July 13, 2018 by In the long run

Canary in the coal-mine – Emerging market contagion

Macro Letter – No 100 – 13-07-2018

Canary in the coal-mine – Emerging market contagion

Emerging market currencies, bonds and stocks have weakened
Fears about the impact of US tariffs have been felt here most clearly
The risk to Europe and Japan is significant
Turkey may be the key market to watch

As US interest rates continue to normalise and US tariffs begin to bite, a number of emerging markets (EM’s) have come under pressure. Of course, the largest market to exhibit signs of stress is China, the MSCI China Index is down 7% since mid-June, whilst the RMB has also weakened against the US$ by more than 6% since its April low. Will contagion spread to developed markets and, if so, which country might be the ‘carrier’?

To begin to answer these questions we need to investigate this year’s casualties. Argentina is an obvious candidate. Other troubled countries include Brazil, Egypt and Turkey. In each case, government debt has exacerbated instability, as each country’s currency came under pressure. Other measures of instability include budget and trade deficits.

In an effort to narrow the breadth of this Macro Letter, I will confine my analysis to those countries with twin government and current account deficits. In the table which follow, the countries are sorted by percentage of world GDP. The colour coding reflects the latest MSCI categorisation; yellow, denotes a fully-fledged EM, white, equals a standard EM, green, is on the secondary list and blue is reserved for those countries which are so ‘frontier’ in nature as not to be currently assessed by MSCI: –

EM Debt and GDP

Source: Trading Economics, Investing.com, IMF, World Bank

For the purposes of this analysis, the larger the EM as a percentage of world GDP and the higher its investment rating, the more likely it is to act as a catalyst for contagion. Whilst this is a simplistic approach, it represents a useful the starting point.

Back in 2005, in a futile attempt to control the profligacy of European governments, the European Commission introduced the Stability and Growth Pact. It established at maximum debt to GDP ratio of 60% and budget deficit ceiling of 3%, to be applied to all members of the Eurozone. If applied to the EM’s listed above, the budget deficit constraint could probably be relaxed: these are, generally, faster growing economies. The ratio of debt to GDP should, however, be capped at a lower percentage. The government debt overhang weighs more heavily on smaller economies, especially ones where the percentage of international investors tends to be higher. Capital flight is a greater risk for EM’s than for developed economies, which are insulated by a larger pool of domestic investors.

Looking at the table again, from a financial stability perspective, the percentage of non-domestic debt to GDP, is critical. A sudden growth stop, followed by capital flight, usually precipitates a collapse in the currency. External debt can prove toxic, even if it represents only a small percentage of GDP, since the default risk associated with a collapsing currency leads to a rapid rise in yields, prompting further capital flight – this is a viscous circle, not easily broken. The Latin American debt crisis of the 1980’s was one of the more poignant examples of this pattern. Unsurprisingly, in the table above, the percentage of external debt to GDP grows as the economies become smaller, although there is a slight bias for South American countries to continue to borrow abroad. Perhaps a function of their proximity to the US capital markets. Interestingly, by comparison with developed nations, the debt to GDP ratios in most of these EM countries is relatively modest: a sad indictment of the effectiveness of QE as a policy to strengthen the world financial system – but I digress.

Our next concern ought to be the trade balance. Given the impact that US tariffs are likely to have on export nations, both emerging and developed, it is overly simplistic to look, merely, at EM country exports to the US. EM exports to Europe, Japan and China are also likely to be vulnerable, as US tariffs are enforced. Chile and Mexico currently run trade surpluses, but, since their largest trading partner is the US, they still remain exposed.

This brings us to the second table which looks at inflation, interest rates, 10yr bond yields, currencies and stock market performance: –

EM Markets and Inflation

Source: Trading Economics, Investing.com, IMF, World Bank

In addition to its absolute level, the trend of inflation is also an important factor to consider. India has seen a moderate increase since 2017, but price increases appear steady not scary. Brazil has seen a recent rebound after the significant moderation which followed the 2016 spike. Mexican inflation has moderated since late 2017, posing little cause for concern. Indonesian price rises are at the lower end of their post Asian crisis range. Turkey, however, is an entirely different matter. It inflation is at its highest since 2004 and has broken to multiyear highs in the last two months. Inflation trends exert a strong influence on interest rate expectations and Turkish 10yr yields have risen by more than 5% this year, whilst it currency has fallen further than any in this group, barring the Argentinian Peso. For comparison, the Brazilian Real is the third weakest, followed, at some distance, by the Indian Rupee.

India, Brazil, Mexico and Indonesia may be among the largest economies in this ‘contagion risk’ group, but Turkey, given its geographic proximity to the EU may be the linchpin.

Is Turkey the canary?

The recent Turkish elections gave President Erdogan an increased majority. His strengthened mandate does not entirely remove geopolitical risk, but it simplifies our analysis of the country from an economic perspective. Short-term interest rates are 17.75%, the second highest in the group, behind Argentina. The yield curve is inverted: and both the currency and stock market have fared poorly YTD. Over the last 20 years, Turkish GDP has averaged slightly less than 5%, but this figure is skewed by three sharp recessions (‘98, ‘01 and ‘08). The recent trend has been volatile but solid. 10yr bond yields, by contrast, have been influenced by a more than doubling of short-term interest rates, in defence of the Turkish Lira. This aggressive action, by their central bank, makes the economy vulnerable to an implosion of growth, as credit conditions deteriorate rapidly.

Conclusion and investment opportunities

In Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession? I concluded in respect of Europe that: –

…the [stock] market has failed to rise substantially on a positive slew of earnings news. This may be because there is a more important factor driving sentiment: the direction of US rates. It certainly appears to have engendered a revival of the US$. It rallied last month having been in a downtrend since January 2017 despite a steadily tightening Federal Reserve. For EURUSD the move from 1.10 to 1.25 appears to have taken its toll. On the basis of the CESI chart, above, if Wall Street sneezes, the Eurozone might catch pneumonia.

Over the past few months EM currencies have declined, their bond yields have increased and their stock markets have generally fallen. In respect of tariffs, President Trump has done what he promised. Markets, like Mexico and Chile, reacted early and seem to have stabilised. Argentina had its own internal issues with which to contend. The Indian economy continues its rapid expansion, despite higher oil prices and US tariffs. It is Turkey that appears to be the weakest link, but this may be as much a function of the actions of its central bank.

If, over the next few months, the Turkish Lira stabilises and official rates moderate, the wider economy may avoid recession. Whilst much commentary concerning EM risks will focus on the fortunes of China, it is still a relatively closed, command economy: and, therefore, difficult to predict. It will be at least as useful to focus on the fortunes of Turkey. It may give advanced warning, like the canary in the coal-mine, which makes it my leading indicator of choice.

April 21, 2017 by In the long run

Will technology change the prospects for emerging market growth?

Macro Letter – No 75 – 21-04-2017

Will technology change the prospects for emerging market growth?

The challenge to low-cost manufacturing in emerging markets is from technology
Some industries will benefit but many jobs will be displaced globally
The mercantilist model of emerging market growth will need to adapt
Technology will solve some of the demographic challenges of the developed world

In July 2016 the International Labor Organisation (ILO) released a report entitled – ASEAN in Transformation – in the preface it relates the apocryphal story of a 1950’s conversation between Henry Ford, Chairman of Ford Motor Company, and Walter Reuther, Leader of the United Automobile Workers Union.

Ford asked, “Walter, how are you going to get those robots to pay your union dues?” to which Reuther responded, “Henry, how are you going to get them to buy your cars?” It reminds us that disruptive technology is not new. As the latest wave of innovation begins to disrupt employment globally, it makes sense to reassess the prospects for some of the world’s fastest growing economies.

The ILO report goes on to focus on the impact of technology on ASEAN countries, a region with 632mln people. This is an under-researched topic. They highlight the industries which are most likely to be affected and suggest ways countries can adapt to minimise the impact of automation on employment. This is their conclusion:-

Considerable opportunities for growth exist within ASEAN. Importantly, the local domestic market is expanding, and ASEAN’s middle class is expected to grow to 125 million by 2025. This represents a massive and emerging regional market.

However, threats remain, and in some cases, are intensifying. In particular, a range of labour-intensive sectors in a number of less developed countries are susceptible to major technological disruption, leading to potential large-scale job displacement. The consequences for these countries could be profoundly negative if they are unprepared to adapt.

We are witnessing the emergence of new markets, the potential relocation of production, the rise of new hiring trends and the displacement of lower skilled jobs. Supplying workers with the appropriate skills and competencies remains a major challenge. Overall, concerted efforts are required from all ASEAN stakeholders. They should act now to build a future of innovation and growth shaped with better employment opportunities.

The World Bank Development Report 2016 – Digital Dividends provides a global perspective. Here are a couple of graphs which illuminate the challenging landscape:-

Source: World Bank

If the unadjusted percentages indicated in the graph above are realised the social and political stability of many countries maybe undermined, however, the next graph shows which occupations are likely to be most at risk. It also shows which occupations can be expected to benefit from the productivity enhancing impact of new technology:-

Source: World Bank

Educational challenge

Be an expensive complement (stats knowhow) to something that’s getting cheaper (data).

—Hal Varian, Chief Economist, Google, 2014

Going back to the ILO report, the key to creating workers with the correct skills is designing appropriate education. According to Asian Nation:-

50.5% Asians, age 25 and older, who have a bachelor’s degree or higher level of education. Asians have the highest proportion of college graduates of any race or ethnic group in the country and this compares with 28 percent for all Americans 25 and older.

This graph shows the educational attainment across ASEAN:-

Source: ILO

Singapore scores highly but so does Cambodia, however, it is the low skilled worker who will suffer; the retraining challenges, for Asia and elsewhere, will be substantial. More than 60% of salaried workers in Indonesia and 73% in Thailand are at risk from automation. The highest risk group are employed in Textiles, Clothing and Footware. More than 9mln people are employed in this sector across ASEAN and the ILO estimate that 64% are at risk in Indonesia, 86% in Vietnam whilst in Cambodia that figure rises to 88%.

Business Process Outsourcing (BPO) is another industry which is ripe for automation. There is a heavy concentration of BPO in the Philippines where more than 1mln salaried working are employed. The ILO estimate that 89% are at risk from automation.

Earlier this year I discussed the demise of China as a low-cost manufacturing hub in – Low cost manufacturing in Asia – The Mighty Five – MITI V – Malaysia, India, Thailand, Indonesia and Vietnam. I concluded:-

Vietnamese stocks look attractive, the country has the highest level of FDI of the group (6.1% of GDP) but there is a favourable case for investing in the stocks of the other members of the MITI V, even with FDI nearer 3%. They all have favourable demographics, except perhaps Thailand, and its age dependency ratio is quite low. High literacy, above 90% in all except India, should also be advantageous.

