Total Recall

Matthias: Mr. Hauser, What is it you want?

Doug Quaid: I want to help you.

Matthias: That is not the only reason you are here.

Doug Quaid: I want to remember.

Matthias: Why?

Doug Quaid: So I can be myself, be who I was.

Matthias: It is each man's quest to find out who he truly is, but the answer to that lies in the present, not in the past. As it is for all of us.

Doug Quaid: But the past tells us who we've become.

Matthias: The past is a construct of the mind. It blinds us. It fools us into believing it. But the heart wants to live in the present. Look there. You'll find your answer.

The present tries to forget the past. The past even if washed by the sands of time serves a reminder every now and then.

When Napoleon armies marched across Europe winning many wars despite adverse numbers his confidence in his destiny magnified. He was then the Emperor of Europe from the Atlantic to Poland (Austria in alliance), the largest Empire ever carved in Europe. Having won peace with Russia (however brittle) and the English beyond his reach, he tried the disastrous occupation of Spain across the Pyrenees and lost many men in the Spanish guerilla war before giving up. Lacking the naval force he tried enforcing a continental blockade on the English. When the Russians reneged from the blockade he took the largest force ever assembled to attack the Russian marching across all of Europe. The Russians did not give battle and when Napoleon occupied Moscow, they burnt it down. Over half a million men lost their lives. As Napoleon’s star dipped, old enemies rose to fight again. And, in the Battle of Waterloo, 1815 he lost it all. Creating an empire is one thing, managing it can be quite another.

Bismarck in the same way created Germany out of what were many principalities on the western and southern side of Prussia, maneuvering militarily and diplomatically the Austrians, French and the Russians as he did this. However, once this had happened, he was aware of the power of united German nation and sought to diplomatically assuage the fears of other powers on the continent.

In February 1888, during a Bulgarian crisis, Bismarck addressed the Reichstag on the dangers of a European war. He warned of the imminent possibility that Germany will have to fight on two fronts; he spoke of the desire for peace; then he set forth the Balkan case for war and demonstrated its futility: "Bulgaria, that little country between the Danube and the Balkans, is far from being an object of adequate importance ... for which to plunge Europe from Moscow to the Pyrenees, and from the North Sea to Palermo, into a war whose issue no man can foresee. At the end of the conflict we should scarcely know why we had fought."   

He left a marker for the future leaders of Europe. Ironically, World War I started with Austro-Hungarian Empire attacking Serbia (in the Balkans) leading from one conflagration to another and Germans were fighting the French and the Russians (two-front war). A leading historian of the era, William L. Langer sums up Bismark's two decades as Chancellor: “Whatever else may be said of the intricate alliance system evolved by the German Chancellor, it must be admitted that it worked and that it tided Europe over a period of several critical years without a rupture.... there was, as Bismarck himself said, a premium upon the maintenance of peace.”

We now see another nation rise to change the balance of power in Asia – China. As China changes the status quo, it is changing the behavior of all its neighbors – the bordering countries of its newly propounding maritime boundary (the nine dash line) like Philippines, Vietnam, Malaysia, Singapore; Australia; India; South Korea; and most importantly that of United States and Japan. Japan has as a consequence started reversing the limits it bound its military in post-World War II. This is like all the nations of Europe were aligned against Napoleon. One is already seeing some impact on military spending in the region, SIPRI reported, "Vietnam also continued its rapid rise in military spending, with an increase of 9.6% in 2014, reaching $4.3 billion. Since 2005 Vietnam’s spending has risen by 128%, reflecting tensions with China over territorial disputes in the South China Sea. However, Indonesia decreased its spending by 10% in 2014—a reversal of recent trends, which may prove to be only temporary, given Indonesia’s ambitious military modernization plans. Although military spending in Asia and Oceania remains on an upward trend—with all states in the region except Fiji, Japan and Laos increasing their spending since 2005—the growth rate for most states has been substantially lower since 2009, when the effects of the global financial crisis began to  be felt. For example, while China’s military expenditure doubled in real terms between 2004–2009, it increased by only 48% between 2009–14. Japan, meanwhile, approved a record budget for 2015.” China, however, has the benefit of geography, an ocean frontage of 9,000 miles in the temperate zone, which the other Eurasian power Russia never had, making it both a land power with access to the resources of central Asia and a capability to build sea power.

