China

The Fallacy of Composition: Selling Equity, Buying Gold

gold

Gold has done well in the recent past. Over the last six months it has given a return of around 14% (in dollar terms) and is currently quoting at $1250 per ounce (one troy ounce equals 31.1 grams).  With these returns gold is coming back on the investment radar, though over the last five years the yellow metal has given a negative return of 12%.

Indians have always been fascinated with the idea of buying gold. As per the World Gold Council the consumer demand for gold in 2015 stood at 848.9 tonnes. Of this 654.3 tonnes was gold that went towards making jewellery and 194.6 tonnes was gold that went towards making bars and coins.

Interestingly, India now lags behind China when it comes to gold consumption. In 2015, Chinese consumer demand for gold stood at 984.5 tonnes, around 16% more than Indian demand. The Chinese consumed more gold than India both when it comes to jewellery as well as gold in the form of bars and coins.

The trouble in the Indian case is that the country produces very little gold of its own. In 2015, the domestic supply of gold in India, as per estimates made by the World Gold Council stood at 9.2 tonnes or a little over 1% of total consumer demand. This supply came from local mine production, recovery from imported copper concentrates and disinvestment.

What this means is that India imports a bulk of its gold demand. As Akhilesh Tilotia of Kotak Institutional Equities who is also the author of The Making of India writes in a recent research note titled Selling Equity for Gold: “On net basis, i.e. accounting for the gold which is imported for re-export, Indians bought US$267 billion of gold over the past decade.”

The gold that is imported into India needs to be paid for in dollars. India’s stock of dollars comes in from various things including foreign direct investment(FDI) made into companies and projects and foreign portfolio investment(FPI) made into stocks and bonds.

As Tilotia writes: “According to our calculations, FPIs own a quarter of the outstanding stock of the BSE-200 stocks as of 2QFY16. Over the past decade, India received net equity FII flows of US$119 bn; the net FDI inflow is US$185 billion.”

If we add the FPI and FDI numbers for the last decade it comes to $304 billion. As mentioned earlier India net-imported gold worth $267 billion over the last decade. This essentially means that a bulk of the dollars that came into India through the FDI and the FPI route where used to buy up gold.

As Tilotia writes: “Indians have, over the last decade, traded equity in their private and public companies for gold. Of the US$304 billion that came in as net FDI and FII inflows over the last decade (FY2007-16E), Indians bought gold worth US$267 billion.”

To put it simply, over the years, India has sold stocks to earn dollars and in turn used these dollars to buy gold. While this wasn’t planned, this is how things have turned out. In the process, the country has become a victim of the fallacy of composition.

As Greg IP writes Foolproof—Why Safety Can Be Dangerous and How Danger Makes Us Safe: “This fallacy occurs when what benefits an individual is wrongly assumed to benefit an entire group. For example, if one moviegoer stands, he can see the show better. But if everyone in the audience stands, no one sees better, and everyone is uncomfortable.”

Indians buying gold is a tad like that. When an individual Indian buys gold either as jewellery or as an investment or as a hedge against inflation, it makes sense for him at individual level. But when the same thing happens at a societal level, it creates problems for the country.

Buying gold needs dollars, which can’t be created out of thin air. Further, it can also lead to the value of the rupee against the dollar falling as had happened between May and August 2013, when the dollars coming into India dried up, but Indians still continued to buy gold. As Tilotia writes: “when foreign fund flows dried up, Indians continued to buy gold thereby precipitating worries of large slippages on the current account deficit.”

It also led to the demand for dollars going up leading to the rupee depreciating against the dollar. This led to the value one dollar nearly touching Rs 70. This became a huge problem given that oil imports suddenly became very expensive as Indian oil marketing companies had to pay more in rupees in order to buy dollars they required to buy oil. The demand of oil companies for dollars led to further depreciation of the rupee against the dollar.

Further, these were the days when diesel was subsidised by the government. The government in turn compensated the oil marketing companies for the under-recoveries they occurred. This pushed up the government expenditure as well as the fiscal deficit. The fiscal deficit is the difference between what a government earns and what it spends.

Of course, every time someone buys gold, it takes away money from another productive investment. Gold essentially is useful because it is useless.

All this was an impact of the fallacy of composition which came with Indians buying gold. The government is now trying to address this fascination that we have for gold through the gold monetisation scheme and the sovereign gold bonds. Let’s see how successful they are with it.

