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TRILOGY’S WORLD REPORT
January 2016
HAPPY CHINESE NEW YEAR?
We are a bit premature in bringing up Chinese New Year since the Year of the Monkey does not officially begin
until February 8th. But given the way that Chinese market turmoil has shaken global markets in the first few days of
2016, we think it is worth focusing on whether China’s economy and financial markets could begin to stabilize this
year.
After a steady stream of downside economic surprises and clumsy policy moves, many investors fear that China’s
economic problems could trigger a deflationary global recession. The timing of such a recession would be
worrisome since policymakers in developed nations have little latitude to respond with additional monetary or
fiscal stimulus.
After wading through a slew of recent research reports and data releases, we have the following observations:
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We think fears of an imminent Chinese hard landing are overdone.
Recent data suggests that China’s growth is stabilizing after six rate cuts since November 2014.
Risks that China will depreciate its currency more aggressively have risen substantially.
Policymakers are still encouraging rapid credit growth, despite concerns about excess leverage.
Rapid credit growth may help stabilize GDP growth in the short run, but risks a major credit bust in the
future.
ECONOMIC DATA POINT TO STABILIZATION OF CHINA’S GROWTH
We believe fears of an imminent Chinese hard landing represent a knee-jerk response to China’s stock market
volatility. But the stock market historically has been a poor leading indicator of Chinese growth. Recent data
suggests that China’s growth is stabilizing after six interest rate cuts and four cuts in banks’ reserve requirement
ratios (RRRs) since November 2014.
Reflecting China’s aggressive monetary stimulus, Bloomberg’s Monetary Conditions Index has moved up
substantially in recent months (Chart 1). This index is designed to be a leading indicator of China’s GDP growth and
is sending a positive message. Its improved tone reflects lower real interest rates, the weaker currency, and
continued double-digit growth in total credit. Reflecting improving monetary conditions, Bloomberg’s China
Monthly GDP Tracking Index moved up to 6.7% in December from a low of 6.3% in February (Chart 2).
Focusing on early signs from December data, other signs of economic stabilization include the following:
 Purchasing Managers Indexes (PMIs) for manufacturing were broadly unchanged, with the official PMI up
modestly while the widely tracked Caixin Index was down (Chart 3).
 Services PMIs were mixed, with the official index up modestly while the Caixin Index was down. Both
service indexes remained in expansionary territory (Chart 4).
 A variety of other business surveys from Baidu, World Economics and Market News International were
stable or slightly up.
 Metals prices and the CRB Raw Industrials Index rose modestly in recent weeks, albeit off of significant lows
(Charts 5 and 6).
 China’s nationwide housing prices are now rising on every major index (Chart 7).
TRILOGY’S WORLD REPORT
Of course, one major issue in using Chinese data is that virtually no one trusts the official economic data, especially
not GDP data. Indeed, there is a virtual cottage industry of economists who have tried to develop proxies for the
true state of Chinese growth. This is particularly true since Premier Li Keqiang was quoted by WikiLeaks saying that
China’s GDP data was “man-made” and that he preferred to track the economy’s growth by focusing on growth in
bank lending, rail freight, and electricity consumption.
Bloomberg has created a “China Li Keqiang Index” that tracks just those data items and estimates year-on-year
economic growth of only 2.4% as of November (Chart 8). But the index can be criticized for omitting many other
key indicators such as industrial production, retail sales, investment, and exports. These are included in
Bloomberg’s China Monthly GDP Estimate and support a more positive view of economic growth (6.7% year-onyear) as mentioned above.
Numerous other methods of data analysis also show China’s growth to be lower than the officially reported 2015
figure of 6.9% (Chart 9). That said, we still think that the positive trends shown in China’s Monetary Conditions
Index and other broad-based activity indicators should not be dismissed out of hand. Yes, China’s data is suspect.
But the same can be said of economic data for almost every emerging market nation. In our view, the combination
of what Beijing has called “forceful” policy measures and indications from a broad array of data suggest that some
degree of economic stabilization is occurring.
