We Study Billionaires - The Investor’s Podcast Network - TIP292: Understanding the Chinese Economy w/ Leland Miller (Business Podcast)

Starting point is 00:00:00 You're listening to TIP. On today's show, we have Mr. Leland Miller, who's the president of China Bejibook International. Mr. Miller is a leading expert on China's financial system, and our discussion today focuses on all the intricacies of that complicated and often confusing marketplace. Mr. Miller is a regular guest on CNBC, Bloomberg, and countless other global media outlets. I have no doubt you're going to capture a ton of value from this interview because it's hard to find someone that's more tuned to the Chinese economy. In the interview, I was not able to accompany Stig, but I'll be back with you guys on the following episodes.

Starting point is 00:00:34 And with that, I hope you guys enjoy the show. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to today's show. I'm your host, Stig Borderson, and Leland, thank you so much for joining us here today. Thanks for having me. So, Leland, today we will together take the helicopter U of the Chinese economy and the relationship between China and the trading partners, including the U.S., of course.

Starting point is 00:01:18 Now, it's hard not to talk about the Chinese one whenever we talk about the Chinese economy, and back in August, one U.S. dollar was worth 7.1, and the depreciation of the Chinese one happened very rapidly. Could you talk to us about what happened then, and how would you describe it? the impact of the Chinese economy? In general, the goal of the Chinese government going forward is to keep the currency stable with probably an upward appreciation bias. And the reason for that is that the dollar is a stabilizing factor on the yuan.

Starting point is 00:01:57 And the goal of the Chinese government right now is to push the country more towards consumption. And one of the easier ways of doing it, not easier, but easier than some of the other ways, is to empower households to purchase more. And one way you empower households to purchase more is to put more purchasing power in their pockets, and a stronger currency will do that. So the bias of the Chinese government, in a non-volatile economic scenario, is to keep the currency stable, keep it relatively strong, particularly the rest of the world, to empower Chinese households going forward and to empower this rebalancing idea. where the economy will shift gradually to more of a consumption culture. In the past, seeing the currency move, and certainly if the Chinese economy is under great stress, or trade war, or during an outflow crisis,

Starting point is 00:02:47 or because of some other dynamic, then you'll have a lot of pressure on the PBOC to allow greater depreciation. But as we all know, the PBOC's role has essentially been to step in and strengthen the currency when market forces have been pushing it downward. So the PBOC has had mostly a stabilizing, strengthening for years now. And that's the way the Chinese government would like to keep it. The idea that there's a big devaluation in the wings. The next time there's a downturn of the Chinese economy is very, very unlikely.

Starting point is 00:03:20 The way we describe this is breaking the glass type of emergency mechanism. It's there they could devalue if they absolutely have to, but it would reverse everything else they're trying to do. So there's no real interest in a major devaluation. Again, what they want, a stability, a bias towards strength, and in anything other than an extremely supercharged dollar world, that should be manageable going forward as long as the domestic economy itself remains stable. There is something magical about this one to seven ratio and something that a lot of people

Starting point is 00:03:51 have been looking out for for a long time. At the time of recording, today it's March 10, and one U.S. dollar is worth 6.96 Chinese one, but could you talk to us a bit more about what is a quote-unquote healthy fluctuation? How much will the People Bank of China or the Central Bank of China, how much would they allow if we can even use that word? Well, rather than saying it's a particular percentage or number, I would say it's whatever fluctuations don't bother the rest of the world. Don't make them think that there's instability in the currency. The reason that this window management has broadened over the course of the

Starting point is 00:04:28 past several years has been that people have been more confident in the Chinese government's ability to manage that ban. 2016 was a horror story for the Chinese government. They've learned some of their lessons from that. They realize that markets don't take well to baby depreciations because they think they usher in large devaluations. So the Chinese government's learned lessons. And again, there isn't a specific number here.

