PART I: Economic Developments
Centre of gravity shifts to China from Japan in the 1990s
The period since the end of the Cold War has seen significant changes in the economic structure of the region, and this essay will first highlight the nature of these changes. Later, it will touch upon a few of the important political aspects of the region.
At the end of the Cold War, in the late 1980’s and the early 1990’s, the dominant economic presence in Asia was Japan. With a GDP of $3.02 trillion, it was the second largest economy in the world, and the largest in Asia, by a wide margin. More important, its GDP growth did not stagnate after the dramatic collapse of its stock market in 1989; indeed, its GDP continued to grow rapidly up to 1995 – from $3.0 trillion in 1989, it reached $5.3 trillion in 1995. The total value of its exports in 1990 was $288 billion, larger than the rest of ASEAN combined. It was only after 1995 that the stagnation set in.
This was also the time that China was beginning its spectacular rise. The starting point was the devaluation of the Yuan in early 1994 by 40%. At the same time, Japan was coming under sustained US pressure to raise the value of the Yen. As a result, the Japanese went along with US advice and their currency hit one of its highest values ever, rising below 80 Yen to the Dollar for the first time in history. What this did for the flow of investments is shown in the table below, taken from the ADB:
Table 1 Foreign direct investment, total net
There is a marked rise in the FDI into China, and a decline in Japan. Japan chose to invest in the rest of Asia, especially Thailand. The fall in the value of assets and labour costs in China as a result of the weak Yuan, and, in contrast, the rise in asset values and labour costs in Japan, consequent upon the sharp rise of the Yen, ensured this result. Equally noteworthy is the effect of this currency realignment on FDI in Southeast Asian countries too. Most of them saw a decline in their FDI in either absolute or relative terms, as more and more of the FDI went into China.
The second important development was the Asian Financial crisis that followed It reinforced the FDI trends outlined above, and China emerged with still higher rates of FDI, while Japan remained a net exporter of capital. Among Southeast Asian countries, Singapore alone managed to maintain FDI levels, while all the other major economies suffered a decline.
The effect of this change in investment patterns in Asia was reflected in the changed patterns of trade that followed and was shaped over the two decades or so following the end of the Cold War. The following table, also from ADB reports, shows the change over the period 1990 to 2007, the last normal year, just before the global financial collapse. It brings out clearly that China switched roles with Japan as the principal Asian exporter to the US and the EU. Alone among all the major Asian economies, its relative exposure to these two markets went up significantly – nearly doubling to the EU and more than doubling to the US [in terms of percentages of total exports]. All the other economies, with the partial exception of Indonesia and Malaysia, showed exactly the opposite trend.
In these countries, the share of Asia in their exports went up while that of the EU declined; in most cases the relative weight of the US also declined, including for countries like Japan and Australia. The rise in exports to the rest of Asia is a confirmation of the export of intermediate goods to China that were finished and re-exported from China to the rest of the world. Many Asian companies set up finishing assembly lines in China to save on costs. India provides a partial exception, in that its exports to the US showed a marginal increase.
2: Direction of trade: merchandise exports
It would be important to add the picture of import patterns as well. This shows that for China alone, Asia dropped in importance as a source of imports; for all the other countries covered here, Asia grew in importance – meaning, of course, imports from China came to be increasingly important for these countries. Another noteworthy point is that for China, in 1990, the three main areas in the Table – Asia, Europe, and North America – accounted for close to 90% of its total imports; by 2007, this figure was down to 65%, as it sought raw materials in other parts of the world to meet its industrial needs.
Table 3: Direction of trade: merchandise imports
To sum up, the period after the Cold War saw a marked shift in the pattern of investment and trade, which placed China at the centre of the money flows (capital and trade flows, rather) linking Asia with the rest of the world, especially Europe and North America. In a sense, the pre-Cold War pattern of economic interaction in Asia, which had Japan at the centre, was displaced by one that brought China into that role. The entry of China into the WTO in 2001 was an added factor that boosted both FDI and its trade exchanges – and again, the US was one of the principal promoters of this development.
