Vijay Kumar Gaba

 As per the news agency Bloomberg’s calculations using IMF database and historical exchange rates, the size of the Indian economy in ‘nominal’ cash terms at the end of March 2022 quarter was US$854.7bn vs US$816bn for the UK economy. By this standard, India was the 5^th largest economy of the world as on 31 March 2022, behind the USA, China, Japan and Germany.

This apparently innocuous, and mostly inconsequential, statistical data point has been subject of an intense discussion in India media – both mainstream and social.

The pro establishment groups have celebrated this data point as an important milestone in the resurrection of the Indian economy, especially under the stewardship of Prime Minister Narendra Modi. They have forcefully argued that the Indian economy surpassing the UK’s economy highlights the rising status of India in the global economy; and symbolizes the undoing of 200years of British slavery.

The groups opposing the establishment claims highlighted that the absolute number of GDP is meaningless. On the relevant parameters like per capita GDP, human development index, extreme poverty & hunger, etc., India lags far behind the UK. They argue that in fact, the position of India in most of these parameters has slipped lower in the past few years.

I see merit in both the arguments. The Indian economy growing despite all adversities and limitations over the past 75years ought to be a matter of pride for all the citizens. We are entitled to celebrate the achievements of our farmers, professionals, and entrepreneurs. At the same time it is also true that the pace and direction of growth is not adequate; and there is a scope to do much better. We need to address the quality and sustainability of the growth. The rising regional, social and individual disparities; inadequacies of growth in terms of human development and quality of life; and poor employment intensity of growth ought to be a matter of concern for the policy makers as well citizens.

Insofar as the statistics is concerned, in my view, the more appropriate benchmark would be China. Both Indi and China embarked on the journey of rebuilding the nation in late 1940s. In fact China started two years after us in 1949 when the civil war ended. Both started the process of accelerated economic reforms in the early 1990s. At that time both the countries had similar GDP and other economic conditions. Both the countries have similar demographics. However, the Chinese economy is now six times bigger than us.

One could argue that India and China are incomparable because of the vastly different political structure in these two countries. China has an authoritative regime and a significantly less transparent governance structure; whereas India is a reputable democracy with a more transparent and accountable governance structure. This is a fair point but certainly not incontestable.

The economy of the UK has been stagnating for over a decade now. The current GDP is almost the same as it was in 2014. The demographics have been worsening. Brexit has further slowed down the growth. It was a natural trend that India will surpass a stagnating UK, like it did with Italy, Australia and Canada in the past one decade, in due course. It may be a cause of celebration due to our colonial past, but there is little to celebrate in real economic terms.

It may be pertinent to note that the UK economy has been stagnating for almost a decade now. The latest GDP of the UK is almost similar to what it was in 2014. Brexit has also impacted the UK growth adversely. On the other hand, the GDP of India has been consistently growing, albeit at a much lower rate that what all of us would desire. India’s GDP would have overtaken the UK in 2017, if demonetarization had not slowed the pace of growth of India’s GDP. In the past one decade India’s GDP has overtaken the GDP of countries like Italy, Canada and Australia. It has meant little for India and Indians. The queue of Indians seeking to migrate to these countries has only become longer in this period.

At the current pace, it will take at least two decades for India to become a middle income country (per capita GDP at US$12000 from the present US$1961). Becoming a developed country like the UK, Canada and Australia will take much longer.

Celebrating every milestone in the journey is good; provided we do not lose sight of the destination. Celebrations that distract us from our goals are best avoided.

It is a basic human tendency to long for what they do not possess. It is common to find people who have struggled very hard to achieve certain goals; but almost instantly feel dissatisfied with (or indifferent to) the outcome. They either realize that it was not something they actually wanted in the first place; or they immediately shift the goal post and begin to struggle/strive for a different/higher goal. This basic human tendency, that often manifests in a constant need to move, evolve and grow, is at the core of all economic growth and development. And perhaps this is the key factor that undermines the issue of sustainability.

Metaverse is nothing but a realization that humans never wanted to globalize in the first place. They like to remain confined to their caves and tribes. It was perhaps the starvation and disease that would have forced the first tranche of immigration.

Of course since the end of the stone age, this realization has taken more than 5000 years; many rounds of polluting industrialization; chopping of billions of trees; extinction of many species; killing of millions of people in wars, to dawn upon the mankind. And it may actually not be the full circle and we may still want something more once we realize the goal of living in a predominantly virtual world.

If I may put this hypothesis in a more recent context-

·         The people of USSR were sick of the central command economy and wanted a democracy that facilitates their participation in the global growth and development; besides making the governance structure transparent, corruption free and progressive. Gorbachev gave them an opening to the world they were struggling to live in. In less than two decades, they chose to hand over the power to an authoritative leader who is not even committed to any socio-political ideology; aspires to restore Tsarist colonial ambitions and cares least for the global order, transparency and accountability.

