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Sunday, July 01, 2012

A tale of two economies and two currencies

by Percy S. Mistry, in the Financial Express.

A fortnight's visit to China in April, to understand better the progress it has made with public and corporate governance, was startling in its revelations. Having been to China years earlier, to advise the State Commission on Reform of the Economic System (Ti-Gai-Wei) in 1988-1994, it was amazing to realise in retrospect that, over the last two decades, much of the advice given then, had actually been taken and applied.

That was in sharp contrast to experience in India. The advice provided there -- e.g. through the Mistry Report and innumerable interactions with MoF and RBI over the years - was applauded by the private financial system for which it was intended (less so by public financial institutions which need to be privatised). But such advice was taken and implemented by MoF and RBI only grudgingly and at the margins of insignificance in terms of impact.

What was most strikingly apparent during the visit was the resolution and purposefulness with which China and its institutions are governed. That applies to public institutions and agencies at various levels of central, provincial and municipal governance, state-owned enterprises (SOEs), and the rapidly growing number of private Chinese companies; whether domestically owned or joint ventures with multinationals involving both public and private partners. It was no surprise to confirm that China is much better governed at central, state and municipal levels than India; where public governance is deteriorating by the day. But, that Chinese companies now seem better and more responsibly governed than their Indian counterparts came as a rude shock!

The impression of corporate and public governance in China now being well ahead of India (and a lot of what now mistakenly passes for the 'developed world' as well) emerges despite the occurrence of the Bo Xi Lai/Gu Kai Lai affairs that were unfolding at the time. One almost got the sense of careful orchestration and stage management of these 'affairs' by two competing factions for influence within the ruling Politburo and its supporting Standing Committee as the future leadership/management team that takes over in October was being put in place.

To be sure the case is invariably made that such resolution and purpose is usually (or can only be) exemplified by a totalitarian state like China, rather than a democratic state like India. After all, China is unhindered by the cumbersome processes of democracy. It has yet to provide many of the personal and human freedoms/rights provided in much of the world and in large emerging countries like India. Yet, despite the correctness of this perception, one cannot help but feel that blaming the Opposition, parliamentary process and democracy, as GoI invariably does routinely (to explain its incompetence and loss of nerve for losing the plot on macroeconomic management), stretches the excuse a bit too far.

One wondered after the China visit whether India is the world's largest democracy as it always claims, or whether it is the world's largest abuse of democracy. Abuse: because of the make-up and mind-set of its parliamentarians and political class, and because of the characteristics of the poor and destitute electorate that engenders, propagates and perpetuates at each election such a dysfunctional polity with such destructively counterproductive tendencies, habits and behaviors.

China still has to cross the Rubicon of political democratisation and full extension of human rights taken for granted elsewhere. Until it does so, the world is right to be sceptical (if not perturbed) about its inexorable ascendancy into a position of global hegemonic power. But one gets the sense (almost with certainty) that China -- in its own imitable way and in its own time unhurried and unbowed by external pressures -- will develop a 'democratic' or 'quasi-democratic' model that suits its purpose and characteristics.

Learning hard lessons from Russia, where it is clear in retrospect that economic and political liberalisation were carried out in the wrong sequence and in the wrong manner, China will do so without destabilising itself in the way that Russia did. The Chinese leadership has no desire to repeat what happened in Russia - i.e. the emergence, after a period of total confusion during the Yeltsin era, of a KGB-controlled/inspired kleptocracy under Putin's leadership. That kleptocracy has now replaced the econo-political apparatus (and power) of the former communist state. Russia's situation has evolved in a manner that, if one thinks about carefully, has some disturbing indirect parallels with 'liberalization' in the Indian case.

The Indian public-private kleptocracy (a peculiarly Indian type of PPP) that has emerged in India post-1991 reforms, has not involved the membership of a repressive state intelligence apparatus, as in Russia. India has never had an intelligence apparatus worthy of the name or of any note. The only threat it poses (hopefully but not assuredly) is to Pakistan. That too is an ineffectual, minuscule threat given how poorly Indian intelligence (if that is not an oxymoron) is organised, funded and conducted. But, the Indian kleptocracy that has emerged after 1991 has certainly involved core relationships between established Indian political dynasties and large corporate houses (especially newer ones) that emerged after the Emergency.