Most of the data given in the tables above are percentages – only the FDI figures are actual magnitudes. When we bring in the actual figures for all these activities, we see also the explosive growth that actually took place. The investment figures for China alone show a 400% increase between 1995 and 2007. Trade figures show a similar explosive growth. Between 1990 and 2007, global trade, dominated as it was by Asia and the OECD area, grew 300%; global GDP grew just 50% over this period.
The ‘Triffin Dilemma’ and the Dollar
These figures bring in the so-called Triffin dilemma: that the currency required for financing trade will become debased over time, since the country that issues this currency must run current account deficits, and hence the value of that currency must steadily depreciate. That has been the story of the US dollar and of the US economy. Financing the demand for trade was thus a major challenge – and one that the US Federal Reserve took the lead in meeting, though the European and even Chinese central banks also contributed.
Source: www.nowandfutures.com
This led to very high rates of monetary expansion in the US, rates that were certainly higher than the GDP growth rates would have justified. Under normal circumstances, one of the results of this would have been inflation, but this period saw, instead, a rapid rise in asset values – particularly equities and real estate. In addition, there has also been a consumer boom, fed again by easy money. In the chart above, it is important to point out that the figures for M3 after 2006 are derived from other data, because the Fed stopped publishing these figures from early 2006, the time that a new Chairman took over.
But there is another very significant aspect that needs to be highlighted. Fed data on M3 go back to at least 1959, and the Fed also shows M3 figures after removing M2 values [“Non M2 M3”]. This in effect, gives a broad indication of the role of foreign money in the overall money supply in the US economy. The data show that this value – non-M2 M3 as it is called in the Fed data – was 1% of the total in 1959, but by 2006, it stood at 35% of the total money supply.
In order to understand the process of finding an outlet for the vast sums of money and savings being generated in this process, a little history would be useful. The kind of rapid growth and concentration of wealth in a few countries that the 1990’s and the 2000’s produced, had happened once before – in the 1970’s, after the rapid rise in oil prices. The US archives of the late 1960’s and early 1970’s bring out the dilemma that the country faced then. Demand for liquidity to finance global trade was growing much faster than the Federal Reserve could meet. The reason was that the US dollar was on the gold standard and that placed a strict discipline on the amount of liquidity that could be generated.
In the event, the Nixon Administration took the dollar off the gold standard in 1971, and finally, in 1973, allowed the dollar to free-float, thus removing the restraints on the Federal Reserve to loosen the monetary aggregates. This allowed the four-fold jump in oil prices to be absorbed, and for trade to continue to expand rapidly. At that time, i.e., in the 1970’s, western banks transferred the surpluses generated to East Europe and to Latin America. Of course, it had also led to the high inflation that the Reagan-Volcker team was determined to fight.
It was not hard for Reagan and his team [chiefly the Chairman of the Federal Reserve Volcker] to squeeze Money supply in the late 1970’s and early 1980’s because the affected parties were the Eurodollar markets [which did involve some US banks, mainly commercial banks] and the recipients of the loans were in East Europe and Latin America. The result of the monetary tightening was a sharp recession in the early 1980’s. This period also saw a decline in oil prices, and a slowdown in trade. In turn, this shows that an accommodating monetary stance in the early 1970’s was a necessary condition for world trade to continue its rapid growth, and to absorb the higher oil prices.
A similar boom in trade [and oil prices] started again in the late 1990’s, but this time the big trading power, as shown above, was China. And once again, the US monetary policy accommodated the requirements of the booming trade and the consequent rise in commodity prices. And once again, huge surpluses began to be accumulated by the major exporters. Thus was born what Alan Greenspan was to call the global savings glut. But, this time round, the recycling was done within the US itself – in various financial instruments and the housing sector, including mortgages to customers who were unable to pay off those mortgages – and the most exposed were the US investment and commercial banks themselves. Hence, when the sub-prime crisis broke, the US financial authorities had no option but to do everything to contain the knock-on effects of this crisis. This is why the cycle this time is playing out differently and the outcome is still uncertain. At least as far as America is concerned, there is no clear consensus even on the diagnosis. Fixing the problem is still some distance away.
