Emerging Markets

Special Report

The aim of this Special Report is to elaborate on and explain the different views on China that have coexisted at BCA in recent years. Although BCA strives to achieve consensus among its strategists, this is not always possible, as has been the case with China. Peter Berezin of the Global Investment Strategy service and Yan Wang of China Investment Strategy have been positive, while Arthur Budaghyan of Emerging Markets Strategy has been negative on both China's business cycle and China-related plays. The focal points of divergence are centered on how Peter, Yan, and Arthur view and explain the relationship between savings, debt, and the misallocation of capital, as well as how they see China's potential roadmap going forward. The debate is moderated by BCA Global Strategist Caroline Miller. Caroline: Peter and Yan, the world - including the Chinese government - is climbing a wall of worry about China's debt load. Why are you guys still smiling? How many Maotai did you have last night? Peter: I don't know what a Maotai is, but I am sure that if I had more than one I wouldn't be smiling this morning. But yes, I am not as worried as Arthur that China is in the midst of an unsustainable credit bubble. Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors in the global equity market (Chart 1). The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 2). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 3). Chart 1Chinese Banks: Unloved And Unwanted Chart 2Recent Credit Bubbles Developed ##br##Amid Widening Current Account Deficits Chart 3Hong Kong Is The Correct Analogy Yes, there is a lot of debt in China. But there is a lot of savings too. In fact, to a large extent, China's high debt levels are just a function of its high saving rate. The evidence suggests that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies (Chart 4). China sits close to the trend line, implying that its debt stock is roughly what you would expect it to be. Chart 4Positive Correlation Between National Savings And Indebtedness Arthur: Allow me to both agree and disagree with Peter. No, there is no bubble in Chinese equities, but yes, there is a bubble and euphoria in China's property market. Property prices have risen exponentially and are extremely high by any metric. Chinese bank equity valuations have already adjusted, but bank stocks could still sell off if their profits shrink considerably, as I expect. Bank shares are not expensive, but not cheap either, if one adjusts for non-performing loans. I concur that China's property market adjustment will likely resemble that of Hong Kong as opposed to that of the U.S. As Peter noted, in Hong Kong in the late 1990s, property prices plunged by 70%, but few homeowners defaulted on their mortgages. Yet property starts/construction also collapsed by 80% (Chart 5). Chart 5Hong Kong's Property: ##br##Few Mortgage Defaults ##br##But Collapse In Construction Presently in China, the risk is not mortgage defaults but a renewed drop in property construction as well as other types of capital spending. Less construction/capital spending entails less demand for commodities, materials/chemicals and industrial goods. China's residential and non-residential construction activity will contract anew as speculative/investment demand for property weakens. Yan: I agree with Peter that China's rising debt is fundamentally a function of the country's abundant savings. Moreover, the fact that the country's massive savings pool is primarily intermediated via the banking sector and other debt instruments exacerbates the debt buildup. If a country's savings are primarily intermediated by the stock market through equity financing, then high savings do not necessarily lead to high debt, as "savers" become "shareholders" rather than "creditors." In China's case, the country's still relatively undeveloped and volatile equity market has not yet been able to play a meaningful role in financial intermediation. Instead, banks still play a dominant role channeling financial resources. In other words, China's high savings and a banking-centric financial intermediation system are key drivers of the ever-rising debt level. In fact, as long as these two features persist, the country's debt will inevitably continue to rise, as it simply reflects the accumulated savings. Caroline: Arthur, does this line up with how you think about the relationship between savings and debt? Arthur: My thesis has been that China's abnormal credit growth has been the result of speculative, euphoric behavior among Chinese banks and the shadow banking system - and not the natural result of the country's "excess savings," as Peter and Yan have argued. What economists call "savings" or "excess savings," non-economists refer to as "overproduction" or "excess capacity." This is about concepts, not about China. In economic science, the term "savings" is used to denote the number of goods and services that a nation has produced but not consumed - i.e., they can be used for investment or exports. Peter and Yan are using this textbook definition of "savings." Hence, by "savings" or "excess savings" they mean "excess production." Logically, the glut of goods and services does not flow to banks and create deposits. In brief, "savings" or "excess savings" are real economic variables and have nothing to do with bank deposits - i.e., "monetary savings." Peter, Yan and many other commentators make this mistake by mixing up national savings - which is literally output of goods and services that were not consumed by households and government - with "monetary savings," i.e., deposits in the banking system. I have no doubt China has had a high savings rate, i.e., it has had overcapacity and over-production in a number of sectors. The textbook concept of national savings is calculated as a residual from the national accounts and balance of payments. In particular: Savings - Investments = Current Account Balance and Savings = Investments + Current Account Balance A few remarks on the economic interpretation of this equation are in order. First, in any country, "excess" national savings over investment, i.e., current account surpluses, lead to an accumulation of net foreign assets, but has no implication on domestic loan creation.1 Second, a country that invests a lot and does not run a large current account deficit will have a high savings rate as per the economic textbook's definition of national savings. The opposite also holds true. Critically, national or household savings are in no way linked to the amount of deposits at banks. When households decide to save a part of their income, they do not create new deposits or "monetary savings." They save deposits that already exist in the banking system. To sum up, the amount of deposits in the banking system does not change as a result of households' decision to save a part of their income. When a person gets paid in cash and deposits that cash in a bank as a savings deposit, there is no new money created either. That cash was a deposit and was withdrawn from a bank a few days before, and now this cash returns to the banking system as a deposit again. In this case, the amount of total outstanding money supply in the economy (cash plus deposits) has not changed. In general, when a bank receives a deposit, it does not create new money, or "monetary savings." The deposit simply moves from one bank to another or from cash to deposit. The amount of money supply does not change. When a country enjoys a lot of overcapacity, strong bank loans or money growth will not cause inflation and interest rates will stay low, encouraging more borrowing. This is why in Peter's Chart 4 there is a positive correlation between the national savings rate and debt-to-GDP ratio across countries. Overcapacity entails low inflation; the latter keeps nominal interest rates low, which in turn entices more borrowing and debt build-up. In brief, the linkage between national savings/excess capacity and the credit-to-GDP ratio is indirect via subdued inflation and low interest rates that encourage debt build-up. Caroline: Arthur, you have made the case that savings are not a constraint to loan origination. Can you elaborate? Arthur: The banking system does not intermediate "savings" or "excess savings" from the real economy into loans. The commercial banking system as a whole creates deposits at the time it originates loans. This is true of all countries. Indeed, whenever commercial banks make a loan, they simultaneously create a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart 6). In other words, bank loan origination creates deposits and money.2 Chart 6Commercial Banks: Credit Origination Creates Deposits China's banking system has a lot of deposits because banks have created too many loans. In addition, a bank does not need liquidity (reserves at the central bank) for each loan it originates. It still requires some liquidity to settle its net balance with other banks or to meet minimum reserve requirements. If a bank creates a loan but still has excess reserves at the central bank, it may not require liquidity to "back up" the loan. There are many variables that constrain bank loan origination, but they do not include national savings or "excess savings." We discussed these constraints in detail in our EMS report titled Misconceptions About China's Credit Excesses.3 Finally, when central banks opt to keep short-term interest rates steady, they must provide commercial banks with as much liquidity as the latter demands. This point is greatly relevant to China. For the past few years, China's central bank has silently moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money) (Chart 7). As a result, nowadays the People's Bank of China (PBoC) has very little quantitative control over money/credit creation by commercial banks. Chart 7The PBoC Has Begun Targeting Rates In Recent Years It is Chinese commercial banks that effectively drive money/credit/deposit creation. The PBoC decides whether or not to accommodate banks' liquidity needs by allowing interest rates to rise or fall, or by keeping them steady.4 To conclude, what habitually drives credit booms in any country are the "animal spirits" of banks and borrowers - not national savings. This has been the case in China too. Caroline: Peter, do you agree with Arthur's assessment? Peter: I don't want to get bogged down in the weeds of monetary theory, but let me briefly address two distinct points that I think Arthur is making. The first is the claim that the ability of banks to create money "out of thin air" is somehow not constrained by the volume of bank reserves and cash in circulation (the so - called "monetary base"). The second is the claim that there is no meaningful link between savings and deposits. I think Arthur is wrong on both counts. On the first claim, it is true that when a bank issues a loan, it also creates a deposit. To the extent that bank deposits are treated as "money," this expands the money supply. This is simply the "money multiplier" taught in introductory economics classes. Where Arthur's logic falls short is in his implicit assumption that all lending translates into additional bank deposits. It doesn't have to. Some of the deposits will be withdrawn and kept as cash. Governments have complete control over how much cash there is in circulation by virtue of their monopoly over the printing press. As long as cash exists, central banks can influence the broad money supply via open market operations. By the way, this is true even in banking systems where there are no reserve requirements. Regarding Arthur's claim that lending can occur without savings, this is often true when someone is borrowing money to buy an asset. However, it is generally not true if they are borrowing money to finance new spending. Let me offer a concrete, albeit somewhat whimsical, example to illustrate this point. Suppose I am living in a closed economy where no one saves anything. Now, let's imagine that I decide to throw a party for myself and need to borrow $1000 to do this. Who is going to provide me with the resources? Well, we just said that no one wants to save, so "something" has to adjust for me to have my party. That "something" is the interest rate. In order to entice someone to spend a bit less, the bank (on my behalf) will offer depositors a higher interest rate. If rates rise by enough, someone will decide to forego a bit of consumption today in order to have more consumption tomorrow. In other words, my decision to borrow must result in someone else's decision to save. So do savings create debt or does debt create savings? The answer is both: interest rates adjust to ensure that the two end up being different sides of the same coin. Caroline: Yan, what's your perspective on China's high debt profile? What could you be missing? Yan: As you can see Arthur and I view China's debt profile through different theoretical lenses. I don't think we can fully reconcile our different frameworks on the matter, but we hope our debate can deepen clients' own understanding of this issue, so they can make up their own minds. What I do want to stress is that those analysts who fear that China's corporate debt problem constitutes an alarming systemic financial risk focus exclusively on the rapid increase in the country's debt-to-GDP ratio. While undoubtedly there is merit to this ratio, I think it is also important to validate this judgement by looking at other indicators. In our previous research, we looked beyond this widely cited conventional indicator for corroborating evidence of a "debt bubble." Our findings suggest that the level of Chinese corporate sector leverage is not as precarious as widely perceived. For example, in the Chinese corporate sector, the area of China's economy where investors worry most about leverage, the debt-to-asset ratio of China's industrial sector has been falling since the late 1990s, down to 56% from 62%, contrary to popular belief (Chart 8). State-owned enterprises have witnessed an increase in their debt-to-asset ratio since the global financial crisis, but it has barely reached late 1990s levels, and has actually rolled over in recent years. Meanwhile, SOEs are a shrinking part of the overall economy and therefore, when looked at in conjunction with the private sector, have not moved the needle on the broader trend of corporate balance sheet "deleveraging." This stands in stark contrast to Japan's corporate sector at the peak of its debt bubble. In the early 1990s, Japan's corporate sector debt-to-asset ratio topped out at 78% when the country's "balance sheet recession" began (Chart 9). Even after two decades of deleveraging, Japan's current corporate debt-to-asset ratio is comparable to China's. To validate this conclusion, we also calculated several other key ratios to compare the leverage situation of Chinese listed companies relative to their global peers. Ratios such as liability-to-assets, net debt-to-EBITDA and interest coverage assess both leverage levels and debt servicing capacity. As Chart 10 shows, our extensive survey, both from the top down and the bottom up, suggests that China's leverage situation is comparable if not superior to its global peers. Chart 8The Leverage Picture From A Balance Sheet Perspective Chart 9Japan's Debt Bubble And Deleveraging Chart 10Leverage Ratios: How China Compares Therefore, I think we should be skeptical about the widely held view that China's corporate sector leverage is precariously high. It is at a minimum inaccurate, if not misleading, to rely solely on the debt-to-GDP ratio to reach such an ominous conclusion. Caroline: Arthur, I take it you don't agree? Arthur: Since January 2009, China's corporate and household debt has risen by RMB 130 trillion (about US$ 19 trillion) or by 100% of GDP (Chart 11). I do not believe even the most sophisticated financial/credit systems can allocate such amounts of credit in such a short time and not misallocate capital. By capital misallocation, I am implying investments in projects that do not generate sufficient cash flow to service debt. The accounting value (valuation) of assets is irrelevant in these cases; the cash flow generation is critical. The debt-to-GDP ratio is a much more superior measure to debt-to-asset-ratio. The basis is that the GDP is a proxy for cash flow, while accounting value of assets could be extremely inflated during a credit bubble. To be sure, I am not suggesting that all investments in China have gone sour. Nobody knows the extent of capital misallocation in China. But I suspect it is large enough to make a difference for the macro outlook/business cycle. Caroline: Peter, you have made the comparison between China today and Japan in the 1990s. Could you expand on that? Peter: Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 12). In order to keep unemployment from rising, the Japanese government was forced to run large budget deficits. In effect, the government ended up having to absorb the private sector's excess savings through its own dissaving. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 13). Chart 11China: The Credit Boom Chart 12Japan Relied On Fiscal Largesse And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 13China: Debt Increased When ##br##The Current Account Surplus Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (please see Chart 8). In effect, China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere": They are a necessary evil. Caroline: Arthur, your thoughts? Arthur: What Peter and Yan in effect propose is that Chinese banks should continue creating credit/money "out of thin air" in order to create demand for these "excess" goods, i.e., overcapacity sectors. In a nutshell, a number of Chinese companies made bad decisions by over expanding capacity, and now banks have to continue lending/creating demand to justify these bad investments. As a result, persisting explosive credit growth has allowed these unviable or zombie enterprises to survive, and they are not compelled to restructure. This is not how capitalism and markets work. This is de facto socialism. Socialism usually does not lead to prosperity. One of the key reasons behind the failure of socialist economic models is that productivity growth in socialist systems is very low, often close to zero. The basis is that productivity growth is generated not by government officials but by the private sector and entrepreneurs. China's economic success over the past 35 years or so has been due to allowing private enterprises to function and flourish - not because government officials necessarily made correct business and investment decisions. I am for countercyclical fiscal and monetary policies. However, the credit boom in China has gone well beyond the countercyclical policy framework. The concept of countercyclical policies does not suggest that the government or public banks should continue to spend in perpetuity to support fundamentally unviable businesses that invested too much and created excess capacity. Besides, "countercyclical" means for a couple of years. China has been expanding bank/credit/money for about nine years - since January 2009. Peter and Yan argue that they should keep doing it further. If the authorities do what Peter and Yan propose, investors should be structurally - not cyclically - bearish on Chinese stocks. Chart 14There Has Been No Shortage ##br##Of Demand Since 2010 The basis is that a socialist growth model is not friendly for shareholders. Shareholders often lose money when companies operate for maximizing employment rather than profits. This is why Chinese SOEs and bank stocks trade at low multiples - because they destroy capital and value for their shareholders. Notably, "overproduction" and "excess capacity" could be an outcome of either a demand downturn or oversupply/overproduction. Keynes recommended countercyclical policies to fill the gaps when demand shrinks. Chart 15Fiscal Outlays & Credit Origination ##br##Are Close To 50% Of GDP In China's case, there has been no domestic demand downturn to warrant multi-year countercyclical policies. China did the right thing in early 2009 to offset its export plunge amid the Global Financial Crisis, and it helped the global economy recover. However, since 2010 global demand and mainland exports have been stable (Chart 14), making the extended and ongoing credit boom in China unwarranted and excessive. As to the argument that most credit should be counted as a form of fiscal spending, I do not think Chinese policymakers themselves would agree with this statement. In fact, if this is correct, it would mean that government officials are allocating about 50% of GDP each year. Chart 15 illustrates general (central plus local) government spending and annual credit origination as a share of GDP. How fast would productivity grow in an economy where government bureaucrats allocate 50% of GDP annually? It is true that China's central government has a low debt load so it can afford to take over a large chunk of corporate debt. If and when they do so, I will change my view. So far, they have not done this, and will likely only contemplate such a policy move when things get really messy. Investors do not want to be long China plays going into such a scenario. That said, a tactical buying opportunity could emerge when the government takes over a large chuck of corporate debt. Caroline: Yan, how worried should we be about the misallocation of capital in China? Yan: Every economy experiences some level of capital misallocation. The real question is whether China's level of capital misallocation is more serious than that of its global peers. Theoretically, if a country has a bigger capital misallocation problem than others, the economy should have systemically lower capacity utilization, weaker pricing power, and lower profitability. These metrics are easily cross-referenced: Chart 16 contextualizes China's industrial sector capacity utilization ratio relative to global peers. By and large, most countries' capacity utilization ratios hover around 80%, not much different from China's, especially since the 2000s. In fact, barring some obvious outliers, capacity utilization ratios across countries have been largely synchronized, reflecting the ebb and flow of the global business cycle. Chart 16Capacity Utilization: A Global Perspective Industrial sector output prices have shown similar swings (Chart 17). Almost all countries suffered producer price deflation in recent years, and are now experiencing a synchronized upturn in wholesale pricing power. China's falling PPI was widely regarded as a tell-tale sign of misallocation of capital. Conversely, this was in fact more a reflection of stagnating global aggregate demand and weak resource prices worldwide than structurally weak pricing power among Chinese manufacturers. Chart 17Producer Prices: A Global Perspective Similarly, Chinese listed companies' deteriorating Return on Equity (ROE) was again singled out as a sign of capital misallocation. This view is easily debunked by Chart 18, as ROEs have fallen in all major markets. In fact, Chinese companies' ROEs have been structurally higher than the global averages. Even some Chinese sectors that have been derided as being plagued by massive overcapacity and inefficiency such as materials and energy exhibit ROEs almost identical to their global peers. The important point is that we should put China in a global context, rather than analyzing it in isolation. Some Chinese firms' efficiency and profitability have weakened notably over the past several years, but to me, this is more of a reflection of the sluggish global macro backdrop, rather than an indictment of China's discrete growth model. Caroline: Turning to the investment implications, Yan, how does the debt bubble concern impact your view on Chinese equities? Yan: Global investors' widespread concerns over Chinese debt levels and other macro issues have contaminated Chinese stocks with a broad-brushed bearish undertone. Chinese equities have been unduly punished, underweighted and under-owned for many years. As shown in Chart 19, Chinese investable stocks' ROEs have been structurally higher than the global benchmark, and have followed similar cyclical fluctuations. However, their stock prices are trading at massive discounts to the global benchmarks, based on conventional yardsticks (Chart 19). This in my view represents the "China risk premium," which is unjustified and unsustainable. I expect the misperception will eventually unwind, and Chinese shares will be re-rated. This is the fundamental factor supporting my positive view on Chinese equities. Strategically it makes sense to overweight Chinese stocks against their global peers. Chart 18Chinese ROEs Are Not Inferior To Global Peers Chart 19Chinese Equities' Large Valuation Gap Caroline: Arthur, how does your view impact your outlook for investment prospects in China and the rest of the emerging markets space? Arthur: There has not been any adjustment in China's corporate leverage. Deleveraging in China has not yet started. On the contrary, the credit bubble is getting larger. I mean the credit-to-GDP ratio continues rising exponentially and credit and bank loan growth remain in double digits (Chart 20). It is very risky to be bullish on financial assets linked to a bubble when the adjustment has not yet begun. It is like running in front of a steamroller trying to collect pennies. Besides, when there is a major imbalance in the system like the credit bubble happening in China now, I tend to overplay the importance of marginal policy tightening and underplay the significance of easing. Recent marginal policy tightening in China - in particular the clampdown on shadow banking, including banks' off-balance-sheet asset expansion - will cause credit growth to decelerate. This is a major risk to Chinese and EM growth in the second half of this year (Chart 21). Chart 20China: Money/Credit Is Still Booming Chart 21Is China's Recovery At Risk? Even if China does not have a full-blown crisis, we are likely to experience another down leg in China plays, commodities and EM risk assets similar to the second half of 2015, when Chinese import volumes contracted and global markets tanked. A few words about the potential adjustment trajectory are in order. I have been negative on China's growth and China-related plays in global financial markets since 2010, but I have never used the word "crisis." China may or may not have a crisis, but investors holding risk assets exposed to China's growth will suffer considerable losses again similar to the 2011-16 period. It is essential to differentiate cyclical from structural growth drivers. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, China will move toward a socialist model and structural growth will tumble. That said, the growth deceleration would be gradual, as depicted in Chart 22. Chart 22Toward Socialism = Secular Stagnation And Inflation If we assume China's productivity is currently growing at a rate of about 5.5-6% (which is already very high and hard to sustain), and if the country embarks on a socialist path, odds are that productivity growth will drop by 50-100 basis points in each of the following years. In five years or so, productivity growth would be only around 1-3%. This path is the ultimate recipe for economic stagnation in China. The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-cycles around a falling primary growth trend. The latest acceleration in China's growth is probably one of these mini-cycles. How can investors invest in this scenario? The stylized mini-cycles depicted in Chart 22 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. In short, investing around economic mini-cycles is difficult because it assumes near-perfect timing. Caroline: Peter, is it all that bad? Peter: I think Arthur is too pessimistic. Investors have been predicting a Japanese debt crisis for years. It hasn't materialized and probably won't. They are making the same mistake about China. If China averts a debt crisis, as I think is likely, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions in local-currency terms. For global bonds, the implications are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Caroline: Yan, do domestic politics play into your outlook for the RMB versus the dollar and on a trade-weighted basis? What is your outlook for monetary policy given recent signs of improving economic momentum? Yan: How President Donald Trump will deal with China on the RMB issue is a wildcard. Recent rhetoric suggests that the new U.S. administration intends to follow normal legal protocol to decide if China is manipulating its currency. This is a significant departure from Candidate Trump's repeated campaign trail promises. If the U.S. Treasury follows the formal process laid out in the statute, it is unlikely to label China a currency manipulator in the next semi-annual assessment to be published in April, simply because the country does not meet all the criteria for that label at the moment. The odds of an immediate clash between the U.S. and China on the RMB have ebbed. From China's domestic perspective, how the People's Bank of China intends to manage the exchange rate is also a thorny issue. From a long term point of view, the PBoC clearly wants to achieve a free-floating exchange rate, but the recent downward pressure on the RMB due to elevated capital outflows has forced the PBoC to heavily intervene to prevent a vicious, disorderly cycle, in which currency depreciation and capital flight reinforce each other. In terms of monetary policy, China's improving economic momentum has allowed the PBoC to follow the Fed in raising short-term interest rates. However, tighter capital account control measures will remain in place until the downward pressure on the RMB from capital outflow dissipates. Moreover, investors have been overwhelmingly focused on the negative economic effects of a weaker RMB, somehow ignoring the reality that as the world's largest manufacturer and exporter, China also stands to benefit from a weaker currency. In my view, the depreciation of the trade-weighted RMB since 2015 has played a critical role in reflating the Chinese economy (Chart 23). A weaker RMB has helped producer prices to reflate, and lowered the real cost of funding for manufacturers, which in turn has eased China's monetary conditions and supported cyclical growth improvement. In this vein, the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the currency. Caroline: Peter and Arthur, is rampant capital flight still a risk? Where do you see the RMB heading over the coming 12-18 months? Peter: I think the RMB will weaken somewhat over the coming year, but that is more a reflection of my bullish view on the dollar than a bearish view on the yuan. Much of the capital flight that China has experienced recently has just been an unwinding of the hot money flows that entered the country over the preceding four years. Despite all the talk about a credit bubble, Chinese corporate external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 24). At this point, most of the hot money has exited the country and hence, I expect the pace of capital outflows to subside. Chart 23A Weaker RMB Leads Cyclical Recovery Chart 24The Rise And Fall Of Corporate Foreign Credit Nevertheless, the chronic shortfall of domestic demand that I described earlier will keep pressure on the Chinese government to try to export excess production abroad by running a larger current account surplus. This requires a weak currency. Thus, while I don't expect the yuan to plummet, I don't expect it to soar either. Arthur: I believe the RMB is set to depreciate by 10% or more against the U.S. dollar in the next 12 months or so. The Chinese yuan is not expensive, but it will stay under downward pressure because the mainland banking system has created too many yuan. When the supply of money goes vertical, its price drops. It seems the Chinese people are sensing there is too much RMB floating around, and they are trying to get rid of local currency. They have been overpaying for properties and have been shifting their wealth into foreign currencies. Finally, in China, the real deposit rate has turned negative (Chart 25, top panel). In the past, when the real deposit rate turned negative, the central bank hiked interest rates (Chart 25, bottom panel). If households do not get a more attractive deposit rate, they will opt for foreign currency, real assets like property or riskier investments domestically. All of this entails negative consequences for China's financial stability. Chart 25Real Deposit Rate Is Negative In brief, I expect capital outflows to persist and policymakers to allow the currency to depreciate further. Caroline: Peter/Yan/Arthur: Final thoughts: What are each of you watching for signs that China's macro landscape is evolving as you expect? Conversely, what would signal that your assessment has missed the mark? Peter: I am watching for signs of a policy mistake. Until China can reorient its economy towards one that is more consumer-centric, it will have to rely on high levels of investment to sustain aggregate demand. Any attempt to aggressively curb debt growth will only backfire. Arthur talks about resource misallocation from subpar investment projects, but there is no worse resource misallocation than a person who wants a job but can't find one. I am also watching trade policy. I don't think a trade war between China and the U.S. is in the cards for the time being, but if the U.S. economy turns down in 2019, as I expect, Trump will be backed into a corner. And with another election looming, he will strike out at China. That could trigger a global trade war. Yan: I agree with Peter that we should watch for policy mistakes and some sort of "Trump shock," both of which constitute downside risks. A less talked-about risk is potential growth overheating, which could require much tighter policy, leading to greater economic volatility. In fact, some cyclical indicators that are tightly linked to industrial activity have rebounded sharply, which is also reflected in the rebound in some raw materials prices. If exports get a further boost from continued improvement in the U.S. economy, the possibility of China's economy overheating cannot be completely dismissed. Another potential trouble spot is the housing market. The Chinese authorities have begun to tighten housing policy, but developers appear to be gearing up for another construction cycle. Sales of construction equipment such as heavy trucks and excavators have soared. Historically, construction machine sales have been tightly correlated with real estate development (Chart 26). If history is any guide, the renewed strength in construction equipment sales could be a harbinger of an impending boom in new home construction. This is good news for business activity and GDP growth, but probably antithetical to policymakers' broad agenda. We will follow up on these issues closely in our future reports. Arthur: The key variables to watch are various interest rates, credit/loan growth and inflation - in addition to keeping an eye on lending standards and credit demand. Recent increases in borrowing costs amid the enormous credit overhang give me confidence to argue that China's credit origination and economic growth are bound to decelerate later this year. A billion-dollar question is whether the recent rise in China's consumer inflation is transitory or the beginning of a notable uptrend (Chart 27). If consumer price inflation rises to 3% and higher, the game will be over - interest rates will need to go up and credit growth will tumble. If interest rates do not rise amid intensifying inflationary pressures, capital outflows will escalate and the currency will depreciate a lot. Chart 26An Upturn In Housing Construction? Chart 27China: Inflation Is Picking Up I will be wrong if policymakers manage to slow down credit growth from 11-12% toward 7-8% or so without generating notable economic weakness. This can occur only if productivity growth in China accelerates meaningfully. It is difficult to observe productivity growth in real time - it is a black box. 1 Please see Emerging Markets Strategy Special Report, titled "Do Credit Bubbles Originate From High National Savings?" dated January 18, 2017, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 4 Please see Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com.

