China’s Economic Shift: Moving Away From Global Integration
We’re going to spend December looking ahead at 2024’s prospects. We have an optimistic outlook for many global markets: in coming weeks we’ll describe why we’re bullish on Japan and India in particular, as well as giving our outlook on the United States.
But today we’ll start with perhaps the murkiest of our year-ahead interests: China. What is the general landscape for investors in China? With Chinese markets in the doldrums, do we see opportunity, or a red flag? To tip our hand, we don’t generally view China as fertile ground for investors (more about that below) -- but its outsized influence on global markets and economies means that it’s essential to watch. That’s a major reason why we write about it.
China Downgrade
A topic we’ve been mentioning for years -- China’s slow-motion descent into the economic troubles brought about by overleverage, deteriorating domestic policy, and geopolitical tensions -- is entering more deeply into the mainstream. On Tuesday, Moody’s revised its outlook on China’s government credit ratings to negative from stable. This change underscores the global concern over rapidly rising local government debt and the deepening property crisis in the world’s second-largest economy; this suggests the need for greater financial support for debt-burdened local governments and state firms, presenting broad risks to China’s fiscal, economic, and institutional strength.
The situation is further complicated by persistently lower economic growth and ongoing retrenchment in the property sector. China’s equity markets have fallen to nearly five-year lows, reflecting concerns about the country’s growth trajectory (as well as a lack of domestic appetite for speculation, which is one of the primary drivers of the Chinese stock market). The cost of insuring China’s sovereign debt against default has also risen.
Despite maintaining China’s “A1” long-term local and foreign-currency issuer ratings, Moody’s anticipates the country’s annual GDP growth to slow down significantly in the coming years, with projections of 4.0% growth in 2024 and 2025, and an average of 3.8% from 2026 to 2030. This outlook revision comes ahead of the Central Economic Work Conference (an annual meeting held in China which sets the national agenda for the economy and the country’s financial and banking sectors), where advisors will likely call for a steady growth target for 2024 and increased stimulus.
Analysts note that the A1 rating remains high in investment-grade territory, and the downgrade will not trigger forced selling by global funds. But still, it is a significant change.
The Chinese economy’s struggle to mount a strong post-pandemic response has been exacerbated by various factors, including the crisis in the housing market, local government debt concerns, slowing growth, and geopolitical tensions. These have collectively dampened the momentum of the economy, which is continuing to decelerate from its historic phase of rapid expansion.
Local Government Debt
China is grappling with a hidden debt crisis as local governments -- cities and provinces -- have accumulated off-balance-sheet government debt estimated at $7 trillion to $11 trillion. To address the issue, Chinese authorities are swapping hidden debt for new government debt; local governments are urged to issue special refinancing bonds to replace off-balance-sheet debt, with about $200 billion raised so far. Experts believe that a more substantial debt swap of around $700 billion may be needed to resolve the hidden debt problem.
JP Morgan recently wrote an extensive report on China’s LGFV debt problem, estimating this debt has grown to over 60 trillion renminbi, and represents almost half of China’s government debt.
Source: Morgan Stanley Research
This problem has been apparent for many years, but seems finally to be coming closer to a boiling point. Analysts long assumed that debt taken on by localities would eventually make its way to the central government’s balance sheet. The reason that may be problematic is described below. The imbalances create the specter of an intolerable currency crisis, and in response to that threat, China is intensifying its efforts to isolate its financial system from the rest of the globe -- efforts that we think are ultimately doomed to failure.
Key Economic Concerns
Historically, China was known for its robust economic growth and integration into the global market; however, in the last decade, the Chinese government’s emphasis on maintaining a stable currency has led to an enormous accumulation of domestic money supply. As a preventive measure against destabilization caused by internal debt problems, and against capital flight from China as corrupt oligarchs try to move their wealth to the west, China has increasingly resorted to financial isolation, limiting both incoming and outgoing financial flows.
