The Anglo-Saxon media, fake or otherwise and its avid readers, has become trapped in the Thucydides Trap of framing relation to relations between China and America. This began with President Obama's "Pivot" towards China. Escape from the Thucydides Trap has become almost impossible since President Trump came into office. Containment of China has now "pivoted" towards confrontation in the public domain.
(Source: Google Trends)
China for its part has refused to walk into this trap, in recognition of the fact that fighting on an opponent's terms is a strategic defeat. China therefore uses the contact and friction with America to frame its alternative global solution to the challenge, perhaps in order to make America fight on Chinese terms. Both nations are on the same planet, but on different pages in how they wish to frame the narrative.
Despite the failure of President Trump's political and economic agenda to gain full traction, in the face of domestic and global obstacles, the comparison and contrast between American and Chinese 21st Century strategy is becoming discernible. America is defaulting back to almost post World War II global boundaries and protocols, whilst China is expanding its amorphous ones into regions abandoned through American withdrawal.
The last report observed China attempting to expand into the global vacuum being created by a strategic withdrawal by America. Further potential expansion room was recently signaled by Secretary Tillerson, in the form of the territory that will be effectively vacated in his proposals to cut the State Department budget by 29%. Most of these cuts will be borne by foreign aid programs, which will provide fertile ground for China to plant its own seeds under the broader heading of its Belt and Road initiative. As America positions for strategic withdrawal however, it is leaving some capital markets booby traps behind to slow the Chinese advance down.
(Source: Bloomberg)
After allowing some time for its analysts to evaluate the potential impacts of the Belt and Road policy announcements at the recent Silk Road Summit, Moody's became the first western ratings agency to deliver a verdict. This verdict was not positive, as China was downgraded to A1 from Aa3. This is the first downgrade since 1989, so it is symbolic of China moving into a new phase of its modern economic history. Apparently, this next phase is viewed as a more risky undertaking than the previous phase on the tailwind of globalization. Ostensibly, Moody's was giving its verdict on China's ability to deflate the regional property bubble whilst maintaining momentum in economic growth. The timing of the downgrade, on the back of the Silk Road Summit suggests an ulterior motive to frame the Belt and Road strategy in a domestic economic context.
Moody's was indirectly opining on the flow of funds from China's main cities to its lower tier cities, which has been fueled in large part by a booming shadow banking credit bubble. It does not take much imagination to translate this impact on the domestic flow of funds into the context Belt and Road capital flow. China has already clamped down on capital flight, which has contained flows within its national boundaries and exacerbated its property bubble. This delicate balance of domestic and global flows will need to be managed with great skill as the Belt and Road strategy is executed.
(Source: The Daily Shot)
Since China's debt is largely held domestically, the Moody's downgrade will have little immediate global impact. The Chinese authorities have already clamped down on capital flight, so global contagion has already been mitigated. The downgrade has effectively cut China off from global borrowing at worst, or has made it far too expensive at least. The leverage problem has thus been firmly isolated within Chinese capital markets. The domestic leverage problem may even get exacerbated as further foreign borrowing has been choked off by Moody's downgrade. Currently, the private debt bubble stands at 216% of GDP. With GDP growth slowing this ratio will rise even further. This debt represents a massive counter-cyclical stimulus that came as a reaction to the Credit Crunch. The challenge facing policy makers is to unwind this leverage situation, by curbing borrowing and simultaneously stimulating growth.
Going forward, as China starts to shift its growth driver from the domestic economy to the Belt and Road territories, this downgrade is not the most auspicious support for global fundraising. China will therefore be forced to divert capital from the domestic economy to the underwriting of the Belt and Road. Such capital rationing will need to be skillfully and rationally managed in order to sustain both the domestic economic and stimulate the Belt and Road growth.
PBoC Governor Zhou Xiaochuan's latest comments, signaled how policy makers would like to manage this economic transition going forward. His comments were aimed at blocking the economic headwind that the recent Moody's downgrade has created. He called for foreign financial institutions to be allowed greater access to China, using the rhetorical disguise of competition preventing the domestic banks from underachieving rather than a stated intention to respond to the downgrade. In addition, he exalted domestic banks to go out and look for opportunities along the Belt and Road. China therefore intends to replace a domestic shortfall in capital, created by a diversion away from the domestic economy to the Belt and Road, with foreign capital.
