The cusp of a lost decade, is China at risk of Japanification?

In the latest episode of the Emerging Markets Equities podcast, Nick Robinson sits down with Bob Gilhooly to look at all things China. Covering geopolitics and potential comparisons between China today and Japan 30 years ago. 

Transcript

Nick: Hello, everybody, this is Nick Robinson from abrdn, and you're listening to the Emerging Markets Equity podcast, the show that explores the factors that underpin our thinking on emerging markets. We ask our expert guests the big questions from key individuals to evolving trends, all with the goal to identify and profit from opportunities in the region. In today's episode, we're going to touch base again, on some of the key economic issues that emerging market investors are grappling with at the moment. In my conversations with clients, there are two big issues that keep coming up. Firstly, China, and all that's going on there in terms of economic growth, stimulus, and the geopolitical tensions that continue to escalate, particularly with the US. And then the second other big issue is interest rates and inflation and how the changing interest rate cycle will impact economic growth going forward, both in the US and also in the broader emerging market space. So, joining me today to tackle these issues is my colleague, Bob Gilhooly. Bob has been on the podcast before and he's a senior emerging markets economist within the abrdn research institution, based in London. He's been with the firm for four years. And prior to joining, he was at the Bank of England, where he worked as a senior economist covering Asia with a focus on China. So, Bob, welcome back to the podcast. How are you?

Bob: Great, thanks Nick. Thanks for having me back on.

Nick: Well it's great to have you back on. Let's start with China. So, there's a lot going on there. And we've come pretty much full circle from the start of the year when we had all this optimism about the economy reopening. You know, today, we've got increasing stress in the property market, but spilling over into the financial sector. Every day brokers seem to revise down their economic growth forecasts for the country. And the stock market's been really sold off. It's been a tough year to be invested there. Yet, so far, monetary, and fiscal stimulus announced by the government has been pretty piecemeal. So, the question is, what do you think President Xi is waiting for in order to announce something more substantial and why is he so reluctant to apply stimulus?

Bob: Yeah, I think probably the main reason why current policy are ceding incremental, and as you know, as you put it, reluctant, is one of kind of still wanting to not lose progress on the de-risking side of their policies. So, you know, they've definitely paid quite a large cost to try to deleverage real estate developers, that does appear to be have been a bit ham-fisted particularly to begin with. And they've had to try to kind of roll back some of those red lines that really introduced that kind of shocks to the real estate sector. So I think, you know, they're reluctant to concede defeat, reluctant to try to kind of build up or let any more risks build up within the property sector, you know, indeed you think about it, and kind of with construction is indeed, you know, maybe running an unsustainable pace, you know, 2022 is the first year of Chinese population declined, if you, if you kind of keep propping up the property market, to some extent of taking activity from the future, and then you're just going to end up with a slowdown at a later date anyway. I think there's probably some similar arguments on the de-risking side, around kind of why maybe credit growth has been a little bit maybe more constrained than we've been used to. So, I think here the argument is that, you know, there's definitely a cost of the post global financial crisis credit boom, that was unleashed to support the economy. You know, that cost came through capital misallocation weighing productivity, and then a large building risk in the shadow banking sector. So again, kind of reluctance to kind of go big here, given the have actually made a reasonable amount of progress kind of de-risking and kind of reducing size of shadow banking sector. But aside from this kind of de-risking, I think, actually, there's a couple of other explanations for this kind of why not a substantial, why not reluctance. I think capacity and effectiveness definitely play a role here. Local government finances were put under a lot of stress over the pandemic with large costs of maintaining zero COVID not least the kind of huge numbers of PCR tests that the local governments were running, but also just a weak economy meant they weren't getting in as many tax revenues. Combine that with this regulatory shock to real estate, you know land sales, which are an important part of local government fiscal space, were also falling. Then there's a question about effectiveness and kind of willingness. So, you know, in theory, the government could just transfer money to households and kind of try to boost confidence that way, but I think there's a few political economy reasons why that's a bit less likely, you know, the Communist Party is kind of biased a bit of investment, relative to consumption. But I think there's also a kind of political economy angle, or unwillingness to maybe build up social security liabilities. And then you know, it's probably also just questions about the effectiveness, that households are actually still accumulating access saving. So, it doesn't really imply their kind of balance sheets, at least on net, are in such a position that they would kind of really need money to help. So, it's really kind of case of kind of effectiveness there. And then maybe, you know, there's just the change policy priority set growth probably just doesn't quite matter to the authorities as much as it used to. Yes, youth employment is causing a lot of consternation within China. But as long as kind of aggregate unemployment doesn't get out of hand, that has actually been pretty stable. I think, you know, your 30s are kind of happier to kind of focus some of their attention on the strategic industries try to think about the resilience of the economy and face of the tensions with the US economy, the US administration.

