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China's Role as King Counterweight Persists - Global Exchanges

FICC Podcasts February 22, 2022
FICC Podcasts February 22, 2022

 

In this week's episode, Stephen Gallo is joined by BMO's Colin Hamilton, for an in-depth discussion of China's role as a global macro counterweight to numerous phenomena which have persisted in the global economy — but externally to China. This 2-year long counterweight dynamic doesn't seem to be in its end stages yet, so this week's episode covers the implications for the foreign exchange markets and specific commodity prices.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Stephen Gallo:

Hi, welcome to Global Exchanges episode number 34. In this week's episode, I will be joined by BMO's Colin Hamilton, for an in depth discussion of China's role as a global macro counterweight to many of the phenomena which have been persisting in the global economy, but mainly externally to China. This two year long counterweight dynamic doesn't seem to be at an end yet. And today we will dive into a few of its implications for the foreign exchange markets and specific commodity prices. The title for this week's episode is China's Role as King Counterweight Persists. Hi, I'm Stephen Gallo, a London based FX strategist. Welcome to Global Exchanges presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's co-host.

Stephen Gallo:

In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:

We strive to make this show as interactive as possible. So don't hesitate to reach out by going to bmocm.com/GlobalExchanges. Thanks for joining us.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Stephen Gallo:

Okay. So as usual to begin the podcast Global Exchanges, I will mark the date. It's February 22nd, 2022. And as mentioned in the introduction, this podcast is going to be focusing on China, but we're also privileged, I think, to be able to bring in a guest this time around, and for the second time, Colin Hamilton will be joining Global Exchanges. Colin is BMO's commodity analysts, and he covers a range of commodity markets. But also importantly, because of its key role in global trade and those markets, he is also one of our in-house experts on China. Colin, welcome to Global Exchanges again.

Colin Hamilton:

Thank you, Stephen. Great to be with you.

Stephen Gallo:

Okay. So Colin, now that I have you here and based on the title of this podcast, the idea of China acting as a global macroeconomic counterweight, for the past one to two years or so, I've been referring to China as something of a counterweight to the rest of the global economy in a macro sense. So for a bit of color for listeners, it initially bounced back from COVID more quickly than the West. It began to withdraw stimulus earlier than the West. It entered its manufacturing stroke/commodity inventory destocking phase and demand slowdown earlier than the West. And it has experienced overall lower consumer price inflation, and now it has slowing producer price inflation while in the West we have the opposite.

Stephen Gallo:

And Chinese policymaker, probably this is the most important thing, Chinese policy makers are going in completely the opposite direction with stimulus to their Western central bank and government counterparts. So as such, I want to get a sense from you on how far disinflationary forces in China can run and how much monetary and fiscal stimulus policy makers will ultimately throw at the problem. Can we expect China's role as a counterweight to Western inflation continue? Or do you think it will start to add to inflation as the stimulus feeds through?

Colin Hamilton:

I think that's a great way of looking at it, Stephen, in terms of the counterweight. As you say, if we were talking about this six months ago, China was entering the energy crisis. Now you could argue that we're entering an energy crisis everywhere else. And China had to change policy pretty quickly to try and alleviate some of the pressures. The same way that the rest of the world may have to do over the coming months. What it meant though, was by pulling back on commodity demand, that's the marginal buyer. And I always view China as the marginal buyer of commodity units, even though it's the biggest beast in the room to a certain extent. When prices get high, the Chinese buyer tends to step back first.

Colin Hamilton:

But through that D stock and through precious in the property market, which I know we'll talk about during this podcast, what we've seen is growth so quicker than Beijing wanted. Now what's actually interesting, what's unusual is that growth rhetoric started to come to, I would say November last year, we started to see more growth rhetoric, but it wasn't really backed up with stimulus. They basically said the usual infrastructure lever, local government please go and do lots of projects, try and get a fiscal impulse coming through.

Stephen Gallo:

Sorry to direct you, but do you think that one of the reasons for that is because of leverage risks in China already preexisting conditions?

Colin Hamilton:

Absolutely, absolutely. Particularly local government level. Often in markets we focus on the corporate level, but at a local government level, there's still a lot of concern there. That's, China's Achilles heel. There's still a lot of uncertainty about local debt. And it's one of the key elements they are trying to eliminate in the five year plan, that's the level of local government debt. But the local governments because they hadn't been selling land to the developers for the past six months they said, "Look, we've got nothing. We cannot do anything." What it means now, we're expecting into the NPC meeting coming up in a couple of weeks time, we will see the PBOC as, as they said themselves, open the monetary toolbox a little bit. They'll have to go a little but unconventional. The question is when will it come through?

