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.
And under Ben Bernanke, an important point, the FOMC became a collegial democracy. It’s not anymore that monarchy it used to be under Alan Greenspan. And each one of the twelve members is strong, opinionated, smart, and they have their own voice. And under Janet Yellen, the genie is out of the bottle. She’s by definition a very consensual person. So it’s going to be truly a committee decision. Of course, she has more weight than the rest of the committee but she cannot impose her will.
So I think the changing composition of the FOMC might lead them to start sooner and go faster especially if they worry about financial stability. This is the other risk that I worry about. Asset bubbles are another factor that may be considered by some members of the FOMC in terms of when to start and how fast to hike.
OR: Do you think the market understands that it’s consensual now?
Roubini: They do understand that this is consensual and, in some sense, they are worried about that because there is a bit of a cacophony of views. And every time even one of the non-voting members speaks, then that can move the market. One of the reasons why Ben Bernanke – and he told me this personally – decided a few years ago to have a press conference was that he was frustrated by this cacophony of all these different views of all the different FOMC members. He wanted to say, “Okay, at the press conference, I’ll tell you at least what’s the central view of the FOMC.”
That has been only a partial success because everybody who is a member of the FOMC still gives speeches. They never coordinate with each other. Maybe the members of the Board do a little bit but not the regional Fed governors, and this noise continues. So markets are more worried about the fact that there is not one voice but there are twelve or seventeen voices within the Fed, and they don’t know how to read who says what and what it means and who has the most impact.
OR: Do you think there is any probability that they will get this just right or is it almost a certainty that will either be too early or too late? How could anybody calibrate to that extent?
Roubini: It’s certainly a knife’s edge. One of the risks we spoke about was exactly that they start too soon and they normalize too fast. The other risk is actually I think a greater risk, that they go too slowly and they create a huge bubble. That’s already starting with frothiness in a number of financial markets. If you think about the risk of going too slowly, we’ve had now five years of zero policy rates, we’ve had QE 1, QE 2, operation twist, QE 3 is not going to be over until the end of this year, then they’re going to stay on hold at least through the middle of next year.
And then, they officially said based on the mean forecast of FOMC members that it is going to take them through the end of 2018 at the earliest to normalize from zero to four. That’s three years and a half. Last time around between ‘04 and ’06, it took them two years between the middle of ‘04 and the middle of ‘06, a too little, too late, measured pace, twenty-five basis points every meeting, preannounced. And you created the mother of all bubbles, subprime, then housing, then credit, then equity, and then the financial bubble, and that boom in a bubble went into a bust.
This time around, they’re not going to even start hiking until at least the middle of next year, and it is going to take them not two years, but three-and-a-half up to four years to go from zero to four percent. Last time around the increase was from 1% to 5.25%, the previous time was until 6.5%, but this time around it will be to 4%.
So the risk in my view is not that there is a bubble today, there is already frothiness, but that exiting so slowly is going to create a bubble in credit, in the equity market, possibly even again in housing twelve months from now, twenty-four months from now. And then as we saw last time around, the boom in a bubble eventually leads to a bust and then a crash with a lot of collateral damage. I think that’s a big risk. Again, not over the next twelve months but, I would say, if you look at the twenty-four months horizon, the risk that we have another boom and bust, I think is something that markets are not considering seriously right now.
I worry that if this loose monetary policy and the exit from it is going to be continuing, the risk is that, give it twenty-four months, this frothiness goes into an outright bubble in credit, in real estate and in equities. And eventually, if that were to occur, with a lot of leverage in the financial system and the real economy, then we’re maybe two years away from that being a real boom that eventually in the next thirty-six months could lead to a debt bust and a crash. It’s certainly, a risk that markets are underestimating. We’re just repeating the same mistake of the last decade. It’s something you have to worry about certainly.
OR: Does the credit market scare you right now?
