The Hong Kong China 50 Index, which includes the top 50 Chinese companies listed in Hong Kong, Shanghai, and Shenzhen, dropped nearly 6% on Monday on heavy volume. Stocks with significant foreign holdings were hit particularly hard, with Alibaba, Tencent and Meituan each tumbling more than 10%. Bloomberg data suggests that overseas investors sold a record net $2.5 billion of mainland shares via Hong Kong Connect, putting the year-to-date cumulative foreign flows into negative territory. The RMB declined to its weakest level since 2007.
Foreign dumping of Chinese assets on Monday reflected the poor reception by the international community of the unveiling of the new Chinese leadership lineup on Sunday. Much of the news coverage in the western media focused on the fact that the members of the new standing committee of the Politburo have strong ties with Xi. One western commentator wrote: "This is a leadership that will be focused on achieving Xi’s political goals, rather than pursuing their own agendas for what they think is best for the country,”
Unlike the market, we prefer to view the new leadership as a glass half-full as opposed to half-empty. In the past, a new Chinese president often had to spend more of his first term consolidating his power base than on getting things done. The fact that Xi in his third term will not have to engage in factional political infighting should allow him to focus his energy on implementing his policy agenda. This is not inconsistent with our view that now that the Party Congress is over, China will start to gradually relax the zero-tolerance policy. If we are right, this should be bullish for oil and commodity currencies like the AUD.
We also think that the market is misjudging the ascendancy of Li Qiang to the standing committee and as the presumed premier. Li studied business administration and holds an MBA degree from Hong Kong Polytechnic University, a top-tier Asian business and technology school. Li was one of Jack Ma’s most visible supporters in the China Communist Party leadership. As the party secretary of Shanghai, he brought Elon Musk’s Tesla to Shanghai. Li’s track record is that of economic and financial innovation in the Shanghai Free Trade Zone and bringing in major foreign investment that was up by 32% in 2021 despite Covid. In our view, recent capitulation by foreign investors may be providing a good opportunity to go long the Chinese stock market (David Woo and Uwe Parpart)
[Note: The term Zhijiang refers to the Qiantang River, which runs through the province, but is often used as a poetic reference for the greater Zhejiang region. The term was first used as the title to Xi Jinping's book Zhijiang Xinyu (之江新语), a book compiling the political philosophies of Xi Jinping during his five-year term as party chief of Zhejiang, published in 2007.]
“Loyalist, loyalist, loyalist” was the unvarying mantra of the Western press and commentariat after Shanghai party chief Li Qiang walked onto the stage in the number two position behind CPC General Secretary Xi Jinping on Sunday.
By precedent, the number two position on the Standing Committee of the Politburo is designated as the incoming Premier, leader of the “North Palace” (State Council), the “South Palace” being the headquarters of the party secretariat.
Over the past ten years, as Premier Li Keqiang ruled over the “North” and President Xi over the “South”, there was no outright rivalry or positional jockeying between Li and Xi. But there was friction, there were disagreements over policy direction, and – most importantly – complaints from the "South" over the lack of expeditious execution of policy.
Now this friction will disappear. Most policy papers authored by Xi Jinping while he ran Zhejiang province were drafted by his secretary Li Qiang. And he will have a freer, more trusted hand than his predecessor.
Who is Li Qiang?
A loyalist, says the commentariat, satisfied with a dismissive term, and too lazy to inquire further.
Li is a native of Wenzhou, one of China's highest-income cities. It was the first major city to embrace economic reform in 1978, was the first to set up private enterprises, and hasn't stopped since. Per capita income over the period has grown 500-fold.
Wenzhou is also known as the cradle of mathematicians of the greater China region. Shu Shien-Siu (born 1912) hails from Wenzhou, did his graduate studies in the 1940s at Princeton and MIT, and later helped found the high-tech "Silicon Valley" industries of Taiwan. Li, with an MBA from Hong Kong Polytechnic University, continued in Zhejiang and Shanghai in that direction and spurred reform at the Shanghai Special Economic Zone.
Then he failed to deal effectively with the Covid Omicron virus in Shanghai. Politburo “Iron Lady” Sun Chunlan was sent in to handle a harsh lockdown. Xi Jinping nonetheless wants his experience and reform drive to run the Chinese economy. Sun, meanwhile, has been retired.
Newly appointed politburo members Zhang Guoqing, Liu Guozhong, and Yin Li are tipped to serve on Li’s new State Council team come March 2023.
Zhang will oversee industrial policy. Currently party secretary of Liaoning, he previously served as mayor of megacities Chongqing and Tianjin. He holds a doctorate in economics from Tsinghua University and attended an executive management course at Harvard Business School.
