Episode 17: China Carefully Opens Capital Markets as Shares of Global GDP, Trade Grow

U.S.-China rhetoric may de-escalate, if not actual bilateral tensions. Meanwhile, China’s relaxation on investment restrictions encourages greater foreign portfolio inflows into local A-share equity and bond markets.

Transcript

China Carefully Opens Capital Markets as Shares of Global GDP, Trade Grow

Rocky Wang: European also need this deal when they come back to talk to Biden administration because when China, the two elephants fighting in the small room, who suffered? Everyone else suffer, right? I think European in particular stuck in the middle. So with this agreement with China, with quite meaningful concession from China, in terms of IP, intellectual property rights, or market access shares, I think European can also engage a certain interesting conversation with the U.S.

Charles Roth: Hi, welcome to another episode of Away from the Noise, Thornburg Investment Management’s podcast on key investment topics, economics and market developments of the day. I’m Charles Roth, local markets editor at Thornburg. We’re joined today by Lee Rocky Wang who runs our international equity and ESG strategies. Welcome Rocky.

Rocky Wang: Thank you, Charlie.

Charles Roth: So the last time we had you on Away from the Noise in June you discussed how quickly China’s economy was generally recovering from the pandemic, although you noted that some sectors were lagging. Uh, before we get an update on that you also discussed the fraying in U.S. China bilateral relations. Well, now we have a new administration in Washington. Yet the Biden’s administration’s comments so far suggest that aspects of Trump’s hard line on China will continue. So during her confirmation hearing to take over the U.S. Treasury, Janet Yellen cited Beijing’s quote abusive trade practices and, and said the U.S. is ready to use the full array of tools to address dumping products, erecting trade barriers and giving illegal subsidies to corporations. How do you see bilateral relations evolving. Is there much room for improvement?

Rocky Wang: That’s very good questions. Honestly, at this moment it is too early to, to make a full assessment of, on this coming Biden administration. Yes, I watched the Yellen speech presentation on the TV, you know, just don’t forget she has a different hat now. You know, before she was a central banker working for the Fed, so what she says more like a balanced independence. Now she’s a part of the administration so to a certain extent she become politician. A politician is supposed to speak always certain party lines and what she said regarding China and actually is not surprise to me. Just giving her new title. So what do I think? You know, let’s step back and then Charlie, think about it for the past 4 years and and, and Donald Trump administration and it sounds like a China U.S. pretty bad in the relation go south year by year and last year just, just worst ever. But you know what? I, I’m, you and me are business people. We look at everything from a more financial commercial perspective. Here’s some data I want to share with you guys is for the past 4 years, starting from ’16, 20, 2016 what happened in terms of China and this stress of situation between the two countries. You know what, and I’ll give you some numbers, right? In terms of GDP global market shares, China for the past 4 years, global GDP shares increasing from 14.8 percent to over 18 percent, and U.S. pretty much flat in terms of global GDPs, 24, 25 percent Chinese actually increasing. And in terms of Chinese export, one of Donald Trump policy is Chinese export at unfair pricing practice, but you know what? Chinese global market shares in terms of manufacture export market shares actually increasing from 15 percent to over 16 percent, and that’s kinda interesting. So basically, the conclusion from here is actually Chinese had been benefitting from the Donald Trump administration, 4 years of administration. So that’s kinda interesting. So, the question here is what, what, what happens under the Biden administration. Do you think Biden will unwind all the trade tariff, or is that really his top priority? My answer is no. I don’t think Biden will any time soon in a rush to unwind all the trade tariff, which Donald Trump put into the first place, so no. Do you think uh, Biden will continue to be the so-called free trader as he was in the Obama administration like 6, 7 years ago? Or what happened was quite a different from here on-shoring not off-shoring is inevitable I think yes. I think Biden will have a different political setup of geopolitical but also in terms of trade relations with China. I don’t think his policy will be pro trade, pro global. I don’t think so because what is different. So, my point is I think the relationship between the two country will be de-escalate. I think the positive is they probably start reengaging conversation, but whether there’s materiality in terms policy shift, I don’t think so. I think a people expectation on the honeymoon of two countries, I think that gestation probably will be crash, and I think any of the de-escalation might be the best scenario you and me can expect from here.

