Emerging Markets

Special Report

Highlights Both the massive inventory accumulation and robust underlying consumption have been driving Chinese crude imports in recent years. Chinese crude oil import growth will decelerate in 2021 due to a slower pace in the country’s oil inventory accumulation. The country’s underlying crude oil consumption growth will remain robust this year, which will support a still positive growth in Chinese crude oil imports this year. Strong Chinese crude oil imports are positive to global oil prices this year. Feature The gap between China’s total crude oil supply and its domestic crude oil consumption has been widening in recent years, due to a massive buildup in Chinese crude oil inventory (Chart 1A and 1B). In fact, China’s crude oil inventories have quadrupled in the past five years, exceeding two billion barrels as of November 2020 and are equal to about 70% of OECD total inventory (Chart 2). Chart 1AA Massive Buildup In Chinese Crude Oil Inventory Chart 1BChina: Total Crude Oil Supply Growth Has Exceeded Its Domestic Consumption Growth In addition, China’s crude oil import growth has been outpacing domestic oil consumption growth, while domestic production remains stagnant (Chart 3). Chart 2Crude Oil Inventories In China Have Quadrupled In The Past Five Years Chart 3China: Crude Oil Import Growth Has Been Stronger Than Its Domestic Consumption Growth Will China maintain its strong crude oil import growth this year? How will the interplay between domestic consumption and imports evolve in 2021? We expect China’s crude oil consumption growth to remain solid in 2021, growing at an annual rate of about 6-7% and up from the 4.5% growth rate reached in 2020. However, China’s crude oil imports are likely to increase by 4-6% in 2021 from the previous year, slower than the 7.2% growth seen in 2020. The moderation in Chinese oil imports in 2021 will mainly be due to a slower pace of crude oil inventory buildup. Understanding The Surge In Crude Oil Inventory Chart 4China's Crude Oil Inventory Buildup: One Major Driver Behind Its Strong Imports Since 2016 The massive buildup in domestic crude oil inventory has been one major driving force behind the strong growth in China's crude oil imports since 2016 (Chart 4). As oil prices continue to rebound, and given China’s existing large oil inventories, we think the pace of inventory accumulation in China will slow in 2021. Therefore, growth in Chinese oil imports this year will likely moderate. China’s crude oil imports currently account for about 75% of the country’s total crude oil supply. Since China’s domestic crude oil production has been stagnant in the last decade, the fluctuations in Chinese crude oil imports are largely driven by the change in the country’s total demand, which includes both domestic consumption and changes in inventories. China’s crude oil import growth has significantly outpaced domestic consumption growth in the past five years, leading to a buildup in inventory. China’s crude oil inventory includes Commercial Petroleum Reserves (CPR), which are held by refiners and traders; and Strategic Petroleum Reserves (SPR), which are held by the government. Our Chinese crude oil inventory proxy1 was constructed based on the crude oil flow diagram shown in Chart 5.  Chart 5How Did We Derive Our Chinese Crude Oil Inventory Proxy? Our research has suggested that since 2016, most of the buildup has occurred in CPR. This is due to the following: The government in 2015 required refiners to keep their inventory level at no less than their 15-days requirement for operation use. Chinese refinery capacity had been expanded at a compound annual growth rate (CAGR) of 2.8% during 2016-2019. These existing and new refineries have been building their inventories to meet government regulations in the past several years.  In addition, the government started to allow independent refineries to import crude oil by setting a quota in mid-2015, and the import quotas have been increased every year. In 2020, the quota reached 184.6 million tons, equaling to about 3,700 kbpd, nearly five times the quota in 2015. The total increase in imports of these independent refiners over the past five years was about 2,950 kbpd, accounting for 70% of the increase in the country’s total crude oil imports during the same period. Chart 6China: Rising Run Rates For Its Independent Refineries Independent refiners import crude oil for both refinery purposes and to meet the new inventory requirement. Over the last several years, the increased amount of quota has improved Chinese independent refiners’ profitability and refinery capacity run rate, as the import quota allows these private sector refiners to save operating costs by cutting out the “middleman” and by actively managing their own feedstocks. For example, Shandong has the largest number of independent refineries among all provinces. Chart 6 shows that the run rate of the region’s independent refineries has surged since 2016, from about 40% in that year to 75% this year. In addition, since 2016, the fluctuations in their run rates have become much more closely correlated with global oil prices.   Commercial crude oil users have much larger physical reserve space than the SPR. Notably, they tend to sharply increase their imports when crude oil prices are low.  In addition, inventory accumulation often occurs when credit/financing is available with low costs and refiners expect higher prices ahead. Meanwhile, our research shows the SPR development has been slowing considerably in recent years, resulting in little inventory buildup in SPR. The last time the National Bureau of Statistics (NBS) reported the SPR data was December 29, 2017. It showed the SPR was about 37.73 million tons by mid-2017, not far from the country’s target of 40 million tons for the first two phases2 of SPR. This suggests that the country was at least close to finishing its second phase of the SPR in 2017. Since then, there has been little information about the third phase of the SPR progress. We have only been able to find two pieces of news on that subject, and both suggest the construction of the third phase of SPR has been stagnant, and the planning of two sites only started in 2019. As the average construction time for projects in the second phase of SPR was about four years, we do not think these sites were completed in 2020. The NBS data shows that even during the period of mid-2015 and mid-2017, the SPR had only increased by 234 kbpd, about 117 kbpd per year. In comparison, the Chinese total crude oil inventory increased by 600-700 kbpd per year in 2016 and 2017. Clearly, SPR only accounted for a small share of the Chinese total crude oil inventory. Looking forward, we expect a much slower pace of crude oil inventory buildup in China in 2021. Our forecast is based on the following factors: Current Chinese crude oil inventories (CPR and SPR combined) are already in the upper range when comparing the OECD countries (Chart 7). Although the IEA data shows that Japan and Korea have oil stocks of 200 days and 193 days of their respective crude oil net imports, Chinese oil inventories are currently equivalent to 195 days of crude oil net imports and much higher than the 90 days the IEA requires OECD countries to hold. With Brent oil prices having risen by a lot from the April 2020 trough and elevated domestic crude oil inventories, both government and commercial users will likely slow their purchases of overseas oil for inventory accumulation. In comparison, Chinese crude oil inventory accumulation growth slowed sharply in 2018 when Brent oil prices rose by 95% from their trough in mid-2017 (Chart 8), A significant portion of Chinese oil inventory buildup was accumulated over the past five years. At 1,170 kbpd, the largest annual accumulation was in 2020, higher than the 700-900 kbpd fill per year during 2017-2019. Chart 7China's Crude Oil Inventory: No Longer Low Chart 8China: Rising Oil Prices Will Likely Slow Down Its Pace Of Crude Oil Inventory Accumulation We do not expect the fast inventory accumulation of 2020 to repeat in 2021. Instead, a mean-reversal in the inventory accumulation pace will likely occur. Table 1Our Estimates Of The Scale Of Chinese Crude Oil Inventory In 2021 Our baseline estimate based on China’s 2021 import quota and refinery capacity3 is that Chinese crude oil inventory will increase to 207-210 days of Chinese crude oil imports by this year-end, up from 192 days at last year-end (Table 1). With already-elevated crude oil inventory, the pace of the inventory accumulation in China will be slower than last year. Bottom Line: After a massive buildup over recent years, the pace of inventory accumulation in China will slow in 2021 and probably onwards as well. As a result, Chinese oil import growth will converge with the pace of domestic consumption growth. China’s Robust Crude Oil Consumption Growth In 2021 Chart 9China: Resilient Domestic Crude Oil Consumption Growth In 2020 Despite the pandemic outbreak, last year’s underlying consumption of crude oil in China was resilient at a year-on-year growth of 4.5%, even though the rate was smaller than the average growth of 6-7% in 2018-2019 (Chart 9).  The growth in oil consumption last year was mainly from the non-transportation sector. The output of non-transportation fuels, including fuel oil, naphtha, petroleum coke, and petroleum pitch, are mostly having impressive growth, suggesting strong consumption in sectors like chemical products, steel sector and infrastructure (Chart 10). For example, naphtha is the primary feedstock for ethylene production. Ethylene is the building block for a vast range of chemicals from plastics to antifreeze solutions and solvents. Transportation fuel consumption was weak in 2020, with the output of major transportation fuels including gasoline, diesel oil and kerosene in contraction (Chart 11). Chart 10Strong Consumption In Non-Transportation Sectors in 2020 Last Year Chart 11Transportation Fuel Consumption Was Weak In 2020 In 2021, we expect the underlying consumption growth of crude oil in China to increase to 6-7% from last year’s 4.5%. This will be in line with its growth in both 2018 and 2019 (Chart 9 on page 7). First, the consumption of transportation fuels will likely recover this year. Transportation fuels are the largest consuming sector for Chinese petroleum products. Based on British Petroleum data, gasoline, diesel and kerosene accounted for 55% of total Chinese oil consumption in 2019. We expect the transportation fuel consumption growth to be stronger (i.e., 6-7%) than its five-year compounded annual growth rate (CAGR) of 4.1% during 2015-2019. Chart 12China's Automobile Sales Correlated Well With Its Crude Oil Imports Automobile sales in China correlated well with the country’s crude oil imports (Chart 12, top panel). Despite a year-on-year contraction of 2% for the whole year of 2020, automobile sales had been strong with a double-digit growth nearly every month since May. Only 5% of these automobiles are new energy vehicles (NEV). About 80% of them are gasoline cars and 15% are diesel automobiles. Annual total car sales still account for about 9% of total existing automobiles (Chart 12, bottom panel). This means a 6-7% growth in the transportation consumption of passenger cars and commercial cars is very possible in 2021. The number of airports and airplanes are still on the uptrend in China. The CAGR of Chinese kerosene consumption rose from 10.1% during 2010-2014 to 10.6% during 2015-2019. This suggests that the kerosene consumption growth in China could reach 11% in 2021. Domestic gasoline and diesel prices are near decade lows (Chart 13). This will encourage consumption of these fuels. Second, the oil consumption growth in the industry sector will likely be larger than the 5% in the recent years (Chart 14). Based on the NBS data, the industry sector accounts for about 36% of China’s petroleum product consumption. Chart 13Low Domestic Gasoline And Diesel Prices Encourage Fuel Consumption This Year Chart 14Robust Oil Consumption Growth In The Industry Sector In 2021 Third, infrastructure spending and property market construction will slow in 2H2021 given the credit, fiscal, and regulatory tightening that has been taking place. However, construction only accounts for about 6% of Chinese petroleum product consumption.  Given all of this, achieving a 6-7% underlying consumption growth of crude oil in China this year is possible. Taking into consideration the slower pace of inventory buildup, we expect China’s crude oil imports to increase by 4-6% in 2021 over the previous year, slower than last year’s 7.2% growth. Bottom Line: The underlying consumption growth of crude oil in China is likely to increase to 6-7% in 2021 from last year’s 4.5%, providing solid support to China’s crude oil imports. What About Other Factors Affecting Chinese Crude Oil Imports? Currently, both domestic crude oil production and net exports of Chinese petroleum products exports are small contributors to the growth of Chinese crude oil imports. However, as the Chinese petroleum export sector becomes more competitive in the global market, it will likely take a bigger share of China’s crude oil imports going forward. Chart 15Net Exports Of Chinese Petroleum Products Are On The Uptrend We expect domestic crude oil output to be stagnant in 2021. The breakeven prices for most domestic oil fields are US$50-60 per barrel. Without a considerable rally in oil prices, the total domestic crude oil output is unlikely to pick up. Moreover, due to the massive crude oil inventory buildup in recent years, Chinese oil producers may constrain their output. In this scenario, a reduction in domestic crude oil output by 1-2% in 2021 from 2020 is possible. Nonetheless, this will only increase China’s oil imports by a small amount of about 40-80 kbpd. The net exports of Chinese petroleum products are on the uptrend (Chart 15). Currently net exports of Chinese petroleum products account for only about 6% of Chinese crude oil imports.  