How UPA turned NDA’s economic growth into shambles

upaVivek Kaul 

In both love and war, it makes sense to hit where it hurts the most.
The war for the next Lok Sabha elections is currently on. And there is no love lost between the two main parties, the Congress and the Bhartiya Janata Party (BJP).
The BJP today hit out at the economic performance of the Congress led United Progressive Alliance government, over the last ten years.
Politically, this makes immense sense given the bad state the economy is in currently. Economic growth as measured by the growth in gross domestic product (GDP) is down to less than 5%. The GDP grew by 4.7% between October and December 2013.
The rate of inflation as measured by the consumer price index had been greater than 10% for a while and has only recently come below 10%. The consumer price inflation for February 2014 came in at 8.1%.
Industrial activity as measured by the index of industrial production (IIP) was flat in January 2014, after falling for a while. The overall index grew by just 0.1% during January 2014. Manufacturing which forms a little over 75% of the index fell by 0.7% during January 2014, in comparison to January 2013. This primarily is on account of the slowdown in consumer demand.
People have been going slow on spending money because of high inflation. This has led to a scenario where they have had to spend more money on meeting daily expenditure. Retail inflation in general and food inflation in particular has been greater than 10% over the last few years, and has only recently started to come down. Given this, people have been postponing all other expenditure and that has had an impact on economic growth. Anyone, with a basic understanding of economics knows that one man’s spending is another man’s income, at the end of the day. When consumers are going slow on purchasing goods, it makes no sense for businesses to manufacture them. When we look at the IIP from the use based point of view it tells us that consumer durables (fridges, ACs, televisions,computers, cars etc) are down by 8.3% in comparison to January 2013. The overall consumer goods sector is down by 0.6%.
This slowdown in consumer demand was also reflected in the gross domestic product(GDP) numbers from the expenditure point of view. Between October and December 2013, the personal final consumption expenditure(PFCE) rose by just 2.6% to Rs 9,81,463 crore in comparison to September to December 2012. In comparison, during the period October to December 2012, the PFCE had grown by 5.1%.
The lack of demand along with a host of other reasons also means that the investment climate for businesses is not really great. This is reflected in the lack of capital goods growth, which was down by 4.2% during January 2014. If one goes beyond this theoretical constructs and looks at real numbers like car sales, they also tell us that the Indian economy is not in a good shape as of now. Smriti Irani,
a television actress turned BJP politician summarized the situation very well, when she said “Today, as the Congress-led UPA leaves office, it leaves behind a legacy of an economy which has been mismanaged.” Yashwant Sinha, former finance minister and senior BJP leader, went a step ahead and said that “an investment crisis” and “a crisis of confidence in the economy”. The Congress party is likely to react to this attack by the BJP by following the conventional line that it has always followed. The party is most likely to say that India has done much better under the UPA than the BJP led National Democratic Alliance (NDA).
Prima facie, there is nothing wrong with the argument. Between 1998-99 and 2003-04, when NDA was in power, the average GDP growth rate was at 6% per year. Between 2004-05 and 2012-2013, when the UPA has been in power the average rate of growth has been at 7.9% per year. If one takes into account, the GDP growth rate for this financial year i.e. 2013-2014, this rate of growth will be lower than 7.9%,
but still higher than the 6% per year achieved during NDA rule.
But it is worth remembering here that the economy is not like a James Bond movie, where the storyline of one movie has very little connection with the storyline of the next. An economy is continuous in that sense.
The rate of economic growth in 2003, a few months before the UPA came to power, was at 7.9%. The rate of inflation was at 3.8%. In fact, the rate of inflation during the entire NDA term averaged at 4.8%, whereas during the first nine years of UPA regime between 2004-2005 and 2012-2013, it has averaged at 6.7%.
If we take the rate of inflation during this financial year into account the number is bound to be higher. The index of industrial product, a measure of the industrial activity in the country,
was growing at 8% in early 2004. Currently it is more or less flat.
The fiscal deficit for the year 2003-2004
came in at 4.5% of the GDP. The fiscal deficit for the year 2012-2013 was at 4.9% of the GDP. The fiscal deficit for the year 2013-2014 has been projected to be at 4.6% of the GDP. Fiscal deficit is the difference between what a government earns and what it spends.
As I have explained in the past, this number has been achieved through accounting shenanigans and does not reflect the real state of government accounts. The expenditure and thus the fiscal deficit of the government
is understated to the extent of Rs 2,00,000 crore. This is not to say that there wouldn’t have been any accounting shenanigans under the NDA rule, but they would have been nowhere near the present level.
The broader point here is that the NDA had left the economy in a reasonable good shape on which the UPA could build. And the first few years of growth under the UPA rule came because of this. In simple English, unlike James Bond movies, growth under the UPA cannot be separated totally from the growth under the NDA. The growth under UPA fed on the earlier growth under the NDA.
That’s one point. The second point that needs to be brought out here is that the massive economic growth during 2009 and 2010,
when India grew by 8.5% and 10.5% respectively, was primarily on account of the government expanding its expenditure rapidly.
The government expenditure during 2007-2008 had stood at Rs 7,12,671 crore. This has since rapidly grown by 123% and stood at Rs 15,90,434 crore for 2013-2014. While this rapid rise in government expenditure ensured that India grew at a very rapid rate when the world at large wasn’t, it has since led to substantial economic problems. During the period Atal Bihari Vajpayee was the Prime Minister of India, the government expenditure grew by 68% and stood at Rs 4,71,368 crore during 2003-2004.
This rapid rise in government expenditure in the last few years has led to loads of problems like high interest rates and inflation, as an increase in government spending has led to an increase in demand without matched by an increase in production.

