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'Big lessons from the faulty analysis that spiked the Shanghai stock market'

ProTips from Andrew Polk, Trivium China

On April 24, equity analysts interpreted a phrase used in a Politburo meeting readout to signal a new round of economic stimulus. And, the Shanghai stock market, one of the world's worst performers, spiked 2%. 

On April 25, having much earlier advised and protected clients, Andrew Polk of Trivium China published an analysis in Trivium's daily (and free) 'Tip Sheet' that explained why the market had gotten the signal wrong - there was no stimulus coming.

Later, Andrew and I talked about how he reached his conclusions. His explanation is a masterclass in how experience, discipline, and some tedious slogging, combined with a sound analytical framework, lead to good China analysis.

1. The Politiburo speaks, the market spikes

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‍source: CNBC 

Words move markets. Investors, traders, and analysts scrutinize every comment made by the U.S. Federal Reserve. And, how they interpret these comments moves markets. Sometimes up, sometimes down, sometimes both in the same day. 

Parsing the Politburo. In China, where policy and economics are even more tightly intertwined, readouts from Politburo meetings are even more carefully parsed for clues that indicate changes in how the economy is going to be managed. And, how these are parsed likewise moves markets.

Getting the Poliburo wrong. Over time, phrases in Politburo readouts become associated with specific policy changes. So, when you see a certain phrase, you interpret this as a signal. Unless...

  • The phrase has lost its connotation or taken on a new one, or
  • The phrase is mechanically pulled out from a context that strips the expected connotation from the phrase.
  • Either way, you get what the Politburo meant wrong.

Case in point. Andrew Polk of Trivium China: 'The Politburo - China’s 25 highest-ranking politicians -  held its monthly meeting on April 23 and discussed Q1 economic performance and the policy outlook.'

  • ''When the readout from the meeting came out, the markets got really excited because the readout included the phrase, "We need to expand domestic demand."'
  • 'Under the Hu-Wen administration that phrase used to be a very clear signal of coming stimulative measures for economic activity.'
  • 'So, everyone jumped on that and said, "Oh, it looks like the Chinese top leaders are going back to the stimulus playbook of the Hu-Wen era and are looking to expand domestic demand again."'
  • 'And, the Shanghai composite jolted in reaction – up 2% on Tuesday, April 24, the biggest one-day jump so far in 2018.'

The excitement. An example from Bloomberg, April 24: 'China Stocks Get Adrenaline Shot From Policy Easing Signals.'

  • 'Chinese stocks got a much-needed shot in the arm Tuesday, gaining the most in two months amid signs the government is willing to ease its tightening campaign to avoid an overly sharp economic slowdown.'
  • 'The rally followed a meeting where policy makers mentioned the need to boost domestic demand for the first time since 2015, and dropped a reference to deleveraging.'
  • '“The Politburo meeting sends a signal that China may roll out fiscal stimulus and supportive monetary policies to resolve financial risk and stabilize markets,” said Ken Chen, a Shanghai-based analyst with KGI Securities Co. “That has boosted sentiment on the market, especially for blue chips.”'
  • Mr. Chen's analysis was echoed by many other equity analysts.

The problem. Mr. Chen and the other analysts were wrong about what the Politburo meant. Andrew explains.

2. How to parse Politburo pronouncements

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‍source: South China Morning Post     

Andrew: '"We need to expand domestic demand" has been a buzzword or buzzphrase, if you like, in China signaling stimulus is coming.'

  • 'Analysts saw it in the Politburo meeting readout and said, "That's what they used to mean when they said this, and so it must mean that again."
  • 'They didn't realize the nature of that phrase has changed over the past five or six years.'
  • 'The analysts should have done a more careful reading.'

