David (1:02 – 22:56): Hi, I'm David Richter, Asia sovereign strategist for MetLife Investment Management based in Tokyo. We recently held our annual China Deep Dive conference entitled “U.S. China 2033: Distilling the Scenarios Ahead”, in which we invited leading experts to help address the key question of where the U.S. China relationship is headed over the next decade. To do this, former White House adviser and Georgetown University professor Evan Medeiros kicked off the conference with a brainstorming session and ran through a series of five scenarios, so called empathy to enmities scenarios that might possibly unfold for the U.S. China relationship over the next decade.
In Evans view, the U.S. China relationship today is incredibly fraught and difficult and is experiencing a long-term structural decline. The two countries are locked into a strategic and ideological competition and both sides know this, even if the Chinese doesn’t acknowledge it publicly. China's worried about the intensity of economic and tech competition constraining its domestic development, while the US is worried about competition that leads to a military accident or miscalculation. Both wants stability, but for different reasons. Evan believes that U.S. China relations today are in the early stages of a long process of negotiating implicitly the terms of their strategic competition and the boundaries of that competition. The current high-level dialogue that we're seeing attest to a mutual desire for stability, again, each for different reasons. But this is only a cyclical near term trend. We should have no illusions that the perceptions, the policies, and the behaviors on both sides are being driven by a broad spectrum of competition, where interests diverge more than they converge on an array of issues, whether economics, military technology, or ideology. What’d being debated, i.e., the various scenarios that could unfold over the coming decade, is about the scope, the pace, and the intensity of this divergent process, and how well that it can or cannot be managed.
According to Evan, there's a broad range of scenarios that could play out over the next decade, but he offered five: the status quo scenario, two that are more benign and two downside scenarios. His status quo scenario, U.S. China competitive coexistence, which is by now familiar, consists of constant tensions over security, economic, technology and ideology, with Taiwan acting as a constant irritant with repeated cycles in the relationship with lots of ups and downs as well as episodic communications and cooperation. Lots of starts and stops and substantial economic and technological de-risking. His two more benign scenarios for the next decade, consist of a U.S. China condominium, or bipolar world in which the U.S. and China define the terms of global politics, where there's broad convergence and interest, especially on global challenges, but were irritants in the relationship are substantially diminished, and the Taiwan issue is in a stable political framework, if not resolved.
The other benign scenario, U.S. China détente, consists of a relationship that settles into a predictable pattern of competition and cooperation. Security competition is bounded by communication, confidence building measures and arms control. There's also consistent cooperation on a variety of global challenges in this scenario where economic and technological exchange remains substantial but bounded and a source of common interest. Two downside scenarios for the next decade consists of a US China emerging rivalry scenario where security competition in Asia heats up with respect to Taiwan, South and East China Seas or Korea, where there's constant risk of conflict, intended or accidental, due to a lack of constraints and guardrails where ideological competition accelerates and shrinks space for dialogue and cooperation and where economic and tech decoupling also accelerate.
Finally, a U.S. China cold war scenario, consisting of a security crisis or limited conflict, sending us China relations into a spiral of hostility and enmity. Japan and Australia fortify to contain China militarily. The US undertakes a major defense buildup in Asia, and the quad becomes more NATO like. We see substantial economic and tech decoupling, and full-on ideological competition. A further extension of this scenario is what Evans calls a global Cold War where China and Russia align with North Korea and Iran against the US and the global West in a sort of 1950s Redux.
Now, having gone through Evans various potential scenarios, which is the likeliest to materialize over the coming decade? To try and answer that question, we picked up from where we ended last year's conference, borrowing the Honorable Kevin Rudd's recommended approach, as laid out in his keynote session, which is to focus on five key variables and factors that will drive the relationship over the coming decade, four of which are China driven China's growth model, it's challenging demographics, tech competitiveness and foreign policy and a fifth scenario, US policy toward China.