Starting point is 00:04:53 It's just whatever ban, the market feels comfortable and not. thinking that there's panic by the government or inside the Chinese economy. I like the way that you phrased this, Leland, and it kind of takes me to the next question that I have for you. So let's talk about the U.S.-China trade war. And one of the reasons why we did want to bring you on is because you were an expert in China, you're expert in this relationship between U.S. and China. And we would really like to zoom out a bit more and talk more about the big lines and

Starting point is 00:05:23 the geopolitical situation. Now, if you look back January 15, the first sign of the truth was seen whenever the U.S. and China signed the long-awaited to face one trade deal at the White House, easing 18 months of trade tension between the world's two biggest economies. Could you talk to us about what has happened since then in the trade war and what do you as an expert look out for in particular? The trade war is on an indefinite hiatus. And what that means is that President Trump got a lot of the United States.

Starting point is 00:05:55 commitments or large-scale purchases through the election and beyond. And if the Chinese come close, either adhere to those commitments, which is highly unlikely, it's not going to happen, actually, or they come close, or they look like they're giving their best efforts, then you may see complete trade peace for the remainder of this year through the election, because it's in the Chinese government's interests to focus inward. And if they can take care of the trade tensions, with some promised buys. It's not comfortable for them, but it's better than the alternative. And for President Trump, there are a lot of elements that this U.S.-China trade war has been supposedly about. There's been forced technology transfer. You're talking about IP overall.

Starting point is 00:06:39 You're talking about market access for foreign companies. But what really makes Trump tick and what he's focused on is the bilateral trade deficit. And as a result, as long as phase one looks like it's solving at least temporarily, some of the woes of the bilateral trade deficit. His administration has been focused on laying the trade war down, particularly through the election, and not focusing on any of the other big issues. So as long as the Beijing president happy on purchases, then you have trade peace through the 2020 election. The one issue here is that this should not be looked at as a two-year deal. It should more fairly be looked at as two-one-year deals. because both sides are very incentivized to keep to peace through the first year.

Starting point is 00:07:25 President Trump hopes it gets him reelected. Beijing hopes it buys them some time to focus inward. Second year is going to be trickier because the numbers are so high. That's even before coronavirus hit that it will be very, very difficult to come anywhere close to hitting the targets that Beijing has agreed to, particularly without violent implications and without interfering in other trade relationships that Beijing has. So the first year of the deal is seen as being relatively fluid in terms of maintain the peace

Starting point is 00:07:55 and particularly with the coronavirus hitting. The second is going to be an entirely different story. We'll have to see what the state of the global economy is at that point. But there will be very different political considerations from the U.S. side in particular. And so there may be very different considerations in terms of whether this deal continues much beyond the first year. Having said that, and with the press going so many different directions whenever this was covered and still today, what would you say as, let's call you an insider if you allow me, what would you say is the most misunderstood whenever we're reading and learning about this trade war? Well, I think what's misunderstood is what it's about. I think people are starting to get this idea, but it's not widely understood enough. When the United States start, what is now seen as this U.S.

Starting point is 00:08:43 China trade war. It was about bilateral trade deficits. It started with Section 301 investigation, which again focused on problems the United States has historically had with the Chinese government in terms of restricting market access, technology transfer, IP infringement, core structural issues. It also had to do with something called Made in China 2025, which is the fact that the Chinese government had a very high-powered program to supercharge its advanced manufacturing, whether it's 5G or quantum computing or artificial intelligence, et cetera, and do that with a heavy state hand with the attempt, and this was explicit, to run the rest of the world out of advanced manufacturing, become the world leader in all these core sectors.

Starting point is 00:09:28 And one of the frustrations that many people have, including myself, is it as you work through what we just did in phase one, this wasn't about curing any of those structural woes. As a matter of fact, made in China 2020, got taken off the agenda very, very early on in the process. This was purely about purchases. This was purely about managing the bilateral trade deficit. And as a result, if this is all we get, if phase one isn't phase one,

Starting point is 00:09:55 but phase one is the U.S.-China trade deal, then we've given up a spectacular opportunity and an enormous amount of leverage to effectuate real change in return for some very transient commodity purchases that may actually work against us in a few years when U.S. farmers, for instance, become more dependent on Chinese markets, giving Beijing more leverage over U.S. economy. You know, one of the things that I found very fascinating, when we're reading and learning

Starting point is 00:10:22 about this is how we here on the U.S. side focus on the different parties. You have the White House and they have their own agenda. You have the corporations that have their own agenda. You would say the unions would have their own agenda. But let's try and turn the tables and look at the major players on the Chinese side. I think it's very interesting to see because I think in the U.S. we tend to see that we might have different interests, but China, that is this one uniform entity, and they want XYC. There are a lot of different players in China, too. Could you talk to us about some of the bigger players? There certainly are these different players with different vested interests. The difficulty is saying anything and knowing you're right.

