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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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How Trump's tariffs impact China's trade/currency relations with Japan & Korea

China markets update with TRACK's Bob Savage

'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.'

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.

‍From a movie, 'Death by China' made by Peter Navarro

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'

‍The Trump brand means '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.'

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

I am not a sci-fi fan, but I did see Minority Report in 2002. I don't remember anything about the movie, except the scene where Tom Cruise is walking down a shopping mall hallway and ads pop up, one after another, each tailored to Tom's preferences. Fast forward 15 years (just 15 years) and Alibaba's New Retail is getting us closer to that experience.

Ed Tse, founder of the Gao Feng consultancy and the leading expert on Chinese innovation, introduced me to New Retail in a recent conversation. You will find his explanation of New Retail below, along with a couple of videos showing New Retail in action - as amazing today as Minority Report seemed years ago. Perhaps even more amazing is the China business strategy, the 'Third Way,' that made things like New Retail possible. Ed explains the Third Way in Part Two of our discussion that I will be posting soon. Chinese do do things their own way, as the Third Way again demonstrates. For now, have a look at the future today. And, stay tuned for Part Two for Ed's explanation of the Third Way that made New Retail possible.

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

‍ 'Minority Report' - 2002 sci-fi...

'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)
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'Trump's tariffs just first shot—the big China action is Section 301'

Leland points out that President Trump's really big trade move against China yet to come, that is, Section 301 penalties. If you aren't up to speed on 301, you will be after you read and watch Leland's comments. As Leland says, with Section 301, 'regardless of how Section 232 steel and aluminum tariffs end 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.'

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.'
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A world of debt mortgages our economic future

Reuters
Irresponsible borrowing by the US, China and India imperils global growth

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.

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.

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2017 China Property Report

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.

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.

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.

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.

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

Volume growth decelerated further in September across tiers

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

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.

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.
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The extraordinary power of China's corporate 'mega ecosystems'

AP

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.

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.

‍‍Meituan-Dianping, which is best known for its food delivery service, has moved to offer car hailing in competition with Didi. © AP

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.

‍‍Tencent Holdings has built one of the China's most successful mega ecosystems, including mobile payment service WeChat Pay, which can be used at some vending machines in the country. © Reuters

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.

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."

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China's trade surplus up, RMB weaker

China markets update with TRACK's Bob Savage

'The RMB did not like the trade data at all, and it weakened immediately - over 1% today.' '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.

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.' 

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

Image
‍I said trade surplus, not 'Trading Places'

'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.' 

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

Image

'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.'

'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.'

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What we import from China

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.

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.

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China's RMB oil futures exchange—the 'story of the year'!

‍The Shanghai International Energy Exchange:blowing up more than oil

There's a lot to follow in China. And, I had missed reports about the opening of the Shanghai International Energy Exchange or INE, likely this quarter. But, during my interview with Bob Savage, the well-respected analyst of global markets and CEO of TRACK, he told me the INE could be the 'story of the year.' That's a big - and interesting - claim about something that seems like one more ho-hum Chinese entity. Bob explained that the INE will create the an RMB-denominated oil futures contract. The first such contract in a petrodollar world, where China is largest crude oil importer. If RMB oil contracts - even just for trade with China - catch on, then the whole global oil trading regime will change. And, given the massive size of the global oil trade, a shift from dollars to RMBs will both erode the dollar as a reserve currency, and push the RMB closer its goal of becoming a full reserve currency.

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

Image
‍That twisty thing is the RMB after it replaces the dollar

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.'
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What Hiring Activity Says About Firm Valuations in China

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.

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.

It Takes A Village.png

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.

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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.

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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.

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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?

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Applying AI / Machine Learning To Identify Patterns In China Housing Markets

Real Estate Foresight has published a series of notes to clients under the theme “In Pursuit of Patterns”, revealing some interesting patterns (or lack thereof) found among the key indicators for the China’s housing markets (house prices, sales volumes, land sales) and their relationship to the overall stock market and Chinese developers stocks

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Is China's Economic Power a Paper Tiger?

The People’s Republic of China has surely seen faster GDP growth than the United States for most of the past forty years. It's the value of that growth that's questionable.

The Chinese economy is strange in many ways. Not only is it a hybrid between private capital and state control, but very few people directly invest in the mainland — and yet everybody is interested in how the second largest economy in the world is going to develop. That’s because Chinese demand determines the prices of world commodities, and the operations of multinational companies in China impact earnings. When the yuan falls, markets across the world get jittery. China watchers accept the fact that official Chinese data is severely flawed, and often simply fabricated, yet they still use it to analyze the Chinese economy and markets because there are few alternatives. One alternative, however, is the China Beige Book International (CBB), a research service that interviews thousands of companies and hundreds of bankers on the ground in China each quarter. They collect data and perform in-depth interviews with Chinese executives.

This article is appeared on The National Interest

GDP Is Overrated, or Worse

It seems strange to say this with China having reported faster growth in gross domestic product (GDP) for decades. First, it’s worth asking if and when Beijing will admit that its economy struggled. For instance, China reported 7.9 percent GDP growth for the second quarter of 2009 yet continued the world’s largest loan program, and saw much of it turn to debt despite the supposedly fast growth. It’s almost as if the economy did not do nearly as well as the Communist Party claimed.

Still, the People’s Republic has almost surely seen faster GDP growth than the United States for most of the past forty years. The question is its value. For ordinary Chinese, disposable income (as reported by Beijing) is less than halfof GDP per capita. Disposable income is money that can actually be spent while GDP per capita is an accounting device, with little relevance in the real world.

Even less relevant is GDP adjusted by purchasing power parity (PPP). PPP requires computing a price level for all of China and comparing it to all of America, itself slightly absurd. It relies on “the law of one price”—arbitrage across open markets causing prices for the same product to equalize. Chinese market barriers mean arbitrage often fails. Related, PPP is meant to apply to consumer buying power, while consumption is less than 50 percent of Chinese GDP. GDP adjusted by purchasing power is a poor measurement for many countries, including China.

Net Private Wealth

Simple GDP is better than that, but it’s far from the only measurement and may not be the most important. The resources available to countries to pursue national interests are captured in net national wealth, which again takes the form of money that can be spent rather than an accounting result. If conceptualized and measured accurately, annual GDP should capture contributions over time to the stock of wealth. It should be not be surprising that Chinese GDP turns out not to be tightly associated with wealth.

Credit Suisse compiles net private wealth in most national economies going back to 2000. The data are unstable in that there can be later revision, so the most recent results should be considered tentative. Against that, there are two reassuring features: (i) any bias should be considerably smaller than the bias of the Chinese government and (ii) the results do reflect China’s rise through 2012.

From 2000–2012, net private Chinese wealth jumped from $4.66 trillion (less than India’s today) to $21.7 trillion, close to a 14 percent annual growth rate. American net private wealth over the same period rose from $42.3 trillion to $67.5 trillion. While the absolute advantage for the United States expanded, it did so by only $8 trillion because U.S. annual growth was only four percent. China was easily outperforming.

The situation has changed sharply since then. From the end of 2012 to the middle of 2017, Chinese net private wealth has climbed $7.3 trillion, annual growth never touching 9 percent. American net private wealth jumped $26 trillion. The American base was much bigger and American growth also became a bit faster. The result: mid-2017 Chinese net private wealth was $29 trillion and American net private wealth was over $93 trillion. The Federal Reserve supports the Credit Suisse number, putting American household net worth at $96 trillion.

Just as GDP is not the perfect measurement of economic performance, nor is private wealth. Neither provide information about growing global concerns about inequality. But wealth does reframe the U.S.-China discussion. Claims that China is about to eclipse the United States are untenable in the face of $64 trillion less in net private wealth. Claims that China is outpacing the United States are challenged by the private wealth gap widening by $18 trillion in the past four and a half years after widening by less than half that the previous twelve years. In terms of private wealth, China is barely visible in America’s rear mirror.

The Public Sector

Of course Credit Suisse could just be wrong about the PRC. And there are two more questions to raise. The first is whether U.S. dominance since 2012 reflects American stock and property bubbles being bigger than China’s property bubble, so that the gap will narrow when all bubbles pop. This is entirely possible, but will not matter much. Private wealth declines of the magnitude seen during the global financial crisis, for instance, would leave the U.S. $56 trillion ahead, the same-size gap as 2014.

