Liquidity has returned in global financial markets. Volatility has picked up. Speculators have unwound a part of their long dollar bets ahead of the inauguration of the new US president. As a result, US Dollar has come under selling during the first two weeks of the New Year. The rally in currencies against US Dollar has been quite broad based. However, Indian Rupee has failed to capitalize on this cheer and strengthen. It should come as no surprise to readers as I had hinted to such a phenomenon in the column I penned a couple of weeks back. I talked about why RBI would not be aggressive in its intervention, after a near USD 10 billion selling binge over the previous quarter. Lack of RBI intervention and a constant drip of outflows from FPIs would ensure Rupee underperforms the rest of Asia. Commodity prices are holding out and that is supporting commodity currencies too. Expectation that US would step up its fiscal lead infrastructure push and the new administration would allow banks to step into commodity trading, could be part of the package of factors driving commodity prices higher. However, the concerning aspect of this commodity rally is record speculative long positions in a number of major industrial commodities. Incase this hope rally fails to get its wish list fulfilled, the unwinding can be brutal and swift. In such a scenario, we may see currencies of commodity producers once again underperform the currencies of commodity users.
When we discuss commodities, it is not complete unless we touch upon China. Over the past week, a few major economic data was released from China. China saw a large acceleration of the Producer Price Index to 5.5% in the final month of 2016, highest in more than 5 years. However, the December jump was all about commodities. Factory-gate prices in the steel and fuel-refining sectors were up 35% and 17% from a year earlier, respectively, against just 5.5% for producer prices as a whole. Part of that is a low base of comparison, as most industrial commodities bottomed out last winter, along with Chinese producer price inflation in aggregate. There is a tight positive correlation between the time series data of PPI inflation in China and time series data for major industrial commodities denominated in Yuan. Hence, it is purely a global dynamic. However, what is disconcerting is not inflation but the continued surge in leverage in the economy and collapsing productivity of capital in China.
Total social financing in China, a broad measure of credit growth, came in at 1.63 trillion Yuan ($236 billion), down from 1.74 trillion Yuan in November but well above expectations of 1.30 trillion Yuan. Outstanding total social finance expanded 11.6 percent year on year in December, easing from 11.8 percent in November. To date, many have relied on the TSF invented by the Chinese authorities in 2011 as a way of capturing a larger slice of the country’s shadow banking activity, but various private studies have shown that TSF fails to capture the true extent of credit creation in China. For example, the People’s Bank of China’s “domestic credits” series continues to show a much higher growth rate — 21.2 percent year on year in November. Some other estimates have placed the number anywhere between 20-50% of GDP. Compare the rise in credit in the economy with its official nominal GDP growth, which is between 6.5%-7%. Therefore, in order to create a growth rate of 1% it takes 3 to 7 times of credit. Such a large expansion of credit is making the Chinese economy was lopsided and dangerously levered to become more precarious. Various credit to growth metrics is simply off the charts. In history, countries with much lesser credit binges have suffered economic and even financial crises. China could be delaying it by making full use of the benefits of a fiat currency system. However, the longer they continue in this fashion, the more painful will be the transition.
China’s transition away from producer/investment economy to a consumer oriented economy had been recognized long back but things have become more lopsided. Vested interest and then the global financial crises led adjustment in savings-investment-consumption flows have made China unwilling to bear of the cost of such a transition. A move away from producer/investment led model to consumer led model will require China to embrace a long period of slow GDP growth. A sharp decline in investment spending and reduction in leverage would lead to rise in unemployment. Unemployment is China is a social problem. In a country of a billion ruled by an autocratic party system, economic pain can trigger unexpected political reversals. The fear of preventing such an outcome has compelled the China’s political elite to undertake desperate and suicidal economic measures. They may have dug themselves into a bigger hole for the future.
China has to grapple with a new world economic order where America and other developed nations, like UK, who have run large current account deficits to continue in that path. The rise of right wing populism across the developed world is already talking about changing the way global trade agreements have been framed. Such a move would adversely affect China. It is not just China, countries like Germany, who have seen their current account surpluses zoom to record levels would feel the pain too. Japan too is not far behind. At the global level, some ones current account surplus is formed out of some one else current account deficit. Current account surplus or excess savings, goes into funding current account deficit of countries with deficit savings. The deficit country export demand to surplus nations. Therefore, as countries like US and UK enact measure to further reign in their current account deficits or export of demand to countries with large current account surplus. These countries would feel the effect in their economies. China has already faced the crunch between 2008 and 2016, where in its current account surplus has shrunk from 10% to below 3%. Such a massive fall in surplus in less than a decade causes large increase in unemployment in the economy. However, China has been able to avoid it by allowing massive amount of credit driven investment binge in the economy. However, they have not only delayed the adjustment, but also have made the inevitable realignment bigger and more painful.
As we cruise through 2017 and even possibly in 2018/2019, I expect Chinese economic, financial and political realignment to be the major event that galvanizes global politics, economics and financial markets.
Before I conclude, let me touch upon the trends in major currency markets. US Dollar can continue to correct over the next couple of weeks. There is an interesting development occurring in the intermarket landscape. MSCI equities and Asian Dollar Index (which falls when dollar strengthens against Asian currencies) generally move in lockstep. However, during inflexion points, MSCI EM equity index tends to lead Asian Dollar index. Currently there is a glaring divergence between the two indices. The nature of divergence and the fact that since 2001, MSCI equities have shown leading characteristics, we would be alert to signs of a BEARISH REVERSAL IN THE US DOLLAR. An upswing in the Asian Dollar Index (ADXY on Bloomberg) to play catch up to MSCI equities would be a bearish omen for USDINR. Such an observation runs counter to the expectation that US Dollar remains in a strong wicket due to divergent path of policies in US and rest of world. However, we would not like to ignore such a major inter market signal. Hence, would stay alert to reversal. In the mean time, USDINR is expected to trade within a range of 67.70/90 and 68.40/50. A break of this range is needed to trigger the next trend in USDINR.