Asia

Highlights Market-based geopolitical analysis is about identifying upside as well as downside risk. So far this year upside risks include vaccine efficacy, coordinated monetary and fiscal stimulus, China’s avoidance of over-tightening policy, and Europe’s stable political dynamics. Downside risks include vaccine rollout problems, excessive US stimulus, a Chinese policy mistake, and traditional geopolitical risks in the Taiwan Strait and Persian Gulf. Financial markets may see more turmoil in the near-term over rising bond yields and the dollar bounce. But the macro backdrop is still supportive for this year. We are initiating and reinitiating a handful of trades: EM currencies ex-Brazil/Turkey/Philippines, the BCA rare earth basket, DM-ex-US, and the Trans-Pacific Partnership markets, and global value plays. Feature Chart 1Bond Yield Spike Threatens Markets In Near Term Bond Yield Spike Threatens Markets In Near Term Bond Yield Spike Threatens Markets In Near Term Investors hear a lot about geopolitical risk but the implication is always “downside risk.” What about upside risks? Where are politics and geopolitics creating buying opportunities? So far this year, on the positive side, the US fiscal stimulus is overshooting, China is likely to avoid overtightening policy, and Europe’s political dynamics are positive. However, global equity markets are euphoric and much of the good news is priced in. On the negative side, the US stimulus is probably too large. The output gap will be more than closed by the Biden administration’s $1.9 trillion American Rescue Plan yet the Democrats will likely pass a second major bill later this year with a similar amount of net spending, albeit over a longer period of time and including tax hikes. The countertrend bounce in the dollar and rising government bond yields threaten the US and global equity market with a near-term correction. The global stock-to-bond ratio has gone vertical (Chart 1). Meanwhile Biden faces immediate foreign policy tests in the Taiwan Strait and Persian Gulf. These two are traditional geopolitical risks that are once again underrated by investors. The near term is likely to be difficult for investors to navigate. Sentiment is ebullient and likely to suffer some disappointments. In this report we highlight a handful of geopolitical opportunities and offer some new investment recommendations to capitalize on them. Go Long Japan And Stay Long South Korea China’s stimulus and recovery matched by global stimulus and recovery have led to an explosive rise in industrial metals and other China-sensitive assets such as Swedish stocks and the Australian dollar that go into our “China Play Index” (Chart 2). Chart 2China Plays Looking Stretched (For Now) China Plays Looking Stretched (For Now) China Plays Looking Stretched (For Now) While a near-term pullback in these assets looks likely, tight global supplies will keep prices well-bid. Moreover long-term strategic investment plans by China and the EU to accelerate the technology race and renewable energy are now being joined by American investment plans, a cornerstone of Joe Biden’s emerging national policy program. We are long silver and would buy metals on the dips. Chinese President Xi Jinping’s “new era” policies will be further entrenched at the March National People’s Congress with the fourteenth five-year plan for 2021-25 and Xi’s longer vision for 2035. These policies aim to guide the country through its economic transition from export-manufacturing to domestic demand. They fundamentally favor state-owned enterprises, which are an increasingly necessary tool for the state to control aggregate demand as potential GDP growth declines, while punishing large state-run commercial banks, which are required to serve quasi-fiscal functions and swallow the costs of the transition (Chart 3). Xi Jinping’s decision to promote “dual circulation,” which is fundamentally a turn away from Deng Xiaoping’s opening up and liberal reform to a more self-sufficient policy of import substitution and indigenous innovation, will clash with the Biden administration, which has already flagged China as the US’s “most serious competitor” and is simultaneously seeking to move its supply chains out of China for critical technological, defense, and health goods. Chart 3Xi Jinping Leans On The Banks To Save The SOEs Xi Jinping Leans On The Banks To Save The SOEs Xi Jinping Leans On The Banks To Save The SOEs Chinese political and geopolitical risks are almost entirely priced out of the market, according to our GeoRisk Indicator, leaving Chinese equities exposed to further downside (Chart 4). Hong Kong equities have traded in line with GeoRisk Indicator for China, which suggests that they also have downside as the market prices in a rising risk premium due to the US’s attempt to galvanize its allies in a great circumvention of China’s economy in the name of democracy versus autocracy. Chart 4China/HK Political Risk Priced Out Of Market China/HK Political Risk Priced Out Of Market China/HK Political Risk Priced Out Of Market China has hinted that it will curtail rare earth element exports to the US if the US goes forward with a technological blockade. Biden’s approach, however, is more defensive rather than offensive – focusing on building up domestic and allied semiconductor and supply chain capacity rather than de-sourcing China. President Trump’s restrictions can be rolled back for US designed or manufactured tech goods that are outdated or strictly commercial. Biden will draw the line against American parts going into the People’s Liberation Army. Biden has a chance in March to ease the Commerce Department’s rules implementing Trump’s strictures on Chinese software apps in US markets as a gesture of engagement. Supply constraints and shortages cannot be solved quickly in either semiconductors or rare earths. But both China and the US can circumvent export controls by importing through third parties. The problem for China is that it is easier for the US to start pulling rare earths from the ground than it is for China to make a great leap forward in semiconductor production. Given the US’s reawakening to the need for a domestic industrial policy, strategic public investments, and secure supply chains, we are reinitiating our long rare earth trade, using the BCA rare earth basket, which features producers based outside of China (Chart 5). The renminbi is starting to rolling over, having reached near to the ceiling that it touched in 2017 after Trump’s arrival. There are various factors that drive the currency and there are good macro reasons for the currency to have appreciated in 2016-17 and 2020-21 due to strong government fiscal and monetary reflation. Nevertheless the People’s Bank allowed the currency to appreciate extensively at the beginning of both Trump’s and Biden’s terms and the currency’s momentum is slowing as it nears the 2017 ceiling. We are reluctant to believe the renminbi will go higher as China will not want to overtighten domestic policy but will want to build some leverage against Biden for the forthcoming strategic and economic dialogues. For mainland-dedicated investors we recommend holding Chinese bonds but for international investors we would highlight the likelihood that the renminbi has peaked and geopolitical risk will escalate. There is no substantial change on geopolitical risk in the Taiwan Strait since we wrote about it recently. A full-scale war is a low-probability risk. Much more likely is a diplomatic crisis – a showdown between the US and China over Taiwan’s ability to export tech to the mainland and the level of American support for Taiwan – and potentially a testing of Biden’s will on the cybersecurity, economic security, or maritime security of Taiwan. While it would make sense to stay long emerging markets excluding Taiwan, there is not an attractive profile for staying long emerging markets excluding all of Greater China. Therefore investors who are forced to choose should overweight China relative to Taiwan (Chart 6). Chart 5Rare Earth Miners Outside China Can Go Higher Rare Earth Miners Outside China Can Go Higher Rare Earth Miners Outside China