In the debate on whether China should appreciate its currency or keep it stable as I argue, it’s worth going back to some basics to clear things up.

For a ‘home’ country, consider the identity from the national income accounts:

X – M = S – I = Trade (Saving) Surplus

where X is exports and M is imports (both broadly defined), and S is gross national saving and I is gross domestic investment.

The left hand side of the identity suggests that a depreciation of the home currency will make exports cheaper in world markets, and they will expand. Similarly, the home country’s imports will become more expensive in domestic currency, so they should contract. Thus the conventional wisdom has it that the overall trade balance should improve if the underlying price elasticities are even moderately high. This seemingly plausible result is very intuitive, so even journalists can understand and perpetuate it.

But this ‘elasticities’ approach is basically microeconomic and quite deceptive. In this model, the export supply function is looked at on its own— and the demand for imports is looked at on its own—even by supposedly sophisticated econometricians who purport to measure separately the price elasticities of exports, and of imports, to exchange rate changes. Thus it is called the elasticities approach to the trade balance.

But if you analyse the right hand side (S – I) of the identity, the emphasis is macroeconomic. For the trade balance to improve with exchange depreciation, overall domestic expenditures must fall relative to aggregate output. After some minor algebraic manipulation, this is the same thing as saying that domestic saving must rise relative to domestic investment. Looked at this way, one cannot presume that domestic net saving will rise when the dollar is devalued.

Indeed, the presumption may go the other way when domestic investment (fueled in part by multinational firms) is sensitive to the exchange rate. Suppose the RMB were to appreciate sharply against the dollar. This might set off a minor investment boom in the US where expenditures rise, and a major slump in China’s huge investment sector, so that expenditures fall, the economy slumps, and imports contract. This is what happened to Japan in the 1980s into the mid-1990s when the yen went ever higher. Japan became a higher-cost place in which to invest, large Japanese firms decamped to invest in lower cost Asian countries, and in the US itself. The trade surplus of the slumping Japanese economy increased!

No wonder China is reluctant to appreciate!  Like Japan, its trade (saving) surplus would likely not diminish and foreigners, in the US and Europe with the misleading elasticities model in their heads, would come back and say ‘you just didn’t appreciate enough’. With this adverse expectation of continued appreciation, the upshot would be further hot money inflows, a bigger build up of dollar foreign exchange reserves, and a potential loss of internal monetary control.

Ronald I. McKinnon is the William D. Eberle Professor of International Economics at
Stanford University.

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Most observers judged as a failure the December meeting in Copenhagen of the Conference of Parties of the UN Framework Convention on Climate Change (UNFCCC). But then the usual way of judging such meetings is to look for a communiqué that voices sweeping aspirations, such as the G7 ‘decision’ at L’Aquila last summer to limit global warming to 2 degrees centigrade. In reality, without any evidence of countries agreeing what is each one’s share of the burden, such proclamations are worthless. Better tiny steps on the ground than giant flights of rhetoric.

Is there any sign of progress, even tiny steps? President Obama arrived in Copenhagen on the last scheduled day of the conference, and personally hammered out a rough agreement among a few of the most important countries that are not yet participating in quantitative targets: the US itself, China, India, Brazil and South Africa. Consistent with the dysfunctionality of the UNFCCC, a few small trouble-making countries then prevented the general assembly from adopting this new ‘Copenhagen Accord.’ At that moment, it could have been seen as still-born.

And yet, early in 2010, there have appeared important rays of hope for those who would like to see genuine progress in addressing emissions of greenhouse gases. The Copenhagen Accord called for countries to specify, with an initial deadline of January 31, what steps they were prepared to take in the current decade.

The response was better than anticipated.  By March, 102 countries (comprising 81% of global emissions), had responded by submitting plans. More importantly, seven of the biggest non-Annex I parties (developing countries) were among those specifying numbers for 2020 – quantitative emission targets – even though they didn’t have to do so. The seven were Brazil, China, India, Indonesia, Korea, Mexico, and South Africa.  (So did Israel, Singapore, and some others.)  The submissions are summarized in the table here, which is an abbreviated version of one prepared by the US Climate Action Network.

Some American businessmen and environmentalists will complain that the reductions in carbon intensity that China and India are talking about are not much different from the efficiency improvements that they would probably be achieving anyway, under Business As Usual (BAU). This is true. But it is not reasonable to ask much more than this from the poor countries in their first budget period. Nor is it necessary to ask any more than this, in order to forestall leakage to developing countries. Fears of leakage and lost competitiveness have probably been the number one obstacle to a legal agreement, for example in the US Senate.

Much more serious is the critique that China and the other developing countries are not yet prepared to commit legally to these numbers. But, then, that is equally true of the United States. While the road ahead may seem murky, in a sense it is clearer than it has been in awhile. Such manageable-sized forums as the G20 and the Major Economies Forum should strive over the next year to firm up commitments around numbers such as these, as a first step toward a comprehensive and longer term trajectory of emission targets.

The numbers in the table can be evaluated by the yardstick of formulae that I have used in the past to suggest what emission targets would be appropriate for various countries. My suggestion has been that the still-poor countries, like India, should commit to BAU in the first budget period, while countries at the next stage of development should commit to reductions from BAU that are proportionate to their income. This is the ‘Progressive Reductions Factor’.

The graph below shows cuts, expressed relative to BAU, on the vertical axis, and income per capita on the horizontal axis. One can see a progressive pattern, even if it is not as sharp as those implied by the Kyoto targets among Annex I countries. The EU, for example, proposes relatively steep cuts, even though its BAU already features lower emissions per capita than, say, Russia.