The fundamental limitation of net private wealth lies in “private.” It is total national wealth which enables pursuit of national interest—the public sector must be included. This is not an easy task. The Party suppresses information on debt problems in the PRC’s huge banking system. The U.S. government’s evaluation of public-sector assets is questionable. However, U.S. federal debt and gross Chinese state assets are both very large, narrowing the wealth gap.

There are official Chinese data on state corporate assets that at least have been internally consistent for some years. These put mid-2017 gross assets at 145 trillion yuan and liabilities a bit over ninety-five trillion yuan, for $7.4 trillion in net state corporate assets at official exchange rates. However, there are strong incentives for state firms to overstate assets and understate debt. This corporate asset figure should be seen as a maximum.

Other public liabilities include central and local government debt. These are considerably smaller than state corporate debt—their official level was $4.1 trillion at the end of 2016. Beijing’s numbers for this have become suspiciously stable and a comparable Bank of International Settlements (BIS) number is $1.1 trillion higher at the end of March 2017, rising such that $5.3 trillion can be used as the mid-2017 estimate.

The biggest state asset beyond corporate holdings is land. It is generally difficult to assign value to large amounts of land because mass sales would cause prices to plummet. It is more difficult in the PRC due to the government’s distorting role. Data over time on revenue from land sales imply a very round value of state land assets of $3.7 trillion at the end of 2016. It is probably a bit higher by mid-2017, though sales are unstable.

This land value could be too low, just as corporate liabilities are probably too low. But the errors run against each other, leaving a rough estimate of public sector assets as adding $6 trillion to net private wealth. Chinese national wealth mid-2017 is therefore approximately $35 trillion, perhaps a bit higher.

On the American side, the main event is federal debt, $19.8 trillion in mid-2017. State and local debt added almost $3 trillion to that. Simple. The problem lies with assets, meaning property.

The federal government owns over 27 percent of all U.S. land while state and local governments push that above 33 percent. Estimates of the worth of this land run from less than $3 trillion for federal and local combined to more than $125 trillion for just federal (using dubious assumptions about commodities). The Federal Reserve puts U.S. government nonfinancial assets at $14 trillion in mid-2017, $10 trillion in state and local government buildings, so its figure for U.S. net wealth exceeds $88 trillion.. But selling those buildings would crush prices, implying a far lower present value.

An indirect calculation based on broader Federal Reserve real estate data yields $9.1 trillion in combined government assets mid-2017. This puts the American public sector position at negative $13.6 trillion and net national American wealth a little below $80 trillion. The wealth gap closes when the public sector is incorporated, but it’s still huge.

American Choices

Land value estimates are imprecise, at best. Asset prices mean wealth can shift sharply. The Credit Suisse private wealth data have been—and can again be—revised. But Credit Suisse, the U.S. Treasury, the Federal Reserve, the BIS, and even the Chinese government (with respect to state corporates and land sales) provide cohesive data over time.

The United States is nearly $45 trillion ahead of China in net national wealth. Further, the gap is not presently closing. It is not closing in private wealth in isolation, it is not according to BIS debt data, and it is not according to this calculation method which utilizes Chinese reporting. In this sense, faster Chinese GDP growth is revealed as somewhat meaningless, at least starting this decade.

If America chooses not to compete with China in East Asia or lead globally, then no wealth advantage matters. When and where we choose to compete, the resource advantage rests overwhelmingly with us, and it will for the indefinite future.

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Will Chinese Commodities Derail The Global Reflation Trade?

Leland Miller and Derek Scissors on why investor excitement over Chinese capacity cuts this winter is oversold, and the serious implications for the global reflation trade.

For over a year, commodities bulls have feasted on China. In the aftermath of the recent Communist Party Congress, many investors are now drooling over the prospect the boom will continue, based on Beijing’s promises to supercharge its campaigns against overcapacity and pollution this winter. If such pledges are fulfilled, the thinking goes, substantial chunks of steel, aluminum, and other refining capacity will be taken offline, rebalancing markets and providing rocket fuel to already frothy prices. 2018 could prove to be an even more amped-up version of 2017.

For over a year, commodities bulls have feasted on China. In the aftermath of the recent Communist Party Congress, many investors are now drooling over the prospect the boom will continue, based on Beijing’s promises to supercharge its campaigns against overcapacity and pollution this winter. If such pledges are fulfilled, the thinking goes, substantial chunks of steel, aluminum, and other refining capacity will be taken offline, rebalancing markets and providing rocket fuel to already frothy prices. 2018 could prove to be an even more amped-up version of 2017.

Not so fast. Investors are misreading what a winter of capacity or production cuts—an overlooked distinction—would truly mean for China’s commodities sector. Assuming the government follows through in its war on steel and aluminum capacity this winter—and since this campaign appears to bear Xi Jinping’s imprimatur, we expect as much—the effect could well be bullish for prices in the short run.

However, there is a danger in drawing more far-reaching conclusions, especially that commodities are primed for another banner year. In our view, previous efforts to cut net capacity have been illusory. If capacity is finally being cut this winter, there is still so much excess that production could survive unscathed for years. If, instead, it is production being cut for immediate environmental gains, it may simply re-emerge in the spring—all bets should be short-term. Any extended price rally relies on both the cuts being real this time and continued robust demand, despite the latter being increasingly unlikely.

To see this, investors should reconsider the fundamental question: What actually caused key commodities to rally in China over the past year? The official narrative implies a combination of sizzling demand and the government’s touted reductions in supply—a view widely accepted by markets. Take steel. The Ministry of Industry and Information Technology in late October declared the steel industry had already met its full 2017 target for cutting capacity 50 million tons, after reportedly meeting its similarly ambitious target for 2016. Critically, any distinction between gross cuts and net ones is glossed over.

Many traders accept this narrative because it accords closely enough with their own observations. For example, by 2017 Chinese iron ore imports had jumped to record levels and steel prices were rocketing skyward. Some high-profile capacity cuts were evident, such as those in Tangshan, China’s largest steel-producing city. Under these circumstances, the notion that Beijing had finally gotten serious in targeting excess capacity seems sensible.

Sensible, but not accurate. Our firm’s China Beige Book proprietary commodities survey, which includes hundreds of companies across steel, aluminum, copper, and coal, tracks capacity, production, and investment as reported by the firms themselves. Despite the fact that these firms have a very strong incentive to parrot the government story that they are cutting net capacity, for an astounding six straight quarters they have told us precisely the opposite. While some capacity has indeed been taken offline, as Beijing notes, net capacity rose from the second quarter of 2016 through the third quarter of 2017 in every one of these core industries.

The problem extends beyond capacity to production, specifically overproduction. In aluminum, for example, the percentage of firms reporting rising inventory has been at least 20 points higher than those reporting falling stocks in each of the six quarters. Supposed capacity cuts cannot mean much while inventory continues to pile up.

If not supply cuts, what explains the rally? For over a year, the counterpart to blistering demand has been speculative capital inflows. This is not unusual for China, as the “moneyball” at various times rolls into property, stocks, and bonds, as well. Here, it has kept commodities prices rising skyward for over a year. But, just as it has done with stocks and (recently) bonds, the moneyball also quickly rolls away when chosen markets lose their shine. If commodities demand weakens, investors relying on supply cuts will be exposed.

This could happen quickly. Many China bulls take comfort in the strong 2017 macroeconomic performance as indicating commodities demand will remain robust. In China Beige Book data, though, all four commodities sub-sectors showed substantial demand weakness in Q3, off what may have been a Q2 peak. While this so far represents just one quarter, not yet a trend, any extended slide will cause the moneyball to flee. Until genuine supply reduction becomes clear, there could be intense and sustained downward pressure on prices.

Chinese commodities, like the economy, remain in many ways a black box, so investors can be excused for holding to a government narrative. But there could be serious repercussions from taking government projections at face value. A sharp rather than slow commodities reversal, unexpected in the aftermath of the Party Congress, would reignite doubts about Chinese growth. It would also elevate questions over global growth. To the extent the commodities rally is important to global reflation, a sustained fall in Chinese prices would shake confidence elsewhere.

Recent behavior by various central banks suggests that interest rate hikes could also be held hostage to Beijing’s supply decisions. What happens in China no longer stays in China.

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Novel Data on China's Auto Loans - An Inefficient Market

Source: Granite Peak Advisory

The continued growth of China’s auto sales has relied increasingly on consumer credit, according to the WSJ; but, granular data is hard to come by. So, we created a process to collect, clean, and structure data from online auto loan offerings. Our findings imply that the auto loan market, like many credit markets in China, runs on two parallel tracks, and is woefully inefficient.