Can Go Higher Market forces have only begun to register the fact that Taiwan is the epicenter of geopolitical risk in the twenty-first century. The bottleneck for semiconductors and Taiwan’s role as middleman in the trade war have supported Taiwanese stocks. It will take a long time for China, the US, and Europe to develop alternative suppliers for chips. But geopolitical pressures will occasionally spike and when they do Taiwanese equities will plunge (Chart 7). Chart 6EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk South Korean geopolitical risk is also beneath the radar, though stocks have corrected recently and emerging market investors should generally favor Korea, especially over Taiwan. The first risk to Korea is that the US will apply more pressure on Seoul to join allied supply chains and exclude shipments of sensitive goods to China. The second risk is that North Korea – which Biden is deliberately ignoring in his opening speeches – will demand America’s attention through a new series of provocations that will have to be rebuked with credible threats of military force. Chart 7Markets Starting To Price Taiwan Strait Geopolitical Risk Markets Starting To Price Taiwan Strait Geopolitical Risk Markets Starting To Price Taiwan Strait Geopolitical Risk Chart 8South Korea Favored In EM But Still Faces Risks Over Chips, The North South Korea Favored In EM But Still Faces Risks Over Chips, The North South Korea Favored In EM But Still Faces Risks Over Chips, The North   Chart 9Don't Worry About Japan's Revolving Door Don't Worry About Japan's Revolving Door Don't Worry About Japan's Revolving Door The North Korean risk is usually very fleeting for financial markets. The tech risk is more serious but the Biden administration is not seeking to force South Korea to stop trading with China, at least not yet. The US would need to launch a robust, multi-year diplomatic effort to strong-arm its allies and partners into enforcing a chip and tech ban on China. Such an effort would generate a lot of light and heat – shuttle diplomacy, leaks to the press, and public disagreements and posturing. Until this starts to occur, US export controls will be a concern but not an existential threat to South Korea (Chart 8). Japan is the geopolitical winner in Asia Pacific. Japan is militarily secure, has a mutual defense treaty with the US, and stands to benefit from the recovery in global trade and growth. Japan is a beneficiary of a US-driven tech shift away from excess dependency on China and is heavily invested in Southeast Asia, which stands to pick up manufacturing share. Higher bond yields and inflation expectations will detract from growth stocks more than value stocks, and value stocks have a larger market-cap weight in European and Japanese equity markets. Japanese politics are not a significant risk despite a looming election. While Prime Minister Yoshihide Suga is unpopular and likely to revive the long tradition of a “revolving door” of short-lived prime ministers, and while the Liberal Democratic Party will lose the super-majorities it held under Shinzo Abe, nevertheless the party remains dominant and the national policy consensus is behind Abe’s platform of pro-growth reforms, coordinated dovish monetary and fiscal policy, and greater openness to trade and immigration (Chart 9). Favor EU And UK Over Russia And Eastern Europe Russian geopolitical risk appears to be rolling over according to our indicator but we disagree with the market’s assessment and expect it to escalate again soon (Chart 10). Not only will Russian social unrest continue to escalate but also the Biden administration will put greater pressure on Russia that will keep foreign investors wary. Chart 10Russia Geopolitical Risk Will Not Roll Over Russia Geopolitical Risk Will Not Roll Over Russia Geopolitical Risk Will Not Roll Over While geopolitics thus poses a risk to Russian equities – which are fairly well correlated (inversely) with our GeoRisk indicator – nevertheless they are already cheap and stand to benefit from the rise in global commodity prices and liquidity. Russia is also easing fiscal policy to try to quiet domestic unrest. The pound and the euro today are higher against the ruble than at any time since the invasion of Ukraine. It is possible that Russia will opt for outward aggressiveness amidst domestic discontent, a weak and relapsing approval rating for Vladimir Putin and his government, and the Biden administration’s avowed intention to prioritize democracy promotion, including in Ukraine and Belarus (Chart 11). The ruble will fall on US punitive actions but ultimately there is limited downside, at least as long as the commodity upcycle continues. Chart 11Ruble Can Fall But Probably Not Far Ruble Can Fall But Probably Not Far Ruble Can Fall But Probably Not Far Biden stated in his second major foreign policy speech, “we will not hesitate to raise the cost on Russia.” There are two areas where the Biden administration could surprise financial markets: pipelines and Russian bonds. Biden could suddenly adopt a hard line on the Nordstream 2 pipeline between Russia and Germany, preventing it from completion. This would require Biden to ask the Germans to put their money where their mouths are when it comes to trans-Atlantic solidarity. Biden is keen to restore relations with Germany, and is halting the withdrawal of US troops from there, but pressuring Germany on Russia is possible given that it lies in the US interest and Biden has vowed to push back against Russia’s aggressive regional actions and interference in American affairs. The US imposed sanctions on Russian “Eurobonds” under the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991 (CBW Act) in the wake of Russia’s poisoning of secret agent Sergei Skripal in the UK in 2018. Non-ruble bank loans and non-ruble-denominated Russian bonds in primary markets were penalized, which at the time accounted for about 23% of Russian sovereign bonds. This left ruble-denominated sovereign bonds to be sold along with non-ruble bonds in secondary markets. The Biden administration views Russia’s poisoning of opposition leader Alexei Navalny as a similar infraction and will likely retaliate. The Defending American Security from Kremlin Aggression Act is not yet law but passed through a Senate committee vote in 2019 and proposed to halt most purchases of Russian sovereign debt and broaden sanctions on energy projects and Kremlin officials. Biden is also eager to retaliate for the large SolarWinds hack that Russia is accused of conducting throughout 2020. Cybersecurity stocks are an obvious geopolitical trade in contemporary times. Authoritarian nations have benefited from the use of cyber attacks, disinformation, and other asymmetric warfare tactics. The US has shown that it does not have the appetite to fight small wars, like over Ukraine or the South China Sea, whereas the US remains untested on the question of major wars. This incentivize incremental aggression and actions with plausible deniability like cyber. Therefore the huge run-up in cyber stocks is well-supported and will continue. The world’s growing dependency on technology during the pandemic lockdowns heightened the need for cybersecurity measures but the COVID winners are giving way to COVID losers as the pandemic subsides and normal economic activity resumes. Traditional defense stocks stand to benefit relative to cyber stocks as the secular trend of struggle among the Great Powers continues (Chart 12). Specifically a new cycle of territorial competition will revive military tensions as commodity prices rise. Chart 12Back To Work' Trade: Long Defense Versus Cyber Back To Work' Trade: Long Defense Versus Cyber Back To Work' Trade: Long Defense Versus Cyber By contrast with Russia, western Europe is a prime beneficiary of the current environment. Like Japan, Europe is an industrial, trade-surplus economy that benefits from global trade and growth. It benefits as the geopolitical middleman between the US and its rivals, China and Russia, especially as long as the Biden administration pursues consultation and multilateralism and hesitates to force the Europeans into confrontational