Notice that Korea and Mexico both lie below the line.  This means that, according to the numbers they submitted in January, these two are a bit more generous than others, given their incomes. A possible reason is that each is hosting a relevant multilateral meeting toward the end of the year, which they want to succeed (G20 and UNFCCC, respectively).

But Brazil and South Africa appear even more generous by this metric. Perhaps there is a problem in that these four middle-income countries are among seven who expressed their goals directly in terms of BAU. (For the others, we have always computed ourselves the difference between the country’s emission goals and the corresponding BAU numbers in the WITCH model.) Perhaps these countries have in mind for themselves a BAU baseline that is higher than international modelers would forecast, in which case their numbers would need to be adjusted before being compared with others. In any case, it is clear that countries could not necessarily be allowed to assert their own BAU baselines; either the numbers themselves or the process for selecting them would have to be a subject of negotiation, like the other parameters.

This article was first published here at Jeff Frankel’s Weblog.

Jeffrey Frankel is James W. Harpel Professor of Capital Formation and Growth at the Harvard Kennedy School of Government.

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The Hatoyama administration has approved a fiscal 2010 budget containing ¥561.8 billion in expenditure on a new ‘individual household income compensation system’ (kobetsu shotoku hoshō seido) for farmers, to be launched in April. This income subsidy will compensate farming households for losses incurred as a result of higher production costs and lower market prices. The scheme will begin with a ‘model project’ targeting rice farms nationally.

The process undertaken in determining the budget for the policy illustrates how little has changed in agricultural policymaking under the Democratic Party of Japan (DPJ) compared to the Liberal Democratic Party (LDP). The final decision reflected the budget amount requested by the Ministry of Agriculture, Forestry and Fisheries (MAFF). Objections from the Ministry of Finance (MOF), aimed at limiting the income subsidy to large-scale farmers or farmers in specific regions, were overridden. Political intervention from the ruling party proved decisive in this tug-of-war. In the budget request documents submitted by the DPJ last December, it lobbied for the full amount requested by the MAFF to be allocated.

The new income compensation policy was simply too important in the DPJ’s Upper House election strategy to fall victim to spending constraints. The scheme was quarantined from the budget-screening process undertaken by the Government Revitalisation Unit (GRU) last November. In insisting on all rice farmers being eligible for the scheme, the DPJ was also aiming to reduce the dependence of small-scale rice farms on the agricultural cooperative organisation (JA), because of JA’s key role as an electoral support organisation for the LDP.

MAFF Minister Akamatsu Hirotaka called the income guarantee ‘the bedrock supporting farms’.

Direct income subsidies to individual rice-farming households will be calculated in the range of ¥10-15,000 per ten ares (i.e. a 10th of a hectare) of farmland. Some DPJ politicians pushed for an even higher amount.

Because of the way in which the direct income subsidy is calculated, it will be classified as an ‘amber box’ subsidy by the WTO, owing to its potential to distort production and trade. At the same time, the government is calling the scheme ‘a safety net for trade liberalisation’ enabling it to promote FTA talks with Japan’s trading partners, even though the DPJ is divided on the issue of FTAs and agricultural trade liberalisation.

Complicating outcomes from the policy is its direct linkage to the rice acreage reduction policy (gentan), designed to reduce rice production. Only those farmers following ‘rice production quantity targets’ (i.e. rice production cuts) set by the government will receive the direct income subsidy. But even farms making a profit from their rice sales will be eligible for the compensation if they observe quantity targets. The policy linkage produces conflicting objectives: the income subsidy promotes rice production while the gentan reduces it. Reinforcing the gentan will help to keep rice prices high. This will potentially reduce the costs to the government of farm income compensation, but it will do nothing for consumers. Furthermore, the gentan is widely viewed as undermining the vitality of Japanese agriculture because it stifles incentives for producers to increase output.

The major criticism of the farm household income compensation scheme is that it will not improve the competitiveness of Japanese agriculture. It places pressure on small-scale farmers with high production costs to stay in farming, and for some of them to withdraw land that they currently lease to larger-scale ‘business’ farm households. Some DPJ politicians are defiant in the face of this criticism, arguing that ‘small-scale farms also play a role in supplying food and preserving the environment. There is no need for policies to encourage the development of large-scale farms’. Clearly they do not represent the interests of entrepreneurial farmers who want to increase their farm size and therefore their profit margins, a group that will now find it much harder to obtain land from small-scale farmers in order to expand their operations.

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With the number of foreign residents in South Korea exceeding one million as of May 2009, many scholars, journalists, and bureaucrats claim that Korea has become a multiethnic or multicultural society. This idea needs to be put in proper perspective. The total number of foreign residents in Korea, the majority of whom are temporarily visiting migrants or students, accounts for only 2.2 per cent of the country’s total population. In addition, Chinese residents represent, at 57 per cent, the highest share of these foreign residents, and about half of these Chinese residents have Korean ancestry. Korean society is still largely ethnically homogeneous and racially distinctive, and the term ‘multiethnic Korea’ remains an unconvincing descriptor.

In addition, many Koreans are yet to accept that Korea is in the midst of a demographic shift. For many, Korea is a homogeneous nation that should maintain a strong ethnic national identity based on shared blood and ancestry. This identity has become a totalitarian force in politics, culture and society. Korean national pride in being a single-race state is driving discrimination and prejudice against those who are not seen as ‘pure’ Koreans. To make matters worse, Korea lacks an institutional framework to promote a democratic national identity that would allow for more diversity and tolerance. Consequently, many foreign residents have limited access to medical care, education and welfare. This means that many foreigners resident in Korea feel increased antagonism toward Korean society.

