Development Bank Research Bulletin

A new political economy: China grew at 10.9% in 1H06

China grew at 10.9% in the first half of 2006, and 11.3% in the 2Q, surprising almost all major investment banks.

"Maybe this is a new economy" said Stephen Green, China economist for Standard Chartered Bank, "Maybe China can grow fast without inflation"

I am not sure whether China can grow fast without inflation, but I am expecting the fast growth this year and I am not surprised at all.

As I wrote in the Bulletin back in April, things are changing in China. It may not be a "new economy", but it is certainly a "new political economy!"

The Communist Party's 17th national convention is upcoming in the second half of 2007, and thus major personnel promotion decisions will be made in the first half of 2007. Every provinical boss is working hard to secure political capital before the event, and GDP is the key political capital. In today's new political landscape where strongman politics is phasing out, GDP becomes more and more important a bargaining stake for provincial bosses.

So don't expect a slowdown in the second half. The economy is going to operate at full speed.

As I wrote in that article:

"Year 2006, however, is the last year of the 2002-2006 political cycle, and based on past experience, should grow at the lowest speed. The economy however grew at the highest speed in ten years. Something must have changed. One speculation is that the incentive structure has changed. In the past, provincial heads worked hard in the first and second year of the cycle to impress their national boss. Now they work hard in the last year to pro-actively build up political capital for their future career which will be decided in the 2007 national meeting of the Communist Party, and the best political capital in China is GDP, GDP, GDP!  At national level, central government wants to slow down the investment boom, but provincial bosses have made up their own minds. "

Czech Republic to overtake East Germany in seven years

What could explain why East Germany, with all the rule of law and administrative integrity in place, plus 1 trillion euro of subsidy, is soon going to be overtaken by Czech Repbulic (in gdp per captia) which is plagued by rampant "looting" and "no law and no finance"? Labor market inflexiblity is the key.

The economic transition in the East Bloc is always said to be a failure. Rapid convergence didn’t happen, income level stagnates, reforms and polices are wrong... Nevertheless, to give a fair judgment, we need to find a proper benchmark, because otherwise we don’t know how things otherwise would have evoled.

For Czech Republic, the perfect benchmark is East Germany. Before taken over by the communists, The Czech lands (Bohemia and Moravia) were at similar level of economic development as what later became Democratic Republic of Germany. Four decades later, at the time of communism’s collapse, Czech was poorer than East Germany. East Germany is bigger than Czech (population: 16 million vs. 10 million at the time of transition), but not much bigger. They are not only neighbors, share a lot of historic background, but also similar in industrial structure (as a result of Soviet planning) at the time of transition.

What did East Germany get afterward?  East Germany got pretty good institutions (legal system, political system, business environment) in place in short period of time, , rapid transfer of knowledge and know-how from fellow Germans from the West through training and transfer programs, efficient banking sector as a result of the direct takeover of East German Bank by more efficient Frankfurt banks, and on top of all these, one trillion Euro of fiscal transfer to finance massive public investment in equipment and infrastructure.

With all of these perfect advantage, East Germany was supposed to be converge to living standard in the West pretty soon and further widened the gap with its Easter neighbor the Czech Republic.

In the Czech Republic, in contrast, legal system is not functioning, “looting” was rampant among corporate managers in the midst of mass privatizations, business environment is plagued by corruption and bureaucracy red-tape, inflation was high and fiscal policy was not working for most of the 1990s, financial system was in bankruptcy until foreigners start to take over some of them......and not to forget, there is no "West Czech Republic" that can inject one trillion Euros.

All of these contracts will forecast East Germany’s rapid and certain dominance of Czech Republic in terms of economic growth and rising GDP per capita.

The results in hindsight however contract such predictions made back then. Yes, Now East Germany is still some 15% richer than Czech Republic (note that East Germany started richer), but the trend in the past seven years or so will project that with another seven years, the Czech Republic is going to take over East Germany in terms of GDP per capita, if Czech Republic continues to growth at 3.3% /year while East Germany at 1.0%/year.

