Over the past few years, and particularly since the election of Donald Trump as President of the United States of America in November 2016, China-bashing has become a generalized phenomenon in the US.
From the ill-timed and ill-conceived US trade war launched in February 2018 to Wall Street analysts and hedge funds repeatedly predicting the collapse of the Chinese economy, not one day goes by without a negative color being put on the news that come out of China.
The latest example being today’s release of China’s Q3 GDP that came out at 6.5 % instead of the 6.7 % expected and that is presented as a significant slowdown.
But 6.5 % is still way higher than the US 4.1 % and is not due to a massive one-off and financially perilous tax-cut. 6.5 % is actually a strong number considering the natural decrease in growth rates as the Chinese economy matures and becomes the world’s largest consumer society.
To put thing in perspective, 6.5 % of a US$ 12 trillion economy amounts to US$ 780 Billion of GDPbeing added every year, or the entire economy of the Netherlands being added every year.
Yesterday’s report from S&P estimating that Chinese Provinces may have accumulated US$ 6 trillion of debt through investment vehicles was also presented as a major impediment, but no one highlighted the fact that even if the number proved to be correct, when added to the official Chinese Government debt of 47 % of GDP, the total amount would reach 97 % of GDP, or the equivalent of France’s 97 % debt to GDP and way below the US Federal debt to GDP of 105 %, to which the 11 % of GDP of local debt should be added for a proper comparison.
Moreover, in China, and contrary to what is happening in the USA, the vast majority of the debt was created to finance infrastructure projects that are giving the country a productivity edge in the long term and not to finance deficits.
The general tone of western comments about China is negative and fails to put in perspective the achievements of China over the past 40 years.
Interestingly enough, the negative bias of Washington and Wall Street vis a vis China is not shared by American corporations that are doing business with China, whether they are sourcing products and manufacturing there or just selling into the massive Chinese consumer market.
Surely, they all had to adapt to a different culture and different ways of doing things, but overall, a large part of the success and profitability of Americans corporate icons such as Apple Inc. come from the competitiveness and reliability of their Chinese manufacturing partners.
An interesting phenomenon is the divergence in the behavior of the financial markets of the two countries, particularly the stock market.
Since 2009, US equities have risen by 400 % while Chinese equities are still trading at the level they were at back in June 2009.
And this is happening despite the doubling of the Chinese economy from 5 to 12 Trillion USD while the US economy grew barely at 2 % per annum on average over the period.
This unusual divergence translates into massive valuation differentials, with US equities at the top end of historical measures while China is at the bottom of the world markets in comparative terms.
US equities trade at extremes of valuations not seen in a century while Chinese equities are trading at a discount to their own book value.
The main reason behind this abnormal divergence is a general lack of confidence of investors vis-a vis China.
Today, in Dollar terms, US equities represent 40 % of the total pool of equities of the world while Chinese equities represent barely 5 % of that same pool despite the Chinese economy being 2/3 the size of the US economy and is growing 3 times faster.
Granted, China has been slow to open its financial markets and capital repatriation rules are still preventing large institutional money to allocate as much capital to China as they should from a strategic standpoint, but the rules have been relaxed significantly over the past few years and volumes could and should be larger.
What is also surprising is that most Chinese large caps are corporate giants that already dwarf most of their American, Japanese and European counterparts, use the same accounting rules and procedures and are audited by the same western audit firms.
Ali Baba, JD.com, Baidu, HuaWei or Weibo are managed the same way their US counterparts are and their bosses, such as Jack Ma, are as familiar with San Francisco or New York as they are with Beijing.
America fears the growing importance of China politically and economically and worries about being overtaken by a power they do not understand.
Most Westerners fail to understand the Chinese system and therefore do not trust it, but few have actually spend time or studied the Chinese political system enough to venture beyond their negative perception.
And very few would admit that the Chinese political system and governance could actually be more efficient than the traditional western democracies.
But America seems to forget that the US free-wheeling capitalist system has exported to the world the two largest economic crises of the past 100 years, the 1927 crisis and the 2008 crisis, with significant damages to its own economy and to the the rest of the world.
Whether they like it or not, the Chinese system of Governance has enabled it to transform what was the poorest, least equipped, most brainwashed and least efficient economy of the world in 1975 into the second economy of the world in less that 40 years, pulling out of poverty hundreds of millions of Chinese, building the best infrastructure with the latest technology and grooming entire generations of highly educated scientists, researchers, managers and businessmen.
And all this without any major political or economic hick-ups, despite the huge size of its population.
