Development Bank Research Bulletin

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.

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

The first fund to invest in North Korea: want to join?

Investing in North Korea? It is certainly a brave men’s game. But now you have an opportunity a London-based fund that is going to tap into North Korea’s rich natural resources.

According to Ohmynews:

“London-based Chosun Development & Investment Fund LP is trying to raise US$50 million (euro40 million) to exploit, as it says on its Web site, ''opportunities in the Democratic People's Republic of Korea ... one of the last frontiers of global investing.'' It claims to be the first such fund dedicated to investing in North Korea.

The fund's manager, Anglo-Sino Capital Partners Ltd.,hasreceived regulatory approval from Britain's Financial Services Authority, providing the green light to begin soliciting investors.”

They have several experienced partners on board, e.g. Lynn Turk, a former U.S. diplomat with expertise in North Korean affairs, Robert Fox, a fomer group vice chairman of investment bank Dresdner Kleinwort Benson. See the list of the investment team members.

There are certainly a lot of risks. But as Colin McAskill (the fund’s exclusive investment advisor) said: ''They have gold, silver, zinc, masses of iron ore, all that the rest of the world, particularly China, needs right now''

Disclaimer: I am not responsible for any of your investment decisions.

Presidential democracies were 4.9 times more likely to default than parliamentary democracies

What types of countries are more likely to default on their sovereign debts? It is a multi-billion dollar question.  Professor Emanuel Kohlscheen has a new finding: Presidential democracies were 4.9 times more likely to default on external debts between 1976 and 2000 than parliamentary democracies.  The reason is, as he argues, that  parliamentary democracies are less likely to default on their liabilities as the confidence requirement creates a credible link between economic policies and the political survival of the executive.

Why are there serial defaulters? Quasi-experimental evidence from Constitutions (PDF file)
Abstract: Presidential democracies were 4.9 times more likely to default on external debts between 1976 and 2000 than parliamentary democracies. This paper argues that the explanation to the pattern of serial defaults among a number of sovereign borrowers lies in their constitutions (on serial defaults see Reinhart, Rogo. and Savastano (2003) and Reinhart and Rogo. (2004)). Ceteris paribus, parliamentary democracies are less likely to default on their liabilities as the confidence requirement creates a credible link between economic policies and the political survival of the executive. This link tends to strengthen the repayment commitment when politicians are opportunistic. I show that this effect is large and statistically significant in the contemporary world even when comparison is restricted to countries that are twins in terms of colonial origin, geography and economic variables. Moreover, the result persists if OECD democracies are excluded from the sample. Since the form of government of a country is typically chosen at the time of independence and highly persistent over time, constitutions can explain why debt policies in developing countries are related to individual histories.

New evidence: Politically Connected Firms are prevalent around the world

Professor Mara Faccio’s new paper (publisehd in the American Economic Review)  shows that politically connected firms are prevalent around the world (not only in Thailand, Indonesia), and the announcement of a new political connection (e.g. businessmen entering politics) results in a significant increase in value.

Politically connected firms (PDF file)
Abstract: Examination of firms in 47 countries shows a widespread overlap of controlling shareholders and top officers who are connected with national parliaments or governments, particularly in countries with higher levels of corruption, with barriers to foreign investment, and with more transparent systems. Connections are diminished when regulations set more limits on official behavior. Additionally, I show that the announcement of a new political connection results in a significant increase in value.

What do Brazilian firms get for contributing money to politicians? More money.

Businessmen are not running charity organizations; They are pragmatic and calculating;  They wont’ give you money for free. For every dollar they give you, they will at least recover the costs. Last time I covered an academic paper about Thai elections, which shows that businessmen-cum-politicians reap huge benefits after they get into power. This is true for Brazil too. Let me show you a recent study.

Stijn Claessens and  Luc Laeven (World Bank) and Erik Feijen (University of Amsterdam) examine political campaign finance in 1998 Brazilian elections and find that elected politicians might  be  able to feed back to their financial supporters by directing more banks credits (presumably from state-owned banks) to them.

Every investor in Brazil (I would say it is more the case in Italy where everything is about politics) understand such game; As a matter of fact, we find that stock prices of those listed firms that contributed to politicians rose sharply over  election days.

A further question I would like to ask is: if the rule of the “game” is so clear, why do some firms contribute while the others do not?  Well, certainly I don’t believe that those who don’t contribute are cleaner in their conducts. But why don’t they contribute?

In many developing countries, those who contribute to politicians are actually the least connected. Politicians in Brazil routinely request kick-backs or "monthly-payment" from the business community. A tape revealed that Waldomiro Diniz (an advisor to the Minister Jose Dirceu) was extorting the gambling mafia of Rio de Janeiro to gain funds for Worker's Party political campaigns. These mafias are just underdogs. Those who are truely connected sit on corporate boards.

Those tycoons who really hold de facto power don’t give a shit to these politicians: In January 2002, Celso Daniel, who had already been appointed coordinator of Lula's campaign for the October elections was murdered. Unless there emerges a strongman military dictator, it is more likely that the tail (business tycoons) will wag the dog (politicians)!

