The World has breathed a major sigh of relief that the Greece led Eurozone crisis is averted, yet another time, as a result of the high-level summit of Europe’s leaders at Brussels on October 27, 2011. The world’s most powerful leaders, ministers, investors and bankers had to undertake weeks of intense negotiations to arrive at the latest settlement. The size of the bailout fund, the European Financial Stability Facility (EFSF) has been increased from 440 million Euros to 1 trillion Euros, with a leverage of four to five times of its corpus. The lenders or the bondholders to Greece have agreed for a loss of 50 percent while converting the existing bonds into new loans. Greece itself would be handed over a new bailout fund. The European banks would be recapitalized to an extent of an additional 1 billion Euros while the countries in potential default like Greece and Italy have agreed to implement reforms. Stock markets, the world over, have greeted the Eurozone outcome with the ramping up of all the indices. That said, there is concern if the restructuring and rehabilitation would have a lasting impact or whether there would be a quick return to the specter of public debt crisis again.
At the heart of the crisis lie excessive and profligate public and private spending on the back of easy and unchecked loans, and in some cases asset bubbles supported by artificially high prices. The solution now proposed of stringent austerity measures including layoff of workers, reduction of salaries, pensions and benefits and cutbacks in public and private investments not only cause social strife but also run counter to demand stimulation that is required for economic revival. The way all the European leaders had to cooperate to resolve the crisis in just one country of the 17 country Eurozone points to the highly coupled nature of global economy and the threat of contagion effects of collapse of any one economy on the entire global economy. The Eurozone crisis, which followed the crisis in the US triggered by the lowering of sovereign rating, clearly demonstrates the fragile nature of global economy. It is of discomfort that the economic crises are being sought to be tackled by financial means rather than by sustainable structural reforms on the back of industrial competitiveness, and demand-supply balance. The root cause which is the economic behavior of nations and societies needs to be addressed.
Like individuals, nations also display an economic behavior. A nation whose society, or sections of the society, prematurely considers that the peak of affluence has been achieved would give a goby to the core concepts of productivity and innovation as well as equity and equality that drive continuous development. A nation which tries to achieve growth through top down investments rather than grassroots development would face lopsided development. The competitive behavior of emerging nations, and the states or provinces within nations, unfortunately has been ignoring such requirements. Governments have sought the easy way to attract development and foster industrialization by offering fiscal sops or incentives and subsidies rather than by creating durable high quality infrastructure. This trend has been more so in respect of India where State governments typically vie with each other to create favored state for individual corporations.
Societies also tend to chase affluence sans productivity. As an economy begins to transform itself skews in demand and supply of talent take place, with enhanced job opportunities chasing limited skill sets. This, in turn, drives up wage structures in certain classes of employment while leaving a broad base of jobs relatively untouched. This, in turn, leads to a spurt in the consumption of luxury goods and premium products. For each luxury car imported into India, for example, seven to ten sedan cars based on locally made components can be produced, leading to much greater employment generation and more equitable wealth generation. In such skewed societies imports tend to be on unproductive lifestyle products rather than essential technological tools and equipments. Gross capital formation thus tends to be channeled into activities with poor capital-output ratios, sub-optimizing overall growth potential and maximizing inequities. Emerging nations need to strengthen their institutional mechanisms to ensure that economic behavior is appropriately shaped. Some of these are discussed below.
Islands in deserts?
World economy is certainly in the throes of major change. While everyone expects the centre of gravity to shift to emerging markets especially India and China, the transition is beset with substantial volatility and fluidity. Factors of market strength and supply competitiveness are dramatically influencing how the established and new economies shape themselves. Emerging markets cannot be smug under the assumption that they would be driving the future economic waves simply by demographic advantage or through investment flows. Nor can the emerging markets accept the premise any more that the Western style reforms and investment banking solutions are the panacea of globalization. Excessive public investments or private consumption are also not a long term solution for economic sustainability. By all accounts, the increasing speed with which global funds take flight is panning out to be inversely proportional to the decreasing pace with which the nations are able to grow their real economies.
