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Market Thinking - China A share inclusion is significant over the long term

China A share inclusion is significant over the long term

Market thinking

  • The Singapore Summit looks to be an example of waiting for the event rather than getting caught up in the warm up routine. Although this is only the start of a process, we feel it is broadly positive for Asia
  • Meanwhile the G7 meeting highlights how the US is looking to renegotiate all trade deals not just China and wishes to cease being ‘the piggy bank that everybody’s robbing’. Perhaps rather than wanting to impose higher tariffs he is trying to get everyone to cut tariffs? This would make for different winners and losers.
  • It is important to distinguish policy from politics. For both China and the US, government policy is more important than monetary policy right now. Interesting that for China, many of its perceived problems are being dealt with through greater use of technology.

The Trump/Kim summit in Singapore appears to have produced a positive result, something that appears to have caught many people by surprise in the wake of the apparent problems in the pre-Summit period. The old mantra of taking President Trump seriously but not literally (as opposed to the other way around) has never been more relevant  than this last week in my opinion. Looking ahead, as ever, I tend to the more optimistic view and would regard this as a big win for Asia generally. Reduction of tension, particularly of the military drills will be much appreciated on the peninsula (they were always timed for the sowing and the harvesting season which didn’t help farmers). It looks likely now that the US can now start bringing home some if not all of the 30,000 troops that have been stationed on the peninsula, although  obviously there will be resistance in some quarters in the early stages.  Meanwhile  the private sector is busy working out how to make money from a newly  ‘open’ North Korea, including presumably thinking about President Trump’s comments about developing their beaches(!) The rush to develop tourism in Myanmar might be the nearest parallel here.

An interesting conference call on the summit organised by Citi and featuring Ambassador R Nicholas Burns (currently at Harvard JFK school of government) made the interesting point that excluding South Korea and Japan from the talks was arguably a tactical mistake as well as acknowledging the role so far of China who were also in the background. He also pointed out that this is just the start of a process, so presumably there is plenty of time to bring all the local players in. What is important in my view however is that in many senses integrating the hermit Kingdom into the wider world economy  is now ‘an Asian issue’.

China has reportedly assumed a role as ‘guarantor and mediator’ so this is clearly another element of ‘Chimerica’, the reality that the bilateral relationship between the two largest economies comes first.  And so in a sense is the spat at the G7, where President Trump appeared to fall out with all ‘America’s Allies’, suggesting he regards those groupings as no longer relevant . This is very  important in thinking about future trade policy. Some are saying that “he is making friends of our enemies and enemies of our friends” but another way of thinking about it is that contrary to some commentary that he doesn’t understand the value of free trade, he actually wants tariff free trade, but doesn’t want it to be unilateral.  As he put it, “fair trade is now to be called fool trade if it is not reciprocal.” He referred to the EU as ‘brutal’ to the US, but added that “they know that the gig is up” and insisted that tariffs were “going to come way a long way down”. As previously discussed, it seems likely that the steel and Aluminium tariffs, while assumed to be aimed at Asia in general and China in particular, were actually more about Canada and Mexico and NAFTA where previous discussions about reform had stalled. Similarly the original talk about tariffs on cars was aimed specifically at Germany rather than Japan or Korea, or indeed China. Subsequently he is talking about Japan, but if we look and listen carefully it appears that he is focussing in particular on Japanese cars that are assembled in Canada and Mexico.  Elsewhere in Asia he mentioned India,” where some of the tariffs are 100%. And we charge nothing”. 

At the moment, investors seem to be worrying that a)  the US will put tariffs on foreign imports  and that b) this will reduce the demand for them and thus the profitability of exporters to the US. In addition c) this would reduce the disposable income of US consumers due to the higher duties, unless competition among exporters leads to them cutting their prices (and profits). What if actually the result is to reduce tariffs in other countries and thus benefit their consumers but harm their import substituting companies? Are we looking at the right winners and losers here? I would expect to see announcements that those auto assemblers exploiting NAFTA relocate instead to the US.

The fact that President Trump referred to America as ‘the piggy bank that everybody’s robbing “ also plays into wider issues such as paying for NATO – the notion that America is effectively paying for standing armies in Germany and South Korea is clearly an issue. He mentioned bringing home soldiers from Korea as it was too expensive to keep them there. It will be interesting to see what he says next on the forces in Germany. The Pentagon won’t like it, but perhaps we have seen the US peak as a provider of troops and now shift more to be a retailer of weapons systems?  The piggy bank notion is almost certainly also a factor in talk about deals such as the Paris Climate accord, which committed the US to pay in billions while developing countries including China appeared to have little reciprocal obligations. It could be argued that much of this is theatre ahead of the US mid-term elections, but we should not lose sight of the importance of policy rather than politics.

Travelling in Europe last week with my colleague (Senior Asian Economist) Aidan Yao, I realised that as European Investors are waking up to the notion of investing in China,  for the majority of Europeans the view of China is still pretty much exactly what my own view was when I moved to Hong Kong almost five years ago; an overdependence on trade, a lot of misallocated capital in the wake of the Global Financial Crisis (GFC), ghost cities, high debt levels and so on. However, as I have been explaining, I rapidly realised that my own views on China back in 2013 were already out of date and obviously we have had five more years of development since then. As Aidan’s presentation neatly puts it, China is actually going through its third rebalancing, the first was the opening up phase from 1978 when China embraced the world and, catapulted by joining the WTO back in 2001, trade  rose from around 7% of GDP to almost 70%. The second phase came post GFC when the economy rebalanced towards investment  - including the mis-investment  discussed earlier, while the third phase, which began around five years ago is a rebalance away from investment towards consumption. Indeed, in the latest quarter, Consumption was over 70% of GDP.