Charles Roth: It’s quite ironic you mention Biden’s role in, in the Obama administration when he was vice president. It was obviously during that time that the US and its Asia-Pacific partners essentially negotiated the Trans-Pacific Partnership, which was due to be ratified as Donald Trump essentially took over. He pulled out of the TPP, as it was called, and the TPP excluded China. Late last year, interestingly enough, China signed the Regional Comprehensive Economic Partnership with really a majority of East Asia countries, and the RCEP excludes the US. So on the trade front in Asia, the US has certainly not advanced its position and China has. China, I would also note, recently concluded a deal, an investment deal with Europe. So it’s interesting to think about what these trade and investments pacts mean for both China and the US in terms of global trade and investment flows and with that in mind, what it means for the value of the dollar.

Rocky Wang: That’s very good questions. Actually, Thornburg, as a team, we’re watching that two events very closely. Here’s my opinion, probably a little bit different from the mainstream media told us is I think the first one regarding RCEP, Regional Co, Comprehensive Economic Partnership, which China signed with pretty much with Asian countries, but I don’t think that’s material. I think that’s just recognition of what already happened, and maybe China make a certain concession on the tariff, but that’s already happened. I think a major part of Asian countries and already pretty much economic integrate into the so-called Greater China of picture and what, what sign is just recognizing what already happen. What actual more important is China relationship with Japan in terms of free trade or free trade with South Korea, which more mature but so far, those three party hasn’t got any agreement. Actually, those things will be material. So in terms of substance, I think RCEP’s more like a headline token value rather than anything materially change from here just because already happened. Regarding the China European Tr, Agreement, they signed in a rush, in a hurry, right before this transition of power in the U.S. I think China did that, in my opinion, is for the convenience purpose because what Number 1 nightmare for China from here is they are aware Biden will likely go back to the old friend airlines in Europe and trying to build a kind of unifying front line and engage China or change China. That’s the worst scenario. I think China doesn’t want to see that happen. That’s why they kinda signed the deal. Make quite a concession to, particularly, to European energy space and the telco space and all the, all the made-up industries. I think Europeans very happy. But on the other hand, European also need this deal when they come back to talk to Biden administration because when China, the two elephant fighting in the small room, who suffered? Everyone else suffer, right? I think European in particular stuck in the middle. So with this agreement with China, with quite meaningful concession from China, in terms of IP, intellectual property rights, or market access shares, I think European can also engage a certain interesting conversation with the U.S. trying to maximize their value, in terms of dealing U.S. on trades, on so many digital product, all the things, so it’s like a three-party type of, game theory, kinda play here but in terms impacting the dollar, I don’t know. I don’t think the dollar will be meaningful impact to agreement. I think the dollar more likely impact by how aggressive fiscal policy from Washington D.C. and the Biden administration and what’s kind of a differentiation of monetary policy across different country, for example, between ECB and the Fed. I think that’s more the driving force of the dollar direction rather than this too agreement. For most part, I think it’s kinda token value rather than any kind of serious material of substance value.

Charles Roth: Certainly one of the factors that play into currency strength or weakness is the growth rate of an economy and China’s was actually the only major economy to grow in 2020, expanded a real annual 2.3 percent rate last year and, and in the December quarter, which is perhaps the most im, important, in terms of measuring annual GDP, the growth rate was 6.5 percent. It beat expectations by quite a bit, yet China’s growth appeared quite imbalanced with domestic consumption rather soft, as China’s retail sales shrank 3.9 percent last year. Imported good demand was also kinda week so the bulk of the GDP growth contribution in China came from net exports and gross fixed capital formation. Those are the traditional drivers, of course, of China’s economic growth. What’s your outlook for China’s economy this year? Do, do you see domestic spending weakness lingering? Which sectors or types of companies are, are you seeing the most attractive in, in terms of investment opportunities?

