End of the Year

“For last year's words belong to last year's language

And next year's words await another voice.”

― T.S. Eliot, Four Quartets

Another year is going by and it has been nothing but tumultuous – 

• trade war between US and China;
• real wars in Syria, Ukraine & Yemen amongst others;
• Brexit and political fracturing of Europe with the recent riots in France, the budget wars with Italy and right-wing movements;
• Crude prices and markets went on a tear and have cratered towards later part of the year;
• Global liquidity has been declining with the Fed reducing its balance sheet and raising rates and ECB also stopping QE – this puts global liquidity in reverse.

This list can go on regarding the year past but that is not to forget the lessons of the years gone by. But the way things are set up I see the following trajectory into the next 3-5 years:

• The US markets have witnessed the most unprecedented bull run with very low interest rates and quantitative easing. This is now in reverse. The low interest funded buybacks, high yield issuances, frothy tech valuations are all going into reverse. This reversal will have an impact on real estate, consumer confidence and most important US tax collections. The US is already running on twin deficits – current account and fiscal. Any increase in deficit has to be funded whether by domestic or international savings. US domestic household saving with the baby boomers retiring is decline and will continue at least till the mid-2020s. Which means either corporate savings rise to fund this or current account continues to rise. The easiest path to creating this rise in corporate saving and a decline is US debt is massive decline in the dollar. Once the path of Fed tightening is over this is exactly where we are headed and this will have to large.
• US is by far the largest global consumer and settler of global savings, this dollar decline will essentially mean an erosion of export market for key exporters – Japan, South Korea, China and Germany – which extremely negative for their GDP and their banking systems. And, these are the markets in severe demographic decline only needing their export markets to maintain their manufacturing base and living standards.
• Let me explain China a bit more here. China exports is prior to 2008 was roughly 30% of GDP, when the crises hit it fell 25%. It then started the massive banking driven expansion and where we are is Debt to GDP has gone from 100% to 300% of GDP, GDP being ~$13trillion. Today 18% of GDP is exports and 50% of GDP is investments and by most measure 50% of that is a waste in terms of economic value but not employment. Doing the math again excluding the wasteful, 18% * $13 trillion divided by ($13 trillion - $13 trillion * 50% * 50%) = 2.34 / (13 – 3.25) = 24%. We are pretty much at the level of dependency it was post the financial crises, notwithstanding domestic consumer market growing. With its local markets frozen with over-investment, this is why it cares too much about its export market.
• To top this off US in the first time in 75 years in exporting oil. What was in the global market of ~90m barrels a day was importing in excess of ~10m barrels is now exporting. While this is a bloodbath in the shale markets but this has been forcing US shale technology to evolve rapidly Basic Horizontal Drilling (2004) to Advanced Horizontal Drilling (2011) to Pad Drilling (2014) to Multilateral Drilling (2016) and US full cycle breakeven which was the highest in world in 2012 at $90 is today below $40 just above Saudi crude (the lowest cost in the world) and expected to go even lower. This single issue has been causing a nightmare for the Middle-East with a key market disappearing, with that the pricing and the onset of security disinterest (Trump deciding to leave Syria is the latest example).
• Now add lowest cost of energy in the world to a declining reserve currency and you get a paradigm the investment of the living years in not used to. So, what are some of the implications:
• Hoarding of gold by major central banks as in the last few years;
• Manufactured exports especially that dependent on energy or petrochemicals to the US will suffer and north Asia with its premium priced oil supply will be worse off.
• For the global markets:
• The exporter asset markets are in decline as a combination of demography, currency cost and oil (unlike US notice none of these markets have internal energy supply) leave alone increasing defence costs (which I shall not cover here);
• US markets are the most overvalued and will be in decline until the Fed stops destroying money and initiates the next phase of interest decline / QE / dollar value destruction which might initiate in the 3Q 2019;
• India will also witness a decline but the relative decline will be protected by INR strength and low oil price. The next phase when the USD decline comes India is likely to enter the bull market favoured by the triumvirate of exchange rate strength, low interest rate and low / benign oil prices.

o   Political crises in many nations as employment and incomes suffer (look a France / Italy) and US itself has the political divisions become more and more embedded resulting in a more internal looking country and potentially giving up on its security commitments (like Japan which is acquiring carrier battle groups for the first time since 2^nd world war)

“I will honour Christmas in my heart, and try to keep it all the year. I will live in the Past, the Present, and the Future. The Spirits of all Three shall strive within me. I will not shut out the lessons that they teach!”

