China and India are currently among the fastest- growing economies in the globe. Together, the two nations represent 38% of the global population. Continued growth of the world’s second and fourth largest economies, respectively, (measured by PPP-based GNP) at the current rates or higher, has enormous implications for the globalization process under way and the consequent restructuring of world economic order itself.
In 1997-98, several of the most dynamic and fast-growing East Asian economies suffered severe financial crises that devastated them. It revealed that growing economies could not be sustained with weak financial systems.
Economic history is strewn with examples of countries that grew promisingly at first, only to falter and fall behind because of a crisis, and were then unable to regain the earlier momentum. Such examples are found in Latin America and in East Asia.
There are other countries, such as the US and those in Western Europe, which experienced sustained growth in the modern period and matured economically to become developed countries.
Which category will China and India find themselves in? 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 they will find it difficult to recover?
According to 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. I will argue here that, China and India will fall into the first category, unless both countries carry out fundamental reforms of their financial systems.
Can the two nations reform their financial systems to obviate a financial crisis and also meet the requirement of sustained growth, or are there constraints that would prohibit this? I will argue 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.
The present system
The main function of the financial system is to mobilize resources through financial assets or debt instruments and to allocate these 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 this. The architecture encompasses institutional regulators such as the Securities and Exchange Board of India; international standards of accounting and transparency in transactions; corporate governance norms for management, shareholders and other stakeholders; banking and prudential norms such as the Basel II norms that limit soft-budget and moral hazard constraints.
By current standards, both China and India have impressive macro-economic fundamentals such as a high, 6-8% annual growth rate, relatively low inflation, foreign exchange reserves exceeding 10 months of imports, and a declining headcount ratio of poor people. The perception today is that both economies will fuel global growth in the future.
While this perception may be pleasing to the policymakers of the two nations, it is worth remembering that economic history is full of such favourable perceptions evaporating when the reality 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 the early 1960s, that perception evaporated. In the 1980s, Japan was expected to overtake the US and the Japanese, in fact, had begun to buy up prized real estate and major US corporations. That trend stands completely reversed.
In the case of the ‘Asian Tigers’, the World Bank, in a volume The East Asia Miracle, had unabashedly advocated the export-led free trade strategy of the East Asian economies. Its celebrated remark that these economies had got their “basics right”, implying other countries had not, came back to haunt the World Bank after the 1997 crisis. It did attempt damage control in a subsequent volume: Rethinking the East Asia Miracle, but the institution’s credibility was hit hard because the very area where the East Asian countries got their basics wrong was the financial system—it was to monitor this that the World Bank and IMF were set up under the 1944 Bretton Woods Charter.
India and China have secured their current macro-economic fundamentals by increasingly milking their financial systems without nurturing these with reforms. As a result, the structural parameters in their banking and fiscal sectors indicate a looming crisis. The institutional development in their financial systems is also out of sync with the needs of increasing globalization.
At present, the banking sectors in the two economies are internally ill-equipped to meet the challenge inherent in the developing financial crisis. This is because of dominant government ownership and lack of self-regulation on market principles; a lack of modern prudential and governance norms; weak, opaque, non-independent regulatory bodies; and directed credit and captive finances. Besides, their 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 are bank- and budget-centric because the stock markets are small, prone to insider trading and rigging. Their bond markets are underdeveloped.
However, India’s financial system is relatively better structured on prudential norms than China’s, even as it has yet to fully emerge from the shackles of the Soviet-style command mindset. Even today, state-owned banks, which receive 80% of all deposits, are compelled to deploy about half the funds in low-interest, albeit low-risk, government securities (to finance the fiscal deficit), another 20% in directed credit, and 25% in mandatory reserves. Such straitjacketing of bank fund dispersal applies to other financial institutions in insurance, provident fund and employees state insurance as well. Indian financial intermediation relies less on market-based risk management than government policy.
Imminent financial crisis
Empirically, it has been observed that a financial crisis descends on an economy via three different routes of causation:
(1)A run in the foreign currency market that induces a banking collapse, triggering a fiscal crisis.
(2)A banking collapse that causes a fiscal crisis, which induces a foreign currency run.
(3)A fiscal crisis that triggers a banking crisis, which induces a foreign currency run.
Which routes are China and India likely to follow to an expected financial crisis? Both countries do presently face severe financial systemic problems but these are of different kinds and require different corrective measures.
China needs to privatize its banking system. This would enable the private sector to emerge as an independent centre of economic power, which the Chinese Communist Party doesn’t seem ready to accept. The party had undertaken reforms because it wanted to legitimize itself and not to develop independent alternatives. 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 Xiaoping understood that and launched reforms.
Dramatic, but it is the reality in China. There is clearly a Catch-22 type political bind. 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 even sustaining the present GDP growth rate, without increasing total factor productivity—which requires reforms that China can’t politically carry out.
India’s problem is that its 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 budget allocation for amortization of past loans. And, pruning allocations for defence, pensions, subsidies, police, employees compensation, counter-guarantees etc., which account for over 90% of the revenue, is not politically feasible.
Besides, government investment in the economy has also been reduced progressively with the creation of 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 that the current macro-economic fundamentals have been attained by running the system to the ground, e.g., containing inflation by financing the large government deficit with a surplus of private savings over private investment.
Thus, political compulsion and constraints are driving both China and India 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.
Subramanian Swamy, a former cabinet minister, teaches economics at Harvard University in the summer term. Comments are welcome at firstname.lastname@example.org