transformational trend.

…..other empirical studies

Empirical studies on fast growing economies indicate that a slowdown kicks in typically when the per capital income reaches around the USD 16,500 mark.  China will achieve that by 2015.  There is no cast-iron law on slowdowns, of course as not all fast-growing countries slow when they reach the same per capita income levels. But slowdowns come sooner in countries with a high ratio of elderly people to active labor-force participants, which is increasingly the case in China, owing to increased life expectancy and the one-child policy implemented in the 1970’s.

Slowdowns are also more likely in countries where the manufacturing sector’s share of employment exceeds 20%, since it then becomes necessary to shift workers into services, where productivity growth is slower. This, too, is now China’s situation, reflecting past success in expanding its manufacturing base.

Most strikingly, slowdowns come earlier in economies with undervalued currencies. While currency undervaluation may work well as a mechanism for boosting growth in the early stages of development, when a country relies on shifting its labor force from agriculture to assembly-based manufacturing, it may work less well later, when growth becomes more innovation-intensive than labour-intensive.

Finally, maintenance of an undervalued currency may cause imbalances and excesses in export-oriented manufacturing to build up, as happened in Korea in the 1990’s, and through that channel make a growth deceleration more likely and the economy vulnerable to external shocks.

…..how big is the bubble

On Thursday, Moody's Investors Service downgraded China’s property sector from "stable" to “negative". This may have something to do with the significant property construction in China despite the large number of vacant and under-performing commercial and residential properties.  There are approximately 64 million vacant apartments in China, essentially creating "Ghost Cities." These vacancies are due in large part to the speculative investment leading to the  increasing divide between China's rich and poor leaving many without adequate housing.

Residential housing investment as a share of China's GDP has tripled from 2% in 2000 to 6% in 2011 - the same mark the U.S. housing market hit before imploding. Additionally, over the past eight years, housing prices in China have gone up 140 percent nationwide and as much as 800 percent in Beijing.

China's central government has launched several rounds of regulations in order to cool down the over-heating market. It remains to be seen on how effective they are. Meanwhile there is a bubble that is waiting to be burst.

…..the extreme view

Gordon Chang, author of ‘The coming collapse of China’, contends that the glitzy Shanghai, increasing foreign trade and investment, and a developing high-tech sector do not represent the real China. Instead, the real China is characterized by massive banking problems, failing state-owned enterprises (SOEs), corrupt and repressive Chinese Communist Party (CCP) rule, dissident movements such as Falungong, and separatists in Tibet and Xinjiang. The situation is so critical that "Beijing has about five years to put things right". Unfortunately, he believes, the shock of China's World Trade Organization (WTO) obligations, the government's lack of fiscal resources, the straitjacket of Communist Party ideology, the Party's lack of ideological authority, and the power of the Internet mean there is no hope. China is a lake of gasoline and one individual "will have only to throw a match. An extremely grim view indeed!

In summary

Finally, which side should we believe? We will have to wait a few years before we see whether either of them got it right!  My view is that China will begin to encounter a slowdown in growth but will still post super growth by Western standards, although not as blistering as in the past.

Higher wages and demand from a growing Chinese middle class, while raising costs, will increase domestic consumption and reduce export, resulting in a rebalancing of the economy, a goal that has been elusive so far.

China will continue to be a manufacturing powerhouse, possibly more at the lower end of the technology spectrum.  The higher-end goods or products lead by innovation and breakthrough technologies are more likely to be in the developed world.

Both the pace of investment and economic growth will slow with a decisive shift to domestic consumption as the main driver of economic growth.

While there are headwinds, prognosis of a major collapse is far too dramatic.  China will remain a significant global player both in political and economic terms.  An economically strong China is vital for global growth, I say, break a leg for that!

Law of Large Numbers

If you thought this blog is about probability theory of the law of large numbers, please read no further!

This note is about......the absence of law for large numbers!  Or more precisely, a totally different set of rules!!

Every time a despot or a politician is ousted, stories of their ill-gotten wealth make the headlines. This begs the question(s) – why were they allowed to stash? Why does this not hit the news while they are in power? Why is stashing cash so easy? When does wealth become ill gotten so that it becomes topic of national interest?  Is it only after a dictator or a politician is ousted? Does it require a revolution in a country to bring it to the fore?  A multi-trillion dollar issue, quite literally!!

