Nomura felt the risks in China were sufficiently non-trivial to assign a one-in-three likelihood of a “hard landing” commencing before the end of 2014
Almost 18 months ago, global brokerage firm Nomura in its China Risks report provided six reasons why it thought the risk of a hard economic landing in China had increased. They were: 1) overinvestment and excessive credit; 2) rudimentary monetary policy architecture; 3) too many privileges to state-owned enterprises; 4) potential unintended consequences of financial liberalization; 5) the Lewis turning point associated with a dwindling supply of surplus rural labour; and 6) the setting in of growing pains from worsening demographics and increasing strains on natural resources.
The brokerage defined a “hard landing” as an abrupt slowdown in real GDP (gross domestic product) growth to an average of 5% y-o-y or less over four consecutive quarters, and Nomura felt the risks were sufficiently non-trivial to assign a one-in-three likelihood of a hard landing commencing before the end of 2014.
Eighteen months on, while Nomura’s base case is that China’s economy will grow, on average, by 7.5% in 2013-14, the macro risks remain high and it has kept the one-in-three likelihood of a hard landing commencing before the end of 2014.
To help quantify the macro risks on an ongoing basis Nomura constructed its China Stress Index (CSI). It is made up of 18 indicators that are first standardized and then weighted. The CSI indicates that hard-landing risks steepened after the global financial crisis and has yet to reverse course; in fact, it rose from 101.5 in Q4 2012 to 101.6 in Q1 2013, a record high on quarterly basis
Decomposing the latest data point of the CSI—March 2013—reveals that its elevated level is because of strong credit growth, including shadow financing outside the official banking sector, and a frothy property market
The record high CSI reading is consistent with the main findings from Nomura’s recent thematic report. The brokerage highlighted three symptoms that preceded major financial crises in Japan, US, and Europe, namely the rapid build-up of leverage, the rise in property prices, and a decline in potential growth. Such symptoms also currently prevail in China.
Nomura also focussed on an interesting phenomenon that it called the “5-30” rule: financial crises in large economies are usually preceded by the domestic credit-to-GDP ratio rising sharply by 30 percentage points (pp) in the five years before the crisis is triggered. So it is not only the level, but also the speed of the debt build up, and China is in the “5-30” rule danger zone.
It appears that the rapid build-up of stress in the economy has weighed on asset prices. The renminbi forward used to price in appreciation against the US dollar now prices in a depreciation, in line with the rapid rise in the CSI in recent years. Equity prices in Shanghai have performed poorly in recent years, which probably also reflects an elevated risk premium.
Real GDP growth slowed from 9%-10% in 2008-11 to 7.8% last year, which is still strong, but there is concern among investors over its quality and hence sustainability, given the heavy reliance on debt-financed housing and infrastructure investment. Nomura believes that asset prices reflect such concerns.
Recent economic development suggests investors’ concerns are warranted. GDP growth in Q1 slowed to 7.7% from 7.9% in Q4 2012, despite very aggressive policy easing as total social financing reached an historical high. The HSBC flash manufacturing PMI dropped to 50.5 in April from 51.6 in March, despite positive seasonal factors that usually drive April readings of the PMI up. Moreover, there are many signals that the government is now tightening controls on shadow banking activities. For instance the China Banking Regulatory Commission announced several guidelines in March to tighten regulations on wealth management products and contain banks‟ exposure to local government financing vehicles. The government set the target for M2 growth for 2013 at 13% in the National People’s Congress, suggesting monetary tightening beyond Q1, as M2 growth was 15.7% in March. Nomura believes these tightening measures are necessary and will help to contain systemic risks, though in the short term they will lead to a growth slowdown.
The brokerage believes that most pivotal for the outlook to it CSI and hence China’s hard-landing risk is policy. If the government tightens policy further in 2013 (which is Nomura’s baseline case), growth will slow to 7.2% in Q4, a small price to pay, for avoiding a systemic financial crisis.