The Chinese have during the last 30 years tried to transition to proactive engagement with the international system and from a taker to a maker of international order. The ability to maintain the current trajectory of change is significantly dependent on it economic growth. As Kaplan points out, “Two debates are under way over China. The first, about Beijing’s aggression in the South and East China seas, is between naval strategists and diplomats who know little about economics. The second, about the fragility of the Chinese economy, is between economists who know little about naval strategy and diplomacy.” But depending on the trajectory one could see internal strife with Tibetans or the Uighurs or increasing friction at sea inspired by nationalism or a managed transition where US power gives way to Chinese in the South China Sea. The number of annual protests in China has grown steadily since the early 1990s, from approximately 8700 “mass group incidents” in 1993 to over 87,000 in 2005. In 2006, the Chinese Academy of Social Sciences estimated the number of annual mass incidents to exceed 90,000, and Chinese sociology professor Sun Liping estimated 180,000 incidents in 2010. These incidents are a marker of the break in social contract with its people as income divide widens, job security reduces or the environment degrades and this is what could seriously tear down internal political consensus of a single party rule. The downturn in the Chinese economy is already causing global pain; an implosion would seriously damage global economic stability and internal security. For my views on the Chinese economy please refer to http://poleconomyindia.blogspot.in/2015/08/china-everything-overdone.html.

It is not that the American Empire rose in complete harmony with world. Thomas Jefferson, in the 1790s, awaited the fall of the Spanish Empire "until our population can be sufficiently advanced to gain it from them piece by piece." In the late 19th century, foreign territories such as Hawaii and Latin America were sought after by the United States. Roosevelt supported the Panamanians to revolt against Columbia and in turn they granted US control of the Panama Canal Zone. The Teller Amendment and the Platt Amendment were used in unison to grant the United States the right to intervene in those territories if that particular government was deemed unfit to rule itself. The American government held the power to both criticize and occupy these nations if they were deemed to be unstable. But two things that were important through all of this - consistent growth in economic might (barring the great depression) and World War II which literally tore down the European empires and with it the old world order.

The Chinese may like to be like the Americans but are behaving like Napoleon when they ought to manage like Bismarck.

What made headlines?

“To read a newspaper is to refrain from reading something worthwhile. The first discipline of education must be to refuse resolutely to feed the mind with canned chatter.”

Liquidity unwind

Estimates suggest through various phases of QE starting January 2009 ~$500bn came into Asia ex-China, ~$40bn was lost during the 2013 taper fit the markets threw and ~$30bn has been lost in the last 3 months. The markets lost small sums compared to the noise factor in the press. But what this suggests is the level of potential unwinding that is possible if interest divergence were to be become stark. Already the reduction in dollar reserves across countries from Saudi Arabia, Russia or China is causing a quantitative tightening.   

In India, credit growth is getting constrained at the one end by the low levels of inflation - WPI was -4.1% in July and GDP deflator Apr-June was 1.8% and the other by very high bad loans – NPA and restructured assets have reached ~11%. Second, the choking of the capital expenditure in infrastructure or heavy industry in the last 4-5 years has created not only the bad loan issue but also ensured that equity capital in stuck in the these projects and potentially wiped out as a consequence of cost and time over-runs or now due to steep commodity declines. The third is from 2009 onwards physical savings continuously exceeded financial savings (historically physical was around 50%-55%) to the extent that in the last couple of years become almost 2x. This savings went predominantly into real estate which is now facing decline in value and transactions, consequently wealth effect and liquidity are both gone. Fourth, the focus on reducing black money in the economy by the government and the Supreme Court is beginning to bite. The recent decline in equity market valuations surely add to this but on the debt side we have lost only 1% of what we did in 2013. 