postures against these powers. Chart 13Political Risk Still Subsiding In Continental Europe Political Risk Still Subsiding In Continental Europe Political Risk Still Subsiding In Continental Europe Meanwhile Russia and especially China need to court Europe now that the Biden administration is using diplomacy to try to galvanize a western bloc. China looks to substitute European goods for American goods and open up its market to European investors to reduce European complaints of protectionism. European domestic politics will become more interesting over the coming year, with German and French elections, but the risks are low. The rise of a centrist coalition in Italy under Mario Draghi highlights how overstated European political risk really is. In the Netherlands, Mark Rutte’s center-right party is expected to remain in power in March elections based on opinion polling, despite serious corruption scandals and COVID blowback. In Germany, Angela Merkel’s center-right party is also favored, and yet an upset would energize financial markets because it would result in a more fiscally accommodative and pro-EU policy (Chart 13). The takeaway is that there is limit to how far emerging European countries can outperform developed Europe, given the immediate geopolitical risk emanating from Russia that can spill over into eastern Europe (Chart 14). Developed European stocks are at peak levels, comparable to the period of Ukraine’s election, but Ukraine is about to heat up again as a battleground between Russia and the West, as will other peripheral states. Chart 14Favor DM Europe Over EM Europe Favor DM Europe Over EM Europe Favor DM Europe Over EM Europe Chart 15GBP: Watch For Scottish Risk Revival In May GBP: Watch For Scottish Risk Revival In May GBP: Watch For Scottish Risk Revival In May Finally, in the UK, the pound continues to surge in the wake of the settlement of a post-Brexit trade deal, notwithstanding lingering disagreements over vaccines, financial services, and other technicalities. British equities are a value play that can make up lost ground from the tumultuous Brexit years. There is potentially one more episode of instability, however, arising from the unfinished business in Scotland, where the Scottish National Party wants to convert any victory in parliamentary elections in May into a second push for a referendum on national independence. At the moment public opinion polls suggest that Prime Minister Boris Johnson’s achievement of an EU trade deal has taken the wind out of the sails of the independence movement but only the election will tell whether this political risk will continue to fall in the near term (Chart 15). Hence the pound’s rally could be curtailed in the near term but unless Scottish opinion changes direction the pound and UK domestic-oriented stocks will perform well. Short EM Strongmen Throughout the emerging world the rise of the “Misery Index” – unemployment combined with inflation – poses a persistent danger of social and political instability that will rise, not fall, in the coming years. The aftermath of the COVID crisis will be rocky once stimulus measures wane. South Africa, Turkey, and Brazil look the worst on these measures but India and Russia are also vulnerable (Chart 16). Brazilian geopolitical risk under the turbulent administration of President Jair Bolsonaro has returned to the 2015-16 peaks witnessed during the impeachment of President Dilma Rousseff amid the harsh recession of the middle of the last decade. Brazilian equities are nearing a triple bottom, which could present a buying opportunity but not before the current political crisis over fiscal policy exacts a toll on the currency and stock market (Chart 17). Chart 16EM Political Risk Will Bring Bad Surprises EM Political Risk Will Bring Bad Surprises EM Political Risk Will Bring Bad Surprises Chart 17Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Bolsonaro’s signature pension reform was an unpopular measure whose benefits were devastated by the pandemic. The return to fiscal largesse in the face of the crisis boosted Bolsonaro’s support and convinced him to abandon the pretense of austere reformer in favor of traditional Brazilian fiscal populist as the 2022 election approaches. His attempt to violate the country’s fiscal rule – a constitutional provision passed in December 2016 that imposes a 20-year cap on public spending growth – that limits budget deficits is precipitating a shakeup within the ruling coalition. Our Emerging Market Strategists believe the Central Bank of Brazil will hike interest rates to offset the inflationary impact of breaking the fiscal cap but that the hikes will likely fall short, prompting a bond selloff and renewed fears of a public debt crisis. The country’s political crisis will escalate in the lead up to elections, not unlike what occurred in the US, raising the odds of other negative political surprises. Chart 18Reinitiate Long Mexico / Short Brazil Reinitiate Long Mexico / Short Brazil Reinitiate Long Mexico / Short Brazil While Latin America as a whole is a shambles, the global cyclical upturn and shift in American policy creates investment opportunities – particularly for Mexico, at least within the region. Investors should continue to prefer Mexican equities over Brazilian given Mexico’s fundamentally more stable economic policy backdrop and its proximity to the American economy, which will be supercharged with stimulus and eager to find ways to use its new trade deal with Mexico to diversify its manufacturing suppliers away from China (Chart 18). In addition to Brazil, Turkey and the Philippines are also markets where “strongman leaders” and populism have undercut economic orthodoxy and currency stability. A basket of emerging market currencies that excludes these three witnessed a major bottom in 2014-16, when Turkish and Brazilian political instability erupted and when President Rodrigo Duterte stormed the stage in the Philippines. These three currencies look to continue underperforming given that political dynamics will worsen ahead of elections in 2022 (possibly 2023 for Turkey) (Chart 19). Chart 19Keep Shorting The Strongmen Keep Shorting The Strongmen Keep Shorting The Strongmen Investment Takeaways We closed out some “risk-on” trades at the end of January – admittedly too soon – and since then have hedged our pro-cyclical strategic portfolio with safe-haven assets, while continuing to add risk-on trades where appropriate. The Biden administration still faces one or more major foreign policy tests that can prove disruptive, particularly to Taiwanese, Chinese, Russian, and Saudi stocks. Biden’s foreign policy doctrine will be established in the crucible of experience but his preferences are known to favor diplomacy, democracy over autocracy, and to pursue alliances as a means of diversifying supply chains away from China. We will therefore look favorably upon the members of the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) and recommend investors reinitiate the long CPTPP equities basket. These countries, which include emerging markets with decent governance as well as Japan, Australia, New Zealand, and Canada all stand to benefit from the global upswing and US foreign policy (Chart 20). Chart 20Reinitiate Long Trans-Pacific Partnership Reinitiate Long Trans-Pacific Partnership Reinitiate Long Trans-Pacific Partnership Chart 21Reinitiate Long Global Value Over Growth Reinitiate Long Global Value Over Growth Reinitiate Long Global Value Over Growth The Biden administration will likely try to rejoin the CPTPP but even if it fails to do so it will privilege relations with these countries as it strives to counter China and Russia. The UK, South Korea, Thailand and others could join the CPTPP over time – though an attempt to recruit Taiwan would exacerbate the geopolitical risks highlighted above centered on Taiwan. The dollar is perking up, adding a near-term headwind to global equities, but the cyclical trend for the dollar is still down due to extreme monetary and fiscal dovishness. Tactically, go long Mexican equities over Brazilian equities. From a strategic point of view we still favor value stocks over