Nick: Thanks, Bob. And I suppose picking up on some of your comments on the post GFC credit boom, and consumer balance sheets, there's been more recently, some comparisons made between China today and Japan 30 years ago, and specifically the concern that China might be falling into what's been termed a balance sheet recession. And this is a fairly new subject to me. But my understanding and correct me if I'm wrong, is that the idea is that after the bursting of an asset bubble, consumers become more concerned about their personal balance sheets. And so, the overwhelming urge for them is to repay debt rather than consume. So, stimuluses essentially becomes ineffective as any money that lands in consumers wallets goes straight to repaying debt, rather than back into the economy. So, do you think that's a risk?

Bob: Yeah, you're right. It's definitely there's a lot of kind of high level somewhat concerning parallels with Japan, you know, if we kind of take a bit of a step back. I think there's a few reasons why well, you know, first of all, Chinese growth, of course, has actually slowed quite a lot. Mentioned population shrinking already, but you know, with the Chinese economy is ageing, very rapidly, so similar to Japan, and there's risks of the property sector bubble that were such a key part of Japan slide into its lost decade. But then there's also the kind of fact that China has been maybe hitting up on the limits of an export led development model. Indeed, Japan US trade tensions in the 1980s were kind of quite a large factor leading to the Plaza Accord, which was then a key part of actually kind of driving the Japanese bubble and kind of leading to that subsequent lost decade. So yeah, I think there's a bit of a parallel there on the trade tension side that began under President Trump. And you know, I'd probably broad out, you know, I think he did a really good job explaining the balance sheet recession, I kind of also broaden it out a bit to one of a kind of fear of deflation. And deflation for China certainly been getting a lot of attention recently. So, we had CPI turning negative for the first time, in a long time in July, we also had Q2, year on year GDP deflator also turned, turned negative. And why does that matter. Well, you know, if people are kind of expecting falling prices, potentially that means your kind of real interest rate structure of the economy is higher, it also means, you know, to the extent that if you’re a firm, potentially, if you're if goods prices are falling, or the price your outputs falling, it actually becomes harder to repay those debts. So, you know, if you were already worried about your debts and wanting to try and repair your balance sheets, that's a much tougher, tougher ask in a world of kind of falling prices. Now I think actually, you know, while this kind of Japanification balance sheet recession is getting a lot of attention. I think there's a few counter arguments. One would be you know, I think Chinese disinflation deflation currently is probably a bit overstated. You know, there's a very large base effect coming through the inflation calculation from energy and that should fade that should push headline inflation back up to around about 1% by the end of the year. If you look at high frequency measure GDP deflator that's probably also rising, not falling. And then there's kind of some more structural arguments, you know, Japan was around about 70 to 80% are kind of equivalent of kind of stage of development in the US. If you look at GDP per capita, you know China still has a lot of development potential GDP per capita is, you know, much lower and they're running about 25% of that of the US and indeed even if China's workforce is maybe kind of beginning to shrink, you know, there's still quite a lot of scope for China to boost the quality of its workforce by improving education, improving skills, you know we should still see some kind of offset there from human capital, even if the number of kind of workers is less supportive than it used to be. It's also worth bearing in mind, China's property market wasn't a private property market until 1997, 1998, there's probably still some scope to upgrade the housing stock in China. Similarly, when we look at kind of numbers around urbanisation or the share of agriculture in the economy, still implies to us, you know that there's a bit of support that can still be tapped from that kind of development and urbanisation process, too. And, you know, I've always had the impression when I've been to China, particular that, you know, the Chinese authorities, I think, are students of Japan's rise and fall. So yes, they maybe took some inspiration from its export led development model. But I think this kind of concern about its lost decades does guard against policy risks to some extent, key differences also include, you know, there's obviously state own banking system within China probably gives you a more powerful lever to say to carve out bad loans, if need be. And you know, the labour market is very different, as well. So, I think that probably guards against some have this kind of mild, persistent deflation that Japan had, given they don't have the kind of same kind of job for life labour market structure. I mean, that all said, I do worry a bit about the effectiveness of policy. So, could stimulus become ineffective. And there is a risk, I think it may be that the authorities take kind of some of the wrong lessons from Japan's lost decades. Indeed, you know, I think the key one for me would be this kind of danger, actually of doing incremental policy. You know, yes, Japanese government debt did rise a lot through the 1980s. But I think actually, if you look at it again, it was always very piecemeal, the Japanese government always very, really reluctant to deploy fiscal policy. It needed to largely do this to offset rising corporate and household savings at a national level. I don't think it never really quite did enough to turn around the kind of private sector dynamics get that confidence back into the system. And your confidence about the Chinese economy does seem to be does seem to be very low at the moment, I do think this kind of incremental approach while trying to hold in de-risking is one that doesn't, you know, it's not a free lunch. It does come with risks, too.

