1. Will China Weaponize the RMB and U.S. Treasury bonds?

Bob Savage of TRACK says: 'In its talks about tariffs with the U.S., China appears to be discussing - in addition to, of course, to preventing other U.S. goods from coming in - two retaliatory measures to persuade the U.S., "You don't want us to do this,"':

1. 'Devaluing the RMB'
2. 'Selling U.S. Treasuries.'

1. Devalue the RMB. Devaluation is 'one quick way of making up for how tariffs hurt you.'

• 'But, that currency movement could be very ugly if the Chinese wanted it to be.'
• 'If China destabilized its currency, this would wreak havoc on the order of inflation and cause even more market volatility.
• 'In the end, 'the aims of the U.S. tariffs would backfire.'

But, for China it would also create, 'plenty of new problems, so China would not to want to do that.' Devaluation would:

• 'Promote the idea that there's an outflow of capital.'
• Panic markets. 'Destabilizing the RMB could panic some of the money that has been found a home for the rich Chinese in their stock market, or in their property market, or even in the nascent bonds market.'
• Cause a round of devaluations. 'If China's devaluing its currency, other countries are going to have to devalue their currency.'
• And, 'destabilizing the currency reverses a lot of the goodwill that Xi is trying to promote with the rest of the world.'

2. Selling U.S. Treasuries. 'As we know, China is one of the largest holders of the U.S. Treasuries [see the chart, above].

• 'And, in China, there has been open discussion, even before the proposed tariffs, as to, "Why are they investing in those Treasuries?"'
• Some argue, 'Treasuries are not really doing a lot for China other than being a placeholder for U.S. dollars.'
• 'One Chinese government adviser this week even talked about selling Treasuries and investing more in 'One Belt One Road' or in other ways that help the rest of the world.'

Higher U.S. interest rates. 'If China sold even a tenth of its bonds, interest rates on the benchmark U.S. Treasury 10-year bond could inch beyond the 3% level.'

• With the annual U.S. budget deficit about to top $1 trillion and the Fed pulling back, this would create a bearish bond market, pushing U.S. borrowing costs higher.

But, as rates sharply increased, the value of China's remaining Treasuries would, in turn, tank, and China would lose billions.

2. Markets whipsawed...consider the soybean 

' Both China and the U.S. are clear about they want from their respective trade agendas. Bob Savage of TRACK says:

• For China, 'more U.S. exports of intellectual property wrapped around technology.'
• For the U.S., 'a much smaller trade deficit with China, spurred potentially by selling them more cars, maybe a little bit more commodities, and a lot more junk, like U.S. movies or other intellectual property. And, we would love to have Fidelity, or BlackRock, and Goldman have offices all over China.'

'Those things are going to take a lot of time.'

• 'In the interim the markets are moving up and down on every release about whether the trade discussion is going well or not.'

Consider the soy bean. 'China is threatened retaliatory tariffs on U.S. soybeans. The U.S. is one of the largest producers of soybeans. If China's not going to buy them, we're going to have an excess capacity.'

• 'So, last week, we saw a soybean selloff.'

'But there was a complete dislocation in whole soybean supply chains. Downstream products, like soybean oil, didn't move at all in the same way.'

• Why? 'Because the talks are going on and off so quickly. One day we're talking to each other, and the next day we're threatening each other.'
• 'So the truth is, you have an order for soybean oil, it doesn't matter:  you have to deliver it, and you can't short that stuff.'
• 'The fact is, to fill the orders, you're going to need soybeans to make soybean oil, so all you're doing is creating windfall opportunities for these processors to take some of these commodities and play off of them.'
• 'Eventually, the net result is going to be inflation.'

'This highlights the problems with a market that's speculating on the success and failure of the bravado of two big countries talking loudly to each other about what they want in their trade agendas.'

3. U.S.-China trade war: collateral damage

Bob Savage of TRACK: 'My favorite saying relating to the trade dispute is an African proverb, "When elephants fight, it's the grass that suffers."'

• 'When powerful nations are conflicted, the weak ones suffer the most, so it goes for the market reactions to the US and China rumpus over trade.'
• 'The countries that are going to be hurt most by a prolonged U.S.-China discussion about trade, leading perhaps to even more minor skirmishes over tariffs and tit-for-tat actions are emerging Asia and many of the allies of the United States.'

'So, the rest of the world is looking less sure and less happy over the fight. There are unintended consequences to this U.S.-China squabble because trade reflects the integration of global businesses into a complex supply chain.'

'German carmakers are an example of losing out.'

'Germany exports cars to China, but most of them are German-branded cars made in the United States.''So, Germany would be hurt almost immediately if China slaps tariffs on U.S. autos.'

'The two biggest losers are Canada and Mexico thanks to NAFTA.'

More losers: 'Korea and Japan are deeply integrated into the manufacturing processes in China of high-end consumer products like smartphones.'

• 'They export, for example, integrated circuits that go into products like smartphones.'
• 'China then assembles the imported parts into finished products.'
• 'And, these products are shipped to the U.S. as 'Made in China.' 

'This is the outcome of bilateral trade disputes in globalized world economy.'

• 'We're far more developed than the mercantile world of the 15th and 16th centuries.
• 'And that's why economists are up in arms - we're well beyond this.'

4. Beyond trade

'Economists have been arguing against trade wars since the 1930s.

• 'The fear of a further rise in protectionism is a clear downside risk to global growth and an upside risk for inflation.'
• 'We may be forcing the Federal Open Market Committee (FOMC) to respond to U.S. loose fiscal policy and tighter labor markets with rate hikes that also reflect a splintering of the global trade rules set after World War II.'

'This rumpus isn’t a child’s game even though it appears to have a tit-for-tat quality to it.'

• 'Beyond trade fears remain real economic doubts as the push for growth to drive up inflation hasn’t been convincing in places where demographics, technology and excess capacity hold (Japan, Europe, and some Asian Emerging Markets like Korea).

'The other geopolitical stories have taken a backseat to the headlines but perhaps will show up in markets again with...

• 'Hungary re-electing nationalist Orban as PM – highlighting the ongoing splintering of EU politics.'
• 'Syria continuing with gas attacks – highlighting the inability of the world to control war crimes or bring peace with a corrupt leader.'
• 'Hamas continuing with protests in Gaza.'
• 'Germany suffering another terror act as a van plows into a crowd in Munster..'

'Perhaps the most important story from last week and for the week ahead is in the fear for markets – it’s reflected in US stocks, not in bonds or foreign exchange (FX).'

• 'The lack of FX reaction to the ongoing political noise is notable but understandable in the context of 2016-2017 when central bankers successfully counteracted political events like Brexit or even the election of Trump.'
• 'Whether that continues maybe the key to understanding risk events for the rest of April and for 2Q.'

'It requires a great imagination to hope that this all ends well. I'm not sure it will. But, until then there are two things that we're going to have':

1. 'Increased volatility in currencies, especially in emerging markets' and 
2. 'Increased nervousness over interest rates.' 

5. Sort of surprising U.S. & China trade numbers

Bob Savage of TRACK: 'The trade war theme is still far more in the front of traders and investors fears than some larger conflagration in Syria.' 

'U.S. total trade deficit up $57.6bn – worse than the $56.5bn expected.'

• 'But, China's trade surplus with the US fell to $15.43 billion, below the $20.96 billion level of February.

'The China trade data today was the big release with exports lower and imports holding.'

• 'China March trade flips to deficit of $4.98bn after surplus of $33.75bn – worse than +$27.2bn expected – first deficit in 13-months.'
• 'Imports up 14.4% year-on-year;  exports fell 2.7% over the same period.'
• 'Most of this can be linked to the noise of the Chinese New Year.
• 'But not all. 'China is in the midst of its own transformation from investment led growth to domestic consumer focus.  This isn't about trade tariffs but the needs of the Chinese people.'  

Peter Navarro, along with Wilbur Ross, won the tariff debate. Dr. Navarro, a few years ago, wrote Death by China, where he lays out his arguments why the U.S. must confront China on trade, currency, business, and the rest.

And, to drive the point home, he also made a one hour and 20 minute long movie. The few seconds from the film, below, will give you the flavor of Dr. Navarro's thinking.

But, with the steel and aluminum tariffs, he seems to have missed his target. China doesn't export a lot of steel to the U.S., although by shipping through third countries, it does supply more than the official numbers indicate. You just can't trust Chinese data.

Whether you agree with the proposed tariffs or not, the tariffs have gotten the attention of the markets. Yet, one that hasn't received a lot of press is the currency market.

So, I invited experienced forex trader and markets expert Bob Savage, CEO of TRACK,  to explain how the tariffs are affecting the currency market generally and China and Asia more specifically. 

1. The 'Trump Risk Premium'

Bob Savage, CEO of TRACK, explains: 'The currency markets are embroiled in trying to figure out whether the Trump tariffs on steel and aluminum are good or bad for the U.S. economy and the U.S. stock market.'

'Just like other markets, in the foreign exchange context, the dollar already has a "Trump risk premium" built into it.'

• 'In forex terms, the "Trump risk premium" is measured by how much higher our real rate is than the rest of the world's.'
• 'The G7 real rate in Europe is negative, the G7 real rate for Japan is negative, but for the U.S., it's positive.'
• 'That indicates to me that no one has faith that we are going to pay our bills or that this president means what he says.'