Emerging markets have enormous scope for development but need also macroeconomic stability to sustain growth. The paradigm of growth in emerging countries is dependent substantially on such countries feeding their products and services to developed markets on one hand and expanding their respective domestic markets through new technologies, often based on imports from developed markets. Global economic coupling is, therefore, a fact of the current global order. A shrinking developed world, in economic terms, would eventually have a depressing influence on the growth of emerging markets as well. The concepts of global cooperation as evidenced by Eurozone and G 20 efforts are appropriate. That said, the emerging markets as well as the developed markets need to learn from the experiences of the last five years to get global growth back on track, with equity, stability and rapidity.
Central financial institutions
If there is one universal lesson that has emerged from the global liquidity crisis and its aftermath it is that central institutions such as the Federal Reserve in the US, Bank of England in UK, European Central Bank, Bank of Japan and Reserve Bank of India play a major role in stabilizing truant economies. Conversely, weak central institutions or central institutions constrained by bureaucratic and political influences would be incapable of protecting and growing the respective national economies. On the whole, it appears that except in respect of India, various central institutions, especially of developed economies, have been less than proactive and prudential in the oversight. The velocity of fund flow in the developed world is so high that any oversight or regulation was seen to be counter to the free market culture. The last few years have been teaching us through successive crises that proactive regulation by the central financial institutions would be better than retroactive intervention after the economies are battered by institutional collapse. The latest US rating resolution and Eurozone resolution point to the continued influence of political and governmental institutions on the empowerment and functioning of the central financial institutions.
The linkage between the policies of the central financial institutions and the response of the stock markets is another important consideration. While central institutions cannot, and should not, take policy decisions with an eye on the stock markets, undue unpredictability and suspense in key decisions seem to lead to stock market speculation and volatility. Given that there could be shades of right and wrong in any policy decision and given also that any policy decision has a strategic objective it would probably make better sense for the central institutions to lay down a rolling twelve month policy regime which also indicates potential, not necessarily mandatory, policy moves that could be taken should the economy behave in certain manners. India has benefitted in the past by reducing the mystique (in terms of incentives, subsidies, duties and taxes) from the annual budgeting process. Probably, the same approach would be appropriate for policy pronouncements from the central financial institutions. The latest forward guidance from the Reserve Bank of India on future rate revisions, for example, has had a positive effort on the Indian stock markets.
Too big to fail, too small to succeed
One of the striking takeaways of the global liquidity crisis is that the bigger the institution the greater is the adverse impact of its failure. This has been demonstrated in as diverse institutions as financial services industry (Bear Stearns and Lehman Brothers) and automobile sector (General Motors). The developed markets, despite the existence of strong anti-trust regulations, have enabled scale-intensive mergers and acquisitions. At the same time, studies of such mergers and acquisitions have also established that several of these have eroded rather than added value, even ignoring the undesirable trauma of factory closures and job eliminations that accompany such mega mergers and acquisitions. Emerging nations in their quest for global scale of their industries must be conscious of the need to insist on appropriate logic of such transactions. Fundamentally, the emphasis needs to be on achieving efficiency independent of scale as a first preference. Institutions such as National Competition Commission must play a positive and proactive role in enabling micro-economical growth of industries in alignment with macro-economic fundamentals. The concept of financially bailing out those who are too big to fail cannot be allowed to distort the fragile economic systems of the emerging nations.
The need to balance the big with the small is the essence of prudent macro-industrial management. While growth is an inevitable impulse of all companies, growth is not the only way to become profitable. Niche in products and services enables small and medium enterprises to contribute to the national economy. Central, shared services of technology and marketing, usually sponsored by the governments could help small and medium enterprises retain the agility, efficiency and nimbleness of their small and medium enterprises with the scope and scale of shared services. Some of the established principles of Indian economic management such as big corporations and government procurement organizations supporting the small and micro enterprises are relevant but have not delivered so far due to technological and marketing insufficiencies. Probably, a holding corporation to support micro enterprises of an industrial value chain could provide the needed resources for product development and marketing while enabling the individual enterprises focus only on cost-effective manufacturing.