When Roman Abramovich buys up Chelsea FC or Thaksin buys Man City or Mohammed Al Fayed makes significant business investments, the source of their wealth seldom attracts sufficient scrutiny.  Whereas you and I would be asked to explain much smaller credits in our account sighting “Know your Customer” (KYC) and Anti money laundering (AML) rules.  It seems that those rules go out of the window for large numbers….

Why is stashing cash so easy?

It is reported that the wife of ousted Tunisian President Zine al-Abidine Ben Ali shoved 1.5 tons of gold (worth $60 million) in her bag before fleeing to Saudi Arabia last month. However, illicit funds are not always so brazenly swept from a nation.  We have this image from movies where guys show up with a million dollars of ransom in a small suitcase – apparently, you can’t do it: as it takes three small suitcases!

But there are many ways of moving money to the international money centers with the help of lawyers, accountants and bankers. During one of my forensic audit assignments, many moons ago, I had unearthed a suspect transaction wherein a Libyan official had carried bearer bonds worth $ 200 million in a bag to London where it was deposited with a private bank.  There are other ways too…payments from corporates’ to a web of companies in the guise of commissions or consultancy fees for contracts……names like A. Raja, Kalmadi, Adnan Khashoggi and Ottavio Quattrocchi rings a bell…

The World Bank estimates $20-40 billion is stolen from developing countries each year, while a report from Global Financial Integrity put that figure over $1 trillion annually. Often this money is held through a web of companies for the benefit of politicians, ruling families, cronies, corrupt officials and tax dodging businessmen.

Leading the list is China, which reportedly lost over $200 billion annually in illicit financial flows since 2000. During his 30-year-rule, Hosni Mubarak and his family reportedly amassed a fortune estimated up to $70 billion. It is estimated that the Libyan leader has plundered over $20billion with several American and European banks managing his wealth. Many Indian politicians and businessmen have their billions stashed in Leichtenstein, Switzerland, St. Kitts, Channel Islands, Luxembourg etc. And the government is dithering to come out with the details.

Most of these kleptocrats also own significant real estate, financial and business assets in the western world and their families enjoy a very lavish lifestyle while the vast majority of their countrymen struggle for daily meal. 

The estimates of illicit money in the major wealth centres like Switzerland, Leichtenstein and other financial safe havens in the western world is mind bogglingly large. 

The rules are there……..

The Financial Action Task Force (FATF) is an inter-governmental body whose purpose is the development and promotion of national and international policies to combat money laundering and terrorist financing. In order to protect the financial system from money laundering and terrorist financing risk and as part of on-going efforts in this area, the FATF has identified and will work with jurisdictions with strategic AML/CFT deficiencies.

FATF has laid out measures to be taken by financial and non financial businesses and professions to prevent money laundering and terrorist financing.  The rules are all there…..but the enforcement of these rules are neither stringent nor consistent.

So what makes it easy…

Switzerland, Britain, and the United States are historically financial beehives for kleptocrats looking to stash money, because their cities offer the best bankers, lawyers, and financial resources. In these countries with large concentrations of financial advisors, with clusters of services such as banks, lawyers, corporate advisers – there is everything that is required to manage wealth.  Money is often laundered through a web of legal entities and structures. It's like untying the Gordian knot. These people have protected themselves with various layers and to break through all these layers is a complex procedure.

About 27 percent ($2 trillion) of the world's privately held offshore wealth is managed in Switzerland, according to Boston Consulting Group.  Switzerland's new Return of Illicit Assets Act, which took effect Feb. 1 allows the Swiss government to determine the legality of funds of any person hailing from a "failing state". 

The focus seems to be on remedial measures than preventative measures.  How do these institutions and countries get away from not enforcing the laws in the first place? Stricter enforcement of rules with severe consequences for non-compliance has to be way ahead.

What can be done?

In June, the US Justice Department launched a new Kleptocracy Asset Recovery Initiative.  It is well laid out that Banks must take reasonable measures to establish the source of wealth and source of funds related to their customers and the beneficial owners of the funds.  

