Indian Defence Review

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.