Consumption Tax Increase a Necessary Next Step for Japan

Decades of deflation and economic stagnation has left Japan in a struggle to restore fiscal health. However, despite outrageous public debt levels (over 200% of GDP), the country’s rapidly aging population has put pressure on the government to increase spending on public services. Forced to evaluate the country’s various sources of revenue, the government boldly raised Japan’s consumption tax from 5 percent to 8 percent as of April 1st.

Since Prime Minister Shinzo Abe’s induction into power, he has focused his efforts on stimulating economic growth through a series of structural reform measures referred to as “Abenomics”. Despite economic progress, particularly in conquering deflation, Japan’s recovery is still fragile. A consumption tax increase at this stage of economic recovery has the potential to undo much of Abe’s progress. However, new revenue generation measures is vital to restoring Japan’s fiscal health and bringing down Japan’s high level of public debt.

Social security spending, coupled with low economic growth, is the main factor behind Japan’s surge in public debt. As a direct result of Japan’s rapidly aging population, social security spending has risen by roughly 60 percent since the early 2000s.

Alternatively, capital spending has been on the decline and non-social security spending has remained stable at 16 percent of GDP, one of the lowest percentages in the OECD. With little room for adjustment in other areas of government expenditures, a rise in the consumption tax rate is the most efficient way to meet Japan’s increasing demand for social security.

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Japan’s persistently weak economy and decline in working age population has resulted in a significant drop in tax revenue.  Japan’s 5 percent consumption tax rate is among the lowest in the world, making it the most appealing source of revenue generation to adjust. According to Bloomberg Businessweek, by raising the consumption tax to 8 percent, the government should be able to generate an additional 4.5 trillion yen ($43.6 billion) in the new fiscal year.

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Besides its comparatively low rate, the consumption tax increase is appealing for a number of other reasons. As opposed to raising income taxes, a rise in the consumption tax provides a more stable source of revenue. An aging population implies that spending exceeds income, making the consumption tax increase more robust. With a steady decrease in the working population, generating revenue through labor will become progressively less effective.

Furthermore, an increase in Japan’s Value Added Tax (VAT) is the most efficient source of revenue compared to its alternatives. In the final stage of implementing the new tax law, the tax rate is expected to again increase to 10% in 2015. However, given the incremental rise and low starting level of the increase makes this the least detrimental to economic growth. According to the IMF, unlike a tax on income, a VAT rate increase won’t distort household saving decisions, investment decisions, or trade.

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Lastly, raising the consumption tax is relatively easy to administer. Japan’s VAT has a broad base and a uniform rate that is more easily implementable than would be a tier based income tax increase.

Although contradictory to some of the policies and goals of Abenomics, a rise in the consumption tax is a necessary next step for Japan’s overall fiscal stability. A progressively aging population, an increasing demand in public service spending, and public debt levels over 200% of GDP calls for the Japanese government to rethink their revenue strategies. Japan’s decision to incrementally raise the consumption tax could prove to be just what the country needs to begin stabilizing its fiscal imbalance and continue on its road to recovery.

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Taiwan’s Protest against Trade Agreement with China: Political or Economic Issue?

Since the Cross-Strait Service Trade Agreement was carelessly passed in Legislative Yuan in Taiwan, thousands of Taiwanese people disappointed and occupied legislative Yuan, hoping that President Ma can withdraw this agreement and publish a related law to regulate the process of trade agreement. In April 10th, after President Ma promise to reexamine the agreement and publish regulation of trade agreement, the protesters lived in Legislative Yuan started to retreat.

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Resource: CNN

Cross-Strait Service Trade Agreement is an extension of Economic Cooperation Framework Agreement (ECFA) which was signed in 2010 and planed to gradually lowering the tariff of trade and limits of service industry. As China has become the largest export country and occupied 40% of international trade of Taiwan, Taiwanese government believes that strengthen the trading policy with China is significant to economic growth of Taiwan. They also concerned about the entering of China, South Korea, and Japan to ASEAN would lower the competitiveness of Taiwanese goods toward these countries.

The tax of trading fabrics, petroleum, machines, and automobile accessories has been lowered since ECFA was announced in 2010. Protesters claimed that the volume of trading was triggered while the price was shocked by overwhelming quantity of Chinese goods, leading to the decrease in producers’ welfare in Taiwan.

The service trade agreement is mainly about:

1. Lowering the regulation of investing in Taiwan’s hospital, logistic, Chinese medicine, publishing, sightseeing industry.

2. Lowering the regulation of banking system.

3. Lowering the regulation of investment immigration.

Obviously, opening market is good for increasing capital and trade, and lead to GDP growth. But why so many Taiwanese object to this agreement?

