Brad Setser

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Cross border flows, with a bit of macroeconomics

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Chindia (or maybe not)

by Brad Setser
March 23, 2007

The similarities between China and India have seized many (see Martin Wolf's column and the resulting discussion).   Both China and India have enormous populations — and enormous scope to increase their urban labor force as their absolutely enormous rural population migrates towards urban areas.   Both have grown very rapidly recently. Indian growth is now close to Chinese levels.   Both have grown on the back of strong investment.   Both have experienced strong credit growth.  Both have booming stock markets — though the timing of their respective booms hasn't always coincided perfectly.   Both have experienced rapid reserve growth.

And both have the potential to exert an enormous influence over the global economy.   China, for that matter, already does.

Still, I have been far more struck by the differences than the similarities.  And not just the obvious ones — China's modern infrastructure is often contrasted with India's crumbling infrastructure, China's supposedly efficient version of bureaucratic capitalism (and the absence of political reform) is often contrasted with India's democratic but sometimes more chaotic political institutions.    

No, what has struck me is that India's recent acceleration is having a lot of the effects that one conventionally would expect — rapid credit and investment growth have led to inflation and current account deficits — while China's recent strong growth hasn't had the effects one would expect.  Jon Anderson of UBS has argued that China is one massive economic puzzle for conventional macroeconomists.  He is right.   India isn't.  Or at least as big of a puzzle.

India has experienced a massive credit boom over the past few years, well detailed by in a highly recommend Global Economic Forum piece by Chetan Ahya of Morgan Stanley.  Bank credit has grown in relation to GDP — and relative to deposits.   The surge in credit has contributed to a boom in investment.  Indian household savings are comparable to Chinese household savings. Indeed, Louis Kuijs found that household savings are a higher share of India's GDP than China's GDP.  But India's government and private sector have far more need to borrow these savings than China's government and private sector.   As a result, Indian savings lag Indian investment, leading to a current account deficit.

Strong credit growth has also been one factor pushing up inflation.   Higher rates of inflation, in turn, have led the RBI to push up interest rates.   Inflation is now in the 6.5% range — faster than in the US or Europe, so India's real exchange rate would appreciate even if the nominal exchange rate stayed stable.   And nominal interest rates are now 7.5%.   That is lower than nominal GDP growth — but I suspect the gap between India's nominal interest rates and India's nominal GDP growth isn't as big as the comparable gap in China.

Higher interest rates are pulling in foreign capital.  As Andy Mukherjee continues to note, India has emerged as a popular carry trade destination.  India's capital account isn't fully open, but it seems to be open enough.   Strong inflows led to very rapid reserve growth in February. Those inflows seem to be creating trouble for the RBI.   Sterilization isn't easy.  This week, India's efforts to tighten liquidity to slow credit growth seem to have gotten in the way of the need for cash to make tax payments, pushing up short-term rates and the rupee and pulling foreign money in.  Those are the kind of difficulties, in a sense, that one would expect from large scale capital inflows and rapid reserve growth in the context of a fixed exchange rate.

And yes, I do think India, like China, should allow its exchange rate to appreciate.  Some Indian analysts do to.  A stronger rupee would help contain inflation — and, at some point, reach a level that reduces India's need for sustained reserve growth.

Contrast India with China.    Credit growth in China also has been strong — faster than GDP growth.  Bank credit to GDP is rising – and rising from a very high level.   But as fast as credit has grown, it hasn't kept up with deposit growth.  So the lending to deposit ratio in China's banking system is falling (note DeLong's ballpark math; China's banks are increasingly lending to the central bank rather than state firms).  

Even after the recent rate hike, Chinese interest rates are far lower than Indian rates.

No doubt they are — as the Economist argues this week — too low.    Denise Yam of Morgan Stanley thinks so.  She writes:

The interest rate rises so far have left rates still way below the neutral level consistent with the pace of economic growth, fostered speculation in asset markets, and left China vulnerable to a rebound in excessive investment.

China keeps lending rates well above deposit rates, so the banks have a strong incentive to lend their spare cash out to private firms at 6% and change rather than lend to the central bank for 3.25% (less for shorter maturities).   Since the banks have plenty of cash on hand, they should be lending even more at current interest rates.

China's government, however, doesn't let the banks lend out as much as they want.    Administrative controls keep credit growth below lending growth — creating a built-in market for central bank paper.  But even so, sterilization has been partial.  

China's ability to combine a massive investment boom with an even bigger boom in savings and thus a rapidly rising current account surplus is a puzzle — investment booms usually lead to current account deficits, or at least smaller surpluses.  But perhaps the biggest puzzle of all — as Brad DeLong notes — is how China has been able to combine stupendous reserve growth, partial sterilization and low inflation.  

Theories abound.  

The reservoir of labor in China's countryside is part of the answer.   But perhaps not the entire answer.  India also has a reservoir of labor in its countryside, yet a boom – combined with rapid reserve growth — is still generating inflation there. 