Inconvenience of election promises

Narendra Modi is a master of rhetoric and this was principal amongst other aspects that laid the foundation of his victory. The Indian constitution recognizes the Parliament as the highest decision-making body with the Prime Minister at its helm but does not in the same breadth take away the powers or allow the Parliament to override the state governments or the courts or the upper house which has representation of the states at the center. It is designed as a check to protect the basic character of the nation from violent majoritarian-ism. No leader would get elected if he points out his constraints to the electorate and no leader unless he steps in the chair understands these constraints fully anyway. Thus, the aspirational high before elections is designed to fail.

Having said this, the regionalism of India represented by many regional political parties, of which I have written many times, ensures a permanent divergence of views. And in this specific case the presence of overwhelming majority center, has forced regional parties to collaborate to protect their turfs while they live to fight each other another day. A declining Congress has limited stake in constructive behavior, as its victory is more likely to come from the BJP’s mistakes.  

Having said this, politics is the art of working with 'material at hand' and turning promises to reality. "In order to govern, the question is not to follow out a more or less valid theory but to build with whatever materials are at hand. The inevitable must be accepted and turned to advantage." - Napoleon Bonaparte

When it rains

If the twin crises of economic malaise and Ukraine were not enough for Europe, it has stepped onto the new crises brought by fighting and political instability across its southern arc from Syria to Libya. The migration of millions of people to Europe has sparked fear and guilt. Sweden has received the highest number of application (more than 8 / 1000 population), UK the least (under 1 / 1000 population). While Germany at almost 3 per 1,000, is receiving 68% of the EU refugees. In context the levels are the highest ever since the cold war – for example Germany has received ~2x the applications it did at the peak of the Yugoslav war which were the highest till date. The sharing of this burden is causing friction within the European Union and the fear of accepting large Muslim population from the war torn countries is also sparking demographic tensions at a time when Europe is facing a decline in its dominant Christian population.

Europe prior to WW II had hegemony over North Africa and this was the source of cheap labor. When they lost their empire, they had no choice but to allow controlled migration to ensure availability of labor. But they never assimilated this population which can be seen in the ghettoization of Muslims even cities which claim to be multicultural like Paris. This non-acceptance has its roots in the wars fought with Islam for over 1,000 years. This is was a period where Christian Europe had great evangelical zeal to kill and convert its enemies, be it Islam or different strains of Christianity. While Europe sapped its zeal to allow peace within Christianity, slivers of Islam maintain that zeal and continuously espouse that they speak for the rest of Islam. European nation states are about shared history, language and common values, the migrated Muslims share none of these.

Europe will turn again to welcome immigration in the next 2 decades as its population decline deepens but this would come out of need rather than the current burden of conscience.

Indrani Mukherjea…?

Incompatibility accentuated by decline in money flow leads to breaking of marital vows resulting in current mess. All the worlds’ problems seem to be in one microcosm and I am sure we can find more. Well hasn’t the media got it all…

China - Everything Overdone

“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 1/3^rd 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

Desire for Certainty

"If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts, he shall end in certainties.”  ― Francis Bacon, The Advancement Of Learning

Human beings long certainty. A young man wants the certainty of a college degree and a great job and an old man the certainty of health and pension (or whatever social security there may be). Business wants the certainty of buyers, suppliers, infrastructure, finance and so on. Imagine if every day the route to work were different or if the bank kept moving its neighborhood ATM every month!! The wealth and advancement of mankind has been through understanding the nature and cause of uncertainty and giving it greater certainty. But the critical aspect driving advancement has always been the intensity of search for uncertainty and the motivation to give it certainty. It is a conundrum – more certain you are, less the motivation.

The uncertainty of food resulted in early man undertaking huge migration routes. The need for subsistence and preponderance of an agricultural economy continued to drive human endeavor for thousands of years from innovating at war to Europeans finding a route to India for spices. The pace of change till the middle ages was even and incremental.

But then came the European age. Since the Roman times, the area at edge of Europe (then called Promontorium Sacrum) in Portugal was prohibited for people as they thought the demons of the Atlantic would take them. These demons began to be banished when Henry the Navigator built a school for explorers of the Atlantic where Vasco de Gama, Magellen and Columbus went and thus began the European centuries. The European exploration of the globe resulted in 2 critical changes:   

1. By bringing various geographies into their fold they not only interconnected the globe but also unified them in a European thinking, especially the elite (and the invention of the printing press helped);
2. Extraordinary wealth and motivation (money and political power) that came with the new explorations propelled Europe in the fields of art, philosophy, political thought, natural / social / applied sciences etc.     

