China, oil, panic and recession….(Part 1)

The global equity sell-off has been brutal so far in the year 2016. Many global equity indexes have plunged into bear territory. There is enormous panic and fear about a forthcoming global recession. Are we going to have a recession? I don’t know. But I don’t think so. But then, I don’t know. And this is how investors worldwide are feeling right now – they don’t know. This “don’t know” phase is quite a dangerous phase for worldwide capital investments – because companies will be unwilling to commit to major investments if there is uncertainty, especially if there is uncertainty in global asset prices. 

But let’s examine some of the major panic-spots, as I would like to call it, right now:

China: Chinese economy is growing slowly. Now, there is a difference between growing slowly vs. no-growth or negative growth. In this case, Chinese economy is still growing, albeit quite slowly and understandably so. Because of this slowdown in the Chinese growth, there is a worldwide re-pricing of many major assets. For example, China consumed almost half of the global iron-ore production in the past decade. Now that China is growing slowly, how much will the fair value of a metric ton of iron ore be? And that question is exactly what is being answered by the markets right now – meaning, there is a strong re-pricing of assets going on globally, particularly of many commodities, based on supply and demand. And many global companies made a classic mistake of over-producing commodities during the boom time without forecasting a slowdown in the demand growth. This along with the often-generated market over-reaction, not to mention the gazillion modern leveraged financial products that have been created in the market, has caused an extreme downward spiral of many commodity prices. But if you wither out the market over-reactions, I believe that some of the slowdown in China will actually be compensated with a slight growth in a handful of other countries like India, Indonesia, South Korea etc. 

Now, with respect to the Chinese retail investors chasing the equities higher without any fundamentals to support them over the last two years – I think this is in the rear-view mirror now. After a more than a 50% plunge in the Chinese stock markets within the last year, the needed correction is almost done. There may be a little more shakeout, but I believe most of the correction on this front with respect to the crowding retail investors has been done already.

My biggest fear when it comes to China is their banks’ exposure to high risk loans within their domestic economy that could turn into bad debts. While China has massive forex reserves, with almost $2 trillion of them in liquid assets to handle any risk to their money-supply and credit markets, with sufficient capital controls in place, a mere sign of any major trouble to any major Chinese financial institution could have enormous unintended consequences with ripple effects across the globe. It is in this space one has to watch carefully, though the communication from the Chinese authorities has been almost nil, if not incomplete, in this space to re-assure global investors.

Now with regard to US banks, I don’t think there is much direct exposure on the loan-front to the Chinese economy. So any talk of a US banking crisis due to China is unwarranted.

The other major concern I have is how the Chinese authorities will manage their currency this year. China cannot steer its economy to its growth target this year without devaluing their currency. How they would devalue their currency is the billion-dollar question? If it is a major one-off devaluation, then there is a high probability that that will cause a jolt to world financial markets; and panic and competitive devaluation could follow, thereby risking global growth. If it is a gradual devaluation over the course of the year, then they might be able to sail through the muddy waters. This is something that we need to wait and see to get a little more data and to understand where exactly they stand with respect to their transformation to a more private retail consumption and services based economy. 

I will continue with my discussion on the current status of global crude oil prices and its effects in my next

Negative? Nah, nah, Janet!

The topic of negative interest rate is back again. The equity markets are getting pounded all across the globe. And the primary reason for this is: Panic! There is enormous investor panic out there about the ability of the global central banks to steer the world economy; about China; about oil; and about nations that rely primarily on commodity exports; and about banks that might have high exposure to some of the bad debts associated with all of the above.

And what is the one thing that central bankers should avoid doing during this climate? - Causing further panic! But that is exactly what some members of the Federal Reserve have been doing recently. They are succumbing to this investor panic and panicking themselves in some respect. They are worried if they will be blamed if something goes awry. But I also have to give them some leeway as markets, some economists and experts have been pulling them in all directions to do this, do that, say this, say that. And in that course, the words “negative interest rates” have been pulled out, rather forcefully, from the mouths of some members of the Federal Reserve, including its chairwoman Janet Yellen.

In my opinion, a negative interest rate, or a talk of it, will send the financial markets into a dizzy spin of chaos and panic, if not already - because a negative interest rate will seal the final nail in the credibility-coffin of the Federal Reserve and its ability to steer the US economy without causing another massive recession. Instead, I would suggest that the Fed keep its tongue steady and assure markets that they are in control; and that they would be flexible with regards to the timing of any further interest rate hike. Now, I have to admit that they have been saying that they are flexible, that they are data driven and have tried to assure that the US economy is in solid footing. But my problem is that in the same breath, they also talk of things like negative interest rates – which unnerves global investors – because this tells those investors that there could be something that they don’t know or don’t see that could be lurking behind the shadows of the global economy. And this has caused a flight to safety with all global equity indexes plunging into bear market territory in recent weeks. Ironically, in today’s sentiment driven financial markets, if the Fed panics about the state of the global economy, they will ultimately be blamed as I fear that their panic would be the trigger for the real panic in the real economy.

Bottom line: The Fed should weed out the noise from the panicking equity markets and communicate with a steady tongue.

In the next post, I will discuss about China, oil and their relationship to the current global panic in equity markets. 

It happened!

The Federal Reserve lifted the federal funds rate by 25 basis points today - the first in almost a decade. Congratulations. Good job. Right decision. 

Zigzag Fed!

I am really starting to doubt the credibility of the members of the Federal Reserve. Every serious policy maker should have known and did know that China was overheating this year, especially their stock markets. And predictably, the Chinese stock markets took a severe hit this year. And everyone should have known that such a hit in the Chinese stock markets would expose the excesses and balance sheet weaknesses in their state-owned enterprises. But all along, the heads at the Federal Reserve kept saying that any slowdown in China will not impact the United States’ economy in a significant way – and thereby, given their “reasonable confidence” in inflation and growth projections are met, they would start the normalization of interest rates starting from this year.

China took a hit. Emerging markets started showing signs of slowdown as a result. But this shouldn’t impact the US economy in any significant way, right – as per the Fed? But no! It does suddenly. Now the slowdown in China is dragging global growth down. And now that weakness in global growth has started to impact the inflation and growth projections for the US economy – and this is as per the Fed. Wow! I would have expected such a sudden shift in fundamentals from an under-grad student, but not from the world’s most powerful central bankers.

To make matters worse, different FOMC (Federal Open Market Committee) members come on different TV channels on different days and espouse different policy proposals for the near term monetary policy. Such a confusion and non-alignment in what should have rather been a consensus by now begs one to wonder if the world’s economy is safe with these experts. And by the world’s economy, I literally mean each and every world citizen who has any form of monetary wealth - as the decision by these monetary policy makers has a potential to impact everyone.

The Fed says that they are data dependent, but no amount of data seems to be enough for them to come to a conclusion or a consensus. If they need the data until a day before they make a decision to increase the fed funds rate by 25 basis points (0.25%) to be in sync with their “reasonably confident” projections, then there is something terribly wrong here. Either the data that they are looking at it is not accurate or their communication skills are terrible.

The point is – the Fed doesn’t know where the full employment is. They cannot understand why the core inflation hasn’t picked up even after the unemployment has fallen significantly. To an extent, they correctly blame the lack of fiscal policy support from the US Congress, but beyond that, their mystifying zigzag communication (and probably understanding) is very much disconcerting for a participant in the economy like me, who is just an ordinary person looking forward for a stable global financial growth. 

Infrastructure, not interest rates!

In the US, currently, inflation is very low (atleast as per the official data) and has remained and is expected to remain low for a considerable amount of time. And so some, like the Federal Reserve Bank of Minneapolis president Narayana Kocherlakota, have called for further easing of monetary stimulus. They even argue for a negative interest rate in the US, meaning, pushing the federal funds rate below the 0% bound (check this link). And with all due respect, I have to disagree with this proposal.

First of all, let’s take a look at the global economy today. The United States’ economy, in all parameters, has considerably rebounded from the recession era lows (not just the stock market – which has had a massive bull run for the past 6 years - but the real mainstream economy itself, has rebounded nicely).  In the last two years especially, the job market has been relatively healthy and quite resilient. Consumer spending has grown. Consumer confidence in the economy has grown. Services industry has grown. Manufacturing rebounded nicely last year, but has been quite badly hit this year (due to a stronger dollar and weak global growth – and I will get to it in a minute). All this happened at a zero bound interest rate setting. But was that the only factor that spurred growth? Absolutely not!  

As much as the monetary stimulus was effective, an equally important factor for the growth in the last 6 years was China. China’s fiscal stimulus was a boon to a large part of the world. Countries from Australia to Brazil, Thailand to South Africa, Japan to Russia, Indonesia to Switzerland and many more profited from the immense investments that took place in China. These investments not only contributed to higher commodity prices – which made nations like Saudi Arabia immensely rich in forex reserves – but also increased the sheer number of Chinese middle class consumers – whose purchasing power was a boon to many - like the Swiss watch makers and German car makers. So the global economy itself largely benefited from these investments in China, and that had a positive effect on the United States as well. Along with all these positives, a lot of mistakes were done (in terms of quality, size and credit) in these investments in China – for which China is paying a price now. And not just China, the world itself is paying a price now – not because China overdid things, but rather because the world under-did things. In other words, the major factor that is holding back global growth today is a lack of capital investments globally. What China overdid, was underdone by the rest of the nations.

Now this gets us back to the negative interest rate. Do we need it? In my opinion, no! – because the root of this problem goes back to a sudden slowdown in the Chinese economy. Naturally, the Chinese economy overheated and is going through a cooling phase. And along with it, all the nations that benefited from the Chinese super-growth story are going through the slowdown as well. During this phase, China is also, rightly, going through a transformation to shift its economy’s over-reliance on manufacturing, export and investment-led model to a decent reliance on consumer-driven, more services and innovation-based model. But this will take time. As a close observer of global finance, I have no doubt in my mind that China will ultimately be successful in this transition. But I have also no doubt in my mind that China will make a lot of mistakes during this transition phase – mainly due to their inexperience, and not necessarily inability, in managing such a heavy transition in such a massive economy.

A negative interest rate in US will do nothing more than provide a cushion, to a certain extent only, for currency instability in China and other emerging markets. But barring that small advantage, the negative interest rate will only lift up asset prices globally – which again goes to this thinking of monetary strategists that – if asset prices go up, consumers will feel more confident to spend and this in itself will provide a boost to the economy. But what kind of boost is that? A boost given by artificial demand! I call it “artificial” because the consumers will be forced to make use of their money even when they would have preferred to save. Such a strategy severely distorts the global supply & demand, investments, free markets and asset prices. We followed such a strategy at the depth of the global recession – as a temporary and a priority measure to reboot the economy and create sufficient demand. But we are well past that phase now. Repeating that again and again will only set us up for a long term pain through distorted capital flows and more recessions or setbacks.

Money is still cheap. That is not the problem here. It’s the application of money that is the problem. Where do we apply the cheap money available? Can we start with worker training /skill training programs? Or can we start with more affordable housing for the poor that would reduce their rent burden? Can we start with putting more money in the hands of families with children that will reduce their child care costs? Or can we resolve the immigration problem that will help lift business investments and thereby demand? Can we start with reducing the health care costs of middle-income and poor families by transferring some of the wasteful agricultural subsidies into the health care and medical research sectors? Or at the very least, can we employ the thousands of unemployed without a college degree by repairing and improving the transportation and sanitation infrastructure?

It all boils down to two words – “capital investments” or "fiscal stimulus" – not just in US, but also in countries like India, Indonesia, nations in Africa etc. (especially by commodity importing countries - now that commodity prices are so cheap). That is the right kind of stimulus needed now, not negative interest rates, to push the global economic growth to a higher and more sustainable trajectory. 

Donald Trump – the 1980’s man?

So I have been following Donald Trump a little and honestly, I liked the way he kicked back everyone who made fun of him as a clown, joker etc. Today, those same people in the media are just frightened of his rise and have toned down their commentary on him – and this was clearly fun and exciting to watch. Almost everyone who joked about him, not in the distant past, are now clearly shocked in the way he has gathered momentum.

And initially, I liked how Donald Trump was able to identify key issues that have affected the growth of the middle class in the US negatively – particularly, the trade deals with different countries. For example, no one can argue that the Chinese currency wasn’t a factor that affected the US manufacturing industry over the past decade (though I have a slightly different take and don’t blame China completely for every manufacturing job lost in the US – more importantly, I believe it was a direct consequence of the global free trade campaign that was kick-started by the US and other western powers to find and open new markets across the globe – a consequence which has been negative for many, but has been very positive for many many more people across the globe – including many in the US middle class).

But there is no question that trade over the past decade with a country like China, which pegged/manipulated and today manages the currency through heavy government intervention, has severely distorted the flow of capital across the globe. It has also resulted in sudden seismic changes for which the US middle class and frankly, many middle and lower-income groups across the world were not ready. All this created severe stress in the financial growth of the middle class in the US and many other western countries.

But all this said, is Donald Trump’s plan to charge a tariff on all products imported from China or for that matter from Mexico – a country which by the way has a cost advantage to manufacture products there purely from a standard of living standpoint (and probably less regulations) – the right way to go?

Mr. Trump says that he would charge 35% import tariff on all products manufactured in Mexico and shipped into the United States. As wonderful that this might seem, the simple fact is that the World Trade Organization, for which both the US and Mexico are party to, will simply rule this tariff as protectionist and probably as against the accepted rules – thereby opening the window for Mexico and other countries that trade with the US to slap countervailing duties and tariffs on all products shipped from the US – and for that matter, WTO, as far as I know, allows a broad range of options to impose countervailing duties and other protectionist measures that can seriously cripple American industries trying to capture a share of the market in these economically important nations.

It might be true that in any protectionist or trade war, China, Mexico and other such countries might stand to lose more than the US – but I don’t think we are on a war as to who would lose more, but instead on a co-operation as to how much would each make more. Mr. Trump’s policies are like taking the clock back to the past – when all seemed well and good. But that was also a time when China was still a very poor country, India was not open for business at all and the Euro currency did not exist. And so much more has since happened in the last few decades. Who would have expected that American companies can sell millions of phones, clothes, cars, heavy equipment, technology etc. to a country like India, or a country like China? Who would have expected the capitalist American middle class to more than double their investments within half a decade by investing in the communist China? Who would have expected that American shoes and German cars will be exported to Africans when all that was expected at some point in time in the past was an import of an African disease?

And who would now expect to reverse all this progress by starting a trade war through protectionist measures such as import tariffs? Not me and not the people who understand the basics of free market economics.

Obviously, there are heavy distortions in the world economy today – the capital controls and currency manipulation in China is a case in point (or) the delay in opening up of some sectors in India is a another example (or) the presence of a cartel that tries to control and manipulate the prices of oil globally..and I can go on and on. But how we address these issues is as important as these issues itself.

When Adam Smith, the great free-market Scot, repeatedly advised the British government in the 18^th century that trade with the East Indies (India) would be much preferable and would in fact create more wealth to Britain than the mercantilist policies followed by the Great Britain in East Indies, the British didn’t seem to listen. Ultimately, the British did create a lot of wealth by expanding their colonization and mercantilist policies, but that came at what cost is a question that should be in everyone’s minds – especially when the same (and probably more) could have been achieved through just using the principles of free market theory and trading with all these “colonies”.

Likewise, though Mr. Trump identifies the issues in hand correctly, his solutions make one ask – “at what cost?”

Devaluation of the Renminbi

On April 9^th of this year, I wrote in this blog that the Chinese stock markets were going crazy by reaching new peaks every day and that it was better to get out of Chinese stocks. In the months that followed, the stock markets in China took a hit and lost more than 50% of its value – in fact, the declining trend was put to a pause only because of the aggressive interference by the Chinese government (there are still thousands of companies whose trading is yet to resume after the Chinese regulators halted them).

Today, the Chinese government shocked (or should I say annoyed) the global financial markets by devaluing its currency, Renminbi, by 1.9% against the US dollar and other major currencies. I was not shocked. This move by the Chinese made a lot of people in the US and other parts of the world who trade with China angry complaining that this devaluation was giving an unfair advantage to Chinese exports. It did not make me angry, though I felt a little sense of “missed opportunity”.

The Chinese authorities set a reference rate every day for the renminbi against the US dollar and other major currencies – and allow the currency to trade within a band of 2% from that reference rate (plus or minus 2%). In currency markets, they call this as “managed float” of a currency. It has to be noted that the band was much less than 2% years ago and over the course of the years, China has increased the trading band to 2% with the reference rate as the mid-point.

I, as most people, would like to see the renminbi to freely float. And I, as most people, would like to see the renminbi appreciate in value rather than depreciate in value (given China’s account surpluses, it is only natural to expect the renminbi to appreciate over the long run to a more stable and fair value). But all that said, today’s devaluation of the renminbi has caused over reaction in the markets and among policy makers, people and politicians.

In the recent past, I have advocated for a stronger renminbi through interference in the markets – a.k.a currency manipulation. The reason for that is that I am counting on China in the years and decades to come to create a global engine of consumer-driven growth. And in many respects, it is time for China to start taking up that role – given their account surpluses, forex reserves, state investments plateauing and their massive population. But what I am talking about is a significant re-structuring of the economy that would initially slow down the growth by a significant margin before picking up steam. And that requires enormous political will in a communist nation. Today’s action made it clear that the government is not ready yet to go through that tough road of re-structuring. Fine, that’s ok, but I am atleast expecting that they would take the smooth road of re-structuring – which they seem to be. In other words, if I have to wait for the renminbi to depreciate first before it starts appreciating, then I am ready to do that – provided there won’t be any artificial hindrance to its appreciation when the time comes.

Other than that, all the hue and cry about today’s action by the Chinese monetary authorities to devalue the renminbi is not warranted, in my opinion. Everyone demands China to float their currency freely (and I do too, though I am okay with a managed float during extreme volatility) and if China had indeed freely floated their currency, we would have seen the renminbi to depreciate far more in value this year than the 1.9% that the authorities devalued there. The Chinese economy has been doing terribly this year, there has been an exodus of foreign money from stock markets – and all this should have dented the renminbi to a significant extent (well above the 1.9% devalued today) even if it were left to market forces. Instead the renminbi stayed stronger than the market would have priced it because the renminbi tracked the strengthening US dollar throughout this year.

One significant change that the Chinese authorities did today is to start taking the previous day’s final value of the renminbi into their calculation rather than the previous day’s reference rate to set the next day’s reference rate. This is akin to dancing with the markets in the direction the markets take the currency’s value. In my mind, this is a significant and a positive change in the way the “managed-float” of the renminbi is carried out on a daily basis. If China had followed this methodology from the start of this year, we would have seen the renminbi depreciate by 1.9% (or even more) by now – albeit that would have been a gradual depreciation rather than today’s sudden devaluation.

What is important for the US and other trading partners of China is not to complain about their actions today, but rather to welcome it and make sure that China follows the same methodology even during times when the market forces pull the currency in the opposite direction (when the renminbi is supposed to appreciate). And the US and other trading countries should also put pressure on China to gradually increase the trading band to 3% or more instead of the 2% that they currently have (and make sure that China actually allows the value of its currency to reach the upper and lower limits of the band if the supply and demand requires it to).The pressure could also be put to eliminate other forms of capital control that China currently has in place. 

And by the way, on a different issue, as long as China maintains a trading band for its currency on a daily basis, the renminbi should NOT be added to the basket of reserve currency list by the International Monetary Fund.