The reason, as Professor Jennifer Hunt (McGill University) suspects is rooted in the labor market in East Germany.  East Germans are half as productive as their Western counterparts, but with the slogan “The same pay for the same work” they are demanding the same level of salary.  In 2003, although Eastern GDP per capita was only 67% of the western level, disposable income per capita was already 82% of the western level.  Western firms thus would rather expand their facilities in the West to serve the new consumer market in the East, instead of employ workers in the East.

It is certainly a good and attractive slogan that everyone gets the same pay, but when you are not as good as others (at least at this moment before you go through some skill training), demanding the same level of wage as the smarter people are getting can only give you two results: (1) unemployment; why would employers (except the public sector) want to pay more to get less. (2)  lower paid and dirty jobs that people in the West don’t want to do; so you are segregating yourself by your own decision. As an old communist-era axiom in the Czech Repubic goes: "We pretend to work, and they pretend to pay us". True in East Germany now.

The whole plot was conspired by the labor unions in the West, which got higher wage pact for their comrades in the East. The true intention was to price out East German workers from the market, not to show solidarity!

Reference:

Jennifer Hunt: Is the transition in East  Germany as success?  (pdf file)

Technology industry and the over-educated Russia

In a Goldman Sachs research note (pdf file), the human capital of four BRIC countries are analyzed.

It is found that, China has only marginally more tertiary graduates than Russia despite having 10 times the population of Russia.

Russia, despite much lower income than the U.S., already reaches 60% the U.S. level, in terms of tertiary graduates per capita.  Among population over age 25, in the U.S. there are 192 tertiary graduates in every 1,000 people, while in the Russia, it is already 115. The correspond number for China and India are merely 16 and 14, respectively.

Russia seems to have huge potential in moving to higher value-added technology industries than India does!

The research also finds that Russia has almost as many science and engineering PhDs as Germany, which is much richer than Russia.

But when it comes to the number of R&D workers, i.e., those who went through the education and are actually applying what they learn in the college to what they are supposed to do,  Russia starts to fall behind China and Japan. India is nowhere in the sight.

For Russia, the gap between number of people with science and technology degrees and the number of R&D professionals  seems to corroborate the worry by  cops around the world: mafia organizations are entering a new level of sophistication after Russians enter the trade, because most Russian mafia members have Ph.D. degree in physics or mathematics.

Goldman Sachs: China makes largest progress in energy efficiency than other developing countries

Goldman Sachs publishes a note "Improving energy intensity across the BRICs"  (pdf file). There are several interesting take-away points:

(1) China’s energy use per unit of output in industry fell by 56% between 1994 and 2003, which is the largest energy-efficiency improvement progress in developing world. In the same period, India only achieves reduction of 30%, and Brazil almost makes no progress.

Why is everyone blaming China for using too much energy?! China uses more energy simply the population is larger and the economy is still in the early stage of industrialization, and as such a large economy, China is already making much better progress than others.

(2) Russia remains the most energy-intensive countries in the world, The country’s energy intensity is close to three times that of US.

Not surprising, considering that the government is subsidizing energy (for Russian residents) to such an extend that electricity is almost free. By the way, Venezuela always consumes a lot of gasoline, because the price is heavily subsidized. I always say that letting market to determine the price is the best weapon against energy waste.

(3) In China, non-industrial sector is twice more energy-intensive than industry.

I have no idea why!

(4) Projection results show that BRICs (except Russia) will consume much less energy per capita than the current level in more developed economies (U.S., Japan, etc) when  they reach the same income level of developed economies.

I.e., both now and in the future, Americans will remain the heaviest user of energy, even on per capita term.  Why do Americans still point fingers at developing countries and keep on blaming China for exhausting the energy resources of the planet?

