You can’t tell any kind of a story without having some kind of a theme, something to say between the lines.
I focus on three key themes here which may differ from the conventional market wisdom. They are the Sino-US trade outlook, China’s growth and macroeconomic policy and the economic implications of the prevailing socio-political volatility on Hong Kong.
There will be no final settlement on China’s trade dispute with the US for a long time to come because the ultimate economic problem lies in the global saving-investment imbalance, led by China in the East with surplus savings and under-consumption and by the US in the West with deficit savings and over-consumption. The US has trade deficits with over 100 countries, a bilateral trade war with China cannot solve this multi-lateral trade deficit with the rest of the world.
Any short-term agreements signed will serve to set the stage for further negotiations. China’s senior leaders has come to a consensus since May 2019 to engage in a prolonged trade fight with the US even at the cost of more domestic economic pains. Its strategy is to exhaust the US by a rotating tactic of fighting and negotiating – after each round of fighting China will negotiate with America; and if the negotiation fails they fight again; and then negotiate and then fight… The circle goes on until the US is exhausted and come to an agreement. Beijing will up the ante after each round of failed negotiation to make the settlement conditions tougher.
The trade war is mutating, in my view, from a macro risk of economic imbalances to a micro risk of cut-throat technology competition. The most recent flash point of conflict over technology is a bill, introduced in May 2019 by US Congressman Jim Banks, to bar US pension plans from investing in Chinese assets. But there has been no reaction by the House on the bill for over 180 days since it was proposed, this usually means that the bill is dead by now.
More crucially to the development of the future trade war is the Administration’s ban on US sales of technology to Huawei. However, instead of strangling Huawei, the US sales ban has prompted it to survive without US chips. US tech suppliers have turned out to be big losers in this technology fight at this stage.
There are pressures from both Congress and the Senate to keep Huawei permanently on the “Entity List”, in which Huawei was placed since May 2019. The US Administration is also laying grounds for future bills for squeezing Huawei and other Chinese firms out of the US 5G system and barring them from the US tech market.
However, Huawei has defied US pressures and continue to survive by building new smartphones and developing 5G base stations without using US chips. Its latest smartphone Mate 30, released in November 2019, which competes with iPhone 11, contains no US chips at all. Huawei has moved away from American parts at an unexpectedly fast speed. US companies are facing a growing substitution risk in the markets in China, Asia and other emerging markets.
China’s drive to shake off its dependence on US parts goes beyond smartphones. Huawei can now build 5G base stations, which are a key part of the infrastructure needed for the high-speed network, without US components. The US strategy of isolating Huawei seems not working.
Huawei’s strategy to go independent of US supplies is simply switching to other, especially European and in-house, chip suppliers. NXP Semiconductors of the Netherlands and HiSilicon (Huawei’s in-house chip design firm), have been the biggest winners so far at the expense of big loss of Chinese business by the American firms, including Qualcomm, Intel, Qorvo, Skyworks Solutions, Broadcom and Cirrus Logic. Going forward, the trade war will be fought mainly in the technology sector. Any companies and industries that are involved in the global supply chains that are connected to China will be affected.
Further rise in the trade tension in the short-term may prompt China to scale back on its FX intervention and allow the renminbi to weaken further under market forces as part of the negotiation tactic. This does not mean that China has a devaluation policy, but it does imply that the tail risk of the trade war igniting another round of currency war has risen.
In the longer-term, the US effort to decouple from China by breaking up the global supply chains will be quite disruptive to the world’s production ecosystem. The broken supply chains will be inefficient, turn the clock back on globalisation and reverse the trend of disinflation.
De-globalisation will also result in financial fragmentation, which will disrupt the global technological landscape. Restrictions on technology transfers and linkages, justified on the national security basis, will give rise to competing and non-compatible standards, leading to excessive competition, hurting innovation and pushing up costs, leading to slower adoption and even inferior products.
China’s recent economic data shows initial signs of stabilisation. But downside risk remains with prevalent deflationary pressures. Both the NBS and Caixin price gauges are still hovering below the 50 boom-bust line. This lack of pricing power most likely reflects weak corporate confidence, as manifested in the companies’ unwillingness to restock inventories despite stronger demand recently.
More broadly, liquidity has yet to show a sustained recovery. M1 and my estimate of free liquidity have remained in the doldrums since 2Q 2019 (Chart 1). Selective easing has only been able to prevent liquidity contraction but failed to engineer a sustained upturn. Free liquidity has also been dragged down by the recent pick-up in CPI inflation which, in turn, is boosted by pork price inflation due to the swine flu. Since food prices (in which pork is a significant component) carry a much more crucial weight in the CPI basket in developing economies like China than in developed economies, surging food prices will weigh on consumer spending and, hence, GDP growth.
So the expected economic recovery in 2020 will be modest, with core CPI (and upstream, PPI) inflation pinned to the floor. This underscores my argument that selective easing would not be able to engineer a robust self-sustaining economy upturn. Beijing will need to remind the markets repeatedly, in the form of small steps easing, that massive reflation would not be needed.