RISK OF A WEAKER CHINESE YUAN HAVE RISEN SUBSTANTIALLY
Even if we are correct that China’s near-term growth prospects have stabilized, the other major issue that has
helped roil global financial markets is whether China is now willing to let the yuan weaken substantially to help
meet the government’s objectives for growth. The answer to that question is likely to be yes, especially in view of
the fact that Beijing permitted a substantial weakening of the yuan so soon after the International Monetary Fund
(IMF) approved its inclusion in the Fund’s prestigious basket of reserve currencies.
All major reserve currency nations have at times permitted their currencies to weaken in response to domestic
economic conditions, so why not China? In fact, one reason to be more optimistic about the potential stabilization
of China’s economy is that some weakening of the currency should help China’s net exports begin to improve.
With China’s broad effective exchange rate down by about 7% since its peak last April, there should be a modest
contribution to an improvement in China’s net exports.
Markets are right to be concerned that a material improvement in China’s net exports could require substantial
further depreciation of the yuan. Analysis by Bloomberg Intelligence Economics recently concluded that a drop in
the yuan to 7.70 to the U.S. dollar would be needed to boost export growth to 10% year on year by the end of
2016 and add 0.7% to GDP growth.1 This analysis is based on looking at the historical relationship between exports
and the real effective exchange rate (REER) (Chart 10).
According to a survey by Bloomberg, the consensus among currency forecasters is for the yuan to weaken only
marginally from 6.57/USD currently to 6.70/USD in the fourth quarter of this year (Chart 11). That forecast implies
a depreciation of only 2% from current levels – which, to be fair to the currency forecasters, is likely yet to have
incorporated their collective reaction to the People’s Bank of China’s recent moves to weaken the yuan.
1
See Fielding Chen and Tom Orlik, “How Low Could Yuan Fall to Restore China Export Growth, Bloomberg Intelligence
Economics, January 7, 2016.
TRILOGY’S WORLD REPORT
It is worth noting that options markets put the likely range of the yuan in this year’s fourth quarter at (+/- one
standard deviation) at 6.22/USD to 7.62/USD. The weaker figure implies that the options market is assigning about
a 15% chance that the yuan will weaken to that level or beyond by the fourth quarter. In effect, currency options
now imply the yuan may move by as much against the U.S. dollar as the euro, yen, or other major currencies do.
That marks a major sea change from a period of many years of steady appreciation of the yuan/USD exchange rate.
The benefits to China of depreciating the yuan do not come without costs. A major cost to China’s economy from
yuan depreciation is capital outflows, since investors who are concerned about further yuan depreciation have a
strong incentive to pull their money out of Chinese assets. Based on the past relationship between cross-border
capital flows and the yuan/USD exchange rate, Bloomberg Intelligence Economics recently estimated that a drop in
the yuan to 7.70/USD could trigger an additional $670 billion in capital outflows (Chart 12).
That degree of capital outflow would still leave China with more than $2.6 trillion in foreign exchange reserves,
which suggests that the problem could be manageable. But such estimates are subject to enormous uncertainty,
especially if outflows were to accelerate from the recent pace. Indeed, recent data suggest that the pace of
outflows has accelerated in recent months with China posting a record $108 billion decline in its foreign exchange
reserves in December (Chart 13). That left China with $3.33 trillion in foreign exchange reserves then, which was
already down substantially from a peak of $3.99 trillion in June 2014.
A drop of $108 billion in foreign exchange reserves in one month annualizes to a pace of $1.3 trillion, or about 13%
of GDP. The accelerating pace of outflows must be of some concern to China’s extremely risk-averse, stabilityoriented leadership team, which spent years after the Asian financial crisis of 1997 building up a large stock of
foreign exchange reserves as insurance against financial calamity. Since they must know that China’s buildup of
domestic debt is running substantial risks of a future financial crisis (see below), China’s leaders will be loath to see
their financial margin of safety diminish as foreign exchange reserves decline.
But if Beijing is committed to maintain reasonable growth even as the economy transitions away from an
investment-led growth model, its leaders may have no choice but to pursue further currency depreciation.