However, Chinese refineries are increasingly competitive in global gasoline and diesel markets, since most of the new refineries in the country are high technology equipped and highly efficient. In addition, last July, China started issuing export licenses to private refiners, and we expect the trend to continue. According to Bloomberg, China is set to surpass the US to become the world’s largest oil refiner in 2021. As such, in the coming years we expect rising Chinese exports of petroleum products will demand more imports of crude oil.  We expect Chinese petroleum products net exports to rise by 100-150 kbpd in 2021 15-20% growth from last year), which may increase our estimate of China’s year-on-year crude oil import growth from 4-6% to 5-7% in 2021. However, increasing Chinese petroleum product exports does not increase global final demand for oil. It cannot be viewed as a fundamentally bullish factor for oil prices. Bottom Line: Stagnant domestic crude oil output and rising net exports of Chinese petroleum products will also lead to an increase of China’s crude oil imports.  Investment Implications Chart 16China: An Increasingly Important Factor For Global Oil Demand Strong crude oil imports by China have supported global oil prices in recent years. China has become an increasingly important driving force of global oil demand. Its oil imports currently make up about 12% of global oil demand, more than doubled from a decade ago (Chart 16). The country’s crude oil imports will continue expanding this year. Even at a slower rate, the robust oil consumption and imports from China will remain a positive factor for global oil prices in 2021. Beyond 2021, however, the country’s crude oil import growth outlook is facing increasing downside risks. Demand that is due to inventory accumulation is ultimately finite and non-recurring. Moreover, more oil accumulations in 2021 on top of China’s already elevated oil inventories may weigh on Chinese oil imports beyond 2021. In the meantime, US crude oil producers may benefit from continuing strong purchases from China. In 2020, China significantly ramped up its crude oil imports from the US, as the country has pledged to boost purchases of US energy products under the phase one trade deal signed with President Trump in January 2020. Chart 17Chinese Imports Of US Crude Oil May Continue To Rise In 2021 In 2020, Chinese imports of US crude oil in volume terms were 155% higher from a year before (Chart 17, top panel). Its share of total Chinese crude oil imports also spiked from 1-2% in late 2019 to 7-8% in the past several months (Chart 17, bottom panel). In the meantime, China’s share of US crude oil export also jumped from 4.6% in 2019 to 14.7% last year. In 2021, our baseline view is that China will want to show goodwill to the newly elected Biden administration by continuing to boost its crude oil purchase from the US. This will benefit US crude oil producers. However, if China buys more from the US, it may buy less from other countries.   Ellen JingYuan He  Associate Vice President ellenj@bcaresearch.com     Footnotes 1By deducting crude oil used in refineries and in direct final consumption from the total supply, we derived the flow of inventory and the level of changes in inventory. By using the cumulative value of the flow inventory data, we were able to derive the stock of inventory. We assume the initial inventory in 2006 was zero. This assumption is reasonable as the first fill of the SPR was in 2007 and the stock of CPR was extremely low at that time as well. In addition, based on the data from the National Bureau of Statistics, we found out that the direct final consumption of crude oil without any transformation only accounted for about 1-2% of total supply. 2 In 2004, the government planned three phases of SPR construction, targeting 10-12 million tons of crude oil SPR for the first phase, 28 million tons for the second phase, and another 28 million tons for the third phase. 3The import quota for independent refiners in 2021 has been increased by 20% (about 823 kbpd), and the country’s refinery capacity will expand at about 500 kbpd per year over 2021-2025. Cyclical Investment Stance Equity Sector Recommendations

Highlights The incidents of state-owned enterprise (SOE) bond defaults late last year reflected deteriorating corporate balance sheets and exposed local governments’ weakening fiscal positions. Both were preexisting conditions that worsened due to the pandemic. China’s policymakers have vowed to accelerate restructuring the SOE/corporate sector, but they face a dilemma between economic stability and painful reforms; the outcome will ultimately depend on policymakers’ pain thresholds. In the next 6 to 12 months, the policy tightening cycle will continue and credit growth will decelerate. Chinese stocks are already more expensive than before the start of the last policy tightening cycle. We recommend a neutral position on domestic and investable stocks for now. Feature The days of China’s unconditional bailout of state firms may be over. In the past six months, Beijing has embarked on a series of reform agendas, including restructuring and stricter regulations targeting SOEs and the broader spectrum of the corporate sector. When three SOEs defaulted on bond payments late last year, neither the central nor the local government supported those firms. Allowing market forces to allocate capital to more productive firms by driving out the less efficient companies is structurally positive for the Chinese economy.  