Vijay Kumar Gaba

Presently, the global markets are looking jittery as the magnitude of the crises and their impact is not assessable. Besides, there is no visibility of a cohesive global plan to manage these crises, as was the case with Global Financial Crisis in 2008-09; even though these apparently regional crises have definite global repercussions. Next few months are very critical in my view. Lack of a united response could push the global economy deeper into a Stagflationary mess that can push the economic recovery process 3-4years down the lane.

“The crisis of today is the joke of tomorrow” — H. G. Wells (English Author, 1866-1946)

As of this morning, a number of regional economies appear struggling with some sort of crisis. The factors causing these crises are varied; and in many cases even trivial. Collectively, these regional crises appear to be clouding the global economic recovery; and threatening a protracted phase of stagflation (negative or very poor real growth).

In particular, the sharp rise in global energy prices is a matter of serious concern for all. The prices of natural gas and coal are now at decade high. Crude oil prices are also at 5yr high and forecasted to move further in view of expected harsh winter. Consequently, the electricity prices and transportation (shipping and freight) costs have also risen sharply. The sharp inflation in energy prices is becoming a global crisis and being seen as a major threat to the global economy recovery.

From a plain reading of the events across the globe, inter alia, the following factors appear to be catalysing some sort of crisis, impacting the global economic recovery from the Covid-19 pandemic.

1.    Supply chain disruptions caused by labour displacement due to the pandemic; underinvestment in capacity building in past one year; uneven recovery across sectors and geographies; etc.

2.    High tide of pandemic stimulus ebbing.

3.    Erratic weather patterns across the world adversely impacting the crops.

4.    Hard geopolitical and trade related positioning between groups led by China and the USA.

5.    Precipitous shift in the business models towards ESG and digital, leading to significant change in demand and supply patterns for carbon and decarbonized products; material shift towards renewable energy and electric mobility, etc.

6.    Rising fragility of global financial system, with burgeoning debt both at the sovereign as well as household levels.

7.    Hardening nationalist positioning constricting free movement of labour and capital (e.g., Brexit).

The following are some of the instances that reflect the changing business conditions, demand supply patterns and the crises emanating from these.

US – Business consolidation and uncertainties hurting the supply chain

"Sorry. No French Fries with any order. We have no potatoes", a board at the Burger King in Florida read this week.

The shortage of trucks and driver is choking the supply chain across US. As per the industry sources, “Truck drivers that would transport cargo on flatbed trucks are being recruited away by Walmart and Amazon to exclusively pull box trailers or shipping containers. Large items like steel piles and premade concrete pieces either can't fit or can't be loaded into containers or box trailers. Vendors tell me demand is as high as 40:1, meaning for every available flatbed truck there are up to 40 waiting customers. The roads around the NYC metro area are as clogged with truck traffic as ever, but we're facing longer waits and higher prices to haul non-containerized cargo.”

One of the largest shipping ports in USA (San Pedro, LA) reported that some 60 container cargo ships idling at the entrance of the port complex last week. With an increase of 30.3% in cargo volume as compared to the same period in 2020, the congestion at ports is showing no signs of easing.

As per WSJ reports - The armada of cargo ships is due to surging volumes and unpredictability in global supply chains caused by the Covid-19 pandemic, and exacerbated by shippers pulling holiday-season imports forward to avoid delays later. The congestion at ports is one of a number of global bottlenecks as ports juggle strong consumer demand and shortages of workers and equipment caused by pandemic-related health and safety measures. These challenges have been  leading to significant delays and additional logistics costs.

UK gasoline crisis – Brexit may have a role to play

As the country heads into what could be a harsh winter, the US energy prices are soaring. In past nine months, the prices of natural gas in UK have risen over 250%. Though multiple factors could be attributed to the precipitous rise in energy prices and consequent second round inflation, logistic issues are cited as one of the principle reasons.

The complexity of the situation forced Paul Scully, the U.K.'s minister for small businesses to comment, “We know this is going to be a challenge and that's why we don't underestimate the situation that we all find ourselves in.”