But a real difference can only be made, when they start throwing the facilitating bankers, lawyers and accountants in jail and cancelling banking licenses of conniving institutions for “Knowing their Customers too well”!!

That will be a pipe dream!!!

WikiLeaks and Free Speech

Julian Assange, founder of WikiLeaks, and his website have gained such prominence following leaks of sensitive information. In the process, they have reignited issues of freedom of information / speech.

What is the ideology of WikiLeaks?

You have to use IP address 213.251.145.96 for gaining access to their website [as the web hosts have kicked them out!] and their stated mission is:

“WikiLeaks is a non-profit media organization dedicated to bringing important news and information to the public. We provide an innovative, secure and anonymous way for independent sources around the world to leak information to our journalists. We publish material of ethical, political and historical significance while keeping the identity of our sources anonymous, thus providing a universal way for the revealing of suppressed and censored injustices”. 

WikiLeaks came into prominence with the release thousands of documents on Afghan War and a video footage of Iraq War showing a collateral murder.  The footage shows US troops shooting civilians including two Reuters’ journalists and laughing over it  [Collateral murder].

Time Magazine had this on WikiLeaks - "Could become as important a journalistic tool as the Freedom of Information Act."

Freedom of Speech

The US prides itself as a beacon of democracy and a practitioner of Free Speech.  The First Amendment to the Constitution in 1791 established, in no unequivocal terms, the right to practice any religion and the freedom of speech and no law can ever be passed to overturn this.

It will not be exaggeration to say that the democracy is underpinned by journalism. Freedom of press does not exist outside of democratic societies. There is no democracy without press freedom.

The WikiLeaks saga, however, has raised questions on the limits to this freedom of speech. Journalists argue that they are in the disclosure business and revealing secrets is part of its trade description. “News is what somebody somewhere wants to suppress; all the rest is advertising”. Lord Northcliffe, a news baron of the early 20^th century. 

I can visualize the likes of Vinod Mehta and Manu Joseph, editors from Outlook and Open magazine respectively, nodding their head in agreement and grinning gleefully…[see Radia Tapes controversy- [Barkha Dutt 1 of 4 ;  Vir Sanghvi – but more on that some other time!]

More importantly the immediate questions that are being raised are –

·       Does freedom of speech equate to "freedom to publish all and any information one can gain access to"?

§  Do journalists carry a sense of responsibility for their actions?

§  Do they owe a duty of care and accountability?

These have surfaced in the wake of the latest set of WikiLeaks revelations and the investigations carried out by The Sunday Times and BBC’s Panorama into the activities of FIFA.  Believers and supporters of freedom of speech equally advocate right to privacy and exercise of discretion to ensure that public interest is served in such disclosures.

Daniel Ellsberg and the Pentagon Papers

Any discussions on freedom of speech would be incomplete without delving into the watershed case of ‘Pentagon Papers’. Daniel Ellsberg, a former government analyst had served in the Pentagon.  He later joined Defense Secretary Robert McNamara who had instituted a secret study on Vietnam War. Neither President Lyndon Johnson nor the Secretary of State knew about the study until its publication.  Ellsberg had contributed to this top-secret study regarding the conduct of the Vietnam War during 1967. The compilation of the study, which was contained in 43 volumes and 4100 pages, was completed in 1968.  These documents later became known collectively as the ‘Pentagon Papers’.

Initially Daniel Ellsberg tried to engage the National Security Adviser but failed.  In February 1971 Ellsberg discussed the study with New York Times and gave 43 of the volumes to them in March. The Times began publishing excerpts on June 13, 1971.  Subsequently, Ellsberg gave the documents to other newspapers.

President Nixon's first reaction to the publication was that since the study embarrassed the Johnson and Kennedy administrations, not his, he should do nothing. However, Kissinger convinced the president that not opposing publication set a negative precedent for future secrets [ of course to prevent release of the Watergate Scandal tapes!]. Kissinger went on to brand him as “The most dangerous man in America”. The administration argued Ellsberg and Russo were guilty of a felony under the Espionage Act of 1917, because they had no authority to publish classified documents.

