‘India lacks drivers for 9% growth’

If economists were stellar constellations, Jim Walker would be Ursa Major. The grizzly former CLSA economist and founder of Asianomics, an independent economic research agency, has a disconcerting record of being so right with his bearish predictions. He famously foresaw the 1997 Asian currency crisis two years before it exploded; and as early as in 2007, when the world was still high on an asset-bubble party, he warned of a coming apocalypse. Today, in an interview he gave DNA in Hong Kong, he has just as grim an outlook on the global economy (“brace for a double-dip recession”), China (“a very dangerous time”) and even India (“No growth drivers, and a high fiscal deficit’). Excerpts:

How serious is the risk of overheating in India?
I really don’t think that the Indian economy needs to be worried about overheating. I’m more worried about where the growth drivers will come from over the course of the next six to nine months. The trade side is going to level off over the rest of this year.

Interestingly, there are a lot of shipments of goods from Asia to the US and elsewhere. But while sales in US retail companies were up 1% year on year, inventories were up 13%. So, while goods are being shipped to the US and Europe, there’s not much buying of those goods. And when we look at the internal demand dynamics in India, the thing that hasn’t come back yet is private capital investment. There’s been an uptick in the money supply and credit numbers recently.

 

A lot of it was associated with infrastructure projects, private power projects and the like. But not an awful lot from the private manufacturing, investments, services sector. The government is partly crowding it out, partly because of the fiscal deficit. So, I’m not worried about inflation in India; the monetary numbers are not strong enough. But there’s obviously inflation in certain areas of the Indian economy: food prices have been one of the key ones. And since growth in money supply is weak relative to previous years, the increase in consumer prices will suck demand out of other areas of the Indian economy.
 

So you don’t share the view that your favourite central bank — the RBI — is behind the curve? Is it still your favourite?
It’s still my favourite, and I don’t think it’s behind the curve. It’s raised interest rates slowly and sensibly, and I suspect it will raise them again. But I don’t think we’re going anywhere fast in the interest rate cycle in India. As much as anything, these are signals from the RBI to the government that the government must become more prudent in its spending.

 

What needs to be done to get the growth drivers in place?
The government can help a lot in terms of promoting growth in India by reducing some of the barriers on the infrastructure side and ramping up the special economic zones opening process; however, you want to be careful in doing that, given the global crisis we're living through.

It still means India can easily achieve 5-7% real GDP growth, but whether the economy can get a sustainable 9% growth is much more questionable.

 

Is the engine not humming on all 12 cylinders?
The private sector is ready to roar if the de-bottlenecking process is addressed more fully. At the moment, the economy is ticking over nicely, but not charging ahead. In some ways, there's nothing wrong with that, because when you charge ahead, the banking sector makes more mistakes, and private companies make mistakes. You may get the benefits of strong growth for a while but then you get the downside of a cycle. With interest rates where they are in India, with the cost of capital high, private sector is responding to those signals, which is to make sure that investments that are put in place have a high return. It's good for those of us who are involved in equity markets; it just means that economic growth tends to be a bit lower.

 

What are the key macro themes in India over the next few years?
One of the themes that will become more and more in the public eye is the fiscal deficit. I get worried sometimes because I'm not sure there's been any structural improvement over the last decade. There was an obvious improvement through the mid 2000s, but a lot of that improvement comes because it's only once every few years that India goes through the Pay Commission awards for the public sector. So, a lot of what looked like 'structural improvement' in the government's deficits was because it hadn't given any pay rises to civil servants for long. Then, when the Commission comes up, we go back to a structural deficit of 5% or more of GDP.

 

The reason why that becomes more of a concern going forward is that markets' attention has now shifted. They were always worried about public deficits, but if growth was okay, they tended to forget that. But what's happening with this crisis, and especially the European problems, is that the focus of attention has been turned very much on deficits. India does not come out well in this respect and hasn't addressed the structural problem.

 

Won't the macro fall in place with help from the windfall from the auction of 3G and broadband spectrum and the proposed disinvestment program?
These are positives, and they're welcome. But it depends on what the government does with it. At the moment that's not clear. There's no commitment to pay down public debt, which is one of the things you would hope with disinvestment. When you're getting rid of some of your assets, you want to make sure that the public debt mountain is reduced somewhat.