Colin Hamilton:

In terms of actual market dynamics, we're assuming it has been more classical fixed asset investment style, perhaps social housing led. But these projects still take, I would say six months to get going. Sentiment is definitely improving ahead of that but in terms of end demand, it may take a little while. Now in terms of it therefore depends where the rest of the world is in the inflation cycle at that point in time. It's very rare for China to actually stimulate when PPI is still running at 9%. We haven't seen this before. I think they'll be trying to target it rather than going broad brush to try and let some of the pressures ease.

Stephen Gallo:

So if we can put this into some kind of visual context for our listeners, if you were to take a look at Chinese producer price inflation right now and overlay it with say, U.S. producer price inflation or German producer price inflation, you would basically see divergence. China edging lower in year over year terms and the year over year growth rate still accelerating perhaps though at a slower rate in the West. So the view you're taking is that the policy makers in China aren't going to be aggressive enough to reverse that. We're still going to see that trend of disinflation persist, but they're going to stimulate enough so that it doesn't collapse.

Colin Hamilton:

That is correct. Yes. What we've seen is what the Chinese government love is stability. And they've stabilized the energy market. So if you think of it, coal pricing has halved from the peak. Now, that's still 50% higher than the government would've liked before the energy crisis. But they've stabilized at that level and that message has got out to the wider. So the immediate disinflation pressure is easing a little bit, but what they're now looking to is keep it at this level rather than necessarily push things higher.

Colin Hamilton:

We've had a lot of them in commodity markets over the past month, a lot of Chinese government job owning effectively to say, "Look, why are we paying so much for R&O? Why don't we bring our buyers together to try and negotiate better prices? Why don't we settle on RMB, all the old classical taxes benefit, which tells me they want to push growth order, but also tells me they are still worried about constraints at the current time. So I don't think they're going to stimulate enough to push inflation higher, but they want to be able to react when inflation in the rest of the world maybe starts to peak.

Stephen Gallo:

Okay. So the description of China as something of a global macro counterweight is not really a bad one, it's still relevant?

Colin Hamilton:

It's still absolutely valid in my reasoning.

Stephen Gallo:

And the other point I want to make as well is that people in the United States, Canada, parts here in Europe, we're familiar with the extent to which Chinese port closures contributed to supply shortages on the good side and more inflation in the West. However, I think it's important to point out that is a function of ultimately a Zero-COVID strategy policy and demand, which is demand hitting and disinflationary. So even though we felt inflationary effects of it, it's still a sign that China is in a modest disinflationary cycle.

Colin Hamilton:

Absolutely. And then the banks will be lending more aggressively. And when the banks lend, what they know to lend into is corporate CapEx. So we will see a lot more corporate CapEx coming through. The port closures are really an interesting one because the way I look at it and the rest of the world, you have to think like a purchasing manager at the moment. You spent much of the past year worried about that container that's stuck in a Chinese port, you're worried about that container again with the Zero-COVID policy.

Colin Hamilton:

So for as long as China Zero-COVID policy comes through in terms of goods, there'll be some sort of risk premium in there because purchasing managers will be nervous. And they will be thinking, "Well, I will not lose my up for overpaying for something, I'll lose my job for not having something." And that is what keeps the inflation cycle going a little bit longer until end demand pushes back. Now that's what we're waiting for. Wait to see if when in the consumer demand starts to push back up the chain.

Stephen Gallo:

Okay. That's interesting. I have some thoughts on that in terms of its implications for the RMB. We'll cover that in a little bit. All right, Colin, so at this point what I need to do for the sake of our listeners, I need to remind them why we're talking about China in this sense in an FX specific podcast. Why are we talking about the disinflationary cycle that China is in and the fact that policy makers have moved towards more stimulus, not less?

Stephen Gallo:

This is what I want to get into now. I think the main point I would make, and again, we're back to the counterweight narrative is that China's disinflation and a cycle will have a bearing to a degree through spillover effects on how quickly Western central banks are going to tighten policy. Obviously these central banks have domestic economic inflationary conditions that they have to pay attention to. But if disinflationary forces are coming from China, emanating from China and policy makers are being relatively cautious with stimulus there, I think the first thing is that will put a break to a degree on dollar appreciation. Do you want to chime in on that point, Colin, and either echo it disagree with it?

