Hello and welcome you are listening to Patrick Boyle on
Finance, a podcast exploring ideas from quantitative finance,
examining events occurring in markets right now and financial
history to see what lessons can be taken away, including
interviews with some of the most interesting people in the world
of finance. To learn more about the podcast,
visit on finance.org. Possibly the two most important
things to have understood in markets over the last few years
have been how Chinese deleveraging would impact the
global economy and the economic impact of COVID lockdowns and
the eventual reopenings that followed.
Right now, a huge change is occurring in China as the
government made an abrupt decision last month to halt the
nation's severe 0 COVID policy. We're now seeing the world's
second largest economy reawakened while simultaneously
being hit by a massive wave of COVID infections.
We're also seeing a push from Chinese policy makers to
stimulate the economy, which is still suffering from a bursting
real estate bubble. China additionally announced
just this morning plans to relax restrictions on developer
borrowing, dialing back the three red lines policy that
burst the nation's real estate bubble.
China's 0 COVID policy looked like it worked back in 2020,
when millions of lives were lost in other countries while China
appeared to keep the death toll significantly lower.
But as other countries vaccinated and reopened the
Chinese 0 COVID policy became a huge burden on Chinese people
and the Chinese economy, possibly due to the slowing
economy or the ballooning cost of running the program.
The Chinese government began easing the COVID testing
requirements in late November. Without the constant testing,
the policy stopped working. Omicron began spreading, first
in Beijing and then in the rest of the country.
The authorities moved to lock people down once more, but this
time, residents fiercely resisted.
They'd had enough. After almost three years, St.
protests erupted in China for the first time in decades.
While the demonstrations didn't last very long, the government
possibly realized that they couldn't win against millions of
angry citizens who were willing to disobey lockdowns.
In December, the government gave in.
Sick people could now isolate themselves at home, and health
codes were no longer required to enter most places.
The 0 COVID policy was replaced by the leaded rip policy.
A wave of coronavirus hit the country and people began staying
at home once again, this time either by their own choice or
because they were sick. Beijing returned to looking like
a ghost town in December. In Chinese state media,
President Xi has declared victory over the pandemic.
The virus is little worse than the flu, according to government
experts, which of course raises the question why the extreme
lockdowns? The Chinese government has
changed the definition of what qualifies as a COVID death,
ensuring that the official number of fatalities will remain
well below those that have been observed in the West.
It's difficult to know what the illness and death rates in China
actually are, as the government keeps this data classified.
But 10s of millions of people do appear to be catching the virus
every day in China, and hospitals and funeral homes have
been overwhelmed. According to the scientific
journal Nature, China's overall vaccination rate is above 85%.
That high rate was achieved with a vaccination passport system,
where the unvaccinated were prohibited from entry to many
public buildings and workplaces. According to the epidemiologist
Ben Cowling, the domestic Chinese vaccinations offer
sufficient protection against severe disease for adults under
the age of 60. Unfortunately, older and more
vulnerable people were less likely to go places that
required a vaccination passport and thus the elderly mostly
remained unvaccinated. Additionally, there are more
multi generational households in China than in the West.
Around 40% of over 60 year olds live with their married children
in China, compared to around 10% in Europe and 20% in the United
States. I have no expertise on the
effectiveness of the various vaccines I'm presenting the best
information that I could find online, but a doctor I spoke to
said that he can only speculate about the effectiveness of the
Chinese vaccinations. But an unvaccinated elderly
population, particularly in intergenerational households, is
pretty much Covid's ideal hunting ground.
So that is the situation being faced in China right now.
While the end of China's 0 COVID policy has reduced worries about
lockdown related supply chain problems, the nation is
struggling with a high number of infections, which adds different
pressures to the Chinese economy and the global supply chain.
One way or another, China's management of its reawakening
will have a huge impact not just on China, but on the rest of the
world. The sudden reversal of policy in
China has been chaotic to start with, as factories have been
struggling to deal with high absenteeism due to sick workers.
Illness is not the only problem that China is faced with,
though. The nation is confronted with a
slowing global economy, dragged down by high inflation and
energy crisis and geopolitical turmoil.
Faced with higher interest rates, Western shoppers have
been tightening their belts and spending less, which doesn't
help the export driven Chinese economy.
Chinese exports fell in November compared to a year earlier, led
by a 25% decline in exports to the United States.
Westerners, who had spent heavily on things like exercise
equipment and other manufactured goods from China during the
pandemic, are now feeling more budget conscious.
The Chinese consumer is not spending much either, and
convincing people to spend after three years of on and off
lockdowns won't be easy. Many Chinese workers are looking
for ways to rebuild their savings rather than ways to
spend them. Car dealerships in China are
struggling to deal with unsold inventory.