― Charles Dickens, A Christmas Carol

Imbalance to Inequality to Chaos

About 20 years back archaeologists discovered a new site, Gobekli Tepi, in south-eastern Turkey which they have been digging till almost 2014 given the expanse and number of layers. The site dates back to some believe 11,500BC and it suggests a level of human ability and organization which was earlier believed to have been possible much later, as in 3,000-4,000BC. Of course, there are multiple other theories on the human race from alien intervention to decimation of advanced race but this is front and centre of mainstream academia. In essence confronted with the provable facts we have changed our views. But changing our views has not lead to material change in people’s lives except the perception of it. Such is not the case with many other areas where changes in views and actions have much deeper and lifetime consequences.

In the mid-90s and then continuing into the new millennium, US had significant trade imbalances with the rest of the world. These trade imbalances were settled in the financial markets through import of savings and keeping cost of capital substantially lower than in the past. However, on the other side was the impact on industry, wages and employment. To alleviate the social impact of stagnating wages, Fed essentially kept interests artificially low creating a housing bubble generating home equity or income out of thin air. In 2008, the effects of the imbalance and the consequent policy came to roost. I am sure this story has been told many times over (http://poleconomyindia.blogspot.com/2015/12/imbalance.html).

To prevent the blow-up of financial markets all the developed major central banks created unprecedented balance sheet expansion and China essentially gave its banks a free hand to lend. The intention was (1) to prevent a significant slowdown; (2) prevent collapse of financial institutions; and (3) create wealth effect resulting in demand creation. This third intention has resulted in inequality across markets by punishing savers of all types - pensioners, insurers, workers etc. (http://poleconomyindia.blogspot.com/2017/07/when-economics-plays-politics.html)

The above actions have led us to where we are today. Many may trace these events to even earlier act of moving to fiat money and they may be correct leaving a system open for human intervention leaves a door for corruption of action but that is for another time. 

We are moving to world that neither my generation or before experienced. What we have seen is for most parts is a unipolar world, with open trade and capital flow was where incrementally the world trended towards. The US was the global balancer ensuring free global trade and the settler of global imbalances with its deep markets. The clear direction is being disrupted and we are looking at a world getting more chaotic. There are two other aspects which have ensured that political elite have lost appetite to be an instrument of change:

• The decisive intervention of central banks post 2008 financial crises and beyond have made the political elite reliant on them to rescue the markets and asset prices and not undertake structural changes;
• The rapidly emerging problems of demographic decline and technological change have sharpened inequality. It is a problem the OECD countries have no clear answer to and it is sapping their political energy.

So, what has changed in the world’s largest economy,

• Open economy has resulted in real wages in the US stagnating for 4 decades while college tuition and healthcare costs have tripled in value leading to wealth of top 0.1% being equal to the below 80%;
• US military in the last few decades has been continuously involved in many theatres of which the nation is now tired of expending blood and treasure for no strategic benefits;
• The internal politics is undergoing fractious change with the “baby boomers” retiring over the next decade while the “millennials” emerge as the next big voting bloc, who have not even a distant image of the 2^nd world war or the cold war and, therefore, why should the country remain engaged. This retirement will also raise the cost of capital as the boomers draw their retirement funds;
• This means a US economy which is the least dependent on global trade and with the massive expansion in shale production the dependence on middle-eastern oil is minimal and no political inclination can afford to “let go”.

With these factors in play why should the security architecture and the economic institutions shaped by the America even survive. Global supply chains will shift as a new protectionist economic architecture takes shape besides low energy cost. Trump is nothing but a manifestation of these factors.

China has benefited hugely from its accession to WTO and the US navy has ensured a relatively free of cost global commerce. This period of cooperation is coming to a close. US sees this as a free ride while continuing to use the American markets for trade, investments and intellectual property resulting in an emerging threat to US supremacy. This for the China would mean:

• Lack of ability to earn US dollars via exports will result in a current account deficit. Therefore, increasingly there is a desire to price commodities in yuan. Whether the exporting countries are willing to take a limited liquidity instrument is a critical decision point. Any problem in this count means an implosion in the currency and delay in rebalancing the economy. Increase in USD interest rates (10Y - 2.99%) by Fed and the spreads to China bonds (10Y - 3.47%) is narrowing making any alternate strategy by China ever more difficult to execute;
• The Chinese prior to the opium wars always had a current account surplus. What happened subsequently is regarded as a century of humiliation. The Chinese will always remember this and they do not want revisit this at any point. Further, the economic structure needs open export and investment markets. High dependence on the real estate and infrastructure of almost 30% of GDP which creates almost no incremental economic value, high internal leverage (since 2012 incremental nominal GDP growth has been less than total interest service cost) and declining population (of ~1billion working age, China will lose 45 million by 2030 and then additional 150 million by 2050) will keep the dependence on export market high. The trade war and deleveraging is already bruising the currency, stock and credit markets. The US wants China to rebalance faster along with change in political direction. This essentially can sink the Communist Party. So, this trade war has a long way to go before any party throws in the towel as much one may read about any reconciliation or even an interim settlement;
• As in the US, inequality is high. More than 550 million live on less than $5.50 a day while top 1% owns 33% of wealth. Legitimacy will require the regime to resolve this issue. Anti-corruption campaign is much showing purpose to address this as it is about removing obstacles to Xi’s power;
• Lack of protection of the US navy means one will have to expend the effort to build a blue water navy to ship oil from a warring middle-east across the Indian ocean, through the Malacca straits into South China Sea. Not only this increases the cost, it leads the Chinese to build expensive ports and pipelines in Pakistan and Myanmar to protect these shipments;
• The American pressure could not have come at a worse time when its seeks to rebalance its economy and Xi cannot afford to look weak just as he declared himself the latest emperor.

Change in China is resulting in Japanese military forsaking its self-defence posture and beginning to re-arm itself. It recently launched a new helicopter carrier, which as per experts can also be converted quite easily to an aircraft carrier enhancing its force projection capability. That aside, Japan is undergoing an amazing experiment in its financial markets. JGB market is $10trillion (>2x GDP) and BOJ has bought 47% of it. To top this up it is now it is top 10 shareholder in 40% of Japanese listed companies. All this to hold rates to zero. But recently the interest rates on 10yr started to fly – 3 July 2018 it was 0.03% and 3 August 2018 it was 0.111% - 3.7x in a month. At the previous rate ~25% of Japanese budget was used for debt servicing. Rest, I leave to the readers imagination.

The demand environment in EU has been suffering due declining working population and it is manifesting itself in the banking systems of places like Italy and Spain. Italy (owes 25% of its GDP to Europe, leave alone internal debts) it seems may give up on Europe any day and it would be catastrophe, but who can tell the time. Russians are pressing in East trying to rework their environment before the decline in population and economy over the next 15-20 years weakens their strategic capability. They could cooperate with the West, it needs the West to essentially scale their game where the Russians believe that is the only choice left. The trust option West gave up when it pursued Nato’s incremental expansion eastward against the commitments given post the Soviet fall. And, finally the biggest issue the German massive export surpluses with both southern Europe (financed by Germany itself) and rest of world. These surpluses will only grow as population ages and internal demand declines while supply is maintained with robotics, AI and other new age technologies. Unless the policy direction changes EU internal sustenance and its relationship with US are always a question market.

In this chaotic global environment, what does it mean for India (http://poleconomyindia.blogspot.com/2016/09/india-future-fast-forward.html):

• The lack of interest of the US navy over a period of time to protect the supply lines with the troubled middle-east and growth Chinese presence will mean greater pressure on the India navy to reform and acquire requisite assets. Our army-land focussed mindset and consequently the budgets will need to undergo a change;
• US pressure on Iran and Russia, will need us to deftly play the board as one is large oil supplier and our only alternate route to Central Asia and second is on whom we still depend for our military supplies;
• While lot of our focus goes towards Pakistan, it is nothing but a spoiler. Terrorists which used to number in the thousands in the Valley have now dropped to 250 or so at an average given the security measures. The internal divisions will continue to lead the Pakistan and its polity from one crisis to another. The more we build our strength and wield the stick, the more constrained their “already limited” space becomes;
• India cares about international trade but given its large domestic market and positive demographics it is not really a large player in global trade. But more importantly cares about international investment as it not only supplements its capital deficiency, its allows a technology transfusion. However, international trade and investment will both suffer given rising cost of capital and excess capacity globally. Managing local resources, expanding economic potential (education, quality infrastructure) and demand dynamics will be critical.

10-15 years hence I hope to revise my views based on “archaeological economic” findings. But as I have said in my previous articles, this period of stress and geopolitical disruption will foster rapid innovation – AI, hypersonic, blockchain, quantum computing and many others.

“Man cannot discover new oceans unless he has the courage to lose sight of the shore.” - Andre Gide

Postscript

One of the fundamental reasons the Congress agreed for a division of the country was Jinnah wanted a weak centre and large share of power at the state level allowing him to significant control over national politics by dominating Punjab and Bengal, the two Muslim majority states. Also, given Punjab geographical position and contribution to the Indian army Jinnah would have a veto on India’s defence.

