Risk assets got back in the groove last week, as policy makers once again managed to keep spooky realities from coming out of the closet. Greece not only chickened out but also surrendered to Troika, in order to secure more debt from Euro zone to repay Euro zone and IMF. The fear of unknown has become so great for Greek policymakers that all their year and half talk of “fire and brimstone” proved hollow. Germany managed to call the ‘big bluff” of Greeks right at the moment, when it mattered most. US, then IMF and even ECB made some noise about offering Greeks a way out to future in the Euro zone, through debt haircut, by Germany and other northern European nations snubbed it. Therefore, the ‘kicking the can” down the road exercise, continues, but we believe now with every kick the can is becoming too heavy to do so in the future. While economists may find it difficult to accept how the obvious choices are becoming too difficult to accept in the Euro zone, one being large-scale debt restructuring, other being reforms in south and retooling of economic model in north and finally a move towards political union and fiscal union, but politicians find it easier to drag the status quo as long as they can. After all the ex-PM of Luxemburg and current President of the European Commission, Jean-Claude Juncker captured it well in his statement, “We all know what to do, but we don’t know how to get re-elected once we have done it.”
Chinese economy continues to grind downhill; no amount of glossy data can change that reality. However, they continue to mesmerize the world with their ability to control stock markets. There was lot of praise for the new leadership in China, post third Plenum in November 2013. Experts said that China will be able to transition its economy from a centrally planned, command and control autocratic structure to a market-driven capitalistic system. History however warned observers and analysts to remain grounded in their enthusiasm. There are enough examples where economies who have tried to engineer such a transition had to proceed through a phase of pain and even turmoil. It is like trying to learn cycling for the first time. The command and control structure is like a bicycle with support wheels and market-driven economy is one without. I have been warning about a significant slowdown in the Chinese economy since mid- 2013 and facts suggests that economies in Asia and EMs have peaked between 2012-2014 time period.
Over the past two decades, Chinese economy has grown in leaps and bounds, with the total economic size becoming USD 10 trillion now, more than 5 times our economy and second largest in the world, with US being between USD 16-17 trillion. Chinese diverted resources away from households towards investments and export sector. As a result, interest rates were repressed and wage growth happened slowly. Labour rights and labour benefits were kept under tight leash to keep the cost of doing businesses low. Various kinds of economic and political measures were undertaken to promote exports and investments at the cost of consumers. As a result, Chinese GDP grew much faster than the growth that happened in household income. Corporates and businesses, which were linked with investments and exports, flourished. Chinese economy became exports driven and investment driven.
Now, with both the engines burned out, the world wants Chinese consumer to save the day. How can that happen? Transition towards a consumption lead economy will take many years, if done correctly. The world economy is facing savings glut or supply glut and Chinese savings glut is only aggravating the problem. Unless, economies are found, who can absorb the excess savings, higher unemployment and bigger financial and hard assets bubbles will occur. Remember, if excess savings cannot find excess demand somewhere, it gets miss-allocated into non-productive investments, causing asset booms and busts. We are experiencing one such a mega trend of miss-allocation with over-valuation in hard assets (which has started to deflate in many parts of the world), in financial assets and even new economy business (the second technology boom and first biotech boom).
Post third plenum, Chinese policymakers tried changing the economic model, by asking local governments to stop issuing more debt. A sudden stoppage of credit flow to the leveraged part of the economy, caused significant disruption to growth. China has amassed debt which is close to 3 times its size of the economy. With such high leverage, last thing China needed was disinflation to deflation and weak real growth and that is exactly what it is getting now. Growth is weakening fast, making debt servicing problematic. Faced with a weak global economy and domestic economic down turn, Chinese leaders blinked.
Late last year, they allowed LGVs to once again issue fresh debt, on top of their existing high debt levels, and also asked banks to finance those debt and then in turn, refinance it with the central bank. At the same time, it was happy promoting an equity boom at home. Eager to provide citizens a way to escape from the imploding real estate bubble, where they have 65-70% of their wealth invested, it literally pied piped masses into the stock market. An equity boom helped Chinese companies to raise much needed equity to provide some cushion to their debt laden capital structures. However, as many countries have found in the past, and now the Chinese, when you take financial booms too far too fast, it can unravel all of a sudden and in an ugly manner.
There are media reports, that people may have pledged their houses to take out loans to invest in the equity derivatives and equity cash market. When such a frenzy ends, it can be quite costly. At the peak of the equity boom, Chinese stock markets reached a peak of USD 10 trillion, with most of the equity being held by domestic retail investors. Imagine a collapse in such a mega equity boom, whose size is 5 times our own economy, socio-economic implications cannot be ignored. Therefore, it is no surprise that Chinese policymakers have reacted the way they have, as a financial asset implosion can prove costly. China has shown the world, that it has little appetite to bear the pain of economic restructuring and that is not a good news for the medium to long term.
Over the long term, we expect Chinese policy makers to try every trick in the book (may be invent some new ones too) to throw tons and tons of good money after bad. As a result, they might be able to avert a sharp and climactic debt driven economic implosion, like what many countries in the west have suffered over the past 100 years. However, such an exercise may pro long the pain, much more than what Japan experienced over the past three decades. We expect China to launch stimulus measures, a mix of monetary and fiscal, to stimulate more debt driven investments, drive consumption and weaken Yuan. Once China enters the currency war, there may be geo-political blowbacks. We will wait and watch.
By Anindya Banerjee,
Analyst, Kotak Securities