After failing to persuade the Times to voluntarily cease publication on June 14,  the Attorney General and President Nixon obtained a federal court injunction forcing the Times to cease publication after three articles. The newspaper appealed the injunction, and the case NewYork Times v. United States and the case came up to the Supreme Court.  

On June 18, 1971, the Washington Post began publishing its own series of articles based upon the Pentagon Papers and the Assistant U.S. Attorney General not surprisingly asked the paper to cease publication. After it refused, the government unsuccessfully sought an injunction at a U.S. district court. The government appealed that decision, and on June 26 the Supreme Court agreed to hear it jointly with the New York Times case. Fifteen other newspapers received copies of the study and began publishing it. On June 30, 1971, the Supreme Court decided, 6–3, that the government failed to meet the heavy burden of proof required for prior restraint injunction.  One of the judges wrote:

“Only a free and unrestrained press can effectively expose deception in government. And paramount among the responsibilities of a free press is the duty to prevent any part of the government from deceiving the people and sending them off to distant lands to die of foreign fevers and foreign shot and shell.” - Justice Black

Ellsberg said the documents "demonstrated unconstitutional behavior by a succession of presidents, the violation of their oath and the violation of the oath of every one of their subordinates". He added that he leaked the Papers to end what he perceived to be "a wrongful war".  He further added - “I felt that as an American citizen, as a responsible citizen, I could no longer cooperate in concealing this information from the American public. I did this clearly at my own jeopardy and I am prepared to answer to all the consequences of this decision.”

Ellsberg surrendered to the authorities in Boston and admitted that he had given the papers to the press. He was later indicted on charges of stealing and holding secret documents by a grand jury in Los Angeles. Federal District Judge Byrne declared a mistrial and dismissed all charges against Ellsberg [and Russo] on May 11, 1973, after several irregularities appeared in the government's case.

[A viewing of the Pentagon Papers documentary entitled “The most dangerous man in America” is highly recommended].

How does this compare with WikiLeaks?

WikiLeaks’ reported source, Army Pvt. Bradley Manning, having watched Iraqi police abuses, and having read of similar and worse incidents in official messages, reportedly concluded, “I was actively involved in something that I was completely against.” Rather than simply go with the flow, Manning wrote: “I want people to see the truth … because without information you cannot make informed decisions as a public,” adding that he hoped to provoke worldwide discussion, debates, and reform.  WikiLeaks released the video as well 250,000 documents of diplomatic cables, now referred to as “Cablegate”.

In contrast to Pentagon Papers, critics of WikiLeaks point out that, WikiLeaks’s huge data dump as an indiscriminate act of dissemination of data that included the names of agents and sensitive diplomatic cables endangering lives in the process. Some have even likened it to no more than rifling through the neighbour's bins and publishing their bank statements on the internet. The official line is that diplomacy depends on secrecy. It is part of statecraft going far back into history. By compromising secrecy, WikiLeaks and the media outlets that feed off its website are placing the whole system of international relations in jeopardy.

The notion that millions of Americans already had access to 250,000 confidential diplomatic files beggars belief. Many of the diplomatic cables released by the WikiLeaks confirm what journalists, and most sensible citizens, loathe — that what is said in private does not accord with what is said in public.  Diplomats regard such hypocrisy as typical, just as they accept the compromises necessary to get along with despots. It is part of their trade.

However, the history of journalism suggests that democracy has benefited from a knowledgeable and informed citizenry. Society thrives on transparency and accountability.

Politicians have, however, resisted such notions including the reporting / televising of Parliament or Senate or Congress for years. This does not mean that freedom of speech war has been won because those in the know inevitably develop alternative ways to conceal things from the public's knowledge.

However, In the digital age both journalists and citizens have many ways to discover more than ever before. It is easy for whistle-blowers to bring material to the public domain.  Based on the leaks thus far, short-term consequences might be embarrassing, though it is questionable whether they will ever be as catastrophic as so many officials and spokesmen are claiming.

At the same time, it is changing the face of journalism too. The newspaper journalists have now the responsibility to turn the leaked cables into sensible, readable news.  Contemporary journalists are still doing what their ancestors did, that is, making sense of heaps of knowledge for the wider public good.

