By Jay Roberts
On the receiving end
It’s been a rough ride for stocks in China and Hong Kong. Global equities have eked out a 1.2 percent gain in 2018, while Hong Kong’s Hang Seng Index (dominated by Chinese companies) is down by 5.3 percent, the Shanghai Composite has fallen by 14.6 percent, and the Shenzhen Composite has declined by 18.4 percent. From the January peak, the latter two indexes are in bear market territory. Hong Kong is arguably correcting from a euphoric peak in January after a handsome 36 percent gain in 2017. The same cannot be said for China: Shanghai was only up by 6.6 percent while Shenzhen actually fell by 3.5 percent.
There are several reasons for the underperformance. China’s process of deleveraging, or rather curtailing excessive growth in riskier areas of its credit markets, has been going on for a while. “Total social financing,” a broad measure of credit growth in China, rose by 9.8 percent y/y in June, a sizeable number but actually its lowest level of growth on record (since 2003). Chinese bond yields have risen, with the rise in global corporate bond yields surely not helping. All in all, onshore borrowing conditions have tightened in 2018. To be clear, things aren’t falling apart. Much of this is a deliberate result of policy as China finds answers to the common investor concern that its debt levels were growing too quickly. But the slowdown continues.
Additionally, and much more prominently for global investors, there is the escalating trade dispute between the U.S. and China. As the punchy rhetoric has translated into actual policy and real-money tariffs over the past few months, losses for Chinese equities have accelerated. Most of the decline has occurred since May. Some fiscal stimulus measures from the government in July provided a short-lived hiatus for stocks. Renminbi weakness has raised the mercury further.
The real issue
China ran a US$375B trade surplus with the U.S. in 2017. It’s easy to think that this is the focus of the U.S. It’s also easy to think, therefore, that the answer is “simply” to reverse the trend, for example to get China to buy more oil and gas from the U.S. But the trade surplus is not the real issue. And the answers are far from simple. The crux of the problem is that the U.S. is demanding that China change its laws, regulations, and behaviours. That’s a real challenge and why the dispute could easily evolve into a series of battles, or rather a trade war.
In our view, the trade surplus is largely a red herring, especially when one considers that a sizeable chunk of the goods coming from China are produced by multinational companies that effectively use China’s scale for the assembly of products, often with key value-added components coming from other countries. Smartphones are perhaps the most obvious example.
The dispute properly began in March 2018 when the Office of the United States Trade Representative, headed by Robert Lighthizer, published a statement outlining the administration’s response—primarily tariffs and investment restrictions—to “China’s unfair trade practices covered in the USTR Section 3011 investigation of China’s Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation.”
The report concluded, inter alia, that China uses foreign ownership restrictions to pressure U.S. companies to transfer technology; that China restricts foreign technology licensing, resulting in terms that unfairly favour Chinese companies; that China systematically invests in U.S. companies to generate large-scale technology transfers; and that China conducts and supports cybercrime against U.S. companies.
Importantly, the short statement contains this stand-alone sentence: “The Chinese government’s technology transfer and intellectual property policies are part of China’s stated intention of seizing economic leadership in advanced technology as set forth in its industrial plans, such as ‘Made in China 2025’.” Effectively, the U.S. administration is accusing China of buying, coercing, or stealing its way to acquire U.S. technology in order to rapidly upgrade its economy. This is fueling nationalistic views that position China as a threat to U.S. hegemony, or “seizing economic leadership.”