'How much the U.S. president is supported abroad is a measure that we all want to try to correlate to how it affects markets.'

• 'The U.S. is a special case because we need about $400 to $500 billion of foreign money to fund ourselves.'
• 'Otherwise we have to do it internally, and that requires a shift in our savings mechanisms -  we would have to force Americans to buy their own bonds.'
• 'Instead, we force other countries to buy our bonds.'

'The petrodollar argument of the 1970s is a classic example, where the difference between Trump and Reagan may well be in that recycling of U.S. dollars abroad.'

• 'Because we have big trade deficits, the money has always traditionally gone back to the United States in funding our budget deficits.'
• 'This is not the case when you have a negative view of U.S. growth and a negative view of how the world is going to react to U.S. deficits.'

2. Trump's tariffs: a coup China soft power

Bob Savage, CEO of TRACK, believes 'China's going to try to do a couple of things with the U.S. tariffs.' 

'One is defensive - making sure that this doesn't hurt them competitively.'

• 'China doesn't officially import a lot of steel and aluminum to the U.S.,  But, its trading partners Korea and Japan do.'
• 'So, Korea and Japan could be tempted to make a traditional reaction to tariffs - devalue the currency. And, China will use its reserves to buy Yen and Won to head that off.'
• 'I note, though, that Korea and Japan's steel and aluminum exports to the U.S. aren't really big enough to justify devaluation, but the issue still needs examination. More later.'

'Two is public relations - using the tariffs to try to win the mantle of the good player in Asia and the international arena, to show that they're not retaliatory and reactive to U.S. noise, but instead very thoughtful, and plodding, and fair in their way. All to the U.S.'s disadvantage.'

• 'In Asia, China has already been working to position itself as the 'good player,' as, for example, becoming, the go-to provider for capital in emerging markets, expanding the One Belt One Road and their new infrastructure plans there, and so on.'

 'All this certainly is putting Asia in a tight spot.'

• 'They don't feel that the U.S. is offering them anything.'
• 'They don't feel like China is perhaps the right player to go to, but it might be the only choice.'
• 'If I'm reading Beijing correctly, the leadership in China would like to offer Asia and the world an alternative to U.S. hegemony to Trump's madness. And, the tariffs play right into China's hand.'  

3. The RMB-Yen & RMB-Won relationship...it's complicated

Bob Savage, CEO of TRACK, says: 'When it comes to Asia, these tariffs are really difficult to put your head around, because they affect Korea, they affect Japan, and their trade relations with China are incredibly important.'

• 'Therefore, I'm looking at how the Renminbi-Yen and Renminbi-Won relationships trade.'
• 'Especially, how China manages the Won and Yen to the Renminbi, and whether this is its preparation for a harsher game ahead.'

'If you look at the chart of Won and Yen, below, they've broken out.' 

• 'The Yen is considerably stronger. If you were just trading this on a technical basis, if you were going, "I want to be long Yen and short Renminbi."
• ''Korea is not quite the same game, but it certainly is no longer a game where Korea gets a free pass because of North Korean worries or a new government.'

'Both of those countries need to see that they can't competitively devalue to gain any market share at all.' 

'In this case, Japan and Korea wouldn't want to devalue anyway because steel isn't a huge part of their export path. It's really about autos.'

'But, it makes a point here about the traditional way of dealing with tariffs, and this is the key point: what do tariffs really mean? How do you deal with a tariff, if you're a country? There's two ways.'

• 'One is you substitute a product.'

'Or, two, you devalue your currency to make up for the tariff.

• 'Here's what I mean. I'm in Japan, and I get slapped with a 25% steel tariff, and my steel happens to be (but, in fact, is not) what is in demand for high-end products, and the United States is using it.'
• 'Well, then you're going to try to devalue the currency to give your companies a competitive advantage to make up for the disadvantage of the tariff.'
• 'But, now it looks like that game isn't going to work.'

'The reason why devaluations probably don't work for emerging markets or the G7 currencies this time around is that China is going to be able to use its reserves to buy those currencies and prevent them from weakening too quickly.'

• 'We've seen China this year actively buying Korean Won and Japanese Yen along with the euro. This was originally taken as a sign of China's displeasure with holding U.S. assets'
• 'But, it is also a larger game of trying to live in a world where China is trying to manage its currency and how it trades against a 24 other currencies.'

'In this case, Japan and Korea are being told by China, "You're no longer going to be given a free ride to devalue when you have an economic hiccup," because it has an immediate impact upon China.'

1. 'E-commerce' is rapidly evolving into 'New Retail.' Jack Ma, Alibaba

'Ed Tse, founder of the Gao Feng consultancy, says, 'Recently, Alibaba has gotten significantly into New Retail. In his October 2016 letter to Alibaba shareholders, Jack Ma wrote':

• 'Commerce as we know it is changing in front of our eyes.'
• 'E-commerce' is rapidly evolving into 'New Retail.'
• 'The boundary between offline and online commerce disappears as we focus on fulfilling the personalized needs of each customer.'

Ed explains, 'New Retail combines of online retail and offline retail.'

• 'This is also known in China as "O.M.O." or "Online Merging with Offline" - merging through technology - sensor technology, online payment, artificial intelligence, and so on - to make the customer experience very much hassle-free.'
• 'This is an entirely new ecosystem for retail.'
• 'And, besides its own stores, Alibaba is now working with a large number of offline retailers so that they can build their own New Retail ecosystems.'

Amzaon led the way. 'China needs a pioneer. What the Chinese are very good at is picking up a concept and applying it in China in a much more intensive and much faster manner.'

• 'In this case, the pioneer was Amazon Go, and the outcome is Alibaba's New Retail.'

'With Alibaba, ecommerce is still the core. But, through ecommerce, it also built the basic infrastructure and the basic capabilities relying on big data. On connectivity. On its ability to create an ubiquitous user space.'

• 'Alibaba's Taobao, the online commerce platform, for example, has something like 500 million daily active users. Ubiquitous database, user space.'
• 'To do something like New Retail, you have to have that kind of ubiquitous user space. You have to know each of the users, individually.'
• 'Alibaba will know you, "Malcolm Riddell," individually. Even though it has an ubiquitous database with information about hundreds of millions of users on that database, Alibaba knows you individually.'
• 'And, using that information Alibaba can personalize your New Retail shopping experience.'

Ed describes how the Alibaba's New Retail might work as an ecosystem.

• 'You register on the app, or if are a user of Alibaba's Taobao you don't need to register.'
• 'If you a user of Taobao, Alibaba already knows your preferences, what kind of products that you like.'
• 'When you go to a store, you are identified right away through facial recognition or body recognition.'
• 'You go in and robots will automatically take you to where your favorite products are. You go to your aisle, you look at a product. You may make some choices. You scan the QR code.'
• 'The app will know or automatically what kind of product you want to buy or don't want to buy.'
• 'Then, you press a button, check out, and just walk out.'
• 'The merchandise will be delivered by smart logistics to your home within "X" number of hours.'

2. New Retail, a 'third way' ecosystem among ecosytems 

New Retail is one of a multitude of ecosystems that are part of China's 'Third Way' of doing strategy.

• In Part Two of our conversation, Ed Tse, founder of the Gao Feng consultancy will explain more about the Third Way. 
• For now, here's a brief explanation. 

Ed notes, 'Lots of people ask me, "It seems that all of a sudden there are so many Chinese companies that have become so big, so valuable, so quickly. How did they do it?" I answer...'

• 'The very best Chinese companies, or the fastest growing Chinese companies are those who adopt the "third way" of thinking about strategy.'
• 'Using "third way" strategy, they make multiple jumps from business to another business to another business, and so on - as the chart below shows.'

'In the process, they fill in the gaps in capability through creating ecosystems - a network of collaborators - who can help them.'

• 'You put all of a company's ecosystems together, and they become one mega-ecosystem.'
• 'That mega-ecosystem is the major contributor to the high valuation of these kind of companies.'

3. Watch New Retail in action

Alibaba has a website, Alizila: News from Alibaba.

Here are two pretty amazing short videos from the site that show the New Retail experience for customers.

Have a look.

'Take a Tour of a Hema Supermarket and Experience "New Retail"'(3:03 mins)

'The "New Retail" Inside Alibaba: How New Retail Is Changing Everything' (5:28)

1. 'Today's tariffs just Trump's first shot - the real China action is Section 301'

[Note: If you're not up on the difference - and it's a vitally important difference - Section 232 and Section 301, please go to part 2, below.]

Leland Miller, CEO of China Beige Book told me: 'Donald Trump just announced several minutes ago that he was indeed going forward with Section 232 tariffs on steel and aluminum. Here's my take and some context.'

'When the Trump administration was originally developing the strategy for responding to China trade problems, they evaluated two major lines of attacks using tariffs.'