With the number of foreigners in Korea increasing rapidly, the Korean government faces the urgent responsibility of ensuring that they can live in peaceful co-existence with ethnic Koreans. Both the Korean media and concerned Korean scholars have argued that anti-Korean sentiments held by foreign residents are damaging the national pride and competitiveness of Korea. The United Nations Committee for the Elimination of Racial Discrimination issued a warning in August 2007, saying that ‘Korea has to embrace the multi-ethnic character of contemporary Korean society, and the image of an ethnically-homogeneous Korea is now a thing of the past.’

Korea has acted in response to these concerns. In 2005, the Korean government officially recognised the concept of ‘multiculturalism’, and established a wide-range of multicultural institutes, policies, and practices. These developments were specifically designed to support a special group; families with foreign spouses. Subsequently, 2008 saw the enacting of ‘The Act to Support Multicultural Families’ building upon the 2005 decision in a systematic way by providing multicultural families with welfare benefits such as medical care, schooling, cultural and leisure activities, and social networks.

Despite this progress, ‘multicultural policies’ do not apply to other migrant groups, notably foreign workers resident in Korea. As of October 2009, there were about 700,000 people classified as migrant workers in Korea. These workers are covered by the ‘Employment Permit System’ (EPS), introduced in 2004, which allows small and medium enterprises (SMEs) to employ workers from 15 approved countries (workers come mainly from China, Vietnam, Philippines, and Thailand). The workers come for the so called ‘3D – dirty, dangerous, and difficult’ jobs. The EPS replaced the Industrial Trainee System (ITS) which was heavily criticised for not preserving the human rights of migrant workers.

The EPS is not without flaws. For example, workers under the EPS are bound to their employers for a three-year period, during which they are forbidden to change jobs without their employer’s permission. Workers may shift employment only four times in total, and must find a new job within two months of unemployment in order to stay in Korea – they otherwise become undocumented. It is noted that the number of undocumented migrant workers has decreased since the introduction of the EPS.

Once workers are classified as undocumented, they face harsher treatment. Crackdown and forced deportation is the government’s key policy to get rid of undocumented migrants, and 23 detention facilities have been set up nationwide. On February 11, 2007, a fire in Yeosu Foreigner’s Detention Center killed 10 migrants who were being held there until deportation. This tragedy shocked Korean society, revealing the brutal conditions and human rights abuses faced by migrant workers in detention facilities. The Yeosu case led to constant protests against Korea’s current labor migration policies by a coalition of Korean migrant workers, local unions, and international labor and human rights organisations, demanding that the human rights of migrant workers be upheld.

The global economy has produced a diversified landscape of international migration, and Korea, as an active participant, has changed as a result. The influx of migrant workers and foreign spouses to Korea has drastically changed the country’s demographic make-up. For Korea, becoming a multiethnic society is no longer a matter of choice, but a reality that must be lived with.

The road towards becoming a truly multiethnic society still seems long and arduous, and presents many challenges. Nonetheless, in the early stages of the transition, the Korean government’s tentative multicultural policies suggest that there is room for optimism. It may take Korea a long time to fully embrace ethnic diversity, but by carefully taking one step at a time, the road to reform will become easier.

Kyoung-Hee Moon is assistant Professor, Department of International Relations, Changwon National University, Korea.

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China has been criticised in some quarters as the party-spoiler at last year’s Copenhagen Climate Change Summit. Its steadfast refusal to allow international monitoring of its emission level led to a collapse in reaching a meaningful international agreement. The earlier euphoria over China’s far-reaching announcement on emission reduction targets had all but disappeared. It seems that many commentators believe that China is pursuing an economic development strategy at all costs.

But there are also voices emanating from China that strongly urge Beijing to take this historic opportunity to tackle the challenge of climate change and assert China’s global leadership in green and renewable technologies. One of the leading voices from the chorus is Hu Angang of Tsinghua University. He is one of China’s most respected and cited economists and an influential author of series of books and reports that seek to provide policy remedies to address many of China’s problems on its long march to be great again.

In his latest book on ‘China confronting global climate change’, Hu argued for an innovative solution to deal with China’s dilemma in meeting the challenge of climate change.

How does China reconcile the seemingly conflicting objectives of emissions reduction, industrialisation, and economic development?

Given that China is not only the world’s largest energy producer but also the largest emitter of anthropogenic global warming-inducing carbon dioxide, China must assume the grave responsibility of tackling the challenge of climate. Despite the glittering modern façade of mega-metropolises such as Beijing and Shanghai, and the mind-boggling statistics of China’s economic achievement, it is still a developing country with a vast swathe of hinterland yet to be touched by industrialisation.

In addition, China has a very fragile environment that is burdened with an enormous population.  It is a main victim of climate change-induced natural disasters such as floods. Therefore, China must actively seek an international solution to this problem. On the other hand, the current of domestic opinion in China has yet to reach a consensus on conflicting aims between growth and climate change. Many still see the key role of the state as delivering economic growth and reducing poverty.

Hu Angang proposes an emission reduction scheme that is applicable internationally as well as domestically to China based on the principles of fairness and efficiency. He challenges the traditional dichotomy of developed countries versus developing countries in climate change debate with four new divisions based on the Human Development Index, HDI.  He argues that major emitters including the United States and China should bear the brunt of responsibility for emission reduction.

In his work, he points out that as of 2006, there were 70 countries with 1.6 billion people in the first division with high HDI representing 25.5 per cent of world’s population. They are the main group responsible for emission reduction and, he argues, it should be mandatory for them to devise a unified, multilateral plan to achieve that goal.

Of the top twenty emitters in the world, 14 emitters belong to the first division of high HDI, and their reductions should be made mandatory.  There are 5 other countries belonging to the second division of medium to high HDI, and they should be subject to conditional emission reductions. Of all top twenty emitters, only India belongs to the third division of medium HDI, and it should be encouraged to actively pursue an emission reduction strategy.

