“There are decades where nothing happens; and there are weeks where decades happen.”― Vladimir Ilich Lenin. It has been a remarkable two weeks. Since I last wrote a piece here, China may well have lit the fire in the magazine which was accumulating dry gun powder for a long time now. In my last article I talked about how China needs to devalue the yuan and I didn’t have to wait long to see it unfold. There are number of reasons why they did it, from economic to political. I will touch upon them as the story unfolds. Meanwhile in Asia, the entry of China into the currency war may well have the effect of bombs being dropped. World economy has been on the slowdown path for a long time now and may be financial markets, are recognizing it finally.
I have written about how 2008 was a classic reset button in the global savings imbalance. It saw a key component of its economic landscape, the developed world lose it leveraging game. As a result, global demand floundered. Faced with a sudden stop in demand for its exports, the developing world pumped trillions of dollars of credit into the economy, through monetary policy and fiscal policy route. Net result was a V shaped recovery in demand and an even bigger surge in supply. In other words, the savings glut intensified. The excesses supply faced even weaker demand. Once the effects of stimulus began to wane, the EM economies weakened. In fact, since 2011, the positive effects of economic steroid began to be outweighed by unintended consequences of the same. Asset inflation and general price level inflation in the developing prompted central banker to tighten money supply and cost of money, end result was an accelerated pace of unwind of the economic growth.
China is no democracy and there the situation is similar to what it was during the time when Pharaohs ruled Egypt. There was a common knowledge that as long as Pharaohs ruled, the river Nile shall never run dry. In China, vast amount of migrant population believe that the autocratic government shall always ensure that there are enough jobs to go by and they get paid in a timely manner. If the government can not ensure that, like it happened in Egypt, when the river Nile finally ran dry, the common knowledge faces a serious challenge. End result can be social disharmony. Therefore, it was not surprising that Chinese government reacted the way it did during 2008-09. China created close to USD 23 trillion of debt into the economy between 2008 and 2014, taking its total debt to GDP ratio to 300% or USD 30 trillion.
China initially may have thought that 2008 was just a passing phase and the good old days will return. However, that did not happen, China had to keep on pumping greater and greater stimulus and its wait with extraordinary policy, which was supposed to be small and brief, became large and long. The consequences were a giant credit bubble, backing sizable amount of over capacity from industries and infrastructure sector. China’s voracious appetite for industrial commodities caused commodity exporting nations to add significant amount of capacity too. History is a guide that greater the super cycle in commodities has been and for greater the duration, greater has been the supply response. This time the supply response was in epic proportions. All these capacities in China and abroad became financed by artificially suppressed cheap money sloshing in the global financial system. So, the developed world central banks too played a pivotal role in this game of savings glut or supply glut.
The asset inflation across the globe had two major legs, hard assets, commodity and real estate and financial assets, stocks and credit. The first to collapse was the hard assets, beginning 2011, with bullion, the hard money and then finally everything else from end 2013 and first half of 2014. Deflation, a product of excess supply backed by credit against weak demand, became more and more entrenched in the global economic system. The cheap money sloshed away from hard assets into the financial assets. Remember, when excess savings cannot find avenues in the real economy to be invested, it either ends up creating unemployment or it gets misallocated as asset bubbles. The stock market boom picked up more and more countries from Europe to Asia to Africa to Latam. However, such a shift caused an ever widening chasm between real economic fundamentals, which was on a down ward trek and financial asset valuation. The chasm was filled by enormous faith in central bankers but which different parts of the world gave different names, be it hope trade for India or the great reform trade for China. The end result was investors took greater and greater risk per unit of return.
I have always argued that once China enters currency war, it can get messy, like what US did to European powers during 1930s. China is fast running out of options. Its leadership is showing a sense of panic. China wanted to wean its economy away from investment-export lead growth model to a consumption driven one. However, the cost of such a transition and a weak global economy and a subsequent equity bubble bust, has made it question that approach. Now it is resorting to its old bag of tricks – pump prime by allowing heavily indebted local governments to borrow more to build more capacity, remove all kinds of sensible restrictions in the bloated real estate market, loosen monetary policy and allow yuan to devalue by the market. China also wants a greater role in the global monetary game and a step in that direction, it believes, is having its currency as a part of SDR of IMF (Factsheet: Special Drawing Rights) .
China has been facing record outflows for the past five quarters and that may have intensified further. It is estimated close to a USD 1 trillion may have exited China over the past 18 months. However, the Chinese central banks have been busy selling US Dollars from its reserves to keep the Yuan stable against the US Dollar. The sharp rally in the US Dollar against almost all global currencies since 2013 may have had a debilitating effect on the Chinese exporters, especially at a time, when the world trade pie is shrinking due to weak global economy and waning trade intensity. China was facing deflation, fast weakening real economy, very high real rates due to deflation and now tight monetary policy, thanks to selling of the US Dollars from the central bank. The situation was fast becoming perfect storm for China. China may have also tried to send a warning shot to Washington before the Chinese Premier and the US President HU Jintao meet mid of next month. The message is like this, allow us a greater role of the global monetary system or else we can unleash damage on world economy, through competitive devaluation and trade war.
In all this India remains a gainer as well a loser of this multi-year shift in global economic shift. One hand, there is significant portion of the economy which is dependent on hard assets. Four major sections of the economy, employs significant amount unorganized labour force and also some amount of organised labour too:- 1) Real estate and construction 2) mining and processing 3) Gems and jewellery 4) Agriculture . A hard asset bust has not only come as a drag on their income but also on their wealth. Add to this the fact that state and central governments depend on sizable source of their direct and indirect revenues from the sector. Indian government has been trying to resuscitate investment growth. They are up against a tough opponent. Historically government investment share of total investment has been between 20% to 30%. India is not a command and control economy like China and hence there is limited effect that government spending can have without private sector support. There is serious lack of demand in the economy and as a result the corporate sector is facing multi-year lows in capacity utilization levels and they are also leveraged.
The gainers of the hard asset bust may have been largely the urban consumer, but much of higher disposable income may now be getting saved as economic uncertainty remains high. A similar phenomenon is being played out in the world economy as well. However, as the real estate unwinds even deeper even this section of winners from the commodity bust can feel the pinch because mortgage sector, which some refer to as a bubble, has engaged a portion of the urban population through EMIs. Since last year, I have been warning that a hard asset bust will have adverse impact on India as well, and demand may flounder, as the country may lose the engines which were driving it all along.
Now turning attention to financial markets, we believe a major positive development is unfolding for certain sections of the Indian export community. Finally the Rupee has become unglued and it is depreciation fast against a whole host of currencies. Rupee is facing the biggest brunt against the European currencies and getting some ground back against some its peers in the Asian and EM region. However, Rupee still remains a major outperformer in that group. US Dollar has appreciated close to 3.4% against the Rupee and even the Japanese Yen has appreciated. Euro and Yen remain the carry funding currency and if they continue to surge, it can mean more pain can be inflicted on EM assets, including India, causing USD/INR to spiral higher. In the past I have written about how the carry play has shifted since early part of 2014 and how it can change asset play equation around the globe. Over the next week, Indian Rupee may depreciate further, towards 66.50/70 levels on spot. An active central bank intervention may cap the advance for now. However, we may be seeing a long duration shift in the way risk assets behave, the omnipotence of the central banks, may be getting challenged by the hard economic realities. If so, then a near term range of 64.50 and 66.50 may become the launch pad for a move towards 68.00/70.00 over the longer term.
Anindya Banerjee, analyst, Kotak Securities