India’s role in Europe’s financial stability

Should India offer to bail Europe out?

A few days ago in his Mint column, Narayan Ramachandran, Takshashila geoeconomics fellow, argued that India must directly offer to bail out Europe.

In an INI9 (9 Minute conversations) segment recorded yesterday, Narayan and I discuss this idea further.

The geoeconomic implications of the upheavals in the Middle East

A summary of discussions at the Friends of Takshashila Geoeconomics Roundtable in Singapore on 26th March 2011

Why is this important?
India is much more linked to the global economy today than it was a decade ago. As compared to 2001, today a majority of India’s manufactured output is exported. External demand drives exports and newer exports like services and engineering goods have a higher demand elasticity. If global economic growth is hit, investment, income from exports and remittances will be impacted, hurting India’s own economic growth.

In such a situation, an Indian government will face the need to cut its expenditure. It is more likely to cut down on capital spending (infrastructure) than on revenue spending (entitlements and social programmes). This, in turn, will not only cause macroeconomic problems (like inflation) to worsen in the short term, but also constrain the sustainable growth prospects of the Indian economy.

There is, therefore, a greater need for India’s policymakers to pay attention to the economic implications of the developments in the Middle East.

It’s the Gulf that matters more
So far, other than Bahrain and Yemen, the political unrest has largely taken place in North Africa and the eastern Mediterranean. These have limited oil and host relatively fewer Indian expatriate workers. If, however, the unrest spreads to the Gulf Cooperation Countries—Saudi Arabia, Kuwait, Oman, Abu Dhabi/UAE—and Iran, the implications will be of an altogether higher degree of seriousness. While the United States is unlikely to encourage regime change in the GCC countries—which are among the biggest purchasers of US arms—there is a risk that the Saudi-Iran dynamic could take a destabilising turn.

These developments impact India directly and indirectly through their effect on the global economy, through three main channels: by affecting the oil price, investment and remittances.

Oil price
Even if a Gulf state undergoes regime change, it will still have to continue to export oil and gas. However, the risk of unrest, potential increase in demand in Japan and speculation are likely to continue to cause oil prices to rise further. Rising oil prices affect India by hurting the balance of payments, worsening the fiscal deficit (due to oil subsidies) and by damping global economic growth.

(According to one estimate, visible and hidden oil subsidies would amount to between 2.2% of GDP to 3.6% of GDP at crude oil prices of $100/barrel and $120/barrel respectively. )

A closer economic relationship with Russia might be a way to manage the oil-price related risks emanating from the Middle East.

Investment
Lower global growth is likely to hurt inward investment. However, some participants also felt that India could buck this trend if the Indian government carries out measures that can convince investors of India’s long-term growth potential. This calls for the urgent and bold introduction of the so-called second-generation reforms. (Prime Minister Manmohan Singh’s statement at the Business Standard awards ceremony were mentioned in this context, although his ability to carry these out remains in question.)

The move by some GCC countries to provide fiscal handouts to their citizens, in an attempt to stem the unrest, could turn out to be a positive for India. Some of it will translate into revenues for Indian exporters and some into higher remittances by Indian expatriate workers. Also, to the extent that Gulf sovereign wealth funds have lower sums to invest in a discretionary manner around the world, it is to India’s benefit.

Remittances
India is one of the world’s largest recipients of remittances, a significant fraction of which originate from the Middle East. However, to the extent that the unrest does not affect the GCC countries, remittance flows will not be significant impacted.

The relationship between oil price and remittances suggests that the “sweet spot” for India is when the oil price is around $50/barrel. At this level, there is robust economic activity in the GCC countries and a corresponding robustness in the remittances to India. But this equation falters when oil prices go upwards of $90/barrel, after which the impact on economic activity and remittances turns negative.

Impact on India
First, the primary risk to India is of political upheavals in the region causing a global economic slowdown and, in consequence, slowing down the pace of India’s economic growth. According to one estimate, these events could reduce India’s GDP growth rate by up to 2 percent. This is likely to disproportionately hurt the poorer segments of society, especially in urban areas, more than others.

Second, the evacuation and resettlement of Indian expatriates might not be smooth and could generate some short-term political problems. This would be harder to manage if there is a surge of evacuation as a result of a precipitate crisis, the risk of which is estimated to be low. Also, the return of Indian expatriate workers could turn out to be beneficial in the medium- and long-term due to the infusion of new ideas, skills and innovation.

Open questions
Three questions were raised: To the extent that the rise of Islamic radicalism and militancy is, in part, backed by money from the GCC countries, would a sustained increase in oil prices and fiscal measures by their regimes lead to an increase in funding for extremist groups operating in India?

What would be the impact of lower remittances on Pakistan’s domestic politics, and how might that affect India?

