India and China are engaged in separate but parallel struggles with
inflation. Both have responded by monetary tightening. Such tightening
affects inflation via its effect on demand and its interrelation with
the supply side of the economy. This article, therefore, analyses
macroeconomic determinants of the supply side of China's and India's
economies and its effect on inflation and their relative growth rates.
In particular it considers the relative efficiency of investment in
China and India and the consequences of this for inflation and growth.
As this article is somewhat more statistical than most on this
blog it may be useful to summarise its conclusions - readers can turn to
the article for the supporting evidence.
1. Analysis of macro-economic parameters clearly confirms other forms
of study that both
the Chinese and Indian economies are up against or approaching
inflationary capacity
constraints. Therefore, for example, the analysis that China is facing
an overall
problem of 'overcapacity' is the reverse of the truth - China is facing
an overall problem of constraints on capacity which has inflationary
consequences.
2. As China is suffering from inflationary capacity constraints the
argument made by some commentators that in 2009, and at present, China's
policy makers should aim at increasing domestic demand only via
increasing domestic consumption, and not also increasing domestic
investment, is false - such a policy, by increasing demand but not
tackling capacity constraints, would increase inflationary
pressures. The Chinese authorities in 2009 were therefore right to have
expanded both domestic investment and domestic consumption. This remains
the correct policy.
3. India's domestic savings level combined with a policy of accepting
a moderate, i.e. up to 3% of GDP, balance of payments deficit makes it
credible for India to aim at a double digit, or close to double digit,
economically sustainable growth rate. The projections for India's growth
at the latest Indian Prime Minister's Economic Advisory Council,
of 7.2% in the current fiscal year and over 8% in the next, appear
even moderate compared to the macro-economic potential - indicating that
either, or both, India has ample strategic margin to contain inflation
or that
growth rates will exceed these projections.
4. There is not a statistical basis for the claim that India is able
to make more efficient use of investment than China and therefore that
India will be able to match China's growth rate with a lower level of
investment. India's efficiency of the use of investment, from the point
of view of economic growth, is almost exactly the same as China's and
therefore, unless there is a change in this, their relative growth rates
will continue to be determined by which country invests a higher
proportion of GDP.
5. China, on the basis of the level of of investment achieved in
2009, should be able to sustain the approximately 12% GDP growth which
is likely in the early part of 2010 without seriously destabilising
inflationary capacity constraints. However further acceleration,
without an increase in the level of investment, would be likely to
produce unsustainable capacity constraints and therefore the Chinese
authorities are correct to have begun to rein in the rate of
acceleration of the economy.
The more detailed analysis of these points follows.
* * *
On 12 February China's central bank raised banks' reserve
requirements for the second time in a month. India raised bank
reserve requirements on 29 January.
The struggle with inflation in both China and India is
complicated by short term inflationary pressures created by climatic
effects which have contributed to capacity constraints in food
supply.(1) But other more general inflationary pressures are due to
capacity constraints in sectors in which additional investment can
potentially tackle the problem in the medium or short term.
In regard to capacity constraints in China Geoff Dyer noted in the Financial Times:
'According to Yu Song and Helen Qiao at Goldman Sachs, the most extreme
example is in the auto sector, where extra shifts mean factories are
running at above capacity. They also see emerging bottlenecks in
electricity, coal and even in aluminium and steel which only a few
months back seemed to be suffering from chronic overcapacity. "The
capacity overhang has been quickly whittled down in major industrial
sectors," they wrote in a recent report.'
Analysing the situation in
particular industries, while important, is however not sufficient to
estimate how serious are overall inflationary capacity constraints.
There will always necessarily statistically be examples of
'overcapacity' and 'undercapacity' in an economy, even when overall
macro supply and demand are in balance, as it is in practice impossible
to exactly match these in all sectors. Pointing to cases of either
overcapacity or undercapacity, whether statistical or relying on
anecdotes, therefore does not resolve the issue - it will always be
possible to find these cases. Only overall consideration of the balance
between demand and supply can determine whether deflationary
overcapacity or inflationary lack of capacity is dominant.