To assess that first China scenario, its economic growth model, we turn to Nicholas Lardy from the Peterson Institute. Nick believes that the current growth model has essentially run out of steam, and although there's still ample growth potential for China, it can only be harnessed with the right policy priorities and more reforms. China's investment intensive model has led to slowing growth, with investment as a share of the economy remaining very high, more than in any other country at around 40% of GDP. Moreover, returns have declined. Look no further than China's state-owned enterprises to see that return on assets have halved to around 2% in the current decade versus 4% in the last. Ultimately, consumption will have to play a greater offsetting role in generating growth, but that will occur only gradually over time. Based on current trends, Nick believes that China's average potential growth in the next decade is about 4%, although 6% could be achieved with the right policy priorities and reforms.
Given the state's key role in the economy, Government policy makes a big difference in China, as we've seen with the policy induced property slowdown over the last couple of years. Now in terms of policy priorities, Nick believes there are three that would help China reach its higher growth potential. The first would be more pro-growth policies. The second would be policies that prioritize private over public investment. And lastly, policies that could ease geopolitical tension. All appear to be a low probability at present. On reform specifically, although most low hanging fruit have been picked, more SOE reforms would be helpful but are unlikely as a public sector remains a key source of control for Beijing. So for all these reasons, 4% average growth is Nick’s next baseline for the next decade, although for the record, he sees little evidence of balance sheet recession playing out ala Japan over this timeframe.
To assess the second China variable, its demographic challenges, we turn to Arthur Kroeber from Gavekal economics. Although China is facing huge demographic challenges with its low birth rate and aging population and a less educated and skilled workforce, Arthur believes that demography is not destiny, and that China's demographic challenges are overstated, particularly for the next decade. He believes policies rather than demographics have been the main reason for China's ongoing growth slowdown, and that China still has a large urban labor force that can be relied upon to offset its national demographic challenges in the coming decade. He also believes that over the longer term, good policies can offset demographic decline and sustained potential growth at around 5%. Such policies would need to promote a more educated and skilled labor force for example, to increase high school and university education as well as to raise the retirement age all of which would be more effective than scrapping the one child policy drawing from the experience of other countries. And so overall, demographic challenges don't appear to be a major factor for the next decade. But Arthur believes China needs to roll out good policies to address the longer-term growth headwinds that will come with this demographic decline.
To assess China's third variable, its tech competitiveness, we turn to Andrew Mok Senior Research Fellow at the Center for China and Globalization in Beijing. Chris Thomas, Founder of Integrated Insights also in Beijing, and Paul Triolo, from Albright Stonebridge to shed their various views on this complex topic.
First, it's a foregone conclusion that the U.S. and China want to reduce reliance on each other and become more technologically independent. Both sides have implemented policies that support local companies but punish foreign competitors. Both sides have also pushed for decoupling in different ways. Beijing advocates more direct government involvement in company leadership, while Washington controls the actions of not just its own domestic firms but foreign firms as well. And so over the next decade, it's fair to assume that two mostly separate supply chains will materialize with firms splitting operations to compete in both. Now with that as a backdrop, Andrew believes that China's competitive edge will ultimately prevail, given its whole of government push on science and tech, which will drive R&D investment. China continues to lead the world and patent filings and the publishing of scientific papers and having had prior successes in large scale tech development programs, Andrew believes China's centralized system will generate significant capital and resources for investment in the chip sector.
Decision making will be more streamlined, and its culturally unified approach will create a cohesive national strategy to further enhance its tech competitiveness. As computing power is the first domino in this competition, Andrew believes China has multiple paths to success. The first is to establish a self-reliance semiconductor ecosystem by investing in R&D and manufacturing facilities reducing its reliance on foreign tech. The second is to form strategic partnerships with key manufacturers and leverage economic and political clout to challenge US imposed restrictions. The final path to success, includes China's breakthroughs in non-silicon technologies or next generation chips, sort of related tech such as, memory and photonic chip technology.
On the other hand, Chris Thomas was more cautious on China's prospects over the coming decade. Chris thinks the U.S. will succeed because of a combination of R&D investment and its access to an ecosystem that supports both scale and profitability. The U.S. will also continue to attract the top technical talent and employ the most capital for investment. Also, market forces and profit potential will play key roles in the U.S.’s success. The profit pool and countries aligned with the US is much greater than for countries aligned with China, Russia, Iran etc. Chris also says that the global chip market will not be won with superior end to end components, but with a superior supporting ecosystem that facilitates efficient connections within broader tech systems. In this regard, the U.S. leads in cloud infrastructure and software advancement, making an ecosystem more efficient, and allows for operating at a larger scale.