The continued growth of China’s auto sales has relied increasingly on consumer credit, according to the WSJ; but, granular data is hard to come by. So, we created a process to collect, clean, and structure data from online auto loan offerings. Our findings imply that the auto loan market, like many credit markets in China, runs on two parallel tracks, and is woefully inefficient.

The complete data set includes auto loan offers from 71 lenders across 278 cities. The sample covers micro lenders, such as Credit Ease and Hexindai, as well as state-owned mega-banks like Bank of China and the Agricultural Bank of China. The collected data maps total interest payments on 12-month, 100,000 yuan loans to credit requirements like collateral, job status, and monthly wages.

The results show a bimodal distribution of total interest payments between official bank lending and the shadow banking sector. For example, Bank of China’s “Personal Consumption Credit Loan” requires a total interest payment of only 2,700 yuan. Meanwhile, the median for non-bank lenders was an extortionary 22,600 yuan.

Our initial hypothesis was that shadow lenders, free from banking sector regulations, would set auto loan rates via the market mechanism, further study of which would illuminate how credit is priced in China. That was wrong.

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The eye-test reveals no obvious connection between total interest payments and the credit requirements posted in loan offerings. Further, we found no evidence in correlation or multiple regression tests that borrower monthly wages, employment status, home value, collateral, days to process, or location offer explanatory power for variations in total interest payments.

We must conclude that either the listed loan requirements are only decorative, or that China’s auto lending market is highly inefficient – which suggests an opportunity for investors.

Contact us for the complete auto-lending data set.

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'Inside China’s quest to become the global leader in AI'

The World Post

'The RMB did not like the trade data at all, and it weakened immediately - over 1% today.' '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.

SHANGHAI — If all goes as planned, China hopes to be the world leader in artificial intelligence by 2030. If successful, Beijing’s “moonshot” initiative – recently unveiled by the government – has the potential to be a game-changer not just for Chinese society but for global geopolitics as well. My bet is that China will indeed reach its goal over the next decade, in part because of how far it has already come. While so much of the world today lacks clear direction, China has an edge in its ability to combine strong, top-down government directive with vibrant grassroots-level innovation. Beyond this, China has an abundance of data to train AI-learning algorithms because of its huge population of Internet users – more than 700 million. China’s thriving mobile Internet ecosystem also provides a test bed for AI researchers to collect and analyze valuable demographics and transactional and behavioral big data and to conduct large-scale experiments at a much higher level than foreign counterparts. 

This combination places Beijing in a unique position to dominate AI in just over a decade. It would be imprudent to expect otherwise. To understand why, look no further than the country’s current technological advancements. China is investing in AI at the local level Today, a number of local governments in China are offering financial incentives to encourage AI-related innovations. With the government’s assistance, Guizhou, one of the poorest provinces in the country, has become known as China’s “big data hub.” Major Internet companies such as Apple, Alibaba, Tencent and Qualcomm have set up new big data centers in the province, in large part due to this initiative. And in 2016, government data reported a 10.5 percent growth in Guizhou’s gross domestic product, one of the highest GDP increases among China’s provinces and municipalities. Another example is the municipality of Chongqing. It was one of the first municipalities in China to establish a bureau to support local AI development. In May, Chongqing partnered with Baidu, a local search engine, to foster AI and big data. Elsewhere in China, Xiong’an New Area, a newly established district near Beijing, and Guangdong-Hong Kong-Macau Greater Bay Area, a city cluster, have also incorporated AI in their development plans as a key economic growth engine.

China is inspiring tech to prioritize AI The Chinese government’s favorable policies have inspired innovations across a wide range of tech players in the country. Leading Internet giants such as Baidu, Alibaba and Tencent, rising start-ups like iCarbonX and SenseTime, as well as “unicorns” – companies that have reached $1 billion valuation – like Didi Chuxing and Xiaomi are either adopting AI technology already in their operations or investing in it. Baidu, for example, has shifted its company strategy from “mobile-first” to “AI-first.” Some of its initiatives include DuerOS, a conversational AI system that can be integrated into smart devices such as speakers, televisions and refrigerators; Project Apollo, an open source platform for the research and development of autonomous vehicles; and Baidu Brain, an AI platform with 60 different AI-enabled services. Its rival Tencent has also established its own AI lab, which developed the software that famously defeated high-ranking Japanese “Go” player Ryo Ichiriki earlier this year. Additionally, Chinese health care start-up iCarbonX is building a digital “ecosystem” using AI technology to collect users’ biological and psychological data, provide personalized health analysis and predict users’ health status. 

And SenseTime, a Chinese AI start-up founded in 2014, focuses on innovative computer vision and deep learning technology. In July, SenseTime claimed it had raised the largest single round investment in AI globally at $410 million. Still, there are some significant gaps to close before China becomes the world leader in AI. According to a recent AI report from Tencent Research Institute, the number of AI companies in China lags behind those in the United States, especially in the areas of core components and processes. China still falls short of the U.S. when it comes to new ideas and research related to AI but appears to have the upper hand in the application and implementation of these AI technologies. Another potential challenge is geopolitics. According to an unreleased Pentagon report cited by Reuters, the U.S. government views Chinese investments in American AI start-ups as a potential threat to national security. As a result, the U.S. wants to scrutinize cross-border investment in sensitive AI technologies. On top of that, the Trump administration has proposed a 10 percent cut to the National Science Foundation’s spending on “intelligent systems.” This could present potential opportunity for China, through strong government support and financial incentives, to attract U.S. talent to set up AI labs and conduct pilots in China. 

China has some work to do before it successfully harnesses the potential of AI. But it has the resources and talent to reach its goal – and now it has the political will to make it a national priority. That combination will be hard to beat. This was produced by The WorldPost, a partnership of the Berggruen Institute and The Washington Post.

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Novel Data on China's Mortgage Loans

Source: Granite Peak Advisory

China’s banks are directed by the state, without irony, to “vigorously promote reasonable home ownership.” Their most recent annual reports repeatedly bury in the notes this line, or some variant of it, as an explanation for the explosion of mortgage lending over the previous 12 months. Granular mortgage data however, is hard to come by – so we created a process to collect, clean, and interpret that information.

China’s banks are directed by the state, without irony, to “vigorously promote reasonable home ownership.” Their most recent annual reports repeatedly bury in the notes this line, or some variant of it, as an explanation for the explosion of mortgage lending over the previous 12 months. Granular mortgage data however, is hard to come by – so we created a process to collect, clean, and interpret that information.

The complete data set spans 83 cites and 118 banks, 26 of which are listed in HK or the Mainland. The resulting 853 bank-city combinations include data on the interest rates and down payment requirements for first and second homes.

As you can see below, the wide regional divergence of average mortgage rates reflects China’s balkanized real estate market – the average mortgage rate in Changzhou is nearly 100 basis points lower than in Zhengzhou.

Data on down payments gives us another angle for understanding regional differences in China’s housing market. While the down payment requirement for a first home remains under 40% for nearly all cities, there is a much wider dispersion of down payment requirements for second homes – the mean down payment in frothy housing markets like Shenzhen, Nanjing, and Suzhou all top 70% whereas Northeastern cities like Shenyang and Harbin require only 30%.

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According to PBOC data collected from Wind Information, new home loans totaled 42% of all new loans over the past 12 months. Therefore, bank-level mortgage rate data offers predictive power for forecasting interest income of a large section of bank new business. For example, we can use the data to see that the average first home mortgage rate offered by Guangfa Bank is 45 basis points higher than that for HSBC, and the dispersion of rates offered by CITIC is much greater than Everbright.

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Contact us for the complete set of data set of first and second home mortgage rates and down payments for all 853 bank-city pairs.

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China’s property market risks are rising, says data expert

Photo: Jonathan Wong

Price trends in China’s housing market are unsustainable, according to Real Estate Foresight chief executive Robert Ciemniak who worries that excessive leverage among homeowners could lead to a crisis. Real Estate Foresight founder and chief executive Robert Ciemniak has made it his business to gather and interpret real time data on China’s residential property market. He gives his thoughts on what’s to come in China’s housing market.

What do you regard as the key indicators to watch when forecasting property prices in China’s major cities?