Martin Luther said at the Diet of Worms, "Unless I am convinced by Scripture and plain reason - I do not accept the authority of the popes and councils, for they have contradicted each other - my conscience is captive to the Word of God. I cannot and I will not recant anything for to go against conscience is neither right nor safe. God help me. Amen." The initiation of this thought changed the way European mindset replaced and challenged the teachings of the Church. Again Hobbes, like Locke, stated that true revelation can never be in disagreement with human reason and experience. Luther, Hobbes, Locke, Bacon, Descartes and many of their contemporaries drove Europeans to reason and scientific discovery but fundamental underlying belief was “world is predictable and laws of nature can be deciphered”.

Just go to https://en.wikipedia.org/wiki/Timeline_of_scientific_discoveries, it lists the major scientific discoveries since 3^rd Century BC, the pace of discovery from the 17^th century onwards is breathtaking. A simple aspect like home water and sanitation we see today provides certainty of using it at a time one likes; it is regarded as the most productivity enhancing change ever.

On the political front, from the Napoleonic Wars, when the French sought to rule Europe and in turn the world, Europe has always sought political certainty. The Congress of Vienna convened in 1814, the League of Nations in 1920 post World War I, and United Nations in 1945 post World War II and then the European Union in 1993 have all been institutions in this direction. In the two world wars it is estimated over 100m lives were lost, mostly European. This is in addition to a similar number estimated to have been lost in the 3-4 centuries before that in global conquests. In parallel, advent of democracy and the social revolutions (i.e. French Revolution) made governments increasingly responsible for their citizen’s well-being.

In an endeavor to improve the lives of their citizens and to protect their lives, the West sought greater and greater certainty on daily and political life. While science gave them greater control over their lives, wealth gave them greater comforts, politics was fickle and intermittent but its desire was only growing. This acute need for certainty is Europe’s gift to the world.

One can witness the global horror, as Yugoslavia in the 1990s tore itself or the Ukranian issue now as if there borders have never moved. When house prices in the US which continued to climb till 2008 until it could no longer keep going, everywhere across the globe individuals and institutions bet on the certainty of this and the world is still recovering from the imbalance. 

We know and understand more than we ever have and with it our inherent desire to ‘receive in the band’ of certainty has only gone up. Only look at how we gasp to situations that only a century ago we would have taken in our stride…

“Let go of certainty. The opposite isn't uncertainty. It's openness, curiosity and a willingness to embrace paradox, rather than choose up sides. The ultimate challenge is to accept ourselves exactly as we are, but never stop trying to learn and grow.” ― Tony Schwartz

What’s happening?

Never think that lack of variability is stability. Don't confuse lack of volatility with stability, ever - Nassim Nicholas Taleb

The last few weeks have seen significant volatility in the international markets with only one market China which has been an exception. Last year’s decline in energy and the commodity complex led to a singular decline in global bond yields (of course Uber, SpaceX and Airbnb also have a deflationary impact). And, as the bund yield declined so did the EUR/USD touching a low of 1.05 and then recovering now with yield correction back to 1.14. While the S&P 500 has continued to nudge higher over the last year delivering 13% YoY return, STOXX 600 has appreciated 15.7% YoY and within that the German markets have gone up 18.9% benefiting disproportionately from EUR decline.

10 Yr Yield	Current	1 Month Ago	1 Year Ago	1M Change	1Yr Change
US	2.15%	1.89%	2.49%	0.26%	(0.34)%
Germany	0.62%	0.11%	1.31%	0.51%	(0.69)%
Japan	0.39%	0.32%	0.58%	0.07%	(0.19)%
China	3.37%	3.62%	4.17%	(0.25%)	(0.80)%
India	7.95%	7.78%	8.79%	0.17%	(0.84)%

The US bond yields are reacting to 2 factors principally – oil and an anticipation of Fed rate increase later in the year backed better GDP data (Q2 GDP 3x stronger than Q1 in the last 15 years). The recent reversal in German yields has been driven by a combination of factors:

• Sharp pick-up in German PMIs and global oil prices (brent has recovered from under 50 to 67 levels);
• Large supply of government paper despite the ECB purchases;
• A proposal from European governments that infrastructure funding would be beyond Maastricht budget criteria;
• The potential of Greece default in July.