The government officials and the prime minister himself have maintained that there is no shortage of the fuel in the country. It is the shortage of the drivers that is causing supply chain disruptions for fuel and food. The government is even contemplating to call the army to help bridging the supply chain gaps.

While there is no official word on labour shortages, it is estimated that labour supply may have got choked due to Brexit; travel restrictions due to Covid19; and less number of labour participating due to Covid19. The chief economist of KPMG speaking to media estimated that labour shortages may take 6 more months to fully resolve.

Andrew Goodwin, chief U.K. economist at Oxford Economics, told CNBC – “Households have got this big stockpile of savings to spend, but that will be starting to ebb away a bit simply because the bad news we're having on things like inflation. I suspect, we're going to end up in a situation where the reality is a little bit disappointing to what we were expecting say three months ago. And that's simply because of these issues with supply shortages, both in terms of sort of constraining output and also just eating into consumers' purchasing power."

Though the US economy is expected to reach pre Covid level by 3Q2021, demand pull is not something that is being cited frequently as one of the primary reasons for inflation spike. It is mostly the supply chain disruption.

Another popular view is that “It’s outrageous to suggest the current UK energy situation is the result of a rapid transition away from fossil fuels. It is primarily a gas crisis, fuelled by the nation’s slow transition to lower carbon sources. The origins of the crisis are complex, and date back many years.”

“Gas prices in Europe are at record highs, but the European Union’s internal energy market – of which the UK is no longer part – allows member states to trade with each other in a way that balances prices out.

This means EU countries can’t always take full advantage of very low energy prices, but at the same time means they’re protected from very high prices.

The UK, as an independent country outside the internal EU market, can take better advantage of low energy prices. But at times like these, when energy prices are very high, it left highly exposed to price shocks.” (Prof Aimee Ambrose, Sheffield Hallam University)

China’s decarbonization plan – Beijing Winter Olympics in play?

In the last week of September, the production line of a solder company in Kunshan was silent. In previous years, the factory was busy, stocking up for the National Day holiday. However, due to strict local power restrictions, they have temporarily had to suspended production. “All companies are going to stop production,” one manager explained, “When the policy first came out, it was thought that it wouldn’t affect processing companies. But since September 27, it requires all companies to stop production.”

Steel, non-ferrous metals, chemicals, textiles, and other energy-consuming industries are all affected. Unlike the previous round of flexible measures, which aimed to reduce energy consumption by 10%-30%, the current power control policy is more stringent. Now, local authorities are implementing an “open 2, stop 5” measure; companies will only be allowed to operate for two days a week. Most will have to reduce their production by 90% or shut down completely.

China aims to keep power consumption under control with carbon neutrality targets in mind. In August, the central government issued the “Barometer of 2021 Half-Year Regional Energy Consumption Intensity & Total Amount” – also known as the energy consumption “double control” plan. Under this plan, provinces must manage “total energy consumption” as well as “energy use intensity” while meeting their five-year targets.  (International Tin Association)

Some observers suspect that this plan is primarily aimed at ensuring blue skies during winter Olympics in Beijing; while other believe that it is part of the long term plan to decarbonize the Chinese economy.

The impact of “double action plan” is that Global consumers are already facing shortages of smartphones and other goods ahead of Christmas. The Global Times reported that “Multiple semiconductor suppliers for Tesla, Apple and Intel including ESON, Unimicron and ASE groups, which have manufactured plants in the Chinese mainland, recently announced they will suspend their factories’ operations to follow local electricity use policies.”

Brazil agriculture – snow and drought cause havoc

Brazil faced an unusual cold weather with froth killing the crop, followed by one of the severest drought in many decades. Brazil is also one of the worst affected countries due to Covid-19 pandemic in terms of the fatalities.

The New York Times reported, “Crops have shriveled up under searing heat. Immense water reservoirs, which generate the bulk of Brazil’s electricity, are growing alarmingly shallow. And the world’s largest waterfall system, Iguaçu Falls, has been reduced from a torrent to a trickle.”

Several states in the country are facing the worst drought in at least 90 years. The crisis has led to higher electricity prices, the threat of water rationing and a disruption of crop growing cycles. Agriculture, an economic engine of the nation — which relies heavily on hydropower — is now at risk.

