Where is China Going?

Blain’s Morning Porridge, 8^th December 2021 – Where is China Going?

“When the winds of change blow, some build walls while others build windmills..”

This morning – Evergrande will default, but the Chinese economy will probably avoid a property contagion crisis as the government becomes increasingly interventionist. Longer term, how will China evolve to cope with its damaging Covid lockdown policy, Growth and Demographics?

I’m going to go off on something of a tangent on China this morning.. It can hardly come as much of a surprise to markets that S&P says Evergrande’s default is “inevitable”. (One of my highly coveted No Sh*t Sherlock awards is on its way to the US debt rating firm for stating the downright bleeding obvious).

Evergrande’s quietus will be a step towards China’s managed deflation of its property bubble, and it’s got massive implications for current and future investors in the economy. Let me stress I don’t believe China’s economy is about to vanish in a cloud of evaporating property dreams, or that a social revolution is around the corner on deflating consumer expectations. But, change will occur.

I expect China will successfully avoid Evergrande contagion destabilising the economy, and manage a soft-landing, but there is fundamental shift underway – a slowing economy, lethargic growth, and a shift away from capitalism towards a more interventionist state-controlled economy is underway. The economy will also be damaged as a result of the strict lockdown policies – and will likely struggle to reopen.

Growth expectations are now around 5% – far below numbers we assumed were deemed necessary by the party just a few years ago. Even that number could be under pressure as the scale of the property effect on the economy comes into play, while China’s isolationist response to Covid means the fast spreading Omicron variant could play havoc with reopening the economy.

The Thoughts of Chairman Xi now absolutely dominate and set the internal debate – begging the question: just how will China emerge from the immediate uncertainties of a Property Wobble, Covid and Geopolitical Tension, and the long-term question of how China fits into an evolving global economy?

And, all the time, hiding in the background is the demographic reality: can China get rich before its aging demographic leaves it struggling?

It’s increasingly difficult to say where China is headed. There is an article in the WSJ: “China Increasingly Obscures True State of Its Economy to Outsiders” summing up how the economy is being shut to outsiders, and the lack of real intelligence available to anyone trying to figure out what’s rea going on. The best we can do is listen to comments around issues like “disorderly expansion” and “stability” – and figure what it means for investment opportunities in China. (Making barely educated guesses with little real information is stock in trade for any market strategist… )

What is clear is the CCP sees danger and has now embarked on economic stimulus to reinvigorate activity – easing policy in terms of lower Minimum Lending Requirements for banks, and lowering rates even as the global trend is towards tightening. Meanwhile, the economy is being reconstructed to away from free-enterprise towards greater state control and intervention, with regional governments given responsibility for sorting the property mess.

It all sounds fine in principal, but the history of China includes a critical sub-thread of pernicious regional corruption. That’s a sweeping charge to make, but the Chinese are remarkable traders and entreprenuers – give them space (as happened under Deng Xiaoping) and they thrive pursuing wealth, culminating in the success of China’s many billionaires. Close that door, and the road to riches is more likely to be perceived to be via the state bureaucracy.

There are close parallels between what’s happening in China and Soviet Russia’s economic history last century – after the revolution a period of chaos and civil war, near economic collapse, before a period of economic reform and liberation of free markets (the New Economic Policy period), before authoritarian figures seized back control of the economy to pre-empt political reform that might have seen them replaced. (In China, as I’ve written about before, it also a case of factions: What’s the Driving Force in China.)

The CCP is now trying to engineer a soft landing – a survivable property crash-landing, which will have internal and external effects.

• Domestically, housing costs are unsustainably high, but a crash would devastate China’s middle classes.
• Internationally, its going to be fascinating to see how defaulting property firms deal with offshore investors – do they ensure they are well treated in default to secure future engagement, or is China willing to risk long-term offshore disappointment by leaving foreign bond holders with the bulk of losses?

(Trading defaulted China property debt is going to be a fascinating market – how to play it when the rules are changing?)

However, the real issues aren’t just the tactical questions of how many other Chinese property developers will tumble, how it may impact local banks, or what local governments do, but the strategic issues determining what direction the Chinese Communist Party (CCP) takes next.

There are a number of key themes emerging:

How does the CCP replace Property as the core driver of the remarkable growth of China over the last decades? Property accounted for 33% of GDP growth – a massively distorting share. Growth was achieved by persuading Chinese consumers to leverage themselves into property – effectively their wealth is aligned with the success of Government avoiding a messy collapse. Call it Stockholm syndrome if you want – but its little wonder the Chinese middle classes are willing to go do the increasingly strident “patriotic” line pushed by the CCP on issues like Taiwan or the coming Winter Olympics.

I’ve read much about China becoming the world’s renewable energy builder – but frankly, solar panels and wind turbines are the easy options. China can do them, but hasn’t developed the more difficult technologies we need to diversify renewable energy – that really would be value added.

The past 30 years of spectacular China growth was not achieved on the back of home-grown technology innovation, productivity gains across Chinese industry, or a financial revolution propelling Chinese banks to the forefront of the global economy and financial system.

China remains a follower rather than leader in key technologies and industries. It has tried to address its perceived weakness with strategies like the Belt & Road project and debt-diplomacy – enthusiastically lending on infrastructure projects to promote growth likely to boost Chinese exports. These are perceived badly in the West – which is equally keen to protect markets it sees as theirs.

As the government flexes its increasing control of the economy you have to wonder where China’s private sector fits in – and thus its investibility. The big billionaire names have been “disciplined” and the stock prices of the big firms have suffered in line. The jury is out on how to invest in an increasingly closed China economy – which may have accidently crippled itself as result of lockdown damage.

Five Things To Read This Morning

FT – China to Tighten rules for tech companies seeking foreign funding

BBerg – Evergrande Restructuring Puts Onus on Xi to Limit Contagion

FT – Will China have to loosen policy?

WSJ – Voters Pessimistic About Economy, Biden’s Leadership, Poll Finds

Thunderer – I’ve really hit the buffers, admits Nick Train

Out of time, and back to the day job!

Bill Blain

Strategist – Shard Capital