Cam Hui, CFA | (604) 724-8404 Page 1

Quantitative & Strategy

INC.

IS CHINA READY FOR THE NEXT DOWNTURN?

Highlights

Michael Pettis is one of the few China watchers who has established a time frame for China to resolve its problems. He

outlined a scenario four years ago where China would not crash, but experience a “long landing” where growth gradually

decelerates.

My “best-case” rebalancing scenario, as I think you know, consists of an upper limit to average GDP growth of 3-4% over the

presumed decade of President Xi's administration (2013-23), driven by growth in household income of 5-7% and commensurate

growth in household consumption. Although when it comes to China I have been the big, bad bear for so long that perhaps I tend

to want to understate my pessimism, I nonetheless always try to remind my clients, sometimes not very loudly if I am in a public

forum, that this is not my expected “most likely outcome”.

He went on to elaborate that his best guess is the current pace of credit growth was only sustainable until 2017–2018:

My guess (and it is only a guess), is that China can continue the current pace of credit growth for another 3–4 years at most, after

which it cannot grow credit fast enough both to roll over what Hyman Minsky suggested was likely to be exponential growth in

unrecognized bad debt (and WMP and other shadow banking assets will almost certainly be absorbed into the formal banks), and

to provide enough new lending to fund further economic activity. If there is less time, as I think Anne Stevenson might argue, or if

Beijing cannot get credit and rebalancing under control before then, I think we can probably assume my “orderly long landing”

scenario is less likely.

Here we are, four years later. How is China managing its “long landing”?

We find that China faces both long- and short-term obstacles. In the long run, its growth is unsustainable and Beijing

needs to make adjustments. In the short run, the Fed appears intent on engineering a U.S. recession, which, combined

with Trump’s trade war, are headwinds to Chinese growth and policy adjustment process. The risks are rising rapidly,

and don’t count on China to sail through the next global downturn as smoothly as the last one.

Cam Hui, CFA September 17, 2018

cam@pennock@ideahub.com

Cam Hui, CFA | (604) 724-8404 Page 2

September 17, 2018

Quantitative & Strategy

Is China Ready for the Next Downturn?

The bears have been warning about China’s unsustainable debt for years. So far, it has been a

“this will not end well” investment story, with no obvious bearish trigger and no time frame

for a crisis.

Exhibit 1: The China Bears’ Favourite Chart

Source: Datastream

Michael Pettis is one of the few China watchers who has established a time frame for China to resolve its problems. He outlined a scenario four years ago where China would not crash, but experience a “long landing” where growth gradually decelerates. Pettis elaborated on his best-case scenario in an email to us (see Michael Pettis on the risks of the long landing scenario):

My “best-case” rebalancing scenario, as I think you know, consists of an upper limit to average GDP growth of 3–4% over the presumed decade of President Xi’s administration (2013-23), driven by growth in household income of 5–7% and commensurate growth in household consumption. Although when it comes to China I have been the big, bad bear for so long that perhaps I tend to want to understate my pessimism, I nonetheless always try to remind my clients, sometimes not very loudly if I am in a public forum, that this is not my expected "most likely outcome".

He went on to elaborate that his best guess is the current pace of credit growth was only sustainable until 2017–2018:

My guess (and it is only a guess), is that China can continue the current pace of credit growth for another 3-4 years at most, after which it cannot grow credit fast enough both to roll over what Hyman Minsky suggested was likely to be exponential growth in unrecognized bad debt (and WMP and other shadow banking assets will almost certainly be absorbed into the formal banks), and to provide enough new lending to fund further economic activity. If there is less time, as I think Anne Stevenson might argue, or if Beijing cannot get credit and rebalancing under control before then, I think we can probably assume my "orderly long landing" scenario is less likely.

Here we are, four years later. How is China managing its “long landing”?

Cam Hui, CFA | (604) 724-8404 Page 3

September 17, 2018

Quantitative & Strategy

Hitting The Debt Wall?

As Pettis had predicted, the cracks are appearing in China’s credit-driven growth engine.

Remember how Chinese stock prices are tanking? Benn Steil at the Council on Foreign

Relations found that the cause is not the trade war.

