This post is a guest con­tri­bu­tion by Chetan Ahya, Der­rick Kam and Jenny Zheng of of Mor­gan Stan­ley (MS 18.39 ↑0.60%).

Back­drop: Have Both Nations Been Liv­ing on Bor­rowed Growth for Too Long?

Fol­low­ing the credit cri­sis, both China and India relied on aggres­sive tac­ti­cal mea­sures to revive growth quickly. Given the pace at which the exter­nal envi­ron­ment was dete­ri­o­rat­ing then, policy-makers in both China and India had to act quickly and deci­sively to boost domes­tic demand.

• Specif­i­cally, in China, the key dri­ver of domes­tic demand was an aggres­sive credit expan­sion – close to a 30pp rise in the ratio of bank loans to GDP (exclud­ing non-bank loan lend­ing by banks), in addi­tion to some sup­port from the expan­sion in the government’s bud­get deficit. Bank loans to GDP has been main­tained at these high lev­els of close to 130% until recently.

• In India, the biggest dri­ver was the dou­bling of the national fis­cal deficit – from 4.8% of GDP in the year end­ing March 2008 to 10% in the year end­ing March 2009. By our esti­mates, the national deficit is likely to be 9.2% for the year ended March 2012 – imply­ing that the gov­ern­ment has now main­tained this expan­sion­ary fis­cal pol­icy for four years in a row.

China’s Fetish for Invest­ment, India’s for Consumption

As growth began to slip imme­di­ately after the credit cri­sis, China focused on sup­port­ing invest­ment with the large rise in the ratio of bank loans to GDP. India focused on sup­port­ing strong con­sump­tion (par­tic­u­larly rural con­sump­tion) growth with its major fis­cal stim­u­lus. These stim­u­lus mea­sures were largely instru­men­tal in help­ing China and India to recover quickly from the global reces­sion. Indeed, this counter-cyclical response – a rise in bank loans in China and fis­cal expan­sion in India, respec­tively – had also been employed dur­ing the 2001 US reces­sion and global growth slowdown.

Macro Sta­bil­ity Risks – Only Symp­toms of Low Pro­duc­tiv­ity Dynamic

The stim­u­lus mea­sures helped to boost growth quickly – but they also brought macro sta­bil­ity risks. A major rise in prop­erty prices, infla­tion pres­sures and bank­ing sec­tor asset qual­ity issues – symp­toms which sur­faced in China and India over the course of 2010-11 – are only a reflec­tion of the low pro­duc­tiv­ity dynamic of growth dri­ven by tac­ti­cal stim­u­lus, in our view.

We believe that the aggres­sive pol­icy stim­u­lus was not based on what was truly needed for achiev­ing a sus­tained growth trend in these coun­tries. Rather, the stim­u­lus mea­sures were based on what both gov­ern­ments could do best in that short period in response to the sud­den growth shock on account of the credit cri­sis. Given the sharp and rapid pace of the dete­ri­o­ra­tion in growth con­di­tions, we believe one can hardly ques­tion this move at the time the credit cri­sis was unfolding.

How­ever, per­sis­tent reliance on tac­ti­cal mea­sures for such a long period (Sep­tem­ber 2008 to late 2010) was at the heart of the emer­gence of these symp­toms of macro sta­bil­ity risks.

Delever­ag­ing in DM – A Reminder to China and India

Fol­low­ing the 2001-02 global slow­down, low real inter­est rates and the rise in lever­age in the US and Europe had sup­ported strong growth in their domes­tic demand and over­all GDP growth.

• The expan­sion in US/European domes­tic demand meant that China ben­e­fited from strong growth in exports… In China, net exports con­tributed an aver­age of 1.9pp to over­all GDP growth of 12.1% between 2004-07. Strong growth in invest­ment aimed at build­ing capac­ity to feed exports demand was the other key anchor of GDP growth.

• …while the low real inter­est rate envi­ron­ment meant that India (along with many other emerg­ing mar­kets) gained from a major rise in cap­i­tal inflows. For India, the sharp rise in cap­i­tal inflows over F2005-08 meant that real inter­est rates declined to aver­age just 2.1% even as GDP growth aver­aged 9.0%, led by strong growth in pri­vate investment.

