China Watch

Doug Nolan

I’ve held the view that Chinese finance has been at the epicenter of international market unease. The U.S./China trade war was not the predominant global risk.

It has had the potential, however, to become a catalyst for Chinese financial instability.

And there remains a high probability for an eruption of Chinese disorder to quickly reverberate through global markets and economies.

To be sure, rapidly deteriorating U.S./China relations were a major contributor to this summer’s global yield collapse and bond market dislocation.

At this point, I’ll assume some “phase 1” deal gets drafted and then signed by Presidents Trump and Xi next month in Chile.

In the grand scheme of things, little will have been resolved.

It appears many of the most critical issues between the world’s two rival superpowers have been excluded from the initial compromise, I’ll assume tabled for some time to come.

Short-term focused markets are content with a “truce,” welcoming a period of reduced risk of a rapid escalation of tensions.

Perhaps near-term financial risks have subsided in China.

A counter argument would point out that Beijing’s push to improve its negotiating position forced officials to once again hit the Credit accelerator.

Did Beijing push its luck too far?

I would point to the $1 TN of additional household (chiefly mortgage) debt accumulated over the past year.

China’s Household borrowings were up 15.9% in one year, 37% in two, 69% in three and 138% in five years.

Importantly, Beijing’s stimulus efforts stoked China’s historic mortgage finance and apartment Bubbles already well into “Terminal Phase” excess.

How deeply have fraud and shenanigans permeated Chinese housing finance?

Similar to P2P and corporate finance?

China’s Total Aggregate Financing (TAF) increased 2.273 TN yuan, or $321 billion during September.

This was almost 20% ahead of estimates – and 5% above September 2018.

After a slower July, Credit growth accelerated to place the quarter’s Credit expansion slightly ahead of comparable 2018. At $2.646 TN, year-to-date TAF expansion was 22% above 2018.

With rough estimates of $600 billion of Q4 TAF growth and a $600 billion 2019 increase in national debt, China’s total system Credit growth will approach $4.0 TN.

At $240 billion, September growth in Bank Loans was 24% ahead of estimates.

Loans grew at the fastest pace since March – and almost 14% above September 2018.

Bank Loans expanded $1.924 TN y-t-d, up about 4% from comparable 2018.

September Consumer Loan growth was only 1% above September 2018, with third quarter expansion down a notable 7.8% y-o-y.

Chinese GDP expanded at a 6.0% y-o-y pace during Q3, slightly below estimates (and the “lowest level since 1992”). According to Bloomberg, “Consumption’s contribution increased to 60.5% from 55.3%; Investment’s contribution slowed to 19.8% from 25.9%.”

That growth continues to slow in the face of 12.5% y-o-y Credit (TAF) growth portends instability ahead.

With surging household debt and inflating housing markets, the ongoing consumption boom comes as no surprise.

Property Investment was up 10.5% y-o-y, continuing the powerful momentum unleashed with Beijing’s 2016 stimulus measures.

Retail sales were up 7.8% y-o-y in September, in line with estimates.

Beyond the acute vulnerability to any weakening of Credit growth, the Chinese Bubble economy is demonstrating obvious signs of imbalances and price distortions.

While the housing boom for the most part is ongoing, auto sales have slowed markedly.

October 12 – Bloomberg: “Chinese auto sales fell in September for the 15th month in 16, extending their unprecedented slump despite government efforts to support the world’s largest car market. Sales of sedans, sport utility vehicles, minivans and multipurpose vehicles dropped 6.6% from a year earlier to 1.81 million units… The only increase since mid-2018 came in June, when dealers offered big discounts to clear inventory.”

Meanwhile, weaker-than-expected trade data point to waning economic momentum.

October 13 – Reuters (Yawen Chen and Gabriel Crossley): “A slide in China’s exports picked up pace in September while imports contracted for a fifth straight month, pointing to further weakness in the economy and underlining the need for more stimulus as the Sino-U.S. trade war drags on… September exports fell 3.2% from a year earlier, the biggest fall since February… Total September imports fell 8.5% after August’s 5.6% decline, the lowest since May, and were expected to fall 5.2%.”