Special Report

The aim of this Special Report is to elaborate on and explain the different views on China that have coexisted at BCA in recent years. Although BCA strives to achieve consensus among its strategists, this is not always possible, as has been the case with China. Peter Berezin of the Global Investment Strategy service and Yan Wang of China Investment Strategy have been positive, while Arthur Budaghyan of Emerging Markets Strategy has been negative on both China's business cycle and China-related plays. The focal points of divergence are centered on how Peter, Yan, and Arthur view and explain the relationship between savings, debt, and the misallocation of capital, as well as how they see China's potential roadmap going forward. The debate is moderated by BCA Global Strategist Caroline Miller. Caroline: Peter and Yan, the world - including the Chinese government - is climbing a wall of worry about China's debt load. Why are you guys still smiling? How many Maotai did you have last night? Peter: I don't know what a Maotai is, but I am sure that if I had more than one I wouldn't be smiling this morning. But yes, I am not as worried as Arthur that China is in the midst of an unsustainable credit bubble. Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors in the global equity market (Chart 1). The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 2). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 3). Chart 1Chinese Banks: Unloved And Unwanted Chart 2Recent Credit Bubbles Developed ##br##Amid Widening Current Account Deficits Chart 3Hong Kong Is The Correct Analogy Yes, there is a lot of debt in China. But there is a lot of savings too. In fact, to a large extent, China's high debt levels are just a function of its high saving rate. The evidence suggests that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies (Chart 4). China sits close to the trend line, implying that its debt stock is roughly what you would expect it to be. Chart 4Positive Correlation Between National Savings And Indebtedness Arthur: Allow me to both agree and disagree with Peter. No, there is no bubble in Chinese equities, but yes, there is a bubble and euphoria in China's property market. Property prices have risen exponentially and are extremely high by any metric. Chinese bank equity valuations have already adjusted, but bank stocks could still sell off if their profits shrink considerably, as I expect. Bank shares are not expensive, but not cheap either, if one adjusts for non-performing loans. I concur that China's property market adjustment will likely resemble that of Hong Kong as opposed to that of the U.S. As Peter noted, in Hong Kong in the late 1990s, property prices plunged by 70%, but few homeowners defaulted on their mortgages. Yet property starts/construction also collapsed by 80% (Chart 5). Chart 5Hong Kong's Property: ##br##Few Mortgage Defaults ##br##But Collapse In Construction Presently in China, the risk is not mortgage defaults but a renewed drop in property construction as well as other types of capital spending. Less construction/capital spending entails less demand for commodities, materials/chemicals and industrial goods. China's residential and non-residential construction activity will contract anew as speculative/investment demand for property weakens. Yan: I agree with Peter that China's rising debt is fundamentally a function of the country's abundant savings. Moreover, the fact that the country's massive savings pool is primarily intermediated via the banking sector and other debt instruments exacerbates the debt buildup. If a country's savings are primarily intermediated by the stock market through equity financing, then high savings do not necessarily lead to high debt, as "savers" become "shareholders" rather than "creditors." In China's case, the country's still relatively undeveloped and volatile equity market has not yet been able to play a meaningful role in financial intermediation. Instead, banks still play a dominant role channeling financial resources. In other words, China's high savings and a banking-centric financial intermediation system are key drivers of the ever-rising debt level. In fact, as long as these two features persist, the country's debt will inevitably continue to rise, as it simply reflects the accumulated savings. Caroline: Arthur, does this line up with how you think about the relationship between savings and debt? Arthur: My thesis has been that China's abnormal credit growth has been the result of speculative, euphoric behavior among Chinese banks and the shadow banking system - and not the natural result of the country's "excess savings," as Peter and Yan have argued. What economists call "savings" or "excess savings," non-economists refer to as "overproduction" or "excess capacity." This is about concepts, not about China. In economic science, the term "savings" is used to denote the number of goods and services that a nation has produced but not consumed - i.e., they can be used for investment or exports. Peter and Yan are using this textbook definition of "savings." Hence, by "savings" or "excess savings" they mean "excess production." Logically, the glut of goods and services does not flow to banks and create deposits. In brief, "savings" or "excess savings" are real economic variables and have nothing to do with bank deposits - i.e., "monetary savings." Peter, Yan and many other commentators make this mistake by mixing up national savings - which is literally output of goods and services that were not consumed by households and government - with "monetary savings," i.e., deposits in the banking system. I have no doubt China has had a high savings rate, i.e., it has had overcapacity and over-production in a number of sectors. The textbook concept of national savings is calculated as a residual from the national accounts and balance of payments. In particular: Savings - Investments = Current Account Balance and Savings = Investments + Current Account Balance A few remarks on the economic interpretation of this equation are in order. First, in any country, "excess" national savings over investment, i.e., current account surpluses, lead to an accumulation of net foreign assets, but has no implication on domestic loan creation.1 Second, a country that invests a lot and does not run a large current account deficit will have a high savings rate as per the economic textbook's definition of national savings. The opposite also holds true. Critically, national or household savings are in no way linked to the amount of deposits at banks. When households decide to save a part of their income, they do not create new deposits or "monetary savings." They save deposits that already exist in the banking system. To sum up, the amount of deposits in the banking system does not change as a result of households' decision to save a part of their income. When a person gets paid in cash and deposits that cash in a bank as a savings deposit, there is no new money created either. That cash was a deposit and was withdrawn from a bank a few days before, and now this cash returns to the banking system as a deposit again. In this case, the amount of total outstanding money supply in the economy (cash plus deposits) has not changed. In general, when a bank receives a deposit, it does not create new money, or "monetary savings." The deposit simply moves from one bank to another or from cash to deposit. The amount of money supply does not change. When a country enjoys a lot of overcapacity, strong bank loans or money growth will not cause inflation and interest rates will stay low, encouraging more borrowing. This is why in Peter's Chart 4 there is a positive correlation between the national savings rate and debt-to-GDP ratio across countries. Overcapacity entails low inflation; the latter keeps nominal interest rates low, which in turn entices more borrowing and debt build-up. In brief, the linkage between national savings/excess capacity and the credit-to-GDP ratio is indirect via subdued inflation and low interest rates that encourage debt build-up. Caroline: Arthur, you have made the case that savings are not a constraint to loan origination. Can you elaborate? Arthur: The banking system does not intermediate "savings" or "excess savings" from the real economy into loans. The commercial banking system as a whole creates deposits at the time it originates loans. This is true of all countries. Indeed, whenever commercial banks make a loan, they simultaneously create a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart 6). In other words, bank loan origination creates deposits and money.2 Chart 6Commercial Banks: Credit Origination Creates Deposits China's banking system has a lot of deposits because banks have created too many loans. In addition, a bank does not need liquidity (reserves at the central bank) for each loan it originates. It still requires some liquidity to settle its net balance with other banks or to meet minimum reserve requirements. If a bank creates a loan but still has excess reserves at the central bank, it may not require liquidity to "back up" the loan. There are many variables that constrain bank loan origination, but they do not include national savings or "excess savings." We discussed these constraints in detail in our EMS report titled Misconceptions About China's Credit Excesses.3 Finally, when central banks opt to keep short-term interest rates steady, they must provide commercial banks with as much liquidity as the latter demands. This point is greatly relevant to China. For the past few years, China's central bank has silently moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money) (Chart 7). As a result, nowadays the People's Bank of China (PBoC) has very little quantitative control over money/credit creation by commercial banks. Chart 7The PBoC Has Begun Targeting Rates In Recent Years It is Chinese commercial banks that effectively drive money/credit/deposit creation. The PBoC decides whether or not to accommodate banks' liquidity needs by allowing interest rates to rise or fall, or by keeping them steady.4 To conclude, what habitually drives credit booms in any country are the "animal spirits" of banks and borrowers - not national savings. This has been the case in China too. Caroline: Peter, do you agree with Arthur's assessment? Peter: I don't want to get bogged down in the weeds of monetary theory, but let me briefly address two distinct points that I think Arthur is making. The first is the claim that the ability of banks to create money "out of thin air" is somehow not constrained by the volume of bank reserves and cash in circulation (the so - called "monetary base"). The second is the claim that there is no meaningful link between savings and deposits. I think Arthur is wrong on both counts. On the first claim, it is true that when a bank issues a loan, it also creates a deposit. To the extent that bank deposits are treated as "money," this expands the money supply. This is simply the "money multiplier" taught in introductory economics classes. Where Arthur's logic falls short is in his implicit assumption that all lending translates into additional bank deposits. It doesn't have to. Some of the deposits will be withdrawn and kept as cash. Governments have complete control over how much cash there is in circulation by virtue of their monopoly over the printing press. As long as cash exists, central banks can influence the broad money supply via open market operations. By the way, this is true even in banking systems where there are no reserve requirements. Regarding Arthur's claim that lending can occur without savings, this is often true when someone is borrowing money to buy an asset. However, it is generally not true if they are borrowing money to finance new spending. Let me offer a concrete, albeit somewhat whimsical, example to illustrate this point. Suppose I am living in a closed economy where no one saves anything. Now, let's imagine that I decide to throw a party for myself and need to borrow $1000 to do this. Who is going to provide me with the resources? Well, we just said that no one wants to save, so "something" has to adjust for me to have my party. That "something" is the interest rate. In order to entice someone to spend a bit less, the bank (on my behalf) will offer depositors a higher interest rate. If rates rise by enough, someone will decide to forego a bit of consumption today in order to have more consumption tomorrow. In other words, my decision to borrow must result in someone else's decision to save. So do savings create debt or does debt create savings? The answer is both: interest rates adjust to ensure that the two end up being different sides of the same coin. Caroline: Yan, what's your perspective on China's high debt profile? What could you be missing? Yan: As you can see Arthur and I view China's debt profile through different theoretical lenses. I don't think we can fully reconcile our different frameworks on the matter, but we hope our debate can deepen clients' own understanding of this issue, so they can make up their own minds. What I do want to stress is that those analysts who fear that China's corporate debt problem constitutes an alarming systemic financial risk focus exclusively on the rapid increase in the country's debt-to-GDP ratio. While undoubtedly there is merit to this ratio, I think it is also important to validate this judgement by looking at other indicators. In our previous research, we looked beyond this widely cited conventional indicator for corroborating evidence of a "debt bubble." Our findings suggest that the level of Chinese corporate sector leverage is not as precarious as widely perceived. For example, in the Chinese corporate sector, the area of China's economy where investors worry most about leverage, the debt-to-asset ratio of China's industrial sector has been falling since the late 1990s, down to 56% from 62%, contrary to popular belief (Chart 8). State-owned enterprises have witnessed an increase in their debt-to-asset ratio since the global financial crisis, but it has barely reached late 1990s levels, and has actually rolled over in recent years. Meanwhile, SOEs are a shrinking part of the overall economy and therefore, when looked at in conjunction with the private sector, have not moved the needle on the broader trend of corporate balance sheet "deleveraging." This stands in stark contrast to Japan's corporate sector at the peak of its debt bubble. In the early 1990s, Japan's corporate sector debt-to-asset ratio topped out at 78% when the country's "balance sheet recession" began (Chart 9). Even after two decades of deleveraging, Japan's current corporate debt-to-asset ratio is comparable to China's. To validate this conclusion, we also calculated several other key ratios to compare the leverage situation of Chinese listed companies relative to their global peers. Ratios such as liability-to-assets, net debt-to-EBITDA and interest coverage assess both leverage levels and debt servicing capacity. As Chart 10 shows, our extensive survey, both from the top down and the bottom up, suggests that China's leverage situation is comparable if not superior to its global peers. Chart 8The Leverage Picture From A Balance Sheet Perspective Chart 9Japan's Debt Bubble And Deleveraging Chart 10Leverage Ratios: How China Compares Therefore, I think we should be skeptical about the widely held view that China's corporate sector leverage is precariously high. It is at a minimum inaccurate, if not misleading, to rely solely on the debt-to-GDP ratio to reach such an ominous conclusion. Caroline: Arthur, I take it you don't agree? Arthur: Since January 2009, China's corporate and household debt has risen by RMB 130 trillion (about US$ 19 trillion) or by 100% of GDP (Chart 11). I do not believe even the most sophisticated financial/credit systems can allocate such amounts of credit in such a short time and not misallocate capital. By capital misallocation, I am implying investments in projects that do not generate sufficient cash flow to service debt. The accounting value (valuation) of assets is irrelevant in these cases; the cash flow generation is critical. The debt-to-GDP ratio is a much more superior measure to debt-to-asset-ratio. The basis is that the GDP is a proxy for cash flow, while accounting value of assets could be extremely inflated during a credit bubble. To be sure, I am not suggesting that all investments in China have gone sour. Nobody knows the extent of capital misallocation in China. But I suspect it is large enough to make a difference for the macro outlook/business cycle. Caroline: Peter, you have made the comparison between China today and Japan in the 1990s. Could you expand on that? Peter: Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 12). In order to keep unemployment from rising, the Japanese government was forced to run large budget deficits. In effect, the government ended up having to absorb the private sector's excess savings through its own dissaving. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 13). Chart 11China: The Credit Boom Chart 12Japan Relied On Fiscal Largesse And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 13China: Debt Increased When ##br##The Current Account Surplus Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (please see Chart 8). In effect, China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere": They are a necessary evil. Caroline: Arthur, your thoughts? Arthur: What Peter and Yan in effect propose is that Chinese banks should continue creating credit/money "out of thin air" in order to create demand for these "excess" goods, i.e., overcapacity sectors. In a nutshell, a number of Chinese companies made bad decisions by over expanding capacity, and now banks have to continue lending/creating demand to justify these bad investments. As a result, persisting explosive credit growth has allowed these unviable or zombie enterprises to survive, and they are not compelled to restructure. This is not how capitalism and markets work. This is de facto socialism. Socialism usually does not lead to prosperity. One of the key reasons behind the failure of socialist economic models is that productivity growth in socialist systems is very low, often close to zero. The basis is that productivity growth is generated not by government officials but by the private sector and entrepreneurs. China's economic success over the past 35 years or so has been due to allowing private enterprises to function and flourish - not because government officials necessarily made correct business and investment decisions. I am for countercyclical fiscal and monetary policies. However, the credit boom in China has gone well beyond the countercyclical policy framework. The concept of countercyclical policies does not suggest that the government or public banks should continue to spend in perpetuity to support fundamentally unviable businesses that invested too much and created excess capacity. Besides, "countercyclical" means for a couple of years. China has been expanding bank/credit/money for about nine years - since January 2009. Peter and Yan argue that they should keep doing it further. If the authorities do what Peter and Yan propose, investors should be structurally - not cyclically - bearish on Chinese stocks. Chart 14There Has Been No Shortage ##br##Of Demand Since 2010 The basis is that a socialist growth model is not friendly for shareholders. Shareholders often lose money when companies operate for maximizing employment rather than profits. This is why Chinese SOEs and bank stocks trade at low multiples - because they destroy capital and value for their shareholders. Notably, "overproduction" and "excess capacity" could be an outcome of either a demand downturn or oversupply/overproduction. Keynes recommended countercyclical policies to fill the gaps when demand shrinks. Chart 15Fiscal Outlays & Credit Origination ##br##Are Close To 50% Of GDP In China's case, there has been no domestic demand downturn to warrant multi-year countercyclical policies. China did the right thing in early 2009 to offset its export plunge amid the Global Financial Crisis, and it helped the global economy recover. However, since 2010 global demand and mainland exports have been stable (Chart 14), making the extended and ongoing credit boom in China unwarranted and excessive. As to the argument that most credit should be counted as a form of fiscal spending, I do not think Chinese policymakers themselves would agree with this statement. In fact, if this is correct, it would mean that government officials are allocating about 50% of GDP each year. Chart 15 illustrates general (central plus local) government spending and annual credit origination as a share of GDP. How fast would productivity grow in an economy where government bureaucrats allocate 50% of GDP annually? It is true that China's central government has a low debt load so it can afford to take over a large chunk of corporate debt. If and when they do so, I will change my view. So far, they have not done this, and will likely only contemplate such a policy move when things get really messy. Investors do not want to be long China plays going into such a scenario. That said, a tactical buying opportunity could emerge when the government takes over a large chuck of corporate debt. Caroline: Yan, how worried should we be about the misallocation of capital in China? Yan: Every economy experiences some level of capital misallocation. The real question is whether China's level of capital misallocation is more serious than that of its global peers. Theoretically, if a country has a bigger capital misallocation problem than others, the economy should have systemically lower capacity utilization, weaker pricing power, and lower profitability. These metrics are easily cross-referenced: Chart 16 contextualizes China's industrial sector capacity utilization ratio relative to global peers. By and large, most countries' capacity utilization ratios hover around 80%, not much different from China's, especially since the 2000s. In fact, barring some obvious outliers, capacity utilization ratios across countries have been largely synchronized, reflecting the ebb and flow of the global business cycle. Chart 16Capacity Utilization: A Global Perspective Industrial sector output prices have shown similar swings (Chart 17). Almost all countries suffered producer price deflation in recent years, and are now experiencing a synchronized upturn in wholesale pricing power. China's falling PPI was widely regarded as a tell-tale sign of misallocation of capital. Conversely, this was in fact more a reflection of stagnating global aggregate demand and weak resource prices worldwide than structurally weak pricing power among Chinese manufacturers. Chart 17Producer Prices: A Global Perspective Similarly, Chinese listed companies' deteriorating Return on Equity (ROE) was again singled out as a sign of capital misallocation. This view is easily debunked by Chart 18, as ROEs have fallen in all major markets. In fact, Chinese companies' ROEs have been structurally higher than the global averages. Even some Chinese sectors that have been derided as being plagued by massive overcapacity and inefficiency such as materials and energy exhibit ROEs almost identical to their global peers. The important point is that we should put China in a global context, rather than analyzing it in isolation. Some Chinese firms' efficiency and profitability have weakened notably over the past several years, but to me, this is more of a reflection of the sluggish global macro backdrop, rather than an indictment of China's discrete growth model. Caroline: Turning to the investment implications, Yan, how does the debt bubble concern impact your view on Chinese equities? Yan: Global investors' widespread concerns over Chinese debt levels and other macro issues have contaminated Chinese stocks with a broad-brushed bearish undertone. Chinese equities have been unduly punished, underweighted and under-owned for many years. As shown in Chart 19, Chinese investable stocks' ROEs have been structurally higher than the global benchmark, and have followed similar cyclical fluctuations. However, their stock prices are trading at massive discounts to the global benchmarks, based on conventional yardsticks (Chart 19). This in my view represents the "China risk premium," which is unjustified and unsustainable. I expect the misperception will eventually unwind, and Chinese shares will be re-rated. This is the fundamental factor supporting my positive view on Chinese equities. Strategically it makes sense to overweight Chinese stocks against their global peers. Chart 18Chinese ROEs Are Not Inferior To Global Peers Chart 19Chinese Equities' Large Valuation Gap Caroline: Arthur, how does your view impact your outlook for investment prospects in China and the rest of the emerging markets space? Arthur: There has not been any adjustment in China's corporate leverage. Deleveraging in China has not yet started. On the contrary, the credit bubble is getting larger. I mean the credit-to-GDP ratio continues rising exponentially and credit and bank loan growth remain in double digits (Chart 20). It is very risky to be bullish on financial assets linked to a bubble when the adjustment has not yet begun. It is like running in front of a steamroller trying to collect pennies. Besides, when there is a major imbalance in the system like the credit bubble happening in China now, I tend to overplay the importance of marginal policy tightening and underplay the significance of easing. Recent marginal policy tightening in China - in particular the clampdown on shadow banking, including banks' off-balance-sheet asset expansion - will cause credit growth to decelerate. This is a major risk to Chinese and EM growth in the second half of this year (Chart 21). Chart 20China: Money/Credit Is Still Booming Chart 21Is China's Recovery At Risk? Even if China does not have a full-blown crisis, we are likely to experience another down leg in China plays, commodities and EM risk assets similar to the second half of 2015, when Chinese import volumes contracted and global markets tanked. A few words about the potential adjustment trajectory are in order. I have been negative on China's growth and China-related plays in global financial markets since 2010, but I have never used the word "crisis." China may or may not have a crisis, but investors holding risk assets exposed to China's growth will suffer considerable losses again similar to the 2011-16 period. It is essential to differentiate cyclical from structural growth drivers. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, China will move toward a socialist model and structural growth will tumble. That said, the growth deceleration would be gradual, as depicted in Chart 22. Chart 22Toward Socialism = Secular Stagnation And Inflation If we assume China's productivity is currently growing at a rate of about 5.5-6% (which is already very high and hard to sustain), and if the country embarks on a socialist path, odds are that productivity growth will drop by 50-100 basis points in each of the following years. In five years or so, productivity growth would be only around 1-3%. This path is the ultimate recipe for economic stagnation in China. The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-cycles around a falling primary growth trend. The latest acceleration in China's growth is probably one of these mini-cycles. How can investors invest in this scenario? The stylized mini-cycles depicted in Chart 22 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. In short, investing around economic mini-cycles is difficult because it assumes near-perfect timing. Caroline: Peter, is it all that bad? Peter: I think Arthur is too pessimistic. Investors have been predicting a Japanese debt crisis for years. It hasn't materialized and probably won't. They are making the same mistake about China. If China averts a debt crisis, as I think is likely, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions in local-currency terms. For global bonds, the implications are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Caroline: Yan, do domestic politics play into your outlook for the RMB versus the dollar and on a trade-weighted basis? What is your outlook for monetary policy given recent signs of improving economic momentum? Yan: How President Donald Trump will deal with China on the RMB issue is a wildcard. Recent rhetoric suggests that the new U.S. administration intends to follow normal legal protocol to decide if China is manipulating its currency. This is a significant departure from Candidate Trump's repeated campaign trail promises. If the U.S. Treasury follows the formal process laid out in the statute, it is unlikely to label China a currency manipulator in the next semi-annual assessment to be published in April, simply because the country does not meet all the criteria for that label at the moment. The odds of an immediate clash between the U.S. and China on the RMB have ebbed. From China's domestic perspective, how the People's Bank of China intends to manage the exchange rate is also a thorny issue. From a long term point of view, the PBoC clearly wants to achieve a free-floating exchange rate, but the recent downward pressure on the RMB due to elevated capital outflows has forced the PBoC to heavily intervene to prevent a vicious, disorderly cycle, in which currency depreciation and capital flight reinforce each other. In terms of monetary policy, China's improving economic momentum has allowed the PBoC to follow the Fed in raising short-term interest rates. However, tighter capital account control measures will remain in place until the downward pressure on the RMB from capital outflow dissipates. Moreover, investors have been overwhelmingly focused on the negative economic effects of a weaker RMB, somehow ignoring the reality that as the world's largest manufacturer and exporter, China also stands to benefit from a weaker currency. In my view, the depreciation of the trade-weighted RMB since 2015 has played a critical role in reflating the Chinese economy (Chart 23). A weaker RMB has helped producer prices to reflate, and lowered the real cost of funding for manufacturers, which in turn has eased China's monetary conditions and supported cyclical growth improvement. In this vein, the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the currency. Caroline: Peter and Arthur, is rampant capital flight still a risk? Where do you see the RMB heading over the coming 12-18 months? Peter: I think the RMB will weaken somewhat over the coming year, but that is more a reflection of my bullish view on the dollar than a bearish view on the yuan. Much of the capital flight that China has experienced recently has just been an unwinding of the hot money flows that entered the country over the preceding four years. Despite all the talk about a credit bubble, Chinese corporate external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 24). At this point, most of the hot money has exited the country and hence, I expect the pace of capital outflows to subside. Chart 23A Weaker RMB Leads Cyclical Recovery Chart 24The Rise And Fall Of Corporate Foreign Credit Nevertheless, the chronic shortfall of domestic demand that I described earlier will keep pressure on the Chinese government to try to export excess production abroad by running a larger current account surplus. This requires a weak currency. Thus, while I don't expect the yuan to plummet, I don't expect it to soar either. Arthur: I believe the RMB is set to depreciate by 10% or more against the U.S. dollar in the next 12 months or so. The Chinese yuan is not expensive, but it will stay under downward pressure because the mainland banking system has created too many yuan. When the supply of money goes vertical, its price drops. It seems the Chinese people are sensing there is too much RMB floating around, and they are trying to get rid of local currency. They have been overpaying for properties and have been shifting their wealth into foreign currencies. Finally, in China, the real deposit rate has turned negative (Chart 25, top panel). In the past, when the real deposit rate turned negative, the central bank hiked interest rates (Chart 25, bottom panel). If households do not get a more attractive deposit rate, they will opt for foreign currency, real assets like property or riskier investments domestically. All of this entails negative consequences for China's financial stability. Chart 25Real Deposit Rate Is Negative In brief, I expect capital outflows to persist and policymakers to allow the currency to depreciate further. Caroline: Peter/Yan/Arthur: Final thoughts: What are each of you watching for signs that China's macro landscape is evolving as you expect? Conversely, what would signal that your assessment has missed the mark? Peter: I am watching for signs of a policy mistake. Until China can reorient its economy towards one that is more consumer-centric, it will have to rely on high levels of investment to sustain aggregate demand. Any attempt to aggressively curb debt growth will only backfire. Arthur talks about resource misallocation from subpar investment projects, but there is no worse resource misallocation than a person who wants a job but can't find one. I am also watching trade policy. I don't think a trade war between China and the U.S. is in the cards for the time being, but if the U.S. economy turns down in 2019, as I expect, Trump will be backed into a corner. And with another election looming, he will strike out at China. That could trigger a global trade war. Yan: I agree with Peter that we should watch for policy mistakes and some sort of "Trump shock," both of which constitute downside risks. A less talked-about risk is potential growth overheating, which could require much tighter policy, leading to greater economic volatility. In fact, some cyclical indicators that are tightly linked to industrial activity have rebounded sharply, which is also reflected in the rebound in some raw materials prices. If exports get a further boost from continued improvement in the U.S. economy, the possibility of China's economy overheating cannot be completely dismissed. Another potential trouble spot is the housing market. The Chinese authorities have begun to tighten housing policy, but developers appear to be gearing up for another construction cycle. Sales of construction equipment such as heavy trucks and excavators have soared. Historically, construction machine sales have been tightly correlated with real estate development (Chart 26). If history is any guide, the renewed strength in construction equipment sales could be a harbinger of an impending boom in new home construction. This is good news for business activity and GDP growth, but probably antithetical to policymakers' broad agenda. We will follow up on these issues closely in our future reports. Arthur: The key variables to watch are various interest rates, credit/loan growth and inflation - in addition to keeping an eye on lending standards and credit demand. Recent increases in borrowing costs amid the enormous credit overhang give me confidence to argue that China's credit origination and economic growth are bound to decelerate later this year. A billion-dollar question is whether the recent rise in China's consumer inflation is transitory or the beginning of a notable uptrend (Chart 27). If consumer price inflation rises to 3% and higher, the game will be over - interest rates will need to go up and credit growth will tumble. If interest rates do not rise amid intensifying inflationary pressures, capital outflows will escalate and the currency will depreciate a lot. Chart 26An Upturn In Housing Construction? Chart 27China: Inflation Is Picking Up I will be wrong if policymakers manage to slow down credit growth from 11-12% toward 7-8% or so without generating notable economic weakness. This can occur only if productivity growth in China accelerates meaningfully. It is difficult to observe productivity growth in real time - it is a black box. 1 Please see Emerging Markets Strategy Special Report, titled "Do Credit Bubbles Originate From High National Savings?" dated January 18, 2017, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 4 Please see Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com.

Special Report

The aim of this Special Report is to elaborate on and explain the different views on China that have coexisted at BCA in recent years. Although BCA strives to achieve consensus among its strategists, this is not always possible, as has been the case with China. Peter Berezin of the Global Investment Strategy service and Yan Wang of China Investment Strategy have been positive, while Arthur Budaghyan of Emerging Markets Strategy has been negative on both China's business cycle and China-related plays. The focal points of divergence are centered on how Peter, Yan, and Arthur view and explain the relationship between savings, debt, and the misallocation of capital, as well as how they see China's potential roadmap going forward. The debate is moderated by BCA Global Strategist Caroline Miller. Caroline: Peter and Yan, the world - including the Chinese government - is climbing a wall of worry about China's debt load. Why are you guys still smiling? How many Maotai did you have last night? Peter: I don't know what a Maotai is, but I am sure that if I had more than one I wouldn't be smiling this morning. But yes, I am not as worried as Arthur that China is in the midst of an unsustainable credit bubble. Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors in the global equity market (Chart 1). The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 2). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 3). Chart 1Chinese Banks: Unloved And Unwanted Chart 2Recent Credit Bubbles Developed ##br##Amid Widening Current Account Deficits Chart 3Hong Kong Is The Correct Analogy Yes, there is a lot of debt in China. But there is a lot of savings too. In fact, to a large extent, China's high debt levels are just a function of its high saving rate. The evidence suggests that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies (Chart 4). China sits close to the trend line, implying that its debt stock is roughly what you would expect it to be. Chart 4Positive Correlation Between National Savings And Indebtedness Arthur: Allow me to both agree and disagree with Peter. No, there is no bubble in Chinese equities, but yes, there is a bubble and euphoria in China's property market. Property prices have risen exponentially and are extremely high by any metric. Chinese bank equity valuations have already adjusted, but bank stocks could still sell off if their profits shrink considerably, as I expect. Bank shares are not expensive, but not cheap either, if one adjusts for non-performing loans. I concur that China's property market adjustment will likely resemble that of Hong Kong as opposed to that of the U.S. As Peter noted, in Hong Kong in the late 1990s, property prices plunged by 70%, but few homeowners defaulted on their mortgages. Yet property starts/construction also collapsed by 80% (Chart 5). Chart 5Hong Kong's Property: ##br##Few Mortgage Defaults ##br##But Collapse In Construction Presently in China, the risk is not mortgage defaults but a renewed drop in property construction as well as other types of capital spending. Less construction/capital spending entails less demand for commodities, materials/chemicals and industrial goods. China's residential and non-residential construction activity will contract anew as speculative/investment demand for property weakens. Yan: I agree with Peter that China's rising debt is fundamentally a function of the country's abundant savings. Moreover, the fact that the country's massive savings pool is primarily intermediated via the banking sector and other debt instruments exacerbates the debt buildup. If a country's savings are primarily intermediated by the stock market through equity financing, then high savings do not necessarily lead to high debt, as "savers" become "shareholders" rather than "creditors." In China's case, the country's still relatively undeveloped and volatile equity market has not yet been able to play a meaningful role in financial intermediation. Instead, banks still play a dominant role channeling financial resources. In other words, China's high savings and a banking-centric financial intermediation system are key drivers of the ever-rising debt level. In fact, as long as these two features persist, the country's debt will inevitably continue to rise, as it simply reflects the accumulated savings. Caroline: Arthur, does this line up with how you think about the relationship between savings and debt? Arthur: My thesis has been that China's abnormal credit growth has been the result of speculative, euphoric behavior among Chinese banks and the shadow banking system - and not the natural result of the country's "excess savings," as Peter and Yan have argued. What economists call "savings" or "excess savings," non-economists refer to as "overproduction" or "excess capacity." This is about concepts, not about China. In economic science, the term "savings" is used to denote the number of goods and services that a nation has produced but not consumed - i.e., they can be used for investment or exports. Peter and Yan are using this textbook definition of "savings." Hence, by "savings" or "excess savings" they mean "excess production." Logically, the glut of goods and services does not flow to banks and create deposits. In brief, "savings" or "excess savings" are real economic variables and have nothing to do with bank deposits - i.e., "monetary savings." Peter, Yan and many other commentators make this mistake by mixing up national savings - which is literally output of goods and services that were not consumed by households and government - with "monetary savings," i.e., deposits in the banking system. I have no doubt China has had a high savings rate, i.e., it has had overcapacity and over-production in a number of sectors. The textbook concept of national savings is calculated as a residual from the national accounts and balance of payments. In particular: Savings - Investments = Current Account Balance and Savings = Investments + Current Account Balance A few remarks on the economic interpretation of this equation are in order. First, in any country, "excess" national savings over investment, i.e., current account surpluses, lead to an accumulation of net foreign assets, but has no implication on domestic loan creation.1 Second, a country that invests a lot and does not run a large current account deficit will have a high savings rate as per the economic textbook's definition of national savings. The opposite also holds true. Critically, national or household savings are in no way linked to the amount of deposits at banks. When households decide to save a part of their income, they do not create new deposits or "monetary savings." They save deposits that already exist in the banking system. To sum up, the amount of deposits in the banking system does not change as a result of households' decision to save a part of their income. When a person gets paid in cash and deposits that cash in a bank as a savings deposit, there is no new money created either. That cash was a deposit and was withdrawn from a bank a few days before, and now this cash returns to the banking system as a deposit again. In this case, the amount of total outstanding money supply in the economy (cash plus deposits) has not changed. In general, when a bank receives a deposit, it does not create new money, or "monetary savings." The deposit simply moves from one bank to another or from cash to deposit. The amount of money supply does not change. When a country enjoys a lot of overcapacity, strong bank loans or money growth will not cause inflation and interest rates will stay low, encouraging more borrowing. This is why in Peter's Chart 4 there is a positive correlation between the national savings rate and debt-to-GDP ratio across countries. Overcapacity entails low inflation; the latter keeps nominal interest rates low, which in turn entices more borrowing and debt build-up. In brief, the linkage between national savings/excess capacity and the credit-to-GDP ratio is indirect via subdued inflation and low interest rates that encourage debt build-up. Caroline: Arthur, you have made the case that savings are not a constraint to loan origination. Can you elaborate? Arthur: The banking system does not intermediate "savings" or "excess savings" from the real economy into loans. The commercial banking system as a whole creates deposits at the time it originates loans. This is true of all countries. Indeed, whenever commercial banks make a loan, they simultaneously create a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart 6). In other words, bank loan origination creates deposits and money.2 Chart 6Commercial Banks: Credit Origination Creates Deposits China's banking system has a lot of deposits because banks have created too many loans. In addition, a bank does not need liquidity (reserves at the central bank) for each loan it originates. It still requires some liquidity to settle its net balance with other banks or to meet minimum reserve requirements. If a bank creates a loan but still has excess reserves at the central bank, it may not require liquidity to "back up" the loan. There are many variables that constrain bank loan origination, but they do not include national savings or "excess savings." We discussed these constraints in detail in our EMS report titled Misconceptions About China's Credit Excesses.3 Finally, when central banks opt to keep short-term interest rates steady, they must provide commercial banks with as much liquidity as the latter demands. This point is greatly relevant to China. For the past few years, China's central bank has silently moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money) (Chart 7). As a result, nowadays the People's Bank of China (PBoC) has very little quantitative control over money/credit creation by commercial banks. Chart 7The PBoC Has Begun Targeting Rates In Recent Years It is Chinese commercial banks that effectively drive money/credit/deposit creation. The PBoC decides whether or not to accommodate banks' liquidity needs by allowing interest rates to rise or fall, or by keeping them steady.4 To conclude, what habitually drives credit booms in any country are the "animal spirits" of banks and borrowers - not national savings. This has been the case in China too. Caroline: Peter, do you agree with Arthur's assessment? Peter: I don't want to get bogged down in the weeds of monetary theory, but let me briefly address two distinct points that I think Arthur is making. The first is the claim that the ability of banks to create money "out of thin air" is somehow not constrained by the volume of bank reserves and cash in circulation (the so - called "monetary base"). The second is the claim that there is no meaningful link between savings and deposits. I think Arthur is wrong on both counts. On the first claim, it is true that when a bank issues a loan, it also creates a deposit. To the extent that bank deposits are treated as "money," this expands the money supply. This is simply the "money multiplier" taught in introductory economics classes. Where Arthur's logic falls short is in his implicit assumption that all lending translates into additional bank deposits. It doesn't have to. Some of the deposits will be withdrawn and kept as cash. Governments have complete control over how much cash there is in circulation by virtue of their monopoly over the printing press. As long as cash exists, central banks can influence the broad money supply via open market operations. By the way, this is true even in banking systems where there are no reserve requirements. Regarding Arthur's claim that lending can occur without savings, this is often true when someone is borrowing money to buy an asset. However, it is generally not true if they are borrowing money to finance new spending. Let me offer a concrete, albeit somewhat whimsical, example to illustrate this point. Suppose I am living in a closed economy where no one saves anything. Now, let's imagine that I decide to throw a party for myself and need to borrow $1000 to do this. Who is going to provide me with the resources? Well, we just said that no one wants to save, so "something" has to adjust for me to have my party. That "something" is the interest rate. In order to entice someone to spend a bit less, the bank (on my behalf) will offer depositors a higher interest rate. If rates rise by enough, someone will decide to forego a bit of consumption today in order to have more consumption tomorrow. In other words, my decision to borrow must result in someone else's decision to save. So do savings create debt or does debt create savings? The answer is both: interest rates adjust to ensure that the two end up being different sides of the same coin. Caroline: Yan, what's your perspective on China's high debt profile? What could you be missing? Yan: As you can see Arthur and I view China's debt profile through different theoretical lenses. I don't think we can fully reconcile our different frameworks on the matter, but we hope our debate can deepen clients' own understanding of this issue, so they can make up their own minds. What I do want to stress is that those analysts who fear that China's corporate debt problem constitutes an alarming systemic financial risk focus exclusively on the rapid increase in the country's debt-to-GDP ratio. While undoubtedly there is merit to this ratio, I think it is also important to validate this judgement by looking at other indicators. In our previous research, we looked beyond this widely cited conventional indicator for corroborating evidence of a "debt bubble." Our findings suggest that the level of Chinese corporate sector leverage is not as precarious as widely perceived. For example, in the Chinese corporate sector, the area of China's economy where investors worry most about leverage, the debt-to-asset ratio of China's industrial sector has been falling since the late 1990s, down to 56% from 62%, contrary to popular belief (Chart 8). State-owned enterprises have witnessed an increase in their debt-to-asset ratio since the global financial crisis, but it has barely reached late 1990s levels, and has actually rolled over in recent years. Meanwhile, SOEs are a shrinking part of the overall economy and therefore, when looked at in conjunction with the private sector, have not moved the needle on the broader trend of corporate balance sheet "deleveraging." This stands in stark contrast to Japan's corporate sector at the peak of its debt bubble. In the early 1990s, Japan's corporate sector debt-to-asset ratio topped out at 78% when the country's "balance sheet recession" began (Chart 9). Even after two decades of deleveraging, Japan's current corporate debt-to-asset ratio is comparable to China's. To validate this conclusion, we also calculated several other key ratios to compare the leverage situation of Chinese listed companies relative to their global peers. Ratios such as liability-to-assets, net debt-to-EBITDA and interest coverage assess both leverage levels and debt servicing capacity. As Chart 10 shows, our extensive survey, both from the top down and the bottom up, suggests that China's leverage situation is comparable if not superior to its global peers. Chart 8The Leverage Picture From A Balance Sheet Perspective Chart 9Japan's Debt Bubble And Deleveraging Chart 10Leverage Ratios: How China Compares Therefore, I think we should be skeptical about the widely held view that China's corporate sector leverage is precariously high. It is at a minimum inaccurate, if not misleading, to rely solely on the debt-to-GDP ratio to reach such an ominous conclusion. Caroline: Arthur, I take it you don't agree? Arthur: Since January 2009, China's corporate and household debt has risen by RMB 130 trillion (about US$ 19 trillion) or by 100% of GDP (Chart 11). I do not believe even the most sophisticated financial/credit systems can allocate such amounts of credit in such a short time and not misallocate capital. By capital misallocation, I am implying investments in projects that do not generate sufficient cash flow to service debt. The accounting value (valuation) of assets is irrelevant in these cases; the cash flow generation is critical. The debt-to-GDP ratio is a much more superior measure to debt-to-asset-ratio. The basis is that the GDP is a proxy for cash flow, while accounting value of assets could be extremely inflated during a credit bubble. To be sure, I am not suggesting that all investments in China have gone sour. Nobody knows the extent of capital misallocation in China. But I suspect it is large enough to make a difference for the macro outlook/business cycle. Caroline: Peter, you have made the comparison between China today and Japan in the 1990s. Could you expand on that? Peter: Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 12). In order to keep unemployment from rising, the Japanese government was forced to run large budget deficits. In effect, the government ended up having to absorb the private sector's excess savings through its own dissaving. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 13). Chart 11China: The Credit Boom Chart 12Japan Relied On Fiscal Largesse And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 13China: Debt Increased When ##br## The Current Account Surplus Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (please see Chart 8). In effect, China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere": They are a necessary evil. Caroline: Arthur, your thoughts? Arthur: What Peter and Yan in effect propose is that Chinese banks should continue creating credit/money "out of thin air" in order to create demand for these "excess" goods, i.e., overcapacity sectors. In a nutshell, a number of Chinese companies made bad decisions by over expanding capacity, and now banks have to continue lending/creating demand to justify these bad investments. As a result, persisting explosive credit growth has allowed these unviable or zombie enterprises to survive, and they are not compelled to restructure. This is not how capitalism and markets work. This is de facto socialism. Socialism usually does not lead to prosperity. One of the key reasons behind the failure of socialist economic models is that productivity growth in socialist systems is very low, often close to zero. The basis is that productivity growth is generated not by government officials but by the private sector and entrepreneurs. China's economic success over the past 35 years or so has been due to allowing private enterprises to function and flourish - not because government officials necessarily made correct business and investment decisions. I am for countercyclical fiscal and monetary policies. However, the credit boom in China has gone well beyond the countercyclical policy framework. The concept of countercyclical policies does not suggest that the government or public banks should continue to spend in perpetuity to support fundamentally unviable businesses that invested too much and created excess capacity. Besides, "countercyclical" means for a couple of years. China has been expanding bank/credit/money for about nine years - since January 2009. Peter and Yan argue that they should keep doing it further. If the authorities do what Peter and Yan propose, investors should be structurally - not cyclically - bearish on Chinese stocks. Chart 14There Has Been No Shortage ##br##Of Demand Since 2010 The basis is that a socialist growth model is not friendly for shareholders. Shareholders often lose money when companies operate for maximizing employment rather than profits. This is why Chinese SOEs and bank stocks trade at low multiples - because they destroy capital and value for their shareholders. Notably, "overproduction" and "excess capacity" could be an outcome of either a demand downturn or oversupply/overproduction. Keynes recommended countercyclical policies to fill the gaps when demand shrinks. Chart 15Fiscal Outlays & Credit Origination ##br##Are Close To 50% Of GDP In China's case, there has been no domestic demand downturn to warrant multi-year countercyclical policies. China did the right thing in early 2009 to offset its export plunge amid the Global Financial Crisis, and it helped the global economy recover. However, since 2010 global demand and mainland exports have been stable (Chart 14), making the extended and ongoing credit boom in China unwarranted and excessive. As to the argument that most credit should be counted as a form of fiscal spending, I do not think Chinese policymakers themselves would agree with this statement. In fact, if this is correct, it would mean that government officials are allocating about 50% of GDP each year. Chart 15 illustrates general (central plus local) government spending and annual credit origination as a share of GDP. How fast would productivity grow in an economy where government bureaucrats allocate 50% of GDP annually? It is true that China's central government has a low debt load so it can afford to take over a large chunk of corporate debt. If and when they do so, I will change my view. So far, they have not done this, and will likely only contemplate such a policy move when things get really messy. Investors do not want to be long China plays going into such a scenario. That said, a tactical buying opportunity could emerge when the government takes over a large chuck of corporate debt. Caroline: Yan, how worried should we be about the misallocation of capital in China? Yan: Every economy experiences some level of capital misallocation. The real question is whether China's level of capital misallocation is more serious than that of its global peers. Theoretically, if a country has a bigger capital misallocation problem than others, the economy should have systemically lower capacity utilization, weaker pricing power, and lower profitability. These metrics are easily cross-referenced: Chart 16 contextualizes China's industrial sector capacity utilization ratio relative to global peers. By and large, most countries' capacity utilization ratios hover around 80%, not much different from China's, especially since the 2000s. In fact, barring some obvious outliers, capacity utilization ratios across countries have been largely synchronized, reflecting the ebb and flow of the global business cycle. Chart 16Capacity Utilization: A Global Perspective Industrial sector output prices have shown similar swings (Chart 17). Almost all countries suffered producer price deflation in recent years, and are now experiencing a synchronized upturn in wholesale pricing power. China's falling PPI was widely regarded as a tell-tale sign of misallocation of capital. Conversely, this was in fact more a reflection of stagnating global aggregate demand and weak resource prices worldwide than structurally weak pricing power among Chinese manufacturers. Chart 17Producer Prices: A Global Perspective Similarly, Chinese listed companies' deteriorating Return on Equity (ROE) was again singled out as a sign of capital misallocation. This view is easily debunked by Chart 18, as ROEs have fallen in all major markets. In fact, Chinese companies' ROEs have been structurally higher than the global averages. Even some Chinese sectors that have been derided as being plagued by massive overcapacity and inefficiency such as materials and energy exhibit ROEs almost identical to their global peers. The important point is that we should put China in a global context, rather than analyzing it in isolation. Some Chinese firms' efficiency and profitability have weakened notably over the past several years, but to me, this is more of a reflection of the sluggish global macro backdrop, rather than an indictment of China's discrete growth model. Caroline: Turning to the investment implications, Yan, how does the debt bubble concern impact your view on Chinese equities? Yan: Global investors' widespread concerns over Chinese debt levels and other macro issues have contaminated Chinese stocks with a broad-brushed bearish undertone. Chinese equities have been unduly punished, underweighted and under-owned for many years. As shown in Chart 19, Chinese investable stocks' ROEs have been structurally higher than the global benchmark, and have followed similar cyclical fluctuations. However, their stock prices are trading at massive discounts to the global benchmarks, based on conventional yardsticks (Chart 19). This in my view represents the "China risk premium," which is unjustified and unsustainable. I expect the misperception will eventually unwind, and Chinese shares will be re-rated. This is the fundamental factor supporting my positive view on Chinese equities. Strategically it makes sense to overweight Chinese stocks against their global peers. Chart 18Chinese ROEs Are Not Inferior To Global Peers Chart 19Chinese Equities' Large Valuation Gap Caroline: Arthur, how does your view impact your outlook for investment prospects in China and the rest of the emerging markets space? Arthur: There has not been any adjustment in China's corporate leverage. Deleveraging in China has not yet started. On the contrary, the credit bubble is getting larger. I mean the credit-to-GDP ratio continues rising exponentially and credit and bank loan growth remain in double digits (Chart 20). It is very risky to be bullish on financial assets linked to a bubble when the adjustment has not yet begun. It is like running in front of a steamroller trying to collect pennies. Besides, when there is a major imbalance in the system like the credit bubble happening in China now, I tend to overplay the importance of marginal policy tightening and underplay the significance of easing. Recent marginal policy tightening in China - in particular the clampdown on shadow banking, including banks' off-balance-sheet asset expansion - will cause credit growth to decelerate. This is a major risk to Chinese and EM growth in the second half of this year (Chart 21). Chart 20China: Money/Credit Is Still Booming Chart 21Is China's Recovery At Risk? Even if China does not have a full-blown crisis, we are likely to experience another down leg in China plays, commodities and EM risk assets similar to the second half of 2015, when Chinese import volumes contracted and global markets tanked. A few words about the potential adjustment trajectory are in order. I have been negative on China's growth and China-related plays in global financial markets since 2010, but I have never used the word "crisis." China may or may not have a crisis, but investors holding risk assets exposed to China's growth will suffer considerable losses again similar to the 2011-16 period. It is essential to differentiate cyclical from structural growth drivers. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, China will move toward a socialist model and structural growth will tumble. That said, the growth deceleration would be gradual, as depicted in Chart 22. Chart 22Toward Socialism = Secular Stagnation And Inflation If we assume China's productivity is currently growing at a rate of about 5.5-6% (which is already very high and hard to sustain), and if the country embarks on a socialist path, odds are that productivity growth will drop by 50-100 basis points in each of the following years. In five years or so, productivity growth would be only around 1-3%. This path is the ultimate recipe for economic stagnation in China. The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-cycles around a falling primary growth trend. The latest acceleration in China's growth is probably one of these mini-cycles. How can investors invest in this scenario? The stylized mini-cycles depicted in Chart 22 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. In short, investing around economic mini-cycles is difficult because it assumes near-perfect timing. Caroline: Peter, is it all that bad? Peter: I think Arthur is too pessimistic. Investors have been predicting a Japanese debt crisis for years. It hasn't materialized and probably won't. They are making the same mistake about China. If China averts a debt crisis, as I think is likely, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions in local-currency terms. For global bonds, the implications are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Caroline: Yan, do domestic politics play into your outlook for the RMB versus the dollar and on a trade-weighted basis? What is your outlook for monetary policy given recent signs of improving economic momentum? Yan: How President Donald Trump will deal with China on the RMB issue is a wildcard. Recent rhetoric suggests that the new U.S. administration intends to follow normal legal protocol to decide if China is manipulating its currency. This is a significant departure from Candidate Trump's repeated campaign trail promises. If the U.S. Treasury follows the formal process laid out in the statute, it is unlikely to label China a currency manipulator in the next semi-annual assessment to be published in April, simply because the country does not meet all the criteria for that label at the moment. The odds of an immediate clash between the U.S. and China on the RMB have ebbed. From China's domestic perspective, how the People's Bank of China intends to manage the exchange rate is also a thorny issue. From a long term point of view, the PBoC clearly wants to achieve a free-floating exchange rate, but the recent downward pressure on the RMB due to elevated capital outflows has forced the PBoC to heavily intervene to prevent a vicious, disorderly cycle, in which currency depreciation and capital flight reinforce each other. In terms of monetary policy, China's improving economic momentum has allowed the PBoC to follow the Fed in raising short-term interest rates. However, tighter capital account control measures will remain in place until the downward pressure on the RMB from capital outflow dissipates. Moreover, investors have been overwhelmingly focused on the negative economic effects of a weaker RMB, somehow ignoring the reality that as the world's largest manufacturer and exporter, China also stands to benefit from a weaker currency. In my view, the depreciation of the trade-weighted RMB since 2015 has played a critical role in reflating the Chinese economy (Chart 23). A weaker RMB has helped producer prices to reflate, and lowered the real cost of funding for manufacturers, which in turn has eased China's monetary conditions and supported cyclical growth improvement. In this vein, the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the currency. Caroline: Peter and Arthur, is rampant capital flight still a risk? Where do you see the RMB heading over the coming 12-18 months? Peter: I think the RMB will weaken somewhat over the coming year, but that is more a reflection of my bullish view on the dollar than a bearish view on the yuan. Much of the capital flight that China has experienced recently has just been an unwinding of the hot money flows that entered the country over the preceding four years. Despite all the talk about a credit bubble, Chinese corporate external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 24). At this point, most of the hot money has exited the country and hence, I expect the pace of capital outflows to subside. Chart 23A Weaker RMB Leads Cyclical Recovery Chart 24The Rise And Fall Of Corporate Foreign Credit Nevertheless, the chronic shortfall of domestic demand that I described earlier will keep pressure on the Chinese government to try to export excess production abroad by running a larger current account surplus. This requires a weak currency. Thus, while I don't expect the yuan to plummet, I don't expect it to soar either. Arthur: I believe the RMB is set to depreciate by 10% or more against the U.S. dollar in the next 12 months or so. The Chinese yuan is not expensive, but it will stay under downward pressure because the mainland banking system has created too many yuan. When the supply of money goes vertical, its price drops. It seems the Chinese people are sensing there is too much RMB floating around, and they are trying to get rid of local currency. They have been overpaying for properties and have been shifting their wealth into foreign currencies. Finally, in China, the real deposit rate has turned negative (Chart 25, top panel). In the past, when the real deposit rate turned negative, the central bank hiked interest rates (Chart 25, bottom panel). If households do not get a more attractive deposit rate, they will opt for foreign currency, real assets like property or riskier investments domestically. All of this entails negative consequences for China's financial stability. Chart 25Real Deposit Rate Is Negative In brief, I expect capital outflows to persist and policymakers to allow the currency to depreciate further. Caroline: Peter/Yan/Arthur: Final thoughts: What are each of you watching for signs that China's macro landscape is evolving as you expect? Conversely, what would signal that your assessment has missed the mark? Peter: I am watching for signs of a policy mistake. Until China can reorient its economy towards one that is more consumer-centric, it will have to rely on high levels of investment to sustain aggregate demand. Any attempt to aggressively curb debt growth will only backfire. Arthur talks about resource misallocation from subpar investment projects, but there is no worse resource misallocation than a person who wants a job but can't find one. I am also watching trade policy. I don't think a trade war between China and the U.S. is in the cards for the time being, but if the U.S. economy turns down in 2019, as I expect, Trump will be backed into a corner. And with another election looming, he will strike out at China. That could trigger a global trade war. Yan: I agree with Peter that we should watch for policy mistakes and some sort of "Trump shock," both of which constitute downside risks. A less talked-about risk is potential growth overheating, which could require much tighter policy, leading to greater economic volatility. In fact, some cyclical indicators that are tightly linked to industrial activity have rebounded sharply, which is also reflected in the rebound in some raw materials prices. If exports get a further boost from continued improvement in the U.S. economy, the possibility of China's economy overheating cannot be completely dismissed. Another potential trouble spot is the housing market. The Chinese authorities have begun to tighten housing policy, but developers appear to be gearing up for another construction cycle. Sales of construction equipment such as heavy trucks and excavators have soared. Historically, construction machine sales have been tightly correlated with real estate development (Chart 26). If history is any guide, the renewed strength in construction equipment sales could be a harbinger of an impending boom in new home construction. This is good news for business activity and GDP growth, but probably antithetical to policymakers' broad agenda. We will follow up on these issues closely in our future reports. Arthur: The key variables to watch are various interest rates, credit/loan growth and inflation - in addition to keeping an eye on lending standards and credit demand. Recent increases in borrowing costs amid the enormous credit overhang give me confidence to argue that China's credit origination and economic growth are bound to decelerate later this year. A billion-dollar question is whether the recent rise in China's consumer inflation is transitory or the beginning of a notable uptrend (Chart 27). If consumer price inflation rises to 3% and higher, the game will be over - interest rates will need to go up and credit growth will tumble. If interest rates do not rise amid intensifying inflationary pressures, capital outflows will escalate and the currency will depreciate a lot. Chart 26An Upturn In Housing Construction? Chart 27China: Inflation Is Picking Up I will be wrong if policymakers manage to slow down credit growth from 11-12% toward 7-8% or so without generating notable economic weakness. This can occur only if productivity growth in China accelerates meaningfully. It is difficult to observe productivity growth in real time - it is a black box. 1 Please see Emerging Markets Strategy Special Report, titled "Do Credit Bubbles Originate From High National Savings?" dated January 18, 2017, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 4 Please see Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com.