We believe that this extremely favourable global envi­ron­ment, apart from struc­tural domes­tic fac­tors in both coun­tries, played a big role dur­ing the 2003-07 period in lift­ing growth rates for China and India.

How­ever, the credit cri­sis and the sub­se­quent delever­ag­ing in US and Europe have dis­rupted this benign global envi­ron­ment that had ben­e­fited China and India. We saw a short period of revival in exports and cap­i­tal inflows into the region over the course of 2010-11, but the emer­gence of sov­er­eign con­cerns in the devel­oped world has again reminded us about the sus­tain­abil­ity of these two dri­vers. Con­sid­er­ing the major struc­tural chal­lenges that the devel­oped world now faces, the exter­nal envi­ron­ment will likely be less benign than in 2004-07 – sug­gest­ing that policy-makers in China and India will have to seek sus­tain­able sources for domes­tic demand engines of growth for their respec­tive economies.

Growth Is Slow­ing Again

After recov­er­ing strongly from the credit cri­sis, growth in China and India is slow­ing again. The emer­gence of macro sta­bil­ity risks forced policy-makers to tighten mon­e­tary and fis­cal pol­icy to con­trol domes­tic demand.

• In China, tighter mon­e­tary con­di­tions and the grad­ual with­drawal of fis­cal incen­tives have cur­tailed domes­tic demand.

• India is see­ing a broad-based slow­down in domes­tic demand. Per­sis­tently high infla­tion has eroded pur­chas­ing power and has forced the gov­ern­ment to slow down its expen­di­ture growth, the major dri­ver of rural consumption.

Just as domes­tic demand had begun to slow, exter­nal demand con­di­tions turned less sup­port­ive as the sov­er­eign debt sit­u­a­tion in Europe inten­si­fied dur­ing the sum­mer of 2011. Export growth for the region weak­ened; sequen­tial growth (sea­son­ally adjusted) had aver­aged close to zero since March 2011.

More­over, the risks to the growth out­look for both China and India are skewed to the down­side, in line with our global team’s view on Europe and the US. Bar­ring a quick recov­ery in the devel­oped world, the exter­nal envi­ron­ment could again be a drag on the region’s growth outlook.

Aggres­sive Tac­ti­cal Eas­ing Is Not an Option

We believe that there is grow­ing recog­ni­tion among policy-makers that the low pro­duc­tiv­ity dynamic of growth dri­ven by tac­ti­cal stim­u­lus had resulted in the emer­gence of macro sta­bil­ity risks. As such, if eco­nomic con­di­tions evolve in line with our base case out­look, we do not expect policy-makers to engage the same old aggres­sive pol­icy response, as it would quickly revive the macro sta­bil­ity risks. We do expect some pol­icy eas­ing in China and India, but the pol­icy response would likely be less aggres­sive than in 2008-09.

In China, we expect policy-makers to pro­ceed with fur­ther pol­icy eas­ing to cush­ion the mod­er­a­tion in growth. We believe that the PBoC will favour quan­ti­ta­tive adjust­ment through RRR cuts, open mar­ket oper­a­tions (OMO) and win­dow guid­ance, while keep­ing the pol­icy rate unchanged for now.

In India, we expect the RBI to ini­ti­ate pol­icy rate cuts by March-April 2012 when infla­tion­ary pres­sures start soft­en­ing, deliv­er­ing a cumu­la­tive 100bp cut in pol­icy rates in 2012. The RBI would also likely con­tinue to inject liq­uid­ity via open mar­ket oper­a­tions and/or via a reduc­tion in CRR to pre­vent a sharp rise in inter-bank rates.

What Would Help Revive it on a Sus­tain­able Basis?

Investors remain focused on the next round of tac­ti­cal responses – but we believe it is essen­tial to watch the efforts from policy-makers in China and India to revive domes­tic demand in a sus­tain­able man­ner through strate­gic pol­icy responses. We would also high­light that the source of domes­tic demand growth mat­ters as well.