Export-led China economic boom now over
The foregoing provides the backdrop to the current economic situation. It is now possible to take stock of the situation as it stands today. The most important conclusion that may be drawn is that the Chinese economy is facing two major structural challenges. The first is that the period of easy money in America is coming to an end. Even if there is another round of quantitative easing, it will be short-lived, and its results will be disappointing, as they have been for the two earlier rounds. True, interest rates are effectively zero, as they are in Japan and the EU. However, the two rounds of quantitative easing have not been universally welcomed and their results, as mentioned above, are definitely mixed.
What is more, despite the QE, as the graph above shows, all the money aggregates have fallen in the period up to the middle of 2011. Necessarily therefore, the Chinese central bank has had to step up its liquidity injection, and it has done so with a will. Chinese M2 figures today have reached close to 200% of the GDP. This monetary expansion is causing inflationary pressures, since the asset markets in China are not as well developed as in the West. Secondly, they are also causing asset prices to go up, especially in real estate, which accounts for some 20% of the Chinese GDP.
The second major structural challenge before the Chinese economy is to cope with the declining export markets. The US market has held up well, and US imports are now higher than in 2007, the last normal year before the financial upheavals began. Nonetheless, China’s export performance has suffered: since its record trade surplus in 2007 of $295 billion, it has seen a consistent decline to the point where in 2011 it was down to $155 billion – or a near 50% decline on four years. The leaders are clearly aware of this challenge and have been trying to shift to domestic consumption as the driver of the economy. But, the results so far have not been encouraging. In 2010, the level of domestic consumption was just 33% of GDP, though it had risen somewhat in the last year.
One could go so far as to say that this model of economic growth – heavy reliance on FDI, and export-led growth spurred by that foreign investment, plus an accommodating monetary stance in the US – has run its course. There is nothing surprising in this. In their time, this was precisely the model adopted by Japan and Korea and then by the Asian Tigers. The fact is that this model gives very rapid rates of growth, but cannot be sustained for more than two decades or so. The Chinese are now facing the same limitations, and it would be fair to say that this model has run its course.
It also allows us to draw the conclusion that China remains more dependent on America for its continued growth than the other way round. The clearest evidence for this may be seen in the fact that, in the period after 2008, Chinese markets bounce whenever the Fed signals an easing, and slip when the reverse happens – the causal relationship goes one way only.
Equally important, the real economy in China is clearly running into trouble. Not only are the figures for exports, imports and GDP growth indicating a clear slowdown, there are troubling signs of growth of inventories of industrial products, unsold housing and commercial units, and even declining sales in the auto industry. These are the biggest sectors in the Chinese economy, and together add up to serious dangers to the Chinese growth model in the future.
There is one more issue to be disposed of. It is frequently mentioned in the media that America is dependent on China for the deficits it is running up. It is argued that America imports the money that it uses to buy from China and for its other [profligate] expenditure. The table below gives the actual picture. It shows two things. It shows that Chinese holdings are actually off the peak of July 2011, when the Chinese held US$1.3 trillion in US Government paper. It fell to US$1.15 trillion in august 2012 and has risen again to US$1.26 trillion at the beginning of 2013.
The table also shows that Chinese holdings amount to 20% of the total foreign holdings of US debt, and this itself translates to 6% of the total US debt. It is high, but a far cry from the kind of dependence that the media projection would imply. Of course, none of this should suggest that the US debt is not a problem – it unquestionably is. And QE3 is not helping. But the question of dependence on China is what is of concern here, and that is clearly not the case. In fact, Chinese monetary figures are causing greater concern, both because of the monetary aggregates mentioned above, and also because non-performing assets in the Chinese banking sector are growing and are being re-located in off-balance sheets vehicles. This kind of manipulation rarely ends well.