 

Markets around the world appear to be feeling feisty. Is the worst of the crisis over or do they not know something?
Equity markets globally have got ahead of themselves. They're not really taking into account the prospects of a double-dip recession, which I think are growing.

 

We're still in the early stages of this crisis. If I were to employ a baseball analogy, I would say we're maybe in the third innings of a nine-inning game - and that's if it doesn't go into extra innings.

 

A double-dip recession in just the US?
If we're talking about the US, we're talking globally. Europe is in a much worse state than the US. And China is going to be slowing. The numbers are looking bad in the US, but the rest are looking pretty bad as well.

 

What's bad about the data from the US?
The weekly leading indicator is now at (minus)5.7; it's been falling for a couple of months.

 

Lumber prices are down 40% from the recent peak. The Baltic Dry Index is back down at low levels. If you look beyond the media hype, the numbers are very soft all over the world, and particularly the US. The recent numbers from the credit market, the commodities market and the leading indicators are all looking at a double dip.

 

Is this then a bad time to be pushing for austerity and easing the debt burden? Can you 'cure a patient by drawing blood'?
There's two sides to it. First, if you continue to build public debt, it might have some positive short-term impact on growth, but there's a very negative medium- to long-term impact. People start changing their behaviour in anticipation that taxes are going to rise. Japan is a good example of this. The more the public sector spends, the more the private sector saves.

 

The second is this: the Keynesian effects of public spending are that when public sector spends, economic activity goes up, there is a multiplier effect, and economic growth is supposed to get better. But there's very little evidence for that anytime in history. But there's a body of evidence for the non-Keynesian effects of public spending: when you cut public sector deficit, private sector confidence and activity goes up so much that it more than compensates for the cut. It was established in Ireland in the late 1980s and in Scandinavia in the 1990s.

 

The assumption that everyone makes is that as governments withdraw, economic activity will decline. That's not proven. It is a very complicated question but I'm not convinced that it should be seen as bloodletting or as solving the problem by applying leeches to the wound.

 

So what's a workable roadmap for the retreat from debt?
Governments and markets have failed to recognise that you can't solve an overleverage burden by providing more leverage. The only way you get rid of the problem of leverage is to allow people to reduce the debt burden.

 

Will the UK, where a spend-slashing budget is to be presented, be the first mover? The UK has been the one country where the debt burden has gone up in the last year. Their public sector deficit is $163 billion, one of the worst in the world. They might reduce that somewhat. And that's at least a move in the right direction. But the biggest problem in the UK is that private sector debt levels went up in nominal terms, not just relative to GDP. In Europe and the US, the private sector was paying down debt last year, but not in the UK. The UK has not even begun the process of rebalancing the private sector balance-sheet. To my mind, that leaves the sterling looking like by far the most overvalued currency in the world.

 

A couple of years ago, you flagged the risk of stagflation. Is that still a risk?
We're very firmly in the deflation camp for the reason that regardless of what governments do, the private sector will deleverage - and fast enough to offset even the governments' efforts at printing money. This is the lesson of Japan, and will be the lesson of the US and Europe over the next few years.

 

But stagflation is not outside the bounds of possibility. And that possibility is being driven by central bank policies: at the root of all the problems are the central banks. The Bank of England bought every single government bond issued in the UK; the ECB is now a free money-printing machine for banks in peripheral Europe. The US Federal Reserve Board was heavily involved in buying mortgage-backed securities all of last year. That's the kind of thing that can cause stagflation - or worse, hyperinflation.

 

For now, we assign extremely low probability to that. But stranger things have happened. The worst of it is that people continue to nurse the notion that inflation will get rid of debt! Inflation only causes unemployment; it doesn't get rid of debt, which will go up every bit as fast as inflation because interest rates adjust to make the debt accumulate even faster.

 

So, what should people do: crawl into bunkers?
No, they should probably continue to hold cash, and be invested in good companies with good dividend yields; they should not be worried about making just 5-6% a year on their investments, and not 50-60%. Those days are gone.

 

We're now in a very different world from the last 20 years of credit excess and borrowing, we are now in a world of repayment and deleveraging. That will be the case for a generation. For the next 10-20 years.

