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Cam Hui, CFA | [email protected] Page 1
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Quantitative & Strategy
HOW WORRIED SHOULD YOU BE ABOUT CHINA?
January 28, 2019
EXECUTIVE SUMMARY
For investors, China is becoming the elephant in the room. The country accounts for roughly one-third of global GDP growth, and its economic growth rate is decelerating. Ken Rogoff believes China is hitting the debt wall:
Harvard professor Ken Rogoff said the key policy instruments of the Communist Party are losing traction and the country has exhausted its credit-driven growth model. This is rapidly becoming the greatest single threat to the global financial system.
"People have this stupefying belief that China is different from everywhere else and can grow to the moon," said Professor Rogoff, a former chief economist at the International Monetary Fund. "China can't just keep creating credit. They are in a serious growth recession and the trade war is kicking them on the way down," he told UK's The Daily Telegraph, speaking before the World Economic Forum in Davos.
“There will have to be a de facto nationalisation of large parts of the economy. I fear this really could be 'it' at last and they are going to have their own kind of Minsky moment,” he said.
How worried should we be about China?
Our base-case scenario is no crash in 2019. The limited stimulus package announced by
Beijing will have some effect, and it will likely buy the country another two or three quarters
of growth. At the same time, China is desperate to reach a trade agreement with the U.S.
The Trump administration has also shown that it is highly sensitive to stock market
movement, and it is also eager to reach an agreement. As one simple example, after stock
prices weakened on January 22, National Economic Council director Larry Kudlow
appeared on CNBC to sooth markets and deny reports that a planned meeting between
Chinese and American negotiators had been canceled. This is a signal that American
negotiators are sensitive to pressure from Wall Street to make an agreement.
Expect difficult negotiations to last right up to the March 1 deadline, but a limited deal to
be signed. But that will not be the end of the story. The next battle will be over review,
enforcement and verification of reform initiatives.
On the other hand, the fundamental nature of the Sino-American relationship is changing.
Years of negotiation with past administrations have led to a sense of promise fatigue from
both sides of the aisle. A consensus is emerging that China is becoming a strategic
competitor. Cold War 2.0 has begun, and 2020 will be a difficult year for U.S.-China
relations as aspiring candidates will try to show how tough they are on China.
Apocalypse Not Yet, but be wary.
Cam Hui, CFA [email protected]
Table of Contents
How Worried Should You Be About
China? ................................................... 2
Signs of China Weakness Everywhere .. 3
China’s Long-Term Challenges ............... 6
The Shrinking Private Sector ................... 9
The Short-Term Policy Response .......... 12
The Trade War Wildcard ....................... 13
Apocalypse Not Yet? ............................. 14
Cam Hui, CFA | [email protected] Page 2
January 28, 2019
Quantitative & Strategy
How Worried Should You Be About China?
Emerging market (EM) stocks have been on a tear lately. But some EM countries are more
equal than others. The chart below shows that while EM stocks have begun to outperform
global equities (bottom panel), China continues to lag compared to other major markets like
Brazil and India.
Exhibit 1: Some EM Countries Are More Equal than Others
Source: Stockcharts
For EM equity investors, China is becoming the elephant in the room. The country accounts for roughly one-third of global GDP growth, and its economic growth rate is decelerating. Ken Rogoff believes China is hitting the debt wall:
Harvard professor Ken Rogoff said the key policy instruments of the Communist Party are losing traction and the country has exhausted its credit-driven growth model. This is rapidly becoming the greatest single threat to the global financial system.
“People have this stupefying belief that China is different from everywhere else and can grow to the moon,” said Professor Rogoff, a former chief economist at the International Monetary Fund.
“China can’t just keep creating credit. They are in a serious growth recession and the trade war is kicking them on the way down,” he told U.K.’s The Daily Telegraph, speaking before the World Economic Forum in Davos.
“There will have to be a de facto nationalisation of large parts of the economy. I fear this really could be ‘it’ at last and they are going to have their own kind of Minsky moment,” he said.
How worried should we be about China?
Cam Hui, CFA | [email protected] Page 3
January 28, 2019
Quantitative & Strategy
Signs of China Weakness Everywhere
For global investors, the only question that matters for global growth is China. Right now, all signs point to a slowdown. We won’t bore you with Chinese economic statistics, which can be made up. However, we can consider other China-related free market indicators:
Commodity prices
Australian property market
Korean exports
German industrial production, whose capital goods are exported to China
Chinese auto sales
Then there is the trade war. In addition to these signs of short-term weakness, another source of concern is the Sino-American trade war, which remains unresolved.
