New York | In this issue of The Institutional Risk Analyst, we continue our discussion with a long-time reader and a corporate finance and risk officer who has decades of experience in New York, China and Korea.
The IRA: When we last spoke you were explaining how China is ‘weaker’ than many in the West perceive, and that weakness in turn influences China’s actions. How does this play into what we are witnessing in the current trade war?
Ricardo: China’s economy was facing challenges and had been slowing before the trade war with the US erupted, but the trade war certainly does not help. The GDP growth rate has been declining for years, but is now touching 27-year lows. China is structurally over-invested in manufacturing and real estate development capacity. Over-investment and unproductive investment leads to low and even negative productivity growth. And these ‘investments’, when uneconomically viable, lead to bad debts, which by many estimates have been increasing, separate and apart from the recent trade war impacts. China’s overall official debt levels continue to worsen. Unofficial estimates from International Institute of Finance and others place China’s debt at more than 300% of GDP. Truth is, given the government’s heavy involvement State Owned Industries and Town Village Enterprises, along with the government simultaneously owning banks, pension funds, and common corporations, and one branch of government lending to another, no one really knows China’s debt level. Worse yet, from a risk perspective, the cross-lending concentrates risk, rather than dispersing it. If the trade war was not happening, I suspect more discussions in financial circles would be focused on China’s debt problems.
The IRA: The figures you cite seem to support the “China is weak narrative.” We've been fascinated by the absurd saga of heavily levered conglomerate HNA, which seemed to place unacceptable burdens on China's payments system. What action can Xi Jinping and the CCP do then in its spat with the US?
Ricardo: The US just slapped billions of dollars on Chinese goods, and China retaliated with more tariffs on US goods. The impact is as would be expected, with the trade war hurting industries on both sides. But for Xi Jinping and the CCP to buckle under perceived foreign pressure would politically damaging in front of their domestic audience. Especially with the 70th anniversary of the founding of modern China approaching in October – China needs to project strength. One would hope and expect that quiet negotiations were going on behind the scenes and out of the limelight to reach an accord, but even here we face unique constraints. On the Chinese side, Xi Jinping has tightened ideological control in all aspects of life, demanding that the party line be strictly adhered to, which means information is getting filtered much more before it gets t o the top. This is partly why China misread Trump. And on the US side, Trump equally disdains expert opinions and old “China hands”, meaning back-door channels are fewer than at any other time in the last forty years. This leads to a higher risk of wrong decisions or mistakes.
The IRA: That does not sound promising.
Ricardo: What I am highlighting in possible “wrong decisions and mistakes” are tail risks. Most likely path involves cooler heads prevailing and a more modest path. The real question is when do US consumers, farmers and manufacturers feel the pinch and voice their concerns, such that political pressures start to sway Trump?
The IRA: And Hong Kong? What are we to make of the events there? Certainly seems that the Trump trade measures have contributed to popular protests against Xi and the Chinese Communist Party.
Ricardo: The protests in Hong Kong are not like the ones in Tienanmen thirty years ago, but there are important lessons to be learned. The protests in Tien-an-men thirty years ago posed an existential threat to Communist rule. There were visible fissures in the politburo leadership between Zhao Ziyang and Deng Xiao Peng; local military was not believed to be reliable towards putting down the movement, thus requiring 250,000 troops be brought in from the remote provinces; the protests were spreading to other cities; the protests were gaining legitimacy with ordinary workers outside of the student-led protests; the protests were happening in the heart of the nation’s capital - Beijing.
The IRA: All true. But today social media is far more widespread, accelerating the potential for disruption inside China. Or is this a misreading of the situation?
Ricardo: Fast forward to today. There are no visible fissures amongst CCP leadership; local HK forces are working to quell the disturbances; the protests are not spreading outside of HK; ordinary people in China view HK as already spoiled and coddled; and HK is far from Beijing. Basically, there is a very different situation between then and now. The (tail) risk again, however, is wrong decisions and miscalculations. Beijing will not hesitate to use force if it believes such is necessary, though they have and will try to avoid such as long as possible, with the hope that the protests dissipate similar to the Umbrella Movement of 2014.
The IRA: So how does one trade this?
Ricardo: In the short run, if I was running a quant shop I’d train my algos to watch internet traffic from HK. If that drops dramatically, i.e. China makes HK suddenly go dark, I’d brace for the worst. Unlikely, but a non-zero risk. Medium term, I’d look at how to play the renminbi. Given what we’ve discussed, would you want your life savings tied to their currency?
The IRA: Thanks Ricardo