Economy

Special Report

Highlights Few emerging market peers have a track record of democracy like India does. Russia and others have long histories of political instability and one-man rule. Several large EMs have experienced stints of military rule in the post-WWII era. While India’s democratic credentials are real, these should not be exaggerated. India’s political system suffers from some structural and cyclical vulnerabilities. These imperfections deserve attention today, more than ever, given that India trades at a record premium to peers. From a strategic perspective, we remain Buyers of India. India’s democratic traditions will lend political stability as the country’s economic heft grows. However, on a time horizon, we recommend paring exposure to Indian assets. A loaded state election calendar awaits in 2022, which will be followed by crucial state elections in 2023 and general elections in 2024. While we expect the incumbent political party to retain power in 2024, history suggests that the road to general elections is paved with policy risks. Policymakers tend to shift attention from market friendly-reform to voter-friendly policies as these key state elections approach. Additionally, geopolitical risks for India are ascendant as dangerous transitions are underway to India’s west and east too. Feature Investors regard India as being exceptionally well-off on political parameters. It is viewed by many as the blue-eyed boy of emerging market democracies. And for good reason. Despite its massive population and very low per capita incomes, India has remained a functional democracy for over seventy years. Democratic political regimes are a relatively new trend. The number of democracies began exceeding the number autocracies in the world only very recently in 2002 (Chart 1). India was one of the earliest adopters of this trend compared to emerging market peers. Its democratic traditions are so well-entrenched now that they are comparable to those of some of the most developed economies of the world (Chart 2). To add to these democratic credentials, every government at the national level in India has completed its full five-year term since 1999, thereby offering stability. Investors greatly value the political stability that India offers. While political stability is only one factor that investors consider, India has traded at a 28% premium relative to democracies and a 67% premium to non-democracies like Russia and China over the last decade (Chart 3). ​​​​ ​​​​​​ In this report we highlight that while India’s democratic credentials are real, these should not be exaggerated. The political system in India is solid but far from perfect. It suffers from both structural and cyclical vulnerabilities. These imperfections deserve attention today more than ever, given that India trades at a record premium to peers (Chart 3). Also, a closer look at India’s political system is warranted given that both geopolitical and macroeconomic risks for India are ascendant. With India, the devil always lies in the details. India is the largest democracy of the world but is also one of the few large democracies that follows a first-past-the-post (FPTP) method of determining election winners and has no effective limit on the number of political parties that can contest elections. Most democracies, either combine an FPTP system with natural or legislative limit on the number of competing political parties (such as in the case of UK and US) or rely on a non-FPTP system, with specific vote thresholds to enter Parliament. The combination of an FPTP system along with a system that allows multiple small political parties to exist entails challenges and makes the system vulnerable to some structural policy problems that are often overlooked. These include: A Tendency To Go All-In: An FPTP system means that at an election, the contestant with the highest number of votes is declared the winner even if the victory margin is very low. For instance, the narrowest victory margin recorded at an Indian constituency-level election is a mere 9 votes! Such a system where the winner takes all, irrespective of the victory margin, creates perverse incentives for contesting candidates to go all-in on populism ahead of elections. Indian elections have thus seen candidates offer everything from food and free laptops, to free alcohol and hard cash, in a bid to woo voters in the run up to elections. Too Many Players Can Spoil The Election: An FPTP system alongside a multi-party system can lead to very high degrees of political competition. While competition is usually a virtue, very high levels of political competition tend to fragment the electorate. Owing to these reasons, political competition in India tends to be very high in general. For instance, the last two general elections in India saw 15 candidates contest from each constituency on average. This compares to an average number of contestants from each constituency being 5 for UK or 6 for Canada. The problem with this fragmentation is that the victorious politician may lack a strong popular mandate. Smaller Indian states bear the brunt of this problem. The smaller the state, the cost of the pre-election campaign is lower, so the number of contestants shoots up in smaller regions (Chart 4). Rent-Seeking Becomes A Necessity: Such a system which combines FPTP and no major entry barriers for contestants arguably encourages rent-seeking behavior, which election winners frequently display. Populist spending promised by candidates to lure voters ahead of elections can be very high, especially when political competition is stiff. Winners then are keen to recover this “sunk cost” and to create a war chest for the next election. This prompts the rent-seeking that often becomes a necessity for candidates who run expensive election campaigns. To conclude, few emerging market peers have a sustained track record of democracy like India does. Russia and others have long histories of both political instability and one-man rule. Brazil, Turkey, Thailand, South Korea, Taiwan, and Indonesia have all experienced stints of military rule and revolutions in the post-WWII era. Whilst India’s political stability credentials are solid, the existence of high degrees of political competition alongside high degrees of social complexity will spawn both structural and cyclical policy risks in India. Navigating India’s Political Peculiarities It is heuristically convenient to assume that policy risks in India are uniform across time. However, in this report, we highlight that policy risks for India hardly tend to be the same through the five-year term of a political party in charge at the national level. The five-year term of any central government in India is paved with cyclical policy risks. The good news is that there is a method to the madness. We present a simple method to identify a “pattern” to the cyclical policy risks: We break down India’s general election cycle into a five-year sequence. Year 1 is defined as the year after a general election takes place (such as 2020) and Year 5 is defined as the year in which a general election takes place (such as 2019 or 2024). (See the Appendix for a quick overview of India’s political system.) Given that India has 28 states and a state government’s term lasts five years, about six state elections are held each year. After identifying this five-year sequence, we then identify specific states that become due for state elections during this five-year period. Such a characterization of India’s election cycle shows how the five-year period from one election to the other is hardly the same. In fact, it becomes clear how policy risks tend to be definitively elevated in the years leading up to a general election. Year 3 in such a framework sees elections in some of India’s largest states (size), India’s politically most sensitive states (sensitivity), and India’s socially most complex states (complexity). 