Jim O'Neill: A 10-step programme to tap into India's potential

India's Growth of  > 10% over the next 10 to 20 years is not out of the question

Jim O'Neill 

Tuesday 25 June 2013 

It's fashionable to say the era of strong emerging-market growth is over. As the US recovers, the global cost of capital will rise, holding back investment – against this background, avoiding the next crisis is the best that most emerging economies can do. If you take this view, India might seem a perfect example, with its widening current account deficit, heavy public borrowing, persistent inflation and weak currency. 

I don't think so. As a general matter, emerging-market gloom is overdone. India, in particular, could teach the pessimists a lesson. 

Last week I made a quick visit to see the chief minister of Gujarat, Narendra Modi. He'd asked me to give a presentation on how India could realise its still-enormous potential. I went through points I'd first discussed in a paper I co-authored with Tushar Puddar in 2008, "Ten Things for India to Achieve its 2050 Potential". It's striking to me that, five years later, our recommendations don't need revising.

I'll state no opinion on Mr Modi's chances of becoming Prime Minister after next year's general election – it's been announced that he'll lead the opposition Bharatiya Janata Party in that campaign. 

He's a controversial figure. Detractors call him a sectarian extremist (and worse). I will say this: he's good on economics, and that's one of the things India desperately needs in a leader.

Like all Indians, Mr Modi loves acronyms. Me too. I admire his MG-squared (minimum government, maximum governance) and P2G2 (proactive, pro-people, good governance). That sums it up pretty well. I don't think it's a coincidence that Gujarat has avoided the slowdown which has almost halved India's national rate of growth. The state just keeps on growing at double-digit rates.

Long-term growth depends ultimately on just two things – the number of workers and how productive they are. India's demographics are remarkable. The country is on track to grow its workforce by 140 million between 2000 and 2020. That increase is the equivalent of the working population of France, Germany, Italy and the UK combined.

Even with unspectacular growth of a little more than 6 per cent a year, by 2050 India's economy could be 40 times bigger than it was in 2000 – about as big as the US economy will probably be by then (though not as big as China). But it could do so much better than that. Growth of 8.5 per cent over the entire period is possible – with growth of more than 10 per cent over the next 15-20 years not out of the question – provided it makes some changes. 

It's all about productivity. India scores poorly on indexes of economic variables that are critical for economic efficiency – worse than Brazil, China and even Russia. To change that, it needs to do 10 things:

1. Improve its governance. This is probably the hardest and most important task – the precondition for the rest. Mr Modi is right: whoever leads the next government in 2014, India needs maximum governance and minimum government. There is no point having the world's largest democracy unless it leads to effective government.

2. Fix primary and secondary education. There's been some progress here, but a huge number of young people still get little or no schooling. I sit on the board of Teach for All, a global umbrella organisation for groups that encourage the brightest graduates to spend at least two years teaching. Today India has about 350 teachers in these programmes. They could do with 350,000 or more.

3. Improve colleges and universities. India has too few excellent institutions. Its share of places in the Shanghai Index of the world's top universities should be proportional to its share of global gross domestic product. Make that an official goal. 

4. Adopt an inflation target, and make it the centre of a new macroeconomic policy framework. 

5. Introduce a medium to long-term fiscal policy framework, perhaps with ceilings as in the Maastricht treaty – a deficit of less than 3 per cent of GDP and debt of less than 60 per cent of GDP.

6. Increase trade with its neighbours. Indian exports to China could be close to $1 trillion by 2050, nearly the size of its entire GDP in 2008. But India has little trade with Bangladesh and Pakistan. There's no better way to promote peaceful relations than to expand trade – and that means imports as well as exports. 

7. Liberalise financial markets. India needs huge amounts of domestic and foreign capital to achieve its potential – and a better-functioning capital market to allocate it wisely. 

8. Innovate in farming. Gujarat isn't a traditional agricultural producer, but it has improved productivity with initiatives like its "white revolution" in milk production. The whole nation, still greatly dependent on farming, needs enormous improvements.

9. Build more infrastructure. I flew in to Ahmedabad via Delhi, and out via Mumbai, all in a day. I got where I needed to go – but it's obvious how much more India needs to do. Adopt some of that Chinese drive to invest in infrastructure.

10. Protect the environment. India can't achieve 8.5 per cent growth for the next 30-40 years unless it takes steps to safeguard environmental quality and use energy and other resources more efficiently. Encouraging the private sector to invest in sustainable technologies can boost growth in its own right.
India's potential is vast – and given the will, it can be tapped. 