Such divisions are not carved in stone and are subject to change as countries move up the ladder to a higher division of HDI. For example, once a country moves from second division to the first division, its emission reduction effort becomes no longer conditional but mandatory.

Different regions and provinces of China are also divided into four divisions according to HDI. For example, the major urban centres such as Beijing and Shanghai along with the prosperous coast provinces, with high HDI, belong to the first division. The rest of country is categorised according to the level of their HDI achievement.

Hu Angang’s plan to link emission reduction to HDI is an alternative way to bridge the old divide between the developed and developing countries in the debate over the respective responsibility for climate change. The additional principles of inclusion of major emitters in any global emission reduction framework would also ensure that major emitters from the developing world would shoulder a fair share of their responsibility depending on their available resources.

We ought to pay more attention to voices from China on the issue of climate change, especially from someone as distinguished and influential as Hu Angang.

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The persistent decline in Malaysia’s economic performance since the East Asian Financial Crisis (EAFC) of 1997/98 and the government’s mishandling of the global shocks that preceded the Global Financial Crisis (GFC) were a key reason for the ‘political tsunami’ that hit Barisan Nasional (BN) at the 12th General Election (12GE) on 8th March, 2008. Two years on the economy remains in the mud due to a sluggish global economy, ineffective stimulus plans to address the GFC and most importantly, a lack of political will to put through bold reforms to get the economy back on track.

Like many economies in East Asia, Malaysia evaded the direct impact of the sub-prime crisis but was caught in the after effects – its main export markets collapsed, suffering the worst decline since the EAFC. The economy contracted by 1.7 per cent in 2009, after recording growth of 6.7 per cent and 4.5 per cent in 2007 and 2008 respectively, and the country was in a recession for the first three quarters of 2009, recovering only in the fourth quarter, as the government’s RM67 billion stimulus packages kicked in alongside a mild global economic recovery. But any suggestion that this represents a turn-around in Malaysia’s economic fortunes would be premature, as Malaysia’s economic fundamentals are all on a downward trend.

The BN government was shocked by the results of the 12th General Election. Prime Minister Abdullah Ahmad Badawi was rendered a lame duck as he fought both an incipient revolt within the United Malays National Organisation (UNMO), and Anwar Ibrahim’s threat to form a new government together with defectors from BN. These circumstances produced a populist RM205 billion 2009 Budget (an increase of 4.4 per cent compared to Budget 2008), announced in August 2008, that was geared to please the ‘Rakyat’ in the event a snap election was needed. The budget exacerbated Malaysia’s worsening fiscal balance but had little effect on the economy – Malaysia’s key economic indicators began to deteriorate (see the below table). Malaysia also recorded its 11th straight year of deficit spending.

After much criticism for its inaction on the GFC, the BN government introduced a RM7 billion stimulus package focusing on infrastructure in November 2008. The quantum was criticised as being too small (1 per cent of GDP) and poorly targeted to have any significant effect on the economy. A second stimulus package was announced in March 2009, but this was more of a strategy designed to strengthen the governmental grip on the Malaysian economy than a revival package. Nevertheless, at RM60 billion (approximately 9 per cent of GDP), the package was unprecedented in Malaysia. It was then followed by a RM191 billion Budget for 2010, announced in October.

Fundamentally, the major problem was that none of these policy responses were sufficiently focused on real solutions (e.g. providing sufficient capital for small and medium scale enterprises). Instead, they continued to strengthen the role of the government in the economy (the Prime Minister’s Department and Khazanah received the bulk of the allocation). Rather than focusing upon the welfare of the nation, the policies were directed at infrastructure projects and ‘goodies’ that made the Rakyat happy. Malaysia’s ensuing fiscal deficit in 2009, at 7 per cent, is the highest since 1987.

Unemployment increased by a relatively small amount to 4 per cent. But this apparently respectable rate masks the real impact of the GFC upon workers welfare. In fact, the brunt of Malaysia’s unemployment problem is faced by Malaysia’s migrant workers – estimated at about 20 per cent of the Malaysian labour force – who are often repatriated during a crisis and thus are not counted in official statistics. Further, changes in workplace arrangements (e.g. forced no paid leave, shorter working hours, change from permanent to contractual work) hid the real impact of the crisis on workers. Inflation reached a record high in 2008 as the government reduced costly fuel subsidies. The Rakyat countered, suggesting that BN first resolve corruption before removing subsidies. However, 2009 saw deflation as private sector spending collapsed.

Promisingly, when Najib Tun Razak, previously Malaysia’s Finance Minister, became Prime Minister, his first move was to introduce economic reforms designed to move Malaysia to a high income economy by 2020. Najib correctly realised that Malaysia’s economic problems were structural. Growth in exports, GDP and income per capita had been declining since the EAFC.

But after a flurry of insubstantial announcements, Najib hit a brick wall called Majlis Perundingan NGO Melayu (MPM) – a coalition of Malay/Muslim opportunists and supremacists who demanded that Najib’s New Economic Model contain affirmative action for Malays despite the consensus view that such affirmative action was the main reason behind Malaysia’s deteriorating economic fundamentals. The New Economic Model (NEM), due to be announced by Najib in March 2010 has been postponed to mid-year after protests from MPM. More worryingly, in focusing upon the services sector, Najib’s NEM ill advisedly destabilises Malaysia’s economic back-bone – manufacturing and resource based industries. This attempt to gain quick growth by ‘mining’ the services sector may result in unintended neglect – after all, such a fate befell the agriculture sector under Mahathir’s push for industrialisation.