However, the pursuit of meaningful SOE and broader corporate reforms will be a tough choice for Chinese policymakers this year while the economic recovery is underway. Ultimately, the degree and speed to reform SOEs will depend on how much near-term pain policymakers are willing to endure. We recommend a neutral position in Chinese stocks for now. We expect the financial markets to experience frequent mini-cycles in 2021 due to policy zigzags. Risks for policy miscalculations cannot be ruled out; equity prices will falter if Chinese authorities push for deeper reforms and tighter industry regulations while scaling back stimulus at the same time. Chinese stocks are already expensive and are vulnerable to authorities opting for much smaller stimulus and harsher corporate/SOE reforms. SOE Defaults: Policy Response Matters More Than Defaults Chart 1Policy Zigzags And Market Mini-Cycles A flurry of high-profile defaults by state firms late last year unnerved investors and pushed up onshore corporate bond yields. Beijing’s move to allow SOEs to fail forced investors to reprice bonds issued by state firms as much riskier propositions. Following the defaults in November, the PBoC injected unusually large interbank liquidity; the de jure policy rate dropped and Chinese stock prices rallied (Chart 1). In our view, the recent liquidity injections do not provide enough evidence that macro policy is shifting to an easier bias. Despite a retreat in the short-term interbank rate, the authorities have plowed ahead with reforms and initiated more restrictions in key industries. In the coming months, investors should expect the following: SOE reforms will tolerate more bond defaults. Bank loans and local government bonds make up nearly 80% of China’s total domestic credit, whereas corporate bonds (including SOEs and local government financing vehicles (LGFVs)) account for only 10% of the total (Chart 2). Thus, even if corporate bond defaults push up yields, Beijing may see this as a small price to pay in the near term, in exchange for a market-driven system cleansing to eliminate inefficient SOEs. This outcome will be negative for corporate bonds (Chart 3). Chart 2Corporate Bond Issuance Make Up Only A Small Portion Of Total Financing Chart 3Periods Of Financial Tightening Dampen Corporate Bond Market Chart 4Higher Funding Costs Will Discourage Corporate Borrowing Policymakers may underestimate the unintended consequences of SOE defaults on credit flow and the broader economy. The central bank was able to engineer a sharp drop in its policy rate last month, which may prompt policymakers to believe that interbank liquidity injections are efficient market-calming measures and rising corporate bond yields will not impede overall credit growth. This may be true in the short term, however, tightened policy in the name of reforms has previously pushed up both the 3-month SHIBOR and bank lending rates, leading to a significant slowing in credit growth and an eventual slowdown in economic expansion (Chart 4). Reasons for such chain reactions are twofold. First, banks become more risk averse during a tightening cycle and charge higher premiums when lending to smaller financial institutions and the private sector (Chart 4, bottom panel). Secondly, although Chinese SOEs can borrow from banks at much lower interest rates than private-sector entities (Chart 5), their heavy indebtedness makes them hyper-sensitive to even a slight uptick in financing costs. Chinese SOEs rely more on bank lending than bond issuance for financing and SOE borrowers dominate China’s bank credit to the corporate sector.1  Chart 6 shows that the rise in the weighted average lending rate in 2017 was relatively minor compared with levels that prevailed in the past decade. Nonetheless, a less than one percentage point hike in the lending rate materially slowed credit growth and the investment-driven sectors of China's economy. Chart 5SOEs Tend To Have Lower Borrowing Costs, Partially Reflecting Implicit Government Guarantees Chart 6Small Rise In Lending Rate, Large Fall In Credit Growth   Regulatory pressures will lead to de facto tightening. As outlined in our 2021 Outlook report, as part of the macroeconomic policy normalization, credit growth will likely decelerate by two to three percentage points this year from 2020. The extended Macro Prudential Assessment (MPA) System will wrap up by year-end and financial institutions will need to start slowing their asset balance sheets to meet the assessments. Moreover, last week the central government revised Measures for the Performance Evaluation of Commercial Banks. The modified version factors lending to the new-economy sectors and micro and small enterprises into the performance evaluation and salaries of the state-owned and controlled commercial banks’ management.2 The new measures will likely dampen the banks’ propensity to lend to old-economy sectors, such as real estate and traditional infrastructure. All in all, a faster-than-desired slowdown in credit growth will ensue if policymakers simultaneously allow more SOE/corporate defaults, undertake industry reforms, and implement tighter banking regulations in 2021. This is negative for both economic growth and the equity market. Bottom Line: Chinese policymakers will likely allow more SOE defaults in the coming months. In addition to an increased number of SOE defaults that is negative for the corporate bond market, sped up industry restructuring and more stringent regulations may lead to a sharp fall in credit growth and stock prices. Worsening Old Economy SOEs’ Financial Positions Chart 7SOEs Are Less Efficient Than Private Firms In Profitability And Productivity An acceleration in SOE reforms may trigger near-term risks, but a delay in restructuring China’s loss-making SOEs will have repercussions in the long term. The explicit and implicit government protections for SOEs have eroded their efficiencies compared with the private sector (Chart 7). The most significant side effect is a rapid rise in SOE leverage and diminishing profitability in some of the old economy sectors. It may be a dead end for the government to continue bailing out state firms with inefficient operations and financial losses. A Special Report we previously published  showed that among SOEs in the industrial and construction sectors, which account for half of all SOEs in China, the adjusted return on assets (ROA) versus borrowing costs has been negative since 2013 (Chart 8). This suggests that SOE investment funded by higher leverage cannot produce sufficient income to repay debt. During the last tightening cycle that started in late 2016, policymakers managed to rein in local SOE debt growth, but it reversed course in 2018 due to a collapse in domestic demand (Chart 9).  As Chart 8 illustrates, ROA among SOEs in the industrial and construction sectors has significantly deteriorated since then. Chart 8SOEs Financial Gains From Debt Are In Deep Contraction Chart 9China Was Successful In Reining In SOE Debt, But Only Briefly Bottom Line: A continued capital misallocation by perpetually leveraging SOEs and LGFVs with negative marginal operating gains will eventually lead to a self-reinforcing debt trap. In turn, that would precipitate a default en masse and necessitate a larger government bailout. Another Layer To The SOE Reform Dilemma The central government’s SOE reform agenda is further complicated by the involvement of local governments (LGs). We have several observations: First, a meaningful SOE restructuring, which would require consolidating/liquidating some of the unprofitable SOE assets, may expose the LGs’ fiscal vulnerabilities to both investors and regulators. The fiscal weakness of China’s provincial-level governments is illustrated by the bond-payment default of Yongcheng Coal, a SOE from Henan Province. Henan is economically sound with GDP growth above the national average. However, when considering the province’s direct and hidden debt, debt servicing costs, and liquidity availability, Henan is in a group of 10 provinces with the worst fiscal conditions in 2020.3 This implies that LG officials may not have been able to bail out Yongcheng even if they wanted to. Moreover, cash-strapped LGs have reportedly formed reciprocal and entrenched relationships with local SOEs. These SOEs may carry debt for LGs and in turn, free up an LG’s borrowing capacity. When these SOEs fail, the credibility of LG officials may be questioned and investigated by the central government. As such, LGs are incentivized to protect their local SOEs.  