The column originally appeared on Vivek Kaul’s Diary on March 11, 2016

Chinese Growth is Bad for Global Economy

china

In yesterday’s edition of the Diary I talked about how Chinese banks have unleashed another round of easy money, in order to push up economic growth. The Chinese economic growth for 2015 was at 6.9% which is a two-decade low. Many China watchers and economists believe that the real economic growth is significantly lower than this number and is likely to be more in the region of 4-5%.

In order to push up economic growth Chinese banks lent out a whopping 2.5 trillion yuan (around $385 billion) in January 2016, the highest they ever have during the course of a month. This increased borrowing and spending if it continues, as it is likely to, will lead to creation of more capacity in China.
The creation of this excess capacity will provide a short-term fillip to the Chinese economic growth as more infrastructure, homes and factories get built. The trouble is that the Chinese economy is unlikely to absorb the creation of this excess capacity.

As Satyajit Das writes in The Age of Stagnation: “China continues to add capacity to maintain growth. If it is unable to absorb this new capacity domestically, it might seek to increase exports to maintain production and growth. This would exacerbate global supply gluts and increase deflationary pressures in the global economy.” Deflation is the opposite of inflation and essentially means a scenario of falling prices.

Household consumption as a proportion of the Chinese economy has fallen over the years. In 1981, household consumption made up for 51.7% of the gross domestic product(GDP). Starting in 1990, the household consumption as a proportion of the Chinese economy started to fall and by 1999, it was at 45.6% of the GDP.

By 2009, the number had fallen to 35.3% of the GDP. In 2014, the household consumption to GDP ratio stood at 36.6%, not very different from where it was in 2009.

What does this tell us? As Michael Pettis writes in The Great Rebalancing—Trade, Conflict and the Perilous Road Ahead for the World Economy: “In any economy there are three sources of demand—domestic consumption, domestic investment, and the trade surplus—which together compose total demand, or GDP. If a country has a very low domestic consumption share, by definition it is overly reliant on domestic investment and trade surplus to generate growth.” Trade surplus is essentially the situation where the exports of a country are more than its imports.

This is precisely how it has played out in China. In 1981, the Chinese investment to GDP ratio was at 33%. In 2014, the number stood at 46%. What does this tell us? By limiting consumption, the Chinese were able to create savings. These savings were then diverted into investments and the investment created excess capacity in the Chinese economic system. In 1982, the Chinese savings had stood at 35% of the GDP. By 2013, Chinese savings had jumped to 50% of the GDP. The investment to GDP ratio during the same year stood at 48%.

The excess capacity was taken care of by exporting more. And that is how the Chinese economic growth model worked all these years. What this means that with a low consumption rate, the Chinese have always been more dependent on investment and exports to create economic demand. In the 1980s and 1990s, the high rate of investment made immense sense, when China lacked both infrastructure as well as industry. But over the years China has ended up overinvesting and creating excess capacity, and in the process become overly dependent on exports, if it wants to continue to grow at a fast rate.

As Pettis writes: “With consumption so low, it would mean that China was overly reliant for growth on two sources of demand that were unsustainable and hard to control. Only by shifting to higher domestic consumption could the country reduce its vulnerability and ensure rapid economic growth. This is why in 2005, with household consumption at a shockingly low 40 percent of GDP, Beijing announced its resolve to rebalance the economy toward a greater consumption share.”

In 2014, the household consumption to GDP ratio stood at 36.6%. Hence, the shift towards consumption driving economic growth has clearly not happened. The point being that the country is now addicted to the investment-exports driven growth model. In this scenario, every time there is a slowdown in economic growth, China resorts to the tried and tested investment led economic growth model. And the first step in this model is to get banks to lend more.

As Pettis writes: “The decision to upgrade is politically easy to make because each new venture generates local employment, rapid economic growth in the short term, and opportunities for fraud and what economists politely call rent-seeking behaviour, while costs are spread through the entire country through the banking system and over the many years during which the debt is repaid.”

This explains why Chinese banks lent 2.5 trillion yuan in January 2016, the most that they ever have. The trouble is that this round of economic expansion will lead to more excess capacity. And this will lead to a push towards higher exports and in the process hurt the global economy.