Price data (i.e. CPI at six-year high and PPI at three-year low) also support the view of monetary disorder and an imbalanced economy:

October 14 – Market Watch (Grace Zhu): “Rising pork prices pushed China's consumer inflation to its highest level in nearly six years in September… The consumer price index rose 3% in September from a year earlier compared with the 2.8% expansion recorded August… The government aims to keep consumer inflation under roughly 3% for 2019. In the first nine months of the year China's CPI rose 2.5% from the same period a year earlier… Food prices in September surged 11.2% on year to set the strongest pace in nearly eight years and extend August's 10.0% gain.”

October 14 – Reuters (Yawen Chen and Gabriel Crossley): “China’s factory gate prices declined at their fastest pace in more than three years in September, reinforcing the case for Beijing to unveil further stimulus as manufacturing cools on weak demand and U.S. trade pressures. The producer price index (PPI), considered a key barometer of corporate profitability, dropped 1.2% year-on-year in September…”

The Shanghai Composite dropped 1.3% Friday, the largest decline since September 17th – giving back about half of last’s week’s gain.

According to Bloomberg, Chinese defaults this week reached an annual all-time high, with more than two months to spare.

There must also be some system stress smoldering below the surface.

October 16 – Financial Times (Don Weinland and Sherry Fei Ju): “China’s central bank made an unexpected Rmb200bn ($28bn) injection into the banking system on Wednesday, highlighting policymakers’ concerns over liquidity levels as economic growth falls to a 30-year low. Policymakers have worried that liquidity constraints over the past year have made banks less willing to lend to companies at a time when the Sino-US trade dispute is also proving a drag on economic activity. ‘It suggests that the [People’s Bank of China] feels the interbank market needs more liquidity,’ said Julian Evans-Pritchard, senior China economist at Capital Economics. ‘Whether or not the goal is to push down interbank rates or simply to keep them broadly stable is unclear at this stage.’”

I have suggested it was no coincidence China’s August money market instability was followed some weeks later by U.S. “repo” market tumult. I

t was interesting to see both the PBOC and Federal Reserve actively adding liquidity this week. A “phase 1” deal is at hand, while quarter-end funding issues have subsided.

Why then does pressure persist in both funding markets?

October 18 – Wall Street Journal (Michael S. Derby): “The Federal Reserve injected both temporary and permanent liquidity into the financial system Friday. The permanent addition came by way of $7.501 billion in Treasury bill purchases, which are aimed at growing the Fed’s nearly $4 trillion in holdings… The New York Fed also on Friday added $56.65 billion in short-term liquidity to financial markets. In a repurchase agreement operation that will expire on Monday, the Fed took in $47.95 billion in Treasurys, $500 million in agency securities, and $8.2 billion in mortgage-backed securities. The Fed’s operations on Friday are part of an effort to help tame volatility in short-term rate markets with temporary and permanent injections of liquidity… On Thursday, the Fed added $104.15 billion in temporary liquidity.”

Fed funds futures price in an 88% probability of a third Fed rate cut on October 30th.

Those sure seem like rather short odds considering the backdrop, including an easing of trade tensions and near-record stock prices.

There will be a number of dissents if the FOMC accommodates market expectations.

Shouldn’t the Fed’s restart of balance sheet expansion support the case for holding off for now on an additional rate cut?

Some bond selling on a rate cut announcement wouldn’t be all that surprising.

Curiously, a Friday evening announcement from the ECB: “ECB Policy Makers Don’t Expect More Easing in Coming Months.”

October 18 – Bloomberg (Piotr Skolimowski, Jill Ward and Paul Gordon): “European Central Bank policy makers don’t expect any more monetary easing in coming months despite a likely downgrade in their economic forecasts in December, according to euro-area officials. The interest-rate cuts and quantitative easing pushed through by President Mario Draghi in September are enough to see the euro-zone economy through its slowdown unless it’s hit by shocks such as escalating trade tensions or a no-deal Brexit, the officials said, speaking on condition of anonymity. The vehement opposition by some governors to those measures dampens the chance of more action any time soon, they added.”

