In the long term, will “easy money” come from China as well?

chinaVivek Kaul

The Chinese economic growth for 2014 was at 7.4%, a tad lower than the official target of 7.5%. This is the slowest rate that the country has grown at in 24 years.
In the aftermath of the financial crisis that started in September 2009, the Chinese government pushed the banks to ramp up lending. In a recent piece
for the Wall Street Journal, Ruchir Sharma of Morgan Stanley estimates that “since 2008 the money supply has nearly tripled to $20 trillion” in China. Sharma further writes that China ordered up “new spending” which totalled to “12% of GDP, by far the biggest stimulus of this period.”
This helped the Chinese economy to keep growing at a fast rate in the aftermath of the financial crisis, even though growth in most of the other parts of the world collapsed. The trouble was that a lot of this money went towards creating infrastructure which was not required in the first place. It also led to a huge property bubble.
As Sharma puts it: “This decay is symbolized by the bridges, apartment complexes and half-empty shopping malls rising across China—many of them wasteful projects that were hurriedly seeded in 2009 and will sap growth in the future. The message: When the state spends in haste, it will repent at leisure.”
At the same time the productivity of Chinese capital has been coming down. It now takes more capital and more loans to get the same amount of economic growth going than it did in the past. In a recent study carried out by two economists
working with the Chinese National Development and Reform Commission (NDRC), a top economic planning and regulatory agency in China, came up with some interesting results.
The study found that China’s incremental capital output ratio has risen dramatically over the years. It averaged at 2.6 for the period between 1979 and 1996. It has since jumped to 4 between 1997 and 2013. What this means is that before 1997 it took an average investment of $2.6 to get $1 of GDP growth going. Since 1997, it has taken an average investment of $4 to get $1 of GDP growth going.
The economists also found that the delivery rate of completed capital projects has come down dramatically over the years. The number stood at 74-79% in the late 1990s and has since fallen to around 60%, implying that 40% of the Chinese investment projects have either not been completed or did not finish on time.
The negative effects of the spending binge are now starting to be felt. As Wei Yao of Societe Generale wrote in a recent research note titled
China: deceleration as usual, easing as routine and dated January 20, 2015: “More strikingly, property investment growth collapsed to -1.9% year on year from +7.6% year on year, the first contraction in 18 years! Construction data further confirmed that developers are struggling. New starts remained in deep contraction, falling 26.1% year on year; growth of floor space under construction fell below 10% year on year for the first time since mid-2000; and completion growth plummeted to 1.2% year on year from 11.4% year on year in the previous month.”
The non performing loans of banks are also rising at a rapid rate. As Yao wrote in another note dated November 20, 2014, and titled
China: easing by not easing: “The non performing loan stock has been growing at a 35% clip this year. Smaller banks have seen faster deterioration, with non performing loans rising 50% year on year. The worse is still to come and banks know it.”
All this does not augur well for the Chinese economy and the government is trying to initiate what economists call a “soft landing”. This may also include ensuring that the Chinese economy does not grow as fast as it was in the past.
As Li Baodong, a Vice Foreign Minister, told reporters after the latest economic growth numbers came out: “China has entered a new normal of economic growth…That is to say we are going through structural adjustment and the structural adjustment is progressing steadily.”
This is a clear hint of the fact that the Chinese government is neither looking at spending more nor pushing banks to lend more, in order to push up the falling economic growth. “The chance of aggressive policy easing remains small,” writes Yao.
The trouble is that the Chinese investment forms a major part of the investment happening all over the world. As Sanjiv Sanyal of Deutsche Bank Market Research writes in a recent research note titled
The Capital of China is Moving: “China’s domestic investment currently accounts for a disproportionate 26 per cent of world investment, up from a mere 4 per cent in 1995. In contrast, the United States saw its share peak at 35 per cent in 1985 but now accounts for less than a fifth.”
Why is Chinese investment such a dominant part of total global investment? “China’s dominance is driven by the fact that it saves and invests nearly half of its $10.5trillion economy,” writes Sanyal.
But it is becoming more and more difficult to fruitfully deploy $5 trillion (around half of $10.5 trillion). This is primarily because the “country…already has brand new infrastructure, suffers excess manufacturing capacity in many segments and is trying to shift to services, a sector that requires less heavy investment.”
This means that Chinese investment will go down in the coming years. Hence, if the Chinese savings rate continues to remain the same or does not fall at the same rate, it will lead to surpluses.
Chances are that the Chinese savings rate will not decline primarily because China is ageing at a very rapid rate. “The experience of other ageing societies such as Germany and Japan is that investment rates fall faster than savings rates,” writes Sanyal.
In another research note
Bretton Woods III and the Global Savings Glut published in October 2013, Sanyal explains this theory in detail. Sanyal basically says that when people are young, their spending needs are greater. Hence, they need to borrow money in order to consume and/or build assets (like homes). But, as they age, their savings rise and they build up a stock of wealth, which they spend in their old age. Countries work along similar lines. Basically, what this means is that as a country ages (with the average age of its population rising), it tends to save more.
By 2030, China would go from being significantly younger to the United States to becoming significantly older to it, with a median age above 40. The excess savings that will be generated need to be absorbed somewhere.
A lot of this money is likely to find its way into the United States, feels Sanyal. And this might help the US government to continue borrowing from foreign countries. It would also keep interest rates low and help Americans keep their excess consumption going by borrowing. “The next round of global economic expansion may require the United States to revert to its role as the ultimate sink of global demand,” wrote Sanyal in the October 2013 note.
In his latest note Sanyal also states that the United States “has the necessary scale to absorb China’s surplus and the poor state of its infrastructure provides many avenues for fruitful deployment of capital.” Nevertheless, he goes on to write that “history suggests that some of this cheap money would inevitably find its way into trophy assets and bubbles.”
As far as theories go, this one sounds pretty logical. Let’s see how it goes. That only time will tell.