Rocky Wang: Yeah, I watching those two datas, actually pretty impressive but the past is past, right? I think the devil is in the detail. You really look at what happened, why the China has print out such pretty impressive headline GDP growth for last year particularly for the fourth quarter. And I give them credit. I think they did the right thing and they pretty much of engage of start of this campaign in terms of lockdown and their cities is more willing to put on a mask versus you know, huge unwillingness in other part of world. I think to give them credit. They do pretty good job on that front but you have to look at the details of what’s driver of those pretty impressive headlines, right? Export, amazing, right? Actually, Chinese surplus with U.S. hit a new high but I would say look at the details. Why China’s export could be such of big growth last year. I think part is when the global supply chain pretty put on hold and the Chinese supply chain and with a pretty compressive of the support at home and that country’s so far had being delivered well in terms of pandemic contained, I think that’s means just wide chain within Chinese not as disruptive as other places. That’s why they can continue export. But don’t forget. They also take market shares from other countries. What I read is, for example, in the textile spaces, Indian or those (INAUDIBLE), those countries, actually is pretty, were picked pretty big in, before the pandemic but during the pandemic, they shut down so a lot of those exported tickets actually shipped to China and make Chinese a lot of manufacture. What I read is pretty working 24 hours, 7 days. I think that’s kinda one-off phenomena. I think with Indian starting normalize, when there’s a traditional export country starting normalize with the cure of vaccine, I think those tickets probably likely go back because those countries definitely continue have the comparative labor advantage with Chinese labor so I think that’s called a one-off. So back to the asset investment, there’s actually some positive sign on that, if you look in the details. In the past, when you talk about the China fixed asset investment, you’re always thinking they’re just a few more roadways, nobody going to use it. In the past 1 year or 2 years, Chinese fixed asset investment, or we call government sponsored those capital intensity investment are shifting away from those tow road infrastructure or house or properties and more shift to other stuff to supporting data cloud, supporting hotware technology. On that front, I would call those very productive of fixed asset investment that will help China position well in the coming years, in terms of import substitution. They realize their technology supply from other countries could be vulnerable and unfavorable political situation so they trying to, so, do the so-called import substitution. They want to put their money to build their cloud, to build their data center, to build their kind of technology intensive capital projects. I think the probably positions China has actually more serious competitive in that space in the coming decade, in the coming years, so for we’re looking for this year, I think the China headline numbers probably is no more the same like big headline numbers, actually as high as other countries. Here’s my base cases. I think there are some countries, in particular, in second half, will have a dramatic V shaped recovery. I say Indian or other emerging markets, even including Brazil and, actually, on the comparative basis of Chinese headline numbers probably will not be the highest for 2021 just because last year, on apple apple basis, they’re not down that much. That also means other countries will have a more U-shaped type of recovery than China, so from that perspective, I’m paused on China but I just, if we just look at GDP numbers, I looking for opportunity in other emerging market economy, even in Europe and to a certain extent, in U.S. as well.

Charles Roth: Yeah, that’s very interesting. So the base, the facts obviously will work against China, is what you’re suggesting in 2021. I was looking at the contribution to GDP growth in China and it’s amazing how flexible the economy was, so the contribution from consumption in the third quarter was about 28 percent and it expanded to nearly 40 percent in the fourth quarter. Gross fixed capital formation, fixed investment actually went down in the fourth quarter from the third quarter, from 46 to about 38 percent and then net exports was, went down as well, so quite interesting the agility, really, of the Chinese economy quarter to quarter, as it recovered from the pandemic and shifted toward its growth drivers that it’s focusing on and, as you pointed out, gross capital formation is really focused, not on infrastructure, as much as the digital economy. I wanna shift gears a, a little bit and talk about what that has meant in terms of investment, in terms of the attractive opportunities and how those are playing out, not just within China but between China and Hong Kong and so I’m thinking specifically in terms of the stock connect, which linked the Hong Kong exchange with the stock exchanges in mainland China so Shanghai and Shenzhen. Interestingly, in the first 3 weeks of this year, 2021, we’ve seen nearly 30 billion in southbound flows, so from mainland China into Hong Kong. That’s about a third of the total inflows in all of 2020. Big Chinese tech and telecoms that are listed in Hong Kong have been major recipients of those inflows from the mainland. Foreign funds, it appears, have been selling down their holdings, those exposures, but, um, obviously, mainland flows are, are picking up the slack. Now, what, what we’ve seen in recent years is that there’s been quite a discount in Hong Kong listed H shares to the mainland listed A shares. So if someone who invested in both H shares, as well as A shares, listed in the mainland exchanges, how, how do you think about choosing between H shares and A shares, where, where there are dual listings.