·         China, which has consistently supported Pakistan’s demand of self determination by Kashmiri people at all global platforms, refuses the same rights to the people of Tibet and Taiwan. The Chinese authorities and businesses demand equal rights for their companies from the governments of foreign jurisdiction where such Chinese corporations have established operations. However it refuses to allow similar justice and freedom to its own corporations and entrepreneurs like Jack Ma.

·         We find that for almost a decade the central bankers of the developed world struggled to create inflation and full employment in their respective economies. When the inflation finally occurred, it is now their biggest problem.

·         The farmers, agriculture experts and politicians in India clamored for farm sector reforms for many decades. But when a significant part of these reforms were delivered, people launched a movement for reversal of these reforms.

·         The industrialists and financial market participants long for accelerated economic and fiscal (tax) reforms. However a mere mention of withdrawal of Income Tax exemptions and concessions (e.g., LTCG) makes them apprehensive.

The simple point is that the investors should not get passionately attached to a new trend or event. Most of these could be ephemeral; and could evaporate as soon as these go out of media headlines.

 I find nothing more disturbing than demolition of a long preserved and much cherished image or belief. Occurrence of this often gives rise to cynicism, shaking the core of the belief system. The recent act of violence in Japan is one such event.

People of my generation have known Japanese people for their politeness and commitment to non-violence. The pictures of Japanese crowds showing remarkable patience and calmness during adversities have been much cherished by post WWII generations. The assassination of the former Japanese Prime Minister Shinzo Abe, last week, while he was addressing a public meeting has shattered many images I was carrying in my mind. This is perhaps first of its kind of act of violence since assassination of Inejirō Asanuma, the then Chairman of the Japan Socialist Party. However, in the pre-war era, political assassinations were rather commonplace in Japan. Japanese people took pride in their martial and imperialistic traditions. Many believe the 1945 nuclear attack on Nagasaki and Hiroshima overwhelmed Japanese society, burdening it with the guilt of being one of the main characters in the two disastrous world wars and losing its pride to the USA.

In fact, after decimation of the manifest fascist forces (e.g., Germany and Italy) and imperialistic forces like Great Britain, Japan and Austro-Hungarian empire post WWII, the world has been a rather peaceful place as compared to the preceding 2000yrs. The conflicts post WWII have mostly been contained. Even during the height of the cold war between NATO and Warsaw Pact countries, and shenanigans of star wars, there had never been a threat of escalation to the scale of larger World War.

However, if we correlate some of the recent events and trends, the picture that would emerge is not very comforting. For example, consider the following events and trends:

·         Assassination of Shinzo Abe.

·         Numerous acts of violence across USA and Europe, apparently perpetrated by random people who are not radicalized.

·         Blatant violation of international laws by Russia in invading Ukraine, as energy starved Europe overlooks the devastation of a sovereign nation.

·         China is threatening its neighbours’ territorial and economic integrity.

·         USA handing over Afghanistan to Taliban.

·         Communists (or socialists) winning elections (re-elections) in many jurisdictions, e.g., US, Germany, France, Italy, Australia, Chile, Mexico, Argentina, Bolvia, Peru, Honduras, and Columbia, etc. Polls are indicating that Bralians are most likely to lecet a leftist eader in October election, as Chinese premier Xi Jinping further strengthens his position at 20^th National Congress of CCP later this year.

·         Reliance of population on governments for meeting basic needs rising exponentially along with the rise in the ffinancial and fiscal vulnerabilities across the globe.

·         Frequency of mass public protests rising in various jurisdictions.

·         Tendency of governments to overregulate and over govern increasing across jurisdictions.

·         Expansion of NATO.

When I look at these events and trends and many other similar things happening around, I get a feeling that people of the world are tired of pretending politeness, being democratic and practicing non-violence. They appear eager to get over their guilty conscience and establish supremacy of their respective races. We may in fact be close to the return of Vikings Age 2.0.

In the past 6-7 decades, we have seen many countries being invaded in the garb of restoring or establishing democracies or people’s rule in these countries. Russia’s invasion of Ukraine ends that façade. This will perhaps re-establish the legitimacy of colonialism and imperialism. We shall see multiple such instances in the coming decades.

Before we reach a stage when the new Roman, British, Ottoman, Qing empire would rise, we need to cover a long distance. Who covers this distance fast while conserving enough energy and stamina to occupy the post would decide the new world order, maybe 40-50years from now.

More thoughts on this later.

 In the past couple of months there has been a visible rise in the reports expressing fears of an implosion in Japanese, Chinese and Russian economies. The reasons behind these fears are quite diverse. Of course there is nothing new in these reports. Experts have been predicting an implosion in the Japanese economy since the early 1990s’ in the Chinese economy since 2008 and the Russian economy since 1917.

Personally, I do not subscribe to any of the theories that forecast implosion in the Japanese, Chinese and Russian economies in the near future. Nonetheless, I believe that the study of the growth, fiscal and indebtedness profile of Japan is important from two viewpoints, i.e., (i) impact on the global economy, should the BoJ losses control over the situation; and more importantly (ii) impact on the global economy if the US economy (consumption, growth, fiscal profile, etc.) follows the Japanese economy and gets trapped in this vicious cycle of high debt and low growth; and the consequences if USD loses its prominence as the global reserve currency.