Over the next few years I remain confident about these economies but the headwinds of technology will blow through these markets, nonetheless. Low cost manufacturing has to be set alongside, efficient inventory management and transit costs. In the apparel industry, where trends change in a rapid and unpredictable fashion, the advantage of fast design to production lead times makes the benefits of robotic production, geographically close to the consumer, much more alluring.

In a fascinating post on LinkedIn – Robots Take Over – The Apparel Production – Susanna Koelblin – discusses the decision by Adidas to transfer a part of the production of their sports shoes back to Germany for the first time in more than 20 years. Another “Speed factory” will open in the US later this year. Here are some of her observations:-

It took 50 years for the world to install the first million industrial robots. The next million will take only eight. Importantly, much of the recent growth happened in particular in China, which has an aging population and where wages have risen…

German robot maker Kuka, acquired last year by China’s Midea, estimates a typical industrial robot costs about 5 euros an hour. Manufacturers spend 50 euros an hour to employ someone in Germany and about 10 euros an hour in China. Rather than seek out an even cheaper source of labor elsewhere – in another emerging Asian economy, say – Chinese manufacturers are choosing to install more robots, especially for more complex tasks. China isn’t getting rid of the work, just the workers…

It is in fact China which is leading the world in terms of the installation of industrial robots, but relative to the size of its workforce these concentrations are still relatively low. China boasts 4.9 robots/1,000 workers while Germany tops the world ranking at 30.1/1,000. That is almost twice the concentration of the US and four times that of the UK.

The current level of earnings in manufacturing still favours the work force of the MITI V but as the cost of automation continues to fall and average earnings in, lower cost Asia, rises, an inflection point will be reached:-

Source: Trading Economics

Manufacturing wage inflation has been high in Indonesia partly in response to earlier currency depreciations – over 10 years the Rupiah has declined by 46% against the US$ whilst manufacturing wages have increased by 164%. All these emerging economies maintain a manufacturing cost advantage relative to robotic automation, however, for countries like Malaysia, which has seen its currency decline by 46.7% over the last five years, whilst manufacturing wages have only risen by 37.6%, the competitive advantage versus robotic automation is narrowing. Malaysia now has a manufacturing wage cost which is slightly higher than China’s.

Interestingly, India has seen a real-terms improvement in export competitiveness. Its currency has fallen 21.4% over five years but manufacturing wages have only risen by 14.6%. Vietnam and Thailand have seen export competitiveness decline, yet in both cases they have had considerable room for manoeuvre.

I am in agreement with Dr. Jing Bing Zhang, Research Director of IDC Worldwide Robotics, we should not be worried about automation derailing the emerging market growth model over the next decade. This is what he said in a recent interview with the Diplomat:-

There are different schools of thought… From my research, I don’t see it. Maybe we will be less dependent on human labor. But there is no way this will eliminate the need for people in the next 15-20 years. We are entering high speed growth for robotics but in 2014 global density for robotics was still very low at 66 per 10,000 employees, 36 in China, 57 in Thailand, and close to none in India.

The uptake of robots does not appear to have damaged employment in Germany where unemployment recently dipped below 4%, the lowest level since 1981. One can argue that demographic forces are at work here but Germany has the highest concentration of robots relative to workers globally.

Chatham House – Robots and pensioners to the rescue – examines a different aspect of automation and demographics, focussing on Japan:-

Bleak demographics saddle Japan with a potential growth rate of less than 1 per cent, economists say, unless there are aggressive moves to accept more immigrants, boost the role of women in the workforce and overhaul workplace inefficiencies to increase productivity.

Yet despite its real and chronic problems, Japan may arguably be faring better than the image often projected of a country on the brink of an abyss. Japan still feels safe, prosperous and dazzlingly futuristic. While the overall economy has stagnated, GDP per head has outperformed most of the developed world, including Germany and France, according to World Bank figures − partly a consequence of the population crunch…

Most importantly, a shrinking population fosters innovation to boost productivity. Writing in the Financial Times, Michael Lind, a senior fellow at New America, a Washington think-tank, argued that a labour shortage can be a blessing rather than a curse: ‘Where labour is scarce and expensive, businesses have an incentive to invest in labour-saving technology,’ he wrote, ‘which boosts productivity growth by enabling fewer workers to produce more.’

That is precisely what is happening in today’s Japan, with investment pouring into robotics, industrial automation and artificial intelligence. Furuta notes that a similar phenomenon took place in 18th-century Japan, under the Tokugawa shoguns, when sharp population declines due to famine and natural disaster spurred an age of innovation in science, the arts and agriculture. Such thinking has prompted Prime Minister Abe to embrace the idea that Japan’s population crunch may have a silver lining: ‘Japan may be losing its population. But these are incentives,’ Abe said in a speech last year. ‘Japan’s demography, paradoxically, is not an onus, but a bonus.’

In my previous Macro Letter – No 72 – Low cost manufacturing in Asia – The Mighty Five – MITI V – I reproduced the latest Deloitte Global Manufacturing Competitiveness Index, here it is again:-

Source: Deloitte

The MITI V are all expected to rise up the competitiveness ranking over the next three years – with the exception of Thailand which remains unchanged in 14^thplace.

I remain optimistic about emerging market growth, but keep in mind the industries which will benefit from technology and those which will be harmed. For example, the software developers of India look well placed to thrive; the garment workers of China may not.

March 10, 2017 by In the long run

Low cost manufacturing in Asia – The Mighty Five – MITI V

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Macro Letter – No 72 – 10-03-2017

Low cost manufacturing in Asia – The Mighty Five – MITI V

Low cost manufacturing is moving away from China
Malaysia, India, Thailand, Indonesia and Vietnam will continue to benefit
Currency risks remain substantial
Stock market valuations are not cheap but they offer long term value

The MITI V is the latest acronym to emerge from the wordsmiths at Deloitte’s. Malaysia, India, Thailand, Indonesia and Vietnam. All these countries have a competitive advantage over China in the manufacture of labour intensive commodity type products like apparel, toys, textiles and basic consumer electronics. According to Deloitte’s 2016 Global Manufacturing Competitiveness Index they are either among, or destined to join, the top 15 most competitive countries in the world for manufacturing, by the end of the decade. Here is the Deliotte 2016 ranking:-

Deloitte_-_gx-us-global-manufacturing-table-rankin

Source: Deliotte

The difficulty with grouping disparate countries together is that their differences are coalesced. Malaysia and Thailand are likely to excel in high to medium technology industries, their administrations are cognizant of the advantages of international trade. India, whilst it has enormous potential, both as an exporter and as a manufacturer for its vast domestic market, has, until recently, been less favourably disposed towards international trade and investment. Vietnam continues to benefit from its proximity to China. Indonesia, by contrast, has struggled with endemic corruption: its economy is decentralised and this vast country has major infrastructure challenges.

The table below is sorted by average earnings:-

MITI_V_-_Stats

Source: World Bank, Trading Economics

India and Vietnam look well placed to become the low-cost manufacturer of choice (though there are other contenders such as Bangladesh which should not be forgotten when considering comparative advantage).

Another factor to bear in mind is the inexorable march of technology. Bill Gates recently floated the idea of a Robot Tax, it met with condemnation in many quarters – Mises Institute – Bill Gates’s Robot Tax Is a Terrible Idea – examines the issue. The mere fact that a Robot Tax is being contemplated, points to the greatest single challenge to low-cost producers of goods, namely automation. Deliotte’s does not see this aspect of innovation displacing the low-cost manufacturing countries over the next few years, but it is important not to forget this factor in one’s assessment.

Before looking at the relative merits of each market from an investment perspective, here is what Deliotte’s describe as the opportunities and challenges facing each of these Asian Tigers:-

Malaysia

…has a low cost base with workers earning a quarter of what their counterparts earn in neighboring Singapore. The country also remains strongly focused on assembly, testing, design, and development involved in component parts and systems production, making it well suited to support high-tech sectors.

…is challenged by a talent shortage, political unrest, and comparatively low productivity.

India

Sixty-two percent of global manufacturing executives’ surveyed rank India as highly competitive on cost, closely mirroring China’s performance on this metric.

…highly skilled workforce and a particularly rich pool of English speaking scientists, researchers, and engineers which makes it well-suited to support high-tech sectors. India’s government also offers support in the form of initiatives and funding that focus on attracting manufacturing investments.

…challenged by poor infrastructure and a governance model that is slow to react

…As 43 percent of its US$174 billion in manufacturing exports require high-skill and technological intensity, India may have a strong incentive to solve its regulatory and bureaucratic challenges if it is to strengthen its candidacy as an alternative to China.

Thailand

When it comes to manufacturing exports (US$167 billion in 2014), Thailand stands slightly below India, but exceeds Malaysia, Vietnam, and Indonesia. This output is driven largely by the nation’s skilled workforce and high labor productivity, supported by a 90 percent national literacy rate, and approximately 100,000 engineering, technology, and science graduates every year.

…highly skilled and productive workforce creates relatively high labor costs at US$2.78 per hour in 2013.

…remains attractive to manufacturing companies, offering a lower corporate tax rate (20 percent) than Vietnam, India, Malaysia or Indonesia. Already well established with a booming automotive industry, Thailand may provide an option for manufacturers willing to navigate the political uncertainty that persists in the region.

Indonesia

Manufacturing labor costs in Indonesia are less than one-fifth of those in China.

…The island nation’s overall 10-year growth in productivity (50 percent) exceeds that of Thailand, Malaysia, and Vietnam,

…manufacturing GDP represents a significant portion of its overall GDP and with such a strong manufacturing focus, particularly in electronics, coupled with the sheer size of its population, Indonesia remains high on the list of alternatives for manufacturers looking to shift production capacity away from China in the future.

Vietnam

…comparatively low overall labor costs.

…has raised its overall productivity over the last 10 years, growing 49 percent during the period, outpacing other nations like Thailand and Malaysia. Such productivity has prompted manufacturers to construct billion-dollar manufacturing complexes in the country.

Deliotte’s go on to describe the incentives offered to multinational corporations by these countries:-

(1) numerous tax incentives in the form of tax holidays ranging from three to 10 years, (2) tax exemptions or reduced import duties, and (3) reduced duties on capital goods and raw materials used in export-oriented production.

Forecasts for 2017

In the nearer term the MITI V have more varied prospects, here are Focus Economics latest consensus GDP growth expectations from last month:-

Malaysia Economic Outlook 2017 GDP forecast 4.3%

…GDP recorded the strongest performance in four quarters in Q4, expanding at a better-than-expected rate of 4.5%.