Experts said the arid landscape, which coincided with a rise in illegal deforestation over the past months in the Amazon rainforest, could lead to a devastating fire season. Enforcement of environmental regulations is weak in the rainforest, and fire season traditionally begins in July.”

Before the worst drought in a century, Brazilians were surprised by unusual snow fall in July. At least 40 cities in the Rio Grande do Sul reported thick ice, while 33 others witnessed heavy snowfall reaching up to a meter high in some places, according to several reports. For most of the Brazilian population it was their first snow experience. The snow materially damaged sugar, citrus, and coffee farms.

“We’re left with a perfect storm,” said Liana Anderson, a biologist who studies fire management at Brazil’s National Center for Monitoring and Early Warning of Natural Disasters. “The scenario we’re in will make it very hard to keep fires under control.”

Brazil, is the world’s biggest exporter of coffee, sugar and orange juice. Poor Brazilian crop means that the global coffee and sugar prices have shot up sharply.

Conclusion

These are only some of the instances of regional crisis that are having global impact. The prices of food and energy are rising across countries. The productions lines are working at sub optimal capacities due to input shortages. The policy makers are hoping that these crises are all transitory and would ease in next few months (mostly on their own) as the pandemic related curbs are eased and bottlenecks are removed. However, in the interim severe damage could be caused to many small and medium sized business and households.

Presently, the global markets are looking jittery as the magnitude of the crises and their impact is not assessable. Besides, there is no visibility of a cohesive global plan to manage these crises, as was the case with Global Financial Crisis in 2008-09; even though these apparently regional crises have definite global repercussions. Next few months are very critical in my view. Lack of a united response could push the global economy deeper into a Stagflationary mess that can push the economic recovery process 3-4years down the lane.

Future market price target is usually the least important and most subjective component of an equity research report. The household investors must not act solely based on the “price target” flashed on their TV screens or social media timelines. They must spare sometime to go through the details and get hold of all the strings attached before taking any investing decision.

In a T20 cricket match, a statistical algorithm predicted that chances of Team “A” winning are 79%. The result was flashed on TV screens and a viewer promptly bet a dinner for two on Team “A” victory, with his friend. 

Two overs later, a rookie Team “B” bowler claimed a hat trick and the statistical predictor was now showing chances of Team “B” winning as 83% (from 21% earlier).

The general elections concluded just 3 hours ago. The TV screens were flashing results of exit polls showing Party “A” sweeping the elections with 65% of seats. The ticker on TV however did not show the disclaimer, which said that a 1.2% swing could change the results in favor of Party “B”.

A viewer who had a bet with his wife (a supporter of Party “B”) one year of dishing if the Party “B” wins majority, rued his reliance on TV breaking news for the full one year,

A prominent global brokerage house (XYZ) released a research report for ABC Ltd, giving a 12month price target of Rs400 (against the current market price of Rs210). The TV channels, social media timelines and newspaper headlines flashed “XYZ forecasts 90% gain for ABC Ltd”. Hundreds of investors rushed to buy the stock of ABC Ltd, without caring to read the research report. The report actually built multiple scenarios and highlighted multiple risks. Rs400 target, i2 months hence, was based on a completely blue sky scenario, with no risk playing out. It also assumed that the collective wisdom of market will get influenced by the analyst’s unconventional pricing method for the company.

As it happened – the sky came out to be clouded; some risk factors mentioned in the report also played out and market did not care to agree with the unconventional pricing method of the analyst. The stock price plunged to Rs75 a year later. Most investors booked losses; cursed the analyst and alleged him to be in cahoots with the unscrupulous market operators and corrupt company management.

Indifference to details may be one of the most unfortunate parts of the entire investment process of household investors (commonly referred to as the retail investors). In their eagerness and greed to make money faster than others, these investors usually act on headlines without actually caring to go into the details. It is also seen that the reliance on “Research Reports” by the household investors is mostly misplaced. Most of them only care to read the “price target”, without going into the analysts’ rationale for such target; or caring about detailed analysis of the business of the company. For household investors, it is critical to understand the types of equity research reports and their components.