Chart 10More Defaults, More Bank Lending Secondly, removing the government’s bailout of SOE debt defaults does not negate the underlying factor eroding SOE productivity: the government’s support of local SOEs with easier access to bank loans. Banks, which heavily influence LGs, are not always vigilant about risks associated with local SOE debt. Banks provide loans at preferential rates to localities and their affiliated SOEs. In return, LGs often award banks financing opportunities for profitable infrastructure projects. In this regard, local SOE bond defaults are not necessarily detrimental to bank profits because banks can make up their losses through financing more lucrative projects. Studies show that even when some LGs have experienced large-scale SOE bond defaults, lending to these LGs from commercial banks actually increased relative to other forms of financing (Chart 10). Beijing must take bold measures to break up the long-standing relationship between LGs and SOEs in order to achieve any market-oriented reform of local SOEs. The LGs will likely strongly resist severing the connection. Lastly, given that SOEs are often deployed to support the central government’s economic, political and strategic initiatives, LGs can use those grand initiatives to help justify their local SOEs’ existence - even unprofitable ones. Bottom Line: Beijing faces a tough choice between implementing effective SOE reforms and worsening local governments’ fiscal conditions with negative implications for economic growth. While allowing more SOE bond defaults can force investors to reprice SOE credit risks, as long as the implicit government support for SOEs through bank lending still exists, allocating capital to more efficient private-sector companies will be a formidable task. Investment Conclusions Some economists argue that China’s SOE debt should be considered part of public-sector leverage because many SOE investments are affiliated with government projects. Additionally, Chinese SOEs have accumulated massive assets, which can more than offset their debt4 and make SOE bonds and debt low- risk propositions. Moreover, even though the government may allow more SOE bond defaults, if the defaults threaten China’s financial stability, then the government can move non-performing debt from LGs and SOEs to the balance sheets of the central bank or central government. There are several issues with this argument. The stock of assets in a large portion of Chinese SOEs5 has persistently failed to generate sufficient cash flow to service debt, which implies that the true value of the assets may be low and will likely be sold at below cost when liquidated. It is not useful to compare book value of assets with debt because the true value of assets is contingent on the income/cash flow that they generate. We agree that public-sector leveraging/deleveraging is fundamentally a political choice in countries with control over their own monetary policy and debt is in local currency. Theoretically, a country can monetize public and private local currency-denominated debt via a central bank or government- controlled commercial banks. In such a case, the authorities will have little control over inflation, the exchange rate, and the long-term productivity.   For now, Chinese policymakers seem to be on a path of accelerating reform, an indication that they want to avoid bailing out state firms and private-sector companies. In addition, President Xi’s “dual circulation” mantra emphasizes the importance of improving the country’s corporate efficiency and productivity. We think that consolidating some inefficient SOE sectors in the old economy fits such initiative. Our baseline view is that the SOE consolidation process will be gradual and the PBoC will provide sufficient liquidity in an effort to prevent market jitters. At the same time, the sharp turns in the policy rate in the past six months are prime examples of the periodic oscillation in China’s policymaking between maintaining economic stability and pursuing meaningful reforms. The policy swings will create mini-cycles for Chinese risk asset prices. Chinese stocks are not cheap compared with values at the start of the last policy tightening cycle (Chart 11A and 11B). We recommend a neutral position on domestic and investable equities for the time being. CHART 11AInvestable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle CHART 11BA-Shares Are Less Expensive, But Valuations Are Still Elevated   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Based on the OECD estimates, SOEs’ share of China’s total corporate debt escalated from 46% in 2013 to roughly 80% in 2018.  2Banks included in the new appraisal system are state-owned and state-controlled commercial lenders, and other commercial banks may also refer to the guidelines. Lenders will be evaluated yearly and the results will be factored into the annual reviews of top bank executives as salary determinants. Each of the four new categories will carry an equal weighting. The “national development goals and real economy” category has four benchmarks: serving the government’s “ecological civilization strategy” to encourage lending for green industries and companies; serving strategic emerging industries; implementing the “two increases” - inclusive lending to micro and small enterprises; and implementing the “two controls” - nonperforming loans and borrowing costs of micro and small enterprises. The category “controlling and preventing risks” includes metrics on bad loan ratios, the nonperforming loan growth rate, provision coverage, liquidity ratios and capital adequacy ratios. 3“Seeing Through the Frosted Glass: Assessing Chinese Local Governments’ Creditworthiness”, Pengyuan Rating Public Finance Report, June 2020 4Chinese SOE assets are estimated to have reached 2.3 times China’s 2019 GDP, whereas their debt is close to 130% of GDP. 5IMF estimated that about a quarter of Chinese SOEs were operating at a loss in 2017. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. We illustrate why and how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Detecting productivity for macro strategists is akin to doctors diagnosing a patient – it entails more art than science. Inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. Feature By far, the most critical variable determining long-term economic growth is a country’s productivity. This report presents why productivity matters for investors and examines how to gauge productivity growth given it is practically impossible to measure accurately. We use the framework presented in this report to analyze long-term trends in individual EM economies. In a follow-up piece, we will present a practical application of this framework by ranking developing economies according to their productivity and long-term growth potential. This report does not discuss what is needed to boost productivity because the policy prescriptions are well known and are widely available in economic literature. That said, we have outlined some of these in Box 1. BOX 1 The Basic Formula For Long-Term Growth For any economy, the potential growth rate is what can be achieved and sustained in the very long run. It can be expressed as follows: Potential (real) growth rate = productivity growth + labor force growth Given that we can use demographic data to approximate the number of people entering and exiting the labor force for each year over the next 18 years, the labor force growth variable can be easily estimated. Hence, the key unknown in the above formula is productivity growth. In a developing economy, it is difficult to measure productivity accurately (Chart 1). That is why when analyzing the long-term outlook, we first assess whether the country has effectively implemented the structural reforms needed to achieve faster productivity growth – some of which are listed below. We combine these observations with symptoms associated with either strong or weak productivity growth in order to assess an economy’s potential growth trajectory. Chart 1Productivity Growth Estimates For EM/China Recommended policies to raise productivity growth typically include: building hard and soft infrastructure, improving education and training, investing in new technologies and equipment, promoting entrepreneurship and formation of new businesses, promoting competition, augmenting R&D spending, importing foreign “know how,” and fostering industry clusters that specialize in certain products or processes. Why Does Productivity Matter For Investors? Following are the investment implications of productivity growth: 1. Productivity is the sole driver of growing prosperity, which is reflected in rising per capita real incomes (Chart 2). Productivity = output per employee per hour  = (real GDP or output) / (number of employees x number of hours worked) Rising productivity creates more income that is shared between employees and shareholders. If productivity rises by 5% and hourly wages increase by 2.5% in a year, unit labor costs will drop by 2.5%. In such a case, the 5% increase in productivity is shared equally between shareholders and employees. A lack of productivity gains and resulting stagnant income for both employees and business owners might lead to rising socio-political tensions and ultimately to political instability. 2. Strong productivity gains allow an economy to grow faster without experiencing high inflation (Chart 3). The upshot is reduced cyclicality in economic activity, i.e., business cycles are characterized by longer expansions and shallow and less frequent downturns. Equity investors will thus likely pay higher equity multiples due to the reduced cyclicality of corporate profits. Chart 2Productivity Is Ultimately Reflected In Rising Real Income Per Capita Chart 3China: Strong Productivity Growth Has Kept A Lid On Inflation   The rationale is that robust productivity advances allow the economy to expand with low inflation with no need for monetary tightening. The relationship between productivity and inflation is discussed in detail below. A structurally low inflation environment allows policymakers to promptly deploy large monetary and fiscal stimulus when faced with economic downturns. In addition, low interest rates are also associated with higher equity valuations. On the contrary, a lack of productivity growth makes business cycles short-lived. Inflation will rise faster during a business cycle expansion in an economy with low productivity growth. In turn, interest rates will rise more rapidly in those economies, short-circuiting the expansion. Equity investors will be reluctant to pay high multiples for companies operating in such environments. 3. On a microeconomic level, high productivity gains are typically associated with higher profit margins and vice versa (Chart 4). Shareholders assign higher equity multiples to enterprises with higher profit margins and return on capital. Chart 4Faster Productivity Growth = Wider Corporate Profit Margins Besides, wider profit margins allow companies to tolerate higher real interest rates. High real interest rates attract foreign fixed-income capital supporting the nation’s exchange rate. Given that labor costs make up a large share of costs in many companies, unit labor costs are a critical determinant of corporate profitability. Meanwhile, selling prices, sales as well as input prices are often beyond management control. Therefore, raising productivity (output per hour of an employee) is one of the few ways to lift corporate profitability and, by extension, return on capital. Unit labor costs = (wage per person per hour) / productivity 4. Rapid productivity advances allow companies to become more competitive without currency depreciation (Chart 5and Chart 6). Exchange rates of countries that achieve faster productivity growth typically appreciate in the long run. Chart 5Switzerland: High Productivity Has Sustained Competitiveness/Export Volumes Despite Currency Appreciation Chart 6China and Vietnam: Rising Export Market Share Reflects Productivity Gains   Enterprises with higher productivity can drop their selling prices with limited impact on their profitability. By doing so, they can undercut their competitors and gain market share. Hence, solid productivity gains also entail a competitive currency, eliminating the need for central banks to hike interest rates in order to defend the exchange rate. 5. High indebtedness – in both public and private sectors – is easier to manage amid brisk productivity gains because the latter generate strong economic growth and relatively low nominal interest rates. Robust income gains among businesses and households, as well as for the government via taxation, enable indebted agents to service higher debt loads. Besides, nominal GDP growth above nominal interest rates arithmetically implies a drop in the public debt-to-GDP ratio. In brief, the economy could “grow into its debt” with robust productivity gains. In