M. R. Venkatesh is a colleague of mine in the struggle against corruption in Indian economy and society. We are together in the Action Committee Against Corruption in India. Venkatesh may be a chartered accounted but he has already made a name through his writings as a scholar of the financial system. While we may wax eloquent on various economic growth theories, the bottom line is that if a nation does not have a sustainable financial system then its growth will not last.
In 1997-98, several of the most dynamic and fast growing East Asian economies suffered severe financial crisis that devastated them. It revealed that growing economies could not be sustained with a weak financial system. Many of the East Asian "tigers" have been emaciated to the point that even after a decade and a half, they have not recovered. Japan is one such example.
Economic history is strewn with examples of countries that grew promisingly at first, only to falter and fall behind because of a crisis, and then unable to regain the earlier momentum. Such examples are found in Latin America and in East Asia.
There are other countries such the US and of Western Europe, that in the modern period experienced sustained growth and matured economically to become developed countries.
Today we ask: Into which category will China and India find themselves in, say, two decades from today?
Hence, the question of some importance today is: Will China and India continue to grow at least at the same rate(of the last two half decades) or higher, during the next two decades ? Or will either or both slow down or suffer a "bubble burst", a crisis from which the two countries will find it difficult to recover?
According the findings of scholars, an efficient financial system is the defining condition for determining into which of the two categories nations will, sooner or later, find themselves in.
By that defining condition, I will argue here, China and India will fall into the first category in the company of nations of Latin America and East Asia, unless both countries carry out fundamental reforms of their respective financial systems.
Can the two nations reform their respective financial systems to obviate a financial crisis and also meet the requirement of sustained growth, or are there constraints that would prohibit the China and India from carrying out these reforms?
I propose to argue here that political constraints and economic compulsions in both countries are such that these required reforms cannot be carried out. Financial crisis thus seems highly probable.
II. The Financial System in China and India
The main function of the financial system is to mobilize resources through financial assets or debt instruments and to allocate these mobilized resources efficiently and optimally to achieve the highest rate of return, or maximize the growth rate of the economy.
This function is embedded in a "financial architecture", i.e., a payments system with a medium of exchange, a transfer mechanism of resources mobilized from savers for lending to borrowers/investors, and with insurance and diversification reduction in risk in repayment of the same. Financial architecture is constituted by
- institutional regulators such as the SEBI,
- international standards of accounting and transparency in transactions,
- corporate governance norms for management, shareholders and other stakeholders,
- banking and prudential norms such as those posted by Basel II norms that limit soft-budget and moral hazard constraints.
By current international standards, both China and India have impressive macroeconomic fundamentals such as a high growth rate in the range of 6 to 8 percent per year, a relatively low inflation rate, a foreign exchange reserve level exceeding 10 months of imports, and a declining headcount ratio of poor people. The perception today is thus that both economies are going strong and will fuel global growth in the future.
While today’s popular perception of China and India in this regard may be pleasing to the policy makers of the two nations, it is important to remember that economic history is full of such favourable perceptions evaporating before the reality that dawns with a bang. At one stage, many countries of Latin America were considered more wealthy and dynamic than North America. But in the late 19th century that was reversed. In the 1940s Argentina, Brazil and Chile were thought to be the nations that would join the developed countries club. But by early sixties, that perception also evaporated. In the 1980s, it was widely perceived that Japan would overtake the US, and Japanese in fact had begun to buy up prized real estate and become owners of US major corporations. That trend has now been completely reversed. In the case of the ‘Asian Tigers’, the World Bank had published with a volume titled The East Asia Miracle which was an unabashed advocacy of the export-led free trade strategy of East Asian economies. The celebrated World Bank remark that these economies had got their “basics right”, and by implication other countries had not, came back to haunt the World Bank after the 1997 crisis.
The Bank did attempt damage limitation by subsequently publishing another volume titled: Rethinking the East Asia Miracle, nevertheless the institution’s credibility was hit hard because the very area where the East Asian countries had got their basics wrong was the about the financial system, to monitor which the World Bank and IMF were set up in the first place under the 1944 Bretton Woods Charter.
The current macroeconomic fundamentals have been secured in China and India by increasingly milking the financial system without sustained nurturing of it by reforms, and instead by sweeping the developing malaise in the system under the carpet. That is, macroeconomic fundamentals have been ensured in both countries at the cost of the structural parameters and institutional quality.
