Policy-makers in China changed direction by implementing new security measures in Hong Kong and removing a target for GDP growth. Despite these decisions, which have been met with alarm by some investors, select Chinese assets continue to be relatively attractive, especially when compared with other EM assets. Yet, market dynamics will depend more on how DM countries manage their exits from lockdown.
Delayed by the Coronavirus pandemic, the annual National People’s Congress (NPC) meeting that started May 21 revealed a meaningful shift in Chinese policy, both in terms of domestic growth strategy as well as Beijing’s engagement with the rest of the world. The local focus as a response to the pandemic’s economic losses is in line with other EM countries, highlighting that countries are turning domestic in a crisis-stricken world with little global coordination or leadership. Despite these decisions, which have been met with alarm by some investors, select Chinese assets continue to be relatively attractive, especially when compared with other EM assets.
Geopolitics of Hong Kong Security Law
The overarching decision was the implementation of a new security law for Hong Kong. Coming on the back of mass protests in 2019, huge GDP losses, and the sensitivity of Hong Kong’s special status as a global financial centre, it is a remarkable show of force. The domestic political signal is clear that the leadership in Beijing will not tolerate any dissent outside of the Communist party. For investors, the international ramifications are more relevant as this is an unequivocal message to the US that the bilateral rivalry is going to escalate and it is a show of political muscle too. Do not be distracted by the commitment to maintain the Phase 1 trade deal, as that is simply an effort to calm tensions until the US election in November.
Given the lack of urgency on the matter, China’s active choice to break implicit red lines reveals that Beijing views itself in a position of strength in the post-Covid world, especially vis-à-vis the US. The inescapable conclusion is that we are about to enter Trade Wars 2.0, i.e. spill-over into capital markets with the possibility of morphing into global Cold War 2.0. We have been highlighting this risk since 2018, noting that US measures could be “structured to raise or lower incentives of investment into particular asset classes or financial instruments”.1 In this regard, the initial shot of the US Federal Retirement Thrift Investment Board (FRTIB) to exclude investments in global indices with China A-Shares exposure was a harbinger to come. The FRTIB decision was only going to affect about $15 billion of exposure to China, but if other US state pensions follow suit, that would rise to about $22 billion. The major shift in rivalry is from goods and services trade (that started during China WTO days) towards technology (Huawei etc.) and investments.
Until today, the assumption had been that Hong-Kong listed shares as well as US-listed ADRs of Chinese companies could evade such measures. The NPC’s announced imposition of the security law makes that unlikely. Hence, total affected US assets could easily exceed $100 billion, which would need to find exposure elsewhere, primarily in the home equity market. Nonetheless, we see this as a gradual reallocation, and bearing in mind that Chinese investment in US equities is likely to decline as well over the same period, cancelling out some of the changes in flows. But as with the trade wars, the real damage could be across emerging markets, even if there are selective winners benefiting from such reallocations.
Domestic Stimulus Package And Removal of Growth Target
The other signals from the NPC regard domestic economic policy and are equally significant. First, the removal of the growth target under the pretext of the pandemic removes a major policy constraint in Chinese policy making. That target is unlikely to come back even if the removal was couched within the Covid-19 crisis. Instead, we can expect a policy framework that is more flexible to address structural issues over time, now being liberated from a quantitative straitjacket. As indicated in his 2020 opening speech by Li Keqiang, domestic, balanced growth in a modernised technologically progressed China is a priority. The post-Wuhan rhetoric from Chinese leadership has been gradually de-emphasizing the growth target which was considered a sacrosanct metric for China to achieve. As we argued earlier2 , China and other Asian countries need education and labour reforms to focus on productivity and technological contributions to growth distribution. A better target of focus for many Asian countries facing the middle income trap is GDP per capita rather than GDP growth.
For 2020, the clear priority is job creation and the main vehicle will be greater indebtedness to achieve it. The upside is that generating employment numbers is much easier (especially if you countenance greater fiscal deficits) than affecting GDP. The permission for local governments to increase borrowing as well as both the monetary and regulatory easing for the financial sector means Chinese debt levels will continue to rise to new records, likely to far exceed 350% of GDP of combined government, household and corporate debt. In a debt-swamped world, this will mean competition for creditors amid a sharply lower growth rate.
The geopolitical effect will only be felt in 2021 and beyond. The US election rhetoric on China will be shrill but policy action limited until after the election. We therefore expect the Renminbi to remain range-bound as a result, perhaps with a slight downward bias at least till year-end.
More short term, it would be a mistake to think the geopolitical rupture would make Chinese equity allocations any less appealing. The diversification benefit is likely to remain high, though continued outperformance in the coming months will depend on how DM countries manage their exits from lockdown.
Similarly, the geopolitical fallout into capital markets suggests that Chinese bond spreads over US Treasuries should widen in the future. Domestic stimulus measures will inevitably lead to higher debt ratios which will matter in the context of a semi-closed capital account, so longer-term yields would need to rise. The inclusion of China in benchmark bond and equity indices is making investing in Chinese financial markets more accessible and will ensure strong capital inflows at least through 2022.
1 De Montpellier, Hentov and Petrov, “Desperate Measures: The Next Downturn and How Policy Makers Will Respond”, State Street Global Advisors, September 2018, p. 11
2 Roy, A and Le, A (2018), “Asia at a Crossroads: Demographics, Economics & Investment”
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