Colin Hamilton:

What I'd like to say Stephen is that we think last year, China was actually to a certain extent exporting some inflation into global markets in certain areas. If you think of what the world was short of, we were short of mass, we were short of healthcare equipment. Every government was bidding against each other for these products. So we're seeing that withdrawn, of course. So China's losing that element. We didn't see the same commodity export push in certain areas that we might have seen in the past. And that was down to the carbon policy.

Colin Hamilton:

Now what's interesting now with the economy under pressure, well, economic growth is outweighing environmental pressures at the current time. We may see a little bit more commodity price deflation. So production is under pressure. We're seeing production ramped up again across many of these commodities. We would expect it to bleed out as classical disinflationary pressure and to the global markets, which we haven't seen for the past six to 12 months. And again, if that is going to ease the inflation cycle in the rest of the world, well, that plays through into central bank policy.

Stephen Gallo:

Let me just ask you about something on that point. Okay. This is something that I have been writing about or signaling for a while, which is that it seemed to me that Asia in general, but more specifically, China would be moving slower than its Western counterparts, particularly Europe on decarbonization. And you're in fact confirming that, you're basically saying that.

Colin Hamilton:

Yeah. I do think China has a longer term strategy, but even in the steel market, they had a 20, 25 carbon peak. That's not been pushed back to 2030 to give them a little bit more wiggle room. President Xi has nailed his flag to the mask. The target is there. He wants that to be part of his legacy. But for now, well, the economy needs a shot in the arm. And that's why we're seeing a bit more policy come through to support that. And the decarbonization efforts will be there in the background. And it'll be interesting. China's no longer funding coal fire power plants overseas, but that's a small element. We need to see a lot more coming through. China obviously has the best Delta in terms of potential decarbonization, but it's going to take them longer to get there.

Stephen Gallo:

I think this is a big issue for China's relative competitiveness. Over the course of the year, no matter what happens with the property market, if there's an improvement in the property market or consumer demand relative to the export sector that could happen as the stimulus kicks in. I still think that, that slower decarbonization push in China is a hit to the relative competitiveness of U.S. exports, European exports. And so one currency pair in particular I've been focusing on is Euro China. And I still think that that is in a medium term, long term down trend. It's being held up a little bit now by expectations for a reduction in ECB stimulus. But from a competitiveness angle I think that's something that's going to remain in vogue, as they say over the course of 2022, maybe into next year as well.

Colin Hamilton:

And the only hope Europe almost has is that China with all the efforts they're making in things like solar and wind, China's actually the technology leader in a number of reviews there now. So you may get more disinflation pressures coming through, but at the moment, if we think of it, bear minds, even we have every country in the world looking to reshore away from China, looking to alleviate China risk with some of the developments that taken place over the past two or three years.

Stephen Gallo:

It's going to be really tough to transition, really tough to transition, especially with regulation around decarbonization. Yeah. Okay. Colin, so moving the discussion along, I think, listening to you for the past, just over 10 minutes or so, the gist I'm getting is that commodity prices, commodity markets are tight, despite China. Would you say that's correct?

Colin Hamilton:

Absolutely true. China has not been pushing things hard in the past six months. It has been the rest of the world.

Stephen Gallo:

Okay, excellent. So that I think leads us into a brief discussion of the property market, because obviously with Evergrande, this was a big focus last year. What assumptions about the property market are you currently making and how are they feeding into your forecast for key commodity prices? For example, the timing of the rebound, any relevant links to the autumn NPC, pressure on local government balance sheets, et cetera. Take us through that.

Colin Hamilton:

So if we think of the property cycle, even new starts, so new starts and land sales continue to be very weak. We are actually expecting them to improve a little bit in the first quarter. We haven't seen that improvement. Now clearly push is coming to shove in terms of policy, and as a result of that we are expecting the shackles and developers to be released a little bit over the coming period. It took China a lot longer to unwind Evergrande than we thought because I had tentacles in a number of places. And the challenge in the property market is the property market moves in China and the entire industrial economy moves with it, because so much wealth is tied up in the property side.

Colin Hamilton:

Number one priority, stabilize property prices. And that's why we have seen the PBOC look to asset management companies and other areas to step in and stop property prices falling more, because that gets you negative wealth spiral. Now that is getting construction activity going, because quite frankly, if they don't, they will have unemployment problem. There'll be a lot of migrant construction workers who will not have jobs to go to in the coming months.