I noted a few pointers for this study from some recent reports relating to Japan. These simple and most visible pointers indicate where the US economy could head if a new set of innovative monetary and fiscal policies are not implemented soon. This would be as imperative as the first set of innovative monetary and fiscal policies implemented in the wake of the global financial crisis.

Japanese Debt – the vortex

As per some recent reports the Bank of Japan (BoJ) now owns over 50% of $12.2trn debt issued by the government of Japan. The public debt of Japan is now 266% of GDP. The Public Debt to GDP ratio of Japan has consistently worsened since 1992, when it was below 70%. Considering that the GDP of Japan is rising at a snail pace of 1-1.5%, and the debt is growing at a faster rate, it is most likely that the debt situation may worsen further.

The sharp rise in debt has not been much of a problem so far as it has been accompanied by consistent fall in bond yields. In fact the yields have been negative during 2015-2020. Moreover, since most of the government debt is bought by BoJ and local banks and funds, Japanese yields have been insulated from global trends for the past 3 decades. Even during the global financial crisis, the Japanese bond market remained mostly unaffected by the global turmoil.

The BoJ has been struggling with persistent deflationary pressures for most of the past three decades. For most part of the past two decades, the inflation in Japan has been in negative territory. Inflation has persisted below the target 2% rate, except for a brief violation in 2014 in recent months.

Though the BoJ has not taken the path of monetary tightening to ward off the inflation, the local bond yields have risen to positive territory. Moreover, the reversal in the monetary policy of the global central banker has materially widened the gap between the Japanese and global bond yields. Nothing new in this, but the questions about sustainability of Japanese public debt are hitting the headlines again. Recently, it was reported that “The Bank of Japan may have been saddled with as much as 600 billion yen ($4.4 billion) in unrealized losses on its Japanese government bond holdings earlier this month, as a widening gap between domestic and overseas monetary policy pushed yields higher and prices lower.”

In recent years, the household debt in Japan has also started to rise. Household debt in Japan had reached a high of 78.7% of GDP in 2000. It subsequently declined to a low of 59.9% in 2015. As per the latest available data, it had again reached 67.4% of GDP in December 2021. Japanese households owe a debt of US$3.2trn; which is 23% of total domestic credit of US$13.5trn. A rise in lending rate could further slow the economic growth in Japan; besides enhancing the stress at household level.

 “No brainer” or “mo’ brainer”

What should an investor make out of a situation - when the RBI governor makes a public statement, two weeks before a scheduled monetary policy committee (MPC) meeting, asserting that it’s “no brainer” to expect that the committee will hike rates in the meeting? Especially when this assertion comes a day after the government has taken some very effective fiscal measures to control inflation and less than 3 weeks after the RBI had announced an unscheduled rate hike.

To me, at first it sounded like a confident Central Banker in full control of the situation. He exuded confidence that (i) the external situation of India is strong and the RBI shall be able to manage the current account deficit (CAD) comfortably; (ii) the central government might not have to revise the fiscal deficit target projected in FY23BE since revenue collections are strong; (iii) there are clear signs of growth reviving as reflected in rise in imports despite higher prices and strong exports; and (iv) the RBI is in control of the yield curve and INR exchange rates.

However, on second thought, I feel that the RBI is perhaps as perplexed by the current economic situation (global and domestic) as anyone else. In fact the Governor himself admitted that the situation is volatile and dynamic. Till the February 2022 MPC meeting, the Committee assumed that the inflation is transient and there is no need to tighten the policy but the Russia-Ukraine war changed the dynamics and in April 2022 meeting it was decided to (i) withdraw accommodation; and (ii) hike the effective reverse repo rate by 40bps (that immediately lifted overnight rate by 40bps). Within one month the RBI made an unscheduled 40bps hike in Repo Rate, palpably to preempt INR exchange rate slide in view of the imminent US Fed Rate hike.

The question is when so many external variables, which are not under control of RBI, are operating at different levels, having unpredictable impact on the Indian economy, how could the RBI term a future policy decision “no brainer”?

The Governor admitted that for now inflation is top priority and not the growth. The government appears to be in full agreement with this stance of the RBI. The government has recently diverted Rs one trillion of capex (Road and Infrastructure) allocation towards price maintenance to calm fuel prices. The government has also raised export duties on steel and restricted the export of wheat. The government has also taken measures like hike in subsidies on LPG and fertilizers. Reportedly, the government is also considering limiting sugar exports. Higher cotton prices have reportedly hurt textile exports in the past few months. Recently, the government has also extended the free food scheme for 90million households by six months till September 2022.

Juxtaposing all these, I could deduct the following:

(a)   To control prices, the RBI and Government have decided to sacrifice growth. Higher rates may further delay the private investment recovery. This means the supply side constraints may continue to hinder the growth for longer than previously anticipated.

(b)   The measures taken by the government may hit exports and therefore widen the already worrying CAD.

