Fraser Howie on How Slowing Growth, Rising Debt Levels, and Global Skepticism Will Define China's Next Chapter

Fraser Howie is one of the most astute observers of China’s banking and financial systems, and his book Red Capitalism: The Fragile Foundations of China’s Extraordinary Rise is required reading for anyone who wants to understand China’s transformation from an impoverished backwater into a powerhouse of authoritarian capitalism. Fraser has spent over two decades trading, analyzing, and writing about Asian stock markets and has worked for companies including Bankers Trust, Morgan Stanley, CICC, and CLSA. He is a regular commentator on Asian financial markets and monetary policy for international print and television outlets.

MarcumBP’s Drew Bernstein caught up with Fraser recently to understand his views on how the economic and business environment is changing and the challenges that Chinese policymakers face.

China's Slowing Growth Trajectory

Drew Bernstein:  

Let’s start with the big picture of where China's economy is headed. Some analysts now say China's GDP growth numbers are vastly overstated and see signs of an incipient recession. Others maintain the government is now going to be engaging in another round of stimulus that keep the growth engine humming. Where do you come out?

Fraser Howie:     

As always with China, it's so big that both of those narratives are true in their own way. We know that the GDP and many other statistics in China are massaged.  Whether real growth is six percent or three percent or four percent is almost secondary. What's very clear is the path of growth is downward. There's no real chance of that recovering. Quarterly data that shows a stronger economy merely means it's not falling as fast as it was.

But I think more important is the new global environment for China, which has frankly never been seen before. If you're a foreign company looking go into China, doing business in China is becoming much more problematic.

As for companies onshore, it's very tough for private companies, especially. You see a rise in defaults on private companies. You see an urge to get money out of China for fear that there aren't quality investments onshore.

As for stimulus, it's very clear that the government is not going for the big bazooka stimulus. But they have certainly not stepped back from supporting their economy. They are trying to finesse things, because they wasted a lot of money bailing out companies and banks in the past, and they realize that this ultimately can't go on forever. But confidence in the government and its capacity to act remains high.

"Whether real growth is six percent or three percent or four percent is almost secondary. What's very clear is the path of growth is downward. There's no real chance of that recovering." 

This is not Venezuela. If China wants to build some massive infrastructure or release some money into the financial system, it's going to follow through on that. As long as there's confidence in China’s government following through, things will continue to trundle along or grind slowly down.

Is it a recession? It depends. Are you private? Are you state-owned? Are you foreign? It is a mixed picture. But it's certainly a bleak and a very difficult environment to do business in now.

DB:

Let’s turn to China's banks, as you're arguably the leading foreign expert on China’s banking system. What shape are the loan portfolios and balance sheets of China's large banks in today?

FH:

For the large state-owned banks, they're certainly not insulated from problems. But because of their sheer size, they command a lion's share of deposits. So, they have that liquidity. When you get further down the list, whether it's city or provincial or commercial banks, they don't have that national reach for deposits at all, and so things become much harder.

The big banks continue to lend primarily to state-owned enterprises. Even as the government tries to bring in targeted measures to push money into the private sector, the safer banks are just not willing to lend to these private companies. Why? Because the private sector is struggling to make a return. And there’s no implicit backstop to the credit.

Do I trust the large banks’ non-performing loan numbers? No, of course I don't. But there’s little reason to see a massive credit default coming. There's clearly pressure on some of these smaller companies, clearly a lot of bond defaults. But the government will act when required. That's not saying the government bails everybody out. But when it comes to depositor's funds, I think the government is going to do all it can, including forcing organized mergers and consolidation.

Three or four years ago we were talking about these problems being out there. They rolled the dice again — they extended debt and rolled over bonds.  Now the ability to do that's become even harder.

Move to a Cashless Society

DB:

The massive growth of China’s digital payment platforms, Alipay and Tencent, has had a huge impact on how ordinary Chinese handle their payments, take out loans, and manage savings. What are the implications for the banking system?

FH:

The Chinese financial system has changed dramatically because of the rise of services like Tencent with WeChat Pay and Alipay. While foreigners have been kicking and screaming to get into China’s financial services market for many years, even if you were able to come in now, the entire environment has moved against you. Whether you are MasterCard or Visa or whatever, you're coming into a very different China.

The cashless society has been able to take root in China so fast because the infrastructure beforehand was so poor. I've lived in Hong Kong and Singapore and traveled the world, and I find it very easy to pay for things with a credit card. In China, it was not easy — credit cards were not accepted. Now China has leapfrogged the developed world in pervasive cashless payments, and that looks very impressive. But I don't think it's a replicable model elsewhere.

