Keywords

Emerging markets; the BRICs; emergence of China; decline of Japan; Abenomics; East-Asia syndrome; Brazil; India

13.1 The Rise of Emerging Markets

In the 1960s, a French economist coined the label “Third World” for all countries that would not fall under the then popular “First World” reference to western nations. The First World consisted of America, Western Europe, and Japan. Successively, as a term, the Third World has been changed into “countries in the process of development,” and later on became “developing countries” as well as “emerging markets.”

Though the label “emerging markets” is nowadays common currency, there exists no solid block of nations behind it in terms of economic development, industrialization, family planning, and standard of living.¹ But there is a group of nations nicknamed BRICs—which stands for Brazil, Russia, India, and China. Three out of these four economies constitute this chapter’s theme.

Of course, there are as well other countries in emerging markets, such as South Korea, Taiwan, Thailand, and Indonesia in Asia; Turkey and Egypt in the Middle East; Mexico, Chile, Peru, and Argentina in South America. These will not be individually examined in this text, but they are part of the broader references made in this introductory section.

If South Africa was added to the BRICs (to which it does not really belong), then they would make up 43 percent of the world’s population.² As one of the experts interviewed by CNBC pointed out, there are no other economics that can compete with BRICs. China is already a major global player, and it grows faster than the Asian economies surrounding it.³

Another interesting fact about emerging markets, particularly in terms of a trend, is that in the course of the 6-year economic crisis (2007 to today) they have shown a high degree of resilience, even if they were not entirely immune to global economic weakness. For instance, in 2012 Asian GDP grew somewhat below 5 percent⁴ compared with 6.6 percent in 2011. A 5-percent GDP growth is great when contrasted to Europe or to America. Even if in the years preceding the crisis emerging markets were accustomed to much more than that, the trend held.

Moreover, by mid-2013, downward revisions to emerging market GDP growth forecasts appear to be coming to an end. Analysts have started to expect emerging market GDP to increase to 5.3 percent in 2013, while Germany revised its 2013 growth forecast to a mere 0.6 percent. IMF projections also talk of moderate growth in emerging markets in the course of this year.

Even if the economy were not globalized, it is unavoidable that economic crisis in the richer markets will affect those ascending. Nobody has yet found a way to defy gravity. As the larger emerging markets are not able to compensate for the drop in economic activity in the western world, they therefore underperform. Brazil is expected to head toward zero GDP growth. India, too, has problems, and in the course of 2012, China gradually reduced its forecasts.

Nevertheless, despite growth projections well below those of the twenty-first century’s first decade, the economy in several emerging markets has been supportive. Talk about structural reforms lifted some of the bigger emerging economies. Russia announced possible tax relief in the energy sector to encourage investment. By all evidence, China had a soft landing. India spoke of policy measures making it easier for foreigners to invest in the retail sector.

One would be justified in thinking that these are minor amends and in the end they may account for little depending on the intensity of the next crisis. As Japan reminds us, the export-led growth model is an unreliable one. Even if a policy of investment and infrastructure, followed by the better-off developing economies, is sound, it tends only to work in conjunction with exports—particularly when the country’s consumers are not spending that much.

In that sense, the key risk to the near-term growth outlook for the emerging markets is external shocks from advanced economies. This is a double cutting knife because western economies also suffer—at least in regard to their household debt and current account (balance of payments)—from too much money flooding into the emerging markets. (A trend which is now reversing itself)

Developing economies certainly need to upbring their internal market, but this takes lots of preparation (including a psychological one of the consumers). It cannot be done at high speed. Analysts say that consumer growth will remain defensive in China, India, and Indonesia in 2013 even if it is especially supported by policy, for instance in China. Resurgent inflation is also a latent threat, and in this case, Indonesia and India are most vulnerable, limiting government policies to promote growth.

Theoretically, the Indonesian economy should have been strong because of the country’s important natural resources, oil being one of them. But inland, the price of oil was kept cheap, with the result that it was overused and spoiled. Indonesia is no more the oil-exporting country that it used to be. Russia is a better example of how to leverage what is beneath the soil.

In 2012, the Russian economy grew faster than expected. GDP expanded as compared to 2011, mainly driven by positive real income growth. While economists expected that the Russian economy will slow down in 2013, one of the reasons being that the government is unlikely to commit to further salary increases, others look toward a positive economic growth in 2013.

As with China (Section 13.2), a crucial question is whether domestic Russian demand can offset weaker export growth. The uncertainty of an unqualified positive answer led analysts to the projection of a moderate slowdown in Russia in 2013; nevertheless a positive growth.

From a structural point of view, the emerging markets’ strength has to do with their improving domestic consumption, relatively high savings rate and rather strong investments. From a more cyclical standpoint, emerging markets’ balance sheets are healthier than those of major western economies, so there is no pressure for them to go through austerity like several European countries had to do, because of rising mountains of public debt.

Emerging markets, however, do have hick-ups. In the late 1990s, during the most difficult days of the Asian crisis, the IMF extended bailout packages attached with reform conditions that were, as usual, strict. The harder working nations profited handsomely from this support. Combined with significant currency devaluations, the Asian governments’ implementation of reforms made it possible to quickly restore competitiveness.

In early 2013, Egypt confronts a difficult economic scenario (much of it its own doing), and asked for an IMF loan. The Egyptian pound fell. By contrast, Euroland’s common currency sees to it that European countries cannot devalue to restore competitiveness. This makes it even more important to implement structural reforms with resolve, which is simply not happening.

Nearly all emerging countries have put their hopes in international cooperation, favorable tariffs in western countries, and global economic convergence. However, Morgan Stanley’s Ruchir Sharma, head of the bank’s Emerging Markets and Global Macro, says that international economic convergence is a myth. Part of his argument is that “… few countries can sustain unusually fast growth for a decade, and even fewer for more than that. Now that the boom years are over, the BRICs are crumbling; the international order will change less than expected.”⁵

While the BRICs label (like the PIIGS)⁶ might have been primarily a marketing concept which reduced the whole emerging market space to only a handful of larger countries, this was not a random selection. It was simple cherry-picking. Other emerging markets have more pronounced problems, and therefore, they are not particularly appealing in an investment sense. Their growth prospects are not appealing because of reasons ranging from social strife (the case of Argentina) and economic issues, all the way to heavy indebtedness.

This does not mean that the BRICs are free of such problems, a reason why in mid-2012 (as a group) they fell out of the wall relative to the S&P 500 index. Beijing and New Delhi are locked in long-standing border disputes. Russia is stepping up its military investments to counter China’s; and Brazil finds out that economic trust is difficult to build after it is shaken.

In addition, it is not easy to promote mutual prosperity when economies run at different levels. The interests of a commodities exporter are not the same with those of an importer, particularly when downward revisions to emerging markets growth projections are a reversal of previous trends. This could change again as the IMF forecasts emerging markets growth rising moderately into 2013 and further into 2014.

Sentiment about China’s outlook (Section 13.2) has improved, and there have been longer term structural policy measures announced in India and Russia. Still, for the time being there are more policy announcements than corrective actions. Analysts think that once announced measures are implemented, they should be helpful to the economies where they apply, provided that reforms make the labor market more flexible and facilitate economic restructuring.

