Forward Guidance

China’s Deflation Trap | Brian McCarthy On The Popping Of The World’s Biggest Bubble Ever

Fri Feb 09 2024

Chinaeconomyinvestment-led growthhousing marketPBOCcredit creationeconomic challengestech sectormonetary policycurrency managementUS-China relations

Description

China's investment-led growth model is facing challenges due to malinvestment, credit accumulation, and geopolitical factors. The housing market is experiencing misallocation of resources, and the role of the PBOC in credit creation differs from other central banks. China's economic challenges include reliance on citizen liabilities, suppressed interest rates, and potential devaluation risks. Shifts in investment and infrastructure funding pose conflicting situations for local authorities. The tech sector faces challenges in achieving entrepreneurship and intellectual property rights. Monetary policy and currency management are difficult due to debt levels and external risks. US-China relations involve trade policy, tariffs, and doubts about cooperation on climate issues. Potential solutions include merging struggling real estate companies and recapitalizing state-owned banks. Future scenarios may involve devaluation, deflation, or currency break. Implications include declining property sales, wealth destruction, and limited global impact. The impact on global markets is minimal except for commodities. The risk of major devaluation in China's currency is currently low.

Insights

China's investment-led growth model is unsustainable

China's investment-led growth model has become unsustainable due to malinvestment and credit accumulation.

China's housing market faces misallocation of resources

China's housing market is experiencing a massive misallocation of real resources, with tens of millions of empty apartments.

The PBOC's role in credit creation differs from other central banks

The degree of credit creation in China is decided by the NDRC, not the PBOC, and Chinese banks are given specific lending targets by the government.

China's economic challenges include reliance on citizen liabilities

China's economy relies on forcing citizens to hold liabilities, resulting in a high savings rate and weak social safety net.

Shifts in investment and infrastructure funding pose challenges

Investment in Chinese real estate is declining, leading to a shift towards other sectors like manufacturing and infrastructure. Funding infrastructure projects becomes more difficult as local government revenues from land sales dry up.

Challenges in China's tech sector and stock market

China's tech sector faces challenges in achieving entrepreneurship and respecting intellectual property rights. The stock market has been collapsing, and shorting Chinese equities has been a bearish strategy.

Challenges in China's monetary policy and currency management

It is difficult for China to ease its monetary policy due to the pressure on the currency and the unsustainable level of debt. Structural change requires devaluing the currency, but there are no signs of that happening.

US-China relations involve trade policy and doubts about cooperation

The Biden administration is more hawkish on China than the pre-Trump bipartisan consensus. There are doubts about China's credibility in cooperating on climate issues.

Potential solutions and risks in China's economic situation

The Chinese government is considering merging struggling real estate companies and recapitalizing state-owned banks. Risks include a sharp devaluation of the Chinese yuan and uncertainty about the market rate for the currency.

Implications and global impact of China's economic challenges

China's economic challenges have direct effects on commodity exporting nations and may affect companies heavily reliant on profits from China. The impact on global markets is minimal except for commodities.

Chapters

China's Unsustainable Growth Model
Misallocation of Resources in China's Housing Market
The Role of the PBOC in China's Credit Creation
China's Economic Challenges and the Value of Liabilities
Shifts in Investment and Infrastructure Funding in China
Challenges in China's Economic Recovery and Technology Sector
Challenges in China's Monetary Policy and Currency Management
US-China Relations and Trade Policy
Potential Solutions and Risks in China's Economic Situation
Potential Scenarios and Future Outlook for China's Economy
China's Monetary Policy and Government Intervention
Implications and Global Impact of China's Economic Challenges
Limited Impact of China's Economic Situation on Global Markets

Summary

Transcript

China's Unsustainable Growth Model

00:00 - 07:53

China's investment-led growth model has become unsustainable due to malinvestment and the accumulation of credit.
Xi Jinping decided to stop this unsustainable path and coalesced his decision around solidifying power for his second term as leader.
Geopolitical factors, such as the Trump tariffs and the great power struggle between the US and China, also influenced Xi's decision.
China is undergoing a structural headwind rather than just a vanilla recession.
The scale of what is happening in China is two to four times larger than previous economic busts like Japan's or the 2008 financial crisis.
China's reliance on bad investments to hold up GDP will make it difficult for them to continue as investment falls.
Unlike the 2008 financial crisis in the US, China can prevent a similar collapse due to its control over credit allocation through state-owned banks.
The risk ultimately rolls up to the government, raising questions about credibility and people's willingness to hold liabilities.

