Emerging Markets

Trepidation engulfs commodity markets like a fog weaving through half-deserted streets. Central bankers huddle in muttering retreats, growing more cautious by the day. EM growth concerns – particularly slowing trade volumes, and the drama surrounding Sino – U.S. trade negotiations – contribute to this. Europe’s slowdown as Brexit approaches, and a U.S. government that seems forever at loggerheads also sap investor confidence. Nonetheless, the level of industrial commodity demand – oil and copper in particular – continues to hold up. By our reckoning, EM growth still is positive y/y. And central bank caution – along with less-restrictive policies – provides a supportive backdrop for industrial commodities down the road. The production discipline we expect from OPEC 2.0 this year sets the stage for a continued rally in oil prices. Given our view on EM growth, we continue to favor staying long oil exposure, and remaining exposed to industrial commodities generally via the S&P GSCI position we recommended on December 7, 2017. Highlights Energy: Overweight. We are closing our open long call spreads in 2019 Brent, having lost the ~ $1/bbl premium in each. We are opening a new set of similar positions in anticipation of the next up-leg in Brent. At tonight’s close of trading, we will go long Brent $70 Calls vs. short $75 Calls in June, July and August 2019. Base Metals/Bulks: Neutral. Metal Bulletin’s benchmark iron ore price index for China traded through $90/MT earlier this week, as supply concerns continue to weigh on markets in the wake of evacuations from areas close to tailings dams used by miners.1 Precious Metals: Neutral. Bullion broker Sharps Pixley reported the PBOC’s gold reserves total almost 60mm ounces, up 380k ounces from end-2018 levels. Russia’s state media outlet RT proclaimed: “China on gold-buying spree amid global push to end US dollar dominance” on Tuesday. Ags/Softs: Underweight. Last week’s USDA WASDE report estimates world ending stocks for grains will be up slightly for the 2018-19 crop year at 772.2mm MT vs 766.6mm MT previously estimated in December. A January report was not issued due to the U.S. government shutdown. Feature In discussions with clients in the Middle East last week, few contested the assertion OPEC 2.0 is determined to keep supply below demand this year, in order to draw down global oil and refined product inventories.2 This strategy worked well for the coalition after it was stood up in November 2016. Back then, production cutbacks, an unexpected collapse of Venezuelan output, and random outages in Libya and elsewhere combined with above-average global demand to keep consumption above production. This led to a drawdown in OECD inventories of 260mm barrels between January 2017 and June 2018. OPEC 2.0 is off to a strong start on its renewed effort to rein in production and draw down inventories. OPEC (the old Cartel) cut nearly 800k b/d of production in January m/m, bringing members’ total crude output to 30.8mm b/d.3 The largest cut once again came from KSA, which reported it reduced output by just over 400k b/d m/m in January. This follows a 450k b/d reduction in December 2018 reported by the Kingdom in last month’s OPEC Monthly Oil Market Report. For March, KSA already is indicating it plans to drop production to 9.8mm b/d – 1.3mm b/d less than it was pumping in November 2018. There are some signs of discord within OPEC 2.0. Rosneft CEO Igor Sechin once again is arguing against the coalition’s production-cutting strategy, this time in a letter to Russian President Vladimir Putin.4 This is not the first time such disagreements were aired: In November 2017, leaders of Russia’s oil industry walked out of a meeting with Energy Minister Alexander Novak following a disagreement with the government on extending OPEC 2.0’s production-cutting deal launched at the beginning of the year. In the end, the deal was extended after President Putin weighed in.5 A Deeper Look At Demand Uncertainty These supply-side issues are not trivial, and pose significant risks to our price view. All the same, Russia does benefit from higher oil prices, in that inelastic global demand in the short-to-medium term produces a non-linear price increase when supply is reduced. Russia’s OPEC 2.0 quota calls for production to fall from 11.4mm b/d production basis its October 2018 reference level (11.6mm b/d at present) to 11.2mm b/d in 2019. As long as Russia’s participation in the OPEC 2.0 coalition advances its economic and geopolitical interests – i.e., higher revenues than could be expected without having a direct role in global production management, and in deepening its ties with KSA – we expect it to remain a member in good standing in OPEC 2.0. At the moment, the bigger issues center on the state of global demand for industrial commodities. Unlike the situation that prevailed during the first round of OPEC 2.0 cuts, global markets no longer are seeing a synchronized global recovery in aggregate demand. Rather, EM commodity demand growth – the engine of global growth – has been trending down at a slow and constant pace since the beginning of 2018. This is not news: It shows up in our new Global Industrial Activity (GIA) index, and we’ve been writing about it and accounting for it in our metals and oil demand projections for months (Chart of the Week). Chart of the WeekCommodity Demand May Be Bottoming BCA’s GIA index is heavily weighted to EM commodity demand. Based on our estimates, it appears to be close to or in a bottoming phase and ready to turn up within the next quarter. It is worthwhile pointing out that even with the slowdown over the past year or so, BCA’s GIA index still stands significantly higher than the level registered during the manufacturing downturn of 2015-16. This also adds color as to why the OPEC market-share war launched in November 2014 was so devastating to prices – demand was contracting while supplies were surging from OPEC 2.0 states and from U.S. shale-oil producers. Pessimism Is Overdone We have maintained for some time commodity markets are overly pessimistic on the global growth outlook, mainly because of their gloomy view on the Chinese economy, and anticipated knock-on effects for EM growth arising from this view. Our colleagues at BCA’s Global Fixed Income Strategy succinctly capture the current mood pervading global markets: “… this current soft patch for the global economy is occurring alongside an extreme divergence between plunging growth expectations and more stable readings on current economic conditions. The fall in expectations is visible in the most countries, according to data series that measure confidence for businesses, consumers and investors.”6 We continue to expect the slowdown in EM to persist in 1H19 based on our modeling and actual consumption data. Part – not all – of this is due to the slowdown in China, where policymakers are moving to reverse earlier financial tightening with modest fiscal and monetary stimulus in 1H19. We continue to expect the Communist Party leadership in China will want to start increasing stimulus later this year or in 1H20, so that it hits the economy full force in 2021 in time for the 100th anniversary of the founding of the CCP. Such stimulus will bolster industrial commodity demand. Still, this is difficult to call, particularly the form stimulus will take. President Xi appears committed rebalancing China’s economy – i.e., supporting consumer-led growth – and may want to keep policy powder dry, so to speak, to counter a recession in 2020 or thereafter. Stimulating the consumer economy in China could boost consumption of gasoline, and demand for white goods like household appliances at the expense of heavy industrial demand. Oil and base metals used in stainless steel would benefit in such an environment. Timing this rebound remains difficult. It appears to us that oil and, to a lesser extent, base metals have undershot their fair-value levels (based on our modeling) on the back of negative expectations and sentiment. If we are correct in this assessment, this should limit the negative surprises going forward and open upside opportunities for commodity prices (Chart 2). Chart 2Technically, Oil's Oversold Under The Hood Of BCA’s Newest Model Because demand is so difficult to capture, we continually are looking for different gauges to measure it and cross-check against each other. We developed our Global Industrial Activity index to target the actual performance of commodity-intensive activities globally. Each component is selected based on its sensitivity to the cycle in global industrial activity, hence on the cycle of global commodity demand. This is different from the BCA Global Leading Economic Indicator (LEI), which uses a GDP-weighted average of 23 countries’ LEI. By relying on GDP, the LEI weights in the indicator favor DM countries and do not account for the growing share of the service sector in these economies (Chart 3).7 Chart 3GIA Captures Commodity Demand Our GIA index focuses on commodity demand, which is fundamentally different from proxies of global real GDP growth or global economic activity. Nonetheless, we included the BCA global LEI with a small weight (~ 10%) in our index to capture DM economies. This inclusion does add information to our new gauge. Our GIA index correlates with Emerging Markets’ GDP, copper and oil prices with lags of one to three months. This index is designed to measure the strength of the underlying demand for commodities. It does not account for the supply side and other idiosyncratic shocks that affects each commodity. For instance, our index captures ~ 55% of the variation in the y/y movement in oil prices; adding our oil market supply and sentiment indicators on top of the demand variable raises this to more than 