Our analysis shows sales volume growth tends to lead house price growth. But one must be wary of headline-only figures. For example, June national sales volumes growth was plus 14 per cent year-to-date, year on year. But the figure was minus 26 per cent for Tier 1 cities. Understanding policy shifts remains critical as the market continues to follow policy-driven cycles of easing and tightening.

To what extent are housing markets in different cities diverging in terms of prices and market forces?

Sales and price performance are highly divergent across city tiers and also districts of cities. Currently, the momentum is with the lower-tier cities, where prices and volumes are picking up.

China seems to have embarked on a plan to create several “megacities”; how do you anticipate developments like this affecting prices and the movement of people?

I think the high-speed rail lines and metro lines connecting mega cities with smaller cities are the most important factors. It has contributed to the boom in lower tier cities, possibly with a twist. People will move to bigger cities, make money there, but get outpriced. They can buy property back in their hometown easily.

Systemic risk is said to be accumulating in the form of rapidly rising Chinese household debt, mostly used to buy property. Could China be setting itself up as the world’s next financial crisis instigator?

Yes, the risk is certainly building up. It goes up with any increase in leverage, as has been the case for housing, but the starting point was quite low. We are probably at the point now where, if this continues, it could be a real systemic problem.

You have mentioned that the property development sector in China is very fragmented. Is this changing or evolving?

It’s a large, fragmented market for new home sales. There are over 1 billion square metres gross floor area in annual sales, and even the largest Chinese developer only sells around 2 to 3 per cent of that each year. Institutional investors focus on the top 10 or 20 listed developers in Hong Kong; but there are around 90,000 ‘real estate development enterprises’ in China, according to the National Bureau of Statistics.

There are drivers for consolidation. Limited land supply and rising land prices means it might be easier for larger players to buy smaller developers or their existing projects, rather than buy new land at auction. As policy tightens, more developers could therefore wind up being bought by larger developers.

Where are we now in terms of policy and what do you foresee for overall prices in the next few years?

We entered a clear policy tightening cycle around the end of September last year, with a visible slowdown in sales and price growth as a result. But we haven’t yet seen any interest rate hikes that would really affect the market, as mortgage lending has grown significantly.

I think the cycles will continue over the next few years, with this cycle being more important given the need for market stability ahead of the Party Congress in a couple of months.

What sectors of the property market in China do you see as having the best near to midterm future?

I think the new home sales market is becoming a ‘product market’, i.e., the quality of the product – the design, layout, size, fit-out – matters much more. Among major cities, we see positive near-term momentum in Wenzhou, Ningbo, Shenyang, Beihai, Chongqing and Dalian.

This article appeared in the South China Morning Post print edition as: Policy key indicator for China market
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The father of business consulting in China knows why eBay failed there

Photographer: Calvin Sit

In the early 1990s, when China was still struggling to shrug off the straightjacket of its planned economy, the man appointed to lead the first business consulting firm allowed in the nation was immediately confronted with the scope of the challenge ahead.

By Joseph Catanzaro, INTHEBLACK

In the early 1990s, when China was still struggling to shrug off the straightjacket of its planned economy, the man appointed to lead the first business consulting firm allowed in the nation was immediately confronted with the scope of the challenge ahead. 

“There wasn’t even a concept of what a company was,” says Dr Edward Tse. “Everything was a state-owned enterprise (SOE), and a SOE is very different from a company like we know them today.”

Tse, raised in Hong Kong and educated both there and in the US, was poached from McKinsey & Company by Boston Consulting Group (BCG) in 1993. BCG was the first business consulting firm given approval by the Chinese Government to set up shop in mainland China.

The nation was beginning to open up to the world under economic reforms, and BCG saw potential in both China and Tse. It has proven to be a wise choice. Tse is held in high esteem in China: he’s the man everyone wants to know and he’s regarded as one of the best management consultants in the business. 

Made managing partner of BCG’s China practice, Tse says his initial work with China’s fledgling business community wasn’t just about convincing potential clients that his people could do a good job, but being good at convincing them what they did actually constituted a job. 

“People asked, ‘what do you guys actually do?’. We’d say, ‘well, we manage a consulting firm to advise companies’. They’d shake their heads. They couldn’t understand what a consulting firm was.”

Fast-forward two decades, and both China and its consulting industry are vastly changed. In 2016, foreign direct investment in China grew by 4.1 per cent year-on-year to US$118 billion, reports China’s Ministry of Commerce. China’s consulting sector, which is helping guide those foreign companies and local businesses, was valued at about US$3 billion in 2015 by UK-based Source Information Services. In early 2017, IBISWorld put the sector’s worth at US$25 billion. 

China business pioneer

Sitting on a high-speed train traveling at hundreds of kilometers per hour through what is now the world’s second biggest economy, Tse says he believed early on that the potential rewards of doing business in China would far outweigh the challenges. He waves away the suggestion he is the founding father of China’s now booming consulting sector, despite his role as the first to steer a practice through those uncharted waters. Instead, he puts his appointment down to “right place and right time”.

“At that time there weren’t many ethnic Chinese strategy consultants and so demand and supply made it happen,” he says. 

Others believe Tse is just being humble. 

“Edward Tse must be considered a pioneer in the field of business consulting in China,” says Shane Tedjarati, a former client and now president of Global High Growth Regions for Honeywell. “I’ve known Dr Tse for over two decades and he’s provided invaluable advice on numerous industries, including automotive and high technology.”

All Tse will admit is he was busy from the get-go. In the early 1990s, foreign firms suddenly had access to the most populous nation on the planet. 

“We [BCG] received a frenzy of inquiries and projects, right away,” Tse says. 

In the past 20 years, he has continued to advise companies on how best to enter the China market, initially at BCG, and later as Booz & Company’s senior partner and chairman for Greater China. 

Along the way he’s written award-winning books on China business strategy and management (The China Strategy in 2010 and China’s Disruptors in 2015), had board appointments on Chinese state-owned giants including Baoshan Iron & Steel, and been given government advisory roles in Hong Kong and Shanghai. 

He’s also earned himself a reputation in business circles as a China whisperer. Tse is tight-lipped about his client list, but it’s understood it includes some of the biggest names in global business, across a wide range of sectors. 

The China market evolution continues

Tse, however, is not one to rest on his laurels. He says, in China, it isn’t an option. “The China market is still evolving. The China market we knew 20 years ago is different to the market 10 years ago, and the China market today. It’s a moving target.” 

There are some big factors behind China’s ever-changing business landscape, Tse explains. Foremost is that China’s transition to a totally free market economy won’t be completed for another few decades, meaning the business landscape will continue to shift as protectionist legislation is scaled back and SOE monopolies are challenged.  

That’s one reason why Tse has continued his own evolution. Just before Booz & Company merged with PwC in 2014 (becoming Strategy&), Tse struck out on his own to found the Gao Feng Advisory Company, which is firmly rooted in China.  

After decades of telling foreign companies their China business needed to be more China-centric, Tse took his own advice. 

“China was always at the fringe, not the core, for the big multinational companies,” he says, “and that also applied to the big consulting companies, because they were headquartered in the West.”

“People asked, ‘what do you guys actually do?’… They couldn’t understand what a consulting firm was.”

Tse’s Gao Feng practice is at the front of a new wave of Chinese consulting firms that are beginning to compete with the multinational players in China. With about 100 consultants spread across Beijing, Shanghai and Hong Kong, it is still a small practice, but Tse says Gao Feng is punching above its weight and is now often “invited to compete with the big firms”. 

His first suggestion for businesses looking to break into China is not to arrogantly assume that the one-size-fits-all approach successfully used in 100 other markets will work there. This isn’t a revelation, because he’s been saying it for 20 years; the surprise is that many foreign business leaders still think their company is the exception, and does not have to adapt. 

“China’s transition from a planned economy is still going on and in my opinion it will take another few decades to complete that transition,” he says. “This is unique. I don’t know another country in the world doing this. 

“You have got a much more complex [business] ecosystem in China. The players are not just pure commercial players: you have private companies and multinationals, but you have also got SOEs who play a different ball game … the government is also very involved in driving the economy.”

Secrets of success and failure

Underestimating just how different China is, and where problems and competition may arise, has been the death knell of more than one bid to enter the China market, says Tse. This pitfall can be avoided, he adds, but it involves giving up something global head offices rarely like to relinquish: control. 

“You have to put the brainpower for the real decision-making here in China,” says Tse. 

