On 24 September, China’s central bank pivoted and initiated aggressive monetary easing, cutting the policy rate by 20bps and reserve requirement ratio (RRR) by 50bps. Added to this, there was support for the property sector with banks having to lower mortgages rates (50bps) and down payments for a second home lowered to 15% from 25%. Furthermore, many existing support measures will be extended until the end of 2026.
Finally – and this may be the most surprising policy announcement – there was support for the equity market. This will be a RMB500bn swap facility for brokers and funds to buy stocks, allowing them to swap a more illiquid asset for cash that can then facilitate equity market activities. On top of this, it will also set up a RMB300bn refinancing facility, through which banks and brokers can lend cheaply to companies to allow them to do share buybacks (with the opportunity to expand this facility).
All these policies were followed up by a press conference at which the message from the authorities was clear – we want growth and we want the equity market to go up.
Reaction to the market reaction
We saw a very strong reaction in the Chinese equity markets. Our sense from speaking to brokers is that much of this was driven by short covering and buying via futures funds as there was a strong need to manage underweight/short positions.
The big question is: ‘Will this be the turning point for [China’s] economy and the inflection point for the equity market?’. We do not believe this will be the case
The big question is: ‘Is China firing the so-called ‘big bazooka’ and will this be the turning point for its economy and the inflection point for the equity market?’.
We do not believe this will be the case. However, an aggressive easing policy on the monetary side is very likely to be a necessary condition for easing the pain in the economy, so from that perspective, it is a positive.
In many ways we think this monetary easing is overdue as deflationary forces have clearly been in play for some time. To make a real change from a structural growth perspective, we believe China has reached a point where strong monetary easing needs to be matched with additional fiscal support. This would be more likely to boost the demand side of the economy in the short term and break the negative spiral on consumption and asset prices.
Our long-held view is that China is highly likely to enter a similar form of debt/deflation as played out in Japan in the late 1980s/early 1990s and for most of the following decade (or longer). There are differences between China today and Japan back then, but there are also a number of similarities.
Put simply, in our view China’s business model is broken. Mass manufacturing and export via cheap government-negotiated industrial land – and all the related support – funded by ever-reflating residential land has broken down. This was caused by a combination of higher wages, a significant drop in productivity, massive overcapacity in many industries and what we see as ‘strange’ domestic policy initiatives (from the Communist party – particularly President Xi – and above all private entrepreneurs). Then there is geopolitics, particularly a massive backlash from the west against China trying to dump its overcapacity in the name of being a mercantile nation. These factors have broken the business model, in our view: at the very least, it has been severely impaired.
There are a few growth pockets in China where, as stock-pickers, we are finding opportunities. We see China becoming an exporter of consumer and capital goods in the years to come, with growth coming mainly from the broader emerging market countries, or what might be described as the ‘global south’. This comes from our ‘New Multipolar World’ view, which we have spoken of often in client meetings, presentations, webcasts and monthly reports. It is important to highlight that these trends will not happen quickly, so we do not expect a sharp deterioration in China’s domestic economy, nor do we expect Chinese exports to the US or Europe to collapse overnight. Instead, we would describe this more as death by a thousand cuts. The US/China trade model was (and still is) sizable and it will not unwind fast, but the point is that there will be a relatively strong negative second derivative, i.e. a negative delta in these trends.
China is between a rock and a hard place. The political situation and deflation are biting into the Chinese economy which has spilled over into weak consumer sentiment. The consumer has a very high savings rate and animal spirits among entrepreneurs seem absent. We are in the Austrian School of Economics camp whose chief advocate, Friedrich Hayek, described such a situation as “secondary deflation”: increased liquidity leads to further weakness in demand and the only potential short-term solution is a Keynesian-style fiscal stimulus to force a move in demand.
Why has China been so slow to react and why are we not seeing fiscal stimulus already? This is where we believe the ‘hard place’ comes in. China, particularly Xi, sees itself on a mission to be a superior technology-driven economy that will challenge and even overtake the US on the global stage. In that way China is seeking to be the equivalent for the BRIC+ countries of what the Bundesbank was in the old days for Europe, i.e. all surplus capital is recycled via this one institution. You also reach the status of the Fed, with global monetary policy influence and even access to seigniorage as a move towards the global south/BRIC+ – think here of a digital renminbi and China’s Belt and Road policies.
For this to play out, you need a strong balance sheet and this is China’s dilemma. If it uses monetary and fiscal stimulus, it risks the ‘new Bundesbank’ status it has been trying to establish. It also risks further deterioration of its balance sheet which is not in great shape in the first place, although it has some debt capacity at a central government level. In addition, we understand that Xi despises the US model of bailing out private companies and supporting consumers as you end up with the wrong consumption and too much debt. However, past policy mistakes are catching up and not using the classic set of tools is becoming problematic for the longer-term political strategies – hence being caught between the rock and a hard place.