Persecution of Assange

It is not totally unexpected then, given the red faces in the administration, Julian Assange is being pursued by the Interpol, the Swedish Sergeants, the British Police and commercial organizations like Mastercard, Paypal and even Amazon have jettisoned him. Most of the media are demanding that Julian Assange be hunted down, with some politicians calling him to be branded a terrorist and punished with a death penalty. It would not be far fetched to speculate that the various actions being pursued are at the behest of US, whether by arm-twisting its cronies or by its allies across the world.

Daniel Ellsberg commented - "If I released the Pentagon Papers today, the same rhetoric and the same calls would be made about me. I would be called not only a traitor—which I was then, which was false and slanderous—but I would be called a terrorist... Assange and Bradley Manning (Private from US army – the source of the leak) are no more terrorists than I am. Every attack now made on WikiLeaks and Julian Assange was made against me and the release of the Pentagon Papers at the time.

WikiLeaks has let the genie of transparency out of a very opaque bottle, and powerful forces in America, who thrive on secrecy, are trying desperately to stuff the genie back in.  Ironically enough, in a recent commentary in Pravda: “What WikiLeaks has done is make people understand why so many Americans are politically apathetic … After all, the evils committed by those in power can be suffocating, and the sense of powerlessness that erupts can be paralyzing, especially when … government evildoers almost always get away with their crimes. …

The American people should be outraged that their government has transformed a nation with a reputation for freedom, justice, tolerance and respect for human rights into a backwater that revels in its criminality, cover-ups, injustices and hypocrisies.”

 “The corruption of the press is part of our sad reality, and it reveals the complicity of the oligarchy.” Monsenor Romero.  Sadly, that is also true of the media situation across the world today.

The challenge is to make the truth available in a straightforward way so that the public can draw its conclusions.

“There is nothing concealed that will not be revealed, nothing hidden that will not be made known. Everything you have said in the dark will be heard in the daylight; what you have whispered in locked rooms will be proclaimed from the rooftops.” – SAAII.

As Charles Dickens put it, “There is nothing so strong ……. as the simple truth.”

As the Chinese curse goes – “May you live in interesting times”  - The Assange judicial saga has just begun!!!!!.  Meanwhile the fight for freedom of speech takes a new turn….with retaliatory cyber attacks!!! 

India v China - Crouching Tiger, Roaring (or Slowing) Dragon

Comparisons between India and China have always evoked enormous interest but in recent times this has taken the top slot for discussion in economic forums and cocktail circuit alike.

The graph below (source: EIU) shows the expected growth rates of the two Asian engines of global growth and refers to a slowing growth rate in the Chinese economy.  It is important to recognise that slowing growth rate of China’s is by design as it turns its focus on the quality of its growth (balanced economy and wider distribution of prosperity). 

World Bank expects India to eclipse China’s growth rate in 2011/12 when China is expected to grow at a rate of 8.5% as opposed to India’s 8.7%.  Obviously one has to remember that India is growing from a smaller base and the absolute growth will still be higher in China. India may also outpace China’s growth rate as it is coming off a lower base. India’s income per head would have to grow at 8% a year for 17 years to match the level China enjoys today. One year of faster growth does not, then, mean that India is somehow overtaking China.

Both countries have large population and huge income disparity. Both countries are grappling with the challenge of keeping the economic growth inclusive, though unsuccessfully with increasing economic disparity. And that’s where the similarity begins and ends.

China is essentially a manufacturing powerhouse while India has focused on services to drive economic growth.  China is much bigger (about 4x of India) and stronger with much better execution of infrastructure projects compared to India (a glaring example is - Beijing Olympic Games v New Delhi Commonwealth Games).  China has the ability to execute projects within a predictable time frame and at reasonable cost as it has less legal hassles to deal with.

It is expected that both countries will continue to grow strongly, however, the future bodes well for India. The reasons are largely demographic. China’s one-child policy, introduced in 1978 will result in the number of young Chinese (15-29-year-olds) falling sharply after 2011, depriving the country’s factories of mobile young workforce. Within a couple of years, Chinese youngsters will be outnumbered by their Indian counterparts, even though India’s population will not match China’s until about 2025. In 2020 the average age in India will be 29 versus 37 in China and 48 in Japan.