(The column appeared on as a part of The Daily Reckoning as on Jan 23, 2015)

10 things the Modi govt should do in the next budget


Vivek Kaul

The finance minister Arun Jaitley will be presenting Narendra Modi government’s second budget next month in February 2015. The budget other than being a revenue and expenditure statement of the government is also the time when governments tend to announce their policy stance on various issues. It is also the time around which major economic reforms tend to be announced.
Keeping these factors in mind, here are 10 things that I would like to see Jaitley do in his second budget.

1) The assumptions of revenue growth need to be more realistic. In the budget for this financial year Jaitley had assumed that the government revenue receipts would grow by 15.6%. The total revenue receipts for the period April to November 2014 have grown by half that rate at 7.8%. The tax growth had been assumed to grow at 16.9%, whereas the actual growth in tax collections between April to November 2014 has been around one-fourth of that at 4.3%.
The Indian economy has been growing at the rate of around 5% per year. There haven’t been any major changes that tell us that the economy will grow at a significantly faster rate in the next financial year. Keeping these factors in mind Jaitley should keep his revenue projections realistic, unlike this year. Between April to November 2014, the fiscal deficit was already at 99% of the annual target, making Jaitley’s projections look totally ridiculous. Such a situation can be avoided next year.

2) Over the last few years, the government has assumed that disinvestment of its holdings in public sector units will bring in a lot of money. But that hasn’t turned out to be the case. Take the case of the last financial year when it was assumed that the government will raise Rs 54,000 crore through disinvestment. It actually managed to raise only Rs 19,027 crore.
For this financial year, Jaitley has projected that the government will raise Rs 58,425 crore through disinvestment. But only Rs 1,700 crore has been raised so far, with only around 11 weeks left for the financial year to end.
News-reports now suggest that the government is really trying hard to push disinvestment through. Instead of waking up at the end of the financial year, the government along with a big disinvestment target also needs to have an annual plan where they go about disinvestment all through the year. This is a better way of approaching the issue and Jaitley should look at it seriously in the next budget.

3) The fiscal deficit number needs to be correctly stated. In the last financial year, the then finance minister P Chidambaram managed to meet the fiscal deficit target that he had set through accounting shenanigans like postponing the payment of expenditure that had already happened and forcing public sector companies like Coal India to pay up huge dividends.
From the looks of it, Jaitley might want to do the same thing this year as well, in order to meet the fiscal deficit target of 4.1% of GDP that he had set when he presented the budget in July 2014. As mentioned earlier, the fiscal deficit for the first eight months of the financial year was already at 99% of the annual target. And the only way that Jaitley can now meet the fiscal deficit target is by doing the same things that Chidamarbam did last year. The finance minister should not fall for this temptation and come up with the “real” fiscal deficit number. My bet is he won’t.

4) In the Mid Year Economic Analysis, the Chief Economic Adviser to the finance ministry Arvind Subramanian wrote that: “Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world. The ripples from the corporate sector have extended to the banking sector where restructured assets are estimated at about 11-12 percent of total assets. Displaying risk aversion, the banking sector is increasingly unable and unwilling to lend to the real sector.” This has led to a situation where banks aren’t interested in lending and corporates aren’t interesting in investing.
In order to get around this problem Subramanian suggested that: “it seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward, not to replace private investment but to revive and complement it.”
In simple words, the government should increase its capital expenditure to “pump-prime” the economy and get the investment and growth going again, feels Subramanian. It would make huge sense to have a dedicated revenue stream to finance this expenditure, instead of financing it all through borrowing. This could be through a massive disinvestment programme, a cess on petrol/diesel etc. This will make great accounting sense as well, where sale of public assets will finance the creation of newer public assets instead of financing regular expenditure of the government.