'Careful reading.' How do you do a careful reading? Andrew and Trivium China show you three steps:

  1. Trace the 'etymology' of the phrase.
  2. Check the context where the phrase is used.
  3. Consider what makes sense. 

1. Trace the 'etymology' of the phrase 

  • 'We went back and read through all the Politburo readouts from the economic meetings, which take place generally in April and December, and it was pretty clear by reading those how that phrase had evolved over the past few years.' 'We found that the Politburo hadn't used the term "to expand domestic demand" since late 2013.' 'And, we saw that the last couple of times that they just used the term "domestic demand," or even "increasing domestic demand," it wasn't followed soon by stimulus.'
  • 'In fact, the last time the Politburo used that exact phrase -  "We need to expand domestic demand" - was in December 2013.' 'The next time 'domestic demand' was mentioned was in April 2014. And, it was still seven months until stimulus started.''Then, in November 2014, the PBoC embarked on an easing cycle that included six cuts to benchmark interest rates over the course of 12 months, for a total reduction of 165 basis points in the key lending rate – and the Politburo never once talked about “increasing domestic demand” during that period.'
  • 'By tracing the history of how the phrase has been used, we could see that it hasn't really meant stimulus since Xi Jinping has taken power. So there's no real reason to read that new phrasing as stimulative.'

2. Check the context where the phrase is used

'So, despite the initial stock market reaction, the Politburo statement is much less than meets the eye for several reasons':

  • 'The actual key message from the readout was to underscore the “three tough battles” as policy priorities in 2018 – i.e. addressing financial risks, fighting pollution, and alleviating poverty. So risk containment is still top dog.'
  • 'The bit about “expanding domestic demand” comes at the end of a long sentence listing a host of priorities, which also included keeping fiscal policy “constant” and monetary policy “neutral.”'
  • 'While the Politburo hasn’t used the term “domestic demand” for several years, it has often identified the need to “expand aggregate demand.” They used that phrase four different times in 2016, and once in 2017. Those mentions were not followed by stimulus.'
  • 'The replacement of “aggregate demand” with “domestic demand” is all about the looming trade war. Policymakers are rightly concerned that trade tensions may have a major effect on growth. If that is the case, they will try to offset those negative effects.'

'When we saw how the phrase was used in the context of the entire Politburo readout, it was pretty clear that they didn't have stimulus in mind.'

3. Consider what reading makes sense 

'Standing ready to support the economy in the face of a potential trade war is a far cry from pump-priming credit and investment to stave off an organic economic slowdown.'

'Taking the entirety of the Politburo statement together, then, it is pretty clear that Xi Jinping was saying “we will support growth in response to a trade war if we have to, but we are mostly still focused on risk containment.”'-'Top policymakers see that the economy is broadly slowing, but so far they are still comfortable with the current growth range, especially on the nominal side.'

'But, even if the Politburo did mean, "We're going to do some stimulus activity," it's unclear to me where exactly that stimulative activity would come from.'

'When analysts were saying, "This is a signal that macro policy is loosening," I ask them, "What would the stimulus look like right now?"'

  • 'China is pretty much maxed out on the fiscal side.'
  • 'With deposit rates at just 1.5% – already a negative real yield thanks to inflation at 2.1% – the PBoC does not have room to cut on the monetary front.'
  • 'Moreover, they're trying to contain the big markets in real estate right now, so there's really is no room to cut interest rates.'
  • 'Interbank rates are currently elevated, and there's a tightening cycle in the US, so a marked acceleration in credit growth just doesn’t seem feasible.'
  • 'So, with the financial derisking that's going on - and financial derisking was clearly underlined in the Politburo readout - they can't really boost bank lending at the same time that they're trying to get banks to reduce interbank activity and keep bank funding tight.' 

'If analysts had stepped back to consider what makes sense, they would have seen that China doesn't have any good options to stimulate the economy now, even if it wanted to.' 

The bottom line

'The bottom line: There is no stimulus coming.'

  • The analysts and then the market got it wrong.
  • Why? 'I think it was a bit of a lazy reading of "We need to expand domestic demand."'

And, how.    