13.2 The Ascent of China

In the twenty-first century, the Chinese economy expanded quickly beating forecasts and continuing to do so as western nations confronted the economic, financial, and banking crisis which started in 2007. China has been a fast-developing emerging country with plenty of room yet to grow. It invests a lot, and though such investments might not always generate good returns for the banks that lent the money, they do contribute economic growth.

China also depends on its hard-working population as well as the Chinese of the diaspora throughout most of Asia. For instance in Indonesia, ethnic Chinese make up just 3 percent of the population, but they control an estimated 70 percent of Indonesian business. China and other Asian countries are part of the entrepreneurial model which advises:

In this century’s first decade, China’s internal market consumption was at the level of 20 percent to 25 percent of GDP; the balance has been going to exports. This cannot continue forever. To sustain growth, internal consumption should be at least 50 percent of GDP, but as long as the export boom lasted, it provided China with the hard currency it needed to pay for infrastructural and industrial equipment (which it could not otherwise acquire), as well as to create a war chest in hard currencies:

This provides double evidence: of sound management of the economy and of persistent effort. The Chinese leadership followed Lao-tze’s, the Chinese philosopher’s, thoughts. He lived 2500 years ago and his motto was: “Ruling a great country is like cooking a little fish.” A light touch is needed for a good meal; the result of applying this recipe to the economy has been growth.

The pace of this growth made economists wonder whether China can or cannot sustain its high rate of investments, as well as the destinations of its produce. Because export-oriented industries employ an estimated 200 million people, weakening exports figures are a big concern for the country’s economy at large.

Critics say that Chinese growth is unbalanced because it is highly dependent on investment as a source of demand and driver of the economy. This argument has a point as between 1997 and 2010 gross investment rose from 32 percent to 46 percent of GDP, while household consumption somewhat fell.⁷

While there is indeed evidence that China’s policy overemphasized investment, the pros answer that infrastructural works were not only necessary for social and industrial improvement, but as well for adjustment of the economy to a new production model—as consumer export markets are no more as strong as they used to be. Capital equipment is indeed a crucial part of the global market, most particularly in Southeast Asia where China is redirecting its exports.

While today China’s economy is not as dependent on exports as it used to be, foreign markets are important because, in the early part of this century China worked itself into becoming the world’s largest manufacturing power. Its output of mechanical and electrical engineering surpassed America’s in 2010,⁸ now accounting for roughly 20 percent of global manufacturing.

This is not only true of labor costs. Increases in land prices, machinery, environmental and safety regulations as well as taxes, all play a part even if the biggest cost factor is labor as wages rose by 10 percent in 2012 alone. Coupled with export problems, this suggests that in 2013 economic growth will not return to a double-digit annual increase even if destocking continues.

The way an article in The Economist had it “some low-tech, labor-intensive industries, such as T-shirts and cheap trainers, have already left China. And some are employing a “China+1” strategy, opening just one factory in another country to test the waters and provide a back-up.”⁹ The irony of this reference is that China is discovering firsthand the reasons which made western companies to delocalize.

This means that China’s new leaders in the Politburo Standing Committee will face major challenges in the next years. The country’s size alone will not be a problem. But to achieve sustained growth for a population of 1.4 billion, people will require continuing refocus from export-led growth to more balanced growth which capitalizes on the home market.

The good news for the new political leadership is that Chinese consumption continues to grow at a low double-digit level. The bad news is that still private consumption only comprises 34 percent of Chinese GDP, while 49 percent comes from fixed investments. Hence, the latter to determine whether China’s overall economic growth meets or misses the nation’s expectations.

Another piece of good news for China’s economy is that in spite of growing production costs, China’s exports are increasing again, particularly toward the United States. All by itself, however, this is not enough. Not only the internal market must be sustained in a growth path but also investments have to be optimized in regard to the country’s overall strategic plan, even if optimization is one of state capitalism’s weaknesses.

Other questions, too, are pertinent to the Chinese nation’s future. Will the new leadership be able to squash the tendency of managers in both “plain capitalism” and “state capitalism” to run companies to suit their own interests rather than the interests of their owners and customers? Or will the top brass be too distracted by other duties to exercise proper oversight? And how far will the politicians go in controlling the companies’ mission toward a balance between commercial and the social requirements?

Neither are these the only short to medium term challenges. China is entering the group of countries known as “middle-income.” Many governments get stuck in this setting and go on to experience much lower growth rates than they did prior to entering it. Another one of the BRICs, Brazil, was already a “country of the future” in the 1960s and 1970s—and so it is still is today. Countries fall into that trap when they stick to labor-intensive sectors which are more and more challenged by cheaper-producing countries.

Climbing up the ladder is a “must,” but the decision needed to do so does not come as matter of course. A prerequisite is that the country opens its political system, as several smaller countries have done in Southeast Asia. Another prerequisite is the avoidance of micromanaging its currency because this has adverse fallouts.

China has relied on keeping its currency in a peg against the US dollar. This allowed it to export at cheaper prices than it would have otherwise, but it’s a policy which also has downsides. This is particularly true of a country that has been importing large quantities of energy and other materials at higher prices than it could have otherwise. The aftermath is that of igniting inflation, of which China had its share.

Iron ore and base metals are a case in point. The country’s share of global demand stands at around 60 percent for iron ore and 40 percent for base metals. In crude oil demand, China’s share is 11 percent, less than that of base metals but still high. For every country, the optimal exchange rate for its currency is a balancing act; one difficult to define, let alone to achieve.

“Treasure the things that are difficult to attain,” urges a Chinese proverb. It is sage advice but the proverb does not say “how.” One has to find his own way. Back in March 2009, China’s central bank tried to do just that. It suggested replacing the US dollar as the international reserve currency with a new global system to be controlled by the IMF.

At the time, analysts said that proposal was an indication of Beijing’s fears that quantitative easing and other actions being taken by the Federal Reserve would have a negative impact on China. To replace the dollar-based global system, the People’s Bank of China suggested expanding the role of special drawing rights (SDRs).

Currently, the value of SDRs is based on a basket of four currencies: US dollar, yen, euro, and sterling, and they are used largely as a unit of account by the IMF and some other international organizations. China’s proposal would have expanded this basket creating a new basis of SDR valuation which involves all major economies and also, setting up a settlement system between SDRs and other currencies.

It is appropriate to note that the Chinese are not the first to come up with the SDR suggestion. Joseph Stiglitz of Columbia University and former chief economist of the World Bank has also proposed expanding the role of SDRs to lay the foundation for a world currency. And in the 1940s John Maynard Keynes made a similar suggestion about the need for a world currency, but Keynes’ idea was set aside as the dollar became the international currency.

Still the Chinese proposal of an IMF-led international currency was a bold move, which documents how far the country has gone in gaining self-assurance. More than two centuries ago, Napoleon Bonaparte, the French emperor, warned: “Let China sleep, for when the dragon awakes it will shake the world.” China is now awake, but to shake the world it still has to take many crucial, and sometimes painful, decisions whose outcome is less than certain.

13.3 China Faces Important but Not Unprecedented Challenges

As far as unprecedented challenges in the Asian continent are concerned, let me start with the heavy artillery. China is the most populous nation in the world, and India comes right next to it. In both countries, life expectancy has zoomed. In India, it has reached 65 years¹⁰ and stands somewhat above that in China. Longevity, however, is not just a piece of good news; it’s a challenge whose impact may upset the most meticulously made plan which forgets to account for it.