Those corrosive relationships have become deep-rooted and taken hold in various avatars at central and state levels. At each of these levels they involve different business houses and different political dynasties; some of which have become organised medium-scale businesses in their own right, specialising in unique forms of rent extraction.

Taken together, they have resulted in Indian corruption becoming an organised mega-industry post-1972, from the localised handloom cottage industry that it was in the 1952-72 era. That mega-industry has its own codes, institutions, intermediaries, processes and lexicon (peti and khokha). It has resulted in a unique form of crony capitalism, favouring those business houses in India that originated mahacorruption and have since become its principal beneficiaries.

Indeed, such corruption has become embedded in the Indian economic system. It is so essential to the 'functioning' of its post-1991 quasi-market, improperly liberalised economy -- where the grant of licenses and inexplicable asymmetries in regulation play such a key role in introducing anti-market distortions and subsequent market failures -- that one now sees the visible damage being done to the functioning of the economy as ham-handed attempts are made to root it out.

One could make a good case that, in part, the slowing down of the Indian economy, and the rapid decline in corporate investment following the 2G-scam, is the result not only of macro-economic mismanagement and poor judgement by the FM/MoF, but also because corruption can no longer be relied upon by corporate houses to get things done in the way they once were. If the people (politicians, bureaucrats, regulators and police) a corporate house 'buys' -- through corruption in the political and bureaucratic systems, to retain its strategic and tactical advantages over its competitors in its main markets - can no longer be relied upon to deliver the goods, then what is the point of taking risks that simply cannot be managed?

Corruption is not only an Indian phenomenon. It occurs in China; possibly to a greater extent. Its totalitarian regime has not expunged it, although it pretends to have. Petty corruption at lower levels of officialdom is neither as pervasive nor as predatory as it is in India. But at the upper reaches it certainly seems omnipresent. Indeed most Chinese (in the public and private sectors) suspect that members of the Politburo and Standing Committee are engaged in concealed corruption on a scale that might make Indian corruption seem amateurish.

Corruption in China arises (and is fuelled) from pervasive state ownership of large public manufacturing, exporting, service and transport enterprises, of public construction companies that have benefitted from massive public spending on infrastructure (of which 10-15% of all contracts is allegedly accounted for by kick-backs), from public ownership of the banking system, and over $3 trillion in reserves that are increasing by 10% annually. On that amount of reserves, over $1-2 billion a day can easily be salted away via accounting errors and omissions and through improperly accounted-for effects of supposed daily exchange rate fluctuations or mark-to-market losses on sovereign bond purchases.

Rumored public estimates of proceeds transferred abroad by the top leadership in China invariably range from $100-150 billion over the last five years. If one extrapolates from that figure the proceeds of corruption at lower levels of governance (especially at municipal levels where the granting of land leases is the major source of leakage), figures of around $1 trillion over the last 5-10 years do not appear as outlandish as they might.

Certainly the ostentatious wealth displayed by Chinese political and business families abroad lends substance and credence to these estimates, in the same way that the lavish life-styles and expenditures of expatriate Russians in London give credence to its own kleptocratic state.

Yet, despite the functioning of both the Chinese and Indian economies being profoundly affected by corruption (of different sorts) the growth and resilience of the Chinese economy does not appear to have been as adversely affected by it as has been the case in India. Instead, quite the reverse! The Chinese economy is displaying extraordinary resilience in the face of externally generated headwinds that are slowing down its dynamic export machine. All the talk about hard and soft landings for the Chinese economy seem moot after the April visit. China has managed to orchestrate a reasonably soft landing with growth slowing to < 8% levels with China switching gradually to a domestic-consumption led rather than export-led growth strategy.

But it takes time for a super-tanker the size of China with its $6-7 trillion economy to change course and reverse gears. The single most effective instrument to induce and accelerate such a change - i.e. opening its capital account and floating its currency to result in more rapid market-driven appreciation of the Chinese Yuan (CNY) or Renminbi - has been eschewed as a policy tool to bring about more rapid switching.

