Indian Defence Review

Why should developments in the American housing / subprime market in 2007 and currently continuing into 2008 be of any interest to the defense analyst ? Well … probably it’s because what’s happening in subprime today has military implications and have the potential to change the balance of power globally. It is also the reason why a defense journal in New Delhi is carrying this article.

Very briefly, the theory here is that trouble which started in the US Housing Market and which led to the subprime crisis, will now lead to a recession in America. This recession in turn, will lead to the demise of the Chinese Communist party due to massive unemployment in the coastal region of China, as Chinese exports that currently contribute to 40 per cent of the GDP will take a huge hit. The problem will get especially acute due to the absence of a strong domestic market in China. Since the only part of China that is doing well is the coastal belt (interior agrarian economy is a mess), a dramatic rise in unemployment in coastal regions will create huge law and order issues all over that country. In the massive internal strife that follows, Tibet will be set free, and democracy will return to Burma. All this is  expected  to happen over the next two to three years.

“¦Chinese Communist party due to massive unemployment in the coastal region of China, as Chinese exports that currently contribute to 40 per cent of the GDP will take a huge hit.

The paper below goes into the compelling economic and political rationale for this forecast. The following commentary is therefore an example, of how two people, if shown the same data, can come to vastly different conclusions. All data used is from the Economist, Newsweek, The Economic Times and the BBC.

Angela Merkel met the Dalai Lama in September 2007. The US invited him to Washington and the US Congress, on October 17, 2007 despite severe opposition from the Chinese government, presented him with the Congressional Gold Medal which is the highest civilian award in the United States. It was in October 2007 again that the US also imposed sanctions on Burma and two months later, in December, the US House of Representatives again voted unanimously, 400-0, to award Aung San Suu Kyi the same Congressional Gold Medal. These events look un-connected, but they are not.

Analysts do not issue a Megatrend Watch on a quarterly basis or even on a yearly basis. They issue such reports only at a possible inflection point, as they can then capture a whole big move. These events, including subprime could therefore be the first symptoms of a megatrend. Most people have failed to connect recent events with what is happening in the financial markets as they have been so conditioned to huge volatility in the markets that even a global financial crisis has got passed over as an event, that given some attention, can somehow be resolved.

US Heading for a Recession

The current financial crisis has moved beyond  the subprime market, and is now affecting not only lenders and borrowers in subprime transactions, but global liquidity itself, as the biggest banks around the world are wondering how exposed their counterparts are to junk paper. This lack of trust has occurred because subprime loans were mixed with good paper by greedy bankers and traded as Collateralized Debt Obligations that investors around the world  gobbled up. The problem is so big that even the central banks may not be able to step in and provide liquidity. Over the next few months, close to $ 1 trillion or $ 1000 billion of loans are going to be reset to higher interest rates, which in turn will create huge problems in the markets.

10 percent of the Chinese population (most of it in coastal cities) controls 45 percent of the nations wealth with the per capita income in Beijing and Shanghai at $ 4000/ year levels. But the hundreds of millions of Chinese living in villages have an average per capita income of just $ 400 / yr.

Senior economist and former Treasury Secretary of the United States, Dr Lawrence Summers has in a recent financial times article dated 25th Nov 2007 said that the crisis will move from the US housing market to credit card companies. This will hit consumption and there could be a dramatic decrease in consumption as the prices of individual homes in the United states as an asset class could fall by up to 25 percent.

On the other side of the Pacific, Professor Esuke Sakakibara has similar thoughts. In a recent oil industry conference in Hyderabad, he said that it is critically necessary to be vigilant in 2008, as US housing and subprime losses could now be substantially higher than the latest figures published by the OECD, which put the losses at US $ 300 billion. This according to Professor Sakakibara, is due to off balance sheet items like mortgage backed securities (MBSs) and collateralized debt obligations (CDOs) coming back to banks balance sheets through an option, embedded in the contract to sell back to the original financial institution which issued the paper. This, according to the professor, has serious implications for the markets.