To look clearly at the root
of the issue of capacity constraints it is therefore
necessary to look at the overall situation – i.e.
at the macro-economy. Examination of this for both China and India
reveals major implications for short term anti-inflationary policy and
for long term determinants of growth.
China or India cannot increase capacity only via increased
efficiency of investment
The first point revealed by
examining the macroeconomic constraints is that neither China nor India
can significantly increase capacity, to overcome inflationary supply
side issues, by simply increasing their efficiency of investment. To
overcome current domestic capacity constraints they would both have to
raise the level of investment in their economies.
To demonstrate this, ideally
fully up to date studies on total factor productivity in the two economies
would be used to evaluate investment efficiency. However studies of
total factor productivity on India are less frequent than those for
China and such analyses by their very detailed nature are also in
general not fully up to date.
Studies of total factor
productivity which have been carried out for China show clearly that,
contrary to myths presumably spread by those who have not examined the
figures, China's use of investment is highly efficient in terms of
international comparisons as is India's.
Given the lack of, and
problem of timeliness of, total factor productivity studies a less
statistically precise, but indicative and relatively current, measure is
to calculate the correlation of the level of investment with GDP growth
– i.e. what percentage of GDP India and China have to invest to
generate 1% GDP growth. Such analysis confirms the situation found by
the total factor productivity studies and casts a clear light on the
situation facing both China and India. Such analyses, in turn, can be
brought more fully up to date - yielding a less statistically precise
result than total factor productivity studies but one that can be used
as a policy tool.
Efficiency
of investment in China and India
Taking a five year moving
average, to smooth out purely short term fluctuations, China has had to
utilize 3.7 percent of GDP in fixed investment for its economy to grow
by 1 percent. To give detail, in the five years to 2008, the latest for
which there is full data, China's GDP grew at an average annual 10.8
percent, and it invested an average of 40.7 percent of GDP – yielding a
3.7 percent of GDP in fixed investment correlation with 1 percent GDP
growth.(2)
India's efficiency in the
use of investment in terms of generating growth is almost exactly the
same as China's. Over the same period India's economy grew an average
8.5 percent a year and its share of fixed investment in GDP was 31.0
percent – i.e. India also invested 3.7 percent of GDP to grow by 1
percent.(3)
As neither China nor India during the latest five year
period suffered intolerable macro-economic imbalances it may be assumed
that 3.7% of GDP devoted to investment to generate 1% GDP growth is
consistent with sustainable macro-economic stability.
Figure 1 below shows the development of this ratio
over a longer time frame. This data shows the dramatic decrease in the
percentage of GDP that had to be devoted to investment to generate
economic growth in China after the economic reforms starting in 1978 and
as a result of the economic opening up in India.
In the case of both China and India the percentages of
GDP that had to be devoted to investment fell from around 6% of GDP
prior to their economic reforms to the present 3.7% of GDP level – i.e.
the efficiency of investment, from the point of view of generating
growth, increased by around 50%.
To take an international comparison, at the end of the 1970s China, India and the US each had to
invest about 6% of GDP to generate 1% of GDP growth.However after this the efficiency of investment, from the point
of view of generating GDP growth, greatly improved in both China
and India and it deteriorated in the US - the US, even before the onset
of the 2008 recession pushed the figure higher, had to invest 7.8 percent of GDP to grow by 1 percent.(4) Both China and India's efficiency of investment, from the
viewpoint of GDP growth, is currently therefore more than twice that of
the U.S.
The trends for the three countries are shown in Figure
1.
Figure
1
Historical examination shows
both China and India have among the most efficient sustained uses of
investment in generating growth in post-World War II history – far
better than the U.S., Europe or Japan at present. China and India's
economies, in short, grow so rapidly both because they have very high
investment rates and because that investment is now used
very efficiently – this interaction being multiplicative.For present purposes, however,
the significance of these figures is that China and India have little
scope for increasing their capacity, or sustaining or raising their
growth rates, simply by achieving efficiencies in capital use - both
countries are already up against the boundary of what any country has
achieved in a sustained way in this field since World War II. It is
implausible that a significantly superior investment to GDP growth ratio
can be achieved in either country – although major efforts will be
required to maintain what is already a highly efficient use of
investment. India's and China's growth rates could therefore only be
maintained or increased by maintaining or increasing the allocation of
GDP to investment.