Highlights Chart of the WeekCopper Term Structure, Inventories##br## Are Not Reflecting Scarcity Transitory supply disruptions and financial demand have kept copper prices buoyant, but these influences will wane. A surge in inventories (Chart of the Week), coupled with slower Chinese demand growth as reflationary policies wind down, will prevent a sharp rally in copper prices. A stronger USD also will weigh on base metals in general, copper in particular. Energy: Overweight. We continue to expect oil inventories to draw throughout the rest of this year and next and are positioned for a backwardated forward curve in WTI. We are adding to our long Dec/17 vs. short Dec/18 WTI spread, which, as of our Tuesday mark to market, is up 183.33% since it was elected on Mar 13/17, and going long Dec/17 Brent vs. short Dec/18 Brent position basis tonight's close, as a strategic position. We also are adding a tactical position in WTI, buying $50/bbl calls vs. selling $55/bbl calls for July, August and September delivery basis tonight's close. Base Metals: Neutral. We remain neutral base metals longer term. Transitory supply disruptions in copper markets will subside, while reflationary stimulus in China will wane, keeping a lid on prices near term (see below). Precious Metals: Neutral. Gold rallied 3.7% following the Fed's rate hike last week. We expect this to reverse as the Fed ratchets up its hawkish rhetoric. Our long volatility position in gold - i.e., long a June put spread vs. long a June call spread - is down 27.5%, following the post-FOMC meeting rally. Ags/Softs: Underweight. We remain bearish, and are comfortable on the sidelines going into the month-end planting-intentions report from the USDA. Higher output of corn and beans in South America and a well-supported USD keep us bearish. Feature Actions taken by Chinese policymakers to slow the property market, wind down reflationary policies, and resume the pivot to services- and consumer-led growth will be critical to the evolution of copper demand, hence prices. Near term, we expect transitory supply disruptions in key mines in Chile, Peru and Indonesia will be addressed, and ore output will be restored. A stronger USD will present a headwind to copper demand, and will lower local production costs in Chile, Peru, Indonesia and elsewhere. Supply And Demand Shocks In the short-term (i.e. 2-3, months), copper prices should remain supported by the disruptions at Escondida in Chile, Grasberg in Indonesia, and more recently at Peru's biggest mine, Cerro Verde. Additionally, flooding in Peru is disrupting copper mining and transport operations beyond Cerro Verde, forcing the declaration of force majeure. BHP Billiton's third meeting with union officials at its Escondida mine failed to end to the strike. This is the world's largest mine - producing ~ 1.1mm MT/yr, or 5% of world supply. Escondida hasn't produced any copper since the strike began on Feb 9/17. This has reduced Chilean copper output 12% yoy as of February, and reduced Chile's GDP by ~ 1%. Unions this week showed interest in resuming talks with management, however. A settlement between PT Freeport Indonesia (PT-FI) and the Indonesian government re export permitting for Grasberg output has yet to materialize. PT-FI produced ~ 500k MT last year. As of this week, PT-FI restarted producing around 40% of its capacity. Lastly, strike action at the Cerro Verde mine is set to end today by order of the Peruvian government, but union officials said the strike would resume Friday if no agreement is reached with management. Cerro Verde produced ~ 500k MT of copper last year; the mine currently produces 50% of its capacity, after replacement workers were hired by the company. The lost output of these three mines accounts for ~ 10% of the global copper mine output. These developments clearly represent a transitory, albeit unexpected, supply shock with effects that should start to dissipate as these issues are resolved. It is worthwhile noting that copper is trading lower in the wake of this news, suggesting markets either prepared for labor action ahead of time - building precautionary inventories ahead of the labor-contract negotiations now underway - or that demand growth is slowing. We think a combination of both likely explains the price weakness following the transitory supply disruptions noted above. On the demand side, any optimism about rising copper prices due to an expected $1 trillion fiscal package in the U.S. is misplaced. Indeed, increased U.S. infrastructure spending - a largely unknown demand-side factor in terms of its details and dimensions - does not figure prominently in our assessment of future copper and based metals prices. The U.S contribution to global copper demand, and to base metals consumption in general, remains limited and has been decreasing in the last decades. U.S. copper demand now represents ~ 7.5% of world copper demand. Therefore, the U.S. market has a relatively small influence on copper prices compared to China, which accounts for close to 50% of global demand (Chart 2A and Chart 2B). Chart 2AU.S. Copper Consumption Pales Relatively To China Chart 2B We believe recent run-up in copper prices mainly was due to financial demand rather than physical demand (Chart 3). This elevated demand from financial investors could elevate price volatility, as any new fundamental information that provokes a sudden change in the copper outlook - e.g., faster restart to once-sidelined production, say, at Glencore's Katanga Mining facilities in the DRC, which are scheduled to be back on line later this year and next - could lead to an exodus of investors out of their long positions. Copper ETF holdings and copper open interest have been elevated in past weeks, and can have a significant effect on the evolution of copper prices (Chart 4).1 Prices have started to trend lower, a development that bears watching, given the still-high speculative holdings of the red metal. Chart 3Speculators Are Exiting Copper, ##br##Even As Supply Disruptions Mount Chart 4China PMI Vs. Copper Net Speculative Positions: ##br##Spec Positioning Matters For The Red Metal Global Copper Fundamentals Keep Us Neutral Looking at the next 6 to 12 months, we see no clear evidence to be bullish copper given supply-demand fundamentals. On the supply side, Australia's Department of Industry, Innovation and Science (DIIS) estimates mine output will be up 3.1% this year to 21mm MT - roughly in line with our estimates - and 4.1% next year to 21.8mm MT. Refined output hit a record high of almost 23.6mm MT last year, and is expected to increase 2.5% next year to 24mm MT. By 2018, the DIIS expects refined output to be up 4%, at 25mm MT. Large production gains were reported by the International Copper Study Group (ICSG) for Peru, where mine output was up 38% at 650k MT last year, offsetting lower mine production in Chile, where output was down 3.8% to 220k MT. Global production estimates by the DIIS for 2016 were in line with ICSG estimates for both mine production and world refined production. The ICSG estimates were released earlier this week. Global demand was up 3% last year at 23.4mm MT, and is expected to increase 2% this year to 24mm MT and 3% next year to 24.6mm MT, based on DIIS's estimates. These estimates also are in line with the ICSG's assessment of global sage. The ICSG estimated global demand last year was up ~ 2%. As is apparent, global supply and demand for copper have been, and will remain, relatively balanced this year and next (Chart 5).2 This will be supported by countervailing fundamentals: Global economic activity is picking up, especially in the manufacturing sectors of major economies, which will be supportive for copper prices (Chart 6); and, running counter to that, A strong USD, coupled with inventories at close to 3-year-high levels, will keep copper prices from escalating dramatically.3 Chart 5Global Copper Market Is Balanced Chart 6Global Growth Synchronization Is Underway China's Reflationary Policies Will Wind Down While reflationary policies launched over the past couple of years will continue to stimulate the Chinese economy in 2017, the fiscal and monetary impulses from them are waning. China's manufacturing sector, fixed-asset investment and the property sector are expected to stay strong during the first half of the year, which will support copper demand (Chart 7). However, this stimulus is winding down, and, following the 19th National Congress of the Communist Party in the autumn, we expect it to decline at a faster pace: These lagged effects of the wind-down of fiscal and monetary stimulus will be apparent - particularly in the property markets. Policymakers likely will reduce and re-direct policy stimulus to support consumer- and services-led growth, and continue to invest in the country's electricity grid, which accounts for about a third of China's copper demand. Net, demand likely will grow, but at a slower pace. Global copper inventories are now at an elevated level, which suggests there is no alarming scarcity in the market. This is corroborated by the contango observed in the copper futures market (Chart of the Week). An important takeaway from last week's People's Congress is that the main objective of Premier Li's work plan is to maintain economic and social stability. This primary objective is now more important than the Communist's Party's growth objective, and can be seen in the lower GDP growth target approved by policymakers (6.5%) going forward. The Chinese fiscal impulse already has started to roll over - government expenditures are now growing at a rate of close to 7.5% versus a peak of 29% in Nov/15 (Chart 8). This poses a risk to the downside for base metals prices, given that much of China's base-metals demand is dependent on government expenditures. Chart 7Fixed Asset Investments Are Resilient Chart 8Expansionary Chinese Fiscal Policy Is Slowing Down Chart 9China Might Have Reached A Sustainable Growth Path That said, recent data from China showing resilient industrial activity and fixed-asset investments despite the roll-over in government expenditures gives hope the economy reached a sustainable growth path and that it will stay buoyant throughout the year (Chart 9). China's Red-Hot Property Market Will Cool China's housing sector has, since the economy's liberalization in the late 1990s, grown into one of the most important drivers of its GDP. Most of the 2002 - 2010 increase in base metal prices - nearly 85% - can be explained by the spectacular growth in the Chinese housing sector.4 Building construction accounts for close to 45% of total copper consumption in China (Chart 10). Within that, residential construction makes up 70% of China's real estate investment, according to Australia's DIIS.5 Globally, China accounts for a third of the copper used in construction, according to the CME Group.6 This equates to ~ 10% of global copper usage. Chart 10Building Construction Is Crucial For Copper Demand In 2016, the Chinese real estate sector experienced extremely high growth, which was mainly fueled by easy access to credit, interest-rate cuts, easing of mortgage rules and an income effect from reflationary policies. This tendency reversed in late 2016 - early 2017, as can be seen in Chart 11. Looking forward, the evolution of the housing market will rely heavily on the policy path taken by the Chinese government. In the second half of 2016, the high level of speculative demand apparent in the property market red-flagged Chinese authorities that a price bubble was developing, producing an inflated debt load that posed a risk to future economic growth. President Xi repeatedly affirmed that China's priority going forward will be to keep the economy stable. This implies keeping the property market stable by nudging investment behavior and expectations to control the supply-side of the market. This is reflected in President Xi statement: "houses are for living in, not for speculating" during the recent Peoples Congress.7 Chinese authorities will maintain loan restrictions and stricter selling conditions implemented late last year, for first- and second-tier cities, where prices increased dramatically. First-tier newly constructed residential building prices were up on average by 18% year-on-year in February 2017, and the National Bureau of Statistics of China's sales price index of residential buildings in 70 large and medium-sized cities was up 11.3% in 2016. For other cities - where home inventories are still elevated and prices are relatively stable - the government could keep its facilitating policies in place, to encourage consumption and to draw down inventories of unsold homes. These developments will introduce downside risk to copper prices, given the importance of Chinese residential construction. Still, the Chinese government cannot allow real estate prices to drop suddenly, or even to slow too much, given that housing remains the main savings vehicle - directly or indirectly - for households. According to Xi and Jin (2015), Chinese citizens save around 70-80% of their wealth via the property market. It is true that financial innovation and the opening of Chinese financial markets should help households save using alternative strategies. However, changing households' savings behavior is not an instantaneous process. Moreover, we believe reflationary policies in other sectors of the economy will remain accommodative during the first half of the year, as headline and core inflation are still at relatively low levels (Chart 12). And, as mentioned previously, we expect continued investment in China's power grid, which will support copper prices this year and next. As the consumer economy grows, we would expect demand for electricity to continue to grow. Chart 11China's Property Market Peaked In 2016 Chart 12Inflation Close To Six-Year Lows Bottom Line: Combining these opposing effects, Chinese demand should remain high enough to maintain copper prices at a relatively stable level in 2017. However, following the 19th Communist Party later this year, we expect reflationary stimulus to wind down and for fiscal and monetary policy to be directed to supporting consumer- and services-led growth, which is less commodity intensive than heavy industrial and investment-led growth. We strongly believe the Communist Government will strengthen its focus on stronger enforcement of environmental regulations, which will introduce new supply-demand dynamics to the copper market. We will be exploring the "greening" of China in subsequent research, and its implications for base metals demand. Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 We found that year-on-year variations in copper prices and in speculative long open interest exhibit a feedback loop - there is two-way Granger causality between them (i.e., they are endogenously related and each of their lagged values explain variation in the other's current price). The causality is stronger from copper prices to speculative long open interest; however, it also is significant the other way around. This means that in period of high speculative interest in copper - similar to what we experienced following the U.S. presidential election in late 2016 - the open interest variable is actually driving copper prices in the short term. We have also been able to explain copper prices by modeling year-on-year percentage change in the broad U.S trade-weighted index (TWI), Chinese PMI and in speculative long open interest. We find a 1% increase in the yoy speculative long open interest leads to a 0.19% increase in yoy copper prices. The adjusted R2 of the regression is 0.84. 2 The ICSG estimated there was a 50k MT deficit last year, trivial in a 23.4mm MT market. 3 We estimated the long-term relationship between copper prices, china PMI, world copper consumption and the U.S. TWI using a cointegrating regression. Interestingly, we found that, in equilibrium, a 1% increase in the China PMI variable translates to a 1.17% increase in copper prices. This relation can obviously be thrown out of equilibrium following an exogenous shock to the fundamentals of any of the variables in the model. The adjusted R2 of the regression is 0.71. 4 Please see "The Evolution of The Chinese Housing Market and Its Impact on Base Metal Prices," published by the Bank of Canada, March, 2016. It is available at http://www.bankofcanada.ca/wp-content/uploads/2016/03/sdp2016-7.pdf. Using an approach that accounts for the uncertainty around the official data, the lack of consistency in the data and the high level of seasonality and volatility in the data, the authors concluded that the Chinese GDP would have been around 9% lower at the end of 2010 in a scenario in which the housing market did not grow after 2002. Following this, they estimated two vector-error-correction models (VECM), one with the actual level of global activity, and one where the Chinese activity is 9% lower. 5 Please see "China Resources Quarterly" published by Australia's DIIA. It is available at https://industry.gov.au/Office-of-the-Chief Economist/Publications/Documents/crq/China-Resources-Quarterly-Southern-autumn-Northern-spring-2016.pdf 6 Please see "Copper: Supply and Demand Dynamics," published by the CME Group January 27, 2016. 7 Please see "Xi says China must 'unswervingly' crackdown on financial irregularities" published by Reuters. It is available at http://ca.reuters.com/article/businessNews/idCAKBN1671A0 Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights Please note that today we are publishing an abbreviated Weekly Bulletin as tomorrow we will publish Great Debate: Does China Have Too Much Debt Or Too Much Savings? The latter report will elaborate on long-standing view differences on China within BCA. I will be debating my colleagues Peter Berezin and Yan Wang on the issues surrounding China's savings and debt as well as the growth outlook. Arthur Budaghyan Feature Singapore: MAS Will Cap Interest Rates Higher U.S. interest rates will temporarily place upward pressure on Singaporean local interest rates (Chart I-1). However, Singapore is not in position to tolerate higher borrowing costs due to lingering credit excesses and deflationary pressures that currently prevail in its economy. The Monetary Authority of Singapore (MAS) will therefore respond by injecting liquidity to keep interbank rates low. The MAS operates monetary policy by guiding the exchange rate - and by default - often allowing interest rates to fluctuate freely. Yet higher interest rates are not an optimal policy option at the moment. If and as U.S. interest rates and the U.S. dollar rise, the MAS will intervene to cap local rates even if it entails a weaker Singapore dollar. While there is a recovery going on in non-oil export volumes and narrow money (M1) (Chart I-2), many other cyclical indicators are still negative. Chart I-1Rising Libor Rates Will Exert ##br##Upward Pressure On Singaporean Rates Chart I-2Singapore: Non-Oil ##br##Exports Are Picking Up The exchange rate-targeting system was introduced in the early 1980s when exports stood at 150% of GDP. Today, exports relative to GDP have fallen substantially to 115% of GDP (Chart I-3). On the other hand, total private non-financial sector debt levels have risen to 180% of GDP (Chart I-3). Therefore, the Singaporean economy has become much more leveraged to interest rates and somewhat less exposed to global trade. Improving exports will not be sufficient to offset the negative impact of rising borrowing costs. Moreover, our proxy for interest payments on domestic debt has also surged and now stands at close to 10% of GDP (Chart I-4). What is precarious is that the rise in interest payments relative to income has occurred in a period when rates are close to record-low levels. Chart I-3Singapore: Debt Is ##br##Overshadowing Exports Chart I-4Singapore: Interest Payments Are ##br##Large Despite Record Low Rates If borrowing costs rise, it will likely cause major debt deflation concerns. The MAS will not allow this to happen. Employment is stagnating, while employment in the construction and manufacturing sectors is contracting (Chart I-5). Weak employment has weighed on the consumer sector. Retail and department store sales are still shrinking (Chart I-6). Chart I-5Singapore: Employment Is Weak Chart I-6Retail Spending Is Contracting Importantly, the real estate sector, one of the major pillars of the Singapore economy, is depressed. Property prices across the board are deflating, while vacancy rates are rising (Chart I-7). Bank loan growth to property developers has also stalled (Chart I-7, bottom panel). Weak economic growth should be reflected on banks' balance sheets. Surprisingly, non-performing loans (NPLs) among Singapore's three largest banks still stands at a low 1.4%. If and as loan losses begin to rise, commercial banks will rush to increase provisioning for these losses, which will hurt their profits and keep credit growth subdued. Furthermore, Singaporean banks are also very exposed to Malaysia. Singapore's largest banks have extended loans to Malaysia of approximately 67 billion Singapore dollars - or 16% of GDP. Aggregate external loans stand at 137% of GDP (Chart I-8). Economic fundamentals are currently very weak and will continue to deteriorate in Malaysia. This warrants more assets write-offs among Singapore banks and less appetite to expand their balance sheet. Chart I-7Property Sector In Singapore Chart I-8Singaporean External Loans Are Enormous On the whole, if Singaporean interest rates begin to rise due to either depreciation of the Singapore dollar or higher U.S. interest rates, the central bank will intervene to bring local rates down. It would not be the first time the MAS has intervened to bring down interest rates. In 2015 when EM risks escalated, local interbank rates spiked. The MAS promptly injected liquidity in the banking system by buying back its outstanding MAS bills, and by also purchasing government securities, supplying liquidity to the banking system. This essentially placed a cap on interbank rates. Chart I-9Go Long Singapore Real ##br##Estate Stocks Vs. Hong Kong What is noteworthy is that the Singapore dollar weakened as a result of the intervention, although the MAS's official monetary policy stance was not stimulative - i.e. the monetary authorities did not target to weaken the trade-weighted SGD. In that instance, the MAS decided to focus on interest rates/funding market stability and ignore the exchange rate's response. This highlights that despite the MAS's official monetary policy framework of guiding the exchange rate, it will not allow interest rates to rise. Unlike Singapore, Hong Kong does not operate an independent monetary policy and as such will be forced to import higher U.S. rates. As a bet on higher interest rates in Hong Kong and the U.S. relative to Singapore, investors should consider going long Singaporean real estate stocks and shorting Hong Kong real estate stocks. Chart I-9 shows that Singaporean real estate stocks outperform Hong Kong's when the latter's interest rates/bond yields rise relative to Singapore and when Singapore's M1 growth accelerate relative to Hong Kong. As discussed above, the MAS has the capacity and will to inject liquidity to lower interest rates. Hong Kong, however, does not have this privilege due to the currency's peg to the greenback. Besides, Singapore's property correction is now much more advanced than Hong Kong's. In fact, Hong Kong property prices are still rising, i.e., the real estate market adjustment in Hong Kong has not yet started. While both city states are vulnerable to a potential slowdown in Chinese inflows, Hong Kong real estate prices will ultimately fall from a higher starting point. Bottom Line: A rising U.S. dollar and U.S. interest rates may exert upward pressure on Singaporean local interest rates. However, the Singaporean central bank will respond by injecting liquidity, which will cap rates relative to the U.S. and Hong Kong. This opens a tactical trade opportunity (for the next 3 months): Long Singapore real estate stocks / short Hong Kong real estate shares. Asian equity portfolio investors should have a neutral allocation to Singapore stocks within the EM/emerging Asian benchmarks. Ayman Kawtharani, Research Analyst ayman@bcaresearch.com Colombia: Not Out Of The Woods Yet Even though global economic growth has been improving and commodities prices have rallied, Colombia's growth is still bound to disappoint. We remain structurally bullish on the nation's longer-term prospects. That said, there will still be more downside this year. Credit growth will continue to decelerate, despite the beginning of a rate cut cycle (Chart II-1). Interest rates are still high, both in nominal and real terms (Chart II-2). This along with poor consumer and business confidence (Chart II-3) will depress credit demand and spending. Chart II-1Colombia: Negative Credit Impulse Chart II-2Borrowing Costs Are Still High Chart II-3Consumer & Business Confidence Are Weak Furthermore, the central bank's liquidity injections into the banking system have dropped considerably (Chart II-4). In the past few years, abundant liquidity provisioning by the central bank had allowed commercial banks to sustain robust credit growth. Hence, a withdrawal of banking system liquidity will cap loan origination. The current account deficit remains wide at $12.5 billion, or 5.2% of GDP. Financing such a wide deficit will prove challenging. Besides, BCA's Emerging Markets Strategy team believes oil prices are at risk of additional declines. Hence, we are bearish on the Colombian peso. Fiscal policy is set to tighten as the budget deficit has ballooned due to strong spending and shrinking revenues (Chart II-5). Recently introduced tax reforms represent a step forward with respect to the country's structural reforms agenda, as it will simplify the tax code and reduce corporate tax rates. Chart II-4Withdrawal Of Liquidity Will Cap Credit Growth Chart II-5Government Fiscal Balance Is Deteriorating However, redistributing the tax burden onto individuals, mainly by increasing the VAT from 16% to 19%, will reinforce the slump in household spending. In terms of high frequency data, there are little signs of economic revival (Chart II-6). Retail sales volume remain tame. The latest bounce in this series most likely reflects consumers front running the impending VAT hike. Furthermore, oil production is likely to decline further, and non-oil exports are still contracting. In terms of financial markets, we recommend the following: We are closing our bet on yield curve flattening - receive 10-year/pay 1-year swap rates. Initiated on September 16, 2015, this trade has produced a 190 basis-point gain (Chart II-7). At the moment, the risk-reward for this position is no longer attractive. Chart II-6Cyclical Economic Activity Remains Subdued Chart II-7Take Profits On The Yield Curve Trade We remain neutral on Colombian equities and sovereign credit relative to their respective EM universes. Even though our long Colombian bank stocks/short Peruvian banks bet has been deep in the negative, we are reluctant to cut it. The basis is that Colombia's central bank may opt to cut rates further, even