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Listen to a Chat on China’s Foreign Investment Policy Reform

Lei Wang, CFA
Portfolio Manager and Managing Director
3 Feb 2021
1 min listen

China’s relaxation on investment restrictions encourages greater foreign portfolio inflows into local A-share equity and bond markets.

Read Transcript
Listen to a Chat on China’s Foreign Investment Policy Reform

Rocky Wang: Europeans 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 suffers, right? I think European in particular stuck in the middle. So with this agreement with China, with a quite meaningful concession from China, in terms of IP, intellectual property rights, or market access share, I think Europeans can also engage in certain interesting conversations 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, global markets editor at Thornburg. We’re joined today by Lei Rocky Wang who runs our international equity and ESG strategies. Welcome, Rocky.

Rocky Wang: Thank you, Charlie.

Charles Roth: 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. Before we get an update on that you also discussed the fraying in U.S. China bilateral relations. Add link to https://www.thornburg.com/insight-commentary/podcasts/examining-chinas-covid-19-recovery-and-ailing-us-relations/ Well, now we have a new administration in Washington. Yet the Biden administration’s comments so far suggest that aspects of Trump’s hardline on China will continue. During her confirmation hearing to take over the U.S. Treasury, Janet Yellen cited Beijing’s quote abusive trade practices 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 a very good question. Honestly, at this moment it is too early to make a full assessment of the Biden administration. Yes, I watched the Yellen speech presentation on TV. 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 is more like balanced independence. Now she’s a part of the administration so to a certain extent she has become a politician. A politician is supposed to speak along certain party lines and what she said regarding China is not a surprise to me, given her new title. So, what do I think? You know, let’s step back and then Charlie, think about it for the past four years in the Donald Trump administration and it sounds like the China U.S. relations are pretty bad and went south year by year. Last year was just the worst ever.

But you know what? You and I are businesspeople. We look at everything from a more financial and commercial perspective. Here’s some data I want to share with you:  for the past four years, starting from 2016 to 2020, what happened in terms of China and this stress of situation between the two countries? I’ll give you some numbers. In terms of GDP global market share for the past four years, China’s global GDP share increased from 14.8 percent to over 18 percent, and the U.S. was pretty much flat in terms of global GDP, with 24, 25 percent. Chinese GDP was actually increasing. And in terms of Chinese exports, one of Donald Trump’s policies was leveled against Chinese export unfair pricing practices, but you know what? Chinese global market share in terms of manufacturing exports actually increased from 15 percent to over 16 percent, and that’s kind of interesting. So basically, the conclusion from here is that China had been benefitting from the Donald Trump administration, for four years of the Trump administration. That’s kind of interesting.

The question here is what happens under the Biden administration. Do you think Biden will unwind all the trade tariffs, or is that really his top priority? My answer is no. I don’t think Biden will be any time soon in a rush to unwind all the trade tariffs, which Donald Trump put into the first place, so no.

Do you think Biden will continue to be the so-called free trader as he was in the Obama administration like six or seven years ago? Or what happened was quite 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 of what is different. So, my point is I think the relationship between the two countries will be de-escalated. I think the positive is they probably will start re-engaging in conversation, but whether there’s materiality in terms of a policy shift, I don’t think so. I think people’s expectations on the honeymoon of the two countries, I think that gestation probably will be the crash, and I think any of the de-escalations might be the best scenario you and I can expect from here.

The Regional Comprehensive Economic Partnership, Global Trade and Value of US Dollar

Charles Roth: It’s quite ironic you mention Biden’s role in the Obama administration when he was vice president. It was obviously during that time that the U.S. 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. On the trade front in Asia, the U.S. has certainly not advanced its position and China has. China, I would also note, recently concluded a deal, an investment deal with Europe. It’s interesting to think about what these trade and investments pacts mean for both China and the U.S. in terms of global trade and investment flows and with that in mind, what it means for the value of the dollar.

Rocky Wang: Those are very good questions. Actually, the Thornburg investment team is watching those two events very closely. Here’s my opinion, probably a little bit different from what the mainstream media told us. I think the first one regarding RCEP, Regional Comprehensive Economic Partnership, which China signed with Asian countries, is not material. I think that’s just recognition of what already happened, and maybe China is making a certain concession on the tariff, but that’s already happened. I think most Asian countries are already pretty much integrated economically into the so-called Greater China picture and signing the agreement is just recognizing what already happened.