Congress leaders were aware of the internal divisions and hoped that the federal structure would ensure adequate freedom for the states (and consequently for Punjabis, Tamils, Marathas or Bengalis) while the centralization project continued at a glacial place over a period ensuring a national identity. A strong central government is critical in this process to accumulate, project power internationally and also in moving this process ahead. GST, a national value added tax, extinguishing regional boundaries, is prime example of centralizing. If we do not have a strong centre, we will surely meander but this is not the time.

Growing System Constraints

“The source of the global crisis through which we are living can be found in the great trade and capital flow imbalances of the past decade or two.” ― Michael Pettis, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy

Imagine two parts of the world, one producing more and more and the other consuming more and more. These extreme parts are represented by China, the producer, and US, the consumer. But unlike being the result of income growth this production and consumption cycle is being fed by profuse amounts of leverage. Roll back two decades East Asia and South East Asia is culturally a big saver, ensuring low cost of capital with abundant labour with state directed policies to ensure large scale production and US a deep consumption market. This cycle broke when the Great Financial Crises hit, exports fell and consumption retrenched. But then as China and the US turned on the loose monetary policies, the imbalance not only got deeper but the excesses of spending on production and consumption is now resulting in over-capacity and corporate bad debt in China on one side and inequalities and decline in savings and potential consumer bad debt in the US.

$ trillion	US	China
M2	13.9	27.5
GDP	19.4	11.9
M2/GDP	71.6%	229.9%
Household Debt / GDP	78.5%	48.0%
Non-Financial Corporation Debt / GDP (1)	83.5%	162.5%
Federal Debt /GDP	97.0%	46.3%

Note: M2 Data as of March 2018, GDP CY2017, Debt Data as of September 2017

(1)    Total credit to non-financial corporation (core debt)

	2013	2014	2015	2016	Q32017
China	140.7%	149.9%	162.7%	166.4%	162.5%
US	88.3%	80.9%	78.0%	83.3%	83.5%

Source: Trading Economics, BIS

While US debt as percentage of GDP been largely constant over last 5 years, it has been growing nominally. US savings rate touched 2.9% last December the lowest since November, 2007. Chinese debt has been growing rapidly as a percentage of GDP. Also, the statistics in China miss some of the debt like structures created by local governments or wealth management products which are debt in the guise of commodity exposure etc – which seem to suggest much higher levels of leverage on all parameters. Corporates (HNA, Anbang, Evergrande), capacity shut downs of steel, coal etc and even some belt and road initiatives like Hambantota (which get 1 ship monthly) are examples of growing bad debt concerns. As these loans are managed, the central bank and the government have helped create massive money supply and leverage to allow for GDP expansion to continue at targeted rates and stabilize the interbank / lending market. Otherwise, why would China need 3 times US level of money supply? The corollary of this issue a closed capital account for the fear of losing even couple of percentage points of M2 (2% of M2 = ~$550bn) moving out of the country will create both a liquidity crisis locally and a forex crisis with global implications.

The other side of this coin is to understand the global demand economics. The US consumption market is 3x China consumption market and almost 2x European consumption market. All the talk about the trade war is essentially about demand capture. The current Trump administration is demanding what Robert Rubin (Treasury Secretary) demanded during the China WTO accession, but Bill Clinton wanted a win and put Madeline Albright (Secretary of State) in charge of negotiations and she gave in. Given the structure of the Chinese economy or for that matter the European economy it will be next to impossible to create a US comparable consumption market:

• The Chinese system has been based on ensuring limited wage growth (changed recently) and financial repression of households. This ensure the households share of GDP will continue to be low, unless significant economic reform is carried out to ensure wealth transfer. In the last few years we have only seen Xi encouraging the growth of the government sector over the private sector in old economy areas and controlling the new economy companies by various methods including putting Communist Party members in positions in the company;
• Second, is the dramatic aging of both Europe and China, will ensure a decline in consumption in Europe and limit China’s ability to create a deeper consumption market at home;
• The Eurozone construct continues to constrain southern Europe, look at the largest market Germany struggling to grow beyond 0.5% at even full employment while Italy is the other extreme of loaded with bad loans and high unemployment;
• Consequently, US, China and then India will be the only healthy consumption economies of scale in the next 15-20 years, subject to any systemic crises not happening in any of these markets like China population declining even beyond current projections.