A version of this column was originally published by Bloomberg News

The New Conumdrum: Will Treasury Yields Normalise in 2014-2015 ?

One of the key question in financial markets is whether the 30-year Treasury bond market rally has come to an end and that recent below-average yields (of < 2% in past two years) will rise back to more 'normal' levels that reflect America's new economic outlook of slightly firmer GDP growth and moderately higher inflation. 

In another words, will America be emerging into a new era of 3% real GDP growth in the next two years after struggling at the 2.2% average level in the post-recovery period of 2010-2013?

This is what the consensus of economists are expecting at present due to various reasons such as the cheap gas effect, housing market recovery or narrowing fiscal deficit. As we enter into the second half of 2013 and as the markets attempt to build up expectations of the outlook for 2014, more economists may converge to that view. 

In my view, they are either driven into that bullish consensus due to the buoyancy of the U.S. stock market, the upward trend in the U.S. dollar or simply because the Federal Reserve is allowing the 10-year Treasury yield to rise slowly suggesting to market players that the deflation era is over. 

But if that is the case, then this recovery is an odd one: inflationary pressures are benign, global demand is sluggish and the U.S. consumer is not spending in any big way apart from a steady 2% real growth year-on-year.

My guess is that real GDP growth will surge towards 2.5% in 2014 and then regress back towards the 2% level again by 2015. 

The Treasury market is harder to predict especially when there is a big government propping up the market. Treasury yields can either (a) rise towards the 3-4% level if inflation moves higher in a stagflation scenario or (b) remain trading at the 2% level if the Fed continues to buy Treasury bonds to keep yields low.

From an financial strategist perspective, there are three strategies that can be adopted: (1) reversion to the mean (2) carry trade (3) momentum. The Fed's easy monetary policy has caused the US$ to be an instrument of carry trades whereby investors borrow cheaply in US$ to buy foreign assets that fetch higher yields (e.g. emerging markets, Japanese stocks, etc). 

But the Fed's QE policy is also preventing the Treasury market to revert back to the mean. Thus, the carry trade will induce greater imbalances in the economy as consumption and investment is driven more by asset prices than by real savings. 

At the end of the day, even financial markets have to revert back to the mean as prices cannot go up continuously (witness Japan).  Hence, momentum will build up, weaken and then reverse in the other direction until the central banks come in to support asset markets again. 

This is the conundrum for global central banks: how to exit gracefully from their easy money policies without disrupting financial markets? If they are confident that their economies are able to stand without the clutch of artificially low interest rates, then they should have no hesitation in slowly scaling down their QE policies or allowing interest rates to normalise. 

But the latter may not be the case as global banks still have lots of leverage and low quality assets on their books. So if the central banks' hidden mandate is to save their leveraged banking system (which is much the case in Europe), then we will be stuck with QE to infinity: an era of high market volatility and uneven economic growth.

 

High Industrial Linkages Between Malaysia vs Japan, China vs Korea and US vs Korea

How globally interlinked are the Asian economies with the advanced economies? To answer this question we take a look at the correlations of the quarterly year-on-year growth of the industrial output of several regional countries.

We find that three correlation pairs stand out as shown in the charts below: 1. Malaysia's IPI is fairly well correlated to Japan's IPI over the 2005-1Q2013 period . 2. China's IPI is also well correlated to Korea's for the 2008-1Q2013 period. 3. The industrial output of Korea and the US has a R Square correlation of 66% over the 2005-1Q2013 period.

Looking at the summary table below, it appears that Malaysia is the most exposed to the global economy given its high 95% export/GDP ratio, which has actually come down from 113% back in 2005. Malaysia also has a low historical growth of 3% for the IPI compared to China (14.3%) and Korea (5.7%).

So as a global investor, which country would you avoid and which country would you feel safe investing in? Just based on the charts alone, the brighter outlook for US manufacturing in the years ahead (due to the cheaper gas theme) is likely to benefit South Korea given the correlations between the two countries' IPI. Does this mean that more US manufacturers, who may go either further upstream or downstream depending on the shape of new technologies, will outsource their semiconductor chip components to Korea? The details of the linkages need to be explored further.

The Eurozone's problems are worse than a question of creditor-debtor imbalances and worse than the US-China issue. This aspect of the crisis was raised in Stephen King's article in The Independent news online portal (Now opened, the door to exit eurozone can no longer be shut).

Looking from the Far East and having spent years growing up in Europe, it is so clear to me that the Euro politicians are fighting to achieve the European superstate goal with a flawed currency union. The next step is fiscal union and that implies a finance minister as well as leader stamping out every form of democratic or sovereign right of the 17 member countries.

