Wow! You will want to read the last bullet point here! Bloomberg has been on a tear for Chinese analysis insights as of this morning, and if things weren’t so interesting in the markets overall I’d have more time to go over them. Here’s the rundown, and you can find more after the jump:
- China’s development potential is put in context of the underlying power and structure of the economy. For further reading on my understanding of this topic, please feel free to read/revisit this piece on China’s savings rate, since it will come in handy in the analysis steps a little bit further down the line.
- Lloyd Blankfein is bullish on China in the long term, assuming that Xi does reform right and takes his time on the growth path. I would probably frame this as “prioritize development over growth”. I do think that the large development needs and structural shifts needed to be undertaken by Xi will require support if they are not to throw China over the other end of differential equation equilibrium into straight-up recession while doing a lot of capital market reforms.
- And the real kicker: Japan Exchange Group wants to get in on the Hong Kong – Shanghai Stock Connect somehow! This has several implications, but mostly it is another indication that Japanese interest in the Chinese capital markets is sky-high (sort of expected), and that a large part of that will be processed through Hong Kong. More for later analysis after the jump.
Time to break it down by news item, and then bring it all back around for a total whole:
1. China’s development potential
Looking at China as “35 years of unbroken 8% growth” is a… rather unhelpful way of approaching the whole problem. For three different projects during my first semester of MSc studies, I looked deeply into the different ways of growth that China could potentially take. It is one of the fastest growth spurts in history in constant currency terms, and looking at it sort of requires a lot of mental adjusting in the way that it’s easier to add a fat multiplier to a small growth company but the same ratios at a large-cap company scale look unsustainable. It is, though, not unprecedented in structural terms or in GDP/capita growth.
The Bloomberg article rattles off Singapore, Hong Kong, Japan, Taiwan and South Korea as examples of those countries that have managed to crack the GDP/capita levels that implies avoiding the middle income traps. My own studies make the comparisons to post-war Japan particularly striking, and in that light the 1980’s Japan looks completely different. Let’s ignore Hong Kong and Singapore for the remainder of this analysis as they are small city-states, and focus on the +10 million population economies. For several reasons, it’s not a surprise that all these economies where in East Asia:
- There was a lot of catch-up to get done to the rest of the world. The base effect was simply incredible and allowing relatively easy growth from a low base simply by opening up trade and having a lower cost-basis.
- Japan, Korea and Taiwan could export their way around to development by employing demographic dividends giving them access to relatively cheap labour.
- All of these economies have received a lot of US support post WWII.
- Global capital markets existed for these countries’ growth spurts, allowing investors to pile in capital in droves and increase valuations in expanding economies.
- All countries had the ground work more or less done by authoritarian regimes (Meiji Restoration in Japan, KMT dictatorship in Taiwan, and the Korean War situation for South Korea) that required buildup of the countries’ industries and economic capabilities.
- Massive, culturally favoured savings rates and currency reserves allowing for cushioning of the economies as they reformed.
What, then, of all of this does China have today? As mentioned in the article, we can check off the catch-up factor. Ding! Demographic dividend is argued about when it will start fading, but at the moment it looks strong. Ding! US support? Not really close, but looking at the trade deficit it is possible to make an argument that the USA’s free markets have been a massive positive, although outright support is out of the question. Bzzzzt! Global capital markets are there more than ever, and with a global growth malaise China has been looking extremely attractive. Ding! Authoritarian regimes doing the ground work is the big question, but can anyone say that Xi isn’t in a remarkably envious position relative his historical peers domestically? Sure, he might have dissent in the populace to a degree, but he has power over the country – the strongest since at least Deng Xiaoping’s early years – and he isn’t afraid to wield it. Ding! Savings rates? Look at the post in the opener line. Dammit, the dinger broke!
Adding to this, China is in a much better position to use the capital markets here. This is because of China’s size, connections like Hong Kong, Singapore and Taiwan allowing for gradual offshore openings and “shielding” from adverse capital market effects (1997 Southeast Asia, anyone?), and large packets of sidelined capital in the immediate neighbourhood, including all the five areas Bloomberg mentioned.
So, if we accept on face value that China is in a relatively good position to develop, what is the main buffer against outside risks? Well, first you have the debt structure in China, which is largely centered on policy banks lending to almost everyone with a connection, meaning politicians and SOE’s. Thus a large part of China’s debt structure is with banks, allowing the government to accept more debt should there be a problem in the future to at least diffuse risk from the financial system somewhat. Opening up and diffusing risk away from the banks with capital market openings will be greatly needed but it is a process that increases with ease as the banking system is gradually defused. Good indications in this area are already on my radar! Then we have the aforementioned savings that will cushion China a lot, allowing it to use local currency and not facing massive outflows or shortfalls in liquid instruments.