(c)    The Forex reserves are already down by US$50bn in the past six months. Keeping yields lower and INR stable may require more USD selling by RBI, at a time when CAD is vulnerable. Obviously the external situation might not remain as comfortable as the Governor is asserting.

(d)   The primary factors driving the inflation, viz., extreme weather conditions; global supply chain bottlenecks; Russia-Ukraine war; and Sino-US tensions etc. are beyond the control of the RBI and might continue to put inflationary pressures on Indian economy. So it could very well mean marked stagflationary conditions for a wider section of the Indian economy.

In my view, we all lie in a flux and there is nothing which is “no brainer” at this point in time. The situation is too dynamic to predict anything with reasonable certainty.

Presently, there are two diametrical opposite views about the evolving global situation.

As per the first view, there are conspicuous signs of global growth slithering down as the inflation has begun to destroy the demand, except the food for which demand is largely inelastic. In the recent readings of composite leading indicators have expanded for only one fifth of the countries (vs over 90% in April 2022). PMIs for most developed countries are nearing July 2020 levels. The growth engine of the world, i.e., China is stuttering with the latest growth forecasts fading to 3.9 to 4.5%. The monetary tightening by a number of central bankers has already started to show some results. Consequently, the commodity prices have started to cool down and inflationary expectations should ease going forward. It is therefore likely that the present monetary tightening cycle may reverse much earlier than previously forecasted. This view thus assumes a broad status quo on the present global order.

The second view however assumes a radical shift in the global order. As per this view, the extant global order that is characterized by deflation, independent central banks, globalization, minimum government, rising share of corporate profits in GDP, longer cycles and lower volatility is coming to an end. The emerging global order is remarkably different. It shall be characterized by regionalization, larger socialist governments, pricing power with labor and commodity producers, lower corporate share in profit, high real rates and inflation and poor equity returns.

I am struggling to form a view that lies in between these two extremes.

(mo’ brainer (noun): A situation or puzzle or predicament that is more difficult than it at first seemed; the opposite of a "no brainer"; something that requires more than one person (i.e. mo' than one brain) to figure out.)

The First World War resulted in the decimation of some large empires like the Ottoman Empire, Russian Empire, and Austro-Hungarian Empire. By the end of the war, the map of Europe had changed dramatically. The communists had taken over power in Russia and neighboring smaller states to form the Union of Socialist Republics (USSR). Many other states in the Eastern Europe also saw the rise of communism. Germany and Italy fell for an ultra-nationalist (fascist) propaganda. The European imperialists like Portugal, Spain, France, Netherlands (Holland) and Britain started to lose their grip over their colonies in Asia and Africa. The Spanish Flu and the Great depression also shaped the politics of Europe in the post war period. This war also saw the emergence of the USA as a formidable global power.

The Second War completed the transition to the new world order with the decline of the British Empire, division of Germany and Korea, destruction of Japan and strengthening of the USA and USSR. The process of decolonization that started post second war resulted in about 3 dozen states in Asia and Africa gaining autonomy or independence.

Many new institutions were created and multilateral treaties were signed, palpably to maintain peace and accelerate the process of rebuilding the countries destroyed by deadly wars, natural disasters, and colonial exploitation, many global institutions. United Nations, International Monetary Fund, NATO, Bretton Woods, WTO, Warsaw Pact, Vienna Convention, Paris Peace Accord, Geneva Convention are some of the prominent institutions and treaties.

Within a decade of the end of WWII, the world became bi-polar with the USA and USSR holding the pole positions. The USA was leading the larger non-communist world, providing technological and strategic support to the countries. Its currency US Dollar (US$) obviously became the preferred medium of exchange and also store of value. The USSR was extending its influence in communist Eastern Europe and Central Asia.

Colonialism was now reinventing in the form of economic and strategic dependence. The wars were now more driven by economic maneuvering rather than the movement of troops. The global energy crisis triggered by the events in Iran in the 1970s, led to the USA denouncing the gold standard (free convertibility of US into defined quantity of Gold) in 1974. The US and Saudi Arabia deal to price its oil only in US$ terms established the greenback as unquestionable global reserve currency, as most post war financial institutions were already under US control and dealing in US$ mostly; and major commodity markets (CBOT, LME, NYMEX etc.) were already pricing global commodities in US$ terms. Post dismantling of the USSR in the 1990s and China joining the WTO in the 2000s, the position of US$ in global trade and finance strengthened further.

However, post the global financial crisis of 2008-09, the unprecedented expansion of the US Federal Reserve balance sheet (implying quantitative easing or printing of new money) has triggered a debate over sustainability of US$ as global reserve currency. Emerging global powers like China and India have also been aiming for a larger role in the global institutions like IMF, to the detriment of US influence over these institutions.

The currency (and tariff) wars between US and China and US and Europe in the past one decade are other manifestations of the global reset. China has also been motivating its trade partners to deal in CNY. Covid-19 pandemic caused recession and lockdown has allowed time to global powers to rethink their strategies and plan their futures.