Starting point is 00:11:02 There's very little visibility into how some of these political battles are waged. So it would be a mistake, as you suggested, to think that Xi Jinping runs monolithic China. What he says goes, and China has one opinion about reform or restructuring or trade deals or the state of the currency or GDP targets or any of the core issues. The problem is that it's not always obvious who's pushing back, especially the senior levels of the party. Certainly during the U.S.-China trade war, President Xi was getting enormous pushback domestically on some of the things that he was offering up. There were suggestions in the media.

Starting point is 00:11:39 There were suggestions by public intellectuals. There was discussion, certainly, on the online blogs, about how China wasn't taking a tough enough stance, et cetera. It's hard to pinpoint who some of these actors are, bad for their health to itself identify. But certainly, there's a very diverse discussion behind the scenes. It's just not always easy to figure this out. We do know, certainly the PBOC has its own vested interest. The NDRC has its own vested interests. Certainly very ultra-rich. Chinese have their own vested interests. And so there's a diversity of opinion that's not always transparent. Who's holding what view at any given time? So, Leland, I'm really excited to speak with you here today because you're coming from China and Facebook International. And we're not just talking about the

Starting point is 00:12:23 conventional metrics like GDP, inflation, unemployment. You also track those. I don't want to say to be fair, but it's just such a wealth of information of what you guys are doing. But perhaps before we dig deeper, could you give us like the helicopter view of the Chinese economy and especially how that is different than the US economy? Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord.

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Starting point is 00:16:54 Chinese growth rate, even though it's nowhere near 6% reality, has been much stronger than the United States for many, many years now. And part of that's because China in many ways is a developing economy and not a developed economy. The incomes of the average Chinese are tiny fraction of what they are in the Western democracies. So China is this big, powerful economy, the second largest in the world, but also is developing in that it's not rich. Its people are not rich.

Starting point is 00:17:23 And so it has very interesting facets of both a developed economy and a developing economy. The historical reliance on growth for China has been based around investment. And what that essentially means is that when the Chinese government wants to spur growth, the government steps in, it builds. It's usually heavy transportation, heavy infrastructure, and it creates growth that way. Now, the problem with this, of course, is that many of these development, programs are non-productive. And as a result, they're spending an enormous amount of capital on programs that are not adding to productivity in the economy. Now, this has been okay for a long

Starting point is 00:18:01 time because even though China has built up an enormous amount of non-performing loans from some of these projects that just aren't returning any investment, the country's gotten richer, people have gotten richer, and growth has been fast enough to either keep pace with debt. That's no longer true, but it's going fast enough that there hasn't been a problem. a new error. And so there's a lot of fear on the part of the Chinese government that the old method of continuing to just spend, spend, spend is not going to work as China's debt flow gets too critical. And as the economy slows down. And it doesn't slow down because of mismanagement per se. It slows down simply because so much good money has chased after bad for so long

Starting point is 00:18:43 that the return on investment of projects, of companies inside the economy have slowed down. And as a result, you're going to have much slower growth going forward, no matter how well the economic officials in Beijing operate going forward. So you're going to have to manage the economy in a very different way. I think there's a sense of urgency in Beijing about managing the economy in a different way. The question is, what type of problems are you willing to deal with along the way that won't make you turn back and run scared back to the old method? What type of economic dislocations are acceptable and which ones are not? not. And I think where this gets into particular problems is when you start talking about the jobs market, you start talking about potential layoffs. It's one thing to talk about how you're going to

Starting point is 00:19:29 restructure the economy to allow zombie firms to fail and allow state firms to stand on their own two feet and compete with private firms. But if you see firms going under or you see financial products defaulting, you see risk injecting the economy, that means there'll be failure. And if there's failure, that means there's economic losses and there's job losses. And these are very very difficult concepts for the party to digest because for a long time there haven't been any. So this is a very critical time for the Chinese officials, for Chinese economic policymakers, how do they transition to a risk-based economy that allows the government to not have to backstop everything explicitly or implicitly because they can't in reality do that?