80% (Chart 4). Chart 4Combined Indicators Work Best The index is divided into four main components, which gauge the demand-side impacts of (1) trade; (2) currency movements; (3) manufacturing demand; and (4) the Chinese economy, given its importance to overall commodity demand. The GIA index’s Trade Component combines EM import volumes and an estimate of global dry bulk shipping rates to gauge demand. Readers of the Commodity & Energy Strategy are familiar with our use of EM trade volumes as a proxy for EM income.8 This week, we introduce a new proxy for shipping rates using the Baltic Dry Index (BDI) as a proxy of global economic activity. Our methodology is based on the approaches taken by James D. Hamilton and Lutz Kilian in their respective models that use the BDI to proxy global growth.9 We created two alternative measures based on each of their approaches and average them to come up with our own proxy of the cyclical factor of global shipping rates driven by demand. Both of our alternative measures use a rebased version of the real BDI, which uses the U.S. CPI to deflate the nominal value. Because it picks up the surge in shipping activity in 2H18 resulting from the front-running of tariffs in the Sino – U.S. trade war, the Trade Component of our GIA index gives the most positive readings of all the components (Chart 5, panel 1). By the end of this month, we expect the effects of this front-running to avoid tariffs will wash through the gauge, and we will have greater clarity on the state of global trade. Chart 5Performance Of GIA Components The Currency Component uses a basket of currencies that are sensitive to global growth – i.e., the currencies of countries heavily engaged in trade – and the Risky vs. Safe-haven currency ratio built by BCA’s Emerging Market Strategy.10 This allows us to capture the information regarding the state of global economic activity contained in the highly efficient and forward-looking currency markets. This component collapsed in March 2018, but seems to have bottomed recently (Chart 5, panel 2). The Manufacturing Component looks at the PMIs and various business conditions and expectations surveys for countries that have large industrial exposures to the economic health of EM.11 Currently, this component signals a continuation of the downward trend first observed at the beginning of 2018 (Chart 5, panel 3). Lastly, the Chinese Economy Component uses two indicators of the country’s industrial output: the Li Keqiang Index, and our China Construction Indicator. Despite the fact that the slowdown in China is at the center of investor pessimism re global demand, this component is still holding well (Chart 5, panel 4). It has a moderate negative trend, but is not alarming for commodity demand. Moreover, we expect some stimulus in the second half of the year, which should keep this component supportive for commodity prices. Industrial Commodity Demand Still Holding Up Our GIA index proxies demand for industrial commodities, which is closely aligned with EM GDP – as GDP grows, demand for industrial commodities grows (Chart 6, panel 1). The GIA index is more correlated with copper prices than with oil prices, but it still provides an excellent snapshot of the state of demand for these commodities (Chart 4). Chart 6GIA, Meet Dr. Copper Also, it is interesting to note there appears to be only one large specific supply shock that affected the copper market’s relationship with global demand (Chart 6, panel 2). Our new index supports the Market’s “Dr. Copper” argument, in the sense that copper prices are pretty much always aligned with global industrial activity. We also note that the recent Sino – U.S. trade tensions have pushed copper below the value that is explained by our demand proxy. Bottom Line: The resolve of OPEC 2.0 to reduce production is not in doubt. OPEC (the old Cartel) reported this week its member states cut nearly 800k b/d of production in January m/m, bringing members’ total crude output to 30.8mm b/d. On the demand side, new GIA index indicates things are not as bad as sentiment and expectations would indicate. If anything, we expect the combination of OPEC 2.0’s resolve and rising demand for industrial commodities – oil and copper in particular – to lift prices as the year progresses.   Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Footnotes 1      Please see “Brazil evacuates towns near Vale, ArcelorMittal dams on fears of collapse,” published by reuters.com on February 8, 2019. 2      OPEC 2.0 is the name we coined for the producer coalition of OPEC states, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC states, led by Russia, which recently agreed to cut production by ~ 1.2mm b/d to drain commercial oil inventories and re-balance markets globally. 3      Please see the February 2019 issue of OPEC’s Monthly Oil Market Report, which is available at opec.org. 4      Please see “Exclusive: Russia’s Sechin raises pressure on Putin to end OPEC deal,” published by uk.reuters.com February 8, 2019. 5      Please see “Russian oil unsettled by talk of longer production cuts,” published by ft.com November 15, 2017. 6      Please see “A Crisis Of Confidence?” published by BCA Research’s Global Fixed Income Strategy, published February 12, 2019.  It is available at gfis.bcaresearch.com. 7      The components of the global LEI are also different from our GIA index, and more market-oriented. For details on each series included in the LEI, please see “OECD Composite Leading Indicators: Turning Points of References Series and Component Series,” published February 2019. It is available at oecd.org. 8      Please see BCA Research’s Commodity & Energy Strategy Weekly Report “Trade, Dollars, Oil & Metals ... Assessing Downside Risk,” where we discussed the relationship between EM imports volume, EM income and commodity prices, published August 23, 2018, and is available at ces.bcaresearch.com. 9      The best approach is still debated in the literature. For more details on Hamilton and Kilian’s measurements, please see James D Hamilton, “Measuring Global Economic Activity,” Working paper, August 20, 2018 and Lutz Kilian, “Measuring Global Real Economic Activity: Do Recent Critiques Hold Up To Scrutiny?” Working paper, January 12, 2019. By selecting EM only import volumes and our proxy shipping rate based on the BDI, we narrow our Trade Component to factors that are mainly linked to industrial activity and commodity-intensive sectors. 10     Our basket of currencies includes Korea, Sweden, Chile, Thailand, Malaysia and Peru. The risky vs. safe-haven currency ratio average of CAD, AUD, NZD, BRL, CLP & ZAR total return indices relative to average of JPY & CHF total returns (including carry). 11     This includes Korea, Singapore, Sweden, Germany, Japan, China and Australia. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades     TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades Closed in 2018

Special Report

Highlights In their current form and size, perpetual bonds issuance and the central bank bills swap program are unlikely game-changers for the banking system in China. However, this mechanism constitutes monetization of banks’ capital and bad assets, i.e., recapitalization of banks, by the PBoC via quantitative easing. Hence, this scheme can be presently viewed as a bazooka that has not yet been loaded by the government. If the authorities pursue this program on a large scale without forcing banks to acknowledge and write off bad assets, banks would regain power to expand their balance sheets, fostering a cyclical economic recovery. Nevertheless, the growth model based on continuous “out of thin air” money and credit expansion inevitably leads to falling productivity growth and rising inflation. Therefore, the economic outcome over the course of several years would be stagflation, which is profoundly bearish for the currency. Feature The Chinese authorities recently launched a Central Bank Bills Swap (CBS) program to boost liquidity and facilitate issuance of commercial banks’ perpetual bonds. Box I-1 on pages 12-13 elaborates on the scheme and provides more detail about the program. Under the CBS program, Chinese banks can buy each other’s perpetual bonds, then exchange these bonds for central bank bills and pledge those bills at the People Bank of China (PBoC) to receive funding. Insurance companies are also allowed to purchase perpetual bonds, but they cannot pledge them with the central bank for funding. What are the macro implications of this program? Can the government use this scheme to recapitalize the banking system? Does the CBS program amount to quantitative easing? Will it be sufficient to boost credit growth in China in 2019? We have conditional answers to these questions – i.e., they all depend on the extent to which the scheme is actually utilized by the authorities. On the one hand, the CBS program could potentially become a proverbial bazooka used by the government to recapitalize the banking system via the PBoC monetizing banks’ bad assets. By doing so, the PBoC would be expanding its balance sheet by injecting excess reserves into the banking system – i.e., quantitative easing. Consequently, it could help banks accelerate credit and money growth, in turn helping the economy. The long-run collateral damage in this scenario, however, would be an RMB depreciation. On the other hand, the authorities could limit the usage of the scheme via various regulatory approvals and norms. In such a case, the impact of the program on money/credit growth and the real economy as well as on the exchange rate would be limited. In other words, it might end up being no more than a tool to help the four large banks meet BIS's TLAC requirements. At the moment, there is not enough information to determine whether the program