Textbook economic models suggest that if investment declines relative to savings, the nation’s current account
surplus must widen – which is starting to happen now. But to accommodate that widening of the surplus almost
always requires a real depreciation of the exchange rate.
Under a fixed currency regime – think of the Euro area – the real depreciation requires outright deflation in wages
and prices to restore external competitiveness. This type of deflation has been called “internal devaluation” in the
Euro area. When such deflation occurs against the backdrop of a highly indebted financial system – think of Greece
– the result is a sharply contractionary “debt deflation.” For a highly indebted system, the problem with deflation
is that the real burden of debt increases as prices decline, which contributes to waves of bankruptcies and
intensive efforts to pay down debt.
When the exchange rate is allowed to depreciate, real depreciation can be achieved without outright deflation in
wages and prices. That can mitigate risk to a highly indebted financial system, while using higher inflation and
currency depreciation to bring about the decline in real wages needed to improve external competitiveness. Given
the highly indebted nature of China’s domestic economic system, avoiding further internal devaluation and
deflation pressures may now be viewed as the lesser of two evils as their economy copes with strong market forces
caused by over-investment and excess capacity that have built up over many years.
Even now, with bank loan rates of about 4% and producer-price deflation of about 6%, real interest rates remain at
a punitive level of nearly 10% for many corporations. A combination of lower interest rates – which may weaken
the yuan – and higher inflation (or a reduced pace of deflation) would do much to reduce pressure on China’s
export-oriented corporations. Against this logic, it makes sense that currency options markets are no longer
putting zero probability on further large movements in the yuan/dollar exchange rate.
TRILOGY’S WORLD REPORT
One indication that a big exchange rate adjustment may be considered comes from a recent Bloomberg radio
interview with economist Adam Posen, president of the Peterson Institute for International Economics. According
to Posen, IMF chief economist Maurice Obstfelt “is pointing out that there is a risk here that, just like for a small
country, they may be better off doing a big exchange rate adjustment and getting it over with than try to fight it in
dribs and drabs.”2 Posen also indicated that China’s policymakers might need to consider more stringent controls
on capital outflows as well.
CHINA’S DEBT MESS: NO DELEVERAGING FOR NOW, CRISIS RISKS ARE RISING ON A THREE-TO-FIVE YEAR
HORIZON
The rapid rise in China’s debt to GDP ratio in recent years has been widely noted by economists and market
analysts for a very good reason: rapid increases in debt relative to GDP have frequently led to sharp growth
slowdowns or financial crises – or both at the same time. According to analysis by Emerging Advisors Group, since
the end of 2008 the aggregate domestic credit/GDP ratio (including both bank and formal non-bank lending)
increased by nearly 100 percentage points (Chart 14).3 What is truly remarkable about this development is that a
full 25 percentage points were added in the past twelve months alone.
Although the People’s Bank of China (PBoC) wrote persuasively in late 2013 about the need to reduce leverage in
the financial system, the costs of making such adjustments were clearly deemed too high by China’s senior
leadership. Growth was already slowing due to the weak external environment and the real estate slump in China,
so authorities clearly opted to force-feed the system with rapid credit growth. Emerging Advisors Group estimates
that as of the end of November, aggregate domestic credit was growing by 18.5% on a year-on-year basis, which is
three times faster than nominal GDP growth (Chart 15). This includes credit extended by banks and shadow banks
and implies that China is still adding new leverage at a feverish pace.
The dilemma for potential investors in China is this: on a flow basis, this is probably very good news for China’s
GDP over the near term and helps explain the “green shoots” of economic stabilization we discussed earlier. On a
stock basis, however, the deterioration in balance sheets implied by this feverish growth in leverage raises
numerous questions about when it might stop, what might stop it, and what will be the consequences for China’s
growth when the credit taps are finally shut off? At a minimum, we suspect that it will eventually lead to a multiyear slump in property markets and broad-based illiquidity and bankruptcy troubles for local governments and the
construction and infrastructure businesses that feed off of rapid growth in leverage.