…acceleration in fixed investment and resilient private consumption. Exports also showed a significant improvement, growing at the fastest pace since Q4 2015, thanks to a weaker ringgit and rising oil prices. However, the external sector’s net contribution to growth remained stable as imports also gained steam. Government consumption, which contracted for the first time since Q2 2014, was the only drag on growth in Q4, reflecting the government’s commitment to its fiscal consolidation agenda for 2016.

India Economic Outlook 2017 GDP forecast – 7.4%

Economic activity is beginning to firm after demonetization shocked the economy in the October to December period. The manufacturing PMI crossed into expansionary territory in January and imports rebounded.

…Despite the backdrop of more moderate growth, the government stuck to a market friendly budget for FY 2017

…which was presented on 1 February, pursues growth-supportive policies while targeting a narrower deficit of 3.2% of GDP…

…five states will conduct elections in February, with results to be announced on 11 March. The elections will test the electorate’s mood regarding the government after the economy’s tumultuous past months and ahead of the 2019 general vote.

Thailand Economic Outlook 2017 GDP forecast 3.2%

Growth decelerated mildly in the final quarter of 2016 due to subdued private consumption and a smaller contribution from the external sector. The economy expanded 3.0% annually in Q4, down from 3.2% in Q3.

…January, consumer confidence hit a nearly one-year high, while business sentiment receded mildly. On 27 January, the government announced supplementary fiscal stimulus of USD 5.4 billion for this year’s budget, which ends in September. The sum will be disbursed specifically in rural areas in a bid to close the growing inequality between urban and rural infrastructure and income. This shows that the military government is set to continue providing fiscal stimulus to GDP this year, which should spill over in the private sector via higher employment and improved economic sentiment.

Indonesia Economic Outlook 2017 GDP forecast 5.2%

…economy lost steam in the fourth quarter of last year as diminished government revenues caused public spending to fall at a multi-year low.

…household consumption remained healthy and the recent uptick in commodities prices boosted export revenues.

…for the start of 2017…momentum firmed up: the manufacturing PMI crossed into expansionary territory in January and surging exports pushed the trade surplus to an over three-year high.

…poised for a credit ratings upgrade after Moody’s elevated its outlook from stable to positive on 8 February. All three major ratings agencies now have a positive outlook on Indonesia’s credit rating and an upgrade could be a catalyst for improving investor sentiment.

Vietnam Economic Outlook 2017 GDP forecast 6.4%

…particularly strong performance in the external sector in 2016. Despite slower demand from important trading partners, merchandise exports, which consist largely of manufactured goods, grew 9.0% annually. The manufacturing sector is quickly expanding thanks to the country’s competitive labor costs, fueling manufacturing exports and bolstering job creation in the sector.

…industrial production nearly stagnated in January, it mostly reflected a seasonal effect from the Lunar New Year, which disrupted supply chains across the region.

…manufacturing Purchasing Manager’s Index, though it inched down in January, continues to sit well above the 50-point line, reflecting that business conditions remain solid in the sector. Moreover, the New Year festivities boosted retail sales, which grew robustly in January.

Currency Risk

The table below shows the structural nature of the MITI V’s exchange rate depreciation against the US$. The 20 year column winds the clock back to the period just before the Asian Financial Crisis in 1997:-

Currency_changes_MITI_V (1)

Source: Trading Economics, World Bank

Looking at the table another way, when investing in Indonesia it would make sense to factor in a 4% annual decline in the value of the Rupiah, a 2.2% to 2.4% decline in the Ringgit, Rupee and Dong and a 1.3% fall in the value of the Baht.

The continuous decline in these currencies has fuelled inflation and this is reflected to the yield and real yields available in their 10 year government bond markets. The table below shows the current bond yields together with inflation and their governments’ fiscal positions:-

MITI_V_-_Bonds_Inflation_Fiscal

Source: Trading Economics

Indonesian bonds offer insufficient real-yield to cover the average annual decline in the value of the Rupiah. Vietnam has an inverted yield curve which suggests shorter duration bonds would offer better value, its 10 year maturity offers the lowest real-yield of the group.

Whilst all these countries are running government budget deficits, Malaysia, Thailand and Indonesia have current account surpluses and Indonesia’s government debt to GDP is a more manageable 27% – this is probable due to its difficulty in attracting international investors on account of the 82% decline in its currency over the past two decades.

Stock Market Valuations

All five countries have seen their stock markets rise this year, although the SET 50 (Thailand) has backed off from its recent high. To compare with the currency table above here are the five stock markets, plus the S&P500, over one, two, five, ten and twenty years:-

MITI_V and US_Stocks_in_20yr

Source: Investing.com

For the US investor, India and Indonesia have been the star performers since 1997, each returning more than six-fold. Thailand, which was at the heart of the Asian crisis of 1997/98, has only delivered 114% over the same period whilst Malaysia, which imposed exchange controls to stave off the worst excesses of the Asian crisis, has failed to deliver equity returns capable of countering the fall in its currency. Finally, Vietnam, which only opened its first stock exchange in 2000, is still recovering from the boom and bust of 2007. The table below translates the performance into US$:-

MITI_V_-_Stock_performance_in_US_20yr

Source: Investing.com

Putting this data in perspective, over the last five years the S&P has beaten the MITI V not only in US$, but also in absolute terms. Looking forward, however, there are supportive valuation metrics which underpin some of the MITI V stock markets. The table below is calculated at 30-12-2016:-

MITI_V_PEs_etc

Source: Starcapital.de, *Author’s estimates

Conclusion and Investment Opportunities

Vietnamese stocks look attractive, the country has the highest level of FDI of the group (6.1% of GDP) but there is a favourable case for investing in the stocks of the other members of the MITI V, even with FDI nearer 3%. They all have favourable demographics, except perhaps Thailand, and its age dependency ratio is quite low. High literacy, above 90% in all except India, should also be advantageous.

Thailand and Malaysia look less expensive from a price to earnings perspective, than India and Indonesia. Their dividend yields also look attractive relative to their bond yields, perhaps a hangover from the Asian Crisis of 1997.

Technically all five stock markets are at or near recent highs:-

MITI_V_-_stocks_-_distance_to_high

Source: Investing.com

The Vietnamese VN Index is a long way below its high and on a P/E, P/B and dividend yield basis it is the cheapest of the five stock markets, but it is worth remembering that it is still regarded at a Frontier Market, It was not included in the MSCI Emerging Markets indices last year. This remains a prospect at the next MSCI review in May/June.

Given how far global equity markets have travelled since the November US elections, it makes sense to be cautious about stock markets in general. Technically a break to new highs in any of these markets is likely to generate further upside momentum but Vietnam looks constructive both over the shorter term (as it makes new highs for the year) and over the longer term (being well below its all-time highs of 2007). In the Long Run, I expect these economies to the engines of world growth and their stock markets to reflect that growth.

January 27, 2017 by In the long run

The Risks and Rewards of Asian Real Estate

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Macro Letter – No 69 – 27-01-2017

The Risks and Rewards of Asian Real Estate

Shanghai house prices increased 26.5% in 2016
International investment in Asian Real Estate is forecast to grow 64% by 2020
Chinese and Indian Real Estate has underperformed US stocks since 2009
Economic and demographic growth is supportive Real Estate in several Asian countries

Donald Trump may have torn up the Trans-Pacific Partnership trade agreement, but the economic fortunes of Asia are unlikely to be severely dented. This week Blackstone Group – which at $102bln AUM is one of the largest Real Estate investors in the world – announced that they intend to raise $5bln for a second Asian Real Estate fund. Their first $5bln fund – Blackstone Real Estate Partners (BREP) Asia – which launched in 2014, is now 70% invested and generated a 17% return through September 2016. Blackstone’s new vehicle is expected to invest over the next 12 to 18 months across assets such as warehouses and shopping malls in China, India, South-East Asia and Australia.

Last year 22 Asia-focused property funds raised a total of $10.6bln. Recent research by Preqin estimates that $33bln of cash is currently waiting to be allocated by existing Real Estate managers.

Blackrock, which has $21bln in Real Estate assets, predicts the amount invested in Real Estate assets will grow by 75% in the five years to 2020. In their March 2016 Global Real Estate Review they estimated that Global REITs returned 10% over five years, 6% over 10 years and 11% over 15 years.

This year – following the lead of countries such as Australia, Japan and Singapore – India is due to introduce Real Estate Investment Trusts (REITs) they also plan to permit infrastructure investment trusts (InvITs). Other Asian markets have introduced REITs but not many have been successful in achieving adequate liquidity. India, however, has the seventh highest home ownership rate in the world (86.6%) which bodes well for potential REIT investment demand.

UK asset manager M&G, make an excellent case for Asian Real Estate, emphasis mine:-

Exposure to a diversified and maturing region which accounts for a third of the world’s economic output and offers a sustainable growth premium over the US and Europe.

Diversification benefits. An allocation to Asian real estate boosts risk-adjusted returns as part of a global property portfolio; plus there are diverse opportunities within Asia itself.

Defensive characteristics, with underlying occupier demand supported by robust economic fundamentals, as showcased by Asia’s resilience during the European and US downturns of the recent financial crisis.

What M&G omit to mention is that investing in Real Estate is unlike investing in stocks (Companies can change and evolve) or Bonds which exhibit significant homogeneity – Real Estate might be termed the ultimate Fixed Asset – Location is a critical part of any investment decision. Mark Twain may have said, “Buy land. They’re not making it anymore.” but unless the land has commercial utility it is technically worthless.

The most developed regions of Asia, such as Singapore, Hong Kong, Japan and Australia, offer similar transparency to North America and Europe. They will also benefit from the growth of emerging Asian economies together with the expansion of their own domestic middle-income population. However, some of these markets, such as China, have witnessed multi-year price increases. Where is the long-term value and how great is the risk of contagion, should the US and Europe suffer another economic crisis?

In 2013 the IMF estimated that the Asia-Pacific Region accounted for approximately 30% of global GDP, by this juncture the region’s Real Estate assets had reached $4.2trln, nearly one third of the global total. During the past decade the average GDP growth of the region has been 7.4% – more than twice the rate of the US or Europe.

