Features : Eastern Promise


As the global economy continues to struggle, many are hoping China and India will save the world from a synchronized dive into recession.


Growth industry: India’s call center business is flourishing.

As the United States and other countries slide into deflationary recession, governments and central banks are pumping liquidity into the financial system, recapitalizing banks and launching a variety of fiscal stimulus packages to get consumers spending again. But will this be enough?

The answer, according to many, including Goldman Sachs chief economist Jim O’Neill, is that it will not—unless China and India, with their combined populations of nearly 2.4 billion, also start spending more freely. For the Asian giants this implies a shift from previous export-driven growth toward domestic consumption. It also raises the question of which of these is best placed to weather the storm.

“There is more scope for China to do it than India,” says Vanessa Rossi, senior research fellow with the International Economics Program at the London-based think-tank Chatham House. “Over the past decade,” she points out, “China’s share of global GDP has doubled.” It is now by far the largest single contributor to world economic growth, which Goldman Sachs analysts expect to halve from 3.2% in 2008 to just 1.6% this year. Of that greatly reduced global growth, China is expected to generate more than 60%, while India’s contribution is likely to reach nearly 20%. Taken together, they may provide three-quarters of the world’s domestic demand growth this year. Their behavior will make an enormous difference to how long and hard this global recession will be.

China’s role is crucial. Although its economy is expected to slow from recent double-digit growth, it should nonetheless continue to grow at a faster pace than any of the other large emerging economies. Moreover, China enjoys more leeway than any other major economy. According to the International Monetary Fund, it is running a current account surplus of nearly $400 billion a year, equivalent to 9.5% of the country’s GDP, and has accumulated some $1.8 trillion of foreign currency reserves, most of them held in US treasuries.

India, by comparison, is running a deficit equal to 2.8% of its GDP—considerably less than America’s 4.6% but still on par with developed countries such as France or Italy that are now entering recession. And while India’s foreign reserves have risen tenfold over the past decade, they currently stand at less than $300 billion. China is therefore far better positioned to spend its way out of recession by expanding domestic demand.

But is China’s leadership ready to do so? The signals so far are mixed. The $586 billion fiscal stimulus announced last fall was a decisive move, though it is focused on infrastructure spending rather than boosting consumption more immediately through tax cuts. Is it enough? Rossi estimates it is equivalent to 2%-3% of GDP but adds that it is not clear whether all of this is new money or not. Nor is it yet clear how—and how soon—it will be spent. China has been through its own real estate bubble, with property valuations in Beijing, Shanghai and other hotspots now declining and putting pressure on developers and financiers alike.

“They have got to move the focus of their construction industry to new areas like Sichuan, where there is need for infrastructure,” says Rossi. “That naturally poses a major logistical challenge.” But that will not provide an immediate economic stimulus. As Wensheng Peng, director and head of China research at Barclays Capital, points out: “The need for approvals and funding means that getting new infrastructure projects moving takes time, so the earliest impact of new spending on the economy is likely to come from the acceleration of existing projects. This government-led investment cannot be expected to fund infrastructure spending for long, so private sector investment must pick up when global conditions improve.” So China’s fiscal stimulus package could be both too little and too late to have much impact on the world’s slide toward deflation.

China’s Policy U-Turn
The second plank in China’s reflationary strategy has been a combination of aggressive interest rate cuts and loosening prudential rules on bank lending—an abrupt about turn on previous policy intended to curb inflation. “China had raised prudential ratios for its banks over the past two years to 17% so as to help cool down an overheating economy,” Rossi explains. “Now it has reduced them to around 15%, so a lot of cash can be injected into the economy through loans. In addition, there is an enormous pool of savings pent up in the banking system.” China has a huge advantage, she says, as “no other country in the world can readily afford action on this scale.” If it is done, she believes that China’s economic growth rate could hit 7% to 8% in 2009.

While that would bring growth close to government targets, it might not be enough. The economy is already showing signs of a downturn. Goldman Sachs notes that electricity production weakened for the first time since 1998, while the growth in industrial production has softened to levels not seen since the aftermath of the Asian financial crisis. Exports held up well last year compared with other major Asian economies, such as Japan or Korea, which have been harder hit by the decline in purchases of auto and consumer electronics products. But Peng warns that “China’s exports are now weakening,” and, as laid-off factory workers in southern China protest, the authorities have moved to shore up exports by devaluing the renminbi.