• 'One line of attack was Section 232 - that's what you're hearing about today.'
• 'Today's 232 move is just for steel and aluminum tariffs, it's not China specific, and it's something that relies on the ability of the White House to be able to say, "National security dictates that we regulate these imports with particular tariffs."
• ''The big problem with that as a China move: China is not a major exporter steel or aluminum to the U.S. So, this is not really something that's going to hit China particularly hard directly.'
• 'Indirectly, this will hit China. China has been sending its steel through third-party countries in Southeast Asia and elsewhere so that it comes into the U.S. not identified as Chinese. Today's action is partly designed to stop this.'

'But, because these are tariffs on global imports, this is going to upset a lot of America's strongest allies.'

• 'You're already having foreign delegations rush to the White House right now to lobby to get them out, carve them out.'
• 'Trump hasn't signed anything yet. So, you could see carve outs for allies in the final document.' 

'What the President might do after making such a splash today brings us to the other line of attack: Section 301.'

• 'Section 301 has always been the White House's underlying platform - its center- for the anti-China assault on the trade side.'
• Why? 'Unlike Section 232, Section 301 targets unfair trade practices, not products; and it targets a specific country, not the whole world.'
• 'So, with 301, the President has the power to basically do whatever he wants to China on the tariff side in order to deal with the fact that the Chinese have been stealing intellectual property and a 301 investigation has found them guilty of that.'

'In response, he has the option to either have a very mild action or something that would be much larger than what he announced today with Section 232 tariffs on steel and aluminum, much more severe.'

• 'If he went for something severe, such as broad sectoral tariffs - tried to take down, say, China consumer electronics - then, you would have justifiable reason to call this a trade war.'

'With today's 232 tariffs on steel and aluminum, there was actually strong opposition across the government, across the administration. Even within the White House where, except for a handful of people, advisors were very, very against this - they think Trump's opening up Pandora's box.'

• 'So, it's interesting that there's not much opposition to the country-specific Section 301.'
• '301 is likely to go forward as planned. We just don't know how big yet.'

'How big 301 actions will be depends on how this 232 tariffs saga ends up'.

• 'As I mentioned, if 232 goes forward in anywhere close to the current way it's being described by the President, it is absolutely against the wishes and inclinations of almost everyone, within most of the industries, even within the Trump White House.'
• 'Republicans in Congress don't want it, either. So there's a lot of politics to this.'
• 'The President's backed himself into a little bit of a corner - I think you're most likely going to see 232 going forward, but the chances are that it gets pulled back some.'
• 'All this is something that's going to have to be sorted through before the President decides whether these 232 tariffs are enough, whether he has to pull 232 back a bit, or whether he wants to go even bigger with 301.'

'The President's impulse seems to be to go bigger. And 3o1 - it's faster, it's louder, it's bigger, than other routes, such as going through WTO processes.'

• 'Section 301 essentially allows the President to right the wrongs that he believes have not been dealt with by the WTO.'
• 'Wrongs that in his mind and in the minds of Wilbur Ross and Peter Navarro and Bob Lighthizer that the Chinese have been committing for years, for decades now.'
• 'Where WTO has not done anything about them, and other Presidents have not done anything about them, he will.
• 'And, quite frankly, what the President wants here is a big splash - if he uses 301, he can show that his campaign rhetoric about being a strong warrior on trade is credible.'

'For these reasons, I believe that you're seeing right now - regardless of how 232 ends up in the next few days - you're seeing the beginning, not the end, of Trump's aggressiveness on trade.' 

'And, I don't think people have prepared themselves yet for the fact that 301 is coming.'

2. Section 232 & Section 301: The Difference

Leland Miller explains the difference between Section 232 (Trade Expansion Act of 1962) and Section 301 (Trade Act of 1974).

'Broadly speaking, these are two very different measures.'

• 'Section 232, is product specific and focuses on whether imports of that product threaten U.S. national security. The President can take any actions to “adjust the imports of an article and its derivatives” or other non-trade related actions he thinks are necessary to protect national security.'
• 'Section 301 is country specific and allows the U.S. to impose trade sanctions on foreign countries that either violate trade agreements or engage in other unfair trade practices.'

'The Section 232 tariffs the President has announced today are specifically for steel and aluminum.'

• 'Steel and aluminum are each the subject of an active 232 investigation and their imports have been deemed threats to national security.'
• 'Because of these findings, the President has declared their import  threats to national security, and that's why he's taking action on them.'
• 'When he signs the tariff orders, the effect is global. That means, the President is putting steel and aluminum tariffs on imports from everywhere around the world, but he can carve out certain countries to be exempt.'

'Section 301 is very different -  it's country specific, not product specific.'

• 'Section 301 has to do with unfair trade practices - in this case, it is intellectual property theft, and it is a China-specific investigation that nailed China.'

 'The idea behind how to push an aggressive trade front against China has always been centered around 301.'

• 'That's the way you really get at China, not through 232, which is global, but through 301, which allows China-specific application.'

Those who can’t lead, borrow. The American, Chinese and Indian governments boast of the strength of their economies, yet they are also borrowing intensely. Such a situation is not only contradictory, it will also prove harmful to their chances at global leadership in the future. A strong economy means government should spend less and not need to borrow at all. In all three countries, policymakers appear oblivious to the consequences of failure on this score. Will the US or China lead in coming decades? When will India become a global challenger? The answers may be neither and never. Instead the world could see a slow slide into a long stagnation.

Few people consider India a truly global actor but, within the next 20 years, it will have both the world’s largest population and largest labour force. It will be difficult in 2040 for the global economy to be healthy if the Indian economy is not. There is obviously a long way to go before then, and India is not going in the right direction. The government of Narendra Modi, prime minister, is obsessed with the title of “fastest-growing major economy” and insists India will reclaim that spot in 2018 or 2019.

Yet central government borrowing will rise this year as a share of GDP, from an already excessive figure. The core of the higher deficit is a jump in the simple revenue shortfall, which overwhelms one-time accounting tricks used by politicians everywhere to dress up ugly budgets. In addition, Indian states borrow even more intensively than the national government.

A country growing rapidly with a young workforce should not need to do this. More important, a poor country which seeks at least a full generation of such growth should not borrow against that future. India is showing neither the vision nor will to become an economic leader.

Many would claim China already is such a leader. It qualifies in terms of size and no shortage of people tout its performance. They acknowledge that Chinese GDP growth, for instance, has slowed by half in the past 10 years, but point out this is natural as the size of GDP expands.

What is not natural is China’s bad track record on debt: according to the Bank of International Settlements, every measure of debt — consumer, government and corporate — has risen as a share of GDP for the past decade. China went from a low-leverage country in 2007 to having a worse debt position than the US in 2017, despite the fact that the US itself has borrowed heavily.

The bulk of Chinese debt is corporate, not explicitly government. But the bulk of corporate debt has been incurred by state-owned enterprises and underwritten by central and local government, as these firms borrow almost entirely from state-owned banks. It is thus China’s central government which has authorised a decade-long explosion in debt accumulation, even while trying to convince the world it offers a superior model of development.

Those who favour US global leadership can be reassured by China’s poor choices. But America’s own choices are disturbing. The US already faces enormous spending obligations in the form of entitlement programmes. Combined national government spending on healthcare hit $1tn in 2015 and social security spending is projected to hit an additional $1tn this year.

The 2017 federal budget deficit was $650bn and expected to rise over time as the country ages. Now, enter the tax cut. Congress and the administration had reason to cut corporate tax rates, but they did so by $1.5tn and with no offsetting tax increase elsewhere. The recent spending bill adds $300bn to that.

The federal deficit could thus reach $1tn in 2018 and, if not this year, then next. This is not happening during a crisis like the one in 2008. While there are problems with labour force participation and inequality, unemployment is 4.1 per cent and the US economy added $7tn in wealth over the most recent 12 months. Yet national debt is set to soar.

US federal borrowing has no justification. If China is telling the truth about its economy, it has no excuse for its corporate debt. If India wants a bright future, it cannot mortgage it now. No country has ever prospered from heavy government borrowing when times are good. Yet this is what the world’s economic leaders have to offer. They are walking into quicksand and could drag everyone else with them.

1. Fear and simplicity.

A 'sense of terrible crisis [was] a prerequisite for an Asian economic take off,' Bill says. 

• Fear. Following the events that befell Asian countries - such as, the Korean War and the Chinese civil war - each nation faced the real possibility that it might not recover. This made leaders more willing to take great risks and their peoples more willing to accept them.
• Simplicity. 'These countries' economies, when they're getting started, are basically agriculture, infrastructure, and some very primitive manufacturing.' This makes the plan simple: 'stimulate growth, build infrastructure, and open and marketize the economy.'

2. Simplicity to complexity - and new crisis. 

With success comes more complex economies, politics, and societies. 'And, then you gradually get to a point of complexity, where there is an economic and political crisis of some kind.' Time for a transformation.

• China's leaders realized this and reached consensus about the need for reform during Hu Jintao's 'lost decade,' 2002 to 2012.
• The guide for reform: China 2030, jointly prepared by the World Bank and China and adopted by the Third Plenum in 2013.

3. Slower reform, bigger debt. 

The decision for leadership: quick reform and lower GDP, or slow reform, maintaining higher GDP but accumulating debt in support of inefficient industries.

• China chose slower reform, higher GDP, and increasing debt.