The above is what the newspapers and some very senior people are saying. My own view is very different and is based on a question.

What has the western world to gain by allowing this global financial crisis to develop? If they really wanted to, they could have easily tightened lending regulations to ensure that the subprime problem did not happen in the first place. Anyone who has any experience with government knows that this statement is true.

“¦the situation was retrieved, but only when the West & Japan went in with huge amounts of money to buy cheap assets in South East Asia

It therefore appears that the forces of globalization will be unleashed only when the strategic drivers behind the current market conditions allow the market to drop to a point where the prize would be big enough to put together a comprehensive rescue package to revive the world economy.

The South East Asian currency crisis of 1997–98 gives us some indication of where we are headed. The crisis started out as a property market bubble in the beginning, and we saw the price of Dubai crude going below $ 10 per barrel. Asset prices also crashed and there was huge unemployment. Finally, the situation was retrieved, but only when the West & Japan went in with huge amounts of money to buy cheap assets in South East Asia. The recovery came, but outsiders ended up controlling a substantial portion of the economy in the ASEAN region.

This time around, the triad countries (the US, EU and Japan) have a lot to gain by letting the subprime problem get so big, that it creates a global systemic problem in the markets which needs policy intervention at the highest levels in the Government. But the money bags will not come in and mount a rescue attempt till. China is taken out.

The Rationale

China had some 87,000 public unrests in 2005 (reported by the BBC), with the ire directed at communist party officials in various provinces. 10 percent of the Chinese population (most of it in coastal cities) controls 45 percent of the nations wealth with the per capita income in Beijing and Shanghai at $ 4000/ year levels. But the hundreds of millions of Chinese living in villages have an average per capita income of just $ 400 / yr. This huge disparity is the biggest threat to stability in China. The latest problem now is galloping inflation which is close to 6.5 percent currently. The prices of essential commodities and of some staple food items have doubled over the past few months. There has also been news of stampedes for food when discounts were offered by a retail chain.

Chinese exports have surged in recent years from 20 percent of the GDP in 2001 to 40 percent of GDP in 2007. For some , this suggests that China will be hit hard by a US recession.

Chinese exports have surged in recent years from 20 percent of the GDP in 2001 to 40 percent of GDP in 2007. For some , this suggests that China will be hit hard by a US recession. However there are two arguments which certain analysts are putting forward which do not support this hypothesis. The first is that only 21 percent of Chinese exports go to the US while another 47 percent of exports head for other Asian countries. This, according to the analysts, means that China is not going to feel the heat of a US recession.

The second point, according to these commentators, is that the recent surge in exports has been achieved by working on imported raw materials and therefore the net export dependence is much lower than the 40 percent GDP number being talked about and export dependence may be actually only 10 percent . These people are also saying that only 6 percent of the Chinese workforce is in export oriented industries, so there is no danger of a slowdown in China. To be fair to these analysts, if what they are saying is true then it is absolutely correct to say that China may be in safe waters.

There is however strong evidence in the trade surplus numbers to suggest that the above mentioned optimists are wrong and that China could have a problem coming its way. Chinese trade surplus has increased sharply from an average of 3 percent of GDP in 2003 to 8 percent of GDP or $ 218 Bn in 2006 to 10.5 percent of GDP or $ 262 Bn in 2007. These numbers mean that China is producing far more than it consumes and that the domestic market cannot absorb all that excess manufacturing capacity. Though the Chinese domestic market has been growing as well, driven in the main by huge investments in infrastructure and housing ,it is still confined to consumption along the coast. As the interior of China is still a mess, it is therefore this coastal economy which is the decision maker on China’s fate. Economists will tell you that it is always what happens at the margin that decides what happens to the rest of the 100 percent. These are proven concepts like the laws of physics.

If Chinese exports were to drop drastically, driven by a US recession, the only part of China that is doing well (the coastal region) will also have howling mobs on the streets.

