Growth in China, it is said, is slowing. GDP growth has reportedly fallen from 9.7 per cent in the first quarter of 2011, to 9.5 per cent in the second quarter, 9.1 per cent in the third and 8.9 per cent in the fourth. Much is being made of these numbers, though the 9.2 per cent average over 2011 is still high and the government has itself attempted to slow the system to rein in inflation.

One can sense an element of schadenfreude here. For too long now China has been showing up the rest of the world with its high rates of growth. This is especially true of the United States, which imports much from China, depends on inflows of capital from that country to finance its deficits, and is always looking for the next country to challenge its global supremacy.

However, if China’s growth is indeed slowing, this is no cause for even the US government to celebrate. A poorly performing China can drag the US down as well. Not just because China, with its large geographical size and population, is the growth pole that prevents the multi-speed global economy from sinking into another crisis. But because China is too important a market for the large multinational corporations that symbolise US economic power.

This last fact has been driven home by the recently released estimates yielded by the 2009 edition of the five-yearly benchmark surveys of the operations of US multinational corporations conducted by the Bureau of Economic Analysis of the US Department of Commerce. According to those figures, growth in the value added by US multinational firms slowed by almost half from 4 per cent to 2.2 per cent between 1999-2004 and 2004-09. However, that deceleration was accompanied by a shift in the relative importance of parents and majority owned foreign affiliates (MOFAs) in the aggregate performance of US MNCs. In 1999 and 2004, parent firms accounted for a little more than three-quarters of valued added by US MNCs. But since then the share of parent firms in valued added by US MNCs has fallen by close to 10 percentage points to 68.3 per cent in 2009. In sum, while operations of parent companies still dominate the activities of US MNCs, there appears to have been a significant shift in US multinational operations away from parent firms at home to affiliates abroad.

Of relevance here is the fact that, of the countries that were locations contributing to the increment in the operations of US multinationals over 1999-2009, China was one. The Asia-Pacific region, which accounted for 18 per cent of the value added by majority-owned affiliates of US multinationals in 1999, contributed 26 per cent of the increment in their value added during the decade ending 2009. And within the Asia-Pacific, China, which accounted for less than 4 per cent of the value added by MOFAs in 1999, contributed close to 19 per cent of the increment in MOFA-value added in that region during the relevant decade. Manufacturing accounted for a dominant 61 per cent of MOFA value added in the China, as compared with a much lower 42 per cent in all global locations.

These facts are particularly significant because of the nature of US multinational operations in China. There is a perception that China, with its large reservoir of relatively cheap labour, is a target for relocative investments by international firms. These firms, including multinationals from the US, are seen as using China as a low-cost production base for global markets, including markets in their parent countries. And the Chinese government is seen as exploiting this opportunity by maintaining an undervalued exchange rate so as to enhance the country’s export competitiveness.

But what the BEA’s benchmark survey has revealed is that the large increases in the value added of US multinational affiliates in manufacturing in China “reflected expanded production to serve the large and growing local market.” About two-thirds of the total output of US MNC affiliates was sold to local customers in both 1999 and 2009. On the other hand, the share of their output sold to U.S. customers declined from 16.3 per cent in 1999 to 10.2 per cent in 2009.

So China’s growth matters, since it is an important market for US firms located there. And what is important is not to look to their return, but to ensure that profits from China are used to invest in jobs at home.

There is a palpable sense of gloom and impending doom in most discussions of the world economy today. Even before, several economists had argued that the excessive optimism about ”V shaped recovery” that was being used to describe the economic revival in 2010 was premature and misplaced, especially as none of the fundamental contradictions of global capitalism that led to the previous crisis had been adequately addressed. But they were once again written off as Cassandras by the financial media, which desperately sought sources of ”good news” and future engines of growth particularly among the emerging markets.