China

The focus in China is moving to quality of growth rather than pursuing quantitative growth targets.  Where does this ‘quality of growth’ likely to reflect?

§         Reduce economic and social disparity – Pursue policies to help the weakest strata of society through wage support, self employment programmes and the development of health care and social security;

§         Boosting domestic consumption as a share of overall GDP growth – increasing domestic consumption is a priority for China to further insulate its economy from external shocks; India scores well in this respect.

§         Restraining the current account surplus.  China is increasingly coming under pressure from the US to revalue the CNY.  As part of this, increased flexibility of the CNY is likely to persist, including more appreciation and further steps to boost its usage. The developments currently taking place in Hong Kong are interesting as China aims to further boost the usage of CNY for trade settlements.

§         Reducing carbon footprint- steps to deliberately restrain the output of energy polluting industries.

India

While China opened up to foreign direct investment in 1978, India opened much later, in 1991 following the balance of payments crisis. India still has massive catching up to do, particularly in infrastructure. While the level of infrastructure is clearly substandard and fails dramatically in any direct comparison with China, India has planned to invest US$ 1 trillion in infrastructure projects during the plan period 2012-17. Poor infrastructure, it is estimated, knocks off a full 2% of the GDP growth.  It remains to be seen as to how much of the spend in projects is realised in quality infrastructure and how much of it is consumed in graft and scams! 

India has remarkably positive demographics. India is also turning its focus on pursuing policies to boost agricultural productivity which, if successful, might help boost trend growth considerably. The above factors will have positive influence on growth rates.

India is about to experience some years of Chinese growth rates.  It is not yet certain whether India will become the world’s fastest-growing big economy in 2011. If it does so, it will have to be thankful to China for shifting its focus to quality of growth, more than its own effort!

The debate should be India & China

The combined GDP of the BRIC nations might exceed the US GDP before this decade is over.  Below are two interesting graphs that show the composition of world GDP over time and it is quite telling.

Interesting data points: 

1) In 1700 India, China and Europe had about the same GDPs at 20% of world GDP each;
2) From early 1800s China and India are straight down hill while the US is straight up;
3) Around 1973 India and China awoke and are starting to climb back, while US and Europe fell respectively.

A peek at the history tells us that up to the 1830's, India and China were 50 percent of the world's G.D.P., and then they missed the entire revolution of industry.  It may well be time for the Asian giants to dance!

Conclusion
Both countries are expected to enjoy strong economic growth.  To put this in the context of the world economy, there is a decisive shift in the balance of economic power from the West to the East.

So if you take a long view of this game, this journey has just begun! Enjoy the ride!!

CURRENCY WARS

Barely two years ago, even as the financial system was staring into abyss, there was an overwhelming desire from major countries to act in concert.  The fear of a global financial meltdown was too powerful a motivation that propelled the G20 towards a unanimous agreement for a coordinated policy action. This now seems like a distant memory as countries are pursuing their domestic goals as such fears have dissipated.

This is further accentuated by a divergence in economic outlook between the East & the West and the effects of policies pursued in some regions are having adverse impact on others.

In the West growth is faltering as the effects of fiscal stimulus fades. A double-dip is possible if there is a policy misstep, a further shock or a loss of confidence. With this backdrop, timing of policy tightening is the big fear for the Central Bankers’ in the West.

Basle 3 regulations imposes increased requirements for bank capital and liquidity.  The mood was “never waste a good crisis”. It seemingly assumes capital and funding will be available cheaply and in abundance to meet the new requirements.  The reality cannot be farther from this.  It will neither cheap nor will it be limitless.  Any increased cost of raising capital and liquidity by banks will be passed onto customers.  To the extend demand for capital and funding cannot be met banks will limit lending.  

Regulatory actions to appease the public now seems likely as politicians force draconian measures on banks, that will most likely lead them to shrink balance sheets and restrain lending.  This will herald a new credit crunch.  Although a global deal, the reality is the US never adopted its predecessor Basle 2 and some countries may implement different measures now. With change in political scene in the U.S. it remains to be seen whether some the measures may soften as high unemployment in the west continues to be the major political issue.