China has shown itself to be a voracious consumer of raw commodities. For commodity prices, the industrial metal-to-gold ratio is a cyclically sensitive indicator of industrial demand, net of commodity price inflation (red line). This indicator has also shown itself to be highly correlated to risk appetite, as measured by the U.S. equity to UST ratio (grey bars). Current readings indicate continued demand deceleration.
Exhibit 2: Industrial Metals/Gold Ratio Still Weakening
Source: Stockcharts
We have all heard about how China’s great big ball of liquidity leaked out and went into real estate in Australia, Canada, the U.S., and other places with golden visa programs, like Portugal. Property prices in Australia, which has been an outsized recipient of Chinese hot money, has been tanking. We can also personally attest to similar conditions in Vancouver and Toronto.
Cam Hui, CFA | [email protected] Page 4
January 28, 2019
Quantitative & Strategy
Exhibit 3: Australian Property Prices Are Tanking
Source: National Australia Bank
South Korea is one of China’s closest trading partners. The latest figures show that its exports,
which are also correlated with global EPS growth, have collapsed.
Exhibit 4: South Korean Exports Are Plunging
Source: Nordea Markets
Cam Hui, CFA | [email protected] Page 5
January 28, 2019
Quantitative & Strategy
The same could be said of German industrial production and M-PMI.
Exhibit 5: Germany Also Slowing
Source: Nordea Markets
What about the Chinese consumer? Hasn’t Beijing been trying to rebalance growth away from
credit-driven infrastructure spending to China’s household sector? The weakness in Chinese
auto sales tell a story of a stressed out consumer.
Exhibit 6: Chinese Auto Sales Are Weak
Source: Zero Hedge
Cam Hui, CFA | [email protected] Page 6
January 28, 2019
Quantitative & Strategy
China’s Long-Term Challenges
While these short-term worries are spooking the markets, it is impossible to understand China
without first analyzing her long-term challenges before drilling down to the shorter-term policy
responses to those problems. As we see it, China’s long-term challenges are:
A looming middle-income trap
An overleveraged economy
The rising tension between Xi Jinping’s desire to retain tight political control and the
urgency to address the challenges of excess leverage and slowing growth
A fast-growing EM country hits the middle-income trap occurs when its growth slows after
reaching middle-income levels as they encounter developmental roadblocks to achieving high-
income status. According to World Bank estimates, only 13 of 101 middle-income economies
have achieved the transition to high income for the period from 1960 to 2008. Antonio Fatás
of INSEAD summarized China’s challenge with falling growth rates using South Korea’s
development path as an example.
Exhibit 7: Is China Hitting the Middle-Income Trap?
Source: Antonio Fatás
Fatás added the following caveat:
In summary, the deceleration of GDP growth rates in China can be seen as a natural evolution of
the economy as it follows its convergence path, in particular if we use recent decades in South Korea
as a benchmark. Let’s not forget that South Korea is one of the best performer for countries in the
range below 50% of the U.S. GDP per capita. So using South Korea as a benchmark we might
be providing an optimistic benchmark for Chinese growth.
Cam Hui, CFA | [email protected] Page 7
January 28, 2019
Quantitative & Strategy
China is following the well-trodden development path followed by South Korea, Taiwan and
other Asian Tiger economies. China is running out of cheap labour fast, and its import
substitution strategy of producing cheap imitation goods has also near the end of its useful life.
Beijing’s policy response is to raise development by migrating up the value-added chain with
an industrial strategy intended to achieve dominance in STEM research (see How China Could
Dominate Science from The Economist). One major leg of this is the China 2025 initiative, which
is running into U.S. and other Western objections about intellectual property theft and market
access by Western companies (more on that later).
In addition, as the China bears’ favourite chart shows, China’s policy response in the wake of
the GFC of a shock-and-awe campaign of credit-driven infrastructure stimulus has left in its
wake a risky debt build-up.
Exhibit 8: A Risky Debt Build-up in China
Source: Datastream
Additional efforts at credit-driven stimulus are becoming less and less effective. Additional
credit creation is resulting in less and less GDP growth.