will be a game changer for the banking system in China, leading to a surge in credit and broader economic recovery. Both total assets and broad credit growth among banks remain very weak for now (Chart I-1). In other words, it is a bazooka that has not been loaded, and may never be loaded because of the potential for seriously negative ramifications over the long term. Chart I-1Chinese Banks: Total Assets And Broad Credit Growth Consequently, we maintain our view that China’s growth will continue to disappoint in the first half of 2019, and that China-related plays, including many emerging markets (EM), remain at risk of a renewed selloff. Bank Recapitalization? In theory, the issuance of perpetual bonds along with the CBS program can be used to recapitalize the banking system. Each bank can buy perpetual bonds issued by other banks up to 10% of their core Tier-1 capital. These banks can get cheap financing from the PBoC by swapping these perpetual bonds with central bank bills, and then pledging those bills at the central bank to get funding. Hence, under this scheme, the PBoC will be financing purchases of perpetual bonds, which means the monetary authorities will indirectly be funding banks’ recapitalization. It is an “open secret” that Chinese banks would be considerably undercapitalized if they were forced to recognize non-performing assets. The non-performing loan (NPL) ratio currently stands at 1.9%, and the special-mention loans ratio is at 3.2%; and the sum of both is at 5.1% of total loans (Chart I-2, top panel). NPL provisions presently amount to 3.4% of total loans. Chart I-2Chinese Banks Are Massively Under-Provisioned When expressed as a share of total risk-weighted assets, the aggregate NPLs and special-mention loans are equal to 4.2% (Chart I-2, bottom panel). At 2.8% of risk-weighted assets, NPL provisions are extremely inadequate. Assuming non-performing assets turn out to be 10% of total risk-weighted assets, some 40% of banks' capital would be wiped out, according to our simulation presented in Table I-1. This is after accounting for existing provisions and assuming a 20% recovery rate of non-performing assets. Provided that risk-weighting assigns a zero weight to banks’ claims on the government, a 50% risk weight to claims on households and a 100% weight to claims on companies, the assumption of 10% of non-performing assets in total risk-weighted assets is reasonable. This is especially the case when the enormous credit boom of the past 10 years is taken into consideration. As a result, in this scenario the capital adequacy ratio (CAR) will drop from its current level of 13.8% to 9.4%. This will bring the CAR below the regulatory minimum of 11%. To raise the CAR to the regulatory minimum of 11%, the banking system would require RMB 2 trillion of capital. This is greater than the maximum potential demand for perpetual bonds that we estimate to be up to RMB 1.4 trillion. To estimate this number, we assumed all banks purchase perpetual bonds in amounts equal to 5% of their core Tier-1 capital and all insurance companies buy perpetual bonds in an amount equal to 5% of assets. This is not an underestimation of potential demand for perpetual bonds since there are currently limitations on banks’ ability to issue and purchase these bonds as elaborated in Box I-1 on pages 12-13. In short, it is not clear if perpetual bond issuance and the CBS will be sufficient to undertake full recapitalization of the banking system and allow banks to accelerate their balance sheet expansion to finance an economic recovery. Bottom Line: In their current form and shape, perpetual bonds and the CBS program are unlikely to be a game-changer for the banking system in China. However, if the authorities eliminate limitations and change regulatory norms, the scheme could potentially be used to recapitalize China’s banking system. This is why this scheme can presently be viewed as a bazooka that has not yet been loaded by the government. Does CBS Represent QE? Its Impact On Liquidity And Money Supply The CBS program is a form of quantitative easing (QE). It will expand the PBoC’s balance sheet and banking system liquidity (excess reserves at the central bank), as elaborated in Box I-1 and Diagram I-1 on pages 12-14. If pursued on a large scale, this scheme would constitute monetization of banks’ capital and their bad assets by the central bank. The mechanism is already in place, but the extent to which authorities will use it to recapitalize banks remains unclear. Even though the CBS program will expand banking system liquidity – i.e., excess reserves at the central bank – it will not – however - affect broad money supply. The basis is simple: Banks’ excess reserves at the central bank are not part of the broad money supply in any country. Banks use excess reserves to settle payments between one another and with the central bank. Banks do not lend out excess reserves. Further, only a central bank can create excess reserves, and it does so “out of thin air.” In brief, excess reserves rather than corporate and individual deposits constitute genuine banking system liquidity. Barring lending to or buying assets from non-banks – which does not typically occur outside of QE programs – central banks do not create broad money or deposits.1 Money/deposits, the ultimate purchasing power for economic agents, is created by commercial banks “out of thin air,” as we have discussed and illustrated in our series of reports on money, credit and savings.2 Having adequate capital and liquidity as well as positive risk appetite, banks can expand their balance sheets, i.e., originate loans and buy various securities. When banks make loans or purchase assets from non-banks, they simultaneously create deposits and new purchasing power. Chart I-3 demonstrates that in recent years, excess reserves in China’s banking system have been flat, yet banks’ assets and the supply of money has expanded tremendously. The opposite can also occur: Banks’ excess reserves can mushroom, but banks may actually be reluctant to grow their balance sheets. This was the case after the Lehman crisis with U.S. banks and in the wake of the European debt crisis with euro area banks. Chart I-3China: Excess Reserves And Broad Money Finally, we have elaborated at great length in our past reports that China’s money and credit excesses do not stem from its high household savings rate. Rather, like any credit bubble in any country, China’s leverage is due to the creation of credit/money “out of thin air.”2 Bottom Line: Perpetual bond issuance and the CBS program will expand the banking system’s excess reserves, but not broad money supply. Besides, it is not certain that excess reserves will accelerate loan growth. Credit origination by banks depends on many other factors such as banks’ willingness to expand their risk assets, loan demand and the regulatory regime and norms. Deleveraging Has Not Yet Started One cannot discuss the potential for a monetary bazooka in China without an update on the status of deleveraging. The fact is that deleveraging in China has not even begun: Credit is still expanding faster than nominal GDP growth. The most common way to measure leverage/debt is to compare it with the cash flow that is used to service debt. Nominal GDP is a measure of cash flow in an economy from a macro perspective. The debt-to-asset ratio is a poor measure of leverage because asset valuations are often subjective: Assets are valued by debtors themselves. Besides, apart from distressed credit investors, one does not want to be a creditor to a country or company that has to sell assets to service its debt. Stock and bond prices of debtor countries or companies tailspin when the latter have to sell assets to service debt. The top panel of Chart I-4 illustrates that China’s enterprise and household domestic credit/debt is still expanding at an annual rate of close to 10% at a time when nominal GDP growth has slowed to 8%. Chart I-4China: Deleveraging Has Not Even Begun Consistently, the debt to GDP ratio has not declined at all (Chart I-4, bottom panel). In this context, a rhetorical question is in order: Should China ramp up money/credit growth and monetize banks’ NPLs, given that deleveraging has yet to take place? Economic Ramifications Of Deploying The Bazooka What would be the economic ramifications if the Chinese authorities once again promote and allow unrelenting money/credit expansion “out of thin air” to bail out zombie banks and companies? Cyclically: If the authorities compel banks to acknowledge NPLs and write them off as and when the PBoC finances their recapitalization, banks may not be in a position to accelerate loan growth. This scenario entails that credit growth and hence cyclical sectors in China would remain weak for a while. In contrast, if the authorities pursue recapitalization of banks without forcing them to acknowledge and write off bad assets, banks would regain their power to expand their balance sheets, fostering a cyclical economic recovery. Structurally (in the long term): The growth model based on continuous “out of thin air” money and credit expansion inevitably breeds economic inefficiencies, falling productivity growth and rising inflation. In short, the economic outcome over the course of several years would be stagflation. Chart I-5 illustrates that China’s ICOR (incremental capital-to-output ratio) is rising, or inversely that the output-to-capital ratio is falling. This entails worsening economic efficiency and slowing productivity growth. Chart I-5Symptoms Of Rising Inefficiencies Chart I-6 shows a potential stylized roadmap for the Chinese economy in the years ahead if the credit and money bubbles are inflated further without corporate restructuring, bankruptcies, the imposition of hard budget