2022 will mark the beginning of Year 3 of the current five-year cycle and will see: Size: The most loaded state election schedule which will affect more than a quarter of India’s population (Chart 5). Sensitivity: Elections take place in most of India’s northern region (Chart 6), which is a key constituency for the ruling Bhartiya Janata Party (BJP). ​​​​​​ ​​​​​​ Complexity: Elections take place in some of the most socially conflict-prone states such as say Manipur (Chart 7). Year 3 of India’s cycle is also worth bracing for as it typically sees the policy machinery’s attention shift away from big-ticket reform to populism. This is probably because Year 4 sees some of the poorest states in India undergo elections (Chart 8) and then Year 5 sees a general election. ​​​​​​ ​​​​​​ What becomes clear now is that India is set to enter the business-end of its five-year election cycle in 2022. So, what specific policy changes should investors expect? The Road To Elections … Is Paved With Policy Risks Irrespective of the political party in power at the centre, populism as a theme tends to become more defined in the two years leading to a general election in India. For instance, history suggests that government spending in the two years leading up to a general election tends to be higher than in the previous three years (Chart 9). The last time this theme did not play out was in the run up to the elections of 2014 when in fact the incumbent i.e., the Indian National Congress (INC) lost elections to the Bhartiya Janata Party (BJP). Distinct from the fiscal support to the economy that tends to rise in the run up to elections, it is notable that even money supply growth, inflation to an extent and even the pace of Rupee depreciation tends to be faster in India in the years leading up to a general election (Chart 10). ​​​​​​ The run up to Year 3 and Year 4 of India’s election cycle also tends to see the announcement of voter-friendly policies that may not necessarily be market-friendly. Examples of this phenomenon include: Record Increase In Revenue Spends Ahead Of 1999 General Elections: In 1998 the-then Finance Minister oversaw a whopping 20% year-on-year increase in revenue expenditure. This is almost double the average growth rate of 13% seen in this metric over the last 25 years. Farm-loan Waiver Ahead of 2009 General Elections: In 2008 i.e., the year before the general elections of 2009, the Indian National Congress (INC)-led central government announced its decision to write off farm loans of about $15 billion (in inflation-adjusted terms today). Demonetization Decision Ahead Of 2017 Uttar Pradesh State Elections: The BJP-led central government announced its decision to demonetize 86% of currency in circulation in November 2016 in a bid to prove the government’s commitment to crackdown on black money. GST Rate Cuts Ahead Of 2017 Gujarat State Elections: The Goods and Services Tax (GST) council announced a cut in the GST rate for over 150 items in November 2017. This was ahead of Gujarat state elections that were due in December 2017. Such decisions are known to work with voters. The incumbent political party that announced these policy decisions, in each of the three cases cited above, won the elections that they subsequently contested. Just last week, the Indian Government decided to repeal farm sector reform related laws which it had announced a year ago. It is not entirely coincidental that this pro-voter decision has been announced just a few months ahead of critical state elections due in 2022. Key State Elections To Watch In 2022 State elections are due in seven states in India in 2022. State elections due in 2022 will have an indelible impact on India’s policy outlook for 2022 because the BJP is the incumbent party in most of these states and BJP’s popularity has suffered because of the pandemic (Chart 11). The government’s decision last week to roll back farm sector reform is a great example of this phenomenon. Of all the state elections due in 2022, the two key elections that will have the biggest bearing on the 2024 general elections will be the elections in Uttar Pradesh in February 2022 and in Gujarat in December 2022. BJP’s popularity in these states should be closely watched to get a better sense of the 2024 general election outcome. The BJP won about 80% of the cumulative seats these two states offer at the 2019 general elections. At the last state elections held in Uttar Pradesh in 2017, the BJP stormed into power in the state, winning 77% of seats. BJP’s entry into power there was symbolic as the road to New Delhi is said to pass through this state (Chart 12). Gujarat on the other hand has been a BJP stronghold and PM Modi began his political innings as the chief minister of this state. Despite being in power in Gujarat for over two decades, the BJP managed to retain power in this state at the last elections held in 2017 (Chart 13). ​​​​​​ ​​​​​​ Accurate pre-poll data for these states will be available only closer to election day. Our early on-ground checks suggest that the BJP is set to almost certainly retain power in Uttar Pradesh in 2022. However, the BJP runs the risk of losing some vote share in Gujarat owing to the anti-incumbency effect it faces and owing to the rise of parties like the Aam Aadmi Party (AAP) in the state of Gujarat. Another tool that can be used to estimate the likely result of these two key state elections is the economic growth momentum in these states. State election results from 2021 suggest that this macro variable matters a great deal. While it is not the only variable that matters, the incumbent lost elections in large states in 2021 when growth decelerated excessively (Chart 14). For instance, in 2021, Tamil Nadu saw its GDP growth decelerate significantly but West Bengal saw its GDP growth decelerate by a lesser extent. Notably, the incumbent was displaced out of power in Tamil Nadu but managed to retain power in West Bengal possibly because of several factors including a lesser slowdown in economic growth (Chart 14). If GDP growth were to affect election outcomes in 2022 as well then, the incumbent i.e., the BJP, will comfortably retain power in Uttar Pradesh but may have to deal with the risk of losing some vote share in Gujarat. This is because economic growth accelerated in Uttar Pradesh over the last five years before the pandemic. GDP growth rates remained high in Gujarat but the pace of acceleration was weaker (Chart 15). ​​​​​​ ​​​​​​ However, from the perspective of the general elections of 2024, BJP’s position in these two states remains fairly strong, and this is true even if it experiences minor setbacks in the upcoming state elections. National parties like the BJP tend to enjoy greater fervor amongst