Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  Will China Deepen the Fault Line or Bridge It?

  Will the world become more balanced in the future as the late developers continue to grow? The experiences of Germany and Japan offer grim portents for the future. A number of late developers will be joining the ranks of the middle-income nations, if not the rich, in the near future. Will they continue to depend excessively on exports, or will they be able to reform their economies, making the needed transformation back to balanced growth, once they have become rich? Of especial importance is China, which barring untoward incidents, is likely to become the world’s largest economy in a decade or two. Although China has a huge domestic economy, it too has followed the path of export-led growth.

  Chinese households consume even less as a share of the country’s income than the typical low average in export-oriented economies. Because economic data from China, as in many developing countries, are not entirely reliable, economists constantly attribute any Chinese aberration to data problems. But assuming the data are broadly right, why is Chinese household consumption so extraordinarily low? In part, it is because Chinese households cannot rely on the traditional old-age safety net in Asia, namely children. As a result of the government’s policy of allowing most couples only one child, six adults (four grandparents and two parents) now depend on one child for future support.26 No wonder adults, especially older ones, are attempting to increase their savings quickly. To make matters worse, many of them have lost the cradle-to-grave benefits that once came with jobs with state-owned firms, and the costs of needed services like health care are rising quickly as the economy develops. China is trying to improve its pension and social security system, but countries typically take decades to convince citizens that they will get what is promised from such schemes.

  China also faces a more traditional problem related to export-led growth strategies. As a proportion of the total income generated in the Chinese economy, household incomes are low. Wages are low because they are held down by the large supply of workers still trying to move from agriculture to industry. Household income is further limited because the subsidized inputs to state-owned firms, like low interest rates, also mean households receive low rates on their bank deposits. Moreover, a number of benefits such as education and health care are no longer provided for free by the state, eating further into discretionary spending.

  Finally, consumption may be low because Chinese households feel poorer than they actually are. State-owned firms do not pay dividends to the state and because households do not own their shares directly, they do not see the extremely high profits made at state-owned firms as part of their own wealth. Of course, in the long run, it is hard to believe that the wealth created by these state-owned firms will not be recaptured for the public good. For now, though, households believe they have no part in it, and they consume less than they might if they believed they were richer.

  Low domestic consumption, of course, makes the economy excessively reliant on foreign demand. Moreover, even if the Chinese can find ways to boost household consumption in a crisis, it constitutes only a small share of overall demand, and thus the effect on growth is small. Therefore, the Chinese authorities typically try to stimulate investment when they need to keep up growth in the face of a global slowdown—and they do need strong growth to keep up with the expectations of the people. They push loans from the state-owned banking system to local governments and state-owned firms, who then do more of what they were already doing, without regard to long-run profitability. Thus far China has successfully followed the principle “Build it and they will come.” But rapid investment in fixed assets carries many dangers, especially once the basic infrastructure is in place. As Yasheng Huang of MIT points out, Chinese bureaucrats have a penchant for glamour projects—vast airports, fancy modern buildings (typically housing the bureaucrats themselves), and enormous malls. It is not clear that this way of stimulating the economy will remain sustainable. China’s leadership has adapted in the past when necessary. Can they step away from the seductions of export-led growth and fixed-asset investment before it is too late? Only time will tell whether China will deepen or mend this fault line.

  Summary and Conclusion

  The late developers were not innovators initially: they had no need to innovate because rich countries had already developed the necessary technology, and the technology could be licensed or “borrowed.” Instead, they tried to remedy a fundamental deficiency: the weakness of existing organizations—even while tackling more traditional development problems like the lack of basic education and skills in the workforce and deficiencies in the health care system. The process of strengthening organizations, in their view, required massive but careful government intervention. Infant firms had to be nurtured. The very real danger, as evidenced in India’s stagnation during the 1960s and 1970s, was that the infant firms would demand permanent protection and then strangle growth.

  One option was to increase internal competition by reducing barriers to entry and eliminating various subsidies. But governments thought this would waste resources and be potentially harmful to the incumbents who had only recently become profitable. Moreover, the internal market was small, made even smaller by the repression of households in favor of producers. The solution instead was to use the disciplinary power, as well as the attractiveness, of the large global market. Governments forced the now-healthy firms to compete to export, using the threat of opening up the economy to foreign investment to keep firms on their toes.

  There were considerable pressures on the government to prevent it from forcing this change. Businesses would have loved protection to continue so that they could lead a quiet, profitable, life. But a few governments, typically authoritarian ones that managed to avoid the influence from the private sector that comes with having to fight elections, drove the transformation to an export orientation.27 Those are the growth miracles that we celebrate today.

