Asia

Highlights Years of extremely high real borrowing costs have decimated Indonesian firms’ return on capital. But tight money constraints have also forced them to improve their operating efficiency meaningfully. A cut in real rates to realistic levels will rotate Indonesia’s equity leadership to non-financial sectors. Equity investors should continue underweighting this bourse but put it on an upgrade watch list. Bond investors should overweight Indonesia in an EM portfolio. Feature Indonesian stocks have gone nowhere for the better part of a decade. Relative to its EM benchmark, they have been down (Chart 1). This is surprising given that the country grew at a robust 5% + pace during this period. So, what’s ailing this stock market? More importantly, when and how can this bourse break free? A Tale In Two Parts A malaise that has plagued Indonesian markets for so long stems from a form of financial unfairness that the country’s borrowers have been subjected to: too high real borrowing costs, for much too long – both in absolute terms and relative to their ASEAN peers (Chart 2). This has stymied Indonesia’s domestic demand, and in turn, the profitability and share prices of its non-financial firms. Chart 1Indonesian Stocks Have Underperformed For A Decade Despite Robust Growth Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 2Indonesia: The Economy Has Been Plagued By Sky-High Borrowing Costs Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   The origin of secularly high Indonesian interest rates in general, and bank lending rates in particular, is rooted in the country’s inflationary past in the 2000s. Back then, CPI would often flare up to double digits, which would in turn induce the central bank to keep rates consistently high as they feared runaway inflation. In the 2010s, however, inflationary pressures gradually dissipated, giving way to disinflationary forces. Both headline and core CPI has stayed below the central bank’s target since 2015 – a target that itself has been falling sequentially. Last year, they fell below the targeted lower band. The GDP deflator is now in outright deflationary territory (Chart 3). Despite the sea-change in the inflation backdrop in the 2010s, the authorities continued with a rather tight monetary policy. That is, policy rates did not keep pace with falling inflation. As a result, real policy rates kept inching up throughout the decade (Chart 4). Chart 3Inflation Has Given Way To Disinflationary Forces... Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 4...But Policy Rates Didn't Follow Suit, Leading To Rising Real Rates... Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   What’s more, banks have been reluctant to pass on the policy rate cuts to their lending rates in the past couple of years. The result has been consistently high real borrowing cost – banks’ prime lending rate hovering around double digits – for firms and households. Bank's lending rates – in both nominal and real terms –are much higher compared to their peers elsewhere in ASEAN (Chart 4, bottom panel and Chart 2, bottom panel). Chart 5...And Benefitting Lenders At The Expense Of Borrowers Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Over time, high real borrowing costs led to an effectively two-tiered stock market. While banks benefitted immensely from the consistently high interest income; non-financial sectors, facing dwindling revenues and high borrowing costs, were hamstrung by the same. The dichotomy has become more entrenched since 2016 when inflation dropped another notch. All this has led to diverging stock performances: bank stocks soared, massively outperforming the rest of the Indonesian markets. They, in fact, also outperformed other EM banks. Non-financial sectors, on the other hand, languished. As did the Indonesian small cap index – where non-financial firms make up 87% of the market cap (Chart 5). This diverging performance of banks and non-banks stocks is quite unusual. Since banks are by far the main source of financing for non-financial firms in Indonesia, their performance is usually leveraged to the performance of their clients (i.e., borrowers). If borrowers/non-bank companies do not do well, it is equally hard for their banks to do well. In this light, the diverging performance is indicative of an unlevel playing field: where one sector (banks) benefits at the expense of the other. Hamstrung By Elevated Borrowing Costs High borrowing costs in real terms will have unintended consequences going forward. What’s more, such settings will eventually prove counter-productive even for the banking sector. Very high real borrowing costs is distressing the financial health of Indonesian firms. Their interest expenses as a share of revenues and operating profits have been rising sharply in recent years (Chart 6). This is weighing on their net profit margins. Notably, rising interest costs is not a result of a surge in borrowing. Bank credit in Indonesia has been flat since 2013 at a rather low level of 35% of GDP. Bank credit to all private and public non-financial corporations has stayed flat at an even lower 17% of GDP (Chart 7). Chart 6Firms' Interest Expenses Relative To Sales/Earnings Have Risen A Lot... Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 7...Even Though Their Borrowings Have Stayed Under Control Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   The non-financial corporations’ other domestic and foreign indebtedness (e.g., debt securities issued and foreign bank borrowing) amount to another 15% of GDP. Thus, the total indebtedness of all non-financial corporations amounts to about 32% of GDP, which has hovered around the same level since 2015 and is not alarming (Chart 7, bottom panel). The main reason why non-financial firms’ profitability drifted down is that their nominal sales decelerated meaningfully, but some costs (specifically, borrowing costs) did not. The sales growth rate of the listed non-financial firms has been lower than the banks’ actual lending rates for the past several years. This clearly led to a massive blow to their return on capital (Chart 8). Over time, persistently high real borrowing costs will result in a rising number of firms being rendered unviable. Real domestic demand will decline, which will cause further disinflation, and nominal sales of these firms will further decelerate. Eventually, companies will struggle to pay down their debts. During a downturn, whether caused by a pandemic or by regular business cycles, the problem will become more acute. In short, persistently high real lending rates will eventually come back to haunt banks. Notably, banks’ NPL ratio was rising even before the pandemic-related recession hit (Chart 9). Going forward, they are slated to rise more as firms’ sales have plummeted. For now, various Covid-19-related loan and interest repayment moratorium measures until March 2021 could mean that the reported NPL figures would artificially stay low. But eventually, the true extent of NPLs will become apparent, which will weigh on bank profits. Chart 8Decelerating Sales Amid High Borrowing Costs Decimated Firms' Return On Capital Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 9Struggling Firms Will Cause Further Rise In Banks' Bad Loans Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   Unrealistically high real lending rates can backfire for banks in other ways too. High real lending rates would lead to an ‘adverse selection’ of borrowers. That is, only borrowers with a tolerance for very high risk would be willing to borrow at such high rates. This is not a sustainable business model for banks in the long term. As for listed non-financial firms, since the ratio of their foreign indebtedness to total indebtedness is already very high – more than half of the total debt (Chart 7, before), there is little room for them for further foreign borrowing (and in taking on more currency risks). As such, they are squarely dependent on local borrowing, and therefore on local interest rates, for future growth. Real borrowing costs of the order of 10% is extremely restrictive for any economy to overcome, let alone one flirting with recession. From a macro perspective, the only way for Indonesia to boost growth now is by significantly reducing real borrowing costs:  large policy rate cuts and incentivizing banks to bring down the lending rates. The upshot of monetary easing will be currency depreciation. The latter will help boost inflation, contributing to lower real interest rates. Rising Distortions Elsewhere Chart 10Falling Return On Capital Has Discouraged Equity And FDI Inflows To Indonesia... Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates The distortions caused by persistently high real rates can be seen elsewhere in the economy. Indonesia has been receiving a meager amount of foreign equity portfolio inflows (Chart 10). The reason for this is that foreign capital tends to flow into those countries where return on capital is high and/or rising. A diminishing return on capital in Indonesia has discouraged foreign equity capital inflows. Crucially, as we argued above, although Indonesian banks have been profitable, their business model of the past several years is not sustainable. Besides, bank stocks have rallied a lot and are expensive. As such, they are no longer as attractive an investment for foreigners. Gross FDI inflows into the country have also slowed since 2015 (Chart 10, bottom panel) – coinciding with the drop in return on capital. Indeed, the stock of foreign direct investments in Indonesia, relative to its GDP, has fallen sharply over the past few years. In short, foreign equity portfolio and direct invest flows have been measly due to falling rates of return