How will China influence us

Business Standard, 25 January 2016

It is likely that China will fare poorly for a few years. What does this mean for us in India? There is a possibility of a global financial crisis which will roil all emerging markets including India. The problems in China will exert a drag upon global tradeables prices which will adversely affect profitability of tradeables producers in India (while benefiting buyers). The `China model' will command less respect in India, which could help improve policy formulation.

There is considerable gloom in China. From mid 2014 onwards, a significant scale of capital flight began. It is estimated that over 18 months, capital flight of $1.5 trillion has taken place. This is partly about the gloom. The Chinese elite are not optimistic about the future, and are putting capital and family members out of harms way.

This is also about exchange rate policy. Just as capital went into China when the central bank produced a one-way bet of predictable appreciation, capital is now leaving China as the central bank has produced a one-way bet of predictable depreciation. To private persons, it is wise to take capital out of China as the range of possibilities runs from a 20% depreciation to no depreciation. Politicians and bureaucrats like to have control, and dispense political favours by `managing volatility', but this causes harm along the way.

The mainstream view in global finance, as expressed in the VIX, is that no big problem is imminent. However, each international financial crisis is different in its own way. We are in uncharted territory from many points of view. No central bank in world history has sold $100 billion a month in fighting currency speculators. Never in world history has there been such a large economy which was not a market economy. There is no telling what parts of the process could malfunction.

We in India should start envisioning problematic scenarios and the potential channels of influence into India. There are two natural analogies from the past, which inform our thinking about the future. By and large, India did a good job in the difficult 2008 crisis, and mis-handled the minor crisis of 2013. We should mull over these contrasting experiences. In 2008, we allowed the market to work, and got a big rupee depreciation. In 2013, we tried to fight the currency depreciation with a 400 basis point interest rate hike and a slew of reversals of reform.

The retreat from a market determined exchange rate, from 2013 onwards, has induced moral hazard: firms are betting that the government will be their risk manager. The costs of exchange rate management are borne by the economy, and the benefits are concentrated in the reduced hedging costs of firms. The bets that have been placed will generate heightened political pressure, in the scenario of a large depreciation, where firms will ask for muscular government action in response to a depreciation. In order to forestall these unpleasant scenarios, the process of shifting away from the post 2013 exchange rate regime needs to begin well ahead of time.

The second channel of influence into India is through prices of tradeables. In China, concepts of accounting and profit are not well understood by many firms. Many unprofitable firms are kept alive through directed credit. Scaling down production, laying off workers and closing factories is often politicised, and the political pressure is in favour of preserving the status quo. The combination of these forces results in more `zombie firms' who are producing and selling at prices below cost.

Because China is such a large country, the pricing decisions of their firms have ramifications all over the world. The Chinese crisis is adversely impacting prices and profitability in markets where Chinese firms are significant players. This has two consequences for India. We will get a surge of protectionist lobbying by tradeables companies. This could threaten the 25-year movement towards greater openness to trade. Reduced profitability in tradeables will also reshape the contours of the emerging balance sheet crisis in the Indian private sector.

At the same time, firms and industries who buy these cheap tradeables will do well. For people with long time horizons, this is a good time to stock up on tradeables. As an example, if a firm plans to build an assembly line populated with Chinese machine tools, this is a good time to accelerate those plans, as prices for these machine tools will be favourable in 2016 and 2017.

From a financial markets viewpoint, this is a time to buy protection against large negative movements of Nifty and INR. If India fails to reform the exchange rate regime, there could be considerable opportunities for macro trading. This is also a time to look at equity analysis and credit analysis through the lens of tradeables versus non-tradables.

The last channel of influence is through the space of ideas. For many years, China's success had encouraged the socialist streak in Indian policy thinking. China seemed to suggest that there was an alternative to liberal democracy and a market economy. It showed a path for control of the economy by politicians and bureaucrats: for industrial policy, government led public investment, exchange rate policy, repression of the financial system, forcible resettlement of peasants, etc. Chinese policy strategies were held up as a model for what India should be doing.

This was a distraction from the main track which India is on: the construction of a liberal democracy, characterised by the rule of law, and a well functioning market economy. This negative influence would now matter less. We would now be able to better focus on building India as a mature market economy. This involves narrowing the work of the State to addressing market failures, embracing the Constitution and the rule of law, and the construction of State capacity for addressing market failures. This involves retreating from government intervention and emphasising the subtlety of policy frameworks that reshape incentives.

Back up to Ajay Shah's 2016 media page
Back up to Ajay Shah's home page