from Follow the Money

Chindia (or maybe not)

March 23, 2007

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The similarities between China and India have seized many (see Martin Wolf's column and the resulting discussion).   Both China and India have enormous populations -- and enormous scope to increase their urban labor force as their absolutely enormous rural population migrates towards urban areas.   Both have grown very rapidly recently. Indian growth is now close to Chinese levels.   Both have grown on the back of strong investment.   Both have experienced strong credit growth.  Both have booming stock markets -- though the timing of their respective booms hasn't always coincided perfectly.   Both have experienced rapid reserve growth.

And both have the potential to exert an enormous influence over the global economy.   China, for that matter, already does.

Still, I have been far more struck by the differences than the similarities.  And not just the obvious ones -- China's modern infrastructure is often contrasted with India's crumbling infrastructure, China's supposedly efficient version of bureaucratic capitalism (and the absence of political reform) is often contrasted with India's democratic but sometimes more chaotic political institutions.    

No, what has struck me is that India's recent acceleration is having a lot of the effects that one conventionally would expect -- rapid credit and investment growth have led to inflation and current account deficits -- while China's recent strong growth hasn't had the effects one would expect.  Jon Anderson of UBS has argued that China is one massive economic puzzle for conventional macroeconomists.  He is right.   India isn't.  Or at least as big of a puzzle.

India has experienced a massive credit boom over the past few years, well detailed by in a highly recommend Global Economic Forum piece by Chetan Ahya of Morgan Stanley.  Bank credit has grown in relation to GDP -- and relative to deposits.   The surge in credit has contributed to a boom in investment.  Indian household savings are comparable to Chinese household savings. Indeed, Louis Kuijs found that household savings are a higher share of India's GDP than China's GDP.  But India's government and private sector have far more need to borrow these savings than China's government and private sector.   As a result, Indian savings lag Indian investment, leading to a current account deficit.

Strong credit growth has also been one factor pushing up inflation.   Higher rates of inflation, in turn, have led the RBI to push up interest rates.   Inflation is now in the 6.5% range -- faster than in the US or Europe, so India's real exchange rate would appreciate even if the nominal exchange rate stayed stable.   And nominal interest rates are now 7.5%.   That is lower than nominal GDP growth -- but I suspect the gap between India's nominal interest rates and India's nominal GDP growth isn't as big as the comparable gap in China.

Higher interest rates are pulling in foreign capital.  As Andy Mukherjee continues to note, India has emerged as a popular carry trade destination.  India's capital account isn't fully open, but it seems to be open enough.   Strong inflows led to very rapid reserve growth in February. Those inflows seem to be creating trouble for the RBI.   Sterilization isn't easy.  This week, India's efforts to tighten liquidity to slow credit growth seem to have gotten in the way of the need for cash to make tax payments, pushing up short-term rates and the rupee and pulling foreign money in.  Those are the kind of difficulties, in a sense, that one would expect from large scale capital inflows and rapid reserve growth in the context of a fixed exchange rate.

And yes, I do think India, like China, should allow its exchange rate to appreciate.  Some Indian analysts do to.  A stronger rupee would help contain inflation -- and, at some point, reach a level that reduces India's need for sustained reserve growth.

Contrast India with China.    Credit growth in China also has been strong -- faster than GDP growth.  Bank credit to GDP is rising - and rising from a very high level.   But as fast as credit has grown, it hasn't kept up with deposit growth.  So the lending to deposit ratio in China's banking system is falling (note DeLong's ballpark math; China's banks are increasingly lending to the central bank rather than state firms).  

Even after the recent rate hike, Chinese interest rates are far lower than Indian rates.

No doubt they are -- as the Economist argues this week -- too low.    Denise Yam of Morgan Stanley thinks so.  She writes:

The interest rate rises so far have left rates still way below the neutral level consistent with the pace of economic growth, fostered speculation in asset markets, and left China vulnerable to a rebound in excessive investment.

China keeps lending rates well above deposit rates, so the banks have a strong incentive to lend their spare cash out to private firms at 6% and change rather than lend to the central bank for 3.25% (less for shorter maturities).   Since the banks have plenty of cash on hand, they should be lending even more at current interest rates.

China's government, however, doesn't let the banks lend out as much as they want.    Administrative controls keep credit growth below lending growth -- creating a built-in market for central bank paper.  But even so, sterilization has been partial.  

China's ability to combine a massive investment boom with an even bigger boom in savings and thus a rapidly rising current account surplus is a puzzle -- investment booms usually lead to current account deficits, or at least smaller surpluses.  But perhaps the biggest puzzle of all -- as Brad DeLong notes -- is how China has been able to combine stupendous reserve growth, partial sterilization and low inflation.  

Theories abound.  

The reservoir of labor in China's countryside is part of the answer.   But perhaps not the entire answer.  India also has a reservoir of labor in its countryside, yet a boom - combined with rapid reserve growth -- is still generating inflation there. 

Like Martin Wolf, I think the restrictions on bank lending -- combined with the government's own high rate of savings -- have been crucial to China's ability to hold down inflation and thus sustain an undervalued exchange rate.  The government has effectively locked up a lot of Chinese savings in the banking system where it is lent to the central bank at low rates.  And since the RMB is expected to appreciate, Chinese savers have been willing to keep a large fraction of their funds in the banking system despite the low deposit rates.

Still, the absence of more inflation in China is a puzzle.  India's reserve growth -- even, I think, in relation to its GDP -- hasn't been comparable to China's reserve growth.  But India's reserve growth has coincided with far more visible signs of overheating, far higher inflation and far more obvious difficulties with sterilization than China's reserves growth.      At least that is how it seems to one external observer.

UPDATE: John Makin of the AEI on Chinese monetary policy.  By comparison, I am a model of restraint!