October 18 – Bloomberg (Jeff Kearns): “The International Monetary Fund warned that global economic risks have risen as central banks reduce borrowing costs and that stronger oversight is needed to ease threats to an already shaky expansion… ‘The search for yield in a prolonged low-interest-rate environment has led to stretched valuations in risky asset markets around the globe, raising the possibility of sharp, sudden adjustments in financial conditions,’ the fund said. ‘Such sharp tightening could have significant macroeconomic implications, especially in countries with elevated financial vulnerabilities.’”

The entire world these days has “elevated financial vulnerabilities,” certainly including China.

Saturday's Brexit vote will be fascinating.

Global economic policymakers are playing with fire

Too much of what ails the world economy is the result of ‘stupid stuff’

Martin Wolf

House on fire

“Don’t do stupid shit.” With the last word turned demurely into “stuff”, this became known as the “Obama doctrine”.

It reflected the lessons Barack Obama had learnt from his presidential predecessor’s unnecessary Iraq war. For many, the doctrine was defeatist.

Today, I see its merits. It would be wonderful to see intelligent action in response to our many challenges. Yet, today, application of the Obama doctrine would be a relief.

This is true, not least, for the world economy.

As Kristalina Georgieva, the new managing director of the IMF, said in her curtain raiser for this week’s annual meetings in Washington DC: “In 2019, we expect slower growth in nearly 90 per cent of the world. The global economy is now in a synchronised slowdown.”

Joint research by the Brookings Institution and Financial Times is bleaker still, describing our situation as “synchronised stagnation”.

What is driving this slowdown, particularly stark in industry and trade? A big part of the answer seems to be rising uncertainty.

This, argue the Brookings authors, is due to the “persistent trade tensions, political instability, geopolitical risks, and concerns about the limited efficacy of monetary stimulus”.

Such uncertainty has, notes Gavyn Davies, become “entrenched”.

In its latest World Economic Outlook, the IMF forecasts growth of world output at just 3 per cent this year, down from 3.6 per cent in 2018.

In the high-income countries, aggregate growth is forecast at 1.7 per cent, down from 2.3 per cent last year.

In emerging economies, the decline is from 4.5 per cent to 3.9 per cent this year. Growth of the volume of world trade is forecast at just 1.1 per cent this year, down from 3.6 per cent last year.

This is far below the growth of output: it signifies deglobalisation, with respect at least to trade.

Chart showing trade leads the global slowdown

Crucially, risks are all on the downside. The trade conflicts between the US and its principal trading partners might get worse. If so, integrated supply chains, not least in high-tech products, could be badly disrupted. Brexit may be chaotic.

Geopolitical risks also abound, especially in the Middle East, but also in Asia. Above all, relations between the US and China are worsening. Significant financial fragilities exist too, notably the high debt of non-financial corporates. The threat of cyber attacks remains, as does mega-terrorism. We persist in failing to tackle climate change.

Depressingly, much of what threatens the world economy is due to “stupid stuff”. Donald Trump’s trade policy is wrecking the underpinnings of the postwar trading system, thereby creating huge uncertainty, in pursuit of the silly aim of bilateral balancing. Brexit is stupid: it will destroy a fruitful partnership with the UK’s neighbours and partners. The burgeoning friction between Japan and South Korea is stupid, too: it weakens both countries in a region ever more dominated by China.

Chart showing uncertainty is rising

We are collectively playing with fire. Worse, we are doing so while living in a flammable building. As Lawrence Summers tells us, the danger is not so much a global economic slowdown, as the difficulty of doing much in response.

In this context, the recent shift in Federal Reserve policy, towards lower rates, and the associated decline in interest-rate expectations are particularly telling.

Even in the US, it was impossible for the Fed to raise the short-term rate above 2.5 per cent in this cycle, before cutting it.

In other big high-income economies, the room for a conventional policy response to a slowdown is still more limited.

Chart showing tech supply chains have increasingly relied on China

Importantly, this tells us that structurally deficient aggregate demand, on which some of us have been writing since before the 2007-08 financial crisis, remains pervasive.