The irony is that China’s political system is the closest thing you can find to America’s corporate governance system, touted as being the best and the most efficient of all times
In the West, a corporation has different stakeholders : Clients, Shareholders, General Assembly of Shareholders, Board of Directors and Executive Management.
Funnily enough, in America the CEO of the Country – The President – is elected by the Clients – The People.
Just imagine any American corporation where the CEO would be elected by the Clients of the Company ! Would you invest in that company ?
In China, the political system is modeled on the same stakeholder’s logic.
The People are the Clients, the Chinese Communist Party Members are the shareholders, they are represented by a General assembly; the National Congress of the Communist Party, which elects a Board of Directors, the Standing Committee of the Communist Party, which in turn designates the executive management; The President, Prime Minister and the Ministers.
In America, anyone can become President regardless of their experience, if they have the clout, money and support of a political party.
In China, no one can become a CEO unless he has the appropriate credentials professionally and intellectually.
In the US, the country’s CEO is elected by the Clients. In China, The CEO is chosen by the Board of Directors.
In the West, CEOs are elected on promises to the Clients. In China they are selected on the basis of their their track record.
Sounds Familiar ?
The very fundamental difference between the West and China is that in China, if you want to get into politics, you join the ranks of the Chinese Communist Party.
Politics is not done on the public place through Fox TV or CNN, but within a highly structured professional organization of 90 million members and 3.3 million local cells the role of which is to manage the country and the mission is to improve the lives of the citizens.
The Chinese Communist Party is an organization that specializes in public policies and trains professionals to become public service managers with the appropriate expertise and credentials.
People are fooled by the word “Communist” which is in inherited from its past, but the only “communist” part remaining is the internal democratic process and centralized organization.
Political Debate does happen in China and final decisions are taken democratically, but they take place behind the close doors of the Party and by Party members who are familiar with the issues at stakes and their consequences.
In a country of 1.3 Bln. people, moving the masses through media communication is a dangerous exercise and may not lead to the right decisions.
Unfortunately, Today’s America fully illustrates the reality of that risk.
A President elected by a minority of the the popular votes imposes to the People by decree and with very few checks and balances decisions that are neither approved by the majority of the citizens nor in their best interest…
Europe’s political systems face the same problems as testified by the rise of Nazism and communism in the 1930’s and the emergence of the populist movements today.
The American and Western political systems have developed an inherent contradiction between the way they run the country and the way their run their private corporations.
No Western CEO can implement a strategy that has not been vetted and is regularly controlled by a Board of Directors consisting of seasoned professionals.
Our Western democracies are still run with a Governance system whereby the Clients are asked every four or five years to choose the CEO.
As if in a US corporation anyone would be suited for the job, be they a simple client or a low level employee, if they managed to convince all the clients that they would do a better job than a seasoned professional.
By contrast, China’s system only propels to the top positions people who have proven credentials at managing cities, regions and ministries and who have an outstanding and impeccable academic background, in exactly the same way top positions at US corporations are filled with people who have impeccable track records and proven skilled and have been carefully chosen and vetted by seasoned Board of directors.
And that explains why China has taken such a considerable advance in infrastructure, planning, economic management and public finances when compared to the West, whereas European countries are paralyzed by their polarized democracies and America is paralyzed by the lack of cohesion of its society.
China Inc. is run by professional people using the same corporate Governance organization our Western corporations use.
China’s rise to world dominance is truly scary for America not because of its economic might, but because a new and more efficient system of political Governance is challenging the perceived superiority of the American model of democracy
Modern Democracies emerged in the 18th and 19th century as a rejection of the monarchic and autocratic systems that had ruled the nations of the world for milleniums.
They gave the power back to the People to prevent the arbitrary of Kings and Emperors through the fundamental principle of the Sovereignty of the People.
The American democracy was the ultimate implementation of the democratic system, eliminating the traditional European classes and privileges and allowing any human being to become a citizen and melt-in the nation if they abided by the rules.
Some adopted capitalism and free enterprise as an economic model while some espoused the utopian communist economic ideology.
It took more or less 70 years for the communist economic models to collapse everywhere – North Korea is the only one left – while capitalism succeeded in creating prosperity and massive increases in living standards.
China experimented both !
Under the guidance of Singapore’ Lee Kuan Yew and inspired by the West economic success, Deng Xiao Ping changed the economic model and kept the Communist Party while reforming its internal processes.
Before confronting China and its Government, Donald Trump and American analysts would do well to research history, his opponent’s backgrounds, achievements and track record over the past 40 years.