Source: US Treasury; figures in US$ billion
India faces different challenges
A discussion of these two hurdles facing the Chinese economy is a natural prelude to a brief discussion of the Indian economy. It has the advantage of being driven by domestic demand, with a level of domestic consumption of 65% of GDP. For many years, it was argued that India was not doing enough to develop its exports. In retrospect, the fact that its exports – while growing at a healthy pace – still did not dominate its GDP has turned out to be a plus. Equally, its monetary policy has been restrictive rather than expansionary in the past few years. As a result, it has the option of reducing interest rates when the time is right – i.e., when the fiscal deficit is under better control and better managed by the Government. In fact, the fiscal deficit is the most important weakness in the Indian economy now and it is admittedly hard to tackle for political reasons.
The Indian economy is in need of infrastructure more than anything else and this is where Governmental effort really needs to be focused. Unfortunately, the pace of progress here has been slow. This has been the most important factor holding back Indian growth and is tied to the fiscal deficit, which is crowding out investment in infrastructure. There is a clear understanding among Indian policymakers that this needs to be addressed. The largest items contributing to the fiscal imbalance are subsidies and a start has been made in the petroleum sector to lower these. Food and fertilisers are the other major items and these will clearly be the last to go.
In the Asian setting, what this means is that India remains less exposed to international trade and capital flows than the East Asians were, and hence better equipped to deal with any economic downturns that the global economy may face. This will change over time, but the process will be slow, presenting a degree of insulation to the Indian economy from global headwinds for quite some time. Put differently, India’s challenges are mostly domestic and political.
PART II: Political Developments
On the political side, it would be important to begin with a mention of a certain disjoint in US economic and politico-military strategies in Asia. The foregoing section has shown how America has provided the necessary conditions for the Chinese economic boom since the mid-1990s – through easy money policies; through opening its market for consumer goods [this includes a consumer credit boom]; perhaps also not putting enough pressure on China to allow its currency to find its market value. However, on the political side, US policies have progressively become tougher on China since the end of the Cold War. This dichotomy has held regardless of the nature of the political power in Washington: it was the same trend we saw under President Clinton and there was no real change under President George W. Bush. It continues under President Obama, after an initial wobble towards political accommodation as well. This may be one of the principal reasons why some of the other Asian nations are reluctant to commit to US strategies in the Asia-Pacific.
With this disjoint in mind, it would be fair to acknowledge the fact that an adversarial axis is nonetheless emerging in Asia-Pacific between the US on the one hand and China on the other side. For a variety of reasons, and with some reservations, India is leaning towards the US-led western consensus. In America, though, this is not recognised, and instead, there is a growing consensus among analysts that India has not done enough to reciprocate the effort and goodwill that America has invested in the relationship. It is necessary to address this concern.
Some time in the mid-1960s, the Pentagon did a review of the emerging global situation as a result of the Soviet-Chinese split, and decided that the USSR remained the principal security threat. This, in a way, provided the intellectual underpinning to the opening to China, which followed shortly after. Since the American bureaucratic process remains as deliberative as it ever was, it is not hard to imagine that there was a similar threat assessment after the end of the Cold War, and the Pentagon took the view that China was the main threat now, with the USSR gone, and a pliant Russia in its place.
Shift in American attitude towards South Asia in the 1990s
Whether for this or other reasons, it is clear that a change occurred in American approaches to South Asia some time during the second half of the 1990’s. The first Clinton Administration had been a serious thorn in India’s side, and President Clinton became the first US leader since the mid-1960’s to utter the word “Kashmir” in the UN, which he did at the UNGA session in September 1993. To say there was acute concern in Delhi over this would be an understatement. But, happily, by 1997, two US think tanks had come out with a joint Report, calling for a new look at relations with India, while maintaining the existing close ties with Pakistan. It was clear that the motive for the new thrust was the danger emanating from China and the authors of the Report, as well as official American visitors, minced no words in spelling this out.