Finally, we have a combination of low equity market capitalization that doesn’t allow for meaningful impairment to local wealth, and a massive currency exchange reserve to draw from should things start getting really hairy. Can China grow forever? Of course not, but it can catch up faster or slower.
2. Lloyd Blankfein’s outlook on China
This is one of the more sensible viewpoints I have seen in a long time. Not rosy like a Victorian garden, but it doesn’t treat the economy with the same view of others who prefer to invoke images of producing the manure used to grow those gardens. Finding the stable growth rate and quantifying the investable opportunity is hard work and probably impossible to any degree of accuracy over the long term, but looking at what processes overheat it and make things too frothy is probably a good start for finding out a good rate of growth.
Just to recap so you don’t have to recall all the linked articles in your head (and pad out this short section) I believe Xi Jinping is on a run to support liquidity in the Chinese economy to slowly allow for greater competition among firms and taking the “support wheels” off the economic engine. He has been seen as willing to tinker a lot with it given the anti-corruption pushes and in so doing forced companies to not be as lavish in their entertainment budgets and ways of courting officials. The signal is really more important than the actions themselves, but it looks a lot like the fluff-cutting and restructuring that one would expect to happen before a large exit/IPO by a private equity firm on the management side of an acquisition, only on the scale of the largest country in the world. On top of this is some indications that the state won’t be there to supply liquidity come hell or high water, and that this thus needs to be supplied and priced by the markets, a signal which in itself should really strengthen the banks once this current nonperforming loans spike is flushed out of the system.
Opening of more free-trade regions in China is another indication that there is at least not a lack of confidence on Xi Jinping’s part on how far the economy has gotten and what it can tolerate in terms of market forces. Seeing more market openings and accelerating the ability of China to play a large part in international institutions, investments and trade is nearly unquestionably positive, and the developments here look rosy for a more functionally growing economy rather than a stimulus-response machine.
3. Japan Exchange Group’s interest in the Stock Connect
Very inspiring overall, and very natural given the new floods of cash going into Japan and all the initiatives that Japanese companies are taking to get more competitive growth rates (particularly if they have to distribute the money to shareholders). There are two dimensions to this that stick out to me:
- It would give Japanese investors a much more direct link to mainland China, providing:
- Something to do with all the cash without doing too much long-term investing
- Much better currency adjusted return potential than are available almost anywhere else, should China opt to allow its stock market to grow.
- The massive addition of liquidity and demand from Japan being able to access Chinese markets have to be a beneficial factor for the launch of the stock connect and the whole mental model of a “Continuing Global Offering” that I am using for understanding the HK-SH Stock Connect. Simply growing your market stably, in steps should be a very good start and what is more natural than allowing one of the most conservative global capital markets to win inroads into your assets? It must surely beat HFT fund prop shops in the US getting unrestrained opportunities to move your stocks!
If I were either Abe or Xi, I would propose announcing this sort of program to be explored after the APEC meeting next week. Abe’s possible overture to win China over to the negotiation table on geopolitics may or may not go particularly far, but I have a really hard time imagining how laying the groundwork for a Hong Kong – Shanghai – Osaka Stock Connect wouldn’t be a win on both sides, with Xi looking to make this opening step a success in increasing valuations and allowing capital market development, and Abe clamoring for a shot of capital gains to feed the GPIF and Mrs. Watanabe as they explore opportunities overseas. Neither of these economies would be expected to move fast on this, but if relations are thawing then even agreeing to mutually beneficial policies would be a good first step!
For more immediate effects, expect further gains in the Hong Kong monetary base, particularly the closing aggregate balances as it is becoming more and more likely that Japanese investors are flocking here. It wouldn’t be incredibly shocking if the 23 600 level is actually defended by overseas investors, given that the Hong Kong dollar is rising towards the 7.75 peak of its managed band against its US counterpart.
4. Summary and putting all these developments in context
If the Chinese economy is to continue growing and make itself more efficient, one key to delivering on those productivity gains is to free up the market to 1) deploy capital more effectively, and 2) allow some firms to fail. The free trade zone setup might accelerate this, and more capital going into China to handle the valuations via a Hong Kong and Osaka channel seems like an incredibly good thing.
Overall, China is in an extremely good position to do this type of expansion, given both local savings, surplus of capital and foreign capital market factors together with the total factor productivity gap that exists against developed markets. Having this ability to extract TFP growth is good, although it is the type of growth that is difficult. With an increase of well-educated Chinese, Chinese nationals with foreign experience, and closer potential ties to regional trading partners such as Taiwan and the opportunity to expand these ties globally through Hong Kong, I think that the growth can go rather smoothly if China just understands and braces for the strains this might cause its capital markets. This could thus put massive gains in the pockets of investors in both Japan and Hong Kong in the initial stages.