4. China's leadership

China's leadership wanted Xi to centralize power. We often hear criticism that Xi Jinping is power hungry. But, in fact, Xi's centralizing of power was part of the consensus leadership plan, what they saw as the only way to push reforms through. 

5. But,

'Xi Jinping may have gone well beyond what the consensus originally intended, and the politicization of the reform may not be exactly what some of the designers of the reform intended.' 

You will find each of Bill's points developed below. Let me know what you think.

Political Fear. 

'The Asian Miracle countries are all countries that were scared out of their minds.'

• 'Japan after World War II. South Korea after the Korean War. Taiwan after the Chinese Civil War. Singapore after a very traumatic separation from Malaysia. And, China, after what I call a "bad hair" century - a  terrible series of crises and wars, ending with the Cultural Revolution.'

'Why is this sense of terrible crisis a prerequisite for an Asian economic take off? Because it creates a certain political environment.'

• 'The leaders are so scared that they're willing to take great political and economic risks. And, to do bigger things, more dangerous things than a normal leader would.'
• 'The people are conditioned the same way. They're scared that society is going to collapse. That their kids won't have anything to eat. They're willing to accept more stressful change than people in a normal, unfrightened place would accept.'
• 'The leaders offer policies and tell the people, "You need to know this is going to be terribly disruptive. And painful. But, it's going to save our society."'

Economic simplicity. 

'The counterpart, on the economic side, is an economic simplicity.'

• 'These countries' economies, when they're getting started, are basic agriculture, weak infrastructure, and some very primitive manufacturing.'
• 'Even the government can figure out what to do in that situation initially: stimulate growth, build infrastructure, and open and marketize the economy.'

'The Asian Miracles have a succession of models, starting with Japan, each asking: How we can create a great economic take off? The common answer:'

• 'Gradually open the economy to foreign trade and foreign investment'. 
• 'Gradually marketize the economy by allowing market prices and other market phenomena to work.'
• And, build infrastructure like crazy.'

'This works for quite a while because politically it's relatively simple.'

• 'That doesn't mean there aren't terrible political struggles, that doesn't mean there isn't a resistance, but it's not the way it would be in Britain, or the  US, or China in normal times when people would push back against these tremendous, rapid changes.' 

'So, all this works for a while. And then, success comes.'

• 'And, then you gradually get to a point of complexity, where there is an economic and political crisis of some kind.'

'Successful economic modernization has eliminated the fear that once energized the  Asia's Miracle Economies.'

• 'Simple economies and politics have been replaced with immensely complex ones.'

'Economic and political complexity are two sides of the same coin.'

• 'The rise of large, rich, efficiently organized economic sectors is the same as the rise of large, rich, powerful interest groups with conflicting interests of immense complexity.'
• And, this creates the crisis of success.

Bill Overholt says, 'China's situation today is a little like that of an entrepreneur, who has invented a good widget, done well in marketing it, the company is taking off, and it's gotten to a certain point where they have to do the IPO.'

• 'Now, it needs professional accounting and professional human resources and so on. It needs a transformation in order to keep going. If it succeeds at that transformation, take off continues, and if it doesn't, it flops.'
• 'The core issue for China is dealing with the social complexity that comes with economic success.'

From simple to complex. 'China doesn's have simple infrastructure, agriculture, and government manufacturing anymore. There are thousands of sectors.'

• 'In the power sector, you have all kinds of different power production systems: coal, solar, wind, hydro. You have conflicts between the producers and the distributors, who are no longer the same companies.'
• 'There are thousands of software firms in conflicts between the users and the owner, inventors. And, so on.'
• 'These sectors are big and powerful and assert their interests.'
• 'China's economy just got too complicated to be managed from a few offices in Beijing anymore.'

'China's leadership recognized the issue; they saw it coming; and they addressed it.'

• 'They decided, "Instead of trying to make all the major decisions in the NDRC, the National and Development Reform Commission, we're going to have market allocation of resources. It's going to be done automatically by the market, and it’s going to be more efficient."'

'From that premise, like somebody developing a system of mathematical theorems, they deduced hundreds of individual policies to implement that market allocation of resources. They consulted Nobel Prize winners, they consulted all kinds of private sector actors, as well as government officials.'

'The end result was China 2030: Building a Modern, Harmonious, and Creative High-Income Society prepared jointly by the World Bank and the Development Research Center of the State Council.'

• 'It's hard to find a more impressive economic plan anywhere else in economic history.'

'China 2030 was announced as a report of the Third Plenum, with great detail about what they planned to do after Xi Jinping took power.'

• But, 'in the politics and implementation, it's gotten complicated.'

Bill Overholt says, 'When they started to implement the China 2030 reforms, first, the leadership had a choice:

• 'Rapid reform, which would mean much slower economic growth', or 
• 'High economic growth, which would mean accumulating a lot of debt and slowing the reform process.'                                   

'What the Chinese have effectively chosen is much slower reform in order to keep the economic growth rate up around 6.7%.'

• 'So, they've acquired a substantial problem of debt as they're trying to keep this engine moving really fast.'

How this works. 'Fast reform would, for instance, involve very rapid reduction of over capacity. Now, the Chinese are reducing over capacity, but not as fast as they might.'

• 'These inefficient concrete and aluminum factories, and other things, accumulate more debt as they wait the reform process.'
• 'Also, and very important politically, local governments have become incredibly indebted, and you can crack down on that quickly, or you can not allow them to work at all for a considerable period of time.'
• 'It's all happening more slowly than it might have otherwise.' 

'The other political decision that has slowed reform is that in effect politics has been given priority over a lot of economic reform.'

• For example, 'The government talks about putting these big State Owned Enterprises on a level playing field with others. It talks about putting them on completely market basis.'
• 'Then they say, "we're going to strengthen the role of the party committee inside these enterprises." They make sure the party committee has control over corporate strategy.'
• 'Well, is it really on a market basis if the party controls the strategy has been strengthened?'

Another example. 'We're going to have the rule of law. It's going to be one of the major things of reform.'

• 'But we're going to strengthen the role of the party commission that oversees the courts’ decisions.'
• 'Well, is it really rule of law if a political commission is ultimately making the decisions?'

'There's a whole series of such things I talk about in China's Crisis of Success as the "Ten Key Contradictions"' (page 248).

'Reform is going forward, but it's going forward at a considerably slower pace than it might have, and with much higher priority for political considerations than was expected when China 2030 was drafted.'

Hu Jintao, Xi Jinping's predecessor, presided over China from 2002 to 2012 or, what some call, China's 'Lost Decade.'

'Under Hu, China's top decision making body, the then nine-person Standing Committee of the Politburo worked a little bit like the U.S. Supreme Court - one man, one vote,' says Bill Overholt.

• 'It wasn't even like the U.S. Federal Reserve, where the Chairman of the Federal Reserve really has tremendous power to drive the outcomes.'
• 'So, reform just wasn't happening, and China's leaders (those with power, whether in or out of office) decided they needed to centralize power to a much greater degree.'

First, 'the leaders chose a much more charismatic, forceful top leader than Hu - Xi Jinping. And, they:

• 'Reduced the Standing Committee to seven members from nine.'
• 'Lobbed off the more extreme political views in order to have an easier consensus. For example, they jailed Bo Xilai, who represented one part of the end of the spectrum.'
• 'Put the, so-called, extreme reformers in a second tier, in the Politburo, not in the top Standing Committee.' And,
• 'Created all these small "Leading Groups," as they're called, to handle the most important problems, with Xi Jinping in charge of them all.'
• 'A tremendous centralization in order to get reform going. That's one part of that consensus decision.'

'Second, they realized that these reforms are painful, and so there's going to be a lot of pushback from all the important power groups of Chinese society. So, they used the Anti-Corruption Campaign as a hammer to push aside these groups who were resisting reform.'

• 'The most dramatic and the first was going after Politburo Standing Committee member Zhou Yongkang who also ran something called the Petroleum Faction. The Petroleum Faction oversaw controlled energy prices and therefore, hundreds of billions of dollars, which they could extract a share of for themselves.'

'The final piece was Xi Jinping himself. 'Xi had a fairly limited personal political base. He's been very concerned that doing painful reforms in the face of tremendous opposition would not work, or maybe not work and get him unseated.'

• 'So, he's spent the first five years using his more centralized powers to eliminate all possible rivals and to try to get all the interest groups as much under control as possible.'
• 'The story has been that the first 5-year term, which just finished recently, is about consolidating power, and the second five years is about implementing the reform process successfully.'
• 'We’ll have to see.'

Bill Overholt believes 'Xi Jinping may have gone well beyond what the consensus originally intended, and the politicization of the reform may not be exactly what some of the designers of the reform intended. There's considerable controversy below the surface over whether reform is consistent with the things I mentioned before:'

• 'Strengthening the party committees rule over corporate strategy', and
• 'Strengthening party control over judicial decisions.'

'After we find out how economic reform is going to work, there's still the question of political complexity. I talk about economic complexity, you've got all these different sectors with computing interests. Well, these are political interest groups, too. They're now very different from what they were at the beginning of reform.'

