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What the crisis in China tells us about India

The Indian economy is more flexible and hence more capable of progressing in the face of a turbulent global economy

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?

Deficient macroeconomic data:On July 4, after six months of keeping its manufacturing PMI a whisker above the 50 mark which separates growth from contraction, China finally threw in the towel and suspended the publication of sector-specific manufacturing data. When a country stops publishing key macro data, I don't quite get the feeling that its leadership is in charge of the crisis. Interestingly, in May, power consumption in China increased by 1.9 per cent y-o-y, the slowest growth since May 2009.

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.

A functioning free market:Other than the Government bond market (which is distorted by the Government forcing banks and insurers to buy Government bonds) and public food distribution system (where prices are set by the Government), most other prices in the Indian economy now float based on demand-supply levels. This helps because free-market-driven competition helps the Indian consumer get a good deal; for example, competitively-priced, high-quality cars available at $10,000, return air fares to Singapore well below US$300, and a range of FMCG consumables at prices well below US$1. The fact that the average Indian avails of these bargains and pumps up consumption is NOT a sign of economic malaise - it is a sign of a functioning economy.

The benefits of a free press:India's free press combined with the Right to Information Act has given further teeth to its democracy. Gone are the days where, Chinese style, the people who rule Delhi could hand over large arms and infra contracts to their friends and family. Whilst this has slowed down capital formation, it has also meant that resource allocation and infra construction has become more efficient in India. To give a pertinent example -- when I visited Uttarakhand two months ago, I heard numerous entrepreneurs complaining about how due to obstruction from the Ministry of Environment in Delhi, the state was not utilising its potential for hydro power generation. To belatedly give this much-abused Ministry some credit, had it signed off on more hydro-electric projects, the devastation caused by the recent cloudburst in the state would have been even more pronounced.

The slide of the 'connected company':India's real triumph over the past five years has been to push back corporates whose core competitive advantage is political connectivity. Our P75 Index (of the 75 most-connected companies) has now underperformed the BSE500 by over 50 per cent over the past two years. In contrast, our 'Good and Clean' portfolios (which are the opposite of the P75) have outperformed the BSE500 by 20 per cent over the same period. As political power fractures in India -- away from the Cabinet in Delhi and towards the state capitals, powerful economic regulators and courts -- corporates can no longer depend on their political sponsors to work the system in their favour. Whilst this lowers economic growth in the short run, in the long run, it should lead to higher growth.
To be sure, India has a long way to go -- any country where over 300 million people struggle to get food to survive cannot claim otherwise. But when it comes to the India vs China economic comparison, the Indian economy is more flexible and hence more capable of progressing in the face of a turbulent global economy. It is therefore not surprising that over 1 year, 3 years, 5 years and 10 years, the Sensex has outperformed its Chinese counterpart by 6.5 per cent, 1.8 per cent, 4.6 per cent, and 2.6 per cent, respectively (and that too in dollar adjusted terms).