Will China's Economic Slowdown Cause a Global Recession? (w/ Tony Nash)
TONY NASH: I'm the CEO and founder of Complete Intelligence. Complete Intelligence is an artificial intelligence platform that forecasts assets, currencies, commodities, equity indices, and also does advanced procurement and revenue for corporate clients. What we're doing is we're using reinforcement learning, which is effectively a number of neural networks. We use right now about 21 different neural networks to test every single asset. Let's say you have a bill of material for a mobile phone, and you've got 7000 items in that mobile phone. We're integrating with an ERP system to put all of that data out of the ERP system for that mobile phone and we're telling that manufacturer exactly how much every element is going to cost them for the next year. If you look at everything as a bill of material, a portfolio is effectively a bill of material. We do the same thing for portfolios, we do the same thing for product revenue forecasts. We look at the world as a math problem. It doesn't matter if it's gold, or a diode or plastic or crude oil, or Japanese yen, it's a number that behaves a certain way and there are anomalies, there are inflections, there are any number of things. We don't have any causal conviction on any asset the way it trades, whether that is traded through a procurement team, or whether that's traded through an exchange, it doesn't really matter to us. We're looking at the behavior of numbers. We have billions data items within our platform. We're running billions of calculations within our platform, and we're running-- for every element that we forecast, we're testing more than a million different potential drivers for that element. We're not enforcing any causality or any driver environment on anything. The underlying hypothesis of what we're doing is very simple. The world is a closed system. When we say that to people, they say, "Well, of course it is," but the way they think of the world doesn't necessarily align with that. From day one, the way we've built our approach, the way we've built our platform, all has the underlying assumption that the world is a closed system, and everything is a tradeoff. I led a global research for a company called The Economist and led Asia Consulting for a company called IHS Market. I spent 15 years in Asia. In that time, I did work with governments across the region. Since starting Complete Intelligence, I was asked by what's called the National Development and Reform Commission to help them on a large infrastructure initiative called the Belt and Road initiative. This was five years ago. I was advising a team within the NDRC on different aspects of the Belt and Road. It was not a formal position, it was not a paid position, I didn't have my expenses compensated, it was all volunteer work. I did it because I wanted to see how China could help the countries around them with infrastructure investment. I also wanted to understand how the Chinese government works. It was an incredible view into the mechanics of the Chinese government and how things work. What I'm seeing in China is a lot of expansion of credit. Of course, that's not hitting. We're seeing economic slowdown, we're seeing demographics slowdown. You have a real aging population. Since 2010, we've seen a real slowdown in economic growth. The official data aren't necessarily reflective of reality. You're seeing expansion of the money supply at an unsustainable rate. You're seeing issuance of debt at an unsustainable rate. You're seeing credit expansion in a way that does not have a multiplicative effect. In fact, it has a divisor effect. There are a number of ways, directions in which China is going that really isn't sustainable. That doesn't mean China will implode by next Thursday, it doesn't even mean China will implode. It just means that their current behavior is not sustainable and something has to change. What we've seen-- my view on Hong Kong is when the British left Hong Kong in 1997, there was wealth accumulation in Hong Kong based on helping outsiders access China and helping China access the outside world. Hong Kong sustains itself by economic throughput transactions. Now, what's happened in that time over the last 20 years is China has developed many of those capabilities itself. Now, when I say China, in this case, I mean the Mainland. Because Hong Kong is part of China, it's a part of the PRC. Many of the capabilities, financial services, business services, professional services, other things are available on the Mainland. Hong Kong, aside from its special status as a currency accumulation and transaction location, there really are not a lot of unique skills in China anymore. What we see is Shenzhen, Guangzhou, other places, at the same economic level with the same earnings potential as Hong Kong, whereas 20 years ago, Hong Kong was way above the rest of China. We're approaching parody there. The opportunity, the economic opportunity in Hong Kong for those 20-year-olds is not what it was for their parents. That's a problem. From my perspective, it seems like a lot of the protest activity in Hong Kong is economically related. Of course, there are political issues as well. If you didn't have the economic dynamics that you have right now, I don't believe you would have the disaffected views that you have related to politics. What we'll have over the next-- well, I would say probably over the next year is we'll have a more assertive Mainland presence in Hong Kong. What we're starting to see is more intra-Hong Kong fighting, different groups in Hong Kong protesting against each other, and some violence and other things that worries me quite a lot. The instability and the political risk in Hong Kong has already