This forces us to recognise not just the “nationalist-populist-protectionist” stupid stuff noted above but, as lethal, the “austerity-as-secular-religion” stupid stuff.

This shows itself not only in terror of aggressive monetary policy, rightly rebuffed by former president of the European Central Bank Jean-Claude Trichet, but in the refusal to accept the alternative, namely, fiscal policy.

People are petrified of government borrowing even though lenders are prepared to pay for the privilege.

Chart showing China tech supply also relies on outside suppliers

It is elementary economics that prices matter. The astonishing fact is that the six largest high-income economies, including now even Italy, can borrow for 30 years at a fixed nominal rate of close to 2 per cent, or less, and so at zero-to-negative real rates, provided central banks deliver on their inflation targets.

One has to be desperately pessimistic about growth prospects to believe it is impossible to manage substantial borrowings, on such terms. This is especially true if borrowing was used to produce high-quality human, intangible and physical assets.

A fixation on eliminating budget deficits, in this context, is really stupid stuff. Should real rates rise again, this would reflect better perceived opportunities and so justify (and facilitate) curbing government spending. Meanwhile, the low cost of past borrowings would be locked in.

Moreover, as Olivier Blanchard has noted, it is usual for safe interest rates to be below growth rates. Today seems to be just an extreme version of this reality.

Chart showing dramatic downward shift in US interest rate expectations

These are fragile times. Some of that reflects the wave of populist nationalism that is now sweeping across high-income countries. But some of it reflects sterile orthodoxy. A modest slowdown is one thing. But a sharp slowdown we refuse to deal with, because of stupidity, would be another thing altogether.

As Ms Georgieva argues, we do need a “renewed commitment to international co-operation”.

This is also the theme of a recent compendium from the Bretton Woods Committee. Today, however, that might be too ambitious. But we could at least stop doing the stupid stuff.

Chart showing very long term borrowing is extraordinarily cheap

Are investors ready for the ‘Doomsday Dollar’ scenario?

What would it mean if the entire paradigm for long-term investing was to change?

Rana Foroohar

Future Dollar Fall

For decades, global savers, and American retirement savers in particular, have been taught that you should put most of your money in an S&P index fund — one that tracked the fortunes of the largest US companies — and then forget about it until you were close to retirement. Since the mid-1980s onwards, that has been more or less good advice. American multinationals were, after all, the best way to buy into globalisation, and globalisation was very good for the stock prices of many big companies.

But recently, I’ve begun to wonder — what would it mean if the entire paradigm for long-term investing was to change?

Globalisation as we have known it is on hold. This much we know. But what if we were also coming to the end of a very long period of financial repression, in which declining interest rates have masked another, more fundamental truth. America’s place in the world has changed, and so has the growth potential of its corporations. If that is the case, then we may be in for a correction not just in the stock prices of US multinationals, but in the dollar itself. That would have profound implications for investors everywhere — from individual savers in the US to giant pension funds in Europe and Asia.

It’s a scenario that AG Bisset Associates has dubbed “the Doomsday Dollar”. At first glance, the idea of US stocks and the dollar going down at the same time seems unlikely. For one thing, the two often go in opposite directions, with a weak dollar making the exports of many US companies relatively more competitive in the global marketplace, as has been the case in recent years.

What’s more, despite some countries like China and Russia moving out of dollar-denominated assets for reasons both political and economic, the dollar remains the world’s reserve currency.

As a study last week from the Brookings Institution pointed out, the dollar’s share of global foreign exchange reserves has declined by only two percentage points since 2007, while the euro’s share is down six points. And, as we all know, neither American politicians nor many of the country’s largest companies have covered themselves in glory during that period.

charts on dollar vs Euro -  features

But shifts in the global reserve system take time. Currency movements can happen more quickly — in fact, as Ulf Lindahl, AG Bisset chief executive, points out, the world’s major currencies tend to move up and down in 15-year cycles. According to his calculations, which track currency movements from the early 1970s onwards, we began a new cycle in January 2017, and despite the dollar’s strength since April 2018, that cycle is still intact. If the thesis holds, the dollar is poised to fall against the euro and yen over the next few years, and by as much as 50 to 60 per cent.