Roubini: It does. If I look at junk bond issuance, last year was at a rate above 2007, and it’s not just the issuance but the spreads have narrowed very much, well beyond even what’s justified by low default rates. And now, all sorts of practices that we thought were very risky like payment-in-kind toggles and covenant-light clauses are coming back really as much as it was in 2007. And now, we have all this M&A activity, we have all these leveraged loans. So I would say one of the places where I see this frothiness in full scale is certainly in some of the credit markets right now. You know with policy rates at zero and long rates so low, lots of people are borrowing lots of money in terms that are not justified by medium-term fundamentals, and that eventually it could lead to a massive correction. Again, not anytime soon but once the Fed starts raising rates a bit faster, that’s where maybe the trigger for that big correction could be. I am speaking about 2016 probably rather than next year.
Europe and the Euro
OR: Let’s talk about Europe for a second. You indicated you think that the tail risk there is dramatically reduced but the euro and its problems still exist. Do you think there is a real deflationary problem going on there and how do you see Europe playing out of the next couple of years?
Roubini: In the short run, there are positives: the risk of a breakup, of a Greek exit, of Italy and Spain losing market access has been lowered, thanks to Draghi’s “whatever it takes” speech. Thanks to the OMT [Outright Monetary Transactions], the ESM [European Stability Mechanism], the beginning of a banking union, the fiscal austerity, some of the reforms, and the recovery from recession to positive growth. So those are the positives.
What are the negatives of the periphery of Eurozone? The potential growth is low because the reforms are occurring too slowly, the recovery is going to be so anemic and uneven, the unemployment rate, 25% in Greece or Spain, 50% among the young, is not going to fall anytime soon. Debt to GDP ratios in the private and public sector are still rising because nominal GDP is not growing, and therefore the issue of medium-term debt sustainability remains.
You have the issue of competiveness that has not been resolved in many of these countries. Trade balances have improved mostly because of compression of imports in the recession. You need to restore external competiveness, you still have a credit crunch, these AQR [Asset Quality Review] and stress tests are going to take all year long until finally you figure out how much the banks need in capital, the euro is too strong, and inflation is too low and falling given tight monetary policy.
Now, one of the policies that has been debated is whether the ECB is going to do more. I think they’re going to do more. I think they are going to decide they have to do an aggressive round of monetary easing with inflation now well below one percent. I have the view that there is still a meaningful chance that they’re going to do quantitative easing as opposed to just credit easing or going through other unconventional policies like a negative deposit rate.
But traditionally the ECB is known to always do too little, too late, too slow, and maybe this time around they’re going to do eventually what’s right but they’re going to do it too late. So that’s another risk. And finally in the Eurozone, you have now austerity fatigue in the periphery, you have bail out fatigue in the core, you have these EU parliamentary elections where populist parties of the right and the left, where anti-euro, anti-Europe [parties] became very popular. So also the political dynamic of Europe is becoming a little bit more tense.
Again, in the short run, things are actually going in the right direction. But think about two years down the line, three years down the line, some of the fundamental problems of the periphery remain still open.
OR: Do you think we’ll see a return to tension between the core and the periphery?
Roubini: Well, tension between the core and periphery may reemerge in a year or so if, for example, in Italy [Prime Minister Matteo] Renzi were to fail and then you have somebody less market-friendly coming to power or if in Greece, the current coalition would fall in the next election and Syrzia, this radical party of the left, comes into power. That’s one source of risk. And then within Europe, there is also the looming potential that the United Kingdom might decide to exit the European Union. Of course, they’re not members of the Eurozone but the Conservatives have suggested that after the general election next year, there might be a referendum about exit in the next couple of years.
OR: Do you think the UK will exit the EU?
Roubini: I would say the chances that the UK is going to vote to exit the European Union is still low but that’s a risk that you have to keep in mind. I think eventually people are going to look at their pocketbooks and the Brits are going to realize they are better off within the European Union. But you cannot rule out that their politics are going to move into a different direction.
OR: Do you think the euro will survive longer term?
Roubini: Experience suggests that once you have a common currency, you need also, first of all, a full banking union, you need a full fiscal union, you need a full economic union. And once you have given up national sovereignty on banking, fiscal, economic affairs from your nation state to the center, Brussels or wherever, then you also need a political union because otherwise, there is an issue of democratic legitimacy of giving up this national power without having some accountability.