Colin Hamilton:

I'm expecting the PBOC to come out with more support, whether implicit or whether direct. And as a result, I would be expecting through the end of the second quarter to see more construction activity coming through. Seasonally always improves in the second quarter, but we are looking for those year and year growth rates to still be negative but to be starting to pick up. And in terms of it, from a commodity standpoint where you'd look to steel and iron ore. They're first in the building. So steel, iron ore, cement, we'd be expecting to see better apparent demand come through there-

Stephen Gallo:

And higher prices.

Colin Hamilton:

And higher prices. [crosstalk 00:16:49]. We've already seen iron ore price has moved actually 50% of the laws we saw last year and expectation of the policy coming through. So that's a key one and obviously that plays into things like the Australian dollar.

Stephen Gallo:

Mm-hmm (affirmative). Mm-hmm (affirmative). Yeah. Okay. That's a good point. So for FX listeners, I guess you already partly have done so, but maybe just to spell it out one more time. If you're an FX investor, what are some of these key commodity markets to watch where you might see signs of Chinese stimulus feeding through? I'm sure you've named some already but-

Colin Hamilton:

Yeah. Absolutely. So steel needs iron ore and Australia supplies 60% of China's needs in terms of iron ore. So that is a key trading link there. In terms of the other ones I'd be looking, obviously South Africa is a big commodity supplier. So with that, we'd be looking for run pricing, particularly as China has zero platinum crude metals, hasn't been geologically blessed with those, so they're very reliant on South Africa in bringing that through. So there are a couple of the areas I'd be looking towards in terms of the key currencies in terms of commodity currencies into China and how they might react in terms of stimulus coming through.

Stephen Gallo:

Okay. So for the remainder of Q1 in our calendar year, well, and perhaps even into Q2, the more supportive Chinese policy makers are of the property sector, the more potential support you might see in some of those currencies, but also in more importantly, even the commodity markets.

Colin Hamilton:

Absolutely. Just put in context listeners, and some of these industrial commodity markets, China is 50% of global demand. So you get China, right? You get these commodity markets, right?

Stephen Gallo:

Yeah. That's one of your key phrases, but you often repeat and it's a great phrase. It's great. All right, Colin, I want to get back to the stimulus question again and towards the end, link it back to the currency, but let's just frame the situation, back end of 2019, early 2020, COVID is just getting started, China stimulus response is just getting started. It was very much old school stimulus. It was very much focused on investment led-growth, infrastructure, net exports and so on.

Stephen Gallo:

This time around because the property market is so central and always has been. And because China needs to rebalance a bit towards the consumer, I get a sense that we may actually see a different stimulus effect this time where the consumer plays a greater role as the housing market rebounds. And actually what it does is on a growth driver basis. It lifts the consumer at the expense of exports and the export sector. What do you think?

Colin Hamilton:

Yeah, it's an interesting one. Now, the property sector is absolutely central to everything. Now, in previous stimulus, what you've seen is more money go to developers for them to spend more money on building more stuff, that has led to the leverage problem at the developer side. What the government is wanting to do is get more money to the consumer, get them feeling wealthier, getting them spend their-

Stephen Gallo:

How are they going to do that?

Colin Hamilton:

Wow, that's an interesting one. I have a theory. And China's getting ahead of other central banks in terms of digital currency. 110 million digital RMB wallets available. They've piloted several schemes in various cities. I can foresee a situation where as part of the new monetary tools we're seeing come through, you get a situation where the government say, "Well, here you are, low to middle income, spend us, bear in mind this plays into president G's balancing up of his economy. Here's 300 RMB in your digital wallet. You have one month to spend it, otherwise it expires on these Chinese brand," which may be ones which the retail side are heavy on. They have an overhang. Now that is such direct policy, you know where the money's going, so in the command economy structure, this makes a lot of inherent sense. And you also get the stimulus to the people you want to be spending to avoid the middle income trap.

Stephen Gallo:

Very interesting.

Colin Hamilton:

Obviously, this is a big shift and it doesn't come without its teething problems, but it may be the sort of thing we see the PBOC and the Beijing government look towards to get the consumers. Which is something they haven't managed to do with this efforts.