What would be the implications of such a shift? For starters, investors outside the US, like European and Japanese pension funds, the family offices that manage the finances of wealthy individuals, and large financial institutions, would be hit hard by depreciating dollar assets. If they began to shift their investment portfolios away from dollar assets, it could exacerbate a downturn in US equities — this is something that many analysts believe is coming anyway, given that stocks are at their second most expensive period in 150 years. That would, in turn, hurt US savers who keep the majority of their retirement portfolios in those S&P index funds.

Some savvy investors already see the writing on the wall and have moved into gold. I would expect other commodities to rise, too.

If the “Doomsday” scenario plays out, investors might also pile into the euro and the yen, which would force US bond yields to rise. That is something that few expect — the conventional wisdom is that we are in an environment of low rates forever. But if yields were to rise, it could help savers who are holding bonds rather than stocks — it would also, however, penalise debt-ridden companies. And as we have already been warned by the Bank for International Settlements, there are plenty of “zombie” firms out there that will have trouble servicing their debt and staying in business if rates rise.

Over the past few decades, we’ve seen not only a bull market for US equities, but plenty of financial engineering. Companies have done what they could to defy economic gravity using everything from the tax code to share buybacks. Central bankers have facilitated this with loose monetary policy. That is why, in my opinion, both US stocks and dollar-denominated asset prices have remained so high, despite so many risk factors in the political economy, and the challenges for business.

Ultimately, if US companies are perceived as no longer being the most competitive in the world, their share price will fall, as will the dollar. Are we at that point? Not yet. But given the erosion of America’s skills base, its ailing infrastructure and lack of research investment, I wonder if we might be soon.

Companies themselves seem to be voting with their feet. A recent EY report shows that the number of Fortune Global 500 companies headquartered in the US declined from 179 in 2000 to 121, while the number headquartered in China grew from 10 to 119. This signals a shift in where companies expect growth to come from in the future — Asia. If that is the case, many of us will need a new investment strategy for a new world.

Gold Could Get a Boost From a Weak Dollar

By Randall W. Forsyth

Photograph by Chung Sung-Jun/Getty Images

You wouldn’t know it from the constant barrage of news on the political and international fronts, but there are positive developments in the background for the financial markets. To be sure, there has been good news with a “Phase 1” tentative trade deal with the U.S. and China, and maybe, just maybe, some Brexit agreement (although it ain’t over until Parliament votes this weekend).

But there is a more positive monetary backdrop developing from lower short-term interest rates and a weaker dollar. And that would be bullish for most risk assets, including U.S. stocks, emerging market debt and equities, and commodities—notably precious metals.
The federal-funds futures market is putting an 89.3% probability of the Federal Open Market Committee voting for a one-quarter percentage-point reduction in its key policy interest rate on Oct. 30, according to the CME Group’s FedWatch. While a number of economists have pushed back on the notion of another rate cut this month, and most Fed officials remain noncommittal, if not opposed, to further easing, the central bank has a long history of not disappointing market expectations. While the betting line can change by game time, the odds now favor a rate reduction at the next policy confab.
The Fed also has begun buying $60 billion a month of Treasury bills, which it contends doesn’t constitute a policy move like past quantitative-easing, or QE, purchases. (See this week’s Economy column.) In actuality, the buying reverses the quantitative tightening, or QT, that occurred as the Fed reduced its assets, while on the other side of the balance sheet, liabilities, notably currency, increased, resulting in an even sharper shrinkage in bank reserves.

Quantitative tightening was supposed to be like “paint drying,” as former Fed Chair Janet Yellen described it, but resulted in the equivalent of 7.5 percentage points of tightening, nearly three times as much as the actual rate hikes, Julian Brigden, chief economist at MI2 Partners, has estimated. QT has kept the dollar stronger than fundamentals would have predicted, he writes in a client note.

A weaker greenback would provide the missing “cornerstone of a reflationary move,” along with lower rates and higher equity prices. Global investors have been piling into U.S. growth stocks, taking advantage of strong currency and equity returns. As the dollar turns, Brigden looks for a rotation from growth to value stocks, which showed signs of starting in early September.

