Economic growth and equity in South Asia

By Kandaswami Subramanian

(April 01, Chennai, Sri Lanka Guardian) Beneath all the current global turmoil, you will find subterranean economic currents, pulls and pressures at work. I regret the day when economists abandoned the term Political Economy and gave the subject the pretentious status of a science. It is more exciting to see the links between politics and economics than to grapple with abstract matrices and algorithms.

For more than a century, ever since that clever Scottish scribe wrote about the “invisible hand”, economists have been swearing by the “market”. The market, instead of remaining a simple institution to transact trade or business, has turned into a Jihadist ideology in the hands of many economists, especially those in the IMF and the World Bank. Successive volumes of World Development Report sought to romanticize the “market” and foist it globally. It was integral to the programs of structural adjustment based on the tenets of the so-called Washington Consensus. For thirty years, ever since Francise Fukuyama predicted the End of History, we were witness to the high tide of neo-conservatism. Fortunately, now, it is in retreat.

No wonder. The reason simply is that countries, especially those at lower levels of developments, have to evolve institutions suited to their needs and genius and there is no straight jacket that fits all. I will also argue that attempts to foist an extraneous model have caused more harm, social disruption and inequity. This is visible in all the continents, especially in the poorer countries in Asia. In recent months, even in Europe and the U.S.

These developments have led to a vibrant debate or rethinking on the subject. In a recent piece in Financial Times, Amritya Sen leans more on Adam Smith’s book on moral philosophy than on the Wealth of Nations. Robert Shiller of Yale University who had predicted the current crisis long before others writes about the need to contain ‘animal spirits’. Financial Times run a special series on the Future of Capitalism. Every economist, analyst or journalist chimes, “We are all Keynesians now”. Suddenly, copies of Das Capital have resurfaced in book shops,. It is interesting to hear the lamentation that is going on among the older economists in the crowd. My anguish is that these have come rather late and at great cost in terms of human misery and deprivation. A major share of that burden is being borne by poorer countries, especially in Asia and Africa.

“The global economic meltdown has already caused bank failures, bankruptcies, plant closings and foreclosures and will, in the coming year, leave many tens of millions of unemployed across the planet. But another perilous consequence of the crash of 2008 has only recently made its appearance: increased civil unrest and ethnic strife.” (A Planet at the Brink, Michael T. Klare, Znet, March 01, 2009).

The riots that erupted in the spring of 2008 in response to rising food prices were marked by the speed with which economically-related violence could spread. Reports in western papers such as the New York Times and the Wall Street Journal covered riots in Cameroon, Egypt, Ethiopia, Haiti, India, Indonesia, Ivory Coast and Senegal. Europe had its share of the misery in Athens, Madrid and French suburbs where Polish migrants are hated. Even China has not been spared as clashes have erupted across much of Eastern China. Though officially described as ‘mass incidents’, they suggest protests by workers over sudden plant shutdowns, lost jobs, pay, etc. China lost 40 percent of its exports last month. The sudden contraction in exports drives people out of the once legendary export zones. Nearly 3 million workers are said to have lost their jobs.

For long, the US Treasury, Fed and neoconservative economists lived in self denial. They were more than convinced that the financial institutions in the US and Europe were strong and resilient and that, given time, the market would correct itself. Of course, they would pump in billions of tax payers’ dollars. While doing so, they breach all the canons of prudential banking which they taught us for decades. They forget all the dire warnings they gave about fiscal deficits when engaged in by developing countries.

Since August 2007, more than a trillion dollar has gone down the black hole and the credit market is yet to revive. The credit spreads continue to gape at the Fed and ECB. Though there is too much liquidity in the system clogging the pipes but, unfortunately, the bankers lack the spleen to transmit it to their counterparts or to entrepreneurs. Confidence in counter party ability to bear or honour risk has not been revived and credit flows remain frozen. Pumping more dollars seems like shipping a dead horse to run.

On date, efforts are on, truly heroic, by the Treasury to clean up the toxic assets or detritus in the banks. All the earlier experience of Secretary Geithner in the New York Reserve and the wizardry of the US Treasury and the team of legendary Economic Advisors including Lawrence Summers seem to take them nowhere. In fact, the capability of the US administration to handle the crisis is itself in doubt. Other parts of the world, especially Asia and the weaker ones in South Asia, are awaiting US revival. Unfortunately, so much of their own economic fate is tied to US revival.

