Corporate debt in the Emerging Markets highlights the impact of the Great Reckoning, with the US dollar and interest rates rising, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
Corporate borrowers in Emerging Markets (EMs) are now facing higher debt service and capital repayment costs, due to the combined impact of dollar strength and rising benchmark US 10-year interest rates. In turn, this risks creating a vicious circle for growth. The latest data from the Bank for International Settlements (BIS) suggest the EMs’ dollar-denominated debt doubled to $3.2tn between 2009 and March 2016. As the IMF has warned:
“China urgently needs to tackle its corporate-debt problem before it becomes a major drag on growth.”
The BIS identified the underlying issue: “Massive capital flows from advanced economies have contributed to accommodative liquidity conditions in a number of Asian EMs. To the extent that this has led to a region-wide accumulation of imbalances, the eventual correction in one country would likely trigger investor retrenchment from its neighbours and test the region’s loss-absorbing capacity.”
We are probably still at a relatively early stage in the process, as the chart highlights for the four Bric economies.
China, with foreign currency borrowings of $1.2tn in Q3 last year seems most at risk initially, as more than half of its debt is thought to be US dollar-denominated. Pressure is already building as the renminbi has fallen by 7 per cent since last March, and domestic interest rates have risen by more than a fifth since Q3. The problems are likely to prove complex to unwind, given that the government has reached the end of the road with its initial response, which was to use its forex reserves to support the renminbi and reduce interest rate pressure. Its reserves have now fallen by a quarter to $3tn since their June 2014 peak, and are approaching the $2.6tn level which is thought to be the minimum required for day-to-day operation of the economy.
Since the New Year, it has therefore adopted a new strategy of further restricting capital outflows and hiking short-term interest rates to deter currency speculators. This highlights that its key issue is now the age-old challenge of managing the so-called ‘Impossible Trinity’, which says it is impossible to maintain a stable exchange rate, free capital movements and an independent monetary policy at the same time.
Unfortunately for Beijing, this challenge is being intensified by Donald Trump’s election victory, given his desire to label China a currency-manipulator – even though there is little evidence to support the accusation. Perception matters more than reality in today’s febrile political environment and clearly the government feels obliged to try and defend the Rmb7:$1 level, ahead of Trump’s January 20 inauguration. But the tools it is using, such as overnight interest rates of 60 per cent plus, as seen early this month, can’t be maintained forever. History suggests they normally only defer the inevitable by further slowing the economy.
India also seems to be moving into the firing line. Its currency is flashing warning signs, having fallen 3 per cent versus the dollar since November, while its domestic interest rates have risen by 3 per cent. The catalyst seems to have been the shock of premier Modi’s demonetisation programme. In theory, this should have led to lower interest rates, given that the amount of cash in circulation has fallen by more than half since November. So it may well be that markets are giving advance warning that investors may need to mark down growth prospects more dramatically, given the impact of the continuing cash shortages across the country.
Brazil and Russia have so far been less impacted by these developments. Brazil’s currency has fallen 3 per cent versus the dollar since October, and Russia’s interest rates have risen by 2 per cent since September. But Brazil’s interest rates have fallen back again after an initial rise, and Russia’s exchange rate has actually strengthened due to hopes that oil prices might stabilise following its agreement with OPEC to cut output.
Unfortunately, as the second chart confirms, the latest trends in chemical production suggest the problems are now set to intensify. As discussed in November, the chemical industry is the best leading indicator that we have for global and national economies. The data strongly suggests that a downturn is already underway in China, Russia and India, while Brazil remains close to recession. If confirmed, this will further weaken currencies. It may also create the potential for interest rates to push higher, as rising levels of default cause foreign lenders to worry about return of capital.
We also cannot ignore the potential for second-order impacts, which tend to become more significant as downturns deepen. In oil markets, for example, OPEC is relying on continued strong demand from India and China to help rebalance global supply and demand. If their demand disappoints, even-deeper output cuts would be required, and these would likely be extremely hard to achieve. The same dynamics also, of course, apply to other commodity markets where supply and inventories are already ahead of demand.