 

Let's turn to China. Last year, you said China would be the economy that would be the worst-affected by the crisis. Economic data since then appears to tell another story. What happened?
I still say China was the world's worst-affected economy. China's stimulus programme was bigger than anybody else's in the world, and it managed to get 8% or 9% GDP growth. The disproportionate response it took to get just 9% growth is amazing. China last year added the equivalent of 44% of the previous year's GDP to its economy in terms of money supply. It happened because China has the ability to tell its banking system to lend or not. Other countries added some 6-7-8 percentage points of GDP on their fiscal side, but very little by way of monetary growth, China's response was amazingly big, which tells you the story that the effect on China of the downward movement in trade was enormous.

 

There are those who say China has come out of the crisis stronger. Are they wrong?
They are wrong on a number of counts. First of all, the way the money entered the system in China promoted a huge building boom: a property boom and an infrastructure growth story.

 

On the face of it, it's fine, except that from what we can gather, very few people are buying the property that's being built. A lot of the loans that went to local
governments to undertake the infrastructure projects are now expected to turn bad. The indications are that the lending to local governments alone last year was anywhere between 20% and 33% of GDP; these are loans outstanding to these local government funding vehicles (LGFVs).

 

Probably about 15 percentage points of GDP took place last year, and of that at least 20% will turn bad. That alone would be between 4% and 6% of GDP, which is incredibly high.

 

I don't know how big this problem is eventually going to be. But the key element in this process is that it's very difficult to work out how sustainable in terms of

a return on capital these projects are going to be. From all indications, the returns from these projects are going to be very small.

 

Is China's economy cooling down owing to policy action - or stalling?
What we've seen in terms of policy action is only tinkering around the edges. It will have an impact because they can tell the banks to stop lending. But the problem is that they continue to send the wrong signal on the price of capital.

 

If your fixed return savings are below the rate of inflation - and it's pretty sure the Chinese are understating real inflation -you will turn to flexible return instruments. In China there are only two: equity market and property.

 

The equity market has been a losing investment for most of the last four or five years, so people are more inclined to go for property. That eventually makes the imbalances in the economy worse.

 

We already have an engorged property sector in China, but the signals being sent by the government's interest rate policy tell people to put more money into property. And when more capital goes into a sector, it attracts labour, materials, and more capital. What you end up with is a very skewed economy; that's exactly what's happening in China.

 

A lot of the problems we're seeing in wage claims in manufacturing, and shortages of workers in parts of the manufacturing sector, are related to the boom in property. Because the property sector is booming in various parts of the country, labour is being diverted there, which makes it much more expensive to hire labour if you are a manufacturer in Guangdong or in the Yangtze river delta or wherever.

 

The whole cost structure of the economy also changes. This is a very dangerous time for China; its policies are being followed through by the people and the economy exactly as the price signals would suggest they should be. The price signals are telling people to build property, to speculate on property, to rush in there.

 

But aren't the administrative measures - the freeze on mortgages for second homes, and so on - sending the opposite signal?
The government is trying to send that signal, but when I was in Beijing recently and speaking to people on the ground, their view is that the government is bluffing, and that the government will never really affect property prices.

 

Is this all smoke and mirrors?
It's dangerous that that's the way people are interpreting these signals. They've stopped buying property in Shanghai and Beijing because they know the government is relatively serious and can do something about Tier 1 cities. But they think the government can't do anything about Tier 2 and Tier 3 cities, because it doesn't have enough economic 'policemen' to determine what's going on. So, the property speculation activity is shifting to other cities.

It's famously said that in China there is no leverage, so there can be no 'property bubble'. There are anecdotal reports of people paying 100% of their homes in cash.

 

Of course, there are people like that. But they represent a tiny fraction of the Chinese population. But it gives an idea that the kinds of properties that are being built are exactly the wrong kind. They attract speculative money from very rich people, rather than being end-user property for ordinary people. If you get down to ordinary folk, they may not borrow much from the bank (because the bank wouldn't lend anyway), but they've borrowed a lot from parents, from relatives, from friends.

 

But does it matter if there's no institutional risk to the financial system of the sort we saw from the US sub-prime market?
There is a risk to the financial system. The risk is that if property prices begin to fall or even just stabilise, the collateral values in the banking sector against all of these local government vehicles begin to come down. They are already problematic for the banks. But if collateral values were to fall as well, the kind of problem that can come from the local government funding vehicles is catastrophic.

 

So, the property sector in China is at the moment a Ponzi scheme, almost the same way that it was in the US between 2003 and 2006. It's built on increasing confidence that prices will never come down. And most Chinese don't believe the government is willing to take the kinds of measures that would ensure that prices come down. When you speak to people, they say the government is just bluffing. The speculation doesn't stop as a result of that: it just moves to different areas.