As Pettis writes: “China is not currently the engine of world growth. With its huge trade surplus, it actually extracts from the world more than its share of what is now the most valuable economic source in the world—demand. A rebalancing will mean a declining current account surplus and reduction of its excess claim on demand. This will be positive for the world.”

What Pettis basically means is that the Chinese household consumption to GDP ratio needs to go up i.e. the Chinese need to consume more of what they produce. But recent evidence clearly suggests that the Chinese government has no such plans and the investment-exports driven led economic growth strategy is likely to continue.

The column originally appeared in Vivek Kaul’s Diary on February 23, 2016

China Unleashes Another Round of Easy Money

chinaIn 2015, China grew by 6.9%. This is the slowest the country has grown in more than two decades. For a country which has been used to growing in double digits for a very long time, an economic growth rate of 6.9% is very low. Further, there are many economists who believe that even the 6.9% number isn’t correct.

A recent report in the Wall Street Journal quotes, an economics professor Xu Dianqing, as saying “that China’s gross domestic product growth rate might just be between 4.3% and 5.2%”.

The Chinese manufacturing sector which makes up for 40.5% of the economy grew by 6% in 2015. Nevertheless, many underlying indicators like power generation, railway freight movements, steel, cement and iron output, paint a different picture. As the Wall Street Journal points out: “Of some 60 major industrial products, nearly half saw output contract in the January to November period, while railway cargo volume fell 11.9% for all of last year, according to official sources.” (Doesn’t this sound similar to what is happening in India as well?)

Given this, it is only fair to ask how did the Chinese manufacturing sector grow by 6% in 2015? And how did the overall economy grow by 6.9%?

The point being that China is not growing as fast as it was and not as fast as it claims it is. Of course, if economists outside the government can figure this out, the government obviously realises this. Nevertheless, like all governments they need to maintain a position of strength and try and revive a flagging economy.

In the world that we live in, economists and politicians have limited ideas on how to tackle an economy that is slowing down. The solution is to get people to borrow and spend more. In a country like China where the government controls large parts of the economy, it means encouraging banks to lend more.

And that is precisely what has happened. In January 2016, responding to the low economic growth in 2015, the Chinese banks gave out loans worth 2.5 trillion yuan or around $385 billion. This is “a new record for a single month!” point out Dr Jim Walker and Dr Justin Pyvis of Asianomics Macro.

To give you a sense of how big the lending number is, let’s compare it to what the scheduled commercial banks in India lent during a similar period. Between January 8 and February 5 2016, the Indian banks loaned out around Rs 72,580 crore or $10.6 billion, assuming that one dollar is worth Rs 68.7. The way RBI declares lending data of banks, it is not possible to figure out how much the banks lend during the course of any month and hence, I have picked up the nearest comparable period.

The Chinese banks lent around 36 times more than Indian banks during a similar period. Of course, the Chinese economy is bigger than India is one factor for this difference.

A number of explanations have been offered for this huge jump in Chinese lending.  One is the revival of the Chinese property sector. Further, with the yuan depreciating against the dollar in the recent past, many Chinese companies are replacing their dollar debt with yuan debt, in order to ensure that they don’t have to pay more yuan in order to repay their dollar loans in the future.

But these reasons clearly do not explain this huge jump in lending. Chinese banks are lending out so much money because the government wants them to increase their lending dramatically.

The idea, as always, is to get people to borrow and spend money, and companies to borrow and expand, and in the process hope to create faster economic growth. The trouble is that all this borrowing and spending will only add to the excess capacity that already exists in China.

As Satyajit Das writes in The Age of Stagnation: “It would take decades for China to absorb this excess capacity, which in many cases will become obsolete before it can be utilised. Yet China continues to add capacity to maintain growth.”

Further, the credit intensity or the amount of new debt needed to create additional economic activity has gone up in China, over the years. As Das writes: “The incremental capital-output ratio(ICOR), calculated as the annual investment divided by the annual increase in GDP, measures investment efficiency. China’s ICOR has more than doubled since the 1980s, reflecting the marginal nature of new investment. China now needs around $3-5 to generate $1 of additional economic growth; some economists put it even higher at $6-8. This is an increase from the $1-2 needed for each dollar of growth 8-10 years ago, consistent with declining investment returns.”

The point being that China now needs more and more money to create the same amount of growth. And this means the effectiveness of borrowing in creating economic growth has come down over the years. This also means that the chances of money that the banks are lending out now, not being returned, is higher now than it was in the past.