• At the beginning of reform, groups like private enterprises were small. Even the party, itself, was smaller, less organized, less well led.
• 'Now you have religious groups, and lawyers and journalists, above all I'd say private sector business, a middle class, all sorts of professional groups that are pushing important political demands.'
• 'It's just as complicated to sort those out as it is to sort out the different economic interests. And, just as you can't sort out all the economic issues from the few offices in Beijing, you can't sort out all the political issues from a few offices in Beijing.'

'What China hasn't yet done, is to come to grips with, not even developed the theory, of how to deal with this political complexity.'

China December house price growth

In December, new home (“commercial residential”) sales by developers increased (in GFA) by +5.3% year-to-date year-on-year (yes - still the same figure as the weighted price year-on-year growth), compared to+5.4% in November.

New home sales slowed down, 2017 the strongest ever in annual sales

In December, new home (“commercial residential”) sales by developers increased (in GFA) by +5.3% year-to-date year-on-year (yes - still the same figure as the weighted price year-on-year growth), compared to+5.4% in November.

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Land sales growth strong, but from relatively low levels

Land acquisition by developers (measured in the construction area) increased by +15.8% year-to-date year-on-year, compared to +16.3%in November. This is a strong pickup in land sales in 2017, though from relatively low absolute levels after the earlier declines.

One of the highlights in our recent 'In Pursuit of Patterns' series of client notes, showed that the land sales growth had tended to lead the price growth and a significant increase in land sales would lead, with a lag, to the subsequent correction in prices.

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Monthly property market indicators (October vs September)

Real Estate Foresight has published the flagship monthly China Property report for November 2017, the most comprehensive analysis of the China housing markets, covering house prices, sales volumes, inventory, land sales, construction indicators, developer performance and an extensive range of macro indicators, as well as the Western media sentiment.

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Price Change for 70 Cities 12M vs 3M (October 2017)

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Volume growth decelerated further in September across tiers

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Price Change for 70 Cities 12M vs 3M (September 2017)

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China housing: What’s changed Jan vs Jun 2017?

This chart shows what really changed in the China housing market between January and June this year, using the year-on-year house price growth rates for 70 cities (NBS data). Back in January, there were quite a few cities in the 20%+ bucket. They subsequently cooled off, while the longer tail rose across, slightly. From our monthly China Property report for July.

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Real Estate Foresight has published the flagship monthly China CityScreener(TM) report for November 2017, a data-driven analysis of the housing markets at the city-level across 70+ major cities in China. Beihai, Xi’an stand out on price growth over the recent 3- and 12-month periods, with the cities in the North East performing particularly (relatively) well, esp. Harbin. The 70+ page report and chart book is available to China Forecast subscribers only (directly and via Bloomberg/Thomson Reuters), free trials available on request.

Nikkei Asia Review

Some observers have criticized China's market economy for lacking the "creative destruction" that is said to give Western capitalism its lasting vitality.

Such doubts are misplaced as the new year is likely to underscore. In recent weeks, Didi Chuxing, the country's predominant ride services app, has moved to add bike-sharing options to its platform and has acquired Bluegogo, a bike operator that had run into difficulties. The move clearly positions Didi, already one of the world's most valuable startups, to take on current bike-sharing leader Mobike. Meanwhile, Meituan-Dianping, which is best known for its food delivery service and has more than 250 million users, has moved to offer car-hailing services in competition with Didi.

The fight is on. Didi Senior Vice President Chen Ting has already said Meituan's move will touch off the "war of the century." In the background is the increasing overlap between the business networks of China's two most valuable listed companies, Tencent Holdings and Alibaba Group Holding. After a series of mergers, both have ended up as key shareholders of Didi. Tencent also backs Meituan and Mobike while Alibaba is a major investor in Ofo, which is Mobike's top rival as well as a partner of Didi's.

Not long ago, many argued that state-owned enterprises were becoming increasingly dominant in China's economy at the expense of the private sector. These observers highlighted government protections enjoyed by state companies and noted their privileged access to resources and market niches.

In reality, the fastest-growing companies in China over the last few decades have predominantly, if not entirely, been entrepreneurial companies from the private sector. According to a study by the Institute of Population and Labor Economics at the Chinese Academy of Social Sciences, new economy sectors, ranging from e-commerce to car-hailing services, expanded twice as quickly as China's overall GDP over the 10 years to 2016. These new economy companies are nearly always private sector companies.

Some observers have criticized China's market economy for lacking the "creative destruction" that is said to give Western capitalism its lasting vitality.

Such doubts are misplaced as the new year is likely to underscore. In recent weeks, Didi Chuxing, the country's predominant ride services app, has moved to add bike-sharing options to its platform and has acquired Bluegogo, a bike operator that had run into difficulties. The move clearly positions Didi, already one of the world's most valuable startups, to take on current bike-sharing leader Mobike. Meanwhile, Meituan-Dianping, which is best known for its food delivery service and has more than 250 million users, has moved to offer car-hailing services in competition with Didi.

The fight is on. Didi Senior Vice President Chen Ting has already said Meituan's move will touch off the "war of the century." In the background is the increasing overlap between the business networks of China's two most valuable listed companies, Tencent Holdings and Alibaba Group Holding. After a series of mergers, both have ended up as key shareholders of Didi. Tencent also backs Meituan and Mobike while Alibaba is a major investor in Ofo, which is Mobike's top rival as well as a partner of Didi's.

Not long ago, many argued that state-owned enterprises were becoming increasingly dominant in China's economy at the expense of the private sector. These observers highlighted government protections enjoyed by state companies and noted their privileged access to resources and market niches.

In reality, the fastest-growing companies in China over the last few decades have predominantly, if not entirely, been entrepreneurial companies from the private sector. According to a study by the Institute of Population and Labor Economics at the Chinese Academy of Social Sciences, new economy sectors, ranging from e-commerce to car-hailing services, expanded twice as quickly as China's overall GDP over the 10 years to 2016. These new economy companies are nearly always private sector companies.

The most valuable Chinese companies today are typically "mega ecosystem" players which operate networks of businesses that can support each other and supplement each other's capabilities. A milestone was crossed last year when Alibaba and Tencent, the mega ecosystem leaders, surpassed Facebook in market capitalization.

The growth of entrepreneurial Chinese companies has been amazing. According to tech-sector funding research company CB Insights, the number of unlisted Chinese companies valued at $1 billion or more -- the so-called "unicorns" -- has risen to 59. The U.S., with nearly twice as many unicorns, is the only country where CB Insights counts more.

The Chinese though are closing the gap fast. Five years ago, CB counted only three Chinese unicorns, less than a quarter as many as it tallied then in the U.S. Those in China now valued at $30 billion or more include Didi, Meituan, Ant Financial Services Group and smartphone maker Xiaomi.

The notion of a business ecosystem is not new. Apple, the world's most valuable company, was a pioneer in this regard when it launched the iPhone back in 2007 and made the App Store its platform for distributing apps. Other leading U.S. tech companies such as Amazon.com and Alphabet are also ecosystem players. Chinese companies, however, have turned out to be even more adept at building such organizations.

Alibaba, Tencent and Xiaomi are prime examples of mega ecosystems. Building out from their original core businesses, they have jumped into a string of new sectors as market opportunities have popped up amid economic reform and technological developments have enabled them to disrupt existing means of doing business.

Alibaba started as a small business-to-business online marketplace almost 20 years ago. Around 2003, when online shopping was emerging, Alibaba jumped in with consumer-to-consumer site Taobao and later business-to-consumer site Tmall. Next Alibaba started Alipay to support mobile online payments and then later used its platform to offer wealth management services, including the Yu'e Bao money market fund, which subsequently became the backbone of its network's internet finance business.

Today, Alibaba's internet finance interests are grouped under Ant Financial, which includes businesses such as electronic payment processing, banking, social credit scoring and financial cloud services. (Alibaba said on Feb. 1 that it will resume its direct shareholding in Ant, exercising rights to take a one-third stake.) Alibaba has also branched into areas including big data, smart logistics, media, auto-mobility and cloud storage. Each sector has its own system which together form Alibaba's mega ecosystem. Though its development took a somewhat different course, Tencent has built a mega ecosystem too.

Chinese companies seem more inclined than their Western counterparts to migrate across sector boundaries and create larger ecosystems. This is perhaps because new market opportunities have been popping up more frequently in China and its consumers have embraced smartphone apps more closely. When they sense an opening, Chinese companies can quickly form ecosystems of collaborative partnerships.

In contrast, most foreign multinational corporations tend to focus on what they have been doing all along and avoid jumping across sector boundaries. This is a result of the "core competence" doctrine that has governed corporate strategy thinking in the West for about 30 years. Whle Chinese companies are more inclined to expand "horizontally" into new sectors, Western companies tend to grow "vertically" to areas upstream or downstream from their original focus.

Besides Alibaba and Tencent, companies like Ping An Insurance Group, Baidu and JD.com are building out mega ecosystems with incredible speed and intensity. Even some traditional manufacturers are moving in this direction. Zhejiang Geely Holding Group has gone from producing entry-level cars to selling premium models with the help of foreign acquisitions and has been the first Chinese carmaker to move into on-demand mobility services. It has also been experimenting with connected intelligent vehicles, shared ownership programs and flying cars, together assembling a sprawling transportation services ecosystem.