America’s fears may be legitimate, but instead of fighting an extremely efficient system, maybe it should find some inspiration on how to improve its own political system.
In a world where military and territorial dominance is no longer the issue and wars have almost disappeared thanks to nuclear weapons, and where knowledge, know-how and technology have replaced oil, gold and copper as the riches of the world, economic and political efficiency are the priority.
The Chinese political system may actually herald a new type of world Governance.
The best illustration of the above is the comparison of the evolution of India and China between 1948 and today.
In 1948, India inherited from Great Britain the best and largest railway infrastructure of the world, an extremely efficient administrative and legal system and scores of civil servants and lawyers educated in the best British universities.
In 1948, China was emerging from a century of decadence, sovereignty abuses by foreign nations, and the plagues of opium and recurring famines.
It had no infrastructure, no industries, a derelict administration and could barely feed its own people.
It spent the next 27 years experimenting to the extreme the devastating adventure of communism that led to the cultural revolution, its 50 million deaths, people brainwashed with ideology and children educated to send their parents to concentration camps.
During that time, the Indias of 1948 split into two countries divided by religion, causing 12 million death, displacing another 50 million and Pakistan split again in two separate nations in the seventies, today’s Pakistan and Bengladesh
Between 1978 and 2018, India operated as a polarized western democracy and China morphed its Communist Party into the current system of political governance, inspired by the West and primarily Singapore.
In those 40 years, China rose from being the poorest country on the planet to becoming the second largest economy of the world, and even the first one in purchasing power terms.
It pulled hundreds of millions of people out of poverty and agriculture. Never in the entire history of humanity such a large number of human beings experimented such increases in living standards.
It built entire industries, banks, insurance companies, universities, technological expertise, it invested massively in infrastructure, built with the latest technologies of our time, and has today the largest and most efficient high speed train network, airports, highways and roads mileage, dams, canals, harbors, internet, fiber optic, nuclear and renewable energy power generation capacity of the world.
Today, 40 years later, at 12.1 Trillion, China’s GDP is FIVE TIMES BIGGER India’s 2.6 Trillion economy.
China’s GDP per capita stands at US$ 8700 4.3 times India’s $ 2000 GDP per capita.
Today, 90 % of India’s 1.3 Billion population still lives in rural areas and survives in agriculture.
Only 34 % of China’s 1.4 Bln population still lives in rural areas and is employed in agriculture
According to the IMF, 23 % of its population is still living under the threshold of poverty with less than 1.25 $ per day.
In China, only 6.5 % of the population still lives under the threshold of poverty.
China has has today 229 civil airports and is adding 75 new ones in the next two years, handling 1.15 Billion passengers per annum, India has 129 civil airports handling 139 million passengers per annum.
We could go on an on with the comparison in terms of highway mileage, trains, aircrafts, power generation capacity, universities, numbers of graduates etc. etc.
The fact of the matter is that the DETERMINING FACTOR that explains the difference in economic and social evolutions between China and India over the past forty years is
THE EFFICIENCY OF THEIR RESPECTIVE POLITICAL SYSTEMS AND PUBLIC GOVERNANCE.
As a polarized democracy, India has had tremendous difficulties in passing the much needed structural reforms and infrastructure investment plans while China’s political system enabled a smooth and efficient global planning, investment, funding and reforms in a country that had no ownership rights, no legal system, no western-educated elite and no infrastructure.
A New World Order
The 2008 crisis marks a turning point in the world economic order and a new long term economic cycle started in 2016.
The Kondratieff cycle of the Chinese Dominance just started and will last for 60 years. It follows the Kondratieff cycle of the American Dominance that lasted from 1949 to 2016, and will correspond to the emergence of China as the next World dominant economic power, in the same way the USA overtook the UK after WWII.
Kondratieff cycles are 60-70 years inflationary cycles that have been identified since the 9thcentury and correspond to new eras of World economic dominance. Think of the Italian merchant cities, Portugal, Spain, The Netherlands, France, the United Kingdom and lastly the USA.
Transitions in world dominance always follow an accumulation of structural factors such as high economic growth rates, sound public finances, quality of infrastructure, quality of education and the mastering of technologies and armaments.
China has been growing at double-digit growth rates for the past decades and even if its growth is bound to decline structurally as the economy matures, it will continue to grow faster than the US economy for the coming decade.
Donald Trump’s tax breaks of December of 2017 amounted to a shot in the arm of an economy that was already on a strong recovery momentum and it yields the fast 4.2 % growth rates of the first and second quarters of 2018.
