China’s combination of heavy reliance on investments, export weaknesses and its debt sinkhole mean it is like a castle without protection. This is especially troubling in a global economy where Trump’s “anti imports/buy American” mantra is a knight in shining armour to some
Donald Trump’s “anti imports/buy American” mantra is all too familiar to China. Its addiction to growth at any cost means they are too reliant on investment, have too much debt, and have fueled too much global anti trade sentiment to export their way out of trouble this time.
Trump’s mantra is “America first”. Based on the anti free trade bias he has built into his administration already, Trump’s strident promises to retreat from global trade agreements seem much more likely to occur than some of his other promises.
Meanwhile, China is turning up the heat on its long held ambitions to be the new global economic leader. Premier Xi Jinping has positioned China as a “champion of global free trade” since Trump’s election, adding to the momentum they’d already built with their foreign investment strategy (“one belt/one road”), the Asian Infrastructure Investment Bank, its unexpected leadership in the war on climate change, and a frenzy of bilateral trade agreements in 2016.
Despite bold pronouncements by Trump and his team, it could be assumed that Trump would be happy to hand over the often expensive responsibilities of the world’s economic superpower and that China is both willing and able to take it.
Is China about to become the world’s next economic leader?
The short answer is no. They simply aren’t ready, not even close. And while they only have themselves to blame for backing into a dangerous economic corner, Trump’s victory and his promises to make China’s trade with the US more challenging could trap them there.
China’s once miraculous growth model is now dangerously overheating and at increasing risk of blowing up in the next two years if they cannot get it under control. As shown below, they are now faced with a tough choice between a dramatic economic slowdown, social unrest or passing through to unprecedented levels of 300% debt to GDP by the end of 2017.
This year will see a colossal trade battle that is going to spill over into financial markets and the real economies of the rest of the world. China wants to ascend to world leadership soon, but needs trade flows to grow to get there. Trump wants less trade and seems prepared to pick a fight to achieve that. As Wall Street has already priced in all of the positives from Trump’s presidency, the negatives from this sort of battle will cause significant volatility for equities and commodities in particular, with Australia high on the list of collateral victims.
China’s growth model – the recipe for success
Until 2009, China’s secret recipe for creating a miracle economy worked wonders:
- Start with one billion potential workers, the greatest asset for any economy.
- Stir in a dose of controlled capitalism to unlock the potential of that vast human capital asset.
- Boost that human capital’s savings rate by leaving social security safety nets very low.
- Through centralised control, keep interest rates on savings accounts artificially low.
- Trap savings in the country and in those low interest accounts by shutting the door on capital flows out of the controlled environment.
- Encourage (tell) banks to lend those same low interest funds to investment projects in infrastructure, property and factories.
- Those investments mean more jobs for the one billion potential workers to take up, creating even more savings to pour back into the engine room.
- Next, artificially hold down the Yuan’s value with measures such as buying US dollars from exporters at a higher conversion rate than they can get on the free market.
- Deposit any excess savings not loaned for investment into the central bank to buy USD assets, resulting in a higher USD. It therefore boosts export competitiveness and encourages more investment, more jobs and more growth.
This is, of course, grossly over simplified, but doesn’t detract from our central thesis. China can no longer cling to this approach, and in fact it has been overheating since 2009 in an attempt to keep growth above centrally set GDP targets.
Until around 2009, the Chinese growth model was great for China and good for the world. But things have changed.
To maintain growth while the Western World’s demand for their exports collapses, China stepped up its investment spree. Centrally controlled local governments and state owned enterprises borrowed more than ever to fuel investment projects, and China’s GDP continued upwards of 10% a year. By mid 2016, their total debt to GDP ratio passed 250%. This was around the same level as the US and Europe, but an unprecedented level for a country of the low GDP per capita level of China.