Clearly access to abundant user data is key for these kinds of companies. Even bike-sharing services like Mobike and Ofo claim that they are data-centric companies, signaling that they will also build out their ecosystems with consumer lifestyle at the core.

New technologies such as the internet of things and 5G mobile networks will enable companies to crisscross sectors faster and more capably. The operations of China's mega ecosystems will overlap increasingly with each other, driving even more intense competition.

Perhaps more collaborations in some cases or even the merging of mega-ecosystems will take place. The "coopetition" that results would be even more dynamic. The already powerful mega ecosystem players could then get even more powerful. This will be exciting to watch.

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Edward Tse is founder and CEO of Gao Feng Advisory Co., a global strategy and management consulting firm with roots in China, and the author of "China's Disruptors."

February 8: China market moves 

TRADE

In January,

• China's trade surplus fell to $20 billion from $50 billion, year-on-year, and
• Imports skyrocketed 35 %, year-on-year, shocking market watchers.

RMB

The RMB ell over 1% today.

• The most it's traded off since August of 2015 devaluation.

And the RMB has been trading below 6.30 now for over a week, even traded briefly at 6.25 

• 'Many see 6.20 and 6.25 as very important levels because that's the August of 2015 devaluation - from there you had the  August 2015 2% devaluation that unsettled world markets,' according to Bob Savage of TRACK.

Why the weakening? Three reasons, Bob says: 

1. 'The RMB did not like the trade data at all, and it weakened immediately.'
2. 'The news overnight that HNA had a technical default.

• 'The lenders to HNA - Deutsche Bank being probably one of the largest - were immediately under the scope.'
• 'Deutsche Bank shares were hit overnight, and the euro was hit because the banking sector in Europe was under the gun.'

'Overnight, the world has moved a little bit away from its U.S.-centric obsession about equity volatility in the United States and around the world to what's going on in China,' says Bob Savage, CEO of TRACK and member of the soon-to-be-launched China Analyst Network.

Specifically:

1. China's falling trade surplus and
2. The Renminbi's weakening on the trade news and on the news of HNA's credit technical default.

Part one: trade

'There's an obsession with watching what goes on with Chinese trade. China trade is a barometer for global demand for goods. Any change in that trade balance is an indication that something's changing there.'

'And, China's falling trade surplus shocked people. In January, China's trade surplus fell to $20 billion from $50 billion, and imports skyrocketed 35 %, year-on-year. There are two explanations for it.'

 'First is the more boring seasonal effect of the Chinese Lunar New Year holiday, where people realize they'll need goods over February and March but that they're going to be on holiday for a lot of February -  so, they better just get the stuff in in January. Some of the imported goods came that way.'

• Interestingly, 'a lot of theses imports are in commodities and, strangely enough, that just means that Chinese inventory holdings of commodity goods went up.'
• That turned commodities prices bearish today. 'People saw that the Chinese bought a lot of commodities in January, and it means that they're not going to buy a lot in February or probably March as they draw down those inventories.'

Second - and more important in the long run for its potential impact on China's current account - is this.

• 'Overall there's been a 3-1/2% appreciation of the RMB against the dollar.' That's made imports cheaper.
• 'And guess what the Chinese did? They imported more goods, because they felt richer.'
• 'Now, the United States knows a lot about how when you make consumers feel richer with cheaper imports: they import more goods and the trade deficit gets worse.'
• Why is this important? 'China wants to stoke domestic demand,' to become a consumer-driven economy.
• But it succeeds, this 'has an implication for whether or not China continues to be a current account surplus country.'
• If China is 'truly successful in creating domestic consumer demand - like that in Europe, Japan and the United States - then, it's probably going to start running a current account deficit, unless it actually targets trade.' 

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1. Part one: why China's trade surplus is down

'Overnight, the world has moved a little bit away from its U.S.-centric obsession about equity volatility in the United States and around the world to what's going on in China,' says Bob Savage, CEO of TRACK and member of the soon-to-be-launched China Analyst Network.

Specifically:

China's falling trade surplus andThe Renminbi's weakening on the trade news and on the news of HNA's credit technical default.

Part one: trade

'There's an obsession with watching what goes on with Chinese trade. China trade is a barometer for global demand for goods. Any change in that trade balance is an indication that something's changing there.'

'And, China's falling trade surplus shocked people. In January, China's trade surplus fell to $20 billion from $50 billion, and imports skyrocketed 35 %, year-on-year. There are two explanations for it.'

'First is the more boring seasonal effect of the Chinese Lunar New Year holiday, where people realize they'll need goods over February and March but that they're going to be on holiday for a lot of February -  so, they better just get the stuff in in January. Some of the imported goods came that way.'

Interestingly, 'a lot of theses imports are in commodities and, strangely enough, that just means that Chinese inventory holdings of commodity goods went up.'That turned commodities prices bearish today. 'People saw that the Chinese bought a lot of commodities in January, and it means that they're not going to buy a lot in February or probably March as they draw down those inventories.'

Second - and more important in the long run for its potential impact on China's current account - is this.

'Overall there's been a 3-1/2% appreciation of the RMB against the dollar.' That's made imports cheaper.'And guess what the Chinese did? They imported more goods, because they felt richer.''Now, the United States knows a lot about how when you make consumers feel richer with cheaper imports: they import more goods and the trade deficit gets worse.'Why is this important? 'China wants to stoke domestic demand,' to become a consumer-driven economy. But it succeeds, this 'has an implication for whether or not China continues to be a current account surplus country.'If China is 'truly successful in creating domestic consumer demand - like that in Europe, Japan and the United States - then, it's probably going to start running a current account deficit, unless it actually targets trade.' 

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2. Part 2: how far will will the RMB weaken?

'Part two is about the Renminbi today and is the more important story today.'

'The RMB did not like the trade data at all, and it weakened immediately, falling more than 1% -  even though the official rate setting China does every morning suggested that the RMB would, instead, be slightly stronger today.'

'This is the most it's traded off since August of 2015. There are two other reasons for this, besides the trade numbers.'

'First, the news overnight that HNA had had a technical default.'

'The lenders to HNA - Deutsche Bank being probably one of the largest - were immediately under the scope.' Deutsche Bank shares were hit overnight, and the euro was hit because the banking sector in Europe was under the gun.'

Second, the Chinese were looking at where the renmimbi has traded - it's been below 6.30 now for over a week, and it looked like yesterday it was trading at 6.25 for a brief shining moment.'

'This is important because many see 6.20 and 6.25 as very critical levels.'Why? 'Because that's the August 2015 devaluation level -  and from there you had the 2% devaluation that unsettled the world.''It is also important because that's the also level where many thought that Chinese export competitiveness was under threat by a too strong RMB.'

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'So, after the trade number and after the HNA default, which is emphasizes the need for cheap money for the rollover debt, the issue is that RMB weakness is now putting in a floor below 6.30 -  that something the market is going to really watch closely.'

'And, if we think that the RMB could go to 6.40 or 6.50 again, then that has implications for the rest of the foreign exchange world, particularly Korea and Europe.'

What to watch for. 'Today was an exciting day. I'm paying a lot of attention to see if 630 is the new bottom for the dollar-RMB relationship, and to see if there's going to be more concern about:

'Higher interest rates, and 'Debt rollover of some of the more leveraged corporations in China.'

The first year of the Trump presidency saw a record US merchandise trade deficit with China, $375 billion. Exports were the most ever. Unfortunately for the president, so were imports, breaking $500 billion. Even in Washington, half-a-trillion is real money, especially if it will be followed by more of the same.

What is the US buying? One of the many annoying things about trade is all the ways there are to slice up the numbers. Using “3-digit SITC,” because it rolls so trippingly off the tongue, here are the top 10 goods imports from China last year:

This is over half of all imports. Banning a product not on this list — not slapping with high tariffs, banning outright — would cut the trade deficit only 3% or less.

Steel, for example, gets a lot of attention. Combined 2017 steel and aluminum products from China were worth barely half as much as radios. Getting rid of them entirely would leave the bilateral trade deficit at $370 billion, still a record. Solar panels, which have already been hit with tariffs, are so unimportant they don’t even have a category.

So steel and solar don’t matter at all to the trade deficit. Nor does it help to talk about how China should buy more US exports. The last five years of exports to China read $122 billion, $126 billion, $116 billion, $116 billion again, and $130 billion last year. This year isn’t suddenly going to see $250 billion. If we’re lucky, it will see $150 billion.

That probably won’t keep up with 2018 imports. The Republican tax plan is bad for national debt but should put more money in people’s pockets. More money means more spending, including on imports. A rise in US exports to China to $150 billion would be 15%. A 15% rise in imports from China would be $75 billion, meaning a $430 billion deficit this year.

It would be perfectly reasonable for the president to say, “If Americans are buying more things made in China because they have more money, there’s no problem.” A lot of people would agree with that, for good reasons.

But he can’t keep saying China is ripping us off and he’s going to stop it unless the US targets the biggest imports. The trade deficit with China is bigger than with the next eight countries combined. NAFTA? The trade deficit in cell phones and computers alone with China is bigger than the trade deficits for all goods with Mexico and Canada combined.