Now even the most stalwart establishment voices are expressing growing concern and pessimism. Oliver Blanchard, Chief Economist at the IMF, has issued what must be an unprecedentedly sombre and even dismal statement at the close of the year, noting that recovery is at a standstill in the advanced economies and recognising that 2012 may face even worse economic conditions than 2008.

Blanchard refer euphemistically to ”multiple equilibria – self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications” and effectively suggests that unless private expectations are managed better by decisive government policies, negative expectations will become self-fulfilling. But it is harder for governments to ”manage expectations”, because private investors themselves are schizophrenic about government deficits and economic growth. Financial markets effectively appear to demand fiscal consolidation by putting very high spreads on the bonds of governments with high ratios of public debt to GDP or fiscal deficit to GDP. And then investors in these markets are very surprised (and react adversely) when attempts at fiscal austerity reduce economic activity and growth prospects.

This has already created a self-reinforcing cycle of contraction in the eurozone, and as long as European leaders (and incidentally the IMF) continue to press for fiscal austerity, this will continue. Meanwhile the peculiar political configurations in the US make it unlikely that any real fiscal stimulus will emerge to ensure a more broad-based and stable economic recovery. The belief currently expressed by many economic commentators, that a ”big bazooka” in the form of even looser monetary policy of the European Central Bank and the US Federal Reserve, will be sufficient to lift economic activity, is unwarranted.

Chart 1 shows quarterly growth data for real GDP since the trough of the crisis in late 2008. It is evident that Blanchard is completely correct in noting that the recovery in the major advanced economic regions is sputtering if not dying. (Data in all charts is based on IMF’s Global Economic Indicators database.) Output growth in Japan has already turned negative once again in the most recent quarters, while it is sluggish in the US and likely to become much worse in the euro area given the inability to resolve the internal problems of the eurozone.

In the past global recession, many developing countries suffered quite sharp declines in output but then the recovery was also faster and more buoyant. Chart 2 shows a sample of emerging market economies (and does not include China and India about which enough discussion already exists). Real GDP recovered more sharply in the economies that had experienced the biggest slumps, but despite this, since the middle of 2010 there has been a deceleration in almost all of the economies described here.

This sluggish recovery or beginning of renewed recession is of major concern not just in itself, but because even the period of recovery was already not associated with much improvement in labour market conditions. Chart 3 shows that in the three major advanced economic regions, open unemployment rates increased during the Great recession, and since then have remained at these high levels despite subsequent increases in incomes and economic activity. Chart 4 shows that (other than for Turkey and Brazil) a similar process was also under way for the emerging economies considered here.

A September 2011 report from the ILO to the G20 found that in the first quarter of 2011, only a handful of countries (notably, Argentina, Brazil, Turkey and Indonesia) had absolute employment levels that were above the levels of the first quarter of 2008, before the eruption of the global crisis. In some countries both output and employment were still below their earlier levels (including the developed world: European Union, the US and Japan) while in others like South Africa, output had recovered but employment was still lower than in early 2008. So the weakening prospects for the world economy come at a time when labour market conditions are already very fragile across the world.

This is extremely bad news for the developing world. Already, it is evident that it is misplaced and even foolhardy to hope that economic expansion in China, Brazil, Russia and some other countries will be enough to compensate for the slowdown in the advanced economies. In sheer quantitative terms, total incomes and import demand in these countries simply cannot counterbalance the falling net demand from US and Europe. But there are further reasons why developing countries – including those that are currently being expected to save the world economy – cannot expect an easy ride in the coming year themselves.

First, most developing regions are directly affected by the slowdown in import demand from Europe, and to a lesser extent the US. For example, manufacturing exports from developing Asia, particularly China, are already affected by the slowdown in Europe and the process is likely to intensify in the coming months. Second, the reduction in China’s exports affects its own demand, as the complex export production platform it is the centre of in Asia reduces demand for raw materials and intermediates. Third, many developing countries have also been affected adversely by the sudden and rapid outflow of mobile finance capital, as banks and other financial institutions book their profits in emerging markets in order to cover their losses. This has also been associated with rapid depreciation of several emerging market currencies, which causes their import bill for oil and other essential goods to increase, but not necessarily affecting their exporting potential in the current climate.

