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Investing and State-Sponsored Capitalism

We live in an age of state-sponsored capitalism. The massive capital flows into emerging markets in this age rest on very uncertain political foundations. It makes sense to take advantage of the growth prospects in emerging financial markets, but the politics makes it necessary to have a mechanism to anticipate changes in the political posture of a country. The mechanism? Bank debt. Dont invest in EM equities without watcing bank debt.

So what is state-sponsored capitalism?

It is a system where the state is not only a principal actor and arbiter of the economy—all states do this. It is a system where the state goes further: it manipulates market outcomes for explicit political purposes. It does this by driving investment decisions: it tells the banking sector what to do. It also sets the rules in an arbitrary way. This puts vast resources in the hands of state officials who spend billions baling out and protecting vulnerable domestic industries and oligarchs.

They aren’t doing this because they are trying to help domestic economies. They do it because they serve and protect the most powerful interest groups and oligarchs in exchange for tribute. They favor local companies at the expense of foreign competitors. They favor established businesses over risky new ventures. They favor getting rich through the political process rather than through enterprise.

State sponsored capitalism is the opposite of openness. It hampers the flow of people, money, ideas, and initiative. It entrenched itself in the aftermath of the recent economic crisis. Faith in free enterprise was shaken by it, as state-sponsored intervention in the developed world undermined the prevailing narrative in place since the Berlin Wall fell. It remains true that government-engineered interventions cannot outperform markets, but no matter. The obvious hypocrisy created an opening for cold-eyed tyrants in Russia and elsewhere. They have not looked back since.

China is the more interesting case. China was a highly regimented, collectivized state under Mao. Subsequent de-control of Chinese life by Deng Xiaoping led to an explosion of commercial energy. This energy was tapped and shaped by leaders like Zhu Rongji. This energy was the seed. Capital and financing was the needed soil in this still-poor country. So the government granted foreign corporations free entry.

China doesn’t need foreign capital anymore. They need foreign technology. Providing this is bad for business, so foreign companies are loathe to do it. China sketched the handwriting on the wall in dealing with Google. Google didn’t do well in China because state-sponsored capitalism dictated that Baidu would not only be supported, but any competitor would be actively blocked. Online retailing is no different. Ali Baba is the designated princeling of the Chinese internet.

So you now have a politically authoritarian, patronage-heavy economic system with multinational corporations still driven by explicit government directed credit flows. These companies have potential for massive productivity gains provided that the country lightens up further on the controls and ensures that everyone plays by the same rules (reduces corruption). All this is situated in a country of only children that will get old at a historically unprecedented rate. And you can’t have a Facebook account or do decent a Google search.

At the same time, you had the United States, a politically open, militarized state that had a technological edge but not a productivity advantage at least on a cost basis. So huge sectors of industry lost market share, businesses, and ran up gigantic debt due to entitlement spending plus huge trade deficits. Global risk premia recovered from the depressed levels immediately following the fall of the Berlin Wall due to myriad factors. The economic realities of entitlement spending and trade deficits kicked in. These countries found themselves dependent on a broken financial system that was unable to extend credit largely without central bank provided subsidies. They are just as demographically challenged as China and have a completely unstable social contract between the moderately wealthy and everyone else, and also between the young and the old. You can’t post on Facebook, send an email, or do a google search without the United States government possibly knowing about the content.

So it looks like a planetary convergence trade. One could argue that China is becoming a nation of free enterprise, and the United States is becoming more politically authoritarian. Beyond surface looks, change has only gone so deep in China. In fact, credit tells me the changes are largely cosmetic at this point. China has equity and debt markets and production exported all over the world. But it also has very little meaningful ability to price risk.

The best place to assess risk just happens to be where the biggest change in China has occurred: debt. Debt accumulation, that is. Local currency bond issuance increased from CNY 7 trillion in 2007 to CNY 25 trillion in early 2015. The credit market has done more than grow in size. It has evolved. About 35% of the market is corporate debt, split pretty evenly between financial and industrial issuance.

Note that this evolution has only gone so far. Both banks and industrials remain largely state-owned affairs. So you can think of the Mainland Chinese credit market as distinct credits, but a majority of it is influenced by some degree of sovereign backstop. It is unclear how deep and persistent this implicit backstop is, and as a result assessment of credit risk is interconnected and difficult to isolate. Untangling it is nearly impossible, and if macroeconomic problems present themselves, political factors will likely dominate the issue.

See how correlated the whole complex is.

You see yield spreads across the complex that you will see just about anywhere. The sovereign is the benchmark, provincial debt holds tightly to it, and there is a meaningful spread between these government instruments and corporate names. Financials are situated more cheaply than everything else. In fact, financial spreads are an indication of how little things have changed in China, and also the truest measure of real macro-risk levels in China.

Chinese bank bonds trade cheap to industrials because the government forces banks to write down their loan books when inefficient industries approach insolvency. There is no real option to exercise any wind-up rights. Bank book-running function extends to guaranteeing the debt and being the bag-holders for insolvent industrials going BK. It’s typical state-sponsored thinking: full employment over efficiency, unproductivity over wealth creation. You see this in Beijing as much as Obama's White House.

Banks are the best way to gauge macro-risk in a state-sponsored capitalist regime. Not only are they the risk absorbers for every modern economy (as they are everywhere), they also take it on the chin because of political dictates. Currently financial bond yields are cheap to valuation model, but within a trend of receding risk perception. The model strips out bank-idiosyncratic market emotions from valuation.

Market emotions drive the short-term. Financial bond action gauges the extent of Chinese macroeconomic trouble, which will impact risk assets globally.

I’ve made clear enough in prior posts my view that China is headed for an epic, epic debt crisis and there is no alternative to a hard landing. This is a bitter cocktail, and it comes to the table on the verge of China entering an unprecedented demographic collapse. Thanks one-child policy.

Bank bonds are the best signal of when to get out.

Forget trying to hedge an equity portfolio, much less debt. The illiquidity and lack of tools will kill you for even trying.

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