Rocky Wang: I think you seek out a very interesting phenomena, particularly into the first 2 weeks of market movement, particularly where the Chinese local market Shanghai stock exchange versus Hong Kong exchange and back to questions related to the dynamic between same company but have a different share, which is A, is local shares, H is Hong Kong shares. This is a disparity or gap, in terms of valuation, same company but offer the different price but Charlie, just bear in mind, Chinese RMB is not free convertible currency. Hong Kong dollar, which, you know, when we go by local shares, you’re using A shares; you only use RMB to buy local shares but you’re using Hong Kong dollar to buy Hong Kong shares. Hong Kong dollar is packed to U.S. dollar; pretty much it’s proxy to U.S. dollars, it’s not packed to the RMB, so basically, RMB is not convertible so the, the valuation gap between the same company, the two price for the same company is also reflect to conversion cost of if you’re moving a currency from non-convertible currency to not a free currency, like a dollar, like euros, you pay out something, right? So that’s why justifying why there’s a gap between the A shares and H shares. Back to the huge in flow into the Hong Kong stock market, particularly beginning year. You know, I don’t really think it’s fundamental driven. Actually, it’s pretty driven by some kinda interesting volatile policy out of Washington D.C. regarding whether, you know, one day they’re thinking all the major Chinese telco company will be delisted from Hong Kong, another day they change their mind but so far, I think that act stood in place. That kinda triggered the point.

Charles Roth: Do you mean delisted from, from the U.S. exchange?

Rocky Wang: Yeah, de, delisting from U.S. and then list in Hong Kong, so that’s a trigg, trigger demand. For, for example, if you own the U.S. shares from here, probably, if Donald Trump administration rule still in place, you probably become eligible for you to own any kind of a U.S. listed Chinese stock, so you force you to convert into your shares into Hong Kong shares or local shares. Local investor are knocked down. They identify why there will be huge demand for Hong Kong listed shares, particularly related to ADR or Chinese (INAUDIBLE) shares listed in U.S. and but have to come back to Hong Kong so they kind of start in front of running that kind of demand because they’re moving pretty fast. That’s kinda explain most part of the Hong Kong trading volume just spike and into the first week of this year and, but in my opinion, it’s not fundamental driven, it’s more technical reason and I think it’s one-off phenomena but having said that, overall, the valuation of all the stock trading Hong Kong exchange or Hong Kong stock market are relatively cheaper than the local Asias but that, that can be explained by the different demand supply. On the Hong Kong, it’s part of global free market. You and me can buy and selling and where everyone can participate could be anywhere, right? It’s free global market versus local Chinese Asia market, it’s pretty isolated local market, it’s local demand supply. You can see lot of speculation type of the money flow in and out flash around with very minimal international participants, so that’s create a different demand supply dynamic for the two markets quite different so that’s also explain sometime they have little bit quite different behavior. Most likely, local market can easily go extreme either bearish or super bullish or just because of demand supply dynamics, which have no influence, are less impacted by foreign inflow, just because foreign instutional investor so far have not been big player on the local markets. Pretty much it’s a game between the local investors.

