Big, fast and unstable

The Australian, 10 April 2008

In a little over 30 years, China and India have gone from being poverty traps to becoming large, fast-growing economies that are the cynosure. In both countries, there has been a boom in per capita income, consumption, foreign investment, the stock market, international trade in both goods and services, technological skills, domestic and international linkages through travel and telecommunications, overseas study and significance in international relations.

In the recent decade, China and India have enjoyed high growth, and served as locomotives that have fueled growth in the region through trade and investment linkages. What might the future hold?

All market economies experience the phenomenon of the business cycle. Some years are extremely good in terms of economic growth, and other years are below the long-term trend. Employment, investment and profit rates tend to rise in the good times and vice versa.

Both China and India started out with a socialist heritage in which business cycle phenomena, of the kind seen in market economies, did not exist. In India, a good year was one with a good monsoon and vice versa. As the share of agriculture in GDP went down, this uncertainty has diminished.

Private investment is the critical driver of business cycle phenomena in market economies. When the private sector is optimistic about the future, high investment takes place, and vice versa. To the extent that investment is controlled by a socialist government, it tends to be more stable, but as countries step out of the shadow of socialism, there is a bigger role for the private sector in decision making about investment. This leads to business cycles.

In India, there was a remarkable business cycle upturn in recent years. GDP growth did a massive swing from 3.8% in 2002-03 to 9.6% in 2006-07. In this period, investment went up sharply from 23.8% of GDP in 2002-03 to 34.6% in 2007-08: a swing of more than 10 percentage points of GDP.

In China's case, investment has been consistently high, partly as a consequence of a greater role for the government in influencing investment. As China moves forward in becoming a market economy, expectations of the private sector will play a bigger role in shaping investment.

What might happen in a downturn? In a country like Australia, both fiscal policy and monetary policy play a role in stabilising the economy in a downturn. In bad times, tax collections go down, government expenditure on welfare programs goes up, and the central bank cuts rates. In good times, these things are done in reverse.

Neither China nor India have such institutional mechanisms. In India, fiscal stability continues to be a prime concern. In bad times, tax revenues will go down, but the government has to tighten its belt on expenditures as well, to avoid fears of instability of public finances. In India, monetary policy has been hijacked by the task of managing the exchange rate, and there is little freedom to cut rates in a downturn. Similarly, in China, monetary policy has lost all room of maneuver owing to exchange rate pegging. In China also, there are concerns about fiscal stability (though not as acute as those seen in India), which will limit deficit expansion in a downturn.

In summary, while China and India today are enjoying good times, their high GDP growth should not be taken for granted. Neither country has the institutional framework for stabilisation through fiscal and monetary policy, as is found in mature market economies like Australia. GDP growth in both countries will be volatile. In India's case, in the last decade, GDP growth has ranged from near 4% to near 10%.

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