As Ruchir Sharma put it in a December 2013 piece in the Financial Times
“With consumer prices rising at an average annual pace of 10 per cent during the past five years, India has never had inflation so high for so long nor at such an unlikely time…Historically, its inflation was lower than the emerging-market average, but it is now double the average. For decades India’s ranking among emerging markets by inflation rate had hovered in the mid-60s, but lately it has plunged to 142nd out of 153.”
In fact, if one looks at the incremental capital output ratio, it throws up a scary picture.
Swanand Kelkar and Amay Hattangadi in a December 2013 article in the Mint wrote “the Incremental Capital Output Ratio (ICOR)…measures the incremental amount of capital required to generate output or GDP. From FY2004 till FY2011, India’s ICOR hovered around the 4 mark, i.e. it required four units of investment to generate one unit of output. Over the last two years, this number has increased with the latest reading at 6.6 for FY2013.” Currently, the number stands at 7.
This, in turn, has led to a massive fall in investment. As Chetan Ahya and Upasna Chachra or Morgan Stanley write in a recent research report titled
Five Key Reforms to Fix India’s Growth Problem and dated March 24, 2014, “Public and private investment fell from the peak of 26.2% of GDP in F2008 to 17.3% in F2013. Indeed, private investment CAGR[compounded annual growth rate] was just 1.4% between F2008 to F2013 vs. 43% in the preceding five years.”
What all this clearly tells us is that the economic growth during the UPA rule fed on the economic growth during the NDA rule. The UPA has left the economy in shambles, and the government that takes over, will have a tough time turning it around.
The article appeared originally on www.firstpost.com on March 30, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Wake up UPA. Central planning didn’t work for Soviet Union, it won’t work for you either