The recent Russia-Ukraine war shall give further impetus to the Reset. Russia engaging in non USD denominated trade with partners like China, India, and Iran etc. Reportedly, China and Saudi Arabia are meeting to discuss pricing of oil in non USD terms.

It is not WWIII or the nuclear threat that investors should be worried about in this decade. It is the diminution of the USD as a global reserve currency. If the US cannot borrow in US$ to fund its profligate fiscal and monetary policies, the inflated asset prices will face a reality test almost immediately.

Insofar as India is concerned, I believe that it would be the first time in the past 200 years that India would be participating in a global reset from a position of strength. In all previous resets (colonization, industrial revolution, post war realignments, fiat currency, etc.), India was mostly the adversely affected party.

This time however our exposure to the global economy and geo-politics is much wider and deeper; and so would be the impact of any material change in the global order. It is critical that India demonstrates its competence and willingness to play a prominent role in the global affairs, economic, strategic as well as geo-political, to be accepted as a main player in the game.

In my view India will not be a water boy in the next game. It will be included in the final playing XI as an all-rounder, i.e., an economic, strategic and geo-political major. Look forward to good times ahead, and brace for the turbulence.

 As I indicated last week (see here) to me markets are not looking good, at least for now. And it is definitely not only due to the latest episode of Russia-Ukraine conflict. This conflict has only added to the caution. My primary problem is the lack of adequate growth drivers for the Indian economy.

Whether we like it or not, China is a key factor in India’s policy making function. The China factor materially influences our economic policies, foreign policy, and defense policy. This may be true to a material extent for US, Japan and Korea policy making functions also.

Inarguably, the Chinese economy has been one of the key driving forces for the global economy in past three decades. Chinese have labored hard for over five decades, since beginning of cultural revolution in 1966, to emerge as a potent global force. In past three decades they have subsidized the global economy by providing cheap labor and capital; and funded a large part of the US and EU fiscal deficits since early 2000s. The Chinese support was a key factor in keeping the global market afloat during the global financial crisis. It would not be entirely wrong to say that China also helped the developed economies in protecting “their environment” by letting them relocate most of their polluting industries to China.

In the process, China perhaps digressed a little too further from its core ideology of Marxism. The selective capitalism allowed many “depravities of the West” to permeate the Chinese system, e.g., rampant corruption, flagrant inequalities and conspicuous consumerism. “Growth at any cost”, has perhaps costed too much to the Chinese society and the system. There have been reports of growing dissent amongst citizens for a variety of reasons. The citizens exposed to the global economy and society naturally desired more freedom (especially of expression) tat was denied. The demographic control policies (one child, immigration to cities etc.) also created imbalances and dissent.

In past few years, the Chinese government has sought to change the course of its polices to address some of these issue. For example, -

First, China sought to move into higher orbit by asking to be treated at par with developed countries. They claimed global acceptability for their currency; bigger role in the multilateral institutions like World Bank; dominant role in global trade and commerce through “Belt and Road” and other Initiatives; bigger role in global geopolitics etc. Besides, China has also made substantial strategic investments in Asia, Africa, Latin America and European continents to garner wider support.

USA, that has been dominating the world since the collapse of USSR, obviously did not like the idea and an overt trade war ensued.

Second, China cracked down massively on its polluting industries by shutting huge capacities. This impacted the global supply chains and forced the global corporation to seek alternative supply sources. (India has been one of the major beneficiaries)

Third, to correct its growing demographic imbalances, China abolished its one child policy and allowed upto 3 children per family.

Fourth, Chinese authorities made a paradigm shift in policy towards businesses; and took punitive/restrictive actions against likes of Internet major Alibaba, food delivery leader Meituan, ride hailing app Didi, popular micro blogging app Weibo, and numerous private tuition entities to signal the change in the direction of of winds in China.

Fifth, it prescribed strict financial prudence norms for its real estate sector to ensure that there is no hard landing of the economy. Many prominent developers failed to meet these norms and were forced to take corrective action.

Sixth, and most important, the premier Xi Jinping, proposed a new economic policy framework (“New Development Concept”), comprising of three key concepts –

(i)    “Dual circulation economy,” which seeks to reduce China’s future dependency on export-driven growth, and instead have Chinese domestic consumer demand become the principal growth driver;

(ii)   “Common Prosperity,” which emphasizes income redistribution away from China’s billionaire class to low- and middle-income earners;

(iii)  New “industrial policy,” led by a revamped state-owned sector, giving top priority to new technology platforms as the drivers of the 21st century global economy, including semi-conductors, artificial intelligence, quantum computing, and new forms of advanced manufacturing.

The changes obviously would have far reaching impact on China, as well as the global economy. There are many popular view prevalent about the nature and extent of this impact. One popular view is that like Japan in 1980-1990, China will allow systematic undisruptive dismantling of the froth that has developed in its economy (soft landing). The other view is that 2020-2030 will be the decade of socio-economic revolution in China, as against the decade of cultural revolution (socio-political) during 1966-1976.