on capital. An inability to attract foreign capital inflows, in turn, can weigh on the currency. To be sure, this has indeed been the case for Indonesia: the rupiah has depreciated in tandem with falling return on capital (Chart 11). What has complicated matters more for Indonesia is that of all the international capital inflows the country has managed to attract in recent years, the majority have been in the form of credit, not equity (Chart 12). This is not surprising as creditors prefer high real rates while equity investors dislike high real interest rates. Chart 11...Putting Downward Pressures On The Currency Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 12Higher Dependence On Debt Borrowing Has Incentivized Indonesia To Keep Real Rates High Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   However, rising reliance on foreign debt inflows has incentivized the authorities to keep real interest rates high so that they can continue to attract enough financing for the government and defend the currency. In other words, it has encouraged a vicious cycle of high real rates; lower return on capital; lower equity and FDI inflows, but more debt inflows; and continued high real rates. A Window Of Opportunity Chart 13Years Of Hard Budget Constraints Have Forced Firms To Improve Operating Efficiency... Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Indonesia needs to and can break free from this vicious cycle. In fact, years of tight money policy has laid the groundwork for its non-financial sectors to take off.  As we have argued in the previous report, while cheap money and ample stimulus can be good for share prices in the near to medium-term; excessive stimulus and easy money policies – we refer to these as soft-budget constraints – bode ill for share prices in the long term. Conversely, hard-budget constraints usually force companies into restructuring, deleveraging and cutting wasteful expenditures, and make them leaner and more efficient. In the long run, hard-budget constraints can create conditions for a bull market. Given that Indonesian non-financial firms have been facing years of hard-budget constraints, there are indeed signs that their efficiency is improving. Operating profit margins (EBITDA) have been rising over the past several years. Consistently, operating cash flows relative to sales have also steadily gone up.  These are clear indications of improving operating efficiency (Chart 13, top panel). Non-financial firms’ leverage levels have also stayed under control. The debt-assets and debt-equity ratios have fluctuated within their historical range over the past 10 years (Chart 14). The rising trends of EBITDA and operating cash flows relative to ‘enterprise value’ indicate that the firms’ profitability and valuations have also improved (Chart 13, bottom panel). In other words, firms are now generating much higher operating cash flows and operating profits relative to the price one would need to pay to acquire them. Incidentally, enterprise value is a more comprehensive measure of firm value than is market capitalization, as the former includes the value of firms’ debt and cash balances too, in addition to equity.1  This is to say, save for the exorbitant financing costs and the consequences thereof, Indonesian non-financial firms are not in bad shape. Borrowing cost is the main reason why the firms’ net profit margins have fallen in recent years despite rising operating margins (Chart 15). Chart 14...And Keep Leverage Under Check Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 15Improving Operating Margins Are Weighed Down By Exorbitant Financing Costs Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates   This also means that if and when real borrowing costs decline meaningfully, Indonesian non-financial firms will be in a position to take advantage of it. Their net profit margins will rise, and with that, the odds of more capital spending, future growth and potentially higher share prices. Banks Might Need To Foot The Bill For any meaningful easing of interest expense burden for non-financial firms, the real lending rates need to be reduced by several hundred basis points. This obviously cannot be achieved by reduction of policy rates alone – which is currently at 3.75%. The only other way is to encourage the banks to reduce their lending rates even more than policy rate cuts. This can be done by, say, lowering risk weights to loans meaningfully. It will reduce banks’ capital cost per unit of loans (i.e., banks will have to set aside a lower amount of capital for their loans); and therefore incentivize them to reduce their lending rates so that they can grow their loan books and take advantage of lower capital cost. The secular bull market in Indonesian bank stocks were afforded by the hefty net interest margins they enjoyed for years – both in absolute terms and