A Chinese Puzzle- something has to give…

While the state of the relationship between the US and the PRC, is undoubtedly the single most important bilateral relationship in the world, and the subject of much heated rhetoric about trade balances, currency manipulation and protectionism, even if the recent meeting between their respective leaders avoided such controversy, it is worth bearing in mind that the Middle Kingdom’s geopolitical stance and economic health matter far more broadly.

In this post, we shall focus on economics and finance. To say that the signals are “mixed” is an understatement.

On the one hand, firms such as Morgan Stanley have recently argued that the PRC will escape the notorious “middle income trap” to join the likes of South Korea and Japan as a high income economy. On the other, concerns exist that a combination of trade protectionism and demographics will thwart a necessary shift from an export-led to a domestic consumption-based economy if the PRC is to continue to increase its GDP at anything remotely resembling current levels. Add in the fact that economic statistics on the PRC’s economy and the health of its financial system are somewhat “opaque”, to be polite, and one has the makings of an unexpected systemic shock which would undoubtedly transmit to the wider global economy and financial system.

However, the FT’s Martin Wolf (“Chinese finance is storing up trouble for the rest of the world”) has recently made the case that the current emphasis on trade is missing the point. Rather than worrying so much about current account deficits or surpluses and trade flows, one should pay attention to the PRC’s capital account and the pressures building within the domestic financial system. While the precise levels disclosed may be “fudged”, there seems to be little doubt that the level of debt (at least 250% of GDP) and its above-trend rate of growth, when coupled with uncertainty about the quality of assets and a potential “Ponzi scheme” within the “wealth management products” sector of an unstable and poorly-controlled shadow banking system are factors that point to real fragility.

Yet, because the PRC still imposes capital controls (and has recently attempted to tighten them) in the face of a domestic savings rate that far outpaces the domestic economy’s ability to absorb it, there is a real imbalance within its economy in terms of capital being allocated into productive investments, versus being “wasted”, and constant pressure to export capital somehow.

So, the question arises as to how the PRC’s government (which is notoriously sensitive about maintaining “stability”, and whose legitimacy depends upon delivering ever-rising living standards) will handle the rising internal pressures to invest outside the country in ways that are not masked and distorted by the current need to circumvent exchange controls, or obtain bureaucratic approvals. The fall in reported foreign exchange reserves by USD 1TN (sic) between mid-2014 and early 2017 is a signal of such tensions.

In reality, the PRC’s government faces a dilemma, because if it continues to impose capital controls, while trying to curb excessive credit, it risks its much-vaunted ability to “manage” growth potentially being compromised, with all the adverse political consequences that entails; whereas, if it relaxes those controls it risks destabilizing its already fragile financial system, while also transmitting that fragility (because of its scale) to the wider global financial system. In short, failing to integrate risks internal stability, while allowing more integration not only risks internal stability, but also that of the wider world.

Such issues require careful and calibrated management, not soundbites or rhetoric “for domestic consumption”- whether in the PRC or the US.

At Awbury, we believe that, while there are significant opportunities in carefully-selected risks in the PRC and Asia as a whole, accepting them without understanding the wider context and the real macroeconomic and geopolitical factors that have longer term consequences is simply foolish.

The Awbury Team

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Dear [Donald]… Yours sincerely, Theresa…

Well, she finally sent “The Letter”. In the same week that the EU celebrated the 60th anniversary of the Treaty of Rome, Prime Minister May’s formal letter triggering the so-called Article 50 process was delivered by hand to Donald Tusk, President of European Council, last Wednesday. Perhaps not surprisingly, after a lengthy build-up, the earth did not move, and the Pound Sterling only wobbled slightly and then strengthened.

Nevertheless, the act is far more than symbolic, because no-one really knows what the outcome will be, other than that, supposedly, by the end of March 2019, the United Kingdom (assuming it is still “united”) will exit the European Union. This will occur (absent some miraculous volte-face) whether or not it has managed to agree the terms of that exit with the remaining 27 Members (and assuming no-one else decides, or is forced to follow the same route beforehand.)

As we have written before, it is debatable that Her Majesty’s Government has the capacity (in a literal sense) to negotiate in depth all the various issues that should rationally be addressed before the latter-day “break with Rome”. In explicitly rejecting retaining membership of the Single Market, the letter acknowledges that, if no agreement can be reached on, say, trading and economic relationships, the “default” position is that the UK would have to trade on WTO terms, something that would be less than ideal in every sense for an economy that has benefited significantly from the web of treaties and agreements that the EU has in place.

Of course, there are also legitimate concerns that the UK’s status in the world will be diminished, and that its citizens will become relatively and absolutely poorer than would have been the case had Article 50 not been triggered. Yet, consider the fact that the EU’s own economic-and-monetary affairs Commissioner has admitted that Greece’s GDP has fallen 45% (sic) since 2009 and that unemployment is 50%, arguably because the country’s political class willfully allowed it to be hung upon the cross of the Euro. This is believed to be the worst performance ever by a country hitherto classed as Advanced. So much, for not going the “Grexit” route.

The UK’s negotiators will likely face something of an hiatus until this autumn because of the electoral and political situations in France, Germany and Italy, which adds further pressure to a timetable that is, in reality, going to be impossible to meet in terms of delivering a well-crafted and comprehensive “separation agreement”.

And whether it likes it or not, even if, as the phrase goes “Fog in the Channel, Continent cut off”, the UK is part of Europe, by far its largest trading partner; so it will always be affected by decisions made by European institutions in which it will no longer have a voice. Splendid Isolation is a nonsense and a fantasy, while the prospect of creating some sort of preferred trading relationship with an increasingly protectionist US Administration is decidedly uncertain- even if Mrs. May got the handshake that the far more powerful Ms. Merkel did not.

All in all, the negotiation of “Brexit” is going to increase uncertainty; and potentially de-stabilize an arrangement (the EU) which, for all its faults, has done an admirable job of forestalling Europe’s periodic descent into chaos and of raising the living standards of most of its members.

From Awbury’s point of view, the uncertainties are simply another factor to be taken into account in our constant analysis and monitoring of the risks to which our portfolio is exposed; while at the same time, the probability of unexpected outcomes has a habit of generating dislocations which provide new opportunities. So, nothing new there!

The Awbury Team

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