Types of equity research reports

Equity research reports are prepared for a variety of purpose. The constitution of the report usually differs according to its purpose. For example -

The most common equity research reports are the Sell Side Initiation and Maintenance reports. These are reports prepared by research analysts employed by various brokerages for the purposes of marketing their investment ideas to the clients. The initiation report is the first report on a company by a particular analyst. This report usually contains a detailed quantitative and qualitative analysis of the company. After the initiation report is released, the analyst then releases periodic maintenance reports to update the original data for the new developments like quarterly results; corporate actions, and policy changes etc.

Second popular types of reports are “deal reports”. These reports are prepared by the investment banking research analysts to market the proposed equity issue of the underlying company to the institutional investors. These reports usually have an inherent bias in favor of the underlying company.

Third type of popular reports is “buy side equity research” reports. These reports are usually prepared by the research analysts of the investing entities (e.g., mutual funds, private equity funds etc.) for their internal use purposes. These reports usually are influenced by the guiding principles and investment strategy of the investing entity; and hence may not be relevant to all classes of investors.

The focus, content and emphasis of various types of reports are different based on their objective. Household investors cannot exclusively rely on these reports, made available to them on social media, blogs or friends in right places, for their investment decisions.

Components of a Research Report

The components of an equity research report would depend on its objective and target audience. The basic components of the most popular a “Sell Side Equity Initiation Research Report” would usually consist of following-

·         Description of the Company – Historical background, business, facilities, capacities, promoters, key management, etc.

·         Analysis of the business – Products, applications of products, competitive landscape, demand-supply dynamics, emerging trends, technological advantages, etc.

·         Analysis of finances – Historical trends in capital structure, cost of capital, capital allocation efficiency, leverage sustainability, solvency, advantages (or otherwise) relative to competition etc.

·         Analysis of profitability – Historical trends in margins, growth, return on equity, sustainability of margins etc.

·         Future Projections – Profitability, Growth, Solvency, Sustainability Competition etc. over next 2-4years.

·         Risk factors – Risks to the business, finances, profitability and forecasts

·         Actionable – Buy, Sell, Hold, Accumulate, Reduce etc.

·         Price target – Expected market price of the stock on a given future date.

There are many sources for the details provided in the research reports, e.g., – (i) Factual data available from historical records; (ii) Published research by professional research organizations and Institutions like CRISIL, CMIE, NSSO, RBI, IMF, etc.; (iii) Management presentations and company reports; (iv) Market research by the analyst himself; and ((iv) Analysts’ estimates., etc.

The suggested action (buy, sell etc.) is based on the estimated relative performance; implying that the stock of that particular company is likely to do better (or worse or in line) than competition and/or benchmark indices. In many cases, the actionable is actually not based on the estimated absolute performance of the stock price.

Future market price target is usually the least important and most subjective component of an equity research report. This piece of data in a report is heavily influenced by the analysts’ subjective perception of the business, growth, profitability, and the method of valuation used to derive such target. It is therefore common to have vastly different price targets given by different analysts at the same time, for the same stock

It is akin to a TV commentator forecasting a team’s score in a 50 over match at the beginning of the inning based on the weather conditions, grass on the pitch, and performance of key batsmen & bowlers in previous five innings, etc. Even though their analysis and forecast are based on their experience and available information, their forecasts about the total score seldom come true.

The household investors therefore must not act solely based on the “price target” flashed on their TV screens or social media timelines. They must spare sometime to go through the details and get hold of all the strings attached before taking any investing decision.

In its latest meeting the US Federal Reserve Open Market Committee (FOMC) reiterated its position stated in the last meeting. The Committee maintained status quo on the Fed rate (Repo Rate) and its asset (bond) buying program (US$120bn/month). The limit for single counterparty under reverse repo has been raised to US$160bn from the present US$80bn, allowing the banks to park more money with the Federal Reserve.

The Committee reiterated its stance of last meeting, stating that “If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted”; implying that the FOMC decision on QE continues to be data driven, and the present reading of data guides a gradual unwinding of the monetary stimulus introduced to mitigate the impact of Covid-19 pandemic.