Chris believes that China faces multiple competitive challenges from the U.S. Chips Act as well as some restrictions on advanced technology being sent to China and that China will struggle to gain Cloud customers that are predominantly linked to the US. He also believes that China lacks a true AI business model and requires enormous subsidies just to catch up with U.S. R&D spending. He also thinks that a government owned industry may be challenged to create products that meet market demands, which would suggest that the U.S. will continue to lead China in the commercialization of new technology breakthroughs. The only entity that can fund a large-scale semiconductor industry in China is the Chinese government, but a state-owned chip business would probably struggle to accurately balance demand in a deeply complicated market with government financing. In other words, China having cheaper chips doesn't exactly equate to selling more chips. While the U.S. has domination of the computing cloud market stands is a big advantage and being able to sell its chips as global capacity increases.
Finally on AI, more specifically, Paul Triolo discussed the intensifying competitive landscape playing out within this very complex and politically sensitive segment of the tech industry. Paul stated that U.S. export controls of advanced chips, due to concerns over national and cybersecurity threats of China have been the preferred method of dampening AI competition with China, but that these restrictions are not all encompassing, and there are other pathways for China to gain ground in the competitive AI landscape. Meanwhile, the US has encouraged its allies to impose similar restrictions, which has been controversial and as further complicated its global relationships. U.S. restrictions have also incentivized China to research and innovate domestically, and to reduce reliance on foreign suppliers of critical components, which will likely accelerate its AI capabilities over time.
Finally, he says that US restrictions on companies like Nvidia have resulted in the production of chips just below violation thresholds, so they can still be sold to Chinese markets. All of which points to a still uncertain competitive landscape for this key segment. So, on this critical variable, China's tech competitiveness, our experts had diverging views on whether China can prevail over the US in the coming decade. That said they all agreed that it's highly unlikely that either country can win this competition by doing everything better than the other and that both the U.S. and China will be responsible for core innovations in global technology, as well as the commercialization and manufacturing of those technologies in the years to come.
For the fourth China variable, China's foreign policy, we turned to Agatha Kratz from the Rhodium Group. Agatha assumes China's assertive foreign policy will persist in various forms over the coming decade, principally via its active diplomacy to promote alternative international norms and institutions, its courtship of alliances in the so-called Global South, and more confrontational stance in hotspots like the South and East China Seas, and closer economic and military cooperation with U.S. adversaries such as Russia, Iran, and Venezuela. Agatha’s baseline at least from the European angle was that such frictions won't necessarily lead to more U.S. EU alignment in their approach to China. She believes that U.S. EU policies on China continue to lack harmonization, despite on the surface seemingly going in the same direction, but that improved coordination could be triggered by China becoming a greater political, rather than economic concern for Europe.
For example, if it became more active in conflict zones, like what we're seeing in Ukraine or being seen as the cause for job losses and erosion of Europe's industrial base. Agatha also believes there will be greater competition for the attention and alliances of the Global South, where China can mobilize financial resources to a greater degree than the EU, for example.
A separate but related subtext here is Taiwan. Reva Goujon also from the Rhodium Group suggested that we are already moving up the escalation ladder, and there are substantial economic disruptions that can occur below the threshold of hot conflict. Incremental steps can lead to big change over time, as Beijing seeks to redefine the status quo and its near abroad. This doesn't mean a worst-case scenario is inevitable, but it does take rigorous and holistic analysis to understand how China's macro-economic pressures, external tech controls and security frictions over Taiwan and the South China Sea come together to produce distinct scenario outcomes. Across-straits military conflict over the next decade was deemed a relatively low probability, although Taiwan related tensions will remain a key source of friction for the U.S China relationship, as well as a potential source of accidents and miscalculations, leading to significant headline risk and periods of China-induced economic disruption for Taiwan.
