Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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November 20, 2021

China Crisis – is it turning Japanese?

I'm turning Japanese I think I'm turning Japanese I really think so The Vapors

In the mid-1980s, there was not a single US bank on the list of the top 20 largest global banks. The consolidation of US banks (and other industries) was yet to impact the 1980s world rankings. But the main reason for the US’s poor showing in the 1980s global bank league table was that Japanese banks held 17 of the top 20 places.


It is easy to forget the awe with which the rest of the world held Japan in the 1980s. When I was a child in the 1960s, Made in Japan symbolised cheap plastic consumer goods. It was synonymous with low prices and poor quality. (Cashing in on the irony, heavy metal band Deep Purple renamed their famous live album from the original name of Live in Japan to Made in Japan in 1972). By this time, Japanese goods made for export had progressed from low value-added plastic products to motorbikes, electrical goods and cars. I can remember the first time I saw a Japanese car, a mustard coloured Datsun. As I recall, most people viewed this progress with a sense of disbelief. Who would buy a Japanese car?


By the 1980s, the consensus tune had changed. Japan had extended its reach continuously into other areas of economic life. The consensus view had come to see Japan as the advanced guard of the Asian Tiger economies that had learnt from the West and repurposed capitalism for their requirements. Articles and thought pieces were everywhere showing how Japan, run by engineers and technologists, had fostered a long term symbiotic relationship with its banks and financial institutions. It was a new model from which all should learn. In the space of a few decades since its virtual economic destruction after World War Two, Japan, by the early 1990s, briefly had an economy valued in its local currency that was only slightly smaller than that of the US.


However, what was less evident at the time but became more apparent into the 1990s was government involvement in protecting the currency and the exporting sectors of the Japanese economy. The primary tool for this was an informal monetary policy known as the Guidance Window from the BoJ and the all-powerful MITI, Ministry of the Economy. This policy ensured that Japan’s savings were channelled into specific industries populated by the large and growing industrial conglomerates.


By the mid-1980s, the US had grown uneasy about how Japanese companies were invading their markets for consumer goods and manufactured products and called a meeting in New York in 1985. The Plaza Accord is now widely regarded as the point where the pin was first placed into the Japanese bubble. However, it took another few years for the market to work this out.


Fast forward to today, and the value of the Japanese stock market remains below the level it reached in 1987, and our fascination has long since moved across the East China Sea. The poster child of miracle economies for the last 25 years has become China. The rapid transition from a collectivist rural economy by the reforming ideas of Den Xiaoping was genuinely remarkable. Den repurposed the power of market reforms to transform China’s enormous economic potential into reality. As he said, it doesn’t matter whether a cat is black or white, if it catches mice it is a good cat.


China accelerated through the gears of economic development in subsequent years at a breathtaking pace, fully embraced by the West and its rapacious consumers, which nodded through its acceptance to the World Trade Organisation in 2001. In the two decades since this event, China’s share of world trade has grown from low single-digit percentages to mid-double digit percentages. The economic benefits have been a significant contributor to global deflationary forces seen since the Great Financial Crisis.


When Trump positioned China as enemy number one in his ambition to Make America Great Again in his unlikely bid for the Republican Party presidential nomination in 2016, most of us thought he was going out on a limb to whip up nationalistic support. However, today in the US being anti-China is one of the very few bi-partisan political ideas.


Below the political surface, there are also signs of underlying economic stress to which the increasingly dictatorial Xi Jinping has to respond. While we have enjoyed the spoils of China’s rise in terms of the plentiful supply of iPhones and designer sneakers, we have been less cognisant of the economic growing pains. These pains can no longer be ignored.


George Magnus pointed out China’s key economic issues in his excellent book, Red Flags: Why Xi’s China is in Jeopardy a few years ago. He said these were: debt, middle-income earners, the Renminbi, and an ageing population. Chinese economic policy has changed direction in the last 18 months and exposed many of the issues outlined by Magnus. “Common Prosperity” is a slogan looking to dramatically redirect resources within the Chinese economy towards greater autonomy and self-sufficiency. In so doing, China has to confront its shaky financial economy and, in particular, its obsession with real estate and its rapacious funding requirements, which have developed in an opaque manner. The Evergrande funding crisis has been likened to China’s Lehman moment and highlights how the CCP is trying to do what the West failed to do in the early 2000s and gently deflate the real estate bubble. They may or may not manage to do this, and Evergrande may be more Bear Sterns than Lehman Brothers. We will have to wait and see.


So, what if we are at peak China? What if China is facing a period of economic decline? How does this affect me? It is never possible to know, but there are some scenario’s we might like to consider.


Growth – China has become a significant plank in economic growth over the last 20 years. In particular, it has been a critical consumer of energy and raw materials. If China economic growth slows down materially over the coming period, this can have profound consequences for the world economy.


Inflation – If growth slows too quickly, this can have a deflationary impact on the world’s commodities. I think the best barometer of this is the oil price. However, the successful redirection of China’s economic superpowers to its internal requirements could have inflationary consequences for Western consumers’ reliance on iPhones and sneakers. In short, the world needs to consider the long term costs and benefits of restructuring supply chains away from China.


Monetary Stability – China is looking to reposition an elephant on the head of a pin. The risks involved are many and varied. However, the vector of significant risk for the rest of the world is via financial markets. I have recently discovered the Dollar Milkshake Theory. This counterintuitive but straightforward idea accepts that there is no absolute measure of value in the world of global currencies. Capital driven money flows gravitate to the least bad alternative. In times of financial stress, such as in China, capital flows into the safest, least risky denomination. We saw this most recently in March 2020 when the trade-weighted value of the US$ immediately spiked 4% in the month after the pandemic lockdown. It is noticeable today that while most economic commentaries highlight the sharp rise in US inflation, bond yields have hardly flinched and the US$ has gained 6% in trade-weighted value.


Geo-Politics – As our politicians battle between the “levelling up” interests of the “Red Wallers and the Red Corders”, it highlights the enormous cost of redirecting an economy from the centre. The post-1989 “levelling up” plan in Germany over the last 30 years has involved pumping trillions of Euros into the former East German economy. Yet, today it is estimated to have only closed half the productivity gap with the more prosperous West. The heavy economic lifting in China is enormous and requires people to foot the bill. In the process, this level of commitment might well require a national call to arms. In this context, it is worth noting the heightened rhetoric from Xi Jinping on the CCP’s long-held right to the country of Taiwan. If data is the new oil, semi-conductors is the oxygen that allows data to have life and value in our Ai powered future. Bring back OPEC and its complicated Middle Eastern political ramifications, all is forgiven.


It is pretty easy to read the runes of what might be happening here and reach some uncomfortable dystopian outcomes. It is increasingly likely that the next financial crisis will come from China and its economic repositioning. However, as China lurches towards a more centrally directed economic and monetary policy, the consequences will focus more on the ability of the West, and in particular, the US, to benefit from a relative position of strength with a more decentralised and adaptable economic model. If this is right, then we could see the period of US $ strength continue. The consequences of China deflating its property bubble and restructuring its economy is critical but also unknowable. But we are nearing the end of the era of Chinese exceptionalism, and a new more resilient world economy will be costly to evolve. However, just as the world economy reinvented itself in the 1990s without the Japanese wall of free money or its upward only asset values, it can adapt to a world where China changes its economic shape and role in the world. One thing for sure is that this readjustment will involve bumps in the road and opportunity.




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