It's a huge pleasure to see you again George. We worked together for a while, when we worked in UBS. So you were chief economist at UBS, you are the author of Uprising - which is how emerging markets would shape or shake the world economy and you are always in the FT, it is a great pleasure when I see you in the FT, you are often on BBC, Bloomberg & CNBC and you are also a Glastonbury fan.
I am indeed yeah. One of my indulgences.
But really you are one of the world experts on China and that's why I thought it would great to have a little bit of a chat about how China is evolving and in particular how investors should be seeing China at the moment because we’ve had a red hot EM rally, emerging market rally over the last few years. Maybe you could talk a little bit about the topics in your recent FT article?
China Communist Party 19th Congress
So it’s a particularly interesting time to look at these things because the China Communist Party’s 19th Congress began on the 18th of October, it goes on for a week. It is a very scripted and stage managed affair, I mean the preparation goes on for about a year. I mention that because the significance from an economic point of view is that China has carefully stage managed the economy, if you want to put it like that, so that everything would look just so in the last several months leading up to the Congress. The economy has been growing just as the government would have wanted it to have grown at about, the official number’s been coming in at about at 6.8% to 6.9% year over year, the Renminbi has been stable, if anything a little bit stronger over the last year. Chinese interest rates had gone up a little bit during the course of the first half of this year as part of big financial crackdown on some of the more egregious forms of risk taking and financial malpractice. So it all looks pretty good from an external point of view. So the piece that I wrote really for the FT in the Market Insights column was really about how investors should think about the Congress, and about what happens next. So we can go onto some of these issues.
It is interesting at the moment that MSCI has actually incorporated China or its going to do that in 2018 as part of its MSCI index and as more people buy these trackers, indirectly they are going to be buying a slice of China. So it really matters to everybody who owns a pension or has any kind of investment which is passively tracking global markets, particularly emerging markets.
Very much so, yes because the Chinese market capitalisation of China’s market is now only second to the United States. So as you say whether investors are aware of it or not they will be owning China if they are in tracker funds and it is expected to pull in a large amount of money as a consequence of inclusion in the MSCI index.
Chinese Stock Market
I think the market capitalisation of China’s now something like $10 trillion.
Yes it is, yeah, yeah. So one it matters, two, obviously it then begs the question, do people know what they are buying and I think for most retail investors I think the answer is “probably not”. Obviously the institutional investors who are doing the transactions do know more, and they see and interview companies regularly. But I think people still have to be a little bit aware obviously because the Chinese stock market is not like many other Western markets for example with which we are familiar. We don't have the same sort of transparency in China, there has been, or there was a rout in the Chinese stock market in 2015-2016 which called forth trillions of yuan worth of government intervention, and stock buying programmes and IPO suspensions, and a whole panoply of support measures which the Chinese authority has had recourse to because although they profess a commitment to introducing more market oriented innovations and freedoms for prices in the economy they don't really like the consequences in many respects.
So we have a sort of a strange situation in China where the market does exist but it is a sort of caged phenomenon within a kind of a state directed system which if anything the current leadership under Xi Jinping is actually moving further away from openness and liberalisation and more towards emphasis of state and party control.
If I could just mention one other thing which is interesting I think from an investment point of view because it has very strong implications for governance and for reporting and so on. So the agglomeration of power around Xi Jinping the President is not unprecedented but we have not seen anything like this really since the days of Mao Zedong. And so what this really means is that the institutions which were growing in China during the reform era during the 1980’s and the 1990’s that reform era really stalled a little bit in the 2000s but it has gone backwards since 2012. That means the growth of institutions where custom and law basically tend to be the lodestones of how economic decisions are made and markets function, that institutionalisation is threatened now I think by this almost dictatorial accumulation of power by Xi Jinping and by the transfer of power from technocrats and government ministries to party organisations, committees and cells. Not just in SOE’s, in State Owned Enterprises but in private companies as well. In fact just a couple of weeks ago actually in the beginning of October it was revealed that the government was planning to take stakes, small stakes at least to start with in a some private companies like Baidu, and Tencent and parts of the Alibaba empire.
State Intrusion in Companies
George, is that so that they can acquire power over the decisions of the company.
So that they can actually have a say on the board as it were in terms of decision making. So politics which for many years has been something of a tailwind in China in terms of economic development and infrastructure, and decision making and the wow factor when a lot of people visit China and go to Beijing, Shanghai and big cities. Politics is becoming a bit of headwind now because of the growing role of the party and of political interference and political intervention over the course of the economy and of what companies do, and can do and are allowed to do. So this is another reason why investors need to be a little bit wary about what they are getting exposed to because of the political intrusion of the regulatory intrusion not just from outside the company, which is something that we all are accustomed to, in the UK, US and Europe and so on, but regulatory intrusion from inside the company as a consequence of the growth of the influence of the party.