risen. I think, Hong Kong these days as a financial services sector are really numbered. I don't see that Hong Kong banks, insurance companies and asset managers can hand-on-heart ask people to put billions of dollars in Hong Kong anymore, the risk seems to be too high. Those benefits will flow off to other places. That won't necessarily be an immediate activity. I think that will take a few years to take place. What you've seen is a lot of the transportation activity and logistics activity in Hong Kong, you've seen a lot of that move off into Guangdong, other ports in Guangdong. Now, you're going to see more financial services activity off flow into other parts of China, or Singapore or other places. You'll see more Mainland Chinese activity and even PLA activity in Hong Kong to start to calm the protests. You'll see, because of political risk, and economic risk, you'll start to see more of the concentration of activities in Hong Kong move to other places. We started seeing back in January, February, we started seeing the Chinese yuan breaking 7. We had it for July, August in that neighborhood. We saw it through the different economic indicators. It wasn't necessarily the political unrest, although it's been attributed to some of that stuff and some of the other issues, but there were a number of contributing factors around trade, around the Chinese economy, around other global markets and currencies that pushed our platform to show the CNY hitting 7 or crossing 7. Our outlook, say for the next quarter is a little bit of stability. In September, we have expected a bit of appreciation in CNY. It went to 7.1, we've expected to do appreciate above say between 7, 7.1 this month, then we start to see it to devalue again in October, November. We don't necessarily see an aggressive devaluation, although that's possible. It seems that China devaluing below 7 is very much-- it's problematic from a mental perspective, from a-- currency appreciation in China was seen as a victory, its economic power. As our currency keeps appreciating from say, 8 down to 6.4, I think is where it got, the perspective from China was this is an example of our economic power. To have to retrace back above 7, I think is a bit of a moral defeat. It's a bit disheartening for China to have to do that, because it's seen as economic weakness. Nobody really wants that. Of course, nobody wants to see China implode, nobody wants to see these things dial back, but it's happening. As we see potential, say, ongoing debt related issues in China, as we see impacts of the trade war, it seems there will have to be more devaluation in China for them to be able to just stay solvent. The China story really is one of stopping the regionalization, the economic regionalization that we saw in the 1990s, turning that into globalization. In the '90s, we saw NAFTA, we saw the EU, we saw all of these things come about toward trade regionalization and regional FTAs. In 2000, when China joined the WTO, we saw a lot of the FDI, let's say, in North America into the US to support NAFTA, dissipate really quickly. In the second half of 2000 and in 2001, it just completely fell off. A lot of that investment transitioned to China really, really quickly to be able to support globalization, which was effectively a labor arbitrage. That stayed through-- well, we still haven't really seen that come back to the US. We saw similar dynamics in Europe, we did see in 2015-'16, we saw currency outflows from China really into the US. We saw spike of FDI into the US in 2015-'16 and a lot of that was currency flight from China finding vehicles to invest in in the US to get money out of China. This happened in the wake of the May 2015 Equity Fallout in China, and people were desperate to find places to put their capital. What we're seeing in China is that is so much that they have to invest almost 7, they have to lend almost 7 Chinese yuan to get one yuan GDP. It's a divisor effect. There used to be up until I think, 2006, there was a multiplier effect, where you would lend 1 CNY, and you would get like 1.2 or 1.5 units of GDP created. Now, you lend around 7 CNY to get one unit of GDP. It's terrible, it's really terrible. Since 2010, debt has accumulated. In order to facilitate that, they've had to grow their money supply so M2 in China is about five times the size of M2 in the US, which is incredible. The domestic bank debt in China is about four times the size of domestic bank debt in the US. They're a smaller economy so the load of these things is just unsustainable. This is all, if you look at the charts of debt, of money supply, of other things, it all started in 2010. China hasn't found a way to slow it down, because the economy since 2010, and before was the case as well. Since 2010, the economy is based on flows, it's not based on a stock of debt, it's not based on a stock of money, it's based on a flow of money. The real danger in China right now is if the music stops, and that flow stops, the machine really starts to break down. For China's growth rate, in 2018, and I still stand by this, our view was the China grew at 5.8%. The official data was six point something. We thought it would be 5.8 last year. We stand by that, that still feels about right. It was a dramatic slowdown from the previous year. This year, 2019, our view is 4.4%. Again, we're seeing pretty rapid slowdown in China. If you look at what's happening on the ground in China, again, we feel like that's the case. GDP is overstated. That's not a secret, economists who still forecast a 6.5%, 6.6% growth in China, it's really hard to justify that. We don't see any justification for that. What we're seeing going forward is continued slowdown, gradual slowdown, the big break between, say 2016 and today is leading