Developments in Bric currency and interest rate markets therefore need close attention in coming months, as they may well provide further evidence for our suggestion here in August that the Great Reckoning for stimulus policy failures is now underway.
Paul Hodges publishes The pH Report, providing investors and companies with insight on the impact of demographic changes on the economy.
It is 15 years since Goldman Sachs coined the word BRIC to highlight their argument that growth in the global economy would, in future, be led by the major emerging economies rather than the developed world. The core concept was that China and India would become the dominant suppliers of manufactured goods and services, whilst Brazil and Russia would become dominant suppliers of raw materials.
The idea was, of course, mainly a marketing venture for Goldman, who hoped to use it to stimulate investment activity at a time when many were in a state of shock after the 9/11 tragedy. And their timing was excellent, as the Note was published just before China joined the World Trade Organisation in December 2001:
China’s declared aim of becoming”the manufacturing capital of the world” provided good collateral for their argument
India’s 2002 launch of its “Incredible India” marketing campaign was equally supportive
With this support, the idea of Brazil and Russia moving closer to developed country status, via increasing their role as commodity suppliers, did not seem so far-fetched
The other great virtue of the BRIC concept, as a marketing venture, was that it was impossible to disprove the theory. Anyone who argued that these countries were too poor to really replace the G7′s economic leadership were simply told they “didn’t understand” or were “stuck in the past”. But 15 years is long enough to test the strength of the analysis, particularly in a key area such as autos. The chart above, showing January – August auto sales in the 4 countries since 2006, enables us to focus on some of the key issues:
China has been a qualified success. Its auto sales have risen more than four-fold from 3.2m in 2006 to 14.4m today. But it seems unlikely that this growth will continue in the future, as used cars are now set to become the main growth driver. This market has only developed recently, as auto quality was very poor before Western manufacturing techniques were introduced from 2009 onwards. It is also clear that government policy over the past 2 years has shifted to focus on increasing China’s self-sufficiency in auto production. The main tactic has been to halve the purchase tax on small cars (engines up to 1.6l), as these are primarily Chinese made. This tax reduction expires in October, but it has achieved its objective, boosting the market share for Chinese brands cars to 42.5%.
India has been successful on a smaller scale. Its auto sales have more than doubled from 800k in 2006 to 1.9m today, but the market for motor vehicles is still dominated by motorbikes – which have a 2/3rds market share, with cars at just 12%. Ford’s experience highlights the problem, as it has been forced to repurpose its major car manufacturing investment in India away from the domestic market into exports – which now account for 2/3rds of sales. Ford is also now moving away from pure manufacturing to become “an auto and mobility company”, with its investment in Zoomcar highlighting its new focus on becoming a “full service mobility company”
Brazil, unfortunately, has been a major disappointment. Its auto sales had doubled to 2.5m by 2012, but are back at 1.3m this year. 2013 was, of course, a turning point in the Chinese economy with the appointment of President Xi, and the subsequent development of his New Normal policies, which have taken the economy in a new direction. Xi’s policies are not based on China being the “manufacturing capital of the world”. Instead, he is focused on building a more service-driven economy, based on the mobile internet and greater self-sufficiency. As a result, Brazil is now left with an economy that is dangerously exposed to commodities, in a world where over-supply has become endemic.
Russia has also unfortunately proved a disappointment. Its auto sales doubled from 900k in 2006 to 2m in 2009, but then collapsed back to 1m after the financial crisis. China’s stimulus programme then took them to 1.9m. But 2015 saw a major decline to 1.1m, and 2016 has been worse, with sales back at 900k again.