A weaker dollar and negative interest rates also have boosted hedge funds’ interest in gold, according to Société Générale. The so-called barbarous relic, and exchange-traded funds that track it, such as the SPDR Gold Shares (ticker: GLD), have moved mostly sideways around the $1,500-an-ounce level since late August.

But the bank’s strategists recommend a maximum bullish allocation to gold (5% in its portfolios) because the metal “is increasingly seen as an alternative to cash.” They’re especially bullish on gold since they also expect further Fed rate cuts and a lower dollar. While the bank isn’t advocating a return to a gold standard, it notes that central banks such as the People’s Bank of China are diversifying into the metal.

President Donald Trump has made no secret of his desire for a weaker dollar, which would be consistent with his barrage of tweets calling on the Fed to slash rates. An end to the tariff wars would further ease the upward pressure on the dollar. And that would benefit corporate earnings, as 40% of sales of S&P 500 companies originate abroad. So there’s good reason to bet your bottom dollar that the greenback is close to a top.

Can the US and China Make a Deal?

Driven by domestic nationalist forces and the need to save face, US President Donald Trump and his Chinese counterpart, Xi Jinping, have continued to escalate the bilateral trade war, despite their shared interest in resolving it before the end of the year. To make a deal, both sides need to start taking substantive steps immediately.

Kevin Rudd

rudd8_Thomas Peter-PoolGetty Images_trumpjinpingsoldiers

NEW YORK – Now that the celebrations marking the 70th anniversary of the founding of the People’s Republic of China are over, it is time to direct attention back to the Sino-American trade war. That conflict may well be about to enter its endgame. Indeed, the next round of negotiations could be the last real chance to find a way through the trade, technology, and wider economic imbroglio that has been engulfing both countries.

Failing that, the world should start preparing for its rockiest economic ride since the 2008 global financial crisis. There is a real risk that America will slide into recession, and that the global economy will experience a broader decoupling that will poison the well for Sino-American relations far into the future. There is also a widening window of opportunity for nationalist constituencies in both countries to argue that conflict is inevitable.

Thus far, the trade war has gone through four phases. Phase one began last March, when US President Donald Trump announced the first round of import tariffs on Chinese goods. Phase two arrived with the “Argentine reset” at the G20 summit in Buenos Aires last December, when Trump and Chinese President Xi Jinping announced that they would conclude an agreement within 90 days. That truce imploded in early May of this year, with each side accusing the other of demanding major last-minute changes to the draft agreement.

Phase three could best be described as the “summer of our discontent”: the United States imposed a fresh round of import tariffs, and China retaliated in kind, while also unveiling its answer to the US “entity list.” In response to the blacklisting of Huawei and five other Chinese tech companies, China’s poetically titled “unreliable entities list” threatens to target US firms for exclusion.

Given these developments, why should anyone expect the next round of talks to succeed?

For starters, the US and Chinese economies are both in trouble. In the US, recent poor manufacturing and private-sector employment figures have reinforced pessimism about the economy’s prospects. If conditions were to deteriorate further, Trump’s bid for re-election in November 2020 would be endangered. Likewise, Xi would be weakened by any significant slowdown on the eve of the Communist Party of China’s centenary celebrations in 2021, which will be a prelude to his bid for an already controversial third term starting in 2022. 
Each side says publicly that the trade war is hurting the other side more. But, of course, it is hurting both, by destabilizing markets, destroying business confidence, and undermining growth. Each side also claims to have the economic resilience needed to ride out an extended conflict. On this question, it is unclear who has the stronger argument. America is certainly less trade-dependent than China; but China, though weakened by poor domestic policy choices enacted before the trade war, still has stronger fiscal, monetary, and credit tools at its disposal.

In any case, both sides recognize that they are each holding an economic gun to the other’s head. Hence, despite the political posturing, both Trump and Xi ultimately want a deal. Moreover, they need it to happen by the end of the year to prevent further damage from big tariff hikes currently scheduled to take effect on December 15. That timeline requires that both sides start taking symbolic and substantive steps immediately.