constraints and meaningfully improved capital/credit allocation. The red line represents potential GDP growth, and the dotted red line is our projection. In any economy, the potential growth rate is equal to the sum of growth rates of the labor force and productivity. China’s labor force is no longer expanding and will begin shrinking in the coming years (Chart I-7). Hence, going forward, the sole source of potential GDP growth in China will be productivity growth. Productivity growth has been slowing and will continue to do so if structural market-oriented reforms are not implemented (Chart I-8, top panel). Besides, the industrialization ratio has already risen a lot (Chart I-8, bottom panel). Chart I-7China: No Tailwind From Labor Force Chart I-8China: Productivity Is Slowing With the potential GDP growth rate in China declining, future fiscal and credit stimulus may lead to higher nominal – but not real – growth. The latter will be constrained by a slowing rate of potential real GDP growth. Higher nominal but weaker potential (real) growth entails rising inflation. The combination of higher inflation along with the need to maintain very low nominal interest rates to assist debtors is bearish for the currency. In such a scenario, there will be intensifying depreciation pressure on the yuan from the tremendous overhang of RMBs in the banking system (Chart I-9). The PBoC’s foreign exchange reserves of $3 trillion will not be sufficient to backstop the enormous amount of RMB (money) supply of RMB 210 trillion – which is equivalent to US$30 trillion (Chart I-10). Chart I-9Helicopter Money In China Chart I-10PBoC FX Reserves Are Equal To 10% Of Broad Money Supply If broad money supply continues to expand at an annual rate of close to 9-10% or above, downward pressure on the yuan will escalate immensely, and the Chinese authorities will have no choice but to close the capital account completely and also heavily regulate current account transactions. Bottom Line: If the authorities do not restrain the PBoC’s financing of perpetual bond issuance via the CBS and in the interim do not force banks to write off bad assets, the upshot will be the monetization of banks’ bad assets by the PBoC. This will constitute the ultimate socialist put for banks and zombie debtors, as well as for the entire economy. Business cycle swings, bankruptcies and deflation are inherent features of a market-driven/capitalist economy. A socialist put via promoting unlimited money and credit creation entails long-term stagflation – lower productivity growth and rising inflation. This is very bearish for the currency. Investment Conclusions To be sure, the above analysis suggests that the bazooka has not been loaded and the Chinese economy is not about to stage an imminent recovery. BCA’s Emerging Markets Strategy team maintains its bearish stance on China-related plays worldwide. We are closely monitoring China’s money and credit aggregates as well as indicators from the real economy to gauge when China’s business cycle will revive. So far, these indicators continue to point south. EM risk assets and currencies have recently been boosted by the Federal Reserve’s dovish turn. But as we argued in last week’s report, this will prove short-lived. Global trade, China’s growth and commodities prices are the key drivers of EM financial markets, not the Fed. Provided our negative outlook for these three factors due to the ongoing slowdown in China, we continue to recommend a negative stance on EM in absolute terms, and underweighting EM stocks and credit versus their U.S. peers. The dollar’s weakness stemming from the downshift in U.S. interest rate expectations is running out of steam. Chart I-11 shows that the broad trade-weighted dollar is trying to find support at its 200-day moving average. Conversely, the EM stocks index and copper prices are struggling to break above their 200-day moving averages (Chart I-11, middle and bottom panels). Chart I-11Dollar And EM / Commodities: Mirror Images We believe the dollar is poised for a breakout, and EM and copper are due for a breakdown. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Box 1 Issuance Of Perpetual Bonds And CBS Program The authorities are promoting the issuance of perpetual bonds and the CBS program as a scheme for the country’s big-four banks to raise capital to meet BIS ’s Total Loss-absorbing Capacity (TLAC) requirements for globally systemically important banks. Limitations and other details on the perpetual bonds issuance and CBS program: 24 out of 30 banks listed on the A-share market are presently qualified to issue perpetual bonds as their assets exceed RMB 200 billion, a threshold established by the PBoC. Perpetual bonds will boost the Tier-1 capital of issuing banks. Banks are allowed to purchase perpetual bonds issued by other banks in amounts up to 10% of their core Tier-1 capital. Only primary dealers (46 banks and 2 brokers) can exchange qualified perpetual bonds they hold for PBoC bills, with a maximum exchange period of three years. The incentive for banks to purchase perpetual bonds will for now be low because these bonds consume large amounts of capital. The risk weights for these perpetual bonds ranges between 150-250%. How Does It Work? As Diagram I-1 on page 14 illustrates, when Bank B purchases perpetual bonds from Bank A, the former transfers excess reserves to the latter. The amount of outstanding deposits, i.e., money supply, is not affected at all. Hence, there is no direct impact on the broad money supply. Banks do not require deposits to make loans and buy securities. Banks need excess reserves at the central bank to pay for or settle payments with other banks. When Bank B transfers excess reserves to Bank A, the aggregate amount of excess reserves in the banking system does not change. Bank B can swap these perpetual bonds with central bank bills, and then pledge these bills at the PBoC to get excess reserves. As it does so, Bank B will replenish its excess reserves. Consequently, the amount of excess reserves in the banking system will expand, as will the PBoC’s balance sheet. Overall, the issuance of perpetual bonds and CBS swaps lead to both bank recapitalization and banking system liquidity (excess reserves) expansion. Why has the PBoC decided to fund the issuance of perpetual bonds? Without PBoC funding, demand for perpetual bonds might be very low, and yields on them could spike. Higher yields could lure away capital from other corporate bonds, producing higher borrowing costs in credit markets. On the positive side, the monetary authorities will not only recapitalize a number of large banks but will also do so by capping borrowing costs in the credit markets and injecting more liquidity into the banking system. On the negative side, yields of these perpetual bonds will not be determined by the market. Rather they will be artificially suppressed by potential open-ended PBoC funding. This will preserve China’s inefficient credit allocation system and misallocation of capital in general. In a market economy, the authorities will typically force banks to raise capital in securities markets or privately. More issuance, especially when it comes from many banks simultaneously, typically pushes down the prices of bank stocks and bonds. The basis is securities issuance often dilutes existing shareholders and is also negative for bondholders. This threat of dilution and losing money incentivizes existing shareholders and bondholders of a bank to impose discipline on the bank’s management. Consequently, banks would be better run and capital allocation would be more efficient than it would otherwise be in a system where such oversight and incentives are absent. In brief, the market mechanism deters banks from risky and speculative behavior and contributes to the long-term health of the banking system, as well as the efficiency of capital allocation in the real economy. By allowing banks to purchase each other’s bonds, and with the PBoC financing it, China is not imposing the much-needed market discipline on bank shareholders, bondholders and by extension, bank management. This does not promote efficient capital allocation and higher productivity growth in the long run. Footnotes 1      Money supply is the sum of all deposits in the banking system. Hence, we use terms money and deposits interchangeably. 2      Please see the Emerging Markets Strategy Special Report “Misconceptions About China's Credit Excesses”, dated October 26, 2016, Special Report “China's Money Creation Redux And The RMB?”, dated November 23, 2016, Special Report “Do Credit Bubbles Originate From HIgh National Savings?”, dated January 18, 2017, Special Report “The True Meaning Of China's Great 'Savings Wall'”, dated December 20, 2017 Special Report “Is Investment Constrained By Savings? Tales Of China and Brazil”, dated March 22, 2018, available at www.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights So What? India is overcoming the economic constraints to its strategic rise.  