Consumption Markets and Balance of Payments

Someone asked me the question how is the US able to create massively scalable e-commerce businesses? This got me thinking in a different direction but first a simple answer to the question.

US is by far the largest consumption market globally by a factor of 3-4x compared to any other country in the world. Supported by very high acceptance of the medium and confidence this has allowed for massive increase in the e-commerce market has allowed for this. VC funding and low cost start-up ecosystem is very supportive.

Country	GDP (Nominal)*	Household final consumption (“HFC”) (% of GDP)^	HFC (as % of US HFC)
US	16,244	72
China	8,221	36	25.3%
Japan	5,960	61	31.1%
Germany	3,429	58	17.0%
France	2,614	58	13.0%
UK	2,477	66	14.0%
Brazil	2,253	62	11.9%
Russia	2,030	48	8.3%
Italy	2,014	60	10.3%
India	1,842	61	9.6%

* Nominal GDP 2012 (IMF)  ^ World Bank 2012

Now the other direction, a closer look at the table above shows the key imbalances in the global economy:

• US is the key importing nation driven by its consumption markets, the next three countries on the list are leading exporters globally (China, Japan & Germany). How long will this Balance of Payment imbalances sustain? More of this later; and

• Chinese consumption is the lowest compared globally, significantly below global norms. Investment imbalance and financial repression are primary contributors.

Balance of Payments

The last 2 decades of global expansion has been driven to a large extent by liberalization of trade. The top 4 countries in the list are the principal participants in this exchange. But in the net impact it has been pretty much a one-way traffic. The global financial crises was in many ways a manifestation of the underlying cycle of very high savings in Asia driving cost of borrowing lower in the US which in turn supported the housing bubble. While trade liberalization allowed for continued reduction in product costs. While the financial crises passed the underlying causes were never addressed.

• Chinese followed the global financial crises by their own version of credit boom of which they are now witnessing the limits.The economic impact of faltering export engine was addressed by expanding domestic investment. The Chinese realize this imbalance cannot continue and are looking to take the first baby steps to address the issues. But getting local consumption going requires radical change and this adjustment will mean slower GDP growth (i.e. US in the late 1920s, Japan in the late 1980s). The Chinese & US M2 was ~US$8 trillion around the financial crises. The US M2 is ~US$10 trillion now and the Chinese are exceeding US$16 trillion. The highest money supply expansion ever in history in such a short period.

• Japan has adapted ‘abenomics’ to get their moribund economy moving. But adverse demographics means growth in the economy can only come through higher exports, to where, into the US?

• Germany whose export driven economy self-corrected before the Euro era driven by the exchange rate adjustment is currently finding the adjustment very difficult. >60% of German exports were into the Euro area. As this slows, the German economy will falter unless they can export more, to where, US again?

In my view US will witness a new era of growth driven by shale gas finds and, consequently, cheaper cost of production. This will result in the largest debtor nation pushing back on imports over the next few years. This reduction of imports will also be driven by reduction in underlying commodity prices as the Chinese import falters. However, as imports reduce, it will put structural limits on growth of China and Germany. Japan is trying to find a way in ‘abenomics’ and the Trans Pacific Partnership, which the US believes is in its political interest.

So will this change continue to be supported by currently high consumption in the US. I believe US consumption levels will continue to be high supported by the retiring baby boomers and medical costs, rising interest rates notwithstanding. Finally, production is easier to create which China, Japan and Germany have..but it needs the customers i.e. the US more than ever. 

Poverty of thought

Every passing day as we witness the debate culminating to the next year general elections, the populace is left more and more bewildered of the debate and policies of the respective political aspirants. Of course, the ardent fans of each camp do not care it is just a passing phase.

But there are underlying factors which drives this confusion in the political spectrum. After 10 years of Congress rule of which the last 3 years have been excruciatingly painful, a large part of the urban population is looking for a break from the past, especially the young first voters. The rural voters who have benefitted largely from the variety of largesse or poverty upliftment programs of the government may still vote to a certain extent with the Congress. While corruption may not be a big issue in rural India but where masses have been lifted beyond poverty, fulfilment of aspiration (the next phase after poverty removal) is the next big issue. If one looks at the Congress it is still stuck in the quick sand of poverty and therefore would lose ‘aspiration’ vote.

The BJP right wing politics does not allow for poverty doles and knows that Congress is the ‘champion’ of poverty programs. It is also wary of what happened in 2004 elections. Having said this, it believes rather than charting the true development agenda and articulating the free market policies it would undertake, it is playing anti-thesis to the Congress i.e. highlighting corruption, lack of effectiveness of the poverty programs, low job creation due to lack of governmental approvals etc.

While we may all blame the organizational issues that plague both the national parties, the key fact is they do not understand the unifying vote factor.  In fact given India’s fragmented polity there is none today and this trend has accentuated with the regionalism of the smaller parties.  It at this moment a nation, especially as large and diverse as India, needs a national leader who stems the fraying.