The challenge is the cost of aging to the country’s economic equation, health care and pensions included. Due to the fast growth of its population, Asia is in the frontline of the problems longevity brings along (Africa will be next). China, India, and Indonesia, which make up 40 percent of the world’s population, are set to enter an accelerated phase of population aging over the next decade. Higher health care spending over the next few years will haunt the Chinese leadership, as it does that of the United States and Europe.

Chinese health care expenditures grew by an impressive 18 percent per year over the last 5 years. That’s one of the highest rates in Asia, sparked by the start of health care reforms in 2010 and progressing at an accelerated rate.¹¹ The reforms’ impact has been particularly significant in the government’s contribution to total health care spending. It matters little that China still spends only slightly over 5 percent of GDP on health care, compared to 16 percent in the United States. The pace is all-important. Let’s not forget that:

The rapid rise in health care cost as well as its aftermath is in no way “news” to the western countries. Practically, all of them know very well what rapidly rising entitlements mean in terms of public debt. That’s precisely why developing nations must watch over (and control) health care costs with the greatest attention. If this fails, then those responsible for managing government expenses and the economy are not doing their job.

It is to the interest of China to learn from the West’s mistakes in unsustainable entitlements and in the social net. These are not age-old efforts; they have been made by western nations after World War II, most particularly in the 1960s and thereafter. Social costs must be limited to a level that is affordable and sustainable. Otherwise bankruptcy should be written as a clause of the constitution.

Errors made by other nations are important to the Chinese government which starts to build a social security network. The criticism made by westerners that “it still has a long way to go” is unfair. There is no reason for the Chinese to destroy their economy with the nanny state, the way western countries did. Instead, they should carefully study a priori the social net solution they adopt, keeping in mind that the western State Supermarket is the worst possible policy.

Nobody has provided evidence that a two-digit GDP share by health care is right. Matter of fact, it is wrong. The common citizens, and political leaders, too, must save for a rainy day rather than wait that the government provides everything to them at much higher cost.

As its name implies, “saving for a rainy day” requires a culture of savings. The Chinese excel in this, as the Japanese used to do in elder times. In 2012, household savings as percent of disposable income stood at 40 percent in China, compared to:

Experts project that China’s high saving rate will start falling, as the population ages. Inland capital is already becoming less captive as savers are finding ways to take their money out of the country, contributing to downward pressure on the currency. This is one of the key reasons why China’s bank deposits are now growing at a slower rate than in the past.

There is as well a redistribution of wealth. With the global economic downturn, the country’s richest citizens have become less well-off: the number of billionaires has fallen for the first time since China opened to the West in the 1970s. From about 15 in 2006, the Chinese citizens worth $1 billion or more peaked at 251 in 2011, then fell to 231 in 2012. Anecdotal evidence suggests that also below the $1 billion net worth most of China’s richer people saw their wealth shrink.

Phenomenal savings and plenty of rich households should be a boon for Chinese banks. This is not, however, self-evident. Though their nonperforming loan ratios look as being under control at an (official) average 0.9 percent, their asset quality seems to be deteriorating. There is as well the problem of rolling over local government debt, and the need for recapitalizing some Chinese banks with central government money.

This is another challenge for China’s leadership, in a climate of economic slowdown. Financial analysts say that despite the high level of coverage of nonperforming loans, Chinese banks are not necessarily fully equipped to face a cycle of worsening credit quality, though they can still capitalize on their strengths:

The downside is souring property loans. The infrastructural buildup discussed in Section 13.2 led to a boom in local government financing vehicles (LGFVs). By and large, these have been leveraged off-balance-sheet entities used to get around prohibitions on borrowing and, as such, they have copied all the bad habits of western “special investment vehicles” (SIVs).

According to regulators, at the end of 2011 bank debts of these entities were worth $1.4 trillion. Private estimates tend to be higher, suggesting that between 20 percent and 30 percent of LGFVs loans may be nonperforming. As for real-estate property, at government’s initiative it is undergoing a forced cooling.

An article in the Financial Times points out that two problems can be symptomatic of deeper ones in the structure of a business, as well as in excess capacity in an economic sector: “… fresh credit only delays a reckoning. But, if the problem is disruption in exports, or a short-term dip in domestic sales – which could be the case for many Chinese companies – then the support of lenders becomes crucial … (and) Chinese banks are facing a step-change in their competitive environment.”¹²

The banks may be but not the Chinese government which, capitalizing on current account surpluses, has put together the largest sovereign fund worldwide to the tune of an estimated $1.3 trillion. This is a time-and-a half bigger than the next in line of the United Arab Emirates (UAE), and more than double Saudi Arabia’s.

While the nanny state’s health costs, rapidly expanding social net expenditures and refilling of the banks’ treasuries with taxpayer money are familiar challenges to western sovereigns, another challenge facing Beijing is specific to China (and for totally different reasons, also to India). This is the significant imbalance between the two sexes which is bound to have social and economic aftereffects. So to speak it is part of unwanted consequences.

Three decades ago, Chinese government decided there should be one child per family. But Chinese families like boys not girls. Today, many young men find it difficult to find a wife and it is estimated that by 2020 the gap will be 40 million young Chinese men without women.¹³ In China, as in India, families play the lottery for boys by resorting to abortion, outright killing of newborns, or simply leaving them out in the cold to die. Anecdotal evidence suggests that to stop that practice, the Chinese government is now recording every pregnancy and also uses carrot and stick. A new rule sees to it that if the first newborn is a girl, the parents are allowed to have a second kid and they also benefit from subsidies. For instance, the family is awarded an annual pension for two daughters.

The government tries to break a millennium culture favoring boys, but it would not go away that fast. By contrast, a millennium Chinese (as well as European) culture dying out is that young people support their parents in old age. The reason, sociologists say, is that Chinese girls have got westernized, and they no more want to be slaves to their in-laws.

There is, as well, another social vice confronting China: corruption; stamping it out is a challenge well known in the West and in plenty of other developing countries. In a global fraud survey by Ernst & Young, the auditor, 39 percent of participating companies said corruption is common in countries where they operate. Raghavendra Rau of Cambridge University and Yan Leung Cheung and Aris Stouraitis of the Hong Kong Baptist University examined 166 high-profile cases of bribery since 1971, covering payments made in 52 countries by firms listed on 20 different stock markets.

As in most other countries, some individuals get rich in China through corruption and bribery. According to a number of publicly exposed corruption cases, serious bribery takes place in processes related to bidding for infrastructure contracts, approval of business licenses, and tax collection (among others). The media have reported numerous cases in recent years about multinational corporations bribing government officials to gain business favors. These came to light following official investigations by both the multinationals’ home governments and by the Chinese authorities.

It is to the credit of China’s new leadership that it made the stamping out of corruption a priority. Vladimir Putin did the same on his return to the presidency of the Russian federation. Neither task will be easy, but it has to be done. Hopefully, stamping out corruption will also become a policy in other countries which, during the last couple of decades, allowed themselves to drift into such practices.

