External Circulation Strategy - Moving from Multilateral to Bilateral 

The conclusion of the 20th Party Congress led to major market selloff in Hong Kong because investors were not cognizant of the “stability” thesis in the context of self-sufficiency on food, energy and core technologies notwithstanding the impetus to rejuvenate the nation.  The uncertainties in the investment community are understandable as they had been patiently looking forward to relaxation of Zero-COVID policy and stronger demand side stimuli to improve corporate earnings.  While it is more difficult to comprehend the logic of internal circulation (to be explained later in this paper), the strategic clarity on external circulation is tremendously high.

The series of high-level visits by head of state to Beijing right after the Party Congress testifies the economic importance of China to the rest of the world.  The state visit by German Chancellor Olaf Scholz on Nov 4 with a group of titan conglomerates totaled more than 60 people was monumental as Germany has become the first country from the EU to visit China since 2019.  Prior to his visit, the German cabinet approved an investment by China’s COSCO for a 24.9% state in one of logistics firm HHLA’s three terminals in Hamburg, the largest port in Germany.  In 2021, China was Germany’s most important trading partner for six consecutive years, with total trade (exports to and import from) reaching EUR245.4 billion.  Leaders of other European countries are planning to visit Beijing next year, which includes France, Italy, Spain and Netherlands. 

Panning to the South Hemisphere, the General Secretary of Vietnam also visited Beijing fostering deeper trade ties as China has become Vietnam’s biggest trading partner.  Vietnam custom data shows bilateral trade with Vietnam reached USD165.8bn in 2021, up 33.5% on year.  Pakistan President also came forth to rekindle the next phase of China Pakistan Economic Corridor (CPEC) development, though no concrete financial arrangements were announced.  At the G20 summit in Indonesia, Australia and China achieved diplomatic breakthrough in re-engagement since bilateral relationship turned south in 2016.   The large volume of trade between them needs to secure a floor on their relationship. China’s imports from Australia, mainly attributed to commodities, accounts for 6% of the total imports in 2021. The importance of Chinese market to Australia is unneglectable. China accounts for 39% or 29% of Australia’s total exports in 2021 and 2022 YTD. The meetings were widely reported as constructive and positive by both governments. 

There are no countries suggesting China is going backward in trade openness.  In fact, the opposite is happening.  Although the strength of trade in 2022 was not as strong as previous years, China’s trade surplus in the first 10 months still exceeded USD800bn.  By trading bloc, trade with ASEAN up 14.2%, EU 6.1%, and US 5.0%.

As far as RCEP is concerned, China is ready to take advantages of the tariff-free framework to achieve greater mutual economic benefits.  Under the RCEP, the region is moving steadily towards a large unified market as tariffs gradually will be eliminated.  This development will reconfigure supply chains based on comparative advantages. The intra-regional circulation is thus an extension of China’s external circulation strategy.

In fact, evidences are mounting to substantiate a positive outlook next year.  Trade momentum within the RCEP has been gaining steady traction.  China’s trade with RCEP countries accounted for 30.7 % of total trade value or USD1.6tn in the first 10 months, confirming RCEP has already become China’s largest trading partner.  Exports and imports between China and RCEP members amounted to USD822bn and USD792bn respectively.  In particular, ASEAN accounts for 15.2% of China’s total trade, reaching USD802bn. Breakdown of import shows mechanical and electrical products accounted for 19.3%, basic metals 22.3%, and agricultural & food products 16.1%. Agricultural and food imports from ASEAN totalled USD29.5bn, up 19.3% on year.   The bottom line is China has clearly started importing more from ASEAN, which is crucial because this helps incentivising them to consider using RMB as settlement currency gradually within the bloc in the longer run.