What actually is more important is China’s relationship with Japan in terms of free trade or free trade with South Korea, which are more mature economies, but so far, those three parties haven’t got any agreement. Actually, those things will be material. In terms of substance, I think RCEP’s more like a headline token value rather than any material change from here just because it’s already happened.

Regarding the China European Trade 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, for convenience because what the Number One nightmare for China is from here is they are aware Biden will likely go back to the old friends in Europe and try to build a kind of unifying front line and engage China or change China. That’s the worst scenario for China. I think China doesn’t want to see that happen. That’s why they signed the deal. They made quite a concession to particularly the European energy space and the telco space and all the made-up industries. I think Europeans are very happy.

But on the other hand, Europeans also need this deal when they come back to talk to the Biden administration because when China and the U.S., two elephants, are fighting in the small room, who suffers? Everyone else suffers, right? I think Europe in particular is stuck in the middle. So, with this agreement with China, with quite meaningful concessions from China, in terms of IP, intellectual property rights, or market access share, I think Europeans can also engage in a certain interesting conversation with the U.S. trying to maximize their value, in terms of dealing with the U.S. on trades, on so many digital products, other things, so it’s like a three-party type of game theory.

In terms of impact on the dollar, I don’t know. I don’t think the dollar will be meaningfully impacted by the agreements. I think the dollar is more likely impacted by how aggressive the fiscal policy from Washington D.C. and the Biden administration is and what kind of differentiation of monetary policy there is across different countries, for example, between the ECB and the Fed. I think that’s more the driving force of the dollar direction rather than these two trade agreements. For the most part, I think it’s kind of a token value rather than any kind of seriously material or substantial value.

Investment Opportunities and Economic Outlook in China

Charles Roth: Certainly, one of the factors that plays 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, expanding a real annual 2.3 percent rate last year and in the December quarter, which is perhaps the most 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 goods demand was also weak 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 you see domestic spending weakness lingering? Which sectors or types of companies are you seeing as the most attractive in terms of investment opportunities?

Rocky Wang: Yeah, I watched those two data, actually pretty impressive but the past is past, right? I think the devil is in the detail. You really look at what happened, why China has printed such 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 were pretty much engaged from the start of this campaign in terms of lockdown and their citizens are more willing to put on masks versus the huge unwillingness in other parts of the world. I think give them credit. They do a pretty good job on that front, but you have to look at the details of what are the drivers of those pretty impressive headlines, right? The exports are amazing, right? The Chinese surplus with the U.S. hit a new high, but I would say look at the details. Why did China’s exports show such big growth last year?

I think part of the answer is when the global supply chain was put on hold, the Chinese supply chain had impressive support at home. That country has so far delivered well in terms of pandemic contained. I think that means the supply chain within China was not as disrupted as in other places. That’s why they can continue exporting. But don’t forget they also took market share from other countries. What I read is, for example, in the textile space, India or some southeast Asian countries, which were pretty big before the pandemic in textiles, shut down, so a lot of those exported tickets actually shipped to China, and China increased its manufacturing. What I read is that the factories were working 24 hours, seven days. I think that’s a one-off phenomenon.

I think with India as a traditional exporter of textiles starting to normalize with vaccines, that those tickets are likely to go back because those countries continue to have the comparative labor advantage vs. Chinese labor. I think that’s called a one-off.

So back to the asset investment, there are some positive signs on that, if you look in the details. In the past, when you talk about China fixed-asset investment, you’re always thinking they’re just building a few more roadways, nobody is going to use them. In the past one year or two years, Chinese fixed-asset investments, or government-sponsored capital intensity investments are shifting away from tow road infrastructure or house or properties and to technology, such as supporting data clouds, supporting software technology. On that front, I would call those very productive fixed-asset investments 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 in an unfavorable political situation so they trying to do the so-called import substitution. They want to put their money towards building their cloud, building their data center, building their kind of technology-intensive capital projects. I think this probably positions China as more seriously competitive in the technology space in the coming decade, in the coming years, so I think the China headline numbers probably will actually be as high as other countries.

