Why India is Riskier than China

Stephen S. Roach


NEW HAVEN – Today, fears are growing that China and India are about to be the next victims of the ongoing global economic carnage. This would have enormous consequences. Asia’s developing and newly industrialized economies grew at an 8.5% average annual rate over 2010-11 nearly triple the 3% growth elsewhere in the world. If China and India are next to fall, Asia would be at risk, and it would be hard to avoid a global recession.

In one important sense, these concerns are understandable: both economies depend heavily on the broader global climate. China is sensitive to downside risks to external demandmore relevant than ever since crisis-torn Europe and the United States collectively accounted for 38% of total exports in 2010. But India, with its large current-account deficit and external funding needs, is more exposed to tough conditions in global financial markets.

Yet fears of hard landings for both economies are overblown, especially regarding China. Yes, China is paying a price for aggressive economic stimulus undertaken in the depths of the subprime crisis. The banking system funded the bulk of the additional spending, and thus is exposed to any deterioration in credit quality that may have arisen from such efforts. There are also concerns about frothy property markets and mounting inflation.

While none of these problems should be minimized, they are unlikely to trigger a hard landing. Long fixated on stability, Chinese policymakers have been quick to take preemptive action.

That is particularly evident in Chinese officials’ successful campaign against inflation. Administrative measures in the agricultural sector, aimed at alleviating supply bottlenecks for pork, cooking oil, fresh vegetables, and fertilizer, have pushed food-price inflation lower. This is the main reason why the headline consumer inflation rate receded from 6.5% in July 2011 to 4.2% in November.

Meanwhile, the People’s Bank of China, which hiked benchmark one-year lending rates five times in the 12 months ending this October, to 6.5%, now has plenty of scope for monetary easing should economic conditions deteriorate. The same is true with mandatory reserves in the banking sector, where the government has already pruned 50 basis points off the record 21.5% required-reserve ratio. Relatively small fiscal deficits – only around 2% of GDP in 2010leave China with an added dimension of policy flexibility should circumstances dictate.

Nor has China been passive with respect to mounting speculative excesses in residential property. In April 2010, it implemented tough new regulations, raising down-payments from 20% to 30% for a first home, to 50% for a second residence, and to 100% for purchases of three or more units. This strategy appears to be working. In November, house prices declined in 49 of the 70 cities that China monitors monthly.

Moreover, it is a serious exaggeration to claim, as many do today, that the Chinese economy is one massive real-estate bubble. Yes, total fixed investment is approaching an unprecedented 50% of GDP, but residential and nonresidential real estate, combined, accounts for only 15-20% of thatno more than 10% of the overall economy. In terms of floor space, residential construction accounts for half of China’s real-estate investment. Identifying the share of residential real estate that goes to private developers in the dozen or so first-tier cities (which account for most of the Chinese property market’s fizz) suggests that less than 1% of GDP would be at risk in the event of a housing-market collapsenot exactly a recipe for a hard landing.

As for Chinese banks, the main problem appears to be expos-+-ure to ballooning local-government debt, which, according to the government, totaled $1.7 trillion (roughly 30% of GDP) at the end of 2010. Approximately half of this debt was on their books prior to the crisis.

Some of the new debt that resulted from the stimulus could well end up being impaired, but ongoing urbanization – around 15-20 million people per year move to citiesprovides enormous support on the demand side for investment in infrastructure development and residential and commercial construction. That tempers the risks to credit quality and, along with relatively low loan-to-deposit ratios of around 65%, should cushion the Chinese banking system.

India is more problematic. As the only economy in Asia with a current-account deficit, its external funding problems can hardly be taken lightly. Like China, India’s economic-growth momentum is ebbing. But unlike China, the downshift is more pronouncedGDP growth fell through the 7% threshold in the third calendar-year quarter of 2011, and annual industrial output actually fell by 5.1% in October.

But the real problem is that, in contrast to China, Indian authorities have far less policy leeway. For starters, the rupee is in near free-fall. That means that the Reserve Bank of India – which has hiked its benchmark policy rate 13 times since the start of 2010 to deal with a still-serious inflation problem – can ill afford to ease monetary policy. Moreover, an outsize consolidated government budget deficit of around 9% of GDP limits India’s fiscal-policy discretion.

