PAUL KRAKE - The Demise of the Belt and Road Initiative
(This is part 2 of a report published on September 7, Please find thefirst part here)
President Xi gets a failing grade and the economic flaws are being exposed
The second term / commencement of life long rule by President Xi Jinping has been an unmitigated disaster. Belt and Road is mired in exaggerated numbers, unprofitable projects, severe delays and debt defaults. The Chinese are getting backed into a corner over the determination of the Trump administration’s determination to eliminate the economic interdependency that the United States has with China. China is viewed in Washington circles as a hostile power and as an adversary and economic rival, but at the same time China is the largest foreign holders of US sovereign debt. This places the United States in a susceptible position. While I believe that President Trump is going about the recalibration of the US / Sino relationship in the wrong way, it is clear that it is not business as usual. Tariffs are here to stay, and it is very likely that over the next 12 months, every good imported from China will have a tariff attached. While high profile and therefore politically sensitive products like iPhones may be excluded, there will be enormous political and practical pressures on the likes of Apple to diversify their supply chains away from China and back to the developed world. While the cost will be higher, innovation should over time, offset some of these expenses. The process will be evolutionary, but the outlook is clear.
China has reached “Peak Supply Chain”
The economic outlook for China is dubious. While domestic infrastructure needs continue to bubble along, a weakening of the external sector through tariffs, and the import demands of an ever-growing consumer could see China move to a structural current account deficit in the next several years. This will drain domestic savings (admittedly from very high levels) and reduce the capacity from Chinese banks to lend domestically or for the BRI agenda. Poor demographics are rapidly putting China into a quandary that the aging Japan never faced. Japan was able to cope with its aging workforce and avoid an economic crisis because Japan was a rich nation when demographics became a drag. The legacy issues of China’s one-child policy are coming home to roost because China will become old before it becomes rich. While China’s state sponsored innovation efforts are extraordinary, and they will lead the world regarding efforts in artificial intelligence to name but one field, the economic reality is that the only means available to China to raise GDP per capita is through investment and this will face enormous headwinds. Capital is not limitless and when faced with the option to fund domestically or to fund abroad, it is obvious that BRI capital will take a back seat to the domestic program.
The illegitimacy of the Chinese Communist Party
President Xi leads a Communist Party that is incredibly insecure about its own domestic legitimacy. China’s censorship and the restriction of political and social freedoms have skyrocketed under the reign of President Xi and the eventual development of programs like Social Credit Scoring, a scheme designed to judge the social worth of each citizen, just show how draconian the Party remains. Chinese citizens have bought into the stability and economic prosperity the one-party rule has generated since the death of Mao. However, Mr. Xi is a throwback to a time past and his heavy-handed approach to governing China is all well and good as long as economic and military surety is maintained. While China has no peer militarily in Asia, the economic framework of President Xi is under threat. BRI has been a failure and Chinese dominance of the global supply chain is under pressure from the economic nationalist in the Trump administration.
This isn’t just about the United States. We are witnessing push back against Chinese capital from across the globe. Concerns over data abuses and intellectual property protection mean that large scale acquisitions of assets both physical or corporate will be scarce going forward. Going back to my point about China becoming a superpower, how can China become a true global leader if it doesn’t have global brands and how can Chinese companies like Alibaba, Tencent or Baidu become world leaders if they are not permitted to expand in the West? While they have the ability to take on western peers in the developing world, can you truly be a global influencer if your customer base is in economies where GDP per capita is less than $10,000 a year?
Conclusion: I’ve changed my thinking about the long term attractiveness of Chinese equities
My view that Chinese assets are cheap is a statement of fact. My belief that they offer extraordinary value over the course of the next two to three years is flawed. The work I have done in the last two weeks on BRI, trade, and the supply chain have led me to this conclusion. I am not predicting a crisis for China. I stick to my long-held belief that China doesn’t have a debt problem, it has an ROI problem, and this is reinforced when one examines the economic viability of many BRI projects. China faces a difficult redesign of its economy, one that must be less reliant on the global supply chain. It will be an economy that has to deal with the consequences of a structural current account deficit. It will not be able to rely on economic interdependence with allies because it has none. While intra-Asian trade should grow with regional incomes, China’s absence from the Comprehensive and Progressive Agreement for Trans Pacific Partnership (CPTPP), the renamed TPP, will see a cost disadvantage for China. While Chinese military might and fears of economic reprisal will keep trade channels open, many countries in the region are waking up to the fact that other alternatives are available.
China is currently undertaking a three-pronged stimulus involving monetary, targeted fiscal, and a trade weighted weakening of the RMB. Historically, this has been a positive for Chinese assets, especially equities. While the housing market remains in decent shape, the equity market continues to face domestic selling and while valuations are historically attractive, I am rapidly forming the opinion that a catalyst for a re-rating of stocks is not on the horizon. What will be the reason for the valuation of equities to bounce given all the structural headwinds I have outlined above? Of course, there are positives, especially regarding technology but this may not be enough to alter the trajectory of stocks. Japan has been a value trap for 25 years with the exception of several periods of policy induced euphoria. I suspect, China is heading down the exact same path.