Exhibit 2: Trade Not the Culprit in Chinese Stock Price Decline

Source: Council on Foreign Relations

Instead, he attributed stock market weakness to Beijing’s deleveraging policy to reduce credit

growth.

Exhibit 3: Slowing Credit Growth the More Likely Cause of Equity Weakness

Source: Council on Foreign Relations

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September 17, 2018

Quantitative & Strategy

The cracks are appearing at both the local government and corporate levels. The WSJ reported

that a Chinese city was so financially squeezed that it forced parents to send students to private

schools:

LEIYANG, China—Long before parents clashed with police and officials over school overcrowding,

this southern Chinese city was telegraphing its fiscal squeeze—and exemplifying China’s deep-seated

local debt woes.

After the area’s backbone coal-mining industry entered a slump mid-decade, the Leiyang government’s

revenue began to slide. By February, the government warned the legislature of challenges in providing

education, health care and other social services. Then in May, civil servants went unpaid for more

than a week, until emergency funds arrived. Weeks later, a city-owned company that finances

construction missed a loan repayment to a nonbank lender.

Problems spilled out into the streets both nights this weekend. The city’s plans to deal with overcrowded

public-school classrooms by sending students to more expensive, often inferior private schools drove

hundreds of parents and others to protest. On Saturday, some threw bottles, bricks and firecrackers

at local officials and police, who, by official accounts, then dispersed the crowds, detaining 46 people.

The SCMP reported that private businesses have trouble getting loans even when the

government directed banks to lend to SMEs [emphasis added]:

The Chinese government campaign to get more funding into the hands of small business owners is

struggling.

And a solution to the problem is being more urgent as the trade war with the United States starts to

weigh on the economy.

Small and medium-sized business (SMEs) account for most jobs in the country – up to 80 per cent

by some measures. Each produces a single or a small range of products or services and operates on

small profit margins that are far less resilient to economic disruptions than those at larger firms.

The government has pumped money into the banking system to spur lending to smaller business and

has recently stepped up its verbal intervention demanding action. Anecdotal evidence suggests the

situation has improved, but only modestly.

That is because the push to get banks to lend more to small firms is in direct conflict with the

government’s effort to reduce risk in the financial system.

The results of the focus on SME loan growth have been mixed at best:

But, so far, the process is falling short of expectations. At the end of the second quarter, loans to

micro and small businesses accounted for 32.3 percent of the total outstanding corporate loans, 0.4

percentage point lower than at the end of March, according to data from the People’s Bank of China,

the central bank.

In the first half of this year, new loans for micro and small businesses made up mere 20.9 percent of

new corporate loans, the lowest rate since the data was first published in 2012.

Small businesses face enormous hurdles in obtaining credit:

Jiang Pengming, chairman of a tech entrepreneurs association in Beijing, said small firms, at least in

the green industry, still face egregious requirements to get a bank loan. Banks sometimes demand

collateral that not only includes company assets, but also managers’ personal assets.

“Entrepreneurs, their spouses and children over 18 all have to sign loan agreements, businessmen

over 60 even need to do psychiatric examinations on the same day of signing,” he told the Post. “Still,

firms cannot ensure that they will get a loan by doing so.”

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Quantitative & Strategy

He said that financing difficulties only scratch the surface of the problems facing small businesses in

China. Freeing up more money for lending will not resolve these problems facing SMEs, most of

which are private enterprises.

Instead, SMEs have been turning to the more expensive shadow banking lenders for credit,

which is a sector that the authorities are desperately trying to rein in:

In the past, the shortage of affordable bank credit forced small businesses to turn to other avenues for

financing, particularly shadow bank lending. Peer-to-peer (P2P) lending to SMEs soared to 872.3-

billion yuan (US$128 billion) in 2017, more than 70 times the 12.4-billion yuan in 2013,

according to a report from WDZJ.com, an information platform for the online lending industry, in

December last year.

Chinese SMEs, which accounted for more than 60 percent of the country’s gross domestic product last

year, have been underserved by the traditional banking system for years, so the government’s

programme to reduce financial leverage and debt by under regulated shadow banking institutions has

made their situation worse.