3. 'The art of China-watching': 

then & now

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Andrew shows the kind of careful analysis needed to approach a correct interpretation of Chinese official pronouncements. But, at least today there are official pronouncements. 

When I was CIA case officer in China Operations - that is, a spy not an analyst - I'd see my colleagues in the Soviet/East European Division pulling their hair out trying to figure out what a photo meant.

  • Not a picture of a Red Army missile site - a picture of the old guys standing on the rostrum at the May Day Parade.
  • What their order in line meant, who was in, who was out, and so on.
  • That's one of the ways they tried to get a handle on what was happening in the closed, authoritarian Soviet Union.
  • In the trade (and later commonly), we called it 'Kremlinology.'
  • China, for 'China watchers,' was just as opaque. Maybe even more so. We didn't have as many revealing photos and speeches.

Here's a quote from the CIA's now declassified, 'The Art of China Watching,' written in the mid-1970's, not long before I joined China Operations.

  • 'It is no semantic accident that observers of the Chinese political scene are more often called "China-watchers" than "Sinologists," while analysts of the Soviet Union are frequently referred to as "Kremlinologists."'
  • 'The art of China-watching is imprecise at best, and hardly deserves yet to be called Sinology.' 
  • 'The explanation, or blame, for this often frustrating situation lies mainly with the way the Chinese conduct their affairs. To say the Chinese have a penchant for secrecy is almost an understatement.'

While much has changed in China since then, the 'penchant for secrecy' hasn't. And, 'the art of China watching' is still 'imprecise at best.'

As Andrew has shown, 'China watchers' today, especially in the form of equity analysts, look at words not pictures. 

  • What does a phrase used in an official pronouncement signal?
  • How was it used in the past, and when it was, what happened?
  • Has the phrase taken on a new meaning, and therefore has become a signal of some new outcome?

Parsing meaning in this way is just as challenging - and imprecise - as analyzing a photo. And, when analysts get it wrong, markets move just as much as when they get it right.

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New super-agency, National Supervision Commission—and China's massive government restructuring

'With government restructuring, the biggest thing is the creation of an entirely new branch of government: the National Supervisory Commission. Its entire job is to overlook every single public official in China. It is an institutionalization and deepening of the corruption crackdown that we've seen over the past few years.'

In all, Andrew highlighted four major actions from the Two Sessions:

  1. Chinese government restructuring 
  2. The policy roadmap 
  3. Personnel 
  4. The legislative agenda + the constitutional amendments 

'Government restructuring is the most immediate outcome of the "Two Sessions" - the Chinese People's Political Consultative Conference followed by the National People's Congress - this March,' Andrew Polk of Trivium China told in our recent conversation.

'We're talking about basically a total overhaul of the government. It's huge. It's momentous. And it's just started.'

'With government restructuring, the biggest thing is the creation of an entirely new branch of government: the National Supervisory Commission. Its entire job is to overlook every single public official in China. It is an institutionalization and deepening of the corruption crackdown that we've seen over the past few years.'

'The NSC not only institutionalizes the corruption crackdown, but it also makes sure that the discipline inspectors are now more and more involved in policy implementation. And, when the discipline inspectors get involved, lo and behold, things happen quickly.'

1. What you missed while waiting for the U.S.-China trade war

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Taking term limits off President Xi wasn't the only big change that came out of China's annual lianghui or 'Two Sessions' - the advisory Chinese People's Political Consultative Conference followed by the rubber-stamp National People's Congress - in March.

'With 'Trump and a looming trade war sucking all the oxygen out of China news in March,' as Andrew Polk of Trivium put it, you may well have overlooked four of the actions coming out of the Two Sessions.

