CHINA, INFLATION and GLOBAL GROWTH

By Mathieu Ghanem, September 26, 2022.

The West’s relationship with China has never been straightforward.?Externally it has often been antagonistic and abrasive however at deeper levels there has been a symbiosis which has been the driving force behind global growth and lower inflation.?The question is whether, as we head into stagflation, the West and China can succeed without each other.

Today the West/East divide seems wider than ever which as we head into an inflation-led downturn, is a major concern.?The problem is that when the great financial crisis of 2007/8 hit, it was China, which had benefited from years of foreign investments, that provided the resources needed to return to global growth while maintaining cheaper standards of living for ageing and service-oriented economies in the West.

We looked to Japan for an answer, and we got China

When the last crisis occurred, the West turned towards the East to look for a solution. The writing was on the wall; Alan Greenspan’s mandate was mainly fuelled by easily accessible and cheap credit. The traditional engine of growth of an ascendant economy and its industrialisation was long replaced by an ever-bigger financialisaton geared towards a service-based economy and its almighty consumerism. So naturally, when the bubble burst, to tackle this downturn, the Japanese expert of ultra-loose monetary policies in America, Ben Bernanke, applied the Bank of Japan way.

For more than 12 years, our economies accustomed themselves to these policies. No matter how much money was printed and how low-interest rates were, inflation never appeared. Today as we reach inflation levels unseen in the last 40 years, no one seems to really understand how this has happened.

What if Japan, which was the first country in modern history to face strong deflationary pressures and anaemic economic growth since its late 90s domestic market bubble burst, got it wrong? Or did we finally print too much?

What is it that has now changed and is making us diverge from the Japanese model?

If anything, in the past few years, the emergence of strong populist movements in the West, partially due to increasing negative public opinion around immigration, should have got us closer to Japan, which has barely any immigration, and does not seem to be leaning towards an inflationary scenario.

What about Covid? Data clearly shows that a big chunk of boomers decided to retire from 2 years up to 4-5 years in advance, therefore, again increasing our convergence with the lower active population scenario Japan has been facing for years.

No, this time around something has clearly changed; it is being explained to us that labour gluts are now resulting in higher inflation. But that should always have made sense, when fewer people are available to take on a job, wages must go up and higher prices should follow. Although this has never materialised in Japan, so how come?

The answer can be found in CHINA.

It was predominantly China that kept Japan in its continuous deflationary regime, due to acting as their replacement workforce. Japanese corporates had long delocalised their productions in China and to a smaller extent, in Southeast Asia (Indo, Thailand, etc…), to maintain their access to cheap manufactured goods back home. While enriching its corporates abroad who were tapping into the 90s generational Asian economic boom. And China, in this new globalised world, had become an export-driven economy behemoth thanks to massive and steady foreign investments by the Western world.

In times of higher inflation, never turn your back on a wounded Dragon

Today, the West’s dependency on China, more than ever, in times of higher inflation and global economic deceleration, will need to be restored. The symbiosis of the relationship between China and the West remains and is for now the best outcome for all and the only pragmatic win-win solution.

On the other hand, China’s alignment with Russia over the Ukraine war, the recent military flexing towards Taiwan and the Covid pandemic, have further isolated the country.

Beijing’s attempt to build a domestic market failed at creating an alternative growth model for itself. Now internal and external events have wounded the ‘dragon’, and therefore set the stage for an inevitable return to its previous policies which will have a positive knock-on effect on the rest of the world. The 20th CCP congress will be the turning point.

On why Chinese ambitions will have to be downgraded

Turning to the economy, China is fully aware that it did not find a way to reduce its reliance on exports. The latest turmoil in the world’s biggest economic sector, namely China’s real estate market, comes as confirmation of the above. China’s debt issuance to finance and investing in its infrastructure and real estate rose faster than the economic benefits of that investment. Its real estate developers are facing liquidity events, credit growth is rapidly falling, mortgage delinquencies are precipitously increasing and clearly showing that the sector will not be able to sustain its past growth, leaving it with the fastest growing debt burden in history.

The ramifications of such events will have a long-term impact. Thirty per cent of China’s GDP is directly dependent on it, the largest middle class in the world has accumulated its wealth and savings into it, and any drop in its value creates a painful debasement with the potential for civil unrest. China is already facing various social disobedience movements and has now a 20% youth unemployment.

If China does not want its economy to stall, it needs to pivot quickly. The problem is that the only way forward is the financialisaton of the Chinese economy which is contrary to the harder-line Confucian / communist ideology that Xi has been trying to reintroduce. The strategy must shift towards the opening of equity markets, consumer-friendly credit policies and looking for cross-sector growth.