13.4 The Japanese Economy—A Comparison

In the immediate post-World War II years, Japan was a developing nation. For hard-working Japan, the 1950s and 1960s were a period of rapid recovery and financial development. Some economists called it “the Japanese miracle” as the country’s economy successfully resumed its pre-war strength and set a new pace of industrial and financial relations with the world.

For a large part of the country’s rapid recovery, economists credit the government’s active industrial policy which encouraged strategic companies by administrative measures. These included preferential allocation of scarce resources, tax relief, and the opportunities offered by an undervalued currency.¹⁴ (This advantage, however, turned into disadvantage as the yen stayed too long undervalued leading the Japanese banking industry to global overexpansion and eventual collapse.)

In the economic landscape, an important factor in Japan’s quick recovery was the steady and successful control of inflation. Following American advice, the Japanese government imposed a strict budget balance—a fact from which both the United States and European countries, as well as their central banks,¹⁵ should have applied to their own policies particularly in the aftermath of the economic and banking crisis which started in 2007. But they did not.

The benefits the Japanese economy gained with the balanced budget policy is a first class reference for China as well as the United States, Britain, France, Italy, Spain, Greece to name but a few. Financial stability and hard work saw to it that the Japanese recovery proceeded speedily and by the mid-1950s the country was well in its way of full economic recovery. But times have changed.

Allow me to recapitulate what has just been stated. The first lesson the Japanese miracle taught to the country’s industry and political leadership has been the advantage of generating its own reserves. The second lesson following the wild global expansion in Japanese bank lending which led to the collapse of 1991: that once a market, or an industry, loses its credibility, restoring it takes a very long time—if it comes. The difference could not be starker.

To borrow, Japanese companies had to pay an extra premium over prevailing interest rates, because lenders had lost their confidence to the country as its economy fell from riches to rags. Over the following two decades, Japan’s problems have been compound by an aging society, by mounting global competition and by loss of competitiveness. It is as if one recounts Euroland’s current problems.

At Wall Street, in the first years of the 1990s, securities analysts suggested that the reason why the United States abandoned its trade war against Japan was that the latter faced financial collapse. There was a rumor the Federal Reserve even made an offer to help with expertise in bailing out Japanese banks that got into deep liquidity trouble.

In regard to the Japan premium, financial history as well tells us that the wholesale banking markets cannot effectively handle risk premiums. In the United States, too, big banks that went into trouble, like Seafirst and Continental Illinois, could one day raise billions and the next they could not find a cent. This also happened to the big Japanese banks as: Foreign lenders thought that something pretty nasty lurks in Japanese banks’ spreadsheets, and there were reasons to think so. The news about Daiwa, the failures of the coops, and the shaky trust banks gave to foreign financial institutions nightmares about even bigger monsters.

The Japan premium added to the woes not of one but of all of Japan’s credit institutions. By early December 1995, it reached 25 to 100 basis points over the (now discredited) LIBOR. Matters were made worse by the fact that after years of “good news only,” the markets no more believed the Japanese banks answers, or those of the government.

The powerful Finance Ministry’s reputation was tarnished because it failed to prevent the country’s banks from piling up so many risky loans, and because it refused to provide information on each bank’s status, while it was common knowledge that bad loans had soared. Critics said that the Finance Ministry only expected its pronouncements on the safety of lending to Japanese banks to be treated as a self-evident truth. The market did not like this strong-handed approach.

With the Japanese economy descending to the abyss, the government made the mistake of engaging in deficit financing to bring itself and the economy up from under. Over a period of 22 years, this proved to be a severe mistake, and it constitutes another important lesson which can be learned from the Japanese experience. Yet such a wrong-way policy has been adopted by the United States, Britain, and Continental Europe after the economic crisis of 2007.

Correspondingly the US debt-to-GDP ratio which was also 50 percent at 1991 just past the 110 percent in early 2013, without any results to crow about. No major good news is carried by the wires, let alone news commensurate to the wider and wider indebtedness. Throwing money at a problem never really solves it, though it may make it worse.

Statistics seem to suggest that Japanese companies got more results by reducing their leverage, than from the government’s high spending. This is also true in US business, or even more so. In the mid-1990s, some years after Japan’s huge downturn, Japanese corporate-bond yield were only 16 basis points higher than government-bond yields. By contrast, in late 2008 the corresponding spread in America has been 350 basis points. This huge difference cannot only be due to the fact that the Fed keeps the Treasuries’ interest rate rock bottom. The reason, some of the experts suggest, is that the underlying problems are different:

This explanation is difficult to swallow. If the Bernanke Fed did anything, since 2008, it is to provide liquidity, liquidity, and liquidity through unstoppable quantitative easing and huge purchase of Treasury bonds. Economists who care about financial and monetary stability disapprove of this policy, and investors seem to vote against it with their money. They prefer the corporate bonds.

Still another lesson to be learned from Japan’s experience is that of problems created by the rapid aging of a population. This clearly interests Europe, America, and China, in that order of urgency.

In 2013, about 25 percent of the Japanese population is over 65 years old. The United States features not quite half that percentage (some 12 percent). Many Japanese now work after reaching 60, and many of those who do not would like to. The official retirement age has been raised to 65, and according to experts the population aging problem will not be solved unless Japanese work until perhaps 70 or 75 years old.¹⁶

While there is really no Japanese unemployment to talk about, the cost of labor skid. In 2009, 8 years after the economic debacle, wages in Japan suffered their sharpest drop since tracking began (almost two decades earlier). Retirement age has been increased but at the same time Japan has been a lifelong employment country, and employment takes precedence over the maintenance of salary and wage levels.¹⁷

In the post-World War II years, during Japan’s ascendancy as an industrial power, its companies featured lifetime commitment between company and worker, which meant that employees have more stability in their careers. While this lifetime commitment has been recently weakened, its presence is still felt. (The way a Japanese executive had it, he wished he was born American. When times are tough, the workers are fired, and when times are good, management gets all the bonuses.)

Clearly, an aging Japan has not one but several problems to run after. One of them is that governments became short-lived. As one administration after another tried to fix the economy’s ills by spending even more money, and failed, the political aftereffect is cacophony. This started in the mid- to late 1990s. The way an article in The Economist put it: “…discord in the cabinet, and a woeful absence of discussion about the budget next year and beyond, have left many worried. Foreign allies are wondering what the new government stands for. Investors are beginning to vote with their feet… .”¹⁸

This commentary talks volumes about the importance of political and financial stability. Since 1991, Japan has run continuous fiscal deficits and the international rating agencies downgraded its debt. With its bonds yielding from a tiny 0.1 percent to 2.1 percent, the downside risk of a bearish bet is limited but the upside potential neither looks that great (except for the carry trade).

The irony of course is that in spite of the economy’s travails, and of its own problems, the Japanese government still enjoys some of the lowest borrowing costs in the world. The explanation most frequently heard is that Japan has not been dependent on foreigners for finance, as only a 4 percent of its bonds are owned by nonresidents, and there is a long record of deflation.

Several economists however suggest that even if the carry trade is another potent reason for the attraction of low-yield Japanese bonds, economic discrepancies cannot last forever. The day of reckoning may not be that far away as more citizens reach retirement age, Japanese households are no longer saving as they once did, and the Government Pension Investment Fund, one of the biggest holders of government bonds, has stated that it has no massive new money with which to buy more sovereign debt.