The fact that the PBoC and other officials have gone virtually silent on this topic suggests that China’s senior
leaders have decided to deal with this potential problem by “kicking the can down the road,” which is a familiar
maneuver in almost all political systems. Japan, for example, has allowed its national balance sheet to deteriorate
dramatically for several decades without yet facing a major economic or political crisis. In the process, it has seen a
stunning increase in its gross public debt ratio of nearly 200% of GDP since 1990.
So can China simply follow Japan’s lead and simply deal with potential bad loans in the banking system by taking
those loans off the bank’s books and rolling over the loans at low interest rates or simply monetizing the debt? If
there is any kind of plan, we suspect that is the plan.
2
“Posen Says Investors are ‘Overreacting to China News, Bloomberg Radio, January 12, 2016. We could not find a public
reference to Mr. Obstfelt’s views on this topic – which would be major news - so we assume it came through a private
communication with Mr. Posen and does not represent an official position of the IMF.
3The
analysis of this section draws heavily from Jonathan Anderson, “China Won’t Make it Out of its Debt Mess,” Emerging
Advisors Group, January 4, 2016 (subscription required).
TRILOGY’S WORLD REPORT
That said, the path to such an outcome seems likely to involve a banking crisis well before investors have to worry
about a fiscal crisis. And as Emerging Advisors Group has pointed out, a key feature of credit-driven EM crises has
been through high gearing and funding exposures on the liability side of bank balance sheets. That’s because high
degrees of bank liabilities create the flash point for margin calls on the financial system as a whole. And analyzing a
financial system’s vulnerability to crisis involves focusing on measures like credit/deposit ratios or on net external
liabilities.
On those measures, China is still in good shape even though the direction of change is worrisome. A summary
measure of the credit/deposit ratio in Chinese depository institutions has been rising, but is still well below the
115%-to-140% zone that has typically been associated with EM crisis countries (Chart 16). And commercial Net
Foreign Assets (NFAs) as a percent of overall net assets are still in positive territory, even though the multi-year
trend has been downward (Chart 17).
Emerging Advisors Group has created an EM crisis chart which shows how China looks on these measures relative to
a group of EM nations that have experienced financial crises over the past twenty years (Chart 18). Their conclusion
is that China’s financial health indicators have been deteriorating at a rapid pace, but are still not yet close to the
“red line” zone that has seen countries tip into crisis. Here’s what the chart indicates about nations which
experienced financial crises:
 The average EM crisis country had overall credit/deposit ratios of 140% and net commercial bank foreign
liability positions of 15% of total assets.
 Crisis countries with relatively low leverage (e.g. Turkey and Indonesia) had credit/deposit ratios of greater
than 115% and net foreign exposure of 5% of bank assets or more – which represents the minimum crisis
threshold as shown by the dotted red line.
From this work, we can conclude that China is still relatively far from the red line. But if feverish credit growth
persists over the next three to five years, China’s risks of experiencing a systemic financial crisis will have risen
substantially.
CONCLUSION: CAVEAT EMPTOR
In short, the clock is ticking and China’s growth model appears to face immense long-term challenges. But in the
near term, we think the China stabilization call may be the correct economic view, albeit with currency risk now an
elevated source of concern for foreign investors in China.
For China’s domestic equity investors, the situation is further complicated by the fact that the market looks
reasonably valued with an aggregate price-earnings multiple in the mid-teens primarily because bank shares are
cheap – for very good reasons that flow from the previous discussion. But one key measure suggests that Chinese
domestic equity valuations were still extraordinarily elevated at the beginning of the year, with a median priceearnings ratio of more than 60 times on January 5th even after the 7% plunge at the beginning of the year (Chart
19).4 That compares to mid-teens multiples in most other major markets. Against that backdrop, government
efforts to support the domestic equity market seem futile.