In this con­text, we believe that China should tilt the bal­ance towards boost­ing con­sump­tion growth – while India needs to focus on lift­ing investment.

China Needs to Move Towards Higher-Value-Added Eco­nomic Activ­i­ties, Boost Pri­vate Consumption

In China, a num­ber of struc­tural imped­i­ments have held back pri­vate con­sump­tion growth:

1) Sur­plus labour in pre­ced­ing years, as reflected in rel­a­tively low wage growth, has meant that a larger incre­men­tal share of income has been allo­cated to cor­po­rates rather than house­holds. Hence, the growth in pri­vate con­sump­tion was held back by the rel­a­tively weaker growth in dis­pos­able incomes.

2) There has been a lack of a com­pre­hen­sive social secu­rity sys­tem and access to pub­lic health­care, hous­ing and edu­ca­tion, par­tic­u­larly for migrant res­i­dents. This has fos­tered a strong desire to hold a high level of pre­cau­tion­ary house­hold savings.

3) Until the late 1990s, China had sev­eral restric­tions on own­er­ship of pri­vate prop­erty. As a result, a large pro­por­tion of lower– and middle-income house­holds were not able to tap the pri­vate hous­ing mar­ket and thus expe­ri­enced a lack of secu­rity on that front.

Hence, to address these imped­i­ments, we believe that China needs to ini­ti­ate struc­tural reforms: The ulti­mate goals: to tran­si­tion towards higher value-added eco­nomic activ­i­ties, to accel­er­ate fis­cal trans­fers towards social secu­rity, and to boost pri­vate consumption.

First, a sus­tain­able rise in house­hold dis­pos­able incomes (wages) would help to sup­port con­sump­tion growth.

In this con­text, the gov­ern­ment has been address­ing this issue by steadily rais­ing min­i­mum wages. Indeed, in 2011, min­i­mum wages have risen by an aver­age of 22.0% in 22 of China’s 31 provincial-level regions. Some provinces have already announced fur­ther plans to hike min­i­mum wages in 2012. The gov­ern­ment, in its 12th Five-Year Plan, has also set out to lift house­hold dis­pos­able incomes (wages) at a pace that at least matches the nom­i­nal GDP growth.

We believe that demo­graphic changes will mean that mar­ket forces will also war­rant this rise in wage growth. Accord­ing to UN pro­jec­tions, 18 mil­lion peo­ple will be added to China’s work­ing age pop­u­la­tion over the next decade, one-sixth of what it was in the last decade.

• These sig­nif­i­cant demo­graphic changes indi­cate that the social objec­tives (eco­nomic wel­fare) are chang­ing from aggres­sive employ­ment cre­ation (cre­at­ing enough jobs to absorb the rise in work­ing age population) …

• …to employ­ment enhance­ment (mov­ing employed work­ers up the value chain, thereby giv­ing them the oppor­tu­nity to earn higher wages).

More­over, the CAGR in num­ber of new grad­u­ates has been 21% over 2001-10, ris­ing from 2.0 mil­lion in 2001 to 7.7 mil­lion in 2010. The ris­ing num­ber of grad­u­ates from higher edu­ca­tion insti­tutes will mean that the econ­omy will need to gen­er­ate higher value-added jobs to ensure that their skill sets will be fully utilised.

In order to move up the value chain, the gov­ern­ment would need to reori­ent man­u­fac­tur­ing invest­ment towards higher value-added man­u­fac­tur­ing. In its 12th Five-Year Plan, the gov­ern­ment plans to raise the strate­gic emerg­ing indus­tries’ share of GDP from 4% in 2010 to 8% in 2015. These indus­tries include high-end equip­ment man­u­fac­tur­ing, next-generation infor­ma­tion tech­nol­ogy, biotech­nol­ogy and envi­ron­men­tal pro­tec­tion (includ­ing alter­na­tive energy).

More­over, the pro­duc­tion struc­ture of the Chi­nese econ­omy is likely to shift grad­u­ally towards the ser­vices (ter­tiary) sec­tor as the econ­omy con­tin­ues to mature in its devel­op­men­tal stage.