What’s more, the shadow banking sector continues to grow despite Beijing’s efforts.

Exhibit 4: Shadow Banking Still Growing

Source: Bloomberg

Moreover, Chinese good consumption is in a downward trajectory because of the effects of the

government's deleveraging policy on the economy.

Cam Hui, CFA | (604) 724-8404 Page 6

September 17, 2018

Quantitative & Strategy

Exhibit 5: Deleveraging = Falling Consumption

Source: Goldman Sachs Global Investment Research

Four years after Pettis made his guesstimate, it appears that China is begging to hit a debt wall.

Cam Hui, CFA | (604) 724-8404 Page 7

September 17, 2018

Quantitative & Strategy

China’s Difficult Policy Choices

Indeed, Pettis acknowledged in his latest commentary that China is coming to the end of its

debt runway. Still, he believes that China is unlikely to crash, but it is likely to trade the heart

attack for a chronic disease:

China’s debt problems have emerged so much more rapidly and severely this year than in the past

that, combined with swirling rumors about the country’s leadership, a growing number of analysts

believe that this may be the year that China’s economy breaks. As always, I am agnostic. There is

no question that China will have a difficult adjustment, but it is likely to take the form of a long

process rather than a sudden crisis.

What if there is a trade war, or a global recession?

If the global trade environment forces a contraction in China’s current account surplus, I argue, by

definition it also forces a contraction in the gap between Chinese savings and Chinese investment. This

means that either the country’s investment share of GDP must rise or the savings share must decline

(or some combination of the two). There are literally only four ways that either of these outcomes can

happen. Consequently, there are also only four ways that Beijing can respond, each of which would

drive the economy to one of the four possible outcomes (or some combination of them):

Raise investment. Beijing can engineer an increase in public-sector investment. In theory,

private-sector investment can also be expanded, but in practice Chinese private-sector actors have

been reluctant to increase investment, and it is hard to imagine that they would do so now in

response to a forced contraction in China’s current account surplus.

Reduce savings by letting unemployment rise. Given that the contraction in China’s

current account surplus is likely to be driven by a drop in exports, Beijing can allow unemployment

to rise, which would automatically reduce the country’s savings rate.

Reduce savings by allowing debt to rise. Beijing can increase consumption by

engineering a surge in consumer debt. A rising consumption share, of course, would mean a declining

savings share.

Reduce savings by boosting Chinese household consumption. Beijing can boost

the consumption share by increasing the share of GDP retained by ordinary Chinese households,

those most likely to consume a large share of their increased income. Obviously, this would mean

reducing the share of some low-consuming group—the rich, private businesses, state-owned

enterprises (SOEs), or central or local governments.

Notice that all four paths either raise investment or reduce savings, thereby reducing the country’s

excess of savings over investment. This is what is meant by a contraction in the current account

surplus.

In other words, there are only three realistic policy choices: unemployment, debt or wealth

transfers. While the wealth transfer option appears to be the most logical from a policy

viewpoint, Beijing will face the opposition of entrenched and powerful interests of the rich

tycoons, the party cadres in the SOEs. Pettis concluded:

For the rest of 2018, I expect that we will see different groups in Beijing try to reconcile the need for

slower credit growth with greater growth in economic activity. But because these two things cannot be

reconciled, one group or the other must win. So far it isn’t clear whether we will see growth in economic

activity continue to slow or credit growth pick up.

We don’t know how this story ends, but it sounds like China will undergo a difficult adjustment

in the near future, and there are some very obvious bearish triggers ahead.

Cam Hui, CFA | (604) 724-8404 Page 8

September 17, 2018

Quantitative & Strategy

President Xi, Meet Jay Powell

While the market has focused on Trump’s trade policy as China’s biggest economic threat, we

beg to differ. The biggest threat is the Federal Reserve, which appears intent on engineering a

recession.

While the market has priced in two more quarter-point rate hikes for the rest of 2018, analysts

are starting to focus on when the Fed might pause its rate normalization policy as interest rates

near the neutral rate. Unfortunately, the answer is no, it will not pause.