Further, the NEM target of 5 to 6 per cent growth remains elusive as the global economy remains sluggish. To achieve this target, Malaysia will need to be a more efficient producer to both attract investment and remain competitive. Domestically, inward FDI does not show signs of major recovery as Malaysia’s reliance on low-cost strategy is untenable. With the rise of late movers such as Vietnam, China, Indonesia and India, Malaysia is no longer a favoured FDI destination in the region. Only drastic liberalisation measures (e.g. removal of subsidies, affirmative action policies, retreat of GLCs) and improvement its institutions can see Malaysia return to pre-crisis level growth rates.

After a brief fling with minor reforms, the two years since the March 8, 2008 political tsunami have seen Najib return to business as usual, succumbing to the pressure of Malay opportunists and fundamentalists. It is unlikely that Najib’s forthcoming NEM will address long term persistent decline in Malaysia’s economic performance as his attempts to ‘test the water of economic reforms’ have failed spectacularly. The only possible conclusion is that Malaysia will remain in the mud in the near future.

This article first appeared in here in Malaysiakini.

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In his Budget speech on February 26, India’s finance minister articulated the three important challenges confronting him in preparing this year’s Budget.

These were to restore growth (to 9 per cent, ideally higher); to use this growth to make development more inclusive, particularly by strengthening rural infrastructure; and to address bottlenecks in public delivery mechanisms and institutions.

Somewhat surprisingly, the minister started the part of his speech dealing with ‘consolidating growth’ with a call for fiscal consolidation.

‘In shaping the fiscal policy for 2010-11, I have acted on the recommendations of the Thirteenth Finance Commission (which) has recommended a capping of the combined debt of the central government and the states at 68 per cent of the GDP to be achieved by 2014-15. As a part of the fiscal consolidation process, it would be for the first time that the government would target an explicit reduction in its domestic public debt-GDP ratio,’ the finance minister had said.

As was pointed out by T N Ninan the day following the Budget, this is a vow of temperance after an almighty binge: the targeted fiscal deficit of the Indian central government for 2012-13 of 4.1 per cent ( presented in the Medium-Term Fiscal Programme, or MTFP), if achieved, would be at the same level as in 2005-06. Even on the best case, it will take seven years to undo the extravagance of the last two.

The MTFP openly acknowledges that the pace of adjustment in the revenue deficit is unlikely to be as aggressive as proposed by the Thirteenth Finance Commission (TFC). This is both because revenue buoyancy in the future, even with fast growth, is presumed to be lower than in the recent past, and because the government has taken on revenue expenditure commitments that are not particularly flexible. Thus the squeeze will remain on capital expenditure.

As the Indian Prime Minister’s Economic Advisory Council noted in its mid-February ‘Review’, the fiscal deterioration at the central government has been less on account of automatic stabilisers on the revenue side than due to discretionary increases in revenue expenditure. Changes in the revenue deficit are also a good proxy for changes in the saving (or dis-saving) of the public sector. An important part of the improved saving performance of the Indian economy in the last boom was fiscal consolidation on the revenue account. This has also been sharply reversed, primarily at the central government.

The conclusion is inescapable, even if not particularly novel or surprising. The Central government has been through a massive growth in revenue expenditure prior to and following the general election. This expenditure has used up much of the fiscal space created under the Fiscal Responsibility and Budget Management Act of 2003. Such expenditure was superimposed upon a revenue boom generated by buoyant growth, itself partly the product of benign conditions in global capital markets.

Both these phenomena are well established in the economic literature. The expenditure surge forms part of the literature on what has come to be called the ‘political business cycle’. Equally, there is a rich tradition, particularly for Latin America, which documents the fiscal consequences of capital surges. Low global interest rates transmit themselves to the local economy via the capital account. The surge in growth and asset values boosts tax revenue and induces expenditure which is difficult to unwind when capital starts to withdraw.

Since both the political and economic cycle will persist, and India’s global integration will likely deepen, the TFC’s views on fiscal consolidation need to be examined to see what safeguards they provide to manage these pressures and temptations. Given the convention that India’s finance ministry typically accepts the important recommendations of the Finance Commission, I would not be surprised if the architecture proposed by the TFC had been discussed with the ministry in advance, although I have no idea if this is, in fact, the case.

The basis for the TFC’s proposal is set out in Chapter 9 of its report, entitled ‘Revised Roadmap for Fiscal Consolidation’. Two key propositions are asserted in that chapter. The first is that ‘to create an environment favourable to private investment in the economy’, it is necessary that the ratio of consolidated (that is, central government plus states) liabilities to GDP be reduced below that targeted by the Twelfth Finance Commission (75 per cent of GDP in the last year of the award). The second is that ‘a target-based framework’ needs to be maintained for the award period of the present Commission.

These two principles then lead to the Commission’s recommendations that the consolidated debt to GDP ratio be targeted at 68 per cent of GDP by 2014-15, the figure picked up by the finance minister in his speech, with separate targets for the Indian central government and the states. In the case of the Indian central government, the starting point is an estimated adjusted debt stock of 54 per cent of GDP on March 31, 2010, to be reduced to 45 per cent of GDP by March 2015. A similar exercise is conducted for the states.

Based on these targets, and a belief that the revenue deficit should normally be zero, the Commission specifies a trajectory for both the revenue deficit and the overall fiscal deficit, as shares of GDP. As already noted, if the overall fiscal deficit target is to be taken seriously, one implication of these calculations is that any slippage on the revenue deficit will result in compression of capital expenditure. On the optimistic revenue deficit scenario presented, the central government’s capital expenditure is projected to rise to 4.5 per cent by the end of the award period.

It is an act of courage and boldness on the finance minister’s part to portray fiscal consolidation as supportive, even essential to sustained growth, in what is sometimes referred to as an expansionary fiscal contraction. The finance minister has given himself six months to develop the rules to implement the proposals of the TFC. Their design will be critical to ensure that the right balance is struck between credibility and flexibility, and the TFC has some important suggestions on how this might be achieved, to avoid the licence that caused so much damage this time round.