Amidst the trade dispute, Washington is pushing back against this 'Made in China 2025' plan
|Information technology||Integrated circuits & special equipment
Information and communication equipment
Operating systems and software
|High-end machine tools and robots||High-speed, efficient machine tools
Robots (multiple industries)
|Advanced rail transportation equipment||Build the world’s leading, modern rail transit industry system|
|Energy conservation and new energy vehicles||Technology for advanced combustion engines
Support the development of electric vehicles
|Biological pharmaceutical and high-performance medical apparatus and instruments||Develop new products in chemical medicine, biotech drugs, and traditional Chinese medicine
Develop high-performance medical devices such as imaging equipment, biological 3D printing
|Aerospace equipment||Aviation equipment; form independent, complete aviation industry chain
|Marine engineering equipment and shipping technology||Develop deep-sea exploration|
|Electric power equipment||Promote the development of new energy and renewable energy equipment, smart grid transmission and transformation equipment, and advanced energy storage|
|Agricultural machinery and equipment||Develop advanced agricultural machinery|
|New materials||High-performance structural materials|
Source - China’s State Council, RBC Wealth Management
Made in China 2025
In fact, Made in China 2025 (MIC2025) is not a new plan. It was introduced by the Chinese government in 2015. Other countries such as Germany and Japan have similar national plans. The priorities of the plan include: promote innovation; improve the quality of goods and services; and promote renewable energy and environmentally friendly industry. In short, to move up the value chain and to become more self-sufficient. There are 10 categories in focus (see table). The plan comes with key performance indicators such as target ratios for research versus revenues, patents versus revenues, broadband penetration, CO2 emissions, water usage, and so on.
A new world order
MIC2025 has done more than just ruffle a few feathers in Washington. In an interview with Fox News in March, Lighthizer called MIC2025 a “very, very serious challenge, not just to us, but to Europe, Japan and the global trading system.”
Also in March, Peter Navarro, a big China bear on trade, advisor to the president, and author of the 2011 book Death by China: Confronting the Dragon, stated on Bloomberg Television that China “brazenly has released this China 2025 plan that basically told the rest of the world, ‘We’re going to dominate every single emerging industry of the future, and therefore your economies aren’t going to have a future’.”
Trump’s own statement of June 15 announcing a possible tariff of 10 percent on $200B of Chinese goods stated right off the bat that “these tariffs are being imposed to encourage China to change the unfair trade practices … with respect to technology and innovation.” Indeed, the majority of the products captured under the first round of tariffs are associated with the MIC2025 segments.
In response, China has said that criticisms from the U.S. and EU are hostile to the initiative as it moves China to become a direct, value-add competitor. Additionally, there is a desire in China to become more self-reliant. The recent story of ZTE Corp. (0763 HK) is an excellent example as to why.
A real threat?
MIC2025 sounds impressive, comprehensive, and even commercially threatening, depending on one’s point of view. The reality may be somewhat different, however. MIC2025 was conceived at the top. Top-down initiatives have come and gone with varying degrees of success or failure during China’s modern history. Implementation is via local governments and then via companies, who would apply for funds.
The National Manufacturing Advisory Committee, which advises the Chinese government, published a report outlining problems with the implementation of the plan. The report found that: many local governments simply rebranded existing policies to show adherence; development targets are set too low; local government policies are not market-oriented as they are reluctant to take risks; project approval is lengthy; and there is a lack of coordination among local governments with many choosing similar industries to support, perhaps leading to overcapacity.
Separately, the South China Morning Post2 reported that one city gave 10 percent of its MIC2025 budget to a company to set up a new “smart” liquid milk tea factory —hardly global economic leadership.
The base case is that the U.S. will press on with further measures against China sometime soon, even though one might question the actual threat posed by MIC2025. That these developments come as the U.S. approaches the midterm elections in November is noteworthy. They are also in line with a U.S. administration that is increasingly turning away from the rest of the world under the auspices of getting a better deal.
Most recently, China has stated that it will respond to the second round of U.S. tariffs with another set of its own tariffs, ranging from taxes of five percent to 25 percent, on another $60B of U.S. goods. There are minimal negotiations at present between the two sides. The trade war could take shape. Consequently, we believe China and Hong Kong equities will remain under pressure, although we suspect that much of the damage has already been done to stock prices.
1 Section 301 is a key enforcement tool that allows the United States to address a wide variety of unfair acts, policies, and practices of U.S. trading partners.
Non-U.S. Analyst Disclosure: Jay Roberts, CFA, an employee of RBC Wealth Management USA’s foreign affiliate RBC Dominion Securities Inc., contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since he is not an associated persons of RBC Wealth Management, he may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.