if the peso depreciates anew. In contrast, the Peruvian central bank is more likely to hike rates if its currency comes under downward pressure. Bank share prices will likely react to marginal shifts in relative interest rates between the two countries. Andrija Vesic, Research Assistant andrijav@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Trump's agenda has not derailed ... at least not yet; Europe remains a red herring ... as the Dutch showed; Turkey cannot restart Europe's immigration crisis; Supply-side reforms are still likely in France; The ECB will remain dovish for longer than expected; EUR/USD may rise in the short term, but it will relapse. Feature In this Weekly Report, we focus on the key questions regarding continental European politics. To begin, however, we will briefly address the U.S., since investors are starting to worry about whether President Donald Trump can get his legislative agenda through, given the recent testimony of FBI Director James Comey on the alleged interference of Russia in the U.S. election. There are three points to focus on in the U.S.: Chart 1Trump Not Dead To Republicans Yet The GOP base supports Trump: President Trump was always going to be a controversial president. Anyone who is surprised by it today clearly was not paying attention last year. In the long term, Trump's extraordinarily low popularity will be an albatross around his neck, draining his political capital. However, until the mid-term elections, his popularity with Republican voters is all that matters, and it remains strong (Chart 1). House Republicans have to worry that they could face pro-Trump challengers in primary elections in the summer ahead of the 2018 midterms. As such, as long as the Republican voters support Trump, he still has political capital. Republicans in Congress want tax reform: Budget-busting tax reform is not only a Trump policy, it is a Republican policy. We have already received plenty of signals from fiscal hawks in Congress that they intend to use "dynamic scoring," macroeconomic modeling that takes into account revenue-positive effects of tax cuts when assessing the impact on the budget, in order to justify cuts as revenue-neutral. Republicans are also looking at the repatriation of corporate earnings and a border adjustment tax to raise revenue. Obamacare delay may not mean much: We already pointed out before that the GOP intention to focus on Obamacare first, tax reform second, would get them in trouble.1 This is now playing out. Opposing the Obamacare replacement may make sense to small-government Tea Party members. Repeal, alone, is why they are in Congress in the first place, given the 2010 wave election. But opposing tax cuts - once justified by dynamic scoring as revenue neutral - will be much more difficult. The Tea Party is "small government" first, fiscal restraint second. In other words, if tax reform cuts taxes and reduces revenue available to Washington D.C., "temporary" budget deficits will be easy to swallow. This is not to say that the recent events have not hurt the chances of whopping tax cuts and infrastructure spending. In particular, we think that Congressional GOP members may take over the agenda if Trump loses any more political capital. And this will mean less budget-busting than Trump would have done. Also, tax reform was always going to be difficult as special interests and lobbyists were bound to get involved. Chart 2French Spreads Are Overstated In addition, the probability of an eventual Trump impeachment - were Republicans to lose the House, or grassroots Republicans to abandon him in droves - has risen. Investors can no longer ignore this issue, even though it was initially a liberal fantasy. However, all of these risks to the Trump agenda will likely spur the GOP in the House to focus on passing tax reform while they still have a majority in Congress and control of the White House. We still expect tax reform to be done this year - within the fiscal year 2018 reconciliation bill - as time now may truly be running out for Republicans. Europe, meanwhile remains a focal point in client meetings. Our view that Europe will be a geopolitical red herring in 2017 - and thus an investment opportunity - remains controversial. We will address Brexit and the new Scottish independence referendum in our report next week, to coincide with London's formal invocation of Article 50 of the Lisbon Treaty to initiate the exit proceedings. Popular support for independence in Scotland has been one of our measures of "Bregret" since last summer and it has just sprung back to life, which adds a new source of risk for investors. On the continent, investors are particularly concerned that the upcoming French election will follow the populist script from the U.K. and the U.S. last year. This worry has pushed French bond yield spreads over German bonds to the highest level since 2011, bringing French bonds into the same trend as peripheral bonds (Chart 2). Since the outbreak of the euro area's sovereign debt crisis, a tight correlation between French and Italian/Spanish bonds has signified systemic political risk. We disagree that political events represent a systemic risk to the euro area in 2017. This week, we address five critical questions inspired by challenges to our view presented by our clients in meetings and conference calls. Question 1: Is The Dutch Election Result Important? Few clients have asked for a post-mortem on the March 15 Dutch election, but many asked about the vote beforehand. It has come and gone with little fanfare. Financial media have brushed it aside as it does not fit the neat script of rising Euroskepticism on the continent. To recap, the Euroskeptic and populist Party for Freedom (PVV), led by Geert Wilders, gained five seats in the election (13% of the votes cast), bringing its total support to 20 in the 150-seat parliament. Despite the gains, however, the election was an unmitigated disaster for Wilders, as the PVV was polling strong for most of the campaign and was expected to win between 30 and 35 seats (Chart 3). In terms of its share of total votes, the PVV's performance in 2017 trails its performance in the 2010 general election and the 2009 and 2014 European Parliament elections. Not only did the PVV underperform the past year's polls, but also they only managed to eke out their fourth-best performance ever. Chart 3Dutch Euroskeptics Were Always Overrated Chart 4Austria Leans Euroskeptic... Chart 5...Yet Chose A Europhile President It is a mistake to ignore these results. They teach us three valuable lessons: Trend reversal: In April of last year we warned clients that the upcoming Brexit referendum and U.S. elections had a much higher chance of populist outcomes than the European elections in 2017.2 The basis for our controversial claim was the notion that European social-welfare states dampened the pain of globalization for the middle class. We now have two elections that confirm our view that European voters are just not as angry as their Anglo-Saxon counterparts. Aside from the Dutch, there is also the lesson from the similarly ignored Austrian presidential election last December. Despite Austria's baseline as a relatively Euroskeptic country (Chart 4), the right wing, populist candidate lost his solid lead in the last few weeks ahead of the election (Chart 5). Clients should not ignore Austria and the Netherlands, since both countries have a long tradition of Euroskepticism and their populist, anti-immigration parties are well established and highly competitive. If Euroskeptics cannot win here, where can they win? It's immigration, stupid: Investors should make a distinction between anti-immigrant and anti-euro sentiment. In both the Netherlands and Austria, it was anti-immigrant sentiment that propelled populist parties in the polls. However, as the migration crisis abated, their polling collapsed. This was clearest in the Netherlands, where asylum applications to the EU - advanced by six months - tracked closely with PVV polling (Chart 6). The distinction is highly relevant as it means that even if the populists had taken power, they would not necessarily have had enough political support to take their country out of the euro area. This is particularly the case in the Netherlands, where support for the euro remains high (Chart 7). Brexit is not helping: Much ink has been spilt in the media suggesting that Brexit would encourage voters in Europe to hold similar popular referendums. We disagreed with this assertion and now the evidence from Austria and the Netherlands supports our view.3 Chart 3 shows that the decline in the PVV's support sped up around the time of the U.K. referendum, suggesting that Brexit may even have discouraged voters from voting for the populist option. Geert Wilders was temporarily buoyed by the kangaroo court accusing him of racial insensitivity. But the sympathy vote quickly dissipated and PVV polling reverted back to the post-Brexit trend.4 Chart 6Dutch Populists Linked To Immigration Chart 7The Dutch Approve Of The Euro Bottom Line: The election in the Netherlands provides an important data point that should not be ignored. The populist PVV not only failed to meet polling expectations, it failed to repeat its result from seven years ago. Investors are ignoring how important the abating of the migration crisis truly was for European politics. Question 2: Can Turkey Restart The Immigration Crisis? The end of the migration crisis in Europe clearly played a major role in dampening support for the Dutch and Austrian populists. We expected this in September 2015, when we argued with high conviction that the migration crisis would prove ephemeral (Chart 8).5 How did we make the right call at the height of the influx of asylum seekers into Europe? Three insights guided us: Civil wars end: No civil war can last forever. Eventually, battle lines ossify into de facto borders between warring factions and hostilities draw to a close. The Syrian Civil War is still going, but its most vicious phase has ended. Civilians have either moved into safer zones or, tragically, have perished. Enforcement increases: The influx of 220,000 asylum seekers per month - the height of the crisis in October 2015 - was unsustainable. Eventually, enforcement tightens. This happened to the "Balkan route" as countries reinforced their borders and Hungary built a fence. Liberal attitudes wane: European attitudes towards migrants soured quickly as the crisis escalated. After the highly publicized welcoming message from Chancellor Angela Merkel, the tone shifted to one of quiet hostility. This significantly changed the cost-benefit calculus of the economic migrants most likely to be deported. Given that roughly half of asylum seekers in 2015 were not fleeing war, but merely looking for a better life, the change in attitude in Europe was important. Many of our clients are today worried that Turkey might deliberately restart the migration crisis as a way to punish Europe amidst ongoing Euro-Turkish disputes. The rhetoric from Ankara supports this concern: Turkish officials have threatened economic sanctions against the Netherlands, and accused Germany of supporting the July 2016 coup and the U.S. of funding the Islamic State. We call Turkey's bluff on this threat. First, the number of migrants crossing the Mediterranean collapsed well before the EU-Turkey deal was negotiated in March 2016. This puts into doubt Turkey's role in dampening the flow in the first place. Second, unlike in 2015, Turkey is now officially involved in the Syrian conflict, having invaded the country last August. By participating directly, Turkey can no longer tolerate the unfettered flow of migrants through its territory to Europe, a luxury in 2015 when it was a "passive" bystander. Today, migrants flowing through its territory are even more likely to be parties active in the Syrian war looking to strike Turkish targets for strategic reasons. Third, the Turkish economy is reliant on Europe for both FDI and export demand (Chart 9). If Turkey were to lash out by encouraging migration into Europe, the subsequent economic sanctions would devastate the Turkish economy and collapse its currency. Investment and trade with Europe make up the vast majority of its current account deficit. Chart 8Migration Crisis Well Past Its Peak Chart 9Turkey Depends On Europe Bottom Line: Turkey can make Europe's life difficult. However, the migration crisis did not end because of Turkey and therefore will not restart because of Turkey. Furthermore, Ankara has its own security to consider and will continue to keep its border with Syria closed and closely monitored. Question 3: Is A Supply-Side Revolution Still Possible In France? In February, we posited that a supply-side revolution was afoot in France.6 Since then, the Thatcherite candidate for presidency - François Fillon - has suffered an ignominious fall in the polls due to ongoing corruption scandals. This somewhat dampens our enthusiasm, given that Fillon's program was by far the most aggressive in proposing cuts to the size of the French state. Still, the new leading candidate Emmanuel Macron (Chart 10) is quite possibly the most right-wing of left-wing candidates that France has ever fielded. He quit the Socialist Party and has received endorsements across the ideological spectrum. In addition, his governing program is largely pro-market: Public expenditure will go down to 50% of GDP (from 57%) by 2022; Corporate taxes will be reduced from 33.3% to 25%; Regulation will be simplified for small and medium-sized businesses; Productive investment will be exempt from the wealth tax, which will focus solely on real estate; Exceptions to the 35-hour work week will be allowed at the company level. More important than Macron's campaign promises is the evidence that the French "median voter" is shifting. Polls suggest that a "silent majority" in France favors structural reform (Chart 11). Chart 10Macron's Huge Lead Over Le Pen Chart 11France: 'Silent Majority' Wants Reform As such, France may be ready for reforms and Emmanuel Macron could be France's Gerhard Schröder, a centrist reformer capable of pulling the left-wing towards pro-market reforms. What about the fears that Macron will not be able to command a majority in France's National Assembly? Macron's party En Marche! was founded less than a year ago and is unlikely to be competitive in the upcoming June legislative elections (a two-round election to be held on June 10 and 17). This will force Macron, should he win, to "cohabitate" with a prime minister from another party. Most likely, this will mean a prime minister from the center-right Republicans. For investors, this could be very positive. The French constitution gives the National Assembly most power over domestic affairs when the president cannot command a majority. This means that a center-right prime minister who receives his mandate from Macron will be in charge of domestic reforms. We see no reason why Macron would not be able to work with such a prime minister. In fact, the worse En Marche! does in the parliamentary election, the more likely that Macron will be perceived as non-threatening to the center-right Republicans. What if no party wins a majority in parliament? We think that Macron would excel in this situation. He would be able to get support from the right-wing of the Socialist Party and the centrist elements of the Republicans. And if the National Assembly fails to support his program, he could always call for a new parliamentary election in a year's time, given his presidential powers. In other words, investors may be unduly pessimistic about the prospect of reforms under Macron. Several prominent center-right figures - including Alain Juppé and Manuel Valls - have already distanced themselves from Fillon, perhaps opening up the possibility of a premiership under Macron. In addition, Macron himself has refused to accuse Fillon of corruption, a smart strategy given that he will need his endorsement in the second round against Le Pen and that he will likely need to cohabitate with the Republicans to govern. What of Marine Le Pen's probability of winning? At this point, polling does not look good for her. Not only is she trailing Macron by 22% in the second round, but she is even trailing Fillon by 11%. Nonetheless, we suspect that she will close the gap over the next month. Election momentum works in cycles and she should be able to bounce back, giving investors another scare ahead of the election. Bottom Line: Concerns over Emmanuel Macron's ability to pursue structural reforms are overstated. Yes, he is less ideal of a candidate than Fillon from the market's perspective, but no, we do not doubt that he would be able to cohabitate with a center-right parliament. That said, we cannot pass definitive judgment until the parliamentary election takes place in June. Question 4: Will Germans Want A Hawk In 2019? An Austrian member of the ECB Governing Council, Ewald Nowotny, spooked the markets by suggesting that Bundesbank President Jens Weidmann would be one of the two most likely candidates to replace Mario Draghi in 2019. Weidmann is a noted hawk who has opposed the ECB's easy monetary policy and even testified against Angela Merkel's government during the court case assessing the constitutionality of the ECB's Outright Monetary Transactions (OMT). The prospect of a Weidmann ECB presidency fits the narrative that Germans will want a hawk to replace Mario Draghi in 2019. The idea is that by 2019, inflation will be close to the ECB's target of 2% and Germans would be itching to beat it down. We have heard this view from colleagues and clients for some time. And we have disagreed with it for quite some time as well! As we pointed out in 2012, it was a German political decision to shift the ECB towards a dovish outlook.7 This is not to say that the ECB takes its orders from Berlin. Rather, it is that Chancellor Merkel had plenty of opportunities via personnel decisions to ensure that the ECB followed a more monetarist and hawkish line. For example, she could have signed off on former Bundesbank President Axel Weber, who was the leading candidate for the job in 2011. She refused when Weber signaled his opposition to the ECB's initial bond-buying program (the Securities Market Program). Mario Draghi was quickly tapped as the alternative candidate suitable to Berlin. Later in 2011, ECB Executive Board member Jürgen Stark resigned over opposition to the same ECB bond-buying program. Since Stark was the German member of the Executive Board, convention held that Berlin would propose his replacement. In other words, while Merkel had her pick of Germany's foremost economists, she picked her finance minister's deputy, Jörg Asmussen. Neither Draghi nor Asmussen have a strand of monetarist or inflation-hawk DNA between the two of them. ECB policy has not been dovish by accident but by design. While it is true that the ECB will inhabit a different macro environment in 2017-19 from the crisis of 2011-12, nevertheless we suspect that dovishness will continue beyond 2019 for two key reasons: German domestic politics: Germans are not becoming Euroskeptic, they are turning rabidly Europhile! If the polls are to be believed, Germans are now the most pro-euro people in Europe (Chart 12). Martin Schulz, chancellor-candidate of the center-left Social Democratic Party (SPD), is campaigning on an aggressive anti-populist, pro-EU platform. He has accused Merkel of being too reticent and of providing Europe's Euroskeptics with a tailwind due to her policies. The SPD's recent climb in the polls is stunning (Chart 13). But even if Schulz fails to win, Merkel will have to take into account his brand of politics if she intends to reconstitute the Grand Coalition with the SPD. It is highly unlikely that Schulz will sign off on a hawkish ECB president (or on the return of Finance Minister Wolfgang Schäuble for that matter). Italian risks: While we have been sanguine about this year's political risks, the Italian election slated for February 2018 is set for genuine fireworks. Euroskeptic parties have now taken a lead in the polls (Chart 14). While the election is still too close to call, and a lot of things can happen between now and then, we expect it to be a risk catalyst in Europe. The problem with Italy is that the election is unlikely to provide any clarity. A hung parliament will likely produce a weak, potentially minority government. Given Italy's potential GDP growth rate of about 0%, this means that a weak government will at some point have to deal with a recession, heightening political risks beyond 2018. Chart 12Germans Love The Euro Chart 13Pro-Europe Sentiment Drives SPD Revival Chart 14Italian Elections: The Big Risk Bottom Line: Italy will hang over Europe like a Sword of Damocles for quite some time. The ECB will therefore be forced to remain dovish a lot longer than investors think. We see no evidence that Berlin will seek to reverse this policy. In fact, given the political paradigm shift in Germany itself, we suspect that Berlin will turn more Europhile over the next several years. Question 5: What Is The Big Picture For Europe? What explains the dogged persistence of support for European integration on the continent? Even in the case of Italy - where Euroskepticism is clearly on the rise - we would bet on voters supporting euro area and EU membership in a referendum (albeit with a low conviction). Why? In 2011, at the height of the euro area sovereign debt crisis, we elucidated our view on the long-term trajectory of European integration.8 We highly recommend that our clients re-read this analysis, as it continues to inform our net assessment of Europe. Our assertion in 2011 was that Europe is integrating out of weakness, not out of misplaced hope of strength. Much of the analysis in the financial community and media does not understand this point. It therefore rejects the wisdom of integration on the basis that Europhile policymakers are blinded by ambition. In our view, they are driven by necessity. As Chart 15 suggests, the average "hard power" of the five largest economies in the euro area (the EMU-5) is much lower than the average "hard power" of the BRIC states.9 European integration is therefore an attempt to asymptotically approach the aggregate, rather than the average, "hard power" of the EMU-5. Europe will never achieve the aggregate figure, as that will require a level of integration that is impossible. But the effort lies beneath European policymakers' goal of an "ever closer union." The truth of the matter is that European nation-states - as individual sovereign states - simply do not matter anymore. Their economic weight, demographics, and military strength relative to other nations are a far cry from when Europe dominated the world (Chart 16). Chart 15European Integration Is About Geopolitics... Chart 16...And Global Relevance If European countries seek to shape their geopolitical and macroeconomic environment, they have to act in unison. This is not a normative statement, it is an empirical fact. This means that everything from Russian assertiveness and immigration crises to energy policy and trade negotiations have to be handled as a bloc. But is this not an elitist view? To what extent do European voters think in such grand geopolitical terms? According to polling, they think this way more than most analysts are willing to admit! Chart 17 shows that most Europeans - other than the British and Italians - are "in it" for geopolitical relevance and security, and only secondarily for economic growth. Even in Italy, geopolitical concerns are more important than economic performance, although levels of both suggest that Italy is again the critical risk for Europe. We suspect that it is this commitment to the non-economic goals of European integration that sustains the political commitment of both elites and the general public to the European project. As Chart 18 suggests, European voters continue to doubt that their future will be brighter outside of the bloc. Chart 17Voters Grasp The EU's Purpose ... Chart 18...And Most Want To Stay In It Bottom Line: European integration is not just an economic project. Voters understand this - not in all countries, but in enough to sustain integration beyond the immediate risks. Given this assessment, it is not clear to us that the project would collapse even if Italy left. Investment Implications Given our political assessment, we continue to support the recommendation of our colleague Peter Berezin that investors overweight euro area equities in a global portfolio.10 As Peter recently elucidated, capital goods orders continue to trend higher, which is a positive for investment spending on a cyclical horizon - helping euro area assets (Chart 19). Furthermore, private-sector credit growth remains robust, despite political risks (Chart 20). Chart 19European Economy Looking Up Chart 20Credit Growing Well Despite Election Risk Over the next 6-12 months, we see EUR/USD rising, especially as the ECB contemplates tapering its bond purchases. We recommend a tactical long EUR/USD trade as a result. The euro could rise higher if the Trump administration disappoints the market on tax reform and infrastructure spending, policies that were supposed to supercharge the U.S. economy and prompt further Fed hawkishness. Over the long term, however, we doubt that the ECB will have the luxury of hawkishness. And we highly doubt that Berlin will rebel against dovish monetary policy. In fact, investors may be using the wrong mental map if they are equating Mario Draghi's taper with that of Ben Bernanke. While Bernanke intended to signal eventual tightening, Draghi will likely do everything in his power to dissuade the market from believing that interest rate hikes are inevitably coming soon. Therefore, we suspect that EUR/USD will eventually hit parity, after a potential rally in 2017. While this long-term depreciation may make sense from a political and macroeconomic perspective for Europe, it will likely set the stage for a geopolitical confrontation between the Trump Administration and Europe sometime next year. Marko Papic, Senior Vice President marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 4 The media has suggested that the PVV merely suffered because of the Turkey-Netherlands spat over Turkish political campaigning in the Netherlands. We see no evidence of this. First, the PVV's collapse in the polls predates the crisis by several weeks. Second, the crisis had all the hallmarks of a trap for the establishment. It is not the fault of incumbent Prime Minister Mark Rutte for adeptly capitalizing on the situation. 5 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 7 Please see "Draghi And Asmussen, Not The OMT, Are A Game Changer," in BCA Geopolitical Strategy Monthly Report "Fortuna And Policymakers," dated October 10, 2012, available at gps.bcaresearch.com. 8 Please see BCA Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 9 As measured by the BCA Geopolitical Power Index. 10 Please see BCA Global Investment Strategy Weekly Report, "Three Battles That Will Determine The Euro Area's Destiny," dated March 10, 2017, available at gis.bcaresearch.com.