The change in the approach towards India became clear beyond peradventure after the nuclear tests in May 1998. There was the expected strong reaction from America, of course. However, it was quickly replaced by a dialogue – the first serious one between the two countries. The US President paid the first visit to India in 22 years by an American President, in March 2000. This was clinched during the Kargil war, where America was seen to have backed the Indian position and forced Pakistan to pull back its troops from across the Line of Control.
Implications of America’s China policy for India
The tussle in America over China policy continued and continues. This is a source of concern for India. In 1998 itself, the joint US-China statement issued after the President Clinton’s visit was very troubling. For a start, this came after the nuclear tests, and so there was a stand-alone document on South Asia, which gave to China the role of arbiter in the region. There could not be a more negative message for India. Clinton also became the first President to visit China without also visiting Japan or South Korea, much to the concern of the two allies. It betokened a primacy to China in the eyes of the Clinton Administration, because this was done at the insistence of the Chinese leadership. Therefore, it was a source of serious concern for all the major Asian countries.
Unfortunately, this attitude was reflected again in the joint statement issued at the end of President Obama’s visit in 2009. It was accompanied, and preceded by much talk of a G2. All this serves to tell us that there is an influential constituency in America that favours a strong strategic link-up with China. When this is coupled with talk of how America is dependent on China in the economic sense [which it is not], this makes many Asians ask themselves whether the statements emanating from the Pentagon or the National Security Council reflect the true or even the dominant thinking within America. It would be important for America to address this. One easy test is available: the Pakistan-China agreement on Chashma 3&4. While the first two reactors could be considered to be grandfathered under the NSG guidelines, these subsequent ones clearly are not. US acquiescence in this is bound to be tied up with the country’s approach to both China and Pakistan – and such American acquiescence is bad news for India, regardless of what the Government of India says – or doesn’t say.
It is important to emphasize that there is a lot that the Indian Government does not say. The reality is that, if India were to be more active in support of the US security approaches to the Asia-Pacific, one of the likely reactions of the Chinese would be to apply military pressure on India along the disputed land frontier. The further fear is that, in such an event, India would be alone in facing such pressure. One possible answer, and a very telling one, would be to raise the international focus on Tibet.
Further, there are three issues concerning Tibet that are genuine and legitimate concerns for the international community. The first is the question of Human Rights; the stream of self-immolations that Tibet has seen for at least the past three years is unprecedented and has not received the sympathy and support it deserves. The second is the question of water rights; the Chinese authorities have been building dams and diverting rivers in a way that affects all the lower riparian countries in both South Asia and South-East Asia. This is again a genuine cause for concern, and Tibetan waters are vitally important for many countries in Asia. The third is the fact that there is a UNGA Resolution dating back to 1961 calling for self-determination for Tibet. Admittedly, much has changed since then, including the Dalai Lama’s own proposals to the European Parliament in 1988, but all of these are indications that there is a legal-political issue that needs to be addressed. There was a time when America was keen to raise this matter and India was not. Since then, things have begun to change and it may be time to take a second look at how to approach the matter.
America’s Pakistan Policy – Need for Change
Another issue needs to be raised as well. This concerns Pakistan. America has had a special relationship with that country right since the early 1950’s, based principally on the US assessment that Pakistan was a valuable ally against the USSR. Pakistan, in turn, has made no secret of its own assessment that India was its only enemy, no matter what the Americans said or did during the Cold War. It was only in the 1980’s that both countries really fought the Soviets together, in Afghanistan. Since then, their ways have diverged again, especially over the war on terror. Nonetheless, America has never provided consistent backing to India, despite the growing evidence of Pakistan sponsoring terror against India. True, cooperation in this area has improved, but there is the puzzling decision to accord Pakistan the status of major non-NATO ally. Also, American policies in South Asia remain cautiously neutral on Indo-Pakistan issues.