The monetary and fiscal policies pursued by the West is driving asset prices through the roof in Asia and is leading to the heightened risk of asset bubbles in most Asian markets.

Low interest rates, quantitative easing and loose fiscal policies in the west has encouraged the classic “carry trade” as money flows in search of higher returns to emerging economies. The combination of cheap money, one-way expectations, and the ability to borrow creates the environment in which asset price inflation occurs unabated  and bubbles are created, destabilising economies.

Hence in the west, interest rates will have to stay low to limit the pain. This will feed flows to the east, adding to bubbles and inflation across much of Asia. Thus, currency policy has come to centre-stage. Intervention by China and others to keep foreign exchange competitive for their exports is adding to trade tensions. Consequently, there is an increase in decibel levels around exchange controls, the fear of protectionism and talk of currency wars.

Intervening to stop a currency appreciating is easier than trying to stop one weakening. If a currency is overvalued and the markets decide to sell then it is just a matter of time before it falls. In contrast, governments and central banks can stop a currency appreciating.   

Thus it has become popular to consider exchange controls. Recently Brazil doubled the tax on bond inflows. Thailand re-introduced withholding tax for foreign investors. But if a country has been liberalising, controls may be less effective, being easier to circumvent. Also, any tax will have to be high enough to deter investors if they still think a country's prospects are good. Despite this, such controls are welcome, even if they just deter currency speculators.

In the near-term other measures may be needed. Hong Kong and Singapore have used specific measures to cap their property markets.

Some have opted for currency appreciation, although it has an adverse impact on export competitiveness. Thailand, Malaysia and Singapore, have allowed their currencies to strengthen. Although many Asian currencies are undervalued the big problem is the Chinese renminbi. Thus recent talk of currency wars needs to be kept in perspective.

An important thing to remember is that currency moves alone will not guarantee a stronger global growth. They are only part of the puzzle.  To rebalance the global economy there is a need for the west to save, the east to spend and currencies to adjust.

China, by keeping a strong economic growth, feels it is doing its bit. Hence it is unlikely to shift policy dramatically and as reiterated by them prefer gradualism. Ahead of the G20 meeting in Seoul next week it is always possible that there may be token moves  of appreciation. But may not be enough.

Across Asia, stronger currencies, higher interest rates and macro-prudential measures to curb asset prices with exchange controls to curb speculative inflows may all be needed. However, progress may be gradual. That is a big challenge.

In the west, fragile economies mean a failure to resolve the currency issue could lead to trade protectionism, led by the US. This is why global policy coordination is crucial.

Recent weeks have continued to see mixed data from around the world on the economic outlook. This has added to the air of uncertainty. In addition, uncertainty about future policy stances has increased.

What about Double-dip?

The biggest concern at the moment is - whether there will be a double-dip in the West. Across much of the emerging world, economic conditions are broadly stabilising.  In the West, however, there are enough uncertainties that could trigger a double dip:

§         an external shock e.g. sovereign default by one of the bigger euro zone countries;

§         rising food and commodity prices leading to domestic pressures;

§         a policy misstep;

§         or a loss of confidence.  

Any of these or a combination of these have the potential to derail the fragile economic recovery.  Deleveraging and the overhang of debt take time to work their way through an economy.

As the policy stimulus of the last year wears off, and as some of the Western banks that received aid face the need to roll over borrowings, it is important to be aware of downside risks.  

In the US, big corporates’ appear to be in far better shape than smaller ones, and although credit conditions for small firms appear to be past the worst, they are tough. The situation is the same in the UK. Hence, there is a need for both the Fed and the Bank of England not only to keep rates low, but to do more through quantitative easing. This is particularly so in the UK, where fiscal policy is to be tightened. The UK Comprehensive Spending Review is another reminder to the world of the challenges of unsustainable fiscal deficits facing governments in the West.

