The browning of 'Chindia' (This post appeared first in Mint, daily business newspaper published by India's HT Media Ltd in association with The Wall Street Journal,in New Delhi and Mumbai, Views, Thursday April 12, 2007.)

In the first part of this post, I considered two risks to the continuation of the spectacular growth of China and India: The risk of a cyclical downturn and the risk of serious social and political instability. I now turn to the third risk: The risk of domestic environmental supply-side constraints on economic growth becoming binding.

I want to focus here on the local (national) natural resources of clean, fresh water and fertile land. (Some would add clean air as well.) These are not only important domestic ‘consumer durables’ but also key inputs into the production of the goods and services that are captured by conventionally measured GDP indices. Although both fresh water and fertile land are in principle renewable or restorable given enough time, energy and other resources, they are in practice being depleted, polluted and poisoned at a spectacular, increasing and unsustainable rate.

These resources are either under-priced or not priced at all. In India, for instance, water is supplied to the agricultural sector virtually free of charge. ‘Flat rate pricing’ for agricultural power means that the private marginal cost of electricity use in agriculture is zero. The environmental externalities of land use (erosion, deforestation, desertification) also are not priced properly or internalized in other ways. The environmental consequences are disastrous. The resulting depletion and destruction of water and land resources is a form of environmental capital depreciation, which should be deducted from the net real output or real national income measures used in the growth accounting exercise. Instead, it is ignored. Output is, therefore, overstated. The water constraint is likely to be the first one to become binding in both China and India, certainly within 10 years. It will impair even the production of those goods and services included in conventional GDP measures. By 2020, OWEC (the Organization of Water Exporting Countries that will no doubt be created soon) may well be more influential than OPEC. It may seem strange that with 71% of the earth’s surface covered by water, this would become the binding constraint on growth. Unfortunately, only 3% of this surface water is fresh water.

Well-informed observers of Chindia, such as Martin Wolf of the Financial Times, argue that Chindia will avoid these disasters by learning to price these scarce resources (especially water) appropriately. After all, the advanced industrial countries, including the UK, the US, Germany and Japan, have made considerable strides in that direction.

There are two problems with this optimistic perspective: Scale and speed. When the UK was 50 years into its industrial revolution (around 1820), it had 21 million inhabitants. Today, it has 60 million. The US in 1850 had 24 million people; it had 76 million in 1900 and today has 300 million. Today, a couple of decades into their industrial revolutions, China has 1.3 billion people and India 1.1 billion. Over the 80-year period between 1820 and 1900, UK real GDP grew at an average annual rate of 2.06%. Over the 50-year period between 1850 and 2000, US real GDP grew at an average annual rate of 4.07%.

China proposes to have an annual growth rate of real GDP of not much less than 10%. India shoots for 8% or 9% real GDP growth. What these two countries jointly propose is growth on a cale that is more than 200 times larger than what the UK and the US managed during their industrial revolutions. The national, regional and global environmental impacts will be cataclysmic. Chindia will not have a century or more to figure out how to make growth environmentally sustainable—a process still far from complete in the UK and the US. They have less than a decade. Unless China and India reorient their growth policies towards environmental sustainability, the 21st century may well become the century of Chindia—but for a very different reason from the one prophesied by the current cheerleaders.

I am not arguing that things are bound to go disastrously wrong. It is possible that all water and energy use (including agricultural) in India will soon be priced at something close to long-run marginal social cost. It is, however, more likely that neither long-run marginal social cost pricing of water and power, nor some other effective non-price rationing mechanism for scarce water and power, will be put in place in the foreseeable future. It follows that there is a significant risk that things will go disastrously wrong.

Just how likely are the prompt and massive reorientations of economic and social priorities in both India and China that are necessary to avoid disaster? History offers little guidance, as problems on this scale and of this scope have not occurred before. Because India’s 60-year experience with an open, pluralistic and democratic system of government gives it an edge over China with its 60 years of totalitarian communist party rule, I am more optimistic about India than about China.

But I have serious concerns even for India.

Too many cheers for 'Chindia' (This post first appeared in Mint, daily business newspaper published by India's HT Media Ltd in association with The Wall Street Journal,in New Delhi and Mumbai, Views, Wednesday April 11, 2007.) There has been a world-wide bout of ‘Chindiaphoria’—the widespread conviction that China and India can continue with their current growth rates for a long time, possibly decades. While everything is possible, I believe the risks to economic growth in these two countries are much more serious than markets and pundits recognize. I shall focus on three risks: The risk of a sharp credit contraction and cyclical downturn, domestic and political risk, and environmental risk. The second is obviously not independent of the third.