In our view, Xi still believes the old model works and just needs a few adjustments. One such is going for higher value-add products and technology self-sufficiency, which explains Xi going all-in on a tech-nationalistic strategy. Naturally, we do not have a problem with economies trying to move into higher added value areas, but we fear this is almost doubling down on the old playbook by potentially creating a new set of industries in which China creates overcapacity. This, and the way it is communicated, also risks adding to geopolitical tension – in the end, this feeds back to the return on assets and how this matches up with the liability side of the country’s cashflow requirements. Another risk is of pushing consumers into having a higher propensity to save as they feel the increasing uncertainty.
New China/old Japan
In overview, we see a high risk that China has entered a Japan-style lost decade scenario as far as economic growth is concerned. Given its command-style economy, there is a chance it can move out of this debt/deflation trap faster than Japan did, but we think rebasing such a significant debt build-up and asset inflation bubble (property) in such a large part of the economy will take time. Stimulating the economy can help and we are not saying China should not stimulate; we are simply arguing this economic situation is beyond being fixed with rate-cutting.
Japan had very low/zero rates for a very long period and it did not bring growth back. It is also interesting that the Bank of Japan was slow to react to deflation, as a large part of the market had clearly identified the asset deflation bust, just as we think the People’s Bank of China has been.
Japan’s economy in the 1990s and China’s now both had extremely high savings rates, structurally little consumption and huge investments in manufacturing where the overcapacity was exported, all in the name of being a mercantile nation. Assets were (are) reflated (inflated) and involved a system of an extremely cozy relationship between government and large industrial conglomerates – the keiretsu structure in Japan and state-owned enterprises (SOEs) in China both suffer from the concepts of return on invested capital and cost of capital.
What is the potential positive outcome from China’s momentary stimulus? Japan had a huge clash with the US which played a part in bursting Japan’s bubble and wrecking its business model. However, Japan and the US made up and, with a great deal of commitment to setting up manufacturing plants in the US and so on, corporate Japan was able to get back on its feet. China is now in a similar situation but given how deeply rooted the geopolitical tension is now, the likelihood of the US and China making up is slim.
China’s hope will, in our mind, very much be to go for a model based on exports to the ‘global south’ as a growth opportunity. However, it will take a long time for these consumers to replace the US consumer, which is why we do not see a quick fix from current projected policies where the main toll is cheap and easy monetary support. This might keep the ship afloat but it is unlikely to move it forwards at any real speed.
If Jorry was President…
What would our policy advice be to China? Accept you will never be a new US or a central bank for the rest of the world. Instead, focus on generating a consumer-driven economy and reallocating capital away from those industries with excess capacity. Repair global relations, and play by the global rules which are dictated by the US, for better or worse – but we understand this is a massive ask.
China needs to create a Mario Draghi “whatever it takes” moment times 10. The central government needs to absorb a huge debt burden, by taking on debt from local municipalities and giving them a tax level that allows them to fund their requirements and services as they can no longer rely on land/property selling. SOEs need to be reformed so they provide returns – before eventually becoming privatised – and social support is needed for employees who will be made redundant. Productivity needs to go up, which is not about one smart AI company or similar. This is dealing with a huge set of industrial complexes (SOEs) driven by non-economic return policies, which Xi has not been willing to reform in the name of control and security.
Excess housing stock needs to transferred overnight into social housing. This ‘mother of all fire sales’ will be expensive, but will clear out the excess and is a way to create social prosperity as a huge part of the population still has extremely poor housing facilities. China needs to dial up its Hukou reform to create a more dynamic society.
Essentially, we would encourage the government to bring freedom back to the private sector and take the Communist Party out of the boardroom
Essentially, we would encourage the government to bring freedom back to the private sector and take the Communist Party out of the boardroom. We need a new Deng Xiaoping to repeat: “To get rich is glorious”. Lately, we have seen leading companies trying to talk down their share prices so they will not be in the firing line from the Communist Party. Finally, it needs to credibly rebuild trust with countries in the west, accepting that aligning with Russia and coveting Taiwan does not lead to support from the biggest economies in the world.
Are the above policy suggestions easy to implement and political acceptable for China and Xi? No. This is precisely why we keep a significant underweight in China in our Polar Capital Emerging Market Stars and Asian Stars funds and focus instead on selective stock-picking, where we see the companies that can take advantages of a growth pocket, such as digitisation and software or healthcare products, that we believe can be found in China. Our base case is for a very slow-moving economy, a large part of which will be faced with deflationary pressures, with some pockets of growth that can be monetised by high-quality private sector companies, or Chinese companies that find strong, niche markets overseas where they can be competitive in geopolitically low-risk countries.
Conclusion
As ever, to the best of our abilities we manage risk around what we currently see as a structural underweight. Given the extremely weak sentiment and low weighting in Chinese equities by investors, there will likely be periods of strong rallies, some of which could well happen around the announcement of this new stimulus, in the coming years.
Risk management around events is very difficult and we cannot give any form of guarantee that we will be successful here: our investors should expect periods where we lose relative performance by being significantly underweight Chinese equities. However, we are in a situation now in which we are finding many attractive opportunities across our emerging market and Asian equity universes and we feel comfortable – our long-term performance record should hopefully be a strong guide – that we can deploy capital very well in this part of the world and generate responsible returns by finding our ‘Star’ companies. Over the next few years, we feel it highly likely there will be more Star companies, on a relative basis, outside China than inside.