  • These four actions massively advance Xi Jinping's efforts to assert the Communist Party’s control over economic and foreign affairs, cultural policies, and the appointment and training of cadres.
  • And, are of 'momentous importance for both markets and businesses, especially foreign businesses operating in China,' according to Andrew.
Andrew Polk: 'The four important things that came out of the Two Sessions':
  1. Chinese government restructuring. 'We're talking about basically a total overhaul of the government. It's huge. It's momentous. And it's just started.
  2. 'The policy roadmap. 'The Party and the government are clearer than they've been in many years on exactly what their priorities are.
  3. 'Personnel. 'Important people were put in important places.
  4. 'The legislative agenda + the constitutional amendments. 'These are hugely important over the long term for how the economy operates, and how the political system operates, as well.'

What follows is Andrew's analysis of the first action, 'government restructuring,' as well as its most important outcome, the new, super-agency: the National Supervision Commission.

2. Biggest Chinese government restructuring since the 1980s reform era

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'Government restructuring is the most immediate outcome of the two sessions. We're talking about basically a total overhaul of the government,' says Andrew Polk. The biggest restructuring since the Deng Xiaoping reform era of the 1980s.

 

From Bloomberg:

  • The restructuring will 'solidify Communist Party control over key functions of government, further centralizing power.
  • 'This 'represents China’s most decisive shift yet from 1980s reforms led by Deng Xiaoping aimed at professionalizing the government after Mao Zedong’s disruptive party-led political movements led to famine and bloodshed.'
  • 'At the time, Deng had said “the separation of the party and government” was necessary to unleash an economic boom that continues to endure.'
  • 'Yet Xi has gone in the opposite direction, arguing that China’s centralized system provides an alternative model for countries to get rich without embracing Western democracy.'

And, from the Wall Street Journal:

  • “Xi is telling everyone that not only is the party in charge (it always has been) but also now that the party must be seen as running the government,” said Ryan Manuel, an expert on Chinese politics at the University of Hong Kong.
  • “He wants to use more party methods to rule the government, as opposed to the traditional method of having two separate trains running in parallel, with cadres forced to leap back and forth across the tracks.”

Why it matters. 'If you're a markets person, you don't have time to think about Chinese government restructuring, because you're worried about whether global trade is going to collapse in the next month,' says Andrew Polk.

  • 'So, I understand why people are focused on the trade war, but this stuff is arguably more important in terms of how China's economy is going to evolve.'

An overview from the Wall Street Journal.  'A look at China’s restructuring of government agencies.'

  • 'COMBINED: Separate banking and insurance regulators will be merged into a single agency to better fend off risks in the country’s financial system.'
  • 'SETUP: A national market regulatory administration with sweeping responsibilities will incorporate functions of a half-dozen offices to oversee business competition and practices, from corporate and antitrust regulation to pricing and food safety.'
  • 'RETOOLED: A National Health Commission, with responsibilities over public health issues, is replacing the National Health and Family Planning Commission, de-emphasizing government-set birth limits and refocusing policy for an aging society.'
  • 'REVAMPED: A beefed-up environment ministry will add to its environmental-protection mission, taking on antipollution and conservation functions currently spread across six other agencies.'
  • 'MERGED: Merging the Culture Ministry with the national tourism administration, in a push to develop and promote Chinese culture, and enhance China’s soft power.'

From the same WSJ article. 'Given the plan’s emphasis on control, foreign businesses—which have complained about unfair and selective regulation—are likely to face more formidable government agencies.'

  • 'The newnational market regulatory administration in particular brings under one roof separate bureaus that handled pricing regulation and antimonopoly enforcement, which have in the past pursued high-profile cases against foreign companies.'

Notably absent from the WSJ and other lists in the western media is the new, super-agency: the National Supervisory Commission. Andrew calls this the 'biggest thing' to come out of government restructuring. More on the NSC follows.

3. Biggest big brother: the National Supervisory Commission

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‍'The biggest thing is the creation of an entirely new branch of government: National Supervisory Commission,' Andrew Polk

Xi Jinping owes much of his public support to his anti-corruption campaign.

