India and China are engaged in separate but parallel struggles with inflation. Both have responded by monetary tightening. Such tightening affects inflation via its effect on demand and its interrelation with the supply side of the economy. This article, therefore, analyses macroeconomic determinants of the supply side of China's and India's economies and its effect on inflation and their relative growth rates. In particular it considers the relative efficiency of investment in China and India and the consequences of this for inflation and growth.
As this article is somewhat more statistical than most on this blog it may be useful to summarise its conclusions - readers can turn to the article for the supporting evidence.
1. Analysis of macro-economic parameters clearly confirms other forms of study that both the Chinese and Indian economies are up against or approaching inflationary capacity constraints. Therefore, for example, the analysis that China is facing an overall problem of 'overcapacity' is the reverse of the truth - China is facing an overall problem of constraints on capacity which has inflationary consequences.
2. As China is suffering from inflationary capacity constraints the argument made by some commentators that in 2009, and at present, China's policy makers should aim at increasing domestic demand only via increasing domestic consumption, and not also increasing domestic investment, is false - such a policy, by increasing demand but not tackling capacity constraints, would increase inflationary pressures. The Chinese authorities in 2009 were therefore right to have expanded both domestic investment and domestic consumption. This remains the correct policy.
3. India's domestic savings level combined with a policy of accepting a moderate, i.e. up to 3% of GDP, balance of payments deficit makes it credible for India to aim at a double digit, or close to double digit, economically sustainable growth rate. The projections for India's growth at the latest Indian Prime Minister's Economic Advisory Council, of 7.2% in the current fiscal year and over 8% in the next, appear even moderate compared to the macro-economic potential - indicating that either, or both, India has ample strategic margin to contain inflation or that growth rates will exceed these projections.
4. There is not a statistical basis for the claim that India is able to make more efficient use of investment than China and therefore that India will be able to match China's growth rate with a lower level of investment. India's efficiency of the use of investment, from the point of view of economic growth, is almost exactly the same as China's and therefore, unless there is a change in this, their relative growth rates will continue to be determined by which country invests a higher proportion of GDP.
5. China, on the basis of the level of of investment achieved in 2009, should be able to sustain the approximately 12% GDP growth which is likely in the early part of 2010 without seriously destabilising inflationary capacity constraints. However further acceleration, without an increase in the level of investment, would be likely to produce unsustainable capacity constraints and therefore the Chinese authorities are correct to have begun to rein in the rate of acceleration of the economy.
The more detailed analysis of these points follows.
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On 12 February China's central bank raised banks' reserve requirements for the second time in a month. India raised bank reserve requirements on 29 January.
The struggle with inflation in both China and India is complicated by short term inflationary pressures created by climatic effects which have contributed to capacity constraints in food supply.(1) But other more general inflationary pressures are due to capacity constraints in sectors in which additional investment can potentially tackle the problem in the medium or short term.
In regard to capacity constraints in China Geoff Dyer noted in the Financial Times: 'According to Yu Song and Helen Qiao at Goldman Sachs, the most extreme example is in the auto sector, where extra shifts mean factories are running at above capacity. They also see emerging bottlenecks in electricity, coal and even in aluminium and steel which only a few months back seemed to be suffering from chronic overcapacity. "The capacity overhang has been quickly whittled down in major industrial sectors," they wrote in a recent report.'
Analysing the situation in particular industries, while important, is however not sufficient to estimate how serious are overall inflationary capacity constraints. There will always necessarily statistically be examples of 'overcapacity' and 'undercapacity' in an economy, even when overall macro supply and demand are in balance, as it is in practice impossible to exactly match these in all sectors. Pointing to cases of either overcapacity or undercapacity, whether statistical or relying on anecdotes, therefore does not resolve the issue - it will always be possible to find these cases. Only overall consideration of the balance between demand and supply can determine whether deflationary overcapacity or inflationary lack of capacity is dominant.
To look clearly at the root of the issue of capacity constraints it is therefore necessary to look at the overall situation – i.e. at the macro-economy. Examination of this for both China and India reveals major implications for short term anti-inflationary policy and for long term determinants of growth.
