No China stimulus? Time to buy

Do not buy Chinese stocks because you think a large fiscal stimulus is coming. Buy Chinese stocks because a large fiscal stimulus is not needed.

The bull case for Chinese equities is not that stimulus will rescue the economy. The bull case for Chinese equities is that households are sitting on US$20 trillion in deposits with nowhere to go.

The controlled demolition of the property sector is ongoing. Regulators have curtailed wealth management products and their implicit guarantees.

Capital controls prevent easy access to foreign assets. And the coming flood of high-tech hardware companies in clean energy, semiconductors, aerospace, robotics and biotech will need a vibrant equity market to get off the ground.      

China’s economic transformation will be ill-served by flood-the-zone stimulus which – if we recall – is what got us the real estate bubble and subsequent “three red lines” credit restrictions in the first place. What China’s economic transformation needs is better implementation of “establish the new before abolishing the old.”

What should we make of China’s recent stimulus measures? The grab bag of goodies – reserve requirement ratio (RRR) cut, lowered interest/mortgage rates, special local bond sales, cash for clunker programs – are all bullets pointing in the same direction. But the firepower falls well short of a bazooka.

Trillions of renminbi (RMB) in fiscal stimulus have been dangled but apparently withheld given the non-meeting held by the National Development and Reform Commission (NDRC) after the holidays. What has been offered will help China achieve 5% gross domestic product (GDP) growth this year, hardly a lofty goal.

The only interesting policy is the People’s Bank of China’s (PBOC) unexpected support for equity markets through 1) a collateral replacement scheme to increase risk assets at institutional investors and 2) a program to encourage bank lending for share buybacks.

While some attribute this to an effort to juice consumer confidence, the likelier motivation is an effort by the PBoC to redeploy some of China’s $20 trillion in household bank deposits.

China’s roaring stock market in the past couple of weeks has given the basket of policies a vote of confidence. Note that domestic markets are behaving far more rationally than international markets.

China’s exchanges took one week off from October 1-7for National Day holidays – enough time for international markets to spin wild and unbridled fantasies about fiscal stimulus of RMB2 trillion, RMB4 trillion, RMB6 trillion and RMB10 trillion.

The subsequent whiplash in Chinese equities traded in Hong Kong and through international ETFs occurred in Shanghai and Shenzhen after markets reopened.

Perfectly attributing domestic market confidence is of course impossible. Low valuations from beaten down stocks provide a natural floor.

The NDRC non-meeting should have lanced the boil of massive stimulus expectations. The market has likely determined that China is serious about utilizing equity markets. What it needs to figure out next is that China’s economic woes are not as dire as made out to be.

How well has President Xi Jinping managed China’s economy? Much of the business press is predicting Japan-style stagnation, if not imminent collapse. That, of course, has been the case for decades.

According to one illustrious China-based economist’s 2015 prediction, President Xi’s economic performance should have earned him God Emperor status in the pantheon of China’s communist leaders:

My expectation is that, under President Xi’s term, 2013-2023, average growth rates are unlikely to exceed 3-4%. That’s not my prediction, that’s the upper limit of my prediction…. I think that if President Xi is able to pull off average growth rates of 3-4% during his 10 years in office, he will have accomplished something that we should really be astonished [by]. It would be truly impressive, almost on par with what Deng Xiaoping did in the 1980’s.

In President Xi’s first two terms, China’s economy grew at a 6.2% compound average growth rate (CAGR), nearly double the upper limit of said predictions. China significantly outgrew all major economies except India. Somehow, our economist was not twice as astonished.

Perhaps it was President Xi’s own fault, extending his time in office past the customary two five-year terms. Instead of graduating with double starred first honors from our economist, Xi has only extended his studies trying to earn an unprecedented triple or even a quadruple starred first.

Han Feizi’s assessment of President Xi’s economic performance is considerably less generous. Economic growth of 6.2% CAGR in Xi’s first two terms is not at all astonishing; it was, in fact, modestly below expectations (Covid 2000 to 2022, what can you do?).

Han Feizi did not and does not share our Beijing economist’s bleak assessment of the economy that Xi inherited and thus cannot grant bonus points for outperformance:

[President Xi] inherited a much more difficult economy than we think. There’s a huge amount of debt. There’s a huge amount of unrecognized bad debt.         