Starting point is 00:20:11 But how do you translate the old system into the new system without causing problems that they could threaten the party's existence? That is the story of current day China. So, whenever you say that, I can't help but ask, how do you do that? For you to answer that question, I know that's a grateful question. Like you mentioned before, fiscal policy, there's a method to do it while you're developing country. You have to do your policies different than you've done in the past. Can't build yourself.

Starting point is 00:20:37 You can't just throw money out in society and then growth will come from itself. What are you looking for? What is sound fiscal policy in this day and age for China? To get Beijing credit, they have been moving in that. direction to some degree. What you saw in 2016, the economy was recovering from the early markets panic of January, February 2016 was old infrastructure stimulus. It was back to the old ways of China's heavy investment. You have not seen that the years since. You have not seen that when the economy weakened in 2018 and 2019. You did see stimulus. You saw a very directed stimulus to

Starting point is 00:21:13 provide capital to small and medium-sized enterprises, for instance, in private firms. But you did not see the build, build, build type of programs that you saw in the past. And that's very positive because it means the Chinese government is understanding that there are limits to the old model and they're trying to transition it. Now, our advice for a long time has been stop focusing on GDP growth. Do away immediately with the GDP growth target because it means nothing. One, the number is manipulated. But even if the number were not manipulated, GDP growth doesn't mean what people think it means. GDP growth relates to outproductive growth. So we used to joke that if China want seven or eight percent GDP, all you have to do is build a bridge,

Starting point is 00:21:52 tear it down, build the same bridge again, tear it down, build it, tear it down, and keep going to you hit 7% GDP. You'll hit the number because this is a mathematical construct, but you'll have a thoroughly unproductive use of those funds. That's what Chita has been doing to some degree for many years now. So the getting away from a reliance on infrastructure investing has been positive. But what Beijing has to do is change the conversation from being all about growth to being all about strengthening the economy for the long haul, get away from the idea they can grow at 6% growth. Because what we've been saying for many years now is that within the next decade,

Starting point is 00:22:26 possibly much sooner, China will be growing at 1 to 2% growth at most. And that's where we're headed. And what Beijing is well advised to do is tell people about this earlier rather than later and say this is a way for the Chinese economy to develop in a sustainably stronger way rather than rely on artificial levels of growth that run the risk of having a debt crisis or a stagnant economy, which is similarly problematic. It's very interesting that you say that. I also think it's interesting for the listener to know that the Chinese economy is just

Starting point is 00:22:59 constructed very, very differently than what we're used to in the U.S. So not to do too much macro one-on-one, but if you look at how this GDP number is constructed, you have the consumption, you have your investment, you have the government expenses. And if you look at the U.S. economy, and it's sort of unique, even for a Western developed country, as much as 70% is consumption driven in the U.S. So it's a very different GDP number that you would have in the U.S. than you would in China and has very different implications depending on how the government acts in China. And it sort of like leads me into the next question, because perhaps by comparing to the U.S. for us to get a better grasp of how it's the same or how it's different,

Starting point is 00:23:39 Could you please explain the relationship between the Chinese economy, the People's Bank of China, which is the Chinese Central Bank, and then the Chinese government, how do those three interact and how is it different or the same as in the U.S.? The most important thing to understand about the way that the People's Bank operates inside the Chinese economy is that China is not a commercial financial system. And this is a point that even very sophisticated traders that we work with constantly get wrong. The idea after the financial crisis was, well, the United States had its problems, Europe had its problems, China's next. But the Chinese economy doesn't work their way.