There are some critical issues at hand that the next government needs to address, (1) Restoring institutional integrity and framework starting from the PMO; (2) Regional security i.e. post-2014 Afghanistan, restoring regional trust in the Indian state from Bangadesh to Sri Lanka, relationship with a post-sanction Iran; (3) Economic growth, inflation and fiscal correction (in possibly winding down stimulus environment globally).

There is no one who seems to be talking about how these will be achieved. This period of non-governance, especially given the pressure on the Congress Party, will cause significant strain on other institutions like:

• RBI will be left alone to handle the economy but its hands are tied by foreign exchange markets and inflation. Consumer inflation is primarily driven by logistical issues (principally in food), high property costs and taxes. These are principally in government hands to deal with. For example, encouraging transport using inland waterways and coastal shipping can bring logistics cost down significantly (water transport cost is a 1/4^th or 1/5^th of road cost)
• Armed forces will be left to handle the Kashmir / Pakistan heat, where the hard diplomatic moves would reduce the pain. Changing Iranian equation (initiation of nuclear negotiations with EU and US) provide India with a significant opening to potentially create a counter-balancing situation with Pakistan

I do not think the quality of debate during this election will improve whether pre-manifesto or post. We live in the season of poverty of thought not because our leaders are unable think through the issues (at least in my view) but among the leaders there is no leader who has the conviction of thought to state it. It will be realpolitik all the way.

In the life of a nation, however, the quality of the election debate does not matter, governance post the elections will. If this were a true predictor of that, one would run scared..

The ‘Real’ Estate

Asia has been witnessing a credit boom of its own (nominal credit growth to nominal GDP growth >2x in HK, Malaysia, Indonesia and Singapore) with substantial part of the flows going into real estate with economies like Singapore, Indonesia, China and Thailand enacting measures to cool-off the real estate bubble. Of these economies, Singapore, Malaysia and Thailand have household debt to GDP in excess of 70% which could imply significant pain when interest rates rise. The low interest regime has created substantial interest in real assets.

In India, we have witnessed extremely strong housing credit growth where retail home loans are up over 10x in the last decade and developer loans by banks / HFCs are up >15x. This developer funding has been further supplemented by PE funds, capital markets and informal financing markets. Of the retail home loan growth, 70% of the growth has come from increase in ticket size of the loans, indicating the preponderance of price growth in the market.

Stretched affordability indices as a consequence have meant significant slowdown in absorption rates of apartments. IT sector which contributed most of the absorption through their massive white collar job creation have seen a decline in hiring levels and wage increases.

High housing prices have created their own cost on the economy in terms of knock-on effects on pricing of goods and services i.e. the local fruit seller charges higher as his shop rental and cost of living has gone up, cost of starting a business moves higher, malls suffer due to high rental costs.

Raghuram Rajan in his book Fault Lines wrote, “Easy housing credit has large, positive, immediate and widely distributed benefits, whereas all the costs lie in the future. It has a pay-off structure that is precisely the one desired by politicians, which is why so many countries have succumbed to its lure. It pushes up house prices, making households feel wealthier and allows them to finance more consumption.”

So question is will he act to address the issue as politicians given their interest will not. His first act at targeting consumer inflation is a step in the right direction.

The next question is what got us to the current state of affairs.

Indian RE prices expanded significantly in the post 2006 as the economic expansion resulted in massive increase in costs (i.e. cement prices) and second a belief in long-term prospects attracted massive dosage of capital. This capital was used to purchase land at higher and higher prices. The collapse of 2008-2009 was short-lived as government and the central bank coordinated a stimulus. This was helped by record low interest rates globally.

This stimulus ensured that no adjustment happened plus a short correction resulted in re-affirmation of the investor belief of continued price increases. Private financiers (many times with money diverted from their core businesses) poured in money into the market lured by the returns promised by the builders. Banks which have traditionally viewed real estate as the safest form of collateral kept financing the collateral at higher valuations forming a virtuous cycle. Lack of real returns in stocks and bank deposits and low cost of money for NRI’s ensured continued interest in the RE assets. Corruption proceeds during the last decade as their scale grew larger played their role.

With yields on residential property at record low of 2-3% (compared to lending rate of ~11%) and urban India with slowing incomes and high inflation, the final buyer has balked, investors no longer believe that they can make 20-25% returns from these price levels, banks are hurting with NPAs with no longer have the flexibility of expanding their belief in prices.

This will create an impact on not only consumption levels (consumer wealth) but also house building activity impacting GDP growth further. The central and state budgets have no room to be counter-cyclical measures and increasing interest rates globally will create pressure on the Reserve Bank to maintain spreads high enough to ensure no significant pressure on the rupee. It is likely, given the market structure where stressed asset disposals are not easy and banks do not want aggressive write-offs, we will see a combination of price correction and time discounting.

The retort we see from developers of input cost going up does not hold, even for basic agricultural commodities it is demand-supply model of price determination. It almost seems like a wish to hold on till one reaches the cliff.