However, these tax breaks are increasing the public finances deficit at the peak of the cycle, something that has never happened in US history.
Usually, Tax breaks and Keynesian supply-side policies are used at the bottom of economic cycles to kick-start economic growth momentum, and cycle peaks are used to reduce deficits and restore the heath of public finances.
Donald Trump’s Tax cuts will translate into US$ 1.5 Trillion of additional deficit that will ultimately need to be financed. Most experts agree to say that the additional tax receipts induced by stronger economic growth won’t be sufficient or sustainable enough to compensate for the shortfall.
By contrast, China’s public finances are sound, public debt-to-GDP is half the US ratio, China generates structural trade and current account surpluses, foreign exchange reserves represent 25 % of GDP and China’s Capital Formation is four times the level of investments in the USA.
China is the largest creditor of the world and the least dependent on the rest of the world for its funding.
The US infrastructure is old and derelict. It was really built a century ago and the country has failed to invest in replacement and maintenance.
Congress estimates that America needs to invest US$ 1.5 Trillion just to maintain its existing infrastructure and stay on par with the rest of the world in terms of productivity.
By contrast, almost all of China’s infrastructure is new and was built with the latest technologies, giving it an embedded competitive edge in terms of productivity.
China is already ahead of the USA in size and quality in almost every segment of infrastructure. China’s Airports, highways, trains, ports, fiber optic, internet, nuclear, solar and wind power generation, are already of superior quality to the US installations, but are also fully financed.
More importantly, with a population that is four times the size of the USA and where disposable incomes are rising 3x faster than in the USA, China’s future tax receipts and funding capability will be a significant multiple of America’s public finances clout.
In terms of education, China’s Schools and Universities already produce 4 times more university Graduates than American Universities and the schooling system provides better education to larger proportion of the population than in the USA.
In terms of technology, China today has 10 technology giants that compete with the US icons while operating in a much larger market.
China is catching up fast on Big Data and Artificial intelligence, where they benefit from a considerable size advantage.
Artificial Intelligence and Big Data are all about the sheer size of the data you can collect, analyze, frame into trends and build into self-predictive algorithms.
With a 1.3Bln. population, China’s Artificial intelligence capabilities and speed are four times bigger than the US capabilities and it is highly likely that China’s models and algorithm’s will be more efficient much faster than the US ones.
Moreover, most of the hardware, chips, memories, components, conductors, wafers, used in US tech products are manufactured in factories located in China and manned by Chinese technicians.
China already masters aircraft, space, computer, military, medical, construction, engineering, nuclear and renewable energy technologies on par with the US.
But is also home to most of the rare earth elements that are crucial components of all our day-to-day indispensable technological extensions of ourselves.
China is already way ahead of the pack in terms of electric vehicles, mobile payments, online sales and 5G deployment.
Of the 2.1 million electric vehicles expected to be sold in the world in 2018, 1.15 million will be sold in China against barely 350’000 in the USA.
Lenovo is the world leading manufacturer of PCs and 90 % of Apple computers and smart phone components are produced in China.
The Era of the US political and economic dominance of the world is coming to an end and the rise of China to the world leader position is in motion
The dynamics are already in place and they are unstoppable…
The tariffs imposed by Donald Trump are like trying to build a wall on the beach to contain a Tsunami…
During the coming cycle, China’s economy will surpass the US economy in size and its financial markets will dwarf the financial markets of the USA. They will become the main financial markets of the world as Chinese corporations overtake the current US icons in many industries.
And as we demonstrated higher up, China’s political system is proving to be more efficient than the West’s traditional democracies
China’s rise to this predominant role will have tremendous consequences on the world financial markets and the composition of global savings.
Inadvertently, Donald Trump may have accelerated the rise of China to the position of World Leader
Donald Trump’s abrasive methods of Government and lack of respect for other countries have modified substantially the perception and the standing of America in the World.
In an era where technology and the internet is erasing borders and blending the world populations together more than at any time in the history of Humanity, Donald Trumps’ “America First” has made America no longer legitimate to protect the world and defend shared values.
America is more isolated from the rest of the world than it has ever been in the past 50 years and even its closest traditional allies are questioning their ties with an unpredictable and bullying type of Government.
America is also more divided today than it has ever been since the secession war 200 years ago, making its people less strong. The American Dream has been shattered.