Over the last two years the strength and resilience of the Chinese economy, in the face of the worst global economic and financial crises the world has experienced in nearly a century, have been remarkable, as reflected in its continued build-up of reserves. These now amount to over $3.2 trillion -- despite the impact of the post-Lehman financial crash of 2008 and the rapid deterioration in the economic circumstances of its two largest export markets: i.e. the US and EU. This massive build-up of surplus capital, which it seems unable to use for its own needs, has led China to open its currency market through administrative measures.

The April visit suggested that China is deeply concerned about using exchange rate adjustment as a policy tool, fearing that doing so would destabilise its labour and wage markets. After all the key Chinese imperative to ensure its success as an exporting power has been to manage (manipulate?) its exchange and wage rates so as to import jobs from, and export goods to, the rest of the world for as long as the rest of the world permitted China to get away with it.

And, so far, the rest of the world has done that. In the process, China has built up gargantuan reserves which are likely to grow at 10-20% annually even if its trade account comes into balance. Such unprecedented, large global reserves and the way in which they are managed -- perversely reflecting the limitations and dysfunctionality of China's state-owned financial system -- now pose an economic and political threat to the rest of the world. A continued build up reserves at the same rate as before would be intolerable.

Consequently, China has arrived at the stage where it has no option but to liberalise its currency market and export capital a little more easily in one way or another. It is choosing to do so through administrative measures such as bilateral CNY swaps rather than via traditional open market measures. These measures lead to a number of interesting interim possibilities before full and traditional capital and currency market liberalisation is undertaken.

Until this month, China had focused CNY swaps in local currencies of major emerging market trading partners, and not with developed market partners such as the US and EU. But, a couple of weeks ago, China announced that it would do CNY:JPY swaps with Japan, a developed and large trading partner. Partial capital account liberalisation is also being attempted through gradual opening of the CNY (dim-sum) bond-market in Hong Kong. That market has taken off faster than the Chinese authorities seem comfortable with.

What are the implications of the latest Chinese measure to introduce CNY:JPY swaps? They are not likely to be significant immediately as few internationally traded contracts are denominated in either CNY or JPY.The same arrangement for CNY:USD or CNY:EUR would have been more globally significant and led to CNY internationalisation more quickly.

However, the question raises some interesting possibilities where China-Japan, China-Asean and Japan-Asean trade is concerned. Triangulation on trade and trade-related long term investment among these three large trading blocs/players (more if one includes Korea and Taiwan) holds out interesting possibilities for the growth of Asian markets in regional currency trades and derivative hedges.

Also, Japanese multinationals are major investors in Chinese export production, which is linked to their own export production for global markets, in innumerable and intricate ways. If the CNY:JPY arrangements stabilise the influence of currency fluctuations on such bilateral and pass-through trade then the CNY will benefit and internationalise faster.

How rapidly the CNY becomes an international currency like the USD depends initially on how the Asian/Asean markets perceive movements in the CNY and JPY in the short, medium and long term. As a long-term hold, the CNY seems more attractive than the JPY. The Japanese yen is intrinsically a weak currency issued by a very heavily indebted country that is dying slowly demographically, and is a waning global economic power in relative terms. The opposite is the case for China and the CNY. But long-term currency holds are for investors not traders. And China is denying the world full market access to probably the most significant currency numeraire for long-term investment over the next 30 years.

In the short and medium term, it is difficult to predict what will happen to the value of the CNY relative to other currencies (especially USD, EUR and JPY) because of administrative intervention. If currency markets were left alone the CNY would appreciate significantly against all three; despite the arguments being made that the CNY has found its real effective equilibrium rate and does not need appreciation.

Anyone who believes that does not understand currency markets. Right now the JPY is an international currency that seems to be overvalued, taking Japan's underlying fundamentals and economic prospects into account. Yet it is widely held in global central bank reserves though used to a more limited extent than should be the case for Japan's trade contracts with its various trading partners which, unfortunately, are still denominated more in USD than in JPY.

The Chinese authorities could of course internationalise the CNY faster and more efficiently by opening up their capital markets in a phased fashion; making the CNY at first (up to 2016) a partially and then (2017 and beyond) a fully convertible currency. They are doing it instead in a clumsy, administratively burdensome fashion in the belief that going that route will result in more 'control' over the pace of internationalization.