This is especially relevant as China no longer has a monopoly on low-cost manufacturing.?While it remains strong, it is now in direct competition with the new emerging manufacturing powerhouses that Bangladesh, Vietnam, and parts of LatAm represent, which have more competitive labour costs.

Chinese competitiveness has also been hit by global costs, most notably the price of energy which as the world’s largest importer of oil, puts them at risk.?The access to ‘cheap’ oil based on its support for Russia over the Ukraine war will not continue forever, therefore, China needs to look at other energy options, which will take time to develop. They are also dependent on the rest of the world for 80% of their semiconductor needs, a situation they know they must manage.

On the geopolitical side, China cannot take the risk of being ostracised like Russia. On the issue of Taiwan, the uncertainty of a direct offensive military operation that would result in reclaiming this territory is too high a price for China to bear, its military is not (yet) ready.

The consequences of such warmongering actions for China would deliver a heavier blow compared to the current western sanctions on Russia in respect of the Ukrainian war. As it would result in a broader opposition, involving, other G20 countries such as India and Indonesia this time around. Furthermore, a significant number of smaller economies such as Vietnam, the Philippines and Malaysia would also be in opposition to such actions, which could further deteriorate China’s position.

China is fully aware of its current worsening influence over countries it had strategically and strongly tried to align itself with. Its current position in the Indian Ocean looks decidedly grimmer than just a year ago. Sri Lanka, the flagship country of China’s engagement in the region, which saw over US$ 12 billions of investment over a period of 15 years is now facing a dire situation which has cleared the path of the return of India to what used to be its backyard. New Delhi never accepted China’s growing influence over this island and will fight hard to minimise it. In Pakistan, the ousting of Imran Khan has poured cold water on the development of the China-Pakistan Economic Corridor. Billions of dollars are again at stake for China, which saw Pakistan as a key partner to its one belt one road policy.

China will continue its fait accompli military doctrine around the Himalayas and the South China Sea. There will be a continuous effort from the CCP to bolster its military, but the above factors will mean that it is highly unlikely that China will continue its military escalation toward Taiwan. Taiwan is an annoyance, but a small issue compared with the state of the economy.

The return of the low inflation paradigm? 20th CCP congress

The 20th CCP congress will start in October, which will see Xi Ji Ping move to consolidate his power, as he looks to try to become China’s “ruler for life”. Here are the 2 most likely scenarios - spoiler alert: both will result in positive outcomes for China and both scenarios will help restore the previous deflationary market regime.

A.????Xi Ji Ping cements his power and becomes ruler for life.?If this happens, he can put recent events behind him, reopen and stimulate the economy, and withdraw all Covid restrictions which will positively impact the global supply chain and result in Chinese growth.

B.?????Xi Ji Ping loses his grip. Though unlikely, the pressure of his poor economic record could lead to the congress opting either for a pro-growth candidate or limit Xi’s influence, this could translate into an even larger Chinese market reopening and growth, again lowering supply chain pressures globally and boosting China's economy even further.

When the dragon meets the eagle

In conclusion, the actions over the next few months of the ‘wounded dragon’ is what matters most if one is looking for timing the return of better global supply chains and therefore lower supply driven inflation. This then will have a more long-term effect and influence on the decisions of the Fed, ECB, BoE, BoJ etc.?Whatever the outcome of the CCP congress, we will see a reopening of the Chinese economy, as it gradually abandons its zero covid strategy, which will translate into a buying opportunity both in Chinese stocks and in higher up the curve risk-on assets in the US.

China and the Wests’ relationship are too symbiotic, too interdependent, and for the moment there are no alternatives, so they will have to work together.?China knows it cannot risk a war with Taiwan, that it needs to quickly build back its economy and that its relationship with Russia cannot come as an alternative to its US-denominated reserves and trade relationship which will limit its support in the medium to long term over Russia.

Export remains their best option, together with trying once again to impact their domestic market and create a more resilient consumer demand by providing alternative investment exposure to its middle-class, diversifying them away from real estate. The weakening of the Chinese Yuan versus the US Dollar, which has seen strong demand and remains the undisputed reserve currency of the world, will continue.

If there is unrest in China, due to worsening economic conditions, and it escalates, it will magnify the East-West divide (rural vs urban) and the South vs North divide (cultural divide) which remains Beijing’s Achilles’ heel. China will have to close itself off from the world, resulting in large and painful global supply chain disturbances. It will cascade into much higher inflation in the West with long-term effects. This scenario is unlikely and benefits no one, hence the West and China will look to go back to their previous economic relationship template.

If the Thucydides trap scenario might be still at play, with a warmer confrontation between the West and China, but it should not occur before both blocks manage to be in stronger positions, several years down the line. However, that final confrontation might never happen, either because both players will want to avoid a zero-sum game or because the gap between the two sides would have widened too much for the other to catch-up.