This post is a guest contribution by Chetan Ahya, Derrick Kam and Jenny Zhengof of Morgan Stanley (MS 17.91 ?-1.65%).
Backdrop: Have Both Nations Been Living on Borrowed Growth for Too Long?
Following the credit crisis, both China and India relied on aggressive tactical measures to revive growth quickly. Given the pace at which the external environment was deteriorating then, policy-makers in both China and India had to act quickly and decisively to boost domestic demand.
• Specifically, in China, the key driver of domestic demand was an aggressive credit expansion – close to a 30pp rise in the ratio of bank loans to GDP (excluding non-bank loan lending by banks), in addition to some support from the expansion in the government's budget deficit. Bank loans to GDP has been maintained at these high levels of close to 130% until recently.
• In India, the biggest driver was the doubling of the national fiscal deficit – from 4.8% of GDP in the year ending March 2008 to 10% in the year ending March 2009. By our estimates, the national deficit is likely to be 9.2% for the year ended March 2012 – implying that the government has now maintained this expansionary fiscal policy for four years in a row.
China's Fetish for Investment, India's for Consumption
As growth began to slip immediately after the credit crisis, China focused on supporting investment with the large rise in the ratio of bank loans to GDP. India focused on supporting strong consumption (particularly rural consumption) growth with its major fiscal stimulus. These stimulus measures were largely instrumental in helping China and India to recover quickly from the global recession. Indeed, this counter-cyclical response – a rise in bank loans in China and fiscal expansion in India, respectively – had also been employed during the 2001 US recession and global growth slowdown.
Macro Stability Risks – Only Symptoms of Low Productivity Dynamic
The stimulus measures helped to boost growth quickly – but they also brought macro stability risks. A major rise in property prices, inflation pressures and banking sector asset quality issues – symptoms which surfaced in China and India over the course of 2010-11 – are only a reflection of the low productivity dynamic of growth driven by tactical stimulus, in our view.
We believe that the aggressive policy stimulus was not based on what was truly needed for achieving a sustained growth trend in these countries. Rather, the stimulus measures were based on what both governments could do best in that short period in response to the sudden growth shock on account of the credit crisis. Given the sharp and rapid pace of the deterioration in growth conditions, we believe one can hardly question this move at the time the credit crisis was unfolding.
However, persistent reliance on tactical measures for such a long period (September 2008 to late 2010) was at the heart of the emergence of these symptoms of macro stability risks.
Deleveraging in DM – A Reminder to China and India
Following the 2001-02 global slowdown, low real interest rates and the rise in leverage in the US and Europe had supported strong growth in their domestic demand and overall GDP growth.
• The expansion in US/European domestic demand meant that China benefited from strong growth in exports… In China, net exports contributed an average of 1.9pp to overall GDP growth of 12.1% between 2004-07. Strong growth in investment aimed at building capacity to feed exports demand was the other key anchor of GDP growth.
• …while the low real interest rate environment meant that India (along with many other emerging markets) gained from a major rise in capital inflows. For India, the sharp rise in capital inflows over F2005-08 meant that real interest rates declined to average just 2.1% even as GDP growth averaged 9.0%, led by strong growth in private investment.
We believe that this extremely favourable global environment, apart from structural domestic factors in both countries, played a big role during the 2003-07 period in lifting growth rates for China and India.
However, the credit crisis and the subsequent deleveraging in US and Europe have disrupted this benign global environment that had benefited China and India. We saw a short period of revival in exports and capital inflows into the region over the course of 2010-11, but the emergence of sovereign concerns in the developed world has again reminded us about the sustainability of these two drivers. Considering the major structural challenges that the developed world now faces, the external environment will likely be less benign than in 2004-07 – suggesting that policy-makers in China and India will have to seek sustainable sources for domestic demand engines of growth for their respective economies.
Growth Is Slowing Again
After recovering strongly from the credit crisis, growth in China and India is slowing again. The emergence of macro stability risks forced policy-makers to tighten monetary and fiscal policy to control domestic demand.
• In China, tighter monetary conditions and the gradual withdrawal of fiscal incentives have curtailed domestic demand.
• India is seeing a broad-based slowdown in domestic demand. Persistently high inflation has eroded purchasing power and has forced the government to slow down its expenditure growth, the major driver of rural consumption.
Just as domestic demand had begun to slow, external demand conditions turned less supportive as the sovereign debt situation in Europe intensified during the summer of 2011. Export growth for the region weakened; sequential growth (seasonally adjusted) had averaged close to zero since March 2011.
Moreover, the risks to the growth outlook for both China and India are skewed to the downside, in line with our global team's view on Europe and the US. Barring a quick recovery in the developed world, the external environment could again be a drag on the region's growth outlook.
Aggressive Tactical Easing Is Not an Option
We believe that there is growing recognition among policy-makers that the low productivity dynamic of growth driven by tactical stimulus had resulted in the emergence of macro stability risks. As such, if economic conditions evolve in line with our base case outlook, we do not expect policy-makers to engage the same old aggressive policy response, as it would quickly revive the macro stability risks. We do expect some policy easing in China and India, but the policy response would likely be less aggressive than in 2008-09.
In China, we expect policy-makers to proceed with further policy easing to cushion the moderation in growth.