It seems that Taiwan benefits more from the agreement since China lowers 80 categories of trade tariff while Taiwan lowers 64 of them. However, after further research of these categories, I believe that the number of category is not sufficient to judge because it only depends on how you define those items. Besides, most tariffs of those items in China are still way higher than Taiwan under the agreement.

Advocators may argue that the service sectors in Taiwan are stronger, such as restaurant and hair industry, and Taiwanese can benefit a lot from them. I believe that is true, but not for all the condition. In China, there’s an example that the Chinese and Taiwanese cooperated department store came into law issue because Chinese board members suddenly sued their Taiwanese partner and used their relationship to imprison Taiwanese board members. In fact, not only Taiwanese enterprise but also global firms confront several issues when entering Chinese market. Otherwise, Chinese corporations are more economic of scale while most of Taiwanese companies are small. Taiwanese company may face the merger and outflow of human and knowledge resource because Chinese firms can pay more. Although China and Taiwan should not abandon the opportunity to widen their business cooperation due to several events, we still need to concern more about the fact that Taiwan is a small open economy, while China is more capital abundant and not very transparent to foreign investors.

Most Protesters are aware of political attempt by Chinese government and afraid that Taiwan may be the next Hong Kong. They believe that the lowering limit of Chinese investment and immigration may lead to launching price of real estate, higher cost of health care system, and lowering national security.

Taiwanese want a more strong connection to the world trading system and step on this goal by linking to the rising Chinese economy. As the trend of opening market continues, Taiwan is hard to avoid opening the market. Cross-Strait Service Trade Agreement should lead to the growth of Taiwanese economy for a while, but in the long run, economic growth is questionable.

The main issue is that Taiwan’s economic has been too reliable on export to China. Most of Taiwan’s export to China is IT product, which mainly comes from the intra industry trade. That is, Taiwanese invest factories in China to produce the final product and import component from Taiwan. This horizontal integration causes the trade substitution effect and trade creation effect. The substitution effect causes the decrease in Taiwan’s export to China when China can produce the same product as Taiwan, while the creation effect causes the increase because factories in China need to import components from Taiwan. The OEM industry was strong and mainstream in Taiwan but facing lowering margin and strong competition from Korea and China. Taiwanese need to consider about transferring their industry and focusing on global market.

Reference:

1. http://nccur.lib.nccu.edu.tw/bitstream/140.119/23201/1/930611_1%5B1%5D.pdf

2. http://www.cier.edu.tw/mp.asp?mp=1

 

 

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Pakistan’s Looming Energy Crisis

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Pakistan is experiencing one of the worse energy crises at the moment. Electricity and gas load shedding has deeply disturbed the lives of ordinary citizens, not so much of government officials and policy makers who typically have full access to energy. Imagine how hard it would be to live in a country where people have very limited access to the most basic of needs such as electricity, gas, and water. What is more surprising is that despite having sufficient natural resources such as coal, natural gas, and hydroelectricity, and capacity for renewables, Pakistan remains one of the most energy deficient countries in Asia. Additionally, in spite of its strategic geographic location, surrounded by energy rich Iran and Central Asian economies, and emerging market giants like China and India, Pakistan has done little to tap investment opportunities due to its acute security problems and poor international standing and reputation. Energy supply is indeed in shortage, however, according to many experts, factors such as absence of good governance and rampant corruption are the main reasons behind the energy crisis.

Energy supply has failed to keep up with the rapidly growing demand that comes with the fast growing population. Wrecked with poor management, corruption, and inefficiencies, the energy sector has slowed down the entire economy. Hundreds of factories have shut down, leaving thousands of workers unemployed. Textile industry is hurt the most and contributed to sharp decline in Pakistan’s exports. More so, per day electricity shortage has reached the 5,000 MW mark and the energy consumption rate has increased to 80 percent. The energy crisis should not be mistakenly seen as new phenomena. There has not been a single dam construction since the 1970s, which has greatly restricted Pakistan’s ability to generate hydroelectricity. Energy shortages cost the GDP about 2 percent on an annual basis, and Pakistan’s slow annual growth rate of about 3 percent cannot sustain the economy experiencing bulging population. The population has reached about 200 million people and is growing at an annual rate of about 2 percent, much higher than India and Bangladesh. Natural gas supplies are short 20 percent and domestic oil and natural gas reserves are depleting very quickly. According to some forecasts, Pakistan’s oil and gas reserves will exhaust by 2025 and 2030 respectively.