The problem for investors in Asia-Pacific Real Estate is the heavy weighting, especially for REIT investors, to markets which are more highly correlated to global equity markets. The MSCI AC Asia Pacific Real Estate Index, for example, is a free float-adjusted market capitalization index that consists of large and mid-cap equity across five Developed Markets (Australia, Hong Kong, Japan, New Zealand and Singapore) and eight Emerging Markets (China, India, Indonesia, Korea, Malaysia, the Philippines, Taiwan and Thailand) however, the percentage weighting is heavily skewed to developed markets:-

Country	Weight
Japan	32.94%
Hong Kong	26.40%
Australia	19.81%
China	9.62%
Singapore	6.30%
Other	4.93%

Source: MSCI

Here is how the Index performed relative to the boarder Asia-Pacific Equity Index and ACWI, which is a close proxy for the MSCI World Index:-

msci_asian_real_estate_etf

Source: MSCI

The MSCI Real-Estate Index has outperformed since 2002 but it is more volatile and yet closely correlated to the Asia-Pacific Equity or the ACWI. The 2008-2009 decline was particularly brutal.

Under what conditions will Real Estate investments perform?

There are several supply and demand factors which drive Real Estate returns, this list is not exhaustive:-
Population growth – this may be due to internal demographic trends, such as higher birth rates, a rising working age population, inward migration or urbanisation.
Geographic constraints – lack of space drives prices higher.
Planning restrictions – limitations on development and redevelopment drive prices higher.
Economic growth – this can be at the country level or on a per-capita basis.
Economic policy – fiscal stimulus, in the form of infrastructure development, drives economic opportunity which in turn drives demand.
Monetary policy – interest rates – especially real-interest rates – and credit controls, drive demand: although supply may follow.
Taxation policy – transaction taxes directly impact liquidity – a decline in liquidity is detrimental to prices. Annual duties based on assessable value, directly reduce returns.
Legal framework – uncertain security of tenure and risk of curtailment or confiscation, reduces demand and prices.

The markets and countries which will offer lasting diversification benefits are those which exhibit strong economic growth and have low existing international investment in their Real Estate markets. The UN predicts that 380mln people will migrate to cities around the world in the next five years – 95mln in China alone. It is these metropoles, in growing economies, which should be the focus of investment. Since 1990, an estimated 470 new cities have been established in Asia, of which 393 were in China and India.

In their January 2017 update, the IMF – World Economic Outlook growth forecasts for Asian economies have been revised downwards, except for China:-

Country/Region	2017	Change
ASEAN*	4.90%	-0.20%
India	7.20%	-0.40%
China	6.50%	0.40%

*Indonesia, Malaysia, Philippines, Thailand, Vietnam

Source: IMF

The moderation of the Indian forecast is related to the negative consumption shock, induced by cash shortages and payment disruptions, associated with the recent currency note withdrawal. I am indebted to Focus Economics for allowing me to share their consensus forecast for February 2017. It is slightly lower for China (6.4%) and slightly higher for India (7.4%) suggesting that Indian growth will be less curtailed.

China and India

Research by Knight Frank and Sumitomo Mitsui from early 2016, indicates that the Prime Yield on Real Estate in Bengaluru was 10.5%, in Mumbai, 10% and 9.5% in Delhi. With lower official interest rates in China, yields in Beijing and Shanghai were a less tempting 6.3%. These yields remain attractive when compared to London and New York at 4%, Tokyo at 3.7% and Hong Kong 2.9%. They are also well above the rental yields for the broader residential Real Estate market – India 3.10% and China 3.20%: it’s yet another case of Location, Location, Location.

This brings us to three other risk factors which are especially pertinent for the international Real Estate investor: currency movements, capital flows and the correlation to US stocks.

Since the Chinese currency became tradable in the 1990’s it has been closely pegged to the value of the US$. After 2006 the currency was permitted to rise from USDCNY 8.3 to reach USDCNY 6.04 in 2014. Since then the direction of the Chinese currency has reversed, declining by around 15%.

This recent currency depreciation may be connected to the reversal in capital flows since Q4, 2014. Between 2000 and 2014 China saw $3.6trln of inflows, around 60% of which was Foreign Direct Investment (FDI). Since 2014 these flows have reversed, but the rate of outflow has been modest; the trickle may become a spate, if the new US administration continues to shoot from the hip. A move back to USDCNY 8.3 is not inconceivable:-

usdcny-1994-2017

Source: Trading Economics

Chinese inflation has averaged 3.86% since 1994, but since the GFC it has moderated to an annualised 2.38%.

The Indian Rupee, which has been freely exchangeable since 1993, has been considerably more volatile: and more inclined to decline. The chart below covers the period since January 2007:-

usdinr-10-yr

Source: Trading Economics

Since 1993 Indian inflation has averaged 7.29%, but since 2008 it has picked up to 8.65%. The sharp currency depreciation in 2013 saw inflation spike to nearly 11% – last year it averaged 5.22% helped, by declining oil prices. Official rates, which hit 8% in 2014, are back to 6.25%, bond yields have fallen in their wake. Barring an external shock, Indian inflation should trend lower.

Capital flows have had a more dramatic impact on India than China, due to the absence of Indian exchange controls. A February 2016 working paper from the World Bank – Capital Flows and Central Banking – The Indian Experience concludes:-

Going forward, under the new inflation targeting framework, monetary policy will likely respond even more than before to meet the inflation target and adjust less than before to the capital flow cycles. One concern some people have with the move of a developing country such as India to inflation targeting is that it could result in greater exchange rate flexibility. Having liberalized the capital account progressively over the last two and a half decades, the scope to use capital flow measures countercyclically has perhaps diminished as well.

Thus in years ahead, reserve management and macroprudential measures are likely to play a more significant role in helping respond to capital flow cycles, just as the policy makers and the economy develop greater tolerance for exchange rate adjustments.

The surge and sudden stop nature of international capital flows, to and from India, are likely to continue; the most recent episode (2013) is sobering – the Rupee declined by 28% against the US$ in just four months, between May and August. The Sensex Stock Index fell 10.3% over the same period. The stock Index subsequently rallied 72%, making a new all-time high in March 2015. Since March 2015 the Rupee has weakened by a further 10.3% versus the US$ and the stock market has declined by 7.7% – although the Sensex was considerably lower during the Emerging Market rout of Q1, 2016.

Stock market correlations are the next factor to investigate. The three year correlation between the S&P500 and China is 0.37 whilst for India it is 0.60. Since the Great Financial Crisis (GFC) however, the IMF has observed a marked increase in synchronicity between Asian markets and China. The IMF WP16/173 – China’s Growing Influence on Asian Financial Markets is insightful, the table below shows the rising correlation seen in Asian equity and bond markets:-

imf_china_correlation_rising_-_march_2016

Source: IMF

With so many variables, the best way to look at the relative merits, of China versus India and Real Estate versus Equities, is by translating their returns into US$. Since the GFC stock market low in March 2009, returns in US$ have been as follows. I have added the current dividend and residential rental yield:-

Index	Performance – March 09 – December 16	Performance in US$	Current Yield
S&P500	207%	207%	2%
FHFA House Price Index (US)	9.70%	9.70%	2.20%
Shanghai Composite (China)	50%	49.20%	4.20%
Shanghai Second Hand House Price Index	74%	72.85%	3.20%
S&P BSE Sensex (India)	204%	135.25%	1.50%
National Housing Bank Index (India)	58%*	38.45%	3.10%
*Data to end Q1 2016

Source: Investing.com, FHFA, eHomeday, National Housing Bank, Global Property Guide

There are a number of weaknesses with this analysis. Firstly, it does not include reinvested income from dividends or rent – whilst the current yields are deceptively low. Data for the S&P500 suggests reinvested dividend income would have added a further 40% to the return over this period, however, I have been unable to obtain reliable data for the other markets. Secondly, the rental yield data is for residential property. You will note that Frank Knight estimate Prime Yields for Bengaluru at 10.5%, 10% for Mumbai and 9.5% for Delhi. Prime Yields in Beijing and Shanghai offer the investor 6.3% – Location, Location, Location.

The chart below shows the evolution of the Shanghai Second Hand House Price Index since 2003:-

china_-_ehomeday_-_shanghai_second_hand_house_pric

Source: eHomeday, Global Property Guide

For comparison here is the National Housing Bank Index since 2007:-

Source: National Housing Bank, Global Property Guide

Finally, for global comparison, this is the FHFA – House Price Index going back to 1991:-

us_-_federal_housing_finance_agency_-_house_price_

Source: FHFA, Global Property Guide

The Rest of Asia

In this Letter I have focused on China and India, but this article is about Asian Real Estate. The 2004-2014 annual return on Real Estate investment in Hong Kong was 14.4% – the market may have cooled but demand remains. Singapore has delivered 11.7% per annum over the same period. Cities such as Kuala Lumpur and Bangkok remain attractive. Vietnam, with a GDP forecast of 6.6% for 2017 and favourable demographics, offers significant potential – Hanoi and Ho Chi Minh are the cities on which to focus. Indonesia and the Philippines also offer economic and demographic potential, Jakarta and Manilla having obvious appeal. The table below, sorted by the Mortgage to Income ratio, compares the valuation for residential property and economic growth across the region:-

Country	Price/Income Ratio	Rental Yield City	Price/Rent Ratio City	Mortgage As % of Income	GDP f/c 2017
Malaysia	9.53	4.07	24.6	72.87	4%
Taiwan	12.87	1.54	64.91	78.76	1.80%
South Korea	12.38	2.04	49.1	85.47	2.40%
India	10.28	3.08	32.44	123.44	7.40%
Singapore	21.63	2.75	36.41	134.33	1.60%
Pakistan	12.09	4.08	24.51	156.97	5.10%
Philippines	16.91	3.75	26.69	162.87	6.60%
Bangladesh	12.89	3.25	30.81	181.3	6.80%
China	23.29	2.23	44.83	189.71	6.40%
Mongolia	15.77	9.78	10.22	203.47	1.80%
Thailand	24.43	3.8	26.29	212.03	3.30%
Hong Kong	36.15	2.25	44.35	224.85	1.80%
Sri Lanka	17.49	4.91	20.38	238.64	4.80%
Indonesia	21.03	4.67	21.41	247.68	5.10%
Vietnam	26.76	4.52	22.1	285.55	6.60%
Cambodia	24.32	7.44	13.44	292.43	7%

Source: Numbeo, Focus Economics, Trading Economics

There are opportunities and contradictions which make it difficult to draw investment conclusions from the table above: and this is just a country by country analysis.

Conclusions and Investment Opportunities

Real Estate, more so than any of the other major asset classes, is individual asset specific. Since we are looking for diversification we need to evaluate the two types of collective vehicle available to the investor.

Investing via REITs exposes you to the volatility of the stock market as well as the underlying asset. Investing directly via unlisted funds has been the preferred choice of pension fund managers in the UK for many years. There are pros and cons to this approach, but, for diversification, this is likely to be the less correlated strategy. Make sure, however, that you understand the liquidity constraints, not just of the fund, but also of the constituents of the portfolio. The GFC was, in particular, a crisis of liquidity: and property is not a liquid investment.