And there’s also the question of succession because if power has been centralised around Mr Xi, Mr Xi then the question is who is going to follow? There will be a problem when it comes time for him to leave.
Yeah and this is a problem which all authoritarian regimes and governments have is the problem of succession. So since the 1990’s the Chinese have kind of moved to resolve this by having age limits at which every, well, most senior politicians except for the president himself have to step down from office and by having or following a sort of procedures and norms which lead to the nomination of potential successors at this stage like where we are today in the odd numbered congresses, so we’re just going through the 19th Congress the new leaders would normally be elevated or chosen to sit on the politburo standing committee which is the most senior cabinet level authority in China and we kind of know who the next generation of leaders would be. We will see when this Congress is finished whether that both of those criteria, the age limit and the nomination of new leaders whether that is pursued because there is speculation we can only say it is speculation at this stage that a) the age limit may not be respected in other words one or two very senior officials may stay on regardless of having breached the 68 year old age limit and also that it is possible, many people think that it is possible at least that Xi Jinping has designs on staying in office beyond 2022. So potentially a few things are up in the air at the moment as they haven’t been for two or three decades.
State Owned Enterprises & Politics
Okay and do you think that now China’s going to become part of the MSCI index whether that will actually drive corporate governance reform or do you think the politics will trump any kind of market reforms?
So people will have different views about this. I mean there’s a very compelling narrative which is that having spent the first five years cementing and building control over the party the army and the internal security apparatus that President Xi Jinping will now turn his attention to the economy and to finance and to show his true colours as a reformer and a liberaliser. I think compelling though that narrative is I think it’s most unlikely and certainly it would seem more unlikely in view of the long speech that he gave at the introduction to the 19th Congress this week. So I wouldn't hold my breath to be honest for governance reform. I thinks that’s, I mean there's no question that China will there will be policy changes their will be shifts in regulations affecting state enterprises and private companies. State enterprises they certainly want to turn into national champions and Bigger is Better, more state control is better than less state control, efficiency is not something that they shun necessarily but I think we should not be under any illusion really that politics the number one driver of what will happen to state enterprises and also to the role of the private sector in the Chinese economy.
Socialism with Chinese Characteristics for a New Era
You stated it so eloquently in your FT article you said that the government has these conflicted roles in China as owner, participant and regulator so that’s going to be a problem presumably over the long term if investors are looking for earnings growth.
Yes I think that is a phenomenon that I don't really see being addressed or on the agenda and it is something to which international organisations such as the IMF for example may review China’s progress and rate of change and so on. I draw attention to the fact that the state the party state does have conflicting roles. It is the owner of industries and assets in the economy, it is a participant in the economy and it is the regulator and these normally, well at least in the western kind of setting, we think it’s better to separate these functions and to have a governance system that is basically ruled by the rule of law and an independent judiciary, open and transparent regulations administered by independent institutions and so on and so forth. At least in theory, that’s what we think we are buying when we are active in markets. There is no pretense in China that it is like that at all or it is going to be ever like that. Which is not to say that the Chinese don't have a large body of law and there are certainly, there is a bankruptcy code of sorts there are very sophisticated rules and regulations which are administered by courts that always rule in favour of the government and a lot of foreign companies obviously have expressed concerns about this but sometimes they do get favourable rulings. But it's not the kind of system that we are familiar with and I don't think China makes any bones about the fact that they have no intention of adopting our kind of value systems when it comes to government and governance. In fact, au contraire, they are making a virtue of the fact that they are experimenting with what they are currently talking about this week which is “socialism with Chinese characteristics for a new era” and that may become embodied with Xi Jinping’s name in the constitution. So this is totally different I mean I don't think it comes as any surprise to anybody but it is different. But the idea that it might change, and that China will become a more liberal and open economy, I think we should basically we need a cold shower if that's what we still think.
Inequality and the Gini Coefficient
It is amazing if you look at number of billionaires in China, I think it is more than US: 596 dollar billionaires in China according to the Hurun 2015 Rich List and only 540 in the US and if you look at things like the Gini coefficient which measures income disparity it is very high in China, higher that the US, higher than the UK.