As a first step, China should propose an agreement using the same text as the previous 150-page draft, but with revisions to satisfy its three “red lines.” Specifically, China should remove the US provisions for retaining tariffs after the agreement is signed, and for unilaterally re-imposing tariffs if the US concludes that China is not honoring the agreement. And it should add a commitment that China will execute the agreement in a way that is “consistent with its constitutional, legislative, and regulatory processes.”

Second, China should improve its original offer of a $200 billion reduction in the bilateral trade deficit over time. This negotiating point is based on lousy economics, but it is important to Trump personally and politically.

Third, while China will want to avoid banning state subsidies for Chinese industry and enterprises, it must retain the draft agreement’s existing provisions on the protection of intellectual property and the prohibition of forced technology transfers. Moreover, it may be possible to have each country declare its position on state industrial policy in the official communiqué accompanying the signing of the agreement. Such a statement could even specify the domestic and international arbitration mechanisms that will be used to enforce all relevant laws on competitive neutrality.

Fourth, both sides must create a more positive political atmosphere. In recent weeks, there have been signs that this may happen, including reports of renewed Chinese purchases of American soybeans in September. Though purchases are still well below historical levels, this increase will help Trump to placate angry farmers in his base. The US, meanwhile, has already deferred a 5% tariff hike that was originally scheduled for October 1. It could also issue exemptions for some US firms to sell non-sensitive inputs to Huawei.

Fifth, both sides should regard the November 14-16 Asia-Pacific Economic Cooperation Summit in Santiago as the last chance for signing a deal. Following high-level negotiations between Chinese Vice Premier Liu He and US Trade Representative Robert Lighthizer this month, outstanding problems should be agreed in Beijing in early November. Getting the deal done before Thanksgiving will be critical to undergird US business and consumer confidence for the Christmas season.

I am one of the few commentators who have argued all year that, despite the political fireworks, Trump and Xi’s underlying interests make a deal more likely than not. But the recently announced impeachment proceedings against Trump could throw a wrench into this process. A weakened Trump may be emboldened to take a tougher line against China than US economic interests demand. On balance, however, Trump still cannot afford the risk of a 2020 recession, meaning that a deal remains more probable than not.

Nonetheless, a failure to manage the next two critical months could still cause the entire process to collapse. Both sides have already spent much time preparing a Plan B for 2020: to let loose the dogs of economic war, foment nationalist sentiment, and blame the other side for the ensuing damage. Should that happen, the risk of recession in the US, Europe, and Australia next year will be high, though China would seek to soften the domestic blow through further fiscal and monetary stimulus.

The choice now facing the US and China is stark. For the rest of the world, the stakes could not be higher.

This commentary is based on a recent address to the US Chamber of Commerce in Beijing.

Kevin Rudd, a former prime minister of Australia, is President of the Asia Society Policy Institute in New York.

The Next Phase of China’s Reform and Opening Up

Over the last four decades, China has made major progress on integrating into global networks. But it has a lot more work to do – and must do it while confronting an increasingly hostile external environment.

Andrew Sheng , Xiao Geng


HONG KONG – Over the last four decades, China has integrated into global networks in trade, finance, data, and culture (encompassing social values, religion, and political beliefs). But, as the United States embraces protectionism, continued progress on global integration will require China to adjust its approach.

Since the 1980s, China’s approach to development has centered on experimentation and phased implementation. Thanks to this “pilot and expand” strategy, in 2013 – 12 years after acceding to the World Trade Organization – China became the world’s largest trading economy (for goods). In 2018, its trade-to-GDP ratio stood at 38%, substantially higher than that of the US (27% in 2017).

As for financial markets, China’s leaders have been adamant about ensuring that liberalization will occur only when domestic exchanges and the regulatory framework are robust and credible enough to manage the relevant risks. So policymakers have pursued a two-tier, phased strategy that capitalizes on Hong Kong’s unique position in the Chinese and international markets.