What might be the relative impact of these geopolitical developments on India, China and the United States?

Relating the fiscal deficit to the price of oil

Every $10 increase in oil prices causes a fiscal deficit of between 0.6% to 1.3% of GDP

One of the issues discussed at last weekend’s Friends of Takshashila meeting in Singapore was the relationship between fiscal deficit and the oil price. Aditya Palwankar, who was there, has this to share:

“I had mentioned that every $10/bbl rise in oil prices would impact India’s fiscal deficit by 0.8% of GDP. In fact, as a recent report by Morgan Stanley suggests, it is even worse. It suggests 0.9% of GDP in FY2011 ($85/bbl) and 1.3% of GDP for FY2012 (assuming oil prices at $100/bbl) as the additional subsidy on account of oil price rise.”

Our Oil and Gas analyst Vinay Jaising estimates the under-recoveries at US$14.3bn (0.9% of GDP) for F2011 (12-months ending March 2011), assuming oil at US$85/bbl for F3Q11 and US$90/bbl for F4Q11. For F2012, assuming oil averages US$100/bbl, he estimates oil subsidy burden of US$24.7bn (1.3% of GDP). In fact, for every incremental US$1bbl change in the crude oil price, he estimates the subsidy burden to increase by ~US$612mn in F2011 and US$629mn for F2012. [Chetan Ahya/Morgan Stanley]

Mr Palwankar adds: “The relationship is deduced as follows: sum total of all subsidy on account of oil (LPG, Kerosene, HSD, Petrol and ATF) divided by the nominal GDP of the country. For FY2011 (Apr-Mar), Morgan Stanley expects total subsidy to be $14.3bn and India’s nominal GDP is expected to be $1,600bn. Hence dividing the two we get 0.9% of GDP.

Of course, the 0.8% to 1.3% range is assuming oil prices between $85-$100/bbl and real GDP growth of 8% and nominal GDP growth of 14-15%.

But these appear to be best case scenarios because if oil prices go up to say $120/bbl, there will be a triple whammy, namely a spike in current account deficit (funded through capital flows), increase in oil subsidy (funded through the fisc) and slowdown in economic growth (due to lack of capital). I am not counting the impact on inflation here, to sound not too negative. On the other hand if oil prices come down to $80-85/bbl, we will still be in the region of 0.6-0.7% of GDP in F2012 assuming a nominal GDP growth of 15% and no change in oil prices.

(Let us see) India’s oil subsidy in the context of what it costs to build efficient public transportation systems in urban India. Delhi Metro phases 1 & 2 costs were estimated at $3.3bn in 2004. Even if you were to adjust the cost for inflation (at 10%), it would not cross $6bn. Oil subsidy in each of the previous five years has been at least upwards of $5bn. Had we spent this subsidy in building long term efficient public transportation systems instead, we could have made some impact on the rising demand for oil as also reduce the severe congestion we find on Indian roads.”

Honda discord

It’s an inflection point

In hindsight, the labour strike at Honda’s auto parts manufacturing plants in Guangzhou and Wuhan is likely to prove a turning point in China’s economic history. It is remarkable because it is the first time that the Communist Party of China has permitted an action of this nature in a very long time.

The strike itself was triggered by workers demanding more pay and benefits. Such demands are hardly unusual, even in China. There are mechanisms—with Chinese characteristics—that deal with this, and the relatively stable labour relations are touted as part of the China advantage for foreign investors. The strike implies that these mechanisms failed. In their failure lies the reason why this is a turning point.

In the current geoeconomic context—with the United States keeping pressure on China to revalue the renminbi—Beijing can no longer use the cheap currency as a source of its export competitiveness. If it can’t keep the renminbi undervalued the other option it could use to stay competitive is to not allow wages to rise. That’s an uphill task, because there is an upward pressure on wages as labour productivity increases and skilled labour tends to be in short supply. Attempts to restrain wages, therefore, will is likely to cause resentment and dissatisfaction.

The Communist Party of China, of course, would not want to be the target of this resentment—not least because it is supposedly a communist party. It might well decide to release the pressure by taking the usual route—stoking ‘nationalism’ and channeling outrage towards foreigners.

This creates a new vector: while earlier China only cared about attracting FDI, it will now have to manage the backlash as well. If these two vectors do not balance, we will see hitherto unknown political resultants.

Is Vikram Pandit a geoeconomic realist?

Looks like it

There is much in Vikram Pandit’s speech that The Acorn agrees with:

Mr. Pandit argued that the world could create healthy and sustainable economic growth through completely open trade markets, flexible exchange rates, open capital markets and free labor markets.

“If this were the case, these imbalances would be corrected rather quickly, and the result would be a more broadly distributed sustainable growth rate around the world,” Mr. Pandit said, according to the text of his speech. “Let‘s be realistic: This is very unlikely to happen. We must find a robust self-help program for the interim.”