If Chinese exports were to drop drastically, driven by a US recession, the only part of China that is doing well (the coastal region) will also have howling mobs on the streets. This combination of unrest in the interior and unrest along the coast, can kill the communist party in China. Even the trillion dollars plus (actually it is $ 1.4 tn) that the Chinese have as reserves in overseas banks/US treasuries and real estate, cannot then be deployed at short notice to save the communist party. They cannot even dump the US treasuries they hold as those will lose value as well… it’s not a very liquid situation. This appears to be… Checkmate China!

If the social unrest in China were to happen, the fallout will be felt across Asia and the world. We will then witness history being made as:

A deep recession in the United States can actually lead to regime change in three to four countries. A US recession in very practical terms means that Americans will have to make do with one car less per family (they already have roughly 225 million cars for 298 million people). In China however, this means a large scale loss of jobs along the coast”¦ and regime change.

But the biggest prize is that valuable industrial assets & banks in China will be sold to companies in the US, Europe and Japan… just as it happened in the case of the Asian Tigers. This is what I would call the ‘Ju Jit Su strategy’ (the Japanese martial art  where  the opponents huge strength is used against him). In the case of the Chinese, their huge capacities in manufacturing and exports will turn out to be their undoing in the absence of a strong domestic market. This strategy actually has substantial potential for deployment in the derivative markets depending on an organisation’s physical exposure and the size of its existing paper position.

If the above logic is OK, then what is happening today in the market suddenly starts to make a lot of sense, and we begin to understand why the recent cut of 50 and then 25 + 25 basis points in the Fed funds rate was such a dangerous thing. The cuts let loose a Tsunami of liquidity that saw huge amounts of cash being taken out of the bond markets and end up in the Indian, Chinese and other markets. Please note that the Chinese markets are already trading at an average P/E ratio of 50 / 55 + (for comparison , the Indian NSE has an average P/E of 25 currently). The high P/E ratio in China is therefore extremely dangerous and we now have asset bubbles all over the place. Recently the Bush administration has announced a stimulus package for the US economy. Under the plan the Fed is going to cut the interest rate again by 50 basis points on the 30th of January, 2008, bringing the benchmark rate to 3.75 percent. This will throw even more money at China and India and it is not going to help the United States as we already have the first signs of a global contagion with huge losses at Citigroup, Morgan Stanley and Merryl Lynch among others. It’s a list that is going to get much larger as this is just the beginning. The European and the Japanese banks also bought a lot of Junk paper and for now they are keeping very quiet.

The point I am making is that in a globalized economy it is possible that a deep recession in the United States can actually lead to regime change in three to four countries. A US recession in very practical terms means that Americans will have to make do with one car less per family (they already have roughly 225 million cars for 298 million people). In China however, this means a large scale loss of jobs along the coast… and regime change.

Therefore, the first time since Mr Gorbachev set his  people and the multitudes in Eastern Europe free, the world is again going to see another huge battle for the human spirit. The battle for ideas, that according to Daniel Yeargin resulted in a globalized economy, are now going to have us witness the power of the forces unleashed by Free Markets. This time again, these forces will free countries. Let no one be in any doubt of what market forces can achieve.

The Real Question

Given the potential size of the above prize, will the rescuers be inclined to come in and intervene in the markets in the massive way that is actually needed to preserve the current balance of power?

As far as the Indian military is concerned, there is a still a need for vigilance on the north eastern border, in time though we might need to redeploy those troops as the Chinese threat recedes.

This has huge implications for businesses around the world as currently perceived demand-supply gaps in specific industries are irrelevant when the powers that be, decide on the strategic landscape of their choice.

At a certain level of thinking, everything becomes a trade. It is therefore important for countries and companies to make an attempt to understand the big picture and then play their game in such a way that their strategies and investments are aligned to the larger strategy being played out. Basically you have to make sure you are going to fall in the direction that benefits you. This is very much like the game of Ju Jit Su where the winner falls in the direction that benefits him. Its all about falling artfully. It is good strategy.