The ill-conceived trade war launched by Donald Trump against China has given XI Jing Pin a superb opportunity to champion multilateralism, globalization, cooperation and respect for other nations’s sovereignty.
America’s unilateral withdrawal from several international agreements have left it isolated while the other countries reinforced their cooperation without it, often with the financial clout and support of China.
Even in the case of a change of Government in the US, the damage caused to America’s position of world dominance is irreversible and it will ultimately translate into economic consequences.
A New World Reserve Currency
As the world moves into the Chinese Kondratieff long term cycle the reserve currency of the world will change too, as was the case with the transition between the Sterling pound and the US Dollar after WW2 and Bretton Woods.
As the dominant political and military power, the USA benefitted from what economists call the “exuberant privilege” of having the world reserve currency and being the highest credit risk in a world of FIAT money.
As a result, America has been able to get away with deteriorating public finances and extremely low foreign exchange reserves as the entire world is happy to use the US Dollar as the main trade currency of choice and to use it as the main reserve currency.
US bonds are generally considered to be the safest instruments to store wealth, despite the massive stock of US Government debt in circulation.
America could increase its public finances deficits without limits and without consequences.
The best illustration of the phenomenon is the fact that in 2008, the US exported a major financial crisis to the world because of its own excesses of domestic debt, yet, in the following ten years, the world kept on lending money to the US and buy US treasury bonds by lack of credible alternative.
Another illustration is the extremely low savings ratios of US individuals who are used to live on credit to be compared to the high savings ratios of the Chinese at 35 %.
America is living on borrowed money while China thrives on savings.
But all this is changing fast…
With 1.5 Trillion of predictable deficit at the height of the cycle and another 1.5 Trillion of unfunded, but needed, investments in the coming ten years, when the next economic downturn comes, the US will find it extremely difficult to finance its deficits and investors will start to question their faith in the US Dollar as the best reserve currency and in US debt as the best store of value.
China is completing a major economic and social transition.
Over the past four decades the Chinese Leaders priorities were to pull hundreds of millions of Chinese out of poverty, to achieve agricultural efficiency and to build a solid industrial and service base for its economy.
To create urban jobs and increase living standards, China resorted to the traditional export-led model of development and became the world manufacturer and exporter of everything from clothing, toys, and steel to computers and mobile phones.
Low wages and an artificially-kept undervalued Yuan favored extremely competitive terms for hundreds of millions of Chinese laborers competing head-on with the workforce of the industrial countries in a globalized world.
But the pool of poor workers from the farmlands is now drying up and the agricultural sector now only represents 15% of the Chinese economy today.
Moreover, the export-driven model that has fueled the urbanization of hundreds of millions of Chinese is no longer competitive as labor costs have risen significantly and poorer countries such as Vietnam, Cambodia, or Laos compete at the low added value end of the manufacturing chain.
As was clearly stated by the Chinese National congress in 2013, the priority now is for China to transform herself into the world’s largest consumer economy.
Today, China’s consumption represents US$ 7.17 Trillion, or 58.8 % of its GDP in 2017, against 73 % of GDP in the USA.
Room for consumption expansion is still considerable in China.
Household Debt in China represented 49.3 % of GDP in the second quarter of 2018 against 79.1 % in the USA, where credit cards, mortgages and car loans have been a major drive of economic growth for decades.
As the transition takes place and consumer’s habits evolve with savings ratios diminishing in favor of consumption, China and its 1.37 Billion people stand to become the largest consumer market in the world dwarfing the US consumer market in size.
In the coming decade, the world economy will evolve from a “Made in China” to a “Sold in China”mode and China’s consumers will become the main drivers of the world’s growth.
The export-led development model made China the largest creditor nation of the world with US$ 3.1 Trillion of foreign exchange reserves, or 25 % of GDP.
By comparison US foreign exchange reserves represented US$ 124 Billion last month and never exceeded 1 % of its GDP.
This extraordinary accumulation of China’s foreign reserves is the direct consequence of a pro-active policy of not recycling its Trade and Financial surpluses back into the Yuan and to hoard foreign currencies obtained by selling goods to the world.
Keeping the Yuan artificially low allowed China to keep its labor and export sector competitive for decades, to engineer employment and to facilitate the human migration from agriculture to urban centers.
The sheer size of China’s foreign exchange reserves has become a problem in itself.
As China’s economy matures and relies less on exports and more on consumption, foreign exchange reserves are bound to trend lower towards Japan’s ratio of 15 % of GDP and Europe’s ratio of 10% of GDP. This implies that in addition to the need to recycle its US$600 Billion annual trade surplus in Yuan, China needs to sell circa US$ 2 Trillion of foreign currencies over the coming years to bring its reserves to manageable levels.