Here’s my base case. I think there are some countries in the second half that will have a dramatic V-shaped recovery. I include India and other emerging markets, even Brazil and, actually, on a comparative basis, Chinese headline numbers probably will not be the highest for 2021 just because last year, on an apples-to-apples 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, if we just look at GDP numbers, I am looking for opportunities in other emerging market economies, even in Europe and to a certain extent, in the U.S. as well.

Choosing Between H Shares and A Shares

Charles Roth: Yeah, that’s very interesting. So, the base 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 went down as well. It’s quite interesting the agility of the Chinese economy quarter to quarter, as it recovered from the pandemic and shifted toward its growth drivers where it’s focusing. As you pointed out, gross capital formation is really focused, not on infrastructure, as much as the digital economy.

I want to shift gears 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. 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 three 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, obviously, mainland flows are picking up the slack. Now, 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. If you invested in both H shares in Hong Kong, as well as A shares listed on the mainland exchanges, how do you think about choosing between H shares and A shares, where there are dual listings?

Rocky Wang: I think you raise a very interesting phenomenon, particularly in the first two weeks of market movement between the Chinese local market, the Shanghai Stock Exchange, versus the Hong Kong exchange in the dynamics with the same company having a dual listing. There is a disparity or gap, in terms of valuation, for the same company offered at different prices, but Charlie, just bear in mind, the Chinese RMB is not a freely convertible currency, unlike the Hong Kong dollar. You can only use RMB to buy local shares but you’re using Hong Kong dollars to buy Hong Kong shares. The Hong Kong dollar is linked to the U.S. dollar, pretty much a proxy for U.S. dollars in Greater China. It’s not linked to the RMB, so basically, the RMB is not convertible so the valuation gap between the same company is also reflecting the conversion cost if you’re moving from a non-convertible currency to a free currency, like a dollar, like euros. You pay out something, right? So that’s why there’s a gap between the A shares and H shares.

Back to the huge inflow into the Hong Kong stock market, particularly at the beginning of the year. You know, I don’t really think it’s fundamentals-driven. Actually, it’s pretty driven by some kind of interesting volatile policy out of Washington D.C. regarding whether one day they’re thinking all the major Chinese telco companies will be delisted from Hong Kong. Another day they may change their minds, but so far, I think that act stood in place. That kind of triggered the point.

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

Rocky Wang: Yeah, delisting from the U.S. and then listing in Hong Kong, so that’s a trigger demand. For, for example, if you own the U.S. shares from the U.S., probably, if the Donald Trump administration rules are still in place, you become ineligible to own any kind of a U.S. listed Chinese stock, so you are forced to convert your shares into Hong Kong shares or mainland local shares. U.S. investors are knocked down. There will be a huge demand for Hong Kong-listed shares, particularly related to ADRs or Chinese N shares listed in the U.S. They have to come back to Hong Kong, so they start running that kind of demand because they’re moving pretty fast. That explains most of the Hong Kong trading volume in the first week of this year, but in my opinion, it’s not fundamentals-driven, it’s for technical reasons and I think it’s a one-off phenomenon.

Overall, the valuation of all the stock trading on the Hong Kong exchange is relatively cheaper than the local Asia exchanges, but that can be explained by the different demand-supply dynamics. The Hong Kong Stock Exchange is part of the global free market. Everyone can participate from anywhere, right? It’s a free global market versus local Chinese mainland markets, which are isolated local markets, with mostly local demand and supply. You can see a lot of speculative money flow in and flash out with very minimal international participation, so that creates a demand-supply dynamic for the two markets which are quite different. Most likely, the local market can easily go extremely either bearish or super bullish just because of demand-supply dynamics, which are less impacted by foreign inflow, just because foreign institutional investors so far have not been big players on the local markets. It’s mostly 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 standards, and they had a few years to 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 had a tremendous run, in terms of its share price over that speculation.

I just want to shift, for a moment, to the A-share market. Among major equity markets last year, China’s CSI 300 index, which groups the 300 biggest and most liquid mainland stocks across the ten conventional sectors, lagged only the very tech-heavy NASDAQ composite to produce a total return of 35 percent. 2020 was a good year for Chinese equities. Yet, we often hear that the CSI 300 Chinese A shares are under-owned among global investors, even though the Chinese stock market 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 2021 and over the medium term?