Fourth, there are reasons to be more concerned than many analysts appear to be, about the immediate prospects for the Chinese economy. As the housing bubble in China is pricked and real estate prices fall, this will have negative multiplier effects on all related activities in construction and so on. The debt deflation associated with falling asset prices may also affect consumption and employment. So there is a serious internal threat to growth, unless the Chinese government takes active measures to revive consumption, without relying on expansion of household debt. In many other emerging markets, the previous boom was associated with credit-driven bubbles, and as these are burst, the prospects for economic expansion will similarly be affected.

So there are good reasons for Blanchard of the IMF and others to be gloomy about global economic prospects. However, unless they and others who have real influence on economic policy making across the world argue for a real change in both economic paradigm and current strategy, things are unlikely to look up in the coming year.

This piece was originally published in the Business Line.

For some time now the focus of the discussion on the European crisis has been on Greece. Its wider dimensions, though recognised, were not emphasized. Among those dimensions was the real possibility of a banking crisis in Europe, since a haircut on bank loans to governments as part of the attempt at crisis resolution is unavoidable. Even if the banks are able to prevent that, an actual default failing resolution would hit them.

In the event of a European banking crisis, it cannot remain a regional problem given global financial integration. It would also affect emerging markets, whose growth is seen as crucial to bolstering the “multi-speed” global economy.

One of the consequences of financial globalization has been the increased presence of global banks in developing countries and an increase in their role as lenders in these countries. As of the end of the second quarter of 2011, banks in countries reporting to the Bank of International Settlements (BIS) had foreign claims of $27.3 trillion outstanding. Though a dominant share ($20.1 trillion) of these accumulated claims was in the developed countries, the developing country share ($5.1 trillion) was by no means meagre. What is particularly noteworthy is that the international banks involved are predominantly European. Around 70 per cent of the foreign claims of the global banking system are on account of European banks. Greater financial integration in Europe is one obvious reason. Of the $20.1 trillion claims on the developed countries, $12.3 trillion is in European developed countries, as compared with just $5.6 trillion in the US.

But another reason is that European banks faced with increased competition at home have been seeking out developing countries to expand business and sustain profitability. Close to 19 per cent of the exposure of banks abroad is in developing countries, and this is true of European banks as well. Given the greater role of European banks in total international funding and the importance of a few developing “emerging markets” as recipients of capital, this is of significance. The concentration of emerging market exposure of banks in one region increases the vulnerability of both these banks and their clients.

In the current context, the vulnerability of the developing countries, as demonstrated by the experience during the 2008-09 crisis, comes especially from one source. Having to cover losses at home, recapitalise themselves and improve the risk profile of their lending, European banks are likely to look to retrenching assets in their global operations. Emerging markets are bound to be affected by such moves.

The impact is likely to be greater because of a disconcerting feature of foreign bank claims in emerging markets. They seem to have been driven to a substantial degree by short-term supply side developments in the developed countries. Those developments have also significantly increased foreign claims in the Asia-Pacific, which is seen as buffering the global economy. Claims on developing countries in the region rose by $547 billion during the 2000-2006 period, when there occurred a supply side driven surge in capital flows across the globe. Even during the crisis period stretching from 2007 to the middle of 2009 foreign bank claims in the region increased by $290 billion. And when the post-crisis liquidity infusion made available cheap capital in large quantities to the banking system, the Asia-Pacific developing countries were the locations for an expansion of foreign bank claims to the tune of $596 billion in just two years. A capital surge of this kind, that provided additional grounds for the “decoupling” perspective, makes the region even more vulnerable to a capital outflow or a mere cutback in lending by foreign entities.

