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There are good reasons to imagine that when the epidemic is over, President Xi will liberalize China’s economy to restore economic growth. This is a time to hang tough and even buy the dip.
——Marvin Zonis

China will Liberalize Its Economy After The Corona Virus Epidemic

By Francis Bassolino

The Chinese lunar new year calendar runs in 12-year cycles with each year represented by an animal and an element with 2020 the year of the Metal Rat. In China rats are considered survivors. Resourceful wit endears them to many where this low-brow character sits atop the Chinese zodiac. In the West, mythologies and folklore endow rats with superior senses. When they leave a ship, it is time to go! Facing an epidemic of seemingly thermonuclear proportions many wonder if the gods are telling us it is time to exit China.

We posit that this frenzy is overblown. To the contrary, it is highly likely that after a sharp downturn China will rebound from this crisis with greater rates of growth and a renewed commitment to liberalize its economy.

While the coronavirus may present a grave health threat, it is important to keep things in perspective. This is not the 14th Century when mice traveling along the newly opened Silk Road decimated half of the Eurasian population. Nor is it 1918 when a weak war-torn herd battled the Spanish Flu. Make no mistake—the Wuhan bug will exact a significant toll on China, but it is prudent to maintain a sense of proportion and to act based upon probabilities; not succumb to the fear of the worst-case scenarios.

It is nearly certain that through the first half of 2020 the Chinese economy will post abysmal numbers. The longer-term ramifications of coronavirus, however, will likely have a positive effect on those who maintain focus. Indeed, for those who stay in the game the most pressing problem—beyond staying solvent and sane for the next two quarters—is how to maintain pace with the longer-term opportunities that abound. Savvy actors will buy (and build) on the dip, preparing for all this market continues to offer.

In this chaotic moment filled with the cacophony of newsfeeds written by hacks with an underdeveloped sense of history and mellifluous flair for hyperbole, it is wise to remember Rudyard Kipling’s advice to his son:

If you can keep your head when all about you are losing theirs…yours is the Earth and everything that’s in it.

We continue to have concerns about the rigidity and relative health of China’s institutional infrastructure, but while lower level leaders will face sacrificial demotions to placate the masses no signs have been found portending the collapse of the State. As has been true for the last 30 years, the only ones who seem to gain from the “coming collapse of China” narrative are those seeking media attention or trying to move markets, a la Chanos.

China teems with medium-term potential driven by strong fundamentals including income growth that drives consumption, a robust transition to services as well as the consolidation, growth, and rationalization of the manufacturing base which is undergoing a dramatic reshuffling and transformation.

While services and consumption are the rising stars, manufacturing will continue to play a pivotal role in both China and the global economy. The installed production base—human and physical capital—represents a deep supply chain impossible, and frankly silly, to displace given its ability to continue to add value.

Consolidation and trade dynamics will force manufacturers to modify business models. Some will scale up to world-class leaders while others scale down to high value-added specialists. Some will morph into design, sourcing, and sampling rooms that manage high-volume/low mix production runs in lower cost South-East Asian countries.

Decoupling is an inaccurate, and simplistic, interpretation of events. We are remapping supply chains and resetting the US-China relationship, which will most likely settle into a colder, but more balanced, marriage shortly after the US election.

Much of what passes for “analysis” on China is unimaginative and ill-informed storytelling drawn from second-hand information. Indeed, a lack of accurate intelligence is often a key reason China continues to confound investors and operators, who find it difficult to assess and navigate this expansive dynamic economy. Moreover, even if you can get it, thorough and honest analysis often generates contradictions and conundrums. Facts and trends may generate a story that sounds right but is actually far off the mark.

For example, 2019 was a bad year for the auto industry in aggregate but not for everybody. Passenger vehicle sales dropped by 7.5% from about 23 to 21 million vehicles. This decline was predicable due to the subsidies offered over previous years for electric vehicles and compact cars as this government funding caused front-loading of purchases and distorted trends. Likewise, an ongoing misallocation of cheap capital to vehicle makers, many funded and protected in regional markets, creates further imbalances and actions not driven by economic rationale.

Buried within this macro story of decline, however, is a nuanced story of winners and losers. Auto makers with distinct value propositions are gaining market share while those who peddle subpar vehicles lose. For example, General Motors’ joint venture sales of poor-quality dated models fell by more than 600,000 vehicles, about a 20% decline by volume over 2018.

GM-related ventures account for a stunning 36% of the total fall in vehicle sales in 2019. Ford accounted for another 12% of the total drop as its total sales in China feel to just 200,000 vehicles. Conversely, Honda and Toyota both grew by more than 14% while Benz and BMW expanded by almost 20%. The balance of the sales decline (~1m vehicles) accrued to ~24 other OEs of whom only 10 made more than 500,000 vehicles in 2019, a production level not sustainable in most markets.

