The past week saw a significant shock to world financial markets, thanks in part to egregious mishandling of financial-market regulation by Chinese authorities.

Already reeling from the problem of falling US house prices and rising defaults among poor Americans, global financial markets took an extremely negative view of the measures introduced by China, which were ostensibly to cool down speculation in its stock markets but have only served to increase confusion for all investors. The best description I heard all week of Chinese officials came from a colleague who asked about China’s stock market regulator, “Is Jessica Simpson in charge?” [1] referring to a stereotypical blonde and reportedly ditzy pop singer.

In sharp contrast, and against the expectations of pessimists such as myself, India’s finance minister this week released a “steady as it goes” national budget that hopes to expand on recent economic successes. Amid recently concluded rambunctious state elections that saw the ruling Congress party losing power in two key states and reports of increased sops for various constituents, including farmers, the result proved more palatable.

To be sure, there is much to disagree about regarding the state of India’s financial management, including the government’s excessive reliance on borrowings to fund its expenses. Still, some reforms on tax rates and collection did make it, and the government did not expand on its ill-thought-out plans for rural assistance in this budget, nor did it unveil any price controls aimed at curbing inflation.

Chinese whispers

From many viewpoints, China appears to be two economies rather than one, incompatible entities that are finding it increasingly difficult to co-exist, much like a mismatched couple. The inside track is the elite wing filled with “Communist” Party officials, bureaucrats, business people and local and foreign bankers. On the outside track lies everyone else. The inside track is relatively efficient and often produces phenomenally well-thought-out and well-executed plans. The outside track, on the other hand, is almost always filled with corrupt, incompetent or plain amateurish officials who are tasked with implementing policies made by the inside track but not always accompanied by either clear instructions or achievable objectives.

The most egregious example of this trend was on parade in the past few weeks. In a previous article, [2] I wrote about China’s plans for converting its management approach on its foreign-exchange reserve from a traditional “IMF” (International Monetary Fund) model to a robust resource-based model that better suits the country’s expanding needs. This will have significant implications on global financial markets, which has been handled by Beijing quite discreetly. Indeed, a number of prominent economists and think tanks have been consulted by China in advance of its decision-making on changes to reserves management. This has provided outsiders such as the US government with good insight on proposed changes and their implications.

The contrast with the management of domestic situations could not be more stark. [3] For one thing, China’s effective subsidy to its exporters by keeping its currency stable has generated billions of yuan for these companies and business people to use within the economy. Being business people, many have invested in “hot” areas such as property and stocks. Hoping to ride the bandwagon, China’s middle classes joined in the mania, but funded through bank borrowings in addition to their own savings. The combination helped to push Chinese stock markets to unsustainable multiples, particularly with respect to the valuation of untested firms that simply benefited from listings.

Attempting to curb these excesses one by one produces a “whack the mole” kind of game; indeed, an intelligent approach would start at the root of the problem, namely the country’s undervalued currency. Instead, regulators first tried to trim bank lending and, when banks protested about potential lost income, switched to trying scare stories. Over the past month alone, Chinese market regulators have made announcements, and then contradicted themselves, no fewer than three times with respect to the stock market. In each case, announcements that led to sharp declines in market values immediately were countermanded. Thus the impression of a blind man feeling his way through a tin shop has been created for the entire world to see.

Such shenanigans are usually associated with officials in small banana republics – for example, the senior politicians in The Gambia, who promised a cure for AIDS. That China is even mentioned in such company is bad enough, but the fact that another part of the government functions very effectively in sharp contrast provides a lesson regarding priorities.

India to the fore

Regular readers of this column are undoubtedly aware of my lack of respect for India’s current Congress-led government. My main issues relate to the government’s clueless pursuit of income redistribution without focusing on generation. The idea of cutting revenue expenses to focus on deficits purely for capital spending is lost on the party, which is keener on winning the next election than providing the basis for sustainable growth.

In the above context, this week’s budget satisfied merely by failing to make things worse. In the convoluted logic of modern India, that actually counts as progress. Cuts in tax rates must be welcomed, as are advances in collection efficiency. It would still take a master spender to turn an economy growing at more than 8% to generate a budget deficit, and the Congress always manages that feat. The inability to expand supply has perpetuated the demand-supply gap, in turn increasing both bottlenecks in distribution and providing inflationary pressures.

Still, the good news came from elsewhere – two places, in fact. First, voters showed that they had seen through the government’s fragile economic logic, which has caused inflation to rise on key products including vegetables. Their disenchantment, combined with the experience of corrupt local chieftains, has produced adverse election verdicts in two key states for the Congress.

The second piece of good news is that the corporate sector really doesn’t appear constrained by the government’s lack of ambition. Many industrialists are pushing the boundaries of innovation, and creating significantly more aggressive expansion plans for both the domestic and the export markets. Examples of this trend can be found in sectors as varied as textiles and electronics.

Long journey ahead for both

China’s command economy is still strong, but appears increasingly incapable of managing excesses. Indeed, government officials appear increasingly desperate to provide stability ahead of planned liberalization. I am not surprised by their lack of progress [4] but note that investors are increasingly wary of the lack of transparency.

India in contrast has proved its system of internal checks and balances. While they produce increased instability in politics, they are also pushing the government to gradual irrelevance. Therein lies the good news for future generations of Indian business people.

1. Wikipedia.
2. Sun Tzu’s art of investing, Asia Times Online, February 10.
3. Davos: Pointless pontificators, ATol, February 2.
4. Chinese reforms: The dog didn’t bark, ATol, August 5, 2006.