In hindsight, the recent demolition of the Chinese cram-school industry because of a drastic change of its regulatory regime should not have come as a surprise. Not for naught, China has a single party political system where the single party is the Chinese Communist Party (CCP). Xi Jinping – aka Xi Who Must be Obeyed (XMBO) – is the Secretary General of the CCP and de facto dictator for life. XMBO likes to share his political philosophy and vision. This makes the political process far more transparent than some people would have it. In fact, Xi Jinping Thought is so important that the preamble to the Constitution of the People’s Republic of China mentions this doctrine since 2018. What is Big Brother thinking? Luckily, Xi Jinping Thought, which is researched at dozens of Chinese universities and taught in Chinese schools, may be summarized in fourteen succinct and clear propositions. (Do not worry; we are also very confused by the oxymoronic “humanist communism” doctrine):
- Ensuring Chinese Communist Party leadership over all forms of work in China.
- The Chinese Communist Party should take a people-centric approach for the public interest.
- The continuation of “comprehensive deepening of reforms”.
- Adopting new science-based ideas for “innovative, coordinated, green, open and shared development”.
- Following “socialism with Chinese characteristics” with “people as the masters of the country”.
- Governing China with Rule of Law.
- “Practice socialist core values”, including Marxism, communism and socialism with Chinese characteristics.
- “Improving people’s livelihood and well-being is the primary goal of development”.
- Coexist well with nature with “energy conservation and environmental protection” policies and “contribute to global ecological safety”.
- Strengthen the National security of China.
- The Chinese Communist Party should have “absolute leadership over” China’s People’s Liberation Army.
- Promoting the one country, two systems system for Hong Kong and Macau with a future of “complete national reunification” and to follow the One-China policy and 1992 Consensus for Taiwan.
- Establish a common destiny between Chinese people and other people around the world with a “peaceful international environment”.
- Improve party discipline in the Chinese Communist Party.
The newfound zeal in protecting everything and everybody has far-reaching consequences. Clearly, protecting the use of personal data, the GIG economy’s workers’ rights or children from the dangers of addictive videogames as well as seeking a more egalitarian access to higher education for all students are all high-minded goals. Luckily, in this dash towards “improving people’s livelihood” Chinese officials stopped short of banning MSG. A Rubicon that former Mayor Bloomberg may have crossed.
George Soros admonished investors last week that XMBO’s “crackdown on private enterprise shows he does not understand the market economy”. The reality is that it is not just investors who face a rude awakening; Chinese officials face a home-grown financial crisis as the Chinese economy slows down. According to data from the Bank for International Settlements, credit to the non-financial sector has grown from 239% of GDP in in 2015 to 289% at the end of 2020. Chinese bank stocks are trading well below book value once again. This is very likely because investors anticipate massive equity issuance badly needed to shore up their CoVid battered solvency. Yet nobody dares speak these self-evident truths.
In 2014, when these stocks traded below book value, but not quite at such steep discounts, we concluded they presented an interesting investment opportunity because they were well prepared to face a major credit crisis. These banks were profitable, solvent, and very liquid at the time. In addition, China had capital controls in place. The largest banks were state owned, so there were no issues with state aid. Also importantly, as we see today with the implosion of China Evergrande and China Huarong Asset Management, these banks’ exposure to property developers was much smaller just a few years ago. Today these banks are less profitable, less solvent, and less liquid. The overall level of loan loss reserves to loans outstanding is inadequate if the slowdown continues.
While we agree with those who see this sell off as an opportunity to invest in the fast growing Chinese technology platforms, we are concerned that “old economy” Chinese companies will face a challenging few years. China has been growing above trend since the financial crisis because by taking on a lot of debt both private and public. If as some central bankers fear we are entering a tightening cycle in the US, as inflation becomes an issue, the Chinese economy will suffer an external shock that it is ill prepared to weather without a significant devaluation.
For over a hundred years, the American Way of Life has been the most successful export from the Unites States. Yet, not everything about that culture is good for you. Certainly chewing gum, gunning down burgers and fries with milkshakes or sugary caffeinated drinks, or smoking cigarettes have all very harmful long term effects on one’s health. We have no opinion on the morality of rock and roll or the 60s sexual revolution but some commentators condemn both as detrimental to family life and law and order. Yet no matter how pernicious these habits and mores might be, the 30-year mortgage is possibly the American export that has inflicted the most damage around the world for decades. China is no exception.
When banks start lending to prospective homeowners, inevitably home prices initially go up. While home prices go up not everybody is happy but the financial system hums along nicely in the comfort that collateral values are going up. Eventually and inevitably, home prices reach a cyclical high. Bankers soon realize that collateral values are going down and they curtail new mortgages by imposing stricter terms thus ensuring that property prices continue their slide. Soon this downward spiral affects property developers as many buyers walk away from deposits and all hell breaks loose soon afterwards. There is no need for a sub-prime mortgage market either to make the crisis very deep and long lasting, as we saw in Spain.
China has capital controls in place still today and $3 trillion in foreign exchange reserves, any attempt at a run on the currency would be futile. Yet, officials there have been toying with the idea of opening the capital account further as the stock of foreign exchange reserves has been dwarfed by the parabolic growth of M2 in recent years. We fear that we are in for a protracted crisis and not just for foreign investors.