In other words, the creditors forgive your debts in exchange for political dominion. Eurozone is the prototype for the one world government. A break-up will do everyone good for the long term.

The Fallacy of Composition and the Predicament of Debt

The Keynesians and monetarist economists are wrong in trying to stimulate consumption during downturns by fiscal spending and lowering interest rates. Deleveraging is bad in short term but good for the long term as the increased household and corporate savings is channeled into investments in nation's real capital stock, not into unproductive real estate or financial sector. The only productive government spending is in infrastructure (e.g. Indonesia) not in bailing out banks, corporations and households.

Macro economists and investment strategists should monitor the trend in savings for households and overall savings trend for the economy - especially for developed economies. A rising savings/income ratio means consumption/income will automatically fall (Disposable Income = C + S) but eventually build a base for higher domestic investment (e.g. the US where household savings ratio has improved but unless government deleverages and withdraws the fiscal stimulus of sustaining a budget deficit, households will have little incentive to increase savings further in an environment of artificially low yielding savings deposits).

The asset-based wealth effect through elevated property markets (China, Spore, Malaysia) may also play a role in encouraging households to increase debt levels but this is also not productive for the economy. Countries with loan/deposit ratios below 100% and manageable inflation (e.g. Malaysia) may have more room to grow but the leverage should be driven by well managed corporates rather than households.

Democracy and the Wealth of Nations: A Simple Question of Values

The study of economics today fails to attribute the catalysts of economic development to a crucial combination of human qualities that nurtures a conducive ecosystem for prosperity. What is it that has caused certain peoples in a country to work hard, save and be endowed with entrepreneurial talent? To answer this, we need to look into the psychological mindset and expectations of individuals.

The Individual or the State?

Economists have attributed the rise of modern capitalism to several factors such as the market economy, the utilitarian values of the 19th century or the Protestant ethic. However, they fail to see that behind every burst of economic activity and every technological innovation, is a radical change in the mindset of society. This change is a shift in the social perspective from a culture that puts society’s interest above the well-being of the individual to one that puts the individual’s well-being above that of society.

Which is more important? The individual or the state? Does society exist to serve the individual or does the individual exist to serve society, nation, community or government? The answer is simple: if the individual’s life is finite and death is the ultimate end of the individual, then society and civilization is more important because it will easily outlast human lives. However, if the individual’s soul is eternal, then it is infinitely more important than society, which should rightfully exist to serve man. And this is the foundation of every democratic constitution.

The rise of American capitalism stemmed from a personal strong conviction that all men are born equal and each individual can and should be given equal opportunity to raise his/her economic and social circumstance.

At its best, the free market economy facilitates the individual spirit of enterprise and innovation. At its worst, individualism does lead to a hedonistic society where the rich indulge in ostentatious or unproductive lifestyles while the struggling middle class compete to keep up with their neighbours and peers.

But how do we explain the economic dynamism of Asian countries like China and India where the individual is considered as subservient to society? Social scientists from the West are prone to make the mistake of viewing Asians as placing the community’s interest above the individual’s interest. On the contrary, the typical Asian views the family as an individual unit and upholds the well-being and rights of the family above that of the state/society.

If this were not the case, then Communist China’s transformation into a market economy would not be possible. The economic and social revolution of modern China boils down to many factors but one of the crucial catalysts is this change in the mindset of the people that they can work to improve their economic status. In other words, the well-being of the family (i.e. individual) is as important (officially) if not more important (in practice) than the objectives of the Communist state.

China’s adoption of the free market economy paved the way for the individual family to assert its rights to economic and social progress.

(The gradual opening of the Chinese economy under Deng Hsiao Peng - who was quoted to have said it does not matter whether a cat is black or white as long as it catches mice - in the 1990s paved the way for China to join the World Trade Organisation in December 2001. That landmark event further opened up trade opportunities and helped the country to solidify China's position as a cost-competitive factory for the world.)

China's Increasing Impact on Global GDP

In the past six years, the Chinese economy has started to have a material impact on global GDP growth. Over the 2004-2010 period, China's GDP correlation with global GDP correlation has improved with the R Square rising to 40% from 14% in the 2000-2004 period and 1% in the 1980-2000 period.

While the U.S. and European economies, which together account for half of global GDP remains the biggest drivers of the global economy, China's impact on growth is getting larger over recent years.

Being the second largest economy in the world, one would have thought that China's correlation with global GDP would have been higher. But the rebound in the U.S. and G7 economies from the recession of 2009 has pulled up global GDP by a bigger swing than the rebound in China, which is estimated to have grown by 10% in 2010 versus 9.2% in 2009.