Implication for the relationship between growth and environment : as a country gets richer, it will use less energy (because industry becomes more productive and structural shift to service sector will also save energy). The best weapon against pollution is economic growth, not to turn Africa into a zoo.

Year-half assessment of investment banks’ forecast accuracy on China’s GDP growth

In a previous Bulletin article written back in February, I summarized several major investment banks’ forecast of China’s 2006GDP growth rate.

Now it is time to assess the accuracy of these forecasts after six months have passed.

In the first half of 2006, China was growing at unprecedented and unexpected pace, at 10.9% on year-to-year basis. Only Credit Suisse’s forecast of 10.1% can be said to be in line with the actual outcome. CSFB’s China economist Dong Tao is doing well

Thus most investment banks are revising their forecast up ward:  Deutsche from 9% to 9.9%, Citigroup from 8.7% to 9.3%, and Morgan Stanley from 7.8% to 9.5%. The consensus now is 9.7% (based on data from Consensus Economics).  (Deutsche Bank again is following the herd in setting their forecast! Can they be a little bit braver?)

Morgan Stanley, after two years of very poor performance in forecasting China’s GDP growth finally makes a large upward revision of the number. They have been voicing their worry about China slowdown for a long time, and have been the most pessimistic about growth rate of India and China back in 2004, and 2005.

Stephen Roach in his commentary (10/21/2005) in MS’s Global Economic Forum supplied some explanations on why they were wrong on the "China slowdown", and why they still believed that slowdown in American consumption (as a result of oil shock and low saving rate) may “ultimately” causes a China slowdown. Well, he is wrong again.... I am expecting a follow-up execuse from him

I think China's potential slowdown in the future is more likley to be caused by domestic problem instead of external factors. China is not exporting many durable goods to the U.S., and I think Americans even in recessions have to buy clothes and have to give Christmas gifts to children. I don’t deny that China is dependent on U.S. market, but not in the same way as Japanese do (they export cars, the demand of which is more cyclical)

After BRICs, Goldman Sachs names another eleven promising economies

In Global Economics Paper No.134 “How Solid are the BRICs?” (pdf file), Goldman Sachs names another eleven economies that may emerge as important players by 2050. They are (in alphabetic order): Bangladesh, Egypt, Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan, Philippines, Turkey, Vietnam. Goldman Sachs names them N11 (i.e., the Next Eleven).

P.S. I would say GS forgets another important economy: the Hispanic population of the United States! According to another GS report "The Hispanization of the United States", by 2030, Hispanic/Latino population in the United States will reach 73 million, or 20% of US population. The Latino US is going to become an important emerging (or even industrialized) economy! Be prepared for it.

GS believes that following BRICs (Brazil, Russia, India and China), these eleven economies may become influential by 2050 because of the projected size of their economies.

Among them, Korea and Mexico are particularly important. Mexico will become the sixth-largest economy. By 2050, Korea will become richer (in income per capita) than any  of the current G7s (Canada, France, Germany, Italy, Japan, U.K., U.S.) except the U.S.  GDP per capita of Korea will reach 81,462 USD (in market exchange rate) in 2050, if everything goes smoothly, while Mexico’s will reach 52,990 USD. U.S.’s GDP per capita, standing at 89,663 USD in 2050,  will be still slightly richer than Korea’s.

Currently, US’s GDP per capita stands between 42,000 and 43,000 USD/year, and Korea’s GDP per capita will reach this level between year 2015 and 2020, which is not very far away from now.

In a previous post in the Bulletin, I also discussed why Korea has potentials to become an economic and geopolitical regional power.

Will India collapse in balance sheet crisis? a worse scenario analysis

Special note: this analysis is more a stress-test/worse-scenario type of exercise and "thought experiment". I don’t think a crisis is imminent for India, neither do I think it is a large-probability event. An external debt crisis is in particular impossible. The analysis however, by dissecting the problem, helps you identify the weakest links of the system and hopefully may help inform policy-makers in addressing the problem ealier than later.