First, the cyclical risk. Both India and China are in the terminal stages of a credit boom. So there will be a cyclical slowdown in both. If the monetary and fiscal authorities act in time (they seem well behind the curve in both countries), and if they have the right instruments and the political will and freedom, the credit boom can end with a whimper.

A hard landing seems more likely, since the politically feasible tools for restraining credit growth are only partly effective. China’s authorities rule out the most effective and least distortionary policy response: Raising interest rates and allowing the yuan to appreciate more rapidly. Instead they rely on ineffective increases in reserve requirements and distortionary command-and-control techniques—basically selective credit controls from the central planning days. In India, the belated increases in the Reserve Bank of India’s (RBI) key policy rate to 7.75, and the accompanying increase in reserve requirements by 50 basis points, is rather late and still too little. The effectiveness of these and earlier RBI restrictive measures last year has also been undermined by the extraordinary spectacle of the finance minister, P. Chidambaram, cajoling public-sector banks not to pass on interest-rate increases to borrowers. Other populist, distortionary and, in all but the short run, ineffective anti-inflation measures of the Union government have included a ban on wheat exports.

Second, domestic political risk to growth is seriously under-priced by domestic and global investors. In China, economic liberalization is proceeding side by side with continued political repression. Growing wealth and rising average prosperity levels are accompanied by equally spectacular increases in inequality and, more recently, by growing numbers of people who are worse off and often reduced to living in absolute poverty. The sustainability of such a social-political-economic configuration has never been tested. India has had a representative form of government for 60 years. I believe this is an important socio-political safety valve.

Unfortunately, India needs such a safety valve. It is hamstrung by the widening gap between the urban and rural communities, by the continuing debilitating effects of its caste system, and by serious religious tensions, especially between fundamentalists in the Hindu and Muslim communities. India also has an atrocious record for educating its underprivileged in general, and its women in particular. The Maoist Naxalite terrorist movement is a serious internal threat to security and stability. There is a clear risk of greater religiously motivated extremism and terrorism, and of unholy alliances between home-grown and domestically oriented terrorism and international terrorist movements, especially the fundamentalist Islamist terrorist networks. There is no evidence that the political establishment is about to come up with a policy that is tough on domestic terrorism and tough on the causes of domestic terrorism. Blaming Pakistan for every bomb that explodes is not a policy.

Third, and probably most importantly, the environmental risk. Environmental constraints on growth in Chindia rarely figure prominently in discussions. The same omission invalidates the recent growth accounting exercise for India and China by Barry Bosworth and Susan M. Collins of the Brookings Institution. In this approach, the growth of output is the sum of the contributions of physical capital accumulation, agricultural land area growth, labour input growth and total factor productivity growth. Output is seriously mismeasured and a key input—the services yielded by the stock of environmental capital—is ignored completely. For Chindia, this omission matters even in the medium run.

The environmental constraints I want to focus on are not India’s and China’s contribution to global climate change and to other global environmental externalities, although these are of growing significance. Global warming may bring some benefits to parts of the globe (especially the current cooler and colder regions of the northern hemisphere). It will be an unmitigated negative for the Indian subcontinent and for China.

In my next post, I will focus on how the local or national natural resources of clean, fresh water and fertile land may in no more than a decade become binding constraints on economic growth in Chindia.

China's Environmental Worm is Turning Sooner Than Expected Today's Financial Times (Tuesday July 10 2007) reports that "Campaign to clean the Yangtze under way", "Official willing to sacrifice growth" and "Factories must improve or close". It even looks as though the State Environmental Protection Agency (SEPA) may be developing into something more than a hopelessly understaffed paper tiger . Mr Li Yuanchao, Communist party secretary of Jiangsu province, is quoted as saying that "The measures [to protect the environment] must be strictly implemented even if they cause a 15 percent downturn in the province's gross domestic product'. Probably nowhere in the world is measured GDP a worse proxy for the value of currently produced goods and services than in China, where in the heavily industrialised regions the air is unbreathable, the water undrinkable and much of the soil unfit for cultivation or residential use. The environmental and ecological externalities of the Chinese miracle are of such a staggering magnitude that they will soon begin to impinge even on the production of those things captured in conventional GDP measures. They have long since driven a growing wedge between measured GDP and any measure of economic welfare (MEW). The external effects are partly global in their impact (through global climate change driven by greenhouse gas emissions) but many are national, regional and local in nature. I would add the food safety problems that are now affecting Chinese exports but have been a well-established public health problem inside China to the list of urgent Chinese environmental and ecological challenges. Unless they are addressed promptly, the Chinese miracle could become a nightmare.