As a consequence, the structural parameters in the banking and fiscal sectors indicate a looming crisis. The institutional development in the financial system of the two nations is also out of sync with the needs of increasing globalization, and seems is still defined by Soviet vintage prudential norms and opacity in transactions.
As presently structured, the banking sector in the two economies is internally ill-equipped to meet the challenge inherent in the developing financial crisis. This is because (1) the sector is dominated by government ownership and not self-regulating on market principles (2) a lack of modern prudential and governance norms (3) weak opaque non-independent regulatory bodies and (4) directed credit and captive finances. Besides, the fiscal budgeting has limited scope because of large contingent liabilities and irreducible heads for fund allocation, e.g., subsidies, interest payments and defence.
Moreover, the financial systems of the two countries are bank and budget centric because their stock markets are small, prone to insider trading, rigging and scandal prone. Their bond markets are underdeveloped.
Hence because of these two factors, the financial system in China and India are subject to a double jeopardy that causes the system to underperform and sub-optimise the allocation of resources.
It however needs to be stated here that relatively, India’s financial system is better structured on prudential norms than China’s, even as India has yet to fully emerge out the shackles of the Soviet style command mindset of yesteryears. For example, even today, government owned banks which receive 80 percent of all deposits, are compelled to deploy about half of the funds in low interest albeit low risk government securities[to finance the fiscal deficit]. Another 20 percent in directed credit, and 25 percent in mandatory reserves. Such straitjacketing of bank fund dispersal on government direction applies to other financial institutions in insurance, provident fund and employees state insurance as well. Thus the Indian financial intermediation relies less on market based risk management than government policy.
III. The Imminent Financial Crisis in China and India
Empirically, it has been observed that a financial crisis descends on an economy via three different routes of causation:
- A run in the foreign currency market that induces a banking collapse which triggers a fiscal crisis.
- A banking collapse that causes a fiscal crisis which induces a foreign currency run.
- A fiscal crisis that triggers a banking crisis which induces a foreign currency run.
Hence, the financial crisis is not of a one-way causation. Theoretically, the causation is mutually reinforcing, that could richochet or cascade to a bubble burst, or which can implode by any of the nine possible routes.
Which routes are China and India likely to follow to an expected financial crisis? Both countries do presently face severe financial systemic problems but of different kinds that require different corrective measures to rectify them and thus stave off a crisis.
In China’s case, financial reforms would require privatizing the banking system. This would enable the private sector to emerge as an independent center of economic power, which by all accounts the Chinese Communist Party is not ready to accept. The Party had undertaken reforms because it wanted to legitimize the Party and not to develop independent alternatives to it. After the failure of the Great Leap Forward, the Great Proletarian Cultural Revolution and the Gang of Four, the Communist Party’s credibility was low. Chairman Deng understood that and launched reforms.
Dramatic as the scenario appears, it is the reality in China. There is clearly a Catch-22 type political bind on the financial system reforms. Either China will have to carry out financial reforms and face political upheaval, or retain the political levers on the financial system and face an economic crisis. With a peaked domestic saving rate, a high incremental capital ratio, and an uncertain global market, there is no scope for raising or even sustaining the present growth rate in GDP without increasing total factor productivity—which requires reforms that China cannot politically carry out..
The problem facing India is that the budget finances are perilously close to a debt-trap. For every 25 cents to a dollar as loans to finance the deficit, 24 cents is the allocation in the budget for amortization of past loans. Moreover, the budgetary allocations for defence, pensions, subsidies, police, employees compensation, counter-guarantees etc., which account for over 90 percent of the revenue, are such that it is not politically feasible to prune or reduce.
Besides, government investment in the economy has also been progressively reduced by creating a capital account surplus in the budget to finance the deficit in the current account.
Hence, the fiscal malaise in the Indian financial system is not the current macroeconomic fundamentals but that these have been attained by running the system to the ground, e.g., containing inflation by financing the large government deficit by a surplus of private saving over private investment.
Thus, due to political compulsion and constraints, both China and India are heading into a financial crisis. India may be able to come out of it sooner than China because Indian democracy always intervenes in a crisis by electing those who will bring change.
The present volume of Venkatesh is of articles he has written in various publications. The readers can pick and choose which he or she is interested in because of the wide coverage in topics. But the bottom line of Venkatesh’s writings is that financial system is key to clean and sustained growth. I urge all interested in public policy to read this book.
Dr. Subramanian Swamy
April 9, 2013