It is and the Chinese government itself actually stopped publishing Gini information its own calculations and I think the last official calculation there was the value was something like 46 or 47. So for the benefit of the people looking in the Gini coefficient is the measure of income inequality which is valued between 0 and 1. You could imagine at 0 there's perfect distribution of income amongst everybody and at 1 only one person, or only a handful of people own all the wealth. So that’s the kind of scale. So typically in western countries for example although income inequality has risen over the last 10, 20 years it typically is somewhere between 30, 35, 30, 40 something like that. In China unofficial estimates done by actually universities, not just in China but also, not just in the US but also in China, suggested it may be about 48 to 52 something like that so you have quite high relatively speaking income inequality and this inequality is manifest mostly not just within urban areas between the very rich and normal citizens but particularly between urban and rural areas. Now that, that is something that matters a lot to China and it matters to President Xi Jinping actually because one of his big pitches is reduction of poverty and at least on paper they want to or the government wants to build out further the social safety net so healthcare, education, access to welfare and so on, pensions. But it is a big task right because there are lot of people and at the risk of stating the obvious. I mean rural population is still about 700, a little bit over 700 million people. There's a big programme that they want to aspire to of urbanisation which is not as easy as it sounds because it’s a moot point whether urbanisation leads to faster growth and higher welfare or the other way around and yeah I think the question of who pays is always an issue not just in western countries but for China. So who will pay for the expansion of the social security system? And there is lot of resistance amongst the local and provincial governments which is where a lot of powers and provision of welfare and social security lie. A lot of resistance because they spend a lot of money but they don't have a lot of independent revenue and so they rely on land sales for a lot of their revenues, about a third, and they rely on transfers from central government in Beijing for probably about another quarter of their revenue so on paper it looks like the government has a programme to deal with inequality and they are certainly aware of the issues. The practical elements of implementation are a lot harder.
Trend Growth for China & Link to Share Earnings
And in terms of the growth rate, I mean everyone looks at the growth rate of China and they think “Oh wow! This will give me great earnings growth” but of course it’s not true is it? The two are are just not linked for China they haven’t been for a fairly long time. So do you think they can maintain this level of growth of around 6.5% up to 7% or are they going to drift down to the global 4%, 3% real growth rate over the next decade or so?
Well both very good points to make and to ask. I think the link between economic growth and the stock market as you know it is at best tenuous in a lot of places actually. Although broadly speaking you’d think if the underlying growth of money value of GDP is growing at roughly X% whatever the X is then broadly speaking you think that earnings should grow over time in line with that number. So I think in China the link is probably less tenuous even than it is, oh sorry more tenuous than it is elsewhere simply because the market is, well if we were down the pub I’d say it is rigged, but it is influenced by the activities of state agencies and state banks and regulators and so on. “Influenced” is probably a more polite term than I used before. But also the constituent parts of the index of course though, because they include a lot of state companies and state banks. So that link is, kind of, a little bit kind of uncertain anyway and the issue about whether China can sustain what it reports as almost a flat line, it's not exactly flat but somewhere between 6.7% and 7% is the reported growth rate for the last many many quarters and we know just by looking at other indicators of economic activity that the Chinese economy is more volatile than that.
So let's assume for the moment that it is growing at about six and a half to 6 and three quarters percent, the issue really, there are big issues China has to resolve over the next 5 to 10, 15 years which partly have to do with ageing population, partly to do with whether they will be successful with innovation in artificial intelligence, robotics, big data and modern technology, some of these things will undoubtedly be successes some of them won't be. And these things will be issues China will have to resolve over the medium term.
The most immediate issue though that I think the government has to turn its attention to is debt. And I think that everybody knows that China has a debt problem but we don't really know how big the problem is or when if at all we will get closure. But one way or the other when you deal with debt I mean or try to constrain the growth of debt and underwrite, if you will, a proper deleveraging, in which debt is either retired, written off or redistributed to stronger holders. Inevitably there is no painless way of doing this and the upshot is that when a proper deleveraging begins there will be material decline in China’s growth rate.
There are estimates of what China’s trend growth rate might be over the next 10-20 years which is basically an accounting exercise based on quantity and quality of labour inputs and capital inputs and productivity. That trend growth rate looks like it should be somewhere between 3% and 4% so over time that's where I would expect China’s growth rate to converge down to. It might get there sooner or even below that if there is a material attempt to deal with the debt problem because there always is and debt has to be paid for at the cost of incurring bad debts have to be distributed between consumers or companies or the government.
The Chinese Debt Problem
So I believe in 2007/2008 there was an economist who highlighted the problems of US leverage... oh yeah it was you!