A key concern is that this administrative approach (akin to the route that Indian bureaucrats invariably prefer in the bizarre belief that their control results in better outcomes, despite evidence to the contrary) will lead to a series of significant anomalies. They will create distortions of the kind that usually arise with administrative intervention and an aversion to letting markets do what they do best -- i.e. price discovery. Those anomalies and distortions could damage the world at a time when the global economy is still quite fragile.

Yet the CNY is heading towards becoming a global currency, perhaps second in importance to the USD over the next 20 years and even more important than the USD thereafter. That process is as inexorable as it is inevitable. Indeed that outcome has been delayed too long. For the world's second largest economy, and its second largest trading economy, to continue having a closed capital account, and a non-convertible currency with a fiat-determined price, is an intolerable eccentricity that has damaged the world and provides an unfair structural advantage to China. Oddly, China has been permitted by the world trading community to play by its own rules to its own advantage (and to the detriment of the rest of the world) for too long by asserting the right to control the most significant price affecting its trade with the rest of the world i.e. the price of its own currency.

In an open economy global trading model, world trading patterns, and consequently global investment patterns, as well as global production location and market share, are all supposed to be determined/equilibrated (i.e. with trade, current and capital account surpluses and deficits -- or imbalances -- being sorted out) by markets and not by administrative interventions; with market forces being left to adjust all prices, including currency prices, that affect global trade.

When China respects the notion that market prices should determine the prices of all inputs and outputs that make up the cost of its production, but then asserts the right to control a key price (i.e. the price of its currency), which in turn affects the price of imports from China by other countries, it violates a fundamental precept of the open economy global trading model. The sustained violation of that principle for two decades has in large part been responsible for bringing the global economy to its knees, while allowing China to accumulate extreme reserve surpluses that now pose a fundamental political and economic threat to the rest of the world.

In the post-Bretton Woods world, China is the most egregiously anomalous case of a country (misusing the developing country argument) becoming as significant as it is in the world economy without being obliged to open its capital account and make its currency convertible. All the other rising economies in the 1960s and 1970s (Germany, Japan and several smaller European economies), 1980s and 1990s (Korea, Singapore, Taiwan, some Asean and most Latin American economies) made their currencies convertible and opened their capital accounts.

They did not suffer any of the kind of damage that China claims it would suffer if it did the same. Essentially what China seems to be asserting through its currency management policy is the divine, inalienable right to import jobs from, and export manufactures to, the rest of the world indefinitely by manipulating the price of its currency. That cannot be permitted to continue given the devastating impact such a policy has had on the rest of the world. The CNY must be internationalised sooner rather than later in a market-oriented manner.

If that is so for the CNY then what is the future of the INR? As the next largest emerging global economy after China shouldn't the INR follow a similar trajectory? Until last year many astute commentators envisaged the INR taking its own place in the world, following the CNY as an increasingly significant trading currency. They thought at first that the INR would become a littoral/regional (2015-2020) trading currency and later (2020 onwards) a globally significant trading and reserve currency.

But the dreadful mess that the UPA-2 coalition and central government have made of the Indian economy over the last 24 months, and the shattering of confidence in India on the part of both domestic and foreign investors, has been an object lesson in confirming that India seems incapable of coping with success for any length of time. India seems instead to be more inured at coping with prolonged failure. It seems to know how to cope with that better attitudinally.

Therefore the INR is unlikely to emulate the CNY as a global trading or reserve currency for quite some time yet. Instead the INR is now seen as a temporally if not structurally weak currency that can barely hold its own value, leave alone become a serious trading or reserve currency in the foreseeable future.

Contrary to assertions by the FM, PM, RBI and UPA-2 leaders, none of the wounds that India is suffering from, and have inflicted on the INR, have much to do with negative global influences or Europe. At most those factors may have had only a marginal impact on growth and inward investment. The damage done has been mostly self-inflicted.