This process of indus­trial upgrad­ing and move­ment towards the ter­tiary sec­tor will likely bring with it more job oppor­tu­ni­ties which will be higher value-added in nature – thereby allow­ing for a vir­tu­ous cycle of sus­tain­able growth in dis­pos­able incomes and there­fore con­sump­tion growth.

Sec­ond, to address the issue of improv­ing social secu­rity, the gov­ern­ment could push for afford­able social housing.

This would boost invest­ment in the near term but would ulti­mately boost con­sump­tion, as house­holds feel more secure. The gov­ern­ment has announced plans to con­struct 36 mil­lion units of social hous­ing from 2011–15. We believe that the gov­ern­ment will likely accel­er­ate its efforts to ensure that the con­struc­tion of social hous­ing projects pro­ceeds smoothly and is com­pleted as sched­uled. The gov­ern­ment has announced mea­sures to ease the finan­cial con­straints of the local gov­ern­ment financ­ing vehi­cles, thereby indi­rectly sup­port­ing the con­struc­tion of social housing.

Third, we believe that the gov­ern­ment will work to extend the pro­vi­sion of social ser­vices such as pub­lic edu­ca­tion, health­care and hous­ing for more residents.

This, we believe, will be the key to improv­ing social secu­rity and will also free up dis­pos­able income for con­sump­tion of other goods and ser­vices. In this con­text, one of the pos­si­ble mea­sures that the gov­ern­ment could con­sider is allow­ing the reg­is­tra­tion of migrant urban res­i­dents in a phased man­ner. Accord­ing to the National Bureau of Sta­tis­tics of China, as of 2011, 230 mil­lion res­i­dents are not reg­is­tered under the hukou sys­tem in the city where they are cur­rently resid­ing. Reg­is­tra­tion of these res­i­dents would give them access to the above-mentioned social ser­vices of pub­lic edu­ca­tion, health­care and housing.

We believe that the goal of boost­ing house­hold incomes to raise con­sump­tion will serve as a strate­gic com­ple­ment to accel­er­ate growth in the ser­vices sec­tor, thereby rais­ing the oppor­tu­nity for higher value-added jobs.

We believe that fis­cal pol­icy is likely to play an impor­tant role in sup­port­ing this tran­si­tion towards domes­tic demand. Indeed, China’s gov­ern­ment bal­ance sheet is in a strong posi­tion to pro­vide this sup­port. The government’s fis­cal posi­tion, as mea­sured both in terms of its fis­cal deficit and pub­lic debt to GDP trend, has more than ade­quate room to play this con­struc­tive role. The gov­ern­ment could thus increase its social spend­ing and ini­ti­ate tax reforms to lower the tax bur­den of house­holds to boost consumption.

India: Revival in Invest­ment Is the Key to Recov­ery in Growth

In India, struc­tural mea­sures are needed to help boost pri­vate invest­ment. India will con­tinue to have strong sup­port from favourable demo­graphic trends, as the age depen­dency ratio (pro­por­tion of non-working age pop­u­la­tion to work­ing age pop­u­la­tion) will con­tinue improv­ing until 2040, accord­ing to UN projections.

This war­rants a rise in invest­ment to GDP, which would help to gen­er­ate pro­duc­tive capac­ity, and is cru­cial to kick-start a vir­tu­ous cycle of faster growth in pro­duc­tive job cre­ation – income growth – sav­ings – invest­ments – higher growth, with­out a rise in infla­tion challenges.

Unfor­tu­nately, invest­ment sen­ti­ment in cor­po­rate India has remained weak… Cur­rently, from an entrepreneur’s per­spec­tive, sev­eral fac­tors are adversely affect­ing cor­po­rate confidence:

1) The slow­down in domes­tic demand growth;

2) Weak global econ­omy and slow­ing export growth;

3) Weak global cap­i­tal markets;

4) Rel­a­tively high global com­mod­ity prices in rupee terms hurt­ing margins;

5) Slow­ing pace of exe­cu­tion by gov­ern­ment machinery;

6) Corruption-related investigations.