Why? India faces rising political risk once again as public opinion puts Modi’s tenure in power at risk. However, India will continue to improve its economy, as outside pressures will force it to act coherently as a nation. Stay on the sidelines for now but remain constructive over the long run. Feature “An enemy of my enemy is my friend.” This is to paraphrase Kautilya, a philosopher of the Mauryan Empire, circa 200 BC. Kautilya was the Indian Machiavelli and wrote the Arthashastra to give hard-nosed political advice to rulers who wanted to know how kingdoms and states really behave rather than how they ought to behave.1   The quotation is no less true today than it was in ancient times. It explains why risks are rising to our view that Prime Minister Narendra Modi will remain in power after the election in April or May. This reinforces our underweight position on Indian risk assets over a 12-month time horizon. The quotation also explains why China’s growing influence in South Asia will drive India to continue reforming its economy and befriend the United States, thus supporting an optimistic view of India’s economic and investment potential in the long run (Chart 1). What Is India’s Grand Strategy? India’s geopolitical predicament stems from the fact that it is a relatively rational geographic unit, but one whose political unity is extremely difficult to maintain. Almost every side of the subcontinent is demarcated by forbidding geology: the Himalayas, the Bay of Bengal, the Arabian Sea, the thick jungles of Burma. Even the northwest, the traditional route of invaders, hosts vast obstacles like the Hindu Kush and Thar Desert. Any kingdom that takes shape can soon dream of expanding its borders to a natural stopping place (Map 1). Yet formidable obstacles stand between the cradles of Indian civilization – the Indus and Ganges Rivers – and the river ways and coastal outlets of the south. The Vindhya-Satpura mountains, the Deccan plateau, and the eastern and western Ghats make it extremely difficult for a northern power to govern the various cultures of the southern cone.  This geography ensures that empires are always trying and failing to unify the subcontinent into a coherent whole. As a result, India rarely projects power beyond it. When it does, the projection is short-lived.2    Historically India has seen the rise of five major empires that dominated the subcontinent: the Mauryans, the Guptas, the Mughals, the British, and the modern Republic of India (Chart 2). The Mughals and many other invaders periodically streamed in from the northwest – most often from modern-day Afghanistan and northern Pakistan, but also from Iran and southern Pakistan. Meanwhile several European empires invaded from the sea and established coastal settlements. The British East India Company settled in Bengal and then drove west and south, cutting off the French who had settled on the southeastern shores.   The modern Republic of India, founded in 1947 after Mahatma Gandhi and his followers harassed the British into leaving, feared that the United States would follow in Britain’s footsteps, being the world’s preeminent naval power. The Indians also distrusted the U.S.’s constructive relations with China and Pakistan that aimed to “contain” the Soviet Union. The Soviets, by contrast, could apply great pressure on Pakistan’s flank in Afghanistan and thus proved useful to India. They could also sell India weapons and capital goods as founding Prime Minister Jawaharlal Nehru pursued a socialist path of economic development.  The collapse of the Soviet Union coincided with a balance-of-payments crisis in India in 1991 that resulted in the abandonment of the old command-style economy and the adoption of modern capitalism under the reforms of Narasimha Rao. India also supported the U.S.’s intervention in the region after September 11, 2001 as a way of maintaining pressure on Pakistan’s back door. From this brief history we can glean a few solid points about India’s grand strategy: An Indian empire must establish control along the Indus or Ganges rivers, or both; An Indian empire must assimilate or drive out foreign rulers and unify the north and south; An Indian empire must strive to become the kingmaker across the subcontinent, through influence if not conquest; An Indian empire must fend off an invasion from the sea. The result of Rao’s reforms, India’s achievement of nuclear status in 1998, and nearly three decades of economic growth have been an India that is clearly an emerging “great power.” According to our Geopolitical Power Index, India is today on the cusp of supplanting Russia as the world’s third most powerful state (Chart 3). It surpassed the U.K., its former colonial master, in 1993. Chart 3India On Cusp Of Overtaking Russia In Comprehensive National Power Like China in East Asia, India is modernizing its vast army, developing a blue-water navy, and carving out a sphere of influence in South Asia (Chart 4). Also like China, India’s ambitions of regional hegemony are frustrated by its neighbors. India’s rivalry with Pakistan is foundational and existential – it is as if China faced Taiwan with nuclear weapons. Chart 4India's Military Clout Quietly Rising Today the fragile world order that prevailed in the wake of the Cold War is under severe strain. China’s grand regional ambitions are provoking a harsh reaction from the United States, which is setting up a new “containment policy” to limit China’s technological advance. The U.S. is withdrawing military forces from the Middle East and South Asia as it becomes energy self-sufficient and looking to counter-balance China with its free hand. Meanwhile China’s influence on the subcontinent is growing – already it is a rival to India as a trade partner for India’s South Asian neighbors (Chart 5). The Sino-Indian rivalry has often been overstated – the Himalayas are more than a hindrance. But China’s Belt and Road Initiative (BRI) means that this logic is increasingly out of date. Historically, India faced overland invasions from the northwest and maritime invasions from the northeast. The Belt and Road – of which Pakistan is probably the most comprehensive beneficiary – potentially threatens India from both directions sometime in the future. Chart 5China Encroaching In India's Sphere Of Influence Of course the U.S. and India still face tensions between each other – foremost being the impending withdrawal from Afghanistan and the U.S. “maximum pressure” policy towards Iran (Chart 6). There are also trade tensions with the Trump administration and a broader problem of inconsistent U.S. outreach to India. Nevertheless the logic of “the enemy of my enemy is my friend” suggests that over the long run the U.S. will grow warmer with India as a regional counterweight to China, while India will wish to become less isolationist and cultivate its relationship with the U.S. as a counter both to Pakistan and China. Simply put, China is making historic advances into India’s neighborhood in South Asia and the Indian Ocean basin. Chart 6A Good Sign For U.S.-India Ties: Cooperation On Iran This logic also suggests that India will be driven to continue reforming its economic structure so as to preserve internal unity and South Asian influence. If its economy languishes, it will lose preponderance within its neighborhood and become vulnerable to foreign aggression. Bottom Line: India and the U.S. are likely to see an ever-strengthening strategic partnership. They will overcome hurdles to the relationship because of their mutual need to counter China’s regional ascendancy. India’s Economic Hang-Up India has been ineffective in establishing an international presence because it has only reluctantly and haltingly reformed its economy. Today India’s middle class – measured by the share of adults with total wealth from  $10,000 to $100,000 – is less than 10%, comparable to the Philippines and Thailand. China’s is now above 50%, according to Credit Suisse’s Global Wealth Report (Chart 7).    This weakness stems in great part from policy decisions, namely the dogged pursuit of socialism through the latter stages of the Cold War. The same ruling ideology that prized independence also prized self-sufficiency, doubling down on import-substitution and thus missing the chance to industrialize with the export-oriented Asian Tigers in the 1970s or China in the 1980s. The result of insufficient measures to limit the state, curtail monopolies, contain inflation, and promote trade and private enterprise has been a chronic shortfall of national savings (Chart 8), which are needed to invest in capital projects and boost productivity (Chart 9).3   Chart 8India Lacks National Savings Chart 9India's Lagging Productivity Many of these historic hang-ups have begun to change, however, first under the reforms of the 1990s-2000s and more recently under the government of Prime Minister Narendra Modi since 2014. As a result, there are a number of “truisms” about India’s economy that are no longer true. For instance, while India’s government is said to be small and weak due to its federal structure – which empowers the states – the truth is that its government is not notably smaller than that of other comparable emerging markets (Chart 10). There is no doubt that it is harder for India’s leaders to drive their agenda than it is for Russia’s and China’s leaders, but this is due to the type of government rather than the size. India inherited liberal democracy and rule of law from the British and its own revolutionary leaders built on this foundation, providing relative stability despite its patchwork of languages, ethnicities, and castes. Democratic checks and balances have led to better governance. Chart 10India's Government Neither Small Nor Weak The contrast has had clear effects on demography. India has a strong demographic foundation and hence a large internal market and robust labor force growth. China, by contrast, is suffering from the distortive effects of the “One Child Policy” on its working age population. As a result India’s population will increasingly provide the global labor force as China’s workers become scarcer and rise in cost (Chart 11) and as trade conflicts between China and the West drive investors to relocate supply chains. This is also a risk to India, of course, if job creation lags. But that is where other economic improvements come in. Cumulatively, Modi’s policies have improved the trajectory of a capital formation relative to consumption, which will increase productivity, potential growth, and job creation (Chart 12). Chart 