The Indian government has got away lightly for its profligacy this time round. India may not always be that lucky.

This article was first published here at the Business Standard.

Suman Bery is Director-General of the National Council of Applied Economic Research, New Delhi, and Member of the Prime Minister’s Economic Advisory Council, New Delhi.

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Speculation is rife about when, not just if, China should exit from its policy of stabilising the yuan/dollar rate. Investment banks and hedge funds are making their usual one-way bets. Chinese officials are being closely quizzed for possible hints as to when the great event is going to happen. Governor Zhou Xiaochuan of the People’s Bank of China (PBC) is playing the role of Hamlet. Recently he told a press conference that the currency peg was a ‘special measure’ to help China weather the financial crisis. ‘These policies sooner or later will be withdrawn’. In seeming contrast, Premier Wen Jiabao declaimed on March 5, ‘We will continue to improve the mechanism for setting the renminbi and keep it basically stable at an appropriate and balanced level’.

But must China ever appreciate? With a stable dollar exchange rate since mid-2008, China has been very successful with its bank-financed stimulus package in overcoming the global credit crisis.

Over the past year, the surge in its domestic spending has largely offset the 40 per cent fall in 2008 of its huge export sector. GDP growth is back to a healthy 8 per cent per year, and its domestic spending sucks in imports from other Asian countries, with somewhat lesser direct effects in Europe and the United States. In 2010, China is leading the world out of the global economic downturn, which started with the banking crisis in the United States.

The stable yuan/dollar rate has been essential for the success of China’s domestic credit expansion—more than 30 per cent in 2009. Before July 2008, the renminbi was predictably appreciating at about 6 per cent per year. Unsurprisingly, hot money poured into the economy and there was no outflow of private capital to finance China’s large trade (saving) surplus. The PBC had to intervene massively to buy dollars for RMB to prevent the renminbi from ratcheting up indefinitely. The domestic monetary (inflationary) consequences were partially sterilised by issuing central bank bonds and increasing the reserve requirements on China’s commercial banks. These sterilisation measures disrupted the normal flow of bank credit within the overheating economy.

Then a ‘lucky’ accident happened. Beginning in July 2008, the global credit crunch created an unexpected burst of demand for US dollars. From July to November, the dollar—with the RMB tied to it— shot up more than 20 per cent against the euro and most other currencies. Opportunistically, the PBC then stopped further appreciations of the RMB against the dollar and reset the exchange rate at 6.83 yuan/dollar—where it remains today. For almost a year, the new exchange rate peg was sufficiently credible that hot money inflows stopped  and inflationary pressure declined. The PBC could then safely relax its constraints on the expansion of domestic bank credit—including cutting the reserve requirements of the commercial banks. Whence the minor miracle of China leading everybody out of the global recession.

But the sustainability of this expansion is threatened by the dollar’s significant fall (with the RMB tied to it) after mid 2009, a fall linked to the US Fed’s holding too long to its zero interest rate policy. Now foreigners are again complaining that the RMB (but not the dollar!) is undervalued, and speculators can borrow overly cheaply in New York to finance hot money flows into China and other emerging markets. One consequence is a huge bubble in China’s commercial and residential real estate markets, which is forcing the PBC to try to curb the expansion of domestic bank credit. Paradoxically, the solution for keeping China’s credit expansion going is for the Fed to exit from is zero interest policy—a strategy that, fortuitously, would also relax the constraint on bank credit within the United States.

Like diamonds, can the fixed yuan/dollar rate be desirable ‘forever’? Certainly not if the Fed continues to behave inappropriately. However, if American monetary policy returns to normal with the world remaining largely on a dollar standard, then having the G2 maintain a stable rate of exchange is highly advantageous. During its ‘catch up’ phase over the next decade or more, China will continue to have much higher productivity growth than the United States or Europe. But the natural balancing mechanism is for Chinese manufacturing wages to grow as fast as labor productivity. There are already signs that this may be happening. After taking a huge hit in the global crisis of 2008, Chinese wages have now recovered to where they were before the crisis—with crude estimates suggesting a 10 per cent increase in 2010.

But this happy scenario of very high growth in money wages in China is most achievable when the yuan/dollar rate remains predictably stable. If employers fear that the renminbi may ratchet upwards in the future, they will become much more reluctant to grant high wage increases in the present.

Ronald I. McKinnon is the William D. Eberle Professor of International Economics at
Stanford University.

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Over the past three decades countries have signed a great number of international investment treaties (IITs). There are now close to three thousand such treaties worldwide. While most IITs are bilateral there are some multilateral IITs, such as the Energy Charter Treaty to which Australia and fifty other states are signatories. Common IIT provisions are also contained in investment chapters within some trade agreements, within NAFTA and the US-Australia FTA for example.

Many IITs include dispute settlement provisions that allow foreign investors to bring claims against host states before international arbitral tribunals, relying on the rights contained in the relevant treaty. If successful, the investor-claimant is entitled to a monetary award of damages.

The basic function of IITs is investment protection. IITs place obligations on host states to guarantee certain standards of treatment to foreign investment owned by nationals of another state-party to the treaty. Few grant pre-establishment rights of entry to foreign investors. The post-establishment protections granted by IITs normally include rights to ‘fair and equitable treatment’ and compensation for ‘indirect expropriation’. These rights, as interpreted by arbitral tribunals, often go beyond what investors – whether local or foreign – would otherwise be entitled to under the domestic law of the host state. (This contrasts with international trade law, which is based on the basic principle of national treatment – that is, equal treatment of foreign and local goods under domestic law). In light of current discussion about the inclusion of an investment chapter in a future Australia-China FTA, it is timely to reflect on the costs and benefits of entering IITs.