compared to their peers elsewhere (Chart 16). That said, their share price swings actually depended on the ebbs and flows of banks’ net interest margins (NIM) (Chart 17). As such, any meaningful cut in banks’ NIM will not only weigh on bank share prices, it could cause a rotation of equity leadership from banks to non-banks stocks. Chart 16Steep Net Interest Margins Led To Indonesian Bank Stocks' Bull Run Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Chart 17A Fall In Banks' Net Interest Margins Will Rotate Equity Leadership To Non-Bank Stocks Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates     Investment Conclusions Equities Investors, therefore, should be watching for any whiff of policy change. A meaningful departure from the current monetary policy of imposing high real interest rates on the economy will help usher in a new bull market in Indonesian non-financial stocks, which have languished for several years. That said, we still do not see any concrete signs of change in that policy. Indeed, the central bank’s focus remains on controlling inflation and stabilizing the rupiah. This does not suggest that the authorities are about to adopt a regime of low real borrowing costs for non-banks. Until that happens, this bourse will find it hard to outperform an EM portfolio on a sustainable basis. Investors should continue underweighting this bourse within an EM equity portfolio for now; but put it on the upgrade watch list. Currency The rupiah is likely to stay steady for now. The reason is that the recent improvements in trade and current account balances will likely linger as domestic demand, facing high real interest rates, remains lackluster. A relatively steady current account would obviate the need for strong foreign capital inflows to sustain a stable exchange rate. Crucially, the introduction of the Omnibus Law, while the details are not yet finalized, is likely to encourage capital inflows on the margin. We will discuss the full implication of the Omnibus Law in a subsequent report. Suffice it to say, both current and capital account dynamics are likely to keep Indonesia’s balance of payments afloat – which is supportive of the currency. That said, any whiff of a change in policy toward a lower real rate regime will dramatically change the exchange rate outlook. Should the central bank begin to cut interest rates by any meaningful measures (upwards of 100 basis points), the currency will lose its appeal of the high carry and will depreciate. But as we argued above such a policy shift is not imminent. Fixed Income Chart 18Investors Should Upgrade Indonesian Local Currency Bonds To Overweight Indonesia: Trapped By High Real Rates Indonesia: Trapped By High Real Rates Fiscal deficits have surged to 5% of GDP – as expenditures were raised to cope with the fallouts of the pandemic last year, even as revenues dropped. Going forward, however, fiscal policy will be tightening. In other words, fiscal thrust would be negative in 2021 and probably in 2022, as projected by the IMF. This does not augur well for economic growth. Tight monetary and fiscal policies, weak domestic demand and undershooting inflation represent a bullish cocktail for domestic bonds (Chart 18). Besides, the yield curve has steepened to its highest level in a decade suggesting that the long end of the yield curve offers good value (Chart 18, bottom panel). Dedicated fixed income investors should upgrade Indonesian local currency bonds to overweight in an EM portfolio. Consistently, we are closing our short position in domestic bonds. As to sovereign credit, we are upgrading it to overweight too as a stable currency and prudent fiscal policy bode well for sovereign credit. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1  Enterprise Value = Stock market capitalization plus short and long term debts minus cash and cash equivalents.

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 Policy Zigzags And Market Mini-Cycles Policy 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 Corporate Bond Issuance Make Up Only A Small Portion Of Total Financing Corporate Bond Issuance Make Up Only A Small Portion Of Total Financing Chart 3Periods Of Financial Tightening Dampen Corporate Bond Market Periods Of Financial Tightening Dampen Corporate Bond Market Periods Of Financial Tightening Dampen Corporate Bond Market Chart 4Higher Funding Costs Will Discourage Corporate Borrowing Higher Funding Costs Will Discourage Corporate Borrowing Higher 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 China's SOE Reform Dilemma China's SOE Reform Dilemma Chart 6Small Rise In Lending Rate, Large Fall In Credit Growth Small Rise In Lending Rate, Large Fall In Credit Growth Small 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 China's SOE Reform Dilemma China's SOE Reform Dilemma 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 SOEs Financial Gains From Debt Are In Deep Contraction SOEs Financial Gains From Debt Are In Deep Contraction Chart 9China Was Successful In Reining In SOE Debt, But Only Briefly China Was Successful In Reining In SOE Debt, But Only Briefly China 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 China's SOE Reform Dilemma China's SOE Reform Dilemma 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 Investable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Investable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle CHART 11BA-Shares Are Less Expensive, But Valuations Are Still Elevated China's SOE Reform Dilemma China's SOE Reform Dilemma   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

