China: Are Deflationary Policy Tools Coming?

Modern social democracies are supposed to choose inflation over deflation every time. Equally intriguing is the consensus in modern economic literature put forward by researchers such as Ben Bernanke that because of the inelasticity of nominal wages, falling aggregate demand “only” shows up in increasing unemployment rather than in decreasing per-employee pay.

I am not sure I am allowed to disagree with either of these contentions, but I do.

Fork in the Road

Someone probably said that history is the graveyard of dogma, but alternatively, history is what happens between model periods. The reason I mention this is that we might be at a fork in the road.

I have carefully pointed out tensions in Chinese monetary policy for a very long time now (read here and here). Given a problem of excessive credit, the Chinese authorities – should they wish to direct the situation – have a number of (relatively) mutually exclusive policy responses with no Pareto Optimal outcome. These include:

  • Imposing capital controls,
  • Devaluing the exchange rate, or
  • Hiking interest rates.

Another option could include muddling through with a stop-start combination of all three of the above.

These ideas are now well-covered and stated in the mainstream, although they weren’t when I first began to articulate them. To this, I would add my tentative but growing understanding that the Chinese leadership has a hierarchy of priorities. This starts with avoiding regime change, but does not under all circumstances prioritise social welfare next, ahead of communist morality. The recent decision to lock down celebrity-endorsement sites on social media is an example of this.

More Draconian Policy to Come?

The danger lies in the leadership’s belief that the Long March and the Cultural Revolution were good for Mao’s grip on power (whatever the consequences for the country). For this reason, we should consider the likelihood of the greater use of more deflationary or draconian policy tools.

Our growing confidence in this relatively unexpected outcome stems partly from recent events in a similar type of country. In 2015, Russia went through horrific deflation, in which monthly real annualised wage deflation was often over 10%. This happened whilst the country was essentially still at maximum employment (<6% unemployment).

This was not all down to the oil price, as real interest rates were kept high by the new central bank governor in order to target inflation. (Dismissing this case on the basis that Russia is not a “democracy” is probably missing the point.) Some of the most significant rules of normal economic management would seemed to have been broken.

Still Positive on Emerging Markets

Overall, we are still sanguine about the progress of markets. Except perhaps for technology stocks, we have not gone through a state of frenzied optimism. In addition, if indeed monetary contraction has started, it will take a rainy day for investors to notice. This is because the aggregate equity capital position still seems relatively large compared to the assets being funded. China’s monetary situation is precarious and insolvent, but for the time being cohesive enough to avoid a run on the system.


Portfolio Update

Dovetailing with last month’s letter, one of the latest additions to the portfolio is AKR Corporindo. The company is the largest private fuel and chemical distributor in Indonesia aside from the state-owned company Petronas. We like the pseudo-monopoly position they have in this market. In addition, except for regulation, we feel it has a much stronger, less volatile position in its physical market than say, Tencent has in social media. As a result, the elevated (20x P/E) multiple is not excessive. Having followed its expansion for many years now, we have grown comfortable with its industrial land development strategy. While it is certainly non-core to the existing business, it uses some of the related expertise built up over the years.



This commentary was provided by the portfolio manager responsible for the management of the Redwood Emerging Markets Dividend Fund. Any securities mentioned may or may not be held by the Fund. In addition the Fund may sell these securities at any time or purchase securities that have previously been sold. Nothing in any commentary should be considered a recommendation to buy or sell a particular security.

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