In 2013, China started the process of making its currency fully convertible and generalizing the use of the Yuan as an international Trade and Investment currency.
Today, it is actively engaged in making the Yuan an internationally accepted trade and investment currency.
China is one of the most globally-integrated economy of the world and foreign trade represents 42% of its GDP against 22% in the USA. To reduce its exposure to foreign exchange fluctuations, China needs to encourage the use of the Yuan in foreign trade and to develop investments in Yuan.
In December 2015, the IMF included the Yuan in its basket of strategic reserve currencies alongside the US Dollar the EURO, the Japanese Yen, the Sterling Pound and the Swiss Franc.
As a result, 10 to 20 % of the US$ 11.7 Trillion of aggregate foreign exchange reserves held by central banks around the world must shift into Yuan.
This represents another US$ 1 to 2 Trillion of structural pent-up demand for the Yuan.
The Asian Development Bank estimates that Asia needs US$ 8 Trillion to fund infrastructure construction for the next 10 years.
China knows that its long-term development is linked to Asia and the launch of the One Belt – One Road Initiativeby President Xi Jin Ping in October 2013 is a response to China’s neighbors’ huge infrastructure needs.
At the heart of One Belt, One Road lies the creation of an economic land belt that includes countries on the original Silk Road through Central Asia, West Asia, the Middle East and Europe, as well as a maritime road that links China’s port facilities with the African coast, pushing up through the Suez Canal into the Mediterranean.
Key to its success is the development of an unblocked road and rail network between China and Europe.
The project aims at redirecting China’s domestic overcapacity and capital towards regional infrastructure development, improving trade and relations with Asian, Central Asian and European countries and generalizing the use of the Yuan as an investment currency across the whole region.
In October 2014, China launched the Asian Infrastructure Investment Banktogether with 56 other founding members to promote pan-Asian investment. The AIIB was capitalized at US$ 100 Billion and started its operations on December 25th2015. Its objectives are to finance at least US$ 1 Trillion of investments in the region, most of which will be funded in Yuan.
More than 60 countries, representing a third of the world’s economy and half the world’s population are beneficiaries of the One Belt One Road initiative, and the Yuan is bound to become one of their main, if not THE main, trading and funding currency.
In 2013, China started the process of developing its domestic financial markets to allow market forces to take the leading role in the allocation of savings and capital needs.
There again, the development of free and efficient bond and equity markets in China is not a choice but a necessity.
Over the three decades that saw China grow from being one of the poorest country of the world to becoming one of the richest, investments in infrastructure and production were funded by the state-owned banking system and directed by strategic choices of the Government.
As China matures and becomes an affluent society and the world largest consumer market, efficient capital markets and free market forces are needed to fulfill the financial intermediation function and channel the massive pool of savings accumulated by the Chinese towards productive investments.
Enabling Chinese and International corporations to tap Chinese domestic savings to finance their growth is key to the sustainability of the Chinese economy.
Favoring the development of efficient government and municipal bond markets is key to proper and accountable regional and municipal development and the sustainability of China’s social development.
China’s bond market is already the third largest in the world with US$ 11 Trillion of outstanding debtand US$ 60 Trillion in trading volume.
The inclusion of Chinese Bonds into the MSCI Indexes in 2016 and the establishment of the Hong Kong connect in 2017 opened the market to foreign investors and it is expected to unleash in excess of US$ 10 Trillion of net inflows into Chinese bonds as global portfolios start reflecting the size and weight of the Chinese economy in their global asset allocation.
This represents yet another significant source of structural pent-up demand for the Chinese currency in the years to come.
In the past year, the Chinese currency has fallen prey to speculation following the launch of Donald Trump’s Trade war in February.
The financial markets are interpreting the combination of tariffs on exports and a marginally slowing Chinese economy as a reason for the Yuan to weaken.
Indeed, as the US economy is red hot, US interest rates are rising while China’s monetary policy is accommodative and the spread in interest rates does not favor the Ren Min BI in theory.
However, as the longer-term chart shows, The Yuan has been kept at 8.5 to the US Dollar artificially for decades and started to appreciate in 2005 as China was opening its financial markets.
The market panic of 2015 led to a phase of capital outflows and the Trade war has again countered the structural uptrend.
China’s balance of trade exploded upwards since 2004 and the country has generated hundred billions of USD of surpluses every year for the past 10 years.