This vulnerability needs to be assessed in the context of the collateral damage that a banking crisis in Europe can result in. It would worsen the recession in Europe, which is an important destination for exports from emerging markets. The recession in Europe would in turn precipitate the double dip that can damage Asia’s foreign exchange earnings and growth even more. And finally, the European banking crisis could trigger a global crisis, not just in banking but in the financial sector generally, given the multiple institutions and instruments through which financial markets are interlinked today. If that occurs, what matters is the aggregate exposure of emerging markets to global capital: and that is indeed substantial. In sum, we have at hand a problem that should and does worry not just the G7, but the G20 and more.

The US is by no means the world’s most competitive or strongest economy, though the dollar remains its reserve currency. This intuitively contradictory feature in contemporary capitalism was seen as likely to sap the dollar’s strength, even if there was no clear alternative to it as a reserve currency. The threat to the dollar intensified with the onset of the 2008 crisis and the Federal Reserve’s response to that crisis in the form of an injection of huge volumes of cheap liquidity into the system. With the system awash with dollars, the currency was expected to slide. The evidence too pointed to a medium-term decline of the relative value of the dollar. Countries like China with substantial exposure to dollar-denominated assets were wary of suffering large losses because of the depreciation of the dollar.

What has come as a surprise, however, is the recent sudden rise of the dollar with a parallel fall in the value of a whole host of assets varying from equity to metals and gold which had emerged as the preferred safe havens for investors.

Copper, zinc, steel, silver, platinum and gold, all of which were preferred investment targets for wealth holders and speculators are suddenly being shunned. Silver fell by 34 per cent in value in three days, which was its sharpest fall in thirty years, and copper fell by more than 13 per cent. Gold recently registered its sharpest four-day fall since 1983. There seems to be nothing of substance that is worth holding, even if it is durable. The dollar is the current safe haven, though it may not remain so.

This has occurred in the current atmosphere of fear of sovereign defaults, banking crises and a return to recession. In the midst of that uncertainty, the dollar, which was expected to weaken because of economic circumstances in the United States and was indeed drifting downwards, is suddenly gaining in strength. A host of alternative assets—oil, gold and metals among them—which were targets of a bull run previously are all of a sudden being dumped in favour of the dollar.

The turn to the dollar was particularly sharp after the Federal Reserve announced the launch of its “Operation Twist” in late September this year, which involved selling shorter-term Treasury holdings, and buying long-term debt and mortgage-backed securities to the tune of $400 billion. This move is seen to have sent out two signals. The first is that the Fed was attempting to flatten the yield curve by reducing yields on long-term bonds, with the hope that it would revive housing demand and spur investment. The second was that it was moving away from its earlier practice of quantitative easing, which floods the system with dollar liabilities. These implicit objectives were ostensibly seen as a commitment to act against the slowdown in US growth without undermining the dollar’s value, encouraging a shift to the currency.

This in itself cannot fully explain the fall in the prices of alternative assets, especially gold. What is perhaps happening is that the uncertainty and downturn in equity markets is forcing some investors to sell alternative assets in order to cover losses or meet margin calls. The resulting price decline is possibly forcing those who in herd-like fashion moved into gold, metals and other commodities to book profits or cut losses and exit from these assets. But with nowhere else to go, the shift was to cash. And what form of cash is there to hold other than the dollar, with the euro and the yen in crisis.

In the process developing countries that have been the targets of financial investors and those dependent on commodity exports have become particularly vulnerable. Their financial and commodity markets are destabilised. And their currencies, which were appreciating earlier, have experienced sharp declines. The ultimate source of such volatility is the fact that the world is awash with liquidity as a result of the monetary policies adopted in developed countries. The search for investment opportunities to lodge the capital released by those policies has led not just to the proliferation of “innovative” financial instruments in the developed world, but also to cross-border financial flows to developing country markets, to the speculative acquisition of commodity stocks (see Wise’s earlier post on this), and to investments in a whole range of new asset classes that can serve as stores of value.