It is amusing to look back on the early days, that is, the mid 2007 when the crisis broke out. The emerging economies grouped as BRICS (Brazil, Russia, India and China) in a report by Goldman Sachs titled Dreaming of BRICS brought out in 2003 drummed up global imagination. It was music to the ears of emerging economies, especially to political leaders in countries like India which were included in the report. It referred to the growing power of those countries in the global economic and to the emerging shift in economic balance.

BRICS report was true in parts. Perhaps, it had a hidden agenda. In retrospect or with hindsight, it is clear it over stated the case. Coming from an investment bank with deep interest in investment advisories in growing stock markets, it was an attempt to lure investors into the Asian market which was considered very risky then. It did succeed in promoting investment flows, in particular portfolio flows, into Asian markets, especially the big ones like Singapore, Hong Kong and India. Unfortunately, it also lulled those countries into euphoria and gales complacency. Incidentally, G7 also began to look to the BRICS and involve them in their meetings. For the poor cousins, it was an honour to be invited to sit and share the high table with big powers.

When the crisis broke out, it even bred the smug view that emerging economies were ‘decoupled’ from developed economies and were safe. Some leaders in those countries bragged that they were insulated from the crisis and said they could help the developed economies and provide a buffer to absorb the shock. The “decoupling” mantra was changed at the Davos Economic Forum and elsewhere. Sadly, subsequent later developments belied its tenability. The crisis proved too turbulent and uncontrollable and began to drag all the countries across the globe. What began as a financial crisis began to hurt the real economy in both developed and developing economies. Rather, it was question of degree and developing countries were more hurt. They had higher rate of growth in the aggregate or in statistical terms though not equity. When the crisis struck, they lost both.

It was only by the end of 2008 or early 2009 that IMF and World Bank were seized of the crisis and its gravity. In earlier months, they had under estimated the impact. In successive reports such as World Economic Outlook (WEO) and Global Economic Prospects (GEP) they trimmed incrementally global growth rates. They had not foreseen the crisis in all its ferocity and depth.

For the first time, in its GEP brought out in December 2008, the World Bank acknowledged the marked slowdown everywhere including formerly resilient developing countries. It predicted that global GDP would slip from 2.5 percent in 2008 to 0.9 percent in 2009. Developing country growth was expected to decline from a resilient 7.9 percent in 2007 to 4.5 percent in 2009. Growth in rich countries was estimated to be negative.

Releasing the Report, Hans Trimmer of the Bank said, “We see that the global economy is transitioning from a long period of strong growth led by developing countries to one of great uncertainty as the ongoing financial crisis has shaken the markets worldwide”. “The slowdown in developing countries is very significant because the credit squeeze directly hits investments, which were a key pillar supporting strong performance of the developing world during the past 5 years”.

The WB assessed that with tighter credit conditions and less appetite for risk, investment growth in developing world would fall from 13 percent in 2007 to 3.5 percent in 2009. It was deeply significant since a third of GDP can be attributed to it. The Bank economists also assessed that world trade would contract by 2.1 percent in 2009. For the first time since 1982, the world trade would shrink and all countries would be affected by this drop in exports which was due as much to the slowdown in global demand as to the reduced availability of export credit.

As they went on to elaborate, Growth in South Asia eased to 6.3 percent from 8.4 percent in 2007 and was expected to slip to 5.4 percent in 2009. “High food and fuel prices, credit conditions and weaker foreign demand have led to worsening external accounts and slower investment growth. The downturn is most apparent in India and Pakistna where industrial production fell sharply”.

In many ways it was an unfortunate. The crisis hit South Asia at a time when it had barely recovered from severe terms of trade shock from the global food and fuel price crisis. The food price inflation started to build up around August 2005, reached double digit levels in mid-2006, crossed 20 percent in September 2007 and accelerated to 43 percent by March 2008. The World Food Program (WFP) made dire predictions about famine in parts of the world. Rice had disappeared from the global market and countries like Philippines and Thailand faced acute shortages. Shockingly, before the reforms era, they were exporters of rice. Under IMF reforms, they vacated rice production and created import dependency. When rice trade was in a shambles for various reasons, they could not import rice from any sources in the global markets! For the World Bank, it was a development beyond repair and it had to face the horror of its poverty alleviation program being wiped out. It did make feeble noises and promised support. However, very soon, drop in commodity price inflation lifted the danger.