The interesting part is the fact that over the past three years, the trade surplus has reached record highs and remains structurally at high levels meaning the currency is structurally too low.
As can be seen from the Chart below, Chinese exports are booming and are re-accelerating upwards, testifying of the competitiveness of the Chinese economy and the structural undervaluation of the YUAN.
China’s export problem is structural by nature and Donald Trump analysis of the problem is correct, but the imposing of tariffs will not solve it.
Only a significant appreciation of the Chinese currency will solve it.
To keep its export engine booming and to create hundreds of millions of jobs, China implemented for years a policy of not recycling its trade surpluses into Yuan and to keep them in foreign currencies.
As a result, it built a massive pool of Foreign exchange reserveswhich peaked at US$ 4 Trillion in 2015, or 40 % of GDP.
No country can stay with 40 % of its GDP in foreign exchange reserves, especially if it continues to generate in excess of US$ 400 Bln. trade surpluses per annum.
In sum, the structural forces at play indicate that the Chinese Yuan is about to embark on a one-off, structural and secular path of appreciation, similar to the one experienced by the Japanese yen between 1980 and1990 where its value trebled from 360 to 120 in a matter of 10 years, when Japan was at the exact same stage of its economic development.
But contrary to Japan, the phenomenon will also coincide with the rise of China as the economic and political super-power and the shift in reserve currency and credit supremacy.
This appreciation will be fueled by the US$ 18 to 20 Trillion of pent-up demand for the Chinese currency coming from global investors and foreign exchange reserves rebalancing, and from a generalization of the use of the YUAN in global and commodity trading.
The Chart Below shows the evolution of the Japanese Yen between 1970 and 1995, when Japan was exactly at the same stage of development than China is today, and one can see how the Japanese Yen rose from 280 in 1982 to 110 in 1989, a 157 % appreciation in five years.
And the one below shows how the Japanese Yen rose structurally when the Japanese Trade surplus accelerated sharply in the 1980’s.
Only the doubling of the value of the Yen allowed a containment of the Trade surplus and only its sharp appreciation to 79 in 2010 countered the structural nature of the Trade surplus.
In exactly the way the US Dollar replaced the British Pound when the US surpassed the UK as the dominant economic power after WWII, the Chinese Yuan is bound to become the world’s main reserve, trading and investment currency as China rises to economic dominance in the coming decade.
WE ARE ONLY AT THE BEGINNING OF A POWERFUL PHASE OF STRUCTURAL APPRECIATION OF THE CHINESE CURRENCY THAT WILL MARK ITS ACCESSION TO THE ROLE OF THE WORLD LEADING SUPERPOWER.
The emergence of the World’s largest stock market
China’s stock market had a roller-coaster year in 2015, rising 150 % from October 2014 to May 2015 before falling 40 % by October 2015. Since then it has rallied considerably and reached its 2015 peak again in January 2018 before falling 30 % since then.
China’s stock markets are barely 25 years old while the U.S. stock market is 223 years old. US individual investors have developed an equity culture over generations, Chinese individual investors, although already 110 million of them, are the first generation of investors.
US individual investors keep 40 % of their savings in equities;the Chinese have barely 6 % of their savings invested in the equities.
US shares currently represent 40% of the US$ 76.3 Trillion world equity market while global portfolios exposure to China amounts to less than 5%, despite the Chine economy being already 2/3 the size of the US economy, and en route to surpass it by 2025.
The US Pension fund, insurance and fund management industry is 200 years old, the Chinese insurance and pension fund industry is 30 years old. The development of a pension fund and insurance industry catering for 1.3 Billion people will make it the largest institutional asset management industry in the world in less than 10 years.
In September 2018, China finally authorized local investment products to invest in equities.
As China opens its financial markets and makes its currency fully convertible, and as MSCI increases the percentage of Chinese equities into its Emerging, Asian and World equity Indexes, the proportion of ChineseEquities in global portfolios is bound to rise from the current 5 % to 20 % over time, unleashing US$ 5 Trillion of net inflows into Chinese equities and the Yuan.
In the past few months, and thanks to the new all-time highs recorded in the USA and the 30 % fall in Chinese equities, the valuation differentials between the two equity markets have never been so large.
The US Cyclically Adjusted Price / earning ( CAPE ) ratio stands at a historical high of 31.8 x while China’s CAPE ratio is at 15 x making it one of the cheapest markets in the universe.