…and the gov­ern­ment has lit­tle fis­cal room for manœu­vre: More­over, the already high start­ing point of the fis­cal deficit (9.2% of GDP) implies that the gov­ern­ment has very lit­tle room to pur­sue an expan­sion­ary fis­cal pol­icy to boost pub­lic investment.

Credit pol­icy isn’t enough on its own: We expect the RBI to start cut­ting pol­icy rates from Mar-April 2012 onwards and cumu­la­tively cut pol­icy rates by 100bp dur­ing 2012 to 7.5%. Still, inter­est rate cuts are unlikely to be a suf­fi­cient dri­ver to kick-start the invest­ment cycle, in our view. Indeed, pri­vate invest­ment has slowed even though real inter­est rates remain neg­a­tive. As infla­tion mod­er­ates, real inter­est rates will need to be high for some time to ensure that India lifts sav­ings enough to fund the even­tual rise in investment.

We acknowl­edge that reviv­ing capex in a counter-cyclical man­ner will not be easy: A typ­i­cal capex recov­ery cycle involves cycli­cal pol­icy stim­u­lus reviv­ing domes­tic demand (par­tic­u­larly con­sump­tion) and growth con­fi­dence. This is then fol­lowed by a grad­ual pick-up in pri­vate invest­ment. How­ever, with lim­ited scope for cycli­cal pol­icy stim­u­lus this time and an oth­er­wise adverse macro envi­ron­ment, we believe that reviv­ing the invest­ment cycle quickly will be challenging.

In our view, two key fac­tors can help sup­port the invest­ment and there­fore GDP growth recovery:

(a) Global cap­i­tal mar­kets: Global cap­i­tal mar­kets weigh on cap­i­tal inflows into India and also tend to influ­ence the risk appetite in the domes­tic mar­kets. This fac­tor is par­tic­u­larly impor­tant for India, because its cor­po­rate sector’s invest­ment fund­ing is more depen­dent on cap­i­tal mar­kets com­pared to bank credit. More­over, busi­nesses of many of the com­pa­nies are now linked to the global econ­omy and their invest­ment deci­sions are depen­dent on the global eco­nomic outlook.

Con­sid­er­ing that the devel­oped world is fac­ing major struc­tural chal­lenges, sup­port from the global econ­omy and cap­i­tal mar­kets may not be forth­com­ing. Hence, to sup­port invest­ment growth, the gov­ern­ment needs to focus on pol­icy reforms to get the pro­duc­tive dynamic back, in our view.

(b) Gov­ern­ment pol­icy action: If global sup­port is less forth­com­ing, we believe that the only way to revive invest­ment will be a ‘campaign-style’ effort from the gov­ern­ment which should include major pol­icy reforms and a focused approach to speed up the exe­cu­tion machin­ery of the government.

Thus, the gov­ern­ment could use a two-pronged strat­egy – first, speed up imple­men­ta­tion of major pol­icy reforms…

•· Strengthen insti­tu­tional capac­ity to allo­cate crit­i­cal national resources (land, min­er­als) to the pri­vate cor­po­rate sec­tor in a trans­par­ent man­ner for rapid industrialisation.

•· Enact the Goods and Ser­vices Tax Act (GST; value-added tax).

•· Strengthen insti­tu­tional capac­ity to man­age the award­ing of major infra­struc­ture projects through the public-private route, which should increase transparency.

•· Build a com­pre­hen­sive plan for energy secu­rity along with a sys­tem­atic pro­gramme for energy pric­ing reform.

•· Ini­ti­ate aggres­sive fis­cal con­sol­i­da­tion which aims to reduce the national gov­ern­ment deficit and improve the mix of its expen­di­ture towards devel­op­ment spending.

•· Take mean­ing­ful steps towards divest­ment of the government’s stakes in SOEs.

•· Accel­er­ate infra­struc­ture spend­ing, par­tic­u­larly for power: The gov­ern­ment needs to sys­tem­at­i­cally address insti­tu­tional capac­ity to sus­tain a steady rise in infra­struc­ture spending.