Much has been made of the objection by a number of regional Fed presidents about the

prospect of inverting the yield curve. If the Fed were to maintain its current tightening path,

the 2-10 yield curve is likely to invert either in late 2018 or early 2019. However, investors have

to understand the voting dynamics of the Fed’s monetary policy. The people who really matter

(and have the staff to create studies to support their conclusions) are the permanent voters on

the FOMC, namely the Fed governors, and the President of the New York Fed.

Indeed, these “important” people have spoken. Fed Chair Jay Powell stated in so many words

in his Jackson Hole speech that the Fed is on course to keep raising until something breaks (see

Why the Powell Jackson Hole Speech Was Less Dovish Than The Market Thinks). As well, the WSJ

reported that New York Fed President John Williams was not afraid of inverting the yield curve:

Federal Reserve Bank of New York leader John Williams said Thursday the prospect of a yield-

curve inversion by itself wouldn’t be enough to stop him from supporting further rate rises if he thought

the economy called for them.

“I think we need to make the right decisions based on our analysis of where the economy is and where

it’s heading,” Mr. Williams told reporters after a speech in Buffalo. “If that were to require us to

move interest rates up to the point where the yield curve was flat or inverted, that would not be

something I find worrisome on its own.”

Last week, Fed governor Lael Brainard chimed in with an important speech entitled, “What Do

We Mean by Neutral and What Role Does It Play in Monetary Policy? She intimated that the Fed is

likely to keep hiking even past neutral by distinguishing between the long-term neutral rate,

which is specified in the Summary of Economic Projections (SEP), and the short-term neutral

rate, which varies. Fed policy should focus on the short-term neutral rate, which is a function

of economic data [emphasis added]:

Focusing first on the “shorter-run” neutral rate, this does not stay fixed, but rather fluctuates along

with important changes in economic conditions. For instance, legislation that increases the budget deficit through tax cuts and spending increases can be expected to generate tailwinds to domestic demand and thus to push up the shorter-run neutral interest rate. Heightened risk appetite among investors similarly can be expected to push up the shorter-run neutral rate. Conversely, many of the forces that contributed to the financial crisis--such as fear and uncertainty on the part of businesses and households--can be expected to lower the neutral rate of interest, as can declines in foreign demand for U.S. exports.

In many circumstances, monetary policy can help keep the economy on its sustainable path at full

employment by adjusting the policy rate to reflect movements in the shorter-run neutral rate. In this

context, the appropriate reference for assessing the stance of monetary policy is the gap between the

policy rate and the nominal shorter-run neutral rate.

And the economy is running hot, which means the short-term neutral rate is above the long-

term rate, which Brainard estimated at between 2.5% and 3.5%. The Atlanta Fed’s Q3

GDPNow stands at a sizzling 4.4%, the St. Louis Fed’s nowcast at 4.4% and the New York

Fed’s nowcast is the outlier at 2.2%.

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September 17, 2018

Quantitative & Strategy

Exhibit 6: Atlanta Fed’s GDPNow at 3.8%

Source: Federal Reserve Bank of Atlanta

Even as the American economy displays significant signs of strength, the rest of the world is

weakening, as evidenced by the poor breadth shown by global equity markets.

Cam Hui, CFA | (604) 724-8404 Page 10

September 17, 2018

Quantitative & Strategy

Exhibit 7: Global Equity Market Breadth

Source: Topdown Charts

This combination of decelerating non-U.S. growth and a hawkish Federal Reserve is a recipe

for a global slowdown of unknown magnitude.

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Quantitative & Strategy

Trade War Starting to Bite

On top of that, the trade war is starting to bite. AmCham Shanghai and AmCham China

conducted a survey of the impact of the U.S.-China tariffs, and the effects of the trade war are

starting to bite.

Exhibit 8: Most Companies Report Adverse Effects from Tariffs

Source: AmCham Shanghai, AmCham China

The intent of Trump’s trade policy is to force American companies to bring manufacturing

back to the U.S. Instead, most multi-nationals are opting to move to other countries, and only

6% of the survey sample plan on building American facilities.

Exhibit 9: Companies Are Not Relocating to the U.S.