Rocky Wang: I think it’s very dangerous to call an index, right? And at Thornburg, we’re all picking stocks, we’re not just picking an index. It’s very tricky to call when the index would be up, how much it will be up for the rest of the year, or how much it will be down, so I do not have a strong opinion. I think the Chinese local market, the CSI 300 index, is a local Asia index, so the reality is so far, based my observation, I think the Chinese local A share market is still meaningful in a way and increasingly recognized by the global fund managers. Thornburg as a firm started engaging in the market back in 2014 so we were pretty early among our peers in this country; but for the most part, fund managers living in this part of the world are underweight or they’re still just picking up the research or have started hiring some, in a manner of speaking, analysts to help in digging for individual companies because the reality is those companies do not do disclosure in English, so there is a high language barrier here, so it takes time for global fund managers to pick up the research or investment in that space.

But having said that, let’s look back. Chinese GDP, this year, at the end of this year, was  the second largest economy. The U.S. is still larger. I think based on certain street estimates, based on the current pace of the growth and also given the strong Chinese RMB versus the dollar, the Chinese GDP could be as big as the U.S. or even overtake the U.S. as the largest economy around 2030.  That kind of depends on costs–everyone has different assumptions–but even as the second largest economy, the Chinese market cap is more liquid than the Japanese market. Their market cap is bigger than the Japanese stock market, but in the global index, the weight level is way below the Japanese index level, so that creates a great opportunity.  If the Chinese don’t do bad things, if they continue to do the right thing with improving government, corporate governance improvement, I think they’re on the way to become one of the most meaningful parts of a global portfolio and I think a lot of global fund managers probably need do a lot of quick catch up on that potential. I’m glad to be working with Thornburg because the firm has engaged with the Chinese market for the past six years already.

China Foreign Investment Policy Reform

Charles Roth: I think the MSCI and the other global indices 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. Another part would be the fact that China has had quite a few investment restrictions on foreigners, but 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 program. 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 2019, Beijing also removed limits on foreign investment 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 that matter. Bond 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 around 3.51 percent, so really significant in comparison to what’s on offer in the West. Can you talk about the importance of these reforms to, or for foreign financial investors in China?

Rocky Wang: I think Chinese politicians were under pressure from the negative rhetoric coming from the past four years from the Donald Trump administration, so the Chinese government prepared for the worst scenario. They are also trying to lay down a solid foundation for the future and one item on their agenda is trying to create a big RMB market, trying to make the RMB potentially over time a global currency. That means they also need, okay if you ask Saudi, ask any other country take your RMB as the settlement currency, but you had offer the investment venue for them so that’s one reason they kind of open up of a lot of market, including offering hedges into derivative futures and particularly the 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 much 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 the financial infrastructure to supporting the capital market, to supporting that kind of potential growth. That’s pretty much of a top agenda to Chinese politicians.

Right or wrong, I think they’re heading in the right direction and you’re absolutely right. I think if I look at U.S. 10-year Treasuries trading at 1 percent and the Chinese 10-year bonds trading at 3 ½ percent, I think it’s quite a good carry trade. Meanwhile, you had a stronger RMB local currency as well, so you could get a double gain. While the U.S. continues to worry about deflation, the Chinese are already starting to worry about inflation, so the interest differential between the two bonds also reflects different expectations on the inflation risk for the two countries. I think inflation risk in this country is lower than inflation risk for China, where the growth expectation is still high, so that’s reflected in terms of financial formula. Over time, I think the Chinese have been doing the right thing in terms of market reform and market infrastructure, and if they continue improving the government level, corporate governance, but also improving corporate governance, and meanwhile introduce more solid, strong, legal infrastructure–because when you’re buying derivatives, when you’re long and short stock–you have to make sure you have a solid documentation of legal terms in place. Otherwise, you don’t know, right? That’s happening in China, so they need to follow international global standards, in terms of transparency, in terms of disclosure, in terms of fairness, pricing, settlement, trading. I think it’s still a long way to go but it sounds like they’re heading in the right direction. That just gives a global fund manager like us more confidence over time to make more investments in China and to be less concerned about the risk in China, as they are mitigating certain financial risk through an increasingly solid legal infrastructure and 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 the other thing that you said that is worth highlighting is that China has seen an increase in the strength of the RMB, the Chinese currency, versus other currencies. The dollar has, obviously, been weak, the dollar basket, DXY, last year, lost 12 or so percent, but the Fed, the ECB, the BOJ, and other western central banks have been engaging in a lot of fiscal and monetary stimulus that the PBOC, China Central Bank, 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 podcasts. Subscribe, rate us and leave a review and please join us next time on “Away from the Noise.”