 

How will this end — in a colossal collapse?
It's difficult to predict exactly how it will play out. If it turns out that more and more resources are still going to property, which is not resulting in a return on capital, the government will have to continue to tighten, and at some point, it's going to have to do the sensible thing, which is to raise interest rates.

 

That would be the real signal that they are serious. So far, there's been no serious signal from Beijing. Policymaking in terms of the property market and in terms of the domestic economy has been appalling. What we've seen is only tinkering around the edges.

 

Does a rate hike seem less likely after the yuan move over the weekend?
That depends on how the currency moves. The underlying assumption is that the RMB will strengthen. I'd say that's a bad assumption. The RMB has already strengthened this year against a trade-weighted basket of currencies. If the Chinese are moving back to a managed float against a weighted basket, you should expect the RMB to depreciate against the dollar.

 

Of course, politically that's impossible for the next few weeks, but I don't think there's anything that can be read into the statement from the People's Bank of China that would suggest a significant appreciation. Of course, an appreciation in the exchange rate does mean that monetary conditions in the economy will tighten. But I'd be surprised if that happens.

 

Does that raise the risk of policy errors?
The reluctance to raise interest rates is beyond any kind of economic assessment. You hear some explanations that it would attract hot money, and would put more upward pressure on the RMB, but that's absolute nonsense. We know from the experience of countries worldwide that when countries put up interest rates, capital begins to flee, rather than be attracted, because it senses that the government is serious about slowing down the economy.

 

Nobody puts money to work in an equity market in a country where interest rates are rising. For some reason, many economists and analysts think that if interest rate differentials rise, it will attract money into the country. There's plenty of evidence to suggest exactly the opposite.

 

Will the problem with the local government investment vehicles blow up into a financial crisis?
The banking sector lends against collateral put up by the local government finance vehicles. The only collateral they've got is land. So, the land value is absolutely critical. If property prices begin to slide, collateral values would slide, and the banks would try and pull in some of the loans, and whether these LGFVs actually have the wherewithal to repay any of the loans would become the $64,000 question. All the indications are that they don't have very much money.

 

Could this whole LGFV lending binge be very problematic for the banking system?
Yes, but not now. Companies don't need to repay any of the capital for the full term of the loan; all they need to do is make interest payments. When the loan term finishes, the borrower is supposed to repay the full amount. In the first instance, they will renegotiate with the bank and roll it over. You could probably do that for a year. Most of the estimates have it that we'll begin to see problems from the LGFVs in about 2012, even if the loans are bad now.

 

There are people who say: even if the central government brings banks' bad debts onto its balance sheet, it's not as bad as the debt burden in the West.

The argument is flawed. The US public debt may get to 80% of GDP over the next 10 years. The calculations in China have it that if you take local and central government debt together now, the contingent liability of government is between 50% and 70% of GDP, which is on a par with most countries in the West.

 

The expectations are that Western countries will see a big increase in their debt-to-GDP as a result of this crisis. But the Chinese increase is faster than theirs so far - because of local government borrowing.

 

All of that ignores the fact that a fairly big slice of bank lending is to state-owned enterprises (SOEs) in China. If those contingent liabilities, which the West takes into account in its calculation of public debt, were taking into account, China's debt-to-GDP ratio is over 100% already.

 

We don't know exactly, but the indications are that SOEs have about half of bank lending in China. Bank lending in China is about 134% of GDP. So that means, SOEs are about 65% of GDP in terms of borrowing. Then you add on central government and local government debt, and you have over 100% of GDP.

 

Sure, there are assets to be netted off against that. But that's true of every other country as well. The public debt position in China, if you only look at central government, is very good. But if you add in all of the other contingent liabilities, it begins to look just as bad as everybody else.

 

So, are investors who are betting on China to lift up the world looking at the wrong set of numbers?
There's an agency which ranks transparency of public accounts on a 100-point scale, 100 being the most transparent, and 0 being the worst. The UK is ranked as one of the most transparent countries in the world in terms of its public accounts: it ranked 88 out of 100. China ranks 14 out of 100. Its score in terms of transparency is 14. (India is somewhere at 50 or 60.) People just don't know what's going on in China because of the way accounts are produced.