“While no decisions were made, participants generally viewed that so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate”, the Fed Chairman said in a post meeting conference.

The Chairman also informed that the Committee feels that the Fed is closer to passing the test of “substantial further progress” on employment and inflation. Accordingly, more members now see the first rate hike happening in 2022. It is pertinent to note that in June, when FOMC members last released their economic projections, a slight majority of members had projected rate increase into 2023.

The markets have obviously read what it wanted to in the Fed statement. The bullish response to the Fed statement implies that market is giving more credence to the “slower growth” forecast than the “higher inflation” expectation. The market move post Fed statement implies that the confidence in “November Taper” is much lower given the slowing growth and uncertainties in Chinese markets. Even if the tapering begins in November, the pace may slower than anticipated. Also, the data for the “lift” (rate hike) may not adequate as of now and much more evidence may be required before a concrete lift decision could be taken.

Despite the headline inflation running much higher than the fed target of 2%, FOMC did not appear concerned about price situation. The Chairman repeatedly stressed in his interaction with the press that “he expects price pressures to subside as supply chain factors, goods shortages and unusually high levels of demand return to pre-pandemic levels’; thus reiterating his “transitory” stance on inflation.

Many analysts have related the Fed decision to postpone the question of Tapering to the November meeting, to the debt ceiling fracas in US. “The Fed never makes major changes to policy when there are major unresolved issues in Washington,” said Danielle DiMartino Booth, chief executive of Quill Intelligence. “Between the debt ceiling, budget resolution and potential for a government shutdown, there are plenty of political reasons for the Fed to not change policy.”

In my view, Fed would refrain from taking any decision till the (i) concerns over Covid-19 variants subside materially; (ii) political fracas in US ends amicably; (iii) dust created by Evergrande settles down and (iv) “transitory” nature of inflation is denied. November Taper, if at all happens, would be slow (may be US$10bn/month) and protracted. The rate hike decision is still in the realm of speculation.

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.

Despite the risks inherent in equity share ownership, the traumatic shocks of 1992, 2000, 2008 and 2020, equity remains a popular investment option among both individual and institutional investors. In fact, after the global financial crisis of 2008-09, the riskier equity (startups and pre revenue) has become even more popular with the investors who have been chasing yields on one hand and had access to cheap money on the other hand.

After the market crash due to outbreak of pandemic, the inflows into global equity funds have surged exponentially. The net flows in 2021 YTD alone exceed the net flows during previous two decades (2001-2020).

Anecdotal evidence suggests that one of the main reasons behind this unshakable popularity is the possibility of scoring “big”. It is this chance of multiplying the money in short term, which has attracted hordes of investors to the stock market.

Nonetheless, there is no dearth of people who are scared of the word ‘equity investing’.  Some of them have lost their entire savings in stock market, and the others, considering it another form of gambling, did never invest in shares.

Where do you stand in this picture?

·         Is it true that the investment option, which has statistically given highest returns in all economic conditions, did never work for you?  If yes, did you try to examine the reasons for this?

·         Even if you made fabulous gains in the stock market, could you attribute these to careful planning, or was it a fluke?

·         Do you consider investing in stocks an art and a science, or just a ‘roll of dice’?

 The latest macro data indicates that the Indian economy may be standing at an inflection point. It may have survived a major accident in the form of Covid19 pandemic; luckily scraping through with couple of broken bones and some bruises. The economy is recuperating well and is perhaps ready for discharge from the hospital. Of course, for next few quarters the economy may still need to use the crutches of government spending, before it could walk on its own.

The amount of bill for the recovery from pandemic would mostly be known in next six months. We would also know how the cost of pandemic would be shared between various stakeholders, i.e., government, citizens and businesses.

Post pandemic, the challenges before the government are multifold; and so are the opportunities. A successful resolution of these challenges could trigger a virtuous cycle of growth and catapult the economy to the higher orbit. A failure may not be an option, as it could cause a disaster of unfathomable proportion.

The popular words of Jigar Moradabadi may be used to describe the proposition before the Government of India “ये इश्क़ नहीं आसाँ इतना ही समझ लीजे, इक आग का दरिया है और डूब के जाना है”.