5) Every year along with the budget the government releases a revenue foregone statement. The revenue foregone for the government during the year 2013-2014 has been estimated to be at Rs 5,72,923.3 crore. “The estimates and projections are intended to indicate the potential revenue gain that would be realised by removing exemptions, deductions, weighted deductions and similar measures,” the statement of revenue foregone points out.
The following table shows the exact breakdown of the revenue foregone by the government under various kinds of taxes. It is clear from the table that Indian businesses benefit the most with corporate income tax, excise duty and customs duty foregone, forming a bulk of the revenue foregone by the government.


It needs to be stated here that the revenue foregone is based on certain assumptions. As the statement points out “ The estimates are based on a short-term impact analysis. They are developed assuming that the underlying tax base would not be affected by removal of such measures….The cost of each tax concession is determined separately, assuming that all other tax provisions remain unchanged. Many of the tax concessions do, however, interact with each other. Therefore, the interactive impact of tax incentives could turn out to be different from the revenue foregone calculated by adding up the estimates and projections for each provision.”
While there are many assumptions behind the revenue foregone number, it is too big a number not to be taken seriously. It is even greater than this financial year’s projected fiscal deficit of Rs 5,31,177 crore. The government needs to go through these exemptions carefully and figure out are they really needed. This maybe too big an exercise to be carried out along with the budget, but it can be announced along with the budget and can be carried out over a longer period of time.

6) One of the ticking time bombs in India is the amount of money that needs to be pumped into public sector banks in the years to come. The Report of The Committee to Review Governance of Boards of Banks in India (better known as the PJ Nayak committee) released in May 2014, estimates that between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.”
The report further points out that “assuming that the Government puts in 60 per cent (though it will be challenging to raise the remaining 40 per cent from the capital markets), the Government would need to invest over Rs. 3.50 lakh crores.”
Where is this money going to come from? The government needs to start thinking about the issue seriously. It is not in a position to pump in so much money into public sector banks. So it should start seriously looking at either selling out some of these banks or simply shutting down the poor performing ones. The government does not need to own so many banks. Again, the finance minister needs to tell us what he is thinking about this and the budget would be a great time to do this.

7) Jaitley needs to come up with a time frame and a plan around how soon the government will start paying out all subsidies in bank accounts of citizens directly. This will go a long way in ensuring that subsidies actually reach citizens and do not get siphoned off by the system.

8) Since coming to power the BJP government has made a lot of noise about getting back all the black money that has left the shores of the country. But what about all the black money that is still there in the country? Why not try to recover that? It will be significantly easier to do that. It is time that the government came up with a plan to recover black money within the country as well. The budget would be a great time to announce such a plan.

9) In the previous budget Arun Jaitley came up with 29 new schemes to which he allocated Rs 100 crore each. It is very tempting for the government to try and do everything and in the process spread itself too thin. The government cannot be a part of everything, simply because neither does it have the expertise nor the money. It would be better if it concentrated on a few big things(or ideas) in the budget. But there is no point in being absolutely all over the place.

10) The government expenditure is categorised into two categories—plan and non-plan. Interest payments on debt, pensions, salaries, subsidies and maintenance expenditure are all non-plan expenditure. As is obvious a lot of non-plan expenditure is largely regular expenditure.
Plan expenditure is essentially money that goes towards creation of productive assets through schemes and programmes sponsored by the central government. It is asset creating expenditure.
Nevertheless, what seems to be happening is that plan expenditure gets held back and is only released in the latter months of the year. Take the case of the current financial year. Between April to November 2014, the total plan expenditure of the government stood at Rs 2,93,651 crore or around 51.1% of the annual target of Rs 5,75,000 crore. The ratio was 52.8% for the period between April to November 2013.
The main reason why the government goes slow on plan expenditure and stacks it up towards the end of the year is that it has become the balancing factor in the budget. If the revenue projections go wrong, then the government slashes plan expenditure in order to meet the fiscal deficit target. This is what Chidambaram did in the last two financial years. In 2012-2013, he had budgeted Rs 5,21,025 crore towards plan expenditure. The final expenditure came in 20.6% lower at Rs 4,13,625 crore. In 2013-2014, the plan expenditure was budgeted at Rs 5,55,322 crore. The final expenditure came in 14.4% lower at Rs 4,75,532 crore.
Jaitley is looking to do the same in this financial year as well. He had budgeted Rs 5,75,000 crore for plan expenditure but my guess is that he will have to slash it by Rs 1,00, 000 crore to meet the fiscal deficit target. This practice needs to be done away with and it can only happen if the government works with more realistic projections of both revenue as well as expenditure. The next financial year is a good time to start.

These are the 10 things that I strongly feel the government should be trying to do in the next budget. Let’s see how many of these things happen.

The column originally appeared on on Jan 9, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)