So the process implies that, however slowly, for a monetary union to succeed, banking, fiscal, economic and eventually political union have to occur. The beginning of a banking union has started right now but is at most half-baked; most elements of a banking union are not yet there. There is really no talk about a fiscal union right now because the Germans worry that anything that is a risk sharing becomes a “risk shifting” and becomes a transfer union. A greater economic integration is going to occur very slowly and, of course, unless there is a change in treaty, there is not going to be any political union. And the political appetite in Europe for greater political integration is also very low.
So I would expect that the change in treaty that would lead to a greater economic, fiscal, banking and political integration is not going to occur before 2020 at the earliest. So you’ll have to have elections in Germany and France in ‘17 and after that negotiation to have a change in treaty and then it has to be voted by every parliament or referendum. So, that’s the window at the earliest. So what’s the chance in the next six years that some of the tensions between the core and the periphery or some of the fragility of the periphery reemerges in a way that puts at risk again this European project. I would say it’s a risk.
Of course, the Europeans for the last two to three years have shown through the things they have done that they are actually willing to suffer and stick together. So the immediate risk of a breakup is not there and most likely it’s not going to be there. But if tensions about growth, debt sustainability, unemployment, and so on are going to reemerge and there’s not a faster process of integration, then people are going to come back in the next couple of years and question the viability of this monetary union. So it’s a risk to keep in mind.
OR: Let’s talk about the emerging markets. There’s been a lot of talk about the “Fragile Five.” You’ve added six more, let’s call them the “Roubini Six.” Can you talk a little bit about which you think could potentially have systemic risk attached to them?
Roubini: The Fragile Five is well known. India, Indonesia, Brazil, Turkey and South Africa have a few things in common: current account deficits, fiscal deficits, falling growth, rising inflation above their targets. All of them this year have faced or are facing either legislative or presidential elections that create some political and policy uncertainty. In addition to these fragile ones, there’s a group of at least six countries or maybe more that are fragile for another combination of economic, political and financial reasons. These include, of course, Ukraine, Russia, and Hungary in Central Europe, Argentina and Venezuela, the very populist radical countries in Latin America, and in Asia, Thailand, because there is an internal fight between different parts of the country that can escalate into outright violence.
And we have to consider in addition to fragile emerging markets that there are plenty of countries that actually have stronger economic and financial and policy fundamentals. In Asia, countries like Korea or Malaysia or Philippines or Singapore. In Central Europe, Poland, Czech Republic, Slovakia. In Latin America, Mexico is doing reform, Peru, Chile, Colombia are doing lots of good things. In Sub-Saharan Africa, South Africa is barely growing at 2% but six out of the ten fastest growing economies in the world happen to be in Sub-Saharan Africa. You have growth stories in Kenya, in Nigeria, in Rwanda, in Angola, in Mozambique, in Botswana.
So you cannot group all emerging markets together. Some of them have those fragilities. Some of them have actually economic and policy success. Now they all have in common a few things that are going to be a concern to me. One is that global tailwinds are becoming headwinds. In the last decade, you had 10% growth in China. There’s not going to be any more 10%. It will be 7% or below. You had zero policy rates and easy money searching for yield. However slowly the Fed’s going to exit. And you had the high and rising commodity prices, and now that the correction has started, it’s going to continue, not just because of China.
Some of these economies had loosening of monetary, fiscal, and credit policy and they have macro fragilities. The last decade has been a bit of a decade of lost opportunity for structural reforms in emerging markets. Instead of doing that kind of reform to increase potential growth, many of them moved away from it towards variants of growth models based on state capitalism: too much role of state owned enterprise in the economy, too much role of state owned banks in the allocation of credit and savings to investment, resource nationalism and trade protection as we saw it in China and Russia but also in India, in South Africa, in Brazil, let alone in the more populist countries like Argentina or Venezuela and others.