Banking on banks
Banking competitiveness is as important as industrial competitiveness is to economic stability and growth. India is fortunate that the banking sector does not deal in exotic products as the institutions in developed countries. Even singular products such as derivatives had affected several companies in India in 2008 and 2009. This had reflected poorly on the internal audit and compliance mechanisms of various banks as well as the timeliness of oversight by the Reserve bank of India. This has been reflected in a different manner by the collapse of microfinance institutions in India in wake of the exorbitant interest rates and exploitative arbitrage of concessional funding extended to such institutions and self help groups. Delays in the implementation of prudential capitalization norms of Basel III may render the Indian banks weak in terms of capital adequacy (the first policy statement by the Reserve Bank of India on Basel III is expected only by end December 2011). India has also not taken up stress testing of its banking sector as it ought to have done in the wake of global liquidity crisis.
While the Reserve Bank of India, and the overall Indian banking system, have come out better within the global banking community for their caution and conservatism, it would be inappropriate to rest on this relative success. As the State Bank of India episode has shown Indian banks are saddled with high levels of non-performing assets. Indian banking at one time took upon itself the task of consulting with its clients to develop their businesses on the right lines but has eschewed that path. In the interests of sustaining the asset quality it would be appropriate for the Indian banks to set up on a consortium basis a consulting cum rating organization that could provide asset rating and business improvement services concerning their clients to the banks. The Indian banking system has to move beyond the limited tool kit of repo rates, statutory liquidity ratios and cash reserve ratios to fundamental economic and industrial analysis to ensure that the funds are deployed productively.
Central economic planning
Central economic planning received much criticism from the 1950s for the tilt towards socialistic and command economic model it implied. It was seen as regressive attempting to throttle how human enterprise would like to plan its development. The developments of 2008 and beyond have, however, brought out the risks of a completely unplanned economy. Whether one likes it or not, mixed economy of public and private participation is a matter of fact. Whether the governments should participate in certain capital intensive domains such as power utilities and inherently non-profit driven activities such as education and healthcare is no longer a matter of debate, at least for the emerging markets. Rather than provide huge incentives and subsidies to attract overseas and private enterprises to capital intensive projects, probably it would be better for the governments to provide them through utility rates that the society can bear. That said, it is somewhat inappropriate that the central planning commissions should focus on tax and investment allocations than strategic direction of economies.
India is going through its Eleventh Five Year Plan 2007-12. The Indian planning commission ought to be initiating the Thirteenth Five Year Planning exercise covering 2013-18. The approach to date continues to focus on central and state allocations. Instead, the Indian Planning Commission should focus on major structural transformations that could take India to a different trajectory of development. Some of the strategic game changers for India could be high speed transportation (for example, bullet trains, expressways, freight corridors), optimal energy generation mix (for example, nuclear, non-nuclear), universal social infrastructure (surely, education, healthcare, housing), and focus sunrise sectors (for example, nanotechnology, genetic engineering, semiconductors). The central planning process should focus on identifying, generating and channeling mega investments for strategic game changers for the economy.
Growth with equity
It should be the dream of every economic planner to ensure growth with equity for his or her nation and society. In a global economy, strong domestic demand and equitable spread of life style are essential for growth to be sustainable. The governments cannot abdicate the responsibility for directing growth entirely to free enterprise and private sector. A combination of policy management framework that could govern economic behavior of nations and societies comprising diffusion of growth initiatives, strong central financial institutions, optimal scaling of enterprises, banking regulation and central economic planning would provide a platform for sustainable growth with equity.
Posted by Dr CB Rao on October 30, 2011