Managing capital inflows- Is China doing better?

As I've noted earlier, managing capital inflows is presenting headaches for policy makers. If you let the money roll in, the rupee appreciates. This poses a threat to export growth. Moreover, if you don't intervene to check rupee appreciation, that draws in tons of speculative capital- people bring in money knowing that, when the rupee appreciates, that can take back more in foreign currency. More inflows mean even more appreciation..... where does it all stop?

So the RBI intervenes to check rupee appreciation. It buys up foreign currency. This causes money supply to expand, which can be inflationary. Hence, the RBI resorts to 'sterilisation'- it sells government bonds to absorb some of the money it has pumped in. When the supply of bonds increases, its price falls, which means the interest rate rises. The rise in interest rates, in turn, can dampen growth over time. So, you are damned if you intervene in the forex market, you are damned if you don't.

Since comparisons between India and China are all the rage, we have people who say: look China seems to have done a better job of managing capital flows, their inflation rate is low and their currency pretty stable. Today's BS has an article by two IMF officials that refutes this view. China, they say, is not having a high rate of inflation because of excessive investment in the past. In India, demand has run ahead of investment. But that is not to say that China is free from problems.

Encouraging investment growth are a plethora of tax incentives; low costs of land, energy, water and—most important—capital; and the undervalued exchange rate. The low cost of capital, averaging around 2 per cent in real terms in the last five years, has skewed production toward capital-intensive techniques, and has dried up job creation; the 10 per cent growth in the past few years has created only 2 per cent employment growth.

The undervalued exchange rate has also encouraged import substitution. The
caricature of China as an assembly line, processing imported inputs into cheap consumer goods, is fading into the recesses of history. Assembly-line exports make up less than 10 per cent of China’s trade surplus. Instead, China’s exports are predominantly capital-intensive goods with rising domestic content. As a result, the economy has become more dependent on exports and more vulnerable to fluctuations in external demand.

These imbalances raise concerns that China’s rapid growth may not be sustainable. Continued expansion of capacity could eventually lead to price declines that would cut into profits, increase loan defaults and undermine investor confidence. The price declines could be worse if, at the same time, the global economy slows and protection by and/or competition from other countries makes it more difficult for China’s firms to sell their products abroad.

In other words, while India is making adjustments to high capital inflows here and now, China seems to be storing up problems for the future- some will say, this is true of China in other ways as well.