The diversification of investment portfolios that this proliferation of assets permits was expected to ensure stability. What the world got instead is an increase in volatility.

Though different, the Greek and the US public debt crises threaten a return to the Great Recession of 2008. The world is therefore savouring the reprieve provided by their temporary resolution. But before that ephemeral benefit could be enjoyed comes news of a potential new global economic threat from an unsuspected source: China.

Its source lies in the boom in China’s property market over the last few years, which gathered substantial momentum in the wake of the huge post-crisis stimulus provided by the government to the economy. With a significant share of that stimulus diverted to projects that increased demand for real estate, price increases have been so large that the spiral is now being identified as a bubble.

Moreover, that bubble, some observers expect, is likely to burst in the near future for three important reasons, among others. The first is that the huge, speculative investments made in this sector, especially in housing, to cash in on the price spiral, has resulted in excess supply in many markets, with housing properties lying unsold and unoccupied.

The second is that even as the problem of oversupply was beginning to be sensed in some quarters, the government strengthened its efforts to rein in the housing boom, partly to dampen speculation and prevent a bubble. This was partly because grossly unaffordable housing in the cities was making the government unpopular.

The government was also responding to evidence that its huge stimulus package aimed at moderating the effects of the global crisis was resulting in inflation in the prices of real estate. In addition, the housing and infrastructure boom was contributing to commodity price inflation. To address these issues, it sought to persuade banks to demand larger down payments from clients, increase mortgage rates and restrict lending for multiple housing investments.

Finally, there is the possibility that many who borrowed to finance their housing and real estate purchases may find it difficult to service their debt, since interest rates are being raised to cool an overheated economy. This could increase defaults and foreclosures, bring more housing property to the market, as well as limit additional demand.

Put together these developments are expected to result in a supply-demand imbalance that would reduce house price inflation and even trigger a fall in housing prices. That, in turn, is expected to prick the speculative bubble, leading to a bust in the form of a downward spiral of real estate transactions and real estate prices. The argument seems to be that since government intervention is occurring a bit too late, it is contributing to the onset of a crisis rather than stalling the forces responsible for the build up to the crisis.

Since the prolonged property boom in China had generated a fair share of sceptics who were expecting a bust, this kind of speculation has found much favour. It gained immediacy recently when housing price indices based on prices in 70 cities rose by just 0.2 per cent month-to-month in May and a lower 0.1 per cent in June. On an annualised basis, housing price inflation at 4.2 per cent was, in June, significantly below the 6.4 per cent inflation in consumer prices. The boom was indeed showing signs of tapering off. Was this the prelude to a slump? As if to answer yes, in April, rating agency Moody’s downgraded China’s property sector from stable to negative. This both reflected the mood among investors as well as served as a signal to the more nervous among them.

All this has proved enough for a growing sense of fear about China being the next epicentre of a crisis. A collapse of the property boom in China would have major repercussions domestically. To start with it could dramatically slow growth, since GDP expansion in China is driven substantially by investment, and investment is driven largely by construction, especially of housing and infrastructure.

The real estate market is also a major source of revenue financing state expenditures at the provincial level. The sale of land to developers is a major source of revenues for provincial governments, which then put the money to finance prestige infrastructure projects aimed at attracting investments and winning political attention. If the housing boom trips so will a lot of this infrastructure spending.

Also, a substantial amount of this state spending is financed by credit from the banking system, which tends to view the real estate owned by local governments as the implicit collateral that warrants huge lending. There has been much concern in recent times about the volume and quality of lending by the banks. The first official overall estimate of local government debt in China has placed it at Rmb10,700bn ($1,650bn), or close to 30 per cent of GDP. Clearly, banks lending to local governments have believed that these governments will not default because they have enough resources such as land to pay off the banks when faced with a crunch. The confidence in such judgements seems to be weakening, as reflected in the fact that some investors are moving out of stocks of Chinese banks that are not doing too well.