In my view, China is working on a new model in which the core ideology of Marxism (uncorrupted and equal society) shall become a guiding force; communist party will remain fully in control of markets; and China becomes a great global power. Arguably, it will involve significant geopolitical and trade conflict. Signs iof which are clearly visible to us in China Sea, Afghanistan, and Ladakh.

It remains to be seen how far Xi Jinping would be successful in implementing this new design. Nonetheless, the actions so far speak of the full commitment to the new policy framework. It is in this background that we need to assess the recent developments in China and global markets.

Evergrande – scarecrow or black swan?

One of the basic law of physics is that the higher an object is propelled into the atmosphere, the faster it returns to the earth; unless the propeller lends enough velocity to the object to help it transcend beyond the gravitational orbit of the Earth.

This principle of physics can be applied to the businesses also. A business that is propelled higher using the fuel of debt, risks crashing down to the ground zero, if the business model is not strong enough to take the business out of the debt spiral and place it in the orbit of sustainability. However, in cases where the fuel itself is contaminated (unsustainable debt); the fuel tank (management) is leaking, or the velocity is inadequate (unsustainable business model), the chances of business crash landing increase manifold.

In past one decade, we have seen many examples of this phenomenon in India. The businesses that grew remarkably in the decade of 2000s with the help of easily available credit, but had leaking tanks (unscrupulous management,) contaminated fuel (unsustainable debt) and/or inadequate velocity (poor business models) came crashing down in the decade of 2010s. JPA Group, Suzlon, ADAG, DHFL, Yes Bank, SREI, Bhushan Steel, are only few example. Globally, Lehman Brothers, which crash-landed in 2008, has become epitome of this phenomenon.

Chines real estate sector – symbol of malaise

The Chinese real estate development sector has been under scrutiny for more than a decade now. The sector has been at the core of phenomenal growth of Chinese economy in general and the financial sector in particular for past two decades. The real estate sector development apparently contributes more than one fourth of GDP of China and constituted over three fourth of the Chinese household wealth.

Nonetheless, numerous fables of ghost towns, unsustainable debt, window dressing of lenders’ books have been very popular in the past decade or so. Most bankers, investors and money managers have been worrying about this; though not many might have taken steps to reduce their exposure to Chinese enterprises materially. Perhaps, they were too confident that the Chinese authorities would not let any large business fail, lest it may deter the global investors from investing in Chinese businesses.

The things however have begun to change dramatically since past one year, with the Chinese authorities making a paradigm shift in its policy towards businesses. Though, the punitive/restrictive actions of Chinese authorities against likes of Internet major Alibaba, food delivery leader Meituan, ride hailing app Didi, popular micro blogging app Weibo, and numerous private tuition entities have been signaling the change in the direction of of winds in China, the scare of failure of real estate major Evergrande has drawn greater attention of the entire global markets towards the developments in China.

Evergrande in that sense has become the symbol of malaise prevalent in China, just like Lehman symbolized the malaise in US financial sector during the global financial sector.

For an Indian investors, it is pertinent to understand the Evergrande episode independent of the price action of the past week in the stock markets. Remember, panic is more likely to mislead than guide to a safe haven.

What is Evergrande?

Evergrande, a Guangzhou based real estate developer founded in 1996, is one of the largest real estate developer in China. As per the website of the group, it owns more than 1300 real estate projects (about 780 under construction) in close to 300 Chinese cities; has interest in many other businesses, including sports, media, electric mobility etc.

Evergrande, with over US$300bn in assets (close to 2% of Chinese GDP) is also one of the world’s highest indebted developers with more than US$300bn in dues to lenders and operating creditors. Out of this about US$129mn in interest was due for payment this week and US$850mn of principal repayments are due in next 3months.

Reportedly, the Chinese government has chalked out a bail out for Evergrande. In the arrangement, Evergrande may be virtually nationalized. This should provide some immediate relief to the markets, but it is not important in a larger context. This arrangement just kicks the can a little further to allow soft landing.

What’s the problem?

The rating agency Fitch recently downgraded a host of Chinese developers, including Evergrande; and warned about a “probable default” by the troubled developer. This warning has sent shock waves across the markets, as it was feared that a default by Evergrande may impact the entire real estate development and financial sectors in China directly; and commodities and consumer sectors indirectly.

It is estimated that a crash in real estate sector may hurt lot of homebuyers who have made substantial part payments, and thus impact their financial status materially. It is also estimated that material slowdown in real estate sector, may slow down overall Chinese economy materially, leading to substantially lowered demand for industrial commodities like steel and copper. This may have serious repercussions for global commodities markets; and also impact the consumption demand for things like iPhones in China.

The stocks and bonds of Evergrande and other major real estate developers like SIMIC crashed by 35% to 80%. While the Chinese homebuyers might lose money, if Evergrande projects are not completed in time or are abandoned completely; the global investors who had invested in stocks and bonds of Chinese developers have already lost substantial money. In that sense, the global investors are equally part of this problem.

