Dual circulation policy in China; what does it mean to your portfolio? Evergrande an example.


By way of acknowledgement my thanks to Stewart Paterson of Capital Dialectics for the explanation, he produces a monthly Capital Markets News letter looks at Macro issues and how they impact fundamentals of investing.  I listened to his presentation last night and I thought it useful to share.  If you would like more details log on to ERI-C and you can listen to his explanation or ask me for more details.

Summary 
If you don’t have to invest in China at present then there are better EM/Frontier markets.
If you do have to then SOE’s and those companies closely aligned with ‘Xi’s thoughts’ are likely to outperform going forward as ideology takes precedence over growth.

Background
China often comes out with often vague slogan driven economic policies. Sometimes it is hard to western ears to understand then but it is a mistake to ignore them.
The dual circulation policy is the next step from the 1987 Great International Circulation Policy, that was the framework that provided for the opening up of the Chinese economy. If you had correctly interpreted that as being the pursuit of merchantilist export orientated growth and the link of the monetary base, banking system and money creation to China’s export surpluses would have lead you to invest in the for the likes of Li & Fung, Techtronics, the Shipping companies and Property companies in the 1990’s. So clearly these statements, policy pronouncement are important for long term investment policy.
Also bear in mind that China makes policy pronouncements that set the frame work for the long term.

So Dual Circulation  
Dual Circulation then is about International and Domestic policies.
In China’s case:-
Building up resilience in the Economy, putting the Economy on a ‘cold war’ footing. Preparing the economy for a period of great power rivalry.
So Geopolicitics is very important but also a recognition that the days of prioritising high GDP growth are over. Also a recognition that the goals of the communist party are now the priority and to achieve those the country can no longer high growth. It would be impossible to do both.
The Domestic element effectively means revising the social contract with the people. From you give us monopoly on power and accept the restraints we put on society and we will make you richer year in year out by growing the economy very fast. Now without that fast growth a new definition of the contract is required and it is what President Xi now calls ‘The China Dream’ or the ‘National Rejuvination’.
To understand it one must look at most policy statements through a geopolitical prism, not everything but he refers an earlier report which subscribers have access to ‘Investing in Cold War II’. Many issues can be viewed in a normal way; for example the recent changes in Education, that was not about punishing US investors but all to do with social harmony and a better lifestyle for the mass of the people.
Important whilst geopolitics is important to Dual Circulation it is not everything.
There are 3 key parts of Dual Circulation
1. Party being central to everything; President Xi described it as North South East West. Party control in Society, the economy, everything is paramount. That presents challenges to investors historic thinking and leaning towards the private sector, particularly sectors not dominating the commanding heights of the economy and so more managerial freedom of action this new principle challenges that and hence the investing rationale that underlies that.
2. Going forward ideology trumps pragmatism. So if you looking at the people being promoted, look at the scope for debate on policy, that is being closed down. So if part of the social contract was that the party said our monopoly of power comes with technocractic excellence. Therefore we make the right decisions because we are not under the same pressures as democratic countries that operate under the threat of re-election and so can take a long term view; founded in science and sound policy. That principle is also being challenged.
So there is a rise of social scientists over technocrats. Seen in the growth of small working groups over ministerial responsibility. So now for policy implementation it is a matter of ideology purity over pragmatism and technocrats. That to an extent means loyalty to Xi is replacing loyalty to the party as the means of success. Loyalty to Xi is being conflated with loyalty to China. But with 90 million party members not all agree with all his ideology so some of the statements are deliberately vague so that allows everyone of them room to agree. Plus the party machinery is being worked to ensure that his ideology is paramount.
3. Economic growth is no longer the key driver of policy. Social harmony is a key ingredient of national power, social cohesion and so if rejuvination of the China Dream is the policy goal of the party it is a mistake to look at policy from the standpoint of saying XYZ policy is not good for growth and hence will not happen. That would be a mistake. Growth is no longer a priority.

So on that basis Dual Circulation is an umbrella policy that allows other elements to operate.  The 14th 5 year plan lays out some of those policies.
But you also have subsiduary plans put in place and by looking at them and their objectives & consequences are; you get a much better idea about what it means.
So on the International dimension it is all about national power and there are two elements.
Offensive elements; developing China’s sphere of influence geographically it would be the Belt and Road Initiative (BRI). But also increasing influence by standard setting in things like IoT in tech, AIIB multilaterial development banking and promoting BRI. Its position in the WHO which has been coming under scrutiny recently.
Defensive would be reducing its dependency on any country that will either resist its moves as it hedgemony grows or worse bring attention to them like Australia did over covid. Looks at China’s trade patterns; diversification of hydrocarbons towards countries like Angola and Iran where there is an asymmetric power relationship. It is also looking to weaponise those countries that are reliant on China is key to Dual Circulation.