Symptoms of the Problem
This is evident in various economic policies and practices. For instance, there has been a noticeable tightening of controls over remittances by households and businesses. The government has also imposed stringent restrictions on fundraising activities and set quotas on imports. Though they have a political dimension, these actions are more primarily economic, aiming to control the domestic financial ecosystem and prevent the externally originating economic shocks that periodically trouble more open developing-market economies.
China’s Financial Landscape
China commands a substantial portion of world GDP and international trade. Despite this, as we have described in many letters, the country has maintained a financial system that is far more tightly closed than other global economies its size. The Chinese currency plays a minimal role in global foreign exchange markets (nor can it as long as the Chinese regime maintains total domestic control). Furthermore, the foreign ownership of Chinese assets is surprisingly low -- far lower than it should be given the country’s global economic importance -- showing the limited characters of China’s international financial integration.
A closed capital account, where a country restricts the flow of capital across its borders, is nothing new. However, China’s approach stands out for its rigidity, and for its persistence given the growth and influence of the Chinese economy. It is a profound outlier in the trajectory of opening that typically occurs as countries advance along the path of economic development. Its closed capital account is one of the most restrictive among major global economies.
Source: Emerging Advisors Group
Recent Developments and the 2015 Turning Point
2015 marked a turning point in China’s economic history. The country, which had consistently seen a surplus in its balance of payments, began experiencing massive capital outflows. These outflows were so significant that they prompted the government to initiate a regime of tighter financial and capital controls, in order to curb the sudden and substantial outflow of money -- which could have led to severe economic instability or a currency crisis. This was two years after Xi Jinping’s accession to power; it is hard to avoid the conclusion that his political adversaries -- mainly the competing oligarchic blocs of previous leaders, their political coteries, and their children -- were working overtime to get their wealth somewhere beyond the new regime’s reach.
Source: Emerging Advisors Group
Impact on Current Account Transactions
Notably, China’s restrictions have extended beyond capital account transactions to current account transactions, which typically include trade in goods and services. There has been a deliberate slowing down in the growth of import volumes, and restrictions have been placed on international travel and tourism expenditures. These measures, though economic in nature, reflect the government’s intent to control the flow of money and safeguard their control of the economy against external vulnerabilities.
No Credible Exit Strategy
One of the most challenging aspects of China’s current economic policy is the lack of a feasible exit strategy. The large volume of domestic liquidity -- large and growing rapidly in response to mounting internal pressures -- poses a significant challenge. Opening up the economy to global financial flows would destabilize the currency; this is an eventuality we have often referred to when we suggest that the renminbi is vulnerable to a severe and chaotic decline within the next five years.
The delicate balance between maintaining currency stability and supporting economic growth makes it exceedingly difficult for China to reverse its path towards financial isolation without encountering substantial economic disruptions. Eventually, China will learn a hard lesson about capitalism: namely, that every form of capitalism is vulnerable to stresses beyond its control, and cannot exist and develop without periodic crises of one sort or another -- and the more draconian the attempts to clamp down on the emerging stresses, the more problematic the ultimate resolution is likely to be.
Conclusion
China’s journey from the pursuit of global integration (on its own terms, to be sure) to a stance of isolationism (coupled with a certain geopolitical belligerence, as is often the case during such a transition) is a significant development. While the country’s policy goals have often been aligned with a form of global economic integration, its recent practices tell a rather different story. This shift towards deeper financial, economic, and geopolitical isolation has profound implications for the future of China’s economy.
Because of the relatively minor size of China’s equity market compared to the Chinese economy, it is driven much more by sentiment and liquidity than by fundamentals. While we caution against any strategic commitment to Chinese equities, they can make tactical sense, but only when momentum shows that domestic speculative appetite is active. Current developments continue to reinforce our view that investment exposure to China should be a short-term proposition with a tight stop.
Finally, we’ll reiterate what we wrote two weeks ago: “Many of the shares of Chinese companies that trade as ADRs on U.S. exchanges are in fact issued by variable interest entities (VIEs) domiciled in jurisdictions that are not known for the easy availability of legal redress for investors. In short, when you own such a security, you should not think that you own a share of a company in the direct way you do when you own a U.S., European, or Japanese stock.”
Thanks for listening; we welcome your calls and questions.
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