Global Market Commentary

A Tale of Two Chinas

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The skeptics and haters of the current bull market have spent the last eight years finding reasons and justifications for their skepticism.  One of the favorite reasons for pessimism has been China.

Sometimes China has been a geopolitical boogeyman, with journalists fretting about China’s rise on the world stage and its potential to surpass the U.S. in military or economic power.  We have thought those fears to be baseless and have said so for years.  China has a long, long way to go before it will be able to challenge the hegemony of the U.S. either militarily or economically, even in its own back yard.

Sometimes, conversely, it has been China’s weakness rather than its potential strength that has spooked western observers.  The fear here is that China’s decades-long boom has been a powerful stimulus to the global economy, and if that boom faltered, it would drag the global economy into recession.  A related fear is that China’s boom has been built on unsustainable financial leverage — on a domestic debt bubble that will result in a severe financial crisis.

Since China’s financial system remains almost completely separate from the global financial system, it is irrational to worry that such a crisis would be directly contagious to the banking systems of the developed world, as we have often pointed out.  But put these two fears together, and you get a Chinese slowdown caused by a domestic financial crisis.  However, the global growth picture has brightened considerably over the past year and a half, so there has been less of a feeling that the global rally is so dependent on Chinese growth remaining strong.

These China fears have ebbed and flowed.  They’re currently flowing, thanks to comments from an unlikely source — one of China’s highest-ranking financial officials.

The current governor of the People’s Bank of China, Zhou Xiaochuan, is nearing the end of his long tenure.  He’s a reform-minded man who has long pressed for the liberalization and opening of China’s financial system to the world, and the internal changes that would be necessary for that to occur.  Soon he’ll be passing the baton, so he may feel both freedom and obligation to speak plainly about the dangers he sees if China continues on its current financial trajectory and fails to make reforms.

China’s Central Bank Chief Sounds An Alarm As His Retirement Approaches

Several times in recent months, Zhou has made public comments about the dangers he perceives to the Chinese financial system.  Early in November, he said:

“China’s financial sector is and will be in a period with high risks that are easily triggered.  Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous.  The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing.”

In mid-October, Zhou commented on the sidelines of the Chinese Communist Paty’s 19th Congress: “… Systemic financial risk may trigger a financial crisis, lead to a chain of strong reactions in the market, and have severe impact on the whole economy and employment.”

Zhou went so far as to refer to the risk of a “Minksy moment” — a dreaded term in finance-speak.  It refers to economist Hyman Minsky, whose studies of financial instability have received a lot of attention since the financial crisis.  Minsky basically pointed out how long booms reliably create excessive leverage and risk-taking which then unwind catastrophically when the expansion falters.  (Mainstream academic economists have tended to pooh-pooh the role of purely financial factors in causing recessions.)  A “Minsky moment” is the implosion of asset prices that kicks off the crisis in earnest.

Zhou’s comments have caused a renewed bout of concern about China’s financial stability.  It’s important to keep his warnings in context: this is a reformer who is getting ready to retire and wants to make sure his message is heard loud and clear before he steps off the stage.

The Root of China’s Problems

Excessive leverage in the Chinese financial system is a problem, and the authorities know it.  This is why they have been working to reduce it for years, though without much success.  The Chinese economy has faded and revved again each time the authorities have clamped down, and then loosened up as they couldn’t face the political costs of really reining in the dangers.

China’s rulers have two basic problems.  One of them is of recent vintage — it has come about as a result of the country’s phenomenal success in creating growth and alleviating poverty.  The other problem is not just old, but ancient — it has been one of the key recurring themes that has shaped China’s history for thousands of years.

Problem number one: growth must be maintained at all costs, or those who have been left behind — the hundreds of millions who are still poor and have not been lifted into China’s middle class — could revolt and overthrow the current rulers.  Maintaining growth is a matter of existential survival for the Communist Party.  This is why they blink every time financial restraints threaten to slow economic growth too dramatically… and they end up putting the pedal to the metal once again, even as the eventual crash becomes more likely and more severe.

Problem number two: there is a basic conflict between the center and the periphery.  A famous 14th century Chinese historical novel, the Romance of the Three Kingdoms, opens with the words, “The empire, long divided, must unite; long united, must divide.  Thus it has ever been.”

Here’s how this ancient Chinese problem is currently manifesting.  The roots of China’s financial instability lie in a struggle between the central government, which has most of the revenues, and local governments, which bear most of the burdens of social spending.  Those local governments were also responsible for most of the funding of China’s post-recession stimulus package.  This impossible calculus meant that they had to find money somewhere.  They found it by creating opaque “local government financing vehicles” whose structures and risks were unknown, but which offered attractive yields and a tacit guarantee that the central government would bail out investors (a tacit guarantee that has largely proved true).  Even when the central government permitted them to float legitimate, above-board bonds, their ability to do so was limited, because if they were transparent about their financial state, no one would want the bonds.

So local authorities have created much of the problematic leverage in China’s financial system — not just because they’re in an impossible fiscal situation, of course, but because opaque financing affords all the participants lots of opportunities for corruption.

Current Developments:  Where Do We Stand?

Currently, China is in a tightening mode, and it is having the usual and expected effect — slowing growth and dropping corporate profits.  If the rest of the global economy stays on track, and if the Chinese government does what it has done in the past, it will quit tightening and start loosening again when the pain becomes too great, perhaps sometime in the first half of 2018.

One message comes through from all the deleveraging efforts of the past five or six years — all the deleveraging, all the anti-corruption, all the crackdowns on illegal money flows out of the country, as officials who have stolen funds desperately try to convert it into foreign real estate, foreign insurance policies, or Bitcoin.  The same message comes through in Zhao Xiaochuan’s final plea for reform, openness, and transparency — a plea that most likely will not be heard, because the authorities actually have no “exit plan” from the bubble.  This message is that a day of reckoning is coming for China’s financial system — and perhaps its political system as well.  But that day is not here yet, even if it is getting closer.

Investment implications:  As this newsletter goes to press, enthusiasm generated by the prospect of U.S. tax reform is contributing to a correction in some of the Chinese internet stocks we have favored throughout much of 2017, as money rotates towards U.S. financials, small caps, and other tax-reform beneficiaries.  The current round of tightening in China will create some pressure on Chinese corporate profits in coming months and may act as a damper on enthusiasm for Chinese stocks among developed-world investors.  If the normal pattern holds, we anticipate an easing phase in 2018.  We continue to believe that as long as the global expansion continues, China and other emerging markets will do well for the duration of the bull market.

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