There is urgent need for reform and for an effective governance system that could improve the performance of the energy sector. The country is in the hands of extremely incapable leaders since the 1980s. These so called leaders, consisting of politicians, military generals, and bureaucrats, have sacrificed Pakistan’s long-term economic goals over short-term personal gains. In order to understand how various economic sectors function, it is important to understand the political system of Pakistan. Just to clarify a huge misconception, right wing Islamic parties do not even get 1 percent of the votes and barely win a seat or two in the National Assembly. That is not to say that so called democratic parties that dominate the political scene, Pakistan Muslim League (PMLN) and Pakistan Peoples’ Party (PPP), have been progressive. These two parties are still run by families who laid their foundations in the first place. Over the years, the family members were successful in integrating other elites of the country into their parties and established political monopolies. PPP just finished its five-year tenure in 2013, and PML-N is in majority at the moment and both the parties have alternatively ruled the country for many years now. Most energy producing companies are state-owned and these parties are swift in employing incompetent, visionless, and insincere and, at times, uneducated party members to the top-level postings. As a result, inefficiencies in the energy sector are predestined as relationships are prioritized over merit. The Transparency International ranks Pakistan amongst the world’s most corrupt countries, currently at 127 out of 177, 1 being the least corrupt. The state owned energy companies must be privatized, which will generate more competition, innovation, and efficiency.

Privatization alone will not be enough. There are many privately owned energy companies that are also in crisis because the government did not fulfill its promises of paying subsidies to these companies. The companies have already reached the level of debts that are not sustainable and cannot borrow further to pay off their fuel suppliers. As a result, energy suppliers have cut back on energy production and this vicious cycle of ‘circular debt’ that has reached $4.5 billion remains the quintessential reason behind poor financing of the energy sector. In words of Michael Kugelman of the Woodrow Wilson, ‘A subset of the energy financing problem is an inability or unwillingness to muster the necessary political will to address the money shortage.” He also mentions that the Pakistani government always comes up with national energy plans that are hardly ever implemented due to the lack of political will. The national energy company, Pakistan Electric Power Company (Pepco) experienced a loss of $1 billion as a result of unpaid bills in the FYE 2011. Furthermore, the government fails to subsidize the energy companies because of the crippling fiscal budget. It is widely reported that only 1 percent of the population pays taxes and even less than that pay their electricity bills. It is also widely recorded that no tax payments are received from the highest income bracket as many of them get tax waivers from the government due to their close connections with the government officials. There is also a lot of evidence on tax evasion, misreporting of assets, and money laundering by politicians and the business class.

In addition to funding problems, the existing energy infrastructure is old and needs repairs. The government should invest in new plant and equipment to reduce transmission and distribution losses. Power theft is also a cause of concern, however, the problem could be dealt better with a top-down strategy rather than bottom-up. Many ministers in the water and power and other energy related departments are accused of bribery and corruption on a daily basis, but nothing happens to them in the end. Academicians, researchers, and think tanks have all provided great ways to solve the domestic energy crisis, but no one listens. Many might say that coal is a major pollutant and should not be used as a source of energy, but the country needs to start somewhere. Thar region of the Sindh province has one of the largest proven coal reserves in the world, yet exploitation efforts are still not being made. 81 percent of Chinese electricity is generated from coal, whereas not even 1 percent of Pakistan’s electricity is generated using coal. Pakistan also has a long coast towards the south of the country and sufficient sunny climate, yet the country, despite having the technical expertise, does not produce any energy from solar and wind. It is widely believed by researchers that Pakistan can increase capacity generation from renewables to 20 percent by changing the energy mix towards green technology. Pakistan also has a lot of saline land that could no longer be used for agriculture, but could be utilized for fuel production from algae that grows on saline land.

It is in the best interest of Pakistan to establish collegial ties and enhance trade with its neighbors if it desires to reverse its political, economic, and social decline. Pakistan should not back out of commercial deals that it makes with its neighbors. For instance, in the case of Iran-Pakistan gas pipeline project, under which Iran would export natural gas to Pakistan, Tehran is quite angry, as Islamabad did not fulfill its commitment of constructing the gas pipeline, whereas Iran, on the other hand, already finished construction on their side. Islamabad’s excuse is that the government does not have enough funds to construct the project and that Iran should finance the development of gas pipelines even on the Pakistani side. Notwithstanding, the controversies around the project, it is in the best interest of Pakistan to live up to its international agreements. The country cannot afford to further isolate itself from the global economy by breaking international agreements. Pakistan should take every possible step to improve its domestic security issues, and properly invest in, reform, and restructure the energy sector to heal the bruising economy.