Liu is the party secretary of Shaanxi Province. He previously served as deputy party secretary of Sichuan. He holds a graduate degree from the Harbin Institute of Technology and is designated to take charge of agriculture and food production.
Yin Li is the party secretary of Fujian Province. He is a health professional and has held leading positions in the China Food and Drug Administration and at the WHO. Between 2002 and 2003 Yin completed a study term as a visiting scholar at the Harvard T.H. Chan School of Public Health. He has served as vice minister of health.
Two further key appointments expected in March are the replacements for vice-premier Liu He (age 70) and for PBOC governor Yi Gang, both of whom will retire.
Liu He will hand his mandate over to He Lifeng, the current head of the National Development and Reform Commission (since 2017) and newly appointed politburo member. He Lifeng has collaborated closely with Liu in running economic and financial policies. He studied finance at the Xiamen University School of Economics and obtained a Ph.D. degree. He began his political career in the Xiamen municipal government and was instrumental in establishing the Xiamen special economic zone.
The most likely successor to Yi Gang at the PBOC is Yin Yong, 53, a former deputy central bank governor and current vice party chief in Beijing. He has a Ph.D. from Tsinghua University and a master’s degree in public administration from Harvard University.
Yin ran the State Administration of Foreign Exchange for seven years and is an experienced international monetary economist. Since 2018, he has worked closely with Beijing party secretary Cai Qi, a new Standing committee appointee.
Li Qiang will lead an experienced team of administrators and economists with ample international experience, committed to reform, further opening of the economy, and technological innovation.
These are the Xi loyalists. More important for China’s direction during the next five years are their qualifications and their policy precepts. Loyalism tells us little. The fact that Xi has picked this particular of loyalists tells us something critically important about Xi and his policy direction. (Uwe Parpart)
Washington establishment wants to stop China
Expect no let-up in the American tech war with China. The Biden Administration’s Oct. 6 chip ban followed recommendations from a September report of the US National Commission on Artificial Intelligence, which stated: "China is powering its AI ambitions and military modernization with advanced chips designed and built by firms based in the United States and allied countries. Policymakers must keep export controls and other policies current to the technology and threat, then place the onus on firms to demonstrate that sales of cutting-edge chips to the PRC do not boost Beijing’s military modernization and human rights abuses.”
This report ("Mid-Decade Challenges to National Competitiveness), supervised by former Google Chairman Eric Schmidt and featuring an introduction by Henry Kissinger, is something of a manifesto of the foreign policy establishment and reflects a bipartisan political consensus.
Schmidt and other tech industry leaders have lobbied for years on behalf of a national policy to maintain America’s advantage vs. China, but this denotes a radical shift in tone, from improving America’s game to stopping China by any means necessary. The new sense of urgency for action partly reflects the realization that US electronic design software (EDA) may have boosted China’s hypersonic weapons program: US EDA software may have enabled China to make the advanced chips for its supercomputers that run computer simulations for hypersonic weapons tests, which also rely on US-supplied specialized aeronautical software. (Gabriel Honrada)
China’s guarded response to US semiconductor curbs
The damage to China’s semiconductor industry from the latest US export restrictions is difficult to gauge. In our view, it will depend crucially on how China’s trading partners in Asia respond. Japan leads the world in terms of the broadest range of semiconductor equipment technologies, and most of its IP is local rather than American — unlike ASML, whose EUR lithography machines (required for the most advanced chips) include a large proportion of US IP.
China will account for 28% of the revenue of Nikon’s and Tokyo Electron this year. According to our contacts, Nikon continues to ship semiconductor machines to China. Tokyo Electron hasn’t cut any shipments to China but says it is watching the political situation carefully. A source at the company estimated that its ROE would fall to 20% without its Chinese revenues from a current 37%.
China will struggle to replace American fabrication equipment and EDA tools, but the Japanese can fill many of the gaps in China’s supply chain. (David Goldman)
China will pivot towards Asia even more quickly
As the US-China relationship deteriorates, China will accelerate the integration of its economy with its neighboring countries. The influential Peking University foreign policy sage Jin Canrong called this week for “consolidating economic and trade relations with neighboring countries through RCEP (Regional Comprehensive Economic Partnership), and further opening up through applying for participation in the CPTPP (Comprehensive and Progressive Agreement for Trans-Pacific Partnership).”
China now exports four times as much to Asia as it does to the US. Its exports to ASEAN rose 35% in the past year while exports to the US fell. Asia’s economies are more tightly integrated than ever. South Korea’s exports depend on components imported from China. Japan’s trade with Southeast Asia is tightly integrated with China’s.
With US and European companies coming under increasing pressure to reduce their exposure to China, Beijing’s calculation is that disentangling Asian supply lines from China probably isn’t possible at any price (David Goldman).
