The emerging slowdown

Indian Express, 31st August 2012

Emerging economies survived the global shock in 2008 quite well. But now that the industrial countries have not fully recovered, the crisis in Europe continues, the uncertainty in world markets remains high and large emerging economies are seeing a rapid fall in GDP growth. Weak growth in emerging markets will, in turn, slow down the world economy. In the last decade, growth in the US and China contributed to a benign global environment, which made it possible for India to get away with more policy mistakes. Now, the government needs a bigger focus on building confidence in private investment.

The slowdown of GDP growth in emerging economies appears to be well entrenched now. In 2010, there seemed to have been a rebound in emerging economies, but it has not been sustained. The GDP growth in Brazil declined from 6.1 per cent in 2007 to 2.7 per cent in 2011. China has seen a dramatic fall in GDP growth from 14.2 per cent in 2007 to 9.1 percent in 2011. In 2012, emerging economies are expected to slow down further.

China was a big contributor to post-crisis world GDP growth. China's GDP growth will be roughly 7.5 per cent in 2012. Two factors are at work. There are deeper problems in China's growth model that are beginning to rein in growth. In recognition of these deeper problems, the government pushed towards policies that would yield sustainable growth. These policies inevitably entailed slower growth. Recent indicators suggest that the Chinese economy is slowing down to a greater extent than expected. With consumer prices falling in the last three months, indicating a possible deflation, the Chinese central bank announced two interest rate cuts. China also has significant scope for a fiscal stimulus at the central and local levels.

What was wrong with the old Chinese model of growth? In the pre-crisis years, Chinese families saved half their incomes, and American families consumed more than they earned. Low Chinese consumption was engineered through the exchange rate, monetary policy, financial repression, etc. The delicate balance between China and the US broke down in the crisis. Policymakers everywhere have talked about the need for a rebalanced world in which Chinese households save less and American families consume less. A rebalancing should lead to a lower current account surplus for China, reducing its build-up of reserves; less buying of US treasury bills by China; and lower liquidity and asset price bubbles in the US economy.

A good part of this required adjustment has come about. China's current account surplus has fallen from a high of 10 per cent in 2007 to 2.8 per cent in 2011. While this is good for the world, these changes require substantial changes within China. Growing inventories, a fall in export orders and declining capacity utilisation all suggest that the slowdown in China is intensifying.

The Chinese slowdown is cause for concern worldwide. By itself, this yields slower world GDP growth. Many emerging economies are part of the supply chain that feeds Chinese manufacturing, and have benefited from Chinese demand. A slowdown in China will lead to a decline in their growth. In July 2012, Indian exports to China showed an 8 per cent decline on a year-on-year basis: a sharp contrast to the explosive growth of recent years. The bulk of this decline was in iron ore.

Another channel of impact for India is indirect: through the world prices of tradeables. The world price of things that can be globally traded - for instance, steel - is influenced by over-capacity in China. The Chinese slowdown is exerting a negative influence on the global prices of tradeables. This hampers the profitability, and thus the outlook for investment, of Indian firms that make tradeables. This channel of influence is likely to be more important for India, when compared with the small scale of Indian exports to China.

Chinese households consume about 30 per cent of Chinese GDP, compared to Indian households, which consume about 70 per cent. The value of 30 per cent is the lowest consumption share in the world. If the Chinese economy slows down, there are two possibilities. One is that households continue to earn and spend the same share in GDP. This could lead to social unrest, and further disrupt growth.

Most observers believe that this scenario will not arise. The key is to increase the share of consumption, so that even if GDP growth slows, consumption growth stays strong. This is closely linked to the problems of the Chinese model of growth, which emphasised a very high investment rate. The question before China today is finding a new policy framework involving a lower share of resources going into investment, an increasing share of consumption in GDP, ending the emphasis on export of goods and capital, and settling into a lower but sustainable growth trajectory.

The Chinese leadership appears to have understood that their old growth model was flawed. They appear to be keen on moving towards a new growth model. In other words, it is not likely that the emerging GDP slowdown will bring forth a fresh wave of highway projects to prop up the economy. The recent stimulus measures were small and intended to slow down the speed of reduction of growth rate. The debate within China is about how to shift the growth model. We in India need to factor this into our thinking about our growth model.

From 2004 onwards, the Indian leadership has neglected the foundations of economic growth. The economic policy reforms of previous years, coupled with benign global conditions, gave effortless growth, and the focus of the UPA was on spending. Now we need to re-evaluate our growth model, and ask how to rebuild the confidence of private investors so as to obtain growth even when global conditions are adverse.

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