13.5 “Abenomics,” the Falling Yen and Longevity Risk

The image of Japan given in Section 13.4 is that of today. Though the Abe government might turn things around, such an outcome is by no means a sure bet. Western sovereigns as well as those of developing nations will therefore be well advised to study the rise and fall of Japanese economic and industrial power as a most instructive case study, starting with the reaction of the IMF.

The IMF warned Japan of what in technology we call the “butterfly effect”: the prevailing conditions are such that even a minor happening like a butterfly moving its wings can create a chain reaction. In a similar way, a highly indebted country in a leveraged world can reach the point where even a small rise in borrowing costs (let alone a spike) could create havoc in the financial market and:

With the massive devaluation of the yen, which was his political program, Shinzo Abe took a huge gamble and did not care of the warnings. He knew that Japan was losing its state buffers one by one: the trade surplus had evaporated; post-Fukushima the nuclear industry, which provided Japan with cheap energy, was in disarray; the work force was shrinking every year; the savings rate had fallen to 2 percent from 15 percent in 1990; from the banking industry remained only a shadow of its past glory; and in the international market the yen was expensive, very expensive.

Could it be that the solution to Japan’s deep economic problems passed through a cheap yen? Postmortem, economists and financial experts said that the significant fall in the yen and the rise in stock prices triggered by a change of government created the feeling that Japan is moving again and in the right direction—toward:

This was the impression, but in reality, Japan remained highly exposed to swings in its currency. While in recent years manufacturers shifted production overseas, there were other headwinds to complain about: labor and environmental laws, curbs on energy consumption, high taxes, and tight trade. Most damaging was the servicing of a debt equal to 240 percent of Japanese GDP created during 22 years of a spending spree to restart the economy without getting it done.

Adam Posen, a former member of the Bank of England interest rate setting committee and a Japan expert, says fiscal stimulus ceased to be any help a decade ago and is now counterproductive. Posen advised Japan to rely on monetary policy alone to right the ship but while he bought the monetary policy argument at his exchange rate end, Abe wants to try still another stimulus.¹⁹ This may have political implications. Several Chinese economists and business leaders have criticized this move saying:

By contrast, Christine Lagarde, of the IMF, was supportive. Her thesis has been that the huge monetary stimulus plan unveiled by Japan made sense and its aftereffect can be positive by helping to boost global growth at a time when the outlook is starting to improve. In a year’s time, we shall see who is right.

From engineering the conditions for a falling yen to sticking to his stimulus, Abe’s message has been: “Japan is back.” In February 2013, given the country’s troubled recent history, he carried these three words as a banner to Washington for his meeting with Barack Obama. “Japan is not, and will never be, a tier-two country,” the new Japanese prime minister said. And as an article in the Financial Times had it, not long ago, a Japanese leader would have risked mockery with such assertions.”²⁰

The pride surrounding what might be a national rebirth carried the news, and little attention was paid to another statement—even more vital to the future not only of Japan but for the whole world: Longevity Risk. Longevity-related health care costs and pensions for old people have put the economy under stress beyond any previous experience, and if the trend continues, it will bring disaster.

It is not quite 10 years that insurance companies addressed themselves seriously to the aftermath of longevity risk. Till then, living longer was considered to be one of medicine’s wonders, and of the pharmas laurels. Nobody spoke of the fact that there are costs attached to it, probably unaffordable and unsustainable. As I emphasize in my book Household Finance:²¹

Taro Aso, Abe’s 72-year-old finance minister and deputy prime minister recently joked that old people should “hurry up and die” so that they did not drain the public purse.²² He presumably made that statement as a joke. If so, it is a joke with more truth in it that has even been said. Our society simply cannot afford to be all things to all persons. The public debt we confront today is direct result of trying to do too much in the most clumsy and unsuccessful way. Longevity risk is the new God-size challenge.

Congratulations Taro Aso. This is real straight talk, and it contrasts to that of all other hypocrite finance ministers around the globe who hide the truth from the people. Our society has to make a choice: does it want to support the young or the old? It can finance half-decently one of these two groups (I don’t even expect to do it well, but do it nevertheless).

Octogenarians and beyond should have no more the right to live on “entitlements.” Longevity risk might have been a worrisome subject for the life insurance industry. Now it is building up as the Waterloo for sovereigns. Its skyrocketing expenses will destroy the social system as we know it—or this system should be the subject of a major overhaul which leaves no cost unchallenged: kiss the entitlement goodbye and don’t depend anymore on state pensions. You will hear more, much more, about that challenge during the next 10 years.

13.6 Japan and China. Is There an East-Asia Syndrome?

Syndrome is a medical term for a collection of symptoms with common cause which, however, is not quite understood. The US syndrome of zero interest rates for an estimated half dozen years (or longer) has in its background the symptoms of the 2007 economic crisis, 2008 deep banking crisis, skyrocketing public debt, flooding the market with liquidity, search for full employment, and plenty of unorthodox moves by the sovereign and reserve bank working in unison. By contrast, in Japan the sovereign created the syndrome it now confronts single handed, since the Bank of Japan has followed prudential monetary policies.

Borrowing a leaf from the book of medicine, there is usually a perceivable period of time between an unwanted outcome, for instance, obesity, and a person developing of other symptoms. Something similar might be happening in economics, as well. The Japanese economy’s downhill slide which started in 1991 has led to the so-called Japanification of interest rates, a syndrome widespread in the western world though not in developing countries.

As the case of Japan, the United States, Britain, and Euroland illustrates, when interest rates go to zero they do so for reasons of deep economic weakness, and difficulties in getting out of it. There are reasons keeping them at zero for a long period of time and the symptoms are still around us. Yield would be a scarce commodity in coming years in the West as it has been for over two decades in Japan. All this happens at the worst possible moment as demographics create a lot of demand for savings (Section 13.4).

There should have been no metastasis of the interest rates’ Japanification syndrome to West, given the near zero interest rates record of delivering a pitiful economic resurgence in Japan. This is an easy and ineffective way out of an economic, financial, and banking crisis, and it is followed in the longer term by reserve institutions and governments unable to deal with crisis conditions.

Where the Japanification syndrome has succeeded is in making speculators out of formerly careful investors, and this can hardly be regarded as an achievement. One of the visible aftereffects of Japanification is that Tokyo’s main stock market index has been for low stretches of time a shadow of its former self—which talks volumes about investor confidence. The country which, in the 1970s and 1980s, was on its way to financially conquer the world through superleverage:

Contrary to the American economy and the economies of Europe, China has not caught that syndrome, but nothing guarantees that this will not happen in the future if the economy escapes prudent planning and control. To a worrying mind, the similitude between Japan and China during the phase of steep rise as player in the global economy gives food for thought.

It would as well be proper to remember that when the Japanese downturn came in 1991 (paradoxically) there was a belief in Tokyo that there is no imminent crisis. Eventually nothing forced Japan’s policymakers out of a paralysis, while everyone rushed to put the blame for deflation and rising debt elsewhere than his courtyard.

