Risks Mount in China, From Evergrande to Trade

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Luc de la Durantaye, Chief Investment Officer of CIBC Asset Management.

To understand the development surrounding the failure of Evergrande, we need to put the last 10, 15 years growth model of China into perspective. China has been leveraging its economy with very rapid credit growth over that period. The business model of Chinese companies was not necessarily to maximize profit, but to maximize the size of their companies, which led to an unsustainable trend in credit growth in China and leverage. So the Chinese economy became highly leveraged for a still developing economy. So recently China then made a policy turn to focus, not on its economic growth per se, but rather on the quality of that growth. Going forward, it will mean that you’ll have slower growth coming out of China, which is the negative aspect, but also you’ll have less leverage that the economy will be deleveraging to a certain degree, which will make the economic activity in China more sustainable.

So the Evergrande failure is a calculated risk that the Chinese government is taking. One which has been government induced, and this is very important and probably not a sign of a systemic risk in coming out of China. Some have equated the failure of Evergrande as the equivalent of the Lehman Brothers bankruptcy. We don’t share that view and think that China will manage the real estate deleveraging without leading to a systemic crisis, per se. We have to remember that the financial system in China is fairly closed, and the spillovers into the global economy should be limited. And the Chinese banking system is fairly… The four or five largest Chinese banks are owned indirectly by the government. So very well controlled in that sense. So, that change in policy will lead to slower growth in China over the coming five years. But that is also gradually being priced in markets because the Chinese equity market has been underperforming quite substantially already.

In a broader perspective, on the U.S.-China trade aspect, following the trade restriction towards a technology company, Huawei, Chinese leaders also realized that they were very vulnerable on a few fronts, which they have now planned to address over the coming five-year, in their five-year plan. One is on the semiconductors. China spends roughly 30 billion per month in U.S. dollars on semiconductor imports. More than it’s spent on imports of anything else, including crude oil. So the crackdown on tech companies like Alibaba and BD has to be viewed in this context. China wants to divert investments toward developing an expertise in semiconductors to reduce their dependence on semiconductors. So, they feel very vulnerable with their U.S. counterparts and trade towards semiconductor and technology regulation that they’ve introduced is all aimed to change the focus within China in becoming more independent in semiconductors.

Also, China’s dependence on foreign energy. China imports almost 10 million barrels of oil per day. So at $80 a barrel that’s an annual import bill of close to $300 billion. So along with coal and natural gas as well. So, that’s all included. Most of these imports are seaborne. So this leaves China very vulnerable. The U.S. with its fleet out in the China sea can blockade if they would want it to. I don’t think they would, but certainly that’s another area that China feels very vulnerable. So China’s move away from carbon energy… It wants to move away from carbon energy as rapidly as possible. Their turning to green energy is very real for those reasons.

So the impact of these trade vulnerabilities, with the U.S. in particular, think about the repercussion that this could have. If you are a large oil producer, like Saudi Arabia, and you hear your biggest client wants to reduce its energy consumption, it doesn’t make you feel very good about wanting to invest in growing your own oil production, producing capacity, right?

So it brings us back to the commodity outlook where shortages of supply in oil may stay with us for longer than expected, and should be taken into account in portfolios. China also wants to reduce its pollution more generally, which also means that they will be a smaller producer of other commodities with a similar impact on shortages of production over time and therefore higher prices of commodities. So, going back to what’s the implication on a portfolio? Well, one is potentially, with higher commodity prices, you have higher inflation. So you have to take into account what inflation impact would have on your portfolio. So interest rates, for example, are more likely to stay more elevated than before. You also probably want to have a tilt towards, a better balance towards commodities, to some commodity producers. And you also want to be exposed to alternative energy producers, to name of few of the impacts that at the end of the day, the China-U.S. relationship over the next five to 10 years will bring.