There may be isolated bankruptcy cases in the non-bank financial sector and corporate sector, but the government still has the resources to protect the banking system and avoid a sharp growth slowdown to 5% or below. By contrast, if the government focuses on the short-term business cycle and loses sight of the continued build-up of the financial cycle, by loosening policy again to boost growth (which is a policy mistake and a risk scenario), Nomura believes that it can attain growth of 8% in 2013, but the risks of a systemic financial crisis and economic hard-landing rise. In other words, easing policy this year only postpones the day of reckoning at the cost of sharper growth slowdowns down the road, according to Nomura.
Nomura maintains its out-of-consensus cautious view on China’s economy. Its 2013 GDP growth forecast has been at the low end of consensus. Moreover, the 7.5% growth reflects its baseline view, which it sees as the most likely scenario, but the brokerage also views a one-in-three likelihood of a hard landing beginning by the end of 2014.
From its analysis of China’s macro challenges and risks, Nomura identified 18 indicators to construct its China Stress Index, or CSI for short. Each was chosen not to predict GDP growth per se, but to signal the chance of an abrupt slump in growth. The indicators are forward-looking, so data such as non-performing loans are not included. The data are monthly and start in January 2000. For the indicators that are available only on a quarterly or annual basis, monthly series were interpolated from the longer frequency data. CSI is then defined as a weighted average of standardized indicators as follows:
One limitation of the CSI is that it does not give a probability of a hard economic landing. To do so would require a reference variable measuring past episodes of hard economic landings in China, the obvious one being real GDP. Yet in the past 20 years Chinas GDP growth has not fallen below 5% and before then the causes of hard landings in GDP were influenced heavily by social and political unrest. So what the CSI tells us is: 1) the direction of overall macro risk; and 2) how fast the risk has changed compared with history.
With some sixty days to go for the much hyped new banking licences, the recent news of the Parliamentary Standing Committee on Finance expressing serious views that the guidelines may lead to corrupt practices, makes one wonder what these guys were doing so long
The last date for submission of applications for obtaining a new commercial banking licence to the Reserve Bank of India (RBI) is 1 July 2013, but a storm is brewing in the horizon.
The Parliamentary Standing Committee (PSC) on Finance has almost vetoed the idea in one voice, on the sole fear that the guidelines drawn would invariably lead to corrupt practices.
Chairman of this panel, Yashwant Sinha (BJP) is also not in favour, and has cited examples of the US where, despite its capitalistic and commercial attitude, have not favoured the issue of corporate players entering the banking field.
Earlier, Dr Subbarao, RBI governor had reiterated that banking licences will (or may be) issued to private or public sector entities provided they have sound financial credentials and minimum track record of ten years to start banks. Of course, there is an inherent fear that such institutions, if established, may tend to extend favours to their own corporate associates!
The PSC has expressed fears that guidelines drawn may lead to ‘corruption’. However, the panel did not choose to amend, correct or even suggest means to overcome such possibilities. While we may learn from the experience of other countries, we must remember that our system of financial governance has not permitted banks to go belly up, as they do in several countries, including the US.
The public are not fully aware of the guidelines drawn by RBI. However, what has happened in West Bengal (Saradha case) is an eye opener. Chit funds operate with impunity just in the same manner as deposit collectors!
So, let’s toss a few ideas in the ring:
a) Why not allow all the co-operative banks to mandatorily merge with existing banks?
This may include all other small banks which are still operating in the country.
b) If any new banking licence applicant comes forward with a specific proposal to take over the co-operatives or similar banking institutions, will it have a preferential treatment?
c) If and when the new bank licencee establishes its registered office in a particular state, it will undertake to open its branches in all the designed metropolitan cities and towns, approved by the RBI, but, within the agreed “time frame” ensure that every town in that state will have its branch. Also it will then identify that the move will be to expand its branch network to the neighbouring states, until the operations become pan-India. The RBI can work out a master plan to ensure that in a decade or so, the whole country is covered, and banking operations extended where it did NOT exist before!