Nick: Yeah. Thanks, Bob. So, I guess thinking about another potential source of risk to the Chinese economy is really geopolitics and I suppose the question would be, you know, can China break through the middle-income trap, while at the same time the US is taking such severe steps now to restrict its access to advanced technology? And I suppose I say this in light of the earnings results for Nvidia reported last night was just showing another huge step up in demand for their chips, but at the same time, noting that China is potentially a problem for them, given that restricted access for China now has to for most advanced semiconductors.

Bob: Yeah, look I think, you know, our view is it's going to be a volatile relationship going forward. I think that was quite illustrated by the balloon incident at the start of the year, you know, we had this kind of period of, of hopes have a bit of a thawing in the US China relationship. I think that kind of burst that bubbles, pun intended, so to speak, on that side of things. And yes, you know, we've maybe had some steps for the US administration, Secretary State Blinken went to meet President Xi, Yellen met Premier Li Qiang as well. But you know, these are kind I’d cast them as kind of steps to manage tensions, not really significant ones in terms of de-escalation. So overall, I think it is actually quite hard to escape the conclusion that at least this amplifies risks of China getting stuck into the into the middle-income trap. Partly this is a kind of changing the policy priority mix that I mentioned earlier, you know, if you're focusing more on strategic industries, overall, governments around the world don't have a great track record of kind of picking winners here. So, there's some risk here that you get maybe more capital misallocation, and that kind of feeds into a weaker productivity environment and you're potentially credits being directed away from the broader economy towards those strategic industries. And then if you just think about it, more broadly, the process of development, the academic literature is kind of does ascribe quite a lot of weight to the benefits of foreign direct investment. You know part of this kind of learning by doing story knowledge transfer story. And also if you get more FDI tends to spur competition domestically and spur those firms to innovate. So, you know, to the extent that maybe China isn't going to get quite as much FDI, as it was previously, you know, because firms are kind of considering reshoring, as you were discussing with Gabriel quite recently on the podcast, that is, I think, a bit of a risk to, to kind of China's growth model. I mean, I probably say overall, though, you know, it's, it's a bit too early to throw in the towel and think China's going get stuck in the middle income, income trap, there are signs of China moving still moving up the value chain across various industries, China became the world's largest exporter of cars in Q1 has made quite a lot of progress on the electronic vehicle manufacturing front, it's also the case, you know, I think we should expect some reshoring as part of that move up the value chain to so it's going to lower value added activities move out of China and into other countries, such as Vietnam, or Bangladesh, or that is that is largely to be expected. And then I guess there's a kind of tricky one around government centralisation within the Chinese economic model. And this is, I think, a bit of a double-edged sword. On the one hand, it kind of strengthens policy levers, so maybe, you know, allows more resources to be directed towards kind of areas of strategic interest, in particular, the high-tech sector and quantum computing, AI and semiconductors. But you know, potentially that it has the cost of kind of directing resources elsewhere, it's widely thought, you know, the Chinese authorities are throwing billions of equivalent of US dollars at the problem. And you know, they've been doing this for some time, and still not kind of managed to catch up fully on the semi, the semiconductors side, either. But you know, even if growth is kind of maybe heading from trend rates of 4.5 to 5%, to more like 3.5% over the course, the next 10 years, that’s still enough for China to take the number one spot in the global in the global economy. So, I think on that sense, I think it's probably just a little bit too early given stage China stage of development to think that this tension with the US is necessarily going to derail it. But I think it does add quite a lot of risks across a few dimensions.