Domestically its looking at common prosperity means; that will involve challenging the assumption in the models we have regarding
1. The taxing of corporates and individuals
2. Removing economic moats and economic rents; ensuring that there are no longer opportunities for super profits.
The aim being to deliver a lower the cost of living to the masses; hence the recent moves on healthcare and housing being very important.
Common prosperity is about ensuring social unity & harmony and support for the current regime.

So a good example of this is and building resilience into the wider economy can be seen in the concept that is currently working out and hurting investors is in the three red lines policy. He then again referred to a recent report ‘Chinese Real Estate the next great deflationary shock’.
So 3 red lines through the prism of dual circulation and the objectives of the regime we see:
Firstly to limit leverage in order to protect the banking system.
40 years ago property was important China was a third world nation and its property stock reflected that even in the major cities. But no longer, today its property stock is world leading. So what does it do today for China’s national power? That phase of China’s progress is effectively complete. Future real estate development is relatively unproductive.
Today its property now ties up money that could be better used in other parts of the economy, namely not financing activities that will help China move up the tech ladder.
Furthermore property is where people have been parking money, hoarding wealth outside the state financial system. Remember Xi saying ‘property is for living in’ because he wants the money tied up there being used elsewhere.
Also property has become socially divisive and expensive disadvantaging those who did not get on the ladder early. So a challenge to social harmony.
Then you have the current problems of Evergrande and maybe R&F and others posing a threat to the financial system because of leverage.
Property development should be an asset light process considering that pre sales are allowed and yet Property liabilities account for 65% of GDP. Furthermore local land sales give local authorities cash and hence some local economic control which is at odds of the current theme and trend towards Central Party Control.
So through that prism three red lines makes perfect sense.
It might hurt economic growth short term but its about the quality of the growth going forward and redirecting ‘national resources’ the national savings pool; towards more productive objectives that will help achieve the China Dream.
Going Forward 
We are likely to see a progressive tax system implemented which is likely to include a property value tax, assessed locally and maybe collected locally but sent to the Central Government and then redistributed to those sectors or regions ‘in need’ in order to get the desired balance.
So dual circulation is ideology, re-distribution of wealth that is under central control. Its not all about communism; it is about meeting genuine social and economic needs that exist.
So what have the last 12 months shown us and mean for investors?
It is well known that China saves too much, meaning that there is a capital stock is bloated so total productivity is falling. Meaning no easy growth. Meaning China needed to redefine its social contract.
Dual Circulation doesn’t change that outlook for capital in China but may make it worse. Growth is reduced because resource allocation becomes more planned and less market driven. But China cannot afford to be generous to capital there is too much capital and the stresses on society from a bloated capital stock earning higher returns is too great. So we are likely to see greater state direction of capital.
For example in 2020 China needed to recycle circa $800bn of capital outside the country. Current account rising in part due to covid, strong inflows into China from bond buying, equity and FDI remained firm. That meant China was funding about 5% of the rest of worlds gross fixed captial formation, directly or indirectly; that is a lot of money wanting to get out or being channel out. Which prompts the question why do they need foreign capital. Also how does foreign capital fit into the China Dream?
Key to remember the purpose of Dual Circulation is resilience and that means autonomy in advanced manufacturing; like semiconductors or generally moving up the value chain to reduce foreign dependency on IP etc. So what is the role for foreign capital and how can you earn returns that are sustainable that justify the jurisdictional risk.
The answer is you need to ensure the need to make sure you are aligned with Party objectives (Huawei being a prime example), that in itself raises questions and other risks connected with ESG for example.

So for investors what does this mean.
At a very basic level if you don’t need to invest in China then don’t.
There are other EM markets and Frontier markets that offer better opportunities, markets that are in the same position that China was 20 years ago and will offer similar opportunities to those seen in China when the External Circulation Policy was first put in place. These are countries that will benefit most from bifurcation of the global economy. They will benefit from the cost escalation in China, the geopolitics and the diversification of supply chains and building in resilience in those supply chains.

If you are a dedicated China fund and have to invest you need to rethink the positions. Historically the thinking has been to invest in private companies; where there is dynamism, good management and alignment of minority interest. Companies that benefit from economic rents from brands, oligopily or dominant position. So most foreign portfolio’s are concentrated into areas now under attack from dual circulation.
Going forward there is probably going to be a narrowing of the profit spreads between private sector and public sector; with the private sector less able to command historic profits. The government will ensure that SOE’s do better (they have always been advantages and that is likely to continue and enhanced) so valuations of the private sector companies probably need to be revised lower to reflect levels of profitability that the regulator will allow. So SOE risk is diminished and hence they are likely to outperform

He then went onto to look at China’s ambitions in Taiwan?
Core to the China Dream, unification and the access to the semiconductor business. Peaceful unification is a dream of hope but never achieved, a reminder of past grievences. Politically is serves a purpose to maintain the nationalist dream and is better served by not being achieved. But HK has demonstrated that a peaceful agreement is unlikely to be adhered to and therefore very unlikely.
There were more interesting questions well worth listening too.