Cam Hui, CFA | [email protected] Page 8
January 28, 2019
Quantitative & Strategy
Exhibit 9: Diminishing Returns to Credit Expansion as a Growth Strategy
Source: Bloomberg
Beijing’s policy response is to try and gradually let the air out of the credit balloon through a
deleveraging initiative. The idea isn’t to crash the economy, but to slow credit growth to
manageable levels, to the unregulated shadow banking credit market back under the formal
banking umbrella so that credit can be more easily controlled, and to use specialized tools to
target stimulus when necessary.
Cam Hui, CFA | [email protected] Page 9
January 28, 2019
Quantitative & Strategy
The Shrinking Private Sector
The rise of Xi Jinping as Party Secretary has given rise to a number of difficult policy trade-
offs. Xi ascension was followed by an anti-corruption campaign, which was done to both root
out corruption and to consolidate power. Slowly but surely, Xi has consolidated power and
control of the economy with the Party. That’s where the policy trade-offs come in. Xi’s power
concentration is creating headwinds for the growth engines of the Chinese economy.
First, the change in regime has given greater power to the State Owned Enterprises (SOEs) at
the expense of Small and Medium Enterprises (SMEs). The government recognizes that SMEs
represent the engine of economic growth, but a desire for Party control is stifling their growth
outlook.
Exhibit 10: Private SMEs as 56789
Source: Twitter
Xi’s power consolidation is squeezing out the private sector to the benefit of the SOEs. A
recent Forbes article entitled, “Friends Don’t Let Friends Become Chinese Billionaires” tells
the story:
China Daily reported Friday that unnatural deaths have taken the lives of 72 mainland billionaires
over the past eight years. (Do the math.)
Which means that if you’re one of China’s 115 current billionaires, as listed on the 2011 Forbes
Billionaires List, you should be more than a little nervous.
Mortality rate notwithstanding, what’s more disturbing is how these mega wealthy souls met their
demise. According to China Daily, 15 were murdered, 17 committed suicide, seven died from accidents
and 19 died from illness. Oh, yes, and 14 were executed. (Welcome to China.)
I don’t know about you but I find it somewhat improbable that among such a small population there
could be so many “suicides,” “accidents” and “death by disease” (the average age of those who died
from illness was only 48). I’m only speculating but the homicide toll could really be much higher.
Is it any surprise that a recent Barron’s article reported that about half of high net-worth
Chinese individuals have either emigrated or want to emigrate?
Cam Hui, CFA | [email protected] Page 10
January 28, 2019
Quantitative & Strategy
About 53% of high-net-worth individuals surveyed said they had no plans to emigrate to other
countries, while 38% said they were considering a move abroad. Nearly 9% said they had non-
Chinese citizenship or were in the process of application.
The top destination for rich Chinese to emigrate was Europe, with 30% of respondents picking the
region. Australia and the U.S. tied on the second spot (28%), followed by Canada (27%) and
Singapore (11%).
At the same time, the PBOC’s efforts to slow credit growth are also hitting SMEs much harder
than SOEs. In general, SOEs are more creditworthy because they have the implicit backing of
the government, while SMEs have to survive on their own, which is creating a credit crunch
for smaller Chinese businesses. Bloomberg reported that some companies have resorted to
creative financing techniques to tap credit markets:
The practice is one of several strategies for debtors to enhance their appeal to creditors, including one
where borrowers guarantee each others’ debt. Use of stock as collateral for loans has also sown the
seeds for volatility in stocks.
Another even more imaginative technique is to use the structured finance tactic which sparked
the GFC of slicing up a bond into different credit tranches, where the issuer buys the most
junior “equity” tranche in order to secure financing. With all this inventiveness at work in
Chinese finance, what could possibly go wrong?
Lower rated private companies and local government financing vehicles, or LGFVs, have been the
main users of structured issuance, observers say. One popular method is for the borrower to put up
the money for the subordinated tranche — the first to absorb losses — of the asset-management
vehicle that buys the bonds.
Another key plank of Beijing’s policy response is to refocus growth toward the Chinese
consumer. As Michael Pettis has pointed out in many past occasions, the success of such an
initiative requires the redistribution of income away from the entrenched interests of Party
cadres in the large SOEs to the household sector, which is a difficult task in the best of times.
This cannot be said to be the best of times for the Chinese consumer. A weak job market is
pointing to weak income growth.
Cam Hui, CFA | [email protected] Page 11
January 28, 2019
Quantitative & Strategy
Exhibit 11: China’s Job Market Is Weakening
Source: Gavekal
At the same time, households have been raising their debt levels in order to consume and to
invest (mostly in property). Bloomberg highlighted how Chinese consumers have been piling
on debt, and their debt capacity is well on its way to reaching their limits. In short, don’t expect
too much help from the Chinese consumer.
