A policy paradox explained

Shanghai-based Jonathan Anderson is one of the most respected analysts on China’s economy. As president of boutique research house Emerging Advisors Group he has been generating insights at that firm for global investors for the past 10 years. Recently, he put out a research paper arguing that China’s export boom has nullified much of Beijing’s talk of a ‘Dual Circulation’ economy. Here Anderson shares his views on that topic with WiC and what it will mean for A-shares.

Last year China’s government came up with its Dual Circulation economic strategy. What is it supposed to achieve and has it worked out as intended?

By way of background the phrase Dual Circulation makes reference to Deng Xiaoping’s earlier use of the term International Circulation some 35 years ago. The idea back then was to support China’s opening to international trade and its entry into the global supply chain. But the idea behind Dual Circulation is to stress the opposite – that rather than depend on external demand as its main economic driver, China really needs to focus more on the domestic economy.

The reason, of course, is that over the past few years China has found itself in an unfriendly geopolitical environment, with increased barriers to trade and technology transfer. China increasingly perceives itself as being cut off from the globalisation process and its senior leadership took the view that they had to redouble efforts to boost the domestic economy as a result.

This means boosting domestic demand via such measures as relaxing hukou requirements [the household registration system that largely denies key social services to migrant workers in the cities where they are employed], allowing for greater labour mobility, and other policies to boost household incomes and spending.

It also means boosting domestic supply via greater use of indigenous technology, building local capacity and reducing dependence on foreign investment.

All of this was premised on the idea that China wouldn’t have the same access to external markets as before.

You outline in your research that this is not how events have panned out because exports have been surging in recent months…

Exactly. The irony is that Chinese exporters have never had it better than they do right now. The country did suffer a trade dip during the Trump years when tariffs were imposed and the US stopped buying some Chinese products. The trend looked more worrisome coming into 2020. But all that has changed radically over the past 12 months.

When the pandemic hit China went into lockdown very quickly and came out of it very quickly too; by April it had reopened its factories and the manufacturing sector was more or less fully back online.

Meanwhile, the rest of the world was just going into lockdown in the spring. Of course many countries have never fully come out, with surge after surge of new Covid cases forcing renewed restrictions.

In this environment a lot of global orders went to China. By July and August last year it was already very clear that Chinese export manufacturing had rebounded rapidly and by November and December exports were up more than 20% on pre-Covid levels, compared to numbers that were still very much down in most other major countries.

In other words, China has enjoyed truly massive market share gains. And the export boom is still going; the January and February 2021 numbers were equally strong, suggesting that China is continuing to grab market share from the rest of the world.

Summing up, this is the exact opposite of what China thought it was going to get back at the beginning of 2020, when its senior leadership was formulating the policy direction for the coming five years. The government has been caught completely by surprise by the new trend and most of us economists and analysts were caught by surprise as well. No one expected this outcome … but there it is. Chinese exports are enjoying a phenomenal renaissance.

Are these export numbers sustainable or do they rely on the Covid situation and the abnormality it has created?

That’s a difficult question. Our base assumption is that they won’t prove sustainable, at least not in growth terms. China simply can’t continue to post such dramatic share gains without “deindustrialising” other global producers. And as vaccines finally take hold in the US, Europe and elsewhere, we expect a return to normality, with order books gradually shifting back to the rest of the world as capacity comes back online.

On the other hand, we’re also looking for very strong demand growth in both the US and Europe this year and next as the post-stimulus surge drives consumer spending. If China manages to hold onto some of the share gains it has achieved, the export numbers could continue to boom.

Another looming issue is the trade balance. Roll back the clock to 2019 and the prevailing view was that China was no longer an external surplus economy. The current account balance was nearly flat and net FDI flows were flat as well. FX reserves had not increased in years, and everyone was focused on the end of the “China surplus story”.

But look at the numbers for the most recent months. Based on preliminary estimates, China will post a “basic” balance of payments surplus of 5% to 6% of GDP in the first quarter this year. That’s a huge number, and it raises old questions about global imbalances and an undervalued renminbi. It could bring more talk about Chinese currency manipulation and perhaps a further geopolitical stand-off.

In January and February Chinese exports were up 60% year-on-year. How much has China gained in terms of its share of global exports versus pre-Covid?

If you look at developed-country data for overall industrial import spending, including final manufactured goods as well as semi-manufactured materials and chemicals, for much the past decade China’s share was very stable at around 20% of the total, and the percentage actually fell during 2018-19 when US trade restrictions started to kick in. Now, however, the estimated share for the past three months has jumped to nearly 25%. It’s a huge gain, and we’ve never seen anything like it before. The pace is faster than China was posting even at the very height of the 2000s export boom.

Factory managers in China have told the Financial Times that they are getting a surge in orders because of the Biden administration’s $1.9 trillion stimulus package. The view is that a lot of this money will see consumers buying TVs, laptops, bicycles and so forth – and they are mostly going to be made in China.

Absolutely. The consumer spending numbers have been strong in the US already and the new stimulus package means we can say for sure that the US consumer economy will be firing on all cylinders.

It’s not just China that benefits: US producers and other global exporters will be seeing their order books pick up too. But again, if you look at the continued rapid growth in Chinese exports in January and February this year it suggests that Chinese producers are gearing up for a great 2021.

So Chinese exports could ride the US consumer boom for the rest of the year?

Exactly. And if you think about what this means for official policy, there’s an enormous and growing disconnect between rhetoric and reality.