There is a way for America to address Indian concerns on this score too. This concerns the Line of Control in Jammu and Kashmir. As determined in the 1949 cease-fire agreement signed in Karachi, the line is delimited and demarcated up to the point NJ 9842 on the map. Beyond this, it is supposed to go “north to the glaciers”. For many years, nothing was done about this, but the US Defence Mapping Agency in the late 1970’s, put out maps depicting this line running North-East towards the Karakoram Pass. This line reflects neither the legal position, nor even the actual line of deployment. Since 1984, Indian troops have been deployed along the line running due north towards the Siachen Glacier and the Saltoro Ridge. It would be a very positive signal of the seriousness of the US intent and its strategy of working closely with India in the Asia-Pacific region if the US were to put out revised maps depicting this line in accordance with Indian troop deployment and the legally correct position.
The bottom line is this: until now, America has been looking to cooperate with an India that is strong enough to be a balancer to China, but not strong enough to cause concern to Pakistan.
This is impossible. It isn’t even desirable.
The Indian side has not expressed its objections to this American strategy of balancing India and Pakistan, and therefore has not even raised objections to the supply from America to Pakistan of India-specific military hardware. The Americans have, in turn, put forward the hypothesis that their relations are not a zero-sum game, a denial of the unambiguous and ineluctable reality. The trouble is American pressure in this direction has served to confuse and confound successive Indian Governments and the results are there for all of us to see. India is unprepared for any military action in the near term. Obviously, America is not to blame for this, the fault is entirely on the Indian side – its security decisions are for the Government of India to take, and it has not done a very good job of it. At the same time, it should be pointed out that America does not realise the influence it wields in India.
Counterproductive antagonism towards Russia
The final point concerns Russia: in the Asia-Pacific region, most of the major countries are concerned over recent Chinese behaviour, and this is drawing them together into formal or informal arrangements. This applies to Japan, Korea, and, of course, to many ASEAN countries. One conspicuous exception is Russia. This is not because it does not see the danger that China poses; in fact, many of the top leaders of Russia are quite open about this threat. However, Russia is under pressure from America and the West and finds the Chinese quite supportive on issues of concern – at least at the declaratory level.
To most observers in India, there is no real ground for antagonism between USA and Russia. That country wants good relations with America and Europe, indeed sees itself as part of Europe, but is rebuffed on some of its most important security concerns. The three principal issues are – Ballistic Missile Defence [BMD] deployment in East Europe, the expansion of NATO to include Georgia and Ukraine, and entry into the World Trade Organisation [WTO]. This last is done now, but there is the problem of the Jackson-Vanik amendment. This would still prevent MFN treatment for Russian exports to the US, even though Russia no longer places any bar on emigration. However, because Russia is under pressure from the West, it perforce has to turn to China, which opposes both NATO expansion and BMD deployment in East Europe. Most Russians view China as a medium term source of concern, and are not comfortable with having to depend on China for diplomatic support, but Western policies leave them little choice.
A strategic accommodation between Russia and China is not in anyone’s interest. With the Eurozone in flux, there is a serious risk of creating a heartland coalition if Russia is not handled with sensitivity. It is important to remember too that America needs Russia onside for the Afghanistan end-game. They are as worried as any Indian about the way things are going in that country and they are getting more and more open about it. The recent meeting of the RIC [Russia-India-China] Foreign Ministers issued a communique which expressed concern over the US withdrawal plans. Russia has been expressing this concern for some time now, arguing that ISAF went into Afghanistan under a UNSC mandate and only the UNSC can authorise the end of the mandate. In the absence of any serious engagement with Russia on Afghanistan, there is again the risk that it will find itself perforce pushed into the China-Pakistan camp, which is where it is drifting. Even Putin will be responsive if the West were to ease the pressure on Russia, and one of the important signals he has put out is the appointment of Medvedev as Prime Minister. This is a gesture that he is interested in working out a modus vivendi with America, at least in the initial period of his Presidency.
There are several other issues that need to be addressed, but one stands out: Afghanistan. There is talk of a concert of democracies working together in the western Pacific. It is worth considering whether a similar concert should be put together to address the challenges that lie ahead for Afghanistan, as the 2014 deadline draws near. It is good that India and America have both signed partnership agreements with that country, but both labour under the absence of lines of communication.
Is Baluchistan the key to both Afghanistan and Iran?
April 2013,
New Delhi.