Starting point is 00:24:17 Because it's a non-commercial financial system, the government can order capital to be pushed from one side of the system to the other side. So essentially, if a state entity needs capital, then another state entity will provide that capital, and you'll continue to patch holes on this ship. So you never had an acute crisis, but you have a long, long process of the People's Bank and other. financial entities and economy, insistently providing capital to firms that need it so they don't fail. But the problem with that is you've got a lower return in investment, you've got a lower return on productivity, and essentially you're leading the economy into stagnation. There are advantages, of course, to this approach. One of the questions when coronavirus first hit was what's going to happen to millions of Chinese firms who only have one or two or three months

Starting point is 00:25:05 cash flow, are you going to see a million small, medium-sized enterprises to fall? across the Chinese economy. And the answer was always no, because as long as it's a policy priority for the Chinese government to not allow this, then it won't happen. Of course you'll have losers, of course you'll have firms that don't survive. But essentially, the system is state banks loaning to state entities and state banks loaning the small and medium-sized enterprises. When the state controls all the counterparties, then you're going to have a system that doesn't freeze up in the same way. You're not going to have a liquidity crisis because the government is ordering some firms to lend and others' firms to borrow. Now, that allows you to avoid an acute

Starting point is 00:25:45 crisis in any particular instant, but it also leads to long-term path towards stagnation. Good money continually chases bad and productivity declines. So the economy works very different than in the United States or in the Western world. But the single most important facet of that is how different China's financial system works. Very interesting. And something that I'm happy to say that we will get back to here later in the interview. It is a very unique financial system for sure. Now, China has for many years by a lot of people been considered the primary growth driver, not just for Asia, but for the global economy. And as you mentioned before, we've seen double-GGDP growth in the past. And today,

Starting point is 00:26:26 the official numbers are closer to 6%. Is it the same numbers you see in your data? What is driving the growth in China, or perhaps the lack of growth might be a better way of asking this question? To give one example of volatility that we see in the numbers that is never acknowledged by Beijing, the weakest national growth that we've seen in the last 10 years of serving the Chinese economy, the weakest data was fourth quarter 2015. Chinese official GDP growth that quarter, I believe, was 6.8%. The strongest quarter that we've had in the last 10 years was arguably in the run-up to the party Congress, 2017. China's official GDP growth that quarter, 6.8%.

Starting point is 00:27:10 The idea that the strongest performance we've seen in the last decade and the weakest performance both had a 6.8% GDP growth level. It tells you all you need to know about how accurate these figures are. The GDP figures are meant to signal stability. They're not economic numbers. They're political numbers. What are the three most misunderstood facts about the Chinese economy in the West? Number one, there are no truly good, unmanipulated pieces of Chinese data. One of the things you learn when you start doing deep dives into official data in China

Starting point is 00:27:44 is it's not a case of one headline number like GDP becoming manipulated. And then if you just dig beneath the surface, you get a gold mine of rich, honest information. The truth is that any number that markets begin to rely on, Chinese go back and manipulate it. So, for instance, there's been this idea that the Lee Ketchang Index, which is this mythical beast in which it's electricity consumption and rail cargo and et cetera, is somehow this real way of looking at the economy. Well, as soon as the Lee Kletchang Index started being used by financial firms around the world, the Chinese started manipulating electricity consumption data. They started offering up some very questionable rail cargo data. I think that one of the takeaways on this is that there simply are no pieces of official data that can be trusted because the Chinese want these numbers to be political. They want them to signal stability.

Starting point is 00:28:34 And if they're not signaling that, then they're a problem. The second, I would say, is related to that, the idea that the West does independent China analysis. The state of the industry I'm in is not good. The people that are in it are very smart. The type of assessments that are being done on the Chinese economy right now, however, are very, very great. for. We've been making fun of these Reuters polls that come out with just greatest contra indicator ever is whatever economists in the Reuters poll think about the economy. During the early days of coronavirus, they were predicting 4%, 5% growth in Q1. And prognostications have gotten worse from there.

Starting point is 00:29:08 But what you usually see, if you dig deep enough into the Western analysts of China, they're typically either opining based on Chinese data or they're creating some sort of leading indicator that's a composite of a bunch of different numbers. But those numbers are all. all sketchy Chinese government official numbers to start with. And one of the rules that we try to explain to people is that the first and second derivative of trash is trash. So most of the instruments being used outside of China to evaluate the Chinese economy are just not worth looking at.