There are of course drawbacks to restricting cell phone, computer, and toy imports — people will have to pay more for those things. Unlike steel, exporting those goods is truly important to China and they can retaliate against US soybeans, for example. Eggs have to get broken before the omelette gets made.

Until then, until the main Chinese exports are addressed, “trade war” talk is much ado about nothing. For better or worse, until the Trump administration targets China-made cell phones, computers, toys, furniture, and clothing, US trade numbers will look pretty much the same.

1. China's new RMB oil futures exchange - the 'story of the year'!

Watch for the opening of The Shanghai International Energy Exchange - acronym: INE - this quarter. 

'Story of the year' and 'game changer' are what Bob Savage, CEO of TRACK and member of our soon-to-be launched China Analyst Network, calls the INE. And, the impact goes way beyond oil to bolstering the RMB's challenge to the dollar.

About the INE. The INE will offer the first oil futures contract denominated in RMB, instead of U.S. dollars.

• Chinese buyers will lock in oil prices and pay in RMB, instead of U.S. dollars.
• Oil producers will be able to sell oil to China - the largest oil importer - in RMB, instead of dollars.
• And, the INE will establish a third oil price benchmark (after the WTI and Brent) in RMB, instead of U.S. dollars.
• (note: the 'RMB, instead of U.S. dollars' - that's crux of what follows.)

The INE sounds a little ho-hum until Bob explains its impact on the relationship of commodities and currency: 

• The last time the world saw a reserve currency change was during World War Two when the dollar formally replaced the British pound as the universal medium of global exchange in the 1944 Bretton Woods Agreement.
• But the de facto change began 'after World War One, when more and more contracts started to be denominated in dollars instead of pounds. And, that played a part in the dollar's replacing the pound as the world's reserve currency.' 
• 'The question to ask is: Will the U.S. begin to see an erosion of its reserve currency status when more and more contracts start to be denominated in RMB?' 

'Already, the open interest of the commodity contracts listed in Shanghai in Renminbi far outstrips anything in the rest of the world's commodities futures in commodities combined.' 

• 'What we're beginning to recognize is what has de facto already been the truth: that China's import of a huge proportion of the world's commodities changes the way currencies work.'

'As more trade becomes denominated in Renminbi and more futures contracts become denominated in Renminbi, then the Renminbi becomes a more viable alternative to the dollar, and prices begin to revolve around whether the Renminbi, not the dollar, is holding its value or not.'

Enter the INE. 'The denomination of oil futures contracts in Renminbi exemplifies the role of commodities in the geopolitical fears about the dollar weakness and about the role of China in that weakness.'

• This is why the opening of the INE could 'exacerbate the dollar weakness story because it's an example of the dollar continuing down the path of eroding its reserve status.'

After the INE opens, watch:

• 'How much volume it does and how quickly it expands.'
• 'How many other countries start denominating oil contracts with China in Renminbi. The Saudis have said they might. The Iranians already do. The Russians already do. But, if OPEC, as a whole, starts to denominate both in dollars and Renminbi, it's a game-changer.'

'For all these reasons, the opening of the Shanghai International Energy Exchange, the INE, could be the biggest story of the year.'

• 'The impact might not happen dramatically or immediately, but over time, over maybe the next five years, the opening of the INE could be seen as crossing the Rubicon.'                                                                                                                                                                                                                      

2. U.S. inflation in an RMB world

Bob Savage, CEO of TRACK, riffed on U.S. inflation if we one day lived in an RMB world.

If the RMB moves toward replacing the dollar, then 'the locus of attention about inflation, particularly global inflation, will change from 'what is the policy of the Fed?' to 'what is the policy of the People's Bank of China?' - and, to what is the value of the Renminbi rather than what is the value of the dollar.'

• 'It really moves U.S. inflation from being under Fed control. 
• Instead, 'you have to keep an eye on Chinese demand for commodities. That will set the rates for a lot of commodities that we're dependent upon.'
• 'And, if Chinese demand sets the rates, the currency relationship with China will likewise matter to the U.S. in a much more dramatic way.'

'If China sets the commodities rates, U.S. inflation from imports will be more dramatic.

• 'Up until now, import inflation in the U.S. has been muted because we are blessed with lots of commodities of our own. And, the pricing of those commodities on a world market has never really been part of the story because everything that we buy and sell has been denominated in dollars.'
• 'But, if we start pricing those commodities in RMB terms, then that exchange rate becomes terribly important to the Fed.'

How does an obscure factor like hiring practices impact firm valuation? That was the question posed by Deutsche Bank’s quant strategy group in a 2015 whitepaper titled, “Macro and Micro Jobenomics.” The report concluded that online job postings could be used to predict U.S.  macroeconomic statistics and equity market returns. This piqued my interest – I wondered whether a similar process could be used for valuing A-share companies in China. I began by examining self-reported employee headcounts from listed companies.

Firm-level data from DataYes shows that year-on-year revenue growth correlates positively with headcount. The histogram on the left shows correlation coefficients for the 1600 A-share firms with 10 years of historical data. The chart on the right shows that the correlation between headcount and revenue growth varies by sector. Moving on to the main course, the online hiring data set I used tracks a daily average of 300,000 job postings and covers 819 A-share firms. Each observation includes a job title, location, firm name, education and experience, and pay range. To facilitate cross-company comparisons, I calculated a “hiring ratio” that divides each firm’s total number of unique job postings by employee headcount. I then tested this factor by comparing the private and state-owned sectors.

Unsurprisingly, the private sector is much more active on the job market than China’s state-owned-enterprises. In fact, private firms outnumber SOEs in the data set by a factor of six, and their hiring ratio is more than double that of the SOEs. Insufficient history on Chinese hiring data precludes precisely replicating the back-test methodology of the original whitepaper. As a proxy, I examined the cross-sectional relationship between hiring ratio and firm valuations, which approximate the expectations of future profits from management and investors, respectively.

Controlling for sector, I found that the hiring ratio correlated positively with firm valuation. Obviously, hiring ratio isn’t the sole determinant of firm valuations in China. If it were, most of my banker friends would be out of a job. However, the results of a simple regression results appear predictive enough to warrant consideration. Of course, much more interesting than the model itself are the outliers – firms with a high hiring ratio and low valuation. The absence of evidence is not evidence of absence, so we will therefore consider only the firms with anonymously high hiring ratios. As an exercise, I sorted the 1,000 listed companies with highest market capitalization in China by their residual valuation – that is, the underestimation of price-to-sales ratio relative to hiring ratio. In other words, these are the firms that could be considered under-valued if all else were equal.

These findings leave two questions for further research. First, does diversity of the job postings matter? For example, do investors reward firms for hiring across the whole organization rather than just growing the sales team? Second, does average new hire wages impact valuations? That is, do investors reward firms for winning higher-priced talent, under the assumption that they will improve the bottom line?

1. The Party goes private

The big idea. 

Having made headway in exerting Party control over Chinese society, the economy, and the State, Xi Jinping has his sights on gaining more control of private business, especially the tech/Internet sectors, in two ways:

• The government may buy (or receive 'donated') shares and get board seats. 
• And, Chinese Communist Party Committees embedded in private companies would have a say in major decisions.

What could possibly go wrong?

The background. 

‘The Chinese State didn’t have the capacity to develop things like Alibaba, Baidu, Tencent, and so forth,’ says Harvard's Tony Saich.

• ‘So, it outsourced its Internet and hi tech development to the private sector.’

Since then, the government has pretty much left these and other tech/Internet companies alone. But, that could be changing. According to Wall Street Journal reporting in October 2017:

• 'The Chinese government is pushing some of its biggest tech companies—including Tencent, Weibo and a unit of Alibaba—to offer the state a stake in them and a direct role in corporate decisions.' '
• “This is the thing that keeps Pony up at night,” says a Tencent executive about Mr. Ma, the company’s chief executive.
• 'Even if the plan doesn't go through, the government has another way to gain control: '[A]t Mr. Xi’s urging, a campaign is under way to set up party units in private companies.' This will give Party representatives authority to approve or veto major decisions, say sources, other than WSJ.

Tony Saich gives context: 

This 'reassertion of State and Party control in the private sector is something we've seen before.' 

• ‘Essentially, when the private sector has developed in an area and has become successful, the State and the Party move back into that sector both to try and guide it, but also to take more profits from that sector.’
• ‘I think we’re seeing that now with the hi tech and internet sectors.’

As for Party reps in Internet firms as well as other private companies, Tony says:

• 'In theory, that was probably the case before. But, in practice, the private companies were probably left pretty much alone.’ 
• Now, the government is trying to 'to rein in, bring back in Party and State control over that very vibrant sector, and also to ensure it works more coherently for Party interests.’
• ‘I would suspect that over the next period, we’re going to see a tightening up in that area.’

Why this is important. 

Less tech- and business-savvy Party and State apparatchiks could dampen or even kill the vibrancy and innovation of individual companies and, perhaps, collectively, China's tech/Internet sectors. If that happens initiatives like 'Made in China: 2025' may be jeopardized. Also:

• Mixed government/private companies will have more difficulties obtaining SIFUS approval for U.S. investments.
• Beijing would gain even greater control over the web and even greater access to people's personal data. 
• For analysts, figuring out what's happening in China's economy, tech/Internet sectors, and individual private companies would become a lot tougher. 