Presenting at a seminar on innovation and China,(amongst other meetings)  we were making the point that for most of the problems China is acknowledged to have, the actual answer being pursued is more technology. The aging population and therefore shrinking workforce is a key driver behind investment in automation and robotics for example, while the dependence on trade has not only been diminished by the rapid growth of the rest of the economy – the trade surplus with the US is not much different in absolute term compared to a decade ago, but the % of GDP it constitutes is now below 4% - but the move to greater value added is reducing the exchange rate sensitivity. This was a point we made strongly back in 2016 when a 40% devaluation of the Yuan was being widely promoted as ”a necessary solution to China’s growth problem”.  We didn’t see it that way and clearly nor do the authorities and the drive for Made in China 2025 is the clear direction of policy – something that the US Trade advisor Peter Navarro warned on a few weeks back. This is the true focus of the so called trade wars, the new economy, not the old. The statistics on China are always extra-ordinary  and certainly are when applied to elements of the new economy. Telling a European audience (let alone a US one) that  China has built more than 35,000 km of high speed rail, which is more than the rest of the world put together tends to surprise, as does pointing out that the number of connected consumers, at over 700m, is more than the rest of the developed world combined.

 It is also interesting to note that, while there remains much talk about IP transfer, China actually registered more patents than any other country last year, its volume of research publications was second only to the US and according to quality measures of a standard not too different from Japan.  If we look at research personnel we see China having risen from 1million ten years ago, around the same as the US, to over 4million today. Over the same period, the US has been essentially flat. Investing in people is part of the drive towards higher productivity and higher value added which is pushing the returns to labour as well as capital higher. Urban wages are rising over 8% a year in real terms, which is powering the shift towards consumption  as a driver of GDP.

Another area of discussion was the so called shadow banking system and the concept of deleveraging. As we have mentioned many times in the past, the nature of China’s debt is more important than the level – especially when measured as a % GDP, which as any accountant will tell you makes the error of missing a stock and a flow. The debt, unlike most emerging markets, is held in the corporate rather than the household sector and is largely in the public/corporate rather than private/corporate sector, reflecting the role of local governments and State Owned Enterprises in the investment led growth period post the GFC. Moreover, in common with much of North Asia, the debt is almost all locally held, rather than in foreign currency and thus is not vulnerable to either exchange rate moves or someone else’s monetary policy. This is not to deny that there are bad debts, nor that there wasn’t a significant misallocation of resources post GCF, but it is to highlight that the growth of the Shadow Banking system while arguably a ‘problem’ was actually part of the solution to the misallocation. In effect the authorities were allowing the market to highlight where funding was needed and then once the shadow banking system had allocated capital to regulate the flow. By way of illustration we could have a theoretical example of a large SOE such as a steel company borrowing at preferential rates from a large bank and in turn investing in higher yielding wealth management products offered by the shadow banking system. These products would then ‘invest’ by lending to Small Medium Enterprises (SMEs) at a rate possibly three or four times that available to the steel company.

In a classic example of a little information is a dangerous thing, an outside observer looking at total social financing would likely capture the original loan to the SOE as well as the loan to the SME, in effect double counting. Then, when the authorities move to raise the cost of capital to the SOE and encourage direct lending to the SME we observe first that the rate of interest has risen, second that the volume of borrowing has ‘halved’ and thus conclude that monetary conditions have tightened dramatically leading to fears of hard landing, de-leveraging and so on. In fact the cost to the SME has most likely come down significantly as they are better able to access capital markets while the lending that has disappeared is the middle man in the SOE and the  shadow banking  sector. Thus to observe (as the latest statistics out this week demonstrate)  that China Aggregate finance grew by the slowest since July 2016 is to observe a structural transition rather than a cyclical over-tightening. Traditional RMB lending was broadly in line with expectations, at Rmb 1.2trn (+12.6% yoy) but shadow banking (entrusted loans, Trust loans and undiscounted bankers acceptances) fell by a record amount in May. To some this is a big problem as they believe firstly that the growth of the economy was fuelled solely by credit (it isn’t) and second that the deleveraging is a traditional tightening of monetary policy i.e. the end borrower shrinking their balance sheet rather than the elimination of middle men.

To conclude. Events in Singapore mark a turning point in integrating the final piece of Asia into the world economy. The meeting was highly symbolic and while there will doubtless be bumps along the (likely long) road most sensible observers agree it was the right thing for President Trump to do.  While other major Asian powers, Japan, South Korea and obviously China were kept in the background, they will likely play the dominant role going forward. The fact that the same week President Trump announced that ‘the gig was up’ for the G7 allies on trade barriers  caused almost as much surprise in many quarters, but in my view should not have done. It was entirely consistent with his attitudes so far of resetting the myriad of international agreements which he believes over the years to have moved away from the interests of ordinary Americans. Importantly we should be careful in how we think this will affect subsequent policy. What if (as it appears from this) the real aim is to use America’s economic power to reset global tariffs lower rather than higher and to break down non-tariff barriers? This would produce a very different set of winners and losers. Competitive exporters would prosper (as would importing country consumers) while uncompetitive domestic producers (many of whom represent powerful local vested interests) would find themselves under pressure from lower barriers to entry. Small business and consumers (voters) win while large business and lobby groups (political competition) lose out. Seems like a strategy.

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