Foreign reserves are declining as exports continue to fall because of energy shortages, which is adversely affecting the industrial activity and results in poor macroeconomic performance. The government should also focus on family planning, as Pakistan is not far from becoming one of the most densely populated countries in the world. Other crucial steps could involve investing in human and physical capital, health, improving the infrastructure, pushing the society towards cleanliness just as Singapore has done it in the past, and providing tax incentives for foreign investors to attract foreign direct investments. Pakistan has great examples of India, China, and other Asian economies in front of it, all it needs to do is pick a model, experiment and keep on trying to be better. This cannot be achieved with corrupt and selfish governments. Therefore, it is imperative that the country embarks a political restructuring from top down and strengthens its core institutions such as the central bank, judiciary, and police. A lot of work needs to be done in terms of improving the security situation in the country if Pakistan aspires to attract foreign direct investments in the energy and other important sectors of the economy.

 

References:

Solutions For Energy Crisis In Pakistan Conference Papers: Jointly done by the Islamabad Policy Research Institute (IPRI) and the German Hanns Seidel Foundation (HSF)

Asian Development Outlook 2013 (ADB Report)

Kugelman, Michael, ‘Pakistan’s Energy Crisis: From Conundrum to Catastrophe,’ The National Bureau of Asian Research, (2013)

Mills, Elizabeth,’ Pakistan’s Energy Crisis,’ Peaceworks, United States Institute of Peace (2012)

 

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Indonesia: An Inevitable Choice of Economic Transformation

Indonesia’s growth rate is expected to slow down in the next coming years from an average rate of 6.5% per year in the last decade to a rate of 5% to 5.5% and there is the risk that Indonesia fall into the middle income trap. Indonesia has the potentiality to meet the ambitious growth rate of 7% targeted by government for the period up to 2025 but it is facing some significant challenges which have hampered its economic development and growth. Alongside infrastructural bottlenecks, Structural problems in the economy and low productivity are the main issues which Indonesia should address these issues in order to meet its growth targets.

To achieve the economic goals targeted in Indonesia’s master economic development plan, share of productivity should increase to 4.6% of GDP growth from the current share of 2.9% which requires a 60% increase in the productivity level.

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Indonesia owns substantial amounts of natural resources which can be used to accelerate and sustain economic development of the country. Indonesia is the world’s largest producer and exporter of palm oil, the second-largest exporter of coal, and the second-largest producer of cocoa and tin, and it has large reserves of nickel and bauxite. But over dependency on natural resources has increased risk of “Dutch disease” for Indonesia. Around 60% of Indonesia’s export is constituted of these natural resources which has the least contribution to employment of the country. Dependency on natural resources has covered the need for a growing and productive manufacturing sector and the exchange appreciation resulting from that has hurt competitiveness of manufacturing sector of the country. If Indonesia wants to reach to its goal of high-income status by 2025, it must create a strong manufacturing sector with a diversified production base. Unfortunately, as it was mentioned before Indonesian economy has remained reliant on the production and export of commodity goods with low value-add, volatile prices, and low demand elasticity.

Indonesian manufacturing is shrinking as a share of GDP, exports, and employment. Today Indonesia’s Non-commodity exports account for only 11 percent of GDP which is about one-third that of Thailand and Malaysia. Manufacturing sector accounts for 25 percent of Indonesia’s GDP which has decreased from 28 percent in 2000. Part of this weak performance can be explained by the protection policies which government has implemented to support domestic companies. As a result of these policies competition is restricted, productivity growth is stalled, and FDIs are depressed.

Besides protection policies, a combination of low labor productivity, inefficient investments, and strict labor regulations have badly hurt manufacturing sector of the country. To address low labor productivity, Indonesian government has tried to improve the condition by initiating some changes in the education system of the country but no significant improvement has been achieved yet and education system still is not able to arm young generation with sufficient skills and know-how. This is while increasing labor productivity would have a very significant role in the future prosperity of Indonesia.

Being the forth populist country in the world with 105 million workforce Indonesia will enjoy a demographic bonus in the form of a large working force (40 million new workers) which will reach to its pick in 2030. While this number of work force will created a labor bonus and will increase competitive edge for the country, to efficiently utilize this large number of young work force has remained a big challenge for the government. Government should provide young generation with adequate education and expand labor-intensive manufacturing sector by generous investment, encouraging and flexible business regulations and labor laws.

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Inefficient investment regulations and strict labor laws have discouraged domestic investments, entrepreneurship activities, and FDIs. Among 185 countries, Indonesia is ranked 166 in the ease of starting a new business. Indonesia’s labor laws have placed tight constraints on the firing and hiring of workers and impose one of the world’s highest severance payments. Such regulations has made difficult for corporations to mobilize capital and labor to more productive activities between firms and sectors. This condition discourages labor-intensive manufacturing, dampens growth, and locks out the bulk of Indonesian workforce from high-quality jobs in manufacturing.