Well more than a few of us, to be honest. Yeah the issue without wishing to go full nerd on this but obviously there are two ways we can look at this in terms of trying to understand what’s going on. Generally speaking the consensus looks at the assets. How big are the assets that the banks have lent out? In other words how bad are they, who owns the assets? Where are the non-performing loans, are the banks provisioning against them and how long will it be before we reach the point where if we say residential property prices fall, that suddenly assets don’t look so good anymore, NPL’s start to rise. This is really, really difficult even in the western banking system but in the state owned banking system for the most part the accounting regulations, the recognition of NPL’s the evergreening of loans... I mean these things could go on for quite some time.
We should say that NPLs are non-performing loans. So you lend out money, the loan goes bad and that percentage of bad loans is a measure of credit stress I guess.
Yes exactly. So these things can be fudged and they can be kind of deferred into the future, we don't really know. You know particularly when I say where the banking system is predominantly state owned so I don't really worry a lot that we are going to have a Lehman’s kind of situation in China because I think none of the big banks, none of the big five banks will be allowed to fail. The PBOC, the People’s Bank of China, will provide liquidity, maybe not always knowing where all the nooks and crannies are that they have to provide that liquidity but they will do that. So from the asset point of view I think we can say that over the next 5 years or so probably we will see more stress. The problem as we found out in 2007-2008 in the west also is that the counterpart of the assets obviously are the liabilities that fund them and banks rarely go bust because of the bad assets per se but they will always go bust if they can't fund them and if depositors take their money out and want to go and play elsewhere, so to speak.
So the issue in China is that the banking system’s assets have exploded over the last seven years. But then, by definition, so have the liabilities and those liabilities are not all what we would normally regards as safe liabilities like household deposits or company deposits. In other words smaller banks and non banking financial intermediaries like insurance companies, trust companies and offshore funding vehicles have increasingly grown to rely on repo markets, interbank markets and other ways of raising money which are usually short maturity, overnight to a week to a month maybe and which are inevitably much riskier than household deposits or corporate deposits in the event that something should go wrong and confidence should evaporate and then the lenders into those wholesale markets withdraw the money or their provision. So that’s the issue that I think China will have to pay a lot of attention to during the next two or three years. I think it is that sort of timescale to be honest.
George's New Book & 5 Traps for China
And you are writing another book about China I believe. Do you want to drop some hints about what you are going to talk about?
Yeah so this is a book which will come out sometime during the course of 2018 so I am actually holding back the last chapter until the conclusion of the 19th Congress and unfortunately there’s still a long gestation period before publication can happen. But it’s really it’s a focus really on the, what I call the five traps in China. Thinking about economic development over the next five to ten, fifteen years.
So the first trap, well we have spoken about all of them actually during this interview. I mean the first is the debt trap, so how do you solve the debt trap and when does that come to the fore and related to that is the currency trap, the renminbi trap, which is, it’s really a kind of derivative of the debt trap which is basically that the Chinese want a strong currency, they’d like it used more and more in the world as a funding currency and a financing currency but they have capital controls which have been tightened very significantly in 2016 and so that is not really compatible. You can’t have a global currency if you don’t let people get access to your currency so that’s the second trap.
The third trap is the demographic trap, it’s the aging trap. So China is the fastest aging country on Earth, not the oldest but the fastest aging and of course that will create big issues for individuals and China and for the state because although there is much wider coverage of pension and health care, benefit levels are not that great. So people have used the the cliche about getting old before you get rich and that kind of typifies China’s situation. They will get old in the next 20 years in the way we have taken about in the west 60 or 70 years to do. So that's the third trap.
The fourth trap is the middle income trap which is something which China’s leaders often refer to about getting stuck at a level of development where they may actually, people may actually continue to have rising living standards but relative to the OECD, say, they never actually get better off than they are actually today and that's really about how good are the institutions that nurture productivity growth.
And then the last trap really is a trap because of the politics that drives it. And it's really about the belt and road initiative which is China’s big strategy to I mean the romantic version of this is to rebuild the silk road by land and by sea. But in effect it's a grand statement of foreign policy by Xi Jinping to leave China’s footprint in Eurasia by doing partly direct investment deals but mostly by doing financing of infrastructure in a central Asia, the middle East, Europe and so on including high speed rail and roads, ports and so on and so forth and yeah so the idea is can China build out this kind of belt and road in a way that makes commercial sense and partly given it's kind of history of doing infrastructure at home but also because of the political direction and a lot of people will probably always remain anonymous in state companies for example in the kind of cutting edge or the leading edge of this initiative and admit that a lot of the programs and structures they’re involved with don’t make commercial sense.
That sounds really fascinating. Well George thanks so much for spending time with me. I am sure there will be lots of people who are interested about this and I will farm out any questions to you!
Oh, thanks very much!
Thank you for your time.