…sec­ond, iden­tify 25–30 core infra­struc­ture and indus­trial projects – and fast-track them: The gov­ern­ment could either take up projects already under­way or encour­age new ones that can be taken up for exe­cu­tion quickly to ensure that invest­ment is revived in a more timely fash­ion. These projects could be those with lim­ited call on land/mineral resources.

We believe that the gov­ern­ment should focus in par­tic­u­lar on infra­struc­ture invest­ment, which can be taken up in a counter-cyclical man­ner, because weak global sen­ti­ment could weigh on man­u­fac­tur­ing invest­ment. For instance, many Indian cities need a jump-start in crit­i­cal urban infra­struc­ture facil­i­ties. The cen­tral gov­ern­ment could pro­vide a cap­i­tal grant of about US$10 bil­lion to ini­ti­ate projects worth US$40–50 bil­lion. We under­stand that in many cases the plans for such infra­struc­ture projects are ready – but need a deter­mined push from the cen­tral government.

We believe that such mea­sures could also give a strong boost to for­eign investor sen­ti­ment and would help to revive cap­i­tal inflows as investors look for strong growth oppor­tu­ni­ties in an oth­er­wise gloomy global envi­ron­ment. Among the large economies in the world, India’s struc­tural growth story remains the most com­pelling, in our view. How­ever, pol­icy sup­port would help to keep faith in this growth oppor­tu­nity intact.

Macro Imper­a­tives Will Likely Force the Much-Needed Tran­si­tion, Pace Is an Issue

We believe that policy-makers in both China and India have indeed embraced the view that aggres­sive tac­ti­cal eas­ing will bring the same old macro sta­bil­ity risks. This is also reflected in their cal­i­brated approach towards mon­e­tary eas­ing thus far in this cycle. Encour­ag­ingly, policy-makers have been indi­cat­ing that struc­tural mea­sures are needed to sup­port domes­tic demand on a sus­tain­able basis. Indeed, accord­ing to press reports (China Daily), Vice Pre­mier Li Keqiang had empha­sised that “more pri­or­i­ties should be given to the areas related to improv­ing people’s liveli­hood, so as to boost the domes­tic demand and con­sump­tion” and stressed that “more expen­di­tures should be made in areas such as social secu­rity, edu­ca­tion and healthcare”.

Sim­i­larly in India, Prime Min­is­ter Man­mo­han Singh admit­ted that the gov­ern­ment had taken “a con­scious deci­sion to allow a larger fis­cal deficit in 2009-10 in order to tackle the global slow­down”. He stressed, how­ever, that “like other coun­tries that resorted to this strat­egy, we have run out of space and must once again begin the process of fis­cal con­sol­i­da­tion”. Finance Min­is­ter Pranab Mukher­jee has also indi­cated that, in the con­text of reviv­ing invest­ment and growth, policy-makers will “have to be alert to shape the required pol­icy responses, reform sys­tems, improve the reg­u­la­tory frame­work of our insti­tu­tions to make the most of the oppor­tu­ni­ties com­ing our ways”.

We believe that policy-makers in China could sur­prise with more mean­ing­ful strate­gic mea­sures in 2012.

In India, we believe that a win­dow of oppor­tu­nity for accel­er­a­tion in pol­icy mea­sures could arise after the state elec­tions in March 2012.

Source: Chetan Ahya, Der­rick Kam and Jenny Zheng, Mor­gan Stan­ley, Jan­u­ary 20, 2012.

Dr. Prieur du Plessis is an investment professional with 26 years' experience in investment research and portfolio management. More than 1,200 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns, including his blog, Investment Postcards from Cape Town. He has also published a book, Financial Basics: Investment. Prieur is Chairman and principal shareholder of South African-based Plexus Asset Management, which he founded in 1995. The group conducts investment management, investment consulting, private equity and real estate activities in South Africa and a number of foreign countries. He also serves as Honorary Consul of Slovenia for South Africa, actively developing economic, cultural and scientific relations between Slovenia and South Africa. Prieur is 54 years old and live with his wife, television producer and presenter Isabel Verwey, and two children in Cape Town, South Africa. His leisure activities include long-distance running, traveling, reading, motor-cycling and scripophily. Read more from the author/contributor here.

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