The efforts of President Bambang Yudhoyono’s government to relax such regulations in 2006 were left fruitless after labor unions brought people to streets and opposed the government decisions to reform labor market regulations. In fact the government of democrat party of Indonesia that could get the power after making a coalition with 6 other parties has been very weak in imposing structural reforms. Besides strict labor laws, an ever increasing wage rate has also hurt the manufacturing sector through increasing input costs of the firms that has caused manufacturing sector lose its competitiveness. Government of Jakarta under pressure of labor unions increased the minimum wage rate by 44% in 2013. This while country’s per capita worker productivity has lagged behind the ASEAN average and increased by only 3.4% between 2000 and 2011 while wages rose by 5.5%.

Indonesia needs both, more investment in firms, factories, its people, and its infrastructure and simultaneously, to follow and implement the required reforms in business regulations and labor laws. To ensure a sustainable and broadly shared growth the future government of Indonesia should be ready to make tough decisions at this critical stage in the development of the country.

 

References:

 

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China’s contribution to the Energy self-sufficiency of the US

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During 2000s the innovations and initiatives by the private and the public entities disrupted the US solar energy sector to make solar technology more affordable and efficient. The solar energy deployment in the US increased by 17% in 2007, the sector grew at the rate of 40% from 2000 to 2008, initiatives were taken to reduce fossil fuel subsidies and direct those savings towards renewable energy and the per unit cost of solar energy production reduced over that period. The massive expansion in solar energy sector pulled foreign solar manufacturers such as Sanyo (Japan) and SolarWorld (Germany) among others to set manufacturing units in the US. The glory began to fade for US manufacturers in 2011 when the US companies (Konarka and Solyndra) started to file for bankruptcies. General Electric put on hold its upcoming solar production expansion. The industry immediately acknowledged that the cost effective solar products from China will disrupt the US solar sector but this time the disruption would soften the US competitiveness in favour of China. In the US in 2014, 140000 people are employed in solar sector.

Without delving into details I will put it simply – ‘A major contention for an end user of solar power concerns the comparison of cost per unit of solar power with the cost per unit of the traditional energy source.’ The cost parity in solar power is achieved when per unit cost of solar energy for an end user is same as per unit cost of power from traditional energy source such as coal. Spain, Italy and Germany have already achieved parity.

Facing the tough cost competition from the Chinese solar product suppliers, SolarWorld (German company operating in the US) with the Coalition of American Solar Manufacturing in 2011, filed antidumping (AD) and countervailing duty (CVD) petition with the US Government requesting tariffs to be imposed on the solar cell import from China.

The petition claims –

  1. Imported products from China are being sold in the US at unfair prices.
  2. The Chinese government unfairly subsidizes its manufacturers and exporters.
  3. The dumped and subsidized imports are a cause of material injury to the US industry.

2012

In response the Chinese Ministry of Commerce initiated an Unfair Trade Barrier Investigation into six State level renewable energy subsidy programs in the US. The investigation targeted five states and covered renewable energy technology incentives, including solar. In 2012 China announced it had launched an official complaint at the WTO against US import duties on 22 Chinese products, including solar cells.  The complaint alleged that the US application of CVD on Chinese products was inconsistent with WTO rules and constituted a subsidy to US companies.

In 2012 the US imposed 31% antidumping tariffs on Chinese solar panels. The new tariffs would substantially raise the solar power cost to end users. The law firm representing the US companies said that China posed a particular threat to the developing green energy sector in the US. “Green energy sector would not be developing anymore when cost of green energy is much higher than those from fossil sources”.

Meanwhile in Chinese Solar Industry

The Chinese solar sector was becoming highly competitive and concentrated. After the news on tariff, the large Chinese manufacturers showed interest in shifting manufacturing units to Canada. But the Chinese State owned banks that gave many loans to Chinese solar companies were getting restless from the tariff issue because this would lower profitability of Chinese companies and hence their ability to repay loans. Also the Chinese companies were facing stiff competition nationally so the further cost reduction pressures were mounting. In nutshell, the shifting of manufacturing to Canada would raise costs for Chinese manufacturers and the circumstances did not allow that. At this point please notice that the US is the main exporter of the polysilicon to China and this is the key raw material in the manufacturing of solar cells that Chinese companies produce.

