Why the next global recession will be made in China

china

Vivek Kaul

A Central Intelligence Agency (CIA) paper on China is titled The Art of China Watching. In this paper, the author Gail Solin concedes that “[t]he art of China-watching is imprecise at best….The explanation, or blame, for this often frustratingly lies mainly with the way the Chinese conduct their affairs. To say the Chinese have a penchant for secrecy is almost an understatement.”
This CIA paper was written sometime in the 1970s.
Things haven’t changed nearly four decades later. China-watching is still imprecise at best. Or, as one China-watcher put it in May 2013 “It’s a big black box, and it’s quite scary.”
The Chinese property sector is not in the best shape. Home prices fell by 9.3% between April and June 2014, in comparison to the same period last year. Further, data from the National Bureau of Statistics shows that in August 2014 home prices fell in 68 out of the 70 major cities.
This is a worrying trend given that a substantial part of the China growth story is built on the belief that the real estate prices will only go up. Analyst Wei Yao of Societe Generale explained the situation the best in a recent research note titled
China: easing mortgages will not make the pain go away, where she said that there was a “strong belief in ever-rising property prices” and that “ has been a major incentive for [people] to make investments in this illiquid asset class.”
Once people give up on this belief, they will stop buying property, which in turns will have massive economic consequences. As Yao puts it “Whether there will be a harsh correction in real estate investment or a mild one, the property price developments in the next two quarters will be the key.”
Nevertheless, the data that has come in up until now, isn’t looking too good. As mentioned earlier housing prices fell by 9.3% between April and June 2014. The situation deteriorated further during July 2014, when the sales fell by 16.3%. This has been the deepest contraction in home sales since late 2008, when the current financial crisis started.
The slowdown in home sales has led to the accumulation of unsold homes. As Wei Yao points out in another report titled
China: In the shadow of housing “The ratio of unsold apartments to monthly sales of completed apartments reached an all-time high of 17.1 in June. There is also a big pipeline of projects under construction….Even though growth of floor space under construction has fallen to the lowest level ever, it would take more than 40 months to clear all the supply, based on the current pace of sales – much longer than ever before!”
Further, a major part of the demand for housing in China is now investment led demand. And with falling prices, the investors are likely to stay away.
And this is worrying sign for the Chinese economy. The question is why is the well being of the property sector so important for China? Analysts Manish Raychaudhuri and Rajan Jain of BNP Paribas explain this in a research note titled
On the ground in the Middle Kingdom. As they write “a large part of the Chinese economy is directly or indirectly driven by real-estate activity. 67 different industries are directly or indirectly dependent on property, 25% of incremental employment is directly or indirectly generated by the property sector, and 60% of funding of local governments comes from land sales.”
Land sales are a very important part of revenues of local governments. And if the Chinese are not buying as many homes as are being produced, the local government will not get the kind of prices they were getting for their land in the past. The value of the land sold in 100 major cities fell by 51% in July 2014.
The Chinese government has gone quickly into action and has asked banks to give a “helping hand to first time buyers”. Over and above this, 47 out of 70 major cities have relaxed the home purchase restrictions that they had made.
On September 30, 2014, the People’s Bank of China, the Chinese central bank allowed banks to reduce their home loan interest rate to 70% of their benchmark rate but banks don’t seem to be cutting rates.
As Raychaudhuri and Jain write “Banks seem unwilling to reduce their mortgage lending rates to 70% of benchmark rates (as permitted by the PBOC on 30 September 2014). Most property developers we spoke to feel that the best case would be banks reducing lending rates to about 90% of benchmark rates. The issue seems to be that banks are not sure of the value of their collateral (property prices).”
Given this, home sales haven’t gone up despite efforts being made by the government. “Following the mortgage policy relaxation announcements, enquiries have gone up but not translated into increased sign-ups…Developers expect prices to fall 5-10% in tier-1 cities and 10-15% in tier-2 cities in coming months,” the BNP Paribas analysts point out.
All this means a slowdown in Chinese economic growth. And this slowdown is likely to lead to a slowdown in global growth as well. The reason for this being that China is now responsible for more than one third of global growth. As Ruchir Sharma, head of Emerging Markets and Global Macro at Morgan Stanley Investment Management wrote in a recent column in The Wall Street Journal “China has replaced the U.S. as the main engine of the global economy. Its contribution has more than tripled to 34% of global growth this decade from 10% in the 1990s. The U.S. contribution, on the other hand, has fallen to 17% from 32% in the 1990s.”
With China slowing down, it will mean that its demand for various commodities will fall. As Sharma points out, there has been no growth in the Chinese demand for oil this year. It was at 12% in 2010. And this is one of the major reasons why the price of oil has been falling.
The prices of a lot of other commodities ranging from aluminium to zinc to iron ore and steel, will also take a beating. This is clearly not a good sign for many countries whose growth totally depends on commodity exports. As Societe Generale analysts point out in their September 2014
Global Economic Outlook report “For commodity producers, the implications hereof are already being felt. Those economies that have failed to diversify are now paying the price.”
In fact, the Chinese slowdown is reflected in the producers price index (or what we call the wholesale price index) which has been falling since early 2012. In fact, September 2014, saw the biggest month on month drop of 0.4%, points out Yao. This fall in prices has been transmitted to other parts of the world and commodity export driven economies are already feeling the heat.
Interestingly, Sharma feels that China’s actual GDP growth rate may now be lower than official 7%. Also, what does not help is the huge amount of debt that the various sections of the Chinese economy have ended up accumulating. The total Chinese debt currently stands at around 230% of GDP. In fact, the various sections of the Chinese government remain the biggest borrowers.
As Sharma points out “Since 1960, the nations that indulged the 30 biggest credit binges all saw credit rise as a share of GDP by at least 40 percentage points over five years. Of those 30 cases, 70% ended in a crisis after the credit boom peaked, but 100% experienced a major economic slowdown within the next five years. On average, growth slowed by more than half, to 1.5% from 5%.”
This Chinese slowdown as and when it occurs will pull down the global economy along with it as well.