upaVivek Kaul 

In the last ten years that the Congress led United Progressive Alliance(UPA) government has run this country, its solution for almost every socio-economic problem facing this country, has been bigger government. This was a practice followed by the erstwhile Communist countries all over the world, particularly the Soviet Union. And there was a basic reason behind why the system did not work.
Diane Coyle explains this point in her new book
GDP – A Brief But Affectionate History. As she writes “The communist countries had centrally planned economies, not market economies. Ministries in Moscow set the figures for the total number of all items to be produced in the economy and cascaded that down to specific production quotas for different industries and individual factories. With the benefit of hindsight we can see that the idea bureaucrats could possibly known enough about a large, complex economy to plan it from the center successfully is ludicrous.”
Coyle further explains why central planning did not work. “Individual factories were set output targets by the planning ministry. These were expressed in terms of volume—number of TV sets or pairs of shoes—or even weight. Targets of this kind are easy to meet. It doesn’t matter what the shoes are like, whether they are durable, comfortable, in the right sizes for the majority of wearers, or stylish. It doesn’t matter whether the TV sets work after six months or if the panel at the back constantly falls off.”
While India is no longer centrally planned to this extent, but our love for central planning has persisted. Take the case of the Right to Education which was introduced in 2009. At the heart of the Act is a noble idea of ensuring that education is a human right that should be free and compulsory for all children between the ages of 6 and 14.
But like is the case with all big bang centrally planned initiatives the Act tries to achieve too many things at once. It ordered schools to have infrastructure like playgrounds and toilets. Again noble ideas which easy to mandate by law, but difficult to implement immediately.
Many “bottom of the pyramid” kind of private schools have been providing education at a rock bottom fee. If they are asked to suddenly create adequate infrastructure which meets the criteria set under Right to Education, their cost of operation goes up. Their only option is to pass on this cost and increase the fee that they charge.
The trouble is that even though most parents want to educate their children, they may not be in a position to pay the higher fees.
A recent article on www.bbc.com deals with precisely this issue. It quotes Gitanjali Krishnan, a teacher in a school in Panchsheel Enclave in New Delhi as saying that the school would have to triple student fees to meet the criteria set under the Right to Education. And this is something that parents of the children studying in the school won’t be able to afford. “Our parents are the poorest of the poor, labourers and migrant workers, they won’t be able to afford it,” she said.
This has led to a scenario where schools are simply shutting down. “Baladevan Rangaraju, director of think tank India Institute, who has been monitoring media reports, has counted 2,692 schools shut and 17,871 at risk,” the BBC article said.
State governments are also shutting down schools which don’t meet the criteria set under Right to Education. The thinking among bureaucrats seems to be that in private schools the quality of teaching is not guaranteed. This is a rather stupid argument given that if the teaching in government schools was good, then the government employees and bureaucrats would be sending their sons and daughters to these schools, which is not the case.
Also, shutting down schools is not a solution. Even if the education offered by private schools is not upto the mark, isn’t some education better than no education?
As Parth J Shah, founder president of the Centre for Civil Society writes in a blog “Actually many government schools themselves would not be able to meet the rigid input norms((like playground, classroom size and teacher-student ratio) that the Right to Education has mandated.”
Further, what the Right to Education does like all centrally sponsored scheme is to set a target. And the target is to complete the syllabus. Economist Abhijit Banerjee talked about this sometime back. He conducted a small experiment in Bihar and the results were astonishing. “We did one experiment in Bihar which was with government school teachers. This was in summer around two years ago. The teachers were asked that instead of teaching like you usually teach, your job for the next six weeks is to get the children to learn some basic skills. If they can’t read, teach them to read. If they can’t do math, teach them to do math. At the end of six weeks, these teachers were given a small stipend. They had also been given a couple of days of training. At the end of six weeks, the children had closed half the gap between the best performing children and the worst performing children. They had really improved enormously,” said Banerjee.
So what was happening here? The teachers did not have to complete the syllabus in this case. They had to teach students what the students did not know. As Banerjee put it “The reason was they were asked to do a job that actually made sense. They were asked to teach the children what they don’t know. The usual jobs teachers are asked to do is teach the syllabus – which is very different. Under the Right to Education Act, every year you are supposed to cover the syllabus,” said Banerjee.
Central planning essentially tries to implement what should be the best outcome. But that is easier mandated by the law than implemented in reality. As Banerjee put it “One thing that we forget is that the perfect is the enemy of the good. We are trying to have an education system that is perfect and that every child should come out with wisdom at the end of it and as a result they learn nothing.”
Moving beyond the Right to Education, let’s take the case of the food security scheme, which aims at providing subsidised rice and wheat to nearly 82 crore Indians or 67% of the total population. Again, a big Act which tries to achieve the impossible.
Government data over the years has clearly shown that the percentage of hungry people is very low.
An article in the Mint points out “A February[2013] report of the National Sample Survey Office (NSSO) shows the proportion of people not getting two square meals a day dropped to about 1% in rural India and 0.4% in urban India in 2009-10. Interestingly, the average cereal consumption of families who reported that they went hungry in some months of the year (in the month preceding the survey) was roughly equal to the average cereal consumption of those who reported receiving adequate meals throughout the year.”
Hence, what people need is not subsidised rice and wheat, but food that is more nutritious. Howarth Bouis, director of HarvestPlus, International Food Policy Research Institute (IFPRI), made a very interesting point 
in an interview to the Mint in 2013. “If you look at all the other food groups such as fruits, vegetables, lentils, and animal products other than milk, you will find a steady increase in prices over the past 40 years. So it has become more difficult for the poor to afford food that is dense in minerals and vitamins,” he said.
No steps have been taken to tackle this problem. Over and above this other factors also need to be taken into account. As a research paper titled National Food Security Bill: Challenges and Options authored by economists belonging to the belonging to the Commission for Agricultural Costs and Prices (CACP), which is a part of the Ministry of Agriculture points out “Women’s education, access to clean drinking water, availability of hygienic sanitation facilities are the prime prerequisites for improved nutrition. It needs to be recognised that malnutrition is a multi-dimensional problem and needs a multi-pronged strategy.”
This means taking many small steps in the right direction, which necessarily don’t involve big government and more central planning.
To conclude, the Congress led UPA government is spending its last six weeks in power. And if there is one lesson it can draw from its last ten years in power is that Soviet style central planning doesn’t really work any more and perhaps it never did.
The article originally appeared on www.FirstBiz.com on March 27, 2014