Warren Buffet’s indicator of Market Capitalization to GDP puts the US equity market at 133 % while China’s equity markets represent barely 40 % of GDP
On a Price to Book basis, the US market trades at a historical record 3.5 x while the Chinese equity market trades at 0.9 x, meaning that investors are buying into Chinese equities at a discount from their accounting value and with no value put on future earnings whatsoever.
On a simple Price/ Earning ratio basis, the US equity market trades at 21.7 x current earnings while China trades on a 7.2 x earnings, or three times less, despite the higher growth of the Chinese economy.
The day the Yuan starts appreciating, something China will have to resort to and can engineer even with an accommodative monetary policy, global money will flow into Chinese equities and valuation expansion will take place.
If China’s P/E ratio rises from 7.2 x to 18x which is the world global average, China’s market capitalization will increase from US $ 5 Trillion to 12.5 Trillion.
If you add to that a 50 or 100 % appreciation of the currency as was the case of Japan in the 1980’s, the market capitalization will then swell to US$ 18 or US$ 25 Trillion, dwarfing the size of the US stock market and making it the largest stock market in the world.
If you factor is that once valuation expansion takes place, it rarely moves from an extreme of undervaluation to the median, but always goes through an overshoot on the other side, and Chines P/E’s rise to 30x – Japan reached 40x at the peak of the hype – than the figure becomes closer to 40 or 50 trillion.
The nature of the markets and of market psychology is that the three phenomenon described above are likely to happen to a certain extent over the next five years, making Chinese equities the largest and most favored market of the world.
US Equities are peaking…
The longest bull market in the US history saw equity prices increase by 400 % in 10 years and was fueled by extraordinary monetary conditions.
Zero -interest rates for many years and artificially low bond yields have propelled equity valuations to stratospheric metrics.
The 2018 tax-cuts have delivered a shot in the arm to corporate earnings at the peak of the earnings cycle and fueled incremental enthusiasm from individual investors.
Unfortunately, monetary conditions have now turned and the FED raised rates 8 times in the past two years and is now dealing with the need to contain inflation.
Earnings growth will naturally abate in the future due to rising labor costs, higher energy costs and the fading of the one-off effect of the Donald Trump tax cuts.
IN SUCH AN ENVIRONMENT, JUSTIFYING THE CURRENT VALUATIONS WILL BE DIFFICULT.
The longest bull market in the US history saw equity prices increase by 400 % in 10 years and was fueled by extraordinary monetary conditions.
IN SUCH AN ENVIRONMENT, JUSTIFYING THE CURRENT VALUATIONS WILL BE DIFFICULT.
Although we see the main US indexes attempting to make new highs in the coming months, the larger Russell 2000 index and the leaders of the entire 2008 – 2018 bull market, technology, have already peaked and are rolling over.
Chinese Equities are bottoming out
The 30 % fall in Chinese equities since January 2018 have erased in excess of US$ 3 trillion of wealth for no other reason than Donald Trumps’ Trade War.
Economic growth decelerating from 6.7 to 6.5 % does certainly not justify a 30 % fall in equities that are already trading below book value.
China’s equity market fell back to third position behind Japan in terms of capitalization.
Until today, the Government has avoided intervening, letting hedge funds and foreign investors short the market and individual investors liquidate their equity holdings indiscriminately.
The fall is now creating a situation where liquidation of margin positions could send the entire financial market collapsing, creating a systemic risk to the economy.
Today’s sharp rise in the Chinese indexes and straight talk by the Central bank indicates that China is not willing to let Donald Trump’s domestic political motives affect its own economy.
Chinese stocks are exceptionally cheap, certainly the cheapest we have seen in a decade.
China’s economy is not about to collapse.
America is tightening liquidity while China will be easing monetary policy.
China can ease monetary policy while driving the Yuan higher at the same time.
A simple reversion to the mean will send China’s equity market P/E to 14x, i.e, a doubling of the stock market while it will send the US P/E to 15x, a 40 % fall in value of US stocks.
The current undervaluation of the Chinese Stock Market offers a UNIQUE OPPORTUNITY for global investors to position themselves and build their exposure to China for the LONG TERM
SELL US EQUITIES and BUY CHINESE EQUITIES
As Warren Buffet says, don’t buy equities if you are not prepared to hold them for 10 years…
We are NOT prepared to hold US stocks for 10 years but are willing to own Chinese shares for the next ten years.
For the Record
SELL THE NASDAQ @ 7’200
BUY THE SHANGHAI COMPOSITE @ 3000
BUY THE YUAN ( CNY ) @ 6.92
19th October 2018