China or India cannot increase capacity only via increased efficiency of investment
The first point revealed by examining the macroeconomic constraints is that neither China nor India can significantly increase capacity, to overcome inflationary supply side issues, by simply increasing their efficiency of investment. To overcome current domestic capacity constraints they would both have to raise the level of investment in their economies.
To demonstrate this, ideally fully up to date studies on total factor productivity in the two economies would be used to evaluate investment efficiency. However studies of total factor productivity on India are less frequent than those for China and such analyses by their very detailed nature are also in general not fully up to date.
Studies of total factor productivity which have been carried out for China show clearly that, contrary to myths presumably spread by those who have not examined the figures, China's use of investment is highly efficient in terms of international comparisons as is India's.
Given the lack of, and problem of timeliness of, total factor productivity studies a less statistically precise, but indicative and relatively current, measure is to calculate the correlation of the level of investment with GDP growth – i.e. what percentage of GDP India and China have to invest to generate 1% GDP growth. Such analysis confirms the situation found by the total factor productivity studies and casts a clear light on the situation facing both China and India. Such analyses, in turn, can be brought more fully up to date - yielding a less statistically precise result than total factor productivity studies but one that can be used as a policy tool.
Efficiency of investment in China and India
Taking a five year moving average, to smooth out purely short term fluctuations, China has had to utilize 3.7 percent of GDP in fixed investment for its economy to grow by 1 percent. To give detail, in the five years to 2008, the latest for which there is full data, China's GDP grew at an average annual 10.8 percent, and it invested an average of 40.7 percent of GDP – yielding a 3.7 percent of GDP in fixed investment correlation with 1 percent GDP growth.(2)
India's efficiency in the use of investment in terms of generating growth is almost exactly the same as China's. Over the same period India's economy grew an average 8.5 percent a year and its share of fixed investment in GDP was 31.0 percent – i.e. India also invested 3.7 percent of GDP to grow by 1 percent.(3)
As neither China nor India during the latest five year period suffered intolerable macro-economic imbalances it may be assumed that 3.7% of GDP devoted to investment to generate 1% GDP growth is consistent with sustainable macro-economic stability.
Figure 1 below shows the development of this ratio over a longer time frame. This data shows the dramatic decrease in the percentage of GDP that had to be devoted to investment to generate economic growth in China after the economic reforms starting in 1978 and as a result of the economic opening up in India.
In the case of both China and India the percentages of GDP that had to be devoted to investment fell from around 6% of GDP prior to their economic reforms to the present 3.7% of GDP level – i.e. the efficiency of investment, from the point of view of generating growth, increased by around 50%.
To take an international comparison, at the end of the 1970s China, India and the US each had to invest about 6% of GDP to generate 1% of GDP growth.However after this the efficiency of investment, from the point of view of generating GDP growth, greatly improved in both China and India and it deteriorated in the US - the US, even before the onset of the 2008 recession pushed the figure higher, had to invest 7.8 percent of GDP to grow by 1 percent.(4) Both China and India's efficiency of investment, from the viewpoint of GDP growth, is currently therefore more than twice that of the U.S.
The trends for the three countries are shown in Figure 1.