In fact, as Walker and Pyvis of Asianomics Macro point out: “The China Banking Regulatory Commission reported that official nonperforming loans had jumped 51% year to 1.3 trillion renminbi [yuan] by December, now greater than at the last peak in 2009. While small in terms of the total number of loans out there – the bad loan ratio increased from just 1.25% to 1.67% – it is the direction that is bothersome, particularly given the well-publicised concerns over the accuracy of the data (hint: NPLs are much higher than 1.67%).”

Further, the Reuters reports that the special mention loans (loans which could turn into bad loans or what we call stressed loans in India), rose by 37% in 2015. And bad loans and special mention loans together form around 5.5% of total lending by Chinese lending. Indeed, this is worrying.

This huge increase in lending will obviously push up the economic growth in the short-term. But in the long-term it can’t be possibly good for the economy, as it will only lead to the non-performing loans going up and creation of many useless assets which the country really does not require. The current jump in bad loans of banks happened because of the huge jump in bank lending that happened in 2009, after the current financial crisis started.

Whatever happens, in the short-term, the era of “easy money” seems to be continuing in China. And that can’t possibly be a good thing.

The column originally appeared on the Vivek Kaul’s Diary on February 22, 2016.

China Will Continue to Export Lower Prices Across the World

chinaIn June 2014, the Chinese foreign exchange reserves peaked at $3.99 trillion. Since then the foreign exchange reserves have been falling, first gradually and then at a very rapid pace. Between June 2014 and December 2014, the foreign exchange reserves fell by around $150 billion to $3.84 trillion.

In 2015, the foreign exchange reserves fell at a very rapid rate. During the course of the year, the foreign exchange reserves fell by a whopping $512.7 billion. As of December 2015, the Chinese foreign exchange reserves stood at $$3.33 trillion. They fell by a further $100 billion dollars and stood at $3.23 trillion as of the end of January 2016.

What is happening here? Money is rapidly leaving China. Wei Yao and Jason Dew of Societe Generale write in a recent research note: “China is waging an uphill battle against capital outflows. In the past six quarters a cumulative $657 billion of net capital has left China.”

Yao and Dew write that there are three major areas of outflows when it comes to the money that is leaving China. First, the resident banking outflows have amounted to $353 billion. What does this mean? The Chinese are allowed to move up to $50,000 out of China, every year. Hence, banking outflows of $353 billion means that the Chinese are moving their money out of China. It also means that the Chinese banking system is increasingly integrated with the global financial system.

Second, the non-resident banking outflows have been at $248 billion. This means that the non-resident Chinese are withdrawing their money out of the Chinese banking system.

Further, between 2005 and 2013, the Chinese yuan was allowed to gradually appreciate against the dollar. In late 2005, one dollar was worth around 8.3 yuan. By the end of 2013, one dollar was worth around 6.05 yuan.

Many companies used this era of the appreciating dollar to borrow money in dollars. With the yuan appreciating against the dollar, it made sense to borrow in dollars. At a very simplistic level, a company which borrowed a million dollars when one dollar was worth 8.3 yuan would get 8.3 million yuan when it converted the dollars to yuan. When returning this money in 2013, assuming the entire principal amount of the loan needed to be returned in the end, the company needed only 6.05 million yuan to buy the million dollars, it would need to repay the loan. The interest payments in yuan would also have been lower as the yuan appreciated.

Nevertheless, since the start of 2014, the yuan has been depreciating against the dollar. At the beginning of 2014, one dollar was worth 6.05 yuan. Currently it is worth around 6.52 yuan. This basically means that the Chinese companies which had borrowed in dollars will need more yuan to repay the loans. Hence, the loans are being repaid because the fear is that the yuan will continue to depreciate against the dollar in the time to come. These repayments are also showing up in non-resident banking outflows of $248 billion.

The third and the most interesting item of outflow is the net errors and omissions. This is typically a balancing number and is usually close to zero for most countries, write Yao and Dew of Societe Generale. In the Chinese case this number over the last six quarters stands at $327 billion.

What does this mean? It means that the Chinese are moving their money out of China circumventing the existing regulations. What this also tells us is that the Chinese are not confident about the state of the Chinese economy and are now moving their money out of China, through unofficial channels. And that is indeed worrying.