Charles Roth: It’s quite interesting to see or it will be quite interesting to see what happens with Chinese ADRs in the Biden administration. There were two factors that were causing dual listings to pop up in Hong Kong of ADRs. One was whether those Chinese ADRs would submit to U.S. auditing standard and they had a, can’t remember if it was 2 or 3 years to actually do so. Another was a Trump administrative executive order involving companies that may have dual-use products or services, civilian uses and then military uses and who knows whether the Biden administration will retain either or both of those but certainly, the listings in Hong Kong have been a boon for the Hong Kong stock exchange, which, I believe is, had a tremendous run, in terms of its share price over that speculation. I just wanna shift, for a moment, to the A share market. So among major equity markets last year, China’s CSI 300 index, which groups the 300 biggest and most liquid mainland stocks a, across the ten conventional sectors, lagged only the very tech-heavy NASDAQ composite to produce a total return of 35 percent. 2020 was a, quite a good year for Chinese equities. Yet, we often hear that the CSI 300 Chinese A shares are underowned among global investors, even though the Chinese stock market is, is the world’s second largest, after the U.S. It’s worth about $10 trillion. Why is that and, and how do you view the CSI 300’s prospects in, in 2021 and over the medium term?

Rocky Wang: And Charlie, you know me and I think it’s very dangerous to call it index, right? And at Thornburg, we’re all picking stock, we’re not just picking index, so it’s, it’s very tricky to call why the index would be up, how much it will be up for the rest of year or how much it will be down, so I do not have a strong opinion but just kinda explain why you, you mentioned, I think, Chinese local Asia market, you know, CSI 300 index is local Asia index, so but the reality is so far, based my observation, I think Chinese local A share market is still meaningful in a way and earned by global fund manager, like other folks. We’re actually, Thornburg as a firm, we’re started engaging in market back to 2014 so we’re pretty early among other peers in this country, but for most part of fund manager living on this part of the world, I think they’re under, underweight or they’re, they’re still just picking up the out research starting hiring some, in a manner of speaking, analysts trying to help in digging for individual company because reality is all those companies they do not do disclosure in English so language barrier here is pretty high so take time for global funding manager to pick up research or investment in that space. But having said that, let’s start back. Chinese GDP, this year, as end of this year, second largest economy U.S. still large. I think based on the certain street estimates, based on the current pace of the growth and also giving strong Chinese RMB, stronger RMB convert to dollar just mean more dollar. Likely, the Chinese GDP could be as big as as U.S. or even overtake U.S. as largest economy around the 2030, that kind of year depending of cost; everyone had the different assumptions, but just even as the second largest economy, I think their market caps is more liquid than Japanese market. Their market cap is bigger than the Japanese stock market but on the global index weight level is way below the Japanese of index level so that’s create a great opportunity to structure opportunity if Chinese just don’t really do something bad things, if they continue to do the right thing with improving government, corporate governance improvement, corporate government improvement. I think they’re on the way to become one of meaningful part of a global portfolio and I think a lot of global fund manager probably need do a lot of quick catch up on that potential and I’m glad working with Thornburg because the firm has engaged the market for the past 6 years already.

Charles Roth: A graduated index inclusion as well. I think the MSCI and the other global indices have, have really only in very recent years started to induct Chinese companies into their global indices and, obviously, they’re doing it in a graduated way but that would probably explain a large part of the under ownership, so to say. Another part would be the fact that China has had quite a few investment restrictions on foreigners but in, in recent times, they’ve been relaxing those investment restrictions so they’ve expanded, for example, the types of investments that foreigners can make in the country. I’m speaking about the reforms of the qualified for and institutional investors and, and the RMB qualified for an institutional investor programs. They essentially allow foreigners, now, to use financial futures, commodities futures, options, and, and give them the ability to repurchase bonds, for example, pledge notes for cash and possibly reinvest the funds in funds. They give foreigners access to private investment funds. In, in 2019, Beijing also removed limits on foreign investment in, in Chinese stocks and bonds, which is very interesting, given Chinese sovereign bond yields are sharply higher than what we’re seeing in the west or Japan, for, for that matter. Bond yields, nominal yields are zero or negative and real yields are obviously negative in a number of advanced countries. China’s 10-year sovereign bond yield is, is around 3.51 percent so really significant in comparison to what’s on offer in the west. Can you talk about the importance of, of these reforms to, or for foreign financial investors in China?

