A potential Greek exit from the EU, unravelling of Puerto Rico (PR) debt and a collapse in China’s equities indicate that investors may be starting to witness the opening scenes of the last act in a global leveraging drama that had its first act in Japan (1990) and second during the GFC (2008).

Macquarie Equities Research (MER) discusses in a recent research piece if the dominos are finally falling…

Here are excerpts from the MER report released on Monday 6 July 2015:


What Greece & Puerto Rico have in common…
Potential Grexit, unravelling of Puerto Rico debt and a collapse in China’s equities indicate that investors may be starting to witness the opening scenes of the last act in a global leveraging drama that had its first act in Japan (1990) and second during the GFC (2008). It seems that investor belief in the ability of monetary and public sector policies to delay the day of reckoning until a less painful solution to inevitable de-leveraging is found might be starting to unravel. As usual the weakest dominos are the first to fall.
 
What do Greece and Puerto Rico have in common (apart from sunshine)? First, both are uncompetitive, with a low level of efficiency (external & domestic). Second, political, business and bureaucratic systems are mired in clientelism (patronage), corruption and poor business practices. Third, both have an oversized public sector. Fourth, both carry an unsustainable level of debt (due to inefficiencies, low competitiveness and patronage networks). Fifth, and most importantly, neither country has an independent monetary policy.


…and how different is China? A lot in the short-term not so much in the long term…
How different is China? Whilst its business climate has deficiencies, China remains one of the most competitive on a global basis (international but also increasingly domestic); it runs significant current account surpluses and perhaps most importantly China has a much higher than average degree of monetary and fiscal flexibility, which is completely absent in Greece or Puerto Rico.
 
Whilst most investors are arguing that over the last week China has thrown everything it possibly could at supporting its equity market and failed, MER disagrees. A small interest rate cut, relaxation in reserve requirement ratio (RRR) and margin financing, whilst useful, are not a “bazooka”. These are the similar tentative steps that the European Central Bank was hesitantly deploying in 2009-11, before the “whatever it takes” statement by Draghi and recent quantitative easing. China’s response also remains far away from the Bank of Japan’s policies.

What else can China do? First, MER has argued for some time that growing overcapacity in every facet of China’s industry and economy requires a rapid reduction in interest rates. China currently is the only major economy that operates with strongly positive real interest rates. Second, MER maintains that current RRR restrictions are completely obsolete and should be rapidly reduced towards historic levels (approximately 5%). Third, the People’s Bank of China has to accept that de-leveraging is no longer possible or desirable and it should embark on aggressive quantitative easing (including acquisition of private sector instruments).


….where impact would depend on structural reform
In MER’s view, the case of Greece and Puerto Rico highlights that deleveraging requires significant upfront cost that most societies are unwilling to bear. Whilst moving monetary policy into a neutral gear and allowing business cycle adjustment is the best strategy, in reality any structural reform and de-leveraging requires massive monetary and fiscal lubricants to ensure societal consent. However the experience has been that monetary lubricants, instead of accelerating structural changes, tend to delay them. The question for China therefore is not whether it will stimulate (this is a given, it just a question of size) but could it simultaneously pursue structural reform? The jury is still out but in the shoter-term MER remains overweight on the MSCI China Core Index, expecting a much more robust policy response.
 

Source: Macquarie Research - 9 Jul 2015