12Modi Corrected India's Investment Trajectory On openness to trade, India has largely closed the gap with China and other comparable EMs like Indonesia (Chart 13). And while India has long been highly restrictive toward foreign investment, it is much less so than China (Chart 14), and a slew of policies to ease restrictions has resulted in a surge in foreign direct investment that only recently came off the boil (Chart 15). Chart 13India Not So Closed To Trade Anymore Chart 15Modi Opened India To Foreign Investment Further, while India remains broadly under-invested and has not managed to rebalance its overall economy toward manufacturing, it has created some bright spots within the manufacturing sector, such as autos (Chart 16).4 Modi’s government has significantly improved other conditions that will encourage private investment: the ease of doing business, global competitiveness, infrastructure effectiveness, and human capital (Chart 17). Chart 16Cars A Bright Spot In Indian Manufacturing Bottom Line: India’s grand strategy has historically suffered because internal unity and regional influence could not be achieved with a floundering economy. Over recent decades, however, India’s reforms have accumulated into substantial improvements – and the Modi administration has made some key improvements. But Will Modi Survive? Our baseline case for the general election due in April or May is that Modi and his ruling Bharatiya Janata Party (BJP), along with their allies in the National Democratic Alliance (NDA), will remain in power, if narrowly. However, in recent weeks the public opinion polling has taken a turn for the worse for Modi (Chart 18), raising the odds of a hung parliament or opposition victory. Modi still remains well ahead of Rahul Gandhi, the dynastic leader of the opposition Indian National Congress and its United Progressive Alliance (UPA), in terms of popularity (Chart 19). But in some polling he is barely holding onto a double-digit lead. Meanwhile Gandhi’s sudden viability as a candidate is a significant change from only a year ago. Nevertheless the range of seat projections for the lower house of parliament, the Lok Sabha, is very wide and suggests that Modi’s coalition could still win a majority, as long as the opposition’s current rally breaks (Chart 20).   A critical election dynamic points back to Kautilya’s ancient advice. Recently, two major parties in Uttar Pradesh – the key bellwether state – have joined forces to avoid stealing each other’s votes and thus help the opposition take seats. If this scheme works, then the NDA could be outmatched at the polls.5 For investors, however, the key takeaway is that Modi’s reform agenda is past its peak and policy uncertainty can only rise from here: Modi’s seats will certainly shrink from the landslide of 2014 – the BJP is likely to lose its single-party majority, weakening Modi and his party members on their reform agenda. The support of their NDA allies will have to be bought with favorable policy tradeoffs (Chart 21); The high tide of Modi’s movement has already come and gone in the state governments, where the BJP recently lost Madhya Pradesh, Rajasthan, and Chhattisgarh, among others (Map 2). It is possible to lose these states and still win the general election, as largely occurred in 2004 and 2009, but state governments are a decisive factor in implementing federal policies and Modi’s influence is now clearly on the wane; Estimates of the NDA’s future gains in the Rajya Sabha, the upper house, suggest that even if Modi stays in power, he will never obtain a majority there (Diagram 1) – meaning that lower house bills other than supply bills will be subject to a veto; Diagram 1Modi Unlikely To Gain Majority In Upper House … Ever Modi is unlikely to have enough seats in the two houses to have the option of driving key legislation through a joint session of parliament. This is a rare occurrence but it would be a valuable ace up the sleeve. Modi’s reform movement has already seen high tide. He will struggle to institute reforms if he is weakened in parliament and the states. This is even truer if a hung parliament occurs, or if the UPA ekes out a slim majority. In essence, the next Indian government will likely be hobbled if Modi’s polling and performance do not recover from here – and even then he will not reclaim the political capital of his first term in office. It would be a mistake, however, to believe that reforms cannot get done without Modi. Prime Minister Rao came from the Congress Party, after all. Moreover, it is possible for India to undertake major reforms with a weak coalition or minority government. This was the backdrop of the critical pro-market reforms of the 1990s. But this implies that there would need to be a market riot to induce additional reform momentum, as was the case at that time, and India is not at a comparable crisis point today.  Bottom Line: Modi’s reform momentum is over. The next government will be weaker and less able to drive major pro-productivity reforms. But eventually reform momentum will recover, driven by the geopolitical forces outlined above. Does Modi Matter? What is the basis for Modi’s loss of momentum? The gist of the problem is that Modi’s reforms were structural and therefore entailed substantial economic and social costs. As a result, Modi has lost support. The good news is that Modi’s achievements thus far will continue to yield benefits for India. To highlight a few: The creation of a single market by means of the Goods and Services Tax (GST) is a significant reform that will ensure a strong legacy for Modi in the long run. However, the new tax obviously does not get voters enthused. The new Bankruptcy Law has helped to cleanse economic inefficiencies. But it has resulted in layoffs and financial deleveraging, weighing on credit growth and the broader economy. Demonetization, the sudden replacement of key denominations of money in circulation, has helped to formalize gray and black parts of the economy. But it was executed in a hugely disruptive manner and various scandals have arisen in the wake of it, hurting the ruling party. Controlling the fiscal deficit has been a federal government objective that has had some success. However, Modi and the state governments are more recently boosting spending ahead of the election to avoid what otherwise would be a negative fiscal thrust this year. This is a factor that should play to Modi’s advantage, although it has not so far. It also highlights the difficulty of fiscal consolidation over the long run (Chart 22). Chart 22Election Cycle Fiscal Easing Is The Norm More concerning, both for Modi and for India, is the unemployment rate. Even the official unemployment rate is rising despite the fast clip of economic growth and the pro-growth reforms (Chart 23). A leaked government statistical report suggests that unemployment has indeed gone up and labor participation has fallen more than the government is willing to admit. Chart 23Even Official Unemployment Is Rising The jury is still out on the extent of the current growth slowdown. Some estimates suggest that the output gap is closed, others say slightly negative. While there has been a soft patch in wage growth – particularly among the important 40% of the population that still works on the farm (Chart 24) – the latest data show improvement. Unit labor costs are ebullient and suggest that employee compensation is rising (Chart 25). The reality could make all the difference for Modi’s coalition at the ballot box. Chart 24Rural Wages Improving... But Is It Enough? Chart 25Will Workers Reward Modi? More importantly, if India cannot keep unemployment down amidst significant labor force growth, then Modi will only become the near-term casualty of a more profound problematic trend. Another long-term concern is Modi’s political pressure on the Reserve Bank of India. This has resulted in the replacement of two orthodox and credible central bankers under Modi’s watch. The result is a noticeably dovish policy shift, as confirmed by the cut of the repo rate to 6.25% (from 6.5%) on February 7. This cut and later cuts may be supported by global growth fears but will raise suspicions of political influence. Any damage to the central bank’s credibility will have lasting negative effects since the election result cannot reverse it (at least not fully). It will feed inflation expectations marginally and insofar as it does it will worsen the conditions for sustainable private sector capital investment. However, inflation is currently low and other reforms – such as the RBI’s adoption of inflation-targeting and ample domestic grain production – will help to offset any new monetary policy risk. Bottom Line: Modi’s reform legacy is mostly positive for India structurally, although the erosion of central bank independence is a critical exception. Investment Implications In the short run, cooperation among Modi’s political opponents poses a risk of removing him from power and short-circuiting his reform agenda. In the long run, cooperation between China and India’s South Asian neighbors poses a risk of undermining India’s grand strategy, driving it into the arms of the United States. In both cases Kautilya’s ancient wisdom is on display.   In the first case, a Modi defeat would be negative for India’s policy continuity, currency, and risk assets. The upside to our baseline view of a Modi victory is not high, however, unless Modi and the BJP surprise to the upside and win a substantial majority. This is unlikely unless the polling changes. In the second case, the geopolitical environment will pressure India to continue reforming and improving its economy so as to maintain internal stability, influence its neighbors, and ward off unwanted foreign influence. With China’s Belt and Road putting pressure on India’s strategic interests, leaders in New Delhi will have a continual motivation to focus on improving the economy as well as seeking alliances. This is the only way to ensure India retains its influence within its neighborhood.  