Fears about bank fragility also come from the direct exposure of the banks to the housing market and to real estate developers. Such exposure has been estimated at 20 per cent of bank advances. If this market sours, the hit on banks transmitted through provincial governments will only be compounding a significant level of direct damage. However remote that possibility, rating agency Fitch has decided to save itself from possible ignominy by warning Chinese banks of asset quality risk and declaring that there is a more than reasonable chance of a banking crisis by 2013.

Despite all this, China fears are by no means dominating the headlines. There is much happening elsewhere, in the US and Europe, to keep financial news enthusiasts preoccupied. Further, there are other factors indicating that China may not be anywhere near the brink of an economic precipice. Stress tests, though unreliable even in the best of times, have indicated banks can easily handle a property market downturn. The average Chinese household is not overly indebted with the ratio of household debt to disposable income placed at less than 50 per cent.

Moreover, house ownership even in urban, let alone rural, China, is not very high relative to the population of households. Urbanisation is set to accelerate, with 300 million expected to move to the cities over the next 20 years. With income rising and the government encouraging private ownership of housing, demand is likely to be sustained, even if not just for the luxury housing that is the market that is possibly losing some of its steam. Finally, housing construction is unlikely to slow because of the government’s decision to make the provision of subsidised housing one of its instruments to address the growing inequality in the Chinese economy. The state plans to deliver 36 million subsidised houses over the next five years. If it goes even a part of the way on delivering on that promise, the construction boom would continue.

All this said, the fear of a housing and real estate downturn in China is understandable. These sectors directly and through the contribution they have made to China’s growth have also partly helped prop up the global economy. They are the sectors that draw huge quantities of steel, cement, household fittings and accessories, the direct and indirect demand benefits of which flow to the world market. China is not just an exporter, but an importer as well. So everybody is interested in a stable China. Fortunately for the world, the state is still a major player in China. And the signs are that it is responding to the danger in more ways than one.

This post was originally published by the IDEAs Network.

Days after the July 22 deal on a second bail-out package for debt-strapped Greece, the full import of the package is still being unravelled. There are two basic messages that seem to be emerging. First, the banks, which were initially seen as having been forced to take a well-deserved hit for their lack of diligence as lenders,  have gotten away with a good deal. Second, as a result, while European governments have staked a lot of their money in the hope of saving the eurozone and preventing another crisis, and so have governments elsewhere through the involvement of the IMF, the crisis has not been even partially addressed, but merely postponed.

The second bail-out package is worth 109 billion Euros, just a billion euros short of the 110 billion provided in the first bail-out more than a year ago. According to observers much of this money will come from eurozone governments in the form of new 15 to 30-year loans carrying an interest rate of 3.5 percent. The IMF, which provided €30 billion in the course of the first bail-out, is expected to provide around that much this time too, if Christine Lagarde, its new European head, has her way. And private creditors will swap or roll over 135 billion euros of existing loans into new, longer-term instruments.

This split, it is now estimated, lets the banks off very lightly.  This should have been expected when the Institute of International Finance, the Washington-headquartered association of leading international banks, emerged an important player in the negotiations. According to the IIF, as a result of the deal the banks are set to lose a possibly overestimated €54 billion. But that is far short of the more than €200 billion they would have lost if Greece was allowed to spiral into total default.

It was clear that eurozone governments were keen to avoid that outcome because it would have meant the break up of the zone and a devastating hit for the euro. But so were governments elsewhere scared of the consequences for a financial world that has been just bailed out of a crisis at huge cost and for a real economy that is still limping back to recovery. Using this fact, finance first mobilised the much-discredited rating agencies to hold all to ransom by declaring that any debt restructuring would force them to declare “selective default”. That did not prevent restructuring but was enough to persuade the others involved to soften the hit that finance capital would be required to take.