voters in general elections as opposed to state elections. It hence would take an earthquake defeat in these state elections to alter this assumption – an outcome which appears unlikely at this stage. The takeaway from the above is that investors must brace for the BJP pursuing populist policies over the next two years. In fact, we are increasingly convinced that the BJP government’s budget for FY23 (due to be announced on 1 February 2022) will see a marked increase in transfer payments for farmers in specific or low-income groups in general. The announcement of a brand-new program aimed at lifting incomes of India’s lowest economic strata cannot be ruled out. But from the perspective of the 2024 elections, the BJP appears well-placed to retain power. Investors will face negative policy turbulence in the short run but should maintain a base case of policy continuity over the long run. Investment Conclusions If You Are Playing A Long Game, Then Hold: From a strategic perspective, we remain Buyers of India. India’s democratic traditions will lend political stability as the country’s economic heft grows. Its democratic credentials will also yield geopolitical advantages as America aims to create an axis of democracies to contain autocratic regimes. It is notable that the US’s most recent alliance-formation efforts - such as the Quadrilateral Security Dialogue or the AUKUS nuclear submarine deal - involve some of the oldest democracies of the world. As India sheds its historical stance of neutrality, in favor of closer alignment with the US against China, its democratic credentials will help India deepen its engagement with geopolitically powerful democracies. If You Are Playing A Short Game, Then Fold: The Indian market appears priced for perfection today. We recommend paring exposure to Indian assets on a tactical time horizon. Historically India’s premium relative to emerging markets has shown some correlation with the BJP’s popularity (Chart 16). However, India’s premium relative to EMs has shot through the roof over the last year and hence even if BJP wins the Uttar Pradesh elections (our base case), then it is unclear if that victory will drive another bout of price-to-earnings re-rating for India. Moreover, as outlined, the road to state elections in 2022 will be paved with policy risks as the government prioritizes populism ahead of pro-market reform. The BJP has managed to expand its influence in India over the last decade (Chart 17). But a unique problem now confronts Indian policymakers: while stock markets in India have risen almost vertically, wage inflation has collapsed (Chart 18). Additionally, India has administered a weak post-pandemic fiscal stimulus (Chart 19). We reckon that this fiscal restraint will be tested in the run up to key elections in 2022-23. ​​​​​​ ​​​​​​ Unlike in developed economies, where fiscal stimulus is seen as pro-market because it suggests policymaking is improving and deflationary risks will be dispelled, fiscal stimulus can be market-negative in the context of an EM like India. Increases in populist spending can end up adding to existent inflationary pressures and hence can drive bond yields higher. Stock market earnings too may not end up getting a major boost on the back of increase in transfer payments to low-income groups. This is because the share of market cap accounted for by sectors which directly benefit from pro-poor spending, like Consumer Staples, has been drifting lower on Indian bourses from 10.8% in 2013 to 8.9% today. As we have been highlighting, distinct from policy risks that confront India on a tactical horizon, geopolitical risks confronting India are elevated too. Dangerous transitions are underway to India’s west (involving Pakistan and Afghanistan) as well as east (involving China). While China’s woes drive EM investors to India, any clashes with neighbors will create much better entry points into Indian stocks.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Appendix: An Overview Of India’s Political System India follows a parliamentary model of democracy with a federal structure where the government at the centre as well as state level is elected for a period of five years. The central government of India is formed through general elections that are held every five years. Power is held by a political party (or a coalition of parties) that can secure and maintain a simple majority in the Lower House (or Lok Sabha) through this five-year term. India also constitutes 28 states, each with its own legislative assembly. Each state government is formed through a state election held every five years. Much like at the centre, power is held by a political party that can maintain a simple majority at the legislative assembly for this five-year term.  

Highlights Indonesian domestic demand is struggling to recover in the face of a very tight policy settings. Exceptionally high real borrowing costs continue to hurt non-financial sectors. This will hurt banks too as credit is stymied and NPLs rise. Equity investors should fade the rebound and stay underweight Indonesia in an EM equity portfolio. Indonesia’s external accounts will deteriorate, as the Chinese slowdown weighs on resource prices. Softening commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. Domestic bond investors should tactically downgrade Indonesia from neutral to underweight within an EM bond portfolio. Sovereign EM credit investors, however, should stay overweight Indonesia. Feature Chart 1Indonesian Stock Rebound Will Be Short-Lived After years of underperformance, Indonesian stocks have rebounded in absolute terms and inched up relative to the EM benchmark (Chart 1). Could this be the beginning of a sustainable outperformance? Our research indicates that the answer is no. The Indonesian economy is still struggling. Domestic demand remains lackluster, hamstrung as it is by very high real interest rates and a tight fiscal stance. A flexing export sector, the sole source of strength so far, is set to dissipate as well. Weaker exports will weigh on the nation's financial markets. A budding softness in EM financial markets – emanating from a slowing China and rising US bond yields – will be yet another headwind for Indonesian assets over the next several months. Investors therefore should fade the current rebound and remain underweight this bourse in EM equity portfolios. EM domestic bond portfolios should consider downgrading this market from neutral to underweight relative to its EM peers. Currency investors may consider shorting the rupiah versus the US dollar. Sovereign EM credit investors, however, should stay overweight Indonesia in an EM US dollar bond portfolio. Straightjacketed The main drag to Indonesia’s economic recovery is coming from prohibitively high interest rates in the country. Real borrowing costs for the private sector, of the order of 10% (Chart 2, top panel), are extremely restrictive for any economy to handle, let alone one trying to recover from a debilitating recession. The real rates in Indonesia are also much higher than anywhere else in Asia – for both the private sector as well as for the government (Chart 2, bottom panel). Chart 2The Economy Is Struggling In the Face Of Very High Real Interest Rates Chart 3Absence Of Fiscal Support Is Making The Recovery Harder The fiscal stance does