  • He also owes much of his consolidation of power to the campaign's rooting out some rivals and striking fear into the rest. 
  • Xi has now streamlined and expanded the reach several notches through the creation of the new, super-agency: the National Supervisory Commission.

'With government restructuring, the biggest thing is the creation of an entirely new branch of government: National Supervisory Commission,' says Andrew Polk

  • 'Its entire job is to overlook every single public official in China.'
  • 'It is an institutionalization and deepening of the corruption crackdown that we've seen over the past few years.
  • ''These trends have been in train for a while - and, were just officially canonized in March.'

The National Supervisory Commission replaces the Party’s Central Commission for Discipline Inspection. 

  • The NSC is independent of the State Council, the Supreme People’s Court and the Supreme People's Procuratorate (see the chart above).
  • And, it reports directly to the China's highest legislative body in China, the National People’s Congress.  

'Some people compare this to the establishment of the Department of Homeland Security after 9/11, but it's way bigger than that.'

  • 'It's as if you took the FBI and made it coequal to the executive branch, the legislative branch, and the judicial branch in the U.S.
  • ''The National Supervisory Commission is a brand new branch of government on par with the National People's Congress, the State Council, the Chinese People's Political Consultative Conference.'

For more on the National Supervisory Commission and its impact, there two short videos below. 

3. The National Supervisory Commission: the stick to ensure that policies are implemented

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‍'When the discipline inspectors get involved, lo and behold, things happen quickly.' Andrew Polk     

                                                                                                                                                                              The National Supervisory Commission is also a stick that helps persuade laggards to implement policy.

  • 'The NSC not only institutionalizes the corruption crackdown, but it also makes sure that the discipline inspectors are now more and more involved in policy implementation,' says Andrew

'We've seen this, for example, in the implementation of financial derisking.'

  • 'One reason the financial derisking was initially successful in 2017: when the CBRC, and the CIRC, the CSRC, and the PBOC were going out to do their inspections, the discipline inspectors were going with them.'
  • 'When the discipline inspectors get involved, lo and behold, things happen quickly.'

That could be good or bad. 'So, we've got two scenarios.

  • 'One is potentially having better, more consistent implementation of policy, like we've seen so far in the financial derisking.'
  • ''The other is overzealous policy implementation.'
  • 'For overall policymaking and implementation, these two outcomes are what you have to watch for.'

'If we get more consistent implementation, that's important for foreign investment.'

  • 'Everyone complains that Chinese rules are inconsistently applied from city to city, province to province, day to day, and month to month.'
  • 'If we could get more consistency, then that would be a huge improvement in the environment not only for strategic investors like multinational companies.'
  • 'And, also for portfolio investors, because then they will know when they can get their money out, in what channels they can get their money out, what legal avenues they have to make complaints, and what asset classes they can legally invest in. If you've got consistency in those rules, it would be a huge improvement in the market environment.'

The flipside is over-zealous implementation.

  • 'As we all know, the history of China has been that the center makes policy, but it never gets implemented very well locally.'
  • 'Now the pendulum's swinging all the way to the other side, where policy is sometimes being implemented too zealously.'

'We've seen this in a number of cases,' says Andrew. 'One example is in the push to switch from coal to gas heat.'

  • 'The Central Government said, "You've got to stop using X amount of coal, and start using X amount of gas."'
  • 'It set targets for the northeast of China.'
  • 'The discipline inspectors were out making sure that local governments were hitting it.'
  • 'So, the local leadership in Dongbei, in the northeast part of China, said, "We're going to hit these targets no matter what."
  • ''They ended up shutting down businesses because there wasn't enough gas supply to offset the reduction in coal.'
  • 'And, homes were left out in the cold.' 

'After many such cases, the Central Government has moved to mitigate the problem.'

  • 'For example, the latest environmental regulations clearly state, "Cadres need to carry these out in a way that isn't disruptive to business and people's lives,"
  • 'This is a pretty straightforward acknowledgement that last time they implemented these rules, it was chaotic, and done in a blind fashion.' 