Given this, China will have four issues in its belt and road initiative plan:

• The path to Europe through Russia and Central Asia will be a road to a declining market with high costs but serve to geopolitically stabilize China’s west and access to Caspian and Iranian oil;
• Non-inclusion of India will keep the lines to South Asia via Burma or Pakistan or Bangladesh unstable and without the largest consumption market and only help in resolving partially the Malacca dilemma;
• The security and travel cost of land-based routes will always be higher than shipping (one needs to build infrastructure to enable land-based movement as against the sea being the infrastructure for shipping), it will only increase the debt intensity of China and all the BRI participating economies;
• Biggest of all is a mindset problem. China, unlike the great trading nations like Ancient Athens, Britain or the US, has been a land-based power. Land based powers with their insecure borders tend create control oriented closed systems. A highly managed economy, information barriers, bilateral frameworks (as against open multilateral ones) and people control are all manifestation of this culture. So, unlike the US which opened its markets much wider to make the Bretton Woods system work, China is seeking to capture the market of host countries and assure itself of oil and food supplies.  

It is not to say US is in great shape, the twin deficit of current account and fiscal deficit has only been surging. The fiscal deficit will continue to worsen given the tax cuts recently. We are also in one US’s longest economic expansion which means a recession is nearer. The Fed is raising rates and shrinking its balance sheet to allow it to correct the inequalities it has festered and cut rates in the next recession. It doesn’t have the requisite firepower – historically Fed has cut 300-400bps in a recession but that buffer is not there yet. On top of this the geopolitical discord is only sharpening:

• Russians are actively trying to dominate central and eastern Europe and the caucuses through intelligence operations, subversions, oil and media;
• China related difficulties will continue predominantly in East Asia as it tries to push out of the first island chain;
• Iran is increasing recovering is domination from Levant to Central Asia, as it has manifested in the various empires of ancient Iran;
• Finally, the Europe which made choice two decades back between social spending and military spending and even if there is a significant military threat it would rely on the US. It is in no real shape to support the US militarily.

So, what gives?

The US or Russia / China is unlikely to have a full-blown confrontation at least in the 12-15 years, barring a miscalculation. US is still the hyperpower with effective defence spending exceeding US$1.2trn a year. Russia demography and economy are in terminal decline and it has 10-15 years to recreate a sphere of influence in its near abroad. China will get to an equivalent place militarily as the US probably in 15 years or maybe longer depending how it resolves the problem of high debt, over-capacity, environment degradation, vocal middle-class matched by inflexible institutions. Current stress in the international system will continue but highly unlikely to blow up.

On the economic front, Fed is continuing to raise rates given the political and economic issues low interest rate policy has created. Given the volume of debt and high stock valuations (and property valuation in key centres like London, Sydney, Shanghai, Vancouver or San Francisco etc), a tipping point will be reached, the only issue is when. The collateral pressure of rate increase is already being felt on Saudi and HK peg. The US$ is in for a short squeeze internationally (as I mentioned in my last article) given the rising oil production locally (the Permian shale basin may produce more oil this year than Iran), the Trump tax changes and rising rates. But in the medium to longer run, a decline is baked in given the twin deficits are rising at unsustainable rates. Against the Yuan, the USD has already depreciated 10% in the last year, if the decline were to continue to say 20% - 30% levels it will unleash a deflationary spiral in East Asia and possibly recession/slower growth in the US. Europe will surely go into recession in such a scenario. And, the US given its deficit is actively looking to inflate its liabilities. In this scenario, the world may want a non-dollar system but there is no great alternative except potentially looking at IMF issued Special Drawing Rights.

After 4 relatively comfortable years, India is looking to a difficult year ahead:

• Rising oil;
• Rising international cost of money in the backdrop of a weak local banking sector;
• General elections;
• A tough geopolitical environment.

While the USD is declining against other major currencies, INR is declining against the USD in the backdrop of rising oil and money cost. The above factor will reduce the FDI inflow, making current account financing more reliant on fluid Foreign Portfolio flows or alternatively tightening domestic liquidity and rates.

All in all, world-wide the constraints to growth and peace are only rising.

“Instead of freaking out about these constraints, embrace them. Let them guide you. Constraints drive innovation and force focus. Instead of trying to remove them, use them to your advantage.” ― 37 Signals, Getting Real: The Smarter, Faster, Easier Way to Build a Web Application

Crossword

“Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing ever happened.” ― Winston S. Churchill

US Economy – Key changes and implications

Since July 2017, Brent Oil has been on a tear from $45 to $70 currently. But the new swing producers which is not Saudi Aramco but US shale has gone about improving technology horizontal drilling, hydraulic fracking and incorporating low-cost sensors reducing cost of human intervention and consequently rearing to go in 2018. This has the potential to make America the leading oil producer in the world in 2018 with production in excess of 10 million barrels per day and imports declining from 12 million barrels per day to below 2.5 million barrels per day in a decade. This oil can be sourced from Western Hemisphere. In addition, Trump is looking to allow drilling in hereto before forbidden Alaskan fields. Current, oil prices will not sustain and so will not American dependence on Middle East and the need for protecting those sea lanes of communication.