A further implication of this data is that
as an approximate guide to the macroeconomic situation the 3.7% of GDP
investment to 1% GDP growth ratio indicates a macroeconomic balance
compatible with overall stability - including avoiding excessive
inflation. However if the actual growth rate for China or India is not
supported by a level of investment sufficient to maintain the 3.7% of
GDP to investment for each 1% GDP growth then macro-economic
instability, including inflationary capacity constraints, will occur.
As these ratios have not fluctuated greatly
for twenty years they therefore give a rough but relatively robust
guidance as to the level of investment required to support any given
growth rate.
As both China's and India's efficiency of
use of investment, from the point of view of economic growth, is already
very high India's and China's growth rates could therefore only be
maintained or increased by maintaining or increasing the allocation of
GDP to investment.
India's Investment and GDP in 2009
Turning to estimating the implications of
the above data for the present situation of capacity constraints in
China and India no figures for the breakdown of GDP between investment
and consumption are available for either country for the whole of 2009.
However for India data is available for the first half of that year and
China has published data allowing indirect estimates to be made for the
whole of 2009.
For India fixed investment in 2008 was
34.8% of GDP. Given the correlations above, this
would sustain a 9.4%
annual growth rate. However the 2008
figure was the highest level of
investment in GDP recorded. IMF International
Financial
Statistics data indicates that the proportion of India's economy
devoted to fixed
investment fell in the first and second quarters of 2009 - no more
recent data is given. In the 3rd quarter of
2009, the
latest available figure, India's GDP growth was already 7.9% and
accelerating. India's economy was therefore probably already approaching
the rate of growth that was the maximum that could be sustained by its
level of investment - acceleration of
economic growth was shown by the fact that industrial
production in December, for example, was up 16.8% year on year.
Such a
combination of accelerating GDP growth of around 8%, and a level of
fixed investment which had fallen as a percentage of
GDP, at least during the first half of 2009, clearly indicates that
India's economy was moving up towards its capacity constraints by
the end 2009. To maintain a target of a 9% a year growth rate, for
example, India would
have to invest 33.3% of GDP – a level achieved in only two years (2007
and 2008). While the Indian authorities stress that at present serious inflationary
pressures are confined to food, and are not appearing in manufacturing,
nevertheless the economy is beginning to approach its overall capacity
constraints.
These benchmark parameters therefore
indicate that a 9% a year growth rate is just achievable for India at
the highest levels of investment it has reached, but it is right up
against the economy's investment constraints – confirming the recent
view expressed by Nobel prize winner Michael
Spence that: 'it will be hard to get to 9% and stay there.'
Policies envisaged by the Indian government
that would allow sustaining a higher rate of growth by inward investment
to finance an increased investment level are considered below.
China's investment and growth in 2009
In the case of China no data for the
distribution of GDP between consumption and investment have been
published for 2009 but an indirect calculation yielding ballpark figures
can be carried out as figures for the contribution of different
components of GDP growth in 2009 have been published.
China's year on year GDP growth in the 4th
quarter of 2009 was 10.7% and accelerating strongly – projections of
12-13% year on year growth in the early part of 2010 are not
unrealistic. 10.7% GDP growth, using the correlation between GDP growth
and investment given earlier, would already require 39.6% of GDP to be
invested to be consistent with macroeconomic stability. A 12% GDP growth
would require 44.4% of GDP to be invested and 13% GDP growth would
require 48.1% of GDP to be invested.
The latest year for which measured data for
the proportion of China's GDP devoted to investment are available is
2008 at 41.1% - which would already leave little margin for even a 10.7%
year on year growth rate and is quite insufficient to sustain a 12% or
13% growth rate.
It is clear that the proportion of China's
GDP devoted to fixed investment increased in 2009 but not by enough to
maintain the very high levels of GDP growth that are likely to be
reached given that acceleration beyond 10.7% growth is almost certain in
the first part of 2010.
The published data is not sufficient to
make a detailed calculation of the proportion of China's economy devoted
to fixed investment in 2009 - as the figures for the contribution of
the share of different components to GDP growth that have been issued do
not give a breakdown between fixed investment and accumulation of
inventories
and are in constant and not current price terms, However the published
figures are adequate to give an overall grasp of trends.