The People’s Bank of China, the Chinese central bank, manages the value of the Chinese yuan against the dollar. When a large amount of money leaves China, people and institutions taking their money out sell yuan to buy dollars. This essentially should cause a shortage of dollars in the market. A shortage would mean that the dollar would appreciate against the yuan or the yuan would depreciate rapidly. Over the years, the Chinese have not allowed the value of the yuan to vary rapidly against the dollar. The value has always been managed.

In order to ensure that the yuan maintains its value against the dollar, the Chinese central bank needs to sell dollars and buy yuan. This ensures that there are enough dollars going around in the financial system and hence, the value of the dollar does not appreciate rapidly against the yuan.

The trouble is that the Chinese central bank does not have an endless supply of dollars. Only the Federal Reserve of the United States, the American central bank, can create dollars of thin air. This explains why it has gone slow in defending the yuan against the dollar, in the recent past, and allowed its currency to depreciate against the dollar.

While $3.23 trillion of foreign exchange reserves may sound like a lot of money, it isn’t. The International Monetary Fund has a methodology for calculating the adequate level of foreign exchange reserves. As Yao and Dew write: “Based on the IMF methodology…our calculations indicate that China’s reserves are at 118% of the recommended level. Reserve adequacy has been deteriorating sharply over the past five years.”

This means that adequate Chinese reserves are to the tune of $2.8 trillion. The rate at which Chinese foreign exchange reserves have been falling, reaching a level of $2.8 trillion shouldn’t take more than six months. Also, it is worth remembering here that these foreign exchange reserves aren’t exactly in a vault somewhere. They have been invested all over the world. And the question is how liquid these investments are. Until when can the Chinese keep selling these investments in order to defend the value of the yuan?

Interestingly, Yao and Dew feel that there is a greater than 60% probability that the People’s Bank of China will move towards a free-float and let the market decide the value of the yuan against the dollar. They also feel that there is a 30% probability that the Chinese central bank will continue to follow the current strategy of trying to defend the yuan and at the same time allow it to depreciate against the dollar, now and then.

Either ways, the value of the yuan against the dollar will be at much lower levels in the months to come.

What will this mean for the world at large? It will mean that Chinese exports will become even more competitive than they currently are. And this will lead to China exporting more deflation (i.e. lower prices) to other parts of the world.

The column originally appeared in Vivek Kaul’s Diary on Equitymaster on February 17, 2016

Satyajit Das Tells Us What is Really Happening in China

satyajit das

 

Dear Reader

This is the third and the concluding part of the interview with economic commentator and globally bestselling author Satyajit Das.

Das is an internationally respected commentator on financial markets and economics He is credited with predicting the current financial crisis. He has also featured 2010 Oscar-winning documentary Inside Job.

In this interview I speak to Das around his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril. Like his earlier books, Traders, Guns and Money and Extreme Money, this book is also a terrific read and a must for anyone who seriously wants to understand how things haven’t really changed in the aftermath of the financial crisis, and why the future continues to remain bleak.

In the third and the final part of this interview, Das talks about China and tells us what is really happening in there. He also tells us that “No one wants to believe that stagnation or collapse are the only two likely options”.

Happy Reading!
Vivek Kaul

On page 65 of your new book The Age of Stagnation you write: “Half of the investment in China since 2009 has been ineffective”. What makes you say that?

China’s growth especially after 2008/2009 was driven by a massive debt fund investment boom. A good proportion of this investment can be classified as ‘mal investment’; that is, revenues projects where revenues will be insufficient to cover the borrowing or generate adequate financial returns.

The bulk of investment has been by SOEs[state-owned enterprises] in government-backed infrastructure projects – the tiegong­ji (meaning “iron rooster”), a homonym for the Chinese words for rail, roads and airports. The Ministry for railways is planning investments of around $300 billion, adding 20,000 kilometres (“Kms”) of rail track to the existing network of 80,000 Kms. China’s rail network will become the second-longest in the world behind the US, overtaking India.

China is also having a love affair with the superfast train. Undeterred by accidents and the high cost, further expansion of the high speed rail network is under way. A new service between the southern cities of Guangzhou and Shenzhen travels at 380 kilometres per hour (KPH) nearly halving the travel time to 35 minutes. CSR Corp, China’s biggest train maker, has plans for a super train capable of 500 KPH.

What else is it doing?