China’s Foreign Investment Policy Reforms and Economic Outlook

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.

Rocky Wang: Europeans 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 suffers, right? I think European in particular stuck in the middle. So with this agreement with China, with a quite meaningful concession from China, in terms of IP, intellectual property rights, or market access share, I think Europeans can also engage in certain interesting conversations 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, global markets editor at Thornburg. We’re joined today by Lei Rocky Wang who runs our international equity and ESG strategies. Welcome, Rocky.

Rocky Wang: Thank you, Charlie.

Charles Roth: 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. Before we get an update on that you also discussed the fraying in U.S. China bilateral relations. Add link to https://www.thornburg.com/insight-commentary/podcasts/examining-chinas-covid-19-recovery-and-ailing-us-relations/ Well, now we have a new administration in Washington. Yet the Biden administration’s comments so far suggest that aspects of Trump’s hardline on China will continue. During her confirmation hearing to take over the U.S. Treasury, Janet Yellen cited Beijing’s quote abusive trade practices 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 a very good question. Honestly, at this moment it is too early to make a full assessment of the Biden administration. Yes, I watched the Yellen speech presentation on TV. 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 is more like balanced independence. Now she’s a part of the administration so to a certain extent she has become a politician. A politician is supposed to speak along certain party lines and what she said regarding China is not a surprise to me, given her new title. So, what do I think? You know, let’s step back and then Charlie, think about it for the past four years in the Donald Trump administration and it sounds like the China U.S. relations are pretty bad and went south year by year. Last year was just the worst ever.

But you know what? You and I are businesspeople. We look at everything from a more financial and commercial perspective. Here’s some data I want to share with you:  for the past four years, starting from 2016 to 2020, what happened in terms of China and this stress of situation between the two countries? I’ll give you some numbers. In terms of GDP global market share for the past four years, China’s global GDP share increased from 14.8 percent to over 18 percent, and the U.S. was pretty much flat in terms of global GDP, with 24, 25 percent. Chinese GDP was actually increasing. And in terms of Chinese exports, one of Donald Trump’s policies was leveled against Chinese export unfair pricing practices, but you know what? Chinese global market share in terms of manufacturing exports actually increased from 15 percent to over 16 percent, and that’s kind of interesting. So basically, the conclusion from here is that China had been benefitting from the Donald Trump administration, for four years of the Trump administration. That’s kind of interesting.

The question here is what happens under the Biden administration. Do you think Biden will unwind all the trade tariffs, or is that really his top priority? My answer is no. I don’t think Biden will be any time soon in a rush to unwind all the trade tariffs, which Donald Trump put into the first place, so no.

Do you think Biden will continue to be the so-called free trader as he was in the Obama administration like six or seven years ago? Or what happened was quite 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 of what is different. So, my point is I think the relationship between the two countries will be de-escalated. I think the positive is they probably will start re-engaging in conversation, but whether there’s materiality in terms of a policy shift, I don’t think so. I think people’s expectations on the honeymoon of the two countries, I think that gestation probably will be the crash, and I think any of the de-escalations might be the best scenario you and I can expect from here.

The Regional Comprehensive Economic Partnership, Global Trade and Value of US Dollar

Charles Roth: It’s quite ironic you mention Biden’s role in the Obama administration when he was vice president. It was obviously during that time that the U.S. 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. On the trade front in Asia, the U.S. has certainly not advanced its position and China has. China, I would also note, recently concluded a deal, an investment deal with Europe. It’s interesting to think about what these trade and investments pacts mean for both China and the U.S. in terms of global trade and investment flows and with that in mind, what it means for the value of the dollar.

Rocky Wang: Those are very good questions. Actually, the Thornburg investment team is watching those two events very closely. Here’s my opinion, probably a little bit different from what the mainstream media told us. I think the first one regarding RCEP, Regional Comprehensive Economic Partnership, which China signed with Asian countries, is not material. I think that’s just recognition of what already happened, and maybe China is making a certain concession on the tariff, but that’s already happened. I think most Asian countries are already pretty much integrated economically into the so-called Greater China picture and signing the agreement is just recognizing what already happened.