The published data
show that the shrinkage of China's trade surplus in 2009 meant
declining net exports deducted 3.9 percent from GDP growth. China's
domestic consumption contributed 4.6 percent of GDP growth and domestic
investment contributed 8.0 percent. The two together mean China's
domestic demand increased by 12.6 percent in 2009 – one of the highest
increases in world history.(5) While exact translation of these figures
into current price terms cannot be made, if it is assumed that
inventories remained constant as a proportion of GDP, and that the
consumer and investment price deflators did not diverge excessively,
then they imply that consumption probably rose to around 49% of China's
GDP and fixed investment to around 45%.
Such an increase in the level of fixed
investment in China, as it came on stream, would be counter-inflationary
as it would increase supply by removing capacity constraints and
increasing productivity. However it is clear that, on the basis of
earlier data, such a figure for investment would be scarcely enough, or
insufficient, to maintain the likely rate of expansion of China's
economy at the beginning of 2010 - to recapitulate the figures above, to
sustain a 12% growth rate would require investment of 44.4% of GDP, a
12.5% growth rate would require fixed investment of 46.3% of GDP, and a
13% GDP growth rate would require fixed investment of 48.1% of GDP.
China is therefore clearly already approaching, and may soon exceed, the
rates of GDP growth consistent with macroeconomic stability even after
the increase in investment that occurred in 2009.
Conclusions
What conclusions, therefore, flow from the
situation in China and India noted above?
1. The macroeconomic examination of
capacity constraints evidently clearly underlines the correctness of the
Indian and Chinese authorities estimates that they face significant
inflationary pressures.
2. Claims made in 2009 that China faced a
decisive problem of 'overcapacity', as outlined for example in a
European Chamber of Commerce in China report that was picked up in an editorial in the Financial Times, were the
reverse of the truth. The dominant situation emerging in China's economy
was capacity constraints and not overcapacity – as the Goldman Sachs
report noted earlier rightly outlined.
3. Regarding China,the proposal made by
some economists that China should concentrate simply on increasing
domestic consumption, without also increasing domestic investment, is
clearly wrong and would significantly increase inflationary pressures.
Both increased domestic investment and
increased domestic consumption achieve the desirable goal of reducing
China's exposure to fluctuations in international demand/reduce China's
trade surplus. However consumption, by definition, does not add to
supply whereas investment does – thereby lessening capacity constraints.
Increasing China's domestic demand only by increasing domestic
consumption, without increased domestic investment, would therefore fail
to lessen domestic capacity constraints and, other things being equal,
would thereby increase inflationary pressures.
China's actual economic policy in 2009,
which increased both domestic investment and domestic demand, was
therefore a superior policy to one of only increasing domestic
consumption both from the point of view of the short term struggle with
inflation and from long term growth. The Chinese authorities were
correct to have implemented a balanced development of consumption,
investment and trade. The 2009 stimulus package, which increased
domestic demand via both consumption and investment, has left China
better placed to confront inflationary pressures in 2010.
4. In India Prime Minister Manmohan Singh
has frequently
stressed the investment level as the decisive determinant of growth
and it is therefore almost certain that India's economic policy will be
oriented to ensuring that the lowering of the investment level in GDP,
compared to the previous year, seen in the first half of 2009 is
reversed. The general consensus behind such a policy is indicated by the
editorial call in the Economic Times,
India's most influential financial newspaper, for the government to
'reallocate expenditure
away from
consumption towards investment.'
Discussion with Indian authorities confirms
that a policy instrument to achieve a higher level of investment, to
sustain a higher growth rate includes an acceptance of a moderate
balance of payments deficit. As such a deficit is necessarily
equivalent to a net inflow of savings from abroad it would raise the
total finance available for India's investment. Ballpark figures
indicate that double digit
economic growth should be achievable on this basis of India's domestic
savings plus such a sustainable balance of payments deficit.