  Unfortunately, their growth is still strongly dependent on exports. Government policies, domestic vested interests, and household habits formed during the years of catch-up growth conspire to keep them dependent. The world has thus become imbalanced in a way that markets cannot fix easily: much of my tenure at the International Monetary Fund was spent warning not about finance but about global trade imbalances. The two are linked, for the global trade surpluses produced by the exporters search out countries with weak policies that are disposed to spend but also have the credibility to borrow to finance the spending—at least for a while. In the 1990s, developing countries, especially those in Latin America and East Asia, spent their way into distress. How and why this happened is what I turn to next.

  CHAPTER THREE

  Flighty Foreign Financing

  I N THE 1980S AND 1990S, surpluses produced by exporters like Germany and Japan were looking for markets.1 Poorer developing countries, with low levels of per capita consumption and investment, were ideal candidates for boosting their spending, provided they could get financing. In fact, even though they too focused on producing for export markets, a number of developing countries, like Korea, invested a lot as they grew, importing substantial quantities of raw material, capital goods, and machinery. In doing so, they ran large trade deficits and helped absorb the surpluses.

  Developing countries had to borrow from abroad to finance the difference between what they spent (their consumption plus their investment) and what they produced, as well as to pay interest and principal on prior borrowings. In the 1950s and 1960s, much of this borrowing came from other countries or from multilateral institutions like the World Bank.2 However, in the 1970s and 1980s, Western banks, recycling the mounting petrodollar surpluses of Middle Eastern countries, assumed more of the lending to developing countries. In the 1990s, foreign arm’s-length investors such as mutual funds and pension funds increased their share of lending to developing countries by buying their government and corporate bonds. Thus foreign financing of developing countries became increasingly private and arm’s-length.


  Unfortunately, few countries have the discipline to borrow and spend carefully while running large trade deficits. Indeed, large amounts of foreign financing tend to encourage wasteful spending decisions. Many developing countries learned from terrible crises in the 1980s and 1990s that it was very risky to expand domestic spending rapidly through a foreign-debt-financed binge, whether the expansion was through consumption or investment.

  The boom in busts in the 1990s had varied effects on the behavior of developing countries.3 For those like Brazil and India, which were consuming too much, the financial difficulties made them liberalize their economies and cut back on excessive and populist government spending, leading to more stable and faster growth. The busts led exporters, like the East Asian economies that had been borrowing to fund investment, to curtail investment so as to reduce their dependence on foreign borrowing. They started intervening in their exchange rates, building up exchange reserves, and in the process pumping their savings out into the global economy, ready to finance anyone who wanted to spend more. With the East Asian economies absorbing fewer imports, the surpluses searching for markets elsewhere increased, making the global economy yet more imbalanced. The fault line described in the previous chapter deepened.

  Savings and Investment

  In the perfect world envisioned by economists, a country’s investments should not depend on its savings. After all, countries should be able to borrow as much as they need from international financial markets if their investment opportunities are good, and their own domestic savings should be irrelevant. So there should be a low correlation between a country’s investment and its savings. In a seminal paper in 1980, Martin Feldstein from Harvard University and Charles Horioka from Osaka University showed that this assumption was incorrect: there was a much higher positive correlation between a country’s investment and its savings than one might expect if capital flowed freely across countries.4

  The interpretation of these findings was that countries, especially poor ones like Burundi and Ecuador, could not get as much foreign financing as they needed, so they had to cut their coats to fit the cloth. However, there is another explanation, not necessarily incompatible with the first. Countries might also have chosen to limit their foreign borrowing, thus inducing a strong correspondence between their investment and their savings. But why would they do so if their investment opportunities, once they overcame the organizational deficiencies noted in the previous chapter, were high?

  To try to understand this question, some years ago I undertook a study with Arvind Subramanian, now at the Peterson Institute, and Eswar Prasad, now at Cornell University, in which we looked at the correlation between the average current-account surpluses of developing countries and their growth over recent decades. The current account is just the difference between a country’s savings and its investment. A surplus indicates that the country contributes savings to the global pool, while a deficit indicates that it borrows from the rest of the world to finance its investment. A current-account surplus typically also means a trade surplus: the country exports more than it imports.

  We found a positive correlation for developing countries: the more a country finances its investment through its own domestic savings, the faster it grows. Conversely, the more foreign financing it uses, the more slowly it grows. Of course, a country might need foreign financing either because it saves very little relative to the norm or because it invests a lot. We found that the more a country invests, the more it grows, which is natural: by investing, it increases its roads and machines, all of which go to make its workers more productive. However, the more its investment was financed from foreign sources as opposed to domestic savings, the slower its growth. Interestingly, these relationships did not hold for developed countries. Developing countries, at least the ones that grew fast on a sustained basis, seemed to avoid significant foreign financing.