Starting point is 00:29:43 It's something I think people are understanding more and more now that instability in the Chinese economy is not being signaled when it should be based on these instruments. The last, I would say, is no matter how many times we talk about it, no matter how many times traders lose, there's not a widespread understanding that China does not have a commercial financial system. China's financial system is strictly non-commercial. It allows them to do amazing things in terms of avoiding these acute crises we talked about earlier. They're able to avoid significant problems. They're able to avoid this hard landing scenario, but it causes lack of growth in the long run as debt wildly outgrows growth. And this is the problem going forward. The non-commercial financial

Starting point is 00:30:26 system that China utilizes has enormous advantages in terms of maintaining stability in the short and medium term. But there are significant long-term costs. And that is not understood by even some of the more sophisticated people. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up. And customers now expect proof of security just to do business. That's why, VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a stock two or running an enterprise GRC program, VANTA keeps you secure and keeps your deals moving.

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Starting point is 00:34:06 what is going on, or at least I could say, there are many few outsiders who understands what's going on on the inside of China. Now, could you please first explain how shadow banking is different from commercial banking, perhaps for those who are not too familiar with those two terms, and why it's important to understand shadow banking in detail to understand the economy of a country? Any type of financial institution or instrument that provides capital outside the banking system is a non-bank, and therefore should be considered a shadow bank. So the simplest way of looking at this is any time that money is being handed out in the economy, and it's not from a bank, it's from a shadow bank. It's a very broad definition. Now, this gets tricky very very, very

Starting point is 00:34:48 very, very fast. And one of the reasons it gets so tricky is that shadow banking can mean non-banks, who you borrow from, or it can mean financial instruments that are shadow banking instruments, wealth management products, trust products, negotiable certificates, a deposit. So when you're trying to understand from a quantitative standpoint, how much of China's financial intermediation is shadow banking, how much of the economy is fueled by shadow banking versus bank lending. Now, shadow banking has gotten a bad name in China and elsewhere because it's seen as the Wild Wild West. That's fair.

Starting point is 00:35:23 A lot of shadow banking in China, Ponzi schemes, non-transparent instruments. There's a lot of garbage out there. It's very, very dangerous to households and the Chinese financial system. But part of shadow banking is also very, very necessary and natural. And it was a result of the fact that the Chinese banking system is geared towards providing cheap or no-cost capital to state enterprises and massively disadvantaging other types of entities, small, medium-sized firms, private firms, others. Because state firms, state banks have historically been restricted from offering pricing risk, so from offering capital at what it

Starting point is 00:36:00 should be costing. So if you're only able to doubt 2% loans, banks are left with the difficult problem of do we give it to state-owned enterprises, which are politically backed, do we take a risk on some of smaller firms that might go put. And of course, it's very natural that the state banking system has gravitated to larger firms, which are bigger bets, which are more politically connected. But as a result, huge chunks of the economy have not been able to remain capitalized without some sort of outside intervention. And that outside intervention has been shadow banking. Shadow banking has been a way of working outside the banking system to provide capital. And without shadow banking, China wouldn't be where it is right now, both on the good side and on the bad side.

Starting point is 00:36:39 So, thank you for outlining the concept on a more conceptual level. If we become a bit more focused on what's happening today, what does your data tell you about the trends in shadow banking in China right now? And what are the implications of those findings? The coronavirus may change some of the landscape, simply because firms without revenues, there's a demand shock, there's a supply shock, there's a global demand shock, there's an oil shock, the landscape of shadow banking may therefore change in 2020 because of the dire needs of the economy. But I can outline what we've seen over the past year. And it's been a very different story than what you're hearing about, even from international institutions like the

Starting point is 00:37:22 IMF for the World Bank, who simply take Beijing's official numbers and extrapolate from there. We've seen a dramatic rise in shadow banking over the course of 2019. In order to understand this, You go back to fourth quarter, 2018. The economy saw some of the worst results. We saw every sector was weaker, every region was weaker, every headline metric was down. And something happened in Beijing to change economic policymaking going forward. There was some sort of equivocation. Do we focus on restructuring into leveraging and reform going forward?