d) There are some banks like Central Bank of India (one of the original Five) whose operations are in doldrums. New private banks which were recently licensed have made great strides while CBI is moving at a snail’s pace. Even when CBI celebrated its 100th birthday, there was no reward for its shareholders! It is time government unloads deadwood like this bank and let private enterprise take over and perform.
e) The RBI must encourage corporate bodies, it does not matter whether the proposal comes from the Ambanis, Birlas, Bajajs Mahindras, Jindals or Tatas or whoever, to take over existing banking institutions and infuse the required capital and experienced banking personnel
Finally, even before the issue of new banking licences is settled, it is time Dr Subbarao recognizes the urgent need to review and increase the deposit insurance cover of Rs1 lakh (as at present) to a realistic figure of say Rs25 lakh for an individual or Rs50 lakh for a couple, if held in joint names. While savings are encouraged, the insurance cover of Rs1 lakh necessitates the account holder to open in accounts in number of banks to protect his savings. This ludicrous coverage must be revised immediately.
(AK Ramdas has worked with the Engineering Export Promotion Council of the ministry of commerce and was associated with various committees of the Council. His international career took him to places like Beirut, Kuwait and Dubai at a time when these were small trading outposts; and later to the US.)
A cost surge is imminent in the Indian IT sector because of higher US visa fees, increase in visa rejections and declining utilisation due to reducing fungibility vis-à-vis H-1B holders, says Edelweiss
The US immigration draft bill to be introduced in the Senate will, without doubt, be detrimental to the Indian IT business if implemented. However, brokerage firm Edelweiss, in its sector update said that its impact would be more in the long-term rather than short-term and less dilutive than commonly perceived. Though the draft has not been released, a few of its proposals published in media, if implemented, can impact profits and margins of Indian IT players.
The brokerage believes that a cost surge is imminent on account of higher visa fees and increase in visa rejections and declining utilisation due to reducing fungibility vis-à-vis H-1B holders.
According to Edelweiss analysis, these factors along with hiring locals (including sub-contractors) will impact Infosys’, TCS’ and Wipro’s net margins 88 basis points (bps), 148 bps and 73 bps, respectively.
In the worst case scenario, the impact on margins of Indian IT companies will be three-fold. First, visa fees will catapult almost 100% (from around $5,000 to around $10,000). Second, employee fungibility will be reduced due to lower onsite employees (H1-B holders) and companies will have to maintain a bench of local hires, reducing utilisation level. Third will be the higher average cost of local hires vis-à-vis visa holders. The timeline for local hiring is 25% by FY14, 35% by FY15 and 50% by FY16.
Edelweiss analysis of the above three factors indicates that increase in visa fees can inflate
Infosys’, TCS’ and Wipro’s absolute costs by $13 million, $33 million and $11 million, respectively, while the net margin impact would be 60 bps, 101 bps and 73 bps, respectively, on current FY15 estimates.
Similarly, while increase in bench will spike absolute costs by $3 million and $8 million for Infosys and TCS, respectively, on the margin front, the impact will be 14 bps and 24bps, respectively. Third, the higher local hire cost will inflate Infosys’ and TCS’ absolute costs by $3 million and $7 million and margins by 14 bps and 23 bps, respectively. Wipro’s 36% onsite employees are local hires and hence only visa cost will impact its costs and margins, Edelweiss said in its report.
The brokerage believes, incrementally, top tier Indian IT companies will move up the value chain. This will increase the consultancy component which anyway requires higher onsite resource coupled with higher local talent to fill skill set gaps. Hence, the proposed draft will only fast forward the phenomenon rather than introducing it anew. And probably, the impact would have been more gradual had it not been enforced via legislations. Also, it is worth highlighting that Indian companies have been increasingly hiring local talent since the past few years. According to Edelweiss, escalating visa costs and rejection rates, declining utilisation rates along with higher local hiring will dilute net margins of Infosys, TCS and Wipro 88bps, 148bps and 73bps, respectively. But, at the same time, one would have to wait and watch on-the-ground execution of the bill as a severe talent crunch in developed markets may hinder its strict implementation.