China is constructing around 12,000 Kms of new expressways at a cost of over $100 billion. China road network of over 60,000 Kms of high-speed roads is only slightly less than the 75,000 Kms in the US. China is planning to expand the high-speed road network to 180,000 Kms even though China has only around 40 million passenger vehicles compared to 230 million in the US.

There is a spate of new airports and expansions of capacity at existing facilities. Jiaxing in eastern Zhejiang province is converting a military landing strip into a commercial airport at a cost of around $50 million. The town is only one hour’s drive on brand new expressways from three of China’s busiest international airports in Shanghai and Hangzhou. There are also plans for a high-speed rail line connecting Shanghai and Hangzhou.

In Hunan, local authorities tore down portions of a modern flyway and used the stimulus funding to rebuild it. Stories of ghost cities, such as the empty newly-built city of Ordos, Zhengzhou New District, Dantu and the orange area to the north-east of the Xinyang, abound. There are ghost shopping malls in many cities.

Could you tell us more?

Based on estimates from electricity meter readings, there are more than 60 million empty apartments and houses in urban areas of China. Many of the properties were purchased by people speculating on rising property prices.

The projects have driven a sharp rise in demand for materials like steel and concrete. China now produces more steel than the next eight largest producers combined. China now produces more cement than the rest of the world. But this over-investment in non-productive, low return projects will ultimately reduce growth.

For the rest of the world, the investment boom fed demand for commodities and machinery in the short run. Ultimately, it will create problems in two ways: firstly, many companies globally have over-invested in capacity based on anticipated Chinese demand that may not eventuate; and second, dumping of Chinese overcapacity on global markets will feed disinflationary pressures.

In your chapter on Brics you write that it would take decades for China to absorb the excess capacity that it has created over the years. Can you elaborate a little on that?

Sino-philes attribute the excess capacity to the collapse of global demand. They assume that global demand will rebound strongly increasing the returns from these investments.

Sino-philes also argue that the investments in infrastructure will produce long term economic benefits and returns from increased productivity. They point to the fact that few investment programs of social infrastructure are profitable. They point to the mid-19th century boom in investment in railways in Western countries, which generated economic benefits, but few made an adequate financial return with many going bankrupt. They also argue that China lacks necessary infrastructure.

 So what is the real issue?

The real issue is whether the specific projects are appropriate. China has six of the world’s ten longest bridges and the world’s fastest train. But 40% of villages lack paved road providing access to the nearest market town. High-speed rail lines in China may increase social return, improving the quality of life for the average Chinese if they are wealthy enough to afford to use them. But the financial return on capital invested in these projects will be low.

While many of these large projects are appealing to politicians and demagogues proclaiming superiority of Chinese technical proficiency, investment in improving ordinary train lines, rural roads, safety and more flexible pricing structures may have yielded higher economic benefits.

There are several concerns now about this economic model.

And which are?

First, analysts, such as Pivot Capital Management, argue that the efficiency of Chinese investment has fallen. One measure is the incremental capital-output ratio (“ICOR”), calculated as annual investment divided by the annual increase in GDP. China’s ICOR has more than doubled since the 1980s and 1990s, reflecting the marginal nature of new investment. Harvard University’s Dwight Perkins of Harvard argues that China’s ICOR rose from 3.7 in the 1990s to 4.25 in the 2000s. Other researchers suggest that it now takes around $6-8 of debt to create $1 of Chinese GDP, up from around $1-2 around 20 years ago. In the US, it took $4-5 debt to create $1 of GDP just before the GFC. This is consistent with declining investment returns.

Second, increased level of debt and the often uneconomic projects financed has led to increasing concern as to whether the debt can be serviced.

How much is that an issue?

A 2012 Bank of International Settlements (“BIS”) research paper on national debt servicing ratios (“DSR”) found that a measure above 20-25% frequently indicated heightened risk of a financial crisis. Analysts estimate that China’s DSR may be around 30% of GDP (around 11% goes to interest payment and the rest to repaying principal), which is dangerously high.

The debt problems are compounded by other factors. A large portion of the debt is secured over land and property, whose values are dependent on the continued supply of credit and strong economic growth.

A high proportion of debt is short term, with around 50% of loans being for 1 year, requiring refinancing at the start of each year. As few Chinese borrowers have sufficient operating cash flow to repay loans, new borrowings are needed to service old ones.

