Archive for June 27th, 2007

Concerns over World Economy

June 27, 2007

After some postings on concerns over Indian economy, it is time to look at the world economy. BIS Annual Report for 2006-07 has been released.

Unlike most Annual Reports this one is a good review on World Economy and Financial Markets. The summary is here. As it is a pretty long report, it would take time to read and comment.

I read Malcolm Knight’s (General Manager of BIS) speech on the same, which provides a neat summary. His speeches are quite good and the focus on risk in his speeches is exceptional.

  • See Table 1 (page 1 of the speech) for sure. Most economists have underestimated the growth levels in world economy and the consensus predictions have been lower than actual for most of the years. Infact, it is quite amusing that when growth is falling analyst expectations are higher than actual and vice versa. 🙂 So analysts don’t get it wrong just with India but also with World Economy in general.
  • On Inflation front, the actual has been marginally higher than estimates but overall low inflation.
  • Knight says the trend this year further confirms that this is the era of Great Moderation, the period of low volatility of inflation and output.  

What lies ahead? Or in Knight’s words “potential fault lines”. He says  there are 3 :

  1. Inflation outlook: Core inflation (excluding food and energy) has been higher than the comfort levels for much of 2006-07. Globalization effects seemed to be fading away as wages have been increasing in China and this could lead to high inflation.
  2. Features of Financial cycle: The risk premiums have been really low and most asset prices have increased to all time highs leading to concerns that we might have already gone too far and a correction is on the anvil.
  3. Global configuration of country’s external balances: Current account deficits of developed countries continue to be financed and capital continues to flow in emerging markets. Plus there has been a huge increase in foreign exchange reserves of some Asian countries. Knight remarks:

    In current account deficit countries, the positions have largely tended to reflect buoyant consumer spending and associated declines in household saving as opposed to the accumulation of productive capital that could raise future incomes. As regards current account surplus countries, in those economies that have been building up reserves it has proven increasingly difficult to forestall rapid monetary and credit expansion and asset price rises, which could be aggravating vulnerabilities to financial strains and future inflationary pressures.

    The efficiency of domestic financial systems could also be compromised by these developments. Other distortions pertain more to the global financial system. The management of unprecedented volumes of foreign exchange reserves by the public sector, concentrated in a handful of countries, is bound to raise major challenges of an economic and even a political nature. More broadly, the threat of economic protectionism should not be underestimated.

Hmmm… So this is what BIS thinks.

Knight further says, if he has to point out one concern it is the “unusually low level of inflation adjusted interest rates”. He adds that this factor either lurks behind or is a symptom of the above concerns. Very well put Sir.

What are the policy measures to correct?

1. A need to adjust the fiscal policy by bringing reforms in labour and product markets. There is a need to gradually reduce the costs of healthcare and pensions on the fiscal and make it more market oriented. As times are good, these reforms would be easier to implement now.

2. The monetary policy should try and normalize interest rate levels to contain inflationary risks and this would also help in pricing the risks in the financial markets better.

3. Keep strengthening the financial system. After all, in these good times, financial markets can often play the spoilsport by allocating/channelizing resources to not so prudent deficit unit. When times are good, the probability of risks due to moral hazard/adverse selection increases.

Nice stuff. 

Downside factors in Indian growth story

June 27, 2007

We have been witnessing a lot of literature, media releases, and blogging on Indian economy. They are generally divided into 2 camps- optimistic/hopeful and pessimistic/cautious.

I just came across this paper that falls into pessimistic/cautious category. It is by Shankar Acharya (SA) and is a highly referred paper so one needs to look into it. It is written in 2004 but is still pretty relevant.He lists all the factors that have been cited by the first camp and criticizes them one by one:

1.  Demographic Dividend (Labour): Most analysis just look at broad India numbers and suggest that India would gain from the huge working population and falling dependency ratio.But Acharya does a state-wise analysis and finds states that have the highest fertility rate are laggards (Bimaru States – Bihar, MP, Rajasthan and UP)  and those with lowest fertility are leaders. So is the demographic dividend happening?And when one looks at fertility rates and per capita incomes the disparity grows further as population has grown higher in Bimaru states.

2.  Demographic Dividend (Capital): The conventional thinking is, as people in working age (15-64) group grow so would the savings and the investment or capital in the country. This would mean more capital would be deployed leading to higher GDP growth.The hypothesis is that as the demographic trend cited has begun almost 15 years ago, we should be seeing some effects by now. But Gross Domestic Savings has increased by just 20.4% ( average of 1985-90) to 24.2% in 2002-03  largely because of negative savings of Public Sector.

Before I go on, this point needs to be revisited and revised by  Acharya. As per latest CSO estimates, India’s savings and investment rate has improved quite a bit. The average gross savings and investment rate as a % of GDP (at market prices, as he also takes the same) between 2003-06 is 31% for each.  (And if you look at the respective data as a % of GDP at Factor Cost then it is 34% for each. He criticises a Rodrik paper which says India’s savings rate could increase  to 39%. Well if you look at estimates based on Factor cost, we are getting nearer to the Rodrik guesstimate.)

3. Productivity Growth: SA rightly says that to calculate productivity growth via a metric called Total Factor Productivity Growth is difficult because if output growth is high, TFPG would be high and vice-versa.

4. Others: SA then comments on the well-known problems-  falling standards of  institutions in India (particularly the Indian bureaucracy), the deplorable infrastructure, the slowing down of reform process, agriculture, fiscal stress and increasing inter-regional disparities.

In the whole paper he criticises two pieces, one a paper by Rodrik and Subramanian (RS) and a speech by Kelkar. I have already pointed out above one criticism needs to be re-looked.  

SA also criticises the Planning Commission for assuming 7% plus growth rates in Bimaru States during 10th plan where as they grew by only 4% during 9th plan (1997-02). On checking the growth rates for these states for 10th plan period,                   
                   Net State Domestic Product (2002-05)
Bihar –        9%
MP-             5 %
Rajasthan – 6% 
UP-             4.6%
So, we do witness high growth rates in Bimaru States. But these growth rates need to be taken with a pinch of salt, as the variation (measured by standard deviation) in growth is pretty high. All Bihar, MP and Raj have high variation of almost 15. Only UP has a low variation of just 0.85.  So, a bit of a mixed evidence really.

Overall, a good analysis and helps us know more factors we need to be cautious about while analysing India’s growth story. But then he needs to revisit some facts and revise the paper.  

Assorted Links

June 27, 2007

1. Dani Rodrik divides the development thought process into two schools.

2. Jeff Sachs advises Zoellick on how to fix the World Bank. Thanks to Rodrik for the pointer.

3. Econbrowser has a nice post on Inflation and globalisation.


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