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Is China overtaking the US sooner than expected?
A few days ago I was reading a Bloomberg article, discussing whether Chinese authorities should stick to their 6% GDP growth objective or accept a lower target due to the Coronavirus situation. To maintain a 6% target, the expectation is that China should embark on large-scale monetary easing and government support for the economy. A lower target would lead to a more cautious monetary and fiscal approach. The Chinese government is currently being much more moderate compared to other countries. Germany, in comparison, is launching a $750B program, while the UK is paying 80% of the wages of those unable to work, for a total investment of £350B. The majority of countries are very supportive to their economies with packages around 10% of GDP, and the US is not sparing any expense (see here for a comparison across countries).
US response package
The US has promised unprecedented economic packages. It started with $2T (trillion) from the government. The Federal Reserve is buying unprecedented amounts of assets, last estimated at $4T. More seem to be on the way. As a comparison, TARP, the program launched during the 2008 financial crisis to support the banking system, was “only” $700B, a third of the current spend. That program was also buying safer assets. The current program is going as far as buying junk bonds. The reason the US government is able to spend so much is because the FED is buying Treasuries, financing the government through monetisation of the debt. In practice, the US government is printing money and paying bills with freshly minted dollars. It is important to remember that the USD is a fiat currency, so the intrinsic value of a US dollar is the paper it is printed on (in case of digital dollars there is not even paper). The reason that USDs are valuable is because investors accept their face value. This article from the Washington Post argues that this is possible because “the United States has what has been called the “exorbitant privilege” of having the world’s reserve currency”. The graph below shows that, currently, the USD represents 61% of world currency reserves. Hence, all investors around the world want USDs and so the newly printed dollars do not lead to inflation or debasement of the currency. The author argues that “Americans may be getting something close to a free lunch”. But is there really such a thing as a free lunch?
China response package
China appears to be taking a different path. The government response is much more moderate, with some interventions such as lowering bank reserves, but nothing of the magnitude experienced in other countries. This made me think about the implications and rationale for this move. In my opinion, China thinks longer-term, and in doing so may be preparing to become the world economic leader sooner than expected. According to current estimates, China will overtake the US GDP in 2030, only 10 years from now. I believe this will happen sooner, and it will have significant geopolitical and economic implications.
The future of China
China is investing long-term in a number of areas. For example, the 2025 vision is very focused, concentrated, and rational. China seeks to end its reliance on international technology and upgrade its industrial capability and smart manufacturing by ensuring that innovation, product quality, efficiency, and integration drive manufacturing across 10 key industries. Those industries include advanced information technology; automated machine tools and robotics; aerospace and aeronautical equipment; ocean engineering equipment and high-tech shipping; modern rail transport equipment; energy saving and new energy vehicles; power equipment; new materials; medicine and medical devices; and agricultural equipment. These changes have only been accelerated by the trade war.
Until a few years ago, China was focused on manufacturing goods at low prices. In just a few years, the economic power and innovation created is astonishing. Think about tech giants such as Alibaba, Tencent (we are investors), Baidu, Huawei, and many others. A few days ago, I came across this video showing JD.com’s unmanned warehouse. The pace of innovation in China is incredible.
In economic rankings China is climbing rapidly. The Ease of Doing Business ranking measures international economic competitiveness. The US is dominant but losing ground. In 2010, the US was the 4th most competitive country in the world, while now in 2020 is the 6th. On the other hand, China was 89th in 2010 but in recent years climbed to 31st, and Hong Kong is ranked 3rd.
This economic drive is sustaining Chinese exports. In fact, despite Trump’s trade war, China’s balance of trade with the US remains very large. The graph below shows data to H1 2019. For the full year, the US balance of trade with China was negative $345B, and for the first two months of 2020 it is negative $42B. The decline in surplus is due to the fact that the US is importing fewer Chinese goods, not due to renewed success for US exports. Chinese trade success will not recede any time soon.
This also means that the US needs to finance its consumption. Over the years, the US has been selling assets to finance consumption. The figure below shows the rapid deterioration of US asset ownership. Since the financial crisis, the US sold assets equal to 40% of its GDP. In 2007, net assets equal to approximately 10% of GDP were in foreign hands, while in 2019 the value has climbed to 50%. This means that the US is selling assets to foreigners to maintain consumption levels.
Below we can see how the US ownership of foreign assets is increasing, but at a slower pace compared to the liabilities. The difference is approximately $11T, which is 50% of US GDP. Considering that total wealth of US households is estimated at $113T, the net deficit is less significant but it still represents almost 10% of all assets. On the other hand, China has a net investment position of $2.1T. China’s current household wealth is equal to $23.6T, significantly less than the US, but it is expected to climb to $51.8T by 2028. Thus, we can see that Chinese wealth is increasing and Chinese households are international creditors, while US households are international debtors.