  In creating a bias in favor of producers, developing countries have stunted the development of their financial systems. This makes it hard for them to use foreign financing to expand domestic demand for goods and services effectively. Indeed, with the exception of foreign direct investment—for instance, Toyota’s setting up its own factory in China—foreign financing ultimately relies, either directly or indirectly, on the willingness of the developing-country government to support domestic expansion, rather than on the ability of its private sector to do so. Because foreign lenders focus on the creditworthiness of the country and its government rather than on the specific attributes of the project being financed, and because they effectively obtain seniority over domestic lenders, foreign lending tends to be more permissive than it ought to be, given the benefits of the project. Furthermore, because political compulsions invariably force governments to press hard on the accelerator, countries tend to overuse foreign finance until they are yanked back by a sudden stop in foreign inflows. The ensuing bust tends to set back growth tremendously.

  The Financial Sector in a Producer-Biased Economy

  A government-directed, producer-biased strategy of growth tends to stunt the development of that country’s financial sector. Because banks are told whom to lend to, and because domestic competition among producers is limited anyway, banks tend not to seek out information or develop their credit-evaluation skills. The legal infrastructure to close down weak borrowers, or to enforce repayment from recalcitrant ones, is virtually nonexistent.

  As we saw earlier, the government does try to help producers by setting deposit rates low in order to lower the cost of credit. However, because interbank competition is limited, banks tend to become very inefficient, with bloated staffs and excessively bureaucratic procedures. Anyone who wishes to cash a check at a public-sector bank in a developing country would do well to develop an attitude of resignation while watching the check crawl from desk to desk, adding signature upon signature, before it finally appears at the cashier’s window. These inefficiencies as well as limited competition result in an enormous interest spread (the difference between the bank’s lending rate and its cost of funds): in Brazil, the spread routinely has been more than 10 percentage points even for short-term loans to corporations in good standing, whereas it is a fraction of a percent in industrial countries. Thus much of the cost of capital advantage obtained by setting deposit rates for households very low is lost through inefficiencies in the banking sector.

  Not only do households get little for their savings, but they also find it very difficult to borrow. Lending to households is very risky even in a modern financial system like that of the United States, and doubly so in an underdeveloped financial system. Mechanisms to track credit histories simply do not exist. Because few people have jobs in the formal documented sector, and a significant portion of incomes—such as remittances sent by workers to their parents—are not based on formal contracts, banks have little information on which to base lending decisions. And because the judicial system does not allow easy enforcement of claims against assets, banks cannot lend easily against houses or washing machines.

  Households do borrow from moneylenders, with kneecaps sometimes serving as collateral against default, but such borrowing takes place at astronomical rates of interest. The formal banking system could charge high interest rates to compensate for the risk of default (but lower rates than the informal system), but such practices are typically blocked by politicians, who “fight” for citizens by capping formal-sector interest rates at low levels, thus making lending unprofitable and driving households to the informal and unregulated moneylenders. Everything changes as the financial system develops, but this is a reasonable description of many developing countries’ financial systems in the 1990s.

  I said earlier that there were broadly two reasons a developing country could need foreign financing: if it saved little relative to the norm or invested significantly more than the norm. Let us now consider circumstances in which a country saved too little.

  Saving Little and the 1994 Mexican Crisis

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p; Given that developing-country households find it hard to obtain retail credit, they typically cannot overrun their budgets. Instead, they save for a rainy day, anticipating the difficulties they will experience when times get tough. Unlike its counterpart in the United States, therefore, the underdeveloped financial sector in a developing country makes it difficult for the government to use easy credit as an instrument to carry out populist policies. Instead, the developing country’s government performs the role of the financial sector, borrowing and offering transfers and subsidies to favored constituencies so as to allow households to spend more. So the primary reason a developing country saves little is that the government runs large deficits and borrows to finance them. Usually, these deficits are caused by overspending on transfers and subsidies to politically favored segments of the population—by political logic rather than economic rationale.

  For example, Kenya, a country that survives on international aid and had an annual per capita income of US$463 in 2006, paid its legislators a base compensation of about $81,000 a year, tax free, plus a variety of allowances and perks that effectively doubled their take-home pay.5 In a year of widespread drought, a favored car for legislators was the Mercedes-Benz E class, supported by a “basic” monthly car allowance of $4,719. The legislators had the gall to hold up a drought-relief bill as they demanded a higher car allowance, citing the shoddy condition of the roads in their constituencies as justification. Unsurprisingly, the public’s demand that the legislators fix the roads had little effect, but the raise went through. These “public servants” earned significantly more than most Kenyan corporate executives and more than their counterparts in the developed world.