 (Vivek Kaul is a writer. He tweets @kaul_vivek)

Why Facebook liked WhatsApp

 facebook-logoVivek Kaul 

The messaging company WhatsApp was recently bought by Facebook for a whopping $19 billion. The owners of the start-up will receive $4 billion in cash, $12 billion in Facebook stock and the remaining $ 3 billion in the form of restricted stock units, which will vest over the next four years.
In rupee terms, Facebook paid close to Rs 1,18,000 crore (assuming one dollar is worth Rs 62.2) for Whats-App, a company with just 45 employees. This amount is greater than the individual budgets of most ministries of the Indian government for the next financial year, except the defence and the finance ministries.
So what is it that made Facebook pay so much money for WhatsApp?
Lets compare this with Instagram, a company that Facebook acquired in 2012 for a billion dollars. Interestingly, Instagram had just 13 employees, when it was acquired. Why did Facebook a billion dollars for a company with just 13 employees and 19 times more for another company with just 45 employees?
Computer scientist and philosopher has an explanation for it in his book
Who Owns the Future? As he writes “When it was sold to Facebook for a billion dollars in 2012, Instagram employed only thirteen people…Instagram isn’t worth a billion dollars just because those thirteen employees are extraordinary. Instead, its value comes from the millions of users who contribute to their network without being paid for it. Networks need a great number of people to participate in them to generate significant value. But when they do, only a small number of people get paid.”
In the above paragraph replace Instagram with WhatsApp and the logic stays the same. As of the end of 2013, WhatsApp had around 400 million users worldwide. So Facebook was essentially paying to acquire the number of people who used the messaging service rather than the knowledge and the technological prowess of the people who ran it.
But wouldn’t it be cheaper for Facebook to just build a similar application? In fact, it wouldn’t take much effort on the part of Facebook to develop a similar and even a better application than WhatsApp. So why pay so much money for it?
In fact, WhatsApp like Facebook and Twitter before it is a classical example of what economists like to call a network externality. This is a situation where demand for a product creates more demand for the product.
As economist Paul Oyer writes in his new book
 “A product has a network externality if one added user makes the product valuable to other users…The rise of the internet has made network externalities more apparent and more important in many ways…Perhaps the best example of the idea is Facebook. Essentially, the only reason anyone uses Facebook is because other people use Facebook. Each person who signs up for Facebook makes Facebook a little more valuable for everybody else. That is the entire secret of Facebook’s success—it has a lot of subscribers.”
Again, replace Facebook with WhatsApp in the above paragraph and the logic stays the same. What made WhatsApp very valuable is the fact that it has close to 400 million users. Hence, even though Facebook can create a similar application at a much lower price, it can’t get 400 million people to use it.
Take the case of Google, which launched Google+ a few years back to take on Facebook. The experts felt that Google+ was a better product and some of them even went ahead and predicted that people would now move on from Facebook to Google+. But that did not happen.
As Niraj Dawar writes in
Tilt – Shifting Your Strategy from Products to Customers “For those who want to be a part of a social network, it makes sense to congregate where everybody else is hanging out. There is only one village square on the Internet, and it is run by Facebook. Being on a different square from everyone else doesn’t get you anywhere—you just miss the party.”
This was the main reason why people did not move from Facebook to Google+, even though it may have been the better product. “Google + may offer features such as greater privacy or group video chat,” writes Dawar, but it fails to “create the positive feedback loop, because it makes sense for everybody to be where everybody else already is.”
So even though Google+ was believed to be superior to Facebook, the users continued to stay put with Facebook. As Oyer puts it “Google+ has signed up many users, but it has not put any real dent in Facebook’s dominance. Nobody is going to switch to Google+ from Facebook unless most of her friends do, too, and it seems very unlikely that whole groups of friends will act in a coordinated fashion to move from one social network to another.”
Given this, even though Facebook could have launched a better version of an application on its own, there was no guarantee that people would start using it. Chances were that they would have continued to use WhatsApp. And that explains why Facebook paid a bomb for it.
Also, in a way Facebook was just buying out prospective competition. Many youngsters have their parents and family, as friends on Facebook. This obviously limits the frankness of the conversation that they can have with their “real” friends.
This has led to teenagers preferring to use messaging services like WhatsApp rather than Facebook. In fact, in a recent earnings call Facebook admitted that teens were spending lesser time on its service and were fleeing to messaging applications like WhatsApp WeChat etc. Mark Zuckerberg, the chairman of Facebook, believes that kids are fleeing the format because parents spam their walls with inspirational quotes and tagging them in photographs which they really do not want their friends to see.
Another explanation on why teenagers are fleeing Facebook was offered to me by a friend who has worked extensively in the technology industry in the United States. When it comes to technology, Facebook is not a light app, like the chat sights. There is a newsfeed comprising of various kinds of data and there is always a chance that things get lost to your intended audience under large piles of such data. Also, it might need more memory, something that the lowest priced smartphones, which the kids are likely to use ave may not have.
Due to all these reasons Facebook paid $19 billion for WhatsApp.

The article originally appeared in the Mutual Fund Insight magazine dated April 2014

 (Vivek Kaul is the author of Easy Money. He can be reached at [email protected]. He would like to thank Somnath Daripa for providing some excellent thoughts on the topic)