Exhibit 12: Chinese Household Debt Levels Are Rising
Source: Bloomberg
Cam Hui, CFA | [email protected] Page 12
January 28, 2019
Quantitative & Strategy
The Short-Term Policy Response
In response to the latest slowdown, Beijing has responded with a small stimulus package of tax
cuts and targeted top-down credit growth aimed at SMEs. However, don’t expect the latest
round of stimulus to have the same effect as previous efforts. China’s total tax intake is relatively
low, which puts a limit on the effects of a tax cut.
Exhibit 13: Tax Cuts Will Only Have a Minimal Effect on Growth
Source: Bloomberg
On the credit front, banks are caught between top-down directives of lending to small
businesses and maintaining the credit quality of their loan portfolios. Reports are emerging that
many SMEs simply do not qualify for bank loans, and they must turn to the shadow banking
system for loans at much higher rates. Instead, banks are instead lending money to subsidiaries
of SOEs incorporated to qualify as small businesses.
Cam Hui, CFA | [email protected] Page 13
January 28, 2019
Quantitative & Strategy
The Trade War Wildcard
In addition, China is trying to conclude a trade deal in order to alleviate the negative effects of
the trade war. The latest Bloomberg report detailing the discussions recounted by Wilbur Ross
indicates that both sides are talking, but they are “miles and miles” from reaching a resolution.
China has reportedly offered to eliminate the trade deficit within several years, but the issue of
China’s industrial strategy and intellectual property protection remains a sticking point. The
WSJ reported that American businesses raised the China 2025 strategy as a concern:
In a joint report to the U.S. Trade Representative, the U.S. Chamber of Commerce and the
American Chamber of Commerce in China say Beijing’s ambitious plan to become a global technology
leader is being widely implemented, casting doubt on efforts by Chinese officials to play down its
significance.
There is evidence of “a deep, concerted and continuing effort” by provincial officials to pursue the
central government’s Made in China 2025 plan, which seeks to make China a leader in electric
vehicles, aerospace, robotics and other frontiers of manufacturing, the two business groups say.
Reuters reported that American negotiators have demanded regular reviews of Chinese trade
reform practices, much in the manner of an arms control treaty:
The United States is pushing for regular reviews of China’s progress on pledged trade reforms as a
condition for a trade deal - and could again resort to tariffs if it deems Beijing has violated the
agreement, according to sources briefed on negotiations to end the trade war between the two nations.
A continuing threat of tariffs hanging over commerce between the world’s two largest economies would
mean a deal would not end the risk of investing in businesses or assets that have been impacted by
the trade war.
“The threat of tariffs is not going away, even if there is a deal,” said one of three sources briefed on
the talks who spoke with Reuters on condition of anonymity.
CNBC reported that George Soros went even further and labeled Xi Jinping the “most
dangerous enemy” of open societies. He went on to warn that the U.S. and China are in a “cold
war that could turn into a hot one”.
Cam Hui, CFA | [email protected] Page 14
January 28, 2019
Quantitative & Strategy
Apocalypse Not Yet?
For investors, the critical question is what happens next in China. The biggest issue China faces
is that it is running out of bullets. FT Alphaville characterized China's dilemma as "cakeism",
or the desire to have your cake and eat it too.
Alphaville sat down with economist George Magnus, a former senior adviser to UBS Investment Bank
and the recent author of "Red Flags: Why Xi’s China is in Jeopardy." He describes what's happening in
China this way: "At the moment, we've got an incoherence of policy. It's confusing to us looking at it from
the outside. It must be incredibly confusing if you are an entrepreneur or small business on the inside."
China's version of "cakeism," he says, centers around the leadership's conflicting commitments to de-
risking the financial system on one hand and on the other, hitting elevated growth targets north of 6 per
cent. "You can't really have a determined effort to deleverage the economy and not expect it to have a
material impact on economic growth," points out Magnus.
Its debt-driven growth model is reaching the limits of usefulness. Tightening put the brakes on
growth. Without large scale credit growth, which will exacerbate their real estate bubble, the
economy will crash. The tools available to tinker at the margins, such as rebalancing to
household consumption, and an industrial policy to escape the middle-income trap may have
long-term benefits, but will not help in the short run.
