From Hong Kong, CIBC’s Patrick Bennett joins to discuss all things China. Is the economy entering a slowdown? Is the real estate sector there in deep trouble? What are the tools that the authorities using to provide liquidity? What’s next for US/China relations? (also…will Bipan stop asking rhetorical questions?) Find out in the podcast!
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Patrick Bennett: China has a very firm and an unyielding view on how they see Taiwan. I think there’s a risk premium in the market for that. I don’t think it’s going to go beyond posturing. I mean, I have no guarantee, I have no guarantee of that. But I think that they have managed to, you know, to live in side by side for some time, and I expect that to continue.
Bipan Rai: All right, welcome back, everyone, to another edition of the FX Factor podcast. If you haven’t done so already, don’t forget to subscribe to get that notification whenever a new episode is available on all the big podcast platforms out there, including Spotify, Google and Apple. Today, I’ve invited my colleague and head of Asia Pacific Strategy here at CIBC, live from Hong Kong, Patrick Bennett, to talk a little bit about China and what’s going on there. Welcome back to the podcast, Patrick.
Patrick Bennett: Thanks, Bipan. Good to be here with you.
Bipan Rai: Excellent. So I guess for this podcast, I wanted to focus on China. There’s a lot of news coming out of China, but I’m going to ask you straight off the bat here. PMIs have been dragging lower there over the last several months, and there’s more noise about the real estate sector. Is the economy losing momentum and are things headed towards another slowdown there?
Patrick Bennett: Yeah, look, very good question. Certainly, there has been a loss of momentum, not so much in the PMI, or not so much in the manufacturing PMI that came back quite well in the last, in December. But we saw the numbers for retail sales in December were particularly soft. That’s been one thing that the government, the authorities, have been trying to reorient the economy away from external demand towards domestic consumption. So the fact that retail sales are very soft certainly means that, you know, there’s some work to do and particularly under the influence of shutdowns over COVID and Omicron, et cetera, which we’re all experiencing. You know, there’s some concerns that they may just intensify.
Bipan Rai: Right. So we’ll touch back on the Omicron issue in a bit, but I wanted to really delve into the real estate market for now. Can you just expand for our audience what’s happening there and what specifically are the three red lines?
Patrick Bennett: Yeah, certainly for a start, I think it’s important to note the size of the real estate sector there, and it’s around 30 percent of GDP. It’s quite almost double what the sector is in the US, and certainly there’s been a lot of pressure on the sector of late. We know that the names, we can talk about specifically when we go on and to have the world’s most indebted real estate company, China’s largest company Evergrande, you know, to come under this pressure certainly means that there’s, you know, there’s going to be pressure on the sector even more, and it’s something the authorities have been very alert to and are very quick to try and do something about. The Red Line test, The Bright Line test they’re called elsewhere is about the indebtedness of the company. How much is coming due over three years, how much is coming due over five years and how much is it pernicious rates, etc. Evergrande was not one of the ones that failed all of these tests. There are other sector, other companies which are in a worse situation. But the pressure has been coming on this company for probably over eighteen months now and really came to a head last year. So this is real evidence of the authorities trying to make a stand against this and trying to say, well, you have too much leverage. We realize there’s too much. There’s a bubble forming in this sector and they want to do something about it. So it’s a government mandated tests that these developers must pass.
Bipan Rai: Right. And I think the latest that I read about Evergrande was that China was considering breaking it up in order to contain the crisis. Do you see any risk of that happening in the period ahead?
Patrick Bennett: Yeah, I think there is. That was some headlines that were out earlier this week that they were considering breaking up the company, whereas Evergrande have said that they would like six months or more as any company would like to, you know, to try and restructure and, you know, decide when the bondholders and asset holders take a haircut or not. So I think the fact that the authorities are trying to move down this path suggests that they are or continue to be very serious about getting control of this.
Bipan Rai: Right. And are there any other real estate firms that we should be looking at that could be teetering when it comes to those three red lines that you mentioned earlier?
Patrick Bennett: None that come out by name just, I think, just a sector overall. And I think we just need to keep attuned to what’s happening in the daily media briefings. But there’s no one that stands out above the others.