2013

In 2013, China twice increased import duty on the US polysilicon to the net of more than 57%. The EU and China reached an agreement in early 2013 to set minimum price and volume on solar panel imports from China. The tariffs in late 2013 were raised to 42.1%.

2014

The US opened new antidumping investigation into solar panels from China. This was on request of SolarWorld again. The Chinese companies were buying cheaper solar cells (solar cells are joined together to create solar panels) from Taiwan and then assemble the solar panel to be sold in the US. The Chinese companies were avoiding tariffs if they contained solar cells made outside China.

The US solar industry employees can be divided between solar installers and solar manufacturing workers. Only the fraction of workers is in solar manufacturing. For the much larger solar installation group the Chinese products are better as the installers will install cheaper solar panels for end customers. The solar installations were worth $13bn of which 50% of installed solar equipment was imported from China.

Ongoing

The Department of Commerce sent questionnaires to 24 Taiwanese companies in regards with antidumping investigation. Two companies out of those were selected as final respondents based on manufacturing and export-import capacity. The decision on tariffs is under review and will be released within weeks.

 Conclusion

  • Expensive Chinese solar panels by virtue of higher tariffs imposed on request of a German manufacturer will cause Americans to lose their jobs
  • The US wants India to back off a policy that would require local sourcing for solar energy technology and has sought World Trade Organization enforcement action

The US wants to close borders to foreign made solar products in order to support local manufacturers. The US wants India to open borders to foreign solar manufacturers and not protect local manufacturers. What sort of POWER are we talking about here?

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http://www.nytimes.com/2012/05/18/business/energy-environment/us-slaps-tariffs-on-chinese-solar-panels.html?pagewanted=all&_r=0

http://www.reuters.com/article/2014/02/14/us-usa-trade-solar-vote-idUSBREA1D16C20140214

http://www.bloomberg.com/news/2014-02-13/u-s-considers-solar-trade-duties-in-threat-to-installers.html

http://www.pv-magazine.com/news/details/beitrag/seia-blasts-solarworld-legal-action–calls-for-peaceful-resolution-to-us-china-trade-dispute_100013822/#axzz2y1gLRE6A

http://www.prnewswire.com/news-releases/wuxi-suntech-calls-for-an-end-to-the-us-china-solar-trade-disputes-252485221.html

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Emerging Baku

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I was lucky enough to be selected for last year’s Hassenfeld overseas immersion trip to Turkey and Azerbaijan. I was somewhat familiar with Istanbul as I had been to Turkey before, but had no clue of the rapid development in Baku, the capital of Azerbaijan. Upon arrival to Baku, I saw bustling signs of economic vitality, from a highly developed physical infrastructure such as roads, bridges, and railways to flamboyant motor vehicles, buildings and public parks. No doubt Baku is on the path of becoming one of the leading developing cities of the modern-day, underlying are serious structural challenges such as the excessively centralized political system of the country, over dependence on oil, and environmental pollution that require careful attention.

The Republic of Azerbaijan got its independence from the Soviet Union in 1991, but its history goes back to two thousand years when it was home to Zoroastrians. It is now home to about 9 million people, mainly secular Moslems. Its prime location in Central Asia, neighboring Russia in the north, Iran to the south, Georgia to the west, and the Caspian in the east, makes it an attractive geography. Over 90 percent of Azerbaijan’s exports consist of oil and petroleum products and its main trading partners are Italy, Germany, Turkey, Israel, Iran, France, USA, Indonesia, and China. During the 70 year Soviet rule, about 75 percent of Soviet oil came from Baku, and since independence, companies such as British Petroleum (BP) established oil exploration and extraction operations in Baku. Billions of dollars from oil revenues are being spent on transforming the city into the next Dubai.

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Indeed the city is on the road map of becoming the Central Asian Dubai as the government is massively investing in mega projects such as the development of ports just like the Port Rashid and Port Jebel Ali in Dubai. Hotels such as the Marriott, Hilton, Four Seasons, and designer shops including Zara, Louis Vuitton, Prada, just to name a few, have already sprung up in Baku’s shopping malls and plazas. The government plans to cluster satellite cities in Baku just like the Dubai Media and Dubai Internet cities to make Baku the business hub. Completion of the Baku Flame Towers has already become the hallmark of the city. It marks the ancient linkage of Azeri people with the Zoroastrian religious rituals of fire worshiping, and is likened to the fancy Burj Al Arab building in Dubai. Another hallmark is the 57,519m^2 Heydar Aliyev Cultural Center, named after the third president whose son is now ruling the country, completed in May of 2012. The Center consists of a conference hall, library, and museum and the main motivation behind it was to promote the Azeri culture and attract foreign tourists. Other projects include the construction of islands near Baku just like the Palm Beach Islands in Dubai and the Princess Islands in Istanbul. The estimated cost of developing these islands is close to USD 100 billion.