Will China crash? The current policy response is another effort to kick the can down the road
yet one more time, though this round of stimulus will be less effective than past efforts.
So Chinese officials have been presented with a choice: play the long game and work towards shifting the
economy towards a more sustainable path, or sidestep short-term pain and prop up growth now.
Of course, China wants its cake. And just like the Brits, it wants to eat it, too.
So blame "cakeism" for why the stimulus measures that China has rolled out since the summer have
done little to boost the economy. Rather than a full-scale stimulus programme, China has favoured a
more piecemeal approach this time around, including liquidity injections into the financial system, cuts to
the amount of cash banks have to hold as reserves and infrastructure spending.
But by asking banks to lend more to private and small companies (by cutting the reserve requirement
ratio), and simultaneously urging banks to raise more capital and pay attention to their bad debts,
officials are "not speaking with the same tongue," says Magnus. Ultimately, this could lead China to
fail on both fronts.
Our base-case scenario is no crash in 2019. The limited stimulus package announced by Beijing
will have some effect, and it will likely buy the country another two or three quarters of growth.
At the same time, China is desperate to reach a trade agreement with the U.S.
The Trump administration has also shown that it is highly sensitive to stock market movement,
and it is also eager to reach an agreement. As one simple example, after stock prices weakened
on January 22, National Economic Council director Larry Kudlow appeared on CNBC to sooth
markets and deny reports that a planned meeting between Chinese and American negotiators
had been canceled. This is a signal that American negotiators are sensitive to pressure from
Wall Street to make an agreement.
Expect difficult negotiations to last right up to the March 1 deadline, but a limited deal to be
signed. But that will not be the end of the story. The next battle will be over review,
enforcement and verification of reform initiatives.
Cam Hui, CFA | [email protected] Page 15
January 28, 2019
Quantitative & Strategy
On the other hand, the fundamental nature of the Sino-American relationship is changing.
Years of negotiation with past administrations have led to a sense of promise fatigue from both
sides of the aisle. A consensus is emerging that China is becoming a strategic competitor. Cold
War 2.0 has begun, and 2020 will be a difficult year for U.S.-China relations as aspiring
candidates will try to show how tough they are on China.
Apocalypse Not Yet. Though the short-term policy solutions doesn't address the longer term
problems.
While this is our base-case scenario, other more bearish outcomes are possible, I can offer two
sensitive real-time barometers that can warn of an impending crash in China. The first is the
AUD/CAD exchange rate. Both Australia and Canada are similar-sized economies with high
exposure to resource extraction industries with some key differences. Australia is more sensitive
to China, and its exports are mainly in bulk commodities, such as coal and iron ore. The
Canadian economy is more sensitive to the U.S., and its exports are tilted toward energy. A
disorderly breakdown in the AUD/CAD exchange rate would be an early warning signal that
something is breaking in China.
Exhibit 14: Watch the AUD/CAD!
Source: Stockcharts
In addition, the stability of the Chinese financial system is highly sensitive to the health of its
property market. Should highly levered property developers such as China Evergrande
(3333.HK) break long-term support, it may be a signal of a Lehman-like moment in China’s
banking system.
Cam Hui, CFA | [email protected] Page 16
January 28, 2019
Quantitative & Strategy
Exhibit 15: Chinese Developers Appear Healthy
Source: Yahoo! Finance
The share price of Alibaba, which is a key barometer of consumer spending, is also holding up
well relative to the Chinese stock market.
Exhibit 16: BABA Holding Up Well
Source: Stockcharts
Should any of these key real-time indicators weaken significantly, it would be time to run for
the hills.
Cam Hui, CFA | [email protected] Page 17
January 28, 2019
Quantitative & Strategy
Disclaimer
I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I am
confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and edit
every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions but
final responsibility is my own.
I also certify that I have not and will not be receiving direct or indirect compensation from the subject company(ies) in exchange for publishing
this commentary.
This investment analysis excludes any target price, and is not a recommendation to buy or sell a stock. It is intended to provide a means for
the author to share his experience and perspective exclusively for the benefit of the clients of Pennock Idea Hub (PIH). My articles may
contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and
assumptions. The author does not assume any liability whatsoever for any direct or consequential loss arising from or relating to any use of
the information contained in this note.
This information contained in this commentary has been compiled from sources believed to be reliable but no representation or warranty,
express or implied, is made by the author or any other person as to its fairness, accuracy, completeness or correctness.
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