The article was originally published on www.FirstBiz.com on Oct 18, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek) 

Oil prices are at a 4 year-low now but assuming that they will continue to fall is risky business

 oil

Vivek Kaul

Oil prices have been falling for a while now and have now touched a four year low. As per the data published by the Petroleum Planning and Analysis Cell, the price of the Indian basket of crude oil touched $ 82.83 per barrel on October 16, 2014.
There are several reasons for the fall (You can read about them in detail
here and here). Analysts expect this growth to continue to fall in the years to come. Several fundamental reasons have been offered as an explanation for the same.
As Crisil Research points out in a research report titled
Falling crude, LNG, coal prices huge positive for India “Over the next five years, we expect global oil demand to increase by 4-4.5 million barrels per day (mbpd). However, crude oil supply is expected to increase by 8-10 mbpd. This, we believe, will bring down prices from current levels.”
This augurs well for India as falling oil prices will ensure that the under-recoveries suffered by the oil marketing companies(OMCs) on selling diesel, cooking gas and kerosene, will fall. The government has been compensating the OMCs for these under-recoveries. Falling under-recover will mean lower government expenditure leading to a lower fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.
Analysts Harshad Katkar and Amit Murarka of Deutsche Bank Markets Research in a report titled
Breaking Free point out that “Fuel subsidy could fall to an annual level of $7billion – a 70% reduction over financial year 2014 – by financial year 2020 and potentially reduce the government’s fuel subsidy burden to zero by 2021 driven by elimination of the diesel subsidy and rationalization of the cooking fuel subsidy.”
These arguments sound pretty good. The only problem is that predictions on which direction oil prices are headed invovle too many variables and predicting all these variables at the same time is not an easy thing to do.
On several occasions in the past, well renowned experts have ended up with eggs on their face while trying to predict the price of oil. In January 1974, the Organization of Petroleum Exporting Countries (OPEC) raised the price of oil to $11.65 per barrel. This was after OPEC’s economic commission had determined that the price of oil should be $17 per barrel.
It was around then that the economist Milton Friedman wrote in a column in the
Newsweek magazine where he predicted that “the Arabs … could not for long keep the price of crude at $10 a barrel.”
By early 1981, the price of oil had risen to $40 a barrel. A spate of reasons including the politics of the Middle East were responsible for this rise. Other than the politics of the Middle East, in April 1977, the Central Intelligence Agency (CIA) of the United States had come up with a highly influential report which predicted that the growth of the world oil demand would soon outpace production.
This was primarily because of constraints on the OPEC production. The Soviet Union, another big oil producer, would reach its peak soon. This meant that by the mid-1980s, oil would become very scarce and expensive, the report pointed out.
Customers, including some of the biggest international oil companies, were queuing up to buy oil. The report succeeded in generating sufficient paranoia among the oil-consuming nations as well as the big oil-producing companies. Hence, they wanted to buy as much oil as they could.
All the doomsday predictions regarding the price of oil turned out to be wrong. By 1983, the average OPEC price had fallen to $28 per barrel leading to some members of OPEC offering additional hidden discounts in an attempt to boost their stagnating sales.
By 1986, the price of oil was quoting again at $10 a barrel, proving the CIA prediction to be all wrong. Milton Friedman, though, was right about the price in the end. And Friedman would write a “I told you so” column in
Newsweek which appeared on March 10, 1986, titled “Right at Last, an Expert’s Dream.” This, of course, was in jest. As Friedman confessed, “Timing, as well as direction, is important…I had expected the price of oil to come down far sooner.”
What this tells us is that it is very difficult to predict the long term direction of the price of oil. One reason why oil prices have not risen in the recent past despite the rise of Islamic State of Iraq and Syria (ISIS) is because the outfit has not been able to move into the southern part of Iraq where a major part of the country’s oil is produced. Southern Iraq is dominated by the Shias who do not support the ISIS.
