Development Bank Research Bulletin

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.

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

Inefficient banking sector in China is actually an optimal way of taxation

It is well perceived that China's state-monopoly banking sector (with the help of capital control) is a powerful tool in channelling private sector wealth into loss-making state-owned enterprises and numerous white-elephants public infrastructure projects.

A paper written by several Chinese economists however argues that such a mechanism is actually optimal. The idea is as follows.

In developing countries, it is usually very difficult for the government to collect taxes (everyone hides their income), and official taxation is usually very inefficient (it creates a lot of distortion in the economy and a disproportionate burden on hard-working and smart people). Formal taxation thus becomes very costly and creates a lot of dead-weight costs.

But the government needs money and by whatever means the government will try to extract revenue from the private sector. Conditional on the "grabbing hand" nature of the government, an “implicit taxation” by channeling private sector wealth into low-return public projects, through the monopoly banking sector, becomes an optimal and efficient solution:  it is efficient because (1) the cost of “tax “collection is low (you can avoid it only if you completely go underground) (2) the “taxation” is relatively fair and less distorting (it is proportionate to your existing wealth).

Certainly it is even better if the government does not try to extort the private sector in the first place. But if the government does do it, it is better that it does it through the banking sector. At least you don’t need to pay the robber to rob you, and at least hard-working people don’t have higher chance of being robbed.

When a gun is pointed at you, it makes no sense to fight. Take my money but don't hurt me.

Financial Repression and Optimal Taxation (pdf file)

Chong-en Bai, David D. Li, Yingyi Qian, Yijiang Wang

Financial repression entails an implicit taxation on savings. When effective income-tax rates are very uneven, as common in developing countries, raising some government revenue through mild financial repression can be more efficient than collecting income tax only.

China offers to build 1 M low-cost houses.....for Filipinos though

I was at first very excited when reading the title of the news: “China offers to build 1 M low-cost houses”. Chinese government is starting to fulfill its promise to help low-income people! I thought.

As I read on, however, to my disppointment, I discovered that the houses will be built in Filipinos in Philippines.

I am not saying that China should not share the responsibility in helping poor countries, but come on, there are more people back home in China who are in greater need of housing, and China after all is not a rich country.

Shouldn’t China solve the domestic problems first? Shouldn’t China treat its own citizens well first?

But then I remember something:

Oil reserve, offshore Philippines in China sea!

Then it could be profitable deal.

Time of India: "India 12th wealthiest nation in 2005"???

Times of India: “India 12th wealthiest nation in 2005: World Bank”?  Also in the Hindu

Oh my god! India? Wealthiest nation?  Pankaj Mishra's op-ed "The myth of new India" published in the Hindustan Times makes some very good and sober comments on this type of media euphoria: "Mittal is as much an Indian success story as Sergey Brin, the Russian-born co-founder of Google, is proof of Russian's imminent economic superstardom."

A foreigner, if he never walks out of his Indian hotel and reads only Indian newspaper headlines, will certainly get an impression that Indian is the heaven.

Everyday, you are bombarded by headlines like “Asian Development Bank president: India to become a developed nation soon”,   “Indian banks beat Asian peers” “India to beat China in 10 years: BBC survey” (by the way it was actually a survey of Indians),  “No one has actually made any money in China” , so on and so forth.

Any rankings released by any small organizations, so long as India ranks better than Pakistan or China in one of the numerous components of the ranking system, will be highlighted on the same day on Indian newspapers.

The same is true for China, but never to such an extent. Many Chinese are proud of their country as the 4th largest economies in the world, not realizing that the “wealth” has to be divided by 1.3 billion fellow countrymen, and in an terribly unequal way. But I never see any Chinese newspaper headline that portraits China as one of the “richest” or “wealthiest” nations.

When you read Chinese newspapers, except the state media People’s Daily (which by the way cannot be found in most newspaper stands on the streets. i.e., no one buy it), I will say when it comes to economic news, there is not much difference between Chinese newspapers and Indian newspapers. This is not to say that Chinese media is in any sense free, but that Indian newspapers, at least when it comes to economic news, are as propagandist as Chinese ones. The difference is that: Chinese newspapers are forced to, while Indian newspapers choose to, to please readers.

There is a joke that goes like the following. China and India are the same although one has the strictest media censorship in the world while the other has free media. In Chinese newspapers, you always find a lot of articles about the need for reform and how many hidden dangers are ahead of the economy. In Indian newspapers, you will find the same thing: banking sector problems, pollutions, labor unrest......... in China though!

There are actually quite a few academic studies that try to find out the reason why media industry, even with perfect degree of freedom, will still purportedly propagate biased information. One of the reasons, as many researchers point out, is that readers believe only what they want to believe, and when the benefit of finding out the truth is much smaller than the cost, no one bother to find out.

I think it is quite true. If you cannot do anything about the poverty, why bother emphasizing it on a daily basis. The other day, I saw a BBC article, which highlights the number of Indians living under $1/day. A local Indian commented below the article that: “why do you throw out a number every several days about the poverty of India. We don’t need you to tell me that we are poor. We can see it everyday when we goes to work. We don’t need you to repeat it”

It's qutie true. After you spend you real life in a sweatshop, why don't you want to review your real tough life again when you go home to relax.