Bipan Rai: And what’s the end game for policymakers when it comes to the real estate sector in China? Should we continue to look for the liquidity spigot to be opened again?
Patrick Bennett: Well, I guess it’s a bit of a walking a tightrope for them. It’s been this case for some time that China’s been on one hand trying to reduce leverage and on the other hand, trying to continue to support activity. So while on one hand they want to, you know, support activity by keeping monetary policy accommodative, they don’t want to cut rates so far or cut policy rates to such a level or have banks cut their policy rates to such a level, which encourages increased risk taking by the developers. So it’s kind of walk the tightrope for the last few years, they’ve been able to manage that. So at this stage, it looks like they’ve got one foot, you know, hanging off and, you know, trying to support on the one hand, but trying not to give too much rope to the developers on the other.
Bipan Rai: So we should expect them to continue straddling that sort of fine balance for the next period you’re thinking, right?
Patrick Bennett: Yeah, I think so. I think it’s going to be another one or two years. They’re going to be trying to, you know, just try to straddle that rope as it were, as I say, trying to keep policy accommodated but not having banks, you know, extending credit and increasing rates.
Bipan Rai: So you brought up a really good point with respect to the PBOC and how they’re trying to do things to ease the pressure a little bit. But you know, it’s easy in say the developed markets, whenever a central bank wants to tighten policy to hike interest rates or to do something with the balance sheet. In China, we’ve got all these different tools that the Western audience might not be too familiar with. You know, one of them is the medium term lending facility. Can you speak a little bit to that and what that is?
Patrick Bennett: Yeah, sure. Look, the medium term lending facility or the MLF for short was introduced in 2014. It’s a way that the bank or the PBOC injects money into the banking system. It’s money for one year or more, and each time these MLFs come up and mature, the experience has been or the experience has been certainly over the last couple of years that they are replaced with the same amount or in some cases, more liquidity. What we saw a couple of weeks ago was that the rate at which those were that MLF, those medium term lending facilities were extended at, was cut by 10 basis points and in this case was cut to 285 from 295.
Bipan Rai: Right. And I guess that has a stimulative effect in the economy because it does allow for more lending and more activity to proceed.
Patrick Bennett: Well, yes, exactly. Because look, there’s a few tools that they can use, and perhaps we’ll get to those. But in brief, the Triple R, the Required Reserve Ratio, has been the bank’s main tool that releases liquidity from the excess or from excess of a very large savings in China. And of note, rather, we have seen savings rates go up in the last six or 12 months. Each half percent cut in the Triple R of the average supplier cut releases around 190 billion US, or 1.2 trillion yuan into the system for banks that are able to lend. So savings rates continue to go up that we expect the bank to continue to cut the Triple R. We’re looking for another 50 basis point cut in the second half or the second quarter of this year.
Bipan Rai: Okay. And what about the loan prime rates? We’ve seen a little bit more focus on them as well of late. Can you talk to the audience a bit about what those are and why they’re important?
Patrick Bennett: Yeah. So the loan prime rates, which are submitted by the banks to the PBOC and then the PBOC publishes those. So they’re the levels at which the banks, their prime lending rate to their best clients. And we saw a cut of 10 basis points in the one year and a five basis point cut in the five year to what the five year down to 460 and the one year 370. So there’s still quite a margin between these MLF funds that the bank is extending and the loan prime rates that the banks are offering. And we thought it’s probably appropriate that one year was reduced 10 basis points because that’s where the MLA funds are going to, and the five year was reduced by a smaller amount. So the banks are retaining some margin, and that’s a sector in which most mortgages are set from.
Bipan Rai: So let’s switch gears a little bit and talk about the COVID situation in China. Now we hear a lot about zero COVID and you know how the government there is really resorting to really drastic measures to contain any sort of outbreak that could arise there. Now is the government going to continue with the zero COVID policy, do you think? What’s the endgame there that you’re looking for?