In fact, the current problem may be more intense for the global investors who are over leveraged in the Chinese high yield bonds and have large unhedged exposure to Chinese real estate developers and their lenders, than for the Chinese enterprise and Chinese authorities themselves.

What caused the problem?

Prima facie, managing US$1bn of Evergrande’s payments due in near term, was never a material problem for Chinese government, which virtually owns the entire banking system and has huge surplus in reserves. After all, Indian government with almost one sixth GDP of China, and much smaller banking sector, could manage much larger problems (IL&FS and Yes Bank) with relative ease.

The problem in fact lies in the changing policy paradigm in China.

To implement far reaching reforms in the delinquent real estate sector, the Chinese government outlined three parameters to be followed by all the developers, viz., (i) The liabilities of any developer must not exceed 70% of its asset value (L/A < 70%); (ii) the net debt of developers must not exceed its net worth (net leverage < 100%); and (iii) all developers must have cash which is more than their short term debt (cash to ST debt > 1).

Apparently, the objective of stipulating these conditions was to preempt a systemic crisis that could potentially drag the entire financial system into a deep crisis. Last year a large number of entities failed the test.

The bigger problem was however identified in the business model followed by the developers like Evergrande. They apparently bid for land at very high prices. The local authorities were obviously very happy with these bids as it augmented their revenue substantially. The higher land prices were then passed on to the home buyers with inflated property prices.

This made bankers happy as they could lend more to homebuyers due to higher notional value of the collateral property; but resulted in substantially higher household debt and unaffordable home prices.

The household savings thus got diverted to inflated housing sector rather than the capital starved high technology sector which had to increasingly rely on the foreign capital. It also impacted the private consumption, frustrating the government efforts to make Chinese economy domestic consumption driven from the presently export driven.

To correct all these issues, Chinese authorities took a series of measures, including curbs on VC investment in real estate, and checking the corrupt practices in real estate sector.

Consequently, the real estate developers saddled with unsustainable debt and inflated assets are feeling the pressure. But it is important to note that it is not the real estate alone, but the entire high yielding Chinese debt that is feeling the pain. Also Evergrande may have become face of the problem, but it is certainly not the only one in problem. Many other like it, e.g., SIMIC, Fantasia, Suna, etc are also in trouble.

What are the implications?

A series of defaults in Chinese real estate sector could potentially have multidimensional implications. For example

(a)   It could lead to serious wealth erosion for the Chinese home buyers. To mitigate some of this impact, the Chinese authorities are resorting to transferring the assets of troubled real estate developers to the lenders, who shall get it completed and sell to the home buyers. A variant of this model is being tried in India also with assets of JP Associates, Amarpali, Supertech etc.

As stated earlier, beleaguered Evergrande Group has apparently negotiated a settlement with the lenders for a short tern respite. Besides, the Chinese authorities are ensuring adequate liquidity in the market to stem repeat of post Lehman market freeze and global contagion.

(b)   The bond and stock prices of troubled developers have already seen severe losses. The global investors holding these securities have already weathered the loss. However, it is hard to believe that after having experienced Lehman collapse, these investors had not hedged their risk.

(c)    The developments in Chinese real estate market could lead to material slowdown in the Chinese economy, and therefore the global economy, threatening the fragile recovery from the pandemic. The demand for commodities could collapse leading to sharp correction in prices.

It is pertinent to note that the signs of slowdown in global economy were already emerging  three months ago, with World Bank, ADB, IMF etc downgrading their growth estimates. China had anticipated slowdown in demand for commodity prices and accordingly started liquidating its strategic reserves of steel and copper. The commodity prices mostly peaked three months back. Most central bankers have recognized this trend, terming the commodity inflation as transitory; and refrained from acting on elevated price conditions.

Further, a slower Chinese demand may actually ease pressure on the global logistics and supply chain bottlenecks, thus providing a short term relief to the struggling industries worldwide.

Implications for Indian investors

The Indian investors must see the current developments in Chinese economy and markets as continuation of the trend that started with Trump-Xi trade war. This will only accelerate the move towards China+1 policy of global businesses; which is widely expected to of great benefit for Indian businesses.

In the near term we may see minor outflows from Indian markets, as the global investors with significant exposure to Chinese developers seek to rebalance their portfolios due to losses and redemption pressure. However, in mid to long term this could actually result in higher allocation (China+1) to India by investors also.

The Evergrande episode is expected to refrain the Central Bankers from rushing into monetary tightening; while PoBC continues to ease liquidity. This has obviously alleviated some of the near term concerns of the markets.

The most visible impact for Indian investors would however be the likely easing of inflationary pressures, providing some easing room for RBI.

It is less likely that the Chinese investors would seek to withdraw material investments from India, under the current circumstances, especially when the rules regarding fresh investment from China require much greater scrutiny.

However, beyond the immediate events, we need to keep a close watch on the developments of wider import occurring in China.

Evergrande – scarecrow or black swan?

In media, the Evergrande episode has been termed as sighting of the proverbial Black Swan, a rare event that may disturb the status quo materially.