While Baku has benefited from oil revenues, many citizens are skeptical as to whether these investments are directed towards long-term objectives. Oil dependence has resulted in an over-valued currency, slow growth of non-oil sector, and loss of competitiveness. Annual GDP growth rates of as much as 30, 40, and 50 percent in the past decade prove that oil revenues and government stimuli packages keep the economy going. Inflation has long been in double digits as a result of widening budget deficits. In 2007, the annual inflation rate was 16.8 percent. In the same year, gasoline prices surged by 50 percent, and water and electricity costs also doubled. In addition to chronic inflation, the Manat has been appreciating due to the Dutch disease that hurts the nation’s non-oil sector as currency appreciation leads to loss in competitiveness. The Manat has been increasing in value by 5 and 6 percent against the US$ in the past few years because of higher demand for Azeri oil. As a result, other sectors of the economy have suffered from the Dutch disease, mainly the agriculture sector, which grew at a rate of as low as 1 percent recently. Oil revenues have clearly not been invested uniformly across sectors, which will keep other sectors under terrible strain. Central bank independence is also another concern, as government interference in the Bank’s activities skew economic performance. Many economists are skeptical of the data that gets released by the central bank of Azerbaijan and believe those indicators’ actual values, such as in the case of inflation, are misreported.

Corruption is also a cause of concern. According to the Transparency International, Azerbaijan is ranked as low as 139 out of 176 countries on the corruption scale, 1 being the least corrupt. Ordinary citizens do not have civil liberties such as the rights to freedom of speech, expression, and free press. Inspired by the 2011 Arab Spring, Azeri nationalists made it to the streets to demand basic human rights, but were subject to brutal crackdown by police and law enforcement agencies and many of those are still in jails without any legal proceedings.

Every organization and institution we visited had multiple portraits of the Aliyevs against their walls and the people we met always praised the Aliyevs in their conversations. Azerbaijan is clearly a relationship-based economy where relationships matter more than anything else. We got the opportunity to meet with the owner of the largest foods manufacturing company called the Azersun. He was an old businessman who had fled Iran during the 1979 revolution and established the company upon settling in Azerbaijan. He had close ties with the president and informed us that his success could not have been possible without the support  from the Aliyev family. Nevertheless, he gave us gift bags full of different kinds of Azeri tea, coffee, and sweets and we were very grateful to him for having us over.

While walking by the shores of the Caspian Sea, we smelled petrochemicals in the air and witnessed oil spills in the sea. Located not far from Baku, a large city, Sumgait, which we visited as well, is considered one of the most polluted cities in the world. Blacksmith institute’s study ranks, reports the Time, Sumgait as the ninth most polluted behind Chernobyl. Rankings were assigned on the basis of percentage of toxic chemicals in soil, water, and air. Oil revenues should also be invested in preventing cities and waters from becoming awash with pollution, and oil-drilling practices must be strictly regulated and monitored by the authorities.

It cannot be denied that Baku is transforming into the city of the future, nonetheless the government must address the structural problems the nation faces to ensure sustainability and spread of the Baku growth model to rest of the country. Upon visiting universities in Baku, I can easily conclude that the education standards were also not so impressive after all. In fact, universities in my own home country, Pakistan, could be much better in terms of education quality, the campus, resources, and academic discipline offerings.

English language proficiency both in and outside the universities was quite poor as well. One of the professors at a university pointed out that the government is planning to invest more in human capital and healthcare as part of its economic diversification efforts. As of now, these structural problems within Azerbaijan hold back the economy and lawmakers must address these challenges before it is too late. While Baku emerges as a futuristic city, it is nowhere near Soul, Singapore,Taiwan, or Hong Kong. The East Asian cities are far more advanced in science and technology, banking and capital markets, human capital and health services that ensures long-term economic prosperity of these cities. Baku would be better off following the East Asian growth model rather than following the Dubai model of building flame towers, geometric shaped cultural centers named after the ruling family members, or hosting international events whilst its average citizen is unhappy.