to-- so we don't see that continuing to slow down at the same rate from 7-ish to say 4.4. We're not going to continue to see it. It's not going to be at 1% in say, 2022. That slowdown has settled. One of the big problems that China has is their population peak-- we did a big piece in May that show that China's population will peak in 2023. Their labor force already peaked in 2015, their population will peak in 2023. There aren't enough women to have babies to re-accelerate population growth in China. As their population peaks, their ability to grow the top line economic numbers slows. It's okay if GDP per capita growth for example, but unless the overall economy continues to grow at an accelerated rate, they can't service the US dollar denominated debt and the CNY denominated debt that they have on their books. They have to have accelerated economic growth to service the debt load that they have. Again, these things take time to shake out until they don't. We can be patient for a while and it'll happen. I don't think it's going to happen in the short term but it will happen. It's very hard for especially US dollar denominated debt and foreign denominated debt, euros or whatever, for China to just write that off. The demographics don't look good at all. I guess what we're seeing generally is commodity prices in China on say, the Shanghai Futures Exchange, other things are continuing to come off from highs for a few years ago. It's a very much deflationary backdrop, and I guess the bigger issue is it doesn't only affect China. It affects Korea in a big way. It affects Taiwan in a big way. It affects Southeast Asia in a big way. It affects Japan. We've seen the CNY devalue, they may have to devalue even more in order to be export competitive, because their wages are no longer competitive. As we see that devaluation continue, we'll also see other currencies in Asia devalue. It creates a region with ongoing currency devaluation because what they're producing isn't necessarily unique anymore. China is not a unique spot to produce goods. If you look at the top 10 items that China exports to the US-- computers, wireless goods, things like suitcases, chairs, so on and so forth, all of those 10 goods can be sourced in other places. Computers, wireless goods, office machines, Mexico is a very large manufacturer of those things. Now, they don't manufacture it the magnitude that China does, so it's going to take some time for Mexico to build up to that level but there is a huge substitutionality to the goods that are coming out of China. Things like chairs, suitcases, again, these are all the top 10 exports from China to the US, these can all be made in places like Vietnam, Bangladesh, other places. There is not a unique factor in the large value of items that are coming out of China and China's outpriced itself because of the wages and because of trade issues. The subsidies, the non-tariff barriers that China puts up are creating issues for its trade partners. It's not just the US, the US is the most vocal. It is Europe, it is Japan, it is other people who aren't happy about it. The US tends to be the most vocal and what will happen is the US will negotiate something. I don't think it'll be elegant, but they'll negotiate something and much of the rest of the world will benefit from the wake of that. Because of the trade war and because of the cost of doing business in China, we've started to see Chinese companies actually rotate their manufacturing out of China into Vietnam, because Vietnam isn't affected by the trade war. If we look at, for example, foreign direct investment in Vietnam, for say 2009 'til last year, compared to 2019 to date, that's risen by something like three fold. Chinese manufacturers are realizing they need a lower cost base and they also need to be in a third country. Whether that's assembly or whether that's manufacturer of the whole good, they're having to look in other places. The problem, again, this goes back to the problem of substitutionality and really elasticity of China within the supply chain. Other places can do what China's done. The game plan that it put together in the late '90s to execute in 2000 has done very well but China hasn't necessarily adjusted to that. They need to find something new to raise the level of productivity, to be more profitable to pay off some of the debt that they've accumulated as a country. I was in Asia for 15 years. During that time, I did corporate turnarounds, I built companies in places like the warzone in Sri Lanka, I was the Global Head of Research for The Economist. I did a lot of work with governments and companies across the region. In 2015, I was asked to support a unit within the Chinese government on an initiative called the Belt and Road initiative. It allowed me to get into, say, the middle level of the Chinese bureaucracy and really engage with the people there. It helped me really understand how the Chinese bureaucracy worked, what the priorities really were with the Belt and Road program, and what some of their plan was. I always try to make clear that this was a volunteer position for me. I didn't receive pay from the Chinese government. I didn't receive expense reimbursement. It was a complete volunteer position. It was very interesting for me, because I wanted to understand-- there are a lot of people who talk about China who don't really understand the mechanics of their decisions and I really wanted to understand what the pressures are. Every bureaucracy has pressures. Every company has pressures. I really wanted to understand that. I did that just before I founded Complete Intelligence, and then did Complete Intelligence in Asia for a couple years then moved it to the US. You asked me a question, what are my concerns? Given my