Patrick Bennett: We know the Chinese policy makers can be stubborn, not to coin a phrase there. I think that they want to pursue this right the way through. So I think that this zero COVID, this elimination strategy will continue, certainly for the next few months. It is impacting clearly on consumer activity. As I mentioned earlier, retail sales are very soft. Savings rates have gone up, so consumer confidence is falling. These are some things that have to be considered by the, you know, by the authorities. When we see the Work Council or the State Council meeting in March will get announced the targets for the year and expect to hear more on this strategy at that point, just how they are going to overcome this slump in what is one of their core goals, which has been, of course, to increase consumer spending, which is just not happening.
Bipan Rai: Right. And of course, you know, we’ve spoken for years about how China was exporting deflation, certainly before the COVID pandemic. But now it looks like zero COVID policy is a direct contributor to global inflation. How do you see that progressing as the year goes ahead? Do you think that sort of impulse from onshore policy making will continue to be a contributor to global inflation, especially if we do see further port closures and the like?
Patrick Bennett: Yeah, look, I do absolutely. The port closures that we’ve seen over the last couple of months very much cancel each other out. We’ve seen some closures and some expansion of capacity, but there’s still a lot of backlogs that we know about, a lot of product which cannot get to market while China continues to follow this zero COVID policy. We can expect that certainly through the Winter Olympic time, and perhaps, you know, beyond that. Then I think that that exporting of inflation that we’ve talked about is only going to continue.
Bipan Rai: Right. And on the geopolitical front, we do know that the US-China trade deal that Trump agreed to in early 2020 has now lapsed. What’s the path forward? What are you hearing locally there?
Patrick Bennett: Oh, hearing the tariffs are going to stay in place, that bilateral tariffs will stay in place, at least for the near term. It did appear a few months ago that there was, at least some discussion between the parties, both between US and China, but that hasn’t happened. Has it gone even further than that at this stage? I guess from the US side, we need to look ahead to the, you know, the mid-term and how that being hawkish towards China, you know, plays very well. So I expect that to continue and I expect China to continue to reciprocate in kind with their own tariffs, which if we look at them in a, you know, a net result really only adds to this inflationary pressure because someone has to pay for those somewhere down the line.
Bipan Rai: Yeah. In fact, that was actually going to be one of my next questions. Is the sort of renewed focus here in the U.S. on reshoring manufacturing in key sectors back to the United States? Is that something that you hear a lot about in China and is there any sort of concern there with respect to the US, you know, looking to maybe bringing all the supply chains for key sectors in house?
Patrick Bennett: Certainly haven’t heard a great deal of that. But what we do hear is China trying to corral all the components of manufacturing, be that in increasing their chip production, et cetera. I think that’s only going to continue over the next few years. It does seem to be the case that China is moving towards a situation which is slightly more isolationist if we can coin that phrase for that, and I think that really only contributes, gets back to that exact same point that becomes inflationary for, you know, for global trade.
Bipan Rai: Right. So kind of like an autarchy where we see more of a self-sustaining economy as opposed to more of the trade driven one that we had over the last several decades?
Patrick Bennett: Well, look, that’s right. And I think we’ve discussed here well, certainly we’ve discussed before that, you know, China’s able to close its own borders and grow at a rate that it wants to grow, at a faster rate and to be able to do that, it’s used the assumption of intellectual property and technology from other countries. The Trump administration shut that down to a large degree, and I think that it was a, you know, a positive step forward. China now looks to be going, you know, trying to go its own way again. And I think it’s these global supply chains have been disrupted, and China doesn’t look like re-entering the fray in any great way more than it’s doing now. Then we’re back, you know, back to that same old issue that you know, this conflict and you know, geopolitical, as we mentioned or otherwise, just becomes another risk premium against Chinese assets.
Bipan Rai: And is there any chatter there about what might happen if we start to see a liquidity withdrawal out of the Chinese market? I know there’s generally more of a demand to invest onshore in China, but has there been any sort of, you know, feeling there or any sort of view with respect to potentially U.S. firms are looking to invest less or even moving out of China?
Patrick Bennett: We haven’t seen it yet. I’ve seen some talk about that, certainly. But if we look at numbers of 2021, FDI, I think was, you know, near record $180 billion in portfolio flow in, I think was, you know, five or $600 billion inward. But yes, if we start to see any reversal of that, then certainly that would impact upon our view on the currency. I have read and heard stories about trying to make the investment or offshore or inward investment from Chinese, from US companies into China a little bit more difficult. And I think if we do hear more of that, I think it just continues to play back to the same story we’ve been talking about, and that is, you know, an inflationary environment for the rest of the globe.