By 2016, US$4 trillion in new debt was required to keep fuelling their target GDP growth rate of 6.5 to 6.7% per annum, which represented an additional 40% to 45% of GDP. Alternatively, they could increase their trade surplus by 3-4% of GDP; an increase from the current trade surplus of ~3% of GDP to 6-7% of GDP. That degree of additional surplus pours more foreign capital into the country and avoids the need for more borrowing. So while that jump in their trade surplus wouldn’t reduce the 250% debt to GDP ratio, it would stop its rise and allow Beijing to manage a soft landing for the economy overall.
Then, along came Trump. No one expected it, but Trump won the US election on an “America first” campaign that had anti free trade as its centrepiece. And while Trump is unlikely to even try to get his proposed 45% tariffs on Chinese imports over the line, there is no chance that he would tolerate a rise in US imports from China in his first year of Presidency. A trade surplus increase of that magnitude would have to include a major increase in US imports of Chinese goods. Even if China could pull it off, Trump’s response would be volatile at least.
While the US is not the only importer of Chinese goods, they are the largest, with the ability to impact the trade policies of other western economies trying to favour with the US. An increase in the trade surplus is not looking likely.
Summary – never mind Trump, China is its own worst enemy
In 2017’s first salvos of the China vs US economic battle, the US is a clear favourite. Until two years ago China would have been odds on, but they’ve backed themselves into a corner. Now they have an ugly choice to make:
- Continue on the same path and borrow another 40% to 45% of GDP to maintain GDP growth at target, but in doing so take China’s total debt to a massive 300% during 2017, significantly increasing the material risk of another “Chinese credit crisis”;
- Drop the GDP target and face social unrest from rising unemployment and a loss of face on the global stage, two of the biggest fears of China’s Communist Party; or
- Attempt to increase the trade surplus and start a trade war with the most volatile, unpredictable and clearly mandated leader the US has had in decades.
China’s growth model has passed its used by date. That’s something for Beijing to worry about whilst Washington DC seeks out every opportunity to seize the advantage. For the rest of us, nations all the way down to individuals, we need to start strategising ways to avoid becoming collateral damage.
Investment strategy
Like all such scenarios, the above is a possibility not a certainty. The extent to which you choose to do something to ready yourself depend on two things – 1) How strongly you agree (or disagree) with the above; and 2) whether you are a growth or a defensive investor. The stronger you agree and the more that you are a defensive investor, the more the below strategies will be relevant to you. If you disagree and primarily invest for growth, wait for everyone else to get scared about China and buy on the fear.
Aside from the obvious strategies like avoiding Chinese equities, the implications of this outlook for China are:
- Avoid equity downside risk on major exporters to China, for example iron ore producers such as Fortescue, food/health product exporters such as Bellamy’s or Blackmores, or property groups such as Goodmans.
- Watch for inevitable overreaction when the fall comes. Whenever there is a fall in the value in iron ore, iron producers’ corporate bonds get blindly sold off. FIIG clients that have followed us on FMG and BHP over the past few years have profited from buying at these times. This trade only works for producers with low costs, such as BHP and FMG, as they are the ones that will maintain positive cashflow even with large falls in the price of iron ore.
- Reduce banking sector downside exposure as the risk of a banking sector crisis rises with Chinese debt. Australian banks have very little risk of collapse, but their share prices will suffer a fall in any China credit crisis simply due to concerns about contagion risk and the economic impact on Australia.
- Buy Australian corporate, infrastructure or RMBS bonds with a duration of three to seven years, but diversify well. This duration stands to benefit from the fall in yields that would follow concerns about Australia’s economy in light of its current weakness and deteriorating outlook, if China faces the above challenges in 2017.
- Short AUD, which simply means hold investments in other strong currencies such as USD and GBP, to profit from any fall in the AUD when concerns about China accelerate.
- Favour “real” assets over financial assets where feasible, to avoid the high volatility that comes with financial assets. Real assets are infrastructure, property and agriculture, and are typically not subject to the bull/bear emotional cycle of financial assets such as company equities and bonds. Real assets can be owned as shares (infrastructure equities) or bonds (infrastructure bonds).