In the 20 years since China’s state-owned enterprises began listing shares and raising funds in Hong Kong, the city – with its low taxes and strong infrastructure for enforcing the rule of law – has become a global financial center. In the process, Hong Kong has served as a catalyst and intermediary for broader financial-market liberalization in China, offering a kind of buffer zone for experimenting with the interactions between mainland and offshore renminbi financial markets.

Thanks to this approach, China’s share of global debt and equity markets has increased sharply. In 2004, China accounted for 1.2% of the world bond market, compared with 42.2% for the US, 26.5% for European Union, and 18.7% for Japan. By the end of 2018, China’s bond market had expanded to account for 12.6% of world total, while America’s had shrunk to 40.2%, the EU’s to 20.9%, and Japan’s to 12.2%.

Similarly, mainland China’s share of global equity-market capitalization rose from 1.2% in 2004 to 8.5% in 2018; add to that Hong Kong’s share, and China’s total rises to 13.6%. Over the same period, America’s share of global equity-market capitalization fell from 45.4% to 40.8%; the EU’s dropped from 16.3% to 10.8%; and Japan’s shrank from 16.3% to 7.1%.

Yet China still has a lot of work to do on integration. As a recent McKinsey report showed, more than 80% of the revenues of China’s 110 global Fortune 500 companies are domestic, and foreign ownership in China’s banking, securities, and bond markets remains below 6%. Moreover, the barriers to continued progress are significant. To continue China’s integration into global networks, the authorities will need to overcome at least four major strategic challenges.

The first challenge is to rein in debt, which has increased more than fivefold economy-wide over the last decade, and now exceeds 300% of GDP – similar to advanced-country levels. While China can afford to consume and invest more, given its high domestic savings rate, it will also need to deepen its equity markets, in order to lower long-term debt risks.

Second, China must find ways to advance renminbi internationalization. Since 2009, China’s government has been working hard to expand the currency’s international use. But, according to the Bank for International Settlements, the renminbi accounted for just 2.1% of total daily foreign-exchange trading in April of this year – far behind the US dollar (44%), the euro (16%), and the Japanese yen (8.5%).

China will also need to adjust to having a broadly balanced current account, after decades as a major surplus country. In order to maintain a healthy balance of payments and avoid taking on too much risk, China must now ensure that its capital outflows are roughly balanced with inflows of foreign funds.

The fourth challenge China faces in achieving further global integration lies in the unfriendly external environment, shaped by anxieties over excessive or uneven flows of goods, capital, data, people, and culture. Nowhere is this more apparent than in US President Donald Trump’s administration and its assault on the global trading system, including an escalating trade war with China.

With negotiations having failed to end that trade war – not least because of fundamentally different worldviews – the Trump administration is doing everything it can to “win.” Most recently, it proposed new regulations that would expand the government’s authority, through the Committee on Foreign Investment in the United States (CFIUS), to block transactions relating to technology, infrastructure, personal data, and real estate on national-security grounds. The rules would affect actors, such as China, that trade with countries that are subject to US sanctions.

The escalating conflict with the US puts severe pressure on China’s gradual “pilot and expand” strategy. To be sure, China has broadened its two-tier approach to integration in recent years, incorporating a growing number of mainland provinces into pilot projects like the Shanghai free-trade zone. China hopes that, much like Hong Kong, these pilot cities can sustain its integration momentum, helping it gradually align its legal and regulatory regime with global frameworks for trade, finance, taxation, and other transactions.

But China will need to expand and augment these efforts if it is to protect its linkages to global finance, data, and knowledge networks. Only with bold, smart, and innovative action can policymakers ensure that China’s pilot cities continue to lead the way toward a more open, integrated, peaceful, and prosperous future.

Andrew Sheng, Distinguished Fellow of the Asia Global Institute at the University of Hong Kong and a member of the UNEP Advisory Council on Sustainable Finance, is a former chairman of the Hong Kong Securities and Futures Commission, and is currently an adjunct professor at Tsinghua University in Beijing. His latest book is From Asian to Global Financial Crisis. 

Xiao Geng, President of the Hong Kong Institution for International Finance, is a professor and Director of the Research Institute of Maritime Silk-Road at Peking University HSBC Business School.