For now, investors should steer clear of the Indian currency and risk assets in absolute terms because Modi’s reforms are priced in; election cycle dynamics are undermining monetary and fiscal policy; and the risk of sharp policy discontinuity is rising. On a relative basis, India may also underperform EM in the short term while oil prices rise: oil prices and India’s equity performance relative to EM are negatively correlated.6 Beyond that, however, India is a structural opportunity. Capital investment in China, which has powered much of the structural bull market in commodities and EM assets over the past two decades, is declining, while India’s is improving (Chart 26). Capex is the key to improving India’s productivity and keeping inflation in check even as the demographic dividend pushes up growth rates. Although many EM economies will suffer from a slowdown in Chinese capex, India is not overly exposed to China or global trade, and it is further along than other EMs in its process of bank deleveraging, which opens the prospect of a new credit cycle that will improve its investment outlook (Chart 27).    Chart 26China Capex Down, India Capex Up Chart 27Deleveraging Enables A New Credit Cycle   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Kajari Kamal, “Kautilya’s Arthashastra: Indian Strategic Culture and Grand Strategic Preferences,” Journal of Defence Studies 12:3 (2018), pp. 27-54, available at idsa.in 2      The medieval Chola Kingdom sailed across the Bay of Bengal and as far as Malacca in 1025. Please see  Manjeet Singh Pardesi, “Deducing India’s Grand Strategy of Regional Hegemony from Historical and Conceptual Perspectives,” Institute of Defense and Strategic Studies, Working Paper 76 (April 2005), available at www.rsis.edu. For an in-depth study of India’s strategic history, see Graham P. Chapman, The Geopolitics of South Asia: From Early Empires to the Nuclear Age (Burlington, VT: Ashgate, 2009). 3      Please see BCA Emerging Market Strategy Special Report, “Capital Rationing Is Deterring Growth,” February 28, 2012, and “India’s Inflation: How Serious Is The Problem?” January 26, 2010, available at www.bcaresearch.com. 4      Please see BCA Commodity and Energy Strategy Weekly Report, “India’s Commodity Demand, With Or Without Modi,” February 7, 2019, available at ces.bcaresearch.com. 5      Please see Milan Vaishnav and Jamie Hintson, “As Uttar Pradesh Goes, So Goes India,” Carnegie Endowment for International Peace, February 5, 2019, available at carnegieendowment.org. 6      Please see BCA Emerging Markets Strategy Weekly Report, “EM: Sustained Decoupling, Or Domino Effect?”June 14, 2018, available at ems.bcaresearch.com.  

Special Report

Highlights China’s recently released pro-auto-consumption policy will lead to a moderate 5-8% recovery in auto sales/production this year. However, the impact from the stimulus will be much less than the previous two episodes in 2009 and 2016. The value of Chinese auto sales is likely to increase by RMB 200 billion to 350 billion, which is about 0.2-0.4% of the country’s nominal GDP in 2018. New-energy cars will continue to gain market share with supportive policies. Meanwhile, domestic brand car manufacturers will likely benefit most from the upcoming recovery in the Chinese auto market, while American car producers will benefit the least. We recommend preparing to go long Chinese auto stocks in the domestic market in absolute terms, subject to the terms of a trade agreement with the U.S. In addition, we continue to overweight domestic consumer discretionary stocks versus the benchmark, and versus domestic consumer staples. Feature China is the world’s largest car producer and consumer – its domestic sales account for about 30% of global auto sales (Chart 1, top panel). The country experienced a 3% contraction in auto sales and production through last year, the first year of negative annual growth in 28 years. The contraction rapidly accelerated into the double digits over the past few months (Chart 1, bottom panel). Chart 1Chinese Auto Industry: Policy Stimulus = Recovery In 2019 As the auto sector is an important driver of China’s economic growth, whenever the industry has shown signs of weakness, the central government has typically implemented a series of supportive policies designed to stimulate the domestic auto market. The authorities successfully did this in 2009-2010 and 2016-2017. Late last month, they again announced a set of pro-auto-consumption policies. The question going forward is how effective these measures will be in boosting auto sales. We believe the recovery will be rather moderate compared with the 2009-2010 and 2016-2017 episodes. Chances are that the growth of auto sales and production will recover to 5-8% in 2019. As a result, we recommend preparing to go long Chinese auto stocks in absolute terms, subject to the terms of a trade agreement with the U.S. Cyclical And Secular Forces Shaping Auto Sales A comparison of the current auto market to the one that prevailed in 2009 and 2016 is helpful to gauge the extent of the strength of the pending auto sales recovery expected this year. Box 1 shows the recently released pro-auto-consumption plan by the Chinese government, which focuses on six aspects, including promoting auto replacement, NEV sales, auto sales in rural areas, pick-up truck sales, development of the second-hand car market, and auto sales in cities that have restricted auto sales policies.   BOX 1: China’s Stimulus Package For Domestic Auto Industry The recently released pro-auto-consumption plan by the Chinese government includes: Promoting auto replacement: Providing subsidies to consumers who scrap their older, higher-polluting cars for new, lower-emission or zero-emission cars; Encouraging NEV sales: Providing subsidies to advanced NEV sales and giving more privileges to new energy trucks; Promoting auto sales in rural areas: Providing subsidies to rural residents who scrap their tricycles to buy a truck with cylinder capacity equal or less than 3.5 tons, or a passenger car with cylinder capacity equal or less than 1.6L; Promoting pick-up truck sales: Widening access areas within cities for pick-up trucks; Accelerating the development of the second-hand car market: Allowing second-hand car trades across different cities and provinces; Loosening auto sales restrictions in cities that have restricted auto sales policies. Regarding the amount of subsidies, the government did not provide details.   Putting it all together, we believe that this time the impact from the stimulus will be much more muted than the previous two episodes in 2009 and 2016. First, there is no sales tax reduction measure in this round of stimulus. The most important driver for the auto market recovery in 2009 and 2016 was a sales tax reduction in passenger cars with cylinder capacity equal to or less than 1.6L from 10% to 5% (Chart 2). However, this time, there is no such cut. While the government is maintaining zero sales tax on new energy vehicles (NEV), the sales tax on all automobiles remains at 10% this year. Chart 2The Lessons From The 2009 And 2016 Episodes Second, domestic pent-up demand for automobiles is much lower than it was in both 2009 and 2016. The car ownership rate, defined as the number of passenger cars per 1000 households, has risen significantly to 453 in 2018 (Chart 3). This means that nearly half of Chinese households already own at least one car as of 2018. In comparison, the car ownership rate was only 91 in 2008 and 318 in 2015. Chart 3Less Pent-Up Demand For Autos In 2019 Than Before Third, Chinese households’ debt levels have surged in the past few decades, constraining their ability to purchase cars and other goods (Chart 4, top panel). While many investors compare the cross-country household debt burden relative to GDP, Chinese household debt has already risen to nearly 120% of households’ disposable income, surpassing the U.S. (Chart 4, bottom panel). Chart 4Increasing Households' Debt Burden Constrains Ability To Buy A Car Fourth, while the recent stimulus packages aim to promote auto sales in rural areas, the difficulty of getting auto loans is much higher for the average rural household than for the average urban household, as the former generally have much lower income levels. In addition, peer-to-peer lending, which has become a major source of auto loans in recent years due to lower lending standards compared with banks, has collapsed since last year (Chart 5). With tightening regulations, the difficulty of acquiring auto loans through peer-to-peer lending is currently higher than before. Chart 5Rising Difficulty To Get An Auto Loan Lastly, there has been a structural decline in consumers’ willingness to buy cars due to increasing traffic congestion, limited parking space and more advanced public transportation. Moreover, more mature car rental markets and the rising use of car-sharing services have also helped reduce the need to buy a car, to some extent. This is a major difference from 2009-2010 and 2016. In Chart 6, both falling households’ marginal propensity to consume and declining consumption loan growth suggest a decreasing willingness to consume among Chinese consumers. Chart 6Chinese Consumers: Falling Willingness To Consume With all the aforementioned cyclical and structural forces in place, the impact on domestic auto sales from the recent stimulus package will be smaller in 2019 than in 2009 and 2016. That said, these policies will still be supportive, and likely sufficient to lift auto sales from contraction