Private Sector Development is good for the environment: new data from World Bank’s China office

Private sector and privatization is always blamed for the degradation of the environment. Some self-proclaimed “environmentalists” always insist that greed and evilness is deeply rooted in the heart of  private sector and big “bad” corporations, and only the angel, i.e. the government, can and always benevolently acts as the savior of the earth.

Let’s set aside for a moment the debate on who (private sector or the government) are more greedy (there are certainly more government corruptions than corporate scandals, don't you agree?), and see some hard data first.

The World Bank’s survey results recently released show that, within China, wherever private sector prospers, more efforts are exerted to improve on environmental standards, and residents enjoy not only higher wage but also cleaner air and more green space. When state-owned firms dominate, the reverse happens.

The reason is quite simply: private sector development increases government’s tax revenue, which is necessary (although not sufficient) for the conduction of environmental projects. We always hesitate to talk about money when it comes to environmental protection. How dare we introduce the sinful money into the purest domain of human race: environmental protection?  We sometimes think.

But the cold truth is that: to carry out environment-improving projects, you need money more than lip services. As Dan Harris in the China Law Blog rightly points out: “Copenhagen can afford a state of the art sewage system; Freetown, Siera Leone cannot.”

Certainly private sector development is not a sufficient condition for better environment, but we do know that state-owned firms are always the worse polluters.

The World Bank’s China country office surveys 12,400 firms in 120 Chinese cities. It is found that private sector development varies across China. In Wenzhou and Jiaxing, 99% of the firms are privately owned, while in the old Northeastern rust belt, only 60%. The cross-city variation of private sector development is then closely associated with local environmental standards.

According to an article written by David Dollar (World Bank's China country director) for the Newsweek:

“A good investment climate for firms also goes hand in hand with a good environment for people. As expected, cities with better investment climates tend to have higher wages (averaging $3,000 to $4,000 a year in coastal cities, versus $1,000 in the interior), less unemployment, lower infant mortality and higher education spending.

But surprisingly, they also score higher on environmental measures such as green space per capita, clean-air days per year and percent of water discharge that is treated. For example, cities like Weihai, Qingdao, Suzhou, Hangzhou and Fuzhou all score very highly in terms of business climate, and all treat 97 percent or more of their industrial waste water, with Weihai treating a perfect 100 percent.The opposite is also true. The average waste water treatment rate for cities with poor investment environments was about 78 percent. Why is this so? Cities with poor investment climates tend to have industry dominated by state firms, which often are the worst polluters.”

In an article "China's Pearl River Smells, But the Mayor insists to Swim in it" I posted in this Bulletin some time ago, I reports on the improved river water quality in Guangzhou, a southern Chinese boom town.  An American teacher living in that city comments with his/her first hand experience that the river still smells badly. It is very true that the river still smells. But five years ago, it stunk and it could hardly be called a river. And the river’s water quality is still much better than other Chinese cities.

Why? The reason is very simple. Guangzhou is one of the richest cities in China, and government tax revenue grows at 40% a year, and residents who are now better off financially are very sensitive to the environments surrounding them. Everything comes naturally after a country or a city gets richer.  London stunk too in the 19th  century.

Without private sector development, there certainly will be no greed, no pollution, because the earth will become a large zoo with all human beings living primitive lives. Note that these do not include some half-hearted prominent environmentalists residing in rich countries. They will still stay in New York, complaining about air pollution, and telling media how much they love Africa, as their zoo.

Finally, I have to emphasize that, to re-forest the earth, you need to plant more trees instead of consuming less paper. Research shows that the average American consumes the equivalent of one mature tree every year. This means that, however hard you try, you cannot save more than one tree even if you restrain from using any paper-related products.  But when you use less greeting cards, those people in developing countries who make these cards lose their jobs. I am quite curious why we are making so much fuss about sending paper Christmas cards. Isn’t it more efficient to donate some money to plant more trees instead of going through so many hassles to save one tree every five years?  No.... then a lot of lobby groups will lose their jobs. It is politics, stupid.

Note: I don’t think these “environmentalists” are true environmentalist. To qualify as a true environmentalist, you have to care about lives of the local people more than your daily media coverage. In the case of some labor unions, don’t disguise your own agenda as “helping poor people in developing countries”. If you truly want to help out, let the most capable and hardworking people from the developing countries compete with you and take your job.  And when you say you hate the pollution in New York and like to turn it into Amazon jungle, you must have a concrete plan to move to live in Amazon jungle, and let the local Brazilians to move here to occupy your apartments. Isn’t it a perfect exchange program: you want natural forest, and they want higher living standard. Kenyans are not stupid either, and they don’t want to live in a zoo watched by you, no matter how you portrait nomad life as a perfect integration with the environment. Enjoy it by yourself if you like it.