While China did take on a lot of debt and take it on quickly, Han Feizi fundamentally disagrees that the amount of debt and the quality of the debt is all that problematic.

It has been this correspondent’s contention that the size of China’s economy is significantly understated compared to OECD national accounts (see here).

China’s debt-to-GDP ratio is, thus, closer to ~125-200% instead of the often quoted ~300%. Moreover, this debt largely financed housing and infrastructure – long-lived assets with relatively low maintenance capital – able to generate value for decades.

China still has 15-20% of the population to urbanize. Given urbanization of 1% of the population per year, overbuilt housing should naturally resolve itself by kicking the can down the road.

As such, China’s debt is nowhere near capacity. Xi inherited an economy headed in the wrong direction, not an economy out of runway. With property investment hobbled by redline credit limits in 2020, China nonetheless continued to grow 5% by redirecting lending to advanced manufacturing.

A sentiment that Han Feizi might share with our Beijing economist is that Xi’s record is incomplete. No marks can be given until he sees things through. Things being another transformation of China’s economy and society, which Han Feizi has written about before (see here):

China wants America’s Silicon Valley, but regulated; Japan’s car companies but electrified; Germany’s Mittelstand, but scalable; and Korea’s chaebol, but without political capture. It wants to lead the world in science and technology, but without cram schools. A thriving economy, but with common prosperity. Industry, without air pollution. Digital lifestyles, without gaming addiction. Material plenty, without hedonism. Modernity, without its ills. This is, of course, a wish-list and unrealistically ambitious. But these mad scientists sure as hell are going to try. They’ve developed a taste for it.

Various pieces of this transformation have started to take shape. The anti-corruption campaign under Xi’s tenure has been unyielding and – dare we say? – transformative. China’s once low-trust and loutish public of the Jiang Zemin and Hu Jintao eras is now unrecognizable, able to sustain high-trust business models like shared bikes and take-only-what-you-paid-for vending machines (see here).

The professional environment for China’s young grads is surely far less treacherous than the get-rich-quick-at-any-cost mentality of the go-go days.

Output from the “new three” industries – solar, batteries and EVs – is surging, although capacity appears to be growing even faster. Deflation across multiple sectors has set off alarm bells. Although not ideal, China’s deflation is fundamentally different from Japan’s in its lost decades.

Simplistically, deflation caused by decreasing consumption (demand curve shifting in) is bad; deflation caused by increasing production (supply curve shifting out) is good.

Unlike Japan, which suffered two recessions in the 1990s, demand in China is still growing, if more weakly than optimal. Japan’s deflation started when Tokyo was the most expensive city in the world with cantaloupes selling for $100 each. This is not the same deflation China is currently dealing with.

China’s real disposable household income grew 6.1% in 2023. In recent years, regulators have crimped the income of previously high-flying professionals in finance, tech and real estate. Upper-tier income growth has stalled while lower-tier income growth has been robust.

Economist Simon Kuznets’s prediction that inequality would rise in the early stages of economic development before peaking and falling as wealth increases is playing out perfectly in China while it confounds expectations in more capitalist economies.   

And, of course, Han Feizi does not believe China’s economy is egregiously unbalanced. (Perhaps it’s not even unbalanced at all and thus has no need for massive consumption stimulus.)

This is the key reason Han Feizi was not “astonished” by China’s ability to maintain growth over 6% in Xi’s first two terms. There is no need for consumption to outgrow investment to signal economic health (see here) and thus no need for massive consumption stimulus.

China’s regulators and anti-corruption investigators have ransacked the nation’s banks and brokerages and detained high-profile bankers, attempting to put a leash on an industry with a natural tendency to run amok. The PBoC’s support for equity markets may signal confidence in the clean-up work recently performed.

So, yes, buy Chinese stocks. Valuations are still cheap, and $20 trillion of savings has nowhere to go. Equity markets are being prepared for China’s high-tech future.

Growth is more sustainable in a high-trust and more equal society. No, there will not be a massive consumer stimulus. But that is precisely why you should buy, not sell, China.