Starting point is 00:37:53 Or do we batten down the hatches and protect ourselves against a slowing global economy and President Trump's trade work? What you saw was explosion of bank lending, the inning of 29. not just jump in loans to the normal firms, but a much broader distribution of credit provision to funds that don't typically get the type of capital they need. Again, small-mead-sized enterprises, private firms and others. The disadvantaged firms start getting better access to capital. This is the type of stimulus we saw in 2019 instead of infrastructure investment. As the year went along, it soon became clear that one, banks were resistant to keep sending their funds to small-meatum-sized

Starting point is 00:38:33 enterprises and private firms because they were riskier. As a result, you saw resurgence of shadow finance as 2019 gained steam. The most interesting part of this resurgence of shadow finance, which again did not manifest itself in total social finance data, so it was not seen in official data, at least until the very end of the year. But the most interesting facet of this, what popped up. What we started seeing in the middle of 2019, it was a rise of something called the government-owned shadow banking, which became these credit appendages. So, first, For instance, you'd see shadow banks serve as an intermediary function between formal banks and small medium-sized enterprises, capturing the margin along the way.

Starting point is 00:39:12 And you saw shadow banks being used not just by the private sector, by the government, in order to steer capital inside China's banking system and financial system. This is not ideal. It's rather wasteful. But it shows the extent to which there are real worries about how to get certain firms' capital, the banking system can't solve these problems. And as a result, the government often gets very creative. Now, why did you not see an uptick in the numbers for shadow banking? Well, that's a good question. One of the reasons might have been that all the high-ranking officials, including

Starting point is 00:39:45 Xi Jinping and China for the preceding several years, had talked about how they had wiped away shadow banking. And so it may have been very politically difficult to announce that, hey, now we're suddenly relying on it. In any case, we saw this resurgence of shadow banking. It did boost the numbers, growth numbers and other numbers across the economy more than the expected. But the downside of that is by the end of the year, even with the surge in loans from the banking system, and even with the resurgence of shadow finance, and even with historically high bond issuance, the economy was still slowing down. So even though 2019 saw a dramatic increase in credit provision across the economy, most of this unannounced, still saw the economy not able to stabilize but continuing to slow. And that was a big worry.

Starting point is 00:40:29 It's one of the reasons the Chinese came back to the negotiating table in the trade war, and it's one of the reasons why there's more concerted effort to deal with the economy going forward. So Leland, China's economy has rapidly changed over the past few decades. And at this state, the world's perception of China has changed, and perhaps even more importantly, China's self-perception have changed dramatically. looking away from geopolitics, if that's even possible to do that because it's all interconnected. What are the implications for the global financial markets that China is now the second biggest economy in the world? And most people would say faster than everyone else at the top.

Starting point is 00:41:12 China is this land of opportunity, but it's also the land of missed opportunity. We're in a low rate world, getting lower and lower and lower and lower. And the attractiveness, even of risky Chinese investments, will increase if you've got yielding investments in China that relatively strong yields compared to the rest of the world. So there's this wonderful opportunity that China has to reinvigorate its financial system by opening up and allowing foreign capital in and not having to pay too high rates for it because the rest of the world is close to zero or at zero, below zero. So on the one hand, you've got this enormous opportunity. And financial firms are just trying to get into China and take advantage relatively on tab market. On the other hand, you've got a political system that doesn't want to relinquish control. And as a result, the idea of throwing billions or tens of billions or hundreds of billions into Chinese markets is a very risky proposition because you don't know when you can get your money out.

Starting point is 00:42:05 You don't know whether it's going to be treated fairly while you're there. Don't know it's going to be not going to be disadvantaged against domestic actors. And as a result, you have this very murky prognosis on the future of the future of, you're going to be disadvantaged against domestic actors. And as a result, you have this very burky prognosis on the future of investment in China. Every financial firm is trying to get into China. Every company, every financial firm is talking about how they want to expand in China. But at the same time, they realize that without the rules changing and Beijing's position changing on some of these things, it's going to be a losing proposition. Interesting.

Starting point is 00:42:34 So, Lili, we primarily have equity investors in our audience. What is your number one advice for us who are interested in investing in China for those of us who do look at it as the land of opportunities? I would say don't believe everything you're told. I'm beating this drum a lot and I'm going to continue to beat it. Sometimes conditions are much worse than what's announced. But on the other hand, you've got the opposite problem too. Because nobody trusts what's happening inside the Chinese economy in terms of data and they don't trust Beijing's pronouncements, but sometimes you have overreactions. If you look back at the summer 2015, it was one of the most interesting because we watched the market get increasingly brazzled over development. First, the Chinese stock market crashed. Second, manufacturing index crashed.