I expect 6.1% YoY GDP growth in 2020, with more selective easing measures going into 1Q 2020 (three to four 5bps cuts in the MLF rate, the reverse repo rate and the Loan Prime Rate and 50-100bps cuts in the RRR). Monetary policy is very data-dependent at this stage. Barring any significant domestic credit events and escalation in the trade war risk, the macroeconomic environment will be mildly positive for Chinese assets in the coming year, ceteris paribus that is.
While the PBoC will likely cut rates in a few more small steps in the short-term, China is probably not entering a rate-cut cycle, in my view, due to both macroeconomic and microeconomic constraints. In a broader sense, this implies that Chinese bond yields may be approaching a bottom in the coming months.
To strike a balance between easing policy and containing potential inflationary pressures, the PBoC has, in my view, opted for a low-profile easing approach by adjusting liquidity and interest rates via the money market (reverse repo rate) and lending facility (MLF injection and interest rate) in the face of rising CPI inflation.
At the present stage of development, money market rates in China are not yet an important channel affecting system-wide credit as Chinese banks source most of their funding from retail deposits. Meanwhile, not all banks in the system benefit from MLF injections and rate cuts as the PBoC controls the liquidity allocation from the MLF to only a designated group of banks and directs the MLF liquidity recipient banks to fund specific investments.
Thus, policy easing via adjustments in the reverse repo rate and the MLF are easing efforts without significant systemic effects. They also signal to the market that Beijing is not implementing massive reflation.
Some market players are wondering if China has entered a rate-cut cycle. Perhaps not, in my view.
Firstly, the PBoC aims at keeping M2 growth at the same pace as nominal GDP growth, and M2 growth is now slightly above nominal GDP growth (Chart 2). So there is no urgency for the PBoC to push for significant easing.
Secondly, CPI inflation has risen to over 3%, above the PBoC’s inflation target threshold of 3%, thanks to soaring pork price due to the African swine flu. Granted, core CPI has remained below 2%. But as the economy is expected to stabilise and even recover a bit soon, the concern about broadening inflationary pressures will become more prominent on the PBoC’s radar screen.
Thirdly, the PBoC faces a systemic stability constraint on rate cuts. It has become a top priority for Chinese banks to raise capital, especially for the small and medium-sized banks which are under-capitalised. There have already been a few cases of small bank failures since May 2019. It would be hard for them to attract capital if their earnings are hit by declining lending rates.
Lastly, from a long-term reform perspective, China’s real lending rate is already low. For example, with nominal GDP growing at 7.5%, the prevailing LPR of 4.15% means that China’s prime lending rate is 3.35% below the nominal GDP growth rate. Few countries have the prime lending rate that is 300-350bps lower than nominal GDP growth. Furthermore, China’s real LPR is approaching zero with CPI rising. The point is that if the real lending rate is cut too low, it could backfire on the government’s debt reduction and structural reform efforts by allowing the “zombie firms” to survive.
The most recent flash point in the Hong Kong political turmoil is the new Hong Kong Human Rights and Democracy Act that US President Trump signed on 27 November 2019. It will be a recurring nuisance that strain Sino-US relations, but its impact on the HK economy and market should be minimal. It is not a structural change to Hong Kong’s currency system, and the Hong Kong-US Dollar peg will remain unaffected.
The new US Human Rights Act requires an annual review by the US Secretary of State to certify whether Hong Kong remains “sufficiently autonomous” to justify the US special treatment (see below), and opens the door to US sanctions on Hong Kong officials deemed responsible for human rights abuses. It will become a recurring source of tensions between the US and China, like the annual assessment of currency manipulation (including by China) that the US Treasury conducts. But it does not revoke the United States Hong Kong Policy Act 1992, which gives Hong Kong a “special status” of being treated as a separate entity from the rest of China in terms of customs, trade, investment, technology transfer, immigration and the free exchange between HKD and USD.
Losing its special status would be a major risk for Hong Kong as all US policies that apply to China will also apply to Hong Kong. But the risk of the new 2019 US law rescinding the 1992 Act is low at this stage, in my view, as that would penalise Hong Kong when the US is trying to support it at the same time. Hong Kong is also a major market where many US firms and investors have an extensive presence.
The direct macroeconomic impact of new US law on Hong Kong is limited. The passage of the new Act and, in the grand scheme of things, Hong Kong’s political turmoil since June 2019 have not put financial stress on Hong Kong, despite rumours about capital flight. This can be seen in the HIBOR, which has shown no sharp jumps despite the political turmoil since June 2019 (Chart 3). Compared with the Asian crisis in 1997-98, when three-month HIBOR soared to over 50% at some points, HIBOR’s movement amid the current social volatility has been remarkably low and stable (Chart 4).
Some players have questioned the viability of the Hong Kong-US Dollar peg under mounting political and social pressures, which the new US democracy law may aggravate. There are robust fundamentals underpinning the HKD peg, including a twin surplus, a large FX reserves that are more than two times more than base money and a strong political will to sustain the peg and the new US law is not going to change that.
The stability of the Hong Kong stock market and Hong Kong’s interbank rates shows no evidence of capital flight, despite all the rumours about that. The 2019 Act does not rescind the full USD-HKD convertibility arrangement that the 1992 Act provided so the structure of Hong Kong’s liquidity regime and the HKD-USD Currency Link System will continue to prevail.