In the case of companies therefore, this means that they should concentrate on markets they know best, and stay out of areas where huge turmoil is expected. Acquisitions like those of the Mittals / Tata’s (In India) need to be avoided as asset prices are going to fall. For Indian companies, overseas acquisitions should be focused on serving the domestic market/demand in India. I am personally extremely bullish as far as demand is concerned as I see close to $ 500 billion being invested in the infrastructure sector over the next five to six years. So what I am saying is… if you acquire companies overseas, do so with a focus on serving the Indian Market as this market is not going to disappoint despite the gloom everywhere else. There are specific strategies for this that however go beyond the scope of this note.

The danger here is not of any military misadventure by Pakistan, but close to five million refugees from Sindh could cross the international border into Gujarat after being driven out of Sindh due to a civil war there.

As far as the Indian military is concerned, there is a still a need for vigilance on the north eastern border, in time though we might need to redeploy those troops as the Chinese threat recedes. On the western flank though there is a need for extreme vigilance in the near term, mainly because Pakistan is showing signs of coming apart at the seams after Benazir’s brutal assassination. The danger here is not of any military misadventure by Pakistan, but close to five million refugees from Sindh could cross the international border into Gujarat after being driven out of Sindh due to a civil war there. If this happens, as some fear, our armed forces might actually have to go in and create safe areas within Pakistan. For now however, it’s necessary to take a wait and watch attitude.

Changing Geopolitical Equations (Mediterranean to the Indus)

This section is not particularly linked to the rest of the article, but I shall include it here to save the bother of writing another paper.

A lot has changed since President Roosevelt met King Saud of Saudi Arabia in Feb 1945. US Strategy in the Middle East  is  in  tatters. The US / NATO Afghan campaign has failed to prevent Pakistan from reaching the brink of collapse. Even on the Palestinian question, the US & Israel, by not reading the signals properly have lost the strategic initiative to Hamas.

Those involved with tackling the terrorist threat must first appreciate that Osama Bin Laden thinks like Rockerfeller. His very ordered mind immediately grasped the strategic need for a benchmark project”¦

It would therefore not be unfair to say that the Americans, are in retreat across the entire region, as they do not have any significant ally in military or economic terms from Israel in the west to Australia in the east (except India, of course). In such a scenario, for them to take on Iran is suicidal as they will never be able to hold the country. People seem to forget that though the world has changed a lot since the time of Alexander, the rules for holding/controlling foreign lands as laid out by him remain the same.

Those involved with tackling the terrorist threat must first appreciate that Osama Bin Laden thinks like Rockerfeller. His very ordered mind immediately grasped the strategic need for a benchmark project that would move the theatre of war out of the Middle East to the developed world. Just as Rockerfeller saw that leadership in the oil business, and unprecedented wealth, could be achieved if someone could solve the huge logistics problems in the oil business and bring about price stability, Osama saw the need to establish a new scale in terrorist strikes and to show his cadres that to win, all they needed was to change the rules of engagement. Hence the use of airplanes as bombs, and the authorisation to any individual within the organisation to issue a fatwa. In 1532, Pizzaro, with just 168 of his Spanish soldiers brought the one million strong Inca empire that stretched from Peru to Chile to its knees. Pizzaro used strategy, Osama is doing the same and though his methods are primitive, he has effectively leveled the strategic playing field, which makes the advanced weapon systems of the west useless against his men, who now live amongst their targets in London and New York. The US now needs someone like Abraham to win the war which is now going to be upon us all. Leadership of a very different kind is needed in the new war. It is hoped that the Americans choose wisely this time.

Readers will be in agreement to the above in varying degrees. Actually, though you may disagree with the view totally, you will admit that its a different way of looking at things. All of you, however, will be hoping that if the forecasts come true, the changes will happen as peacefully as possible.

‘Sometimes, 24 hours can bring a total revolutionary change.’ – Aung San Suu Kyi