Stores have little need to order in more goods when they're
already full of unsold merchandise.
So China is faced with slumping demand both at home and abroad.
China's factory activity contracted even more in December
due to sick workers and dampened overall demand.
Service industries in China, like restaurants, found business
in December to be almost as bad as in early 2020 at the start of
the pandemic. Many even closed last month as
their customers stayed home to avoid infection or because they
were already sick. China's official PMI data,
released last weekend, showed a steep decline in economic
activity. It's manufacturing and services
gauges came in at 47 and 41.6 respectively, both falling to
the lowest level since early 2020.
A reading below 50 indicates A contraction.
The key message from that data is that the reopening is not yet
going smoothly. The lifting of quarantine rules
has helped drive sales of airline tickets ahead of the
Lunar New Year holiday on January 22nd this year.
The removal of COVID restrictions also means that
goods are moving through the country much faster.
The time taken to move goods around the country is more than
halved, as truck drivers are no longer constantly being stopped
for PCR tests and health code checks.
Analysts are expecting infection to peak around the Chinese New
Year festivities later this month, as that's when friends
and families get together to celebrate.
The economy is expected to begin recovering after March.
Analysts at Citi forecast retail sales in China will grow 11% in
2023. HSBC projects a contraction in
the first quarter of the year, but 5% growth overall for 2023.
While inflation numbers have been improving in the rest of
the world, some of that improvement has been due to
reduce demand from China. During all of these lockdowns,
should the Chinese economy really heat up, the additional
demand would be inflationary worldwide.
This would be somewhat offset by a greater supply of manufactured
goods coming out of the country, though.
Before the pandemic, China was the world's largest source of
outbound tourists, with 150 million travellers going abroad
each year. The total value of Chinese
worldwide travel was just over 1/4 of a trillion dollars in
2019. McKinsey is projecting that
international travel out of China will jump from 5% of the
2019 level that we saw last month to around 50% by this
summer. This could provide a boost to
tourism businesses around the world.
Foreign executives who've been unable to visit their businesses
in China for the last three years are also likely to be
booking trips into China again soon.
China's economy is expected to miss the 5 1/2% annual growth
target that was set by the government for 2022, and that's
already the lowest target that's been set in decades.
Economists polled by Bloomberg are forecasting full year growth
of just 3% for 2022. In addition to the wave of COVID
infections, policy makers in China are struggling with an
ongoing property crisis that's weighed on the economy for more
than a year. We'll get to that in just a
moment. A broad measure of China's
budget deficit hit a record high in the 1st 11 months of 2022.
This was driven by a few factors.
A slump in land leases to developers, which are a big
source of government income, fell by almost 1/4 from the
prior year. This is mostly driven by the
struggling and debt laden property developers no longer
growing their land banks. Tax cuts are critical.
Part of Beijing's efforts to stimulate the economy also cut
into fiscal income. Official data shows China's
value added tax collection, one of the biggest sources of
budgetary income, fell more than 25% in the 1st 11 months of 2022
after Beijing cut VAT rates and offered rebates in a bid to
revive growth. Revenue from taxes on car
purchases fell by almost a third during the same period as
Beijing cut tax rates to boost big ticket consumer items.
These revenues are also being hit by a severe reduction in
demand for new cars in China. The government's fiscal
spending, led by healthcare and social welfare costs, continued
to grow as Beijing struggle to control the pandemic and provide
a safety net for a fast growing population of jobless adults.
Chinese Ministry of Finance data shows that government healthcare
spending surged 15% in the 1st 11 months of 2022 as policy
makers invested heavily in COVID testing and quarantine
facilities as part of their effort to stamp out the
pandemic. This healthcare spending likely
grew even more in December as COVID infections overwhelmed
hospitals in China. As government financial woes
deepen, the authorities are coming under pressure to cut
back on spending. The government has held the
deficit target unchanged, meaning that the authorities
have to reduce spending in order to offset any drop in revenue.
Public finances could improve next year if the government
decides to reduce control over the private sector, which has
been beaten down in recent years by growing regulations over
issues like data security, And this has particularly been the
case on the tech sector in China.
Now we've talked quite a bit on this channel about the issues of
supply chain disruptions, which were partially driven by the 0
COVID policies and also driven by trade disputes with Western
countries. Many companies that struggle to
import critical components from China over the last few years
have begun diversifying their production and purchasing away
from China. Apple recently announced plans
to move some MacBook production to Vietnam for the first time in
2023. They've been working to add
production sites outside of China for all of their big
product lines for the last two years to make sure that they
don't lose out if there are any future trade disruptions.