10 cr ‘new’ jobs: This number in Cong manifesto shows what’s wrong with India

 congress-party-symbol1

Vivek Kaul

A lot has been written panning the manifesto of the Congress party for the Lok Sabha elections scheduled over the next two months. Given this, I will just concentrate on one point that the party promises in the manifesto.
The grand old party of India has promised to create
10 crore jobs for the youth, if it forms the next government. A very noble idea indeed, at least on paper. Let’s go into this in a little detail.
In order to create 10 crore jobs (or a large number of jobs irrespective of a specific number) primarily four things are required—land, labour, money and electricity.
Let’s look at these factors one by one. If a large number of jobs are to be created, India needs labour intensive manufacturing to progress. But labour-intensive manufacturing in India has slowed down over the years. As Crisil analysts point out in a recent report titled
Hire and Lower: Slowdown compounds India’s job-creation challenge “The decline in employment creation has been compounded by falling labour intensity in the economy…The capacity of labour intensive sectors such as manufacturing to absorb labour has diminished considerably in face of rising automation and complicated labour laws.”
Take the case of the apparel sector. A country like Bangladesh does better at it than us.
Economist Arvind Panagariya in an open letter to Rahul Gandhi in November 2013 wrote that “India exported less apparel than much smaller Bangaldesh and less than one-tenth that by China.” Most Indian apparel firms start small and continue to remain small.
This leads to a situation where they cannot benefit from the economies of scale and hence, cannot compete in the export market. In their book
India’s Tryst with Destiny, Jagdish Bhagwati and Panagariya point out that 92.4% of the workers in this sector work with small firms which have forty-nine or less workers. Now compare this to China where large and medium firms make up around 87.7% of the employment in the apparel sector.
Why is that the case? A surfeit of labour laws are a major reason why Indian apparel firms choose to remain small . Labour comes under the Concurrent list of the Indian constitution, meaning both the state government as well as the central government can formulate laws in this area. “The ministry of labour lists as many as fifty-two independent Central government Acts in the area of labour. According to Amit Mitra (the finance minister of West Bengal and a former business lobbyist), there exist another 150 state-level laws in India. This count places the total number of labour laws in India at approximately 200. Compounding the confusion created by this multitude of laws is the fact that they are not entirely consistent with one another, leading a wit to remark that you cannot implement Indian labour laws 100 per cent without violating 20 per cent of them,” write Bhagwati and Panagariya.
This leads to a situation where the cost of following these laws is very high. Labour costs account for close to 80 per cent of the total costs in the apparel sector. As Bhagwati and Panagariya write “As the firm size rises from six regular workers towards 100, at no point between these two thresholds is the saving in manufacturing costs sufficiently large to pay for the extra cost of satisfying the laws”.
The authors recount an interesting story told to them by economist Ajay Shah. Shah, asked a leading Indian industrialist about why he did not enter the apparel sector, given that he was already backward integrated and made yarn and cloth. “The industrialist replied that with the low profit margins in apparel, this would be worth while only if he operated on the scale of 100,000 workers. But this would not be practical in view of India’s restrictive labour laws.”
Given this, it is not surprising that the Crisil analysts expect the number of fresh jobs being created to fall over the next few years. As they write “Employment generation in the non-agriculture sector will slow down sharply in the coming years as the economy treads a lower-growth path. CRISIL estimates that employment outside agriculture will increase by only 38 million between 2011-12 and 2018-19 compared with 52 million between 2004-05 and 2011-12.”