2 key conclusions seem to stand out from this analysis:
The BRIC concept only appeared to work when China was operating as the “manufacturing capital of the world” following WTO entry. And even then, its success was more apparent than real, as Western demand for its production was inflated by the subprime policies pursued in the West – which then led to the 2008 Financial Crisis. China hasnow recognised under President Xi that this policy has reached its sell-by date, as the ageing of the BabyBoomers means that Western demand for manufactured goods has gone ex-growth
Ford’s experience highlights how India’s future is not going to be as a “China lookalike” focused on manufacturing. Instead, it will be more focused on services – not only due to reasons of affordability and sustainability, but also because of the new opportunities opened up by the mobile internet, as Mukesh Ambani has highlighted. The arrival of the smartphone is a paradigm shift, which will completely change demand patterns due to its ability to enable the “sharing economy”, and more localised producttion on demand via 3D printing.
The BRIC example is thus another powerful example of the dangers created by building an unthinking consensus on the basis of clever marketing by a major player. Goldman have done very well out of the BRIC thesis, as have those companies and investors who were agile enough to play the trend for their own benefit.
But others, who let their judgement be swayed by consensus thinking have, like Ford, made some expensive mistakes. Today, after all, it is very clear that Goldman’s core thesis was simply wrong. Emerging economies have not taken over economic leadership from the G7, and and are unlikely to do so in the foreseeable future.
How much of your day’s wage does it cost you to buy a US gallon of gasoline? This chart from Bloomberg shows the answer for 61 countries, based on prices for 95 octane grade at the end of Q2:
Bankrupt Venezuela is most affordable at 1% of a day’s income (based on GDP/capita)
Kuwait (1%), and the USA, Luxembourg and Saudi Arabia at 2%, are the other most affordable Top 5 countries
In the rest of the G7 countries, Canada is 9th at 3%; Japan is 14th at 4%; whilst Germany (17th), the UK (22nd) and France (23rd) are at 5%; and Italy at 7.5% is 29th
In the BRICs, Russia is 33rd at 9%; Brazil is 49th at 16%; China 50th at 17%; and India 61st at 80% (not a typo)
These are fascinating results as they explain why today’s lower oil prices have not led to a major increase in gasoline consumption. Instead, they confirm that demand patterns in today’s New Normal world are driven by Affordability, not absolute price.
Affordability, of course, depends on more than just the absolute price. Helpfully, Bloomberg also sort the data in terms of average annual gasoline cost (based on the amount of gasoline used per year in 2013, as a percentage of salary), as shown in the second chart:
Venezuela is still most affordable at 0.3%, even though the average driver uses 120 gals/year
China. Hong Kong, Turkey and Belgium make up the Top 5 at 0.5% of average annual salary – using 10 gals, 28 gals, 9 gals and 38 gals respectively
In the G7, France is 6th at 0.5% using 36 gals; Italy (18th), Germany (19th) and the UK (22nd) are all at 1% using 48 gals, 79 gals and 74 gals respectively; Japan is 34th at 1.3% using 114 gals; USA is 47th at 1.9% using 420 gals; and Canada is 58th at 2.7% using 327 gals
In the other BRIC countries, Brazil is 56th at 2.5% using 54 gals; Russia is 52nd at 2% using 88 gals and India is 20th at 1% using 5 gals
2 key conclusions can be drawn from this data.
The first is that analyses suggesting that Country A has enormous potential to double gasoline consumption by comparison with Country B are missing the point. If the cost of a gallon of gasoline in India is 80% of the average daily wage, it is no surprise that the average Indian only uses 5 gallons/year. Unless wages rise dramatically – which would require major policy changes over decades – the country is going to remain near the bottom of the table.
Secondly, one also needs to look at the relative affordability of gasoline in terms of annual spend. As President Obama noted in April:
“The reality for the average American family is that its household income is $4,000 less than it was when Bill Clinton left office.”
Essentially, therefore, the average American is already having to prioritise their discretionary spending. And so whilst they might, or might not, like to drive more miles – the decision to do this won’t just be based on the cost of gasoline, even if the incremental cost of a single gallon is only 2% of daily income.
The gasoline data thus confirms that companies cannot rely on economic growth to drive revenue and profit growth, now that the Boomer-led SuperCycle has ended. The Winners in this New Normal world will be those who can best meet people’s basic needs – for food, water, shelter, health and mobility – in the most sustainable way.