After the MacBook production shifts, all of Apple's flagship
products will have a backup production location beyond
China, iPhones in India and Macbooks, the Apple Watch, and
iPads in Vietnam. Today, labour in Vietnam is
cheaper than in China, but they don't yet have the same quality
of infrastructure. For China, the loss of its lock
on MacBook production symbolizes the overall weakening of its
position as the world's factory. Apple, Hewlett Packard, Dell,
Google and Maida have all made at least some plans to shift
production and sourcing away from China.
It's not just tech companies, either.
Ted Kanis, a senior executive at Ford, told the press that the
supply chain is going to be the focus of this decade.
Over the last 20 years, China has become a major manufacturer
of automobile components. Many manufacturers are now
reducing their reliance on Chinese manufacturing.
These companies by no means plan to abandon Chinese manufacturing
entirely at this stage. That would be almost impossible.
As for one thing, it has become a big market for many of them.
But they are saying that they expect the flow of components
from China to plants around the world to fall over time.
Many automobile manufacturers are saying that they aim to make
parts and cars inside China exclusively for use within the
country, reducing their reliance on Chinese factories for goods
sold overseas, while still retaining a secure local supply
chain for their own plants inside the country.
Mazda, Honda, Ford, and General Motors have all been shifting
production of some components made in China to their home
markets. They say that they're doing this
to increase the resilience of their supply chains, and that it
has nothing to do with decoupling from China.
Nonetheless, this is not great news for China.
A trend towards near shoring or French shoring could be good for
countries like Mexico and India, who might see manufacturing grow
within their economies. The economist Michael Pettis
argues that there's a good economic reason for Washington
to encourage switching production from countries with
large, persistent trade surpluses, like China to
countries like Mexico with balanced trade or even trade
deficits. Doing so, he argues, would
increase global demand and increase direct and indirect US
exports, in line with any increase in US imports.
Because wages and household income make up a larger share of
Mexican output, Mexican export revenues are converted into
imports. In a trade surplus country like
China, workers earn a lower share of their production and
the export revenues are converted into savings, which
are then exported. And there's a net reduction in
global demand. Last year, American investors
put more money into Mexico buying companies and financing
projects than into China, according to an analysis by
McKinsey Global Institute. It's not just Western companies,
either. Some Chinese exporters are now
diversifying abroad, looking at manufacturing in locations like
Vietnam, Cambodia, Mexico and Turkey, where they can
manufacture cheaply and not be as reliant on a factory in a
single location. China's strengths in
manufacturing and its workforce are still hard to beat, even in
the midst of a raging epidemic. But there is more competition
from abroad than ever before, and big companies learned a
lesson when they were surprised by the breakdown in trade with
Russia less than a year ago. They don't want to find
themselves in a vulnerable position again.
Should trade disputes heat up, there will be a real focus on
how Chinese policy makers attempt to fix the country's
ailing real estate sector in 2023.
And that is still an ongoing problem.
As I mentioned earlier, Bloomberg is reporting this
morning that Chinese policy makers are rolling back the
three red lines policy that burst the Chinese property
bubble back in 2021. Details are still sparse, but
policy makers might permit some property firms to add more
leverage by easing borrowing caps and pushing back the grace
period for meeting debt targets set by the policy.
The crisis in the real estate sector, which started when
several high profile developers defaulted on their debt in 2021,
has delayed or halted construction of pre sold homes
across the country. These construction halls
triggered protests by home buyers, some of whom refused to
pay mortgages on unfinished homes.
While Beijing has unveiled a 16 point plan to ease the credit
crunch, the numbers still paint a gloomy picture.
At a key policy meeting last month, leaders vowed to focus on
boosting the economy in 2023, suggesting they would roll out
new measures that improve the financial condition of the
property sector and boost market confidence.
The measures announced so far are not sufficient to drive a
turn around, but policy makers have signalled that more support
is on its way. China's Minister of Finance
recently told the press given the need for more spending to
support the economy, fears have been mounting over the rising
local government debt risks and the potential impact on the
state dominated banking sector. This statement essentially
acknowledges that policy makers are aware that more state
directed infrastructure spending to boost economic activity is
likely to be malinvestment. Productive investment boosts an
economy by more than it increases debt, so this problem
only occurs when there is malinvestment.
As long as Chinese policymakers demand more growth from the
economy than can be sustainably delivered, Beijing won't be able
to prevent the debt burden from rising.
In the short term, the economy is likely to grow as business
activity resuming equates to growth in the long run.
If policy makers don't want debt to grow unsustainably, they will
have to accept more reasonable growth rates below 2 to 3%.
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