not appear to be very supportive either. The government is planning to rein in the fiscal deficit next year to 4.8% of GDP from an expected 5.7% this year. The IMF projects that the cyclically- adjusted fiscal thrust in 2022 will be a negative 0.8% of potential GDP, and a further negative 1.5% in 2023 (Chart 3). The consequence of such restrictive settings is that domestic consumption and consumer confidence are languishing well below pre-pandemic levels (Chart 4). Consistently, loan demand is also very weak. Bank credit for both consumption and production purposes (both working capital and term loans) have barely risen after having shrunk outright last year (Chart 5). Chart 4Domestic Demand Is Soft As Consumer Confidence Remains Low Chart 5All Types Of Bank Credit Are Weak Chart 6Disinflationary Pressures Are Entrenched In The Economy Weak domestic demand is reinforcing deflationary forces. Inflation has been undershooting the lower band of the central bank target for almost two years now. Core and trimmed mean CPI measures have been averaging below 1% over the past year. Headline CPI is below the lower target band despite high oil and food prices (Chart 6, top panel). At the same time, nominal wages are barely rising (Chart 6, bottom panel). Hence, household income growth is subdued, which is sapping consumer demand. Notably, the very high real interest rates in Indonesia today are an outcome of monetary policy falling behind the disinflation curve. In the 2000s, the country’s consumer price inflation would often flare up to double digits, and the central bank used to keep interest rates consistently high. Over the past 10 years or so, however, inflationary pressures have gradually given way to deflationary forces. Even though the central bank has reduced its policy rate, it has not reduced it sufficiently enough to offset the drop in inflation. As a result, real interest rates have risen. Banks, on their part, also refused to fully pass along the rate cuts accorded by the central bank. As such, banks’ lending rates to the private sector, in both nominal and real terms, remained much higher compared to their peers elsewhere in Asia (Chart 2, above).  Part of the reason why the central bank has fallen behind the disinflation curve has to do with the exchange rate stability and Indonesia’s dependence on foreign debt capital inflows. The country needs to offer high real rates to continue to attract enough foreign capital so that it can finance the current account deficit. As long as the central bank has rupiah stability (as a means for price stability) as its mandate, it will not reduce real interest rates. Incidentally, a bill to include economic growth and employment within the central bank’s mandate was submitted to Parliament earlier this year. Discussion over the bill, however, has been delayed. This means that elevated real interest rates will prevail for now in Indonesia, hampering economic growth. Fading Bright Spot Chart 7The Surge In Exports Has Been All About Commodity Prices, Not Increasing Volumes In contrast to domestic demand, Indonesia’s exports did phenomenally well over the past few quarters. That said, there are signs that those heady days are coming to an end: The main reason exports did so well is that commodity prices went vertically up. Export volumes, on the other hand, stayed quite low. This is also evident in the case of coal and palm oil – Indonesia’s two main export items (Chart 7). Since it’s not the volume that drove up the export revenues, the latter is vulnerable to the whims of global commodity prices – of which Indonesia is a price-taker. And commodity prices, in general, have already begun to soften. China is by far the largest destination for Indonesian exports (22% of total), and demand in the Middle Kingdom has been among main reasons behind the recent surge in Indonesian exports. Yet, the fact that China’s credit and money impulses have turned negative is a major concern for Indonesian exports going forward. If history is of any guide, negative impulses will cause a contraction in Indonesian exports over the next year or so (Chart 8). Odds are therefore that the country’s trade surplus will roll over and the current account balance will slip back to a deficit (Chart 9, top panel). Chart 8Negative Chinese Credit And Money Impulses Will Cause Indonesian Exports To Shrink Chart 9Indonesia's Trade And Current Account Balances Have Peaked Chart 10A Slowing Chinese Credit & Fiscal Impulse Is Always A Bad Omen For The Rupiah Meanwhile, Indonesia’s financial account is struggling to stay in surplus as capital inflows have dwindled significantly over the past couple of years (Chart 9, middle panel). FDI inflows are also showing few signs of revival (Chart 9, bottom panel). This indicates that Indonesia’s envisioned reforms, under the ‘Omnibus bill’, are yet to gain much traction and produce meaningful improvements in the economy’s structural backdrop. All in all, the outlook for the country’s external accounts is much less sanguine in the months ahead. That will not bode well for the rupiah, which has benefitted from robust external accounts so far. A material drop in Chinese credit and fiscal impulse has never been positive for the Indonesian currency. In the months ahead, therefore, the path of least resistance for the rupiah appears to be down (Chart 10, top panel). The link is via commodity prices (Chart 10, bottom panel). Notably, most capital inflows into Indonesia are in the form of debt capital inflows. Equity inflows are paltry. The reason is straightforward: foreign bond investors like the extremely high real rates that the country has been offering, whereas the equity investors do not. Yet, in the past couple of years, even debt capital inflows have subsided (Chart 9, middle panel). Should foreign investors turn nervous about the rupiah outlook due to falling commodity prices and/or rising US interest rates, those debt inflows would further subside. Deteriorating capital inflows would cause further weakness in the rupiah in a self-fulfilling prophecy. Domestic Bonds Chart 11Indonesian Domestic Bonds' Outperformance Is Late Indonesian local currency bonds have significantly outperformed their EM counterparts over the past several months (Chart 11, top panel). We have been positive on Indonesian domestic bonds. Going forward, however, the nation’s local bonds will find it difficult to rally in absolute terms and will likely underperform their EM peers. One reason for this is that, given Indonesian yields are already close to post-pandemic lows, it will be harder for them to fall much more. The relative performance of domestic bonds versus their EM peers will also be beset by a vulnerable rupiah – as explained above. The bottom panel of Chart 11 shows that periods of a weaker rupiah are usually associated with Indonesia underperforming overall EM domestic bonds. This is because foreign investors (who hold 21% of Indonesian local bonds) usually head for the exit once the rupiah begins to depreciate. Finally, as was explained in our report last week, various EM assets classes are in for a period of volatility – prompted by a deepening slowdown in China and rising US bond yields. Periods of EM stress do not augur well for Indonesian local bonds’ relative performance vis-à-vis their EM brethren. This is because