Going beyond ASEAN, trade growth with other RCEP members such as South Korea and Japan are also growing steadily. The value of exports to Korea surged 13.8% to USD138bn YTD.  According to Korea International Trade Association, out of South Korea's USD69bn memory chip exports in 2021, exports to China accounted for 48%.  Japan which signed a free trade agreement with China for the first time through RCEP saw bilateral trade amounted to USD89.6bn in 1Q22, albeit turned South in 2H amid lackluster economic condition of Japan.   Economic interdependence between Japan and China remains deep despite a thorny bilateral relationship.  In 2021, China accounted for 21.6% of Japan’s exports and 24.5% of its imports, surpassing the US’ 17.5% and 10.5% respectively.  Foreign direct investment from Japan in China was about USD10bn in 2021.  The economic reality drives Japan and South Korea to secure a stable relationship with China as evidenced by constructive meetings between them at APEC held at Thailand right after G20 Summit in Indonesia.

Although outlook of the global economy remains subdued in 2023, the markedly improved diplomatic environment after the 20th Party Congress alongside steady trade momentum within RCEP pave the way for Beijing to take this strategic window of opportunity to push the agenda of RMB internationalisation forward in 2023.

Internal Circulation - A New Mindset at Play

Considering the dwindling macroeconomic conditions in the past 18 months, deployment of monetary loosening via more aggressive rate cuts and reserve requirement ratio reduction from the old playbook should come forth earlier.  Benchmark interest rate only fell marginally by 20 bps and RRR was lowered by 125bps.  The cautious approach adopted is likely to be attributed to three reasons: (1) Probably the central bank had been waiting for the Fed to halt hiking rates first; (2)  they are vigilant of rising inflation which is a global phenomenon; and (3) loosening monetary policy contradicts the goal of deleveraging in the property sector.

The latest case study says a lot about the new mindset.  CBIRC and PBOC issued a 16-point set of internal directives to promote “stable and healthy development” of the industry.  The prime goal of the measures is to ensure credit support for debt-ridden developers so that they can complete unfinished projects and consequentially hand them over to buyers.  The guideline ordered banks to treat state-owned and private real estate enterprises equally and to extend loans to distressed developers.  However, these measures do not include relaxing the three red lines imposed on banks that stipulate (1) liability-to-asset ratio excluding advance receipts of less than 70%, (2) a net debt-to-equity ratio of less than 100%, and (3) a cash to short-term debt ratio of 1. 

It effectively means banks will have to shoulder more risks for those distressed developers that could be saved with higher probability.  It implicitly means those that can’t be saved will likely be spared.  A deeper consolidation of the sector is due to happen.  Liquidity conditions will improve for selected developers but the overall outlook of the sector ultimately hinges on demand for housing, which are still clearly restrained by unfavorable macroeconomic conditions and on-going intermittent lockdown across nation to fend off the spread of COVID.    According to the property bond and equity prices index from our equity research team, property developers bond prices reaction have been muted versus the hyped responses of equity prices. This indicates that the latest policy is a big step in the right direction at the margin.  The demise of the sector is yet to stage a fundamental reversal.

In the past, the property sector was being used as a cyclical tool to manage the economy.  Although it is reasonable to expect more relaxations will come gradually in 2023, the prevailing management mindset is a clear departure from the past.  The latest rescue plan for the property sector is a supply side policy to better manage risk rather than a demand side stimulus.  A cautious approach is a signature of new economic management mentality.  

Key Infrastructure Push in Utility Investment

China has adopted an investment strategy focuses on utility infrastructure benefiting long term well-being of the population.  The context of comprehending these mega projects is that they are long term projects spanning from at least 5-year to a decade.  They are not exactly counter-cyclical tools to buttress short term GDP growth shortfall.   There are four key infrastructure investment which include water conservancy, increasing solar/wind/electricity capacity, transportation, and data centers.    