(Source: Bloomberg)
Chinese policy makers have also contributed to the isolation of Chinese capital markets, by tightening up on external capital flows this year. This tightening of policy has led to a substantial reduction in the PBoC's balance sheet that is used for foreign exchange transaction enabling. This reduction in the size of the PBoC's balance sheet, should not however be viewed as an exit from its QE program at this point in time. The PBoC has been forced to shadow the Fed, as the Fed has begun to unwind its monetary policy stimulus. To avoid the capital flight that higher US interest rates triggered, the PBoC has been forced to shrink its balance sheet in relation to foreign exchange transaction facilitation. The portion of the balance sheet that is focused on domestic monetary policy however remains expanded and static. The result of the shadowing of the Fed has been that the PBoC has withdrawn liquidity from global capital markets. This withdrawal of global liquidity has been covered in the meantime by an expansion of monetary policy by both the ECB and the BOJ.
(Source: Bloomberg)
The PBoC recently took the opportunity of the Fed's latest hike in interest rates to signal that the shadowing process has been suspended. The PBoC refrained from following the latest Fed interest rate rise, which is a departure from its decision to hike rates within hours of the Fed doing so last March. In addition the PBoC intervened through government bond purchases for the first time to drive yields lower, in a further signal that not only will it stop shadowing but also that it will diverge from the Fed. The PBoC has thus signaled that it is now focusing more on domestic issues and less on the capital flight risk in the global arena prompted by the Fed.
The timing of the Moody's downgrade is unfortunate, as China has been showing signs of wishing to make some concessions on trade with America. Recently a 117-page document entitled the "Research Report on China-U.S. Economic and Trade Relations" was released by Chinese policy makers. The report signals that China would like to formally stabilize trade relations with America and suggests a number of sectors ranging from agriculture, infrastructure and value added technology where American exports will be given greater access to the Chinese market.
It would seem that China wishes to level the playing field further towards America without damaging its own growth industries with too much competition. It has thus turned President Trump's fascination with supporting the industries and technologies of the past against the American economy of the future. China is now substituting its old economy with American imports, freeing up its own resources to pursue the markets of the future. China would also like to gain greater access to American technology intellectual property, through acquisition, as the quid pro quo for opening up its economy to the sectors that President Trump wishes to promote. President Trump will therefore be able to Tweet a tactical victory, in securing deals for America's old economy, because China no longer wishes to compete in this space.
The Moody's downgrade had the knee-jerk reaction of triggering foreign sellers of Chinese assets. This forced market intervention to support prices by Chinese policy makers. Despite intervention to stabilize Chinese equity markets, market sentiment remained negative and consensus continued to grow that monetary policy will be tightened by too much. This pessimistic view gained support from the IMF's similarly pessimistic view of the growing credit market instability risk in China that may coincide with a failure of the Trump fiscal stimulus to engage. Foreign observers failed to take note of the signal that the PBoC is no longer shadowing the FOMC.
It would also appear that western China observers have overlooked the fact that President Xi Jinping requires an economic environment, that is neither contracting nor expanding too aggressively, in order to make his move to tighten his own grip on the executive later this year when the Party meets to reshuffle personnel. It is therefore highly likely that Chinese policy makers and the PBoC are not asleep at the wheel and blindly walking into a credit crunch. Perhaps to remind observers of this fact, PBoC Deputy Governor Chen Yulu reminded all that monetary policy is "neither loose nor tight"; and is in fact "prudent and neutral" in order to create a "neutral and moderate" financial environment for supply-side reform. The Chinese economy, or at least the official data, is now on a glide path into the Party meeting later this year at which the next economic stimulus in line with President Xi's strategy will be revealed. Doubtless this new stimulus will be consistent with the Belt and Road strategy that has been promoted this year.
(Source: Seeking Alpha)
It should also be noted that despite all the doom and gloom, surrounding the tightening of liquidity in capital markets, that Chinese large cap companies are thriving in this environment. They are deleveraging and their free cash flows are growing.
(Source: Bloomberg)
This should be viewed as a successful outcome of policy makers attempting to administer a dose of balance sheet restructuring to make the economy more sustainable in the long run. It should also be a signal that large cap China can withstand much more liquidity tightening and may in fact become the great consolidator, by acquiring smaller cap companies that cannot live through the restructuring. Large Cap China will thus become Mega Cap China. Mega Cap China will replace the State Owned Enterprises (SOE's) as the driver of economic growth and agent of economic transformation. Mega Cap China will also be able to out-compete Global Large Cap rivals on price in the global arena.
(Source: Bloomberg)
The corollary of this boost in free cash flows can be seen in the stagnating performance of Chinese wages. Stagnating Chinese wages are still growing much faster than global peers, especially in developed markets. Chinese workers can thus feel that they are catching up, whilst their employers can still compete on price globally and maintain healthy margins and positive cash flows. China can therefore continue to compete globally, especially when it is creating Mega Cap scale economies at home which boost pricing power and free cash flows even further.