growth stocks and recommend investors reinitiate this global trade (Chart 21). Strategically, wait to overweight UK stocks in a global portfolio until the result of the May local elections is known and the risk of Scottish independence can be reassessed. Strategically, favor developed Europe over emerging Europe stocks as a result of Russian geopolitical risks that are set to escalate. Strategically go long global defense stocks versus cyber security stocks as a geopolitical “back to work” trade for a time when economic activity resumes and resource-oriented territorial, kinetic, military risks reawaken. Strategically, favor EM currencies other than Brazil, Turkey, and the Philippines to minimize exposure to economic populism, poor macro fundamentals, and election risk. Strategically, go long the BCA Rare Earths Basket to capture persistent US-China tensions under Biden and the search for alternatives to China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   We Read (And Liked) … Supply-Side Structural Reform Supply-Side Structural Reform, a compilation of Chinese economic and policy research, discusses several aspects of Chinese economic reform as it is practiced under the Xi Jinping administration, spanning the meaning and importance of supply-side structural reform in China as well as five major tasks.1 The book consists of contributions by Chinese scholars, financial analysts, and opinion makers in 2015, so we have learned a lot since it was published, even as it sheds light on Beijing’s interpretation of reform. 2015 was a year of financial turmoil that saw a dramatic setback for China’s 2013 liberal reform blueprint. It also saw the launch of a new round of reforms under the thirteenth Five Year Plan (2016-20), which aimed to push China further down the transition from export-manufacturing to domestic and consumer-led growth. Beijing’s renewed reform push in 2017, which included a now infamous “deleveraging campaign,” ultimately led to a global slowdown in 2018-19 that was fatefully exacerbated by the trade war with the United States – only to be eclipsed by the COVID-19 pandemic in 2020. Built on fundamental economic theory and the social background of China, the book’s authors examine the impact of supply-side reform on the Chinese financial sector, industrial sector, and macroeconomic development. The comprehensive analysis covers short-term, mid-term and long-term effects. From the perspective of economic theory, there is consensus that China's supply-side structural reform framework did not forsake government support for the demand side of the economy, nor was it synonymous with traditional, liberal supply-side economics in the Western world. In contrast to Say’s Law, Reaganomics, and the UK’s Thatcherite privatization reforms, China's supply-side reform was concentrated on five tasks specific to its contemporary situation: cutting excessive industrial capacity, de-stocking, deleveraging, cutting corporate costs, and improving various structural “weaknesses.” The motives behind the new framework were to enhance the mobility and efficiency of productive factors, eliminate excess capacity, and balance effective supply with effective demand. Basically, if China cannot improve efficiencies, capital will be misallocated, corporations will operate at a loss, and the economy’s potential will worsen over the long run. The debt buildup will accelerate and productivity will suffer. Regarding implementation, the book sets forth several related policies, including deepening the reform of land use and the household registration (hukou) system, and accelerating urbanization, which are effective measures to increase the liquidity of productive factors. Others promote the transformation from a factor-driven economy to efficiency and innovation-driven economy, including improving the property rights system, transferring corporate and local government debt to the central government, and encouraging investment in human capital and in technological innovation. The book also analyzes and predicts the potential costs of reform on the economy in the short and long term. In the short run, authors generally anticipated that deleveraging and cutting excessive industrial capacity would put more pressure on the government’s fiscal budget. The rise in the unemployment rate, cases of bankruptcy, and the negative sentiment of investors would slow China’s economic growth. In the medium and long run, this structural reform was seen as necessary for a sustainable medium-speed economic growth, leading to more positive expectations for households and corporates. The improved efficiency in capital allocation would provide investors with more confidence in the Chinese economy and asset market. Authors argued that overall credit risk was still controllable in near-term, as the corresponding policies such as tax reduction and urbanization would boost private investment and consumption in the short run. These policies increased demand in the labor market and created working positions to counteract adverse impacts. Employment in industries where excessive capacity was most severe only accounted for about 3% of total urban employment in 2013. Regarding the rise in credit risk during de-capacity, the asset quality of banks had improved since the 1990s and the level of bad debt was said to be within a controllable range, given government support. Moreover, in the long run, the merger and reorganization of enterprises would increase the efficient supply and have a positive effect on economic innovation-driven transformation. We know from experience that much of the optimism about reform would confront harsh realities in the 2016-21 period. The reforms proceeded in a halting fashion as the US trade war interrupted their implementation, prompting the government to resort to traditional stimulus measures in mid-2018, only to be followed by another massive fiscal-and-credit splurge in 2020 in the face of the pandemic. Yet investors could be surprised to find that the Politburo meeting on April 17, 2020 proclaimed that China would continue to focus on supply-side structural reform even amid efforts to normalize the economy and maintain epidemic prevention and control. Leaders also pledged to maintain the supply-side reform while emphasizing demand-side management during annual Central Economic Work Conference in December 2020. In other words, Xi administration’s policy preferences remain set, and compromises forced by exogenous events will soon give way to renewed reform initiatives. This is a risk to the global reflation trade in 2021-22. There has not been a total abandonment of supply-side reform. The main idea of demand-side reform – shifts in the way China’s government stimulates the economy – is to fully tap the potential of the domestic market and call for an expansion of consumption and effective investment. Combined with the new concept of “dual circulation,” which emphasizes domestic production and supply chains (effectively import substitution), the current demand-side reforms fall in line with the supply-side goal of building a more independent and controllable supply chain and produce higher technology products. These combined efforts will provide “New China” sectors with more policy support, less regulatory constraint, and lead to better economic and financial market performance. Despite the fluctuations in domestic growth and the pressure from external demand, China will maintain the focus on reform in its long-term planning. The fundamental motivation is to enhance efficiency and innovation that is essential for China’s productivity and competitiveness in the future. Thus, investors should not become complacent over the vast wave of fiscal and credit stimulus that is peaking today as we go to press. Instead they should recognize that China’s leaders are committed to restructuring. This means that the economic upside of stimulus has a cap on it– a cap that will eventually be put in place by policymakers, if not by China’s lower capacity for debt itself. It would be a colossal policy mistake for China to overtighten monetary and fiscal policy in 2021 but any government attempts to