This is the another in a series of articles that makes a fundamental macroeconomic sectoral flow analysis of the economies of key countries across the globe.
The purpose of the review is to see if the local stock market is worth investing in via exchange traded funds (ETFs). These funds are available to all investors, even for non-residents or those not able to trade in the stock market of that country directly.
In this article, we examine China from a sectoral flow analysis perspective to see if the private sector, containing the local stock market, is getting the support it needs from the government and external sectors to continue its march upward.
Details of the methodology employed to analyze these opportunities are available in the sectoral analysis section found later in this article.
The magic formula for success is:
P = G + X
And you can read more about that below.
Which Countries Are Doing Well?
The first port of call is the ETF page at Seeking Alpha and a look at country ETFs and how they are performing.
The chart is from early December 2016. In that time positions have changed a little as the table below shows.
Most countries on the list are in the red and are of no further interest, though we could learn from them what to avoid, as could their governments and politicians. But, as investors, we will leave that to them.
Since the start of this series of articles, China has risen from nineteenth place to seventeenth. China is moving up the chart and shows a 23% growth rate over the last twelve months. China is on the move right now.
One can find the SPDR S&P China ETF (NYSEARCA:GXC) near the top of the SA ETF list, and the current fiscal situation is as follows:
BNP Paribas provide the following independent summary of China's fiscal policy stance:
Economic growth has continued to slow down in early 2016 and real GDP growth could be close to 6.5% year-on-year in Q1, down from 6.8% in Q4 2015. This is at the lower end of the official target range of 6.5% to 7% set up for 2016. By announcing this target at the National People's Congress (NYSE:NPC) in early March, Beijing clearly expressed its intention to stabilize (and therefore boost) economic growth this year. Structural reforms aiming to improve the quality of supply, to re-balance China's growth engines and to promote more harmonious economic development are still medium-term priorities. In the short term, however, the authorities intend to foster demand through a "cautious" monetary policy easing and a more "proactive" fiscal policy...During the NPC, the authorities unveiled a series of economic policy objectives for 2016. On the fiscal front, they are calling for an increase in the "target" fiscal deficit to CNY 560 bn, or 3% of GDP. By announcing the largest fiscal deficit ever targeted in China, the government is clearly signaling its determination to make greater use of its fiscal maneuvering room. Actually, the new tax measures combined with the strengthening in infrastructure spending will further strengthen the easing of the fiscal policy stance, which has already been in expansionary mode since 2012.
(Source: PNP Paribas)
The longer term government budget picture is shown below.
The chart shows that the government has been a net add to the private sector for decades. The net add has been rising since 2010, and this is a positive trend for the private sector.
One notes the familiar longer term pattern of falling deficits and then a recession. It is no coincidence that the one surplus achieved in 2007 played its part in heralding in and making deeper the impact of the GFC and the "great recession" in China.
The value of the budget is important as is shows the money amount being added or drained from the private sector, and this is shown in the chart below:
The chart shows an average add of about 10000 million CNY per year to the private sector, tendency rising.
One should note that China has an enormous capacity for fiscal expansion as most of the heavy lifting to date has been done by the state and local governments by taking on debt.
For instance, the corporate sector and the local government sector are probably issuing too much debt relative to their income flows, while the central government is issuing too little. That might seem like a surprising conclusion but it follows from the understanding of the relations between the sovereign currency issuer and the users of that currency. Corporations, households, and local governments are users of the domestic currency ((NYSEARCA:CNY)), and if central government policy is too tight, economic growth requires that the balance sheets of the currency users become more precarious. This tendency will be compounded if the current account surplus is reduced, or if the central government tries to move toward a balanced budget. For that reason, our main policy recommendation suggests that the central government's fiscal stance should be gradually relaxed so that local government and corporate budgets can be tightened. By loosening the central government's budget but tightening local government and corporate budgets at a measured pace, the PRC can avoid depressing growth or sparking excessive inflation.
(Source: Asian Development Bank)
One very positive channel for this fiscal capacity is the silk road project.
Hoping to lift the value of cross-border trade to $2.5 trillion within a decade, President Xi Jinping has channeled nearly $1 trillion of government money into the project. He's also encouraging state-owned enterprises and financial institutions to invest in infrastructure and construction abroad.
(Source: World Economic Forum)
Some question where the funds will come from for such a bold venture. The macroeconomic picture shows that three current account surpluses could do it easily as could help from government deficit spending.
The long term balance of trade position is shown in the chart below:
The chart shows that China has become an export champion making a long-term average of 400 million USD per year in export income. Even in the face of the great recession, the surplus continues, but growth was flat through 2014-15 and fell in 2016. In absolute terms the dollar amount is enormous and three such years could cover the cost of the silk road project mentioned above.
The chart below shows the capital flow situation.
The chart shows net outflows of capital from China. The net outflow peaked in 2009 at the trough of the GFC stock market crash and have declined in the years since.
On the other hand, foreign direct investment has been consistently rising over time reaching a peak in 2015 and fell slightly in 2016 as the chart below shows.
This indicates that foreign business people are investing in China and casting a vote of confidence with their money. The strongest vote of all.
The overall impact of the external sector is reflected in the current account. The current account balance and trend is positive. After some lows in 2013, the trend is now back up. This is shown in the chart below.
One reads much in the mainstream media about hot capital outflows from China and the presumption that wealthy Chinese are stashing their money overseas to preserve their wealth from a falling local currency unit or worse an economic collapse. Well, the numbers show that the impact of this is overstated as the overall picture is a positive and recovering external sector. Any capital outflows are more than matched not only by foreign direct investment inflows but also by the general trade surplus.