The Congress party hopes to create 10 crore or 100 million jobs in a considerably lesser period of time. In fact, the Crisil estimate suggests that more people will join the agriculture workforce over the next few years. “Due to insufficient employment creation in industry and services sectors, more workers will become locked in the least productive and low-wage agricultural sector. We estimate that 12 million people will join the agriculture workforce by 2018-19, compared with a decline of 37 million in agriculture employment between 2004-05 and 2011-12,” the Crisil analysts write.
Now let’s take the case of electricity. Every new manufacturing set up requires electricity. India currently has the power plants but it does not have the coal required to feed into those power plants to produce electricity. As Neelkanth Mishra and Ravi Shankar of Credit Suisse write in a report titled
Elections: Much Ado about Nothing dated March 19, 2014 “True utilisation in thermal power generation is below 60%, near 20-year lows (reported plant load factor is 65%).”
India does not produce enough coal to feed its power plants despite having the third largest coal reserves in the world. A major reason for the same is that it takes more than 10 years and many permissions to get a coal mine going. In fact, even if coal mines are auctioned to private sector it will take a while to get these mines going. “From the time the blocks are auctioned to the time coal can start to get mined could be another 3-5 years at least,” write Mishra and Shankar. Hence, by the time, the term of the next Lok Sabha will be more or less over.
Now let’s consider the land factor. Over the years, land has been taken over from farmers by the government at rock bottom rates and been handed over to industrialists and real estate builders, who have profited majorly from this. The Congress led UPA government (along with most of the opposition parties) passed the Land Acquisition Act in 2013. This Act goes to the other extreme in comparison to what was happening till this point of time.
As TN Ninan wrote in a recent column in the Business Standard “The land law stipulates that forcibly acquired land must be paid for at two to four times…market prices, in addition to other relief and rehabilitation costs. So the new law will make land acquisition next to impossible, or unaffordably expensive (which becomes the same thing) in most states.”
Ninan also points out that “land prices “ in significant parts of rural India “are higher than those in any rural area of the United States, and in almost all of Europe barring countries like Holland.”
So, for anyone looking to set up a new business enterprise, land will be a huge cost. And this may make the entire idea of setting up a new enterprise unviable.
Finally, let’s consider the money factor. The interest rates charged by banks on loans have been at high levels over the last few years. This is because the fiscal deficit of the government (or the difference between what it earns and what it spends) has exploded. To finance the deficit the government has had to borrow more and hence, crowding out other borrowers. This has led to high interest rates. If interest rates are to come down, the fiscal deficit of the government needs to come down dramatically.
One final factor that needs to be considered here is the ease with which a new business can be started in India.
In a ranking of 189 countries carried out by the World Bank, when it comes to the ease with which a new business can be set up, India stands 179th. Hence, anyone looking to start a new business enterprise in this country, needs to be slightly wrong in the head. And it is ultimately, new enterprises that create many jobs.
If all these factors are taken into account, the promise by the Congress party to create 10 crore jobs, is a big joke played on the people of this country.
The article originally appeared on www.FirstBiz.com on March 27, 2014