Europe has its own set of complexities. Should the European Central Bank (ECB)  tighten in response to the stronger growth in northern Europe – particularly Germany – or ease or stay accommodative to ease the pain in the south and the fringes. Any action will add to tensions. The likely concession may be that the ECB withdraw stimulus but hold off from interest rate hikes. None of this will prevent southern Europe, plus Ireland, from suffering a recession.  But in Germany, rising house prices are seen as an inflationary concern. This is the downside of a one-size-fits-all monetary policy.

Challenges faced by the emerging economies

The consequences of continued low US interest rates have taken its toll on some of the Middle East economies.  Due to the exchange rate peg to the USD in the Middle East, interest rates stayed far lower than where they needed to be for domestic reasons. This fed the boom there. Yet many emerging markets are not pegged to the USD and have chosen to intervene in their currencies.

The Asian economies have the ability to change set monetary and fiscal policy to suit domestic needs.  The lethal combination of cheap money, access to debt or ability to leverage, and one-way expectations is bad news. It fed asset bubbles in parts of the West. It now threatens to do likewise across emerging countries. Bubbles, of course, take time to develop.  The house prices in Tier 1 cities across Asia have all the hallmarks of a bubble. These countries have to act now before it is too late, as experience has shown that the bigger the bubble, the louder the thud!

Currencies do matter

This brings us the biggest topic currently in discussion – Currency Wars. China has started to allow its currency to appreciate gradually.  Yet from a domestic perspective, there may still be some unease about the possible impact on low-value-added exporters, many of which fear increased competition.  Within China, this will add to pressure for industry to move inland to take advantage of lower costs. But it still does not erase the fact that China's currency is cheaper than it should be.

China will, if not already, commence its diversification away from the dollar through its reserves management actions. They are investing increasing proportion of their new reserves into non-dollar assets.

Many countries would like to diversify into the Chinese yuan (CNY) itself. The growth of the offshore CNY (or CNH) market this summer in Hong Kong is perhaps a prelude to China paving the way for internationalisation of its currency in the future – not just for trade, but for more active use in investment and other decisions.

While it is necessary to view the issue of currency adjustment from all sides, the overwhelming view is that the Chinese currency needs to appreciate. Not only does this seem justified on domestic grounds for China, but it is also needed as part of global rebalancing. It would also take the pressure off of others who are intervening to keep their currencies competitive versus China’s.

But such arguments are not helped when the West engages in actively devaluing its currencies by pursuing policies such as “Quantitative Easing” (read printing money)! The latest is the Fed announcing a USD 600bn for QE2.

This crisis was triggered by a combination of factors: a failure to heed warning signs, particularly those associated with large deficits or cheap money; a systemic failure in the financial system itself; and an imbalanced global economy.

Restoring global balance requires a change in the behaviour of how countries operate.  The West (with the exception of Germany) needs to save more; East and Germany needs to spend more and the currencies be allowed to adjust to its NEER co-oefficient of 1 (Nominal effective exchange rate).

Germany manages to export considerably and has done so for some time because of the quality, not the price, of its goods. It should also recognised that China has made a huge contribution to the post-crisis recovery through its domestic policy boost, and through its impact on world trade.

Currency wars are a reflection of uncertain economic times. The fear is that unemployment in the West will remain stubbornly high. Protectionism is always a risk. There have been signs of this in the financial sector over the last couple of years, and the threat of trade protectionism is now resurfacing. How the currency war evolves will have a huge bearing on the global economic recovery.

QE2 is likely to raise the hackles for China and it is giving a legitimate concern for them as the impact this will be felt on the Chinese economy.

Overall, currency is needed not just to prevent a move towards a trade war, but also as part of the process of preventing bubbles across the emerging world. That is why domestic monetary policy such as appropriate interest rates, macro-prudential measures to curb domestic asset prices, and targeted exchange controls to curb speculative inflows may all be needed.

The imminent G20 summit in Seoul next week may not be the forum at which this issue will come to a head. France has put currencies, commodities and even capitalism itself, amongst the topics to be addressed in the G20 next year, when it holds the presidency.  

It remains to be seen whether this may yet blow out into an all out trade war and protectionist actions.  I hope not, as in that scenario every one would be a loser! Will wise heads agree to coordinated action in the coming weeks? Watch this space!