While China is in better shape than India, neither economy is likely to implode on its own. It would take another shock to trigger a hard landing in Asia.

One obvious possibility today would be a disruptive breakup of the European Monetary Union. In that case, both China and India, like most of the world’s economies, could find themselves in serious difficulty – with an outright contraction of Chinese exports, as in late 2008 and early 2009, and heightened external funding pressures for India.

While I remain a euro-skeptic, I believe that the political will to advance European integration will prevail. Consequently, I attach a low probability to the currency union’s disintegration. Barring such a worst-case outcome for Europe, the odds of a hard landing in either India or China should remain low.

Seduced by the political economy of false prosperity, the West has squandered its might. Driven by strategy and stability, Asia has built on its newfound strength. But now it must reinvent itself. Japanese-like stagnation in the developed world is challenging externally dependent Asia to shift its focus to internal demand. Downside pressures currently squeezing China and India underscore that challenge. Asia’s defining moment could be at hand.

Stephen S. Roach, a member of the faculty at Yale University, is Non-Executive Chairman of Morgan Stanley Asia and the author of The Next Asia.


December 26, 2011

Dealing With China’s Troubles

China’s economy seems to be in trouble, which could be a very big problem for the world unless China’s leaders and trading partners ensure that economic strains in the world’s largest exporting nation do not lead to trade confrontations around the globe.

China’s housing bubble appears to be imploding, steel production is falling along with the demand for new construction and real estate developers are tottering, putting banks at risk. The Chinese government, which had been trying to curtail credit to slow the bubble’s rise, abruptly changed course last month, reducing the amount of money banks must keep in reserve at the central bank for the first time since 2008. On top of everything else, foreign demand for Chinese exports has slowed.

A hard landing in China would have an immediate impact from Brazil to Russia, whose exports of steel, lumber and other commodities fed China’s construction boom. And it will slow the world economy, which relies on China as one of the only remaining engines of growth.

But the bigger risk could be a trade war. Chinese leaders eager to hang on to power by showing continued economic growth may be tempted to pursue beggar-thy-neighbor strategies and subsidize exports in ways that would further destabilize a fragile world economy already buffeted by a crisis in Europe.

There are worrying signs that Beijing is going the wrong way. Earlier this month, it imposed a volley of duties against American-made sport utility vehicles. It will have little economic importance as few of these vehicles are sold in China. But analysts viewed the move as a warning that China will retaliate against Washington’s efforts to combat its subsidized exports. And the pace of appreciation of China’s currency has slowed markedly.

The Obama administration must also act with care. It is justified in challenging illegal trade practices, including pursuing its case at the World Trade Organization against illegal subsidies of Chinese makers of solar panels. But it should act multilaterally, including mustering other countries to add to the pressure on Beijing to act by the rules. Unilateral initiatives, like those in Congress to punish China for its cheap currency, are likely to cause more harm than good.

The ball is, however, in China’s court. Beijing must understand that it is a bad idea to double-down on an export-led strategy. There are better alternatives, including sensible stimulus measures like investing in low-income housing and expanding government-run health insurance. These would boost consumer spending and growth, reducing China’s dependence on export markets and investment bubbles. A policy switch like this would stimulate global growth. Sticking to the old game plan will drag the world down.

December 26, 2011

A Pandora's Box in the Middle East


Anyone who is thinking of attacking Iran should be prepared for powerful blows and iron fists.” So declared Iran’s supreme leader, Ayatollah Ali Khamenei, on Nov. 10, speaking in response to reports that Israel may strike Iran’s nuclear plants. But the risk of tit-for-tat attacks raises a specter few seem to recognize: the first radiological war in history.

General Masoud Jazayeri, deputy commander of Iran’s armed forces, indicated what “blows” and “fists” could mean when he warned last month that Dimona — the center of Israel’s never-acknowledged nuclear arms program — was “the most accessible target.”

The significance of the threat goes beyond the risk to Israel’s nuclear weapons program. An attack on the Dimona complex could release the facility’s radioactive contents, posing major long-term contamination risks to the reactor site and beyond.

But in a region where the principle of “an eye for an eye” has long held sway Tehran’s advantage stops there. As the country now housing the Middle East’s largest nuclear power plant at Bushehr, Iran has become the holder of the region’s largest radiological hostage. Does this present an Israeli checkmate? In this volatile part of the world, maybe, but don’t count on it.