Dr Edward Tse

Dr Edward Tse, He points to eBay’s unsuccessful 2002 bid to make it in China. The internet giant ran up the white flag after being beaten by a then much smaller home-grown company, Alibaba. It’s what can happen when a multinational doesn’t give its China office enough autonomy, says Tse. 

“eBay didn’t understand the complexities of the China market. They required everything to be done almost exactly as they they did it in the US,” he says. 

“Alibaba was smaller but its team was flexible and adapted quickly. They understood what the consumer wanted and they developed a locally accepted version of the business model. 

“If it would take a week before eBay [with its head office overseas] could make a decision and come back to China with it, during that one week Alibaba could have made five decisions. This is how Alibaba beat eBay.” 

Implementing a Western, “democratic and by consensus” management style has also often proven a mistake, adds Tse. Most of the successful companies in China, both domestic and foreign, are led by a particular brand of executive that resonates with the local Chinese workforce. 

“The … leaders who are successful at multinationals are usually in a control mode,” he says. “They tend to be viewed as the big boss, someone with authority who has a lot of decision-making power and is able to drive the business in a very local way despite what headquarters wants them to do. They are really quite good at saying this is what we do, we have vision, we have purpose, and the team will then follow.”

The Chinese consumer

The other, obvious side of the success equation is the reception from Chinese consumers. 

Tse says too many multinationals come in with a view that their core product will simply work in China, as is. Yet with little or no brand recognition to rely on, foreign products are often less appealing to consumers than local alternatives. 

Tse points to Coke as a company that did a reasonable job of adapting its product presentation to appeal to Chinese consumers and diversified its product line to capture more market share. 

“They genuinely tried to create a more locally accepted product line. At the same time, while they are trying to develop local products such as juices and Chinese tea, I think they’re still hanging too much on their core carbonated drinks.”

The biggest challenge facing businesses coming into China now, however, is digital disruption.  

Chinese consumers are accustomed to using digital payment systems, expect to be able to order almost every product online on established platforms, and have these products delivered to their door – often in less than 24 hours, says Tse. 

China’s level of technology acceptance and integration is unparalleled anywhere in the world outside of Silicon Valley. 

“If you’re headquartered outside of China, you don’t get a sense of the rapid digital disruption in China,” Tse says. “The local guys based in China know, and I’m sure they inform headquarters, but they don’t get it. They hear the words internet, mobile, digital payment, P2P (peer-to-peer); they hear the terms but don’t understand deeply the change in China.”

For those thinking they can play catch up or feel their way into the market, the first man in China’s consulting sector offers a last piece of advice: “The Chinese consumer won’t wait.” 

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Is china prematurely declaring victory in its reforms?

8/30/17
Xinhua

At the heart of China's economic take-off during the last four decades is a fragile equilibrium between economic reforms and one­ party rule. The communist party has demonstrated pragmatism and adaptability - but just at a time when China seeks to fully enter the knowledge economy and participate in global markets, it has put the brake on further reforms.

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China's unsolved liquidity risk

Source: Wind Info, Author's Calculations

The question we should ask ourselves is, how many of China’s corporate borrowers are paying off existing debt with new debt?

Last week, the International Monetary Fund published the results of its 2017 Article IV consultation with China concluding that the credit gap, the difference between the country’s current credit-to-GDP ratio compared to its historical trend, has begun to moderate. However, I believe this is a flawed indicator of debt-related macroeconomic risk. As I pointed out in my framework for China’s debt problem, the credit-gap ignores the firm-level debt structures that precipitate a liquidity crunch.

As I mentioned in that note, the late economist and Washington University professor Hyman Minsky stylized the credit cycle by sorting firms into three categories based on debt structure. These included hedge units, firms that can repay debt with cashflow from their business; speculative units, firms that can make interest payments using cashflow from their business, but rely on more debt to repay principal; and ponzi units, which rely on more debt for both interest and principal repayments. In Minksy’s framework, the accumulation of ponzi units precedes a corporate liquidity crisis and macroeconomic bust.

The question we should ask ourselves is, how many of China’s corporate borrowers are paying off existing debt with new debt?

Since complete firm-level bank loan data is hard to come by, we can use corporate bond data to approximate the buildup in China’s liquidity risk. Analyzing the prospectuses for 29,600 corporate bonds issued between 2010 and the present, I found that, even as yields rebounded and issuance tanked, the proportion of newly issued debt used entirely to pay off existing debt remained near its all-time high.

While the IMF maintains that the top-line numbers on China’s debt accumulation are moderating, I believe that underlying liquidity issues remain.

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Predicting Chinese stock returns

The Largest Single—Factor Study of China’s Stock Markets

Outside observers paint China’s stock markets as a casino, where picking stocks requires as much skill as roulette, and investors avoid the country in their portfolio allocations. Patterns exist, however, if you know where to look.

China’s equity markets, the second largest in the world, have long confounded Western investors. Outside observers paint China’s stock markets as a casino, where picking stocks requires as much skill as roulette, and investors avoid the country in their portfolio allocations. Patterns exist, however, if you know where to look.

In their paper, “On the predictability of Chinese stock returns” Chen, Kim, Yao, and Yu –  a collaboration of finance professors from American and Chinese universities – examined 18 firm-specific variables known to predict stock returns in the US and their accuracy in predicting stock returns in China. The authors note that their study fills the gap in a Chinese asset pricing literature that focuses only on “a small set of predictive variables.”

Extending their study, I analyzed the predictive power of a list of over 400 factors, the largest single-factor study of China’s stock markets.

Contents

Predicting Chinese Stock Returns............................................1
Introduction...............................................................................3
Factor Summary........................................................................4 
Intuitions about China’s Stock Markets......................................7 
A Detailed Look at Momentum..................................................11 

Overview...................................................................................11 

Coverage...................................................................................12 

Transaction Costs....................................................................13 

Correlations...............................................................................13 

Liquidity and Short Sale Constraints.....................................15 

Liquidity......................................................................................15 

Short Sale Constraints..............................................................16 

Conclusion..................................................................................18 
Appendix.....................................................................................19 

Complete Decile Returns..........................................................19

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Leland Miller on Pressing China Issues

The Epoch Times
Leland Miller, the founder of China Beige Book, spoke with The Epoch Times about which investors and companies are interested in China, the latest developments in the currency, U.S.-China relations, overcapacity problems, and the One Belt One Road Initiative.

The Chinese economy is strange in many ways. Not only is it a hybrid between private capital and state control, but very few people directly invest in the mainland — and yet everybody is interested in how the second largest economy in the world is going to develop. That’s because Chinese demand determines the prices of world commodities, and the operations of multinational companies in China impact earnings. When the yuan falls, markets across the world get jittery. China watchers accept the fact that official Chinese data is severely flawed, and often simply fabricated, yet they still use it to analyze the Chinese economy and markets because there are few alternatives. One alternative, however, is the China Beige Book International (CBB), a research service that interviews thousands of companies and hundreds of bankers on the ground in China each quarter. They collect data and perform in-depth interviews with Chinese executives.

Interviewed By Valentin Schmid, The Epoch Times
The Epoch Times: Who are the investors and companies interested in China and your services?

Leland Miller: There’s people who play the share roulette or people who have a specific company in mind. We see a lot of this in the retail space and they want to get more information from us. They invest in something where they think there is this untapped market either in China or as China goes abroad.

You’ve got macro firms who may not care about the day-to-day in China but want to make sure they understand the dynamics of China demand, of China credit, of China currency, so that they don’t get caught out.

Commodities are in incredibly high demand. We spend a lot of our time dealing with commodities firms now because we have all this data that’s not typically available. Things like net capacity, and a lot of firms have said, “Well, we have no way of checking government numbers…. If they say they’re cutting capacity, we have to believe them.” Well, we don’t believe them, we do it ourselves and what we found is that the opposite is happening across commodities, across time.

So you have all these different types of firms, but I think there is one uniting factor: whether they’re doing China micro, they’re doing China macro, or some niche element of the economy. If they don’t get China right, there are going to be repercussions in their portfolio.

So even people now who have absolutely nothing to do with China are clients of ours because as they keep abreast of what’s going on, they need to understand this and not get knocked from the side off their feet when they weren’t expecting it.

An increasing share of our clients are people who just want to understand China at the 30,000-feet level. Our early clients are people who want to understand at the 30-feet level. And we have everything in between, but also the corporates. The corporates have a very different mind-set: they need to know different things than, say, a hedge fund or other asset manager, who is simply trying to find a good trade.