Unsurprisingly Norway’s $894bln Sovereign Wealth Fund – Norges Bank Investment Management – invests in Real Estate for the long run. This is how they describe their approach to the asset class, emphasis mine:-

The fund invests for future generations. It has no short term liabilities and is not subject to rules that could require costly adjustments at inopportune times.

…Our goal is to build a global, but concentrated, real estate portfolio…The strategy is to invest in a limited number of major cities in key markets.

According to Institutional Real Estate Inc. the largest investment managers in the Asia-Pacific Region at 31^st December 2014 were. I’m sure they will be happy to take your call:-

Investment Manager	Asian AUM $Blns	Total AUM $Blns
UBS Global Asset Management	9.33	64.89
Global Logistic Properties	9.26	20.14
CBRE Global Investors	8.56	91.27
LaSalle Investment Management	8.05	55.75
Blackstone Group	7.58	121.88
Alpha Investment Partners	7.48	8.70
Blackrock	7.32	22.92
Pramerica Real Estate Investors	6.84	59.17
Gaw Capital Partners	6.64	9.16
Prologis	6.08	29.98

Source: Institutional Real Estate Inc.

In their August 2016 H2, 2016 Outlook, UBS Global Asset Management made the following observations:-

Although property yields across the APAC region are at, or close to, historical lows, demand for real estate exposure in a multi-asset context is set to remain healthy in the near-to-medium term. Capital inflows into the asset class will continue to be supported by broad structural shifts across the region related to demographics and demand for income producing assets on the one hand, and (ex-ante) excess supply of private (household and/or corporate) sector savings on the other. Part of this excess savings will continue to find its way into real estate, both in APAC and in other regions…

Real Estate investment in Asia offers opportunity in the long run, but for markets such as Shanghai (+26.5% in 2016) the next year may see a return from the ether. India, by contrast, has stronger growth, stronger demographics, higher interest rates and an already weak currency. The currency may not offer protection, inflation is still relatively high and the Rupee has been falling for decades – nonetheless, Indian cities offer a compelling growth story for Real Estate investors. Other developing Asian countries may perform better still but they are likely to be less liquid and less transparent. The developed countries of the region offer greater transparency and liquidity but their returns are likely to be lower. A specialist portfolio manager offers the best solution for most investors – that’s assuming you’re not a Sovereign Wealth Fund.

November 25, 2016 by In the long run

Protectionism: which countries have room for fiscal expansion?

Macro Letter – No 66 – 25-11-2016

Protectionism: which countries have room for fiscal expansion?

As globalisation goes into reverse, fiscal policy will take the strain
Countries with government debt to GDP ratios <70% represent >45% of global GDP
Fiscal expansion by less indebted countries could increase total debt by at least $3.48trln

…But now I only hear

Its melancholy, long, withdrawing roar…

Matthew Arnold – Dover Beach

Over the course of 2016 the world’s leading central banks have subtly changed their approach to monetary policy. Although they have not stated that QE has failed to stimulate global growth they have begun to pass the baton for stimulating the world economy back to their respective governments.

The US election has brought protectionism and fiscal stimulus back to the centre of economic debate: but many countries are already saddled with uncomfortably high debt to GDP ratios. Which countries have room for manoeuvre and which governments will be forced to contemplate fiscal expansion to offset the headwinds of protectionism?

Anti-globalisation – the melancholy, long, withdrawing roar

The “Elephant” chart below explains, in economic terms, the growing political upheaval which has been evident in many developed countries:-

Source: The Economist, World Bank, Lakner and Milanovic

This chart – or at least the dark blue line – began life in a World Bank working paper in 2012. It shows the global change in real-income, by income percentile, between 1988 and 2008. The Economist – Shooting an elephant provides more information.

What this chart reveals is that people earning between the 70^th and 90^th percentile have seen considerably less increase in income relative to their poor (and richer) peers. I imagine a similar chart up-dated to 2016 will show an even more pronounced decline in the fortunes of the lower paid workers of G7.

The unforeseen consequence to this incredible achievement – bringing so many of the world’s poor out of absolute poverty – has been to alienate many of the developed world’s poorer paid citizens. They have borne the brunt of globalisation without participating in much, if any, of the benefit.

An additional cause for concern to the lower paid of the developed world is their real-inflation rate. The chart below shows US inflation for specific items between 1996 and 2016:-

Source: American Enterprise Institute

At least the “huddled masses yearning to breathe free” can afford a cheaper television, but this is little comfort when they cannot afford the house to put it in.

Anti-globalisation takes many forms, from simple regulatory protectionism to aspects of the climate-change lobby. These issues, however, are not the subject of this letter.

Which countries will lose out from protectionism?

It is too early to predict whether all the election promises of President-elect Trump will come to pass. He has indicated that he wants to impose a 35% tariff on Mexican and, 45% tariff on Chinese imports, renegotiate NAFTA (which the Peterson Institute estimate to be worth $127bln/annum to the US economy) halt negotiations of the TPP and TTIP and, potentially, withdraw from the WTO.

Looking at the “Elephant” chart above it is clear that, in absolute per capita terms, the world’s poorest individuals have benefitted most from globalisation, but the largest emerging economies have benefitted most in monetary terms.

The table below ranks countries with a GDP in excess of $170bln/annum by their debt to GDP ratios. These countries represent roughly 95% of global GDP. The 10yr bond yields were taken, where I could find them, on 21^st November:-

Country	GDP	Base Rate	Inflation	Debt to GDP	10yr yield	Notes
Japan	4,123	-0.10%	-0.50%	229%	0.03
Greece	195	0.00%	-0.50%	177%	6.95
Italy	1,815	0.00%	-0.20%	133%	2.06
Portugal	199	0.00%	0.90%	129%	3.70
Belgium	454	0.00%	1.81%	106%	0.65
Singapore	293	0.07%	-0.20%	105%	2.36
United States	17,947	0.50%	1.60%	104%	2.32
Spain	1,199	0.00%	0.70%	99%	1.60
France	2,422	0.00%	0.40%	96%	0.74
Ireland	238	0.00%	-0.30%	94%	0.98
Canada	1,551	0.50%	1.50%	92%	1.57
UK	2,849	0.25%	0.90%	89%	1.41
Austria	374	0.00%	1.30%	86%	0.54
Egypt	331	14.75%	13.60%	85%	16.95
Germany	3,356	0.00%	0.80%	71%	0.27
India	2,074	6.25%	4.20%	67%	6.30
Brazil	1,775	14.00%	7.87%	66%	11.98
Netherlands	753	0.00%	0.40%	65%	0.43
Israel	296	0.10%	-0.30%	65%	2.14
Pakistan	270	5.75%	4.21%	65%	8.03
Finland	230	0.00%	0.50%	63%	0.46
Malaysia	296	3.00%	1.50%	54%	4.39
Poland	475	1.50%	-0.20%	51%	3.58
Vietnam	194	6.50%	4.09%	51%	6.10
South Africa	313	7.00%	6.10%	50%	8.98
Venezuela	510	21.73%	180.90%	50%	10.57
Argentina	548	25.75%	40.50%	48%	2.99
Philippines	292	3.00%	2.30%	45%	4.40
Thailand	395	1.50%	0.34%	44%	2.68
China	10,866	4.35%	2.10%	44%	2.91
Sweden	493	-0.50%	1.20%	43%	0.52
Mexico	1,144	5.25%	3.06%	43%	7.39
Czech Republic	182	0.05%	0.80%	41%	0.59
Denmark	295	-0.65%	0.30%	40%	0.40
Romania	178	1.75%	-0.40%	38%	3.55
Colombia	292	7.75%	6.48%	38%	7.75
Australia	1,340	1.50%	1.30%	37%	2.67
South Korea	1,378	1.25%	1.30%	35%	2.12
Switzerland	665	-0.75%	-0.20%	34%	-0.15
Turkey	718	7.50%	7.16%	33%	10.77
Hong Kong	310	0.75%	2.70%	32%	1.37
Taiwan	524	1.38%	1.70%	32%	1.41
Norway	388	0.50%	3.70%	32%	1.65
Bangladesh	195	6.75%	5.57%	27%	6.89
Indonesia	862	4.75%	3.31%	27%	7.85
New Zealand	174	1.75%	0.40%	25%	3.11
Kazakhstan	184	12.00%	11.50%	23%	3.82	***
Peru	192	4.25%	3.41%	23%	6.43
Russia	1,326	10.00%	6.10%	18%	8.71
Chile	240	3.50%	2.80%	18%	4.60
Iran	425	20.00%	9.50%	16%	20.00	**
UAE	370	1.25%	0.60%	16%	3.57	*
Nigeria	481	14.00%	18.30%	12%	15.97
Saudi Arabia	646	2.00%	2.60%	6%	3.97	*

Notes

*Estimate from recent sovereign issues

**Estimated 1yr bond yield

***Estimated from recent US$ issue

Source: Trading economics, Investing.com, Bangledesh Treasury

Last month in their semi-annual fiscal monitor – Debt: Use It Wisely – the IMF warned that global non-financial debt is now running at $152trln or 225% of global GDP, with the private sector responsible for 66% – a potential source of systemic instability . The table above, however, shows that many governments have room to increase their debt to GDP ratios substantially – which might be of luke-warm comfort should the private sector encounter difficulty. Interest rates, in general, are at historic lows; now is as good a time as any for governments to borrow cheaply.

If countries with government debt/GDP of less than 70% increased their debt by just 20% of GDP, ceteris paribus, this would add $6.65trln to total global debt (4.4%).

Most Favoured Borrowers

Looking more closely at the data – and taking into account budget and current account deficits -there are several governments which are unlikely to be able to increase their levels of debt substantially. Nonetheless, a sizable number of developed and developing nations are in a position to increase debt to offset the headwinds of US protectionism should it arrive.