This can happen to all nations, and all of the BRICs (as well as other developing countries) should be aware of the risk. For years, Japanese politicians thought the real problem was low productivity growth in Japan, which kept wages low and suppressed demand for goods and services. With such a prevailing political thinking, it is most curious that in 2010 and 2013 the Japanese government favored an increase in the consumption tax in its medium term plan for fiscal reform. An even greater policy blunder was done in 1997 by the then government when it started with consumption tax hikes which ended in a double whammy:

Another major mistake made both by Japanese governments and some of the bigger Japanese companies, was to sacrifice quality to expediency. The torrent of recalls by Toyota is an example. An even better once can be learned by studying the disaster of the Daiichi nuclear plants. China should learn a basic lesson from that case.

Let’s return for a moment to the fundamentals. Right after WWII ended, Japan made a major effort to turn quality into a competitive weapon, and it succeeded. But in the (nearly) seven decades since that time, the top management of Japanese companies changed two or three times over, a new generation came to power and the high quality policy waned.

On March 11, 2011 a vast social, economic, and material damage was created by the 8.9° Richter scale earthquake and 10-meter tsunami which followed it. Theoretically, the tsunami and earthquake were the reasons for the nuclear catastrophe. True enough, they contributed to it, but a much more potent factor has been the low-quality syndrome. The most fundamental causes for the Fukushima major nuclear accident were:

The easy answer has been the switch of Japan out of nuclear power. This, however, further weakens its industrial competitiveness as clean energy takes a leave and the cost of power rises. Though it is not clear how big the bill may be, the case of France and Germany can be taken as a proxy. In France, 80 percent of consumed electricity originates in nuclear power plants. Germany is (unwisely) phasing out its atomic power production. As far as the manufacturing industry is concerned, power costs in Germany are 20 percent higher than in France.

Like Germany, China got cold feet after Fukushima and slowed down its nuclear power program betting, instead, on coal. This is unwise even if the use of coal is now rising worldwide and projections are that by 2020, or so, coal will nearly equal oil as energy source. Fear can induce people to do many funny things—and going backward in energy production is one of them.

The Daiichi plants at Fukushima are a problem, and the better answer to this problem is first class engineering, reliability in design, and top quality control in operations. The return to coal will unavoidably bring more environmental pollution as the medium is rich in CO₂ and China has more CO₂ than it can possibly handle. As for the alternative of wind power, this is just a way to spend money—despite what long-haired greens and other theorists may say about its wonders.²⁴ (To the contrary, solar energy solutions have merits, but for individual installations, not for massive energy production.)

Quality deteriorates over time, if it is not properly and steadily maintained. This leads us to another East-Asia syndrome: infrastructure. Both China and Japan are confronting it but at two different ends. From transport to telecommunications, China needs to build a vast infrastructure (Sections 13.2 and 13.3). By contrast, the Japanese infrastructure, put in place in the 1950s and 1960s, is decaying. (The same is true of the American infrastructure, like the roads and bridges network constructed by the Eisenhower Administration in the 1950s.)

The Chinese government and the Abe Administration in Japan have big infrastructural plans, less known is whether these are conceived in a way to generate returns commensurate to the investments which need to be made. If political choices carry the day, this will add to either and both countries’ public debt without generating output—a case is much more severe in Japan where the national debt stands at 240 percent of GDP and, by all evidence, infrastructural works will be done through deficit financing.

It is also proper to bring to the reader’s attention the syndrome of political and financial stability. For four and a half decades after WWII, Japan had stable governments. Political instability started in the early 1990s after the crash of the banking industry, the stock market, and the real-estate market. Today, China has political stability, and it should be keen to preserve it.

China should also use the economic and technical history of Japanese events from 1991 onward as if they came from a once-in-a lifetime laboratory experiment. With the switch from the Japanese miracle to Japan premium, the country fell off the track. In September 2012, it slashed its second-quarter growth estimate while South Korea unveiled a new round of fiscal stimulus, underscoring the vulnerability of both economies to a slowdown in China, their most important trading partner.

This has been a major economic event at a time globalization is still alive. Much of the weakness came from crisis-hit European Union, China’s biggest trading partner. Chinese exports to the EU fell almost 13 percent in August 2012 compared with a year earlier. The way economists look at this problem is that, if the weakness in the European and American economies continues, China too will be stalling leading to downward revision of its GDP growth and raising fears that the world’s second biggest economy is heading for contraction in spite of the heralded soft landing.

There is no overstatement in suggesting that economic policy and fiscal policy process in the United States, Europe, and Japan are beginning to resemble a bumbling football match punctuated by individual goals, poor refereeing, and shots sailing over the crossbar. At least in America and the EU, governments try to “snatch defeat from the hands of old glory” while until the last elections Japan was playing for time in the hope that time heals all sorrows. Instead:

Nevertheless, surprises are always possible. According to the 21st Century Public Policy Institute, a Japanese think tank, by 2050 the debt-to-GDP ratio could reach a staggering 594 percent unless Japan significantly improves its primary balance. While this “594 percent” is a projection, the current fact of a 240 percent public debt-to-GDP ratio has created doubts and uncertainty.

13.7 The First Letter in BRICs: Brazil

Brazil is a country of 192 million people with a GDP of over $2.5 trillion. Over the last three decades, the Brazilian economy had its ups and downs. From 2007 to 2011, it had a top performance while the western countries’ economies moved south, but the economic news from Brasilia is not so brilliant in 2013.

The 2007–2011 performance, the years of fat cows, is documented through foreign direct investments (FDIs) in the Brazilian economy as well as its currency’s rise in the foreign exchange market. In 2007, there were 221 deals of $34 billion in total value; in 2008, 234 deals of $71 billion; 2009, 189 deals of $52 billion; 2010, 259 deals of $79 billion; in 2011, a whopping 350 FDI deals of $86 billion. FDIs in Brazil collapsed to 80 deals of a mere $16 billion in 2012—the year the country’s economic problems started.

By May 2012, the Brazilian real had weakened against the dollar, and analysts were of the opinion it was likely to weaken further as market sentiment remained weak. This is precisely what has happened, as the central bank did not defend the currency from weakening further. In fact, the Brazilian government wanted to weaken the real. In parallel to this, by 2012 South America’s biggest economy has slowed to a crawl, after a decade of robust commodity-led growth, pushing Brazilians into a debate on whether to embrace a state-led economic model or to return to policies of real devaluations.

This has not been an easy choice. Even by the end of the first decade of this century, Brazil still carried the stigma of the Latin American debt crisis of the 1980s and of Argentina’s default of 2001. Over several years, Brazilian government bonds were rated as junk and its debt yielded more than a 10 percent interest.

The economic environment changed again after Brazils’ “B” became the first letter in BRICs, a term coined by Goldman Sachs to identify the emerging economies with the best potential. Following some years in which everything seemed to fall into place for Brazil, its citizens and its government’s policymakers were forced to rethink the country’s strategic direction. The issue at stake has been:

The Brazilian people put the bar rather high. They wanted to live in a consumer society like the Americans and have social services like Europeans, while their economy grew like an emerging market. These goals are evidently incompatible among themselves, but Brazilians were not alone in wanting a society able to profit from everything.