In turn, this suggests that companies need to adopt new service-led business models. These models will no longer simply be based on the value of the product, but will also include the global value provided by the product.
Policymakers would be better off following the fortunes of the chemical industry, if they wanted to forecast the global economy, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
Capacity utilisation (CU%) in the chemical industry has long been the best leading indicator for the global economy. The IMF’s recent downward revision of its global GDP forecast is further confirmation of the CU%’s predictive power. As the first chart shows, the CU% went into a renewed decline last October, negating hopes that output might have stabilised. March shows it at a new low for the cycle at just 80.1 per cent, according to American Chemistry Council (ACC) data.
By comparison, the CU% averaged 91.3 per cent during the baby boomer-led economic supercycle from 1987 to 2008. This ability to outperform conventional economic models is based on the industry’s long history and wide variety of end-uses. It touches almost every part of the global economy, enabling it to provide invaluable insight on an almost real-time basis along all the key value chains – covering upstream markets such as energy and commodities through to downstream end-users in the auto, housing and electronics sectors. Chemical industry production growth provides similar real-time insight into the major economies, using a year-on-year comparison. Current data for the Bric economies is particularly revealing, as the second chart highlights.
China’s post -2008 stimulus programme had provided critical support for all four countries. But as discussed on beyondbrics last year, China’s adoption of its New Normal economic policies during 2013 initiated a Great Unwinding. Chemical industry production growth has nearly halved since 2014 to just 5.7 per cent a year today. And as discussed last month, much of this output is now aimed at boosting exports (to preserve jobs) rather than to supply domestic demand. There are an increasing number of key products where China has moved from being the world’s major importer to a net exporter – with a consequent negative effect on margins.
Brazil was the early loser from China’s change of economic direction. Its monthly output declined very sharply in early 2014 as China’s stimulus-related infrastructure and construction demand slowed, and growth turned negative in June 2014. Output then staged a minor recovery in the middle of 2015, but has since fallen back to -4.6 per cent again. Brazil now no longer needs to import major polymers such as polyethylene, and has instead become a net exporter.
Russia was similarly impacted by China’s policy reversal, and its monthly output went negative in mid-2014. The collapse of the rouble then temporarily mitigated the downturn, by supporting exports and increasing the attractions of local production versus more expensive imports. But output growth has since staged a precipitate decline since last summer, falling by more than two-thirds from September’s peak of 14.9 per cent to just 4.2 per cent in March.
India has seen similar volatility. Output growth turned negative during 2014, but then staged a mild recovery in 2015 before a renewed decline took place, leaving March output barely positive at 0.4 per cent. In principle, India’s domestically oriented economy should make it more resilient to China’s slowdown, but it is still impacted by the second-order effects of increased competition in Asian markets. Not only is China ramping up its own exports of key products, but companies that had formerly relied on exporting to China are now having to find new homes for their product.
These developments in capacity utilisation and output confirm that major changes are taking place in the global economy and the formerly high-flying Bric economies. Policymakers would perhaps do better with their forecasts if they looked beyond their theoretical models – and focused instead on the chemical industry’s proven ability to provide real-time insight into the underlying transformation taking place in global demand patterns.
Auto manufacturers, their suppliers and investors need to prepare themselves for a triple shock from China’s slowing economy, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
The first shock is already under way. As the chart shows, China’s slowdown has caused passenger car volumes to decline in the Bric economies – which accounted for one in three global sales last year. Volumes in Brazil and Russia have collapsed as their commodity exports have tumbled: Brazil’s sales are down 23 per cent and Russia’s down 33 per cent (January – September 2015 versus 2014).
China’s market has also clearly plateaued. New car sales have fallen in three of the past four months and inventories are close to record levels. India’s sales are the only bright spot, up 7 per cent this year, but India’s market is just a tenth of total Bric volume.
The second shock is focused on China’s own domestic market. As forecast on beyondbrics in June, used car sales are starting to cannibalise new car volumes. The critical issue is that China’s used car market was very small before its stimulus programme began, with only around 1.5m sold in 2008. The lending bubble thus meant new car sales rocketed, as there were so few used cars available.