The table below lists those countries which could reasonably be expected to implement a fiscal response to slower growth:-

Country	GDP	Debt to GDP	10yr yield	Gov. Debt	70% Ratio	90% Ratio	12m fwd PE	CAPE	Div Yld.
Saudi Arabia	646	6%	3.97	38	452	581	?	?	?
Chile	240	18%	4.60	42	168	216	15.6	?	?
New Zealand	174	25%	3.11	43	122	157	19.3	22	4.1%
Peru	192	23%	6.43	44	134	173	12.1	?	?
Bangladesh	195	27%	6.89	53	137	176	?	?	?
UAE	370	16%	3.57	58	259	333	?	?	?
Colombia	292	38%	7.75	111	204	263	?	?	?
Norway	388	32%	1.65	123	272	349	14.2	11.5	4.3%
Philippines	292	45%	4.40	132	204	263	16.4	22.6	1.6%
Malaysia	296	54%	4.39	160	207	266	15.6	16	3.1%
Taiwan	524	32%	1.41	166	367	472	12.8	19	3.9%
Thailand	395	44%	2.68	175	277	356	13.8	17.7	3.1%
Israel	296	65%	2.14	192	207	266	9.4	14.6	2.8%
Sweden	493	43%	0.52	214	345	444	16.1	19.8	3.6%
Indonesia	862	27%	7.85	233	603	776	14.7	19.6	1.9%
South Korea	1,378	35%	2.12	484	965	1,240	9.6	13.1	1.7%
Australia	1,340	37%	2.67	493	938	1,206	15.6	16.1	4.3%
Mexico	1,144	43%	7.39	494	801	1,030	16.6	22.4	1.9%
India	2,074	67%	6.30	1,394	1,452	1,867	15.9	18.6	1.5%
				4,649	8,114	10,432

Source: Trading economics, Investing.com, Bangledesh Treasury, Star Capital, Yardeni Research

The countries in the table above – which have been ranked, in ascending order, by outstanding government debt – have total debt of $4.65trln. If they each increased their ratios to 70% they could raise an additional $3.47trln to lean against an economic downturn. A 90% ratio would see $5.78trln of new government debt created. This is the level above which economies cease to benefit from additional debt according to Reinhart and Rogoff in their paper Growth in a Time of Debt.

Whilst this analysis is overly simplistic, the quantum of new issuance is not beyond the realms of possibility – India’s ratio reached 84% in 2003, Indonesia’s, hit 87% in 2000 and Saudi Arabia’s, 103% in 1999. Nonetheless, the level of indebtedness is higher than many countries have needed to entertain in recent years – ratios in Australia, Mexico and South Korea, though relatively low, are all at millennium highs.

Apart from the domestic imperative to maintain economic growth, there will be pressure on these governments to pull their weight from their more corpulent brethren. Looking at the table above, if the top seven countries, by absolute increased issuance, raised their debt/GDP ratios to 90%, this would add $3.87trln to global debt.

Despite US debt to GDP being above 100%, the new US President-elect has promised $5.3trln of fiscal spending during his first term. Whether this is a good idea or not is debated this week by the Peterson Institute – What Size Fiscal Deficits for the United States?

Other large developed nations, including Japan, are likely to resort to further fiscal stimulus in the absence of leeway on monetary policy. For developing and smaller developed nations, the stigma of an excessively high debt to GDP ratio will be assuaged by the company keep.

Conclusions and investment opportunities

Despite recent warnings from the IMF and plentiful academic analysis of the dangers of excessive debt – of which Deleveraging? What Deleveraging? is perhaps the best known – given the way democracy operates, it is most likely that fiscal stimulus will assume the vanguard. Monetary policy will play a supporting role in these endeavours. As I wrote in – Yield Curve Control – the road to infinite QE – I believe the Bank of Japan has already passed the baton.

Infrastructure spending will be at the heart of many of these fiscal programmes. There will be plenty of trophy projects and “pork barrel” largesse, but companies which are active in these sectors of the economy will benefit.

Regional and bilateral trade deals will also become more important. In theory the EU has the scale to negotiate with the US, albeit the progress of the TTIP has stalled. Asean and Mercosur have an opportunity to flex their flaccid muscles. China’s One Belt One Road policy will also gain additional traction if the US embark on policies akin to the isolationism of the Ming Dynasty after the death of Emperor Zheng He in 1433. The trade-vacuum will be filled: and China, despite its malinvestments, remains in the ascendant.

According to FocusEconomics – Economic Snapshot for East & South Asia – East and South Asian growth accelerated for the first time in over two years during Q3, to 6.2%. Despite the economic headwinds of tightening monetary and protectionist trade policy in the US, combined with the very real risk of a slowdown in the Chinese property market, they forecast only a moderate reduction to 6% in Q4. They see that growth rate continuing through the first half of 2017.

Indian bond yields actually fell in the wake of the US election – from 6.83% on 8^th to 6.30% by 21^st. This is a country with significant internal demand and capital controls which afford it some protection. Its textile industry may even benefit in the near-term from non-ratification of the TPP. Indian stocks, however are not particularly cheap. With a PE 24.3, CAPE 18.6, 12 month forward PE 15.9 the Sensex index is up more than 70% from its December 2011 lows.

Stocks in Israel, Taiwan and Thailand may offer better value. They are the only emerging countries which offer a dividend yield greater than their bond yield. Taiwanese stocks appear inexpensive on a number of other measures too. With East and South Asian growth set to continue, emerging Asia looks most promising.

A US tax cut will stimulate demand more rapidly than the boost from US fiscal spending. Protectionist tariffs may hit Mexico and China rapidly but other measures are likely to be implemented more gradually. As long as the US continues to run a trade deficit it makes sense to remain optimistic about several of the emerging Asian markets listed in the table above.

March 6, 2015 by In the long run

China versus India – Currencies, Reform and Growth

Macro Letter – No 31 – 06-03-2015

China versus India – Currencies, Reform and Growth

India announced a reformist budget, short on detail but market friendly
The PBoC cut interest rates again but are still behind the curve
Chinese and Indian Real-Estate prices continue to decline in real terms
INR/CNY exchange rate will move higher

Last month PWC – The World in 2050 – produced a long-term forecast for economic growth in which they predicted that India could become the second largest economy in the world by 2050 in purchasing power parity (PPP) and third largest in market exchange rate (MER) terms. Putting the scale of world economies in to perspective they say:-

China has already overtaken the US for the number one spot, and will remain as the world’s largest economy in 2050. India could narrowly overtake the US for the number two spot by 2050. However, the gap between the third largest economy and the fourth largest economy will widen considerably. In 2014, the third biggest economy (India) is around 50% larger than the fourth biggest economy (Japan). In 2050, the third biggest economy (the US) is projected to be approximately 240% larger than the fourth biggest economy (Indonesia).

The prospects from the BRIC economies are mixed. Russia is entangled in the geo-politics of the Ukraine and its economy has suffered from falling energy prices as this article from Chatham House – Troubled Times: Stagnation, Sanctions and the Prospects for Economic Reform in Russia explains. Meanwhile Brazil, still reeling from the stagnation of 2013, looks set to head into a fully-fledged recession exacerbated by high, wage-squeezing, inflation resulting from the near 30% decline in its currency. The prospects for India and China are much better.

India

Last week Arun Jaitley, India’s finance minister, announced a budget which he described as “a quantum jump”. Among other things, he intends to:-

Implement an RBI inflation target
Maintain a national government budget deficit of 4.1% of GDP in cash terms
Target a budget reduction to 3% of GDP in 2017-2018
Increase Spending on road construction and power generation
Streamline subsidies and accelerate the de-nationalization of state industries
Introduce a harmonised goods and sales tax, by April 2016, to replace state and federal levies – potentially adding 2% to GDP by creating an India-wide “common market”
Rationalise direct-taxation – cutting corporation tax but closing loopholes, abolishing a wealth tax in favour of an income tax surcharge on higher earners

This amounts to a decidedly reformist agenda, although the speech was light on detail. It removes several barriers to investment in India, although the issue of reform of land laws remains unresolved.

China

Meanwhile, last Saturday, the People’s Bank of China (PBoC) cut interest rates. This is the third accommodative move in as many months. Their motivation appears to be three-fold:-

Stimulate Credit Growth.
The fall in credit as measured by “total social financing” -13.5% y/y in January 2015 versus a +17.5% in January 2014. This may also allow SOEs and SMEs to service existing debt acquired during the indiscriminate credit expansion of 2009.
Alleviate Falling inflation.
The inflation rate has declined by 1.7% since Q4 2014. Lending rates are only 20bp lower over the same period. In other word a “real” tightening of 1.5% has occurred.
Stem Capital Outflows.
The capital and financial account deficit hit a decade high of $91.2bln in Q4 2014. This is a sharp deterioration, in 2013 the capital account surplus for the year was $326.2bln

This action may still not be sufficient to re-invigorate the Chinese economy. It fuels hopes for further accommodation later this year. This could take the form of lower interest rates, additional liquidity, reduction in bank reserve requirements or some form of fiscal stimulus. Last year the Chinese government budget deficit was 2.1% of GDP, there is plenty of room for manoeuver.

China and India as economic dynamos

Before delving into the details of monetary policy in each country, it is worth taking a broad overview of the Chinese and Indian economies from a global perspective.

The table below shows the major economic regions of the world ranked by population: –

Country	GDP-YOY	Interest Rate	Inflation Rate	Jobless Rate	Debt/GDP	C/A	Population
China	7.30%	5.35%	0.80%	4.10%	22.40%	2	1360.72
India	7.50%	7.75%	5.11%	5.20%	67.72%	-1.7	1238.89
EA	0.90%	0.05%	-0.30%	11.20%	90.90%	2.4	334.57
USA	2.40%	0.25%	-0.10%	5.70%	101.53%	-2.3	318.86
Brazil	-0.20%	12.25%	7.14%	5.30%	56.80%	-4.17	202.77
Russia	0.70%	15.00%	15.00%	5.50%	13.41%	1.56	143.7
Japan	-0.50%	0.00%	2.40%	3.60%	227.20%	0.7	127.02

Source: Trading Economics

India and China stand out as the engines of economic growth. They have a combined population of more than 3.5bln. On a GDP per capita basis both countries have far to go. Indian GDP/Capita is $1,165 and China $3,583, compared to Euro Area $31,807 and USA $45,863. However, as PWC say in their report, the gap between the rich and these relatively poor countries is likely to narrow in percentage terms significantly by 2050.