The choice of what “they want to be” is just as difficult and pressing for other emerging countries, too: Russia, China, and India being examples. At the same time, however, with the American, European, and Japanese models looking battered—and Soviet communism in total discredit—there were no brilliant standards left to guide policy choices. Neither is this problem of choice going away as the next few years will be critical for the direction of the world economy. Like it or not, policymakers and the public:

Among major developing countries, Brazil just happened to be the first to hit the essence of this salient problem which is as much political as it is economic. Politically speaking around 2010 several countries, who once were reliable backers of America’s geostrategic goals, went their own way. Brazil and Turkey, for example, sought to broker a deal with Iran over its nuclear program while America and other western nations pushed for new sanctions. This assertiveness was a product of:

Brazil wants the status of a bigger global role. But is it ready to assume the risks and burdens that global leadership requires? In the western press, the BRICs have been lionized as fast-growing superpowers-in-waiting which, at this point in time, is by no means the case as they still have a way to go till they get themselves free from red tape and are to muster the political will to take on global commitments—a domain where only China has so far given clear signals.

In all developing countries, government must start to confront inherited weaknesses, and to this, Brazil is no exception. The annual growth rate it enjoyed over several years looks excellent by western standards, but it is below both what Brazil needs to continue its recent social services claims and what China has achieved.²⁵ Moreover, some of the sources of the faster growth of recent years may now be exhausting themselves. To boost the economy, in mid-2012 the Brazilian government made a broader policy shift:

Particular attention has been paid to giving a helping hand to local manufacturers. The government’s action included reducing the rates industry pays for power, offering to private companies licenses to build and operate roads and railways, and unveiling plans for upgrading major airports and ports. Still a lower overseas demand for commodities, falling investment, and rising household debt saw to it that Brazil’s growth slowed.

Brazil’s efforts were further handicapped by the fact that during the years of rapid growth Brazil became an expensive place to do business. The government blames the currency exchange rate for this, but it is no less true that the bureaucracy itself and its policies are responsible for much of the higher cost.

The tax burden rose from 22 percent of GDP in 1988 to 36 percent in 2012, while the tax system remained too complex. Businesses face a mare’s nest of regulations, and the minimum wage is 3 times that of other developing countries, for instance Indonesia. Therefore, Brazilian manufacturers are struggling.

In addition, the state has started messing around with nationalistic signals for business. An example is the rule that 65 percent of equipment for the deep-water oil industry must be produced at home. This practically guarantees that developing the new oil and gas fields will be slower and it will cost more than otherwise.

Like in other countries, including both industrialized and developing, the government also sets for itself conflicting goals. Dilma Rousseff, Brazil’s president since January 2011, wants to eliminate the fiscal deficit, but has started to cut taxes for favored industries. Critics also say, her effort to drive down costs is too timid, and as costs are rising, investors start looking for lower cost and higher growth markets in Latin America.

All this leads to a changing economic climate which is also documented by the fact that in the first semester of 2012 demand for loans was nearly 8 percent lower than during the same period in 2011. With defaults rising, banks have been tightening their terms. Bad loans in Brazil hit a record high in May 2012, adding to fears that the country may be heading for a deeper than expected slowdown—putting to test government efforts to stimulate borrowing to try to reignite the country’s stalling economy.

The good news is that altogether the Brazilian banking industry is in rather good shape. Its strengths are a rather balanced amount of loans compared to deposits, high profitability ratios, and sound level of coverage of the nonperforming loans. But there are two weaknesses: high level of costs and a growing level of nonperforming loans.

One of the slowdown’s victims has been Brazilian retail sales. Unexpectedly, in mid-2012 they fell the most since the onset of the financial crisis, raising fears for one of the remaining bright spots in the country’s economy. This is bad news for the government inasmuch as the Brazilian consumer (thanks to rising wages and greater access to credit) was one of the main drivers of the country’s growth over the past decade. Concerns are now being heard that the country’s model of growth may be reaching its expiry date as Brazilians struggle to take on more debt, but rising defaults prompts the banks to tighten lending.

An unknown factor of the Brazilian economy is the level of inflation in the coming years. Economists say that emerging countries have never believed the notion that the average price of goods in their economies would magically fall, year after year. While it was possible that there would have been a bit of pressure on prices in some countries altogether for the emerging markets the conditions were inflationary. Between 2007 and January 2012,

This inflation represents a substantial erosion of wealth for anyone who kept local cash under the mattress. While a relative decline in oil prices helped to ease some of the near-term inflationary pressure, the currencies of weaker emerging economies currencies have prevented them from realizing the full benefit of lower materials prices.

Within a global environment characterized by less confidence than in earlier years, Brazilian authorities watch carefully for unfair foreign competition. On September 20, 2012, following Ben Bernanke’s QE3, Guido Mantega, Brazils’ finance minister, warned that the Fed’s “protectionist” move to roll out more quantitative easing will reignite the currency wars, and this will have potentially drastic consequences for the global market.

“It has to be understood, that there are consequences,” Mantega told the Financial Times, adding that the Fed’s QE3 would “only have a marginal benefit (in the US) as there is already no lack of liquidity … and that liquidity is not going to production… instead (it is) depressing the dollar and aimed at boosting US exports.”²⁶

From his viewpoint Guido Mantega is right, but this is not enough to solve Brazil’s developing economic problem. As of January 2013, most market analysts project that consumers will be using much of their income to restructure their balance sheets paying off loans with which they had bought cars and house appliances. Economists suggest that to get the country moving again, the government:

This means working against the current as analysts are slashing their predictions in view of the fact that Brazil is seeing its worst growth performance in a decade or more. A bad surprise was the fall in investment, despite the government’s efforts to lower business costs. A tax on foreign-currency inflows and the central bank’s interventions led to a fall in the strong real of around 20 percent against the dollar in 2012. But economic turnaround is not yet on call.

In conclusion, in spite of being a member of BRICs, Brazil’s economy performed worse than expected particularly in the third quarter 2012, having grown by less than 1 percent compared with the same period of 2011. This comes after a range of measures introduced by the government to try to lift output which did not yet bear fruits. And the fact the global economy still hangs on a fork is not promoting Brasilia’s hopes for a rapid recovery.

13.8 Is India’s Economy Another Falling Star?

In his lecture on “India’s Dilemmas,” in the first days of January 2013, Kaushik Basu, chief economist at the World Bank, dramatized his point by quoting impressive (or, rather, depressing for India) statistics. In 1950, South Korea and India had the same income per capita. Today, South Korea’s is 22 times India’s.²⁷

In 2012, the Indian economy grew by 5.3 percent which (as absolute figure) is not bad, but it does not support the hypothesis of a catch up, apart from the fact that it compares poorly with growth in China. Worse yet, the projection for 2013 is not much better. Government economists talk (hopefully) of GDP growth of 6 percent, but India observers say that it would not be much better than 5.5 percent.

These references reflect the fact that India’s economic growth has been in decline since the first quarter of 2011 when it stood at about 9 percent. It was 8 percent in the second quarter, less than 7 percent in the third and 6 percent in the fourth. It fared worse than expected in the first quarter 2012, and the bad news continued to indicate the slowest growth in almost 8 years, falling far short of the government’s target of 9 percent.

One of the reasons for the decline is lack of confidence, the Indian economy’s longer term growth will depend on the government’s ability to promote investment and continue liberalizing the highly regulated internal market. Because of stiff opposition to such measures, this demands plenty of political courage. Half-way solutions will not do because there is plenty of lost ground to cover, particularly when India is compared with the “Asian tigers” or with China—because of the billion-plus population, increasing military capabilities and value as a trading partner.

