Can a 'China Crash' be 'Advantage India'?
(Nov 24, 2014)
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In this issue:
» Will the next big financial crisis come from China?
» Red flags that point to serious trouble in the dragon economy...
» How will a 'China Crash' affect India in the short term and long term?
» Can India benefit from a 'China Crash'?
» ...and more!
The Indian stock markets are back to their days of glory. Amidst this renewed sense of optimism, the financial crisis of 2008 may seem like a distant nightmare now.
Why unnecessarily think of potential spoilers to the ongoing dream run in Indian stocks?
The reason is that problems time their intrusions exactly when no one is expecting them. From whatever little we know about the human mind and money, financial crises are not aberrations or anomalies. They are parts and parcel of the economic system. Of course, they can have disastrous impacts on the economy and destroy years of wealth. But they are not always bad. They act as corrective mechanisms that aid re-allocation of capital to more productive sectors in the global economic system.
So one may very well ask - Where is the next big financial crisis coming from?
We have a question in response to this - Did the last financial crisis really get over?
We do not think so. How did policy makers and central bankers respond to the 2008 financial crisis? They responded to a debt problem by adding unprecedented amounts of debt. What really happened? A huge flood of capital pushed the crisis a further down the lane... and then more doses of liquidity... and a little more further... This game of "kicking the can down the road" cannot go on endlessly. Someday it has to stop, right?
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Let us give you the bad news right away. The world economy is in a far worse and vulnerable state than before. The Euro zone is again showing signs of trouble. Japan is again in recession. The Chinese economy is slowing down.
Well, we would admit that we are no experts in predicting financial crisis. But from the available signs and indicators, it seems China is the front running candidate for a potential major crash. And given its sheer size and impact on the global markets, no investor can afford to ignore this elephant in the room.
Here are some red flags that hint that China could be heading for some major trouble:
So here we have a bulging debt bubble and a slowing economy. If history is anything to go by, this is the recipe for disaster. It seems that it is now only a matter of when the crisis strikes...
- Commodity prices are crashing!
It is said that if you want to know where commodity prices are heading, there is just one thing you should track: China. As one of the biggest and fastest growing economies in the world, China is the biggest guzzler of industrial and agricultural commodities. So, shouldn't the reverse also hold true? Can commodity prices tell us where China is heading? If this is true, then a China crash is probably already underway since commodity prices are falling sharply.
Iron ore prices have already crashed over 40% this year. They are now at a five-year low.
Look at crude oil prices. Brent crude oil prices are down nearly 30% from their high levels in June this year. Take any major global commodity and you will see prices trending downwards.
- China's wasteful investments and ghost cities...
How has China managed to grow at gravity-defying growth rates for not one, not two, but three long decades? China has been an investment-driven export-oriented economy. It has achieved high growth through continuous and heavy investments in infrastructure and new capacity creation. With the slowing global economy impacting exports, China's economic model is no more sustainable.
As per an article in Agora Financial, about 45% of Chinese GDP is infrastructure investment. A huge portion of these investments is simply wasteful expenditure that is not going to generate revenues. You may have heard of ghost towns in China where massive investments have been incurred. But they are lying vacant and underutilized.
- The ticking debt bomb...
Where did all the money come from to fund these wasteful investments? In its response to the global crisis, Chinese policymakers unleashed massive stimulus programs that have propelled the Chinese debt bubble. China's banks have lent net new credit worth about US$ 5 trillion over the last 6 years.
Despite all these efforts to keep the growth momentum going, the Chinese economy is finally showing signs of fatigue. The economy is slowing down. Property prices are falling. 67 of 70 major Chinese cities have seen a year-on-year drop in new home prices.
Then there is something that happened last Friday and it took everyone by surprise. The People's Bank of China announced a 40-basis point cut in one-year lending rates as well as 25 basis-point cut in deposit rates. While the global markets reacted positively to this stimulus, we believe it is a sign that China is in for big trouble. It is a clear indication that Chinese policy makers are desperately attempting to prop up the economy that is sliding into a slump.
Whenever the China crash happens, the consequences are going to be enormous for the entire global economy. What matters most to us is how it will impact India and what investors can do to protect their investments.
Let us consider some likely short-term and long-term effects of a China crash on India.
Short term impact:
Negative impact - Since short-term stock price movements are driven by liquidity and sentiment, a major crash in China could cause investors to panic out of the Indian markets as well. Remember, the global financial markets are intricately interlinked. FIIs are often the first ones to cash out at the slightest hint of trouble. Given their heavy influence of the Indian stock markets, a China crash could trigger a major FII sell-off and cause stocks to tumble. Late entrants to the stock rally could see significant erosion in the value of their stock portfolios.
Positive impact - While the correction in stock prices could cause temporary pain, we believe it would be an ideal time for Indian investors to make investments in solid Indian companies that are well-shielded from any adverse developments in China.
Medium to long term impact:
Negative impact - As the Chinese economy struggles to keep up its growth rates, it may become more aggressive in dumping its products to India. This could be an area of worry for companies/sectors that have competition from Chinese imports.
Secondly, companies dealing in industrial and agricultural commodities whose prices are determined as per the international market (unlike cement) could be adversely impacted by sharp decline in export demand and low realizations. For instance, iron ore is India's single-biggest export to China.
While exports to China may be impacted, what is reassuring is that China's share in India's total exports is quite meagre. As you can see in the chart below, China's share in India's total exports is just 4.8%. Countries such as Mongolia, Turkmenistan and Gambia have a very heavy dependence on exports to China. These economies could be the worst impacted. Countries such as Australia and Brazil too have a sizeable dependence on exports to China.
Which Countries Are Most Vulnerable To A China Crash?
Positive impact - The good news is that a China crash could also translate into a boon for India. If the Chinese economy continues to slump, it will mean that commodity prices will remain low for quite an extended period. This augurs very well for a country like India that is import-dependent on some key commodities such as crude oil.
Low commodity prices would also mean lower inflation rate in India. There are already signs that inflation in India is cooling down. Low commodity prices coupled with a likely interest rate cut could provide the much needed boost to investments and economic growth in India.
Given India's domestic consumption-driven economy and low exposure to export demand from China, the Indian economy is expected to be relatively lesser impacted by a China crash. Moreover, if China's attractiveness as an investment destination fades, India is quite likely to be a major beneficiary.
According to you, what could be the impact of a China crash on India? Let us know your comments or share your views in the Equitymaster Club.
The benchmark Indian indices traded firmly in the green today. The Sensex closed 165 points higher from its previous day's closing level. Stocks from the IT and metal space were the biggest gainers. Asian markets soared higher with Chinese markets leading the gains on the back on interest rate cuts announced by the People's Republic of China on Friday. Most European markets were trading in the green at the time of writing.
"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets.". - Peter Lynch
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