Does Campaign Finance Imply Political Favors? The Case of the 1998 Brazilian Elections

Abstract: This paper provides empirical evidence that campaign contributions are strongly associated with market expectations of future firm-specific political favors, including preferential access to external financing. Using a novel dataset, we find that firms in Brazil providing contributions in the 1998 campaign to (elected) federal deputies experienced higher stock returns following the election, even after controlling for industry-specific effects. This suggests that federal deputies were expected to shape policy to benefit these firms in particular. Consistent with such political favors, we find that these firms relative to a control group substantially increased their financial leverage in the four years following election, suggesting that contributions gained firms preferential access to finance.

For a review on campaign finance's role in Brazilian politics, please read Professor David Samuels' article: Money, elections, and democracy in Brazil

China and India: Who is hot in 2006? What do investment banks think?

Most investment banks have already released their forecast of GDP growth rates for India and China. Let’s see what they think about these two competitors’ prospects in 2006.
I find only three major investment banks that have released forecasts on both countries. They are Deutsche Bank, Citigroup, and Morgan Stanley.

Deutsche Bank always has no preference!
Deutsche Bank forecasts that China’s GDP will grow at 9% in year 2006, while India will grow at 6.9%. This creates a 2.1% growth gap. Both numbers are almost the same as the consensus in the market. This is not the first time; I have to mention that last year DB did the same thing. DB always agrees with the consensus view!

Citigroup loves Indian foods!
Citigroup however thinks the gap should be smaller. Citi predicts that China will grow at 8.7%, while India at 8.1%, which produces a merely 0.6% gap compared to DB’s 2.1%. I have to mention that Citi’s 8.1% forecast of India's year 2006 GDP growth is the highest among all major IBs. Their forecast of 7.5% for last year also was the highest. Citi does love Indian foods!

Morgan Stanley does not like Asian foods!
Interestingly, Morgan Stanly is very pessimistic about both India and China. Morgan Stanley thinks China will grow at only 7.8% while India at 6.6%. Among all major forecasters who have released numbers for China and India, Morgan Stanley’s forecast is the lowest. Last year MS also was the most pessimistic about the two countries, and missed the target by wide margin. They must have some private information and hard evidence backing their persistent opinion. I will try to find it out and share with readers in the next weeks.

Credit Suisse, Goldman Sachs, and BNP Paribas loves Chinese foods!
Finally, Credit Suisse, Goldman Sachs, and BNP Paribas are quite optimistic about China. They think China will grow at 10.1%, 9.6%, 9.5%, respectively, in year 2006.

Well, it is always to interesting to reexamine at the end of year 2006 how accurate their bets were. Please do remind me to do that.

Some reference readings on investment banks' views on China vs. India:

Morgan Stanley's Report: Indian and China: a special economic analysis
Deutsche Bank's Report:  China and India Chartbook: a visual essay

Indian state-owned banks introduce performance-linked incentive packages for employees: the true story

According to a report in today’s Business Standard, India’s finance ministry decided on a reform plan to improve efficiency in state-owned banking sector. In the plan, not only the chairmen and executive directors but also ordinary employees are entitled to  performance-linked incentive packages.

“Heads of 29 public sector banks are set to get a performance-linked annual incentive package. Besides, all of them will get a lumpsum ex-gratia payment on retirement, depending on the number of years they put in as directors on bank boards.  Down the line, close to 800,000 employees in the public sector banking industry, too, will get incentives, based on their performance in five key areas.”

Five parameters are considered to determine the size of annual bonus,  which includes “credit growth, deposit mobilization, quality of assets, and recovery of non-performing assets.” (The report mentions only four parameters though).

I don’t think such design can help achieve the efficiency goal.

First of all, credit growth and deposit mobilization has nothing to do with efficiency; to the contrary, for India, faster credit growth and deposit mobilization  in state-owned banks actually reduce financial stability and crowd out efficient investment (as state-owned banks typically use the deposits to purchase government bonds instead of to invest in good projects).

Secondly, the “incentive” package is not linked to individuals’ performance but the performance of the whole bank. No employees will work hard to improve quality of assets or to recover non-performing loans, because (1) if he works hard, his colleagues in all branches across India can free-ride on the results as well (2) if he doesn’t work hard, he can still receive bonus pay so long as his colleagues work hard (3) knowing this, no one work hard.

There are restrictions on the total size of the incentive package: “The maximum amount a bank can pay to employees through this route will be capped at 1 per cent of a bank’s profit after tax (PAT).”  Nevertheless, no details are given regarding what fractions of this 1 per cent will be allocated to ordinary employees. Theoretically, all of them may be allocated to the CEO, which did happen in many corrupted countries when they introduced so-called “employee” incentive package. As a matter of fact, I also notice that: “Financial incentives given to chairmen and executive directors will be outside the cap (1 per cent of PAT) applicable to bank employees.”  Ha, I caught you!

I speculate that the plan is drawn up simply for the purpose of legally tunneling money from the state treasury to chairmen and executive directors of state-owned banks.