Potential and active combatants have historically been reluctant to target operating nuclear reactors. The United States, for example, refrained from attacking North Korea’s Yongbyon plant to halt Pyongyang’s nuclear weapons program, in part over radiological concerns. Israel took off the gloves and bombed Iraq’s Osirak reactor in 1981 and Syria’s Al Kibar plant in 2007 before they went into operation, betting that neither country would strike Dimona in retaliation. The bet paid off. Iraq did not have the capacity to strike back and Syria feared the consequences of doing so.

Only in 1991, during the first Gulf war, did we see the first attack on an operational plant, when the United States bombed a small research reactor outside Baghdad. But Iraq had removed nuclear material from the plant before the war started, then tried its own hand at targeting reactors when it launched Scuds at Dimona. The missiles missed their targets.

Iran’s recent threat against Dimona may be mere puffing, but its ballistic missile capacity makes tit for tat strikes plausible, and General Jazayeri’s statement marks only one of many threats. Fortunately, Dimona is no Chernobyl or Fukushima. It has a relatively small reactor, and because it is used for weapons, operators replace fuel more often, reducing radioactive inventory, and Israel may not operate the plant continually.

On the flip side, after decades of service, adjacent facilities — some undergroundhold spent fuel, plutonium and atomic waste that could add significantly to the consequences of an accurate ballistic missile strike from Iran.

Radiological effects would depend on the volume and nature of nuclear isotopes released, seasonal winds and protective measures. Computer models suggest that well beyond the zone immediately in and around the reactor and nearby communities, even the plant’s relatively small inventory of radioactive material could lead to a vast increase in cancers, birth defects and other related illnesses.

There would also be many troubling socioeconomic consequences. Public officials would have to restrict the consumption of foodstuffs from even modestly contaminated zones, and require the evacuation of commercial, industrial and residential districts in radioactive hot spots. The nuclear accidents in Ukraine and Japan suggest a huge increase in stress-related illnesses. Addressing such matters would add to the billions of dollars governments would have to spend on nuclear cleanup.

Bushehr, unlike Dimona, is a very large nuclear power reactor. Located in the northern reaches of the Gulf, the plant only began partial operation in September. It will go to full power early next year, building up an inventory of dangerous elements in the operating fuel as a natural part of the process.

Were a military attack to strike the plant at full power after months of operation, the release of radioactivity could be greater than at Chernobyl. Prevailing north, northwest winds would carry radioactive debris along the Gulf across sparsely populated regions. Given the size of the Bushehr plant, the lessons of Chernobyl and Fukushima tell us that Iran’s cleanup burden, energy loss and medical and population-relocation costs could approach hundreds of billions of dollars over decades.

Despite these grim scenarios, both Israel and Iran can attenuate risks beyond the imperfect air and missile defenses now in place. This includes plant shutdowns in times of crisis and the removal of radioactive elements to more secure locations, as Iraq did in 1991. I

Israel could close Dimona permanently given the plant’s age and mission fulfillment — the old reactor has generated all the weapons plutonium the country requires. Closure would symbolically help to reduce nuclear tensions in the region as well.

Given the dangers, Israel and Iran would do well to ask if opening a radiological Pandora’s box serves either’s interest.

Bennett Ramberg served as a policy analyst in the State Department’s Bureau of Politico-Military Affairs under President George H.W. Bush.

Good Times Down Latin America’s Way

Jorge G. Castañeda


MEXICO CITY – For Latin America, 2011 was, in Frank Sinatra’s terms, a very good year – and 2012 doesn’t look like being so bad either. For a region not always accustomed to things going well, this is a somewhat strange state of affairs.

Three elections were held in Latin America in 2011. Two – in Argentina and Peruwent well; the other – in Nicaragua – was marred by egregious fraud and heavy-handed government intervention in favor of the incumbent. Still, two out of three is not bad in a region where, previously, if elections were held at all, disputes about the outcomes were the norm.

In economic terms, high commodity prices fueled strong growth in South America in 2011, and the modest US recovery benefited nearby countries. In Chile, Peru, Argentina, Uruguay, Bolivia, and, to a lesser extent, Brazil and Colombia, voracious Chinese and Indian demand for raw materials and food boosted foreign reserves, enabled heavy government spending, and sustained high levels of imports. All this led to average growth rates well in excess of 4%.