1. Broken bones need to be strengthened

The foremost priority of the government should be to strengthen the broken bones (MSME Sector and Unorganized Labor). In fact, these two bones were weakening since demonetization in November 2016. Implementation of GST from July 2017 stressed these further. The pandemic was yet another major blow to these two segments.

Many MSMEs may have lost market share to the larger organized players. The changing consumer behavior in favor of digital platforms also seems to have impacted them. Broken supply chains and tighter credit norms also presented challenges before them.

According to a survey by community platform LocalCircles, “about 59 per cent of the startups and micro, small and medium enterprises (MSMEs) in India are expected to scale down, shut down or sell themselves this year due to the impact of the second wave of Covid-19 pandemic.”

Unorganized labor faced large scale displacement due to the pandemic. Many have since returned to their previous places of work; but the challenges remain. Not all of them have got work due to a variety of reasons. The urban unemployment level remains elevated despite economy opening up materially.

 

CMIE highlighted that the composition of this fall in employment in August reveals the challenges India faces in providing jobs. The loss was essentially in farm jobs. Non-farm jobs increased to absorb a very large proportion of the jobs shed in the farm sector to leave a net deficit of 1.9 million jobs. However, the non-farm jobs that expanded were mostly not the kind that could be considered good quality jobs.

2. Driver to accelerate growth need to be applied urgently

The drivers for the acceleration of the growth to swiftly recoup the deficit of two years need to be identified and applied. The government has shown intent to turn this crisis into an opportunity by pushing through some key reforms, especially in farm and manufacturing sectors. For example-

·         The government consolidated 44 labour laws into four codes under the Wage Code Bill, Industrial Relations Code 2020, Occupational Safety, Health & Working Conditions Code 2020 and Social Security Code 2020.

·         The three farm laws -- the Farmers' Produce Trade and Commerce (Promotion and Facilitation) Act, the Farmers (Empowerment and Protection) Agreement on Price Assurance and the Farm Services Act and the Essential Commodities (Amendment) Act – have been implemented to allow farmers to sell their farm produce at a price of their own choosing and even outside their respective states, thereby leading to better rural incomes.

·         The production-linked incentive (PLI) scheme rolled out for many sectors, covering a wide gamut of products and technologies, to encourage the domestic manufacturing sector, promote exports and make the country an integral part of the global supply chain.

·         FDI limits increased in key sectors like defense production, insurance, telecom etc.

·         Significant amendments made in Minerals and Mining laws to end monopoly of Coal India.

3. We need to go way beyond mere ‘V’ shape recovery

Merely achieving a full ‘V’ recovery to the pre pandemic level of economic activity will be inadequate, since pre pandemic the economy was slowing for many years and was completely unable to generate adequate jobs for the burgeoning youth population. The government will need to apply multiple accelerators for the sustainable growth to reach to the target of 8% plus.

4. …while preventing a regression to ‘K’ shape

Fourth, the pandemic has widened the divide in the society, as the recovery so far has been rather ‘K’ shaped. Income and wealth inequalities have widened. Disparities in access to digital infrastructure have amplified the divide in social sectors like healthcare and education. The gap between organized and unorganized sectors has enlarged materially. To maintain harmony and peace in the society, these gulfs would need to be managed.

As per a study done by the Azim Premji University scholars, “one year of Covid-19 pandemic has pushed 230 million people into poverty with a 15 per cent increase in poverty rate in rural India and a 20 per cent surge in urban India."

CMIE data showed that “the unemployment rate has gone up as high as 12 per cent in May 2021, 10 million jobs have been lost just on account of the second wave and 97 per cent of the households in the country have experienced declines in incomes”.

As per the study published by Azim Premji Foundation, almost 60% children cannot access online learning opportunities. Reasons for this varied from absence of a smartphone, multiple siblings sharing a smartphone, difficulty in using the Apps for online learning, etc. The issue of access is further exacerbated for children with disabilities. Among teachers of children with disabilities in their regular classes, more than 90% found them unable to participate in online classes.