So probably the next decade for growth and equities in EM is going to be not as good as the last decade. That’s one thing to keep in mind, and you have to keep in mind also that some countries will have the right political economy to do the structural reform, namely, for example, recently Mexico. There’ll be other ones in Latin America or even in Asia or Central Europe that are not going to have that political capacity to do those reforms and therefore their potential growth may fall 1%, 2%, and therefore their return on their assets is maybe much lower in the next decade than the last one.
So I don’t worry as much about one of them totally blowing up and having a systemic effect. I think the risk right now is low because even Brazil, Indonesia, India, South Africa, and Turkey have done some policy adjustment, and they have a buffer of reserves, flexible exchange rates, they don’t suffer from illiquidity or insolvency, their banks are okay. So I don’t expect to see any of them really blowing up. I am more worried about the slow grind of mediocre economic policymaking that has a toll on growth and leads to greater financial fragility and then to underperformance of equities in some of these economies.
OR: Maybe you could talk a little bit about Japan. You are positive on what’s going on there.
Roubini: Yes. I recently visited Japan and overall I’ve been optimistic about Abenomics. The first two arrows of monetary and fiscal stimulus stopped the deflation, stopped the recession, led to an economic recovery, a weakening of the yen, and a strengthening of the stock market. Of course, the second arrow has been turned into a contraction now from an expansion because they have to deal with the deficit. And the third arrow, this is the most important one, is the one of the structural reforms that are needed in order to increase potential growth and make the debt dynamic of Japan sustainable.
Now some people say there is almost nothing happening in the third arrow. I disagree. They’ll cut corporate taxes, they’ll do some deregulation, they’ll have special economic zones. Hopefully, the Trans-Pacific Partnership with the US and Asian and Pacific countries is going to occur. And there will be other policy decisions that are going to lead to a gradual improvement and liberalization of the economy that’s going to sustain potential growth.
Are they going to do it fast enough compared to what’s optimal and desirable? No. But as long as again they go in the right direction and they do some fiscal adjustment and with the BoJ buying most of the government bonds, the risk of a public debt crisis in my view in Japan is limited. Of course, medium- to long-term, the third arrow is going to be key because to reduce those debt ratios to be able to grow more robustly, you have to do structural reform and increase productivity. So over the next two years, I would say Japan is for now out of the woods, but the third arrow of reform is going to be key to see whether that debt ratio can be stabilized and reduced because if it keeps on rising, public debt already at 200% of GDP and rising, eventually that could lead to a debt crisis. But it’s not the risk I see in the short term.
OR: Would there be a hyperinflation or a huge backup in interest rates? What would happen in that scenario?
Roubini: Well, a debt crisis will manifest itself first of all as people worrying about a credit event occurring in Japan and then long-term interest rates, which are very low now at below 1%, rising very sharply and making the debt dynamic –with high interest rates on the high stock of public debt – even more unsustainable. And then the policy response will determine what happens next. If you print money like crazy, you could end up into a bad inflation equilibrium. If you do a debt restructuring effectively it has to be coercive and you are in a near default mode. Or you could try to keep on monetizing short of something that is inflationary. So the result of that pressure on long yields could be different depending on which policy response does occur.
Inflation vs. Deflation
OR: Globally, are you generally more afraid of inflation or deflation right now? It sounds like deflation.
Roubini: I don’t worry about inflation of goods in advanced economies, in the US, in the UK, in the Eurozone, in Switzerland, in Canada, in Sweden. All central banks are struggling barely to achieve the 2% inflation target, in most of them it is closer to 1% or even below 1% and falling rather than rising. So goods inflation is not my main worry. I don’t worry about outright deflation because I think monetary policy is going to be aggressive to prevent outright deflation from occurring with a caveat that the Eurozone has to do more quantitative easing to avoid the risk of deflation because they are one or two shocks away from deflation.
But I do worry more about asset inflation because all this liquidity is not going into the real economy and real credit growth that leads to excessive demand for goods and services, compared to supply, is inflationary. It’s going all into essentially financial transactions that eventually create frothiness if not bubbles in asset prices. So I worry about asset inflation more than about goods inflation.
OR: Thank you, Nouriel. That’s very interesting.
Roubini: Great talking together today. It was a pleasure.