sum, strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. Rapid Productivity Gains Lead To A Virtuous Circle The following illustrates how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Fast productivity gains allow for either fast wage or rapid corporate profit growth or a combination of the two. As income per capita rises, consumer spending grows and capital owners are willing to invest. New investments create new jobs and income and could also boost future productivity if substantial capital misallocation is dodged. The economy expands at a rapid rate, but inflation and, thereby, interest rates remain capped because the economy’s productive capacity grows in line with demand. Strong income and profit growth as well as stable borrowing costs lead to more credit demand from both households and businesses. Bank and non-bank credit expand but rapid household income gains and healthy enterprise profitability as well as growing government tax revenues support the private or public sectors’ debt servicing capacity. Robust economic growth, elevated real interest rates and high profitability attract foreign capital and foreign inflows lead to currency appreciation. Yet, such currency appreciation should not undermine the competitiveness of local producers – both exporters and those competing with imported goods. As discussed above, sizable productivity gains could reduce unit labor costs and allow domestic companies to drop their prices, sustaining their market shares in both export markets and domestically. Consequently, the trade balance does not deteriorate structurally despite a rapid expansion in domestic demand. Healthy balance of payments support the currency, i.e., the central bank does not need to hike interest rates or draw down reserves to defend the exchange rate. Finally, rapid corporate profit and household income growth as well as reasonably low nominal interest rates sustain high asset (equity and property) valuations for longer. Such a virtuous circle can persist until something breaks or major excesses – for example, capital misallocation, credit or property bubbles – emerge and then unravel. Meager Productivity Gains Lead To A Vicious Circle The following demonstrates how stagnant productivity can set in motion a vicious self-reinforcing circle. With no productivity gains, a business cycle recovery will likely lead to higher inflation sooner than later. The latter will short circuit the economic expansion as the central bank is forced to hike interest rates. If the central bank does not hike interest rates despite rising inflation, real (inflation-adjusted) interest rates will fall and could become negative. Low real rates are bearish for the currency. Either the central bank will be forced eventually to hike interest rates substantially or the exchange rate will continue depreciating. There are two reasons why low real interest rates are negative for the exchange rate: (1) low real borrowing costs will encourage more borrowing, spending, and investment. Such very strong domestic demand in the context of limited domestic productive capacity will lead to a ballooning trade deficit; and/or (2) low real interest rates will discourage foreign fixed-income capital inflows and weigh on the currency. With no productivity gains, any increase in wages will lead to rising unit labor costs and shrinking profit margins; corporate profitability and return on capital will plunge. The sole way to protect profitability amid rising unit labor costs is to raise selling prices. The latter could spur a wage-inflation spiral. Rising unit labor costs and resulting shrinking corporate profit margins leave domestic producers no room to reduce their selling prices to compete in export markets and with imports. The result is less exports, less import substitution and a deteriorating trade balance. In such a case, the only way to restore the competitiveness of domestic producers is to devalue the exchange rate. Declining or low returns on capital will discourage business investment, in general, and foreign direct investment (FDI) in particular with negative ramifications for future productivity. A worsening trade balance as well as diminishing foreign equity and FDI inflows also entail currency depreciation. This feeds into inflation and leads inevitably to monetary policy tightening. Such tightening prompts weaker growth, lower profitability and more foreign capital outflows. This vicious circle can persist until a major regime shift occurs: a dramatically devalued currency that stays very cheap or corporate restructuring and structural reforms that lead to higher productivity. Commodity Prices And Productivity A critical question to address regarding productivity in commodity producing countries is the issue of rising and falling commodity prices. Higher commodity prices lead to improved prosperity and vice versa. Does this mean that high commodity prices should be treated as productivity improvements? There is some ambiguity in regard to this but our preference is not to treat fluctuations in commodity prices as changes in the nation’s structural productivity. Let us consider the examples of Nigeria, which produces and exports oil, and Vietnam, which manufactures and ships smartphones in large quantities. Let us assume that smartphone exports are as important to Vietnam in generating income per capita as oil exports are to Nigeria. A doubling in oil prices amid flat oil export volumes would generate windfall oil revenues which would lift Nigeria’s income per capita. If smartphone prices remain constant but smartphone production and shipments (volumes) double, income per capita in Vietnam would rise as much as in Nigeria.1   The difference between these two scenarios in Nigeria and Vietnam is as follows: Nigeria would be made richer due to the price increases: it would be producing and exporting the same number of barrels of oil but a doubling in crude prices would augment income per capita in Nigeria. The problem is that Nigeria does not control oil prices. If oil prices decline, the nation’s income per capita would also drop substantially. Hence, there would have been no genuine (structural) productivity gains and Nigeria’s prosperity would be at the mercy of the global oil market. In the case of Vietnam, its productivity will have risen as it has succeeded in producing twice as many smartphones as it did last year. The country has built capacity, acquired technology and developed human skills to double smartphone production. This increased capacity, technology acquisition and skills cannot be taken away from Vietnam. This is a case of genuine productivity advancement. In fact, Vietnam could build on these skills and start producing other, more value-added goods. What if Nigeria doubled its oil output and export volume due to more investment and new technologies (as