Critics say that the most important reason for the troubles confronting the Indian economy in the second decade of this century should be found in political fragmentation and weak leadership in New Delhi. Inter alia, these are eroding federal power relative to India’s states, but the greater challenge can be found in negative news related to India’s growth prospects because of:

These are problems well known to the United States, France, Italy, and Spain (among others), and they have much to do with the decline of their economies. One, however, would not expect to encounter them also among the BRICs. A weak administration and poor macroeconomics is a double whammy, which has a debilitating effect on the economy as well as negatively affects market sentiment.

There was a time when India’s future and its fortune looked quite different. There was hope of rapid economic growth after the negatives were overcome. After independence came the hardship, the split with Pakistan, the exchange of populations, the rebuilding of the nation—and with it a wide-ranging educational effort. It has not been easy, but there was a tomorrow.

In the early 1950s, Neil Jacoby, Dean of the School of Business Administration at UCLA and economic advisor to Dwight Eisenhower, was asked by the president to visit India and identify promising projects to which the United States could contribute. Jacoby met with Nehru and the Indian prime minister invited him to come along to a visit to a hydroelectric dam under construction.

Nehru was proud of the Indian infrastructure in the making. What impressed Jacoby was the thousands of people moving around and carrying earth. This can be improved he said to the Indian prime minister: “Earth-moving equipment can significantly better worker productivity; you would not need all these thousands of people.” “But it is for them that I am making the dam,” answered Nehru.²⁸

Finding jobs, particularly in a large country in the early years of its independence, is always a challenge. If properly planned and executed, large infrastructural projects can deliver several times their cost. Not only they provide work opportunities but they are as well the structural elements in building a nation.

Another major challenge is education. Down to basics this is a lifelong project which takes much more planning and effort than a hydroelectric dam. The first goal is to lift-off analphabetism, which is more easily said than done. Difficult enough in a country of small dimensions, it is a colossal task in one (then) of half a billion people with resources²⁹—both human and financial—in short supply.

Nehru’s solution was to bet on the new generation. It made sense. The question was “how”? His answer was to institute learning centers to which went kids from the villages. If my memory is correct, the schools offered 5-year studies. The kids went into the educational cycle at 7 or 8 years of age and returned literate enough to their villages at about 13.

The Indian prime minister’s hypothesis was that the literate kids would pull their village out of illiteracy. It did not happen that way; indeed 5 years after they had come back, the kids had rebecome illiterate. That’s what I learned in 1966 in my meeting with the University of Calcutta, which was asked by the government to look for an alternative educational strategy.

If I were to express an opinion about the greatest handicap which impeded India’s progress in the intervening years, this would be the absence of family planning and corresponding rapid rise of the population. In neighboring China, Mao was right when he instituted and enforced the “one kid per family” policy (Sections 13.2 and 13.3). Drift is always a bad counsel. Let me put it this way:

The building of human capital is not achieved by making people dependent on the State Supermarket for their living. It requires a long-term plan, consumes plenty of effort, and calls for significant investments. A developing nation does not have the resources to be everything to everybody. Even developed nations, the United States and EU’s member states, who tried to do everything spreading them thin, have failed though:

One of the effects of massive changes whose impact is often (and conveniently) forgotten is that the price of quantity is being paid by quality. In the 1980s Indian entrepreneurs worked hard, targetting quality and performance; but today, there is a visible drop in quality. It is as if people don’t care anymore for the work they are doing, and management has lost control.

Moreover, in the subcontinent live in effect “two Indias” side by side. The one is the well-educated 15 percent or so of the total population (Indian friends say 20 percent), which is at par with America and Europe.³⁰ Though no more illiterate (as in the time of independence), the lion’s share of 85 percent lives as a nation in the side and finds it difficult to lift itself from its shoestrings.

Typically, the 15 percent is mainly urban, while the 85 percent is mainly rural, but this is by no means an absolute rule. Neither is this dichotomy a matter of casts, though for evident reasons the untouchables find themselves by large majority in the 85 percent. It needs no explaining that the 85 percent are, so to speak, the underprivileged. High birth rates are one of the main reasons why it is so difficult for them to collectively improve their lot.³¹

The message the preceding paragraphs convey is by no means a one-tantum observation. I had the opportunity to confirm it over more than a decade, from 1978 to 1989, as I was frequently in India for my seminars. Make no mistake about it: 15 percent of the about 1.2 billion people is a large population of 180 million, with a relatively high economic standard, which moves the nation forward but cannot make miracles:

Add to this the usual inefficiencies as well as corruption which comes with big government, and you find that during the last decade the Indian economy has lost the sprint it had in the latter part of the twentieth century. The advantages India gained from exporting information technology services faced competition, energy prices soared, and the global economic crisis which started in 2007 did not help.

While some economists blamed political infighting and negative attitude toward foreign investments for India’s continuing slowdown, the most important reason has been that its economy lost its competitiveness. Along with putting the brakes on growth, inflation remained a big concern, and so did the significant rupee depreciation.

As if to make matters worse, monetary and fiscal policies remain in a deadlock, inflation reduces the scope of interest rate cuts, and budgetary imbalances increases the already high fiscal deficit. Add to this the aforementioned population explosion in and the “two Indias,” and there is no wonder that growth has taken a hit. In several respects, this is a well-known scenario from western countries.

Another one of western viruses which infected India is that politicians have little incentive and no will to deliver essential structural and labor changes or to enact lasting reforms. A ray of hope lies in the fact that in recent elections Indian incumbents who worked to improve economic outcomes are finally throwing out of office poor performers. This is at least the message carried by the media.

For its part, worried about the stagnating economic situation, the Indian government seems to be on the verge of undertaking policy reforms to shore up investor sentiment. To the contrary, the Reserve Bank of India largely stands back, observing the development with the control of persistently high inflation remaining its major concern.

Here is how a study by UBS has looked at this issue “… inflation is easing gradually in Asia, and … most governments in the region can afford to continue to ease monetary policy to support growth …One notable exception is India, where inflation remains sticky due to a weakening rupee and a high public deficit.”³²

This commentary was published in mid-2012, but a year down the line the situation had not improved. As the same analysts were to comment: “Our cautious stance stems from India’s persistent current account deficit, which constrains the (Indian currency) appreciation potential, and also exposes the currency to sudden capital outflows amid risk aversion.”³³

* * *

As of mid-2013, the Indian economy’s growth has slowed to half the rate during the boom years but inflation flared up. At 10 percent, annual inflation is worse than in other major economies, while the government’s failure to reform dragged down the rupee.

With a high fertility rate, every year millions of young people have to find jobs. Reigniting the growth to create them requires radical deregulation of protected sectors like obsolete labor laws, mammoth state monopolies, and the bureaucracies that go along with them. As for India’s infrastructure: roads, ports,power production and distribution they, too, require an urgent and major overhaul.

In conclusion, after Brazil, India is another member of the once-hot BRICs quartet which reports relatively poor economic results. Following several years of relatively good performance, its economic growth is well below what is needed to raise living standards as fast as hoped.

Let’s end this chapter with a last thought. Until western economies return to health, developing countries will be feeling the pressure, but they should not remain just spectators. There is plenty they can do for themselves. Properly managed and assisted India’s 85 percent (we have been talking about) may become the economy’s blessing—the motor that drives the other 15 percent.

End Notes