Figure 1
For present purposes, however, the significance of these figures is that China and India have little scope for increasing their capacity, or sustaining or raising their growth rates, simply by achieving efficiencies in capital use - both countries are already up against the boundary of what any country has achieved in a sustained way in this field since World War II. It is implausible that a significantly superior investment to GDP growth ratio can be achieved in either country – although major efforts will be required to maintain what is already a highly efficient use of investment. India's and China's growth rates could therefore only be maintained or increased by maintaining or increasing the allocation of GDP to investment. A further implication of this data is that as an approximate guide to the macroeconomic situation the 3.7% of GDP investment to 1% GDP growth ratio indicates a macroeconomic balance compatible with overall stability - including avoiding excessive inflation. However if the actual growth rate for China or India is not supported by a level of investment sufficient to maintain the 3.7% of GDP to investment for each 1% GDP growth then macro-economic instability, including inflationary capacity constraints, will occur. As these ratios have not fluctuated greatly for twenty years they therefore give a rough but relatively robust guidance as to the level of investment required to support any given growth rate. As both China's and India's efficiency of use of investment, from the point of view of economic growth, is already very high India's and China's growth rates could therefore only be maintained or increased by maintaining or increasing the allocation of GDP to investment. India's Investment and GDP in 2009 Turning to estimating the implications of the above data for the present situation of capacity constraints in China and India no figures for the breakdown of GDP between investment and consumption are available for either country for the whole of 2009. However for India data is available for the first half of that year and China has published data allowing indirect estimates to be made for the whole of 2009. For India fixed investment in 2008 was 34.8% of GDP. Given the correlations above, this would sustain a 9.4% annual growth rate. However the 2008 figure was the highest level of investment in GDP recorded. IMF International Financial Statistics data indicates that the proportion of India's economy devoted to fixed investment fell in the first and second quarters of 2009 - no more recent data is given. In the 3rd quarter of 2009, the latest available figure, India's GDP growth was already 7.9% and accelerating. India's economy was therefore probably already approaching the rate of growth that was the maximum that could be sustained by its level of investment - acceleration of economic growth was shown by the fact that industrial production in December, for example, was up 16.8% year on year. Such a combination of accelerating GDP growth of around 8%, and a level of fixed investment which had fallen as a percentage of GDP, at least during the first half of 2009, clearly indicates that India's economy was moving up towards its capacity constraints by the end 2009. To maintain a target of a 9% a year growth rate, for example, India would have to invest 33.3% of GDP – a level achieved in only two years (2007 and 2008). While the Indian authorities stress that at present serious inflationary pressures are confined to food, and are not appearing in manufacturing, nevertheless the economy is beginning to approach its overall capacity constraints. These benchmark parameters therefore indicate that a 9% a year growth rate is just achievable for India at the highest levels of investment it has reached, but it is right up against the economy's investment constraints – confirming the recent view expressed by Nobel prize winner Michael Spence that: 'it will be hard to get to 9% and stay there.' Policies envisaged by the Indian government that would allow sustaining a higher rate of growth by inward investment to finance an increased investment level are considered below. China's investment and growth in 2009 In the case of China no data for the distribution of GDP between consumption and investment have been published for 2009 but an indirect calculation yielding ballpark figures can be carried out as figures for the contribution of different components of GDP growth in 2009 have been published. China's year on year GDP growth in the 4th quarter of 2009 was 10.7% and accelerating strongly – projections of 12-13% year on year growth in the early part of 2010 are not unrealistic. 10.7% GDP growth, using the correlation between GDP growth and investment given earlier, would already require 39.6% of GDP to be invested to be consistent with macroeconomic stability. A 12% GDP growth would require 44.4% of GDP to be invested and 13% GDP growth would require 48.1% of GDP to be invested. The latest year for which measured data for the proportion of China's GDP devoted to investment are available is 2008 at 41.1% - which would already leave little margin for even a 10.7% year on year growth rate and is quite insufficient to sustain a 12% or 13% growth rate. It is clear that the proportion of China's GDP devoted to fixed investment increased in 2009 but not by enough to maintain the very high levels of GDP growth that are likely to be reached given that acceleration beyond 10.7% growth is almost certain in the first part of 2010. The published data is not sufficient to make a detailed calculation of the proportion of China's economy devoted to fixed investment in 2009 - as the figures for the contribution of the share of different components to GDP growth that have been issued do not give a breakdown between fixed investment and accumulation of inventories and are in constant and not current price terms, However the published figures are adequate to give an overall grasp of trends. The published data show that the shrinkage of China's trade surplus in 2009 meant declining net exports deducted 3.9 percent from GDP growth. China's domestic consumption contributed 4.6 percent of GDP growth and domestic investment contributed 8.0 percent. The two together mean China's domestic demand increased by 12.6 percent in 2009 – one of the highest increases in world history.