Again, this is a reversal. After a policy change in 2005 the central bank had allowed a 20% appreciation against the US dollar while maintaining an informal peg. But the dollar’s recent strength has made other Asian currencies such as the Korean won more competitive. Should China continue devaluing its currency, it might help traditional exports of low-value-added products and prevent more of them moving to lower cost centers in Asia. But managing the renminbi down to artificially low levels might also provoke an outflow of international investment. It would also aggravate the massive global imbalances that contributed to this recession and, by reducing Chinese consumers’ ability to purchase imported goods, turn any economic recovery into very much a domestic affair rather than one that stimulates trade.

As the world’s largest creditworthy country still enjoying a huge trade surplus, China is well positioned to boost domestic consumer spending. Last year retail sales were rising by 20%-plus, though this was partly fueled by the summer spike in food and other commodity prices. But even with lower interest rates and loosened credit, will Chinese consumers spend more?

The savings habit is deeply entrenched and is reinforced by the absence of an effective safety net in terms of health and social security. Recent statements from the Chinese leadership on increasing the country’s spending on medical care and education suggest a move in the right direction, though, as Peng points out, the plans are still vague. Until Chinese citizens feel more financially secure, they are unlikely to go out spending. Peng says weakened sentiment may even cause people to reduce their spending. Rossi goes further: “Like elsewhere,” she says, “the Chinese consumer will pull back.”


Heavy lifting: China will play a crucial role in kick-starting world economic growth.

India’s Pain Deepens
Can India do any better? Not so long ago, assumptions of continuing double-digit GDP growth, coupled with the “demographic dividend” of having a younger workforce, fueled forecasts of India’s economy overtaking China’s by mid-century. No more. “The Indian government accepts that the economy cannot continue generating 9%-10% growth achieved in recent years,” says Rossi. Moreover, she continues, “Its remarkable growth over the past decade depended much more on free market dynamics and inward investment than is true of China.” When sentiment turned and international investors headed for the door, both its stock market and the free-floating Indian rupee took a nosedive. In dollar terms, Mumbai’s Sensex lost nearly 70% of its value during 2008.

That said, the “crown jewel” of India’s economic renaissance—its $52 billion IT and outsourcing industry—has held up well so far and is looking to expand its global reach. Industry leaders Infosys and Wipro are looking to more “East-East trade,” including contracts with major Chinese banks. Similarly, Indian manufacturing has been diversifying its exports, especially to the Gulf region.

India faces some unique headwinds, though. The terrorist attack on Mumbai and heightened tensions with Pakistan have depressed tourism and capital inflows. And while domestic demand is likely to remain firm, growing at nearly 7% this year according to Goldman Sachs, banks are crimping lending due to rising credit risk, and companies are finding it harder to borrow, owing to their falling net worth.

With private sector investment slowing down, can the government step into the breach by pushing ahead with much-needed infrastructure projects? “There is little confidence that India can crank up its infrastructure and public spending,” says Rossi, partly because of bottlenecks in electricity generation and other areas. More importantly, she adds, “India simply doesn’t have the financial resources to do it because its fiscal and current account deficits are larger.” Goldman Sachs recently revised down its forecast GDP growth for India in 2009 from 7% to less than 6%, largely due to the knock-on effects of the international crisis on both domestic and external demand.

The good news for India is the fall in commodity prices, which, combined with a good harvest, will ease both inflationary pressures and the mounting trade deficit. But in the absence of major fiscal stimulus, Rossi believes this will be “a bad recession for India,” adding that more pessimistic forecasters are predicting that growth will shrink to between zero and 2%.

While India may come to rival China in the longer term, it is not nearly so well placed to come through this downturn, let alone pull the battered Western economies back from the brink. China is well placed to do so, and thanks to “its favorable fiscal position and high savings rate,” say Goldman Sachs economists Peter Berezin and Alex Kelston, the country “is in a position to do more if conditions warrant it.”

The key question is whether its leaders are willing to switch from an investment- and export-driven economy toward one powered by higher domestic consumption. That might lead to a more balanced internal economy, help unwind global imbalances and save the world from what Rossi calls “a synchronized dive into recession.” Only time will tell.

Jonathan Gregson