Today, of course, the market is completely different. New car sales have trebled since 2009 to reach 19.4m last year – vastly increasing the volume now available for resale. These cars also last much longer, due to the adoption of western manufacturing standards. China’s dealer association thus expects at least 10m used cars to be sold this year, confirming the paradigm shift now under way:
- Currently, the used car market is just half the size of the new car market
- In most other countries, at least three used cars are sold for every new car sold
- Now the bottleneck of poor availability has been removed, China’s market will follow global trends
In turn, this will create the third major shock, as it means China will have vast over-capacity as its auto industry expands to produce 30m cars by 2020. Exports are therefore poised to rise, with the government forecasting 3m overseas sales in 2020. But where will all these cars be sold? There is no obvious answer, as no other market can possibly replace China and the Bric’s lost demand growth. Inevitably, this surplus capacity will end up fighting for market share in an already over-supplied global market.
These trends are unlikely to reverse. China’s new Five Year Plan confirms its move away from the Old Normal economy based on exports and vast infrastructure spending. Instead, it is transitioning to a services-led New Normal, based on the mobile internet. So its need for commodity imports will continue to weaken, while new cars will be less affordable as demand becomes based on income rather than property bubble windfalls.
‘Adapt or die’ is therefore the strategic imperative for those who once believed that new car sales in China would always rise at double-digit rates. The good news is that as one door closes, so another is opening. China now offers a major opportunity to develop a service-led business model focused on the used car market. But very difficult times lie ahead for those who continue to hope for a return to the Old Normal economy.
China’s auto sales moved past Europe’s in 2010, and are now close to US levels. But even China is not expected to maintain this surge in 2014. As the chart above shows, sales soared in the past few months (red line) versus 2012 (green). But as the automotive association explains, this was mainly because:
“Panic consumption over vehicle purchase limitations in more cities helped drive sales in the city clusters in the Beijing-Tianjin-Hebei region, the Yangtze River delta and the Pearl River delta.”
The problem, as the blog has discussed before, is pollution. China’s economic surge has meant its atmosphere has become horribly toxic in many of its major cities. Its burning of coal and factory emissions are major causes. But auto emissions also play their part. As Shi Jianhua, an auto association vice secretary general told Bloomberg, “vehicle sales in China are facing pressures brought on by environmental protection, traffic jams and more cities limiting purchases.”
Shi also warned that ”demand for imported luxury vehicles will surely decline as the official frugality campaign spreads beyond the government and affect companies and individual consumers.” Already, for example, China’s military have been banned from buying foreign cars – and they bought over 500k foreign luxury vehicles in 2012, primarily from Mercedes, Audi and BMW.
The World Health Organisation has rated China’s outdoor air pollution as a carcinogen for the first time, due to its links to lung cancer and increased risk of bladder cancer. And as a result of public concern, Tianjin has joined Beijing, Shanghai, Guangzhou and Guiyang in imposing vehicle quotas.
Auto manufacturers and analysts are, of course, still optimistic about the 2014 outlook. But tyre sales seem to be weakening, with inventories of rubber in Shanghai at their highest level for 10 years. Plus, of course, there are growing signs that the new leadership, fresh from its success at the 3rd plenum in November, may be finally about to crack down on China’s lending bubble.
This of course highlights the key problem with the whole BRIC ‘miracle story’ since 2009. It was not due to superior demographics or economic policies. Instead it was simply the result of a panic over loss of exports to the West. Governments simply didn’t want to accept that the world had changed. So they decided to take the seemingly cost-less solution of replacing this lost demand via a massive lending bubble.
Despite China’s sales surge, global auto sales actually fell in November. This, along with the slowdown in BRIC auto sales, may well be a early warning that the bill for this lending binge is starting to become due. Investors in the Shanghai stock market certainly think so. It is now trading at its lowest-ever price/earnings valuation of just 7.9.