Emerging Markets

Highlights Bad news is still looming in the trade war. Public opinion polling in the U.S. gives President Trump more leeway to push the envelope on tariffs and sanctions against China than the consensus recognizes. Trump’s tendency to push the envelope is forcing China into a corner in which structural concessions become too risky. Unrest in Hong Kong reveals the city-state’s political woes as well as the tail-risk of a geopolitical incident in Taiwan. Tariffs on Mexico are still possible. Close long MXN/BRL. Maintain tactical safe-haven plays. Feature Judging by the S&P 500, the Federal Reserve has cut interest rates and the G20 summit between Presidents Donald Trump and Xi Jinping has been a success (Chart 1). Chart 1Trade War? Who Cares! Trade War? Who Cares! Trade War? Who Cares! The problem is that there is not yet a compelling, positive, political catalyst on the trade front. And the Fed has an incentive to wait until after the June 28-29 G20 to make its decision on any cut. At least in the case of the December 1 G20 summit in Buenos Aires there was significant diplomatic preparation ahead of time. That is not yet the case for the summit in Osaka, Japan. And even Buenos Aires ended up being a flop given the subsequent tariff escalation. We are maintaining our tactical safe-haven recommendations – long gold, Swiss bonds, and Japanese yen – until we see a clearer pathway for the risk-on phase to resume amid a summer loaded with fair-probability geopolitical risks: Trump’s aggressive foreign policy, the Democratic primary, China’s domestic policy, the U.S. immigration crisis, and Brexit. Beyond this near-term caution, we agree with BCA’s House View in remaining overweight equities on a cyclical basis (12 months). China’s economic stimulus is likely to pick up further this summer and it still has the capacity to deliver positive surprises. Preparing For The G20 Over the course of this year we have argued for a 50% chance and then 40% chance that the U.S. and China would conclude a trade deal by the G20 summit. However, Commerce Secretary Wilbur Ross and other administration officials, including Chief of Staff Mick Mulvaney, have recently indicated that the best case at the G20 is for the leaders to have dinner and agree to a new timetable that aims to close the negotiations in the coming months. The Trump-Xi summit itself remains unconfirmed as we go to press. This suggests that we were too optimistic about even a barebones trade deal at the G20. We are now extending our time frame to the November 2020 election -- the only deadline that really matters. Diagram 1 presents a cogent and conservative decision tree that results in a 41% chance of a major, Cold War-style escalation in tensions; a 27% chance of a minor escalation that is contained but without a final trade agreement; and a 28% chance of a tenuous or short-term deal. It gives only a 4% chance of a “grand compromise” that initiates a new phase of re-engagement between the two economies. These outcomes clearly represent a large downside risk given where equities are positioned today. Diagram 1Trade War Decision Tree (Updated June 13, 2019) Another Phony G20? And A Word On Hong Kong Another Phony G20? And A Word On Hong Kong Why such gloom when the two sides may be on the brink of a new tariff ceasefire? First, delaying the talks beyond the G20 is disadvantageous for Trump and will make him angry sooner or later. The Trump administration, unlike its predecessors, has made a point of opposing China’s traditional playbook of drawing out negotiations. China benefits in talks over the long run because it gains economic and strategic leverage. This has been the case in every major round of dialogue since the 1980s and it is specifically the case today, as China gradually stimulates its way out of the slowdown that afflicted it at the time of the last G20 (Chart 2). Chart 2China's Bargaining Leverage To Improve On Stimulus China's Bargaining Leverage To Improve On Stimulus China's Bargaining Leverage To Improve On Stimulus Trump would not have called a ceasefire on Dec. 1, 2018 if the stock market had held up amid Fed rate hikes and the Sept. 24 implementation of the 10% tariff on $200 billion. This year the U.S. equity market has bounced back and the Fed has paused, but China’s economy has not yet fully recovered. This gives Trump an advantage that may not last if the talks extend through the rest of the year. And this reasoning explains why Trump raised the tariff rate and blacklisted China’s tech companies in May – to try to clinch a deal by the end of June. He is also threatening to impose tariffs on the remaining $300 billion worth of imports if Xi snubs him in Osaka. If the G20 fails to produce progress, we would bet that Trump will proceed with a sweeping tariff on the remaining $300 billion worth of Chinese imports, whether immediately after the summit or at some later point when he decides that the Chinese are indeed playing for time. How can we be confident of this? After all, Trump’s approval rating has fallen since he escalated the trade war in May and it remains well beneath the average post-World War II presidents at this stage in their first terms, including President Obama’s rating in the summer of 2011 (Chart 3). Recent opinion polls suggest that voters are getting wise to the negative impact of tariffs on their pocketbooks. The financial and political constraints on Trump are not very pressing. Chart 3 We are confident because the financial and political constraints on Trump are not very pressing, at least not at the moment. First, the stock market has risen despite the tariff hikes, so Trump is likely emboldened. Second, Trump is less constrained in the use of tariffs than in other areas. He is bogged down with a Democratic Congress, investigations, and scandals at home. He cannot pursue policy through legislation – he shifted to the threat of tariffs on Mexico because he could not build his border wall. By turbo-charging his trade policy and foreign policy – against China, Iran, Mexico, Russia, most recently Germany … basically everyone except North Korea – he creates the option of turning 2020 into a “foreign policy election” rather than an election about the economy or social policy. A strong economy has not enabled him to break through his ceiling in public opinion thus far and he will lose a social policy election easily (see health care). The risk of his aggressive foreign policy is that it triggers an international crisis. But that would likely benefit him in the polls, given the natural inclination to defend America against foreign enemies. See George W. Bush, 2004 (Chart 4). Third, popular opposition to Trump’s trade war is not clear-cut – voters are ambivalent. In the past we have shown that President Trump’s 2020 run still depends on his ability to increase voter turnout among whites, specifically white males, low-income whites, and whites without college degrees. Recent polls suggest that voters have turned against tariffs and the trade war – namely the Quinnipiac and Monmouth University polls released in late May after the latest tariff hike. But it is essential to dig beneath the surface. These polls reveal that the key voting groups look more favorably than the rest of the country upon Trump’s policies on both trade and China (Chart 5). Chart 4 Chart 5 These voters’ assessment of Trump’s performance overall, across a range of policies, is not disapproving, despite all of the unorthodox and disruptive decisions that Trump has made in his presidency thus far (Chart 6). Chart 6 American voters are neither as enthusiastic about free trade nor as appalled by protectionism as the headline polling suggests. For instance, take the Monmouth University poll, which asked very specific questions about trade, tariffs, and retaliation. If we combine the group of voters who are clearly protectionist with those who are “not sure” or think the answer “depends,” the results do not suggest that Trump is heavily constrained (Table 1). Table 1Americans Are Not As Pro-Free Trade As It Seems Another Phony G20? And A Word On Hong Kong Another Phony G20? And A Word On Hong Kong In swing counties 51% of voters think that free trade is either a bad idea or are undecided. And even 57% percent of voters in counties that voted for Hillary Clinton by more than a 10% margin are in favor of tariffs or unsure. And a majority of voters in the most relevant categories – independents, moderates, non-college graduates, low-income earners – believe that Trump’s tariffs will bring manufacturing back, a highly relevant point for an election that will likely swing on the Rust Belt yet again. This includes Clinton’s most secure districts (Chart 7)! Chart 7 The point is not that Trump lacks political constraints on the trade war – after all, these voters are on the borderline in many cases and concerned about all-out trade war with China. Rather, his aggressive trade tactics enable him to reconnect with and energize his voter base at a time when his other signature policies are tied down. This is critical because his reelection prospects, which we have pegged at 55%, are in great peril, at least judging by his lag in the head-to-head polling against the top Democrats in swing states. Bottom Line: Going forward, Trump has more room to push the envelope than investors realize. A failed G20 summit poses the risk of another selloff in global equities. We are maintaining our tactical safe-haven trades.   What About Xi Jinping’s Constraints? Xi is president for life and must be attentive to long-term ramifications. Chart 8Xi Jinping's Immediate Constraint Xi Jinping's Immediate Constraint Xi Jinping's Immediate Constraint If Trump is tempted to continue pushing the envelope, will President Xi back down? While not constrained by the stock market or elections, he does face the prospect of instability in the manufacturing sector and large-scale unemployment (Chart 8), which Beijing has not had to deal with for 20 years. The point is not to claim that laid-off Chinese workers will turn around and protest against their own country in the face of gunboat diplomacy by capitalist imperialists – on the 70th anniversary of the regime, no less. Rather, Xi is president for life and must be attentive to the long-term ramifications of a disruptive transition in the excessively large manufacturing sector. This would cause economic and, yes, ultimately socio-political problems for him down the road. If Trump continues to move toward his 2016 campaign pledge of a 45% tariff on all Chinese imports, as the 2020 election approaches, China’s leaders have far less incentive to put their careers (and lives) on the line to produce structural concessions. A tariff covering all Chinese goods is an absolutist position that China can only address by doubling down on its demand for full tariff rollback. Yet Trump needs to retain some tariffs to enforce the implementation of any agreement. Thus slapping tariffs on all Chinese imports is almost, but not quite, an irreversible step. This is captured in Diagram 1 via the 29% chance that tensions are contained even if a deal falls through. Tensions are even less likely to be contained if the Trump administration follows through on its threats against China’s tech sector. On August 19, the Commerce Department will decide whether to renew the license for U.S. companies to sell key components to Huawei and other blacklisted companies. If the administration denies the license – and moves further ahead with export controls on emerging and foundational technologies – then Beijing faces an outright technological blockade. It will retaliate against U.S. companies – a process already beginning1 – and will likely act on other threats such as a rare earths embargo. In this case strategic tensions will escalate dramatically, including saber-rattling in the air, in cyberspace, or on the high seas. At the moment political frictions in Hong Kong are exacerbating U.S.-China distrust. Bottom Line: Since President Xi’s constraints are longer-term, he has the ability to deny structural concessions to Trump. But Trump’s ability to push the trade war further and further risks forcing China to a point of no return. There is not a clear basis for the geopolitical risk affecting the global trade and growth outlook to fall. Hong Kong: A New Front In The U.S.-China Struggle The large-scale protests that have erupted in Hong Kong – first on April 28 and most recently on June 9 –are important for several reasons: they highlight the immense geopolitical pressure in East Asia emanating from China’s “New Era” under Xi Jinping; they are rapidly becoming entangled in U.S.-China tensions, particularly over technological acquisition; and they foreshadow the political instability on the horizon in Taiwan. Tensions have been rising between Hong Kong and mainland China since the Great Recession and the shock to capitalist financial centers around the world. The tensions are symptomatic of the dramatic change in China over the past decade; the decline of the post-Cold War status quo; and the broader decline of the western world order (e.g. the British Empire). After all, the West is lacking tools to preserve the rights and privileges that Hong Kong was supposed to be guaranteed when the transfer of sovereignty occurred in 1997. More immediately, the current protests are part of a process going back to 2012 in which the disaffected and marginalized parts of Hong Kong society began speaking up against the political establishment. This emerged because of high income inequality (Chart 9), shortcomings in quality of life, excessive property prices (Chart 10), and the mainland’s reassertion of Communist Party rule and encroachments on Hong Kong’s autonomy. Chart 9 Chart 10Another Source Of Hong Kong's Unrest Another Source Of Hong Kong's Unrest Another Source Of Hong Kong's Unrest A simple comparison with Singapore, the other major East Asian city-state, shows that Hong Kong has trailed in GDP per capita and wage gains, while property price inflation has soared ahead (Chart 11). These structural economic factors contributed to the emergence of the “Occupy Central” protests in 2014, which were smaller than today’s protests but signaled the abrupt shift in the political sphere toward disenchantment and activism. Chart 11Why Hong Kong Is Not As Quiet As Singapore Why Hong Kong Is Not As Quiet As Singapore Why Hong Kong Is Not As Quiet As Singapore The 2016 elections for the Legislative Council (LegCo) resulted in a fiasco by which a number of pro-democracy activists, known as “localists,” were squeezed out of the legislature through a combination of juvenile mistakes and heavy-handed intervention by Beijing and the pro-mainland Hong Kong authorities (Chart 12 A&B). Beijing exploited the occasion to extend its legal writ over Hong Kong society and curb some of the city’s freedoms.2 The democratic opposition and dissidents have been sidelined or repressed — and now they face the prospect of being extradited, given that the LegCo is highly likely to pass the “Fugitive Offenders and Mutual Legal Assistance in Criminal Matters” bill that sparked the protests this year. Chart 12 Chart 12 The exclusion of the localists from power runs the risk of radicalizing them and increasing disaffection, making mass protests likely to recur both in the near term and in future. Hong Kongers are losing confidence in the “One Country, Two Systems” arrangement (Chart 13). They are similarly becoming more disillusioned with mainland China, adding fuel to the fire over time (Chart 14). However, in the specific case of the city-state, there is no alternative to Beijing’s ultimate say – and the older generations will continue to support the political establishment. Chart 13 Chart 14 Nevertheless Hong Kong’s discontents will become entangled in the broader Cold War emerging between the U.S. and China. Beijing is accusing the protesters of being lackeys of foreign powers. The U.S. Congress, on both sides of the aisle, is threatening to declare that Hong Kong is no longer sufficiently autonomous from Beijing and therefore no longer eligible for special privileges. Hong Kong faces rising political dependency on China and the potential for special relations with the United States to decline. Chart 15 Part of Washington’s concern lies with Beijing’s aggressive technological acquisition program. Hong Kong has been able to import advanced dual-use technology products from the United States without Beijing’s restrictions. This is not apparent from the proportion of exports but it is important on the technological level (Chart 15). It introduces a backdoor for China to acquire these goods and has prompted a rethink in Washington. Hong Kong is also accused of facilitating the circumventing of sanctions on U.S. enemies. It thus faces rising political dependency on China and the potential for special relations with the United States to decline. These pressures also highlight why we view Taiwan as a potential “Black Swan.” Similar political fissures are emerging as Beijing expands its economic and military dominance over Taiwan. Of course, the political backlash against Beijing has recently been receding in Taiwanese opinion, due to the fact that the nominally pro-independence Democratic Progressive Party has lost most of the momentum it gained after the large-scale “Sunflower” student protests of 2014 (Chart 16). But there are still several reasons that the January 2020 election could become a geopolitical flashpoint: namely the developments in Hong Kong, China’s handling of them, Beijing’s tensions with Washington, and the Trump administration’s temptation to achieve some key goals with the Tsai Ing-wen administration before it leaves office (including arms sales). Even if the Taiwanese political winds shift to become less confrontational toward Beijing after January, the time between now and then is ripe for an “incident” of some kind. Beyond that, the pro-independence opposition will begin activating and marching against the next government if it proves obsequious to the mainland. Chart 16Taiwan: Pro-Mainland Forces Revive Taiwan: Pro-Mainland Forces Revive Taiwan: Pro-Mainland Forces Revive Chart 17 Over the long run, Taiwan is far more autonomous than Hong Kong, harder for Beijing to control, and much more attractive for Beijing’s enemies to defend – namely the U.S. and Japan. Moreover, as the tech conflict with Washington heats up, Taiwan becomes vital for China’s technological self-sufficiency, putting it at higher risk (Chart 17). Beijing will also frown upon the role of Taiwanese companies like FoxConn for taking early steps to diversify the supply chain away from China. This regional strategic reality is not conducive to U.S.-China trade negotiations. And even aside from the U.S., Beijing’s growing power generates resistance from its periphery. This is true of Chinese ally North Korea, which is trying to broaden its options, as well as a historic enemy like Vietnam. Other countries at a bit more of a distance are trying to accommodate both Beijing and Washington, but are increasingly seeing their regimes vacillate based on their orientation toward China – this is true of Thailand in 2014, the Philippines in 2015, South Korea in 2017, and Malaysia in 2018. These changes inject economic policy uncertainty on the country level. Over the long run we see Southeast Asia as a beneficiary of the relocation of supply chains out of China. But at the moment, with the trade war escalating and unresolved and with China taking a heavier hand, we are only recommending holding relatively insulated countries like Thailand. Bottom Line: Our theme of U.S.-China conflict is intertwined with our theme of geopolitical risk rotation to East Asia. States that have domestic-oriented economies, limited exposure to China, or greater U.S. support – including Japan, Thailand, South Korea, Indonesia, and Malaysia – face less geopolitical risk than those heavily exposed to China (Taiwan) or that lack U.S. security guarantees (Hong Kong, Vietnam). Investment Recommendations In addition to our safe-haven tactical trades – long spot gold, long Swiss bonds, and long JPY-USD – we are maintaining our long recommendation for a basket of companies in the MVIS global rare earth and strategic metals index. The basket includes companies not based in mainland China that have seen their stock prices appreciate this year yet have a P/E ratio under 35 (Chart 18). Chart 18Go Long Rare Earth Firms Ex-China Go Long Rare Earth Firms Ex-China Go Long Rare Earth Firms Ex-China We remain short the CNY-USD on the expectation that trade tensions will encourage Beijing to use depreciation as a countervailing tool, despite our expectation of increasing fiscal-and-credit stimulus. Over the long run, we would observe that trade escalation between the U.S. and China bodes poorly for China’s long-term productivity and efficiency. The basis for a reduction in trade tensions is a recommitment to the liberal structural reform agenda that Chinese state economists outlined at the beginning of Xi Jinping’s term in 2012-13. The current trajectory of “the New Long March,” in which Beijing pursues personalized power and uses stimulus to improve self-sufficiency and import-substitution, goes the opposite direction. It is not a pathway for innovation, openness, and technological progress. A simple comparison of China’s long-term equity total return highlights the market’s lack of enthusiasm about the current administration’s approach (Chart 19). The contexts were different, but the earlier outperformance grew from painful structural reforms and a grand compromise with the United States in the late 1990s and early 2000s. Chart 19The Market Wants Reforms And Trade Deal The Market Wants Reforms And Trade Deal The Market Wants Reforms And Trade Deal We are closing our long MXN / short BRL trade for a gain of 4.6%. This trade has bounced back from the U.S.-Mexico deal to avert tariffs. The agreement was not entirely hollow compared to earlier agreements: it calls for Mexico to accelerate the deployment of the National Guard to stem the flow of refugees from Guatemala and central America and expand the Migrant Protection Protocols across the southern border. Trump’s reversal – under Senate pressure, entirely unlike the China dynamic – gave the peso a boost, benefiting our trade. However, one of the fundamental reasons for this trade – the improvement in Mexico’s relative current account balance – has now rolled over (Chart 20) and the tariff threat will reemerge if Mexico proves unable or unwilling to stem the inflow of asylum seekers into the United States (Chart 21). Chart 20Peso Has Outperformed The Real Peso Has Outperformed The Real Peso Has Outperformed The Real Chart 21   As we go to press, the attacks on tankers in Oman highlight our view that oil prices will witness policy-induced volatility and a rising geopolitical risk premium as “fire and fury” shifts to the U.S. and Iran in the near-term. Our expectation of increasing Chinese stimulus helps underpin the constructive view on oil and energy-producing emerging markets.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The American Chamber of Commerce in China and Shanghai released a survey on May 22, 2019 revealing that while 53% of companies have not yet experienced “non-tariff” retaliation by Chinese authorities, 47% had experienced it: 20.1% through increased inspections; 19.7% through slower customs clearance; 14.2% through slow license approvals; another 14.2% through bureaucratic and regulatory complications; and smaller numbers dealing with problems associated with American employees’ visas, increased difficulty closing investment deals, products rejected by customs, and rejections of licenses and applications. 2 We noted at the time, “Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.” See BCA Geopolitical Strategy, “Strategic Outlook 2017: We Are All Geopolitical Strategists Now,” December 14, 2016, available at www.bcaresearch.com.

Highlights The odds of a cyclical upturn in the global semiconductor sector over the next three to six months are low. Global semiconductor demand will continue to decline due to contracting demand for smartphones, automobiles, personal computers (PCs), and servers. Global semiconductor stocks are still facing considerable downside in absolute terms. We recommend going long Asian semiconductor stocks versus the U.S. S&P 500 semiconductor index. Dedicated EM equity portfolios should stay neutral on the Taiwanese bourse and Korean technology sector relative to the overall EM benchmark. Feature Chart 1 shows share prices of the global semiconductor sector and global semiconductor sales in the past two decades. Chart 1Global Semiconductor Market: Sales & Share Prices Global Semiconductor Market: Sales & Share Prices Global Semiconductor Market: Sales & Share Prices Was last December’s trough in global semiconductor equity prices the ultimate bottom in this cycle? The odds are in favor of a continued contraction in global semiconductor sales and further downside in semiconductor share prices over the next three to six months. Cycle-On-Cycle Analysis Semiconductor sales experienced five recessions over the past 20 years. Table 1 illustrates the peak-to-bottom percentage decline in nominal global semiconductor sales and the magnitude of the drop in global semiconductor share prices in U.S. dollar terms during these five cyclical downturns in this industry. It also indicates the duration of each downturn and the number of months that semiconductor stocks led the bottom in global semiconductor sales. Table 1Key Statistics Of Five Cyclical Downturns In Global Semiconductor Market The Global Semiconductor Sector: Is A Cyclical Upturn Imminent? The Global Semiconductor Sector: Is A Cyclical Upturn Imminent? The current shrinkage of semiconductor sales is worse than the 2011-12 and 2015 downturns. Yet, it is still smaller than the magnitude during the 2008 Great Financial Crisis and the 2001 tech bubble bust. The revenue of semiconductor companies has so far contracted by 24%, which is disproportionally more than the decline in share prices of these companies. The global semiconductor equity index is only 14% below its March 2018 high. It appears as though the market is expecting a quick recovery in semiconductor sales. As per Table 1, in the downturns of 2008, 2011 and 2015, global semiconductor stocks all bottomed before the bottom of global semiconductor sales. Only in the 2001 episode, stock prices bottomed eight months after the bottom in sales. In the current cyclical downturn, global semiconductor sales have so far had only four months of growth contraction,1 far less than the 13-16 months experienced in all the past four cycles. All in all, we would lean against the market’s expectation of an imminent recovery in the semiconductor cycle. The demand downturn will last another three to six months and share prices are facing major headwinds. Global Semiconductor Demand Semiconductor sales are in contraction across countries and regions (Chart 2). In April – before President Trump’s tweet on imposing new import tariff on China, global semiconductor sales growth sank to a negative 15% year-on-year. The short-term (three-to-six month) outlook for global semiconductor demand remains dismal. Chart 3 shows global semiconductor revenue breakdown in terms of end usage. Mobile phones account for the largest share (29%) of the market, followed by PCs (12%), miscellaneous consumer products (12%), and servers (11%). All of these major demand sources are under downward pressure: Smartphone Sales Global smartphone sales are shrinking (Chart 4). According to the International Data Corporation (IDC), global smartphone shipments declined 6.6% year-on-year in volume terms in the first quarter of this year, worse than last year’s 4.4% drop. Chart 2Semiconductor Sales Are In Contraction Across Countries Semiconductor Sales Are In Contraction Across Countries Semiconductor Sales Are In Contraction Across Countries  In the current cyclical downturn, global semiconductor sales have so far had only four months of growth contraction, far less than the 13-16 months experienced in all the past four cycles. Chart 3 Chart 4Global Smartphone Sales: Contracting Global Smartphone Sales: Contracting Global Smartphone Sales: Contracting We expect smartphone shipments to continue contracting in the second half of this year. Major markets such as mainland China and advanced economies have entered the saturation phase of mobile-phone demand. For example, U.S. shipments were down 15% year-on-year in the first quarter due to near-full market penetration. In China, smartphone sales have shown signs of stabilization (Chart 5). However, this is probably temporary and has been driven by the boom in Huawei smartphone sales in China since early this year. The incredible 50% year-on-year growth of Huawei smartphone sales in the first quarter is not sustainable. While global sales of Huawei smartphones increased by 20 million units, total global smartphone sales of all brands fell by 22 million units (Chart 6). The U.S. punitive actions towards China and Huawei have also instigated nationalism in China. This has triggered a Chinese buying-spree of the Huawei smartphone. Chart 5Chinese Smartphone Sales: Temporary Stabilization Chinese Smartphone Sales: Temporary Stabilization Chinese Smartphone Sales: Temporary Stabilization Chart 6 Yet, this has probably reduced the number of potential Chinese smartphones buyers in the near future. After all, many buyers likely made the purchase earlier than otherwise planned in the absence of a trade war. Although Samsung, Huawei, OnePlus, Xiaomi, Motorola, LG, and ZTE have either released or will release their 5G phones this year, the sales growth from 5G phones will not be able to offset the loss in 2G, 3G and 4G phone sales, at least not in 2019. The IDC estimated that 5G phones would only account for about 0.5% of the market share this year. 5G will likely only begin affecting overall semiconductor demand next year, when they account for a larger share of smartphone sales.   Huawei is the market leader in 5G technology. The U.S. boycott of Huawei will likely continue. This will only slow the pace of 5G phone adoption and the development of 5G networks worldwide. On balance, global smartphone demand may only recover next year. Server Demand Global server shipments also experienced a 5% contraction in volume terms in the first quarter of this year, according to IDC (Chart 7). The outlook for the rest of 2019 does not look promising. Global server demand will likely remain in contraction in the second half of this year. Many hyperscale data centers have already purchased considerable amounts of severs in advance of the trade war to avoid tariffs.2 Meanwhile, the escalation in the U.S.-China confrontation has increased economic uncertainties. This may delay potential datacenter investments. Decelerating 5G network development worldwide due to the U.S. ban on Huawei will also tend to discourage new datacenter and cloud services projects. This is because the 5G technology enables datacenter and cloud services to experience a huge improvement in terms of data transfer speeds, latency, connectivity, capacity, reliability and mobility. Chart 7Global Server Shipment: Are In Contraction Global Server Shipment: Are In Contraction Global Server Shipment: Are In Contraction Personal Computers (PC) PCs sales are also in contraction (Chart 8). PC demand has entered into the deep-maturation phase while facing strong competition from tablets and laptops. Auto Sales Global auto sales also sank by 5% in April from a year ago, registering the worst contraction since 2009 (Chart 9). Chart 8Global PCs Sales: Deeply Saturated Global PCs Sales: Deeply Saturated Global PCs Sales: Deeply Saturated Chart 9Global Auto Sales Are In Contraction As Well Global Auto Sales Are In Contraction As Well Global Auto Sales Are In Contraction As Well Regarding auto demand, the Chinese government may continue to implement more supportive policies to stimulate car sales in China. However, we believe the recovery will be delayed. The government has already implemented a number of policies to lift domestic car sales since late January, including providing subsidies to encourage new energy vehicle sales, to promote auto sales in rural areas, and to increase auto replacement. The central government recently loosened auto sales restrictions in the first tier cities of Guangzhou and Shenzhen that have restrictive auto sales policies. However, all of these policies have failed to lift Chinese domestic car sales out of deep contraction. The key reason has been a diminishing willingness to spend among Chinese consumers, as suggested by falling households’ marginal propensity to consume (Chart 10). Bottom Line: Global semiconductor demand growth will likely remain weak and will fail to recover in the second half of this year. The basis is that its major upstream markets (smartphone, servers, PCs and automobiles) are all facing cyclically declining demand. Chart 10Chinese Consumers: Diminishing Willingness To Consume Chinese Consumers: Diminishing Willingness To Consume Chinese Consumers: Diminishing Willingness To Consume Inventories And Prices Chart 11 shows the semiconductor supply chain illustrating the process of manufacturing semiconductors starting with silicon wafers and up to final electronic products. Chart 11 Box 1 explains the role of key segments and players along the supply chain. Box 1 A Brief Explanation Of The Key Segments/Players Of The Supply Chain Both integrated device manufacturers (IDM) and foundries are at the center of the supply chain, responsible for chip manufacturing. In terms of semiconductor sales revenue, Samsung, Intel and SK Hynix are the world’s top three IDM companies and TSMC, Global Foundries and United Microelectronics Corp (UMC) are the world’s top three foundries. While IDMs cover most of the process from IC design, chip fabrication, assembly, testing and packaging, IDM companies still have to purchase raw materials and equipment for the chip-making process. Foundry companies receive orders from IC designing companies like Qualcomm, Nvidia, and Huawei HiSilicon, then purchase needed raw materials and equipment to proceed in the chip-manufacturing process. Both IDMs and foundries can either outsource the tasks of semiconductor assembly and testing or perform them on their own. The final semiconductor products will be used in electronics products, such as smartphones, computers, home appliances, automobiles, etc. Global semiconductor demand growth will likely remain weak and will fail to recover in the second half of this year. The basis is that its major upstream markets (smartphone, servers, PCs and automobiles) are all facing cyclically declining demand. In a typical business cycle, a cyclical downturn begins with a slump in demand for final electronic products (upstream demand). This leads to falling semiconductor sales. As a result, inventory buildup will occur across most of the segments along the semiconductor supply chain. Chipmakers: Producers’ semiconductor inventory in both Taiwan and Korea have reached either a record high or a near-record high (Chart 12). The installed wafer capacities at these two countries are the world’s largest, together accounting for 43% of total global wafer capacity. In addition, the inventory of some major electronic parts and components have also increased considerably in Taiwan (Chart 13). This also implies weaker demand for semiconductor raw materials. Chart 12Chipmakers: A Rapid Buildup In Inventory Chipmakers: A Rapid Buildup In Inventory Chipmakers: A Rapid Buildup In Inventory Chart 13Rising Inventory Of Some Major Electronic Parts And Components Rising Inventory Of Some Major Electronic Parts And Components Rising Inventory Of Some Major Electronic Parts And Components Raw material suppliers: Silicon wafer is the indispensable raw material required in the chip manufacturing process. Japanese companies account for over half of global silicon wafer supply.Chart 14 shows that silicon wafer inventory in Japan has had a significant buildup in volume terms since late last year. Importantly, it is not declining yet. Chart 14Silicon Wafer Inventory: A Significant Buildup As Well Silicon Wafer Inventory: A Significant Buildup As Well Silicon Wafer Inventory: A Significant Buildup As Well Outsourced semiconductor assembly and test (OSAT) providers: Both Singapore and Thailand are OSAT providers while they also manufacture, assemble and export electronic products. Both countries are closer to the downstream side of the semiconductor supply chain. Semiconductor inventory at these two countries has also jumped to a record high (Chart 15).   Chart 15Singapore and Thailand: Record High Semiconductor inventory Singapore and Thailand: Record High Semiconductor inventory Singapore and Thailand: Record High Semiconductor inventory   Importantly, a marginal improvement in demand will tend to support spot prices. For example, in the memory chip market, falling prices denote weak demand relative to excess supply. When prices of DRAM and NAND start to form a bottom or decisively move up, this may indicate the arrival of a cyclical upturn. So far, both DRAM and NAND prices are continuing to fall (Chart 16). In addition, the prices of silicon wafer – the most important raw material used in the chip-making process – have declined in the first half of this year.3  Chart 16Still Falling Memory Chip Prices Still Falling Memory Chip Prices Still Falling Memory Chip Prices Chart 17Deflating DRAM Prices Suggest Downside Risks To Korean Tech Stocks Deflating DRAM Prices Suggest Downside Risks To Korean Tech Stocks Deflating DRAM Prices Suggest Downside Risks To Korean Tech Stocks In short, prices are the most important variable to monitor. Chart 17 exhibits the high correlation between DRAM prices and the Korean technology sector stock prices. Falling DRAM prices suggest downside risks to technology stocks in Korea. Samsung accounts for about 65% of Korea’s tech index and 27% of the overall Korean equity index. Memory chips accounted for 68% of Samsung’s operating profits in the first quarter of this year.   Bottom Line: There has been involuntary inventory accumulation along the entire supply chain of semiconductors. This and ongoing price deflation among various types of semiconductors foreshadow a downbeat near-term outlook. The Interpretation Of Some Positive Developments There have been some positive developments in the past several months. Taiwanese PMI new orders diffusion index in the electronics sector jumped out of deep contraction to reach zero, and Chinese semiconductor imports halted their decline in both volume and value terms (Chart 18). The improvement in the aforementioned data was probably mainly due to large semiconductor purchases by China to hedge the rising risk of U.S. blocking China’s technological development (Chart 19). Chart 18Some Positive Development Some Positive Development Some Positive Development Chart 19China: More Semiconductors Purchases Before The Tariff And U.S. Huawei Ban? China: More Semiconductors Purchases Before The Tariff And U.S. Huawei Ban? China: More Semiconductors Purchases Before The Tariff And U.S. Huawei Ban? Besides, Huawei smartphone sales have been booming, which we deliberated on page 5, could have been responsible for the improvement in these data. This one-off surge will likely dwindle going forward. Investment Conclusions We remain negative on Asian semiconductor share prices in absolute terms. A continued contraction in global semiconductor sales will further squeeze their profits. In relative terms, we are neutral on the Asian semiconductor sector: we continue recommending market-weight allocation to Taiwan’s overall market and the Korean technology sector within the EM equity benchmark. As a new trade, we recommend going long Asian semiconductor stocks and short the S&P 500 semiconductor index over the next three to six months (Chart 20). The Bloomberg Asia Pacific semiconductor index has nine stocks. Samsung and TSMC account for 42% and 38% of the index, respectively. There has been involuntary inventory accumulation along the entire supply chain of semiconductors. This and ongoing price deflation among various types of semiconductors foreshadow the downbeat near-term outlook. Samsung will likely benefit from the U.S. ban on Huawei in the smartphone sector outside of China. In addition, Samsung will win some market share from Apple as the latter does not have a 5G phone to release this year. These positive factors may partially offset the negative impact from falling memory prices and demand on Samsung. The S&P 500 semiconductor index has 13 stocks. Intel, Broadcom, Texas Instruments and Qualcomm are the top five constituents, together accounting for nearly 70% of the index. Most of these companies are IC designing companies, which will likely suffer as Chinese demand for their products shrink due to the U.S. administration's ban on Huawei. This position will also benefit from U.S. dollar appreciation. A firm dollar will hurt profits of U.S. semiconductor stocks. In turn, currency depreciation in Korea and Taiwan will on the margin benefit Asian semiconductor stocks. Chart 20Recommend Long Asia Pacific Semiconductor Stock Vs. S&P 500 Semiconductor Index Recommend Long Asia Pacific Semiconductor Stock Vs. S&P 500 Semiconductor Index Recommend Long Asia Pacific Semiconductor Stock Vs. S&P 500 Semiconductor Index Chart 21The 2015 Experience The 2015 Experience The 2015 Experience Chart 21 shows that global foundry companies outperformed global IC designing companies during the final phase of the 2015 cyclical downturn. Odds are that these dynamics will play out in this downturn as well. Finally, the relative performance of Asian semiconductor stocks versus U.S. ones is oversold and might stage some sort of mean reversion (Chart 20). Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes 1      Please note that here the calculation for “the number of months of the growth contraction” is different from the one for the “peak-to-bottom duration” in Table 1. “The number of months of the growth contraction” equals the number of months when semiconductor sales year-on-year growth is negative. 2      https://marketrealist.com/2019/05/nvidias-data-center-revenue-inference-rendering-and-edge/ 3      http://www.sohu.com/a/300386061_132567, http://news.moore.ren/industry/104958.htm   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, Credit in China has expanded at an exponential pace, with the country’s debt-to-GDP ratio climbing from 143% to more than 250% over the last decade. The speed and scale of China’s debt surge dwarfs Japan and the U.S.’ respective credit binges in the 1980’s and 2000’s, each of which ultimately led to financial market meltdowns. Why should China’s experience be any different? Given that China has pursued a different economic model whereby the banking sector is largely state-sponsored and the currency is tightly managed by the central bank, the answer to this pressing question for global markets is the subject of spirited debate at BCA and within the investment community at large. Clients are already aware that my colleagues, Peter Berezin and Arthur Budaghyan, disagree on the macro and market ramifications of China’s decade-long credit boom. The aim of this report is to provide visibility on the root sources of the view divergence, not to reconcile the gaps. We hope these insights will help shape your own conviction about this important topic. Caroline Miller Global Strategy Feature   Caroline: Arthur, your cautious outlook towards emerging markets in general and China’s prospects in particular stems from your belief that China’s economy is dangerously addicted to credit as a growth driver. Please explain why you dismiss the more sanguine view that China’s elevated debt burden is a function of an equally unusually high household savings rate. Arthur: It is simple: When people use the word “savings,” they typically and intuitively refer to bank deposits or securities investments; but this is incorrect. Chart 1 (Arthur)No Empirical Evidence That Deposits = 'Savings' No Empirical Evidence That Deposits = 'Savings' No Empirical Evidence That Deposits = 'Savings' Money supply/deposits in the banking system have no relationship with the savings rate of a nation in general or households in particular (Chart 1). When households save, they do not change the amount of money supply and deposits. Hence, households’ decision to save neither alters liquidity in the banking system nor helps banks to originate loans. In fact, banks do not intermediate deposits into loans or savings into credit.1 The terms “savings” in economics does not denote an increase in the stock of money and deposits. The term “savings” in economics means the amount of goods and services produced but not consumed. When an economy produces a steel bar, it is registered as national “savings.” We cannot consume (say, eat or expense) a steel bar. Therefore, once a steel bar or any equipment is produced, economic statistics will count it as “savings.” Besides, the sole utilization of a steel bar is in capital goods and construction, and hence, it cannot be consumed. Once a steel bar is produced, both national savings and investment will rise. That is how the “savings” = “investment” identity is derived. Chart 2 (Arthur)Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are More Leveraged Than U.S. Ones It would avoid confusion and help everyone if economists were to call it “excess production” not “excess savings.” Banks do not need “excess production” – i.e., national “savings” – to create loans. Critically, the enormous amount of bank deposits in China is not due to household “savings” but is originated by banks “out of thin air.” In fact, Chinese households are now more leveraged than U.S. ones (Chart 2). Chart 3 The surge of credit and money supply in China during the past 10 years has been due to animal spirits running wild among lenders and borrowers on the mainland, not its households’ “savings.” In short, the root of China’s credit bubble is not any different from Japan’s (in the 1980s), or the U.S.’ (in the 2000s) and so on. Peter: Yes, banks can create deposits “out of thin air,” as Arthur says. However, people must be willing to hold those deposits. The amount of deposits that households and businesses wish to hold reflects many things, including the interest rate paid on deposits and the overall wealth of the society. The interest rate is a function of savings. The more people save, the lower interest rates will be. And the lower interest rates are, the more demand for credit there will be (Chart 3). It’s like asking what determines how many apples are consumed. Is it how many apple trees farmers want to plant or how many apples people want to eat? The answer is both. Prices adjust so that supply equals demand. How about national wealth? To a large extent, wealth represents the accumulation of tangible capital – factories, plant and machinery, homes and office buildings: the sort of stuff that banks can use as collateral for lending. And what determines how much tangible capital a country possesses? The answer is past savings, of the exact sort Arthur is referring to: the excess of production over consumption. So this form of “economic” savings also plays an important indirect role in determining the level of bank deposits. Chart 4 (Peter)China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt I think the main problem with Arthur’s argument is that he is observing an accounting identity, which is that total bank assets (mostly loans) must equal liabilities (mostly deposits and capital) in equilibrium, without fully appreciating the economic forces – savings being one of them – that produce this equilibrium. In any case, the whole question of whether deposits create savings or savings create deposits misses the point. China’s fundamental problem is that it does not consume enough of what it produces. In the days when China had a massive current account surplus, it could export its excess savings abroad (Chart 4). It can’t do that anymore, so the government has consciously chosen to spur investment spending in order to prop up employment. Since a lot of investment spending is financed through credit, debt levels have risen. It really is just that simple.   Arthur: First, neither the stock nor the flow of credit and deposits has any relevance to (1) the economic term “savings;” (2) a country’s capital stock; or (3) national wealth, contrary to what Peter claims. China’s broad money supply (M2) now stands at 190 trillion yuan, equivalent to US$28 trillion (Chart 5, top panel). It is equal to the size of broad money supply in the U.S. and the euro area combined (US$14 trillion each). Yet, China’s nominal GDP is only two-thirds the size of the U.S. Does the level of China’s wealth and capital stock justify it having broad money supply (US$28 trillion) equivalent to the U.S. and the euro area combined? Chart 5 (Arthur)“Helicopter” Money In China “Helicopter” Money In China “Helicopter” Money In China Second, are Chinese households and companies willing to hold all RMB deposits that banks have created “out of thin air”? The answer: not really. Without capital controls, a notable portion of these deposits would have rushed into the foreign exchange markets and caused currency depreciation. Another sign of growing reluctance to hold the yuan is that households have been swapping their RMB deposits for real assets (property) at astronomical valuations. There is a bubble in China but people are looking for reasons to justify why it is different this time. Caroline: OK, let’s get away from the term “savings,” and agree that China continues to generate a chronic surplus of production of goods and services relative to consumption, and that how China chooses to intermediate that surplus is the most market-relevant issue. Arthur, you have used the terms “money bubble” and “helicopter money” in relation to China. This implies that banks are unconstrained in their ability to make loans. Just because savings don’t equal deposits, and banks can create deposits when they make loans doesn’t mean there is no relationship between the flow of credit and the stock of deposits. Arthur: Money supply and deposits expand only when banks originate a loan or buy an asset from a non-bank. In short, both credit and money/deposits are created by commercial banks “out of thin air.” This is true for any country.2 Consider a loan transaction by a German commercial bank. When it grants a €100 loan to a borrower, two accounting entries occur on its balance sheet. On the assets side, the amount of loans, and therefore total assets, increases by €100. Simultaneously, on the liabilities side, this accounting entry creates €100 of new deposits “out of thin air” (Figure 1). Hence, new purchasing power of €100 has been created via a simple accounting entry, which otherwise would not exist. Chart Critically, no one needed to save for this loan and money to be originated. The bank does not transfer someone else’s deposits to the borrower; it creates a new deposit when it lends. Banks also create deposits/money “out of thin air” when they buy securities from non-banks. In China, fiscal stimulus is largely financed by commercial banks – banks purchase more than 80% of government-issued bonds. This also leads to money creation. In short, when banks originate too much credit – as they have in China – they generate a money bubble. The money bubble is the mirror image of a credit bubble. Chinese banks have created 141 trillion yuan (US$21 trillion) of new money since 2009, compared with $8.25 trillion created in the U.S., euro area, and Japan combined over the same period (Chart 5, bottom panel). This is why I refer to it as “helicopter” money. Caroline: If banks need capital and liquidity to make loans, and deposits are one potential source of funds, don't these capital and liquidity constraints drive banks’ willingness and ability to lend, creating a link between the two variables? Arthur: Let me explain how mainland banks were able to circumvent those regulatory lending constraints. In 2009, they expanded their credit assets by about 30%. Even though a non-trivial portion of those loans were not paid back, banks did not recognize NPLs and instead booked large profits. By retaining a portion of those earnings, they boosted their equity, say, by 20%. As a result, the next year they were able to expand their credit assets by another 20% and so on. If banks lend and do not recognize bad loans, they can increase their equity and continue lending. With respect to liquidity, deposits are not liquidity for banks; excess reserves at the central bank are true liquidity for them. The reason why banks need to attract deposits is not to appropriate the deposits themselves, but to gain access to the excess reserves that come with them. When a person shifts her deposit from Bank A to Bank B, the former transfers a similar amount of excess reserves (liquidity) to the latter. When expanding their credit assets aggressively, banks can: (1) create more loans per one unit of excess reserves/liquidity, i.e., expand the money multiplier; and (2) borrow excess reserves/liquidity from the central bank or other banks. Chinese banks have used both channels to expand their balance sheets over the past 10 years (Chart 6). Chart 6 (Arthur)Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Crucially, commercial banks create deposits, but they cannot create excess reserves (liquidity).3 The latter are issued only by central banks “out of thin air.” So, neither deposits nor excess reserves have any relevance to household or national “savings.” Caroline: Peter, Arthur argues that Chinese credit policy has been unconstrained by the traditional metrics of capital adequacy that prevail in capitalist, free-market economies. In other words, there is no connection between the availability of funds to lend via deposits in the banking system, and the pace of credit creation. Rather, the central bank has controlled the terms and volume of lending via regulation and fiat reserve provisioning. You’ve argued that credit creation has served the greater good of propping up employment via investment spending. Moreover, you posit that countries with a surplus of production over consumption will invariably experience high levels of credit creation. Our colleague, Martin Barnes, has analyzed national savings rates (as a proxy for over-production) relative to debt-GDP ratios in other countries. The relationship doesn’t look that strong elsewhere (Chart 7). Please elaborate on why you see credit growth as an inevitable policy response to the dearth of aggregate demand we observe in China? Chart 7 Peter: I would not say that countries with a surplus of production over consumption will invariably experience high levels of credit creation. For example, if most business investment is financed through retained earnings, you can have a lot of investment with little new debt. Debt can also result from activities not directly linked to the intermediation of savings. For instance, if you take out a mortgage to buy some land, your consumption and savings need not change, even though debt will be created. I think Arthur and I agree on this point. Thus, I am not saying that debt is always and everywhere the result of savings. I am simply pushing back against Arthur’s extremist position that debt never has anything to do with savings. Caroline: So what determines the level of debt in an economy in your view, Peter? Peter: In general, debt levels will rise if there are large imbalances between income and spending within society and/or if there are significant differences in the mix of assets people wish to hold. Think about the U.S. in the pre-financial crisis period. First, there was a surge in income inequality beginning in the early 1980s. For all intents and purposes, rich households with excess savings ended up lending their surplus income to poor households struggling to pay their bills. Overall savings did not rise, but debt levels still increased. That’s one reason why Martin’s chart doesn’t show a strong correlation between the aggregate savings rate and debt-to-GDP. Sometimes you need to look beneath the aggregate numbers to see the savings intermediation taking place. Unlike in the U.S., even poor Chinese households are net savers (Chart 8). Thus, the aggregate savings rate in China is very high4 (Chart 9). Much of these savings are funnelled to finance investment in the corporate and public sectors. This fuels debt growth. Chart 8 Chart 9 (Peter)Chinese Households Have More Savings Than The U.S., Europe And Japan Combined Chinese Household Savings Are More Than The U.S., Europe And Japan Combined Chinese Household Savings Are More Than The U.S., Europe And Japan Combined The second thing that happened in the U.S. starting in 2000 was a massive housing boom. If you bought a second home with credit, you ended up with one more asset (the house) but one more liability (the mortgage). The person who sold you the home ended up losing one asset (the house) but gaining another asset (a bigger bank deposit). The net result was both higher debt and higher bank deposits. Lending to finance asset purchases has also been a big source of debt growth in China, as it was in the U.S. before the crisis. The U.S. mortgage boom ended in tears, and so the question that we should be asking is whether the Chinese debt boom will end the same way. Arthur: We agreed not to use the term “savings,” yet Peter again refers to “savings” being funnelled into credit. As I explained above, banks do not funnel “savings” (i.e., “excess production”) into credit. China, Japan, and Germany have high “savings” rates because they produce a lot of steel, chemicals, autos, and machinery that literally cannot be consumed and, thus, are recorded as “savings.” The U.S. produces too many services that are consumed/expensed and, hence, not recorded as “savings.” That is why the U.S. has a lower “savings” rate. Chart 10 (Arthur)The Myth Of Deficient Demand In China The Myth Of Deficient Demand In China The Myth Of Deficient Demand In China Economic textbook discussions on “savings” and “investment” are relevant for a barter economy where banks do not exist. When this framework is applied to modern economies with banks, it generates a lot of confusion.5 Caroline: OK, so Peter argues that an imbalance between spending and income CAN be a marker for high debt levels. Arthur, please explain why you see no relationship between China’s chronic shortfall in demand and authorities’ explicit decision to support growth via credit creation. Arthur: First, China does not have deficient demand – consumer spending and capital expenditures have been growing at 10% and 9.4%, respectively, in real terms annually compounded for the past 10 years (Chart 10). The mainland economy has been suffering from excess production, not a lack of demand. China has invested a lot (Chart 11) and ended up with too much capacity to produce steel, cement, chemicals and other materials as well as machinery and industrial goods. So, China has an excess production of goods relative to firms’ and households’ underlying demand. In a market economy, these producers would become non-profitable, halt their investments, and shut down some capacity. Chart 11 (Arthur)China Has Been Over-Investing On An Unprecedented Scale China Has Been Over-Investing On An Unprecedented Scale China Has Been Over-Investing On An Unprecedented Scale In China, to keep the producers of these unwanted goods operating, the government has allowed and encouraged banks to originate loans creating new purchasing power literally “out of thin air” to purchase these goods. This has created a credit/money bubble. In a socialist system, banks do not ask debtors to repay loans and government officials are heavily involved in resource and capital allocation. China’s credit system and a growing chunk of its economy have been operating like a typical socialist system. Socialism leads to lower productivity growth for well-known reasons. With labor force growth set to turn negative, productivity is going to be the sole source of China’s potential growth rate. If the nation continues expanding this money/credit bubble to prop up zombie enterprises, its potential growth rate will fall considerably. As the potential growth rate drops, recurring stimulus will create nominal but not real growth. In short, the outcome will be stagflation. Caroline: The theoretical macro frameworks that you have both outlined make for interesting thought experiments, and spirited intellectual debate. However, investors are most concerned about the sustainability of China’s explosive credit growth, implications for the country’s growth rate, and the return on invested capital. Arthur, given your perspective on how Chinese credit policy has been designed and implemented, please outline the contours of how and when you see the music stopping, and the debt mountain crumbling. Arthur: Not every credit bubble will burst like the U.S. one did in 2008. For example, in the case of the Japanese credit bubble, there was no acute crisis. The bubble deflated gradually for about 20 years. In the cases of the U.S. (2008), Japan (1990), the euro area (2008-2014), Spain (2008-2014) and every other credit bubble, a common adjustment was a contraction in bank loans in nominal terms (Chart 12). Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (I) All Credit Booms Have Been Followed By Contracting Bank Loans All Credit Booms Have Been Followed By Contracting Bank Loans Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (II) All Credit Booms Have Been Followed By Contracting Bank Loans All Credit Booms Have Been Followed By Contracting Bank Loans Why do banks stop lending? The reason is that banks’ shareholders absorb the largest losses from credit booms. Given that banks are levered at least 20-to-1 at the peak of a typical credit boom, every $1 of non-performing loans leads to a $20 drop in their equity value. Bank shareholders halt the flow of credit to protect their wealth. Chart 13 (Arthur)China: Deleveraging Has Not Yet Begun China: Deleveraging Has Not Yet Begun China: Deleveraging Has Not Yet Begun Chart 14 In fact, credit in China is still growing at a double-digit rate, above nominal GDP growth (Chart 13). Hence, aggregate deleveraging in China has not yet begun. If banks do not curtail credit origination, the music will not stop. However, uninterrupted credit growth happens only in a socialist system where banks subsidize the economy at the expense of their shareholders. But even then, there is no free lunch. Credit origination by banks also expands the money supply as discussed above. An expanding money bubble will heighten devaluation pressure on the yuan in the long run. The enormous amount of money supply/deposits – the money bubble – in China is like “the sword of Damocles” hanging over the nation’s currency. Chinese households and businesses are becoming reluctant to hold this ballooning supply of local currency. Continuous “helicopter” money will only increase their desire to diversify their RMB deposits into foreign currencies and assets. Yet, there is an insufficient supply of foreign currency to accommodate this conversion. The nation’s current account surplus has almost vanished while the central bank carries US$3 trillion in foreign exchange reserve representing only 11% of the yuan deposits and cash in circulation (Chart 14). It is inconceivable that China can open its capital account in the foreseeable future. “Helicopter” money also discourages innovation and breeds capital misallocation, which reduces productivity growth. A combination of slowing productivity growth, and thus potential GDP, and strong money growth ultimately lead to stagflation – the dynamics endemic to socialist systems. Peter: Arthur’s answer implicitly assumes that private investment would increase if the government removed credit/fiscal stimulus. But where is the evidence for that? We had just established that the Chinese economy suffers from a lack of aggregate demand. Public-sector spending, to the extent that it increases employment and incomes, crowds in private-sector investment rather than crowding it out. Ask yourself what would have happened if China didn’t build that “bridge to nowhere.” Would those displaced construction workers have found more productive work elsewhere or would they have remained idle? The answer is almost certainly the latter. After all, the reason the Chinese government built the bridge in the first place was to increase employment in an economy that habitually struggles to consume enough of what is produces. Arthur talks about the “misallocation” of resources. But doesn’t an unemployed worker also represent a misallocation of resources? In my view, it certainly does – and one that is much more threatening to social stability than an underutilized bridge or road. If you understand the point above, you will also understand why Arthur’s comparison between Chinese banks and say, U.S. banks is misplaced. The Chinese government is the main shareholder in Chinese banks. The government cares more about social stability than anything else. There is no way it would let credit growth plunge. Moreover, as the main shareholder, the government has a strong incentive to raise the share price of Chinese banks. After all, it is difficult to have a reserve currency that rivals the U.S. dollar, as China aspires to have, if your largest banks trade like penny stocks. My guess is that the Chinese government will shut down a few small banks to “show” that it is concerned about moral hazard, but then turn around and allow the larger banks to sell their troubled loans to state-owned asset management companies on very favourable terms (similar to what happened in the early 2000s). Once investors get wind that this is about to happen, Chinese bank shares will rally like crazy. Caroline: Isn’t shuffling debt from one sector of the economy to another akin to a shell game? Wouldn’t rampant debt growth eventually cause investors to lose confidence in the currency? Peter: China has a problem with the composition of its debt, not with its total value. Debt is a problem when the borrower can’t or won’t repay the loan. Chart 15 (Peter)China Is On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers I completely agree that there is too much shadow bank lending in China. There is also too much borrowing by state-owned enterprises. Ideally, the Chinese government would move all this quasi-public spending onto its own balance sheet. It would significantly raise social spending to discourage precautionary household savings. It would also adopt generous pro-natal policies — free childcare, education, government paid parental leave, and the like. The fact that the Chinese working-age population is set to shrink by 400 million by the end of the century is a huge problem (Chart 15). If the central government borrowed and spent more, state-owned companies and local governments would not have to borrow or spend as much. Banks could then increase their holding of high-quality central government bonds. Debt sustainability is only a problem if the interest rate the government faces exceeds the growth rate of the economy.6 That is manifestly not the case in China (Chart 16). And why are interest rates so low in relation to growth? Because Chinese households save so much! We simply can’t ignore the role of savings in the discussion. Chart 16 (Peter)China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy As far as the currency is concerned, if debt growth rose so much that the economy overheated and inflation soared, then yes, the yuan would plunge. But that’s not what we are talking about here. We are talking about bringing debt growth to a level that generates just enough demand to achieve something resembling full employment. No one is calling for raising debt growth beyond that point. Curbing debt growth in a demand-deficient economy, as Arthur seems to be recommending, would cause unemployment to rise. Investors would then bet that the Chinese government would try to boost net exports by engineering a currency devaluation. Capital outflows would intensify. Far from creating the conditions for a weaker yuan, fiscal/credit stimulus obviates the need for a currency depreciation. Caroline: Peter, even if we accept your argument that the counterfactual of curbing credit growth in a demand-deficient economy would be a more deflationary outcome than sustaining the government-sponsored credit growth engine, how is building bridges to nowhere a positive sum for investors? Even if this strategy maintains social stability in the interests of the CCP’s regime preservation, won’t investors eventually recoil at the retreat to socialism that Arthur outlines, reducing the appeal of holding the yuan, even if, as you both seem to agree, no apocalyptic debt crisis is at hand? In other words, isn’t two times nothing still nothing? Peter: First of all, many of these infrastructure projects may turn out to be quite useful down the road, pardon the pun. Per capita vehicle ownership in China is only one one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 17). A sparsely used expressway today may be a clogged one tomorrow. Chart 17 (Peter)The Automobile Ownership Rate Is Still Quite Low In China The Automobile Ownership Rate Is Still Quite Low In China The Automobile Ownership Rate Is Still Quite Low In China Would China really be better off if it had fewer infrastructure projects and more big screen TVs? An economy where people are always buying stuff they don’t need, with money they don’t have, to impress people they don’t like, is hardly a recipe for success. I am not sure what these references to socialism are supposed to accomplish. You want to see a real retreat to socialism? Try creating millions of unemployed workers with no jobs and no hope. All sorts of pundits decried Franklin Roosevelt’s New Deal as creeping socialism. The truth is that the New Deal took the wind out of the sails of the fledgling U.S. communist movement at the time. Arthur: I believe that Peter is confusing the structural and cyclical needs for stimulus. When an economy is in a recession – banks are shrinking their balance sheets and property prices are deflating – the authorities must undertake fiscal and credit stimulus. Chart 18 (Arthur)What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? Credit and fiscal stimulus made sense in China in early 2009 when growth plunged. However, over the past 10 years, we have witnessed credit and property market booms of gigantic proportions. Does this economy warrant continuous stimulus? What will productivity growth look like if government bureaucrats continuously allocate 55-60% of GDP each year (Chart 18)? Caroline: Arthur and Peter, you can both argue with one another about the semantic economic definition of the term ‘savings’, the implications of chronic excess production (relative to consumption), and the root drivers of credit growth in China long past the expiry of every BCA client’s investment horizon. Clients benefit from understanding your distinct perspectives only to the extent that they inform your outlook for markets. Will each of you now please outline how you see high levels of credit in China’s economy impacting the following over a cyclical (6-12 month) and structural (3-5 year) horizon: Global growth Commodity prices China-geared financial assets Peter: Regardless of what one thinks about the root causes of China’s high debt levels, it seems certain to me that the Chinese are going to pick up the pace of credit/fiscal stimulus over the next six months in response to slowing growth and trade war uncertainties. If anything, the incentive to open the credit spigots this time around is greater than in the past because the Chinese government wants to have a fast-growing economy to gain leverage over trade negotiations with the U.S. Chart 19 (Peter)Stronger Chinese Credit Growth Bodes Well For Commodity Prices Stronger Chinese Credit Growth Bodes Well For Commodity Prices Stronger Chinese Credit Growth Bodes Well For Commodity Prices Chart 20 (Peter)The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Stronger Chinese growth will boost growth in the rest of the world. Commodity prices will rise (Chart 19). As a counter-cyclical currency, the U.S. dollar will likely peak over the next month or so and then weaken in the back half of 2019 and into 2020 (Chart 20). The combination of stronger Chinese growth, higher commodity prices, and a weaker dollar will be manna from heaven for emerging markets. If a trade truce between China and the U.S. is reached, investors should move quickly to overweight EM equities. European stocks should also benefit. Looking further out, China’s economy will slow in absolute terms. In relative terms, however, Chinese growth will remain near the top of the global rankings. China has one of the most educated workforces in the world (Chart 21). Assuming that output-per-hour reaches South Korean levels by the middle of the century, Chinese real GDP would need to expand by about 6% per year over the next decade (Chart 22). That’s a lot of growth – growth that will eventually help China outgrow its debt burden. Chart 21 Chart 22 (Peter)China Has More Catching Up To Do China Has More Catching Up To Do China Has More Catching Up To Do Keep in mind that credit growth of 1% when the debt-to-GDP ratio is 300% yields 3% of GDP in credit stimulus, compared with only 1% of stimulus when the debt-to-GDP ratio is 100%. That does not mean that more debt is intrinsically a good thing, but it does mean that China will eventually be able to slow debt growth even if excess savings remains a problem. Structurally, Chinese and EM equities will likely outperform their developed market peers over a 3-to-5 year horizon. The P/E ratio for EM stocks is currently 4.7 percentage points below that of developed markets, which is below its long-term average (Chart 23). While EM EPS growth has lagged DM earnings growth over the past eight years, the long-term trend still favors EM (Chart 24). EM currencies will appreciate over this period, with the RMB leading the way. Chart 23 (Peter)EM Stocks: Valuations Are Attractive EM Stocks: Valuations Are Attractive EM Stocks: Valuations Are Attractive Chart 24 (Peter)Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Arthur: China is facing a historic choice between two scenarios. Medium- and long-term macro outcomes will impact markets differently in each case. Table 1 shows my cyclical and structural investment recommendations for each scenario. Table 1 (Arthur)Arthur’s Recommended Investment Strategy For China-Geared Financial Assets China’s Credit Cycle: A Spirited Debate China’s Credit Cycle: A Spirited Debate Allowing Markets to Play A Bigger Role = Lower credit growth (deleveraging), corporate restructuring, and weaker growth (Chart 25). This is bearish for growth and financial markets in the medium term but it will make Chinese stocks and the currency structural (long-term) buys. Credit/Money Boom Persists (Socialist Put) = Secular Stagnation, Inflation and Currency Depreciation: The structural outlook is downbeat but there are mini-cycles that investors could play (Chart 26). Cyclically, China-geared financial assets still remain at risk. However, lower asset prices and more stimulus in China could put a floor under asset prices later this year. Timing these mini-cycles is critical. A buy-and-hold strategy for Chinese assets will not be appropriate in this scenario. In short, capitalism is bad but socialism is worse. I hope China will pursue the first path. Chart 25 Chart 26 Caroline: Thank you both for clarifying your perspectives. Over a multi-year horizon, markets will render the ultimate judgement on whether China’s credit boom has represented a reckless misallocation of capital, or a rational policy response to an imbalance between domestic spending and income. In the meantime, we will monitor the complexion of Chinese stimulus and evidence of its global growth multiplier effect over the coming weeks and months. These will be the key variables to watch as we determine when and at what level to upgrade BCA’s cyclical outlook for China-geared assets. Can’t wait for that debate. Footnotes 1 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 2 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 3 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “China's Money Creation Redux And The RMB,” dated November 23, 2016. 4 For a discussion on the reasons behind China’s high savings rate, please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 5 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “Is Investment Constrained By Savings? Tales Of China And Brazil,” dated March 22, 2018. 6 For a detailed discussion of these issues, please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019 and “Chinese Debt: A Contrarian View,” dated April 19, 2019.

Dear Client, Credit in China has expanded at an exponential pace, with the country’s debt-to-GDP ratio climbing from 143% to more than 250% over the last decade. The speed and scale of China’s debt surge dwarfs Japan and the U.S.’ respective credit binges in the 1980’s and 2000’s, each of which ultimately led to financial market meltdowns. Why should China’s experience be any different? Given that China has pursued a different economic model whereby the banking sector is largely state-sponsored and the currency is tightly managed by the central bank, the answer to this pressing question for global markets is the subject of spirited debate at BCA and within the investment community at large. Clients are already aware that my colleagues, Peter Berezin and Arthur Budaghyan, disagree on the macro and market ramifications of China’s decade-long credit boom. The aim of this report is to provide visibility on the root sources of the view divergence, not to reconcile the gaps. We hope these insights will help shape your own conviction about this important topic. Caroline Miller Global Strategy Feature   Caroline: Arthur, your cautious outlook towards emerging markets in general and China’s prospects in particular stems from your belief that China’s economy is dangerously addicted to credit as a growth driver. Please explain why you dismiss the more sanguine view that China’s elevated debt burden is a function of an equally unusually high household savings rate. Arthur: It is simple: When people use the word “savings,” they typically and intuitively refer to bank deposits or securities investments; but this is incorrect. Chart 1 (Arthur)No Empirical Evidence That Deposits = 'Savings' No Empirical Evidence That Deposits = 'Savings' No Empirical Evidence That Deposits = 'Savings' Money supply/deposits in the banking system have no relationship with the savings rate of a nation in general or households in particular (Chart 1). When households save, they do not change the amount of money supply and deposits. Hence, households’ decision to save neither alters liquidity in the banking system nor helps banks to originate loans. In fact, banks do not intermediate deposits into loans or savings into credit.1 The terms “savings” in economics does not denote an increase in the stock of money and deposits. The term “savings” in economics means the amount of goods and services produced but not consumed. When an economy produces a steel bar, it is registered as national “savings.” We cannot consume (say, eat or expense) a steel bar. Therefore, once a steel bar or any equipment is produced, economic statistics will count it as “savings.” Besides, the sole utilization of a steel bar is in capital goods and construction, and hence, it cannot be consumed. Once a steel bar is produced, both national savings and investment will rise. That is how the “savings” = “investment” identity is derived. Chart 2 (Arthur)Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are More Leveraged Than U.S. Ones It would avoid confusion and help everyone if economists were to call it “excess production” not “excess savings.” Banks do not need “excess production” – i.e., national “savings” – to create loans. Critically, the enormous amount of bank deposits in China is not due to household “savings” but is originated by banks “out of thin air.” In fact, Chinese households are now more leveraged than U.S. ones (Chart 2). Chart 3 The surge of credit and money supply in China during the past 10 years has been due to animal spirits running wild among lenders and borrowers on the mainland, not its households’ “savings.” In short, the root of China’s credit bubble is not any different from Japan’s (in the 1980s), or the U.S.’ (in the 2000s) and so on. Peter: Yes, banks can create deposits “out of thin air,” as Arthur says. However, people must be willing to hold those deposits. The amount of deposits that households and businesses wish to hold reflects many things, including the interest rate paid on deposits and the overall wealth of the society. The interest rate is a function of savings. The more people save, the lower interest rates will be. And the lower interest rates are, the more demand for credit there will be (Chart 3). It’s like asking what determines how many apples are consumed. Is it how many apple trees farmers want to plant or how many apples people want to eat? The answer is both. Prices adjust so that supply equals demand. How about national wealth? To a large extent, wealth represents the accumulation of tangible capital – factories, plant and machinery, homes and office buildings: the sort of stuff that banks can use as collateral for lending. And what determines how much tangible capital a country possesses? The answer is past savings, of the exact sort Arthur is referring to: the excess of production over consumption. So this form of “economic” savings also plays an important indirect role in determining the level of bank deposits. Chart 4 (Peter)China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt China: From Exporting Savings To Investing Domestically And Building Up Debt I think the main problem with Arthur’s argument is that he is observing an accounting identity, which is that total bank assets (mostly loans) must equal liabilities (mostly deposits and capital) in equilibrium, without fully appreciating the economic forces – savings being one of them – that produce this equilibrium. In any case, the whole question of whether deposits create savings or savings create deposits misses the point. China’s fundamental problem is that it does not consume enough of what it produces. In the days when China had a massive current account surplus, it could export its excess savings abroad (Chart 4). It can’t do that anymore, so the government has consciously chosen to spur investment spending in order to prop up employment. Since a lot of investment spending is financed through credit, debt levels have risen. It really is just that simple.   Arthur: First, neither the stock nor the flow of credit and deposits has any relevance to (1) the economic term “savings;” (2) a country’s capital stock; or (3) national wealth, contrary to what Peter claims. China’s broad money supply (M2) now stands at 190 trillion yuan, equivalent to US$28 trillion (Chart 5, top panel). It is equal to the size of broad money supply in the U.S. and the euro area combined (US$14 trillion each). Yet, China’s nominal GDP is only two-thirds the size of the U.S. Does the level of China’s wealth and capital stock justify it having broad money supply (US$28 trillion) equivalent to the U.S. and the euro area combined? Chart 5 (Arthur)“Helicopter” Money In China “Helicopter” Money In China “Helicopter” Money In China Second, are Chinese households and companies willing to hold all RMB deposits that banks have created “out of thin air”? The answer: not really. Without capital controls, a notable portion of these deposits would have rushed into the foreign exchange markets and caused currency depreciation. Another sign of growing reluctance to hold the yuan is that households have been swapping their RMB deposits for real assets (property) at astronomical valuations. There is a bubble in China but people are looking for reasons to justify why it is different this time. Caroline: OK, let’s get away from the term “savings,” and agree that China continues to generate a chronic surplus of production of goods and services relative to consumption, and that how China chooses to intermediate that surplus is the most market-relevant issue. Arthur, you have used the terms “money bubble” and “helicopter money” in relation to China. This implies that banks are unconstrained in their ability to make loans. Just because savings don’t equal deposits, and banks can create deposits when they make loans doesn’t mean there is no relationship between the flow of credit and the stock of deposits. Arthur: Money supply and deposits expand only when banks originate a loan or buy an asset from a non-bank. In short, both credit and money/deposits are created by commercial banks “out of thin air.” This is true for any country.2 Consider a loan transaction by a German commercial bank. When it grants a €100 loan to a borrower, two accounting entries occur on its balance sheet. On the assets side, the amount of loans, and therefore total assets, increases by €100. Simultaneously, on the liabilities side, this accounting entry creates €100 of new deposits “out of thin air” (Figure 1). Hence, new purchasing power of €100 has been created via a simple accounting entry, which otherwise would not exist. Chart Critically, no one needed to save for this loan and money to be originated. The bank does not transfer someone else’s deposits to the borrower; it creates a new deposit when it lends. Banks also create deposits/money “out of thin air” when they buy securities from non-banks. In China, fiscal stimulus is largely financed by commercial banks – banks purchase more than 80% of government-issued bonds. This also leads to money creation. In short, when banks originate too much credit – as they have in China – they generate a money bubble. The money bubble is the mirror image of a credit bubble. Chinese banks have created 141 trillion yuan (US$21 trillion) of new money since 2009, compared with $8.25 trillion created in the U.S., euro area, and Japan combined over the same period (Chart 5, bottom panel). This is why I refer to it as “helicopter” money. Caroline: If banks need capital and liquidity to make loans, and deposits are one potential source of funds, don't these capital and liquidity constraints drive banks’ willingness and ability to lend, creating a link between the two variables? Arthur: Let me explain how mainland banks were able to circumvent those regulatory lending constraints. In 2009, they expanded their credit assets by about 30%. Even though a non-trivial portion of those loans were not paid back, banks did not recognize NPLs and instead booked large profits. By retaining a portion of those earnings, they boosted their equity, say, by 20%. As a result, the next year they were able to expand their credit assets by another 20% and so on. If banks lend and do not recognize bad loans, they can increase their equity and continue lending. With respect to liquidity, deposits are not liquidity for banks; excess reserves at the central bank are true liquidity for them. The reason why banks need to attract deposits is not to appropriate the deposits themselves, but to gain access to the excess reserves that come with them. When a person shifts her deposit from Bank A to Bank B, the former transfers a similar amount of excess reserves (liquidity) to the latter. When expanding their credit assets aggressively, banks can: (1) create more loans per one unit of excess reserves/liquidity, i.e., expand the money multiplier; and (2) borrow excess reserves/liquidity from the central bank or other banks. Chinese banks have used both channels to expand their balance sheets over the past 10 years (Chart 6). Chart 6 (Arthur)Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Broad Money Can Expand Without Growing Banks' Excess Reserves At The Central Bank Crucially, commercial banks create deposits, but they cannot create excess reserves (liquidity).3 The latter are issued only by central banks “out of thin air.” So, neither deposits nor excess reserves have any relevance to household or national “savings.” Caroline: Peter, Arthur argues that Chinese credit policy has been unconstrained by the traditional metrics of capital adequacy that prevail in capitalist, free-market economies. In other words, there is no connection between the availability of funds to lend via deposits in the banking system, and the pace of credit creation. Rather, the central bank has controlled the terms and volume of lending via regulation and fiat reserve provisioning. You’ve argued that credit creation has served the greater good of propping up employment via investment spending. Moreover, you posit that countries with a surplus of production over consumption will invariably experience high levels of credit creation. Our colleague, Martin Barnes, has analyzed national savings rates (as a proxy for over-production) relative to debt-GDP ratios in other countries. The relationship doesn’t look that strong elsewhere (Chart 7). Please elaborate on why you see credit growth as an inevitable policy response to the dearth of aggregate demand we observe in China? Chart 7 Peter: I would not say that countries with a surplus of production over consumption will invariably experience high levels of credit creation. For example, if most business investment is financed through retained earnings, you can have a lot of investment with little new debt. Debt can also result from activities not directly linked to the intermediation of savings. For instance, if you take out a mortgage to buy some land, your consumption and savings need not change, even though debt will be created. I think Arthur and I agree on this point. Thus, I am not saying that debt is always and everywhere the result of savings. I am simply pushing back against Arthur’s extremist position that debt never has anything to do with savings. Caroline: So what determines the level of debt in an economy in your view, Peter? Peter: In general, debt levels will rise if there are large imbalances between income and spending within society and/or if there are significant differences in the mix of assets people wish to hold. Think about the U.S. in the pre-financial crisis period. First, there was a surge in income inequality beginning in the early 1980s. For all intents and purposes, rich households with excess savings ended up lending their surplus income to poor households struggling to pay their bills. Overall savings did not rise, but debt levels still increased. That’s one reason why Martin’s chart doesn’t show a strong correlation between the aggregate savings rate and debt-to-GDP. Sometimes you need to look beneath the aggregate numbers to see the savings intermediation taking place. Unlike in the U.S., even poor Chinese households are net savers (Chart 8). Thus, the aggregate savings rate in China is very high4 (Chart 9). Much of these savings are funnelled to finance investment in the corporate and public sectors. This fuels debt growth. Chart 8 Chart 9 (Peter)Chinese Households Have More Savings Than The U.S., Europe And Japan Combined Chinese Household Savings Are More Than The U.S., Europe And Japan Combined Chinese Household Savings Are More Than The U.S., Europe And Japan Combined The second thing that happened in the U.S. starting in 2000 was a massive housing boom. If you bought a second home with credit, you ended up with one more asset (the house) but one more liability (the mortgage). The person who sold you the home ended up losing one asset (the house) but gaining another asset (a bigger bank deposit). The net result was both higher debt and higher bank deposits. Lending to finance asset purchases has also been a big source of debt growth in China, as it was in the U.S. before the crisis. The U.S. mortgage boom ended in tears, and so the question that we should be asking is whether the Chinese debt boom will end the same way. Arthur: We agreed not to use the term “savings,” yet Peter again refers to “savings” being funnelled into credit. As I explained above, banks do not funnel “savings” (i.e., “excess production”) into credit. China, Japan, and Germany have high “savings” rates because they produce a lot of steel, chemicals, autos, and machinery that literally cannot be consumed and, thus, are recorded as “savings.” The U.S. produces too many services that are consumed/expensed and, hence, not recorded as “savings.” That is why the U.S. has a lower “savings” rate. Chart 10 (Arthur)The Myth Of Deficient Demand In China The Myth Of Deficient Demand In China The Myth Of Deficient Demand In China Economic textbook discussions on “savings” and “investment” are relevant for a barter economy where banks do not exist. When this framework is applied to modern economies with banks, it generates a lot of confusion.5 Caroline: OK, so Peter argues that an imbalance between spending and income CAN be a marker for high debt levels. Arthur, please explain why you see no relationship between China’s chronic shortfall in demand and authorities’ explicit decision to support growth via credit creation. Arthur: First, China does not have deficient demand – consumer spending and capital expenditures have been growing at 10% and 9.4%, respectively, in real terms annually compounded for the past 10 years (Chart 10). The mainland economy has been suffering from excess production, not a lack of demand. China has invested a lot (Chart 11) and ended up with too much capacity to produce steel, cement, chemicals and other materials as well as machinery and industrial goods. So, China has an excess production of goods relative to firms’ and households’ underlying demand. In a market economy, these producers would become non-profitable, halt their investments, and shut down some capacity. Chart 11 (Arthur)China Has Been Over-Investing On An Unprecedented Scale China Has Been Over-Investing On An Unprecedented Scale China Has Been Over-Investing On An Unprecedented Scale In China, to keep the producers of these unwanted goods operating, the government has allowed and encouraged banks to originate loans creating new purchasing power literally “out of thin air” to purchase these goods. This has created a credit/money bubble. In a socialist system, banks do not ask debtors to repay loans and government officials are heavily involved in resource and capital allocation. China’s credit system and a growing chunk of its economy have been operating like a typical socialist system. Socialism leads to lower productivity growth for well-known reasons. With labor force growth set to turn negative, productivity is going to be the sole source of China’s potential growth rate. If the nation continues expanding this money/credit bubble to prop up zombie enterprises, its potential growth rate will fall considerably. As the potential growth rate drops, recurring stimulus will create nominal but not real growth. In short, the outcome will be stagflation. Caroline: The theoretical macro frameworks that you have both outlined make for interesting thought experiments, and spirited intellectual debate. However, investors are most concerned about the sustainability of China’s explosive credit growth, implications for the country’s growth rate, and the return on invested capital. Arthur, given your perspective on how Chinese credit policy has been designed and implemented, please outline the contours of how and when you see the music stopping, and the debt mountain crumbling. Arthur: Not every credit bubble will burst like the U.S. one did in 2008. For example, in the case of the Japanese credit bubble, there was no acute crisis. The bubble deflated gradually for about 20 years. In the cases of the U.S. (2008), Japan (1990), the euro area (2008-2014), Spain (2008-2014) and every other credit bubble, a common adjustment was a contraction in bank loans in nominal terms (Chart 12). Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (I) All Credit Booms Have Been Followed By Contracting Bank Loans All Credit Booms Have Been Followed By Contracting Bank Loans Chart 12 (Arthur)All Credit Booms Have Been Followed By Contracting Bank Loans (II) All Credit Booms Have Been Followed By Contracting Bank Loans All Credit Booms Have Been Followed By Contracting Bank Loans Why do banks stop lending? The reason is that banks’ shareholders absorb the largest losses from credit booms. Given that banks are levered at least 20-to-1 at the peak of a typical credit boom, every $1 of non-performing loans leads to a $20 drop in their equity value. Bank shareholders halt the flow of credit to protect their wealth. Chart 13 (Arthur)China: Deleveraging Has Not Yet Begun China: Deleveraging Has Not Yet Begun China: Deleveraging Has Not Yet Begun Chart 14 In fact, credit in China is still growing at a double-digit rate, above nominal GDP growth (Chart 13). Hence, aggregate deleveraging in China has not yet begun. If banks do not curtail credit origination, the music will not stop. However, uninterrupted credit growth happens only in a socialist system where banks subsidize the economy at the expense of their shareholders. But even then, there is no free lunch. Credit origination by banks also expands the money supply as discussed above. An expanding money bubble will heighten devaluation pressure on the yuan in the long run. The enormous amount of money supply/deposits – the money bubble – in China is like “the sword of Damocles” hanging over the nation’s currency. Chinese households and businesses are becoming reluctant to hold this ballooning supply of local currency. Continuous “helicopter” money will only increase their desire to diversify their RMB deposits into foreign currencies and assets. Yet, there is an insufficient supply of foreign currency to accommodate this conversion. The nation’s current account surplus has almost vanished while the central bank carries US$3 trillion in foreign exchange reserve representing only 11% of the yuan deposits and cash in circulation (Chart 14). It is inconceivable that China can open its capital account in the foreseeable future. “Helicopter” money also discourages innovation and breeds capital misallocation, which reduces productivity growth. A combination of slowing productivity growth, and thus potential GDP, and strong money growth ultimately lead to stagflation – the dynamics endemic to socialist systems. Peter: Arthur’s answer implicitly assumes that private investment would increase if the government removed credit/fiscal stimulus. But where is the evidence for that? We had just established that the Chinese economy suffers from a lack of aggregate demand. Public-sector spending, to the extent that it increases employment and incomes, crowds in private-sector investment rather than crowding it out. Ask yourself what would have happened if China didn’t build that “bridge to nowhere.” Would those displaced construction workers have found more productive work elsewhere or would they have remained idle? The answer is almost certainly the latter. After all, the reason the Chinese government built the bridge in the first place was to increase employment in an economy that habitually struggles to consume enough of what is produces. Arthur talks about the “misallocation” of resources. But doesn’t an unemployed worker also represent a misallocation of resources? In my view, it certainly does – and one that is much more threatening to social stability than an underutilized bridge or road. If you understand the point above, you will also understand why Arthur’s comparison between Chinese banks and say, U.S. banks is misplaced. The Chinese government is the main shareholder in Chinese banks. The government cares more about social stability than anything else. There is no way it would let credit growth plunge. Moreover, as the main shareholder, the government has a strong incentive to raise the share price of Chinese banks. After all, it is difficult to have a reserve currency that rivals the U.S. dollar, as China aspires to have, if your largest banks trade like penny stocks. My guess is that the Chinese government will shut down a few small banks to “show” that it is concerned about moral hazard, but then turn around and allow the larger banks to sell their troubled loans to state-owned asset management companies on very favourable terms (similar to what happened in the early 2000s). Once investors get wind that this is about to happen, Chinese bank shares will rally like crazy. Caroline: Isn’t shuffling debt from one sector of the economy to another akin to a shell game? Wouldn’t rampant debt growth eventually cause investors to lose confidence in the currency? Peter: China has a problem with the composition of its debt, not with its total value. Debt is a problem when the borrower can’t or won’t repay the loan. Chart 15 (Peter)China Is On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers I completely agree that there is too much shadow bank lending in China. There is also too much borrowing by state-owned enterprises. Ideally, the Chinese government would move all this quasi-public spending onto its own balance sheet. It would significantly raise social spending to discourage precautionary household savings. It would also adopt generous pro-natal policies — free childcare, education, government paid parental leave, and the like. The fact that the Chinese working-age population is set to shrink by 400 million by the end of the century is a huge problem (Chart 15). If the central government borrowed and spent more, state-owned companies and local governments would not have to borrow or spend as much. Banks could then increase their holding of high-quality central government bonds. Debt sustainability is only a problem if the interest rate the government faces exceeds the growth rate of the economy.6 That is manifestly not the case in China (Chart 16). And why are interest rates so low in relation to growth? Because Chinese households save so much! We simply can’t ignore the role of savings in the discussion. Chart 16 (Peter)China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy As far as the currency is concerned, if debt growth rose so much that the economy overheated and inflation soared, then yes, the yuan would plunge. But that’s not what we are talking about here. We are talking about bringing debt growth to a level that generates just enough demand to achieve something resembling full employment. No one is calling for raising debt growth beyond that point. Curbing debt growth in a demand-deficient economy, as Arthur seems to be recommending, would cause unemployment to rise. Investors would then bet that the Chinese government would try to boost net exports by engineering a currency devaluation. Capital outflows would intensify. Far from creating the conditions for a weaker yuan, fiscal/credit stimulus obviates the need for a currency depreciation. Caroline: Peter, even if we accept your argument that the counterfactual of curbing credit growth in a demand-deficient economy would be a more deflationary outcome than sustaining the government-sponsored credit growth engine, how is building bridges to nowhere a positive sum for investors? Even if this strategy maintains social stability in the interests of the CCP’s regime preservation, won’t investors eventually recoil at the retreat to socialism that Arthur outlines, reducing the appeal of holding the yuan, even if, as you both seem to agree, no apocalyptic debt crisis is at hand? In other words, isn’t two times nothing still nothing? Peter: First of all, many of these infrastructure projects may turn out to be quite useful down the road, pardon the pun. Per capita vehicle ownership in China is only one one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 17). A sparsely used expressway today may be a clogged one tomorrow. Chart 17 (Peter)The Automobile Ownership Rate Is Still Quite Low In China The Automobile Ownership Rate Is Still Quite Low In China The Automobile Ownership Rate Is Still Quite Low In China Would China really be better off if it had fewer infrastructure projects and more big screen TVs? An economy where people are always buying stuff they don’t need, with money they don’t have, to impress people they don’t like, is hardly a recipe for success. I am not sure what these references to socialism are supposed to accomplish. You want to see a real retreat to socialism? Try creating millions of unemployed workers with no jobs and no hope. All sorts of pundits decried Franklin Roosevelt’s New Deal as creeping socialism. The truth is that the New Deal took the wind out of the sails of the fledgling U.S. communist movement at the time. Arthur: I believe that Peter is confusing the structural and cyclical needs for stimulus. When an economy is in a recession – banks are shrinking their balance sheets and property prices are deflating – the authorities must undertake fiscal and credit stimulus. Chart 18 (Arthur)What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? What Will Productivity Growth Look Like If Public Officials Allocate 55%-60% Of GDP? Credit and fiscal stimulus made sense in China in early 2009 when growth plunged. However, over the past 10 years, we have witnessed credit and property market booms of gigantic proportions. Does this economy warrant continuous stimulus? What will productivity growth look like if government bureaucrats continuously allocate 55-60% of GDP each year (Chart 18)? Caroline: Arthur and Peter, you can both argue with one another about the semantic economic definition of the term ‘savings’, the implications of chronic excess production (relative to consumption), and the root drivers of credit growth in China long past the expiry of every BCA client’s investment horizon. Clients benefit from understanding your distinct perspectives only to the extent that they inform your outlook for markets. Will each of you now please outline how you see high levels of credit in China’s economy impacting the following over a cyclical (6-12 month) and structural (3-5 year) horizon: Global growth Commodity prices China-geared financial assets Peter: Regardless of what one thinks about the root causes of China’s high debt levels, it seems certain to me that the Chinese are going to pick up the pace of credit/fiscal stimulus over the next six months in response to slowing growth and trade war uncertainties. If anything, the incentive to open the credit spigots this time around is greater than in the past because the Chinese government wants to have a fast-growing economy to gain leverage over trade negotiations with the U.S. Chart 19 (Peter)Stronger Chinese Credit Growth Bodes Well For Commodity Prices Stronger Chinese Credit Growth Bodes Well For Commodity Prices Stronger Chinese Credit Growth Bodes Well For Commodity Prices Chart 20 (Peter)The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Stronger Chinese growth will boost growth in the rest of the world. Commodity prices will rise (Chart 19). As a counter-cyclical currency, the U.S. dollar will likely peak over the next month or so and then weaken in the back half of 2019 and into 2020 (Chart 20). The combination of stronger Chinese growth, higher commodity prices, and a weaker dollar will be manna from heaven for emerging markets. If a trade truce between China and the U.S. is reached, investors should move quickly to overweight EM equities. European stocks should also benefit. Looking further out, China’s economy will slow in absolute terms. In relative terms, however, Chinese growth will remain near the top of the global rankings. China has one of the most educated workforces in the world (Chart 21). Assuming that output-per-hour reaches South Korean levels by the middle of the century, Chinese real GDP would need to expand by about 6% per year over the next decade (Chart 22). That’s a lot of growth – growth that will eventually help China outgrow its debt burden. Chart 21 Chart 22 (Peter)China Has More Catching Up To Do China Has More Catching Up To Do China Has More Catching Up To Do Keep in mind that credit growth of 1% when the debt-to-GDP ratio is 300% yields 3% of GDP in credit stimulus, compared with only 1% of stimulus when the debt-to-GDP ratio is 100%. That does not mean that more debt is intrinsically a good thing, but it does mean that China will eventually be able to slow debt growth even if excess savings remains a problem. Structurally, Chinese and EM equities will likely outperform their developed market peers over a 3-to-5 year horizon. The P/E ratio for EM stocks is currently 4.7 percentage points below that of developed markets, which is below its long-term average (Chart 23). While EM EPS growth has lagged DM earnings growth over the past eight years, the long-term trend still favors EM (Chart 24). EM currencies will appreciate over this period, with the RMB leading the way. Chart 23 (Peter)EM Stocks: Valuations Are Attractive EM Stocks: Valuations Are Attractive EM Stocks: Valuations Are Attractive Chart 24 (Peter)Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Earnings Growth In EM Has Outpaced That Of DM Over The Long Haul Arthur: China is facing a historic choice between two scenarios. Medium- and long-term macro outcomes will impact markets differently in each case. Table 1 shows my cyclical and structural investment recommendations for each scenario. Table 1 (Arthur)Arthur’s Recommended Investment Strategy For China-Geared Financial Assets China’s Credit Cycle: A Spirited Debate China’s Credit Cycle: A Spirited Debate Allowing Markets to Play A Bigger Role = Lower credit growth (deleveraging), corporate restructuring, and weaker growth (Chart 25). This is bearish for growth and financial markets in the medium term but it will make Chinese stocks and the currency structural (long-term) buys. Credit/Money Boom Persists (Socialist Put) = Secular Stagnation, Inflation and Currency Depreciation: The structural outlook is downbeat but there are mini-cycles that investors could play (Chart 26). Cyclically, China-geared financial assets still remain at risk. However, lower asset prices and more stimulus in China could put a floor under asset prices later this year. Timing these mini-cycles is critical. A buy-and-hold strategy for Chinese assets will not be appropriate in this scenario. In short, capitalism is bad but socialism is worse. I hope China will pursue the first path. Chart 25 Chart 26 Caroline: Thank you both for clarifying your perspectives. Over a multi-year horizon, markets will render the ultimate judgement on whether China’s credit boom has represented a reckless misallocation of capital, or a rational policy response to an imbalance between domestic spending and income. In the meantime, we will monitor the complexion of Chinese stimulus and evidence of its global growth multiplier effect over the coming weeks and months. These will be the key variables to watch as we determine when and at what level to upgrade BCA’s cyclical outlook for China-geared assets. Can’t wait for that debate. Footnotes 1 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 2 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Reports, “Misconceptions About China's Credit Excesses,” dated October 26, 2016 and “The True Meaning Of China's Great 'Savings' Wall,” dated December 20, 2017. 3 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “China's Money Creation Redux And The RMB,” dated November 23, 2016. 4 For a discussion on the reasons behind China’s high savings rate, please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 5 For a detailed discussion of these issues, please see Emerging Markets Strategy Special Report, “Is Investment Constrained By Savings? Tales Of China And Brazil,” dated March 22, 2018. 6 For a detailed discussion of these issues, please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019 and “Chinese Debt: A Contrarian View,” dated April 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Image   Tactical Trades Strategic Recommendations Closed Trades

The speed and scale of China’s recent debt surge dwarfs Japan and the U.S.’ respective credit binges in the 1980’s and 2000’s, each of which ultimately led to financial market meltdowns. Why should China’s experience be any different? Clients are already aware that Peter Berezin and Arthur Budaghyan disagree on the macro and market ramifications of China’s decade-long credit boom. The aim of this report is to provide visibility on the root sources of the view divergence. To access the full report entitled, “China’s Credit Cycle: A Spirited Debate,” please click here.