Why India is the only game in town

India, not China, is likely to be the main beneficiary of global flows and investments once the immediate panic of the eurozone crisis subsides.

R Jagannathan October 28, 2011 09:00:36 IST
Why India is the only game in town

We are in completely uncharted territory again. The rich world is entering a period of mad, mad, mad, mad money - a period of ultra cheap credit financed by ultra high government debts to finance growth and jobs.

A world awash with state-powered liquidity can only lead to one of the following three, or all three, outcomes: higher general inflation, higher asset prices, and massive cross-border movements of money from low-growth to high-growth regions.

Why India is the only game in town

We are in completely uncharted territory again. AFP

This is where India ought to gain in the year (or years?) ahead. I think it will. Our markets will be on fire, and our growth story will resume - but with high inflation as a corollary.

Put the following facts together - higher interest rates in India versus near-zero or low rates in the US, Europe and Japan, the rupee at Rs 50 to the dollar, and 7-8 percent growth rates, and the prospect of even higher growth in 2012-13 and beyond - and there is only one conclusion: India is where the smart money should head.

The question is not whether, but when.

Here's the underlying logic of this prophecy.

The US is the economy most likely to recover fast - though it still has a few years of painful wealth reduction to contend with. The Americans - government and people - are doing two things to correct the overconsumption of the past. One is reduce debt at the consumer level - which is why the American recovery has been so slow. People are beginning to reduce debts, as a Wall Street Journal report notes.

Says the WSJ: "Since the financial crisis erupted, millions of Americans have ditched their credit cards, accelerated mortgage payments and cut off credit lines that during the good times were used like a bottomless piggybank. Many have resorted to a practice once thought old-fashioned-delaying purchases until they have the cash."

Quoting figures from the Federal Reserve Bank of New York, the Journal says that "total household debt - through payment or default - fell by $1.1 trillion, or 8.6 percent, from mid-2008 through the first half of 2011." Little wonder the US is not seeing an early recovery.

At the government level, the Fed's near-zero rate policy has unleashed an ocean of cash that will have the net result of debasing the dollar's intrinsic value. This is America's revenge against China. America's cheap money policy will have two consequences. It will speed up the American recovery at the cost of inflation and destroy a part of the Chinese advantage and dollar surpluses through the same route.

If US consumption and growth are slowing, where should investors head once the panic over the global financial meltdown ebbs? The answer is India and other emerging markets, and not China.

China is hurting from US actions - and how. Says Ambrose Evans-Pritchard in The Telegraph: "Fed actions confronted Beijing with a Morton's Fork of ugly choices: revalue the yuan, or hang onto the mercantilist dollar peg and import a US monetary policy that is far too loose for a red-hot economy at the top of the cycle. Either choice erodes China's wage advantage. The Communist Party chose inflation."

Let's hear what Satyajit Das, a derivatives expert and author of "Traders, Guns and Money" and "Extreme Money" says on China. Das told Bloomberg in a recent interview that the primary "axiomatic law" of making a bad loan is that you have to write it off. By implication he suggests that China made bad loans to the US which brought on the financial crisis, and this means it will have to write off a big chunk of its $3.2 trillion reserves, most of it in dollars.

Says Das: "It's unsustainable. That's the lesson we should have learned from 2007. We instead shovelled everything under the carpet, and it's going to come back to haunt us. China's going to have to write off its $3 trillion."

This will happen primarily through the American flood of cheap money which will dent the value of the dollar and reduce Chinese wealth held primarily as dollar-assets. China is screaming blue murder about the way the US handled its recent debt crisis which finally resulted in a sovereign downgrade by S&P. It is also wary about US legislation to curb Chinese exports using yuan undervaluation as excuse.

The reason why China will hit a speedbreaker stems from two incongruities. First, no economy of the size of China can ever become a permanent factory to the world without destroying the world economy itself for the simple reason that the world market is not big enough for such a huge exporter to monopolise it. A Korea can be an export tiger, a Singapore can be one, and so can a Taiwan or a Thailand. But China is too big to succeed permanently by being a persistent net exporter.