It was evident to many economists and analysts that the commodity price inflation was brought about by the disruption in the market and the entry into “commodity futures” of hedge funds and other speculators. Commodity had become an asset class and speculators moved away from low yielding stocks into commodity futures. Indeed, they were helped by the loopholes governing the relation between New York and London Exchanges. I have dealt with this at length in a separate paper. (The Fund, Fed and finance feed the famine, Business Line, 16/05/2008).

For its own ideological reasons, the GEP 2009 does not relate the price volatility to speculative forces. It says, “Recent sharp declines in oil and food prices mark the end of what has been the most historic commodity price boom of the past century. Like earlier booms, this one was driven by global economic growth and has come to an end with the abrupt slowdown in the global economy precipitated by the financial crisis”.

Sadly, what the GEP failed to note was that around that date the crisis was precipitated by disproportionate asset inflation unrelated to the requirements of the real economy. In truth, it began to hurt the real economy. However, the links were devious and through banks, especially investment banks like Merrill Lynch and Lehman Brothers which were shadow banks cohabiting the hedge funds, private equity, etc.

It is a long and vexing story and I do not wish to tire you with more details. By now it is agreed that at the root of the crisis lies this monster called “derivatives”. According to a report in Asia Times (Swallow before summer, John Browne, February 21, 2009) which quotes the Bank for International Settlements (BIS), “the world’s total of derivatives investments, including poorly understood credit default swaps (CDS) market reached some US$ 700 trillion at its height or more than 20 times the world’s total annual production. The American portion was about $419 trillion, or some 40 times American annual production”. The imbalances between the money and real economy were unsustainable.

Moreover, the inherently risky securities were used as collaterals for loans. There was massive leveraging leading to new issuances, bonds, etc. The fall in their values resulted in deleveraging which caused all the pain and damage. They are owned by he3dge funds and other mysterious entities. With the fall in values and claims for redemptions, these institutions seek to withdraw from the market suddenly, even at a loss. According to the latest Lex Column of Financial Times (March 24, 2009), “Hedge funds suffered net outflows of $194 bn last year as bedraggled investors pulled their money out according to Hedge Fund Research. Most respondents to a Deutsche Bank Survey of investors worth $1,100 bn managed by hedge funds expect more than a fifth of hedgies to fold in 2009. Close to a third expect outflows to top $ 200 bn this year”. Overall, hedge funds were reported to have lost half their value of about $1 trillion.

It is this phenomenon which brought down the stock markets in Asia, especially in India. In India, legally hedge funds are not allowed to operate. However, the Government and the SEBI wink at them when they operate through other means. The most venerable form is the Participatory Note (PN).

Hedge funds operate through foreign financial institutions (FIIs) via PNs. The exodus of hedge from global markets led to the precipitous fall in Indian stock market values. Stock values have fallen to low levels of around 60 percent. According to the Reserve Bank data, last year, the FIIs had withdrawn $ 23.7 billion. This had also brought down our foreign exchange reserves to uncomfortably low levels and affected our ability to withstand future shocks.

According to a study sponsored by the Asia Development Bank (Global Financial Turmoil and Emerging Market Economies: Major contagion and shocking loss of wealth? Claudio M Loser), “financial assets in emerging Asia rose from 250% of GDP in 2003 to 370% in 2007, an increase in the ratio of 48%”. The report assesses the loss in value of assets and takes into account the impact of currency depreciations, decline in stock prices, and the loss or private and public debt and effect of depreciation on deposits. It finds that “the estimated losses are very large and since end 2008… more than US$ 9 trillion (109% of GDP) for Emerging Asia and the NICs”.

The Report concludes: “Such losses will have an enormous impact on domestic expenditure. The terms of trade/export decline effect will aggravate the situation, as it will reduce incomes by 2.2% of GDP. Thus, emerging market economies economic growth in 2009 will decline by at least 3 percent”.

The UN Commission for Social Development had also studies the impact of the crisis on social development in a document issued as a follow up of the 24th Special Assembly of the UN General Assembly. (The current global crises and their impact on social development, 20th January 2009, E/C/N/5/2009/1). It dealt with several aspects such as the impact on growth and macroeconomic stability; employment; poverty; social expenditures and inequality; and social development and policy directions. The foremost concern expressed was: “The Department expresses considerable concern about the prospects for developing countries and their ability to meet the Millennium Development Goals (MDGs)”. May NGOs and activists have drawn attention to the fact that developed countries (OECD) dragged their feet and could not provide a few billion dollars to meet their aid commitments and help to achieve MDGs by developing countries. They did not hesitate to pump in trillions of dollars overnight to bail out their banks.