The really devastating impact of MoF/FM misjudgement and malfeasance has been on overall investment and in not relieving mounting supply-side constraints sooner. The FM in particular has played a leading role in convincing investors in India and around the world that India is no longer worth investing in. That impression has been reinforced by aggressive but injudicious posturing by the FM/MoF, goaded by their tax hawks, about the 'losses' India suffers from its DTAs with supposed tax-havens (such as Mauritius) and its contradictory if not absurd positions on applying GAAR retrospectively; and attracting the derision of the world at large.

Immense damage has been caused by this failure of judgement, obtuseness and obstinacy in the vindictive vendetta that has been conducted against Vodafone in particular, and foreign firms in general, on the capital gains tax issue. No mention is made at all about the tax gains (direct and indirect) as well as employment gains that have been derived from inward FDI and about the losses that would be incurred if such FDI flows ceased - as they now seem to be doing.

If GoI/MoF were so concerned about revenue losses to the exchequer, from FDI that escapes capital gains taxation, the PM and FM would have done better to look more closely at their neighbours in parliament and state legislatures. They could apply more vigorously and impartially laws on assets disproportionate to income. That approach would provide them with a triple-whammy. It would deal holistically with the phenomena of black money, corruption and tax evasion/avoidance, all at the same time. The revenue raising possibilities from that source would make Vodafone look trivial by comparison.

Had GoI/MoF done that they would have drawn more effective public attention to the generation of black money which official India is exerting every sinew to evade doing in the most clumsy fashion, knowing that to take serious action on that issue would be to indict virtually the entire political class in the country and bring in to the black money net most corporate leaders as well.

The egregious and severely damaging misjudgements on the tax issue, and the mismanagement of the Indian macro- economy since the change of leadership of the Finance Ministry in 2009, have introduced the kind of uncertainty into investment decisions that now make banana-republics and places like Rwanda and Congo seem almost sagacious in comparison with India.

How could this have happened? The answers seem obvious in retrospect. The political and bureaucratic leadership of the post-2009 Finance Ministry appears to have been childishly naive and clueless about how finance or economics actually work. All of India, and corporate sycophants dependent on the state-owned banking system for liquidity and long-term loan largesse, have been worshipping a false god -- as we seem to do relentlessly. Look at how we worship supposed corporate titans with feet of clay. It would be funny if it were not so tragic that one needs to screw up a country before one becomes an eligible candidate for that country's Presidency!!

Compounding the problem of gross malfeasance in short-selling India as an attractive long-term investment destination, GoI's top leadership appears to have as little clue about what leadership or good governance is all about. The other big beasts in the Cabinet (i.e. the Ministers of Home, Defence and External Affairs) all seem to be in the wrong jobs that play to their weaknesses rather than their strengths. As a consequence, GoI and India have lost all credibility at home and abroad. The impression they convey is of gross incompetence and surprising insouciance.

Being clueless seems widespread and endemic. It goes beyond characterising what now seems to be a sorry excuse for a crippled government that needs to be put out of its misery. At the top political leadership level in the UPA, Madam Sonia and Master Rahul Gandhi also appear to have no clue about anything, if the results of recent state elections are to be judged dispassionately.

They and their sycophants in the leadership of the Congress Party (simply a monarchy in drag) still believe in an India that should be managed politically by hand-outs, subsidies and populist sops that break the Union and state budgets. They do not yet believe in sustainable long-term development generating growth of >8% for the next few decades based on productive public and private investment of between 30-35% of GDP. Nor do they believe in reducing poverty through productive and meaningful private employment generation rather than on NREGA type income subsidies and hand-outs. They would rather that, at election time, the poor voted for them out of gratitude for hand-outs, than because employment was generated by private companies investing in the economy that could not be visibly attributed directly to them.

Their attitudes and supposed 'leadership' make proper macro-economic management by anyone almost impossible. They still do not believe in continuing with structural reforms that widen the distance between the polity and the economy, thus limiting the amount of damage the former can do to the latter through negligence, false ideologies about how the poor can be helped, populism and plain economic ignorance.