Stephen Gallo:

We haven't talked so much about the dollar RMB exchange rate. Maybe we can talk about that a little bit more in this towards the end section. But I think that's a possibility for an inflection point in dollar RMB, at least in terms of how much RMB appreciation versus the dollar PBOC is tolerating. Because if there's going to be a shift in growth drivers towards more domestic demand and the stimulus is driving a rebound in the housing market, and the digital currency is further adding to private household consumption, then the currency becomes potentially more important for supporting the port sector.

Stephen Gallo:

And I think based on the long term chart for dollar RMB, that threshold is something like 625 to 630. I think in the near term, although there we could argue, there are secular upward forces on the RMB versus the dollar medium term secular ones. I think 625 to 630 is probably where that inflection point is going to be assuming the stimulus sticks and comes into play later this year.

Colin Hamilton:

I would fully concur with that. The Chinese government takes more active and less active roles in this but there's no doubt that it is a transition for them, and when they're trying, but maybe some new policy, they want still the export sector to play some role. But over the longer term, I think the trend is pretty clear.

Stephen Gallo:

Yeah. Yeah. Okay.

Colin Hamilton:

So Steve, I have a question for you.

Stephen Gallo:

Okay.

Colin Hamilton:

Now that we're talking exchange rates, which is your ability, dollar RMB, it's been actually surprisingly stable to a certain extent over the past six, 12 months. Why do you think that's been and what do you think breaks that?

Stephen Gallo:

Okay. Yeah. I think it's a great question. I think there are a few factors here. The first of all, the current account balance, the current account surplus. China has also been on the receiving end I think of significant financial account inflows. I've been talking about the speed of Chinese decarbonization relative to the U.S. and Europe as a good thing for Chinese competitiveness, but that's probably less of a short term thing and more of a medium term thing.

Stephen Gallo:

So there have been a number of things on the inflow side which have clearly supported the RMB. But I think even more importantly is what Chinese policy makers have not allowed to happen on the outflow side. So there's been a buildup of foreign currency inflows into China and policy makers have really not allowed any of that to flow back out again. Now I have my theories as to why this could be the case. The first is I think given global inflation pressures, of course, mainly outside of China, policy makers are concerned about an economic growth slowdown, both in the developed world and also the developing world or the EM world having ramifications for EM currencies.

Stephen Gallo:

And I think by being cautious with outbound flow, policy makers in China are attempting to prevent the RMB from being the epicenter or the cause or the catalyst for that sell off in EM currency. So that's the first thing. The second thing is here we are, we're nearing the start of the Fed's tightening campaign. I guess there's a risk that the Fed is even more aggressive than what's currently priced in. Certainly China's going to be cautious with the degree of outbound flow it allows until we have certainty over how much or how quickly the Fed is going to move.

Stephen Gallo:

I think those are two of the reasons why we've seen that caution on outbound flow, we've seen that stability in dollar RMB. All right, Colin, I think we're nearly there. And what we're going to do here is I think we're going to end the podcast where we started it thematically. So we were talking about China's role as a global counterweight. Are there any specific things you are going to be looking at over the coming weeks and months to give you an indication of whether or not that status as a counterweight is being maintained or if it's going the other way and now China is actually starting to add to global inflationary pressures? What is it?

Colin Hamilton:

There's one thing I really keep a focus on and it is the China copper import premium. So it's what a buyer is paying to pull material into China for refined copper. Because China's in net import are there. If they are starting to pull more material, that premium will go up and that's the sign that they are actually coming through the signal cycle ahead of the global inflation picking and coming down but-

Stephen Gallo:

But that's not your base case?

Colin Hamilton:

That's not my basis. And at the moment that the import arbitrage for corporate into China is shut, that premium is very low. Chinese buyers, as of now are still acting as counterweight. They are still pulling back when the rest of the world wants goods. And I only expect that to be picking up when number one, the corporate price is probably a little lower. And secondly, demand in the rest of the world is starting to fade.

Stephen Gallo:

Very, very strategic. That is the main message I think from this podcast, policy makers, they are very strategic. Colin, this has been excellent. Thank you so much for joining me on Global Exchanges. We hope to have you again soon.

Colin Hamilton:

Thank you for having me, Stephen. It's been excellent.

Stephen Gallo:

And to our listeners. Thanks very much again for tuning in until next time. Bye-bye.

Greg Anderson:

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocm.com/GlobalExchanges.

Stephen Gallo:

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

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Speaker 3:

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Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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