What actually is more important is China’s relationship with Japan in terms of free trade or free trade with South Korea, which are more mature economies, but so far, those three parties haven’t got any agreement. Actually, those things will be material. In terms of substance, I think RCEP’s more like a headline token value rather than any material change from here just because it’s already happened.

Regarding the China European Trade 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, for convenience because what the Number One nightmare for China is from here is they are aware Biden will likely go back to the old friends in Europe and try to build a kind of unifying front line and engage China or change China. That’s the worst scenario for China. I think China doesn’t want to see that happen. That’s why they signed the deal. They made quite a concession to particularly the European energy space and the telco space and all the made-up industries. I think Europeans are very happy.

But on the other hand, Europeans also need this deal when they come back to talk to the Biden administration because when China and the U.S., two elephants, are fighting in the small room, who suffers? Everyone else suffers, right? I think Europe in particular is stuck in the middle. So, with this agreement with China, with quite meaningful concessions from China, in terms of IP, intellectual property rights, or market access share, I think Europeans can also engage in a certain interesting conversation with the U.S. trying to maximize their value, in terms of dealing with the U.S. on trades, on so many digital products, other things, so it’s like a three-party type of game theory.

In terms of impact on the dollar, I don’t know. I don’t think the dollar will be meaningfully impacted by the agreements. I think the dollar is more likely impacted by how aggressive the fiscal policy from Washington D.C. and the Biden administration is and what kind of differentiation of monetary policy there is across different countries, for example, between the ECB and the Fed. I think that’s more the driving force of the dollar direction rather than these two trade agreements. For the most part, I think it’s kind of a token value rather than any kind of seriously material or substantial value.

Investment Opportunities and Economic Outlook in China

Charles Roth: Certainly, one of the factors that plays 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, expanding a real annual 2.3 percent rate last year and in the December quarter, which is perhaps the most 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 goods demand was also weak 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 you see domestic spending weakness lingering? Which sectors or types of companies are you seeing as the most attractive in terms of investment opportunities?

Rocky Wang: Yeah, I watched those two data, actually pretty impressive but the past is past, right? I think the devil is in the detail. You really look at what happened, why China has printed such 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 were pretty much engaged from the start of this campaign in terms of lockdown and their citizens are more willing to put on masks versus the huge unwillingness in other parts of the world. I think give them credit. They do a pretty good job on that front, but you have to look at the details of what are the drivers of those pretty impressive headlines, right? The exports are amazing, right? The Chinese surplus with the U.S. hit a new high, but I would say look at the details. Why did China’s exports show such big growth last year?

I think part of the answer is when the global supply chain was put on hold, the Chinese supply chain had impressive support at home. That country has so far delivered well in terms of pandemic contained. I think that means the supply chain within China was not as disrupted as in other places. That’s why they can continue exporting. But don’t forget they also took market share from other countries. What I read is, for example, in the textile space, India or some southeast Asian countries, which were pretty big before the pandemic in textiles, shut down, so a lot of those exported tickets actually shipped to China, and China increased its manufacturing. What I read is that the factories were working 24 hours, seven days. I think that’s a one-off phenomenon.

I think with India as a traditional exporter of textiles starting to normalize with vaccines, that those tickets are likely to go back because those countries continue to have the comparative labor advantage vs. Chinese labor. I think that’s called a one-off.

So back to the asset investment, there are some positive signs on that, if you look in the details. In the past, when you talk about China fixed-asset investment, you’re always thinking they’re just building a few more roadways, nobody is going to use them. In the past one year or two years, Chinese fixed-asset investments, or government-sponsored capital intensity investments are shifting away from tow road infrastructure or house or properties and to technology, such as supporting data clouds, supporting software technology. On that front, I would call those very productive fixed-asset investments 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 in an unfavorable political situation so they trying to do the so-called import substitution. They want to put their money towards building their cloud, building their data center, building their kind of technology-intensive capital projects. I think this probably positions China as more seriously competitive in the technology space in the coming decade, in the coming years, so I think the China headline numbers probably will actually be as high as other countries.

Here’s my base case. I think there are some countries in the second half that will have a dramatic V-shaped recovery. I include India and other emerging markets, even Brazil and, actually, on a comparative basis, Chinese headline numbers probably will not be the highest for 2021 just because last year, on an apples-to-apples 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, if we just look at GDP numbers, I am looking for opportunities in other emerging market economies, even in Europe and to a certain extent, in the U.S. as well.