The Epoch Times: How do you see the Chinese currency developing?

Mr. Miller: They took a very risky strategy on the currency dating back to last fall, and it worked. But it didn’t have to work and it may not have worked, and I think it’s worth looking back at this chronology because this could have been a very different year had some of this not worked out. Back in September 2016, the Chinese started to understand that there was a very real chance that the Federal Reserve (Fed) was going to hike in December, and they needed to prepare the currency and prepare themselves for a rate hike.

They started doing that and they weakened the currency. And then when President Trump was elected, they said, “Okay, well, we got to do this even more. We have to weaken right up until he gets elected so that we can come back and say we’re going to strengthen it once he gets elected.” Now it’s a very cynical strategy that happened to work, but what’s interesting is that there was an enormous amount of commentary late in 2016, early 2017, about how — and we see this all the time — now that China is pegged to a basket, it’s not pegged to the dollar, and that the Chinese have made this move.

That is just not correct. They had not switched, there has not been this back-and-forth. The yuan is essentially pegged to the dollar. The seven handle on this, the seven yuan to the dollar is extremely important for a lot of reasons, most importantly the politics around this, the politics with Congress, the politics with Trump, the politics with the Chinese leadership.

And the idea of them creeping closer and closer to 7 was a real major problem. They understood that this was a politically charged number and they got real close to it and they timed it well and they backed off it, and it had been strengthening ever since which has been supported by the fact that the dollar has been in a weakening trend.

But the interesting thing here is they figured out, “We’re going to give Trump little rationale for letting him say we are a currency manipulator. But right up until that point, we’re going to keep weakening, and we’re going to hope that nothing bad happens.”

Shockingly, they got up to 6.9 — it was approaching a danger point where I think markets would have started caring, and they backed off at the right time. So they have had the 2017 best case scenario, they haven’t had these interruptions, they haven’t had a super strong dollar that a lot of people thought was going to happen six months ago.

So the yuan is not on the top of people’s worry list right now but it’s just a matter of time before they have to deal with these dynamics again, unless the dollar is in a long term weakening trend.

The Epoch Times: How do you see U.S.-China relations in the future?

Mr. Miller: The administration understood that China’s a radioactive word if you use it politically, so we’re going to fight back on China, we’re going to save American workers from the tyranny of Chinese goods. That was the calling card for a while. And then of course President Xi and President Trump met at Mar-a-Lago and had this beautiful chat and everything turned around.

President Trump was convinced to give the Chinese some amount of time to fix the trade problem and fix North Korea and a whole bunch of other things. A lot of really smart China watchers have been saying recently that the President is angry that the Chinese have not done what he wanted them to do on the trade side of North Korea and he’s flipped and you’re about to see the repercussions.

I would actually push back against that. I think that what you’re seeing right now is a gradual dissatisfaction with this. But the real tea leaf here will be the South China Sea. The U.S. position in the South China Sea has just been invisible for the most part. I mean, they talk about a few spy ops but they have been mostly invisible for the past six, seven months.

And when the President, the White House, the administration makes this turn and decides: “Alright, China is not going to help us out, we now need a stick and we need a big stick,” you’re going to start seeing developments in the South China Sea. The fact that there has been some push back on trade, the fact that we’re talking a little bit about steel, it’s totally misunderstood.

The steel measures being talked about are not anti-China, although they’ll be sold as that. So I think we need to stop jumping the gun on the idea that the president has turned hostile on China. This hasn’t happened. Do we think it will happen? Yes. I think it’s a 2018 thing. But I don’t think that there has been a major shift in policy.

The Epoch Times: Are the Chinese really tackling the overcapacity problem?

Mr. Miller: There are two stories here. The first is what our data is saying and the second is the mistake I think a lot of investors make in seeing commodities as monolithic in China.

People usually think that they’re either going to cut capacity across the board or they’re not going to cut capacity at all. So what we have been seeing is not cutting capacity. When prices have gone up, a lot of investors said, “Look, the Chinese government is making good on their pledges to cut capacity. Look at prices are going up, imports are going up.” Anecdotally, that suggests they’re cutting capacity.

Now, they are cutting gross capacity, but total capacity added has gone up every quarter and it’s gone up in almost every sub-sector every quarter. They are adding capacity, and this is very intuitive if you think about it. There are all these industries who used to laugh about the economic reports we used to get from these firms quarter after quarter after quarter of higher inventories, worse revenue, no profits, more capacity — it was just a joke.

Now all of a sudden they’re getting this good economic scenario and they are not about to cut back. It makes sense that they’re not cutting back, but the narrative on this is that the Chinese government is hard at work cutting capacity, and it’s totally a mistaken narrative. Now, we tracked this very closely across coal, aluminium, steel, and copper, and there is a very clear dynamic there and it’s been clear for the last year plus. They are not cutting net capacity.

Now the other issue here is the differences between sub-sectors. When you look at coal and when you look at steel, there’s a different long term concern about the two of them. With all these Chinese commodities, there’s potential overcapacity issues, but coal kills people and coal turns people’s lungs black.

And so the idea that the Chinese can continue to crank out coal the same way they can crank out steel, with the same repercussions, it’s not there. So over time I think we will see a pullback on the coal side. It’s an open question as to whether we’ll see it in steel and aluminum; a lot of this might be affected by the trade actions coming out of the United States, but right now the major story here is that investors are guessing.

They’re guessing based on prices and they’re getting this wrong more often than not. They don’t understand the degree to which these sub-sectors are cutting back. In fact, they increasing capacity, they’re bringing more capacity online. They take the old ones and take them offline or the ones that aren’t being used, but they’ll activate others or they’ll build others or they’ll upgrade others. So the overall dynamic is that more capacity is being brought online but then make a very big show of what they take offline or what they blow up.

They used to put TNT into giant iron plants and blow them up to show that the government was doing something. This is the equivalent of this in 2017. But net net, they’re not cutting back right now. They’re trying to take advantage of a good market for their goods and so this is going to shock people. It’s already surprised people; that’s why you see these enormous 5 percent, 8 percent moves in a day on these commodity markets. But it’s going to shock people more going forward when they understand the totality of what has happened over the past year.

The Epoch Times: What are your thoughts on the One Belt One Road (OBOR) initiative?

Mr. Miller: What is the real goal for this? The goal is to exert Chinese influence abroad, it’s to recycle surpluses in goods and services abroad to some degree because of oversupply. It will accomplish certain things but is it a worthwhile project? Is it going to do what everyone thinks it’s going to do? No, of course not.

But there are things being done. It is a project large in scope, it will attract headlines for many years, but at the end of the day is this a game changer for China? No. Have the Chinese ever in any context found a sustainable ability to get returns, to get an actual return on their investment? No. And they’re going into a situation where they’re irritating a lot of these states who think that they were going to be able to use their own labor, but the Chinese are using Chinese firms who are doing quite well so far, and having them do the labor.

There are political problems that brings up. They also have a different situation right now than they did three years ago when you talk about the Forex reserves in the capital accounts. So the idea that they had too much and had to figure out ways of dumping Chinese capital in other places, that problem has reversed itself. Now we are not at any kind of problematic point at around $3 trillion, people have the opposite concerns. I think that if this were not a President Xi initiative that he has attached his name to, this would have been deescalated far more dramatically.

They’re going to have to build it up, it still plays a role, it’s still worth watching, but the idea that this is a real game changer similar to the Asian Infrastructure and Investment Bank which was a political upheaval about a year ago, two years ago, whenever it was, these are not game changers. These are Chinese inefficiencies at work abroad.

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China Doesn’t Have A Real Estate Bubble.

Prices spike in a city. The government puts the screws on the market, and prices go down. Investment then switches to a city with lax policies. Housing prices spike; regulations tighten; prices go down. Investors move on. And so on, and so on.

A subset of ‘The Coming Collapse of China’ is the China real estate bubble, as in this 2016 Fortune headline: ‘China Real Estate Bubble: Will It Bring Down the Global Economy?’

China hasn’t collapsed. And, the bubble hasn’t burst because there isn't one big real estate bubble; instead, there are many smaller bubbles that rise to the surface, burst, and fall back, like the bubbles in boiling water.

You can see this in the graphic, left, which tracks housing prices in individual cities over the past five years. ….

Prices spike in a city. The government puts the screws on the market, and prices go down. Investment then switches to a city with lax policies. Housing prices spike; regulations tighten; prices go down. Investors move on. And so on, and so on.