German inflation expectations have been at 1.87%, so most of the recovery in yields has been real yield from (1.76)% to (1.25)%. Further, in most quantitative easing situations yields typically fell in anticipation of the outcome but once the purchases started yields have in a few months tended to stabilize or rise back to levels 3-6 months prior to the QE.

The ongoing financial repression of savers globally in US, Japan and Euro has been implemented to stabilize government debt to GDP while aiding asset markets to support consumption. The asset markets are supported by reduced cost of capital, lower cost of leverage and these in turn support cash financed M&A activity and repurchases. This move by central bank have tended to enhance beta in stock prices by making risk-free near zero cost of equity being pretty much comprised of equity risk premia and therefore the volatility.

Japan is the highest beta market and global tech has the best operational leverage (with low financial leverage) to benefit as global economy improves and bonds yields rise. Yield plays (utilities, REITs, high dividend stocks) and staples will underperform as US rates rise. USD rise should resume shortly as bunds stabilize.

Chinese Exception

While the globe is witnessing a asset price correction, China is on its own path given its unique economic backdrop of GDP, credit and investment growth. (some recent media articles)

• China’s exports fell 6.4% from a year earlier in dollar terms, after a drop of 15% in March, data from the General Administration of Customs showed Friday. The result was well below the median forecast of a 2.5% increase by 13 economists in a survey by The Wall Street Journal.
• The People's Bank of China (PBOC) reduced both the benchmark lending and deposit rate by 25 basis points to 5.1 percent (third cut in 6 months) and 2.25 percent, respectively, in response to weaker-than-expected economic activity data, which has raised concerns that the government's annual gross domestic growth (GDP) target of "around 7 percent" could be at risk.
• In meetings this week, officials with the People’s Bank of China have called on commercial banks to hold maximum deposit rates at levels set in February and not raise them to a new, higher ceiling the central bank set on Sunday, said two bankers with direct knowledge with the matter. (Given the high levels of corporate and municipal leverage PBOC is worried what higher cost of capital would do) 
• Stock values took off a year ago this month after new rules made it easier for Chinese nationals to buy shares. That encouragement came at the same time wealthy Chinese buyers were increasingly looking for places to invest, analysts say, primarily because Chinese officials were tightening the rules on investing in the property market, the traditional magnet for Chinese money. (Shanghai A share market is up 113% in a year)
• So what if almost two-thirds of new domestic equity investors in China left school before 15? Or that six per cent are illiterate. Wall Street analysts are just as dazzled by market rallies. Okay, three million new account openings a fortnight seems frothy. As does a third of stocks in the Shenzhen A index more than doubling in the past year, with an average price-to-earnings ratio of 180 times. (Sadly forward multiples are harder to calculate as a third of these companies will not be making profits this year.) Bubble watchers point out median earnings multiples for Chinese technology stocks are twice US peer valuations at their dotcom peak. More worrying perhaps is a health-goods-from-deer-antlers producer on 70 times, the seamless underwear manufacturer on 90 times or those school uniform and ketchup makers on 330 times!
• "Almost everyone is doing margin trading, so I am following the trend,” said Zhang, who borrowed as much as 1 million yuan from her brokerage. “If I buy good stocks, the returns can completely cover the costs.” Zhang said she doesn’t pay attention to corporate debt levels, which reached 125 percent of gross domestic product in 2014, according to the McKinsey Global Institute. The aggregate margin lending balance at China's stock exchanges has almost doubled since end-2014 to CNY1.9trn (USD302bn), equating to 3.1% of domestic market capitalisation as of 8 May.
• Chinese businesses raised more than 252 billion yuan ($41 billion) from share sales in 2015 through Thursday, on pace for the busiest year on record, according to data compiled by Bloomberg. At least 30 of those companies, including HeiLongJiang ZBD Pharmaceutical Co. and Silvery Dragon Prestressed Materials Co., are using a portion of the proceeds to pay down liabilities. The Shanghai Composite has surged 120 percent from last year’s low in January and it’s gone 479 days without a 10 percent drop from a recent peak, the longest stretch in its more than two-decade history.