On poverty, the report assessed that the poverty situation had already been made worse by the rising food and energy prices. It calculated that the growth slowdown in the developing world as a whole will add another 60 million to the ranks of the poor. Referring to a World Bank assessment of the fall in the number of people living in poverty line by 300 million, it added, “It is trivially obvious how deep the reversal has been so far – about 60 percent of the gains in global poverty are likely to be wiped out between 2008 and 2009”.

It dealt with the impact on social expenditure and policy direction graphically. Even as public funds are used to support faltering financial sectors, it “raises the fear that the allocation of public resources for social development will be pushed further down the ladder of priorities”. “A great concern is that the most marginalized and vulnerable groups, such as the poorest people, indigenous peoples, persons with disability, youth and older persons will be disproportionately affected by the cutbacks in social expenditure”.

Not to be outwitted or in miss the bus, the World Bank changed its tunes and laments the fate that has befallen developing countries. It is in a note prepared for the meeting of G20 Finance Ministers and Central Bank Governors on 13-14 March 2009. The Bank highlights disturbing facts. (Swimming Against the Tide: How Developing countries Are Coping With The Global Crisis, World Bank). It notes that global industrial production declined by 20 percent and high income developing country activity plunged by 23 and 15 percent respectively. It estimates that developing countries face a financial gap of $270-$700 billion depending on the severity of economic and financial crisis. It is pessimistic about the ability of the financial institutions to meet financing needs of the countries. As it explained, “The challenge facing developing countries is how, with fewer resources, to pursue policies that can protect or expand critical expenditures, including on social safety nets, human development and critical infrastructure”.

The report foes on to elaborate that 94 out of 116 developing countries have experienced a slowdown in economic growth. Of these, 43 have high levels of poverty. “To date, the most affected sectors are those that were the most dynamic, typically urban-based exporters, construction, mining and manufacturing”. “More than half a million jobs have been lost in the last three months of 2008 in India, including in gems and jewellery, autos and textiles”.

Not to fall behind, the IMF has also come out with a similar report this month. (The Implications of the Global Financial Crisis for Low Income Countries, IMF, March 2009). It refers to budgetary strains affecting financial stability and in particular on the ability of the countries to take measures to protect the poor.

Sadly, the preaching is loud. The fund does not have the resources to come to their rescue in a meaningful way. While developed countries like China with huge reserves to provide them. In any case, considering their past performance, the developing countries are averse to getting any assistance from the Washington Twins.

The current vulnerabilities of these economies were the result of FUND/Bank policies based on structural adjustment or the tenets of Washington Consensus. Countries were forced to open their economies and their financial system to foreign investment without creating in advance the required depth and institutional infrastructures to withstand shocks.

Reliance of foreign capital and foreign inflows (portfolio flows) led to vulnerabilities in the banking, financial and foreign exchange markets. I have already given lot of data on asset inflation created by inflows and on the withdrawal by hedge funds. These reinforced each other.

It was the basic assumption of the Fund and the Bank that these flows would never cease and the impact of foreign capital was always beneficial. While promoting capital convertibility, they were playing into the hands of bankers and financiers (read, Wall street!) and did not foresee the contingent crisis implications. In their so-called financial architecture elaborately worked out, there was no provision for restricting inflows at source to safeguard financial stability in recipient countries. Incidentally, even in all the proposals given to G20 do discuss and decide global financial regulation, there is no provision of this nature. All proposals are west oriented and developing countries don’t come in their radar. The issue is very import for them.

By now we have a rich body of academic studies and research on this area. Some of them have been brought out by the Twins. It is the broad consensus that capital inflow by itself will not create growth unless there is depth in the financial market duly endowed the supporting infrastructure. In the absence of these, foreign inflows may play a negative role and weaken the banking system. It can also hinder the ability of the Reserve bank of manage the exchange rate for the rupee. C.P. Chandrasekhar and Jayati Ghosh have elaborated this clinically in a piece published yesterday. (Macroscan - Balance of payments portents, Business Line, March 24, 2009.)