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Beware the debt binge: China may just be the next big bubble to pop

Vivek Kaul

In a previous piece I had highlighted the economic dangers that the next government is likely to face. All the factors highlighted in the piece were local in nature. But in the world that we live in today, international factors also play a huge role.
An international factor that needs to be taken into account is China. The Chinese yuan has been depreciating against the dollar since the middle of January 2014. This, after it had been appreciating against the dollar since the middle of 2010.
In the middle of 2010, one dollar was worth around 6.81-6.82 yuan. Since then, the yuan appreciated against the dollar, at a slow and steady pace. And by January 15, 2014, one dollar was around 6.03 yuan. But since January, the yuan has started to depreciate against the dolllar again. As I write this one dollar is worth 6.18 yuan.
So what is happening here? Why has the yuan suddenly changed course? One explanation is that the Chinese economy is slowing down, but that is not visible in the official data that comes out of China. The famed investor Mark Faber
explained this in a recent interview to Bloomberg Television, where he said China is more likely to see 4% economic growth this year than the 7.5% that the Chinese government is targeting.
As Faber said “if you look at the figures of China, exports are still growing. If you look at the trade figures China exports to Taiwan, so China records exports of so and so much. The Taiwan report imports from China at a much lower level. So which figures are more reliable? I think the figures of the trading partners of China are more reliable. And they would suggest that growth has slown down considerably.”
With exports slowing down, it is in the interest of the Chinese central bank to let the yuan to depreciate against the dollar, to ensure that Chinese exporters stay competitive. With the yuan depreciating against the dollar, the Chinese exporters will earn more yuan for every dollar they get paid for their exports. This will ensure that the Chinese exporters stay more competitive in the global market, where several other countries like Japan are rapidly depreciating their currencies against the dollar to get their exports going.
What makes the situation even worse is the fact that China has seen a major credit binge, where Chinese companies have borrowed more and more over the years.
As economist Worth Wray of Mauldin Economics writes in a recent report “China’s total debt-to-GDP (including estimates for shadow banks) grew by roughly 20% per year, from just under 150% in 2008 to nearly than 210% at the end of 2012 … and continued rising in 2013. Even more ominous, corporate debt has soared from 92% in 2008 to 150% today against the expectation that China’s government would always backstop defaults. That makes Chinese corporates the most highly levered in the world and more than twice as levered as US corporates.”
Another interesting data point clearly shows how much debt China has managed to take on in the last few years. “By another measure, China has accounted for more than $15 trillion of the $30 trillion in worldwide credit growth over the last five years, bringing Chinese bank assets to roughly $24 trillion,” writes Wray. So China has accounted to close to 50% of the loans made over the last five years.
What has made the debt particularly addictive is the fact that the new debt is less productive. As Wray puts it “China’s incremental capital/output ratio rose from 2.5x in 2007 to almost 5.5x in 2012. That means it takes more than twice as much debt to generate a given improvement in growth as it did before the debt binge began.”
The Chinese central bank, the People’s Bank of China, did try to rein in this debt binge in 2012, but that immediately led to an economic slowdown. The government stepped in and in July 2013, it ordered the central bank to go easy on things.
As George Soros wrote in a January 2014 column “Aware of the dangers, the People’s Bank of China took steps starting in 2012 to curb the growth of debt; but when the slowdown started to cause real distress in the economy, the Party asserted its supremacy. In July 2013, the leadership ordered the steel industry to restart the furnaces and the PBOC to ease credit. The economy turned around on a dime.”