'Given all this, it's hard to predict where the next case of over-zealousness may come from, but I think it's going to play out case-by-case.'

  • 'As investors or people doing business in China, you need to be on the lookout for exactly the pace and rationale of policy implementation.'
  • 'And, after a policy is put forth, you need to track the people implementing it to see if they are going overboard.'
  • 'If they are, you need to watch out for the unintended consequences.'
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The Chinese Government’s 9 Economic Policy Priorities in 2018 (and beyond)

  1. Supply-side Structural Reform
  2. Innovation
  3. The “three critical battles”
  4. Deepening reforms
  5. Rural revitalization
  6. The regional development strategy
  7. Increasing consumption and improving investment
  8. Opening up
  9. People’s wellbeing

The Party and government have clearly outlined the key economic policy priorities for the next twelve months. Nine key policy buckets are designated throughout the government work reports from the Two Sessions, and they follow directly from Xi Jinping’s report to the 19th Party Congress.

These are the government’s nine policy priorities in 2018.

1. Supply-side Structural Reform

Supply-Side Structural Reform (SSSR) is the over-arching economic policy framework in China. It has five elements – cutting capacity, deleveraging, property destocking, reducing costs for business, and addressing the economy’s weaknesses. Priorities for 2018 include reducing taxes and fees for business, while cutting steel and coal capacity by 30 million and 150 million metric tons, respectively.

2. Innovation

Making China a “technological superpower” is the guiding star for industrial policy. The government has made no secret about its goals to build a world-class semiconductor industry and dominate Artificial Intelligence in the coming decade. To support this push, the government is effectively becoming the largest venture capital fund in the world. The key priority for 2018 is to do more to attract global talent.

3. The “three critical battles”

Xi Jinping identified the “three critical battles” for 2018 late last year. These are areas in which top leadership wants to make concrete progress over the next twelve months. They are: addressing financial risks, dealing with pollution, and alleviating poverty. While SSSR and innovation are medium-term policy drivers, the “three critical battles” are top priorities for this year.

4. Deepening reforms

The key reform goals are to strengthen SOEs while also trying to encourage private sector participation in the economy. Xi Jinping’s version of “reform” is not the liberalizing kind. Expect SOEs to continue to be beefed up and consolidated, while the government seeks to improve the private business environment by improving intellectual property rights. Fiscal improvements are also a critical element of the reform agenda, as they will support the push for a more unified and efficient national market.

5. Rural revitalization

The rural revitalization strategy is a counterpart to China’s urbanization strategy. Rather than solely seeking to move individuals into urban areas on a wholesale basis, China’s leadership wants to make rural areas more enticing places to live through better infrastructure and public services. Rural residents’ land rights will also be extended by 30 years, once each individual’s initial lease expires.

6. The regional development strategy

Chinese leaders increasingly conceptualize the nation’s development through large regions, rather than along provincial lines. The push toward regional coordination is meant to better integrate swaths of the country, reduce internal barriers to trade and investment, and achieve economies of (very large) scale.

7. Increasing consumption and improving investment

China is still trying to rebalance its economy toward consumption. One key area will be preferential tax policies for purchases of new energy vehicles. This statement may be promising for some foreign companies, “We will support private actors in providing more services in healthcare, elderly care, education, culture, and sports.” However, there are no bold plans for improving investment – the basic plan is to keep dumping infrastructure money into central and western China.

8. Opening up

China’s leadership realizes that it still needs FDI, especially because they need to offset their own outbound spending. Because of that, we expect some genuine loosening to finally take place, especially in the financial sector. Outbound is all about the Belt and Road. On trade, look for the inaugural China International Import Expo to be heavily promoted.

9. People’s wellbeing

Better jobs, more entrepreneurs, higher incomes, improved education, and implementing the Healthy China strategy – those are the goals in this area. The government and Party are taking them seriously, but don’t expect immediate progress, as these are difficult problems.