tighten, the financial market will become vulnerable. A final thought: it is unclear whether there is potential for an improvement in China’s foreign relations contained in this conclusion. What the western world is demanding is for China to rebalance its economy, open up its markets, cut back on the pace of technological acquisition, reduce government subsidies for state-owned companies, and conform better to US and EU trade rules. There is zero chance that China will provide all of these things. But its own reform program calls for greater intellectual property protections, greater competition in non-strategic sectors (which the US and EU should be able to access under recent trade deals), and targeted stimulus for sustainable energy, where the US and EU see trade and investment opportunities. Thus there is a basis for an improvement in cooperation. What remains to be seen is how protectionist dual circulation will be in practice and how aggressively the US will pursue international enforcement of technological restrictions on China under the Biden administration. Jingnan Liu Research Associate JingnanL@bcaresearch.com Footnotes 1 Yifu L, et al. Supply-Side Structural Reform (Beijing: Democracy & Construction Publishing House, 2016). 351 pages. Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Higher yields in China should continue to encourage inflows into the RMB. However, the gap between Chinese and US/global interest rates will narrow. This will temper the pace of RMB appreciation. The RMB remains modestly undervalued. Higher productivity gains in China will raise the fair value of the currency. The US dollar could have entered a structural bear market. This will also buffet the CNY-USD exchange rate. A big driver for the RMB in the coming years will also be widespread diversification away from USD assets. This will dovetail nicely with the ascension of the RMB in global FX reserves. Feature Chart 1The RMB Often Moves With Relative Rates The RMB Often Moves With Relative Rates The RMB Often Moves With Relative Rates The appreciation in the Chinese yuan has been a boon for global bond, equity and currency investors. With extremely low volatility, the yuan has appreciated by approximately 10% since its May 2020 lows. This places the rise in the RMB on par with what we saw in the 2017/2018 period. It also makes the yuan one of the best performing emerging market currencies this year. One of the key drivers of the yuan’s stellar performance has been the interest rate gap between China and the US (Chart 1). The Chinese economy was one of the first to emerge from the pandemic-driven lockdown. As economic activity recovered, so did local bond yields. With global bond yields now on the rise, this raises the specter that Sino-global bond yield spreads will narrow. The implications for the path of the Chinese yuan are worth monitoring. On the other hand, structural factors also argue that the path of least resistance for the US dollar over the next few years is down. This is positive for the Chinese yuan. Which force will dominate the path of the RMB going forward? In this Special Report, we discuss the intersection between the People’s Bank of China (PBoC) monetary policy and the global environment, and what that means for the Chinese yuan on a 12-month horizon. China And The Global Cycle The evolution of the global economic cycle has important implications for the yuan exchange rate in particular, because the RMB is a pro-cyclical currency. The USD/CNY has been moving tick for tick with emerging market equities, Asian currencies and commodity prices (Chart 2). Meanwhile, China has also been a major engine for global growth. Ever since the global financial crisis, the money and credit cycle in China has led the global recovery (Chart 3). With the authorities set to modestly decelerate the pace of credit creation, it will be important to gauge if this is a risk to global growth and, by extension, the path of the RMB. Chart 2The RMB Has Traded Like A Pro-cyclical Currency The RMB Has Traded Like A Pro-cyclical Currency The RMB Has Traded Like A Pro-cyclical Currency Chart 3The Chinese Impulse Leads ##br##The Global Cycle The Chinese Impulse Leads The Global Cycle The Chinese Impulse Leads The Global Cycle     In our view, while the credit impulse in China will roll over, the impact will be to slow the pace of RMB appreciation rather than reverse it, because: The interest rate gap between China and the rest of the world will remain very wide. The current level of 10-year yields in China is 3.3% versus 1.4% in the US. In a world of very low nominal interest rates, a differential of almost 200 basis points makes all the difference. Our base case is that the Chinese credit impulse could slow to 30% of GDP. If past is prologue, this could compress the yield spread to 1.5% but will still provide a meaningful yield pickup for foreign investors (Chart 4). Meanwhile, the real rate differential between China and the US might not narrow much if China continues to reign in credit growth, while the US pursues inflationary policies. Already, inflation in China is collapsing relative to the US, which supports relative real rates in China.   The credit impulse tends to lead the economy by six to nine months, thus, for much of 2021, Chinese growth will remain robust. Overall industrial production is picking up meaningfully, with the production of electricity and steel, and all inputs into the overall manufacturing value chain inflecting higher. This will continue to support bond yields in China (Chart 5). In recent weeks, both steel and iron ore prices have been soaring. While supply bottlenecks are playing a role, it is evident from both the manufacturing data and the trend in prices that demand is also a key driver (Chart 6). Chart 4The China-US Spread Will Stay Positive The China-US Spread Will Stay Positive The China-US Spread Will Stay Positive Chart 5Underlying Economic Activity Is Resilient Underlying Economic Activity Is Resilient Underlying Economic Activity Is Resilient Chart 6Strong Chinese Demand For Commodities Strong Chinese Demand For Commodities Strong Chinese Demand For Commodities China has had a structurally higher productivity growth rate compared to the US or Europe for many years, which will continue. It is also the reason why the fair value of the currency has been rising over the last two decades (Chart 7). Higher productivity growth suggests the neutral rate of interest in China will remain high for many years and will attract further fixed income inflows. China is running a basic balance surplus, which indicates that the RMB does not need to cheapen to entice capital inflows (Chart 8). Chart 7The RMB Is Not Overvalued The RMB Is Not Overvalued The RMB Is Not Overvalued Chart 8A Basic Balance Surplus A Basic Balance Surplus A Basic Balance Surplus Chinese bonds are gaining wider investor appeal. Following their inclusion in the Bloomberg Barclays Global Aggregate Index (BBGA) since April 2019, and in the JP Morgan Government Bond - Emerging Market Index (GBI-EM) since February 2020, FTSE Russell announced the inclusion of Chinese government bonds in the FTSE World Government Bond Index (WGBI) as of October 2021. The inclusion of Chinese government bonds in all of the world’s three major bond indices is a seminal milestone in the process of liberalizing the Chinese fixed-income market. Based on both the US$2-4 trillion in AUM, tracking the WGBI index and a 5-6% weight of Chinese bonds, an additional US$150 billion in foreign investments will flow into China’s bond market following the WGBI inclusion. Moreover, the JPMorgan Global Index team predicts that the inclusion of Chinese bonds in the world’s three major bond indices will bring RMB inflows of up to US$250-300 billion. This will be particularly true if Chinese bonds are perceived as a better hedge against equity volatility (Chart 9). Finally, currencies respond to relative rates of return, which include equity returns in addition to fixed income ones. The relative performance of the Chinese equity market in common currency terms has also moved neck and neck with the performance of the RMB (Chart 10). Chart 9Chinese Bonds Could Become The Perfect Hedge Chinese Bonds Could Become The Perfect Hedge Chinese Bonds Could Become The Perfect Hedge Chart 10The RMB Follows Domestic Equity Relative Performance The RMB Follows Domestic Equity Relative Performance The RMB Follows Domestic Equity Relative Performance Bottom Line: Even though the Chinese credit impulse will continue to roll over, bond investors will still benefit from enticing real interest rates in China as its neutral rate of interest is higher. Equity investors will also benefit from a cheaper market, as well as exposure to sectors that are primed to benefit as the global economy reopens. This combination will sustain the pace of foreign capital inflows (Chart 11). Chart 11Inflows Into China Remain Strong Inflows Into China Remain Strong Inflows Into China Remain Strong The Dollar Versus The RMB          The path of the RMB in the short-term will follow relative growth dynamics between China and the rest of the world, but structural factors such as the dollar’s reserve status will also dictate its longer-term trend. What China (and other countries for that matter) decide to do with their war chest of US Treasuries is of critical importance.  