the relative yield differential of Indonesia with that of EM widens in such periods – as occurred during the 2013 taper tantrum, the 2015 EM slowdown, and the 2020 pandemic (Chart 11, bottom panel). Since another EM risk-off period is around the corner, investors will be well advised to book profits on Indonesian domestic bonds’ recent outperformance and tactically downgrade this market to underweight in an EM domestic bond portfolio. Sovereign Credit Unlike the case of local currency bonds, Indonesia's sovereign credit has metamorphosed into a defensive market over the past several years. Investors now consider Indonesian sovereign credit to be among the safest within EM. This is an upshot of low public debt, including very low foreign currency public indebtedness, and years of orthodox fiscal and monetary policies. Chart 12Indonesian Sovereign Bonds Now Outperform During Risk-Off Periods In previous risk-off periods (such as the GFC in 2008 and the taper tantrum in 2013), Indonesian sovereign credit would typically underperform their EM counterparts. Yet, in more recent episodes (such as the EM slowdown in 2015 and the COVID-19 pandemic in 2020), Indonesian sovereign credit massively outperformed the EM benchmark. These recent instances suggest that during the oncoming risk-off period investors should stay overweight Indonesian sovereign credit in an EM basket.  Notably, the regime change in Indonesia’s sovereign credit characteristics has led to its relative performance (versus overall EM) being decoupled from the rupiah (Chart 12). While the rupiah remains a cyclical currency, the significant improvement in sovereign creditworthiness has turned Indonesian credit markets into a defensive play within EM. Therefore, a weakness in the rupiah in the months ahead will not jeopardize its relative performance. Share Prices Chart 13Indonesian Bank Stocks Failed To Break Out, While Non-Banks Keep Falling The Indonesian equity market is structurally beset by an uneven playing field, where the country’s banking sector has benefitted at the expense of all others. This is a consequence of banks maintaining high real lending rates as well as very wide net interest rate margins for far too long. The outcome is evident in financial and non-financial sectors’ diverging performance over the past decade (Chart 13). Given that the bull market in bank stocks has been contingent on banks’ net interest margins (NIM), any reduction therein will hurt bank stocks (Chart 14). At the same time, maintaining current lending rates and net interest margins will continue to hurt non-financial sectors (i.e., borrowers). In other words, for non-financial sectors to benefit, it will have to come at the expense of banking sector. Since banks and the rest of the stock market have very similar weights in this bourse, this dynamic will make it hard for this market to rally overall in a sustainable manner. Notably, bank stocks have failed to breach their pre-pandemic highs. This is despite net interest margins being quite elevated. The reason is that high real borrowing costs in a weak economy not only discourage credit off-take, but also threaten to raise NPLs further. Indonesian bank stocks are quite expensive as well: their ‘price/book value’ ratio is 2.6 while that of their EM counterparts is 1.1. As such, they will be hard pressed to have another sustainable rally. The other half of Indonesian equity markets, non-financials, are expectedly doing worse in the face of persistently high borrowing costs. So are the small cap stocks – where non-financial firms make up 85% of the market cap (Chart 13, bottom two panels). Notably, since Indonesia is a commodity producer, Indonesian stock prices usually do well during periods of rising commodity prices. Yet, headwinds emanating from weak domestic demand prevented Indonesia from benefitting much from high commodity prices this past year (Chart 15). Going forward, with the dissipating commodity tailwind, the Indonesian market will likely falter anew. Chart 14Any Fall In The Elevated Net Interest Margins Will Hurt Bank Stocks Chart 15Extremely Restrictive Real Rates Prevented Indonesia From Benefitting From High Commodity Prices Furthermore, a period of overall EM volatility is also a negative for Indonesian stocks’ absolute and relative performances. Investment Conclusions An impending relapse in commodity prices will herald a weakness in the rupiah. Currency investors should consider going short the rupiah versus the US dollar. In view of the likely weakness in the rupiah, dedicated EM local currency bond portfolios should pare back their exposure to Indonesia and tactically downgrade this market from neutral to underweight. Expected softness in domestic demand in the face of high real rates, faltering commodity prices and an impending volatility in EM assets - all entail that investors should stay underweight this bourse in an EM equity portfolio.   Finally, given the new defensive stature of Indonesian sovereign credit, asset allocators should stay overweight Indonesia in dedicated EM US dollar bond portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes

Highlights Long-term investors should place up to 5 percent of their assets in cryptocurrencies. As the drawdown risk of owning cryptocurrencies converges with that of owning gold, the cryptocurrency asset-class can reasonably displace gold to take half of the $12 trillion anti-fiat investment market… … with BTC, ETH, and the others taking a third of this half – $2 trillion – each. This means that BTC would double to $120,000, while ETH would quadruple to $17,000. Some embryonic blockchain tokens could do even better. In this list of potentials, we would put Solana, Cardano, XRP, and Polkadot. Underweight gold relative to the other precious metals. As cryptocurrencies eat more of gold’s lunch, gold is set to become a pale shadow of its former self. Fractal analysis: Coffee and Cameco. Feature Chart of the WeekCryptos Are Eating Gold's Lunch... And There's Plenty More To Eat If you’re wondering just how the market value of cryptocurrencies has surged to $2.5 trillion today from $0.5 trillion barely eighteen months ago, there’s a simple answer. Cryptocurrencies have eaten gold’s lunch – displacing almost $2 trillion from the investment value of the yellow metal. And that’s just so far… Given that the investment value of gold still stands at $9.5 trillion, there is plenty more of gold’s lunch that cryptocurrencies can eat (Chart of the Week). As Mark Twain might put it, rumours of crypto’s demise have been greatly exaggerated. When cryptocurrency prices corrected by 50 percent in May this year, the obituary writers got busy. For the 419th time. But since their birth in 2007, every time that they have ‘died’, cryptocurrencies have proved their detractors wrong, with prices quickly resurrecting and reaching new highs. We expect this pattern to continue (Chart I-2). Chart I-2Rumours Of Crypto's Demise Have Been Greatly Exaggerated Cryptocurrencies And Blockchains Are Joined At The Hip To understand the investment case for cryptocurrencies, it is important to realise that the success of a cryptocurrency and the success of its blockchain are inextricably linked. Yet what confuses this matter is that for the best known cryptocurrency of all – Bitcoin – the relationship between the