(5) While exact translation of these figures into current price terms cannot be made, if it is assumed that inventories remained constant as a proportion of GDP, and that the consumer and investment price deflators did not diverge excessively, then they imply that consumption probably rose to around 49% of China's GDP and fixed investment to around 45%. Such an increase in the level of fixed investment in China, as it came on stream, would be counter-inflationary as it would increase supply by removing capacity constraints and increasing productivity. However it is clear that, on the basis of earlier data, such a figure for investment would be scarcely enough, or insufficient, to maintain the likely rate of expansion of China's economy at the beginning of 2010 - to recapitulate the figures above, to sustain a 12% growth rate would require investment of 44.4% of GDP, a 12.5% growth rate would require fixed investment of 46.3% of GDP, and a 13% GDP growth rate would require fixed investment of 48.1% of GDP. China is therefore clearly already approaching, and may soon exceed, the rates of GDP growth consistent with macroeconomic stability even after the increase in investment that occurred in 2009. Conclusions What conclusions, therefore, flow from the situation in China and India noted above? 1. The macroeconomic examination of capacity constraints evidently clearly underlines the correctness of the Indian and Chinese authorities estimates that they face significant inflationary pressures. 2. Claims made in 2009 that China faced a decisive problem of 'overcapacity', as outlined for example in a European Chamber of Commerce in China report that was picked up in an editorial in the Financial Times, were the reverse of the truth. The dominant situation emerging in China's economy was capacity constraints and not overcapacity – as the Goldman Sachs report noted earlier rightly outlined. 3. Regarding China,the proposal made by some economists that China should concentrate simply on increasing domestic consumption, without also increasing domestic investment, is clearly wrong and would significantly increase inflationary pressures. Both increased domestic investment and increased domestic consumption achieve the desirable goal of reducing China's exposure to fluctuations in international demand/reduce China's trade surplus. However consumption, by definition, does not add to supply whereas investment does – thereby lessening capacity constraints. Increasing China's domestic demand only by increasing domestic consumption, without increased domestic investment, would therefore fail to lessen domestic capacity constraints and, other things being equal, would thereby increase inflationary pressures. China's actual economic policy in 2009, which increased both domestic investment and domestic demand, was therefore a superior policy to one of only increasing domestic consumption both from the point of view of the short term struggle with inflation and from long term growth. The Chinese authorities were correct to have implemented a balanced development of consumption, investment and trade. The 2009 stimulus package, which increased domestic demand via both consumption and investment, has left China better placed to confront inflationary pressures in 2010. 4. In India Prime Minister Manmohan Singh has frequently stressed the investment level as the decisive determinant of growth and it is therefore almost certain that India's economic policy will be oriented to ensuring that the lowering of the investment level in GDP, compared to the previous year, seen in the first half of 2009 is reversed. The general consensus behind such a policy is indicated by the editorial call in the Economic Times, India's most influential financial newspaper, for the government to 'reallocate expenditure away from consumption towards investment.' Discussion with Indian authorities confirms that a policy instrument to achieve a higher level of investment, to sustain a higher growth rate includes an acceptance of a moderate balance of payments deficit. As such a deficit is necessarily equivalent to a net inflow of savings from abroad it would raise the total finance available for India's investment. Ballpark figures indicate that double digit economic growth should be achievable on this basis of India's domestic savings plus such a sustainable balance of payments deficit. In 2007, the latest year for which full data is available, IMF International Financial Statistics figures show that India's measured savings level was 37.7% of GDP – although indirect calculation shows this is likely to have slightly fallen in 2008. If a 3% of GDP balance of payments deficit is added to the 37.7% figures, this, creating a domestic and international savings rate of 40.7% of GDP then, based on the correlations of investment and GDP growth, this would theoretically support an 11.0% growth rate. Given India's likely inflow of foreign investment a 3% of GDP balance of payments deficit should be sustainable. In short, India's attempt to achieve a double digit growth rate would appear to be realistic if it can regain its previous peak domestic savings level and supplement this by a containable balance of payments deficit. Interestingly the latest Indian Prime Minister's Economic Advisory Council projected growth rates, 7.2% in the current financial year and exceeding 8% in the next, which are significantly below these which appear possible from this macroeconomic data. This indicates either that India has ample margin to control inflation or that the projections will turn out to be conservative and India's actual economic growth will be higher than these projections. 