Choosing Between H Shares and A Shares

Charles Roth: Yeah, that’s very interesting. So, the base 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 went down as well. It’s quite interesting the agility of the Chinese economy quarter to quarter, as it recovered from the pandemic and shifted toward its growth drivers where it’s focusing. As you pointed out, gross capital formation is really focused, not on infrastructure, as much as the digital economy.

I want to shift gears 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. 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 three 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, obviously, mainland flows are picking up the slack. Now, 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. If you invested in both H shares in Hong Kong, as well as A shares listed on the mainland exchanges, how do you think about choosing between H shares and A shares, where there are dual listings?

Rocky Wang: I think you raise a very interesting phenomenon, particularly in the first two weeks of market movement between the Chinese local market, the Shanghai Stock Exchange, versus the Hong Kong exchange in the dynamics with the same company having a dual listing. There is a disparity or gap, in terms of valuation, for the same company offered at different prices, but Charlie, just bear in mind, the Chinese RMB is not a freely convertible currency, unlike the Hong Kong dollar. You can only use RMB to buy local shares but you’re using Hong Kong dollars to buy Hong Kong shares. The Hong Kong dollar is linked to the U.S. dollar, pretty much a proxy for U.S. dollars in Greater China. It’s not linked to the RMB, so basically, the RMB is not convertible so the valuation gap between the same company is also reflecting the conversion cost if you’re moving from a non-convertible currency to a free currency, like a dollar, like euros. You pay out something, right? So that’s why there’s a gap between the A shares and H shares.

Back to the huge inflow into the Hong Kong stock market, particularly at the beginning of the year. You know, I don’t really think it’s fundamentals-driven. Actually, it’s pretty driven by some kind of interesting volatile policy out of Washington D.C. regarding whether one day they’re thinking all the major Chinese telco companies will be delisted from Hong Kong. Another day they may change their minds, but so far, I think that act stood in place. That kind of triggered the point.

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

Rocky Wang: Yeah, delisting from the U.S. and then listing in Hong Kong, so that’s a trigger demand. For, for example, if you own the U.S. shares from the U.S., probably, if the Donald Trump administration rules are still in place, you become ineligible to own any kind of a U.S. listed Chinese stock, so you are forced to convert your shares into Hong Kong shares or mainland local shares. U.S. investors are knocked down. There will be a huge demand for Hong Kong-listed shares, particularly related to ADRs or Chinese N shares listed in the U.S. They have to come back to Hong Kong, so they start running that kind of demand because they’re moving pretty fast. That explains most of the Hong Kong trading volume in the first week of this year, but in my opinion, it’s not fundamentals-driven, it’s for technical reasons and I think it’s a one-off phenomenon.

Overall, the valuation of all the stock trading on the Hong Kong exchange is relatively cheaper than the local Asia exchanges, but that can be explained by the different demand-supply dynamics. The Hong Kong Stock Exchange is part of the global free market. Everyone can participate from anywhere, right? It’s a free global market versus local Chinese mainland markets, which are isolated local markets, with mostly local demand and supply. You can see a lot of speculative money flow in and flash out with very minimal international participation, so that creates a demand-supply dynamic for the two markets which are quite different. Most likely, the local market can easily go extremely either bearish or super bullish just because of demand-supply dynamics, which are less impacted by foreign inflow, just because foreign institutional investors so far have not been big players on the local markets. It’s mostly 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 standards, and they had a few years to 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 had a tremendous run, in terms of its share price over that speculation.

I just want to shift, for a moment, to the A-share market. Among major equity markets last year, China’s CSI 300 index, which groups the 300 biggest and most liquid mainland stocks across the ten conventional sectors, lagged only the very tech-heavy NASDAQ composite to produce a total return of 35 percent. 2020 was a good year for Chinese equities. Yet, we often hear that the CSI 300 Chinese A shares are under-owned among global investors, even though the Chinese stock market 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 2021 and over the medium term?