back to positive growth this year. Estimating the magnitude of the impact remains challenging, however, due to lingering uncertainty about the size of government subsidies. Based on all six measures listed in Box 1, the scale of subsidies provided by the government will be the major determinant for auto sales growth in China in 2019. In general, the bigger the subsidies, the stronger the push on auto sales. In 2009, both the central government and local government provided subsidies for stimulating auto sales. This time, while the financing sources could still be both central and local governments, local governments’ ability to finance auto consumption stimulus is diminishing due to their much higher debt levels and weaker revenues from land sales than in the past. For now, our view is that the impact from the stimulus will be much less significant than the previous two episodes in 2009 and 2016. Auto sales growth was 4.7% and 3% in 2015 and 2017, respectively. With recently announced stimulus, we expect the growth will be higher than in those years. Bottom Line: We expect that the growth of Chinese auto sales/production volumes will rebound to 5-8% this year, much slower than the 45% growth seen in 2009 and 14% growth in 2016. With a similar growth rate in value terms, Chinese auto sales are likely to increase by RMB 200 to 350 billion, which is about 0.2-0.4% of the country’s 2018 nominal GDP. The Winners And Losers At 5-8%, growth will be equivalent to a 1.5-2 million-unit increase in domestic auto sales. This will lead to a similar increase in auto production, as most cars are domestically produced. In terms of fuel use, automobiles can be classified as gasoline cars, diesel cars and new-energy cars. Chart 7 shows that gasoline cars currently hold 84% market share. In terms of brand, automobiles can be categorized as Chinese brands, Japanese brands, German brands, American brands, Korean brands and others. Chart 8 shows their market structure, with Chinese brands currently accounting for 42% of total market share. As the Chinese auto market is set to have a moderate recovery this year, which kinds of cars will benefit most, and which will benefit least? Even though China plans to gradually reduce its subsidies on NEVs to zero in 2021, several factors suggest that NEVs will still be the biggest winner, taking more market share from both gasoline and diesel cars. The government is aiming to increase the NEV market share from 4.5% currently to 20% by 2025. Assuming total sales rise to 32 million units in 2025 from current levels of 28 million (about 2% annual growth), this would imply that NEV sales will surge to 6.4 million units from 1.3 million currently, which is equal to 26% annual growth over the next seven years (Chart 9). Chart 9NEV Sales: Plenty Of Upside In addition to governments continuing subsidies, the sales tax on NEVs will be held at zero until the end of 2020, a big advantage over non-NEV vehicles, which carry the 10% sales tax. In addition, in cities that have license restrictions on car sales or have time or area restrictions on on-road autos, NEVs are not constrained by such policies, which is an attractive privilege for car buyers to consider. For example, in Shanghai, it costs over 80,000 RMB to buy a license plate for a non-NEV car if the potential buyer is lucky enough to be selected by random draw. In comparison, buying a NEV allows the buyer to have a free license plate. Current NEVs can achieve recharge mileage of 300-450 kilometers, with a price of RMB 100,000 to RMB 150,000 per unit. While the recharge mileage is sufficient for most daily use, prices are no longer substantially higher than prices for traditional gasoline or diesel cars. Major global and local NEV producers are expanding their production in China. For example, Tesla last month started building its mega electric car manufacturing plant in Shanghai, which will initially produce 250,000 cars per year, and eventually ramp up to half a million. This will be about five times the number of vehicles the company currently produces in the U.S. Most NEVs that have been sold in China are Chinese-brand NEVs. However, with China further opening up its auto sector and allowing more foreign NEV producers to invest and produce cars in China, Chinese NEV producers will face increasing competition and may lose some market share to foreign NEV producers. Meanwhile, Chinese NEV-related supportive policies will likely benefit both local and foreign NEV producers as the government is determined to develop the domestic NEV market and encourage NEV sales. That said, local producers will still enjoy slightly more favorable policies than foreign ones. Given that the government is promoting smaller-engine passenger car sales in rural areas and encouraging the replacement of old diesel cars with NEVs, sales and production of gasoline cars may also increase slightly, while diesel cars are likely to rise the least. In terms of brand, Chinese and American brands lost share to Japanese and German brands last year. We believe Chinese brands will benefit most from this year’s government-led auto market recovery for two reasons (Chart 10, top panel): Chart 10Chinese Brands Will Benefit Most From This Year’s Policy Stimulus The authorities will likely favor local brand producers in terms of benefitting from the subsidies they give to car buyers. In addition, local brand cars in general have lower prices than foreign brands, which could be the most attractive feature for price-sensitive rural residents. In the meantime, as the government encourages local auto replacement, this may benefit Japanese and German brands (Chart 10, second and third panels), as buyers with replacement needs will likely upgrade their cars to ones of higher quality and better reputation. Among American cars, while we are positive on American NEV car sales in China, we still expect American cars to continue to lose market share due to weakening sales of American non-NEV car sales (Chart 10, bottom panel). American cars are generally more expensive than Chinese-brand cars, and they are often perceived as slightly lower quality than either Japanese or German brands. Moreover, the ongoing trade dispute may bias Chinese buyers against buying an American car. Bottom Line: We believe NEV producers and Chinese-brand car producers will benefit most from this year’s government-led auto market recovery. Investment Implications There are several important conclusions that stem from our research. First, while rebounding auto production will likely lift demand for many metals, housing construction is artificially supporting demand and is set to decelerate over the coming year (Chart 11). Consequently, we do not believe that accelerating auto production alone is a license to be long industrial metals over the coming year. Chart 11Weakening Property Market Weighs More On Commodity Market Second, within the equity space, we recommend that global investors prepare to go long domestic auto stocks on an absolute basis after the outcome of the U.S.-China trade talks emerges later this month. Rebounding auto production will likely lead to a cyclical improvement in auto producer earnings, which in combination with deeply oversold conditions bodes well for the 6-12 month outlook (Chart 12). Chart 12Look To Long Domestic Auto Stocks In An Absolute Term U.S. negotiators are seeking increased access to the Chinese auto market, which implies that the outcome of the negotiations carries some event risk for domestic producers (particularly if China’s concessions on this front turn out to be large). But our sense is that we are likely to recommend an outright long position favoring domestic automakers barring a trade deal with deeply negative implications for domestic producer market share. Third, our bullish bias towards Chinese auto producers and our constructive outlook for the home appliance market supports two of our existing trades favoring consumer discretionary stocks. Chart 13 highlights that production and sales volume for several home appliance products is depressed, and stands to benefit from a flurry of policy announcements late last month that were intended to support the industry. Chart 13Home Appliances: Rebound Soon On Stimulus As Well Both auto producers and home appliance manufacturers belong to the consumer discretionary sector, and we recommend maintaining a long domestic consumer discretionary position versus both the domestic benchmark and relative to consumer staples (both trades were initiated on November 141). While domestic consumer discretionary stocks are expensive vs. the domestic benchmark on a P/B basis (Chart 14), the sector’s relative P/E ratio is trading at the very low end of its historical range and the trade has eked out modest positive gains since initiation. Chart 14Remain Overweighting Consumer Discretionary Sector Our long discretionary / short staples trade has faired much worse, down 11% since initiation due to a significant rally in consumer staples stocks (rather than losses in the discretionary sector). We recommend that investors stick with the trade over the coming 6-12 months despite the loss, as Chart 15 highlights that the discretionary / staples trade could not be more extreme in terms of relative performance or valuation. Our bet is that this trade will reverse course in 2019, for a meaningful period, in response to a cyclical tailwind from policy. Chart 15Stay Long Discretionary / Short Staples   Ellen JingYuan He, Associate Vice President Emerging Markets Strategy EllenJ@bcaresearch.com   Footnotes 1 Please see BCA Research’s China Investment Strategy Special Report “Chinese Household Consumption: Full Steam Ahead?”, published November 14, 2018. Available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations