Why China had to shift to slower lane?

Planned or no other go?

China is reporting lower GDP growth rates and is vacating the top spot it held for many years. Is there something wrong or is it a common phenomenon? Let us try to understand. China expanded its economy in the last two decades focusing on exports and investments. But the same focus is not bringing further growth so it is turning focus on consumer driven economy. Though China is driven towards it, it is partially intentional.

Digesting mountains of debt is a priority

China's debt (% of GDP) and real estate prices. (Source: MarketWatch)

China's total debt is close to 3x of its GDP. While debt fueled investments contributed to GDP growth, they also took up asset prices. Now property prices in Shanghai are comparable to that of New York. Since half of China’s debt is related to real estate, it needs to ensure its real estate market does not collapse. Further debt/investments in property market will increase the risks beyond manageable levels. Priority for China is to bail out their financial system. So China had to let the wages

rise to improve the affordability in its domestic market to increase consumption and to service debt. When wages rise and currency does not depreciate exports will fall. So China reported lower export numbers for last month. Newspapers and journals said it is a surprise. But the Chinese were not surprised as they knew their next leg of growth does not come from exports. Its imports are also reduced with intentional efforts. China’s defense spending has increased but imports are reduced. Increased wages, Govt. spending in local market, stable currency bringing capital gains from financing activities would help China digest its mountains of debt. Moreover slower growth is unavoidable as the economy base increases.

Strong contender with a grand plan

When economies expand, wages in that country rise. To retain competitiveness, the exporting country will weaken their currency artificially to keep the prices same. China too pegged the currency with Dollar and used the dollars earned from surplus trade as reserves and expanded their monetary base. This had worked well and helped China rise in the economic ranks. Now it seems China has higher ambitions. To be number one, you need to avoid dependency on the exports to the country you want to beat. So China seems to be making required changes. Look at the chart, its currency has not depreciated much in the last three years while wages are consistently going up.

China's increasing wages (Source:tradingeconomics.com) but currency weakening stopped (Source: investing.com)

China's holding in US debt are not growing (Source: MarketWatch)

It has also reduced its money flow into US treasury bills. Now Japan is the largest holder of US debt and not China. China instead chose gold and Euro in the recent past. This change in trend is likely to continue. But it is not just decoupling from dollar. China seems to have higher ambitions of elevating their currency to the status of the dollar. So China is asking its partners to trade in their own currencies. Last year China entered into a multi-billion dollar gas supply agreement with Russia which does not involve dollar. Looking beyond trade, it is promoting a bank for Asia. You do not want a weaker currency when you want to lend your capital. All this reveals China is a strong contender to be a big brother with a consumption led economy and a stable currency.

Next time, when we hear of slower growth in China, we need to remember it is not entierly bad for them. They are working towards changing their image of ‘low cost manufacturing country’ and they have a grand plan.

India races ahead as investment cycle begins

It is IMF and World Bank who agree that India will surpass China in the economic growth rate in the coming days.  (Link: http://www.livemint.com/Politics/nYJREyuCAhz6bdu8u1brTO/IMF-urges-India-to-carry-out-further-structural-reforms.html). Well, the indicators were everywhere. In the last couple of months the following were indicating that India is preparing for its next growth phase.

• Shrinking deficits, less volatile currency
• Lower inflation, lower interest rates
• Rating agencies revising outlook
• Hiring picked up, lower unemployment
• Funds inflow, new projects announcements

 It is all good news. But how the growth would distribute across the society?

Wages rise, savers suffer

• As the stalled projects become functional again, the immediate beneficiary would be labor base and banks. Big infrastructure/construction projects employ low skilled and semi-skilled workers in huge numbers. As the labor absorption increases, wages begin to rise. That pace of expansion would be in double digits.
• The policy focus such as ‘Make in India’ will increase the demand for high skill labor so the large number of workforce would transition into higher incomes.
• As the cash flow comes back into stalled projects, Banks will see their dues coming back to them as NPA's reduce. Credit growth makes a comeback and helps the banks fare better.
• Savers who put their money into fixed income schemes and deposits will get a lower return as interest rates soften. They will have to settle down for lesser returns or move their money into alternate investments.

As growth accelerates, land consumption will increase

• As economic activity sees a surge, asset prices will see a boost. Land consumption will increase. Industrial land demand goes up with increase in production; increased consumption of services need more commercial land and those earning high and moving into better houses increase the demand for housing. Towns will expand their peripheries quickly.
• Inflation may not increase at the same pace of wages as the productivity benefits from the physical capital (infrastructure in place) starts paying off. Lower capital costs will give a breather for business profitability.
• Increasing labors costs will not hurt business sentiment in the near future but take up the average income levels in India (and GDP per capita) like how it happened with our Asian neighbors (Taiwan, South Korea, now China). Even if our GDP per capita doubles from current levels, we would get close to that of Sri Lanka or Egypt. So I suppose there is scope for wage increase without impacting potential economic growth in near term.
• This also means more people moving out of poverty zone, improved lifestyle for middle income population as the income gap will likely reduce from the current levels.

Simplified pictorial of economic cycle

How long this investment phase remains in action is hard to predict as it depends on various factors including political and global developments. Given the circumstances, it would continue for at least 3-5 years. When it tops out, that too will give many indications.

• As the interest rates reduce in India but go up in advanced countries, interest rate spread reduces and the incentive for foreign debt investors to invest in India will reduce. So the fund flow into India would gradually reduce.
• When wages rise beyond productivity improvements, it begins to hurt the prices of goods and services. Exports will suffer. Inflation catches up to fill the gap. That will ask for the interest rates to rise again and the next turn in the economy begins.

Before worrying about the next downturn, let us make most of what is in store for us and not forget to keep an eye on the indicators.

Deepening the bond market: Policy changes are happening

Corporate Bond market is underdeveloped in India. A RBI report shows that India is at a very low position vis a vis some of the major Asian countries.
(Link: http://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=950)

Source: RBI site

Let us understand why it has become a necessity to revive the bond market.

Long term and low cost

Large infrastructure projects require long term, low cost financing to become financially viable. Since these projects (ports, power plants etc.) have long gestation time, cash flow from operations would begin only after couple of years and would remain low until the utilization reaches higher levels. During this first 5-10 years, if the interest rates are higher, they will not be able to service their debt. In such a situation, a company which raised funds at 6-7% interest rates has better chances of success than those paying 12-14% interest rates.

Infra was hit hard

Banks cannot offer lower rates but the bond market is underdeveloped in India. So the infra companies had to borrow from banks to develop their projects. As the global economy slowed down, cash flow in these projects became leaner. That is what led to higher NPA situation India is facing now. Cash flow for many infra companies are lower than the interest costs, they do not have the money to service their loans, so they are restructuring loans and have lost the courage to take up new projects. When Banks do not get the money back, they can’t led it further, so the credit growth in India has come down as there is weak demand for loans and banks do not want to risk lending more money to defaulters. When nobody takes risks, economy shrinks.

Burning hands with foreign debt

Whoever went to overseas market and borrowed at lower rates but in dollar terms, did not gain either as Rupee depreciated a lot. (Let us assume a company borrowed few years ago when Rupee was at 50 a dollar, will need more money to repay their loan now as dollar is at 62 now). All the loan amount cannot hedged, even if it is hedged completely, the hedging costs will take away the benefit of low interest rates.

Reviving Bond Market seems to be the only solution

For all the financing problems India is facing, deepening the bond market seems to be the only solution. It reduces the risk concentration in banking system with higher NPA. Private companies need not depend on banks and can borrow at lower rates by issuing bonds. And they also need to efficiently manage their business, else the bond market would demand higher coupon rate. RBI in the recent past has announced several measures to deepen the bond market. It is pushing corporate to issue Rupee bonds in foreign markets. (Link: http://economictimes.indiatimes.com/markets/bonds/rbi-pushes-biggest-borrowers-to-rupee-bond-market/articleshow/46820409.cms). That takes out the risks arising from forex volatility. Hedging costs and benefits would be transferred to a third party. And it provides access to low cost capital. RBI also intends to open up Govt. treasury market to retail participants. (Link: http://www.livemint.com/Money/1ZEYenE7i9Os4dlLQ9MK2N/RBI-moves-to-liberalize-bond-markets.html#nav=latest_news). Though how big that market is not yet known, it is a right step forward. Whether RBI likes it or not, it has to promote bond market. Will it affect credit growth in Banking? Probably, yes. And they may have to depend on retail customers more. But in a growing country, both bond market and banks will find avenues to grow.

EPFO – The new savior for Govt. divestments

“EPFO to invest 5% of its corpus in stock market” made headlines during this week. 

(Link: http://www.livemint.com/Politics/Zt14mjK3CJKcTDDR5PO5AL/EPFO-to-invest-5-of-its-corpus-in-stock-market.html).

Image Source: Financial Express

Why Now?

Around Rs.8,000 crores funds from Employee Provident Fund (EPF) will find way into Exchange Traded Funds (ETF) of Public Sector companies in which Govt. wants to divest. During the last fiscal year, Govt. could not meet its divestment target. So it had to find new players to help them  with their divestment plans. Finance ministry did not have to try hard to find the elephant in the room. Now EPFO will become another savior along with LIC, UTI getting into market when there are no sufficient takers for the Govt. stake in PSU’s when Govt. wants to sell.

Will it affect EPF subscribers significantly?

EPF is a pensioner’s fund. To keep its risks lower, it had never put money into equity market so far. Now, 5% of the corpus will hit stock market. EPF subscribers need not worry much, as 5% exposure to equity market does not alter risk profile significantly and moreover the PSU’s like ONGC (to which major chunk of money would go now) have given decent returns. LIC (which also has a larger cash pool like EPF) is one of the market makers and had made good money over the last decade in the stock market. Another positive factor is reducing Govt. ownership and increasing retail participation through EPF might make those PSU organizations more responsible in their operations and finances.

Times Ahead

But Govt. would not stop with 5% (this is just initial step) and will increase it to 10% or even higher levels in the coming years. That will bring liquidity to stock market but at the risk of employees contributing towards their retirement. Risk has its rewards too. If PSU become more efficient and offer better returns for their shareholders, EPF subscribers will also see their savings growing at a better rate. Else, this would become another form of tax on them.

RBI chief vs former SBI Chief

It is former chief of SBI vs Governor of RBI. Look at these two articles:

• Former SBI Chief Criticises Rajan for Not Cutting CRR (Link: http://profit.ndtv.com/news/economy/article-former-sbi-chief-criticises-rajan-for-not-cutting-crr-752874)

• Banks Not Lowering EMIs is 'Nonsense', Says Raghuram Rajan (http://profit.ndtv.com/news/economy/article-banks-not-lowering-emis-is-nonsense-says-raghuram-rajan-752845?utm_source=taboola)

Former SBI chief says CRR cut would have allowed banks to reduce interest rate but RBI Governor disagrees. Who is right? While I am no expert on this subject, here is my attempt to understand the situation objectively. Let us understand CRR first.

Purpose of CRR

Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits (currently set at 4%) of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. It is idle money which cannot be lent, so Banks do not earn any interest on it. But it comes at a cost as banks have the obligation to pay interest to depositors on the whole of deposits. Banks do not like this and have been asking RBI to scrap CRR or reduce it. It has come down from a high of 15% during 1990’s to 4% now. But RBI will not scrap CRR as it does serve an important purpose. RBI wants to ensure that Banks do not run out of money when depositors want to liquidate their deposits. CRR along with SLR (at 21.5%) acts as a cushion of safety. When NPA’s are rising which will take out the money from banking system, Banks can still meet their payment obligations to depositors using this buffer. That makes faith in banking system remain intact in troubled times but the absence of it can threaten smoother operations. That is the interest of RBI. But Banks want to maximize their profits.

Credit growth and NPA

Let us look at how banks have managed credit growth and NPA. 

The first chart shows overall trend in credit growth is down but it is important to note that it is SBI and nationalized banks experiencing slower growth while private sector banks are not experiencing such a severe slowdown.

Credit growth in % (Data Source: RBI site)

Similarly SBI and public sector banks have more non-performing assets than their private counterparts. The written off loans reduce the money in banking system. Now we know who managed their loans better.

An IMF report says the percentage of debt owed by loss-making firms reached 23 percent in 2013/14. (Link: http://www.niticentral.com/2015/03/16/imf-report-on-indian-corporates-wakeup-call-for-government-of-india-306869.html). 

Public sector banks have approx. 4% of net NPA (and around 6% gross NPA). If they had done proper due diligence before issuing loans and acted tough on recovering their loans, they would have fared better. But they don’t have all the control as they (public sector banks) all report to Finance ministry and obey the instructions from them. Then why criticize RBI for not cutting CRR? What else to do in idle time? RBI sits on idle money with a purpose. But banks would have made their money without bothering much about CRR.