Since I wrote my last column, a lot has happened in the world financial markets. In fact I would go on to say, it was a little over a week of comedy, drama, suspense and even sci-fi. On one hand, Greeks took northern Europeans by surprise, after it announced that it will hold a referendum on a proposal, which expired before the vote. Then, it went on to present that same proposal, as if like a valiant attempt to make a “ctrl+c and ctrl+z” of the expired creditor proposal, and watermark it as “Make in Greece”. On the other hand, China showed the world how to create a “managed floating” stock market. You must have heard about “dirty floating” currency regimes, where central banks repeatedly intervene to keep price discovery out of the ambit of markets. No one had seen a similar structure for equity markets, now they have, thanks to the valiant attempts by Chinese leadership and Chinese regulators.
What is going on in Euro zone?
I would like to point out, something, which I have talked about many times in the past, and it is that the economic and financial situation in the Euro zone is untenable.
We have to understand, the privilege of a single currency comes with fiscal and political responsibility. With so much of economic and social in congruency between the members of the common currency, what is needed is for a federal Europe. Otherwise the current account imbalances would engulf Euro currency union. Post-unification, weak Euro zone nations got lower interest rates but a stronger currency. Germany got a ready market for 40/50% of its exports, with little or trade barriers and with a relatively weaker currency. Germany, has had policies which suppressed wages and augment exports. Higher exports, weaker consumption and stagnant investment, meant that fiscal surplus and current account surplus were inevitable. Remember, current account balance is a factor of national income minus consumption, minus investments and minus fiscal balance. As Germany capped the drivers of domestic consumption, investment remaining stagnant and that coupled with strong push towards fiscal surplus meant, that Germany clocked a substantially current account surplus. One country’s surplus needs to be consumed by some other countries. Thanks to the monetary union, most of the surplus found its way into the deficit of PIIGS. With lower interest rates and massive surplus heading towards the southern Euro zone members, there was gross misallocation of investments and bubbles were created. Bubbles subisidised consumption binge and that too with high investment and government deficit triggered a sharp rise in current account deficit and debt. So yes, the PIIGS messed-up but Germany, along with surplus nations also had a major role to play in that regard. Therefore, a solution to the problem cannot be just mindless austerity. With unemployment elevated and economy in a deep freeze, a mix of sensible steps are needed. They could be:
1) Large scale debt write-offs across the weaker Euro zone nations.
2) Plans to recapitalise financial institutions impacted by the debt restructuring plan.
3) Fiscal Union.
4) Germany and other surplus nations in the Euro zone enact policies to boost domestic consumption and investment to run down their surpluses and help the weaker nations to export out of the economic funk.
5) Structural reforms in the weaker Euro zone nations and even in countries like France.
With Euro now the second most important global currency and Euro zone banks having operations worldwide, it is global responsibility for Euro zone nations to fix the Euro. A Grexit would put a big question mark on the viability of the Euro as a project Over the weekend, Euro group will be meeting to whether to accept the Greek request for another bailout or not. Greece has shut it banks for days now and it also needs to pay ECB’s on 20th July a sum of 2 billion euros. Therefore, unless creditors can agree to save Greece for now, it can face hard default and even risk an exit from the Euro zone.
German’s are not so convinced that Greece will actually walk the talk. The political situation in Greece remains fluid and too harsh a deal can run the risk of an abandonment by domestic politicians. Therefore, we have to be guarded in our optimism.
Let us assume that over the next couple of days, we do hear from creditors, that they have agreed to bailout. However, without a debt haircut in that plan, I feel Greeks and creditors can be back in the table in a few months, time, possibly in and around Spanish national elections in December 2015.
Now turning my attention to China. Chinese economy has been deflating for over 2 years now. A collapse in industrial commodities is a proof of the same. Chinese car sales fell for the first time in more than two years in June with buyer sentiment hit by slowing economic growth and the country’s stock market crash. For the first half of the year, car sales increased 4.8 per cent over the same period in 2014 — the market’s weakest performance in six years. The domestic economy is feeling the weight of enormous debt accumulated over the last seven years. Since the global economic reset of 2008-09, China’s GDP has doubled, expanding by USD 5 trillion in 7 years. But as shown below, it took a USD 21 trillion expansion of debt outstanding to accomplish that outcome. That is right. It took on USD 4 of debt for every new dollar of freshly constructed GDP. 
With the domestic economy facing deflation and slowdown in real GDP, the USD 27-30 trillion of total outstanding debt appears all the more burdensome. Therefore, it is no surprise that the Chinese leadership has tried everything to halt an equity meltdown, even though many observers have complained that an unprecedented bubble was underway in China. The number of equity account holders touched nearly 90 million, more than the number of members of Chinese community party. Investment bank Credit Suisse estimated that 80% of China’s urban households have put money on the stock market in a major shift of household savings from bank accounts to brokerage accounts. At the same time, domestic investors or global Chinese diaspora held almost all of the market-cap and hence an equity meltdown is by no means a small thing. Even if someone had any shred of doubt of the importance of equity market in the economy, the unprecedented desperate actions of Chinese government has removed that. With domestic economic ills and falling property market, an equity meltdown become a significant burden.
China:- Whole Sale Inflation (%- y/y) 
Over the past few years, Chinese leaders have talked about embracing market economy. However, the actions over the past few quarters have shown that Chinese leadership do not have the stomach to absorb the pains associated while transitioning an economy from command and control mode to market driven. They are chickening out. The global economic transition is making the change so painful for China. Therefore, I would not be surprised if China announces a major monetary and fiscal stimulus to arrest the accelerated pace of economic mean reversion. Such a stimulus package will aggravate the long-term issues but it may be sacrificed for the need for short to medium term political survival. A sharp fall in Yuan is need of the hour, it may finally happen, and which may complicate the global eco-politics. China may finally decide to grab demand from rest of world, adding fuel to the global currency war and trade skirmishes.
We need to understand, that after the debt driven demand boom came to an end in 2006-08, whatever steps the global policymakers have used since then, has added more supply than demand. As a result, we now face an even bigger global supply glut, financed by debt, aggravating the deflationary process.
Over this week, if Germany can agree to play along and offer an olive branch to Greece, we can see a sharp rebound in global risk assets and EM currencies. However, a Chinese stimulus, which may take some more time, would be needed to sustain that over the medium term. Unless China go for easy money, next few months we could be talking about China a lot.
Anindya Banerjee, Analyst, Kotak Securities