The American approach resembles the housing market prior to the GFC. At that time US consumers were using their homes as ATMs to sustain their spending. On a country level, the same is happening. The US is mortgaging ‘houses’ and using the proceeds to buy Chinese goods. Clearly, this is not sustainable. While the US is increasingly pledging its own assets, China is building FX and gold reserves. China FX reserves have always been very substantial and currently sit at $3T. On the other hand, the Chinese appetite for gold is relatively new. As you can see from the graph below, from 2009 to 2019, Chinese gold reserves tripled to approximately 2000 tonnes. At current prices the gold is worth more than $100B.
Hence, in one corner, we have a country that needs an increasing amount of foreign cash to sustain its economy and spending. Reliance on monetary policy, and economic growth at all costs, are also endangering the pillars of capitalism - efficient distribution of capital and Schumpeterian creative destruction - which are necessary for long term growth. These factors remind me of Japan, a country with stagnant productivity and growth, a stubborn inflation. In the other, we have a growing economy, powered by an increasing amount of innovation and long-term thinking which invests the fruits of its export engine into foreign assets, currencies and gold.
When I was discussing my ideas with Deloitte consultant Bronwyn Burns-Tilney, she mentioned that the US will maintain its dominance through soft power, meaning the appeal and attraction of the US compared to China. This is an interesting point and I agree that it might extend the US’s influence. Probably more people want to move to California or New York as opposed to Beijing or Shanghai (according to HSBC, China is the 26th most desirable country for expats, compared to the US that is 23rd). China is also at a disadvantage when it comes to language and appeal. English is by far the most studied language in the world with 1.5B students, as opposed to Chinese with 30M students. Think also about fashion or Hollywood movies. Everyone knows Leonardo DiCaprio or is familiar with Tiffany’s diamonds, but I cannot name a single Chinese actor or fashion brand. These cultural products will make it harder for China to overcome and replace American soft power and cultural appeal (I am European so probably biased).
However, the last few years are showing changing trends. China is investing in infrastructure around the world, especially in Asia and Africa, and has launched institutions such as the Asia Infrastructure Investment Bank (an institution similar to the World Bank; China owns 26% of it, together with 78 other countries). This is expanding Chinese influence in the APAC region. China is also a much friendlier and more laissez-faire counter-party (this has been criticised as supporting dictators). For example, during this crisis, while the US was rumoured to be diverting medical supplies destined to France and Germany, China was donating medical supplies all around the world. This might just be public relations’ initiatives, but the current US administration is not perceived as friendly in many parts of the world. In recent years, the US has started trade wars seemingly indiscriminately with various trading partners across the world. Even allies in Europe are now questioning whether the US is a trusted ally anymore. Overall, the US has still much more soft power compared to China, but cracks in international perception are starting to appear.
Historical precedent: the United Kingdom
A few months ago I read the book “Destined for war: can America and China escape Thucydides’ Trap?”. The Thucydides’ Trap arises when one great power (i.e. China) threatens to displace another (i.e. the US) and war is almost always the result. In the case of the Peloponnesian war described by Thucydides, what made war inevitable was the growth of Athenian power and the fear this caused in Sparta. In 12 of 16 cases over the past 500 years, the result of struggles like this was war. One case in which war did not occur was when the US displaced Great Britain as the global hegemon around the beginning of the twentieth century. Interestingly, if we look at the currency exchange between USD and GBP over the last two centuries, we can see a collapse in the value of the British Pound.
In the graph above, we can see that GBP hovered around 5 USD for a century, and during the American civil war it even jumped to 10 USD. However, after the World War 1, it started its decline from 5 USD to the current 1.2 USD to 1 GBP. Although this is a long term trend, sterling lost 50% of its value in just a few years. Commentators argue that “any hopes of a post-war recovery for the Sterling against the Dollar were dashed by Britain’s emergence from the war with an unprecedented level of debt, nearly 250% of the nation’s GDP with the US holding the majority.” Many countries have paralleled the current Coronavirus battle to a war.
The graph below shows the widening gap between GDP and debt. Over the last 60 years, US GDP increased from $540B to almost $22T today. US debt (includes all debt such as government or corporate) has grown from $763B to $75T today. Hence, while debt was 141% of GDP in 1960, today is 340%. These figures do not include future liabilities such as Medicare. Japanese and Chinese investors hold large amounts of this debt. Times are clearly different compared to 100 years ago, but these are interesting comparisons.
Another historical reason for the fall in GBP compared to the USD was that “the following two decades were characterised by persistent balance of payment problems for the UK”. As we have seen above, the US clearly has balance of payment problems. The US is not only negative with China, but with the world for more than $600B, or 3% of GDP, in 2019.
China has its own debt problems. The graph below shows that China debt represents 310% of its GDP. However, compared to the US, Chinese debt is mostly internal debt, so there is no exposure to international creditors and exchange rate fluctuations. Further, China is growing much faster, so it is more likely to absorb this debt.
The change in economic dominance around the world might not happen this year, but it is happening faster than most people expect. The US is overleveraged and affected by short-termism. China is thinking longer-term with its government and monetary policies. The US monetary policy is risky and might lead to sudden and unexpected consequences such as the devaluation of the USD. This could be prevented with more conservative policies, but the current administration does not seem to worried about these perspectives. Sometimes you get lucky and receive a free lunch, but free lunches every day are harder to come by.
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