But it also led to new doubts about the wisdom of reliance on commodity exports. Chilean economist and politician Carlos Ominami, in his tell-all memoir Secretos de la Concertación, wondered what would happen if China's economy slowed or its real-estate bubble burst. By the end of the year, this seemed to be happening: commodity prices and growth rates were dropping, and 2012, while still promising strong economic performance, will not match this year's success. Sustained lower prices may bring chickens home to roost.

The outliers were Venezuela, despite high oil prices, and the Caribbean Basin: Mexico, Central America, and the islands. These countries export manufactured goods to the US, on which they also rely for tourism and remittances; they lack either the geography or the geology to become great commodity exporters (or, like Mexico, they export all of their oil to the US).

But even the outliers enjoyed decent growth this year. If the US avoids a new slowdown, they may do better than South America in 2012. All told, with the exception of 2009, the entire region will have experienced a full decade of uninterrupted growth – something not witnessed since the 1970’s.

The boom fueled expansion of Latin America’s middle classes. Between 1950 and 1980, most Latin American countries’ middle classes comprised between one-quarter and one-third of the population. Then came the debt crisis of the 1980’s, the extreme structural reforms and financial collapses of the 1990’s, and a new global downturn in 2001. Such traumatic events plunged these countries into the so-calledmiddle-income trap”: unable to grow nor to continue broadening their middle classes.

But, by the second half of the 2000’s, everything changed: prolonged macroeconomic stability, competent center-left or center-right governments, sensible social policies, and global economic growth allowed countries like Mexico, Brazil, Chile, Uruguay, and even Argentina to take the next giant step. By 2008 or so, around 55% of these countries’ populations belonged to the middle class, by whatever definition one used.

Access to credit, more jobs, remittances, the commodity boom, and conditional cash transfers enabled millions to purchase a home, a car, and a better life. This was not a middle class modeled on North Atlantic precedents, and its members’ status is precarious and reversible; moreover, their standard of living is well below that of their counterparts in wealthier countries. But a middle class it is.

These middle-income sectors make up an even larger part of the electorate, since their turnout rates are higher than those of the poor. Political candidates must engage them, occasionally pander to them, and tailor their message to them, all of which steers leaders and parties toward moderate positions. There are no guarantees that this will endure, but it is one of the region’s most impressive achievements in recent years.

Latin America will witness two important elections in 2012, in Venezuela and Mexico, and one non-election, in Cuba. In Venezuela, President Hugo Chávez’s opponents will unite behind a single candidate for October’s presidential election. But everything depends on Chávez’s health, which, like that of Fidel Castro in Cuba a closely guarded state secret.

Will Chávez’s cancer allow him to run (he is as formidable a campaigner as he is a terrible economic manager), win, and govern until 2030? Will he be a stand-in for his more radical brother (and designated successor), Adán? Or will he be too ill to participate? In that case – and most importantly – would he, Adán, and the entireBolivarianelite accept defeat at the polls?

In Cuba, there will be no elections, but matters may come to a head next year. Raúl Castro’s economic reforms have either not been implemented, or are not delivering the expected results; the island continues to depend on Venezuelan subsidies, remittances from Miami, and European tourists.

Cuba’s octogenarian ruling brothers cannot last forever. Something may have to give on the island, especially if their Venezuelan benefactor is no longer in power.

Then there is Mexico, which will hold only its fourth democratic election in its history in a context of rampant organized crime, appalling violence, and rising skepticism about President Felipe Calderón’s war on drugs. With three contending parties, a terrible electoral law, no run-off, and condiderable frustration with 12 years of center-right, often ineffective governments, the outcome is highly uncertain.

That said, Mexico’s political institutions have survived hard times, the middle class rejects extremism, and the US is close by. One would prefer to see Mexico’s presidential candidates offer platforms with ideas and proposals that respond to the challenges facing the country, but this substance deficit occurs everywhere now, almost all the time.

For a region that has suffered so long from frustration and despair over its failures, these are among the best of times. Latin America should count its blessings, and remember that nothing lasts forever.
Jorge G. Castañeda, former Foreign Minister of Mexico (2000-2003), is Global Distinguished Professor of Politics and Latin American Studies at New York University.