Will India collapse in balance sheet crisis?

My evaluation is that: India’s national balance sheet is unsustainable in the long term, but financeable  in the short term. Nouriel Roubini has the same opinion in his article “A balance sheet crisis in India” (PDF file)

First, let me tell you why it is unsustainable in the long term. When evaluating a country’s vulnerability to crisis, we need to examine the overall balance sheet of the country, which include not only the corporate and banking sector, but also the government sector.  This is particularly true in India and China, where the liability can be easily moved between balance sheets of the banking sector and the government as a result of strong state intervention in the economy.

In both India and China, governments are heavily involved in loss-making projects. But the losses are recorded differently.

In China, government forces state-owned banks to extend so-called “soft loans” to industries and enterprises favored by the government’s fiscal goals, and thus the huge losses are recorded in the banking sector as non-performing loans.

In India, the government directly involves in subsidizing these “white elephant” projects,  and then finance the expenditure through issuing government bonds to captive state-owned banks. Indian government thus accumulates huge public debts, which amount to more than 400% of its annual revenue.

We have to understand that, although the losses are recorded differently in India and China, if we examine the balance sheet of the country as a whole, they are not better than each other. If Chinese government increases its public debt to the level of India, she can use the revenue to write off the bad loans of the banking sector for many times. Similarly, if Indian government is to default or restructure on its debts, or there are doubts among depositors about the government’s repayment capacity, Indian banking sector will be broke over night as more than 35% of Indian banking sector’s total assets are in the form of government securities. Currently, government papers are treated as very safe and capital and loss reserve is not allocated to safeguarding against potential future losses, which results in misleading capital adequacy ratios.

In a worse scenario, such structure can cost you dearly. According to Professor Roubini, anything that can go wrong tend to go wrong together:

“Note also that if a bank run were to eventually occur—when and if depositors become concerned about the quality of the bank assets and the sustainability of government  debt—the ability of the Indian government to stem the run via explicit guarantees of deposits may be limited. A solvent government running a low deficit and with little debt may credibly guarantee deposits since it has resources to finance a bailout of the financial system. But an insolvent government cannot credibly backstop the banking system and promise to protect deposits given that the cause of the run is, in the first place, concerns about the solvency of the sovereign. Thus the risks of a bank run and the necessity of a deposit freeze become more severe when the government is effectively insolvent or semi-insolvent.”

Will Indian government default on its debt? India’s public debt to GDP ratio is some 85% and the government is still running large fiscal deficits every year, and even if India can maintain its 7%-8% economic growth rates and the interest rates do not go up, the debt ratio is heading toward 90% by the end of this decade, maybe even faster with the coalition government that will certainly spend more. However, high debt ratio alone will not trigger crisis. India’s public debts have long maturity terms (which however also means that banking sector will experiences large losses when short-term interest rates hike), and are mostly denominated in local currencies (which make India relatively free from crisis in external sector).

Nevertheless, everything that can go wrong will go wrong. When the balance sheet is unsustainable in the long run, it becomes very fragile in the short term too, as participants in the economy are forward-looking. Nothing will happen if India can maintain high growth and low interest rates, and (2) No large scandals happen in state-owned enterprises and banks. But if any one of these factors (growth, interest rate, confidence in public sector) goes wrong, investors will start to reevaluate the situation, and some of them may start to think: hey, the whole system is unsustainable in the long run, someone will eventually have to pay the bill, and I don’t want to be the last one to liquidate my position! 

One may point out that European countries also accumulate huge public debt, and why don’t you worry about them. Well, since when has India become a developed country?

