The Markets According to Dr. Doom

A Conversation with Nouriel Roubini

Roubini on The China Risk

The Octavian Report: What risk right now concerns you the most?

Nouriel Roubini: I worry that markets are underestimating how much of a slowdown in growth is going to occur in China. Of course there is the doom and gloom view of China having a real hard landing, with growth at 3% or 4%.

I’m not in the doom and gloom camp but I think that the consensus of about 7.5% growth is a bit too complacent.  I see Chinese growth slowing down this year to 7%, by next year towards 6%, by 2016 even lower than that.  This problem of the financial system, especially the shadow banks, the buildup of leverage, bad assets, bad liabilities, bad investment, is going to be a severe problem for China.  And China being as large as it is, whatever happens in China, it has consequences for commodity exporters, for emerging Asia, for Japan, and for the global economy through trade and financial links.  So I would say in the short run, I worry about downside surprises coming out of China.

OR: How much do you think that the government there can avoid a hard landing?

Roubini: Well, the positive is that they’re aware of it and they’ve been saying that their growth model is based too much on fixed investment at 50% of GDP and too little on consumption at only 35% of GDP. It’s not sustainable. They have to change it and they have listed reforms at the Third Plenum that if implemented will rebalance growth from capital intensive, low consumption to more consumption and a more labor intensive type of growth.

My worry is that there are two constraints to doing it fast enough.  One is a political constraint.  They want to grow the economy at 7.5% per year to double GDP within the decade.  But that’s inconsistent with slowing down the credit growth. The second is that the interest groups and the lobbyists who are in favor of the old model because they have benefitted from the capital intensive growth tend to be influential in China: state owned enterprises, provincial governments, the state sector, the People’s Liberation Army.  Those who are going to be benefitting from labor intensive, consumption oriented growth, households and workers, are not politically organized because China is not a democracy.

So they said the right things in terms of what they need to do, in terms of a variety of reforms and liberalization.  But my fear is that these reforms are going to occur too slowly. And every time growth is below 7%, they get nervous and they go through another round of credit-fueled fixed investment.  They have done it for the last five years every year. And if they keep on doubling down on this credit-fueled fixed investment, eventually, you could hit a brick wall. You could have a harder landing.  So they are aware of this problem but then they have to accept faster rebalancing and accept growth below 7% to be able to stop increasing the debt and leverage ratio of the economy.

Russia and Ukraine

OR: You’ve mentioned you’re concerned about Ukraine.  Are you surprised by how resilient the market has been?

Roubini: The market has been resilient because they thought, “Well, Ukraine and Russia are not large enough to be systemically important.”  Then, most likely, this “cold war” between Russia and the West is not going to escalate and it’s not going to end up in a full-fledged hot war in Ukraine itself.  But look at when actually it’s becoming really a hot war and Russia is actively destabilizing Eastern Ukraine. And suppose then markets start to get nervous, suppose that Russia threatens to cut off the supply of gas to Western Europe?  If that were to happen, Western Europe is one or two shocks away from another recession.  They are barely recovering from it.  The last thing they can afford is to have a shock on their supply or price of gas coming from Russia.

Fed Policy and Market Bubbles

OR: Do you think the Fed will successfully scale back monetary stimulus, or that they will be too fast or too slow?  Do you think they are really firmly in control?  It seemed last year they lost control of rates inadvertently.

Roubini: Well as you correctly suggest last year even just talk about starting to taper led to that “taper tantrum” re-pricing ten year yields from 1.6% almost towards 3%.  And that led to ripple effects on global financial markets including long-term rates in emerging markets where money started to flow out.  By now, of course, we have tapering started, the markets already priced in that this year, the tapering between October and December.  What’s the new uncertainty about the Fed is, after they finish tapering, how long are they going to stay on hold at zero rates and then how fast will they normalize their policy rates from zero to a new neutral level of 4%?  And there is still a significant amount of uncertainty both about when they will start and how fast they are going to normalize.

Now, the short end of the yield curve is pricing in starting later and normalizing very slowly.  That’s the baseline of the markets and I would not disagree with that baseline. But I would say there is a chance that the Fed could start sooner and faster.  That would occur, I would say, under two scenarios.  One is that suddenly with economic growth recovering, you have a spurt of inflation and then inflation goes up much more sharply and the Fed is behind the curve and has to start sooner and faster. I don’t worry very much about that risk.  I think the risk of having a sudden sharp increase in inflation is very low.

But the other risk that you have to keep in mind is that the composition of the FOMC has changed.  Janet Yellen might be very dovish but she’s on the dovish end of it.  But of the seven members of the Board, this year we have four new members. Stan Fischer is a dove but not as dovish as Janet and of the five other new voting members of the regional Feds in the FOMC this year, three are hawks.  [Charles] Plosser, [Richard] Fisher and the new head of the Cleveland Fed [Loretta] Mester, and only one hawk is out.  So in March at the FOMC you saw this dynamic. Janet Yellen was trying to give a signal that was dovish but then the doubts about the forecast by FOMC members on how much they’re going to hike was more hawkish because the composition of the FOMC has changed.