At least twice a day, we have discussions with clients that revolve around some combination of the following concerns:
- How much and how rapidly Chinese growth is slowing (answer: a good bit, and quite quickly);
- the extent to which Chinese banks are undercapitalized (answer: a good bit – but this is being resolved through the passage of time, fat net interest margins, and the issuance of preferred shares);
- how much overcapacity there is in Chinese real estate (answer: a good bit – but, once again, just like youth, this is a problem that time will fix);
- how much overcapacity there is in steel and shipping;
- how worried should we be about corrupt officials and the behavior of Hong Kong’s university students;
- and how disruptive will be the adoption of robots on China’s manufacturing lines, etc.
The undeniable reality of these concerns means that China’s policy makers have a lot on their plates. But this is where it gets interesting: In all of our conversation with Western investors, the conclusion drawn seems to be that China will likely have little choice but to print money aggressively, devalue the RMB, fiscally stimulate her economy, and basically follow the path trail-blazed by Western policy-makers since 2008. However, we would argue that such conclusions belie both a lack of imagination and an inability to listen.
From our standpoint in Hong Kong, we feel that the internationalization of the RMB is one of the most significant macro events of recent years. And the internationalization is gaining pace: starting from basically nothing in 2008, almost a quarter of Chinese trade will settle in RMB in 2014. See figure 1.
This is a very important development, which could have a very positive impact on a number of emerging markets. Indeed, typical, non-oil exporting emerging market policymakers, whether in Turkey, the Philippines, Vietnam, South Korea, Argentina or India, usually have to worry about two things that are completely out of their control:
- Concern 1: A spike in the U.S. dollar
Whenever the dollar shoots up, it presents a hurdle for growth in most emerging markets for a number of reasons. The first is that most trade takes place in dollar, so a higher dollar means having to set more aside for working capital needs.
The second reason is that most emerging market investors tend to think in two currencies: their own and the dollar. Enter a cab in Bangkok, Cairo, Cape Town or Jakarta and ask for that day’s dollar exchange rate and chances are that the cabbie will know it within a decimal point. This matters because when the dollar rises, local wealth tends to leave local currencies (sell domestic assets) and buy dollar assets (typically Treasuries). But when the dollar falls, the reverse is also true.
- Concern 2: A rapid rise in oil or food prices
Violent spikes in oil and food prices can be highly destabilizing for developing countries where the median family spends so much more of their income on basic necessities than the median Western family. Thus, sudden spikes in the price of food or energy can easily create social and political tensions.
For oil importing countries, a spike in oil prices can lead to a rapid deterioration in trade balances. These tend to scare foreign investors away, thereby pushing the currency lower and interest rates higher, which in turn leads to weaker growth etc.
Now looking through these two concerns, it is hard to escape the conclusion that, as things stand, China is currently helping to abate both:
China’s policy of renminbi internationalization means that most emerging markets are gradually able to weaken their dependence on the dollar. As they do, spikes in the value of the U.S. dollar (such as the one we had in 2014) become less painful.
The slowdown in Chinese oil demand, as well as China’s ability to capitalize on Russian President Vladimir Putin’s difficulties to transform itself from a price-taker to a price-setter, means that the impact of oil and commodities on trade balances is much more contained.
Beyond providing stability to emerging markets, the gradual acceptance of the RMB as a secondary reserve EM currency, and trade currency, has further implications. Jacques Rueff showed convincingly that when global trade moved from a gold-based settlement system to a U.S. dollar-based settlement system, purchasing power was increased.
As Rueff highlighted, if the Banque de France counts dollar claims among its reserves, for example a deposit in a New York bank, this increases the money supply in France without reducing the money supply of the U.S. So both countries can use these dollar assets to grant credit. Replace Banque de France with Indonesian central bank, and USD with RMB and the same causes will lead to the same consequences.
Take the recently issued British Columbia, AAA-rated, RMB dim sum 2-year bond. This bond, yielding 2.85 percent was actively subscribed by foreign central banks, which ended up receiving more than 50 percent of the initial allocation or ten times as much as the first British Columbia CNH issue that took place two years ago.
British Columbia then takes this money and deposits it in a Chinese bank, hereby capturing a nice spread. In turn, the Chinese bank can multiply this money ten times, leading to money creation in China. Meanwhile, the Indonesian, Korean or Kazakh central banks that bought the bonds now have an asset on their balance sheet which they can use to back an expansion of trade with the mainland.
Of course, for trade to flourish, countries need to be able to specialize in their respective comparative advantages – hence the importance of the kind of free-trade deals discussed at the recent APEC meetings. But free-trade deals are not enough; countries also need trade infrastructure, including ports, airports, telecoms, trade-financing banks etc.
Which brings us to China’s ‘silk road strategy’ and the recent announcement by China of a US$40 billion fund to help roll out road and rail infrastructure in the various ‘-stans’ on its Western borders, in an obvious bid to cut the travel time from China to Europe from the current forty days plus (by sea) to ten days or less (overland). Needless to say, such a dramatic reduction in transportation time could help more heavy industry relocate from Europe to Asia.
At the next BRICS summit in Brazil on July 15, leaders of the five member nations are expected to ratify a treaty launching the $50 billion BRICS Development Bank, which Beijing hopes will be modeled on China Development Bank and is likely to compete with the World Bank. This will be followed by the establishment of a China-dominated BRICS contingency fund, challenging the IMF. Also on the cards is an Asian infrastructure bank to rival the Asian Development Bank (ADB).
So it looks like, over the next few years, we will see railroads and motorways being built linking China’s main production centers to Bangkok, Singapore, Karachi, Alma-Ata, Moscow, Yangoon and Calcutta.
We will see pipelines, dams and power plants built in Siberia, Central Asia, Pakistan or Burma; as well as airports, hotels, business centers … and all of this financed with Chinese excess savings and leverage. Given that China today has excess capacity of production in all of the above, one probably does not need too many university diplomas to figure out where the companies that will build this infrastructure will come from.
But to finance all of this, and to transform herself into a capital exporter, China needs stable capital markets and a strong, convertible currency. This explains why, in spite of the Hong Kong population spitting in Beijing’s face, the internationalization of the RMB continues apace, including the Hong Kong-Shanghai connect, the removal of RMB restrictions for Hong Kong citizens etc. And it explains why RMB bonds have delivered better risk-adjusted returns over the past five years than almost any other fixed income market.
Of course, China’s strategy of internationalizing the RMB, and integrating its neighbors into its own economy might fall flat on its face. For example, some neighbors may reject an overly assertive China. Nonetheless, the bigger story in China today is not that of ‘ghost-cities’ or undercapitalized banks.
The major story is China’s willingness to no longer funnel excess savings into US Treasury yielding less than 2 percent, but instead to use that capital to integrate its neighbors’ economies with its own; using both its own currency and low funding cost as an ‘appeal product,’ and on the back end have its own companies pick up contracts. In essence, not very different from what the U.S. did with Europe in the 1940s and 1950s with the Marshall Plan.