References

Valiyev, Anar ‘City Profile, Baku’, School of Public and International Affairs, Azerbaijan Diplomatic Academy, Azeri press article 2012

World Bank Country Profile: Azerbaijan

IMF Country Profile: Azerbaijan

Transparency International Index

http://www.transparency.org/country#AZE

‘The World’s Most Polluted Places,’ Times Rankings http://content.time.com/time/specials/2007/completelist/0,29569,1661031,00.html

‘Bloom and Gloom: Azerbaijan’s economy, drunk on oil, is suffering rapid inflation,’ The Economist 2007

http://www.economist.com/node/8819945

‘How to Spend It: A Small Country goes drunk on oil,’ The Economist 2011 http://www.economist.com/node/21538212

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Shadow banking system in China — Explosion of Risk

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China is now facing issues from its “Shadow Banking System”; a term refers to a diverse set of financial institutions that are performing banking functions outside of regulated depository institutions. There is a ton of talks these days among economists about whether this expansion of risky and complicated financial practices might trigger a major economic crisis in China and thus sending shockwaves around the world. But before addressing this critical issue, let’s look at how it came into being.

It is widely believed that regulated financial system in China gave rise to shadow banking industry. In China, the credit markets are dominated by some major state-controlled banks that focus on lending to State Owned Enterprises or those firms in officially sanctioned industries, while other businesses have limited access to bank credit.

The flip side of the story is that Chinese government also intentionally keeps deposit interest rate extremely low so that it can channel cheap loans to those State-Owned Enterprises. In that case, the low interest rate generated motivation for investors to seek some higher yield investment products. When the demand side for capital (those firms that are not stated owned and are not in favored industries) met the supply side (those investors seeking for higher yield financial products) this is when Shadow Banking market in China came to fill this gap, namely it finances risker borrowers and transactions that banks cannot undertake due to regulation. This practice demonstrates a Chinese old saying: 上有政策下有对策 – meaning when policies come from above, those at the lower levels will find ways to get around them.

According to a report from JP Morgan, Shadow Banking in China nearly doubled between 2010 and 2012 to nearly $ 6 trillion, which is roughly 70% of the nation’s GDP. The pace in recent months remains brisk. Since most of this money is going into risky real-estate developments and other construction projects, there are fears in the market that some attributes of Shadow Banking resemble the toxic subprime mortgage assets that tanked the U.S. in 2008. However, the high government officials in Beijing have no one to blame but themselves, since they have been too slow in reforming the formal banking sector, excessive regulations and bureaucratic interference, they simply don’t let banks operate on a truly market-base, therefore creating grey area for unregulated financial vehicle to jump in.

However difficulty faced by regulators is dilemmatic: since Shadow banking has become an integral part of China’s economy –source of funds for companies who cannot get support from banks, if the government cracks down on shadow banking too hard and too quickly it could cause a major panic. On the other hand, if the government does not move forcefully enough to curb this unregulated market, bad debts issue will escalate which might become harder to resolve later on.

Therefore, in order to solve the Shadow Banking problem, Chinese government should offer somewhat “gentle” policies to squeeze this unregulated market. Here are three possible policy recommendations:

  1.     Since Shadow banking institutions innovate many new products every day, but these products are not necessarily monitored by regulatory sectors, a new financial regulatory body should be established to adapt to the development of the shadow banking system. Its regulatory focus should not only be placed on institutional regulation but also be put on business and financial products monitoring.
  2.     It is also important to push forward reform of interest rate marketization of the banking system and build a multi-level capital market. This would provide investors with more opportunity to receive returns on their money, so that they refrain from seeking out shadowy investments. But there is no doubt that it will take years to reform the Chinese banking system and put it on more stable footing.
  3.     Usually a bond market is the best channel to price those risky corporate debt, since price change reflected market risk would help investors in the shadow banking system to monitor their own risk levels. As China’s corporate bond market (especially for high yield bonds) is still relatively small and undeveloped, an effective bond market should be established.

Finally, in terms of whether the Shadow Banking issue in China will hurt its economy growth or its target GDP growth target of 7.5 percent for the year, I will use a direct quote to answer it:

“The Chinese government not really willing to sacrifice growth, and there’s still a strong desire to keep this job machine running, to keep this economy growing. I think the right question to ask is how long can you go without it hitting a wall and I think the answer is I don’t know.”

——  Bruce Kasman (Chief Economist for Global Research at JPMorgan)

 

 

Relevant articles: http://qz.com/175590/five-charts-to-explain-chinas-shadow-banking-system-and-how-it-could-make-a-slowdown-even-uglier/#/ http://www.economist.com/news/finance-and-economics/21595483-big-default-averted-credit-paroled http://www.marketwatch.com/story/how-china-plays-high-stakes-game-with-its-money-2014-02-26 http://www.businessinsider.com/china-shadow-banks-2014-1 http://www.nytimes.com/2014/01/08/opinion/chinas-shadow-banking-problem.html?_r=0 http://www.peri.umass.edu/fileadmin/pdf/working_papers/working_papers_301-350/WP334.pdf

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