US will pay a high price in the long-term
Export controls on China, though, cut two ways. Lost revenues to American makers of chips and chip tools will punch a hole in R&D and capex budgets much bigger than the $38 billion subsidy of the CHIPS act can fill. It will give China all the more incentive to duplicate American technology and take market share from US firms. It also impacts human capital. 1,400 US-trained Chinese scientists have left senior corporate or tenured positions at top-tier US universities and research institutions over the past two years. About 80% of US doctoral candidates in electrical engineering are foreign, and most of those are Chinese. (Gabriel Honrada).
Russia-Ukraine war: expect an escalation
over the next four weeks
We expect an extreme intensification of the Ukraine War in the month remaining before winter inhibits ground operations. After the sabotage of the Nord Stream II pipeline, the work of highly-skilled state actors, Russia abandoned whatever hopes it might have had for a negotiated solution and subsequently attacked Ukraine’s vital infrastructure. With between 30% (Ukraine estimates) and 50% (Russian estimates) of infrastructure damaged, Russia will attempt to make large parts of Ukraine uninhabitable with drone and missile strikes during the next several weeks. The object is to demoralize the Ukrainians and drive millions of refugees into neighboring countries, creating a political crisis in Germany among others. Ukraine is running low on money and ammunition, and the next US Congress will be less disposed to fund Ukraine than the Biden Administration.
Ukraine meanwhile has massed forces around Kherson, and has both a substantial numerical advantage as well as the benefit of tactical intelligence with the full support of NATO technology and advisers. If the outcome is the loss of Kherson it would be a severe blow to Russia and a humiliation for Vladimir Putin. Ukraine has taken high casualties in the last month’s fighting, but its logical next move is to bet its remaining manpower and munitions on a victory in Kherson. Russia will vigorously defend a city that it now deems part of the Russian Federation.
We are therefore likely to see an intensification of fighting on the ground as well as redoubled attacks on Ukraine's infrastructure. Russia is struggling to keep up with Ukraine’s effective use of NATO’s high-tech intelligence. Several thousand Ukrainian officers are now in intensive training on these systems in NATO countries, and Russia lacks an officer corps capable of using its own technological capabilities. On Oct. 18 Russia launched what was presumed to be a military spy satellite, in a late effort at catch-up. Russia meanwhile has the advantage in low-tech drone swarms that cost a tiny fraction of the anti-aircraft munitions capable of shooting them down.
Russia’s logical move is to hold Kherson at all costs until winter prevents ground operations, and then hope that the high cost of war and the refugee disaster will persuade the West to slacken support for Ukraine. A negotiated solution is out of the question, now that the Biden Administration has staked its credibility on Putin’s humiliation. But an armistice in place without major military operations is possible if Ukraine loses support.
Geopolitical risk is likely to peak during the next month. That may explain why 1-month USD/EUR options are trading at historic highs vs. 6-month USD/EUR options – see Chartbook. (James Davis)
Note: The Global Uncertainty Barometer is derived from the difference between realized (GARCH) volatility of key financial variables and the implied volatility of at-the-money three-month options on the same variables. The implied volatility of major financial variables as such constitutes a risk measure; the difference between realized (historical) and forward-looking (implied) volatility gauges the market’s estimate of the chance of a change in the distribution of outcomes. Here we attempt to distinguish between “risk” (within a well-defined distribution) and “uncertainty” (the possibility that the distribution of risk itself may change). An additional input is the residual of the regression of gold vs. the 5-year TIPS yield. Under normal conditions, gold and TIPS provide a similar portfolio function as a hedge against unexpected inflation and unexpected depreciation of the dollar. The deviation of gold from TIPS reflects a change in the level of uncertainty about fiat currencies in general.
The variables employed areThe S&P 500
The Euro Stoxx Index
Euro
Japanese Yen
10-Year US Treasury
10-Year German Bund
The residual of the regression of gold against the 5-year TIPS yield.
These six variables are decomposed into Principal Components (orthogonal vectors in multidimensional space), and the Risk Barometer is the 1st Principal Component (the risk common to all variables), shown as a monthly moving average of daily data.
Why we like steepeners: 2nd Principal Component (curve slope) explains more variation of the curve when the 1st Principal Component (level) is static. That’s a complicated way of saying that the curve tends to steepen at the end of a tightening cycle.
Sorry, America – China’s just not that into you. China’s exports to Asia are four times larger than its exports to the US or Europe.
China’s export growth last year was overwhelmingly concentrated in Asia in absolute terms….
…and in terms of rate of change.
The Asia Trade Integration Impulse measure below calculates the extent to which Chinese exports are rising to all Asian countries at the same time. The higher the index, the more integrated Asian trade is. It’s clear from the jump in the index after 2020 that China’s export explosion is an all-Asian phenomenon. Asia has become tightly integrated, and China is
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