In summary, as internal and external growth momentum falters, PBOC is reducing rates to support the high levels of corporate and local government leverage. China equity market has seen a massive increase as real estate returns decline and regulations make it a more difficult investment option. Margin lending is on the rise and corporates are raising more and more equity capital to repay leverage, potentially transferring risk to households.

The impact of the Chinese slowdown is widespread – Copper has been on a decline since 2011 was down another 7% for the year, USD/AUD and USD/BRL up 18% and 35% respectively. If China has a hard landing, with a lending crises or growth rates falters under 5% or exchange rates start depreciating, we would again see a revival in global bond bulls.

For the second time in seven years, the bursting of a major-asset bubble has inflicted great damage on world financial markets. In both cases--the equity bubble in 2000 and the credit bubble in 2007--central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of unfettered globalization. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy. - Stephen Roach, Morgan Stanley

The Chinese are making the same mistakes as the west did in keeping asset markets high and now compounding the risks created by historical high leverage based expansion.

Re-engaging an ancient empire

Iran was the oldest Empire in world founded by Cyrus the Great around 600 BC. This imperial inheritance laid the foundations for successive empires that followed i.e. the Parthian, Sasanian and Safavid dynasties. The current Iranian state continues in core form to be geographically common to the erstwhile empires with a landmass greater than UK, France and Germany combined extending from Caspian to the Indian Ocean and running concurrent to the most important energy sea-lane (Hormuz strait) in the south. It has the largest natural gas reserve and the 4^th largest oil reserve in the world.

The political influence of the state extends beyond borders into Syria (Al-Assad regime), Lebanon (Hezbollah), Iraq (Shiite government and militias) and Yemen (Houthis). A continuous series of imperial power develops among the people and bureaucracy a mindset and maturity to manage complex situations almost at a sublime level. And, unlike the autocracies that govern the artificial Arab states, Iran has a far more institutionalized form of governance with deep cultural and bureaucratic heritage which allows it the dynamism. Shia Iran is partially democratic and far more sophisticated, enlightened, and Westernized than benighted, culturally sterile Wahhabi Saudi Arabia - Kaplan. For example, Iran exports its ideology and coalesces these groups into extensions of the regime; Saudi Arabia also expounds its Wahhabi ideology but is unable to exercise even a partial influence amongst its supporters.

This is the nation that will come out of the cold once the nuclear deal is negotiated and that India has ignored. For most parts of the cold war there has been limited convergence in India and Iranian interest. However, the principal points of convergence over the last few decades has been the joint cooperation to the Northern Alliance in Afghanistan, energy imports and helping Iran build Chabahar port to allow access to Afghanistan and Central Asia. But once the US-led sanctions tightened, India withdrew.

Unlike India’s relationships in South-east Asia which are driven more by economic logic and carries limited political burden (despite them wanting India to balance China), Iran is important from a geopolitical perspective. India’s non-aligned history with limited maturity in playing great power politics has kept it away from the complex quagmire of the Middle East. As an aspirational power, we need to have the ability to play the game between the Arabs, Turks, Persians and the Israelis on the one side and the more important from India’s perspective the dynamic in the Iran-Pakistan-Afghanistan theatre. This is our neighborhood and one where we have had cultural and economic relationships for thousands of years.

Global power players understand the situation well. The Russian foreign minister walked out of the meetings as he saw the last round draw to a close to ensure delays and potential derailment and immediately after the last round of talks concluded offered the S300 missile systems. Iran not into the international fold also plays well with the Russian and the Chinese as it is a source of significant US distraction. The Chinese have already placed massive bets in Pakistan, have limited historical relation with Iran. For the US which is already coordinated with Iran on Islamic state, it is critical to engage Iran. With the fall of the totalitarian regime of Saddam Hussain, the middle-eastern balance of power collapsed. A nuclear Iran would trigger ambitions in Saudi Arabia and Turkey. A ‘cooperative’ Iran allows tremendous latitude for Americans i.e. stabilizing Iraq and Syria, while restoring the regional balance of power.