Readers with long memories will remember the article in this series from December 2015, in which the creation of National Champions strategy was first identified. These National Champions were in the process of creating economies of scale and strong balance sheets, to allow them to compete on price in the global economy. Two years down the road, these National Champions are starting to accelerate away from the pack as China prepares to go global with the Belt and Road strategy. Logically one can expect that these National Champions may also acquire their smaller competitors, if said competitors can create economic value within a scale enterprise. The handles of National Champion and Mega Cap China are inter-changeable for discussion purposes. This process of evolution of large industries is evidently more practical and meets the requirements of scale for economic transitions in the Chinese economy. They are in fact the only agents capable of bringing the necessary changes to the Chinese economy, since scale is required to move the economic needle meaningfully in China. Such scale companies are also a pre-requisite in order to move this needle, so that a smooth transition of power at the Communist Party meeting later this year can be achieved.
(Source: Bloomberg)
China's version of capitalism appears to take a dim view of endless competition, that leads to a waste of economic resources, as small competitors seek to gain a defensible market position from which they can consolidate and grow further. Chinese policy makers have read the classical business school texts on the company life-cycle, only as a form of intelligence about the behavior of their foreign competitors. Chinese policy makers have already positioned themselves and their agents of economic change for scale; and are now looking for new ideas to combine with this scale.
This process of creation of Mega Caps is clearly evident in China's national industrial strategy named Made In China 2025. This should be viewed as the Chinese version of "America First". Made In China 2025 relies upon the subtle influence and intervention from the state to enable its success.
The latest example of the invisible hand of the state influencing competitive outcomes, to create Mega Cap China is to be found in the new energy vehicle space. Following its energy policy, new energy powered vehicles are expected to make up most of new vehicle sales in China over the next decade. This dynamic has spawned a bubble in start-ups that offer hybrid and electric vehicles. In response to this "red ocean" of competition, China will now stop offering licenses for new vehicle manufacturers. The result is that the incumbents, who have carbon legacy infrastructure plants and production, can now swallow up the new vehicle competition as they transition to the new vehicle future. With the exception of America, at the Federal Government yet not the State Government level, most developed nations are pressing ahead with compliance with the Paris Agreement on Climate Change. The global market for new energy vehicles is therefore set to grow. China Mega Cap Auto is thus already in a position to clean up at home and take the challenge abroad.
A clear picture is discernible of how China is trying to achieve its ambitious Made In China 2025 development target, which aims at new industries including electric vehicles. First the central government creates demand by providing fiscal and monetary incentives to consumers. Simultaneously it provides fiscal, monetary and regulatory resources for developers of the technology to meet the demand. A swift start-up bubble is created. Industrial incumbents that deleverage and restructure to follow the Mega Cap strategy are enabled and supported to do so. As the start-up bubble challenges the industrial incumbents, China then cuts off the start-ups and leaves them at the mercy of the incumbents.
To enable Made In China 2025 to go global, the Belt and Road strategy has been developed to provide the interface between China Mega Cap and the rest of the world. Made In China 2025 should be viewed as a significant fiscal stimulus since it involves tax breaks and subsidies. This significant stimulus should therefore be taken into account, when looking at what appears to be a tightening of monetary policy and a liquidity clampdown in China. The tightening of monetary policy is necessary to prevent the Made In China 2025 stimulus from getting out of control and wasting resources in another economic bubble.
To complement the land based initiatives of the Belt and Road strategy, China recently launched the maritime version. This new proposal comes in the form of three ocean-based "blue economic passages" that will connect Asia with Africa, Oceania, Europe and beyond.
This proposal was included as part of what was called the "Vision for Maritime Cooperation under the Belt and Road Initiative" by its originator the National Development and Reform Commission and the State Oceanic Administration.
According to this agency, China is willing to engage in multi-dimensional and broad-scoped maritime cooperation in order to create open, inclusive cooperation platforms with countries along the 21st Century Maritime Silk Road. This cooperation is intended to promote mutually beneficial "blue partnerships" and forging a "blue engine" for sustainable development. China sees "blue oceans" where America sees "red oceans" full of Chinese man-made islands.
The IMF may have discerned a clearer picture developing in China's "blue ocean" strategy, despite the pessimism shown by Moody's. In its latest comments, Chinese growth was revised higher despite a strong warning that China still has to get its heavily indebted economy deleveraged. MSCI's inclusion of some Chinese A-Shares in its emerging markets index shows further confidence in the direction of economic policy in relation to rebalancing towards Belt and Road growth whilst domestic over-leverage is worked out. It is therefore clear that not all American perspectives on China are in the "red".