When the Global Financial Crises struck the Fed fund rate went from 5.25% in June 2006 to 0.25% in December 2008, a full 5% reduction. This began increasing in December 2015 to 0.5%, the December 2016 to 0.75% and then March, June and December of 2017 saw three increases bringing it to 1.5%. The Feb proposes to undertake another three step increases in 2018 taking it to 2.25%. In the meanwhile, the major central banks which are in divergence will have no choice but to follow the Fed upwards although with a lag as it normalizes policy rates and builds adequate buffers for the next slowdown or recession. China especially will face tremendous pressure on forex reserves, despite controls on capital account convertibility. The current difference is 10-year UST and China are 1.3% of which more than half may disappear once the Fed completes its interest rate raising cycle for 2018. It is no position to increase interest rates to the extent required given the ~350% of GDP leverage the economy is currently running at so the likely give will be in exchange rates, which in turn will feed into the pressure on reserves.

10-year	% Rate
US	2.66%
German	0.63%
Japan	0.07%
China	3.95%

The recent Trump tax cuts that not only pushes wages for American workers, it also provides benefits for corporations like Apple to move their massive offshore funds home. These cuts will provide a boost in the short term, while they will enhance the federal deficit in the longer run. In addition, the ongoing trade friction is forcing corporations to evaluate how they place at least a part of their supply chain in the largest consumption market globally which consumes almost equal to Euro Area, Japan and China put together. This is, again, leading to higher investment in the US. The trade friction was a given how the export driven economies were essentially freely accessing the US markets without allowing similar benefits to US exporters with both trade and non-trade policies (http://poleconomyindia.blogspot.in/2017/01/stimulus-and-protectionism.html).

While this has happened, unusually, the dollar index in the last year has declined by 11% putting great pressure on export dependent countries. But as the dollar reverses course and the cost of funds rise coupled with a dollar liquidity decline globally due to higher domestic oil production, tax changes and trade friction, the funding pressure on emerging economies, which have relied heavily on dollar credit over the past decade, will rise leading to declining currencies, rising inflation and rising funding costs.  

Old Empires Rise

The dominant story of the last few centuries has been the rise of Western Europe and US and decline of the age-old empires - Ottomans, Persians, Hans, Poles and Indians. We are now witnessing a rise of China, Turkey, Poland, Iran and India and a revival of Russia and Japan. This is happening at a time when the sole superpower is tired of its quagmires of the last 15 years and facing growing challenges in North Korea and China which are beyond the capacity of any other country to tackle.

The above is not only the consequence of breakdown of balance of power in multiple locations at Eurasia but also a cyclical revival of power. Iraq was holding in place the balance in power against Iran which was destroyed by US war, what resulted is a shite led Iran backed government in Iraq. Turkey which is in the process of emerging from the self-imposed self-protective secular camouflage imposed by Kemal Ataturk post World War 1 as a leading power. It is only these powers which can reconfigure and create a sustainable balance of power in the Middle East and till then US has to engage in its balancing act. Where this and the emergence of renewable energy will leave Saudi Arabia is a fear which dominates their regular actions whether in Yemen or against Qatar.

Russian bear that went into hibernation post the collapse of the Soviet Union rediscovered itself with Putin and post 2008 we have seen a continued power projection by Russia in its neighbourhood – Georgia, Crimea, Ukraine and Syria. It continues to significantly fund subversive activities in the entire eastern European landmass. It recognises that its demography is in decline and so potentially is the future of its oil dependent economy. It has a decade to reinforce at its historical buffers in Eastern Europe. But it shares borders with three strong states – Turkey, China and Poland. Russia for most part is European country and it historically that the Russians, Prussians and Austrians that had divided the Polish empire which reached its height in 1619 when it occupied present-day Ukraine, parts of Russia, Belarus, Estonia, Latvia and Lithuania. We are seeing a revival in Polish economy and political power including their national will to ensure their independence – expanding its army and platform acquisitions. Poland is likely to be the flank of Russian and Turkish power projection westward in the current century.