Here are some more statistics which help to show the similarities and differences between the two economies:-

Criteria	China	India
Age structure	0-14 years: 17.1%	0-14 years: 28.5%
	15-24 years: 14.7%	15-24 years: 18.1%
	25-54 years: 47.2%	25-54 years: 40.6%
	55-64 years: 11.3%	55-64 years: 7%
	65 years and over: 9.6%(2014 est.)	65 years and over: 5.8%(2014 est.)
Median age	total: 36.7 years	total: 27 years
	male: 35.8 years	male: 26.4 years
	female: 37.5 years (2014 est.)	female: 27.7 years (2014 est.)
Population growth rate	0.44% (2014 est.)	1.25% (2014 est.)
Birth rate	12.17 births/1,000 (2014 est.)	19.89 births/1,000 (2014 est.)
Death rate	7.44 deaths/1,000 (2014 est.)	7.35 deaths/1,000 (2014 est.)
Net migration rate	-0.32 migrant(s)/1,000 (2014 est.)	-0.05 migrant(s)/1,000 (2014 est.)
Urbanization – Urban	50.6% of total population (2011)	31.3% of total population (2011)
Rate of Urbanization	2.85% annual (2010-15 est.)	2.47% annual (2010-15 est.)
Major cities – population	Shanghai 20.2mln BEIJING (capital) 15.6mln (2011)	NEW DELHI (capital) 22.6mln Mumbai 19.7mln (2011)
Infant mortality rate	14.79 deaths/1,000 live births	43.19 deaths/1,000 live births
Life expectancy at birth	75.15 years	67.8 years
Total fertility rate	1.55 children born/woman (2014 est.)	2.51 children born/woman (2014 est.)
Infectious diseases	degree of risk: intermediate	degree of risk: very high
Literacy – age 15 (can read and write)	total population: 95.1%	total population: 62.8%
	male: 97.5%	male: 75.2%
	female: 92.7% (2010 est.)	female: 50.8% (2006 est.)
School life expectancy	13 years	12 years
Education expenditures	NA	3.2% of GDP (2011)
Maternal mortality rate	37 deaths/100,000 live births (2010)	200 deaths/100,000 live births (2010)
Children under weight <5yrs	3.4% (2010)	43.5% (2006)
Health expenditures	5.2% of GDP (2011)	3.9% of GDP (2011)
Physicians density	1.46 physicians/1,000 population (2010)	0.65 physicians/1,000 population (2009)
Hospital bed density	3.8 beds/1,000 population (2011)	0.9 beds/1,000 population (2005)
Adult Obesity	5.7% (2008)	1.9% (2008)

Source: Index Mundi

From a Chinese perspective the main elements which stand out in the table above are:-

Slower birth rate, aging population and lower fertility rate – according to the UN China’s working age population will decline by 16% between now and 2050
Higher literacy, especially female literacy
Lower mortality rate and higher health expenditure

For India, improvements in education, sanitation and healthcare are key factors.

Indian Monetary Policy

The Reserve Bank of India (RBI) cut their key Repo Rate in December 2014. Despite falling oil prices they have left this rate unchanged as the effects of the currency devaluation of 2013 work their way through the economy. This is an extract from the RBI Bulletin – February 2015:-

On the basis of an assessment of the current and evolving macroeconomic situation, it has been decided to:-

keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 7.75 per cent;
keep the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand and time liabilities (NDTL);
reduce the statutory liquidity ratio (SLR) of scheduled commercial banks by 50 basis points from 22.0 per cent to 21.5 per cent of their NDTL with effect from the fortnight beginning February 7, 2015;
replace the export credit refinance (ECR) facility with the provision of system level liquidity with effect from February 7, 2015;
continue to provide liquidity under overnight repos of 0.25 per cent of bank-wise NDTL at the LAF repo rate and liquidity under 7-day and 14-day term repos of up to 0.75 per cent of NDTL of the banking system through auctions; and
continue with daily variable rate term repo and reverse repo auctions to smooth liquidity

They go on to defend their hawkish stance on inflation:-

The upside risks to inflation stem from the unlikely possibility of significant fiscal slippage, uncertainty on the spatial and temporal distribution of the monsoon during 2015 as also the low probability but highly inﬂuential risks of reversal of international crude prices due to geo-political events. Heightened volatility in global ﬁnancial markets, including through the exchange rate channel, also constitute a signiﬁcant risk to the inflation assessment. Looking ahead, inﬂation is likely to be around the target level of 6 per cent by January 2016.

Their growth forecasts are also cautious:-

The outlook for growth has improved modestly on the back of disinﬂation, real income gains from decline in oil prices, easier ﬁnancing conditions and some progress on stalled projects. These conditions should augur well for a reinvigoration of private consumption demand, but the overall impact on growth could be partly offset by the weaker global growth outlook and short-run fiscal drag due to likely compression in plan expenditure in order to meet consolidation targets set for the year. Accordingly, the baseline projection for growth using the old GDP base has been retained at 5.5 per cent for 2014-15. For 2015-16, projections are inherently contingent upon the outlook for the south-west monsoon and the balance of risks around the global outlook. Domestically, conditions for growth are slowly improving with easing input cost pressures, supportive monetary conditions and recent measures relating to project approvals, land acquisition, mining, and infrastructure. Accordingly, the central estimate for real GDP growth in 2015-16 is expected to rise to 6.5 per cent with risks broadly balanced at this point.

Since this report GDP data has surprised on the upside and the Indian Finance Ministry even suggested their own forecast could be revised to 8.5% – this is how the Wall Street Journal reported it, last week:-

India is in a “sweet spot,” the report said: Inflation has eased, international investors are bullish on India and the government in New Delhi has a strong mandate for change.

If the Modi administration continues improving the business environment and reducing government interference in the prices of food, fuel and other basic goods, the survey said, India’s GDP eventually could experience double-digit growth. That would give the country more resources to help its poor and provide opportunities for its young, growing middle class.

The combination of a relatively weak currency, declining inflation, accelerating growth and a structural reform package, from a government with a strong mandate from its electorate, are a heady cocktail. The RBI underpins these developments by holding back on interest rate cuts. The INR has taken this to heart as the chart below shows. It is still dangerous for the RBI to aggressively cut interest rates – the moderation in inflation needs to feed through to inflation expectations – but inward foreign direct investment could lead to a steady appreciation in the INR over the next couple of years. I wait for technical confirmation of this trend which could see at least a 61.8% correction of the 2011/2013 range (44-68) around USDINR 53:-

Source: Barchart.com

Chinese Monetary Policy

The Peoples Bank of China (PBoC) announced an interest rate cut last Saturday, lowering the one year rate to 5.35% from 5.6% previously. A PBoC official stated “Deflationary risk and the property market slowdown are two main reasons for the rate cut this time,” The PBoC press release was somewhat drier:-

The one-year RMB benchmark loan interest rate and deposit interest rate will both be lowered by 0.25 percentage points, to 5.35 percent and 2.5 percent, respectively. At the same time, the upper limit of the floating range for deposit interest rates will be raised from 1.2 to 1.3 times the benchmark level in support of market-oriented interest rate reform. Adjustments are made correspondingly to benchmark interest rates on deposits and loans of other maturities, and to deposit and loan interest rates on personal housing provident fund.

This is the second rate cut in four months. They also introduced a Standing Lending Facility to create better liquidity:-

To implement the decisions adopted at the Central Economic Work Conference as well as the requirements of the 2015 PBC Work Conference and PBC Money, Credit and Financial Market Work Meeting, to improve the central bank’s liquidity support channels for small and medium-sized financial institutions, to address seasonal liquidity fluctuations in the run-up to Spring Festival, and to promote stable functioning of the money market, the PBC has decided, based on the reproducible experience from the pilot Standing lending Facility (SLF) program participated by the branch offices in ten provinces (and municipalities), to introduce SLF operations in branch offices nationwide. As a result, the PBC branch offices will provide SLF on collaterals to four categories of local legal-entity financial institutions, i.e., the city commercial banks, rural commercial banks, rural cooperative banks, and rural credit cooperatives.

This followed on from a cut to Bank Reserve Requirements announced on February 5^th:-

The PBC has decided to cut the RMB deposit required reserve ratio for financial institutions by 0.5 percentage points, effective from February 5, 2015. Furthermore, in order to enhance the capacity of financial institutions to support structural adjustment, and to beef up support to small and micro enterprises, the agricultural sector, rural area and farmer, and major water conservancy projects, the PBC has decided to cut the RMB deposit required reserve ratio for city commercial banks and non-county level rural commercial banks that have met the standards of targeted required reserve reduction by an additional 0.5 percentage points, and cut the required reserve ratio for the Agricultural Development Bank of China by an additional 4 percentage points.

The continued pegging of the RMB – within tight parameters – to the US$ means that China is a beneficiary of the rising US$, but this is something of a double-edged sword since the currency appreciation has been damaging for Chinese exporters. The slowing of the Chinese economy over the last few months and PBoC action has heralded a much needed weakening of the CNY rate as this chart shows:-

Source: Barchart.com

The PBoC rate cut will probably not be the last action to stimulate economic activity, being pegged to a currency which has been steadily rising on a trade-weighted basis whilst maintaining a substantial interest rate differential is a difficult long-term operation even for an economy as closed to international capital flows as China. The BIS – Assessing the CNH-CNY pricing differential: role of fundamentals, contagion and policy released this week, discusses some of these issues in greater detail, here is the abstract:-

Renminbi internationalisation has brought about an active offshore market where the exchange rate frequently diverges from the onshore market. Using extended GARCH models, we explore the role of fundamentals, global factors and policies related to renminbi internationalisation in driving the pricing differential between the onshore and offshore exchange rates. Differences in the liquidity of the two markets play an important role in explaining the level of the differential, while rises in global risk aversion tend to increase the differential’s volatility. On the policy front, measures permitting cross-border renminbi outflows have a particularly discernible impact in reducing the volatility of the pricing gap between the two markets.

A weaker RMB would help China more than devaluations have aided other emerging market countries since most of China’s debt is denominated in their own currency, however, a major factor acting as a drag on economic growth is over-investment. At more than 50%, China has the highest level of investment as a percentage of GDP of any major economy – in the UK, by contrast, investment amounts to less than 20%.

Asset Markets

Indian Real-Estate

With relatively high short-term interest rates and uncertainty still hanging over the market due to the currency devaluation of 2013, Indian Real-Estate transactions have been sluggish. In 2014 residential sales were down 30% y/y across India’s seven major cities. A growing inventory of unsold properties is weighing on the domestic banks. Real-Estate accounts for around 13% of Indian bank lending. With non-performing loans on the rise, lower interest rates would be very welcome for the banking sector. The chart below shows the age of property for sale and the length of time these properties are taking to sell in the major cities – a region which accounts for around 70% of India’s property development:-

Source: Knight Frank

The National Housing Bank – a subsidiary of the RBI – publishes an index of prices. With an inverted government bond yield curve (1yr 7.83% vs 10yr 7.68% – 4-3-2015) and a substantial over-hang of inventory, it is not surprising that prices are struggling to make much real upside even in the best areas:-

Source: National Housing Bank

A new government initiative called the Smart Cities Project was launched last year with $1.2bln of funding for 2015. Long-term, this will help to deliver the housing and infrastructure India needs, but, near-term, Real-Estate is an asset class which remains supressed. Many apartment buildings stand empty and whilst real prices have not declined significantly, market activity remains very subdued. I do see value developing; there will be an opportunity to invest over the next couple of years as the economy responds to structural reforms.