Misallocation of Resources in China's Housing Market

07:23 - 14:37

China's housing market is facing a massive misallocation of real resources, with tens of millions of empty apartments owned by households and developers.
China aims to pivot towards homegrown technology and high-tech investment, but there is not enough technology work happening to make up for the impending real estate slowdown.
The private sector in tech and property will be heavily controlled by central planners, similar to how big tech companies are now closely tied to the state.
The debt deflation process in China may become nonlinear as asset prices fall and people become reluctant to lend money.
Speculation in China's housing market has been rampant, with industrial bosses and coal bosses buying multiple properties for investment purposes.
A survey found that 23% of purchased apartments were sitting empty without being rented out.
Analyzing the actions of the People's Bank of China requires a different framework than analyzing other central banks like the Fed or ECB.

The Role of the PBOC in China's Credit Creation

14:11 - 21:28

The Federal Reserve manipulates interest rates and credit creation to incentivize lenders and borrowers.
In China, the degree of credit creation is decided by the NDRC, not the PBOC.
Chinese banks are given specific lending targets by the government, which are predetermined.
The PBOC's role is to keep the system liquid enough to accommodate the lending volume without devaluing the currency.
Actions like cutting required reserve ratios or injecting liquidity do not necessarily indicate easing; they are often responses to market conditions in order to meet predetermined lending targets.
The PBOC's role is different from that of the Fed because it does not aim to change market behavior but rather acts behind the scenes to make everything work within set constraints.
Window guidance, a stronger policy than forward guidance, was popular in Japan and China, where banks are told how much to lend by someone above the central bank.
State-owned banks in China fund loans through bank deposits, which now exceed $50 trillion and are three times China's GDP.
Capital controls exist because there is limited demand for these liabilities outside of China.
As long as Chinese banks can continue creating RMB liabilities at a high rate, this debt can be sustained indefinitely.

China's Economic Challenges and the Value of Liabilities

21:06 - 28:08

China's economy has been growing at double-digit rates, relying on their ability to force their citizens to hold liabilities.
The property bubble in China was fueled by narratives like urbanization, despite the fact that the population growth had stopped.
The high savings rate in China is a result of the way the system is built, as someone has to hold the large amount of M2 deposits created.
China forces the foreign sector into deficit through trade barriers and subsidies on exports.
The household sector in China holds a significant amount of liabilities due to a weak social safety net and artificially suppressed interest rates.
The stock market in China has underperformed despite high GDP growth, suggesting that their GDP figures may be inflated.
Housing prices in China are expected to decrease significantly, leading people to question the value of the liabilities they hold in Chinese banks.
People in China are increasingly looking to diversify their assets, including buying gold and Bitcoin as hedges against government devaluation.
Bitcoin is establishing itself as a macro asset that can potentially hedge against government devaluation of currency.

Shifts in Investment and Infrastructure Funding in China

27:45 - 35:02

Investment in Chinese real estate has started to fall, indicating a shift away from a real estate bubble towards other sectors like manufacturing and infrastructure.
Sales in the real estate market have collapsed, which will heavily influence construction activity in the coming years.
China is compensating for the lack of investment in real estate by investing in excess capacity, such as steel mills and cement production.
The drying up of local government revenues from land sales to property developers will make funding infrastructure projects more difficult.
The Chinese leadership wants to maintain infrastructure growth while also controlling debt and bad loans at the local government level, creating a conflicting situation for local authorities.
China is increasing its central government deficit but has not shown a willingness to fully take on the debt risk at the local government level.
There is an assumption that bank deposits and local government debts are guaranteed by the government, but if one were to fail, it could have severe consequences for the entire system.