East Asia is undergoing its own geopolitical dance as China’s rise affects the balance of power with Japan. Japan is already in the process of changing its constitution to change its force configuration to meet the rising challenge of China. China as it faces a more uncertain US presence to protect its energy sea lanes from the Middle East is envisaging oil pipelines running from Pakistan and from Burma to protect itself from the narrow lanes in Malacca straits which India, Japan or the US can significantly constrain and enhancing its naval presence in the Indian Ocean. This in turn is creating threats for India in their near neighbourhood from Pakistan to Nepal to Burma and the Indian Ocean region. India has already become the 5^th largest defence spender globally and may go on to become the 3^rd largest behind China within the next decade. But ultimately China faces the US – in its presence in South Korea, Japan, Taiwan, Vietnam, Philippines and Singapore. This also represents the One Belt One Road geopolitical manifestation besides the desire to stabilise the Xinjiang in its west. China is an economy facing massive leverage, very poor demographics, income imbalance and export dependence. It is erecting significant barriers and internal controls as President Xi tries to manage the contradictions (which I have discussed in detail in earlier articles) and reconfigure the economy. This is where US policies will exercise their maximum force.

Distributed power with multiple balance of power structure was the way the world was before the two superpowers divided it post World War II. We are geopolitically in a pre-World War II world with the material difference that there is still only one superpower.

The crossword of economics and power will work itself out but not without testing the patience of investors and ability and calmness of politicians and generals.

“Nothing whets the intelligence more than a passionate suspicion, nothing develops all the faculties of an immature mind more than a trail running away into the dark.” ― Stefan Zweig, The Burning Secret and other stories

Winning Without War

“War is an ugly thing, but not the ugliest of things. The decayed and degraded state of moral and patriotic feeling which thinks nothing is worth a war, is worse.” – John Stuart Mill, before the battles of Somme and Verdun during the First World War

India has a geopolitical problem with Pakistan and with China also an economic one. The fact these two also happen to be its two largest neighbours also means that they will possibly never go away, it needs better management.

Ancient Greek philosophy believed conflict is omnipresent and in that environment, being prepared is the only deterrence. Neither empathy, understanding or good intentions can resolve the issue. We saw this in operation during the recent Doklam crises as China undertook an operation to change the status on the ground Indian forces with better force posture locally and political support ensured that the status quo was maintained. In Schelling's 1966 work on deterrence, it argued the concept that military strategy can no longer be defined as the science of military victory. Further, that military strategy was now equally, if not more, the art of coercion, of intimidation and deterrence. But to be coercive or deter another state, violence must be anticipated and avoidable by accommodation. So simply put, deterrence is not only defined by capacity but also by the desire and ability to use it. Capacity in today’s day and age is complex (Complex because a single missile fired means coordination between local intelligence, satellite based locations, missile launch command, missile tracking systems, damage assessment) and expensive (just to pick up some hardware – B-2 bomber over $1bn, Abrams tank over $4m, 1 GPS guided artillery shell ~$150,000 or assault rifles over $1,000). India has shown limited ability to inflict damage (except the 2016 cross border raid into Pakistan) despite grave provocations be it Mumbai attacks of 2008 or continued Chinese incursions. Deterrence has limited meaning when one state shows no desire or ability to exercise its might whereas another state can continue to call it unauthorised and uncontrolled action by non-state players.    

A continued economic well-being is important to capacity building in the society. One can see the detrimental effects of a stagnant economy in Europe – how state structures are collapsing as pressure from unemployment is dissipating and changing the political landscape. The massive stimulus program the Chinese adopted in 2008 was in response to this potential social pressure where exports fell 25% (or 8% of GDP) and 25m migrant workers returned home. As India pushes to formalize its economy through GST and demonetization, taking measures to reduce the subsidy burden like free pricing of fuel, or pushing financial assets as against physical assets, the savings capacity of the country and, therefore, our local investment capacity should improve significantly. Higher investment during the 2004-2008 period is what created the conditions for high economic growth. But in a world of Chinese over-investment as I have pointed in my earlier articles, this investment can only be achieved by erecting trade barriers or non-trade ones in areas of national importance like pharma, semi-conductor, electronics or government giving additional incentives. While China will face the detrimental effects debt and of precipitous decline in working age population (and is therefore investing heavily in robotics and AI), India can have a social disaster if it does not provide jobs for its expanding work force.

China’s best partners in Asia are Pakistan and on a good day North Korea. India needs to exercise its national might on the geographic advantage that it enjoys. It sits between the Middle East and the Far East astride the Indian Ocean, practically allowing it dominion on all that transits in between allowing it to exercise influence Africa to Indonesia. It is protected by the Himalayas in the north and the dense forests in the east, which is why China and India never before have fought wars. Only now technology allows each other to inflict damage but creating logistical lines through the Himalayas or via the Indo-Pacific is still a herculean task. Using the Andaman Island chain, India can very effectively bottle up Chinese navy or trade. The only territory that has ever threatened India has been territory via Pakistan. This is the only practical and sustained power projection into India and outside by India. And, this is where China wishes to build the China Pakistan Economic Corridor allowing greater capability on India’s western borders. India needs to shed its reluctance and mindset where alliances meant giving up sovereignty and build firmer alliance structures as PM Abe has suggested with US, Japan and Australia. This alliance structure will not only allow it to improve its defence capability through technology sharing and training but also build specific mutual defence arrangements which could range from simple arms assistance at times of conflict to NATO like joint defence pacts.  

