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