A number of academic studies have also been published on international capital flows or what are called ‘capital bonanzas.’ In a perceptive and exhaustive study (Capital Flow Bonanzas: An encompassing View of the Past and Present, Carmen M. Reinhart and Vincent R. Reinhart, NBER Working Paper No.14121, September 2008) two economists made a study of both advanced and emerging economies. They covered 181 counties for the period 1980-2007 and a sub set of 66 countries for the years 1960-2007 for all regions. They take the view: “Bonanzas are no blessing for advanced or emerging market economies. In the case of the latter, capital inflow bonanzas are associated with a higher likelihood of economic crisis (debt defaults, banking, inflation and currency crashes). The study referred to earlier would also confirms these findings. Given these trends, India would have become vulnerable in due course. The global crisis has quickened the pave and brought it forward. It is indeed true that our banks are safe and have been well regulated by the RBI. But our economy has become vulnerable. The UPA government, in its attachment to the reform process did not heed the warnings of its Left partners. The left succeeded in limited areas like FDI in retail, entry of foreign banks into India, insurance, public distribution program including employment and privatization of public enterprises. As a result, we do have large measure of public safety and equity. This is missing in countries which are autocratic and formally democratic.

Reliance on exports as a strategy for growth was flawed as it assumed that the metropolitan economies will continue to expand for ever. It did not provide for the conflict for markets as between developing countries and the adverse terms of trade. It did not reckon with the need for continued availability and flow of trade credits. Currently, they have dried up and banks in developed countries discriminate against our banks. The swaps provided by the Fed and the ECB do not extend beyond a “charmed circle.”

This apart, excessive reliance on exports tends to weaken domestic production structures and crate vulnerabilities when export markets decline or collapse. I have already referred to the World Band on Indian unemployment in urban export sectors. China is a testimony to this though they were wise enough to confine exports to the southern zones. It did not provide for the unfair regulations imposed by the WTO.

Neglect of agriculture and elimination of subsidies led to the destruction of public distribution system (PDS) in many countries and created food insecurity or even famines in some, e.g. Malawi and Ethiopia. Privatization program of the Fund/Bank bred fragility. The Independent Evaluation Group (IEG) of the Bank drew attention to the while criticizing its agriculture programs in Africa. Though the idea was to vacate the role of the government to enable private sector to step in and make agriculture more efficient, as the IEG explained, “in most reforming countries, the private sector do not step in to fill the vacuum when the public sector withdrew.” Unfortunately, reforms programs failed to promote food security as an anchor. The current crisis has been exacerbated by the weakened role of public sector. If there had been democratic pressures as in India provided by Left partners in coalition governments, there would not have been severe food price/supply crisis. It is ironical that the most recent Congress Manifesto promises rice at three rupees per litre. They have been crying hoarse over the debilitating impact of subsidies. This is yet another impact of democracy on reform politics.

In the post-war years, especially after the ascendancy of the Washington Consensus, the development model which evolved and attempted in the earlier years was abandoned. The adjustment programs put through under the aegis of the Fund/Bank have created serious vulnerabilities. These have been elaborated at length.

The Washington model has been unmindful of public equity and welfare and is more tailored to suit the interests of foreign investors. It puts its faith in higher growth and output and hopes for welfare to trickle down. The logic has not been accepted by developing countries. The Twins have taken note of resistance to their programs and strategies. But unfortunately, given the management and voting structure of these bodies, they have been unable to change. As a result, most developing countries decided to stay way form them.

A year ago, the IMF found itself in an unenviable position where it could not even meet its own budgetary expenses. It is trying to take a new birth exploiting the current crisis situation. Only hope is that G20 which now consists of many members form developing counties, especially China, will not succumb to these pressures. India has always been a camp follower and may not be able to bring any radical idea to the table. There are misgivings about what G20 can achieve in a day.

By and large, the Fund/Bank model may have promoted high rates of growth in some countries. The rate was indeed in the aggregate or in statistical terms. It concealed for long the financial bubble on which it rested. It was regressive in nature and led to grave inequalities and inequities. It sacrificed equity. Where democratic forces were able to contain the reform process, it ensured equity. Unfortunately, it has not been uniform over time or across countries. The recent crisis has proved that in the coming years, at least three or four, there will be neither growth nor equity, Unless and until we evolve a new model of development which is inclusive, the goal appears to be elusive.

(This paper was presented on 27 March 2009 at the "National Seminar on Democracy in South Asia: Challenges and Responses" held at Pondicherry The writer is a Former Joint Secretary, Ministry of Finance, Government of India)

-Sri Lanka Guardian