The banks clearly are under pressure from these platforms. Alibaba’s money market fund was just hoovering up a lot of funds within their investment products. And now they are the primary customer interface. As a Chinese consumer, who do I think of to provide financial services? For many Chinese, it's WeChat and Alipay. It's not necessarily their bank.

But I generally find that people tend still to link those payments systems back to their underlying bank account and don't carry too much within the WeChat payments themselves.

The banks are clearly pushing back with the help of the government. There were some rules came out last year requiring these payments systems start carrying capital buffers and placing their deposits with the central bank.

"The electronic payments platforms allow China to effectively turn you off from the banking system very easily through administrative measures with just a few keystrokes. They also help to keep the flows of capital within inside the system rather than allowing them to leak out."

DB:

That was actually my next question. How does the PBOC requiring they be the custodian of these deposits impact the business models of Ant Financial and Tencent?

FH:

It's probably throwing a bit of a spanner into the works. It's almost certainly going to constrain these companies’ profitability and it sends a very clear signal to them. In Xi Jinping's China, the private sector is subservient to the Communist Party, and the state has no qualms at all about exercising its influence in the financial arena. It has probably curtailed some of their growth and you will see greater caution on the parts of those FinTech companies.

DB:

What challenges does it create for the central bank that China is going cashless so quickly in terms of managing the monetary system and the economy?

FH:

In some ways it probably helps the government, because so much now has become digital. That makes it highly traceable, highly controllable, easy to profile. In the West, there are now more 100-dollar bills in circulation than ever before. Why? Be it bribery, criminal proceeds, tax evasion, or just good old-fashioned libertarian freedom of money — cash gives you a tremendous flexibility. It gives a degree of privacy about how you pay people, how you move your money around, who gets to know about it.

In China, they are trying to automate that information, bring all the data into one system. The electronic payments platforms allow China to effectively turn you off from the banking system very easily through administrative measures with just a few keystrokes. They also help to keep the flows of capital within inside the system rather than allowing them to leak out.

DB:

Both Alipay and Tencent have recently moved very aggressively to expand to international markets. How successful do you think they can be in replicating what they've done in China in other parts of the world?

FH:

It's interesting you mention that. I'm in Singapore and I think basically all the cabs have Alipay or WeChat wallet available as a payment option. And for these platforms, the first step is simply to allow Chinese tourists who have gone overseas to use their domestic account to pay for things offshore. But if you ask the cab drivers how frequently they get used, the answer is, not much.

In developed countries, it's already pretty easy to pay for things. People are much more established with banks and bank cards, credit cards or debit cards. I'm always amazed how much traction local systems can get. Here in Singapore when you speak to the cabbies, half of their payments are something through something called NETS, which is a local Singapore payment system of the Singapore banks. People grow up with it, it works, it's fine. So why am I changing?

Another challenge is that many of these Chinese systems are not compatible even back into China. That's because of currency controls. Even if you've got a lot of China connections or you have a need to go to China, using those systems offshore actually doesn't help you. It's almost like there is a great dividing wall between China and the rest of the world.

Xi's Brand New Shiny Stock Market

DB:

I'd like to shift focus and ask about the capital markets. President Xi has placed his personal prestige between this new Shanghai High-tech Innovation Board. Do you think it's going to be successful in attracting China's large tech companies?

FH:

We know that there are plenty of companies in China who are looking to list and raise funds. If you just open the papers, the Chinese stock market is up three percent just today. It’s been on an absolute tear this year.

So, they will be successful in attracting some domestic startups. Are they going to be able to bring back the likes of Alibaba? That's far from clear. The new tech board is promising to be much tougher on delisting, so it basically gets rid of the lemons a lot quicker. Whereas on the main board you can survive there for years. The real question is, what about two or three years out when these startups, which have growth, don't actually turn a profit or get to critical mass?

If these acorns grow into diseased trees, are they going to follow through with a quick delisting? When it comes to listing companies and pitching a story, at the moment when markets are hot, I think it will be a success. Two or three years from now, if companies are not making a profit and start delisting, it may be a very different story.

"Hong Kong's problem now is it's forever trying to steal someone else's lunch. You're trying to capture Chinese companies, or even more strangely, companies from elsewhere in the world, with some sort of a lure of Chinese capital."

DB:

Last year Hong Kong also made some pretty significant changes to their listing requirements to try and be more competitive for technology and biotech companies. How has that gone so far?