Like Martin Wolf, I think the restrictions on bank lending — combined with the government's own high rate of savings — have been crucial to China's ability to hold down inflation and thus sustain an undervalued exchange rate.  The government has effectively locked up a lot of Chinese savings in the banking system where it is lent to the central bank at low rates.  And since the RMB is expected to appreciate, Chinese savers have been willing to keep a large fraction of their funds in the banking system despite the low deposit rates.

Still, the absence of more inflation in China is a puzzle.  India's reserve growth — even, I think, in relation to its GDP — hasn't been comparable to China's reserve growth.  But India's reserve growth has coincided with far more visible signs of overheating, far higher inflation and far more obvious difficulties with sterilization than China's reserves growth.      At least that is how it seems to one external observer.

UPDATE: John Makin of the AEI on Chinese monetary policy.  By comparison, I am a model of restraint!


  • Posted by OldVet

    Could it be that in China the price of consumption goods is controlled, directly or indirectly, to minimize inflation? Domestic firms are still a large force, as is govt ownership.

  • Posted by isaac

    china’s huge investment in physical capital and fast improvement of human capital probabaly mean China productivity growth is way faster than Indian’s despite market fascination with indian software/outsourcing miracle.

  • Posted by Emmanuel

    Some quick points –

    1. Indian household savings are comparable to Chinese household savings.

    Not quite, I am inclined to say. Consumption in China as a percentage of GDP is 38%, whereas it’s about 60% in India. True, consumption’s share of GDP has been falling as well in India, but not to the same extent as in China.

    2. China keeps lending rates well above deposit rates, so the banks have a strong incentive to lend their spare cash out to private firms at 6% and change rather than lend to the central bank for 3.25% (less for shorter maturities).

    Methinks state-owned banks have little choice in the matter.

    3. China’s modern infrastructure is often contrasted with India’s crumbling infrastructure.

    I’ve been thinking about this one. Since India has more of a service economy orientation (software development, back-office operations, accounting, customer service, entertainment, etc.), this may not be as large a handicap if by weak infrastructure we mean “getting manufactured goods unto ships for export.”

    China is way, way ahead on this count. I wrote about how China has three of the world’s five busiest ports in terms of container traffic. It’s worth a read if you’re interested in infrastructure development.

  • Posted by bsetser

    you all are a demanding audience. my source for India’s higher rate of household savings (as a % of GDP) is Kuijs, 2006, table 4 — i added the link to the post.

    The lower household savings (as a % of GDP) may reflect in part high corporate savings in China (there is a huge gap with India), since the amount of corporate income (and savings) implies that household income is lower as a % of GDP. If labor income to GDP is low v GDP it is harder for household savings to be a high share of GDP, especially if most corp. profits are not disbursed.

  • Posted by LC


    Have you looked at the aggregate capital market size for China and India? My feeling is that China’s aggregate market for capital (banking + equity + bond) is much larger (approximately 200% of GDP) than India’s (approximately 125% of GDP). Given these ratios, the cost of sterilization incurred by PBoC is relatively small vs. RBI’s cost. This might also explain some of the inflationary mystery.
    Also, I think the bank lending to deposit ratio will continue to fall in China as the equity and bond market continues to grow. Just looking at banking figures alone seems increasingly inadequate.

  • Posted by bsetser

    China still doens’t have much of a bond market to speak of (especially if you exclude the AMC and PBoC sterilzation bonds), but its stock market cap has shot way up … (I wonder a bit tho if the number isn’t somewhat distorted by the fact that most of the shares of the big firms aren’t traded … i.e. they are held by the state). but i do think, LC, that you may be on to something —

    m2/ GDP is much, much bigger in china than india. And the indian banks have a lot of GOI bonds, while, setting the aMc recap bonds aside, china’s government hasn’t tapped the Chinese banks for financing to the banks don’t hold lots of GOC bonds. So in a sense the PBoC sterilization bills may substitute for GOI bonds on the balance sheets of the state banks in india, and they may — even now — represent a smaller share of chinese deposits than GOI bonds held by the indian banks. If i have the time, that is definately something worth examining.

  • Posted by Emmanuel

    RE: India’s savings rate and Kuijs. The answer may be on p.10:

    Is it possible that a “corporate veil” means that the distinction between corporate and household sector saving is artificial and does not mean much? If all households have shares and if incentives and decisions of firms are well-aligned with the interests of households, it may not matter much if saving is done by firms or households. Such a situation may describe the relationship between small firms and their owners, and there are concerns that this may affect the data on the composition of saving in India. However, this characterization does in general not describe China well. Shareholdership is not very widespread, and corporate governance of larger firms is such that firms’ decisions and interests are not often aligned with those of households, or in the case of SOEs, the state.

  • Posted by OldVet

    Private savings in India are offset by public dissavings caused by subsidies of water for rural agriculture and petrol. These subsidies amount to controlled price reductions for consumers, on their face deflationary. Yet India has inflation.

