“We had two bags of grass, seventy-five pellets of mescaline, five
sheets of high powered blotter acid, a salt shaker half full of cocaine, and a
whole galaxy of multi-colored uppers, downers, screamers, laughers... and also
a quart of tequila, a quart of rum, a case of Budweiser, a pint of raw ether
and two dozen amyls.
Not that we needed all that for the trip, but once you get locked into
a serious drug collection, the tendency is to push it as far as you can.”
― Hunter S. Thompson, Fear and Loathing in Las Vegas
The rapid change and growth that
the Chinese economy achieved in the last 30 years is unprecedented in human
history. The closed economy was capital deficient and labor surplus. So the Chinese
did what has been often done in the past, like Asian tigers or Japan. They
ensured all the saving were channeled through the government controlled banks,
paid less than market interest rates and they subsidized funds were directed
towards state sponsored industrialization. The supported industries were export
oriented which were supported by subsidies – capital, cheap labor, duty
drawbacks and managed cheap currency. Low wages and suppressed interest rates
ensured the household income and therefore consumption remained suppressed
falling currently to an unprecedented ~36%.
This model remained in place till
2008 when the global financial crises hit. Chinese exports to US, the largest
consumer market, rose from US$50bn in early 1990s to ~100bn by 2000 and post
entry into the WTO rose to excess of US$400bn by 2013 but albeit at a slower
pace since 2008 when it was ~US$300bn. This export income continued to be
sterilized creating domestic money supply and financing infrastructure growth. But
2008 crises when AIG, Bear Sterns and Lehman collapsed drove fear in the heart
of the policy makers - trade finance dried resulting in 25m migrant workers losing
their jobs and exports falling 25% YoY. The crises also exposed the flaws in
the Eurozone, China export capacity did not know where to go.
A one party political system was
unable to bear the stress and it responded by indulging in massive credit
creation to stabilize the economy. The banks opened the purse strings resulting
in current debt levels ~US$27 trillion rising from 100% of GDP to 260% of GDP
in 8 years. Most of the credit went to create excess capacity in industries ranging
from steel, glass, cement, construction machinery etc. A study by Jun Nie and
Guangye Cao for the US Federal Reserve that since 1998 property investment has
risen to 15% of GDP from 4%. By 2025, China plans to move 600 million people to
cities, it’s like building all the cities of Europe in less than a generation.
Such is the scale of Beijing’s intervention.
But for China, the current export
and credit led model has hit a stall with the levels of credit and
over-capacity increasing risk in the system manifold. Productivity of credit is
now almost a 1/3rd of every dollar spent. Even if People’s Bank were
to release all reserves in the system it can create US$4 trillion of credit but
that will fully utilize system capacity.
To overcome this system
constraint, China is trying to rapidly to rebalance the economy towards local
consumption. But that is a tall order which involves removing the financial
repression in the system, changing the cost structure industry and vested
interests (local governments, SOEs and party associated industries) have got
used to. The leadership is centralizing power and forcing change in the
communist party through its anti-corruption program as it negotiates change
with the vested interests. While wage growth has been high in the last few
years it will take much time before the blue collar worker starts consuming, it
is estimated that the bottom 40% consumer 20% while the top 20% consume 40%.
And between 2020 – 2025 workforce will start to decline adding the pressure of
rapidly aging population on the economy.
Policy makers are also hoping
productivity investments in the economy will also allow them to maintain the
requisite growth rates. E-commerce sales which were ~US$300bn in 2012 are
estimated to reach ~US$500bn or almost 10% of all retail sales. China R&D
spends are expected to exceed the US by 2020 if current trends continue. Reviving
the ancient Silk Road route and doing the related investment is another initiative
to stimulate international demand for Chinese products. This is as much a
geopolitical initiative as economic. As the China cost structure undergoes a change
(wage, environment etc), it’s trying to move to higher value add exports like turbines,
machine tools and telecom. This is where German, Japanese and American multi-nationals
have dominated for long. Second, the developed markets are growing sluggishly,
large parts of the developing world is facing the commodity value decline
related headwinds. Further, as the US needs for energy supply declines due to
shale boom, US$ supply globally is reducing and this is where the China is
trying to enhance usage of RMB in international trade to finance its trade.
Internationalizing RMB is another complex challenge Beijing is trying to grapple with. The banking system
has been relatively closed and on a fairly early stage of maturity given the
implicit guarantees run by Beijing. When PBOC restricting permanent liquidity availability
in June 2013, interbank rates shot up dramatically exposing the banking system
to principal element of banking – liquidity risk - and then in 2014 some
defaults have occurred, adding another element. Further, critical element of getting
any currency accepted in the system is the old adage ‘good money drives bad
money out of circulation’. Post World War II, US$ was the principal global
currency. As the European economy recovered the Bundesbank established its
inflation fighting credentials and Deutschemarks entered central bank balance
sheets and began being used more and more as an alternate global currency. This
role of then taken over by the German dominated ECB. Are the Chinese willing
and able to ensure a currency which strengthens over the next 5-10 years to
promote this adoption? While the strength will boost domestic consumption by
enhancing household purchasing power, it strikes at the heart of Chinese low
cost export engine, threatening higher non-performing loans.
Global & India Implications
In the last phase of its economic
cycle, China captured larger share of the global markets through the multiple
incentives it offered, creating a global commodity boom but exporting deflation
in finished products. Now in this phase of growth as cost of production in
China rises, it will export deflation through deficiency of commodity demand
and, given over-capacity, producing at marginal cost.
This is happening in an
environment where the Federal Reserve is seeking to normalize monetary policy. It
creates the risk of capital flight driven by reversal of the carry trade China
has encouraged with its fixed currency and dis-incentive of round tripping done
by corporates (in the last year currency reserve has declined by US$300bn). The
Eurozone / Japan ability to create inflation becomes even more difficult
prolonging a loose monetary policy - even more divergence with US. Commodity
countries like Australia, South Africa, Brazil, Canada, Russia, OPEC are all
facing massive economic headwinds.
Except for the external risk of
large foreign currency loans (which RBI is trying to minimize through reserve accumulation)
and muted international demand, India is a in a sweet spot. For almost the
first time in a decade inflation is in control. This should result in a
recovery of domestic consumption (60% of India’s GDP) – urban and then rural. The
decline in inflation will result in reduction of interest rates, reviving
investment and consumption demand and also relieving the banks from the NPL
stress. But given the lack of inflation, corporate growth will be dominated by
volume growth and profit enhanced by cost deflation. Most banks will find loan
growth challenging until the investment cycle revives as working capital growth
will be limited but investment gains will continue. Midcap corporates are
mostly dominated by commodity based companies and these will have low margins,
they will benefit as their margin expansion result in very large EPS changes. Metals
(China export and inventory valuation), real estate (over building in the last
cycle) and high leverage corporates will, however, not do well. Barring global
shocks, the capital markets will continue to be supported by a declining cost
of capital.
Finally, the system which was
imbalanced due to one country, US, creating most of the global demand will now
begin to rebalance as both the large stimulus engines – US monetary policy and
China credit expansion – go into reverse.
Everything in excess is opposed to nature
- Hippocrates