Nick: Yeah, I mean, it's certainly very interesting. I mean, I suppose we get a more bottom-up perspective of some of the innovation that's going on in China at the moment. And certainly, when we speak to portfolio holdings in the electric vehicle segment or the internet companies, the pace of innovation still seems pretty impressive. And certainly, the chat from these companies is that the lack of access to high end chips is only really having a limited effect on the business today. You know sticking with the US I think, when I was looking back through my notes from when you were last on the podcast, inflation in the US, it just tipped over 9%. And that was about a year ago. So today, inflation has fallen to 3%. But despite this, we've still got the expectation that in the US, we've got a couple more rate hikes ahead, most likely, the importance of that being that peaking rates in the US, eventually, at least when rates start to fall should weaken the dollar and provide a bit of cover for emerging market central banks to start reducing rates. So how do you think the cycle in the US is likely to pan out from here?

Bob: Yeah, you know, our base case is US policy rates have effectively peaked or, or it's very close to hitting the top. It's probably a bit of a knife edge call for the upcoming Fed meeting in September, you know, on the one hand, you mentioned quite a bit of good news coming through on the inflation side there Nick, I think that does give you a bit of a space for a kind of wait and kind of wait and see approach is also possible, you know, that just the lagged effects from the Fed’s tightening, 500 basis points, still kind of hasn't really come fully through the economy. If you look at the credit conditions, as indicated by the senior loan officer survey, in particular, those look, those look quite adverse and imply kind of potentially some quite a reasonably strong kind of tightening credit conditions still to kind of come through. So again, that might be another reason to think that the kind of fed feels like it's kind of done enough I can do a bit of a bit of a wait and see. But on the other hand, activity in the labour market in the US have just been amazingly resilient given the tightening that we've seen, just reading a headline that the mortgage rates in the US have now hit 7.3%. But you know, despite that there's not a concrete proof that the economy is really slowing that materially. The Atlanta Fed nowcast is actually running just shy of 6% annualised. So that's implying actually activity accelerated into Q3, let alone kind of any sort of, kind of moderation on that side. And I think, you know, despite this kind of optimism around kind of, some people been turning immaculate disinflation. So, inflation coming down, growth and labour market remaining rock solid, I think that does also speak to the risk that the Fed maybe has got a bit more to do, you know, I think we can take a bit of comfort from the fact that some of the core inflation measures such as services ex shelter have come down. But also, if you if you take out a few other factors, health has actually been a big part driving that down, if you take that out, things look a little bit more uncomfortable relative to target a little bit less target consistent in that sense. And you'll also know resilient activity could just keep these underlying measures of inflation, kind of too high, too high for comfort. So perhaps after, you know, a bit of a pause, there is this kind of risk, I think, maybe the FOMC needs to resume hiking. So overall, you know, we are a bit skeptical about this kind of immaculate disinflation process, we still see some risks, that recession takes hold, even if this kind of I guess you could think of it as the maybe the runway for the soft landing has actually got a bit bigger, given what's happening activity, inflation, and the labour market there. And then, you know, we'd also take a slightly longer-term view. Either way, if the feds got a bit more hiking to do or it's kind of peaked out, you know, our take is that long term interest rates are likely going to settle back down, eventually, the sort of factors, depressing yields and interest rates after the global financial crisis and before the pandemic. So, it's just kind of inequality relatively tepid potential growth, you know, we don't think those have gone, gone away. So, you know, we think those are good reasons to expect that kind of interest rate kind of structure to ease back down or, you know, we're just, we don't believe we shifted to a kind of a new permanently higher interest rate paradigm, for example.