There are at least two plausible ways in which signing an IIT might benefit a host state. The first is by increasing inflows of private foreign capital. In the social scientific literature, this is widely assumed to be the primary purpose of IITs. There are a number of obstacles to empirical investigation of the relationship between IITs and foreign investment, for instance the difficulty in controlling for reverse causality and endogeneity. However, to the extent that empirical investigation has been conducted, IITs do not appear to encourage inflows of private investment.

Alternately, IITs might benefit host states by leading to more efficient allocations of resources. Allowing foreign investors to compete on a level playing field with domestic investors is likely to lead to more efficient allocative decisions in the product and service markets in which foreign investors operate. But the conferral of rights on some foreign investors that go beyond the rights of other investors is likely to be market-distorting and inefficient. In this respect, the efficiency effects of IITs will depend foremost on whether they confer rights on foreign investment that go beyond national treatment.

It has also been argued that granting legal protection to investment – of any nationality – can encourage governments to make more efficient regulatory decisions. This argument raises more complex issues. The signing of an IIT would only lead to more efficient regulatory decision-making if the risk of liability to foreign investors led government decision-makers to more accurately assess the overall private costs of regulations under consideration, and not just the private costs to the foreign investor. This efficiency gain would then have to outweigh any efficiency loss due to the moral hazard of insuring foreign investors for foreseeable risks of their own investment decisions. Without wanting to over-simplify, it seems unlikely that making decision-makers more sensitive to the impact of their decisions on foreign investors will lead them to better assess the overall costs and benefits of regulations, most of which will not normally fall on foreign investors.

What then are the costs to a state of entering into an IIT? The first is a distributive cost. IITs prescribe liability rules that distribute losses between host states and foreign investors. The immediate consequence of entering an IIT is to require a state to compensate foreign investors for certain classes of loss. If these classes of loss are broader than the losses for which the state would have been liable under its own laws, then the IIT will engender a transfer of wealth from host state to foreign investor. The wider the legal protections granted to foreign investors by an IIT, the greater the transfer of wealth from the host state to private foreign investors.

A second cost to a host state flows from the impact of the risk of liability under IITs on public policy making. This issue has received a great deal of attention from academics and NGOs critical of IITs. Their criticisms are supported by a number of high profile IIT cases in which foreign investors have sued governments for the impact of public health and environmental regulations on the value of their investments. However, the precise nature of criticism has not always been clearly articulated. The fact that IITs may affect a host state’s environmental regulations – to choose an example – is not, of itself, a coherent criticism of IITs. It is the extent to which the risk of liability under an IIT makes a state less likely to introduce efficient, effective or otherwise socially desirable environmental regulations that constitutes a cost of entering these treaties. Evaluating the scale of this cost raises difficult theoretical and empirical questions, but that is no reason to shirk from trying to identify it.

In summary, the net benefits of entering an IIT may be lower than is widely supposed. In particular, provisions of IITs that go beyond guarantees of non-discrimination to grant positive discrimination in favour of foreign investors are less justifiable on efficiency grounds and are likely to incur distributive and public policy costs to a host state. Negotiators should be particularly careful in assessing the marginal benefit of adding IIT provisions that go beyond a right to national treatment.

Finally, there is different type of benefit that states may seek in negotiating IITs, variously described as ‘building confidence’ or ‘signalling friendly economic relations between states’. This objective may be furthered by entering into an IIT, but there is no obvious reason why it would be advanced by allowing investors to enforce treaty rights directly against host states through investor-state dispute settlement. Omitting the investor-state dispute settlement mechanism from IITs would allow states to avoid the costs of entering into IITs outlined above, all of which flow from the direct enforceability of IITs. If the primary purpose of including an investment chapter in a future Australia-China FTA is confidence building, then negotiators should consider omitting investor-state dispute settlement, as was done in the US-Australia FTA.

Jonathan Bonnitcha is a Rhodes Scholar and a Visiting Fellow at the Australian National University.

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While the United States is unquestionably a Pacific power, it lacks a comprehensive Asia strategy. In fact, the US approach to Asia has focused primarily on Northeast Asia – Japan, China and South and North Korea. Appropriately, significant focus has also been given to India in the last five years.

But since the end of the Vietnam War, American focus on Southeast Asia has been episodic and crisis driven. While the US has a substantial reservoir of strength in the region, US policy has failed to connect the dots and develop them into a rational and well articulated strategy. The missing piece of a well advised Asia strategy has been a durable, serious and balanced strategy for Southeast Asia.

Now is the right time to focus on the development of such a national strategy. The lack of consistent US focus in the region has enabled the ascendance of Chinese power, the slow undermining of US business interests and will eventually degrade American security capabilities. In that context, a refocusing of American engagement in the region is due.

The Obama administration has indicated a strong interest in addressing this gap. President Obama has declared himself the ‘first Pacific President of the United States’ and has inaugurated a US-ASEAN Summit that includes all ten of ASEAN’s leaders. Yet while form is moving in the right direction, a substantive framework is required to support enduing American engagement in Southeast Asia based on a clear-eyed understanding of American interests in this vital region.

The approach to this effort should be based on an objective assessment of current and future US interests in Southeast Asia and engage stake holder in government and business, with expertise in business and economics, defense and security policy, human rights and cultural issues, and others.

US is building on a reservoir of strength in ASEAN

The US has significant interests and strength in ASEAN. An informed American policy will recognise and leverage these strengths and build upon them. ASEAN is currently home to far more US investment than China or India, and the region is also a bigger market for US goods and services than either of its larger neighbors. US security assets in the region have been developed over decades and need to be revitalised. The US has significant social and cultural ties with the region that range from education to the arts to people to people ties.

