In recent months, controlling inflation has been the main focus of the Reserve Bank of India. Since March 2010, for the eleventh time on July 26 it raised the repo rate - the key short-term lending rate - by half a percentage point to 8 per cent. Inflation control is becoming a major problem in China though its rate of inflation is much lower than India's 9.4 per cent and is at 6.4 per cent.
Inflation in China is partly the result of a huge amount of liquidity (4 trillion yuan) released in the economy after the Financial crisis hit the world in 2008. But even before the financial crisis, for years China gave subsidised loans to state-owned enterprises (SOEs) and the privates sector. This resulted in much over capacity in the real estate sector and the strengthening the SOEs, but because of its low interest rates China has been able to get a competitive edge over India. Inflation is now up in China mainly due to higher wage rates as its abundant labour supply is no longer assured because of fewer young people joining the labour force as compared to India due to its one-child policy.
In a bid to control inflation, China has raised the repo rate by a quarter percentage point (third time this year) to 6.5 per cent. The government hopes that this will take care of the phenomenon of the negative real interest rate (interest rate minus inflation) and prevent money from flowing out to non-monetary assets.
Despite all efforts, inflation in India remains unabated because of strong external factors like global oil price hike and higher international commodity prices that have jacked up industrial costs. Food inflation, however, remains volatile and seasonal with cereal prices climbing up due to higher minimum support prices offered to farmers by the state governments. The RBI, by raising interest rates, may help to suck out the extra liquidity in the economy and increase savings, but instead of bringing down inflation, it is likely to stave off demand and investment.
Whereas in India a higher interest rate will affect investment and credit offtake, in China it is expected to influence the consumer demand more. In India, there has already been a decline in industrial growth which was only at 5.6 per cent in May 2011 as compared to China's 15.1 per cent in June. China has built ultra-modern infrastructure in recent years and spent 50 per cent of its GDP on fixed assets like transport facilities and factories in 2010.
Government enterprises have also become powerful and 39 out of 42 Chinese companies listed on the Forbes list of 500 world's biggest firms are state-owned enterprises. They, however, have a low return to equity and have gained in weight and stature from low interest rates and easy access to land. They have also got staggering non-performing assets (NPAs) and with higher interest rates, their performance will worsen and there will be more NPAs.
Higher interest rates and relatively higher growth prospects in both the countries, however, will attract foreign institutional investors to pour money into the Indian and Chinese stock markets, though there has been a crash in world bourses following Standard & Poor's downgrade of the US debt rating for the first time in history. There will be a temporary retreat of FIIs from these countries but not for long. The lower credit rating will mean that the US will have to raise interest rates from near zero, which will affect its own economic recovery as financing of public and private debt will be costlier. It could mean a slowdown in demand so that commodity prices will come down and oil prices may stabilise, which may bring down the inflation faced by China and India in due course.
The biggest economy in the world, the US, is not facing inflation but a colossal public debt which crossed the government's stipulated limit recently. Currently the US debt stands at $14.6 trillion. A default has been narrowly averted by a compromise deal between the Republicans and the Democrats, and the limit has been extended by $ 2.4 trillion, but it will also mean a huge spending cut and an austerity package and higher interest rate outgo. It could mean lower export growth for India and China and the rest of the world.
Whether China, which holds the biggest amount of US Treasury bonds ($1.16 trillion), will keep buying them in future is the moot question. It cannot afford not to do so for fear that their value would crash which will in turn devalue its own holdings of US bonds.
Growth in the global demand will also be constrained by Japan's struggle with reconstruction after the March earthquake and the debt crisis in Europe. China, anticipating this problem, has been keen to boost domestic demand but may not be able to do so with higher interest rates necessary for containing inflation. If inflation continues and global demand recedes, India too will not be able to expand the capacity of the manufacturing or services sectors, resulting in unemployment.
The huge government debt will require higher service charges. The government's interest rate payments will take up more than 20 per cent of its current (non-Plan) expenditure, leaving less resources for Centrally-sponsored social development schemes.
Apart from slow export growth, inflation will dampen the demand for consumer goods. Durables will be adversely affected in India as people will postpone their purchases. Even car sales have witnessed a stagnant demand recently. Infrastructure building in India may slow down.
By contrast, China does not have to invest huge amounts in infrastructure. But its competitiveness may be eroded, which has been due to the low cost of capital, land and labour. Much of that advantage stands threatened by inflation pushed up by higher wages and higher interest rates. Its basic assets of a modern infrastructure, and educated and disciplined labour force will help in withstanding any serious decline in GDP growth. The FDI in China is also slated to grow.
The US may undergo a slow recovery and unemployment will remain a problem. In India, the continuance of inflation for another year will undoubtedly spell misery for people with fixed incomes. But with growing clouds over the world economy, the lower global demand may dampen oil and commodity prices. India's commodity exports may be hit and the RBI may be spared from increasing the repo rate further. India's growth rate will decline more sharply than that in China, whose problem of rising wages and overcapacity will remain. In short, China will fare the best!
(The writer is a Senior Fellow at Observer Research Foundation, Delhi)
Courtesy: The Tribune
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