Bipan Rai: Right. And can you comment a bit about what’s happening with respect to China-Taiwan? Is there any sort of risk there that we should be mindful of? And naturally, of course, China-Hong Kong and what the relationship is like there?
Patrick Bennett: Yeah. Look, China-Taiwan for a start has been with us since, what, 1949? That’s only a very small period of time in Chinese history. China has a very firm and an unyielding view on how they see Taiwan. I think there’s a risk premium in the market for that. I don’t think it’s going to go beyond posturing. I mean, I have no guarantee. I have no guarantee of that. But I think that they have managed to, you know, to live in, you know, side by side for some time. And I expect that to continue. I draw analogies sometimes with their situation in North Korea. There’s, you know, a risk premium in Korea for the North Korean situation and any resolution, you know, I think would play very strongly, you know, much more than the status quo in that risk premium is still there. China-Hong Kong, we haven’t heard a great deal more about that in the last year or so. They certainly will face the same zero COVID elimination strategy here in Hong Kong. We hear about a lot of people leaving Hong Kong. I know that to be true. The swing variable has been that no one’s arriving. So net, we’ve had a withdrawal of, you know, the expatriate community. I think if any companies were looking now to be setting up in Asia, then Hong Kong is just not going to be top of their list. And I think that that might take, you know, a couple of years or more to resolve, and that would be the best case scenario.
Bipan Rai: So what are you expecting here from rates in China and also how the yuan is going to perform over the coming year?
Patrick Bennett: Yeah, I expect another cut in the Triple R in the second quarter of this year. I now expect we’ll see another cut in the MLF and the seven day reverse repo for another 10 basis points. The message from the PBOC, though, still remains one of stability, not wanting to extend or expand credit to too great of a degree, but certainly after the soft activity in December. You know, then further stimulus, you know, looks to be necessary. When we look at the currency from that point of view, you know, certainly narrowing interest rate differentials between the US and China and China still has an advantage or still has a premium both in nominal and real rates. Certainly squeezing that tighter takes away one leg of support for appreciation of the yuan. But as we know and we’ve talked about often, there are other elements to that. One as we spoke about previously is the portfolio inflow. And yes, I think if we saw that start to unwind, I think it would be a severe move. You know, it would be a severe dent in those expectations for appreciation. The other has been expansion and surpluses. China has a very steady and solid current account surplus. I think running around two per cent of GDP, the trade surplus has been very large. The last 94, I think, 95 billion US in the month, which is up from a level of around only $40 billion, or an average of $40 billion the last few years. So there are a few things which still are supportive of that appreciation. The narrowing of interest rate differentials to me suggests some caution and just squeezes that view a little bit from this point here. So we’re being very careful about extrapolating the downside from this point. The real support or the real key for China and the currency is if this present slight accommodative stance or slightly more accommodative stance is able to support activity. If it’s not able to do that, then I think that, you know, the appreciation expectation that we have, you know, will actually come under more severe question.
Bipan Rai: Right. Especially we’re recording this a day after the FOMC. And given the hawkish tone that we heard yesterday, I mean, I know we had a target below six for dollars CNH. Are you looking to change that any time soon then it sounds like or are you continuing to stick with the sub six target for the next coming years?
Patrick Bennett: I’m just working on my new forecast now and commentary around that, and I am looking to temper those appreciation expectations based in what I believe and we believe as a team will be, you know, a narrowing in differentials for the next one to two years. So I still think the trend is towards a stronger currency. I still think there’s a demand for flow to go into China, and the capital account is not fully open. But yes, just looking to temper the pace of that appreciation by a modest factor.
Bipan Rai: Wonderful. Thanks again, Patrick, for joining us and we’d love to have you back.
Patrick Bennett: Thank you very much. Always great to talk to you. So hopefully we’ll be able to see yourself and our clients in person sometime in the next few months.
Bipan Rai: Yeah, I agree. Cheers.
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