experience, what are my concerns about the Chinese government? One of my major concerns within the Chinese government right now, with Xi Jinping becoming president for life, with a lot of negative news in China, really, my worry is that bad news doesn't flow up. When I see senior Chinese government officials talk about things, they do talk as if they're not aware of negative things happening at lower levels. I know, everyone puts a brave face on things. That's part of their job. My fear from working alongside people in the bureaucracy there is that bad news only goes so far and then it's not passed up. I think that's a real blind spot for Chinese leadership. My hope would be that they are aware of many of these things and that they would investigate this because it will help them make better decisions. It will help them manage the risk around some of the changes that they need to make desperately in order to navigate the economy through the next few years. We've seen protests in China take up since probably 2011, 2011 through current year. It does contribute to instability in China. I think part of the problem is you have a workforce in China that is older and wealthier than they were 20 years ago. With maturity and wealth, come expectations. We start to have protests in certain areas when the workers have expectations. I don't think that's what the ruling party expects. Obviously, they don't want that. They're in a tough position, they have to allow people to express themselves, but they can't allow it to deteriorate into social instability. The other factor is life is getting more expensive. If you look, for example, at pork prices, and the inflation, pork prices are rising 1% per day in China. You have wages that aren't rising at that rate, you have people trying to provide for their families. They're looking at higher expectations, they're expressing themselves, their wages aren't keeping up with the spend that they need to make. There's a lot of frustration. China has many, many challenges. It's not just Trump and the trade war, it's not just Hong Kong, there are thousands of labor protests in China every year. The interesting part about that is people say, "Yeah, China's a big country, there a lot of people," but there aren't thousands of labor protests in the US every year, you just don't see that. Yes, I would say there are hundreds, maybe small numbers of thousands, but there aren't 10s of thousands of labor protests in the US every year. It is a real issue. It's a generational issue in China, as you see declining workforce population, because again, it peaked in 2015. As you see an older population, and then you see a younger population with higher expectations, you're going to have more pushback. It's just another challenge for the government. How does it damage, say, President Xi or other people? I think it damages them but it's something that they have to figure out how to deal with anyway. If they're going to have a maturing, say, institutional base within their government, they're going to have to figure out how to deal with this. The US figured it out in the '50s, to say, the '70s to the early '80s and it's been relatively peaceful since then, China has to figure it out if they're going to continue to manage the economy. Developing these institutions, and this is one of the big challenges that China has is developing these institutions is a rea-- it's a real challenge and neighbors like China and Korea have developed great institutions. China will develop those institutions, they're just not quite there yet. Our view is that the promise of the Asian century that the social contract that was developed 20 years ago, for the Asian century, which is you give up some social benefit or social freedoms for economic benefit, and we'll continue to provide for you and you'll continue to get wealthier. The challenges that we see in China right now indicate that that social contract is breaking down. If that social contract breaks down, all the excitement of the Asian century really starts to wind down. You have frustration, you have slower growth, you have slower wealth creation, and so on and so forth. In fact, all of Asia-- this isn't just China, but all of Asia has borrowed against the next 30 years to finance the last 10 years. That's a problem. You've seen this globally, but the stereotype of Asians are that they're savers, but actually, what they've done is they've borrowed against the next 30 years to fund the last 10. It's been a great party, I lived there through most of that. It was amazing, but there comes a point where that growth necessarily slows down, because you just can't have the efficiency of economic growth based on credit that you had 10 years ago. That's what's breaking down. The contract of the Asian century, what's happening in the Asian century, the problem for the world is that China's the number two economy, Japan's the number three economy, Southeast Asia has, I think, 600 million people. Very large economies, and they're all slowing at the same time. We're looking for a potential for a global slowdown in say, 2021. It's not 100%, there are a number of things that can push that back. We already see Europe slowing down dramatically. We see China's slowing down dramatically. Japan is already there. The question is, how long can the US resist that global economic drag? I think it can for a while, but I think at some point, the US gets pulled into it, too. We think probably 2021 or so-- but again, things could turn around. Let's say China did a major devaluation and very quickly, they tried to push things back up, or there was another driver somehow. I think that that can potentially be avoided but I think there's a real risk that we see a real slowdown here in the US by say, 2021.