Then there is the so called deal between Saudi Arabia and the United States, where the ruling dynasty of Saudi Arabia is believed to have engineered a fall in the price of oil so as to ensure that the security guarantee that they have from the United States, continues.
The trouble is that with the price of oil now lower than $85 a barrel, the shale oil boom that is happening in the United States and Canada, might not be able to continue. Shale oil is expensive to produce and it is financially viable only if the price of oil remains at a certain level. As analysts of Bank of America-Merrill Lynch point out in a report titled
Does Saudi want $85 oil? “With production costs ranging from $50 to $75/bbl at the well head, a decline in Brent crude oil prices to $85 would likely be a major blow to US shale oil players and lead to a significant slowdown in investment.”
The shale oil boom can lead to a situation where the United States no longer needs to depend on the Middle East and other countries to meet its oil needs. Hence, to some extent it is in the interest of the United States that oil prices continue to fall. At the same time, one reason that dollar continues to be the international reserve currency is because oil continues to be bought and sold in dollars.
Saudi Arabia over the years has cracked the whip among the OPEC nations to maintain a status quo on this front. It is in the interest of the United States that the dollar continues to be the international reserve currency. While every country in the world needs to earn dollars, the United States can simply print them.
And to ensure that dollar continues to be a reserve currency, the United States, needs Saudi Arabia on its side. The Saudis currently would prefer a lower price of oil, in order to make the production of shale oil unviable. At the same time they would like the security guarantee they have from the United States to continue, in order to protect them against the ISIS.
As the Bank of America-Morgan Stanely analysts point out “It should perhaps not come as a surprise that the threat of a stateless group that challenges the status quo by attempting to redraw national borders is shifting incentives for key regional and global players…The Islamic State could present a direct threat to the Arab monarchies at a time of growing social discontent…In our view, Saudi and other regional rulers may prefer to re-engage the US to help protect established borders from the expanding caliphate. What could Arab countries offer the West to help contain this threat? Lower oil prices.”
This issue is too complex to make a prediction on. Nevertheless it will have a huge impact on the direction in which oil prices will go in the years to come. Further, the chances of the current turmoil in the Middle East escalating, still remain. As Milton Ezrati writes in a piece titled
ISIS, Oil, and the Economy on Huffington Post “There is no mistaking the huge remaining importance of Persian Gulf supplies. If the turmoil there were to take a significant portion of this output off line suddenly, the world would be hard pressed to replace it, and prices would rise with all their ill effects.”
He further points out that “the Persian Gulf itself is also a choke point of no small significance in oil transport. The EIA reports that upwards of 35 percent of sea going oil and gas passes through the Gulf and the narrow Strait of Hormuz at its head. If Iran were to become further embroiled in Iraq’s problems or otherwise come to a confrontation with Western powers, the strait would close and the world would find itself without any of this still crucial supply.”
The price of oil is not just determined by the demand and supply equation. The politics of the Middle East and which side of the bed Uncle Sam wakes up from remain very important factors. For any analyst trying to predict the price of oil, taking all these “qualitative” factors into account remains very difficult.
To conclude, what are the lessons that we can draw from this. First and foremost we need to ensure that the price of diesel is decontrolled. And more than that we need to ensure that it continues to be decontrolled in the years to come, even if the global price of oil rises.

The article originally appeared on www.FirstBiz.com on Oct 18, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)