Challenges in China's Economic Recovery and Technology Sector

34:32 - 41:44

The assumption that bank deposits and local government debts in China are government guaranteed is a myth.
Even if the central government had the capacity to clean up bad loans, it would not solve the problem of growing out of the economic challenges.
Xi Jinping's plan to pay back debts through homegrown technology is questionable, as centrally planned systems tend to lack entrepreneurship and can only copy existing technologies.
China has made advancements in certain areas such as smartphones and social media platforms like TikTok, but they also tend to copy technology without respecting intellectual property rights.
While there are some great technology companies in China, macroeconomically, their achievements do not add up compared to the excessive infrastructure development.
The Chinese stock market has been collapsing, and shorting Chinese equities has been a bearish strategy due to misplaced hopes in stimulus measures and a gradual slowdown in growth.
The reopening trade was not as significant as expected since industrial production continued during the pandemic with workers staying at factories.
The consumer economy did recover to some extent, but given China's debt deflation situation, it resembles Japan more than the US.
The property market in China is broken and unlikely to recover, which may not be fully absorbed by the markets yet.

Challenges in China's Monetary Policy and Currency Management

41:26 - 48:39

The Chinese market still has interest rates above 2% despite being in debt deflation.
It is difficult for China to ease its monetary policy due to the pressure on the currency and the unsustainable level of debt.
Reflating and inflating away some of the debt is necessary to reset the system, but it's challenging with a fixed exchange rate against a strong dollar.
China is heavily managing its currency and shutting down the FX market to defend it.
Pumping up the equity market could be a temporary solution, but it may not work in the long term and could have self-defeating consequences.
Structural change in China's economy requires devaluing the currency, but there are no signs of that happening.
External risks include potential credit events in the US economy and Trump's actions towards China.
The Biden administration may have a more hawkish stance on China compared to pre-Trump bipartisan consensus.

US-China Relations and Trade Policy

48:10 - 55:23

The Biden administration is more hawkish on China than the pre-Trump bipartisan consensus, with regards to trade policy and tariffs.
Despite the tariffs still being in place, it has been politically difficult to reverse them even during a period of double-digit inflation.
There are loopholes in the controls on selling machinery to China, as seen with ASML, a Dutch machinery company.
Biden is pressing for cooperation with China on climate issues but there are doubts about their credibility.
The phase one trade deal between the US and China was criticized for not effectively changing China's central planning behavior.
The deal included a list of items that China would buy from the US, but they did not meet the targets and no action was taken.
The speaker is bearish on the entire market and shorting Chinese banks due to concerns about their equity being wiped out.
Shorting Chinese tech stocks is also considered because they are perceived as cheap.
Trading Hong Kong listed China shares can be tricky due to basis fluctuations between offshore and onshore shares.
Chinese banks are being told to lend to property developers despite concerns about their ability to repay loans.
The government insists on using banks for this lending instead of creating a new institution or rolling up debt into existing state-owned developers.

Potential Solutions and Risks in China's Economic Situation

54:57 - 1:02:18

The Chinese government is considering merging struggling real estate companies like Country Garden and Evergrande into a state-owned developer or a new institution.
The government wants to borrow money as a central entity to finish building apartments that were affected by Evergrande's financial troubles.
Rural cooperative banks in China may be rolled into medium-sized banks, which will then be rolled into larger banks.
Bureaucratic foot-dragging by the banks is causing a lack of policy traction.
Investing in Chinese tech companies may be a good opportunity as they are cheap and the war against tech is over.
The Chinese government is hesitant to implement stimulus measures because it could weaken the currency and destabilize the Communist Party.
Historically, devaluing the currency has not been successful for China due to high levels of dollar-denominated debt and controlled exchange rates.
It is uncertain where the market rate for the Chinese currency should be, making it difficult for China to solve its currency problems.