cryptocurrency and its blockchain is ‘back-to-front’. Bitcoin is first and foremost a cryptocurrency BTC, which is secured (against double-spending) by its blockchain network. Meaning that BTC is the main act, and the Bitcoin blockchain is the supporting act. However, for most other cryptocurrencies, the opposite is true. The blockchain is the main act, and the cryptocurrency is the supporting act. For example, Ethereum is first and foremost a blockchain network – a decentralised intermediator of services such as smart-contracts or bond-issuance through decentralised finance (DeFi). Note that over $5 billion of bonds have already been issued on Ethereum and other blockchains, including by the European Investment Bank, the World Bank, and the Bank of China. The users of the Ethereum intermediation services pay the users of Ethereum that validate them in its cryptocurrency, ETH. Crucially, this ability to exchange ETH (and other cryptocurrencies) for intermediation services on the associated blockchain gives the cryptocurrency an economic utility. This economic utility means that the cryptocurrencies of successful blockchain networks can be thought of as ‘digital gold’. Gold derives its utility from its physical attributes – beauty, wear-ability, and electrical conductivity. Whereas, the cryptocurrencies of successful blockchains derive their utility from their means of exchange for the useful intermediation services that the blockchains provide. Furthermore, just as governments and central banks cannot determine the supply of gold, neither can they determine the supply of successful cryptocurrencies. This last point is important because most of the current value of gold comes not from its beauty, wear-ability, and electrical conductivity, but from its investment value as a hedge against the debasement of fiat money. The immediate investment case for cryptocurrencies is that they are set to displace much of this investment value from gold (Chart I-3). Chart I-3Cryptocurrencies Are Displacing Gold's Investment Value Cryptocurrencies Are Displacing Gold As The Anti-Fiat Hedge. Gold is scarce, but we can quantify its scarcity. Geology tells us that, in the earth’s crust, gold is 15 times as scarce as silver. And chemistry tells us that gold sits directly beneath silver in group 11 of the periodic table, meaning that the chemistry to extract gold and silver from their ores is essentially the same. Therefore, based on the geology and chemistry of the precious metals, gold should trade at around 15 times the price of silver. And 15 times the price of silver is precisely where gold did trade for centuries, and broadly where it traded in 1970. Yet by the mid-1970s the gold-to-silver ratio had breached 45, and by the late-1980s it had breached 75, where it stands today (Chart I-4). Why? Chart I-4Gold’s Massive Premium Versus Its Geological And Chemical Fundamentals Comes From Its Investment Value (As A Hedge Against The Debasement Of Fiat Money) The gold-to-silver ratio surged because, in 1971, the Bretton Woods ‘pseudo gold standard’ collapsed and the world economy moved to a fiat monetary system. Lest there is any doubt, a similar surge happened forty years earlier in 1931 when the original gold standard collapsed, before being reconstructed at the Bretton Woods conference in 1944. From these two surges, we can deduce that the premium in gold’s value versus its geological and chemical fundamentals constitutes its insurance policy value against the debasement of fiat money. Some people counter that only a small proportion of gold is owned as an explicit investment, and a large proportion is owned for its beauty and status. Yet this has been the case for millennia, and through most of this history gold-to-silver has traded in line with its geological and chemical fundamentals. Given that the gold price surges post-1931 and post-1971 coincided almost precisely with the introduction of fiat money, it is gold’s insurance policy value against the debasement of fiat money that is setting most of its current value. Based on the gold-to-silver ratio of 75 versus the geological and chemical fundamental value of 15, we can deduce that around four-fifths of gold’s $12 trillion above ground market value, or $9.5 trillion, comes from its insurance policy value. Add to that the current $2.5 trillion value of cryptocurrencies, and we can estimate that the total ‘anti-fiat’ investment market is worth $12 trillion. Of which, gold comprises around 80 percent, and cryptocurrencies around 20 percent. But to repeat, cryptocurrencies can eat much more of gold’s lunch (Chart I-5). Chart I-5Cryptocurrencies Can Eat Much More Of Gold's Lunch The Investment Implications: Bitcoin To $120,000, Ethereum To $17,000 We estimate that absent the displacement of investment value into cryptocurrencies since mid-2020, gold would now be trading at an all-time high of $2150 instead of at $1800. But given that there is much more of gold’s lunch for cryptocurrencies to eat, gold is set to become a pale shadow of its former self. Investors should underweight gold relative to the other precious metals. One pushback we get is that governments will ultimately issue a blanket ban on cryptocurrencies. But our pushback to the pushback is that it is a contradiction to be pro-blockchain and the anti- the ‘joined at the hip’ cryptocurrency which secures and validates the transactions on that blockchain. To resolve this contradiction, governments will try and regulate, rather than ban, cryptocurrencies. Another obvious question is: if Bitcoin is ‘back-to-front’ with its underlying blockchain having less utility and versatility than Ethereum and most other cryptocurrencies, should we still own BTC? The answer is yes, for two reasons. First, in time, the Bitcoin blockchain is likely to become more versatile; second, there will be some investors who hold out for the very long-term possibility that a cryptocurrency does displace fiat money. In which case, BTC would be the prime candidate. As the drawdown risk of owning cryptocurrencies converges with that of owning gold (Chart I-6), the cryptocurrency asset-class can reasonably displace gold to take half of the $12 trillion anti-fiat investment market, with BTC, ETH, and the others taking a third of this half – $2 trillion – each. Although BTC would become a smaller slice of the pie, the pie would be much bigger. From current market values, this means that BTC would double to $120,000. Chart I-6Cryptocurrency Corrections Are Becoming Less Extreme But the real action would be in the other cryptocurrencies. ETH would quadruple to $17,000, while some embryonic blockchain tokens could do even better. In this list of potentials, we would put Solana, Cardano, XRP, and Polkadot. In conclusion, we expect the cryptocurrency asset-class to continue its strong structural uptrend, punctuated by short sharp corrections. As such, long-term investors should place up to 5 percent of their assets in cryptocurrencies. Coffee Is Too Expensive In this week’s fractal analysis, we make two observations: First, for those who want a second bite at the cherry for shorting the uranium meme theme, the spectacular rally in the Canadian stock Cameco offers a good opportunity – given its very fragile 260-day fractal structure, which has successfully signalled five previous turning-points (Chart