Big economies like China and India have to find growth within - and this is what China has avoided doing all along. With investment rates as high as 50 percent of GDP, China's economy is a stunted domestic consumer - and the lessons of the 20th century are very, very clear on this: sooner or later the party ends.

The Soviet Union in the first half of the last century, Japan after the world war, and the Asian tigers in the last four decades built their growth stories around high investment rates and low domestic consumption. They all had to change gears and slow down.

The entry of the Chinese T-Rex in the exports game changed the rules of the world economy. It could go on only as long as the world's largest consumer was willing to offer a willing market endlessly. China tried extending this dream run by lending money to the US - just like a bartender sells booze on credit to the drunkard who's run out of cash. But when the music stops, the bar ends up with bad debts. The low-consumption-high-investment-high-exports growth model is as dated as T-Rex.

China now has to build a market within, and buy more from its trading partners. This means it has to become the engine of world growth by consuming more, not by producing more. This involves a massive shift of resources from investment to consumption - which means higher wage inflation (how else do you consume more?), and slower jobs growth as costs and lower export growth work their way through the system.

Who benefits as the Chinese growth engine sputters? According to Ernst & Young, India will grow faster than China as early as calendar 2013. That's just about a year away.

Says E&Y: "India and China are expected to be relatively less impacted among the 25 rapid growth markets (RGMs) in case of a deterioration of the eurozone debt crisis." The reason: the large size of their domestic markets.

But India will do better than China. E&Y pegs "India's real GDP growth rate to be the highest among all the RGMs starting in calendar year 2013, when the economy is expected to grow 9.5 percent, followed by China at 9 percent. In 2014, India is expected to grow at 9 percent and China at 8.6 percent."

The eurozone crisis is another trigger for this power shift towards India. The crisis has, thus far, been wrongly played out as the story of a frugal Germany trying to foil the overspending PIIGS - Portugal, Ireland, Italy, Greece, and Spain.

However, the truth is somewhere else. Within the eurozone, Germany plays the exact role that China plays in the US-China context: it is a huge exporter, which lends money to the rest of the eurozone to create an export market for its goods. Germany is the eurozone's biggest export economy and creditor.

Just as China can't be factory to the world, Germany can't be the eurozone's biggest exporter forever because someone has to pay for what it sells. This is exactly why it has no option but to bail out the PIIGS. Just as China has to write off a part of its US debts, Germany will have to do so with the PIIGS.

It is Germany's reluctance to see this reality that is at the root of the eurozone crisis. The bottomline is that Germany and German banks have to bail out Europe. If they don't, Germany will be the biggest loser in the crisis.

So let's ask ourselves again: If the eurozone and Germany have to slow down to deal with their internal debt crisis, who benefits? India and emerging markets.

A word about Japan is also worthwhile. Everyone knows that Japan has been a no-growth story for the last two decades. The worry is that Europe is now entering its own decade of slow or no growth when it grapples with its own demographic issues of an aging population, excess welfare costs, and absence of structural reforms in the labour market which has resulted in high unemployment.

But Japan will be part of the US-Europe tsunami of liquidity for its own reasons. In recent months, the yen has been strengthening against the dollar to such an extent that the Bank of Japan will periodically unleash a flood of yen to buy dollars and keep the exchange rate below 75 to the dollar. Beyond this, Japan will slow down even further as its export machine will come to a grinding halt.

The upshot: the US, Japan and Europe (not to speak of the UK and Switzerland) are collectively unleashing a flood of money that will raise inflation all around and - once the panic ends - will make investors move to the high growth zones of the world.

India and some of the smaller emerging markets will benefit from that. The only question is when. If we don't screw up on reform, we can get most of the inflows where we want them - in infrastructure, insurance, telecom, banking, and retail.

If we screw up - which we probably will, given the growing scale of our own money printing operations to fund social security schemes - we will still benefit, but will pay the price with high inflation.

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