China and India: Right Policy, Wrong Place

Op-ed in the Financial Times

January 9, 2012

Indian economic policy reforms have been noteworthy for their near absence, but even more so because the rare exceptions have been in the most questionable areas. Thus, in the aftermath of the recent financial crises, and apparently oblivious to their lessons, India's policymakers have been energetically dismantling restrictions on capital flows. Most recently, as the rupee came under pressure, India has allowed even greater access for foreigners to its stock market.

China too has been selectively increasing foreigners' access to the renminbi. But it remains cautious about fundamental reforms. In fact, though, the two countries should be reversing roles. Consider why.

A relatively closed capital account, combined with financial repression, has helped China sustain its mercantilist policy of undervalued exchange rates. This worked with a vengeance not only in delivering high rates of economic growth but also unprecedentedly strong rates of consumption for the average Chinese citizen. But the cost-benefit calculus is now turning. In particular, three costs are beginning to overwhelm any gains to exports and growth that mercantilism has delivered.

First, China has over-invested, which is driving down the efficiency of capital use and hence future economic growth. More importantly, excessive capital use has sharply reduced the share of the economic pie going to labor by about 10 percentage points in the last decade. The political restiveness in China today reflects to an extent this shortchanging of its workers.

Second, mercantilism has rendered China vulnerable to external shocks. In 2008, its exports fell dramatically and growth would have been derailed but for the fiscal stimulus that Beijing implemented. As the policy space gets reduced, this vulnerability might become more painful. Abandoning mercantilism would allow China to rely more on domestic demand, thus lowering its exposure to outside events.

Third, mercantilism has led to a large buildup of foreign exchange reserves. It was inevitable that China would suffer a loss on these when the renminbi appreciated. Perhaps Beijing can shrug off the losses on its current holdings of $3.2 trillion but sticking to current policies will lead to greater reserves, entailing even larger losses. For example, with a future reserve holding of $5 trillion, a 20 percent renminbi appreciation implies a loss of about 17 percent of gross domestic output. That is not chump change, even for China.

India, on the other hand, has to be more wary about embracing foreign capital. It, unlike China, has been running current account deficits, and opening itself to outside flows to finance them. But China's experience has shown that causation goes the other way. By being relatively closed to foreign capital and sustaining competitive exchange rates, a country can generate large domestic savings. While India does not need to follow China in keeping its exchange rate artificially low, lurching to the other extreme in being so open to outside capital will leave it with an overvalued currency. Growing external imbalances and reliance on fickle foreign finance is a consequence.

A second reason advanced for India's capital opening is to finance infrastructure development. Critical as this is, a lack of funding seems the binding constraint. Infrastructure projects are typically the domain of companies such as Bechtel and investors such as the Ambani family with pockets as deep as the Mariana Trench. Spending on power projects is mainly hampered by the fact that the nonpayment for or theft of power has political blessing, while investment in roads is constrained by corruption in land acquisition. In short, Indian infrastructure does not have a financing problem, it has a governance vacuum.

Finally, if India wants to generate employment opportunities for its army of unskilled workers, its manufacturing sector must expand and thrive, which requires a competitive rupee. Yet opening up to foreign capital is likely to result in an even stronger exchange rate.

In the future China will have to acquire the zeal for foreign capital exhibited by Indian policymakers to rebalance its economy and reduce the mounting distortions. And India must shed its foreign finance fetish to become less vulnerable externally and generate greater employment. On attitudes to foreign capital, China and India should swap places.