I-7). Chart I-7Cameco Is Overbought Second, within the soft commodities, the spectacular rally in coffee combined with the recent sell-off in cocoa has stretched the relative pricing of the two softs to a 10-year extreme, as well as a very fragile 260-day fractal structure (Chart I-8). Chart I-8Coffee Is Too Expensive Accordingly, this week’s recommended trade is to short coffee versus cocoa, setting a profit-target and symmetrical stop-loss at 30 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Dear Client, We will be working on our 2022 Outlook for China, which will be published on December 8. Next week we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Jing Sima China Strategist Feature In meetings with our North American clients this past week, we expressed the view that China’s economic growth is on a downward trend and easing measures have been gradual and modest in scope. Most clients agreed that China’s economy faces tremendous headwinds, however, some investors were more optimistic about the outlook for Chinese stocks in the next 6 to 12 months. Valuations in both China’s onshore and offshore equity markets have dropped to multi-year lows and macro policies have started to ease. Cheaply valued Chinese stocks should have more upside in the wake of policy support. Policy tone recently pivoted to a more growth supporting bias, but the existing easing measures will not offset the deceleration in both credit growth and domestic demand. China’s economic activity may worsen before it stabilizes in mid-2022. Moreover, China’s financial markets do not seem to have priced in the economic weakness. Therefore, in the next one to two quarters, risks to Chinese stocks are tilted toward the downside. Chart 1Chinese Stocks Will Truly Bottom When The Economy Troughs Below are some of the main questions from our meetings and our answers. Q: Policies have started to be more pro-growth. Why do you still underweight Chinese stocks? A: There are two reasons that we maintain a cautious view on Chinese stocks for at least the next six months, in both absolute terms and relative to global equities. First, we do not think that the magnitude of existing easing measures is sufficient to offset the economy’s downward momentum. Secondly, China’s business cycle lags credit growth by about six to nine months. The timing of a turnaround in the economy and stock prices may be later than investors have priced in. In short, we need to see more reflationary measures and a rebound in credit growth to have a legitimate macro fundamental basis to overweight Chinese stocks (Chart 1). Credit growth on a year-on-year basis stopped falling in October. The underlying data in credit creation, however, points to a weakening in demand for corporate loans (Chart 2). Loans to the housing sector are well below a year ago (Chart 3). Chart 2Weakening Loan Demand Chart 3Bank Loans To The Housing Sector Have Not Turned Around Chart 4It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector Despite an acceleration in local government bond issuance in October and RMB300 billion in additional bank loans to support small and medium enterprises, growth in medium- to long-term corporate loans peaked (Chart 4). In previous cycles, a rollover in corporate demand for longer-term bank lending on average lasted more than nine months, suggesting that any policy adjustments will take a while to restore confidence in the corporate sector. Without a decisive pickup in credit growth, corporate earnings growth will be at risk of deteriorating. Moreover, policy tightening since earlier this year is still working its way through the economy and major economic indicators in China continue to decline (Chart 5). We think that China’s economy is set to decelerate even more in the next several months, suggesting that earnings uncertainty will likely rise. This, combined with reactive policymakers, already slowing earnings momentum, and a downward adjustment in 12-month forward earnings, suggests that investors have not yet reached the maximum bearishness for Chinese stock prices (Chart 6). Chart 5No Signs Of Improvement In The Economy Chart 6The Earnings Adjustement Process Is Only Beginning   Q: What is the impact of China’s property market slowdown on the economy? Will recent policy easing stop deterioration in the real estate sector? A: Policy has been recalibrated by relaxing restrictions on mortgage lending and rules for land sales.1 However, the negative financing loop among developers, households and local governments may take longer to improve. Meanwhile, the market may underestimate the downside risks in housing-related activity in the next 6 to 12 months. Chart 7Households' Home Buying Intentions Have Plummeted Our view is based on the following: Home sales will likely remain in contraction in the next two quarters. Aggressive crackdowns on property market speculation in the past 12 months have fundamentally shifted consumers’ expectations for future home prices. The impending pilot property tax reform2 (details yet to be disclosed) will only encourage the wait-and-see sentiment of potential buyers. Home sales contracted by 24% in October from a year ago. In previous cycles, contractions in home sales normally lasted for more than 12 months. Moreover, the proportion of households planning to buy a house dropped to only 7.7% in Q3 2021 from 11.6% in Q4 2020 (Chart 7). Real estate developers have slashed new projects and land purchases to preserve liquidity for debt servicing (Chart 8, first and second panels). Policymakers may succeed in prompting banks to resume lending to developers in order to alleviate the escalating risk of widespread defaults. However, so far the marginal easing has failed to reverse the downward trend in bank credit to developers along with home sales (Chart 8, third and bottom panels). Funding constraints for real estate developers will probably be sustained for another six months, despite the recent easing measures. Construction activity, housing starts, and real estate investment will likely remain in doldrum at least through 1H22 (Chart 9). Chart 8Housing Activities Are Still Falling Chart 9Less Funding = Less Investment And Completions The marked reduction in land sales will impede local governments’ revenues and weigh on infrastructure investment (Chart 10). Real estate and infrastructure financing contributed 50% of the increase in total Chart 10Local Government Revenues Largely Depend On The Housing Sector social financing in 2020. Given that local governments face funding constraints from a slump in land sale incomes, policies on leverage from local government financing vehicles (LGFVs) will have to meaningfully loosen up to allow a rise in bank lending to support infrastructure investment. As discussed in previous reports, an acceleration in local government special-purpose bond issuance can only partially offset weak credit growth. Furthermore, shadow banking activity, which comprises LGFV borrowing and is highly correlated with China’s infrastructure investment growth, remains in contraction and indicates that growth in infrastructure investment is unlikely to rebound strongly (Chart 11). The sharp weakening of real estate construction activities will drag down the demand for building materials, machinery, home appliances and automobiles. Real estate accounts