As you watch the graphic, note the few times when full-press government policies stop all price rises and even cause decline. And, pay special attention to how Tier 1, 2, & 3 cities change places with each other. For fun, watch how Shenzhen goes off the chart, then spectacularly crashes as the local policies kick in. 

This graphic was created by Robert Ciemniak and his colleagues at Real Estate Foresight in Hong Kong. In the video, below, Robert explains what is happening in real time (3 minutes). Fascinating.

Nobody understands the China real estate market better than Robert Ciemniak, founder and CEO of Real Estate Foresight in Hong Kong. Robert is not only a China property guru, but also a Reuters veteran and an international chess master. A wonderful and interesting guy, whom you should get to know.

And you should also get to know Real Estate Foresight. That firm is doing some of the best work on the China property market in the industry.

Robert will go into more detail about the China real estate market later this week. Stay tuned.

Write and tell me if Robert’s graphic has changed your thinking about the China real estate bubble. And, if not, why not? Thanks!

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China's stock markets—are there any patterns?

'I find evidence for dramatic size and momentum effects; that is, small stocks and recent winners are the top performers in China’s stock market. Additionally, I find that high-beta stocks modestly underperform low-beta stocks.'

Western observers commonly compare China’s stock markets to a casino, a wild gambling house where stock picking requires the same amount of skill as a turn at the roulette wheel. While it may be true that in China, ‘the house’ always wins, I’d like to challenge the underlying assumption that China’s markets operate without rhyme or reason. In fact, there exist several clearly observable patterns governing the behavior of China’s stock markets.

Using DataYes’s dataset of 400 factors for A-share stocks, I analyzed the performance of a few well-known factors for predicting future returns. Each one clearly illuminates patterns in China’s stock markets, even if they are unrecognizable at first glance.

To evaluate factor performance, I used a monthly rebalancing decile ranking methodology of factors and returns from January 2011 through May 2017. I calculated the decile returns for three factors: the size effect, where small stocks outperform large stocks, the momentum effect, where recent winners continue to outperform, and the beta effect, where high-beta stocks outperform low-beta stocks. The DataYes factor definitions are respectively the natural log of total assets, current stock price divided by average price over the past year, and beta relative to the CSI 300 index.

I find evidence for dramatic size and momentum effects; that is, small stocks and recent winners are the top performers in China’s stock market. Additionally, I find that high-beta stocks modestly underperform low-beta stocks.

Although Chinese investors worship Warren Buffett, there isn’t an obvious case to be made for value investing in China’s public equity markets. In fact, the most expensive stocks by measures such as price-to-book or price-to-sales outperform their cheaper counterparts. I don’t believe that this implies an “inverse” value effect, but rather that the momentum and size effects swamp out the value effect.

No Value Here

Also, the price to earnings factor produces a return structure with a wrinkle on the low end; that is, the cheapest decile of stocks by this measure outperforms each of the next five deciles. This pattern appears curious, but following closer inspection is simply a predictable distortion in stock market behavior due to government intervention in capital markets.

Specifically, the CSRC will delist firms posting three consecutive years of losses. This requirement incentivizes firm management to book multiple years of losses in one accounting year. Thus, the lowest decile of price-to-earnings ratio is populated with firms employing accounting legerdemain to take on big-bath losses. In fact, 95% of firms in the bottom decile are loss-making firms. Additionally, firms in the bottom decile posted positive earnings in the two years previous to and following their appearance in the bottom decile – which explains why the news of massive losses doesn’t commensurately impact the stock price.

Distorted Earnings Distribution

In sum, although China’s stock markets behave differently from developed markets, they aren’t casinos where stock prices lurch with neither rhyme nor reason. Clear patterns have governed the behavior of stock prices in China, even if investors may struggle to take advantage of them.

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China's higher rates don't matter, yet

Source: DataYes, Author's Calculations

In fact, high yields still haven’t filtered down to borrowers. Using industrial enterprise economic indicators data, I estimated the actual interest rate paid by Chinese borrowers. Over the past six months – as corporate bond yields, SHIBOR, and WMP yields all rose dramatically – the actual interest paid by China’s industrial enterprises fell to an all-time low.

Although China’s corporate debt load continues to worry government officials and tease western observers, borrowers have avoided problems because borrowing costs have plunged for much of the past three years. That’s why the recent spike in corporate bond yields is worrying – should yields remain high, high debt-servicing costs could shock the overleveraged corporate sector. It seems we have all the necessary ingredients for a balance sheet recession.

But, we’re not there yet. In fact, high yields still haven’t filtered down to borrowers. Using industrial enterprise economic indicators data, I estimated the actual interest rate paid by Chinese borrowers. Over the past six months – as corporate bond yields, SHIBOR, and WMP yields all rose dramatically – the actual interest paid by China’s industrial enterprises fell to an all-time low.

Actual Interest Rates Remain Low

Chinese borrowers have maintained low interest payments for two reasons. First, they’ve cut back on borrowing since the rebound in yields. Second, when they do borrow, they do so at below the benchmark lending rate courtesy of a solicitous banking system. So, most existing loans were extended at previous, lower rates, and new loans are significantly underpriced.

How They Ditched the Bill

Despite large and growing debts, China’s borrowers have yet to suffer from a rebound in borrowing costs. Should banks continue to extend credit at below market rates, China’s balance sheet recession will just have to wait.

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A new framework for china's debt problem

Source: Wind Information

In fact, high yields still haven’t filtered down to borrowers. Using industrial enterprise economic indicators data, I estimated the actual interest rate paid by Chinese borrowers. Over the past six months – as corporate bond yields, SHIBOR, and WMP yields all rose dramatically – the actual interest paid by China’s industrial enterprises fell to an all-time low.

I have a problem with most commentary on China’s debt. Allow me to propose a solution inspired by Hyman Minsky’s framework of the credit cycle.

But first, the problem. Analysis of China’s debt typically begins by anchoring on either an estimate of the credit-to-GDP ratio or the so-called “credit gap.” From that starting point, commentators then roll directly into serious-sounding speculation on China’s dystopian future or hopes for a timely rebalancing.

But this starting point is unscientific.

One, the absolute level of debt is irrelevant. While the US continues to rack up foreign debt, Somaliland can’t even get a bank with a SWIFT code. To quote a proverb of unknown origin, “Running into debt isn’t so bad. It’s running into creditors that hurts.”

Two, the credit gap is also irrelevant. This measure, while cloaked in mild computational complexity, is essentially a statistical artifact, no different than the technical indicators employed by chartists. The Bank for International Settlements observes that countries with egregious credit gaps sometimes descend into financial crisis. I see correlation, but no causal mechanism explaining why aggregate credit growth drives individual borrowers into default.

While both pseudo-empirical measurements provide some descriptive power, neither offers a fundamental understanding of China’s borrowers.

My new set of evidence, inspired by Hyman Minsky’s stylized framework of the credit cycle, illuminates the incentives and constraints imposed on the individual economic agents central to China’s debt problem.

The main insight of the Minsky Cycle is that firms can be sorted into three categories based on their level of indebtedness: Hedge Units repay debt solely with cashflows from their business. Speculative Units make interest payments from their cashflows, but must borrow again to repay principal. And finally, Ponzi Units, which must borrow to repay both principal and interest. In the Minsky Cycle, the accumulation of firms in the ‘Ponzi Unit’ classification precipitates financial crisis.

I will not speculate on the probability of financial crisis in China (Michael Pettis does a good job laying out future scenarios). Instead, I will utilize Minsky’s insight to propose a new set of evidence for evaluating the incentives and constraints of China’s borrowers. There are three pieces to the puzzle:

The proportion of new debt issued to pay down existing debt.The debt-servicing capabilities of China’s borrowers.The proportion of bank loans issued under benchmark.

Let’s begin with the use of funds for China’s corporate bond issuers. As China’s overall credit efficiency has dropped, the proportion of bond issuance used completely to pay off old debt has risen dramatically. Among other causes, a growing proportion of China’s debt goes to pay off old debt rather than invest in new productive capacity.

Now, firms might repay old debt with new for one of two reasons: Healthy firms can refinance debt at a lower cost, or zombie firms must roll-over existing debt to avoid default.