For investors in other markets affected by Chinese growth – like all commodity-sensitive markets and most of the
EM asset class – it is a good news, bad news story. The good news is that a near-term stabilization of Chinese
growth could potentially help commodity markets recover. The bad news is that if further yuan depreciation is a
key part of China’s economic stabilization, then commodity prices face yet another headwind from “made in China”
strength in the U.S. dollar and potentially another down leg a few years down the road when China is forced to
deleverage in earnest. On balance, we expect commodity markets to remain in the doldrums unless there is an
impressive upside surprise in China’s growth.
4 Note that
Chinese shares accessible to foreign investors, as reflected in the MSCI China index, trade at a much more reasonable
median price-earnings ratio of 12 times.
TRILOGY’S WORLD REPORT
The good old days for commodity producers of massive, frenetic Chinese credit growth along with a rising yuan
seem over for good. But for consumers of commodities – and that is most of us – there is a silver lining. When
China was booming, there were legitimate concerns that their huge buying power in commodity markets was
“crowding out” rich-world consumers by pushing up prices and reducing their real incomes.5 Now the reverse is the
case, and we think investors could end up surprised by the positive implications for growth in the developed nations
later this year as the immediate negative effects on commodity producers begin to fade.
On that positive note, we wish our readers a happy and prosperous New Year.
William Sterling
Chief Investment Officer
Trilogy Global Advisors, LP
(212) 703-3100
[email protected]
5
Consider this analysis from The Economist, September 11, 2014: “Commodity prices are acting as regulators of global growth.
The emerging markets are first in the queue for supplies because they are often able to use each extra barrel of oil or shipload of
ore more gainfully. Their demand raises prices and lowers real incomes in the rich world, which gets crowded out. Rich countries
had become used to unlimited access to cheap raw materials: prices had been falling for a century or more. Now there is
competition for primary resources. Producers are benefiting and rich-world consumers are suffering, at precisely the time when
they are also increasingly anxious about job security as China and India rise and rise.”
TRILOGY’S WORLD REPORT
IMPORTANT INFORMATION
The opinions expressed above are those of Trilogy Global Advisors, LP and are subject to change. There is no
guarantee that predictions or expectation will come to pass. This material does not constitute investment advice
and is not intended as an endorsement of or recommendation to purchase or sell any specific investment or
security.
Investment involves risk. Investing in the securities of non-U.S. companies involves special risks not typically
associated with investing in U.S. companies. Foreign securities tend to be more volatile and less liquid than
investments in U.S. securities, and may lose value because of adverse political, social or economic developments
overseas or due to changes in the exchange rates between foreign currencies. In addition, foreign investments are
subject to settlement practices, and regulatory and financial reporting standards, that differ from those of the U.S.
The risks of foreign investing are heightened for securities of companies in emerging market countries. Emerging
market countries tend to have economic structures that are less diverse and mature, and political systems that are
less stable, than those of developed countries. In addition to all of the risks of investing in foreign developed
markets, emerging market securities are susceptible to illiquid trading markets, governmental interference, and
restrictions on gaining access to sales proceed.
Certain information herein has been provided by independent third parties whom Trilogy believes to be reliable.
Although all content is carefully reviewed, it cannot be guaranteed for accuracy or completeness.
Any graphs, charts or formulas shown are not and should not be used as the sole basis of making investment
decisions. There can be no guarantee that any forecast or projections will be realized or attained.
Source: MSCI. The MSCI data is comprised of a custom index calculated by MSCI. MSCI makes no warranties or
representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI
data may not be further redistributed or used as a basis for other indices or any securities or financial products. This
report has not been produced or approved by MSCI.
© 2016 Trilogy Global Advisors, LP. All rights reserved.
TRILOGY’S WORLD REPORT
CHART 1
Source: Bloomberg
Aggressive monetary easing has led to a sharp rise in recent months in Bloomberg’ Monetary
Conditions Index for China. This suggests some stabilization or modest improvement in
China’s 2016 growth.
CHART 2
Source: Bloomberg
Bloomberg’s China Monthly GDP Tracking Index improved significantly over the course of
2015, recovering to 6.7% in December from a low of 6.3% in February.