ASEAN is comprised of ten countries, home to over 600 million people with a collective gross domestic product (GDP) of approximately USD1.3 trillion. Together, the ASEAN countries are committed to global engagement. They are the most trade dependent formal grouping of nations in the world with trade accounting for just less than 100 per cent of their aggregate GDP. Indonesia, which anchors ASEAN as its largest member, is the fourth largest country in the world and home to the world’s largest, moderate Islamic population.

On the trade and investment front, ASEAN is home to more than USD153 billion in US investment; more than three times our USD45 billion in China and nearly 10 times our USD16 billion in India. That figure does not even count investment in the oil and gas sector, which could nearly double the total. The US is ASEAN’s largest market and ASEAN is the fourth largest US market after NAFTA, the EU and Japan.

While President Obama has alluded to the importance of trade in Asia in his State of the Union speech and during his Asia trip last November, the fact is that a coherent trade strategy is still not in place. Focusing on this important issue in the context of a broader US strategy for the region is timely and will be a catalyst for progress.

In terms of security and strategic interests, ASEAN includes two of the five US allies in Asia, the Philippines and Thailand. Singapore works very closely with the US providing key access to for military assets. Other countries such as Indonesia and Vietnam have important common interests with the US and are likely to become more engaged security and strategic partners in the coming years. In addition, some of the world’s most important shipping lanes are in Southeast Asia – the Straits of Malacca and the South China Sea. The region also is the source of significant natural resources including oil and gas, as well some of the richest sources of biodiversity on the planet.

Culturally, despite the fact that over the last decade some US policies have been unpopular, notably our Middle East policy and wars in Iraq and Afghanistan, the US is still considered a model for governance, civil rights, political and economic freedom. English is still the predominant language used in business and education, and a large number of ASEAN students study in the United States.

ASEAN is the keystone of a durable US strategy for Asia.

None of these US strengths in ASEAN can be sustained if US policy does not recognise and build on them. With the rising influence of China and India, there is increasing competition for markets, minds and militaries in the region. This is a competition the US should welcome given its significant leadership position.

In this sense, a comprehensive US strategy for Asia generally is incomplete without a strong, well defined core strategy for ASEAN. ASEAN is the place where the most important countries of the Asia Pacific meet and compete, and the US cannot afford to cede or underestimate its foundational interests in this vital region.

In this sense, an ASEAN strategy should account for the rise of both China and India as well as key interests with US alliances in Japan, Korea and Australia. The traditional post-colonial mind set of separating East Asia from South Asia no longer applies. India has traditional cultural, trade, and economic interests in Southeast Asia comparable to China’s. While India has been more internally focused than China in the last two decades, its policy makers, business executives, educators and movie producers have rediscovered ASEAN. The US will benefit from including India in regional architecture in Asia if for no other reason than as ballast helping to balance a fast growing and focused China.

In the area of trade and investment, ASEAN is at the center of the global free trade movement. For ASEAN, this is a matter of survival since its member countries are collectively the most trade dependent in the world. Indeed, countries like Singapore, whose trade is over three times its gross domestic product, would starve without trade and would languish if trade does not continue to expand.

On January 1, 2010 the ASEAN-China Free Trade Agreement took effect. ASEAN has signed a free trade agreement with Australia and New Zealand as well as an FTA with India. Versions of FTA’s are also in place with Japan and Korea. ASEAN members Singapore, Brunei and Vietnam comprise three of the founding eight members of the Trans-Pacific Partnership (TPP) and ASEAN members constitute one third of the Asia Pacific Economic Cooperation (APEC) forum’s members. The US currently has a Trade and Investment Framework Agreement (TIFA) with ASEAN, though talks are relatively inactive. A good US plan for ASEAN be based on an assessment of whether the economic and strategic value of a US-ASEAN FTA would be worth working through the impediments blocking negotiations at this time.

On the foreign policy and security front, ASEAN will be at the center of any regional architecture. ASEAN is the common member in various competing proposals emanating from Beijing, Canberra, Tokyo and other capitals. In her speech on Asian regional architecture in Hawaii earlier this year, Secretary of State Hillary Clinton noted the importance of the ‘centrality of ASEAN’ in her discussion of core principles guiding regionalism. Indeed, ASEAN has existing structures that should be considered in any serious conceptualisation of regional architecture. ASEAN is the host of the ASEAN Regional Forum and Post-Ministerial Conference. It hosts an annual ASEAN Summit, the ASEAN + 3 Summit, and ASEAN + 1 Summits with eight dialogue partner countries, including, as of 2009 the United States.

ASEAN is also a key partner on transnational global issues such as the fight against terrorism. While ASEAN’s Islamic population is overwhelmingly moderate, extremist groups have exploited weak borders and out of date police and national security structures to radicalise small groups and have struck several targets including in Indonesia, the Philippines and Thailand. In addition, ASEAN countries are key stake holders in transnational issues such as nuclear proliferation, climate change, energy policy and development of sustainable renewable energy, management of disease, humanitarian assistance and disaster relief.

For all these reasons and more, the US must conclusively end the policy drift that has taken place since the close of the Vietnam War in Southeast Asia. American interests in ASEAN are significant. A well balanced and clearly defined strategy for ASEAN is the foundation for a realistic and enduring Asia policy. Without such an approach, US national security and the future wealth and prosperity of the country will be exposed to serious risk and an eventual downgrading of our status as a Pacific power.

This article was first published here by CSIS.

Ernest Z. Bower is Senior Adviser and Director of the Southeast Asia Program, Center for Strategic and International Studies, Washington

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