2. 'It's the politics, stupid!' 

The big idea. When Xi Jinping came to office, western observers expected him to tackle China's flagging economy day one. But, Xi had different priorities. (Cue western hand wringing).

• 'When Xi Jinping took over power,' Harvard's Tony Saich says, 'his view was "It's the politics, stupid"' (riffing on Bill Clinton's 1992 winning presidential campaign strategy, summarized in, 'It's the economy, stupid').
• 'The Party's relationship to society was in very dire straits. It was not just the corruption issues, the behavior of officials, but a lack of trust.
• 'The Party had trust issues, too. 'The Party didn't trust the State to carry out its policies, and it certainly didn't trust society.' 
• 'Xi felt there for anything to happen it was essential that the Party itself became stronger, more disciplined, and more unified, and that the Party had to get a much tougher grip over State and over society.'

Society & the Party, it's complicated.  

Society was losing confidence in Party leadership, and the Party didn't (and doesn't) trust society. Xi's Anti-Corruption Campaign went a long way toward restoring confidence in the Party. But, nothing could make the Party trust society. Tony explains:

• The Party 'fears that somehow society is getting away from Party rule and from the dominance of the Party.'
• 'The fear that if society is let loose, it’ll run off in its own merry way, which might be detrimental to, or possibly even in conflict with, Party interests.'
• 'That worried the Party because it could lead to the flourishing of a range of heterodox and unorthodox ideas within society that could undermine Party power.'
• 'So we’ve seen a much tougher control over information flows, over what is acceptable to be talked about, and over what is acceptable to be written about. I don’t see that changing in the next five years.' 

3. The State & the Party, it's even more complicated

Why are Xi and the Party working so diligently to bend the State to the their will?  

China is a one-party state with two bureaucracies: the State and Party. 

• In theory, '[T]he State bureaucracy does the day-to-day job of public administration, and the Party bureaucracy sits next to and controls the way they do it,' Stein Ringen, Oxford professor emeritus told me. 

But, in practice, 

the State doesn't necessarily carry out the Party's policies. Harvard's Tony Saich explains:

• 'What I mean about the Party not trusting the State is not just a question of the corruption.'
• 'It's really about State institutions pursuing their own particular interests that may conflict with the policies that the Party wants to push forward and pursue.''
• Say, for example, on the environment, the Party has good regulations and policies, but State institutions don’t carry them out.'
• Why? 'Because there are vested interests within their localities that benefit from the perpetuation of pollution producing industries.'

The reality. China is '...such a rambling country with so many different institutions and so many different tiers of government that it’s very difficult to control.'

• 'The way China works, people are going to fall in line, seek to appease themselves with General Secretary Xi, and try and follow whatever his directives are.'
• 'But, like most of these things in China, the directives tend to be very vague. This leaves open a lot of potential for local variants and local experimentation.
• 'My translation: Nothing new here. 天高皇帝远 - 'Heaven is high and the Emperor is far away,' as the oft quoted - since the Yuan Dynasty (1271-1368) - proverb goes. 

What it all means

What it all means. Xi may be able to bring Chinese society and the State to heel, but at what cost? Tony posits: 

• 'The Chinese leadership really needs to think about: Where does dynamism come from within its economy and within its society?'
• 'It’s not necessarily within the State-owned sector.'
• 'So, this recentralization could curb the enthusiasm and entrepreneurialism within society.'
• 'And, this may be detrimental to meeting Xi's longer term goals of maintaining stable growth and a relatively peaceful societal framework.'

1. Shift from pragmatism to ideology could make China's managed economy harder to manage

'Black cat, white cat. If it catches mice, it's a good cat.' 

The big idea. The shift from Deng Xiaoping pragmatism to Xi Jinping ideology and Party control could weaken the effectiveness of China's economic policy and decision making. This would undermine the foundations of China's Economic Miracle, and, in turn, the stability and growth of China's economy.

Pieter Bottelier - top China economist, former head of the World Bank in China, and stalwart CHINADebate expert - surprised me when he gave this issue as his sole concern when I asked him, 'What are the policy implications for China's economy from the 19th Party Congress?'

China is still, to a great extent, a managed economy, and the managers are the elite technocrats; they pull levers that in the West we leave to the market.

Elite technocrats are the unsung heroes who guided China's Economic Miracle and navigated the crises that could have derailed it at any point.

• 'One of the pillars of China's Economic Miracle has been the quality of the technocratic elite in the civil service since the start of the economic reforms under Deng Xiaoping in the late 70's.'

Beginning in the Deng era of economic reforms, technocratsoperated in an environment of, '... free debate and free research, as well as unrestricted exchanges between Chinese technocrats and overseas technocrats and intellectuals.' Black cat, white cat.—Pragmatism trumped Party power and ideology.

Now, Party power and ideology trump pragmatism.

• 'The policy environment and intellectual climate within which economic policy is made have definitely changed.'
• 'The recent 19th Party decisions confirmed the political changes that had been underway for some time.'
• 'Politics has moved to center stage.'
• 'Party priorities have changed from economic growth, economic development to party power, party prestige, party control over everything - the economy and, of course, the political system.'
• 'That has potentially very significant implications for the economic policy making environment.'

Beyond the technocrats.  The enshrinement of 'Xi Jinping Thought' in China's constitution further solidifies 'the shift in priorities from pragmatism to party power that translates into an ideologically underpinned party power.'

• For example, 'Chinese universities have all hurried to create institutes for the study of 'Xi Jinping Thought.' 
• Because of this, 'I worry that the very positive and open intellectual climate in China's universities and think tanks in China will become a thing of the past.'
• Chinese academics and think tank experts, unlike those in the West, wield greater influence and have an outsized role in policy making.

What this means. 'Because ideology and party power have drifted back to center stage, the environment within which intellectuals and policy makers have to debate policy options and consider alternatives has changed fundamentally.'

• 'This may lead to the very strict narrowing of the intellectual climate within which the technocrats can operate in the years ahead.'
• 'And that could undermine a significant part of the foundations of China's economic miracle of that last few decades -the freedom of debate, the freedom of research, and the open exchange between Chinese technocrats and foreign intellectuals.'
• 'If that climate, which has been so positive and so open in the last several decades, is jeopardized, we have to worry about the quality of the economic decision making in the years ahead.'
• And, the stability and growth of the economy.

New problems in analysis. 

China's technocrats have proven capable of managing most every problem the economy has thrown at them. They have done such a good job that we don't even notice them or factor their abilities into our analyses. They are just so much background; we take them for granted. 

• That's changed. From now on, figuring out what's happening and what might happen in the economy just got more complicated.
• We have to understand better how the bureaucracies that manage and regulate the economy work, and then dig down a layer or two in.
• We have to assess the technocrats and pay attention to who is appointed - competent economist or ideologue?
• Be ready for some bungling, weak policies, and inept regulation that could put the stability and growth of China's economy at risk.And, catch these before they ripple through the economy. 

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2. No hard landing for China's economy...for now

'Two years ago we were all speaking about, all worried about the possibility of a hard landing,' Pieter Bottelier also told me in our interview.

• 'Very few people are talking about that today.'
• 'Even though the risk has not disappeared completely from the horizon, it's no longer on the top of the agenda of most pundits.'

What's changed? 

'The major factor that has worked out differently from what had been expected is the property sector.'

• 'Real estate markets have recovered instead of deteriorated.'
• 'They have pulled demand for raw materials much more strongly than expected, and exports have been stronger than expected.'
• 'All together manufacturing, gross exports, and the real estate sector, particular the urban property sector, are the main factors explaining why the objective economic situation has improved rather than deteriorated as many people had expected.'

How about the real estate bubble? 'That risk is certainly there. There is in a way a bubble, but the bubble is not about to burst.'

• 'We have seen is a more positive regular evolution of development in the real estate markets. Partly as a result of strong demand and partly as a result of very capable administrative regulation.
• 'Very astute management of the administrative environment at the local level is the main explanatory factors, plus the underlying demand remains very, very, very strong.'
• 'The stock of unsold properties as a percentage of the total supply side has declined a lot in recent, in the last eighteen months. So we have a much more healthy supply-demand balance situation than we had two to three years ago.'
• 'And the prospects, of course, remain uncertain but the likelihood is that markets will weaken in the next several quarters in 2018.'
• 'Total turnover and prices will probably slacken.'
• 'But, I don't expect a collapse as we did a few years ago.'

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3. Technocrats manage China's property sector pretty well

Pieter Bottelier credits 'very astute management of the administrative environment at the local level' for managing China's real estate bubble.

Have a look at one of my favorite charts, above, courtesy of Robert Ciemniak of Real Estate Foresight.

• We can see that the real estate market is not a 'market' as we understand it.
• Rather than the invisible hand at work, local technocrats pull their many levers, tightening and loosening at will.
• Loosen , markets go up. Tighten, markets go down.
• Never out of their control.

Riffing on Pieter's worry that the shift from pragmatism to ideology could weaken economic decision making...

• Imagine that competent technocrats might substitute their best judgement to toe the Party line and keep their jobs.
• Or that they are replaced with cadres who are more ideological than competent.
• Then, the real estate and China's economy really might...