One way traffic, primarily

A book on India and China that concentrates on financial sector reform in the two countries tends to be a bit one-sided since most recognize India’s the leader here, and is therefore certain to fail to deliver on its promise of ‘learning from each other’. So there’s nothing in this compilation of a seminar organised by the IMF, the China Society for Finance and Banking, and the Stanford Centre for International Development, which deals with, for instance, China’s stupendous success in the manufacturing sector or in creating infrastructure (did it follow industrial growth or did it lead it?).

But while the seminar didn’t focus on this, it has other valuable learnings. There is no doubt Chinese growth has consumed a lot more capital than the Indian one, and much of this capital has been vastly subsidised by the state, but one aspect brought out well in a paper by IMF staffers Steven Dunaway and Annalisa Fedelino is the nature of the Chinese deficit. One, fiscal policy in China, unlike in India so far, has been guided by a medium-term focus on fiscal consolidation aimed at making room for future expenditures such as those on, for instance, writing off the banking sector’s bad debts. While the emphasis today is on fiscal consolidation, in the aftermath of the Asian financial crisis, the emphasis was on running a deficit to stimulate demand.

For those who’re convinced India’s done a great job in avoiding any major financial crisis while liberalising gradually, ICICI Bank Executive Director Nachiket Mor’s paper (along with R Chandrasekar and Diviya Wahi) is an eye-opener. Mor argues that the reforms of the 1990s failed to address basic issues while removing some of the safeguards of the earlier system and so it is sheer luck we’re not in the middle of a major banking crisis. Mor shows, through a case study on the Indian steel industry, that most banks still lack the competence to evaluate projects (hence the huge overcapacity that was financed in the 1990s). The so-called health of the banking system, he and his co-authors aver, is largely due to treasury profits booked due to the sharp decline in interest rates. Mere privatisation of banks, is the conclusion, is not enough to fix the problem.

Other papers on China’s banking system record the sharp decline in NPAs due to the massive capital injection by the government, but the banks remain quite weak, and will remain so until the state stops guiding investment/loan decisions. This, of course, was also the reason why the government of China allowed strategic foreign investors to get into the sector—in 2005 alone, total foreign investment in China’s banking sector exceeded $10 bn. The Moody’s index of banking strength in 2004 put India at 24.2 in December 2004 versus China’s 10 and the US’ 77 in that year.

A convincing case is made out for why China will not suffer if it goes in for more exchange rate flexibility while pointing out at the same time that the world is divided on whether the renminbi is undervalued. Domestic banks, for instance, hardly have any great exposure to currency risk. The risk of exports faltering, similarly, is not seen as a major factor considering that more than half of Chinese exports are the final assembly of products made elsewhere—so these will get cheaper with an appreciating renminbi. One study quoted estimates a 10 per cent appreciation of the renminbi will increase the cost of China’s exports to the US by only 2 per cent.

RBI Deputy Governor Rakesh Mohan’s “apparent puzzles for contemporary monetary policy”— how can you have low consumer inflation in the presence of abundant liquidity and increasing asset prices, to cite one of them— remain as valid today as they were a year ago, when he delivered his dinner address at the seminar. One reason for the global decline in inflation levels, Mohan argues, apart from the productivity-linked decline in costs and the China factor, is that fiscal deficits in emerging market economies are less than half their levels in the 1970s and 1980s and that this alone has reduced inflation levels in these countries by 5-15 percentage points. Greater labour migration is also offered as an explanation for this, and the greater share of non-tradeables (service sector) in GDP is suggested as a reason for why, despite currency depreciations, inflation levels have remained low. This paper alone makes the book worth reading, though it must be said, this is not the only one.