Mr. Pandit asserted that the American economic model is the best way to achieve that growth.

“Many of us of course are keenly aware that the U.S. model is not immune to periodic excesses, or to disheartening setbacks that impact the lives of millions of people,” Mr. Pandit said. “Yet it remains a viable model for creating economic growth and raising living standards.”

The elements to unleash this “magic formula,” in today‘s environment consist of six main themes, Mr. Pandit said. First is fostering talent through the creation of large, well-funded universities. Second is a globally competitive tax and industrial policy. Third is an energy policy that reduces inefficiencies and energy costs with limited environmental impact. Fourth is the formation of a public-private partnership to strengthen the nation’s infrastructure. Fifth is the will to address fiscal and savings imbalances with discipline.

And last is confidence in the financial markets — bringing Mr. Pandit’s speech back to some of the systemic problems that nearly pulled Citigroup down during the financial crisis in 2008. [NYT, emphasis added]

Indian CEOs have a lot to learn from Mr Pandit—both in having the right convictions and the courage to express them.

Raging in Beijing

Rio Tinto is the latest of a series of mistakes that China has made recently. Why, and why now?

“Drawing that direct link” the Wall Street Journal says “between the fortunes of (Chinese) steel mills and the interests of the Chinese state has alarmed foreign officials and businesspeople.” It refers to the arrest—on espionage charges—of four employees of Rio Tinto, a British-Australian mining company, amid tense negotiations over the price of iron ore. Coming as it does a few weeks after Australian shareholders rebuffed an attempt by China’s state-owned aluminium company to acquire a bigger stake in Rio Tinto, the possibility exists that China’s move was in part motivated by a sense of retribution.

It is not uncommon for big commercial negotiations to involve an element of trying to find out what the other side’s positions are. Sometimes, the methods used can cross the line of legality and become criminal acts. But to term such acts as stealing “state secrets” and assert that they harmed China’s “economic interests and economic security”, while being technically correct, are clearly the use of state power in the service of the commercial interests. By implication, the commercial interests of China’s state-owned firms are in the service of state power.

One key risk for Beijing is that its actions will set back years of efforts to persuade the world that Chinese state-owned enterprises are independent, commercially run entities, lawyers say. Cash-rich Chinese state companies, scouring the world for deals, must present themselves as profit-driven independent entities to overcome suspicions that they are fronts for the Chinese government.

But the Chinese government’s argument that these companies’ interests are identical with that of the state could now be undermining that effort. [WSJ]

That’s bad news for those who took that argument at face value, and there certainly were many of those. But the reality is, as fellow INI blogger V Anantha Nageswaran has argued, “right now, China has neither a command economy nor a market economy. It has a political economy.” Or Greg Sheridan, one of the most perspicacious Australian commentators, puts it baldly: “One of the most important lessons to come out of this mess is the absolute shattering of the myth that Chinese government-owned commercial entities are not part of China Inc.”

The Rio Tinto case should sensitise the Australian government to the folly of a natural resource exporting economy depending on one big buyer.

But the more important question is: why has China shed the pretence now? It is unlikely that China’s leaders would want the “peaceful rise” theory to be shattered over relatively trivial matters as the price of iron ore. Or for that matter, over an ADB loan programme to India. China cannot aspire to topple the US dollar as the world’s reserve currency unless it has the support of countries such as India and Australia.

One explanation is that it’s gone into their head and the Chinese leadership is flexing its muscles ignoring Deng Xiaoping’s advice to “keep your head down” (of course, his aphorisms were a lot less prosaic).

The other is that the balance of power within the ruling Communist party has become unstable—the factional intrigues within the leadership have resulted in several embarrassing or self-defeating incidents in recent months: making the ADB a platform to push a bilateral dispute ended in China’s total isolation; a poorly-conceived, poorly executed internet monitoring policy that ultimately ended up sparking a trade dispute with the United States; Pyongyang’s belligerence has killed the six-party talks, and undermined China’s regional standing; ethnic rioting in Urumqi and Hu Jintao’s absence at the G-8 summit prompted renewed concern over China’s political stability; and, of course, haggling over the price of iron-ore has successfully alienated the most China-friendly Australian government in more than a decade.

So much bungling in such a short period of time—from a regime that is seen as a deliberate, strategic player—rules out mere incompetence. While an outright leadership struggle is be unlikely, it could well be that a fratricidal war of succession is raging in Beijing.