Starting point is 00:43:20 And strike three later that summer was when their Chinese depreciated the currency just a bit. And everyone thought this was the beginning of currency wars and a major devaluation. In a strike one, strike two, strike three, everyone went into a panic. People got defensive. They started pulling their money from China. had one of the more serious prices in the last decade inside the Chinese economy. What was so interesting then was that we weren't seeing any of it in our data. Well, in 2015, it was actually the opposite problem.

Starting point is 00:43:47 Markets were scared to death that something terrible was having in China. We were actually cracking open our data, not just for that month, not just for that week, but day by day. And we were seeing numbers that came in that weren't problematic. The economy was slowing a bit, but it was slowing very similar to what it did the quarter before and a quarter before that. And so what was very interesting is that reliance on trust in the Chinese government message had fallen to such a low point that people were trusting these anecdotal evidence of problems, stock market problems or manufacturing index law or what they thought was a currency devaluation rather than any data in China. And as a result, markets went down 20, 30%.

Starting point is 00:44:28 We called it one of the best buying opportunities we've seen the last 10 years. And the problem is this, that China has this wonderful opportunity, but again, very difficult to trust Beijing's message because they have a vested interest in selling the stability narrative. And as a result, people miss out on the upside. They miss out on the downside. And it's a real problem that people don't trust the data inside China. They don't trust Beijing's pronouncements. And as a result, you often seem financial actors just scrambling to figure out what's going on. I would like to sort of turn the tables and then ask, is there a premium to be gained in the Chinese stock market or part of the market because of this? Since everyone knows it's fake data,

Starting point is 00:45:11 a lot of people are scared for entering, is there such a thing as the bold and perhaps the stupid also, but perhaps the bold have an advantage of a premium to be gained because of that general perception? Yeah, look, there are hedge funds that do very, very well vesting in the Chinese marketplace. Most of them are Chinese and have an advantage, an informational advantage for one way or another. But if you think you're one of them, you better be sure you're one of them. Because it's very hard to get true insights into what the government's thinking. And the reality is that the A share market is guided not by fundamentals, not even by macro factors,

Starting point is 00:45:49 but based on what government policy is at any given time or what the government wants a signal. There are not that many things you can invest in in China. You can invest in equities, you can invest in bonds, you can invest in property, you can invest in commodities or commodity futures. You can put your money under your bet, but they're not that many options. When government signals that it wants to either steer capital towards a particular area, say the bond market or equities or property or pull money away from an overheated property sector, that will guide the directionality of the A share market more than any other factor in the entire universe.

Starting point is 00:46:24 So there are ways of figuring out where to invest based on the right factors, which are where government is looking, where government is suggesting people look. However, it's very difficult to get ahead of the curve on this if you're not a very connected Chinese firm with very good governmental connections. So absolutely, there are ways to make money in Chinese stock market. Leland, thank you so much for coming here on The Investors podcast and share your knowledge about China and the Chinese economy. That's been absolutely amazing.

Starting point is 00:46:58 We definitely want to give you the opportunity to talk more about, you know, where can people learn more about you, China, Facebook International, and some of the reports that you send out. Certainly, China-Bashebrook on Twitter. We're very active on LinkedIn as well. Let's just say that early going, you spent a lot of time working underneath. the radar, vising firms and how to operate, explaining to everyone. Here's what you need to know about China. Here's what we're seeing in China.

Starting point is 00:47:23 And here's how to stay at a big time danger. Definitely noted on that. We'll make sure to link to all of that in the show notes. Leighton again, thank you so much for taking time out of the business schedule. I speak with Preston and me here today on the Investors Podcast. My pleasure. Thank you for listening to TIP. To access our show notes, courses or forums, go to the Investorspodcast.

Starting point is 00:47:46 This show is for entertainment purposes only. Before making any decisions, consult a professional. This show is copyrighted by the Investors Podcast Network. Written permissions must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP292: Understanding the Chinese Economy w/ Leland Miller (Business Podcast)

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