Emerging markets are fragile in nature. Let’s review some famous Murphy’s laws:
(1) Anything that can go wrong will go wrong.
(2) If there is a possibility of several things going wrong, the one that will cause the most damage will be the one to go wrong. Corollary: If there is a worse time for something to go wrong, it will happen then.
(3) If anything simply cannot go wrong, it will anyway.
(4) If you perceive that there are four possible ways in which a procedure can go wrong, and circumvent these, then a fifth way, unprepared for, will promptly develop.
(5) Left to themselves, things tend to go from bad to worse.
(6) If everything seems to be going well, you have obviously overlooked something.
(7)It is impossible to make anything foolproof because fools are so ingenious.
(8) Whenever you set out to do something, something else must be done first.
(9) Every solution breeds new problems
I more and more feel that Mr. Edward A. Murphy is such a damn-good economist! World-class!

Recommended Readings:

Deutsche Bank Research: India’s public finances: do they matter? (PDF file)

Also two of my previous articles on India's banking sector:

Why is India’s financial system less solvent than China’s

Fix Mexico’s banks, not China’s

Financial Times interviews Lula and Alckmin

Financial Times' Richard Lapper and Jonathan Wheatley has made two long interviews with two leading candidates in the upcoming Brazilian presidential election.

Both Lula and Alackmin are the type of politicians who really try to convincing people by making points rather than by making sensational appeals, which is a bless for Brazilian politics. Indeed, from the long-term historic perspetive, Brazil is probably the most peaceful (baring the everyday petty street crims and the recent Sao Paolo riot) nation in the World. Immigrants from different origins, of different skin colors live quite comfortably along each other (relative to other immigrant nations), and even the military coups turned out to be the least bloody than they usually should be.

Let's see what they have to say to all of us, on the future of Brazil, and how they plan to make it a better one:

Interview transcript: Geraldo Alckmin (Centrist)
Interview transcript: Luiz Inacio Lula da Silva (Left)

My general impression is that,   the two's policies are not fundamentally different (partly because Lula is not that type of radical left, and partly because Alckmin really doesn't have anything new and concrete to impress and convince voters), and Alckmin's inexperience is going to cost him dearly.  Alckmin is much less eloquent and charismatic than Lula, and I don't see hard evidence that Alckmin can really get things done despite his repeated claim that "we have a lot of experiences" in this and in that.

I would bet that Lula is going to be re-elected by large margin.

Times of India champions China-bashing

Times of India: J&K blasts: Chinese grenades, Indian victims

What the hell has Chinese to do with India-born terrorists?

It seems that both China and India relies on nationalism, jingoism, and hatred, to keep citizens' attention away from own domestic problems.

McKinsey says financial sector reform could raise Chinese GDP by 17% a year

A study recently published in May by the McKinsey Global Institute, titled "Putting China's Capital to Work: The Value of Financial System Reform", has found that financial sector reforms in China, if properly executed, would raise gross domestic product by an astounding 17 per cent, or $321bn.

According to the report: better capital allocation would raise GDP by $259bn, while improving the efficiency of the banking system, switching from paper-based to electronic payments, and diversifying the mix of funding vehicles for corporations would raise GDP by $62bn annually.

Another report by McKinsey points out that Chinese domestic banks are more fragile then we thought, when facing foreign competition likely incoming in 2007.

We usually think that foreign banks cannot compete with Chinese local banks in retail banking, because it is prohibitively expensive for any foreign banks to attempt to replicate a nationwide branch network.  McKinsey report however identify an opportunity: just 2 per cent of local banks’ customers account for half of total household deposits and the bulk of banking profits in retail banking. 

This means that it is actually not that difficult for foreign banks to poach away these small number of "high net-worth individuals"  without setting up a huge branch network. These wealthy customers are more likely to have private transport vehicles and shouldn’t care that much about the location of the bank branches, so long as they are located in the posh financial districts.

Bad news for gigantic Chinese local banks though. The report warns that "If even a small number of customers from this group shift to the foreign competitors, existing banks could face a liquidity crisis"

Hat tip: Financial Time: Ready to compete in global markets