    There has to be some similar subsidization process in China, or inflation figures must be much higher than reported. The boom in China is real, the growing inequality of incomes real, and while supply-side bottlenecks are not nearly as sever in China as in India, pain of inflation is being felt. It may be in China, like the US, that the economically visible part of the population and the prices it pays are stable, while the invisible rural segment has powerful inflation that is simply not counted. Or prices are subsidized. It’s either/or, isn’t it?

  • Posted by jeje

    The stock market is rigged. The statistics coming out of government and financial institutions are manipulated. The Fed and the Treasury are F#cking around with money and debt to an unprecedented degree, and all without oversight, audit, controls, regulation, or transparency. Fundamentals no longer apply.

    The story is not about mortgages but about the rapidly increasing inability for PEOPLE to PAY their mortgage.

    The story is not about debating if it’s the banks fault for lending or the PEOPLES fault for borrowing. IT’S THE ECONOMY STUPED! Its not a partisan issue.

    It is time for economists, economic annalists and financial industry advisors and prognosticators to stand up and say enough is enough.

    No more analysis of the symptoms and effects. These efforts are not helping anyone. Enough of the innuendo, the inference, the open ended commentary meant to have us ask ourselves “is this right, is this OK?”

    NO damn it it is not OK. It’s not moral, it’s not ethical, it’s not cleaver to profit from all of this as if money or gold or what ever you prefer and wherever you cleverly put it will help you if the vast majority of the population is hurting bad.

    This is not your grandfathers’ financial crash. All indicators illustrate that a whole s#it load of factors are loaded and set to go at all at once. And the factors for recovery are declining rapidly (energy) or simply not there. It’s 10 times more dangerous than in the 1920’s. People are not going to roam around politely asking for a job or some bread.

    There are no winners, no safe havens for the wealthy as many think. The strategy of quietly getting as much as you can before TSHTF is faulty. Where ya gona go huh? Think about it very carefully because there is no where that won’t be affected and do you really want to try and find that secure, gated location and live with a loaded gun at hand at all times, jumping at every sound?

    Stand up now and tell it like it is. And tell the story of how we can restructure if we just acknowledge the truth, bring together the best minds and create a future, some kind of future that we AMERICANS can knuckle down and work for. It’s TIME we get down to some real work.

    No you will not be ostracized for being “the one who starts the panic”, you will respected as one who had the courage to stand up.

    No more business as usual. That option is over.

  • Posted by RebelEconomist

    The Economist’s argument for higher interest rates in China draws on the received wisdom that the interest rate should equal the growth rate of the economy, but if I recall correctly, this idea is relevant to equilibrium in a highly stylised model in which growth occurs through technical progress augmenting existing inputs as well as new ones.

    This seems an unrealistic representation of China’s growth. China ploughs a large share of output into new capital, because its people are so keen to save that they are willing to invest in even relatively poor projects. The result is that fast output growth goes with a poor marginal return on capital and low interest rates. This does not deter FDI though, because foreigners can bring skills and knowledge that enables them to get a better return on their capital than Chinese savers can. The resulting investment congestion can be messy, so the government tries to restrict investment at home and divert some abroad. As I suggested earlier this week though, I doubt that the authorities can raise interest rates by market operations alone.

    Maybe this growth process is not strictly inter-temporally optimal, but the Chinese care about more than consumption. They want to reach the first world, and independence from foreign technology, as fast as possible. So they build their own planes and launch their own satellites, regardless of competitive advantage (Monday’s post).

    The Indians seem more relaxed. Their population is still growing, so they feel less pressure to save for their old age, and I suspect that India’s development is less driven by national pride.

  • Posted by koteli

    BERLIN (Reuters) – The International Monetary Fund will say further depreciation by the U.S. dollar is needed to help correct global imbalances in its latest World Economic Outlook (WEO), Germany’s Sueddeutsche Zeitung said on Saturday.

    Quoting from a draft of the WEO, the paper said the Washington-based fund argued “extraordinarily aggressively” for a correction in exchange rates, above all so as to reduce the massive U.S. current account deficit.

    The dollar, which slid to a 2-year low against the euro last week, should continue to depreciate in the mid-term, while the yen, the Chinese yuan and currencies of oil-exporting countries in the Middle East should all appreciate, the draft WEO said.

    The WEO, which is due to be published in mid-April, will add that there is no great need for further interest rate increases by the European Central Bank, according to the paper.

    Thanks to solid growth in the 13-nation euro zone, the ECB would not create problems by raising its main lending rate to about 4.0 percent from 3.75 percent at present, the IMF said.

  • Posted by bsetser

    hmmm — i’ll be interested to see what the WEO actually says. It isn’t any secret that the IMF’s exchange rate model suggests that the $ needs to fall further tho. that result appeared in the IMF’s article IV consultation with the US loud and clear.

    any other ideas re: China’s capacity to keep inflation contained?

  • Posted by Guest

    Could it be, that if a large portion of the amount of liquidity supplied is placed in infrastructure, machinery and other assets, is may slow down the circular flow of economic? And that might slow down inflation?