For our fifth and final variable, U.S. policy toward China, we turn to Rick Waters, Head of Eurasia Group's China Practice and Bonnie Glaser, Managing Director of the Indo Pacific Program at the German Marshall Fund. Their baseline is that the U.S. policy posture will also remain assertive over the coming decade, and that the US China relationship will harden in a variety of domains, including national and regional security, technology, economics and trade, intelligence and law enforcement, and ideological competition. On national security, the U.S. will remain focused on strengthening its defense innovation base, on economics and trade, and there is a fundamental question of whether a $700 billion U.S. China bilateral trading relationship and the interdependence that it entails is, in and of itself, a risk. And there's likely to be a political impulse over the coming decades to shrink trade to some degree via moral suasion. On technology, the foundational technologies that are essential to both U.S. competitiveness and to U.S. military strength, will be subject to greater protection by a multitude of tools, not just export controls. And finally, on intelligence and law enforcement, Rick believes that a Cold War already exists between the security law enforcement and intelligence apparatuses in China and in the U.S., and that competition will intensify over the next five to 10 years. This is an area that dominates senior level U.S. policymaker’s bandwidth, which is not well known outside the system.
An alternative view for U.S. policy toward China was also offered by Barney Glaser, where the U.S. returns to a strategy of prioritizing bilateral diplomacy and negotiations with China to address American concerns, which would essentially moderate restrictions on technology transfer, or anti-China coalition's such as the quad and office. However, this would only materialize if the U.S. was convinced that China no longer had both the ambition and the capability to revise the international order in ways that are harmful for it and its partners, which is currently not the base case.
And so to conclude, having looked at the four China variables and U.S. policy toward China, what's the likely scenario for the US China relationship over the coming decade? It appears that China is headed for a decade of lower but relatively stable growth, with demographics representing more of a longer-term challenge. On the tech front, the US will remain a formidable competitor for China, but our speakers agreed that neither country can do everything better than the other over the coming decade. On foreign policy, both China and the US will maintain their assertiveness, but we can't assume that China's assertiveness on the global stage will strengthen U.S. alliances against it. On Taiwan, incremental steps by Beijing can lead to big change over time, but this doesn't suggest that worst case scenarios are inevitable over the coming decade.
With all five variables considered, it would seem that Evans status quo scenario of US China competitive coexistence is the more likely scenario for the coming decade. Again, one of recurring tensions over security, economics, technology and ideology, with Taiwan acting as a constant irritant, repeated cycles and relations, lots of ups and downs, episodic communication and cooperation, lots of starts and stops, and substantial economic and technological de-risking. Essentially more of the same. However, there would be clear risk to the downside with a second Trump presidency with Evans so called U.S. China emerging rivalry being the more likely scenario, where security competition in Asia heated up, where ideological competition accelerated, shrinking the space for dialogue and cooperation and where economic and tech decoupling would gain much stronger traction. Now in terms of what all this might mean for our markets, and portfolio positioning, let me hand it over to Todd Howard, Portfolio Manager for emerging market debt and multisector and Dominic Guillossou, Portfolio Manager for emerging market corporates. Thank you for your attention.
Dominic Gillossou (22:57 – 27:04): Thanks, David.
In terms of what we heard from our speakers during this year's trying to deep dive that David just outlined, I believe the impact on the emerging markets corporate space will be one of continued and increased caution on Chinese corporates given the challenging environment. To be clear, this does not mean that China's un-investable, but rather the risk of investing in China has increased, while valuations in most cases have not kept pace, and consequently investors have reduced exposure.
This trend of reducing exposure to China is not only being felt within the corporate emerging market space, but also within the JP Morgan Asian credit index where investors are seeking an alternative with less emphasis on China and more on Japan and Australia.
I do acknowledge the level of negative sentiment surrounding China may be an opportunity, but I do not believe current valuations reflect these risks in most cases. Furthermore, it appears unlikely there will be a fundamental shift in policy anytime soon. However, it's equally important to note that this is not all bad news for the asset class, as the shift in capital and trade flows will undoubtedly create opportunities for corporates and different jurisdictions, thereby reducing both systemic and idiosyncratic risk for investors.