It's a Holiday Tinged With Gold


Gold has lost a bit of its glow after a remarkable run, but as many economic woes persist, the commodity play still gleams.

Unlike frankincense and myrrh, gold possesses an allure that has only increased over the years, and 2011 will mark the 11th straight time gold prices will end a year higher.

Lately, however, it has lost some of its blinding gleam. In mid-December, the price of gold fell below its 200-day average to finally end a remarkable 732-day streak—the longest since at least 1975—of consecutive finishes above its 200-day trend line. Since peaking near $1,895 a troy ounce in September, spot gold prices have skidded as much as 17%. Corrections of 15% or more are rare and unsettling. There have been only four the past decade, the longest being 2008's eight-month swoon, and concerns are rife that 2012 might finally bring a bigger meltdown.

Yet gold's recent slide smacks more of profit-taking than a fundamental reversal. As one of the best-performing assets, gold has been an easy place to cull profits. Is it any wonder gold's steepest slippages—an 11.2% tumble from Sept. 20 to 26, and a 10.2% retreat over December's first two weekscame just before each quarter ended, when hedge funds often had to raise money to meet liquidations?

Drooping futures further dissuaded the momentum crowd, and some weaker Asian currencies didn't help. For example, the jewelry market drives much of the demand for gold, particularly in China and India, and while gold is up 12% this year in dollar terms, it has jumped nearly a third when measured in Indian rupees, which makes those gold bangles suddenly a lot pricier.

THE CASE FOR HOLDING GOLD hasn't really changed. "In our mind, gold has one key enemy: high sustained real interest rates from a highly liquid currency," notes Michael Purves, chief market strategist at BGC Financial. "We find it hard to imagine that the Federal Reserve will reverse its very low rate strategy in the next three years." Sure, the dollar has held up lately, and housing starts and jobless claims have improved, but U.S. Treasuries still look more like a liquidity harbor than a true safe harbor. Purves, for one, thinks gold could reach $1,800 by next June, from a tad above $1,600 Friday.

For all the forecasts for a 2012 U.S. economic rebound, few of our woes have been resolved. With the U.S. waist-deep in trillions of debt, European banks flailing and the developed world spending beyond its dwindling means, there is no quick fix except for central bankers to print more money to pay off loans and prop up the planet's frail financial system.

The bottom line: "We don't trust paper money," notes John LaForge, Ned Davis Research's commodity strategist, and "gold's bull run reflects a lack of trust and credibility in governments and central banks world-wide to stop printing money at will."

DECEMBER DOESN'T BRING just crowded malls, forced cheer, and strained conversation with long-shunned relatives. In the stock market, it's a chance to get a jump on January—and the January Effect, which describes the tendency of struggling small stocks to rebound early in a new year. On cue, Wall Street brokers have been reminding us how small stocks have outrun big caps in three out of every four Januarys. Since 1926, small stocks have ended a year lower just 27 times.

The following January, they have bounced back with gains averaging 6.7%. Over all years, the average return in January for small stocks is a robust 4%far better than 1.1% for large stocks that same month, or 1.2% for small stocks over all other months.

With such persuasive numbers, the chill toward small caps is thawing a little. The Russell 2000 index of small stocks is down almost 5% in 2011, worse than the large-cap Standard & Poor's 500 index, but the chart of small stocks relative to large has started to turn up slightly since it bottomed this fall.

In a recent quarterly survey of 128 small- and mid-cap investors conducted by Credit Suisse, 41% believed the Russell had bottomed in early October, and another 36% say any further downside probably won't exceed 5%.

Yet it's a little curious that small stocks that have been hardest hit earlier this year haven't rebounded much in November or December, notes Steven DeSanctis, Bank of America Merrill Lynch's small-cap strategist. For example, the quintile of small stocks that held up best through Oct. 31 have fallen another 2.1% since October, while the quintile that fared worst earlier this year gave up another 8.3%.

This year, with investors fatigued by the market's feral swings, "size and quality matter," DeSanctis argues. Macro concerns in the U.S. and Europe and heightened volatility don't bode well for the January Effect, which hasn't come early this year and may not come at all.

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