for about 60% of Chinese households’ wealth, thus any substantial drop in home prices will further weaken households’ propensity to consume (Chart 12). Chart 11More Easing Needed For A Meaningful Pickup In Infrastructure Investment Chart 12Falling Demand For Commodities And Consumer Goods Chart 13AOn The Surface Housing Inventories Are Lower Than Six Years Ago... There are nontrivial risks that the real estate slowdown will evolve into a downturn similar to that of 2014-15. Although the existing housing inventory is more modest than the start of the 2014/15 property downturn, developers have accumulated more debt and unfinished projects in this cycle than in the past (Charts 13A & 13B). Policymakers will have to relax property sector policies much more forcefully to prevent the downturn from intensifying. In the interim, we will likely witness more deterioration in the sector. Chart 13B...But Developers Have Built Up Massive Leverages And Hidden Inventories In The Past Three Years   Q: If the property market accounts for such a big portion of local governments’ revenues, why hasn’t the waning housing market forced policymakers to loosen restrictions? A: We think regulators have been slow to backtrack property market reforms because this year China’s fiscal deficit has narrowed from last year due to lower government spending and improved income from corporate taxes. In previous property market downturns, such as 2011/12, 2015/16 and 2019, property policy restrictions were lightened following major declines in government revenues (Chart 14). However, in 2021 China’s fiscal balance sheet has been stronger than in previous cycles; central and local governments have collected much more taxes, particularly corporate taxes, than in 2020 (Chart 15). Meanwhile, government expenditures so far this year have been lower, resulting in a large improvement in the country’s fiscal deficit (Chart 16). Chart 14Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Chart 15...But This Year Gov Tax Revenues Have Been Strong Chart 16Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales As discussed above, slightly loosened restrictions on land purchases by some regional governments will not restore developers’ confidence and boost the demand for land. The sharp increase in government's corporate tax collection will also start to ebb as economic growth slows and corporate profits decline. As such, even if government expenditures remain the same next year, the fiscal deficit will grow because revenues will be under substantial downward pressure. We expect that Chinese policymakers will have to take more actions to stabilize fiscal conditions. Forecasting exactly when this will occur is difficult, but a benign government balance sheet in much of this year is delaying policymakers’ response to the flagging housing market. Meantime, both policymakers and investors may be complacent about the state of the economy until the full scale of the property sector spillover risk becomes clear.   Q: Rates are low and industrial profit growth has been strong this year. Why has capex been so sluggish? A: Investment growth in the manufacturing sector has been lackluster because their profit margins have been squeezed by rising input costs. On the other hand, investment in the mining industry has been constrained by policy restrictions. An acceleration in China’s de-carbonization efforts this year has likely constrained investment in the mining sector. Even though industrial profit growth has been concentrated among the upstream industries such as mining which profits grew by a stunning 100% this year, investment in the sector was mostly flat from a year ago (Chart 17). During the first half of the year, mid- to downstream firms were caught between rising input prices and a weak recovery in domestic consumption. Manufacturing investment grew faster than the mining sector, but manufacturing profit growth only increased by about 30% year to date (Chart 18). However, we think manufacturing investment growth may improve slightly into 2022 as the sector continues to gain pricing power. Chart 17Mining Sector's Profit Growth Way Outpaced Investment Chart 18Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries   Q: The RMB has been strong against the dollar, despite China’s maturing business cycle. What is your outlook for the RMB next year? A: The RMB exchange rate has been boosted by China’s record current account surplus, wide interest rate differentials and speculation that tension between the US and China will abate. However, all three favorable conditions supporting the RMB are in danger of reversing next year. Chart 19The RMB Has Been Appreciating Despite A Strong USD Chart 20The RMB's Appreciation Deviates From Economic Fundamentals Despite broad-based dollar strength, the CNY/USD has appreciated by 4.5% year to date (Chart 19). The RMB’s appreciation deviates from China’s economic fundamentals (Chart 20).       Strong global demand for goods has boosted Chinese exports while travel restrictions curbed foreign exchange outflows by domestic households (Chart 21). China-US real interest rate differentials have been in favor of the CNY versus USD, bringing net foreign inflows to China’s onshore bond market (Chart 22). Additionally, the recent meeting between President Joe Biden and President Xi Jinping has prompted speculation that the US will lessen tariffs on Chinese imports. Chart 21Large Current Account Surplus Chart 22Favorable Interest Rate Differentials And Strong Fund Inflows Chart 23China's Extremely Robust Export Growth Unlikely To Sustain In 2022 Chart 24A Strong RMB Does Not Bode Well For Chinese Exporters' Profits These factors will likely turn against the CNY next year. First, export growth will moderate as the composition of US consumption rotates from goods to services (Chart 23). Secondly, it would not be in the PBoC’s best interests to let the RMB strengthen too rapidly because an appreciating currency would be a deflationary force on China’s export and manufacturing sectors (Chart 24). While we expect policymakers to maintain their preference for a gradual approach to stimulus, we assign a high probability to a reserve requirement ratio (RRR) cut in early 2022. In this environment, Chinese bond yields will decline, which would narrow the China-US interest rate differential. Finally, while there may be some changes to US tariffs on China, it is doubtful that there would be a broad-based removal of tariffs. Chart 25The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY’s outperformance stands out as it marks a break from its correlation with China’s relative equity performance vis-à-vis the US (Chart 25). The signal from the currency suggests that either global equity investors are overly pessimistic about economic and regulatory risks in China, or overly optimistic about the value of China’s currency. The latter option is more likely at the moment, and the CNY/USD exchange rate is at the risk of converging to the underperformance of Chinese investable stocks next year.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1  China Cities Ease Land Bidding Rules as Property Stress Spreads - Bloomberg 2  China’s Pilot Property Tax Reforms Benefit Markets Despite Short-Term Pain, Analysts Say - Caixin Global Market/Sector Recommendations Cyclical Investment Stance