Deutsche Bank’s take of China, India, Brazil and Mexico: Reports

Below I put together a collection of country research reports produced by Deutsche Bank Research, on several important emerging economies. Let's see what are Deutsche Bank's take of Goldman Sachs's BRICs.

China 2020: challenges ahead (PDF file)
China should be able to achieve high growth for another decade, moving its GDP above that of most industrial countries. Challenges however include a fragile banking sector, rising unemployment, large government debt, and corruption within the one-party political system.

India rising: a medium-term perspective (PDF file)
GDP per capita will double in 2020. Favorable demographics, increasing investment in education and infrastructure and further integration with the world economy are the factors behind DB’s projections. IT-related services, textiles, and the auto-ancillary industry and pharmaceuticals are expected to gain dynamism given India’s comparative advantage.

Brazil: O pais do futuro? (PDF file)
Grow at an average of 3.3% year. Competing against China, Brazil is likely to maintain its position in niche high-tech sectors where it has a competitive advantage. Increased Chinese demand for commodities will provide Brazil with an opportunity to move up the value chain in commodity-related sectors.

Mexico 2020: Tequila sunrise (PDF file)
Geographic closeness to the US gives it an unique advantage. There is fair chance that Mexico’s industrial profile will make a successful transition from low value-added to more sophisticated products.

Russian “corruption market” estimated 3 billion USD/year

Russian thinktank INDEM Fund based on its annual survey estimates that the volume of Russia's “everyday corruption market” (i.e., sum of the bribes to be paid by citizens within one year) is 3 billion USD in year 2005, a slight increase from 2.8 billion USD in year 2004. The methodology of the study takes into two factors that determines the “market of corruption”: (1) corruption risk (authorizer’s corruption pressure onto citizens) (2) corruption demand (citizens’ readiness to bribe)

Several “services” occupy the top positions of “market share”:

(1) Higher education: to enter, transfer, exams, etc (583 million USD);
(2) Free medical service (401 million USD);
(3) Solving problems related to conscription procedure (354 million USD)
(4) Dwelling: to obtain and/or legalize a relevant proprietary interest ( 299 million USD)
(5) To obtain justice in law-court (210 million USD)
(6) to solve problems with road police authorities (obtaining driver’s license, technical examination, road traffic, etc.) (183 million USD) . Obtaining driver's license is quite a "business" in many developing countries; you may also want to read a World Bank report on corruption of obtaining driver’s license in India (hat tip: PSD blog)

The Russian corruption report by INDEM Fund can be found here.

Five billion is certainly surprisingly a small amount, compared to China’s 50-84 billion USD/year, which amouts to 3-5% of China's GDP (according to an global anti-corruption report by OECD, co-authored by among others Janos Bertok). The China and Russia numbers however are not quite comparable, because the Russian number only takes into account everyday bribes, while petty bribe is  actually a relatively smaller problem in China compared to embezzlement of public funds.

In China, according to the same OECD reports, two-third of the corruption fugitives were senior executives of state-owned enterprise. When they fleed(to favorite destination: California, New Jersey, Canada, where extradition treaties are not signed with China), they bring with them huge amount of money.

CLSA: China manufacturing price will have to rise

According to CLSA’s latest Purchasing Manager Index (PMI), Chinese manufacturing firms are having a very good time:  production up, employment up,  incoming business up, new export orders up, backlogs of work up, stock of inventory down. China is (over) heating!

The overall effect for foreigners however is that consumer price and interest rate will move up inevitably in the next several months. I am not sure whether this will continue for ever; based on estimated capacity of power plants and steel mills under construction, in 2007 both electricity and steel capacity in China will exceed demand (currently there is a shortage of both) and the trend of rising input costs is likely to slow down.

According to the CLSA report:

“Production rose for a sixth consecutive month in May, at a rate close to April’s eleven-month high. Output was led higher by increased volumes of incoming new business, which rose at the strongest rate in thirteen months. New order gains were driven by robust demand from both domestic and foreign clients. Growth of new export orders accelerated to the sharpest for twelve months during May.

     Backlogs of work rose for the third consecutive month, with the rate of growth picking up to the sharpest since last December. A number of firms met increased sales from warehouse inventory, contributing to further contraction in stocks of finished goods.

     Latest data highlighted a rise in employment at Chinese manufacturing firms for the second month running in May, though the rate of hiring remained only marginal.

     The quantity of inputs purchased by firms continued to rise in May, with the rate of growth quickening for the fourth straight month to its strongest since April 2005. This contributed to a further expansion of pre-production inventories. Supplier lead times were found to have lengthened slightly for the fourth consecutive month in May, reflecting stronger demand for inputs.

     The rate of input price inflation in the Chinese manufacturing economy surged from April’s already strong pace to a fourteen-month high in May, as 44% of panellists signalled a rise in their average purchase costs since the previous month. Firms widely reported higher prices paid for oil and related products, as well as chemicals and metals.      In order to offset rapidly rising input costs, manufacturers raised their charges again in May. The rate of output price inflation was robust and the sharpest since March 2005, but was still well below that of input prices, reflecting intense competition in a number of markets. This suggests a further squeeze of profit margins.”