The final and most important aspect in this is strategic patience. 

• Pakistan has sought project itself as pivot to this part of the world to the best benefactor it can find in town since it came into existence. While it did this in a continuous effort to allow it parity with India, both its economic as well as social stability now lies threatened. It’s credit rating is the same as Rwanda or Jamaica, with debt over $82bn, reserves less than $20bn and a rising current account deficit (exceeding $3.5bn in the previous quarter). The decline in oil prices have reduced the inflow of aid and remittance from the Middle East, further impacting economic stability. There is the largest concentration of terrorist group that any country has with rising ethnic divide between Punjabis and other constituents like Balochs or Sindhis. In addition, the CPEC corridor with its market rate loans will exacerbate the current account deficit. China also tends to bring its own people for the construction activities and managing the plants allowing for limited local capacity building. Further, if there is a bias in internal distribution of projects it will also cause further dissension. China believes that it can control the outcomes in a politically disturbed country while allowing it to stabilise Xinjiang and helping it work around the Malacca dilemma. Pakistan believes that it will bring it greater control over Baluchistan and allow it to use China more effectively to balance against growing Indian capability. 
• While Pakistan faces a political and economic crisis, China believes it can defy the laws of economic gravity. China’s Tier 1 housing costs are between 50-100 times household income with the likelihood China residential property value may have already surpassed value of the entire world. The stimulus economy it’s created has pushed debt in China to 330% of GDP which has resulted in interest expense being more that incremental nominal GDP since 2011!! At current pace China household debt which is about 60% of GDP in June 2017 is expected at current pace to be 90% of GDP – same as US pre-crises debt levels. In 2014, China forex reserves was 20% of money supply and 55% of household savings. Both these numbers have dropped now to 10% and 30% respectively, which heighten the risk of any panic by households. With continued forex outflow through the trade channel despite the severe restrictions on capital outflows, any issue in this can only be stemmed with a politically problematic devaluation. Recently, Governor Zhou of the China central bank outlined the rising financing risk in the system (https://www.bloomberg.com/news/articles/2017-11-04/china-s-zhou-warns-on-mounting-financial-risk-in-rare-commentary). As China puts capital restrictions so will it restrain FDI which despite be a small proportion of total capex in China (~2.5%) is important given its impact. For example, Enright, Scott & Associates estimates that the impact of US firm Procter & Gamble alone – with its supply chain and distribution channels – was more than US$11 billion on China’s GDP and 600,000 on the nation’s employment in 2014. Why should someone bring in money if they cannot withdraw? The One Belt One Road construct which will mean spending of US$1trillion in countries with low credit rating and still lower abilities to absorb such investments given the high levels of corruption and low human capital base, unlike the Marshal plan post WWII which was in countries with deep human capital and long history or rule of law. Further, it is not that the Chinese are looking to open opening up their markets for cheaper imports to allow these countries to expand their productive capacity. It is unlikely that OBOR will succeed. The Chinese, I am sure, understand their economic predicament of excess debt and bad demographics and they are dealing it in exactly the opposite way the Soviet Union under Gorbachev dealt with it, consolidating control under Xi than loosening as in the case of Perestroika.

It is in India’s interest to keep building internal capacity and global partnerships, and allow the forces to nature to do their work. Chinese economic slow-down/recession will stall military expansion and consequently change behaviour of not only its own but also Pakistan’s which will see the retreat of its 3^rd benefactor after US and Saudi Arabia.

In summary, Deterrence, Economic Growth, Partnership and Patience are the four pillars on which India needs to build the next 5-7 years of its global and regional politics. And, when it gets the opportunity change the ground status in its favour be it in Tibet or in Pakistan or its immediate neighbourhood. Clausewitz, On War, “We can also undertake a limited defensive war, of which there are two distinct kinds.  In the first, we aim to keep our territory inviolate and hold it as long as possible, hoping time will change the external situation and relieve the pressure against us.  In the second, we adopt the defensive to help create the conditions for a counteroffensive and the pursuit of a positive aim.”

"If you love me as you say you do,' she whispered, 'make it so that I am at peace.” ― Leo Tolstoy, Anna Karenina