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U.S.-China trade dispute: Will China Weaponize the RMB and U.S. Treasury bonds?

U.S.-China trade war: collateral damage

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.'

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

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‍Source: Reuters                                                                                                                                                                                                          

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 

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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.'

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'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

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‍'Those who cannot remember the past are condemned to repeat it.' George Santayana.  

'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

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‍Source: Reuters

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.'  
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Behind the U.S.-China trade dispute: 'The West's China gamble has failed.'

What's the root cause of the current friction between the U.S. and China? The West's disappointment that China did follow the western model but its own, argues Ed Tse, CEO of Gao Feng Advisory Company (a member of the China Analyst Network).

Ed's solution: look to the similarities between China and the West, especially in the tech sector, and be alert to China's evolution toward better IPR,  market access, and other contentious issues, not just the remaining shortcomings. 

Below is a video of my discussion with Ed and excerpts from both the interview and his South China Morning Post op-ed, 'Chinese innovation with US characteristics? Maybe China and the West aren’t that far apart, in business at least.'

Ed presents insights that differ greatly from the China Echo Chamber in the U.S. Let me know what you think.

1. Behind the U.S.-China trade dispute: 'The West's China gamble has failed.'

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‍'China has not gone the way the West anticipated.Instead, China has developed its own system.'   

'The looming trade war between the U.S. and China is front-page news around the world,' writes Ed Tse, founder and CEO of Gao Feng Advisory Company, known also as the "father of management consulting in China," in the South China Morning Post on March 29.

  • 'On the surface, it looks like U.S. President Donald Trump following up on his campaign rhetoric of “America first” and part of his strategy to treat China as a “strategic competitor."'
  • 'However, it’s possible to trace the roots of the current impasse to a fundamental mistrust between the West, in particular the U.S., and China.'
  • 'The cover story on the March 3, 2018 issue of The Economist, “How the West Got China Wrong”, epitomises that point of view.'

Here's what The Economist had to say: 

  • 'After the collapse of the Soviet Union, the West welcomed the next big communist country into the global economic order.'
  • 'Western leaders believed that giving China a stake in institutions such as the World Trade Organisation (WTO) would bind it into the rules-based system set up after the second world war.'
  • 'They hoped that economic integration would encourage China to evolve into a market economy and that, as they grew wealthier, its people would come to yearn for democratic freedoms, rights and the rule of law.''The gamble has failed.'

Ed Tse: 'China has not gone the way the West anticipated.'

  • 'Instead, China has developed its own system. Many people call it the "China development model." And, China has found a way that works.'
  • 'It's a bit unreasonable for people in the West to expect there's only one way to run a country - our way - and that every country will need to follow that way.
  • 'Especially, '...given the major disruptive events over the past decade, such as the 2008 financial crisis, the election of Donald Trump as U.S. president, and sluggish economic growth for well over a decade.
  • 'Instead, 'China continues to be a one-party state while embracing some aspects of the Western-defined market economy and maintaining a strong government role.' 
  • Using the China development model, 'Beijing was able to lift China from basic subsistence to a situation where many people now enjoy a reasonable livelihood.'
  • 'Ideology apart, it is difficult to argue that there is only one way to govern, no matter what the context of the country.' 

2. 'Chinese entrepreneurs look to the U.S. for inspiration'

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'The spirit of entrepreneurship in China has not been that different from the spirit of entrepreneurship in the U.S.' Ed Tse

'The real point - the most important point - I made in the South China Morning Post op-ed is that politics aside, or ideology aside, actually there's a lot of similarities between the U.S. and China in terms of business, in particular in terms of entrepreneurship,' Ed Tse told me.

'Entrepreneurship returned to China 40 years ago with the reforms started by Deng Xiaoping.'

'Since then, in fact, the whole format and the spirit of entrepreneurship in China has not been that different from the whole form and the spirit of entrepreneurship in the U.S.'