The onslaught of heatwave and droughts heightened authority concerns on water security.  According to Ministry of Water Resources, they had invested RMB703.6 billion in water conserving infrastructure projects in the first 8 months of 2022.  The South-North Water Transfer Project, that aims at relocating water from the Yangtze River to Northern China kicked off construction in Jul 02 and will carry forward to 2023 and beyond.  Other major projects include Guangdong-Beidu Gulf Water Resources Allocation Project, and the Floodgate Reconstruction Projects along the Yellow River to improve irrigation in the critical grain production region between eastern Shandong province and Henan province. 

Likewise, the authority is expanding the nation’s solar capacity, which saw an 137% increase on year equivalent to 31 gigawatts in 1H22.  Ongoing projects include six large scale renewable projects in Liaoning province comprising wind, solar and nuclear energy aiming to achieve 60GW worthy of power capacity, which is more than the total capacity of Vietnam upon completion.  National Development and Reform Commission is also planning to build a further 450GW of solar and wind capacity in Gobi Desert.  As far as railway transportation is concerned, there are a total of 25 projects underway, which will increase China’s total rail length by more than 5,300km.  Beijing aims to achieve 200,000km of railway by 2035.  Recent project commencement included a key section of Beijing-Xiongan-Shangqiu High Speed Railway so as to improve transportation access to Xiongan, which is picked by President Xi to be developed into a “dream city”.  Elsewhere, a grand project called “East - West Data Transfer” already commenced in 1Q22.  The goal is to develop the digital infrastructure in the West to match the East.  According to National Bureau of Statistics, the growth of data centers averaged 30% per annum from 2015-2020 to 5 million, and are projected to advance more than 20% from now to 2025.

Financing all these mega infrastructures are however a challenge, especially when China’s 31 provinces reported a combined deficit (general public revenue minus expenditure) of RMB6.7tn YTD in October, the biggest deficit since 2012 driven by 26.0% fall of land sales and COVID control measures. General public revenue fell by 4.5% as tax break and value-added tax returns reached CNY3.7tn and CNY2.3tn respectively. On-budget fiscal deficit is projected to rise to 3.2% of GDP in 2023 from 2022’s 2.8%.  Combining with maturing debts from 23 onward till 25, the financial stress of local governments will remain high.  Funding will have to come from Special Purpose Bonds (SPBs).  Although central government sped up the issuance of SPBs, the execution criteria is strict. 

Local governments cannot issue SPBs directly as central government is fearful of them abusing this funding channel.  They must go through an approval process from central government under the condition that the allocated funds must be used in the “same year” the bonds are issued.  Also, repayment to SPBs must come from income generated by the projects local governments have financed.  Due to such stringent requirements, funds raised through these SPBs had not been able fully utilized at the working level.   Once again, the same cautious approach seen in monetary policy is equally apparent in infrastructure investment.

Conclusions

The Anglo-Saxon prescriptions to loosen monetary policy and expansionary policy to heal an ailing economy regardless of long-term structural costs no longer applies to China. Markets participants need to figure out the logic behind the sequence of policies to be expected instead of hyping blindly for fiscal/monetary stimuli based on high-frequency headline economic figures.  In this regard, I argue supply side policies to rationalize risks will continue to prioritize over demand side boosting policies in 1H23.  This is the essence of the internal circulation strategy.  Stimulus will eventually come when long term structural risks are ring-fenced to a degree authorities feel comfortable enough.  It is thus unfair to argue China is walking backwards when they have chosen to take a bitter medicine. Besides, the external circulation strategy is moving in full throttle under a markedly improved diplomatic environment after the 20th Party Congress.     

It was the partial adoption of Anglo-Saxon economic management that brought China into the current economic dilemma.  Beijing is taking the right medicine now to rectify structural ills.  If such route is deemed to be a dangerous option, majority of world leaders would not come forth to secure closer economic ties with China.  It is important to comprehend the grand chess board than over-extrapolating high frequency economic data to argue for monetary loosening because they only expound so much.  Such approach had already proven wrong repeatedly in the past 18 months. 

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