TRILOGY’S WORLD REPORT
CHART 3
Source: Bloomberg
Purchasing Managers Indexes for December point to economic stabilization, with the official
PMI up modestly while the widely followed Caixin Index was down.
CHART 4
Source: Bloomberg
China’s services PMIs were mixed in December, with the official PMI up modestly while the
Caixin Index declined. Notably, both indexes remained in expansionary territory.
TRILOGY’S WORLD REPORT
CHART 5
Source: Bloomberg
Metals prices in China rebounded modestly from historic lows in recent weeks, although it is
far too early to call the bottom in the bear market in metals.
CHART 6
Source: Bloomberg
The CRB Raw Industrials commodity price index has been trending up since late November,
despite recent concerns about China’s economy and financial markets.
TRILOGY’S WORLD REPORT
CHART 7
Thanks to Rapid Credit Growth, China’s Housing Prices are Rising Again
Source: Emerging Advisors Group
China’s nationwide housing prices are up on every major index, indicating that policy
measures to support the economy are beginning to gain traction.
CHART 8
Source: Bloomberg
A simple proxy for GDP attributed to Premier Li Keqiang shows year-on-year growth as of
November of only 2.4% based on growth in credit, rail freight, and electricity consumption.
TRILOGY’S WORLD REPORT
CHART 9
Numerous Proxies for China’s GDP Growth Suggest
Growth is Slower than Official Data Indicate
Numerous other methods of data analysis also show China’s growth to be lower than the
officially reported 2015 figure of 6.9%.
TRILOGY’S WORLD REPORT
CHART 10
Source: Bloomberg
Year-on-year changes in China’s real effective exchange rate (REER) have been strongly
related to export performance. Bloomberg estimates that a 13% drop in the REER could
prompt 10% export growth.
CHART 11
Source: Bloomberg
Currency options imply that the CNY/USD exchange rate will trade in a range of 6.22-to-7.62
in the fourth quarter of 2016, implying much greater CNY currency risk than the consensus
forecast of 6.70.
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CHART 12
Source: Bloomberg
China has let its currency decline from 6.04/USD in January 2014 to 6.59/USD now. The
modest depreciation of 8.3% over nearly two years has prompted large capital outflows.
CHART 13
Source: Bloomberg
China’s foreign exchange reserves stood at $3.33 trillion in December compared to a peak of
$3.99 trillion in June 2014. But the pace of capital outflows accelerated to $108 billion in
December.
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CHART 14
The China Syndrome: Massive Growth in Financial Leverage
Source: Emerging Advisors Group
China’s leverage continues to ramp up. Since 2008, China’s aggregate credit/GDP ratio has
increased by nearly 100 percentage points, of which 25 percentage points were added in the
past year alone.
CHART 15
Unsustainable: China’s Credit is Growing Three Times the Pace of Nominal GDP
Source: Emerging Advisors Group
As of the end of November, China’s aggregate domestic credit was growing at an 18.5% yearon-year pace, which is three times faster than nominal GDP growth.
TRILOGY’S WORLD REPORT
CHART 16
China’s Credit/Deposit Ratio is Deteriorating, but is Not in the EM Crisis Zone
Source: Emerging Advisors Group
The ratio of credit-to-deposits is a useful indicator for how vulnerable an EM banking system
is to a run on deposits. China’s credit-to-deposits measure remains OK, but the trend is
worrisome.
CHART 17
Commercial banks’ net foreign assets (% of overall net assets)
Source: Emerging Advisors Group
China’s banking system is a net creditor to the rest of the world and its net foreign asset
(NFA) position is strong, although there has been a clear downward drift over the years.
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CHART 18
China’s Banking Safety Measures vs EM Crisis Countries
Source: Emerging Advisors Group
China’s banking safety measures imply little near-term risk of a financial crisis, but the
direction of change is a concern. Five more years of rapid credit expansion could push China
into the high-risk zone.
CHART 19
Source: Bloomberg
Even after the stock market rout on the first day of the New Year, the median price-earnings
ratio of Chinese domestic stocks exceeded 60 times.