For the last 18 months, going into the new Five-Year Plan, policymakers have been imagining China as a “fortress economy”. The policy framework was overwhelmingly aimed at how to replace lost global demand and to make China more self-sufficient in an environment of de-globalisation. That kind of thinking completely pervaded recent government meetings and legislative sessions. Whereas the macro reality is the opposite – exports are booming and order books are full.

If you look at how the central bank has been responding, it’s not at all what you would have expected in a “fortress China” scenario either. When the pandemic first hit, we did see a major stimulus package, with banks providing emergency support to the corporate sector. But now that’s gone into reverse: credit policy is tight again and the central bank has been taking away liquidity. Financial regulators have fully refocused on cleaning up balance sheets and deleveraging the smaller and medium-sized banks. This is very much against the grain of the Dual Circulation strategy, which would have focused on loosening up balance sheet restrictions and supporting more loan growth in order to get domestic consumption going.

Based on both these realities – the exports and the deleveraging – do you think the government will hold back on talking up Dual Circulation as a policy imperative?

It’s still early days. We’ve seen a lot of big, convulsive shocks over the past year, with wildly unexpected changes at the macro level. Things could change radically again in the medium term ahead. Specifically, we don’t really know whether China can hold on to its export share gains into 2022 or whether there will be a sharp reversal. So we could wake up in a couple of years and find that China is still faced with the same issues of how to boost local demand in the face of fading exports.

But for the next 12 to 24 months? Yeah, it’s a fair bet you’re not going to hear too much emphasis on the Dual Circulation theme, at least not as a macro concept.

So we can expect Dual Circulation, the sequel, to reappear in 2024?

Maybe. Again, it’s just so hard to say what will happen. There are so many unpredictable geopolitical variables that could insert themselves into the situation between now and then.

Do you think the Chinese government will be pleased with the current situation? It wasn’t what it planned for, but it is still a pretty good outcome?

There’s no question that this has been a pleasant surprise for the government. Chinese manufacturing is booming, incomes are rising again and pulling the rest of the economy along, even though borders remain closed and service sectors like travel and tourism are still depressed.

The main potential negative in all of this is that China could be back on track for another round of trade wars with other countries as trading partners start to focus more on the size of external surpluses and begin to question Chinese trade practices.

Did that come out during the meeting in Alaska at the weekend – i.e. that the US is getting concerned about China’s trade surplus again?

Not yet. It’s still too early. China’s overall balance of payments numbers for 2020 were still weak on an annual basis, given the shocks in the first half of the year, and we won’t have official balance of payments figures for the first quarter of 2021 for a while yet. But six to nine months from now, I suspect that the issue of Chinese surpluses and market share gains in exports will suddenly start to garner a lot more attention.

What’s your view on the direction of traffic in terms of the Sino-US tech war?

This is a separate issue from the macro picture. It is also a piece of the puzzle that hasn’t changed much. US policy is very much aimed at cordoning China off from high-tech areas like chipset development and sensitive electronics markets, while China is still very busy trying to boost domestic production capacity in these areas. This is a long-term issue that will have big ramifications for years to come.

If you look at how things have played out in terms of more standard consumer electronics such as laptops and smartphones, order books have shifted heavily back to China, however. There hasn’t been a successful reorientation of manufacturing away from China at that level. The “Made in China” epic is still going on as it was before.

So tech self-sufficiency is the key part of the Dual Circulation strategy that still survives in the short term as well as long term?

Yes, without a doubt. And to be fair, China will advance some of its demand-side reforms as well, such as the liberalisation of hukou requirements and other efforts to boost labour market mobility and incomes. But other policies will be tighter than previously envisaged. The Chinese are not going to be printing a lot of debt and throwing a lot of credit into the system. They are very much back in deleveraging territory.

What does all of this say in terms of your forecast for GDP growth this year?

Headline GDP growth is going to be phenomenal. Remember that economic activity fell outright in the first half of 2020. Against that low base the year-on-year numbers will be stellar, easily in the 8% to 9% range, and perhaps higher. The figure will come down in 2022, of course, but with global demand recovering and the US stimulus pushing ahead, export strength should allow China to meet 5% to 6% GDP growth targets without too much stress.

Do these numbers make you bullish on the A-share market for the next six to 12 months?

That would be a qualified ‘yes’. As we have long pointed out, China’s domestic A-share market marches to a very different drum to the rest of the world. Historically it has been just as likely to go down than up during periods of economic boom, and just as likely to go up than down during slowdowns and recessions. So the fact that the economy is doing really well doesn’t automatically translate to rising equity prices. A-shares tend to be driven heavily by sentiment, liquidity and a host of other often unrelated factors.

Having said that, the macro numbers do look great right now. Corporate earnings are on a tear in most sectors; the renminbi has been appreciating and will likely continue to do so as long as external surpluses are rising; the property market has done well; and local sentiment is strong. As a result we continue to have a big A-share market position in our own portfolio [Anderson runs a personal proprietary portfolio – the details of which he shares with clients].

So you aren’t too concerned by the bankruptcies and bond defaults we have seen in China’s corporate sector in recent months?

Not very. Things looked a bit problematic in 2019 and the first half 2020, when credit policy was tight and the US trade war was weighing on exports. The property market was flat and our growth estimates were significantly below the official GDP forecasts. This led to a spike in corporate bond defaults in China. But even then we were only talking about overall corporate default rates of between 1% and 2% – no larger than the historical average for the US or Europe and far below what might constitute a “serious” issue.

Since then China has enjoyed the world’s best post-Covid recovery. Exports are booming and the property market is up. Retail spending is back and corporate profits have rebounded sharply. For the foreseeable future, we expect defaults to be moderate and we aren’t looking at this as a major macro risk.

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