The cautious tone of investing in Chinese corporates is being driven by policies that have had a negative impact on the macro, private sector, and geopolitics. These policies can be categorized in three key areas that include political, economic, and foreign policy. Throughout the China Deep Dive, we heard more than once that a change in policy direction could provide an off ramp for China resulting in a more favorable economic outcome. However, as outlined by the speakers, it is increasingly difficult to see how this transpires given the current centralized and state led policymaking approach, which has had a negative impact on both the macro and private sector. This is evidenced by the growth of the public sector through state owned enterprises resulting in reduced efficiency, productivity, and innovation. That in turn has had a negative impact on the economy and thereby growth. Also noteworthy is that those private sector companies in the technology, education, gaming, property, and banking sectors have been heavily leaned-on to conform by the central government and has also weighed heavily on the economy.
Finally, the risk of heightened geopolitical tensions with the U.S. to a lesser extent the EU, resulting in some companies being sanctioned, or other associated risks, cannot be minimized or ruled out. The challenging investing environment in China is not all bad news for emerging market corporates by creating opportunities across different jurisdictions and thereby reducing systemic risk. As capital in manufacturing is reallocated out of China, corporates and other jurisdictions that may have once been crowded out, may now find themselves in a more favorable position, reducing idiosyncratic risk for investors, while at the same time providing additional geographic diversification. Those companies that stand to likely benefit from such a shift include such countries as Vietnam, India, Indonesia, Philippines, and Mexico.
In closing, all of this policy uncertainty impacting the macro private sector in geopolitics, makes investing in Chinese corporates challenging, especially as valuations have not kept pace, with some exceptions. This is why I believe the impact on the emerging market corporate space will be one of continued and increased caution on Chinese corporates until such a time as a fundamental shift in policy, or assets reprice to better reflect the risk. Again, this does not mean China's un-investable as there are some private, semiprivate, and state-owned enterprises that provide a more balanced risk reward profile.Overall, this is not all bad news for the asset class, as it will create opportunities in different countries and corporates. And with that, I will pass it over to my colleague Todd Howard.
Todd Howard (27:05 -30:50): Hello, my name is Todd Howard. And like Dominic, I'm one of the portfolio managers on the MetLife emerging market debt team. Whereas Dominic focuses more on corporates, I work with our team focused on sovereign and local markets and currency ideas. Fittingly, I happen to be in Hong Kong visiting with our Asia sovereign credit team, as I record this message about how we’re positioned in China.
My comments will be relatively brief, as I do not want to reiterate too much of what has already been discussed. I do agree with Dominic on all of his points, and I'll say what he said in a slightly different way, but to re-emphasize our main point. I think that where there's apparently value, there was too much uncertainty or unpredictability and where there is no uncertainty there is little to no value. So, it's tough sledding from an idea generation, as well as a conviction standpoint.
As it relates to sovereign, quasi-sovereign and local assets in China, and in the region, most of these assets fall squarely in the latter camp, whereas they are less impacted by uncertainty, and as a result, the value is not overly compelling. In sovereign and quasi-sovereign space, there is a plethora of dollar paper to consider across a variety of sectors and across the maturity spectrum and in almost all cases, we find paper offered from other countries and other regions of the world to offer better value. So again, given the geopolitical risks and economic challenges facing China, we would want to see a less expensive relationship between China and other similarly rated credits for us to be more meaningfully involved.
With respect to local assets, China government bonds, China has always been an outlier. There are plenty of higher yielding and much more volatile countries to choose within the local universe. However, China's local debt and currency behaves very different than the rest of the benchmark. In other words, it's very low beta. And as a result, it can be used as a defensive asset during times of market volatility.
Our local process always thinks of real rates first, assuming the monetary process is credible with a commitment to price stability. Under that lens China, like many other high-quality issuers in Asia, have relatively high real rates today, given that inflation has been running near zero. However, forward looking real rates are some of the lowest in investment universe. Just as an example, China's tenure real rate today is running near 3%, but by next year, due to inflation increasing, will be closer to 1%.
Indonesia on the other hand, our biggest overweight in the region, has real rates today around 3.8% and forward-looking real rates around 3.7%. So, if you compare that 3.7% next year to China's 1%, it's a pretty easy decision to be overweight one versus the other. Just when looking at real rates, other factors are important to consider, but that one alone stands out as a very compelling difference, As you've heard from Dominique and myself, our portfolios for the time being are significantly underweight China risk, but we're not under engaged, as evidenced by our continued emphasis on China Deep Dive, given the potential opportunities in China, as well as China's impact on the entire market.
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