On June 19, the Fed stated that it would gradually start reducing its purchases of US Government bonds and Mortgage backed Securities so that by June next year, QE is brought to a halt altogether. Between June and July, the rupee depreciated by 5 per cent versus the dollar and the Nifty fell 2.7 per cent. The comparable figures for China are 0 per cent (for the Yuan) and 14.9 per cent (for the Chinese stock market). The contrasting responses of the Indian and Chinese economies to a common global 'shock' -- the Fed's signal of tapering -- gives us a window into how these two economies function and why, from this admittedly biased observer's perspective, India is the market to bet on going forward. (Note: all currency and index data in this column are as of July 8, 2013.)
The Chinese dragon wobbles
Systematic overinvestment: In the years after the Lehman crisis, the Chinese Government went into overdrive to keep the economy stimulated as exports to the wounded Western economies sagged. Investment as a percentage of GDP surged from 39 per cent in 2007 to 45 per cent by 2009. Government-owned Chinese banks were at the center of this stimulus, and now loans outstanding amount to 2x GDP. Given the stories which now abound of overcapacity in China in a host of capital intensive sectors it is questionable as to how much of this investment has actually been put to productive use. That in turn raises the issue of whether the Chinese economy can actually provide the appropriate signals that a free market economy does to generate socially optimal levels of investment.
The inability to generate 'free market' signals: By distorting free market signals, from interest rates to exchange rates, the Chinese Government is exacerbating the hot money outflows triggered by the Fed's 'tapering' signal. Whilst other EMs, such as India and Brazil, have seen their currencies slide by about a fifth in response to tapering, because their exchange rates have depreciated, the quantum of hot money outflows has moderated (as the weaker exchange rate makes the economy more attractive). In contrast, because the yuan is pegged to the dollar, the quantum of outflows from China has been such that it has triggered a system-wide shortage of liquidity. Whilst the Chinese Government is claiming that this is a controlled crisis it is not obvious as to how the Government can control the crisis. For example, if the Chinese Government, the world's biggest non-American holder of US Government bonds, sells US Treasuries to reverse the hot money flows, the fall in the price of US Government bonds, coinciding as it does with the Fed's tapering, will dramatically reduce the value of China's $3 trillion of forex reserves. The muzzling of the press: If you were to believe the steady stream of op-ed pieces produced for newspapers around the world by card-carrying members of the Communist Party (including Economists working for brokerages), the ongoing downturn/crisis is being monitored by the Chinese Premier who, when he deems fit, will step in to save the day and initiate structural reform. In that context, I find it hard to understand why foreign journalists who have worked in China have long complained that their phone calls are tapped and their movements followed. Even stranger is the early July report in the Financial Times about how the Chinese Government wants the press -- national and international -- to say that the economic situation is currently under control. If the truth is so self-evident, why does it have to be dictated to the press?
Why India is not China and why that is good for India
Rational levels of investment:Other than the FY04-09 period, India has never seen a sustained surge in capital investment which is not surprising given India has the highest cost of capital outside sub-Saharan Africa. However, it is not as if India's levels of capital investment are low -- even in the last three years, India's investment/GDP ratio has been at 32 per cent in FY11, 31 per cent in FY12 and 30 per cent in FY13. To put these figures into context, Japan in its heyday of investment -- i.e. in the 1960s -- clocked up figures in the region of 30-35 per cent.