When in a corner, show teeth

A chastened but sanctimoniously aggressive dragon

Qin Gang, China’s foreign ministry spokesman, made some eminently reasonable and sensible points yesterday. The Asian Development Bank’s approval of a loan package to India—which includes financing of a project in India’s Arunachal Pradesh state (which China calls ‘Southern Tibet’ and claims as its own)—he said, “can neither change the existence of immense territorial disputes between China and India, nor China’s fundamental position on its border issues with India…On China-India border issues, China always believes that the two sides should seek for a fair and equitable solution acceptable to both through bilateral negotiation.” (via Indrani Bagchi’s Globespotting blog)

In other words, ADB’s approval of a loan doesn’t change the positions of India and China with respect to the territorial dispute, and that bilateral negotiations (not multilateral economic fora like the ADB) are the place to sort the issue out.

So who were those unreasonable and insensible people who thought otherwise? None other than the representatives of the People’s Republic of China. None of their counterparts on ADB’s governing board agreed. Diplomacy being the art it is, it was left to Mr Qin to sound as if it was someone else who was flagrantly violating the norms of conduct at multilateral economic institutions.

The Chinese foreign ministry, however, does not stop at that. Mr Qin goes on the offensive. The ADB, he warns, “should not intervene in the political affairs of its members. The adoption of the document has not only dealt a severe blow to its own reputation but also undermines the interests of its members. The Chinese Government strongly urges the ADB to take effective measures to eliminate the terrible impact thereof.”

China’s entire approach to the ADB loan issue signals a dangerous portent for Asia. It would perhaps have been understandable if China had limited its protest to a symbolic pro forma objection. To transform the ADB as a forum to push its position in a bilateral dispute is an entirely different matter—and one that has serious implications for its relations with its East Asian neighbours, with whom it has unsettled disputes too. A charitable explanation is that it couldn’t back down without losing face once it had fired the first salvo. If you feel less charitable, you will see fresh signs of a deliberate strategy to flex its economic muscles for purely political ends. When zero-sum games are pursued at positive-sum arenas, the latter quickly become the former.

A new spring?

Looks like there been a change at South Block

Dr Manmohan Singh should not have attended the summit meeting of the Shanghai Co-operation Organisation (SCO) at Yekaterinberg not only because India is formally only an ‘observer’ at that outfit, but also because it is not a club that India ought to join. The co-location of the summit with that of Brazil-Russia-India-China (BRIC) was unfortunate, but even so, there was nothing to stop the Indian prime minister from attending the BRIC event, and insulate himself from the SCO pow-wows. Dr Singh, it turns out, does not have the appetite for such sharp diplomacy.

But recent events suggest that there might be a little more spark in the second UPA government than there was in the first one. First, some tough-minded diplomacy—including a threat to review India’s relationship with the Asian Development Bank—succeeded in isolating China’s attempt to use a multilateral economic forum as an instrument its bilateral political dispute with India. Like at last October’s Nuclear Suppliers Group (NSG) meeting, not only were Chinese moves foiled, but China was completely isolated. Now this is in part due to China’s attempts to overplay its hand, but diplomatic victories are seldom the result of serendipity. There was hard work involved.

Second, Dr Singh’s meeting with Asif Ali Zardari showed a welcome change of style. “I am very happy to meet you,” Dr Singh told Mr Zardari “But I must tell you quite frankly that I have come with the limited mandate of discussing how Pakistan can deliver on its assurances that its territory would not be used for terrorist attacks on India.” In front of the assembled media. Of course, the Indian media reported it, the Pakistani media seems to have ignored it and the Pakistani foreign minister tried to paper it over, but it still is infinitely better than two smiling faces shaking hands as if nothing had happened in Mumbai last November. Beyond style, the substance of the talks appears to be that India is willing to re-engage Pakistan in a dialogue, on condition that between now and July 16th, Messrs Zardari & Co need to deliver a meaningful something on the issue of cross-border terrorism.

Third, the Indian government denied visas to members of a US government outfit that wanted to visit India to audit religious freedom, especially “concerned about judicial processes with regards to the incidents in Gujarat and Orissa are not functioning properly and we only wanted to get them going.” (It’s funny how these groups are terribly selective about improperly functioning judicial processes: for instance, the Kashmiri Pandits marooned in various Indian cities don’t even have a judicial process.) Denying them visas is a gentle way of saying “no, thank you” to these kind American people.

And finally, even in Yekaterinberg, it appears that the diplomatic minders did what they could to distance the Indian prime minister (see the missing) from the SCO publicity material.

If all this appears to be a nice start in managing the form of foreign affairs, it is because the bar was set so low in the last five years. The next five will be rougher and more challenging. So let’s hope it is a new spring.

Update: Now some Pakistani grandee declares that Dr Singh’s remarks are ‘unacceptable’, which is as weird as it is absurd. That is the Indian prime minister’s mandate, and there’s nothing in it for Pakistan to accept or reject. Also, it turns out that top Indian officials repeatedly emphasised to the media that the foreign secretaries will only discuss the investigations into 26/11, nothing more.