In 2007, the latest year for which full data
is available, IMF International Financial Statistics figures show
that India's measured savings level was 37.7% of GDP – although
indirect calculation shows this is likely to have slightly fallen in
2008. If a 3% of GDP balance of payments deficit is added to the 37.7%
figures, this,
creating a domestic and international savings rate of 40.7% of GDP then,
based on the correlations of investment and GDP growth, this would
theoretically support an 11.0% growth rate. Given India's likely inflow
of foreign investment a 3% of GDP balance of payments deficit should be
sustainable. In short, India's attempt to achieve a double digit growth
rate would appear to be realistic if it can regain its previous peak
domestic savings level and supplement this by a containable balance of
payments deficit.
Interestingly the
latest Indian Prime Minister's Economic Advisory Council projected growth rates, 7.2% in the current
financial year and exceeding 8% in the next, which are significantly
below these which appear possible from this macroeconomic data. This
indicates either that India has ample margin to control inflation or
that the projections will turn out to be conservative and India's actual
economic growth will be higher than these projections.
5. China is able to finance all its
investment on the basis of domestic savings. A 45% investment rate of
the type that probably existed in 2009, on the basis of the correlations
previously given between investment and growth, would equate to a 12.2%
growth rate. Given the extreme recessionary pressures at the beginning
of 2009 it is unsurprising that such a growth rate was not achieved last
year but it will be interesting to see if this approximates to the
growth rate achieved at least in the first part of 2010. Preliminary
projections indicates that China's growth rate in likely to be
relatively close to this figure – which would confirm that the
macroeconomic correlations indicated above continue to operate.
6. There appears to be no statistical basis
for the claim that India utilises its investment more efficiently than
China. The statistical data shows that the efficiency of the use of
investment, from the point of view of economic growth, is almost exactly
the same in India and China.
A consequence of the preceding point is
that India will not be able in a sustained way to match or exceed
China's levels of growth without matching or exceeding its level of
investment. If
the efficiency of the use of investment, from the point of view of
growth, is essentially the same in China and India then the growth rate
of GDP depends on the relative levels of investment in the two
economies. Unless the efficiency of use of investment in China declines,
or its level of investment in GDP decreases, then as long as India
continues to invest a lower proportion of its GDP than China its growth
rate will be lower.
7. The final
conclusion is evidently that, on the basis of the above data, both India
and China have sufficient macroeconomic room for manoeuvre to contain
inflationary pressures while maintaining their high growth rates. Any
inflationary threat appearing to seriously threaten the ability to
contain inflation would seem to have to be one coming from the
international arena. Even if China's growth rate in the first quarter of
2010 is around 12% this would not appear to seriously threaten, on the
basis of domestic pressures, a level of inflation that was not
containable - although acceleration beyond that point would hence
Chinese policy makers are clearly correct to be taking measures to rein
back inflation and further economic acceleration. India is locked in a
short term struggle with food price inflation but the
present predictions for economic growth at the Prime
Minister's Economic Advisory Council appear even
rather modest compared to macroeconomic fundamentals and it would be
unsurprising to see India attain a higher rate of growth in the next
financial years than these projections.
Notes
1. In China severe winter weather helped increase vegetable prices by 16 percent in a single month in
December. Within the 1.9 percent increase in the consumer price index in the year to December the
highest rate of increase – 5.3 percent – was for food. China's annual
consumer price index fell in January to 1.5% but food supply constraints
still exist. China's producer price index rose by 4.3% in January.
In India the worst monsoon since 1972 helped produce a 18.0% year on
year increase in the main staple food prices in the week to 6 February. India's benchmark wholesale price index was 8.6% in
January, with India's chief statistician projecting that inflation could reach 10% by March.
In regard to short term food shortages only a limited amount can be
done to lessen the effect of these domestic capacity constraints -
India, for example. has been allowing duty free imports of certain items
and releasing food from stocks.
2. Calculated from China Statistical Yearbook 2009.
3. Calculated from IMF International Financial Statistics.
4. Calculated from IMF International Financial Statistics.
5. This is higher even than the 11.2% increase in domestic demand
this blog had estimated
using earlier data and very conservative assumptions. The fact
that China's domestic demand increased in 2009 even more than such
preliminary and conservative calculations of course confirms even more
strongly the points made in the post
'China's dramatic surge in domestic demand' of the huge scale of
China's increase in domestic demand in 2009.