Rocky Wang: I think the Chinese politician under the pressure of negative rhetorics of coming from the past 4 years, particular coming from Donald Trump administration, so they kinda prepared for the worst scenario but also, they’re trying to lay down a solid foundation for the future and one of their addenda is trying to recreate big RMB market, trying to make RMB become one, potentially over time become global currency. That, that means also need, okay you, if you ask Saudi, ask any other country take your RMB as the settlement currency, you, but you had offer the investment venue for them so that’s one reason they kinda open up of a lot of market, including hedge into derivative futures and particularly domestic bond market, so those RMB circling overseas can recycle back and buy Chinese bonds, which have a 3 + percent yield, so that’s pretty part of all the infrastructure building up, trying to make sure Chinese not necessary to have the second largest economy, over time could be first largest economy but also have financial infrastructure to supporting capital market, to supporting that kind of potential growth. That’s pretty much of a top agenda to Chinese politician. Right or wrong, I think they’re heading the, for the, for the right direction and you’re, you’re absolutely right. I think if I look at U.S. 10 years of trading 1 percent and the Chinese 10 years trading for 3 ½ percent, I think it’s quite a good carry trade. Meanwhile, you had a stronger RMB local currency as well, so you had could be double gain but don’t forget, if U.S. continue worry about a deflation, but the Chinese also, already starting to worry about inflation so the interest differential between the two bonds also reflection people different expectations on the inflation risk for the two countries, I think a inflation risk but this country’s lower for inflation risk, for China, expectation is high, so that’s part of reflect uh, in just, in terms of financial formula, so over time, I think Chinese have been doing right thing and in terms of market reform, market infrastructure and, I just said, if they continue improving the government level, corporate governance, but also improving cover-level cover governors and meanwhile introduce more solid, strong, legal infrastructure because when you’re treating derivative, right, when you’re long and short stock, you have to make sure you have a solid documentation on a legal term in place. Otherwise, you, you don’t know, right? That happening in China, not far way and you can suspend the market anytime, other stuff, so they need to be really, really follow international global standards, in terms of transparency, in terms of disclosure, in terms of fairness, pricing, settlement, trading. I think it’s still long way to go but sounds like they’re, they’re heading for the right direction. That just gave a global fund manager, like us, more confidence over time, to make more investment in China or, or just find a way to mend the risk in China, rather than just kinda only, long-only you can using other way to, to mitigate a certain financial risk but it’s all depending they had a very solid legal infrastructure, along with legal capital market infrastructure as well.

Charles Roth: Yeah, it’s very interesting. So the derivatives essentially will be helpful to foreign investors who wish to hedge, give them options for market-neutral strategies, not just long-only strategies. Perhaps it would attract more foreign capital into Hong Kong as well, not just domestically in the mainland but that would be the target and, you know, the other thing that you said that is worth highlighting is that China has seen an increase in the strength of the RMB so the, the Chinese currency, versus other currencies. The dollar has, obviously, been, been weak, the dollar basket, DXY, last year, lost 12 or so percent but the Fed, the ECB, the BOJ, other western central banks have been engaging in an lot of fiscal and monetary stimulus that the PBOC, China Central Bank, has, has not, which would probably explain why the RMB has been as muscular as it has been recently. Rocky, thank you for joining us.

Rocky Wang: Thank you, Charlie.

Charles Roth: Today’s episode was produced and edited by Michael Nelson. You can find us on Apple, Spotify, Google Podcast or your favorite audio provider or by visiting Thornburg.com podcast. Subscribe, rate us and leave a review and please join us next time on Away from the Noise.

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