One can see the total trend when one compares GDP with the amount of money in circulation. This is shown in the following two charts:
Both charts show a positive rising trend. Note that one is expressed in CNY and the other in USD. When one reconciles the two the amounts balance almost exactly. Also worthy of note is that China has chosen in invest $3T of its financial assets in U.S. Treasuries, one third of that would also pay for the silk road project, funded out of recurrent earnings.
One sees that the value of GDP follows the growth of the money supply. There had to be roughly the same amount of money in circulation to enable the transactions that compose GDP to take place. If there is inflation, it is because more money than GDP is in circulation and vice verse.
In deflationary times simply print more money and enhance the general level of education, health and public infrastructure. This adds liquidity to the system and also long term productive capital into the economy.
One can also deduce the conclusion that austerity policies cannot lead to growth and must shrink both the economy and the money supply and cause deflation.
Most countries follow the western practice of matching government spending with a bond issue so that the government is "seen" to be financing itself and is not inflationary. The macroeconomic result is that the government spending nets to zero. All that has changed is the composition of private savings from wherever they were before into a government bond.
The practical reality is that a currency-issuing sovereign government with a freely floating exchange rate does not need to borrow money any more than a corn farmer needs to borrow corn at harvest time. It is the source of the money/corn.
An unfortunate side effect of the size of those private financial assets invested in government bonds is that it becomes a source of worry for the general public and politicians who do not understand what it represents. The misinformed political response is austerity policy to repay the bond, which was voluntary and unnecessary in the first place.
A currency issuing government with a freely floating exchange rate does not need to issue bonds to finance itself. This practice is a voluntary self-imposed constraint that at the end of the day stifles growth.
Good that China is not caught up in this voluntary government constraint nonsense and will continue to grow and expand while the "advanced" "western" economies scratch their heads and wonder how the Chinese do it and of course claim that it will not end well.
Sectoral Analysis Methodology
Each nation state is composed of three essential components:
- The private sector
- The government sector
- The external sector
The private sector comprises the people, business and community, and, most importantly for investors, the stock market. For the stock market to move upward, this sector needs to be growing. This sector by itself is an engine for growth and innovation. However, it needs income from one or both of the other two sectors to grow in value.
The government sector comprises the government with its judicial, legislative and regulatory power. The key for the stock market is that this sector can be both a source of funds to the private sector through spending and also a drain on funds through taxes.
The government through its Treasury also sets the prevailing interest rate and provides the medium of exchange. Too much is inflationary and too little is deflationary. It puts the oil in the economic engine and can put in as much as its target inflation rate allows. It is not financially constrained, for a sovereign government with a freely floating exchange rate any financial constraint such as a matching bond issue is a self-imposed constraint.
The external sector is trading with other countries. This sector can provide income from a positive trade balance, or it can drain funds from a negative trade balance.
One should note that a negative trade balance also means that a country has traded currency, that is in infinite supply, for real resources that have a finite supply.
For the stock market in the private sector to prosper and keep moving upward, income is required to be put into the flow. Otherwise, the sector can only circulate existing funds, or is being drained of funds and is in decline.
The ideal situation is that the private sector has a net inflow of funds and is constantly growing, thus giving the stock market headroom within which to expand in value. For this to happen, one or both of the other sectors have to be adding funds to the circular flow of income.
This relationship can be expressed by the following formula:
Private Sector [P] = Government Sector [G]+ External Sector [X]
P = G + X
For the best investing outcome, one looks for countries where the government sector and external sector are both net adding to the private sector and causing the local stock market index to rise with the receipt of additional funds.
China is a buy and is on the move right now.
The government sector is net adding to the private sector and just about always has. Moreover, the net add is increasing, and the government has some very big, long range concrete plans for expansion. This is a government that has a vision that extends over decades.
The external sector is a huge net add to the private sector. Even in the face of the great recession, the economy manages a trade and current account surplus.
Overall China ticks the boxes with regard positive flows from both the government and external sectors and this is the reason for its success.
The consistently strong and growing foreign direct investment flows show that business people across the world are investing in China and see profits and good business prospects there. This is one of the strongest votes of confidence there is.
For ETF investment access to China one can buy the following funds:
- iShares China Large-Cap ETF (NYSEARCA:FXI)
- iShares MSCI China ETF (NYSEARCA:MCHI)
- SPDR S&P China ETF (GXC)
- Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (NYSEARCA:ASHR)
- PowerShares Golden Dragon China Portfolio (PGJP)
- Direxion Daily FTSE China Bull 3x Shares ETF (NYSEARCA:YINN)
- VanEck Vectors ChinaAMC CSI 300 ETF (NYSEARCA:PEK)
- iShares MSCI China A ETF (BATS:CNYA)
- CSOP MSCI China A International Hedged ETF (CSOP)
- Deutsche X-trackers MSCI All China Equity ETF (NYSEARCA:CN)
- Direxion Daily CSI 300 China A Share Bull 2x Shares ETF (NYSEARCA:CHAU)
- Deutsche X-trackers CSI 300 China A-Shares Hedged Equity ETF (NYSEARCA:ASHX)
- CSOP FTSE China A50 ETF (NYSEARCA:AFTY)
Some of the above funds are hedged too so that one can protect ones overall return in USD. This is important as it is in China's long-term interest to maintain a low exchange rate so that they can sell their exports at a competitive price. Comments in the press that the Chinese are doing the opposite of this to stem capital outflows are nonsense as the overall macro picture above shows.
In the next article, we will not move far and will take a look at South Korea and why they are doing well.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.