FH:

Decidedly mixed. Hong Kong's problem now is it's forever trying to steal someone else's lunch. You're trying to capture Chinese companies, or even more strangely, companies from elsewhere in the world, with some sort of a lure of Chinese capital.

They obviously regretted missing out on Alibaba and some of these huge listings which went overseas because of the dual voting class. It’s a pretty ropy bag of companies have listed under the new rules. If you're in the biotech or tech space, the pool of investors and the people who know these markets are generally in the States. Hong Kong is coming under increased pressure with this High-Tech Innovation Board in China.

There's certainly a case for listing in your genuine home market, which is the mainland, or for listing in the stock market which is globally known, which is the U.S. Hong Kong is neither fish nor fowl. Just this year, Hong Kong issued a big three-year strategy paper and it basically came down to a few slogans and very simply trying to get more access to China.

DB:

Hong Kong seems to be working hard to become a portal for overseas investors to take short or long positions in the A-share market, and for domestic Chinese investors to invest in overseas securities. Will that strategy be successful for them?

FH:

It's been successful in the immediate term in that what was a very closed market, has become a relatively open market. The settlement system works, and the recent bull market has attracted record flows through their Stock Connect programs. But ultimately, it's destined to be limited.

If you are the Shanghai and Shenzhen stock exchanges — who are ultimately state-owned enterprises paying taxes to local governments and have a lot of clout back into Beijing — why on earth would you say, “Yes, yes, please give our business and access away to Hong Kong?”

These exchanges want investors to come directly to them through the front door. Actually, I was just up in Beijing ten days ago speaking to the regulators, and their view is that Hong Kong is effectively a side door. They want the QFII (Qualified Foreign Institutional Investor) program to be the front door for traditional large investors. But Stock Connect may be a useful tool for smaller or retail investors.

Also, the northbound Connect brings no business to the local domestic Chinese brokerage industry because it's all coming via Hong Kong. As for Hong Kong being a portal for money to go out of China, ultimately, when they sell their shares using Connect, that money goes straight back into China and it is settled onshore. How on earth can Shanghai say we want to be a global financial center when we actually allow all of our business to flow through Hong Kong?

Challenges for China's Central Bank

DB:

Turning back to the central bank, recently the governor of the PBOC (People’s Bank of China), Yi Gang, had a press conference where he took the blame for creating a credit crunch that had a negative impact on small and medium businesses. What kind of pressure is the PBOC under and how do you see their policies evolving?

FH:

The PBOC is basically being asked to do the impossible — trying to clamp down on shadow banking, to follow through with deleveraging, but not harm economic growth. I think shadow banking did play a positive role of financing private companies in some cases. But certainly, it is a non-formal, poorly regulated, poorly documented type of lending. They're trying to clamp down. But then when the slowdown inevitably comes — because these are relatively blunt instruments — they have to rush out with more dedicated and targeted measures trying to help those same private companies.

The PBOC is basically being asked to do the impossible — trying to clamp down on shadow banking, to follow through with deleveraging, but not harm economic growth. 

I think they are in a horrible position of trying to have your cake and eating it. It’s a bit like driving along the freeway. You can veer out of the lane a bit, just as long as you don't go into the oncoming cars or into the ditch.

Because there's so much liquidity, they're constantly having to deal with bubbles, whether it be in property or stocks. They're obviously worried about private sector defaults and the contagion aspects of that. You will see the PBOC continue to be an active policymaker, but a contradictory policymaker, as well.

DB:

How big of a risk is devaluation and capital flight at this point in the cycle and how will that impact PBOC policies over the coming years?

FH:

As long as there is one party rule in China, there will never be a free-floating currency. The capital controls are simply too useful and strong a measure to get rid of. In the immediate term, capital flight does not seem to be much of a problem.

When you have stock markets up 40% and when you have Chinese government and policy bonds coming into global bond indices — we are talking about hundreds of billions of dollars coming in through the bond market — capital flight is not a major concern. We know that MSCI is raising China’s weightings. At the moment, there's a case to be made that lots of net capital is coming into China.

As for devaluation, if you are talking about a 10% type of devaluation, I do not see that happening anytime soon, simply because it’s such a destabilizing factor. I do not even see it being a nuclear option in a trade war. If you want to piss Donald Trump off, go ahead and devalue your currency 10%. He's just going to go ballistic, raise tariffs again, throw more toys out of the pram. I simply don't see the Chinese being willing to employ that. They want everything to be moving in small moves, going up if they can, not going down in terms of asset prices.