5. China is able to finance all its investment on the basis of domestic savings. A 45% investment rate of the type that probably existed in 2009, on the basis of the correlations previously given between investment and growth, would equate to a 12.2% growth rate. Given the extreme recessionary pressures at the beginning of 2009 it is unsurprising that such a growth rate was not achieved last year but it will be interesting to see if this approximates to the growth rate achieved at least in the first part of 2010. Preliminary projections indicates that China's growth rate in likely to be relatively close to this figure – which would confirm that the macroeconomic correlations indicated above continue to operate. 6. There appears to be no statistical basis for the claim that India utilises its investment more efficiently than China. The statistical data shows that the efficiency of the use of investment, from the point of view of economic growth, is almost exactly the same in India and China. A consequence of the preceding point is that India will not be able in a sustained way to match or exceed China's levels of growth without matching or exceeding its level of investment. If the efficiency of the use of investment, from the point of view of growth, is essentially the same in China and India then the growth rate of GDP depends on the relative levels of investment in the two economies. Unless the efficiency of use of investment in China declines, or its level of investment in GDP decreases, then as long as India continues to invest a lower proportion of its GDP than China its growth rate will be lower. 7. The final conclusion is evidently that, on the basis of the above data, both India and China have sufficient macroeconomic room for manoeuvre to contain inflationary pressures while maintaining their high growth rates. Any inflationary threat appearing to seriously threaten the ability to contain inflation would seem to have to be one coming from the international arena. Even if China's growth rate in the first quarter of 2010 is around 12% this would not appear to seriously threaten, on the basis of domestic pressures, a level of inflation that was not containable - although acceleration beyond that point would hence Chinese policy makers are clearly correct to be taking measures to rein back inflation and further economic acceleration. India is locked in a short term struggle with food price inflation but the present predictions for economic growth at the Prime Minister's Economic Advisory Council appear even rather modest compared to macroeconomic fundamentals and it would be unsurprising to see India attain a higher rate of growth in the next financial years than these projections.
Historical examination shows both China and India have among the most efficient sustained uses of investment in generating growth in post-World War II history – far better than the U.S., Europe or Japan at present. China and India's economies, in short, grow so rapidly both because they have very high investment rates and because that investment is now used very efficiently – this interaction being multiplicative.
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This article originally appeared on the blog Key Trends in Globalisation.
Notes 1. In China severe winter weather helped increase vegetable prices by 16 percent in a single month in December. Within the 1.9 percent increase in the consumer price index in the year to December the highest rate of increase – 5.3 percent – was for food. China's annual consumer price index fell in January to 1.5% but food supply constraints still exist. China's producer price index rose by 4.3% in January.
In India the worst monsoon since 1972 helped produce a 18.0% year on year increase in the main staple food prices in the week to 6 February. India's benchmark wholesale price index was 8.6% in January, with India's chief statistician projecting that inflation could reach 10% by March.
In regard to short term food shortages only a limited amount can be done to lessen the effect of these domestic capacity constraints - India, for example. has been allowing duty free imports of certain items and releasing food from stocks.
2. Calculated from China Statistical Yearbook 2009.
3. Calculated from IMF International Financial Statistics.
4. Calculated from IMF International Financial Statistics.
5. This is higher even than the 11.2% increase in domestic demand this blog had estimated using earlier data and very conservative assumptions. The fact that China's domestic demand increased in 2009 even more than such preliminary and conservative calculations of course confirms even more strongly the points made in the post 'China's dramatic surge in domestic demand' of the huge scale of China's increase in domestic demand in 2009.
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