In this effort, another member of the “epistemic community” that finance has built to validate its demands, the European Central Bank (ECB), also played a role. The ECB, too, opposed any restructuring on the grounds that it would reduce the value of the collateral that Greek banks provide for the support it provides them. This combined effort, orchestrated by the IIF, allowed banks to substantially lighten the loss they would have to suffer.

But eurozone governments and the IMF are paying a much higher cost for the deal. According to an analysis reported in the New York Times, this loan-tranche of €109 billion euros that they are providing would be worth only 54 billion euros when discounted, implying a 50 percent haircut. Not surprisingly, emerging market directors on the board of the Fund have objected to the IMF’s involvement in the deal. According to the Financial Times, Paulo Nogueira Batista, who represents Brazil and eight other countries on the IMF’s executive board, declared in an interview that since this is the “first big decision” that Lagarde is taking as head of the fund, she has an ideal opportunity to dispel suspicions of bias towards European bondholders. “The community of fund-watchers around the world will be looking to see if she can transcend her European origins,” he reportedly said.

What is galling to most is the fact that at the end of all this, the problem remains unresolved. Greek public debt is still in excess of its gross domestic product. Servicing that even on slightly lighter terms seems near impossible in the midst of austerity that spells recession. Another bail-out is inevitable. The danger is that next time around governments across Europe and elsewhere may be overcome with bail-out fatigue and just risk wholesale default. The banks and private creditors would then get their due. But that is small comfort, since the fall-out for the rest may be too much to bear.

Don Kohn, deputy to former Federal Reserve Chairman Alan Greenspan at the time when the financial crisis broke, has won himself an unexpected and unusual job. He has been appointed to a new committee which has the mandate to guide the United Kingdom (note not the US) to financial stability. Speaking to British MPs at a confirmation hearing he chose to confess his guilt. According to the Financial Times (May 17, 2011) , he said: ”I deeply regret the pain that was caused to millions of people in the US and around the world by the financial crisis … Most of the blame should be on the private sector: the people that bought and sold those securities, on the credit rating agencies that rated them. But I also agree that the cops weren’t on the beat. The regulators were not as alert to the risks as they could have been and, to the extent they saw the risks, were not as forceful in bringing them to the attention of management, or taking actions, as they could have been.”

Read the full post at the IDEAs Network website.

The real problem facing the country is the neoliberal reform that seeks to attract private capital into a lucrative and sensitive area such as petroleum.

The Comptroller and Auditor General’s (CAG) performance audit of some production-sharing contracts (PSCs) instituted as part of the liberalisation of India’s oil exploration and production policy may turn out to be the next big scam, with more than a whiff of corruption. But, in this season of scams, danger lurks. The danger that much of society can for a considerable period of time miss the wood for the trees. Circumstances strengthen this tendency. In particular, the surprising coincidence of a host of revelations of lack of due diligence, bending of rules, outright manipulation or a combination of all of this that hugely enriches a few individuals and corporations in the private sector and a few functionaries of the state, most often at the expense of the exchequer. Not a day passes without evidence of some new scam.

Whatever may be the cause for this recent increase in scam-related revelations, the surge feeds the notion that corruption has reached unprecedented levels and constitutes the fundamental problem facing India today. The fact that corruption, besides being ethically wrong or morally abhorrent, can influence growth in ways that serve the interests of a few and can therefore be deeply inequalising cannot be denied. But the reason for these developments – which are seen as mere instances of corruption – multiplying in number could be systemic and reflect policy shifts that aim to use state resources to inflate private profit.

Read the full article at Frontline.

One less emphasised lesson from the global financial crisis was that developing countries that are successful in attracting foreign financial investors take a hit when such a crisis occurs because of a reverse flow of capital. Foreign financial firms needing to cover losses or meet commitments at home withdraw their capital generating a credit crunch in emerging market economies.

It is to be expected, therefore, that the crisis-induced debate on regulating finance should revisit not just policies with regard to capital flows into these economies, but also policies with regard to the entry and operation of foreign financial firms. This is particularly important because since the 1980s and especially after the series of currency and financial crises in emerging markets starting in the late 1990s, the presence of foreign financial firms, especially foreign banks, in developing countries has increased substantially.

However, there is a strand in the literature that suggests that it is not the presence of foreign banks per se, but the nature of their presence that determines vulnerability. To quote an IMF study (Kamil Herman and Kulwant Rai (2010), “The global credit crunch and foreign banks’ lending to emerging markets: Why did Latin America fare better?”) based on the experience of countries in Latin America and the Caribbean (LAC): “Following the Lehman demise in the third quarter of 2008, lending by foreign banks to the LAC region slowed rapidly, amid the freezing of global money markets and doubts about the health of banks in advanced economies. Most of this deceleration in foreign banks‘ total credit growth, however, reflected a sharp contraction in cross-border loans to LAC, which are largely denominated in foreign currency and funded in wholesale markets. On the other hand, lending by local affiliates of foreign banks—which is mostly denominated in local currency and funded with domestic deposits—proved much more resilient and continued to expand, even amid the global turmoil.”

Thus, the study concludes, if foreign banks deliver a higher share of their lending through local affiliates, with funding from domestic sources, the risk of a reverse, “homeward flow” of capital in times of crisis is lower. The implication of this argument should be clear. Financial liberalisation of the kind that encourages foreign banks to establish a physical presence and mobilise and lend local currency resources is preferable to liberalisation that merely eases conditions for the cross-border movement of capital. An open door policy must be adopted with respect to institutions and not just their capital.

But by focusing on the possible withdrawal of liquidity due to extraneous reasons, which is obviously likely only when lending is cross-border and in foreign currencies, the IMF study may be missing out on more direct ways in which foreign bank strategies can influence access to credit in developing countries, especially for productive investment.

A recent paper by Hamid Rashid of the United Nations’ Department of Economic and Social Affairs (“Credit to private sector, interest spread and volatility in credit flows: Do bank ownership and deposits matter?”,) points to more complex ways in which foreign banks’ operations can affect credit provision, especially when those banks mobilise local resources and lend in local currencies. Based on data from 81 developing countries the paper points, inter alia, to three important trends. The first is that increasingly foreign banks are displacing domestic banks in the market for deposits. Not only is the deposit share of foreign banks significantly higher than that of domestic banks, but the rate of growth of deposits with foreign banks is also higher. The second is that behaviourally foreign banks are different from domestic banks, displaying a lower average loan-to-asset ratio and an asset portfolio with a higher share of non-lending, high-return activities such as investments in securities. This means that a larger share of deposits goes to support such activities. Third, as foreign banks increase their share of deposits, domestic banks are forced to increase their reliance on non-deposit-based funding to finance their lending (and non-lending) activities. However, the higher costs and uncertainty associated with non-deposit-based funding force domestic banks to reduce their lending activities. Overall, credit availability tends to get squeezed, and inasmuch as other evidence shows that foreign banks prefer retail to productive lending, this would adversely affect lending for investment purposes in particular.

In other words, developing countries should not only consider restricting capital inflows with controls, but also the entry of foreign firms that are the carriers of that capital.

Among the institutions whose role in the development of the less developed regions is well recognised but inadequately emphasised are the development banks. Playing multiple roles, these institutions have helped promote, nurture, support and monitor a range of activities, though their most important function has been as drivers of industrial development.

All underdeveloped countries launching on national development strategies, often in the aftermath of decolonisation, were keen on accelerating the pace of growth of productivity and  per capita GDP. This was the obvious requirement for alleviating poverty and reducing the developmental gap that separated them from the developed countries. To realise this goal, they considered industrialisation to be an important prerequisite. This stemmed from the perspective that modern economic growth was a process characterised by an increase in the
share of employment in the non-agricultural sector, and within the latter by a change in the scale of productive units, the growth of factory production and a shift from personal enterprise to the impersonal organisation of economic firms.

Read the full article at the IDEAs Network.