Over the last three years many of China’s healthy borrowers have exercised the first option, refinancing existing higher-interest debt with new low-yield bonds. In fact, from 2014 through the end of 2016 corporate bond issuance surged as bond yields marched downward. And, as yields rebounded in 2017, corporate bond issuance fell in turn. Therefore, to the first layer of analysis, it appears that many Chinese borrowers are merely optimizing their balance sheets when they repay old debt with new.

However, peeling back to the next layer of analysis reveals evidence that a subset of zombie issuers borrowed to avoid default. Even as Chinese corporate bond yields have rebounded and issuance stalled, the proportion of bond volume issued to pay off old debt reached an all-time high – not the behavior of healthy firms taking advantage of a low-yield environment.

Finally, we can also track the proportion of bank loans made below benchmark to place borrowers along the Minsky Cycle. Currently, the behavior of China’s banking sector implies a subsidization of zombie firms to avoid default. That is, banks restructure debt at lower rates so the borrower can continue to make interest payments. This happened in Japan in the 90’s, and it seems to be happening now in China.

In the absence of bank subsidies to zombie firms, we would expect the proportion of loans issued under benchmark to reflect the true market price for loans. That is, when the benchmark is artificially high, we would expect banks to extend loans at below benchmark. However, the current difference between benchmark and corporate bond yields is its narrowest since 2014, while the proportion of bank loans made below benchmark is at its highest since the financial crisis, implying that banks are restructuring loans at cheaper rates to avoid losses.

In their most recent annual filling, ICBC claimed that net interest margins were hurt by successive reductions in the benchmark lending rate in 2015. However, the growing proportion of loans issued under that benchmark shows banks racing to offer lower interest payments, even as corporate bond yields have rebounded, implying a Japan-style subsidization of zombie firms.

In sum, we as China-watchers need a scientific framework for analyzing the implications of China’s corporate debt. The proportion of corporate debt issued to pay off old debt, the financial health of borrowers, and the loan pricing by banks is a reasonable place to start.

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An inflection point in china's systemic risk

Additionally, given the incentives of regulated institutions everywhere, it is likely that risks have simply begun to migrate to new and more opaque parts of the balance sheet. As China watchers, we should prepare for yet another game of financial risk whack-a-mole.

Chinese banks have reached an inflection point in the accumulation of investment receivables assets, a source of systemic financial risk. The consensus viewpoint claims that for years banks have repackaged non-performing and risky assets into so called “trust beneficiary receipts” – the largest component of the investment receivables account – to avoid taking losses on NPLs and reduce loss provision costs. To catch up to speed on this issue, you can read reporting from the WSJ, FT, and Bloomberg.

Industrial Bank, the largest holder of investment receivables, exemplifies how loss provision requirements incentivize banks to repackage assets like this. The most recent annual report disclosed that they set aside only 0.5% in loss provisions for investment receivables compared with 2.7% for loans.

China’s joint-stock and regional banks (SMB), constrained by relatively smaller deposit bases and a regulation on the ratio of loans to deposits, lustily exploit this part of the balance sheet. However, their accumulation of such assets has finally reached an inflection point – SMB reduced exposure for the first time in five years.

Totaling over 15% of all SMB assets, investment receivables still pose systemic risk for China’s banking system. Additionally, given the incentives of regulated institutions everywhere, it is likely that risks have simply begun to migrate to new and more opaque parts of the balance sheet. As China watchers, we should prepare for yet another game of financial risk whack-a-mole.

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Clearing up a few misconceptions on China's capital flight

Last year, I debunked a popular measure of trade misinvoicing as the culprit for China’s capital outflows. Today, let’s scrutinize two other misconceptions bouncing around the China commentator echo chamber.

“It ain’t what you don’t know that gets you in trouble, it’s what you know for sure that just ain’t so.”

– Mark Twain

Last year, I debunked a popular measure of trade misinvoicing as the culprit for China’s capital outflows. Today, let’s scrutinize two other misconceptions bouncing around the China commentator echo chamber.

But first, a summary of the argument from last year: ‘Trade misinvoicing’ is when trading companies undercharge for exports or overpay for imports so that intermediaries can stash the difference in an offshore bank account. The consensus narrative claims that we can observe this directly via discrepancies in bilateral trade data. So, I showed how to generalize those discrepancies to a time series indicator; and, that this indicator offers zero explanatory power for China’s drawdown of FX reserves.

Today, let’s audit another proposed mechanism of capital flight involving artefacts of China’s trade data. I first saw this proposal in a blog post by Christopher Balding, economics professor at Peking University and owner of a delightful twitter handle. Since, many others have reproduced and repacked a similar analysis. Here is the basic idea:

The differences in key data surrounding trade data is illustrative… Whereas Chinese Customs reports $1.68 trillion and SAFE report $1.57 in goods imports into China, banks report paying $2.55 trillion for imports.  In other words, funds paid for imported goods and services was $870-980 billion or 52-62% higher than official Customs and SAFE trade data.  This level of discrepancy is extreme in both absolute and relative terms and cannot simply be called a rounding error but is nothing less than systemic fraud.

In other words, the difference between imports and bank payments data directly exposes the mechanism by which Chinese nationals ferret money out of the country.

Dr. Balding’s analysis is seductive for two reasons: One, we get to cry that China is imploding. Finally! Two, we’re supplied with further evidence implicating the statistical agencies in China Watchers v. Chinese Economic Data. Both get clicks.

However, a rigorous look at the data rejects this hypothesis. We can construct an indicator of this “systemic fraud” by subtracting the value of imports reported by Customs from the value of bank payments for imports (which is reported by SAFE). Let’s call it, “Bank Overpay.” Then, we compare bank overpay to changes in PBOC FX reserves. A final note, while Dr. Balding appears to be citing annual data from 2015, I use monthly data.

China began hemorrhaging foreign exchange reserves in late 2014. However, banks began ‘overpaying’ for imports nearly three years earlier. The eye-test alone debunks this mechanism as a direct monitor for capital flight. Furthermore, a battery of statistical tests show that a model of China’s FX reserves gains zero explanatory power by including ‘bank overpay’ as a predictor variable.

I can’t explain the discrepancy between Customs and SAFE import data, that could be topic for future digging – perhaps even a trip down to the docks. But, this particular statistical artefact and China’s capital flight are unrelated.

So, what does explain China’s recent bout of capital outflows? I still find this BIS report most persuasive. Robert McCauley and Chang Shu offer two drivers: corporates paying down FX debt and foreigners reducing their stock of RMB deposits. A simple model taking those two as independent variables explains around 70% of the variance in the PBOC’s FX reserves.

Now, let’s move on to China’s capital controls. The echo chamber commentators are tripping over each other to tell us that recent capital controls have staunched FX reserve depletion, and we should put worries of China’s capital flight behind us (read here ,here, and here).

What does the data say?

We can use the concept of covered interest parity to quantitatively observe the efficacy of capital controls. CIP assumes that in the absence of country risk, obscene transaction costs, or (most importantly, here) capital controls, an investor should not be able to capture a riskless profit by arbitraging the interest rate differential between two countries.

The methodology: we calculate an ‘FX implied rate’ for SHIBOR, which is what an investor should earn in China based on both USD funding costs and the expectation of future exchange rates. A divergence between the implied and real rates confirms the presence of capital controls limiting the free movement of capital. On the other hand, convergence would show a relative freedom of capital mobility.

A pile of studies (see here, and here) used this methodology to observe the effect of Japan’s capital controls last century finding that strong capital controls contributed to significant deviations from covered interest parity. Applying the same methodology in reverse, we see that China’s capital controls have recently actually become quite leaky.

The left-hand side plots the one year SHIBOR and FX implied rates, the right-hand side the difference between the two. The convergence of the two rates implies that China’s capital account has become more porous over the last 2 and half years, not less. And, recent capital controls certainly haven’t pinched complete capital mobility.

So what does this all mean?

Although PBOC FX reserves have stabilized for the moment, and the government has simultaneously implemented strict capital controls, I don’t believe the latter to be the cause of the former. Not only that, we still don’t have an accurate quantitative measure to observe in real time by which channel money is leaving the country.

Given China’s massive money supply, the RMB still faces tremendous downside risk should China get hit with another economic shock. Regarding capital flight, I believe that China is not yet out of the woods.

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So many twists and turns to the China Housing markets story

CHINADebate Presentation
Analysis by Real Estate Foresight

Almost everyone on the outside seems to have missed the biggest bull market in China housing in 2016, culminating in policy tightening cycle kicking in at the end of the year. But what's next?

China Property—2017 Forecast

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