The India Thread

Dec. 27 (Bloomberg) -- In the holiday-season euphoria, analysts appear to have become excessively upbeat about Asia's economic prospects for 2006.

According to Credit Suisse First Boston's latest forecast, the 10 biggest economies in Asia outside Japan will expand at a weighted average rate of 7.5 percent next year. Three months ago, CSFB's prediction for 2006 growth was just 6.4 percent.

China and India, the region's two biggest economies, are expected to race ahead, expanding 10.1 percent and 8.5 percent respectively, while gross domestic product in smaller economies -- from South Korea and Hong Kong to Singapore and Malaysia -- will grow between 4 percent and 6 percent, CSFB says.

While an optimistic outlook for Asia is hardly implausible, it's important to recognize that there are risks.

China and India will both face daunting challenges to economic stability in 2006. How authorities in Beijing and New Delhi face up to them may determine whether Asia is able to make the most of the good tidings projected for next year.

The nature of the risks is well-known. Overinvestment is the Achilles' heel of the Chinese economy; India's flaw is too little investment in regard to rapidly increasing consumption. One rising Asian superpower wants to produce all it can now and consume later, the other wants to spend its future income today.

``China's investment demand is based on excessive optimism about the future,'' says Andy Xie, Morgan Stanley's chief economist for Asia. ``India depends on capital inflow to fund its consumption-led growth, like a poorer version of the U.S.''

China and India

Domestic demand in China's red-hot economy hasn't kept up with the country's growing exporting prowess. The result is a persistent trade surplus, expected to triple this year to more than $100 billion. The surplus is acting as a magnet for foreign capital looking to profit from revaluation of the yuan.

Making things worse, a state-dominated banking system wastes export earnings and foreign capital by pumping money into state-owned enterprises in industries where there's overcapacity, such as cement, steel and property.

China needs to shift as much as $250 billion of its economy from investment to consumption just to prevent new bad loans in the banking system, Xie estimates.

India's situation is just the reverse. Merchandise exports are constrained by shortages in basic infrastructure, such as power, ports, roads and airports. Computer software and back- office services, in which the country is the world leader, are still a very small part of the Indian economy.

Amid surging domestic consumption, exports are nowhere close to their potential. That's forcing India to pay for its spending excesses with dollars sent home by overseas Indians or by selling domestic equity to foreigners.

Overcapacity

Neither country's strategy is indefinitely sustainable.

In 2006, China will face a very real threat of trade retaliation in the U.S. If the U.S. Treasury does find China guilty of currency ``manipulation'' and the Congress slaps a proposed 27.5 percent punitive tariff on toys, textiles, shoes and electronics imported from China, it'll be a crushing blow for Beijing's export-led economic growth strategy.

Unless domestic demand in China rises quickly, providing a solution both to the trade surplus and the overcapacity problems, rapid economic growth may be hard to sustain in 2006.

`Urgency'

The Development Research Center of the State Council, a Chinese government think tank, recently pegged excess steel availability next year at 116 million tons, almost three times this year's surplus. A decline in steel prices because of overproduction should be good news for the automobiles industry. Trouble is, there's a glut in car manufacturing, too.

``Oversupply risks loom large,'' said Lehman Brothers Inc. economists Rob Subbaraman and Wenzhong Fan in a report, ``which increases the urgency of promoting domestic consumption.''

India's ballooning trade deficit is becoming a source of concern for overseas investors. The trade gap soared to $27 billion in the first six months of 2005, almost equaling the entire $28 billion deficit of 2004.

Having poured a net $10.5 billion into Indian equities this year, compared with $8.5 billion in 2004, investors are looking closely at the trade deficit and feeling uneasy about 2006.

``Amongst the best performing markets of this year, we're most concerned about India,'' Asia strategists at Merrill Lynch & Co. said in a report last week. ``The deterioration in the current account is being transmitted through the currency.''

The Indian rupee has weakened 2.6 percent against the U.S. dollar in the current quarter, the second-worst performer in Asia after the Japanese yen according to data compiled by Bloomberg.

India's fiscal profligacy -- public debt equals 90 percent of gross domestic product and is still rising -- makes investors jittery about financing even a modest current-account deficit.

Vulnerable

``This macro pressure point,'' say Merrill's strategists, referring to the weakness in the Indian rupee, ``has the ability to feed through the equity market, as we saw with Indonesia.''

After Bank Indonesia delayed raising interest rates to arrest a decline in the rupiah, the Jakarta Composite Index lost 11 percent of its value in August amid a full-blown currency scare.

A quarter-point increase in the Indian central bank's key overnight rate is very likely on Jan. 24.

The resilience of the Chinese and the Indian economies may be tested next year even without an oil shock, a sudden collapse of the U.S. dollar, or a bird-flu pandemic.

``China and India,'' as Morgan Stanley's Xie says, ``look the most vulnerable.''

This holiday season, policy makers in Beijing and New Delhi should fret a little.