the US succeeded in doing with shale oil)? This scenario would qualify as genuine productivity gains. At any oil price scenario, Nigeria’s oil export revenues would double. The sole caveat is that the new oil production should have reasonably low breakevens, i.e., oil production should be viable even if oil prices decline. The same caveat is applicable to Vietnam. The difference between Nigeria (oil) and Vietnam (smartphones) is that commodities prices are much more volatile than manufactured goods prices. Bottom Line: In commodity producing countries, rising commodities prices have the same effect on income per capita as productivity gains. However, per capita income gains originating from higher commodities prices are reversable, i.e., not sustainable in the very long run. Consequently, higher commodity prices should not be treated as structural productivity gains. By contrast, productivity advancements – like Vietnam doubling its capacity to produce smartphones or Nigeria doubling its oil production volume – are non-reversable, i.e., they cannot be taken away. Hence, these constitute genuine productivity gains. Detecting Productivity Is Akin To Doctors Diagnosing A Patient Even in advanced countries, productivity is hard to measure accurately. Hence, any measure of productivity in developing economies should be used with a grain of salt.  How do we carry out long-term analysis of developing economies when the key variable – productivity growth – is hard to measure? How do we make projections about productivity growth going forward? We see structural macro analysis as analogous to the work of doctors. When diagnosing a patient, doctors cannot necessarily observe what is happening in the patient’s body. Doctors conduct various tests and then analyze those results in the context of the symptoms. Putting it all together, they make a diagnosis and prescribe the necessary treatment. Similar to the manner in which doctors rely on symptoms and medical tests to determine where there is sufficient evidence of a disease, macro strategists do not see what is really occurring in their “patient’s” body, i.e., economies. Data for macro strategists is akin to medical tests for doctors. In developing countries, the quantity of economic data available to macro strategists is limited and of poor quality. Therefore, observing symptoms of economies under consideration and interpreting them correctly is crucial to the job of macro strategists for emerging economies. As they can count less on hard data and instead rely more on symptoms, their analysis is more of an art than a science. Symptoms Associated With Productivity: How To Detect Productivity At a country level, robust productivity gains are ceteris paribus typically associated with: A structurally improving real trade balance (exports minus import volumes), which is not due to a cheapened currency or a relapse in domestic demand but is due to domestic producers achieving the following: Becoming more competitive and gaining market share in global trade Succeeding in import substitution (imported products are crowded out by locally produced ones) Low inflation during an extended period of business cycle expansion Corporate profit margins expanding simultaneously with higher wages amid low inflation. A lack of productivity gains are ceteris paribus normally attendant with: A structurally deteriorating real trade balance as: Domestic producers lose market share in global exports Domestic producers lose market share to importers in local markets Rising inflation amid a moderate recovery in domestic demand Lingering downward pressure on corporate profit margins i.e., a modest rise in wage growth leads to a drop in corporate profit margins. On the whole, inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. A widening real trade deficit is a form of hidden inflationary pressure and a sign of lackluster productivity growth. The rationale is as follows: In a closed economy, when expanding demand outpaces the productive capacity of that economy, i.e., productivity gains do not keep up with thriving domestic demand, inflation will rise considerably. In short, rising inflation will be a symptom of paltry productivity gains. In an open economy, when domestic demand outpaces the productive capacity of that economy, inflation might not rise as demand could be satisfied by imports of foreign goods and services. In such a scenario, even though the trade balance will deteriorate, the currency might stay firm for a while because of foreign capital inflows or rising export (commodities) prices. As a result, inflation will stay low for some time. Eventually, when tailwinds from foreign capital inflows or high export prices cease, the currency will nosedive. Importers will have to raise prices in local currency causing a spike in inflation. Why would foreign capital inflows halt? Lackluster productivity gains amidst solid wage increases would cause a corporate profit margin squeeze and profitability will plummet. As a result, both FDI and equity inflows will dry up and the currency will depreciate. The latter will push up inflation considerably. In a nutshell, in an open economy poor productivity growth might not necessarily lead to high inflation where domestic demand can be satisfied by imports. In these cases, we can say that a widening real trade deficit is a form of hidden inflation. The only exception is when the real trade balance deteriorates due to imports of capital goods and/or new technologies that will be used to build new productive capacity. In such a case, a ballooning trade deficit should not be viewed as a form of hidden inflation and poor productivity growth. If consumer goods dominate imports, this would signify low chances of sizable productivity gains in a given country. If capital goods dominate imports, there are higher odds of future productivity gains. If these imported equipment and technologies are properly utilized, they will make the nation productive and competitive in the coming years. Higher productivity stemming from imports of these capital goods/new technologies, i.e., enlarged capacity to produce goods and services at lower costs, will cap inflation as well as expand exports and result in significant import substitution. A Checklist For Detecting Productivity Diagram 1 presents macro signposts that can be used to diagnose whether an economy is experiencing strong or weak productivity growth (these do not include traditional metrices such as education, R&D spending, strong governance, soft- and hard-infrastructure, etc.): Diagram 1A Checklist For Detecting Productivity Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  We assume here that all inputs for smartphones are produced domestically, in Vietnam. This is not a realistic assumption, but we use it only to illustrate a macro point about productivity.