Source: AmCham Shanghai, AmCham China

Despite Trump’s belligerent tone, there will be no winners in this trade war.

Cam Hui, CFA | (604) 724-8404 Page 12

September 17, 2018

Quantitative & Strategy

Exhibit 10: Trump’s Tweet on U.S.-China Trade Negotiations

Source: Twitter

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September 17, 2018

Quantitative & Strategy

The Chinese Chickens Come Home to Roost?

How will all this this affect China? Increasingly, there are calls for the Chinese chickens coming

home to roost, in addition to Pettis’ analysis of Beijing’s unenviable policy choices. Arvind

Subramanian and Joel Felman, writing at Project Syndicate, believes that the era of Chinese

exceptionalism is about to end:

After decades of strong and steady growth, China has developed a reputation for economic resiliency,

even as it piles up ever more domestic debt. But the prospect of declining exports, alongside a weakening

currency, could derail its debt-defying trajectory.

George Magnus recently warned about the combination of the unsustainability of China’s debt,

and its aging population:

Eventually, the government will have to stabilise and reduce the debt burden and excess leverage in

the economy if it is to avoid a painful landing. This will show up in the form of a material reduction

in China’s growth rate in coming years. The Yuan is very likely to weaken as a result over the

medium-term, in spite of restrictions over capital moving overseas.

Rapid ageing – China is the fastest ageing country on Earth – will tend to both lower growth and

sap some of the country’s dynamism. The abandonment of the one child policy in 2015, and the recent

removal of the last government diktats over family size are unlikely to be any more successful in

raising fertility than other measures have been elsewhere. China will need to find other ways to offset

the predicted sharp rise in the old age dependency ratio, which will surpass that of the U.S. in the

next 25 years.

In conclusion, China faces both long- and short-term obstacles. In the long run, its growth is

unsustainable and Beijing needs to make adjustments. In the short run, the Fed appears intent

on engineering a U.S. recession, which, combined with Trump’s trade war, are headwinds to

Chinese growth and policy adjustment process. The risks are rising rapidly, and don’t count on

China to sail through the next global downturn as smoothly as the last one.

Cam Hui, CFA | (604) 724-8404 Page 14

September 17, 2018

Quantitative & Strategy

The Chinese Canaries in the Coalmine

What should investors do? In light of the heightened risks, we suggest that investors monitor

two key stocks as real-time indicators of the health of the Chinese economy.

The first is China Evergrande Group (3333.HK), which is China’s biggest property developer.

Real estate firms like Evergrande are sitting on about 120 billion in offshore USD debt, nearly

double 2016 levels. Reuters reported that “Morgan Stanley estimates that every 1 percent

depreciation of the yuan could shave an average of about 3 percent off developers’ 2018

earnings per share.” Should the yuan weaken for any reason, the stresses are going to show up

quickly in the property sector.

Exhibit 11: China Evergrande Group (3333.HK)

Source: Yahoo! Finance

In addition, investors can also monitor Alibaba as a gauge of the health of the household sector.

Exhibit 12: Alibaba Group Holding Ltd. (BABA)

Source: Stockcharts

Currently, the price of Evergrande has remained stable, while Alibaba has been rolling over,

even before the announcement of CEO Jack Ma’s retirement. Bottom line, don’t panic just yet

until both indicators really tank.

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Disclaimer

I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I

am confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and

edit every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions

but final responsibility is my own.

I also certify that I have not and will not be receiving direct or indirect compensation from the subject company(ies) in exchange for

publishing this commentary.

This investment analysis excludes any target price, and is not a recommendation to buy or sell a stock. It is intended to provide a means

for the author to share his experience and perspective exclusively for the benefit of the clients of Pennock Idea Hub (PIH). My articles

may contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and

assumptions. The author does not assume any liability whatsoever for any direct or consequential loss arising from or relating to any use

of the information contained in this note.

This information contained in this commentary has been compiled from sources believed to be reliable but no representation or warranty,

express or implied, is made by the author or any other person as to its fairness, accuracy, completeness or correctness.

This article does not constitute an offer or solicitation in any jurisdiction.