Overcapacity, protectionism, and rapid shifts in consumer taste are common themes of “Capitalism with Chinese Characteristics,” a volatile process characterized by a frenetic entrepreneurial zeal, fueled by cheap capital, that creates distressed or stranded assets, low profitability, and sometimes world-class organizations like Huawei.

We are at an inflection point where traditional businesses either grow to a dominant position, shrink into a niche specialist or wither slowly to irrelevance. Not unlike many markets, winners master tools of the digital age to continuously deliver better and differentiated products and services, meeting customers where they are and building companies to serve future demand.

But most importantly, winners have a growth mindset. Psychologist Carol Dwek professed that people with a growth mindset will step toward challenges and welcome mistakes as learning opportunities. (See https://www.youtube.com/watch?v=hiiEeMN7vbQ.)

Two examples of this in China last year were Pernod Ricard and BASF. Leaders at these companies took bold steps to grow in 2019 and beyond. The former by announcing the greenfield launch of China’s first whiskey distillery, and the latter by placing a $10 billion bet that engineering plastics demand will grow. This is true leadership: taking calculated risks and generating smart strategies that build for the future.

Dwek notes that the flipside of growth is a fixed mindset. A good example of this is the CCP’s economic policy, which has fixated on control for the past decade while building a plutocracy of companies beholden to the State, like Alibaba. This cycle of extreme constraint on the most dynamic part of the economy—private entrepreneurs and international companies—has ground the economy to screeching halt. As such, we posit that facing declining growth and the hangover of too many Corona viruses, China’s apparatchiks will turn to privatization and deregulation. This is similar to what followed the Asian Financial Crisis, when China began to offload nonperforming state companies and lay the groundwork for entry into the WTO in 2001.

Liberalization will resolve two problems: meeting the US Administration’s demands for more access to the Chinese economy, and restructuring moribund state-owned enterprises. Lord knows the healthcare sector, dominated by the State, needs upgrading given the travesty and tragedy in Wuhan!

The choreographed pageantry of building hospitals in eight days even managed to impress Trevor Noah, when he praised the Chinese on his show The Daily Show. But pride in mass mobilization efficiency can easily turn to anger as people surmise that the outbreak was exacerbated by structural mismanagement. Attention can and will likely quickly turn to the lingering concerns about a lack of coherent economic policy and the ossified political infrastructure.

As such, our bet is that privatization will be used as both a red herring to draw attention away from incompetence and as a rallying cry, heralding of great change and a call for continued unity. Non-core assets in industries outside of Alcohol, Tobacco and Firearms are the areas to watch, including automotive, chemicals, construction, finance, healthcare and industrial.

A narrative is developing that this may be China’s Chernobyl moment, a point demarcating the beginning of the end of the rein of the Communist Party. And while Chernobyl is one lens through which to refract this event there are distinct differences between China in 2020 and the USSR in 1986. Most notably, the CCP’s legitimacy is based upon the dramatic improvements in wellbeing in China over the past 40 years. This track record will give the CCP a pass for many transgressions, even those as egregious as Wuhan. However, Chernobyl did demonstrate that leaders do not have unlimited latitude for lying and abuse. The CCP is pushing the limits of patience.

China’s growth model was built upon favorable demographics, massive savings rates, and high investment/lending. All three of these engines are sputtering. When they have stalled in the past China has used deregulation to goose the economy. Xi is a student of history and one who has seen firsthand, when he led Zhejiang, just how effective and productive China can be when the State just gets out of the way. Xi has been portrayed as a draconian dictator, a title that is accurate but incomplete. He is disliked by powerful people because he has severely constrained their expropriation and corruption opportunities, including cutting off their “wait and see” game by declaring “I’ll keep this job for life”. Once control was ensured a faint groundswell began to reemerge along with a team of advisors that are trying to come up with what we hope will be Xi’s lasting legacy: Thatcherism with Chinese Characteristics, led by Xi and then transitioned to a new leader.

Because we admit that much could, and may, go wrong we commonly assign in our scenario planning the following probabilities: 49:50:1….with a 49% probability of liberalization over the next few years, 50% chance of foot dragging or muddling through with more of the same, and a less than one percent chance that we return to the dark ages or the cultural revolution version 2.0. For the sharp statisticians in the audience, you will see that we are projecting liberalization of some sectors and lots of muddling though. Which seems to be what politics is all about –  compromise.

Chinese and Western folklore agree that mice visiting your home is a good omen, a sign that wealth will follow. At Alaris we look forward to an era which has the ingredients to repeat another roaring twenties decade, when Shanghai also ruled the East. Prepare your reserve for the occasional exogenous event, aka black swan, but “Keep Calm and Carry On.”

 

Francis Bassolino is the Managing Partner of Alaris, an investment and advisory firm based in Shanghai. He can be reached at Francis_bassolino@alaris.com.cn

P.S. These superstitions were on display in the naming of the hospitals that were just built in Wuhan where fengshui masters chose names to calm the spirits in the city: Thunder God Mountain and Fire God Mountain!

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