Potential Scenarios and Future Outlook for China's Economy

1:01:50 - 1:08:38

The Chinese market is currently at an off-market rate, and the only way to solve this problem is to reach a market rate.
If China experiences a maxi devaluation, it could result in 20% inflation overnight.
High unemployment and inflation rates could lead to social unrest in China.
The speaker believes that China should have stuck with their devaluation trade in 2015-2016.
The future of China's economy may follow Japan's path of deflation and slow growth if they are unable to move up the value chain successfully.
A currency break in China could occur due to mistakes by the US Federal Reserve or if Donald Trump gets reelected and imposes tariffs on China.
There is a possibility of a sharp devaluation of the Chinese yuan due to geopolitical breaches or actions by President Trump.
The speaker suggests that repegging the currency at around nine and implementing some degree of inflation could help revive industrial profits and manage the debt load in China.

China's Monetary Policy and Government Intervention

1:08:11 - 1:15:25

The Chinese government's current mindset is to hope for a recession in the US, so that the Federal Reserve can lower interest rates and weaken the dollar, making it easier for China to maintain a favorable exchange rate.
If this strategy doesn't work in the next few months, China may consider other options such as manipulating their currency or recapitalizing state-owned banks.
Recapitalizing banks would involve the government taking a hit instead of private shareholders, allowing the banks to issue more equity and increase private sector ownership.
Chinese banks adhere to international regulations for international business purposes, but domestically they are essentially part of the government.
The Chinese government can borrow money from households by selling bonds to banks in order to fill any holes in bank balance sheets.
This system involves writing IOUs to households instead of providing goods and services for their labor.
The Chinese government does not have a large amount of gold reserves like some other countries do. Their US Treasury reserves are considered hard currency capital in the system.
China tried managing its exchange rate by selling reserves in 2015-2016 but realized it was ineffective. They are not doing that this time and only provide smoothing measures with state-owned banks intervening at times.
Sterilized intervention using reserves doesn't solve the liquidity problem because it doesn't change overall liquidity in the system.
China's reserves compared to M2 (money supply) are not impressive, and domestic investors don't want to hold these liabilities anymore.
Using reserves wouldn't solve China's problem since there is around 50 trillion M2 and limited reserve amounts available.
Increasing stimulus by lending trillions of dollars to real estate firms would not be an effective solution because it would require rekindling speculation, which goes against previous decisions made by the Chinese Communist Party.

Implications and Global Impact of China's Economic Challenges

1:14:57 - 1:22:26

China's investment-led growth model is no longer sustainable and will not return.
The Chinese economy is currently in a debt deflation that cannot be fixed without a reflationary devaluation.
Property sales and construction activity in China are declining, leading to further economic problems.
Annual real estate sales in China have already fallen by almost 50% from their peak.
Estimates suggest that the total value of Chinese residential real estate could be cut in half, resulting in significant wealth destruction.
The Chinese economic slowdown will have direct effects on commodity exporting nations like Australia and Brazil.
The impact of a Chinese recession or depression on the rest of the world's economies will depend on their reliance on commodities and trade with China.
The financial transmission mechanism seen during the 2015-2016 period is currently absent due to the absence of currency devaluation.
Companies that rely heavily on profits from China may experience some stress, but it won't significantly affect employment worldwide.

Limited Impact of China's Economic Situation on Global Markets

1:22:02 - 1:24:44

The impact of China's economic situation on the rest of the world is minimal, except for commodities.
China mainly imports oil and semiconductors, which are used in exported products.
The risk of a major devaluation in China's currency is currently low, as indicated by low option volatilities on the RMB.
Being long on the dollar and having calls on the dollar against the Chinese RMB could be a favorable trade.
Brian's work at Macro Lens includes both US macro and intensive focus on China due to their interplay being a nexus of global risk.
The tenuous currency peg and bubble in China amplify the effects of Fed policy.
A big dollar rally and an overtightening mistake by the Fed could lead to a risk-off episode with significant implications.
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