Highlights Markets largely ignored the uproar at the US Capitol on January 6 because the transfer of power was not in question. Democratic control over the Senate, after two upsets in the Georgia runoff, is the bigger signal. US fiscal policy will become more expansive yet the Federal Reserve will not start hiking rates anytime soon. This is a powerful tailwind for risk assets over the short and medium run. Politics and geopolitics affect markets through the policy setting, rather than through discrete events, which tend to have fleeting market impacts. The current setting, in the US and abroad, is negative for the US dollar. The implication is positive for emerging market stocks and value plays. Go long global stocks ex-US, long emerging markets over developed markets, and long value over growth. Cut losses on short CNY-USD. Feature Chart 1Market's Muted Response To US Turmoil Market's Muted Response To US Turmoil Market's Muted Response To US Turmoil Scenes of mayhem unfolded in the US Capitol on January 6 as protesters and rioters flooded the building and temporarily interrupted the joint session of Congress convened to count the Electoral College votes. Congress reconvened later and finished the tally. President-elect Joe Biden will take office at noon on January 20. Financial markets were unperturbed, with stocks up and volatility down, though safe havens did perk up a bit (Chart 1). The incident supports our thesis that the US election cycle of 2020 was a sort of “Civil War Lite” and that the country is witnessing “Peak Polarization,” with polarization likely to fall over the coming five years. The incident was the culmination of the past year of pandemic-fueled unrest and President Trump’s refusal to concede to the Electoral College verdict. Trump made a show of force by rallying his supporters, and apparently refrained from cracking down on those that overran Congress, but then he backed down and promised an orderly transfer of power. The immediate political result was to isolate him. Fewer Republicans than expected contested the electoral votes in the ensuing joint session; one Republican is openly calling for Trump to be forced into resignation via the 25th amendment procedure for those unfit to serve. The electoral votes were promptly certified. Vice President Mike Pence and other actors performed their constitutional duties. Pence reportedly gave the order to bring out the National Guard to restore order – hence it is possible that Pence and Trump’s cabinet could activate the 25th amendment, but that is unlikely unless Trump foments rebellion going forward. Vandals and criminals will be prosecuted and there could also be legal ramifications for Trump and some government officials. Do Politics And Geopolitics Affect Markets? The market’s lack of concern raises the question of whether investors need trouble themselves with politics at all. Philosopher and market guru Nassim Nicholas Taleb tweeted the following: If someone, a year ago, described January 6, 2021 (and events attending it) & asked you to guess the stock market behavior, admit you would have gotten it wrong. Just so you understand that news do not help you understand markets.1 This is a valid point. Investors should not (and do not) invest based on the daily news. Of course, many observers foresaw social unrest surrounding the 2020 election, including Professor Peter Turchin.2 Social instability was rising in the data, as we have long shown. When you combined this likelihood with the Fed’s pause on rate hikes, and a measurable rise in geopolitical tensions between the US and other countries, the implication was that gold would appreciate. So if someone had told you a year ago that the US would have a pandemic, that governments would unleash a 10.2% of global GDP fiscal stimulus, that the Fed would start average inflation targeting, that a vaccine would be produced, and that the US would have a contested election on top of it all, would you have expected gold to rise? Absolutely – and it has done so, both in keeping with the fall in real interest rates plus some safe-haven bonus, which is observable (Chart 2). Chart 2Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk The takeaway is that policy matters for markets while politics may only matter briefly at best. Which brings us back to the implications of the Trump rebellion. What Will Be The Impact Of The Trump Rebellion? We have highlighted that this election was a controversial rather than contested election – meaning that the outcome was not in question after late November when the court cases, vote counts, and recounts were certified. This was doubly true after the Electoral College voted on December 14. The protests and riots yesterday never seriously called this result into question. Whatever Trump’s intentions, there was no military coup or imposition of martial law, as some observers feared. In fact the scandal arose from the President’s hesitation to call out the National Guard rather than his use of security forces to prevent the transfer of power, as occurs during a coup. This partially explains why the market traded on the contested election in December 2000 but not in 2020 – the result was largely settled. The Biden administration now has more political capital than otherwise, which is market-positive because it implies more proactive fiscal policy to support the economic recovery. Trump’s refusal to concede gave Democrats both seats in the Georgia Senate runoffs, yielding control of Congress. Household and business sentiment will revive with the vaccine distribution and economic recovery, while the passage of larger fiscal stimulus is highly probable. US fiscal policy will almost certainly avoid the mistake of tightening fiscal policy too soon. Taken with the Fed’s aversion to raising rates, greater fiscal stimulus will create a powerful tailwind for risk assets over the next 12 months. The primary consequence of combined fiscal and monetary dovishness is a falling dollar. The greenback is a counter-cyclical and momentum-driven currency that broadly responds inversely to global growth trends. But policy decisions are clearly legible in the global growth path and the dollar’s path over the past two decades. Japanese and European QE, Chinese devaluation, the global oil crash, Trump’s tax cuts, the US-China trade war, and COVID-19 lockdowns all drove the dollar to fresh highs – all policy decisions (Chart 3). Policy decisions also ensured the euro’s survival, marking the dollar’s bottom against the euro in 2011, and ensuring that the euro could take over from the dollar once the dollar became overbought. Today, the US’s stimulus response to COVID-19 – combined with the Fed’s strategic review and the Democratic sweep of government – marked the peak and continued drop-off in the dollar. Chart 3Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Chart 4China's Yuan Says Geopolitics Matters China's Yuan Says Geopolitics Matters China's Yuan Says Geopolitics Matters The Chinese renminbi is heavily manipulated by the People’s Bank and is not freely exchangeable. The massive stimulus cycle that began in 2015, in reaction to financial turmoil, combined with the central bank’s decision to defend the currency marked a bottom in the yuan’s path. China’s draconian response to the pandemic this year, and massive stimulus, made China the only major country to contribute positively to global growth in 2020 and ensured a surge in the currency. The combination of US and Chinese policy decisions has clearly favored the renminbi more than would be the case from the general economic backdrop (Chart 4). Getting the policy setting right is necessary for investors. This is true even though discrete political events – including major political and geopolitical crises – have fleeting impacts on markets. What About Biden’s Trade Policy? Trump was never going to control monetary or fiscal policy – that was up to the Fed and Congress. His impact lay mostly in trade and foreign policy. Specifically his defeat reduces the risk of sweeping unilateral tariffs. It makes sense that global economic policy uncertainty has plummeted, especially relative to the United States (Chart 5). If US policy facilitates a global economic and trade recovery, then it also makes sense that global equities would rise faster than American equities, which benefited from the previous period of a strong dollar and erratic or aggressive US fiscal and trade policy. Trump’s last 14 days could see a few executive orders that rattle stocks. There is a very near-term downside risk to European and especially Chinese stocks from punitive measures, or to Emirati stocks in the event of another military exchange with Iran (Chart 6). But Trump will be disobeyed if he orders any highly disruptive actions, especially if they contravene national interests. Beyond Trump’s term we are constructive on all these bourses, though we expect politics and geopolitics to remain a headwind for Chinese equities. Chart 5Big Drop In Global Policy Uncertainty Big Drop In Global Policy Uncertainty Big Drop In Global Policy Uncertainty US tensions with China will escalate again soon – and in a way that negatively impacts US and Chinese companies exposed to each other. Chart 6Geopolitical Implications Of Biden's Election Geopolitical Implications Of Biden's Election Geopolitical Implications Of Biden's Election The cold war between these two is an unavoidable geopolitical trend as China threatens to surpass the US in economic size and improves its technological prowess. Presidents Xi and Trump were merely catalysts. But there are two policy trends that will override this rivalry for at least the first half of the year. First, global trade is recovering– as shown here by the Shanghai freight index and South Korean exports and equity prices (Chart 7). The global recovery will boost Korean stocks but geopolitical tensions will continue to brood over more expensive Taiwanese stocks due to the US-China conflict. This has motivated our longstanding long Korea / short Taiwan recommendation. Chart 7Global Economy Speaks Louder Than North Korea Global Economy Speaks Louder Than North Korea Global Economy Speaks Louder Than North Korea Chart 8China Wary Of Over-Tightening Policy China Wary Of Over-Tightening Policy China Wary Of Over-Tightening Policy Chart 9Global Stock-Bond Ratio Registers Good News Global Stock-Bond Ratio Registers Good News Global Stock-Bond Ratio Registers Good News Second, China’s 2020 stimulus will have lingering effects and it is wary of over-tightening monetary and fiscal policy, lest it undo its domestic economic recovery. The tenor of China’s Central Economic Work Conference in December has reinforced this view. Chart 8 illustrates the expectations of our China Investment Strategy regarding China’s credit growth and local government bond issuance. They suggest that there will not be a sharp withdrawal of fiscal or quasi-fiscal support in 2021. Stability is especially important in the lead up to the critical leadership rotation in 2022.3 This policy backdrop will be positive for global/EM equities despite the political crackdown on General Secretary Xi Jinping’s opponents will occur despite this supportive policy backdrop. The global stock-to-bond ratio has surged in clear recognition of these positive policy trends (Chart 9). Government bonds were deeply overbought and it will take several years before central banks begin tightening policy. What About Biden’s Foreign Policy? Chart 10OPEC 2.0 Cartel Continues (For Now) Accommodative US Monetary Policy, Tighter Commodity Markets Will Stoke Inflation OPEC 2.0 Cartel Continues (For Now) Accommodative US Monetary Policy, Tighter Commodity Markets Will Stoke Inflation OPEC 2.0 Cartel Continues (For Now) Iran poses a genuine geopolitical risk this year – first in the form of an oil supply risk, should conflict emerge in the Persian Gulf, Iraq, or elsewhere in the region. This would inject a risk premium into the oil price. Later the risk is the opposite as a deal with the Biden administration would create the prospect for Iran to attract foreign investment and begin pumping oil, while putting pressure on the OPEC 2.0 coalition to abandon its current, tentative, production discipline in pursuit of market share (Chart 10). Biden has the executive authority to restore the 2015 nuclear deal (Joint Comprehensive Plan of Action). He is in favor of doing so in order to (1) prevent the Middle East from generating a crisis that consumes his foreign policy; (2) execute an American grand strategy of reviving its Asia Pacific influence; (3) cement the Obama administration’s legacy. The Iranian President Hassan Rouhani also has a clear interest in returning to the deal before the country’s presidential election in June. This would salvage his legacy and support his “reformist” faction. The Supreme Leader also has a chance to pin the negative aspects of the deal on a lame duck president while benefiting from it economically as he prepares for his all-important succession. The problem is that extreme levels of distrust will require some brinkmanship early in Biden’s term. Iran is building up leverage ahead of negotiations, which will mean higher levels of uranium enrichment and demonstrating the range of its regional capabilities, including the Strait of Hormuz, and its ability to impose economic pain via oil prices. Biden will need to establish a credible threat if Iran misbehaves. Hence the geopolitical setting is positive for oil prices at the moment. Beyond Iran, there is a clear basis for policy uncertainty to decline for Europe and the UK while it remains elevated for China and Russia (Chart 11). Chart 11Relative Policy Uncertainty Favors Europe and UK Over Russia And China Relative Policy Uncertainty Favors Europe and UK Over Russia And China Relative Policy Uncertainty Favors Europe and UK Over Russia And China The US international image has suffered from the Trump era and the Biden administration’s main priorities will lie in solidifying alliances and partnerships and stabilizing the US role in the world, rather than pursuing showdown and confrontation. However, it will not be long before scrutiny returns to the authoritarian states, which have been able to focus on domestic recovery and expanding their spheres of influence amid the US’s tumultuous election year. Chart 12GeoRisk Indicators Say Risks Underrated For These Bourses GeoRisk Indicators Say Risks Underrated For These Bourses GeoRisk Indicators Say Risks Underrated For These Bourses The US will not seek a “diplomatic reset” with Russia, aside from renegotiating the New START treaty. The Democrats will seek to retaliate for Russia’s extensive cyberattack in 2021 as well as for election interference and psychological warfare in the United States. And while there probably will be a reset with China, it will be short-lived, as outlined above. This situation contrasts with that of the Atlantic sphere. The Biden administration is a crystal clear positive, relative to a second Trump term, for the European Union. The EU and the UK have just agreed to a trade deal, as expected, to conclude the Brexit process, which means that the US-UK “special relationship” will not be marred by disagreements over Ireland. European solidarity has also strengthened as a result of the pandemic, which highlighted the need for collective policy responses, including fiscal. Thus the geopolitical risks of the new administration are most relevant for China/Taiwan and Russia. Comparing our GeoRisk Indicators, which are market-based, with the relative equity performance of these bourses, Taiwanese stocks are the most vulnerable because markets are increasingly pricing the geopolitical risk yet the relative stock performance is toppy (Chart 12). The limited recovery in Russian equities is also at risk for the same reason. Only in China’s case has the market priced lower geopolitical risk, not least because of the positive change in US administration. We expect Biden and Xi Jinping to be friendly at first but for strategic distrust to reemerge by the second half of the year. This will be a rude awakening for Chinese stocks – or China-exposed US stocks, especially in the tech sector. Investment Takeaways Chart 13Global Policy Shifts Drive Big Investment Reversals Global Policy Shifts Drive Big Investment Reversals Global Policy Shifts Drive Big Investment Reversals The US is politically divided. Civil unrest and aftershocks of the controversial election will persist but markets will ignore it unless it has a systemic impact. The policy consequence is a more proactive fiscal policy, resulting in virtual fiscal-monetary coordination that is positive both for global demand and risk assets, while negative for the US dollar. The Biden administration will succeed in partially repealing the Trump tax cuts, but the impact on corporate profit margins will be discounted fairly mechanically and quickly by market participants, while the impact on economic growth will be more than offset by huge new spending. Sentiment will improve after the pandemic – and Biden has not yet shown an inclination to take an anti-business tone. The past decade has been marked by a dollar bull market and the outperformance of developed markets over emerging markets and growth stocks like technology over value stocks like financials. Cyclical sectors have traded in a range. Going forward, a secular rise in geopolitical Great Power competition is likely to persist but the macro backdrop has shifted with the decline of the dollar. Cyclical sectors are now poised to outperform while a bottom is forming in value stocks and emerging markets (Chart 13). We recommend investors go strategically long emerging markets relative to developed. We are also going long global value over growth stocks. We are not yet ready to close our gold trade given that the two supports, populist fiscal turn and great power struggle, will continue to be priced by markets in the near term. We are throwing in the towel on our short CNY-USD trade after the latest upleg in the renminbi, though our view continues to be that geopolitical fundamentals will catch yuan investors by surprise when they reassert themselves. We also recommend preferring global equities to US equities, given the above-mentioned global trends plus looming tax hikes.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 January 6, 2020, twitter.com. 2 See Turchin and Andrey Korotayev, "The 2010 Structural-Demographic Forecast for the 2010-2020 Decade: A Retrospective Assessment," PLoS ONE 15:8 (2020), journals.plos.org. 3 Not to mention that 2021 is the Communist Party’s 100th anniversary – not a time to make an unforced policy error with an already wobbly economy.