Highlights ­­The U.S. Treasury is unlikely to label China as a currency manipulator in the upcoming semi-annual assessment in April. A bigger threat is the possibility that President Trump unilaterally imposes punitive tariffs or import quotas on Chinese goods through administrative powers. The risk of that at the moment is low. The current episode of Chinese capital outflow can be largely viewed as the unwinding of the RMB "carry trade". The PBoC's official reserves have functioned as a reservoir to buffer volatile cross-border capital flows driven by short-term speculative incentives. Beyond the near term, the Chinese authorities will likely continue to encourage domestic entities to directly acquire foreign assets to improve the returns of the country's overall international investment positions. The grand trend of increasing Chinese overseas investment by the private sector will resume once the downward pressure on the RMB dissipates. Feature As we go to press this week, the Federal Reserve has just released its interest rate decision. The 25-basis-point rate hike was well anticipated, and the markets should be assuaged by the fact that the Fed does not anticipate a more rapid pace of rate hikes than it did in December. As far as China is concerned, the RMB, which has been put on the backburner by global investors in recent months, is once again back in the spotlight, as its descent against the dollar has resumed after a relatively calm period. Both Chinese interest rates and the USD/CNY have been pushed higher by the latest moves in U.S. Treasury prices and the broad dollar trend (Chart 1). Chart 1The U.S. Connection Beyond The Currency Manipulator U.S. Treasury Secretary Steven Mnuchin signaled late last month that he wants to use a regular review process of foreign-exchange markets to identify currency manipulators, which means the U.S. administration intends to follow normal legal procedure to decide if China is manipulating its currency. This is a significant departure from President Donald Trump's repeated campaign trail promises, and has reduced the odds of an immediate clash between the U.S. and China on the RMB. If the Treasury follows the formal process laid out in statutory law, it is unlikely to label China as a currency manipulator in the upcoming semi-annual assessment to be published in April, simply because the country does not meet all the conditions required for being charged with currency manipulation, as discussed in detail in our previous report.1 Even if China was indeed labeled a currency manipulator in the April assessment, the existing procedure does not authorize the administration to immediately impose punitive measures. Instead, the law requires the Treasury to negotiate with the allegedly "guilty" party to correct the currency manipulation and remove unfair trade practices. Even if negotiations fail, the punitive measures that the Treasury must follow under the existing legal framework are largely symbolic for a country like China. The recommended remedial measures such as prohibiting federal procurement from offending countries and seeking additional surveillance through the International Monetary Fund are hardly biting for China. In short, a "currency manipulation" charge, even if it were imposed, would mostly be a symbolic move, and the real economic consequences would be limited. A bigger threat is the possibility that President Trump unilaterally imposes punitive tariffs or import quotas on Chinese goods through administrative powers, which would be far more unpredictable and would inevitably lead to harsh retaliation from the Chinese side. The risk of that at the moment is low. President Trump appears to be occupied with domestic issues and has notably toned down his anti-China rhetoric. Meanwhile, President Xi is reportedly scheduled to visit the U.S. next month, at which time he will likely seek to improve bilateral ties. We expect both sides will try to set up a new high-level mechanism for effective communication and negotiations over key policy issues to replace the annual U.S.-China Strategic and Economic Dialog (S&ED) under the Obama administration. Given the numerous "China hawks" in President Trump's inner circle, trade frictions between the two countries will likely increase, but the risks appear to be pushed out to at least next year. Where Did The Money Go? China's official foreign reserves have stabilized at around US$3 trillion in recent months, compared with a peak of over US$4 trillion in the second quarter of 2014. The common perception is that the People's Bank of China (PBoC) has been fighting a constant bleed of domestic capital, and the rapid decline in its foreign reserves means an ever-smaller war chest, which will eventually force the PBoC to surrender. There has been open debate within China's policy-making circles and prominent think-tanks on whether the PBoC should protect the RMB exchange rate or preserve its official reserves. While the decimal changes in China's official reserves have been grabbing headlines among the financial media of late, much less known is China's total international investment positions. In fact, China having a hefty current account surplus means the country's domestic savings exceed its domestic investment, and subsequently the excess savings become holdings of foreign assets - the PBoC's official reserves are just a part of the country's growing total foreign claims. Therefore, it is important to have a closer look at China's total foreign investment positions to understand cross-border capital flows. On the asset side, since the second quarter of 2014 when official reserves peaked out, China's total foreign assets have continued to grow, albeit at a slower pace (Chart 2). The decline in official reserves has been more than offset by increases in other forms of investments. Specifically, direct overseas investments, foreign loans and holdings for foreign securities increased by US$503 billion, US$170 billion and US$79 billion, respectively, between Q2 2014 and Q3 2016, the latest available data points, compared with a US$792 billion decline in official reserves during the same period. In other words, the country as a whole has continued to accumulate foreign assets, but the corporate sector and households have been increasing their holdings at the same time that the public sector has been trimming positions. On the liability side, the Chinese corporate sector has been paying back foreign debt aggressively since Q2 2014, which also increased demand for foreign currencies and contributed to the decline in the PBoC's official reserves. Loans and trade credit taken by Chinese firms dropped by US$423 billion between Q2 2014 and Q3 2016. The outstanding balance of total foreign loans and trade credit at the end of Q3 2016 stood at US$583 billion, almost half the US$1 trillion peak in Q2 2014 (Chart 2, bottom panel). Regarding foreigners' claims in China, the RMB fluctuation has had no meaningful impact on both foreign direct investments (FDIs) and foreigners' investments in Chinese domestically listed securities such as stocks and bonds. In fact, both FDIs and foreign investments in Chinese securities have continued to rise despite heightened anxieties on the RMB (Chart 3). However, foreigners' liquid holdings of Chinese financial assets, cash and savings deposits have dropped by US$100 billion from a peak of US$441 billion in Q2 2014 to US$340 billion at the end of Q3 2016. This could well be the withdrawal of foreign "hot money" that flew into China in previous years. Chart 2Where Did The Money Go? Chart 3Foreign Investment In China: The Ins And Outs Taken together, the decline in China's official reserves appears less disconcerting. Chinese companies' debt repayments and foreign "hot money" repatriation accounted for the lion's share of the decline in Chinese foreign reserves since 2014. Therefore, the current episode can be largely viewed as the unwinding of the RMB "carry trade": In previous years, when the RMB was appreciating against the dollar, Chinese firms undertook loans in dollars and foreign 'hot money" also rushed into China - the tide has been reversing as the USD/CNY trend has shifted. The PBoC's official reserves have functioned as a reservoir to buffer volatile cross-border capital flows driven by short-term speculative incentives. Chinese Foreign Reserves: The Big Picture While the dominant concern at the moment is that Chinese official reserves, still by far the largest in the world, are not enough to maintain exchange rate stability, easily forgotten is that the consensus was the opposite a mere three years ago (Chart 4). Back then the prevailing view was that the country had too much foreign reserves, which was both a waste of resources and an economic burden. While popular perceptions in the marketplace always swing dramatically, it is important to keep the big picture in mind. At the onset, official reserves currently account for 50% of China's total international investment positions. This is a notable decline from a peak of 71% in 2009, but still far higher than any other major economy (Chart 5). For example, Japanese official reserves account for 16% of total international claims, 26% for Taiwan, and a mere 2% for the U.S. Chart 4Chinese Official Reserves Are ##br##Still By Far The Largest Chart 5Chinese International Assets Are ##br##Primarily Official Reserves As China's foreign assets are primarily represented in official reserves, the return of China's foreign claims is extremely low, as official reserves are mainly invested in risk-free highly liquid assets, with achieving higher returns always having been of secondary consideration. The average return of Chinese foreign assets has been hovering around 3%, not much higher than U.S. Treasury yields (Chart 6). By contrast, foreign investments in China are primarily engaged in the real economy and are able to garner much higher yields. This mismatch, ironically, has led to a net loss in China's international investment position. In other words, even though China is a massive net creditor to the rest of the world, the country's net investment income has in fact been negative, as the country pays a lot more to foreign investors than it gets from its own overseas investments. Chart 6China Gets Less Than It Pays This mismatch has been one of the key reasons why the PBoC in previous years tried to encourage domestic entities to hold foreign assets directly rather than through official channels in the form of foreign reserves. The more recent rapid increase in capital outflows from the Chinese corporate sector and households has challenged the PBoC's near-term priority to maintain exchange rate stability, prompting the authorities to tighten capital account controls to support the RMB. From a big-picture point of view, however, the Chinese authorities will likely continue to encourage domestic entities to directly acquire foreign assets to improve the returns of the country's overall international investment positions. All in all, the near term CNY/USD cross rate will remain largely determined by the Fed action and the broad trend of the dollar, but the PBoC will continue to intervene to prevent major currency depreciation. The RMB is unlikely to depreciate against the greenback more than other major currencies in a period of dollar strength. The grand trend of increasing Chinese overseas investment by the private sector will resume once the downward pressure on the RMB dissipates. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China As A Currency Manipulator?," dated November 24, 2016, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global stocks and bonds have priced in a goldilocks scenario - strong growth and low inflation/interest rates. In the short term, global bond yields are set to rise further. Risk assets, especially EM ones, are vulnerable on the back of higher bond yields. Thereafter, global bond yields will roll over decisively as inflation worries subside. Risk assets will probably recover some lost ground in this phase. Toward the end of this year, growth disappointments in EM/China will resurface and EM risk assets will sell off again. Feature The near-term risks to emerging markets (EM) and global stocks over the next three months or so are potential inflation anxieties in the U.S. and around the world, and a further rise in U.S./global interest rate expectations. Yet looking beyond the short-term, it is not clear that the rise in global inflation will be lasting. Timing zigzags in financial markets is almost impossible. However, if we were to try to speculate on potential swings in financial markets over the next 12 months, our prediction would be that the current growth acceleration will soon lead to heightened inflation worries, and global bond yields will climb further. Having already rallied a lot, global share prices will likely relapse, with EM risk assets being hardest hit on the back of rising U.S. bond yields. Thereafter, there will likely be a period of calm when inflation worries subside due to growth disappointments, and bond yields roll over decisively. Risk assets will probably recover some lost ground in this phase. Yet this calm phase might not last too long as EM/China growth will relapse considerably again toward the end of this year. In short, another global growth scare driven by EM/China is likely to transpire later this year. Any potential U.S. trade protectionist measures will play into this scenario - augmenting U.S. inflation expectations initially when adopted and then, when implemented, dampening global growth. Please note that this is the view of BCA's Emerging Markets Strategy service, which differs from BCA's house view that is cyclically positive on global stocks/risk assets. Neither the inflation fears/higher interest rates episode nor the growth scare phase that we believe is in the cards later this year are bullish for EM risk assets. Therefore, we maintain that the risk-reward for EM risk assets is extremely unattractive at the current juncture, even if global growth stays firm for now. More Upside In Bond Yields Inflation has been accelerating in the U.S. and China: The average of U.S. trimmed-mean CPI and PCE, median CPI and market-based core CPI inflation has risen above 2% (Chart I-1). The individual components are shown in Chart I-2. Chart I-1U.S. Inflation Measures Are In Uptrend Chart I-2Broad-Based Rise In U.S. Inflation BCA's U.S. wage tracker - a mean of four different wage series - is also accelerating (Chart I-3, top panel), signaling a tightening labor market. Wages are critical to inflation dynamics because not only are wages the largest cost component of a business but also higher wages entail more consumer spending, making it easier for companies to raise prices. That said, what drives cost-push inflation is not wages but unit labor costs. In the U.S., unit labor costs have been rising signaling accumulating pressure on businesses to raise prices (Chart I-3, bottom panel). In China, core (ex-food and energy) consumer, retail and trimmed mean consumer inflation are in an uptrend (Chart I-4). Chart I-3U.S. Wages And Unit Labor ##br##Costs Argue For More Inflation Upside Chart I-4China: Inflation Is Picking Up However, disposable income (a proxy for wages) growth in China remains subdued, given economic growth has been very weak (Chart I-5, top panel). Hence, there are no imminent wage pressures in China like there are in the U.S. That said, unit labor costs in China are still rising because output per hour (productivity) growth has decelerated notably (Chart I-5, bottom panel). Real (adjusted for inflation) interest rates have not yet increased much and remain low worldwide. As global growth conditions remain robust and inflation data surprise on the upside, interest rates both in nominal and real terms will likely rise. In the U.S., 10-year Treasury yields adjusted for the average consumer price inflation (currently running at 2.0%) stand at 0.35% (Chart I-6, top panel). Consistently, U.S. 10- and 5-year TIPS yields are 0.6% and 0.2%, respectively (Chart I-6, bottom panel). Provided U.S. growth remains robust and the labor market continues to improve, there are no reasons for U.S. TIPS yields to stay at these low levels. Chart I-5China: Wage Proxy And Unit Labor Costs Chart I-6U.S. Real Yields Are Low A strong U.S. dollar could have been an impediment to a potential rise in real rates, but year-to-date the greenback has been tame. In addition, U.S. share prices and high-yield corporate bonds are handling the news of Federal Reserve tightening well. All of this opens a window for both nominal and real U.S. bond yields to rise in the near term. On the whole, either the U.S. dollar will spike soon or U.S. interest rates will climb further. The latter will eventually cause the greenback to appreciate. This will be especially troublesome for EM risk assets. In China, the real deposit rate has turned negative (Chart I-7, top panel). In the past, when the real deposit rate was negative, the central bank hiked interest rates (Chart I-7, bottom panel). If households do not get a more attractive deposit rate, they will opt for foreign currency, real assets like property or riskier investments domestically. All of this entails negative consequences for China's financial stability. Considering the above as well as improved growth in China and higher bond yields globally, we expect mainland policymakers to tolerate marginally higher interest rates. Notably, China's onshore domestic corporate bond yields, swap rates and the interbank repo rate have already been rising since last autumn - a trend that will likely persist for now (Chart I-8). Chart I-7China: Real Deposit Rates Have Turned ##br##Negative China: Real Deposit Rate Is Negative Chart I-8China: Interest ##br##Rates Are In Uptrend We do not have strong conviction on how persistent and pervasive the nascent inflation uptrend will be in the U.S. and China. Inflation is driven by numerous structural and cyclical variables, and they often work in opposite directions. The outlook for these variables is not identical to draw a definite conclusion about the inflation trajectory in the long run. In this report, we cover just one aspect of inflation - how liquidity and money relate to and drive consumer prices (please see the section below). Bottom Line: Odds are that there could be a global inflation/interest rates scare in the near term, and bond yields will continue rising in the next two to three months. Monetary-Liquidity Approach To Inflation As Milton Friedman famously stated: Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. Yet a relevant question is which monetary aggregates do really impact inflation. Identifying specific monetary aggregates that impact inflation will help us gauge the outlook for the latter. Central bank liquidity provisioning to banks does not necessarily cause inflation to rise. It is money/credit creation by commercial banks that generates higher inflation. In any banking system, it is commercial banks that create loans. Central banks emit and supply banks with liquidity - commercial banks' reserves held at the central bank - but the monetary authorities do not create money directly, except when they finance the government or non-bank organizations directly or buy financial assets from them. Money is created by commercial banks when they originate loans. Similarly, money is destroyed when a loan is repaid to a bank. Commercial banks do not need savings and/or deposits to originate loans. They create a deposit themselves when they grant a loan. Yet banks require liquidity (reserves at the central bank) to settle their payments with other banks. Banks seek liquidity in various ways, such as by attracting deposits, borrowing money from the central bank and in interbank markets as well as raising funds abroad, among other methods. When a bank attracts deposits, these deposits constitute outflows of deposits from other banks, or a drainage of cash in circulation that was once a deposit at another bank and was cashed out. In short, these deposits do not fall out of the sky, and do not constitute new deposits/savings in the banking system and the economy. On the whole, when a commercial bank extends a loan it creates a new deposit, and thereby new money - i.e. it increases money supply. When a bank attracts a deposit, it does not create a new deposit or new money. The existing money/deposit simply moves from one bank to another, or from cash to deposit. The amount of money supply does not change. A bank does not need liquidity (reserves at the central bank) for each loan it generates. It requires liquidity (reserves at the central bank) only to settle its balance with other banks or to meet minimum reserve requirements. If a bank creates a loan but still has excess reserves at the central bank, it might not require liquidity to "back up" the loan.1 This is the reason why quantitative easing programs implemented by central banks in the advanced countries did not produce high inflation. Even though central banks conducting QEs - the Fed, the European Central Bank and the Bank of Japan - supplied a lot of banking system liquidity, and commercial banks' reserves at the central bank skyrocketed, commercial banks initially were reluctant to originate new loans. Where are we presently in money/credit cycles in major economies? Chart I-9 demonstrates broad money growth for the U.S., the euro area, China and EM ex-China. Broad money growth is still strong across the world. In addition, there is a reasonable, albeit not perfect, correlation between broad money and inflation as depicted in Chart I-10. In China, money aggregates in 2015-16 were distorted by the LGFV debt swap. Outside this episode, there is a reasonable relationship, as one would expect: broad money growth explains swings in inflation. The key message from this chart is that the rise in inflation is possible in the near term but is unlikely to prove sustainable and lasting in these largest three world economies if broad money growth continues downshifting. The reason behind the drop in broad money growth is a notable slowdown in bank loans in the U.S. and China (Chart I-11). Chart I-9Broad Money Growth Across World Chart I-10Broad Money Growth And Inflation Chart I-11Bank Loan Growth Slowdown In The U.S. And China It is a safe bet that with more upside in global and local interest rates, bank loan growth is likely to slump in China/EM. Furthermore, given the credit bubble in China and the authorities' efforts to contain risks, odds are that bank loan and overall credit growth will decelerate by the end of this year. On another note, the sheer size of the credit bubble in China is also corroborated by the amount of outstanding broad money. In common currency (U.S. dollar) terms, the outstanding amount of broad money (M2) is almost two times larger in China than M2 in the U.S. and M3 in the euro area (Chart I-12). This is despite the fact that China's nominal GDP is US$11 trillion, smaller than U.S. GDP of US$19 trillion, and comparable to euro area GDP of US$12 trillion. In fact, the outstanding broad money supply in China in absolute U.S. dollar terms is only slightly less than the combined broad money supply in the U.S. and euro area. Chart I-13 illustrates broad money as a share of country GDP in all three economies. The upshot is that Chinese commercial banks have created much more money relative to GDP than U.S. and euro area banks. Chart I-12China's Money Supply Is ##br##Enormous In U.S. Dollars And... Chart I-13...Relative To GDP The question is why China has not had high inflation despite such immense money overflow. The answer is that China has been investing a lot, and the supply of goods and services in China has risen very rapidly too. That said, this money has created a property market bubble in China. We will discuss/debate the issues surrounding China's money, credit and savings in a forthcoming China Debate piece with our BCA colleagues. Bottom Line: What ultimately drives economic cycles and inflation is money created by commercial banks, not central bank liquidity provisioning to banks. China/EM broad money growth is still unsustainably strong and it will fall further. Growth Scare Before Year End? Chart I-14China: Corporate Bond Prices Are Falling If EM/China credit growth decelerates, as we expect to happen toward the end of this year, it will not only cap inflation but also cause a growth scare. Although U.S. and euro area growth could soften a notch from current levels, the main downside to global growth stems from EM/China, as we have repeatedly written. Given China's onshore corporate bonds rallied dramatically in 2015-'16 on the back of massive investor-buying, a further drop in these bond prices might trigger an exodus of funds and a meaningful push-up in corporate bond yields. In fact, the price of onshore corporate bonds continues to make new lows, and is already down 8% from its peak in November 2015 (Chart I-14). Chart I-15U.S. And German Bond Prices More Downside? This will in turn cause corporate bond issuance and other non-bank financing to slump. This will occur at time when bank loan growth is already decelerating, and the authorities are aiming to reduce speculative activity in the financial system via a regulatory clampdown. Ultimately, higher borrowing costs along with regulatory tightening of banks' off-balance-sheet operations will cause a slowdown in China's domestic credit flows in the second half of 2017. The rest of EM will decelerate on the back of a China slowdown, which will reverberate via lower mainland imports and declining commodities prices. In addition, the banking systems in many EMs have not adjusted following the credit boom of the preceding years. Unhealthy banking systems and higher global interest rates will cause further retrenchment in domestic credit creation. Bottom Line: A renewed slump in China/EM growth later this year will trigger growth disappointments globally. Investment Strategy It seems global stocks and bonds have priced in a goldilocks scenario - strong growth and low inflation/interest rates. DM bond yields will likely rise further. Remarkably, both U.S. and German 30-year bond prices have already fallen by 23% from their July highs and there might be more downside (Chart I-15). BCA's Relative Risk Indicator for U.S. stocks versus U.S. Treasurys is over-extended at a very high level (Chart I-16). When this indicator has historically been at similar levels underweighting stocks versus bonds has paid off. Notably, when inflation is rising equity multiples should shrink. This has often been the case in the U.S., though not lately (Chart I-17). Chart I-16U.S. Stocks-To-Bonds Relative Risk Indicator Chart I-17Rising Inflation = Compressing Multiples Chart I-18A Number Of EM Currencies Are Facing Resistance EM risk assets warrant an underweight position across equities, credit and currencies. The list of our country allocation within the EM universe for stocks, credit and local bonds is provided on page 14. Commodities prices in the near term are at risk from a strong U.S. dollar and later in the year from a slowdown in Chinese growth. Several EM currencies are at a critical technical juncture (Chart I-18). We expect these resistance levels not to be broken. We recommend shorting a basket of the following EM currencies versus the U.S. dollar: MYR, IDR, TRY, ZAR, BRL, CLP and COP. On a relative basis, we overweight RUB, MXN, THB, TWD, INR, PLN, HUF and CZK. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 For more detailed discussion on the process of money and credit creation, please refer to Trilogy of Special Reports on money/loan creation, savings and investment, titled, "Misconceptions About China's Credit Excesses" dated October 26, 2016, "China's Money Creation Redux And The RMB", dated November 23, 2016 and "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, links available on page 16. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Geopolitics will not spoil the stock rally yet; European election risks remain overstated; In China, look beyond the National Party Congress; China's reforms could re-launch in 2018 ... ... But India's reforms are gaining momentum now. Feature The global economy continues to surprise to the upside, with the latest round of global purchasing managers' indices (PMIs) confirming that the business cycle continues to accelerate (Chart 1). In the context of firming global growth, the Fed's decision to hike rates may not produce as violent of a reaction from the dollar as last year, giving way to further upside in stocks. And while investors continue to fret about valuations, U.S. stocks are expensive only relative to history, not relative to competing assets, as our colleague Lenka Martinek of the U.S. Investment Strategy service points out (Chart 2).1 Chart 1Because I'm Happy Chart 2U.S. Stocks Pricey By History, Not Peers What geopolitical news could break up the party over the next six months? Europe: As we argued three weeks ago, the European electoral calendar is unusually busy (Table 1).2 However, we have also posited in our 2017 Strategic Outlook that Europe will be a red herring this year, allowing risk assets to "climb the wall of worry."3 The first test of this thesis comes today, with the Dutch general elections taking place. The polls suggest that the Dutch electorate is not following the populist trend of the Brexit referendum and U.S. election (Chart 3), but rather in the footsteps of the little noticed Austrian presidential election in December, which saw the populist presidential candidate defeated. Dutch Euroskeptics, who have led the polling throughout the last twelve months, are bleeding support as election day approaches. Meanwhile, in France, Marine Le Pen is struggling to keep momentum going with only a month and a half to the first round. Thus far, our thesis on Europe is holding. Table 1Busy Calendar For Europe This Year Chart 3Dutch Euroskeptics Are An Overstated Threat The U.S.: Investors will finally get to put numbers to President Trump's rhetoric when the White House announces its budget on March 16. As we argued last week, President Trump is who we thought he was: an economic populist looking to shake up America's status quo. That suggests he will err on the side of greater deficits and large middle-class tax cuts. We do not think Congress will bar his way, as it has rarely restrained a Republican president from profligacy (Chart 4). We could be wrong, but it is unclear if a more fiscally responsible budget would be negative for the markets. On one hand, it may disappoint optimistic growth projections, but on the other, it would mean that the Fed would have no reason to err on the side of more rate hikes in 2017. Meanwhile, while we continue to fear protectionism's impact on the market, it is unlikely that the Trump White House will focus on trade when so many domestic priorities are looming this summer. Russia: As we argued in a Special Report with the Emerging Markets Strategy group last week, Russia may be entering a low-beta paradigm - escaping from its close embrace with oil prices - due to the combination of orthodox monetary policy, modest structural reforms, and growing confidence in its geopolitical predicament.4 This is not the time for President Putin to rattle nerves in the West. He does not want to give Europe and the U.S. a reason to cooperate. We therefore expect Russia's geopolitical risk premium to continue to decline, a boon for European risk assets (Chart 5). Chart 4Budgets: Republican Presidents##br## Get What They Want Chart 5Russia's Calm##br## Is Europe's Profit From a tactical perspective, we believe that the confluence of geopolitical forces supports our continued overweight of developed-market equities versus those of emerging markets. Within developed markets, the BCA House View is to prefer euro-area equities due to overstated geopolitical risks and favorable valuations relative to the U.S. equity market. BCA's Global Investment Strategy has pointed out that euro-area equities are one standard deviation undervalued relative to the U.S., when one applies U.S. sector weights to them (Chart 6). In addition, BCA's U.S. Bond Strategy service believes that Treasury yields have more room to rise, with growth putting upward pressure on inflation and the Fed in a rate-hike cycle. This makes sense to us given that no major geopolitical risk is materializing and considerable upside risk exists in U.S. growth due to Trump's populist policies. Chart 6European Stocks Still A Buy Relative To U.S. In what follows, we take a break from poring over geopolitical risks in Europe and the U.S. and focus on emerging markets. Since January, very few investors have asked us about EM politics, save for the occasional question about Brazil. However, the two Asian giants - China and India - are both a source of risk: the first a downside, left-tail risk and the second an upside, right-tail risk. China: What Comes After The Party Congress This Fall? Since 2013, we have been outspoken in our low expectations for China's structural reforms.5 This view was confirmed with a series of stimulus efforts that displaced reforms, including the local government debt swap program in 2014 and extensive fiscal and monetary easing in 2015 and especially 2016.6 The upside of weak reforms was better-than-expected growth in the short run, as stimulus took effect. Indeed, China has pulled off a remarkable economic turnaround since early last year: infrastructure and housing investment have increased, the weaker yuan has boosted exports, and the global recovery in commodity prices has helped producer prices to recover, easing deflationary pressures (Chart 7). Chart 7Deflationary Pressures Easing Chart 8Stimulus Dropped Off Accordingly, Chinese policymakers, who are attempting to strike a balance between stimulus and restructuring, have begun leaning against the economy's gathering momentum. Government spending has collapsed now that a 6.5% GDP growth "floor" has been established (Chart 8). A new round of property market regulatory tightening began last fall, though it has had little impact so far. Also, the People's Bank of China has begun draining some liquidity (Chart 9). Signals coming out of the "Two Sessions" over the past two weeks, namely the National People's Congress, suggest that the Chinese leadership is content with the current state of affairs. Policymakers set their growth targets for 2017 a little lower than last year's targets and a little higher than last year's actual performance (Table 2).7 It is a line so thin that it is almost imperceptible. They do not want significant change. Chart 9PBoC Draining Liquidity Table 2China's Economic Targets For 2017 This stance fits with a deeper desire to keep the economy on an even keel during a pivotal year for Chinese politics. The legislative session took place under the shadow of the Communist Party's impending 19th National Party Congress - the "midterm" meeting of the party that happens every five years and features extensive promotions, rotations, and retirements for the party leadership. This year's congress promises to be especially influential because of Xi Jinping's ascendancy and the fact that around 70% of the upper tier of leaders will be replaced. Chart 10, which we have been showing clients over the past year to dampen expectations of stimulus, reveals that the party congress is not normally an excuse to throw open the floodgates of credit and government spending. Rather, it is a reason to avoid anything that might rock the boat, whether stimulus or reform. Chart 10Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Thus while government spending has declined, it should be expected to rise again if growth slows down too much for too long. There may be a period of slowdown and market jitters before the leaders reach for the fiscal lever again, but the "Socialist Put" remains in place. Meanwhile, we are not surprised that structural reforms continue to suffer. It is not that China has eschewed all reforms but rather that its reforms have focused on centralizing power for the ruling party and alleviating some outstanding social grievances. These are positive in themselves but they do not address the key concerns of foreign investors relating to economic openness, financial stability, and the role of the state. The recent imposition of capital controls and a host of non-tariff barriers in the name of "state security" exemplify a negative trend. The delayed rollout of the property tax is also a sign of Beijing's proclivity to delay policies that may be financially risky.8 And Beijing has only tentatively attempted to cut back state-owned enterprises. Simply put, a push to overhaul any significant sector or sub-sector does not fit Beijing's priorities at the moment. However, if growth, debt, or asset prices should climb too rapidly, then we expect countermeasures to tamp them down. Even on the geopolitical front - where we have a high conviction view that tail risks to financial markets are higher than the market perceives them to be, both in China and the broader Asia Pacific - there have been some signs of the U.S. and China playing ball on a shared desire for "stability," at least for the moment.9 While we expect a negative geopolitical shock, the market will only believe it when it sees it. All of the above suggest that China will focus on "maintaining stability" this year even more than usual due to the party congress. This is clearly bullish, especially given improving U.S. and global growth. However, the mantra of "stability" and "party congress" should not prevent investors from looking beyond October or November of this year. Chart 11China Needs More##br## Credit For Same Growth Chart 12China Gets Old ##br##Before It Gets Rich Even assuming that China experiences no significant internal or external economic shocks from now until this fall, it is important to remember that China's growth potential is still slowing for structural reasons. Productivity is collapsing and credit dependency is rising (Chart 11). The slowdown stems from deep shifts such as the end of the debt supercycle in the U.S. (weak external demand), the tipping point in Chinese demographics (higher dependency ratio) (Chart 12), and the extremely rapid build-up in corporate debt (Chart 13). Chart 13Corporate Debt Skyrockets Chart 14As Good As It Gets This is what leads our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, to surmise that China is at the peak of its current economic mini-cycle. This is "as good as it gets," as he shows in Chart 14. Barring a situation in which Xi somehow fails to consolidate power at the party congress, the market impact will depend on which of two scenarios follows: First scenario: Xi achieves a dominant position in all party and state organs, yet 2018 sees a continuation of the current pattern of mini-cycles of stimulus, lackluster reform, and foreign policy aggressiveness. Xi implicitly deems the strategic cost of reform too great, as we argued he would do over the past four years, and dedicates his stint in office to the accumulation of power. Perhaps a successor will be able to use these powers to enact painful reforms in the mid-2020s; that is not Xi's immediate concern. This is short-term bullish for global and Chinese growth, long-term bearish for Chinese assets. Second scenario: Xi achieves a dominant position and uses his power to reinvigorate the country's stalled reforms. Hints of big measures emerge in the wake of the party congress in November or December, and January 2018 begins with a bang. This would necessarily mean that Xi accepts slower growth, or even that he imposes it through tighter fiscal policy, real credit control, SOE failures, and aggressive overcapacity cuts. However, Chinese productivity would begin to recover. This is short-term bearish for Chinese and global growth. However, it is the most bullish outcome for the long-term performance of Chinese assets. In China's current state - with capital controls newly reinstituted (Chart 15), Xi lauding the "central role" of SOEs in development, and Xi's administration still focused on purging the party and controlling the media - the second scenario admittedly seems far-fetched. Chart 15Are Capital Controls Working? Moreover, Xi seems averse to risky experiments at home that could weaken the country in the face of unprecedented strategic threats from the United States and Japan. Nevertheless, a 2018 reform push should not be dismissed out of hand. Why? Because an overbearing state, credit excesses, and weak productivity really do threaten the sustainability of the Chinese economy and hence the Communist Party's grip on power. Xi must keep them in check, as the current gestures toward tighter policy indicate. The government has overseen a massive monetary and credit expansion to protect the country from faltering external demand since 2008. As the current account surplus has declined, the country's massive savings have built up at home in the form of debt (Chart 16).10 Yet the investment avenues are restricted by the role of the state. As a result, the inefficient state-supported sector is getting propped up while the shadow financial sector grows wildly and creates murky systemic risks that are difficult to monitor and control. The PBoC has undertaken further extraordinary actions to keep financial conditions loose (Chart 17). Chart 16Savings Invested At Home Chart 17PBoC Lends A Helping Hand What signposts should investors watch for to see which path Xi will take after the party congress? Jockeying ahead of the party congress: The latest NPC session saw some political maneuvering. Several sixth generation leaders made appearances and spoke to media.11 Xi's supposed favorite, Chen Min'er, Party Secretary of Guizhou, distinguished himself by cutting reporters short at a press conference. Meanwhile former President Hu Jintao appeared publicly alongside his apprentice, Hu Chunhua, Party Secretary of Guangdong. Elite party gatherings in the summer, especially any retreat at Beidaihe, should be watched closely for any clues of who may be up and who down, and what general policy trajectory may be forthcoming. Xi's future: First, will Xi Jinping and Li Keqiang establish clear successors for their top two positions in 2022?12 A failure to do so will suggest that Xi intends to stay in power beyond his de facto term limit of 2022. This would mean that Xi will prioritize his own future over painful structural reforms. On the other hand, a clear commitment to a leadership transition in five years may re-focus the Xi-Li administration towards their initial commitment to economic restructuring. National Financial Work Conference: This conference is held every five years, usually connected with a major new financial reform or regulatory push, and due sometime in 2017. The government is looking into serious changes to financial regulation - including the creation of a super-ministry to house the various regulatory agencies. This, or the broader attempt to ensure adequate capitalization of banks, could be behind the delay. New central banker: Central bank governor Zhou Xiaochuan, in office since 2002, may step down this fall. He could be replaced with another technocrat to little fanfare, but his exit introduces the opportunity for shaking up the PBoC regime as a whole. Other new officials: A slew of other appointments and reshuffles will take place this year as a generation of leaders born before the Revolution retires. A new director of the state economic planner, the National Development and Reform Commission, was just named, while late last year a new finance minister took his post. These officials have yet to make their mark. Their statements should be watched closely for any shifts in economic policy emphasis. Time frames for reforms: The market is still waiting for concrete proposals and time frames for major reform initiatives, particularly opening up to foreign competition and restructuring state-owned enterprises. Overcapacity cuts have also had mixed results. We do not expect major advances on big structural reforms this year due to the party congress, but details that can be gleaned about the process and timetables could be important. Bottom Line: Watch for signs of a renewed reform drive after the nineteenth National Party Congress. Xi is not going to reverse what he has done so far. And China is not going to become a market economy on the ideal western model. But a pivot point could be in the cards next year for China to pursue some pro-efficiency reforms that it has already set out for itself in a more resolute way. Xi's decision to stay in power beyond 2022 would be bearish for reforms as it would incentivize the current "Socialist Put" model of policymaking over a genuine paradigm shift. India: What Comes After Modi's Big Win? Prime Minister Narendra Modi has won a crushing victory in India's most populous state, Uttar Pradesh, positioning himself, his Bharatiya Janata Party (BJP), and National Democratic Alliance (NDA) coalition very well for the 2019 general elections. Policymaking is going to become easier for the ruling party - though there are still serious political and economic constraints. We have been long Indian equities relative to EM equities since the "Modi wave" began with Modi's victory in the Lok Sabha or lower house in 2014.13 The end of the commodity bull market signaled an opportunity for India, which imports about a third of its energy. The decline of global trade also heralded the outperformance of domestic demand-driven economies like India. Further, Modi's sweeping victory held out the promise for a reform agenda of tighter monetary and fiscal policy that would reduce inflation and make room for private investment to grow. This would make Indian risk assets attractive, especially relative to other EMs, which were at that time either lagging at reforms or failing to undertake them entirely. Since then we have seen Modi rack up a key legislative victory - the passage of the Goods and Services Tax, in the process of implementation - and engineer a surprise "demonetization" effort late last year to increase bank deposits, bring the country's gray markets into the open, and flush out crime and corruption.14 The ruling coalition's gains in Uttar Pradesh and a few other state elections this year are a striking vindication of popular support after this highly unconventional and controversial maneuver.15 Uttar Pradesh is the most important of these elections. It was slated to be a grand testing ground for Modi well before demonetization. It is the most populous Indian state, with about 200 million people, and the third largest state economy (producing about 10% of GDP). It is the second-poorest state, with a GDP per capita of about $730, it has the highest proportion of "scheduled castes" (untouchables), and ranks around the middle of states in terms of the Hindu share of population - all challenges for the landed, pro-business, Hindu nationalist BJP (Map 1). Politically, aside from its inherent heft in population and centrality, Uttar Pradesh sends the most representatives of any state to India's upper house (31 seats), the Rajya Sabha, where Modi lacks a majority. It is thus a key source of federal power and an important state ally. Map 1Modi's Saffron Wave Takes The Indian Core Given the above, it is hugely bullish that Modi's BJP romped to a historic victory in the state election, winning 312 out of 403 seats (about 39.7% of the vote), up from 47 seats previously. His coalition rose to 324 seats total (Chart 18). The BJP now has the largest majority of any party in the state since 1980. These results were not anticipated. A close election was predicted and opinion polls had BJP winning 157 seats, short of the 202 needed for a majority. This was only slightly ahead of its closest rival, an alliance made up of the local Samajwadi Party and its national partner, the left-leaning Indian National Congress (INC). Exit polls even suggested that the Samajwadi-INC coalition had edged ahead of the BJP. The immediate takeaway is that Modi will have better luck governing Uttar Pradesh itself now that the state government is on his side. Individual states hold the key to reform in India because of the country's size and socio-economic disparities. The state will now be expected to implement Modi's policies faithfully and push approved policies forward on its own. The second takeaway is that while Uttar Pradesh will not give Modi control of India's upper house of parliament, the Rajya Sabha, it will give him a better position there. The BJP has 56 seats in the upper house (fewer than the INC's 59), and the ruling coalition has 74, out of a total of 250. The coalition needs 52 seats for a simple majority. Uttar Pradesh will deliver 10 seats at most by the 2019 general election. Modi would have to win almost every seat of the 56 non-allied seats coming open between now and 2019 in order to win the upper house by that time (Chart 19). That is unlikely, but Modi is moving in the right direction and an upper-house majority cannot be ruled out in the long run. Chart 18Modi's Big Win In Uttar Pradesh Chart 19Modi's National Position Improves Of course, Modi has already shown with the Goods and Services Tax that he can pass very difficult legislation through the upper house without controlling a majority there. This achievement last year was perhaps an even greater surprise than the victory in Uttar Pradesh, which reinforces it. Modi also has a secret weapon: in case of a national emergency, however defined, he can call a joint session of parliament, where his coalition would carry the day. This is now more likely because it is the Indian president who is responsible for calling a joint session, and Modi is now more likely to get his candidate into that position due to the win in Uttar Pradesh. President Pranab Mukherjee, who is affiliated with the INC, will step down on July 25. Though Modi does not have all the votes in the electoral college to choose the president outright, smaller parties may fall in line now that the BJP has so much national momentum.16 Controlling the presidency will also give Modi greater influence over constitutional obstacles and gradually over the legal system. Separately, in August, Modi's alliance will be able to choose the vice president as well. More broadly, the Uttar Pradesh election marks a victory for Modi's style of appealing to voter demand for greater economic development as a general priority over longstanding religious and caste grievances that frequently determine electoral outcomes in state elections. This is a hugely significant indication for India's economic structural reform and nation building. Bottom Line: Modi's victory in Uttar Pradesh is proof that for all of India's sprawling inefficiencies, its political system is capable of responding to the large public demand for economic development. Do not underestimate reform momentum now. Modi's political capital remains high. Investment Conclusions The conventional wisdom has for decades been that China is better at reforming its economy because of its authoritarian regime, whereas India democratized too early and has thus lagged at reforms. We have never agreed with this simplistic view of economic reforms. Structural reforms are always and everywhere painful. As such, they require political capital. As our "J-Curve of Structural Reforms" posits, reforms deplete political capital as the pain spreads through the economy and opposition mounts among both the elite and the common man (Chart 20). Eventually, the government is faced with a "danger zone" in which the pain of reforms lingers, the benefits remain beyond the horizon, and all political capital is exhausted. Many leaders chose to water down the reforms, or back off from them altogether, at this point. Chart 20The J-Curve Of Structural Reform On the surface, authoritarian regimes have massive political capital with which to burst through the danger zone of reform. But this assumption is not entirely correct. In China's case, the political capital for reform came after disastrous performances by the "conservative" political forces. Reformers in China were buoyed by the failures of the "Cultural Revolution" (which ended in 1976) and the 1989 Tiananmen Square protests. Each political and social crisis gave the reformers an opening - following a consolidation period - to pursue controversial economic reforms at the expense of "conservative" forces. The fruit of these reform efforts has been the growth of China's middle class. And while this middle class expects reforms in the delivery and quality of public services, it is not interested in seeing a slowdown in economic growth, no matter how temporary or healthy it may be. As such, Chinese leaders are faced with a significant hurdle to their reform preference: how to convince the public that a slowdown is needed in order to restructure the economy. We are unsure whether the upcoming party congress will make a difference. However, we can see a scenario where President Xi decides to pursue market-friendly reforms because he sees an increase in his political capital. In particular, he may feel that he has cemented his personal dominance over his intra-party rivals and that the aggressive foreign and trade policy emanating from the Trump White House gives him a foil to blame for any downturn in growth. Reform would also be a return to Xi's original agenda, and would conform to the playbook of former president Jiang Zemin, whose precedents Xi has followed in some other areas. Given Xi's modus operandi, a post-consolidation reform drive would be executed relatively effectively and would therefore present short-term risks to Chinese and hence global growth, despite the long-term improvement. Markets are definitely not expecting such a policy pivot at the moment. China bulls are content with the current reforms, while China bears see no chance of the Xi administration changing tack. While we are just beginning to see the potential for a turn in Chinese policymaking towards reforms, India is a much clearer example of a reformist administration. Modi will feel empowered by the Uttar Pradesh election, a political recapitalization of sorts. Foreign investment will likely continue cheering Modi's ongoing revolution (Chart 21). The question now is whether Modi intends to use the infusion of political capital for genuine reforms. After all, the economy is not looking up (Chart 22). Chart 21Foreign Investors Cheer On Modi Chart 22Indian Economy Still Weak The evidence is mixed. First, Modi has not maintained strictness on fiscal spending and the budget deficit is creeping back to where it was when he took over the reins (Chart 23). Rising government spending along with higher commodity prices suggest that inflation will continue making a comeback (Chart 24). Poor food production is also driving up inflation. And higher spending and inflation pose a key threat to the sustainability of the reform agenda, since rising government bond yields will crowd out private investment. Chart 23Losing Budgetary Discipline? Chart 24Inflation Makes A Comeback Second, the RBI will be less likely to pursue a tighter monetary policy with both political influence and weak growth pressing on it. Moreover, Indian stocks are not all that cheap. In 2014, valuations were favorable and the backdrop included cheap commodities, fiscal prudence, and Modi's electoral success. Today, India is trading at its historical mean relative to EM (Chart 25), but using the equal sector weighted P/E ratio, by which India was very cheap back in 2014, India is at a 52% premium now (Chart 26). Chart 25Indian Stocks Trading##br## At Mean Against EM Chart 26Indian Stocks Pricey##br## Versus EM Sector-Weighted We are therefore taking this opportunity to close our long India / short EM trade for a 28% gain (since May 2014). We will reassess Modi's structural reform priorities in future research and gauge whether a new entry point is warranted. We remain optimistic on India in the long run as Modi certainly has the political capital for reforms. The question is whether he plans to use it. Meanwhile, we remain skeptical about China's long-term trajectory. To become fully optimistic about Chinese risk assets in absolute terms, we need to see the Xi administration chose short-term pain for long-term gain. For the time being, China continues to repress its structural problems rather than deal with them head on, relying on minimal openness, high and rising leverage, and state-owned banks and companies. India may be lagging in its reform effort, but it has at least established market reforms as a priority. And the Modi administration has built political capital through the slow and painful democratic process. Over the long term, India's approach is more sustainable. If President Xi wastes the opportunity afforded to him by the upcoming party congress, we suspect that China will face a much higher probability of left-tail economic risks than India over the long term. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "How Expensive Are U.S. Stocks?," dated March 13, 2017, available at usis.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Reflections On China's Reforms," dated December 11, 2013, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com, and "China: The Socialist Put And Rising Government Leverage" in Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA China Investment Strategy, "Messages From The People's Congress," dated March 9, 2017, available at cis.bcaresearch.com. 8 Please see Chong Koh Ping, "No plans for NPC to discuss property tax," Straits Times, March 5, 2017, available at www.straitstimes.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. 11 China's leadership is typically referred to in terms of "generations," with Mao Zedong and his peers the first generation, Deng Xiaoping and his cohort the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth. The fifth generation was born in the early 1950s, the sixth generation was born in the early 1960s. 12 Xi may tweak retirement norms to let close allies, like Wang Qishan, the anti-graft attack dog, stay on the Politburo Standing Committee. This might also suggest that Xi himself intends to overstay his age limit in 2022. 13 Please see Geopolitical Strategy Special Report, "Long Modi, Short Jokowi," dated August 28, 2014, available at gps.bcaresearch.com, and Emerging Markets Strategy Special Report, "Long Indian / Short Indonesian Stocks," dated July 30, 2014, available at ems.bcaresearch.com. 14 Please see "India: Demonetization And Opportunities In Equities," in Emerging Markets Strategy Weekly Report, "EM: Untenable Divergences," dated December 21, 2016, available at ems.bcaresearch.com. 15 Though the mixed results also indicate persistent regional differences. Modi's coalition won seats in Uttarakhand and Manipur but lost them in Goa and Punjab. Gujarat, Modi's home state, will hold elections later this year. Himachal Pradesh will also vote this year and will be a subsequent testing ground. 16 Please see Gaurav Vivek Bhatnagar, "BJP Sweep in UP Will Impact Decision on President, Rajya Sabha Numbers," The Wire, March 12, 2017, available at https://thewire.in/116044/bjp-sweep-will-impact-decision-president/