Nick: Yeah, that's a that's reassuring. I mean, I suppose what does that all mean do you think for emerging markets? And, you know, when we start to see or when are we likely to start seeing a big wave of interest rate decreases in EM? I saw that Brazil's eased relatively recently. I think that's what Chile did as well. But for the most part, they appear to be more or less on hold at the moment.

Bob: Yeah, you know maybe El Nino could throw a little bit of a wildcard into the picture with food prices being a significant real acceleration in the Fed hiking or you know absent kind of really hawkish signal being sent by the Fed at Jackson Hole, or the upcoming fed meetings, I think we're probably actually getting to the point where EMs are probably less constrained by the need to follow the Fed. You know, remaining hikes from the Fed, most likely, we think should be small. Many EMs, of course, hiked more, you know, they hiked earlier and more aggressively than developed markets did. So Latam managed to deliver high real rates. And we've also seen quite a bit of progress on headline inflation and core inflation coming down. Now, you know, it may be a bit too early to declare victory on the inflation front across much of emerging markets. But it is notable that headline inflation has been surprising to the downside, across emerging markets, and you know, after worrying about a period of quite sticky inflation, on the core side, for the first four months of this year, we've actually seen high frequency measures core inflation come down quite a lot to, so you know, take a couple of couple of stats for you. The median month on month rave core inflation, across a sample of around about 25 to 30, major emerging markets was only about 3.5% in May and June, and that's down from almost 11% back in April 2022 and only kind of around about 0.5% points above pre-pandemic averages also to that the interquartile ranges around that kind of distribution have improved quite a lot to. All the which I think kind of puts emerging market central banks into a position where you know, potentially your domestic factors are kind of trumping this global dimension and making the kind of needing to kind of wait and see and hold off given what the Feds doing a little bit less, less pressing. Now, you know, we of course, often talk about emerging markets as a kind of a block, but it's certainly not the case that this is a uniform outlook across emerging markets, you know, our views Latam best placed to kind of continue, easing might be a bit tentative, but we should be able to kind of see further cuts coming through there. Asian central banks, of course, never quite hike to the same extent. But they also generally don't have the same inflation problem, either. So, you know, I think we potentially see some albeit maybe cautious easing, heading into 2024. Central Eastern Europe, well, you know, we always been quite worried that maybe the risks here that they would try to kind of ease too early. And you know still I think ascribe to that to some extent, but even in in Eastern Europe, I think there are some straws in the wind, maybe that this kind of core inflation challenge is being brought down. Poland, Romania, core inflation, there is still looking too hot. If you look at Hungarian inflation, you know, that peaks almost 40% annualised in July last year, you fast forward to July this year that's actually if you look at the month on month moves, that's only running at 2% annualised, that is quite turnaround in the inflationary kind of backdrop.

Nick: Okay, well, it certainly feels like we're potentially setting up for quite a good 2024 in terms of the rate environment. And it's, I always find it quite striking, just seeing how low inflation is now in in Latam, particularly while sitting here in the UK, where inflation is still quite problematic. Perhaps that's a good place to draw the podcast to a close. So, thank you very much, Bob, for joining. It's been a real pleasure to have you on again. 

Bob: Thanks, Nick. 

Nick: And thanks to everyone today who took the time to listen in. If you enjoyed this podcast and please download our other podcasts from our website, or wherever you normally get your podcasts. Watch out for our next episode and tune in.