In recent years, foreign investors have been fleeing the US Treasury market at an exceptional pace. On a rolling 12-month total basis, the US saw an exodus of about US$500 billion in bond flows from foreigners, the largest on record (Chart 12). Vis-à-vis official flows, China has become the number one contributor to the US trade deficit. Concurrently, Beijing has been destocking its holdings of Treasuries, if only as retaliation against past US policies, or perhaps to make room for the internationalization of the RMB (Chart 13). Chart 12An Exodus From US Treasurys An Exodus From US Treasurys An Exodus From US Treasurys Chart 13China Destocking Of Treasurys China Destocking Of Treasurys China Destocking Of Treasurys Data from the International Monetary Fund (IMF) shows that the allocation of global foreign exchange reserves towards the US dollar peaked at about 72% in the early 2000s and has been in a downtrend since. Meanwhile, allocation to other currencies, including the RMB, is surging. Moreover, foreign central banks have been amassing tremendous gold reserves, notably Russia and China, almost to the tune of the total annual output of the yellow metal. A diversification away from dollars and into other currencies such as the RMB and gold will be a key factor in dictating currency trends in the next few years (Chart 14). Chart 14The RMB Rises In Global Currency Reserves The RMB Rises In Global Currency Reserves The RMB Rises In Global Currency Reserves The US dollar will remain the reserve currency of the world for years to come, but that exorbitant privilege is clearly fraying at the edges. This is especially the case as balance-of-payments dynamics are deteriorating. Rising US twin deficits have usually been synonymous with a cheapening dollar. Bottom line: For one reason or another, foreign central banks are diversifying out of dollars. This could be a long-term trend, which will dictate the path of the dollar (and by extension the RMB) in the years to come. Other Considerations Chart 15A Forward Discount On The RMB A Forward Discount On The RMB A Forward Discount On The RMB The RMB has historically suffered from capital outflows, especially illicit flows. This is less risky today than in 2015-2016.1  Nonetheless, investors must monitor this possibility. Typically, offshore markets have anticipated the yuan’s depreciation. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, 12-month non-deliverable forwards expect a modest depreciation in the yuan (Chart 15). Offshore markets in Hong Kong and elsewhere can be prescient because more often than not, they are the destination for illicit flows out of China. However, this time might be different. First, higher relative interest rates in China have lowered the forward RMB rate investors will receive to hedge currency exposure. Second, junkets (key operators in Macau casinos) have been one of the often-rumored vehicles used for Chinese money to leave the country.2 These junkets bankroll their Chinese clients in Macau while collecting any debts in China, allowing for illicit capital outflows. This was particularly rampant before the Chinese 2015-2016 corruption clampdown, when Macau casino equities were surging while equity prices in China were subdued. This time around, with tourism taking a backseat, the Chinese MSCI index is heavily outpacing the performance of Macau casino stocks, suggesting little evidence of hot money outflows (Chart 16). Chart 16China Versus Macau Stocks: Little Hot Money Outflows Like In 2013/2014 China Versus Macau Stocks: Little Hot Money Outflows Like In 2013/2014 China Versus Macau Stocks: Little Hot Money Outflows Like In 2013/2014 Sino-US trade relations will also affect the exchange rate. China remains the biggest contributor to the US trade deficit, even though the gap has narrowed (Chart 17). There is little evidence that the Biden administration will engage in an all-out trade war with China, but the case for subtle skirmishes exists. Chart 17The US Trade Deficit With China Remains Wide The US Trade Deficit With China Remains Wide The US Trade Deficit With China Remains Wide In a broader sense, the pandemic might have supercharged the de-globalization trend witnessed since 2011. The stability and self-sufficiency in the production capacity of any country's core supply chain have become paramount. From the perspective of the US, this means introducing more policies that attract investment into domestic manufacturing, such as clean energy. US multinational companies may also continue to diversify production risk away from China to other emerging countries, among them Vietnam, Myanmar, and India. This will curtail FDI flows into China at the margin (previously mentioned Chart 8). Concluding Thoughts Chart 18The RMB And The Trade-Weighted Dollar The RMB And The Trade-Weighted Dollar The RMB And The Trade-Weighted Dollar While USD/CNY could bounce in the near term, it is likely to reach 6.2 in the next 12 months. Interest rate spreads at the long end already overtook their 2017 highs and are near cyclically elevated levels. The bond market tends to lead the currency market by a few months, since China does not yet have a fully flexible and open capital account. Meanwhile, the path of the US dollar will also be critical for the USD/CNY exchange rate. We expect the USD to keep depreciating, which will boost the RMB (Chart 18).3 A slower pace of RMB appreciation will fend off interventionist policies by the PBoC. While the exchange rate has appreciated sharply since mid-2020, the CFETS rate has not deviated much from the onshore USD/CNY rate. This will remain the case if the pace of RMB appreciation moderates.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Chinese Investment Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at fes.bcaresearch.com. 2 Please see Reuters article “Factbox: How Macau’s casino junket system works,” available at reuters.com. 3 Please see Foreign Exchange Strategy Special Report, titled “2021 Key Views: Tradeable Themes,” dated December 4, 2020, available at bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Years of capital outflows have turned Thailand a net creditor to the world – a rarity among developing nations. The Thai currency is too strong given the state of the economy. The baht is slated to depreciate this year; investors will do well to short it. Equity portfolios should stay neutral this market. Fixed income investors should book profits by downgrading Thai bonds from overweight to neutral in an EM bond portfolio. Feature Chart 1Thai Stocks Steep Underperformance Has Been In Works Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Thai stocks’ recent underperformance versus the EM benchmark has been one of the steepest among EM bourses (Chart 1). What caused such a fall after almost a decade of outperformance? More importantly, does this market offer a good risk-reward now? Our research indicates that the seeds of the underperformance were sown over the past several years. In fact, the underperformance could have been worse had it not been for the Thai currency – which held up rather well. That said, the baht is now vulnerable; and going forward it will likely be the one which will weigh on this market’s relative performance. Currency investors should consider shorting the Thai baht; and for dedicated EM equity portfolios a neutral allocation to Thailand is currently appropriate. Thai Assets Have Long Lost Their Sheen One reason for the potential downward pressure on the baht is investor apathy towards Thai assets. Due partly to over a decade of socio-political upheavals, foreign investors have long lost interest in them. This is evident in the incessant capital outflows: Chart 2As Investors And Corporates Have Long Shunned Thailand Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht The country has witnessed steady portfolio outflows on a net basis - driven mostly by equity portfolio outflows (Chart 2, top panel). Although there have been minor net debt portfolio inflows, they have paled in comparison to equity outflows.   