Of course there is no credible precedent to show that these gulfs could be narrowed materially through state efforts alone. Nonetheless, by building strong bridges (Opportunities and Access) between the two sides which allow the underprivileged to freely and smoothly cross over to the other side, a positive momentum could definitely be created.

5. Need to prepare for short term disruptions that QE unwind might cause

The ultra-loose monetary policies were adopted by the central banks across the world to mitigate the damage caused by the pandemic. These would need to be reversed at some point in time.

 6. Northern borders need to be guarded even more closely

While the world continues to recuperate from the pandemic the geopolitical standoff in Asia is worsening with Afghanistan becoming a symbolic battlefield between US and China (supported by Russia). The worries for India on Northern and North Eastern borders have risen materially with China & Pakistan supported Taliban taking control of Afghanistan, and complete exit of US forces from the region.

7. Erratic Monsoon may spoil the Diwali party

The erratic monsoon and continued supply chain issues mean that the prices of essential commodities (most notably Onion) could rise materially in the forthcoming festival season. As the process of elections in key states of UP & Punjab (and three others) will start around Diwali, keeping food prices under control would be a challenge for the government.

Augmenting supply may not be adequate

The direct measures that the government could take to support the economic recovery are broadly divided in two categories, i.e., (i) the measures to increase the production of goods and services or the supply side measures; and (ii) the measures to support the higher consumption for goods and services or the demand side measures.

The supply side measures usually include direct investment in building enabling infrastructure and augmenting production capacities; or providing incentives to the private sector for investing in capacity building. Some popular supply side measures include building and/or augmenting physical infrastructure and providing investment linked monetary and fiscal incentives, easing production and sales curbs on regulated commodities, relaxing restrictions on import of foreign goods and capital, augmenting money supply and easing credit norms for businesses, etc.

The demand side measures usually include providing monetary and fiscal concessions and incentives to consumers to stimulate demand and increase the utilization of existing capacities. Some popular demand side measures are interest subvention, direct cash benefits, rebate in taxes and levies, subsidizing the retail prices, and relaxing credit norms for consumers, etc.

It is felt that the government strategy to deal with the crisis so far has focused more on supply side measures. The measures to augment demand have been few and inadequate.

The supply side measures that included significant increase in the outlay for infrastructure building, PLI schemes for building capacities to substitute imports and promote exports, aggressive targets for achieving the committed emission norms, credit guarantees, accommodative monetary policy stance etc. These measures are beginning to show some results in terms increased construction activities and higher exports.

The demand side measures included direct cash distribution to farmers and laborers, encashment of LTC, interest subvention on affordable housing, some duty cuts, etc. These measures were materially offset by steep hike in fuel prices, food inflation, wage cuts, higher cost of education and lower rate on savings, etc. Consequently, the household debt has seen sharp rise, private consumption continues to slow down, and unemployment level stays elevated.

Government reluctant to spend

As per CMIE, “GDP data revealed that besides the second wave of Covid-19 deficient government spending constrained India’s economic recovery in the June 2021 quarter from the slump of fiscal 2020-21. Government final consumption expenditure (GFCF) fell year-on-year by 4.8 per cent in real terms during the quarter.

The government expenditure here includes public spending by both, the central and the state government. As per the data released by the Controller Auditor General (GAG), 20 state governments reported a 17.2 per cent increase their expenditure in the June 2021 quarter. But, the central government, on the other hand, kept its expenditure constant at the year-ago level. In real terms, this implies a 4.9 per cent fall in central government expenditure.”

 UBI could be one solution

As highlighted by the World Resource Institute, “About 90% of India’s workforce is informally employed, which includes gig economy workers. This population is extremely vulnerable to economic shocks and needs greater access to formal credit and social safety nets such as insurance and pension schemes.

Beyond employment guarantees, a universal basic income – broader than current schemes that are conditional upon occupation and land ownership – can help provide vital resources for subsistence, or for investing in education and health.”

Household debt needs to be contained

However, as per SBI research, “household debt in rural and urban areas might have doubled in 2021 from the 2018 levels”. SBI economist estimates that “rural household debt increased to ₹1.16 lakh and urban households’ debt to ₹33 lakh and this indicates that COVID impacted households significantly.”