'Chinese entrepreneurs, particular those in the tech sector, have looked towards the U.S. for inspiration since their beginning.'

  • 'I'm talking about the internet companies now, Alibaba, TenCent, Baidu, and many others.'
  • 'When they try to set up the business, when they think about the strategy, when they think about the organization, when they think about the business model, they look to the U.S. - Silicon Valley, the Northwest, the Greater Boston area, and other U.S. tech centers.'

'The mindset, mentality and approach of both the U.S. and Chinese tech companies, as well as their investors, are very similar and many mutual benefits have been built over the years.'

  • 'So, while politically, perhaps, the West may be disappointed that China has not gone its way, from the business standpoint, China and the West – especially innovative centres in the U.S. – have much in common and have adopted very similar philosophies.'
  • 'In fact, the Chinese and the U.S. tech ecosystems are already quite intertwined, and it would be hard to separate the two.'

3. In IPR, market access, and force tech transfer, China is moving in the right direction

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'Premier Li has said that the Chinese government will try not to require or force foreign companies to transfer proprietary technology. Let's see how it goes, but I think Premier Li was sincere.' Ed Tse  

'With or withouta trade war, the Chinese are already moving at least in the right direction,' says Ed Tse.

'The Chinese are actually exercising more stringent protection on the intellectual property rights, not only with respect to the foreigners, but also for the Chinese themselves.'

  • 'It's critical. The Chinese government would like to advance China into a more technologically advanced country. To achieve this, the protection of intellectual property rights has got to be better. The Chinese are not dumb. They're trying to do that.'
  • 'At the same time, it requires some time. The Chinese government is trying to move things in the right direction with the right kind of speed.'

'Also with market access. To just blanketly say the Chinese government has closed the market for foreign participation, including American companies to participate in China market is totally bullshit.'

  • 'There are many sectors in China that are already very open or entirely open for U.S. companies' participation.'
  • 'There are some sectors that are not entirely open, but the direction again is in the right direction.'
  • 'The Chinese government continues to gradually open up industry sectors for foreign participation, and the Chinese government is very committed in doing that.'

'To say, "Well, the Chinese government really forced foreign companies to transfer proprietary technology," again is not always right.'

  • 'There are some situations that actually have been enforced, has been asked for, and of course that's not appropriate.'
  • 'Premier Li has already come out and said that the Chinese government will try not to require or force foreign companies to transfer proprietary technology through this kind of requirement. Let's see how it goes, but I think Premier Li was sincere.'
  • 'By the way, the forced tranfers are not of proprietary technology. Many of these are secondhand or thirdhand technology.'
  • 'The core of technology transferred in the auto industry, for example, is ancient technology.'
  • 'In fact, the foreign companies have really not come forth in any big way to transfer that cutting-edge technology.'
  • [Editor's note: That is also my direct experience in negotiating JVs on behalf of Western clients - the Chinese side demanded the latest technology; I argued - and won - that the Western side would only give older versions.]

'If you look at the direction the China government is taking China, some of these issues are non-issues or quickly becoming non-issues.'

  • 'It's critical for foreign companies, in particular American companies, to really recognize these directions and be willing to participate in the evolution of the China market to capture the  potential that the China market offers them.'

4. 'Focusing on differences will not help us.'

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‍'The Chinese saying “qiu tong cun yi” (求同存异) means “seeking similarities while allowing for differences.”   

'The Chinese saying “qiu tong cun yi” (求同存异) means “seeking similarities while allowing for differences,"' says Ed Tse.

  • 'The West, and the US in particular, should view China in this light.'
  • 'China is on the verge of a sustained, generational rise, and President Xi Jinping has made it clear China would like to play a role in global leadership and governance.'
  • 'By focusing more on the similarities, both global commerce and business will benefit.'

'I would encourage U.S. politicians and U.S. pundits to really look more at the similarities rather than the differences

  • 'Focusing on differences will not help us.'
  • 'Focusing on similarities will.'
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