There have been more FDI outflows from Thailand to elsewhere in the world than inflows into the country. Put differently, not only financial investors, but also foreign and domestic corporates, have been shunning Thailand for several years (Chart 2, bottom panel).  Finally, Thai residents have also been consistently sending their savings abroad - primarily in the form of bank deposits - until Covid19 hit (Chart 3). This tendency reveals that it’s not just the foreigners but also the residents who have long been nurturing a negative outlook on Thai assets. While these sustained capital outflows indicate investor apathy towards Thai assets, it has also fundamentally changed Thailand’s international investment position. The country has now become a net creditor to the world – a rarity among the developing economies (Chart 4). Chart 3And Thai Residents Funneled Their Deposits Abroad For Years Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Chart 4Turning Thailand Into A Rare EM Country Who Is Net Creditor To The World Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   This regime shift has important implications. For instance, currencies of net creditor countries typically fare better than those of debtor countries during global risk-off periods. This is because residents tend to repatriate their money back to the home country during uncertain times. It’s one reason why the baht held up relatively well last year. However, by that same logic, the baht is now likely to underperform debtor nations’ – the majority of EM – currencies during the ongoing global risk-on phase and/or the US dollar decline. Currency Strength Is Transitory Despite steady capital outflows over the years, the Thai currency had held up remarkably well until late 2019. The reason for that was a robust current account surplus, aided by tourism and export revenues (Chart 5, top panel). Mid-pandemic, however, tourism revenues have been decimated. In 2021, the government expects only 5 million tourists compared to 40 million in 2019 (Chart 5, middle panel). Exports are struggling to recover as well. Indeed, despite the massive reflation unleashed by the global central banks and fiscal authorities, Thai exports have failed to take advantage of it – in stark contrast to previous reflation cycles. Of all the export-oriented Asian economies, Thai export revival is the most tepid; and is the only one which is still contracting year-over-year (Chart 6). The reasons are twofold: Chart 5Baht Is Vulnerable As Tourism Got Decimated And Exports Remain Weak Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Chart 6And A Currency That Has Become Expensive Vis-à-Vis Its Competitors Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   A considerable share of Thai exports (24%) goes to other ASEAN countries. Exports to this region have been subpar as these economies are still reeling from the negative ramifications of Covid19 and their domestic demand recovery is very muted (Chart 7). Chart 7Due To A Large Exposure To ASEAN Where Domestic Demand Recovery Is Muted Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   That said, Thai exports to China, Japan and Korea have not accelerated much either – even though Covid19-related negative impacts had been rather limited in those countries. Exports to developed markets like the US and Europe have fared somewhat better – thanks mostly to the massive stimulus in the US and the solid recovery in European demand (Chart 7, bottom panel). The other reason for the poor export performance is that the baht has become rather expensive, especially relative to its other Asian competitors. Chart 8 shows that in real effective terms, the baht has been one of the most expensive currencies for a while among its’ regional peers. This is weighing on Thai competitiveness, and therefore on exports. To be sure, loss of competitiveness is not a new phenomenon for Thailand. The country has been losing export market share for a while now – both relative to emerging markets and to the world (Chart 9). Chart 8And A Currency That Has Become Expensive Vis-à-Vis Its Competitors Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Chart 9Thailand Has Been Steadily Losing Exports Market Share Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   What’s new however is that mid-pandemic with current account balance turning negative by the end of 2020 (for the first time in several years), a strong currency is simply unsustainable. As such, given that the ebbs and flows in exports and tourism revenues have long dictated the baht’s trajectory, they now point to a much weaker currency ahead (Chart 5, bottom panel).  Despite negative net portfolio and FDI flows as well as deteriorating current account, the baht remained well-bid last year, largely due to the substantial repatriation of bank deposits by Thai residents (Chart 3, above). The advent of the pandemic prompted Thai residents to bring back a significant amount of bank deposits that they had been funneling abroad in preceding years. Those inflows prevented the Thai balance of payment from sinking and bid up the baht. That said, this kind of panic-stricken repatriation of capital/deposits happens rarely; the only other instance being during the global financial crisis in 2008, as illustrated in Chart 3. Hence, odds are that going forward such repatriation will slow meaningfully as the Covid19-related panic subsides. In fact, bank deposits might even resume their outward flows, as was the case from 2011 to 2019.  A reversal in deposit repatriation will drastically worsen Thailand’s balance of payments this year and beyond, causing the baht to depreciate. Growth Remains Subpar In the World Economic Forum at Davos last month, the Thai finance minister projected a growth of just 2.8% in 2021, after a contraction of 6.1% in 2020. Clearly, the pandemic-related fiscal and monetary stimulus efforts have proved inadequate to kickstart the economy: Chart 10A Strong Currency Has Added To The Deflationary Forces Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Despite the promise of a substantial Covid19 fiscal stimulus package last year (14% of GDP), actual spending so far has been less than spectacular. Fiscal expenditure has risen a modest 11% year-over-year as of December 2020 (a rise of barely 3% on its 2019 GDP) - not an outlier in the context of recent history. As such, the surge in fiscal deficit to over 6% of GDP is mainly due to collapsed fiscal revenues. Notably, the fiscal authorities have not announced any new meaningful stimulus measures in recent months. On the monetary front, the central bank has little room to cut rates further as policy rates are already approaching the zero-bound (now at 0.5%). Yet, consumer price inflation has slid to a negative territory, dramatically undershooting the central bank target of 1% to 3%. Producer prices are also deflating (Chart 10). Part of the reason for the outright deflation is a strong currency amid depressed economic activity. The deflationary pressures are making the borrowers struggle with high real borrowing cost (i.e., inflation-adjusted borrowing cost). This is because banks’ primes lending rates remain elevated at 5.4%, making real prime lending rates quite steep at 5.7% at a time when the economy is expected to grow at 2.8%. Deflation makes it harder for firms to service their debts. The outcome is usually a shrinkage in margins, loan defaults, or a combination of the two. Indeed, Chart 11 (top panel) shows that corporate profit margins are shrinking as the borrowing costs for non-financial firms are now much higher than their sales growth rate. Low and falling margins do not portend a stock market recovery. Falling return on capital typically discourages capital inflows too. That, in turn, has a negative impact on the currency. This has indeed been the case for Thailand in the past (Chart 12). Last year, the pandemic-induced massive, but one-off, bank deposit repatriation supported the baht. But sooner rather than later the baht will depreciate meaningfully. Chart 11High Real Rates Are Weighing On Profits, And Will Dampen New Capital Expenditure Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Chart 12Falling Return On Capital Discourages Foreign Investors, And Are Bearish For Currency Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   Falling profits also discourage firms from making capital expenditures. Since a new capex cycle is often instrumental to a post-recession recovery, the absence of it means subdued growth ahead (Chart 11, bottom panel). Another issue clouding the chances of an imminent economic recovery is a significant inventory overhang. Chart 13 shows that finished good inventory levels are too high vis-à-vis shipments. At the same time, Thai manufacturing order books are relapsing anew (Chart 13, middle panel). Chart 13Elevated Inventory Amid Falling Orders Means Lower Manufacturing Output Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht The combination of surplus finished goods inventory and falling orders will discourage manufacturing activity. Slowing manufacturing is usually a bad omen for Thai stocks’ relative performance versus EM (Chart 13, bottom panel). Seen from a different angle, the struggling export sector and the anemic domestic demand needs a weaker currency – which could help stimulate output and income. On the other hand, if the baht stays expensive, real variables such as output growth and employment will be hurt. That, in turn, will add further fuel to the ongoing political turmoil. As detailed in our previous Thailand report, the country has entered a precarious time socio-politically, which might last a while. A weaker currency can at least help ameliorate the economic situation to some degree.  Bank NPLs Are Poised To Rise Domestic credit1 in Thailand had risen sharply for several years before peaking at 150% of GDP in 2015. Commercial bank loans peaked at 100% of GDP around the same time.  Credit growth has been meagre in recent years. In fact, most depository corporations have been busy ramping up their securities portfolios instead, since 2018. Part of the indifference towards lending stems from the fact that banks are likely still saddled with bad loans from their previous credit surge: The speed and extent of credit expansion from 2009 to 2016 indicate a high likelihood of capital misallocations. Yet, banks have not made enough NPL provisions, i.e., they have not yet taken enough of a hit on their income statements by way of making provisions. The cumulative amount of ‘impairment loss’ on their income statements since Q1 2011 turns out to be 1300 billion baht. This is just 12% of their average loan book from Q1 2011 to Q1 2015 – a figure that appears to be grossly inadequate compared with other banking systems (Chart 14). By comparison, India’s private sector banks have, in the past 10 years, made a loan loss provision of over 50% of their outstanding average loans from 2010 to 2014. This indicates that Thai banks’ reported gross and net NPL ratios of 3.1% and minus 2% (after adjusting for the current stock of provisions) respectively, are understated. Complicating things further, the pandemic is set to cause another surge in bad debts. Combined NPLs and SMLs (Special Mention Loans) have risen to 11% of the loan book as of June 2020 (latest data available). In case of small and medium enterprise loans, that figure has risen to 19% (Chart 15). Odds are that they will rise further as economic activity has remained constrained since last June. Chart 14Thai Banks Have Barely Cleansed Their Balance Sheets Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Chart 15And Pandemic Is Causing Another Surge In Stressed Loans Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   The bottom line is that Thailand is unlikely to witness a credit-fueled recovery anytime soon. This is because rising bad loans will discourage banks from lending. On the other end, prohibitively high real borrowing costs will discourage demand for loans. The absence of meaningful fiscal or monetary solutions makes the case for a weaker currency even more pertinent, if the country were to experience a decent recovery. Investment Conclusions Chart 16Thai Stock Performance Is Hinged On Foreigners Appetite Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht The outlook for the Thai baht is poor. Given that it is too risky to short it against a falling US dollar, we recommend shorting the baht versus a basket of euro, Swiss franc and Japanese yen. We also recommend a trade of shorting baht versus the Indian rupee. The baht has appreciated significantly against rupee in the past 3 years. The trade should be instituted as a stop sale order at THB/INR at 2.50 (THB/INR is currently at 2.42). On the equity front, foreign investors are likely to stay away from this market as the corporate profitability will remain subpar and currency vulnerable. Notably, it’s the foreign investors who continue to be the marginal buyer of Thai equity; and their abstinence will not go down well with this bourse (Chart 16). Incidentally, energy and financial stocks in Thailand make up 30% of the market cap and 40% of total earnings. As explained above, financial stocks are unlikely to do well. Chart 17Despite The Steep Underperformance Thai Equity Relative Valuations Are Not Attractive Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Even energy stocks (mostly oil refineries) will face strong headwinds in future. The reason is massive refinery capacity expansion by China. The country has added a 1 million barrels/day new capacity since 2019; and another 4 projects worth 1.4 million barrels/day are under construction. China is increasing its exports of refined petroleum products at low prices to grab a market share from the competition. This puts Thai refineries at risk of losing market share to Chinese refineries. Valuation-wise, Thai stocks are not that attractive either. On trailing price/earnings basis, they are 10% more expensive than the EM benchmark. In terms of price/book, they are 10% cheaper (Chart 17). Despite all the negatives, Thai stocks’ underperformance has been far too steep and is already at a 10-year low. Dedicated EM equity asset allocators therefore should stay neutral on this bourse relative to the EM benchmark. In the fixed-income arena, Thai local currency government bond yields are not as appealing anymore as they have fallen relative to other Asian peers. Besides, the baht is also vulnerable. On the flip side, given the subdued growth outlook, bonds will likely remain well-bid. Hence, while local asset allocators should stick with them; foreign asset allocators should book profits by downgrading them from overweight to neutral in an EM bond portfolio.  Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1 In Thailand, commercial bank credit makes up about two-thirds of total domestic credit accorded by all depository corporations. Other credit providers include various finance companies, specialized banks such as Government savings banks, Government housing banks, Bank of agriculture and agricultural co-operatives, Export-Import bank, Small and medium enterprise development bank, Savings Cooperatives/ Thrifts and Credit cooperatives and some others.