Rocky Wang: I think it’s very dangerous to call an index, right? And at Thornburg, we’re all picking stocks, we’re not just picking an index. It’s very tricky to call when the index would be up, how much it will be up for the rest of the year, or how much it will be down, so I do not have a strong opinion. I think the Chinese local market, the CSI 300 index, is a local Asia index, so the reality is so far, based my observation, I think the Chinese local A share market is still meaningful in a way and increasingly recognized by the global fund managers. Thornburg as a firm started engaging in the market back in 2014 so we were pretty early among our peers in this country; but for the most part, fund managers living in this part of the world are underweight or they’re still just picking up the research or have started hiring some, in a manner of speaking, analysts to help in digging for individual companies because the reality is those companies do not do disclosure in English, so there is a high language barrier here, so it takes time for global fund managers to pick up the research or investment in that space.

But having said that, let’s look back. Chinese GDP, this year, at the end of this year, was  the second largest economy. The U.S. is still larger. I think based on certain street estimates, based on the current pace of the growth and also given the strong Chinese RMB versus the dollar, the Chinese GDP could be as big as the U.S. or even overtake the U.S. as the largest economy around 2030.  That kind of depends on costs–everyone has different assumptions–but even as the second largest economy, the Chinese market cap is more liquid than the Japanese market. Their market cap is bigger than the Japanese stock market, but in the global index, the weight level is way below the Japanese index level, so that creates a great opportunity.  If the Chinese don’t do bad things, if they continue to do the right thing with improving government, corporate governance improvement, I think they’re on the way to become one of the most meaningful parts of a global portfolio and I think a lot of global fund managers probably need do a lot of quick catch up on that potential. I’m glad to be working with Thornburg because the firm has engaged with the Chinese market for the past six years already.

China Foreign Investment Policy Reform

Charles Roth: I think the MSCI and the other global indices 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. Another part would be the fact that China has had quite a few investment restrictions on foreigners, but 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 program. 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 2019, Beijing also removed limits on foreign investment 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 that matter. Bond 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 around 3.51 percent, so really significant in comparison to what’s on offer in the West. Can you talk about the importance of these reforms to, or for foreign financial investors in China?

Rocky Wang: I think Chinese politicians were under pressure from the negative rhetoric coming from the past four years from the Donald Trump administration, so the Chinese government prepared for the worst scenario. They are also trying to lay down a solid foundation for the future and one item on their agenda is trying to create a big RMB market, trying to make the RMB potentially over time a global currency. That means they also need, okay if you ask Saudi, ask any other country take your RMB as the settlement currency, but you had offer the investment venue for them so that’s one reason they kind of open up of a lot of market, including offering hedges into derivative futures and particularly the 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 much 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 the financial infrastructure to supporting the capital market, to supporting that kind of potential growth. That’s pretty much of a top agenda to Chinese politicians.

Right or wrong, I think they’re heading in the right direction and you’re absolutely right. I think if I look at U.S. 10-year Treasuries trading at 1 percent and the Chinese 10-year bonds trading at 3 ½ percent, I think it’s quite a good carry trade. Meanwhile, you had a stronger RMB local currency as well, so you could get a double gain. While the U.S. continues to worry about deflation, the Chinese are already starting to worry about inflation, so the interest differential between the two bonds also reflects different expectations on the inflation risk for the two countries. I think inflation risk in this country is lower than inflation risk for China, where the growth expectation is still high, so that’s reflected in terms of financial formula. Over time, I think the Chinese have been doing the right thing in terms of market reform and market infrastructure, and if they continue improving the government level, corporate governance, but also improving corporate governance, and meanwhile introduce more solid, strong, legal infrastructure–because when you’re buying derivatives, when you’re long and short stock–you have to make sure you have a solid documentation of legal terms in place. Otherwise, you don’t know, right? That’s happening in China, so they need to follow international global standards, in terms of transparency, in terms of disclosure, in terms of fairness, pricing, settlement, trading. I think it’s still a long way to go but it sounds like they’re heading in the right direction. That just gives a global fund manager like us more confidence over time to make more investments in China and to be less concerned about the risk in China, as they are mitigating certain financial risk through an increasingly solid legal infrastructure and 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 the other thing that you said that is worth highlighting is that China has seen an increase in the strength of the RMB, the Chinese currency, versus other currencies. The dollar has, obviously, been weak, the dollar basket, DXY, last year, lost 12 or so percent, but the Fed, the ECB, the BOJ, and other western central banks have been engaging in a lot of fiscal and monetary stimulus that the PBOC, China Central Bank, 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 podcasts. Subscribe, rate us and leave a review and please join us next time on “Away from the Noise.”

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