They do not believe that significant reforms are needed, along with an urgent programme of ambitious privatisation, beginning with Air India, extending to state-owned companies in telecoms, transport, minerals, natural resources, manufacturing, services (such as transport and tourism) and most of all privatising the state-owned financial system. It is through the SOBs that many of the weaknesses of the Indian economy are aggravated and exacerbated. The SOBs are also the conduit for exercising the kind of political influence that results in the kleptocratic quasi-market economy that has emerged in India post-1991; through an inimical but pervasive public-private partnership (PPP) between political dynasties and large business houses.

Taken together, the top leaderships in MoF, GoI and UPA -- individually and collectively -- are the PROBLEM, not the solution. Once that diagnosis is accepted, a cure can be found. Until then one can but hope that the next election brings more succour to India than is the case now.

What needs to be done urgently is to revive domestic and foreign investment and growth in the Indian economy. Given the rapidly deteriorating state of public finances, a widening current account deficit, a collapsing Indian rupee, and the entrenchment of structural inflation, which it will take prolonged tightness of monetary policy to control, GoI's room for manoeuvre is limited. But there are options to be exercised. The first is to revive confidence in government on the part of domestic and foreign investors. For that to happen, the MoF's obsession with imaginary tax losses has to be dropped in favour of more investor-friendly policies that attract inward foreign investment in large amounts. If that happens, it will spur domestic investment concomitantly.

A start can be made by putting the Insurance and Pensions Bills immediately before parliament with GoI doing whatever it must with its allies and opposition parties to get these passed. If the cap on FDI in insurance were lifted from 26% to 49% in the next few months it would result in a significant inflow of FDI. That would spill over through linkages into private corporate capital investment as well as investment in infrastructure. Both are needed urgently to relieve the supply-side bottlenecks that have been built up in the economy over the years and which are now responsible for structural inflation becoming embedded.

Similarly, the counterproductive debates and hold-ups on limiting FDI in retail (single and multi-brand) and on moving more urgently with privatising Air-India need to be ended. No national interest is served by imposing constraints and limits in any of these areas.

As far as Air India is concerned, it is now obvious to every Indian that continued public investment in that hopeless airline is a waste of public money. It benefits no one, least of all the poor, to run a state-owned airline simply for the personal convenience of the political class.

The same could be said for BSNL, MTNL, Coal India and all the SOBs. GoI ought to commit itself to privatising all SOEs by no later than 2025 in a phased manner. State governments need to follow suit rapidly in privatising the plethora of inefficient state-level public enterprises they own as well.

Those steps might indicate to the world that GoI/MoF is serious about undoing the immense damage it has done to India and its image as an investment destination since 2009. Unless that is done, with an ambitious far-reaching reform and privatisation agenda which convinces domestic and global investors that GoI really does mean business, then the Indian economy will continue to languish with prolonged sub-par performance. If that happens fiscal performance will worsen, inflation will remain too high, and growth will remain too low.

A financial crisis will ensue. The INR will continue to decline in value internally through high inflation, and externally against other currencies, putting at risk and perhaps even reversing all the achievements of the 1991 reforms.

It would be a sad legacy for a beleaguered and exhausted PM to leave, with the best of intentions but the worst of performance (and corruption) records, as he exits a stage he has played a lead role on for nearly a decade.


  1. Love this "thinking out loud" type of article. Because, it gives us laymen an idea of how economists may be thinking of the various pieces we think of in isolation - exchange rate, export sector, China dominance, etc. How they might be looking at all the different pieces to understand where the global economic machine might transition to next.

    Its interesting to note that Mr. Mistry thinks that INR may have a structural weakness problem. Which should be a structural tailwind for the export sector, but then, global demand is only going to decrease, and there are plenty other countries wanting to export their way into prosperity like China. So, how does this deadlock break, or, does it mean that INR level needs to go even lower - is this a negative spiral of competitive devaluation? Is this also a delayed impact of QE?

    Why aren't policy makers thinking of domestic demand instead, when OECD demand isn't going to be high? There is enough domestic capital in the country. Wouldn't India be a fundamental growth story if it did not have to rely on exports, outsourcing, but instead designed good policies for domestic capital? How long can China/India rely on OECD demand to fund their growth. Aren't we closer to the end of that trend?

    I wish that more Indian economists in the public domain were eager to indulge the blogosphere by thinking out loud on such issues. Atleast, the younger ones should have more time on their hands!


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