The Indian-Iranian equation can build significant commonalities in energy, infrastructure and defense. I had written in December 2014, “But with our old relationship with Iran and our significant interest in Middle Eastern energy, no policy is a 'non-answer'.” It is already past time when India should have started doing the ground work.

European Gauge

In 1948, US implemented The Marshall Plan to aid Europe, in which it gave $13 billion in economic support over 4 years to help rebuild European economies (remove trade barriers and modernize industry) after the end of World War II. However, the first aid went to Greece and Turkey in January 1947 under the Truman Doctrine, which were battling against communist expansion, even before the program was formally initiated. From then till the end of the cold war US continued to provide defense support to Greece. Post the collapse of the Soviet Union, the single currency came into place in a few years. The threat of Russia had dissipated and germanization of EU monetary policy allowed massive increases in spending capacity of EU countries, especially high inflation southern countries. This resulted in low interest rates for countries like Greece and Spain which had very different economies. And, what further depressed rates was the massive Chinese production increases at dollar pegged rates.

The European Coal and Steel Community to the current EU were essentially a political response to the repeated wars between France and Germany and was designed to economically embed Germany in Europe through market access. This market access with no exchange rate adjustment mechanism has resulted in the industrial engine of Germany, the 4^th largest economy in the world, building a ~8% current account surplus. Current account surplus is nothing but a manifestation of incremental saving over investments and lack of internal demand and raw material access has been a critical element of German geopolitical insecurity.  

With the European economy slowing substantially and inflation declining (and now aided by energy prices) post the global financial crises; ECB adopted various measures to keep the system on life support and more recently initiated quantitative easing (essentially financial asset purchases). The resultant impact is a substantial decline in the Euro, currently at 1.09 to USD from 1.4 levels a year back and expected to decline to 0.9-0.85 in the next 2 years. The real yields in Eurozone have already declined below Fed QE levels (10 yr bunds at 0.17%, France at 0.47% vs US at 1.19% and Japan at 0.35%). While this will play out in terms of helping export sensitive countries like Germany or Italy in the international markets and in terms of second order wealth effects due to increasing equity prices across the EU together which hopefully will lift investment, it however does not directly allow for adjustments within EU. The Euro-area countries also continue on their path of reducing fiscal deficits (e.g. Spain 5.6%, France 4.4%) or debt deflation and wage growth has stalled. In essence two aspects impact the Eurozone as always – (1) the overwhelming weight of the cost-effective German export engine; and (2) lack of adequate demand within Germany.   

The economic pressure has resulted in the rise of right wing political parties across the European Union like Podemos in Spain or the victory of Syriza in Greece. Along with the economic pressure, the geopolitical pressure of the European Union has multiplied with the reemergence of Russia (Ukraine conflict and increasing intensity of military exercises) and collapse of order in the middle-east, all on the eastern border of Europe.

The nation acutely reflecting the multiplicity of these pressures is the ancient land of Greece, birth place of western civilization, sitting on the south-eastern border of Europe.

Greece will likely be the first pin to fall under the economic constraints created by the Eurozone. As after WW II, Russia is awaiting this moment where it could have a toe-hold in the Mediterranean. This may also result in a very similar response where EU or the US steps in to prevent the same under a national security paradigm. But this response will alter the complexion of EU. Grexit will raise the gauge pressure to critical levels and EU which in many ways was cajoled together by the US as a geopolitical response post World War II, will be taking a step towards the known unknown…national interest first but path uncertainty may finally make it otherwise.

“Europe and the euro zone have no reason, rationally, to push Greece out of the euro. But this is a system in which many parties, many countries, many governments, many electorates participate and we could have events which, rationally, are not controllable.” – Greek Politician

“The Europeans are still human, and they will encounter terrible choices like those that others face and that they have faced in the past. They will have to choose between war and peace, and as in the past, they will at times choose war. Nothing has ended. For humans nothing significant is ever over.” George Friedman, Flashpoints, 2015