Around one-third of new debt is used to repay or extend the maturity of existing debt. With a significant proportion of new debt needed to merely repay existing debt the amount of borrowing needs to constantly increase to maintain economic growth.

China observers now worry about whether the high absolute levels of debt, rapid increases in borrowing, increasing credit intensity, servicing problems and the quality or value of underlying collateral are likely to result in a financial and economic crisis – a Minsky Moment.

On slightly different note what do you see the impact of the depreciation of the Chinese yuan on global growth?

Most nations now have adopted a similar set of policies to deal with problems of low economic growth, unemployment and overhangs of high levels of government and consumer debt. In a shift to economic isolationism, all nations want to maximise their share of limited economic growth and shift the burden of financial adjustment onto others. Manipulation of currencies as well as overt and covert trade restrictions, procurement policies favouring national suppliers, preferential financing and industry assistance policies are part of this process.

A weaker currency boosts exports, driven by cheaper prices. Stronger export led growth and lower unemployment assists in reducing trade and budget deficits.

With Europe and Japan still actively trying to weaken their currencies and the US owing its recovery in part to this policy, China will be forced to join the global currency wars.

And what are the Chinese hoping here?

First, they will be hoping that it will provide a needed boost to slowing growth through exports.

Second, it will help with the policy of internal rebalancing away from investment to consumption by offsetting the loss of competitiveness through higher wage costs.

But there are risks. Retaliation in the form of competitive QE programs and intervention is possible. In addition, China risks triggering higher inflation and also uncontrolled capital flight which would expose its financial system vulnerabilities. The country’s foreign currency reserves (already down some US$700 billion to around US$3,300 billion) would fall sharply, reducing its financial flexibility.

You seem to remain unconvinced about the world having come out of the aftermath of the financial crisis and you write that a risk of a sudden collapse is ever-present. Why do you say that?

There are three possible scenarios.

In the first, the strategies in place lead to a strong recovery. The US leads the way. Europe improves as the required internal transfers and rebalancing takes place with Germany accepting debt mutualisation to preserve the Euro. Abe-nomics revives the Japanese economy. China makes a successful transition from debt financed investment to consumption. A financial crisis in China from the real-estate bubble, stock price falls and massive industrial overcapacity is avoided. Other emerging economies stabilise and recover as overdue structural reforms are made. Growth and rising inflation reduce the debt burden. Monetary policy is normalised gradually. Higher tax revenues improve government finances. There is even strong international policy co-ordination, avoiding destructive economic wars between nations.

Oh that is clearly a lot to expect…

Such an outcome is unlikely. The fact that current policies have not led to a recovery after 6 years suggests that they are ineffective.

The second scenario is a managed depression, a Japan like prolonged stagnation.

Economic growth remains weak and volatile. Inflation remains low. Debt levels continue to remain high or rise. The problems become chronic requiring constant intervention in the form of fiscal stimulus and accommodative monetary policy, low rates and periodic QE programs to avoid deterioration.

Financial repression becomes a constant with nations transferring wealth from savers to borrowers to manage the economy. Competition for growth and markets drives beggar-thy-neighbour policies, resulting in slowdowns in trade and capital movements.

Authorities may be able to use policy instruments to maintain an uneasy equilibrium for a period of time. But it will prove unsustainable in the long run. Ultimately, a major correction will become unavoidable, as confidence in policy makers ability to control the situation diminishes.

And what is the final scenario?

The final scenario is the mother of all crashes. Financial system failures occur as a significant number of sovereigns, corporate and households are unable to service their debt. Defaults trigger problems in the banking system which leads to a major liquidity contraction, which in turn feeds back into real economic activity. Falls in employment, consumption and investment drive a severe contraction. The problems are global with developed and emerging markets affected.

The downturn is exacerbated by the limited capacity of policy makers to respond. Weakened public finances and policy options (QE and low rates) exhausted in fighting the last crisis limit the ability of governments to respond to a new crisis. Emerging markets are now unlikely to be a source of demand due to their problems. Geo-political stresses are higher than in 2007/ 2008.

Unsurprisingly, no one wants to believe that the stagnation or collapse are the only two likely options. Hubris, as humorist PJ O’Rourke noted is one of the great renewable resources.

Concluded…

The column originally appeared on the Vivek Kaul Diary on January 29, 2016