Black Swan events are, by definition, completely unexpected events of large magnitude and consequences and usually mark a watershed in the history.

No surprises that the prospects of a default, and its perceived potential repercussions sent the global markets into tailspin earlier this week. Traders anticipating a repeat of Lehman moment in Evergrande default, rushed to close their positions. It was feared that failure of Evergrande will have a strong spiral impact on the global financial system and markets. It may result in collapse of China property development market, leading to sharp fall in property prices and erosion of collateral value for banks. The collateral damage will also be felt in metal markets, as China property developers have been a key drivers for the metal demand.

But it is pertinent to note that China real sector, its importance, challenges, problems and threats have all been analysed threadbare in past one decade. There is nothing that is not known to global investors and analysts. It is only the lure of high yield and confidence in Chinese authorities (they would not let it fail) that keeps the investors’ interest alive in this market. China and all its enterprise face close scrutiny of the global community, despite scant availability and low reliability of the information. To be honest very few investors and analysts would not expect the available information to be mostly manipulated. Everyone therefore is always on their guards in relation to anything connected with China. Therefore, Sighting a Black Swan in Chinese context itself is a Black Swan event.

I would therefore like to believe that Evergrande is a scarecrow that has been shown to the global investing community as a warning of the risk of investing in high yield bonds by over leveraging.

It is also a harbinger of the things that are likely to come over next few years. A decade of readjustments in China may require many adjustments in most corners of the world.

On the eve of 75^th Independence Day when you buy a plastic Tricolour from a young child on the traffic signal, would you (a) pause to think that this flag may be of Chinese origin, (b) buy with the idea of helping the poor child; or (c) just buy to demonstrate your feeling of patriotism?

In the post-independence period, the Indian economy has been persistently suffering from a variety of deficits. Though in the financial market parlance the twin economic deficits, viz., current account deficit and fiscal deficit, have been discussed most, these could be the least of worries for Indian economy in the current circumstances. Some of the most worrisome deficits, in my view, include:

·         Growth capital deficit

·         Advanced technology deficit

·         Skill deficit

·         Trust deficit

·         Compliance deficit

·         Governance deficit

·         Productivity deficit

·         Social infrastructure deficit

·         Employment opportunity deficit

·         Demand deficit

On the eve of 75^th Independence day it is important to appreciate that to successfully achieve the objective of self-reliance, as being popularly understood, we must first bridge this multitude of deficits.

Not many people may like hearing this, but the fact remains that in recent years China has been helpful in bridging many of these deficits, especially growth capital, technology, productivity, employment opportunities and demand deficits. Chinese investors have invested millions of dollars in Indian start-ups by way of risk capital. Chinese have supplied affordable solutions in the areas of energy, transportations, chemicals, healthcare, etc. Affordable Chinese consumer imports have created huge employment opportunities for millions of self-entrepreneurs, traders, street vendors, and aided in creation of demand, especially consumption demand. Of course, all this has not been gratuitous on the part of Chinese enterprise and administration. Nonetheless, it has helped to a great deal.

We must pause here and assess that since due to legacy issues we always have a wide and deep trust deficit with China, was it advisable in the first place, to let Chinese and Indian economic interest intertwine so much?

Keeping the jingoistic nationalism aside, we must also consider that the non-essential toys, plastic decorative items, small appliances & tools which are more visible and talked about items, constitute a miniscule part of the total imports from China. The imports are dominated by electronics, engineering products & components, agro chemical, specialty chemical, medical equipment, precious metals and Iron & Steel. Our main exports to China include Cotton, gems & jewellery, copper, ores, organic chemicals. China is therefore present in our entire value chain.

Disengagement with China in markets therefore has to be equally strategic as in case of borders. We cannot and should not do it overnight by taking some whimsical, but popular, decisions. We need to have a strategy to fill the deficits by alternative means and render China redundant before disengaging ourselves. Self-reliance in this context would mean, building capacities in the fields of advanced technology, raising the level of skill, compliance and governance to attract adequate amount of growth capital, raising productivity to enhance savings potential for domestic funding of growth; and bridging the trust deficit between the people and the administration.

This endeavour would inevitably include bringing India into a state of equilibrium by removing social, and regional, economic imbalances, e.g., through-

·         Industries and businesses who have thrived historical on government largesse and not necessarily on the enterprising abilities of promoters giving back to society by way higher taxes, higher voluntary CSR spending, technology upgrade for better resource utilization, etc.;

·         Regions like Gujarat and Maharashtra, which are economically more developed despite not being endowed richly with natural resources, acknowledging that a part of their development is due to imperial designs of British regime and share their wealth with exploited regions like Jharkhand and Odisha;

·         Caste and communities which command ownership of the major part of economic resources and occupy most of the social space, voluntarily vacating some space for the historically oppressed and downtrodden;

·         Populace which has grown to be non-compliant by habit, not necessarily by intention, changing habits like spitting on roads, violating traffic rules, encroaching on pavements in front of their house/shops, exploiting domestic helps and child labor etc.;