Demand will emanate from urbanisation and an increase in high and middle income workers returning to India – after all, the “quality of life” for skilled workers returning home is compelling. A working paper from the Peterson Institute – The Economic Scope and Future of US-India Labor Migration Issues looks at the positive impact of both temporary and permanent Indian labour on US markets, they go on to raise concerns about recent US immigration policy:-

…but US immigration data show that India is by far the most important partner country for both permanent and temporary US employment-based migration: Indian nationals account for about half of all US employment-based permanent migration (e.g., green cards) in recent years.

…The prospects of a US-India totalization agreement for social contributions/taxation as part of an FTA are evaluated. A TA is likely to result in indirect economic losses to the United States from the loss of payroll taxes paid but never claimed by temporary Indian workers in the United States. The substantial political and economic quid pro quo that India would have to commit to in order to incentivize the United States to negotiate a TA would be daunting and seems likely to diminish the attractiveness of an FTA to India.

This 2012 paper from the Institute for European Studies – India’s Returning Elite Knowledge Workers is an excellent insight into the inward migration of skilled workers to the major cities of India’s North East. Here is a summary of the “Brain-Gain”:-

India’s rising independence in the last decade as an economic actor constitutes new issues in global governance for a large skilled workforce. What once constituted a ‘brain-drain’ for Indian actors that emigrated to the Global North (EU and US economic powers), is now resulting in a ‘brain-gain’ for the sending countries. India, as a representative power of the emerging Global South, has been a leader in creating cross-border social networks for entrepreneurship through ties between the Indian expatriate community and local entrepreneurs in industries that are enticing Western agents.

This dissertation project investigates how the ‘brain gain’ of high-skilled entrepreneurs of Indian origin has transformed the landscape of infrastructure and social relations within emergent Global South cities in India based upon elite trans-migrant imaginaries of home. India’s growth as a global power attributed to cross border diasporic networks of Indian transnationals has given rise to a generation of permanently returning migrants to India’s cosmopolitan cities. This paper explores the movement of transnational Indian elites returning from the United States and Europe to postcolonial India. Through ethnographic interviews in Silicon Valley, California, I attempt to understand why social and technological entrepreneurs of Indian origin, those who see their return as a new venture or idea, are returning to accommodate a hybridized Western lifestyle within an Indian socio-cultural context. These entrepreneurs are transforming the peripheries of the cosmopolitan global city through the gated communities where they reside and Special Economic Zones where they work toward developing new business and change in India. By examining the narratives and everyday life of elite diasporic returners in their newfound ‘home’ spaces, I question (a) what are the principle motivations that guide entrepreneurs to return to India (b) whether the cosmopolitan Global South city can function as a hybrid ‘home’ and (c) in locating ‘home’ by transforming their spatial and temporal relationships, how are power relations constituted.

Chinese Real-Estate

Shanghai Real-Estate has risen by 650% since 2000 and by 85% since the last peak in 2007, although nationwide the increase in the period from 2008 to 2013 was a more moderate 20%. The driving force behind this price increase has been urbanisation. In the past 12 years 220mln people have move from rural to urban districts in China. A large number of these new, often unskilled, city dwellers have been employed in construction. It is estimated that 27% of urban Real-Estate is unoccupied. This explains the recent downturn in Chinese Real-Estate prices as this chart of newly built housing shows:-

Source: Trading Economics and National Bureau of Statistics of China

In January the decline was -5.1% versus -4.3% in December and -3.7% in November 2014. Price drops were recorded in 64 of the 70 major cities, compared to 66 in December. Declines are not evenly distributed: the average price of new homes in the country’s four first-tier cities rose for the second consecutive month. The existing housing market is also more buoyant for first-tier cities, rising for the fourth month in a row. In second and third-tier cities prices continue to decline.

Writing in the FT – How addiction to debt came even to China Martin Wolf describes the problem overhanging the Chinese property market:-

China’s huge credit boom has several disquieting features. Much of the rise in debt is concentrated in the property sector; “shadow banking” — that is lending outside the balance sheets of the formal financial institutions — accounts for 30 per cent of outstanding debt, according to McKinsey; much of the borrowing has been put on off-balance-sheet vehicles of local governments; and, above all, the surge in debt was not linked to a matching rise in trend growth, but rather to the opposite.

This does not mean China is likely to experience an unmanageable financial crisis. On the contrary, the Chinese government has all the tools it needs to contain a crisis. It does mean, however, that an engine of growth in demand is about to be switched off. As the economy slows, many investment plans will have to be reconsidered. That may start in the property sector. But it will not end there. In an economy in which investment is close to 50 per cent of GDP, the downturn in demand (and so output) might be far more severe than expected.

Despite this relatively sanguine appraisal of the prospects for the housing market it is worth pointing out that 75% of Chinese individual net worth is tied up in Real-Estate – by way of comparison, in the US the figure is 28%.

Chinese Real-Estate may recover at some point, probably in response to wage growth – currently running at around 8% in real terms, buoyed by state mandated minimum wage increases (13%) and strong growth in private manufacturing (12%). For the present I expect Real-Estate prices to continue to decline. This will eventually exert significant downward pressure on private domestic consumption – an impediment to the policy of “re-balancing”.

Indian Equities

Indian equities have performed strongly due to the currency devaluation, high inflation and relatively strong economic growth. Money supply has moderated in response to higher interest rates but is still sufficient to encourage asset market speculation. The chart below covers the period up to January 2014 but the double digit expansion has continued during the last year:-

Source: RBI

The currency devaluation of 2013 has fed through to higher inflation but the fall in oil prices has narrowed the current account deficit, whilst exports have held up well. This, among other factors, has supported a rise in stocks, despite the RBI’s hawkish stance:-

Source: Bigcharts.com

The SENSEX Index is trading on a current P/E ratio of 18.52. This is still in the lower half of the 5 year range (16.5 to 24). With growth prospects likely to be revised higher, I believe the market will continue to exhibit strong performance over the coming year.

Chinese Equities

The Shanghai Composite performed strongly in Q4 2014 as markets became cognizant of the PBoCs dovish policy shift. Government policy is also supportive, with the continued development of Free Trade Zones remaining high on their agenda. The Jamestown Foundation – “Hope” versus “Hype”: Reforms in China’s Free Trade Zones provides more detail and suggests they may fail to realize their early promise:-

After a year of the Shanghai pilot FTZ, three new FTZs are now being established in the major sea-port cities of Guangdong, Tianjin and Fujian (South China Morning Post, December 13, 2014). Fujian is the closest mainland province to Taiwan, Tianjin specializes in international shipping and related sectors and Guangdong is adjacent to Hong Kong and Macao and is close to Southeast Asia. However, the troubles of the Shanghai FTZ—despite the personal high-level support of Premier Li—suggest that these new FTZs will face an uphill battle in expanding the grounds of economic liberalization in China.

Most Promises Stand Unfulfilled

China’s slowing growth has led many foreign companies to consider scaling back their expansion plans, and the Shanghai FTZ has failed to deliver on the promises of reform that appear necessary to justify foreign companies’ high hopes for a better future business environment in China.

Bi-lateral Free Trade Agreements are also being contemplated. This paper from ECFR – The European interest in an investment treaty with China explores one with the EU:-

Like the EU, China is a global player. Trade and investment talks cannot be viewed in isolation of moves with third parties. Chinese economic agents – from SOEs turning into multilateral firms, to sovereign funds or more dispersed private actors – are in a decisive phase of capital internationalisation as China maintains a large current account surplus.

Recent trade data, however, paints a vulnerable picture in the near-term. This was the data for January, admittedly a notoriously volatile period as it precedes the Chinese New Year: –

Imports -19.9% – forecast -3.2%
Exports -3.3% – forecast +5.9%
Crude oil imports -41.8%
Iron ore imports -50.3%
Coal imports – 61.8%

Another factor impacting the stock market is credit and money supply growth, M2 grew 12.2% in December 2014 down from a high of 13.6% in 2013, however it has regained upward momentum in the last couple of months:-

Source: Cato, John Hopkins University and PBoC

Unless it can be reversed, this declining trend will act as a drag on economic activity. Nonetheless, the stock market has surged ahead – note the dramatic increase in volume traded – anticipating the effect of the PBoC policy shift:-

Source: Bigcharts.com

A longer-term chart shows that the market has some distance to go until it reaches its old highs:-

Source: Trading Economics

The Shanghai Composite is trading on a P/E ratio of 16.33. This is undemanding but the risk of China unpegging and devaluing their currency is a significant risk for the international investor.

Conclusions and Investment Opportunities

Bonds

I have not made much mention of the government bond markets in China or India: it is not because one cannot invest in these markets but due to the relative difficulty of accessing them and their uneven liquidity. They both offer a real yield – China 2.63% and India 2.57% for 10 year (4-3-2015). Both markets are attractive.

Real-Estate

Both China and India are suffering from an overhang of unsold property but the overvaluation is more pronounced in China. India has the additional advantage that interest rates have more room to fall in the event of a sharp downturn in economic activity. India has a younger population and its skilled ex-patriot workers are returning in significant numbers. The Chinese market will take longer to clear. Neither market has finished correcting yet.

Equities

On a price to earnings basis the Shanghai Composite (16.33 times) offers better value than the Sensex (18.52 times) however there is a real risk that the “internationalisation” of the RMB leads to its decline against the US$. The Sensex is making new highs whilst the Shanghai Composite is trading higher after a major correction from the 2008 highs. This is not to suggest that India is trouble free, however, it has more room to grow given its per capita GDP, and less signs of over-investment. Corruption is an issue in both countries but the Chinese administration’s efforts to root out officials who have “feathered their nests” is likely to act as a drag on growth. Indian reform is principally concerned with reducing bureaucratic impediments to the functioning of free markets – closing tax loopholes, reducing state interference in competitive processes and so forth.

The key for growth in both China and India is the inward flow of foreign capital. On January 29^th the UN – Global Investment Trends Monitor – announced that China had become the leading destination for FDI in 2014 ($128bln) for the first time since 2003, however, its growth rate was an incremental 3%. India, by contrast, saw FDI surge by more than 26% to $35bln – this follows a 17% rise in 2013. This trend will continue, accelerated by the reforming zeal of the incumbent regime.

Indian and Chinese interest rates will decline, but Indian rates have more room to fall. Chinese and Indian stocks will rise but, with the currency devaluation behind it, Indian stocks – despite their higher P/E ratio – look better placed to rise.

Currency

Risks for the RMB are on the downside whilst for the INR they are on the upside, the trend is underway:-

Source: Exchangerates.org.uk