DB:

A few years ago, there was a policy directive to make the RMB into a true international reserve currency. Where are we on that project?

FH:

Literally as soon as China got into the IMF’s SDR (Special Drawing Rights) basket, they increased the capital controls. One of the points that I always made with Chinese regulators is, you'll never be a reserve currency, because your capital markets aren't open enough. While China is a huge bond market in terms of issuance, the liquidity of many of those bonds leaves a lot to be desired. It's one thing to go hang them up, but is it a market where you can trade?

If you look at one pool of currency which is the renminbi offshore deposits in Hong Kong, that is basically down 50% from its peak in 2014. It's basically flatlined.

The renminbi is a currency that largely people don't get involved in unless they actually need it. It will not be a reserve currency because the Chinese are still very controlling of it, both onshore and offshore. Your ability to borrow the currency is still highly restricted.

Dollars are like air, atmosphere. You go anywhere and it's there — you can breathe.

You want to change dollars, someone's got dollars, someone's got a use for it wherever you are. That's simply not true with renminbi. Your ability to short the currency, to borrow the currency for whatever reason, is limited. So, I think there's some ways to go before we can even say there is a modicum of success.

DB:

We started off talking about skepticism around China’s published GDP numbers. You've been watching China for a long time. Are there particular data sets that you consider more reliable and others you tend to discount?

Avoiding a Trade War Train Wreck

FH:

The biggest problem with GDP in China is it's not an output of their economy — it's a political target.

When your Premier stands up at the once-yearly meeting of parliament and says the GDP for this year will be this! — that's what it's going to be. So, any indicator that is not political, I would argue provides better information. There is no one data set. I pull numbers from a whole host of places and I take anecdotal stories. You have to look at broader trends, rather than month-by-month.

China is clearly in a much tougher environment right now. You see that with the bankruptcies. Clearly things are slowing down. But there's also a question, if you're an American company and you set up in China, is that even a good idea? You're going to be targeted by your own politicians about why are you sending jobs to China.

On the other hand, you set up shop in Malaysia, nobody even bothers to ask the question. You set up in China you're putting yourself in the cross hairs.

DB:

As an investor, are there particular sectors where you see more opportunity and particular sectors that you would want to avoid?

FH:

I think the shine is coming off of a lot of the hubris in the venture capital space in China. There was a lot of money that went in there just a few years ago and this was going to be the next big thing. I think now there’s a much tougher and more cynical and harsher attitude about these companies being able to deliver, particularly in the consumer space.

The Chinese consumer was held out there as the world's biggest consumer market of the future. Those promises have not actually materialized. Yes, the Chinese consumers are spending. But they're actually spending more on credit than you would like to think. They are not necessarily as rich as you would like to think. They are much more fickle consumers than you would like to think. So I foresee some disappointment on the horizon.

DB:

With all the big U.S. tech companies that are launching in 2019, couldn’t that create the opportunity for these Chinese VC-backed “unicorns” to have successful public exits as well?

FH:

It could work out that way. But I think you need to consider not just the VC exit, but the underlying company businesses. People can make a good return because they've ridden the right part of the cycle and time it just right. But how well is this actually going to develop for public investors? Are you going to get that critical mass to ultimately justify those valuations? And with the Shanghai Tech Board how are the locals going to respond, when all this promise of high tech is exposed? Many of these companies I think will be exposed as not particularly good.

DB:

Last question, where do you think we are heading with the trade war? Is there a path to de-escalate?

FH:

The trade war is very important in some ways. I just read where Jean-Claude Juncker (President of the European Commission) in a meeting with Xi Jinping is saying, essentially: "It's intolerable. We cannot go on like this where China is closed to European companies, yet Europe is open to Chinese companies."

But I think beyond that the domestic environment in China is decisive and it’s clearly suffering. We've been seeing this fast buildup of credit for the best part of a decade in China. Everyone says: "Yeah, yeah, yeah, don't worry about it, don't worry about it." Yet there's a cost to all that debt and that is now very much coming home to roost.

Many of those bonds — I'm thinking local government financing vehicles where there's three to four years of debt issuance — you went through the first one, and they rolled it over. "Hey, look at us, look how great we are." And now the second roll is coming up, and they're saying, "Oh God, we still can't pay any of this off." Everyone’s struggling to just roll over the growing mountain of debt rather than actually pay anything back.

So, wherever you look it's just becoming tougher for things labeled China. A decade ago, everything was "China, China, China let's go, go, go!" Now it's just getting much, much tougher and that has consequences. It's just much tougher to do stuff.