But that seems to be changing now. One reason is the fact that the government and the central bank are looking to rein in the shadow banking sector, which has been a huge source of loans for the Chinese property companies. China is in the midst of a huge property bubble, which has been on for a while.
As The Economist reports in a recent article “Prices are still rising in 69 of the 70 cities tracked by the official statistics (Wenzhou in Zhejiang province is the exception).”
The Chinese banks have been staying away from lending to the Chinese property sector. But the property companies have managed to continue raising money through the “cash for copper” scheme.
I had explained this in a previous piece, but let me recount it here in brief.
The way this works is as follows. A Chinese speculator manages to raise money in dollars. These dollars he then uses to buy copper. He then sells the copper and gets Chinese yuan in return. He then invests the Chinese yuan in wealth management products, which promise huge returns. The money invested in wealth management products is typically lent to borrowers like property developers to whom the banks are reluctant to lend.
And this has kept the property prices high and property bubble going. The cash for copper scheme works as long as the the Chinese yuan remains stable against the dollar or appreciates. A depreciating yuan makes the cash for copper scheme unviable simply because the speculators need more yuan in order to repay their dollar loan. Also, what has not helped is the fact that the price of copper has been falling.
This is another reason why the Chinese government and the central bank have allowed the yuan to depreciate against the dollar. They want to squeeze out the shadow banking sector. A country like China could easily do with more houses for its huge population. But the trouble, as it is in India, the homes that are being for speculators instead of the masses who need homes to live in. As The Economist writes “One fear is that China’s developers are building houses for the wrong people (speculators) in the wrong places (backwaters). Instead of accommodating China’s overcrowded urban masses, too many houses stand empty, serving as stores of value for people dissatisfied with bank deposits and distrustful of the stockmarket.”
This is something that the Chinese government needs to set right, if they want to continue to stay relevant in the eyes of people. Ultimately, it is worth remembering that China is a capitalistic economy being run by a communist party (which is also the government).
Experts believe that the current government is moving in the direction of popping the domestic debt bubble in China. As Wray writes “China’s ruling elite doesn’t appear to be in denial about its debt problem, as we have come to expect from the United States and the Japan of old. In fact, it seems the new government under President Xi Jinping is intent on popping the domestic debt bubble and allowing widespread defaults rather than continuing to leverage the system into an unmanageable crisis or a Japanese-style stagnation.”
As and when this were to happen (given that predicting when a bubble will pop is next to impossible) it will mean huge problems all over the world, particularly emerging economies. As Faber put it in the Bloomberg TV interview “investors are not sufficiently aware that the Chinese economy is far more important for other emerging economies than the United States because China is a large importer of resources. In other words, iron ore, copper, zinc. And at the same time, they are a huge exporter to commodity producers of their own manufactured goods.”
And this formula won’t work any more. “So if the Chinese economy slows down, commodity prices – industrial commodity prices are likely to remain under pressure. They already come down a lot. They remain under pressure and the resource producers have less money. In other words,…Brazil goes into recession. The Middle East does not grow as much as before. Central Asia, Africa and so forth all contract, and then they buy less from China and you have a vicious cycle on the downside.”
What this also means is that Indian exports will take a huge hit and that in turn will have some impact on economic growth. Also, if China grows at 4%, as predicted by Faber, then what is the Indian economic growth likely to be?

The article originally appeared on www.FirstBiz.com on March 25, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)