‘Crumbs Off China's Table': Louis-Vincent Gave Of Gavekal Research On Companies Leaving For Vietnam, India

The media frequently presents the narrative that China's economy is facing challenges in the aftermath of the Covid-19 pandemic. There have been reports that companies are avoiding investments in China and diversifying to other Asian countries, including India. China is also seeing huge capital flowing out, prompted by geopolitical tensions and a slow economy post-pandemic. Bloomberg reported last week that China saw a capital outflow of $49 billion last month, which is the largest since December 2015.

Is the narrative that China’s economy in deep trouble a Western media spin or is it the whole reality? While there is no doubt that factories are indeed leaving China for countries like India, Vietnam and Indonesia, this is happening mostly with industries at the lower end of the spectrum, pointed out Louis-Vincent Gave, founding partner and chief executive officer of Gavekal Research. 

“What's happened really in the past six years is that you've seen China massively move up the value chain in terms of its exports,” he said. “Six years ago China was exporting cotton t-shirts and plastic toys. Today, out of nowhere China is the biggest car exporter, solar panel exporter, battery exporter in the world…so yes, factories are moving into Vietnam, into Indonesia, into India. But so far, this is like the crumbs off China's table,” said Gave. 

In the last six years, China’s trade surplus has gone up from $30 billion to $80 billion, Gave highlighted. “China's trade surplus is as big as the GDP of any country except the top 20 countries in the world. So this is massive in terms of flows,” he said. Similarly with foreign capital fleeing the country, Gave pointed to the fact that most of this is western capital from US and European institutions. “Meanwhile, what's interesting is if you look at money coming in from, say, the Middle East, that's growing very quickly,” he added. 

For the weekend edition of The Core Report, financial journalist Govindraj Ethiraj spoke to Gave about China plus one and China minus one, the idea of ‘desinification’ and Gave’s takeaways from his recent visit to India. 

Here are edited excerpts from the interview: 

To quote an analyst, Zhikai Chen, Head of Asia and Global Emerging Markets Equities, at your alma mater, BNP Pariba, he says, “foreigners are just throwing in the towel”. This was just last week. The MSCI China Index is down 7% in 2023, the MSCI Emerging Market Index is up 3% at the same time. How do we read it here? Is Western media playing it the way it should play it? And are we reading the right signals or are we misinterpreting the signals? 

The challenge always in China is it's such a big country that you can pick at any string and make up whatever story you want to make up. The second thing I would say is I think when you look at the Western media increasingly they've had to change their business model with the internet and most media have moved away from being sources of information to being really deployers of narrative. And today there is no doubt that the narrative is – ‘Oh my God, China's collapsing’. You have seen it on the cover of The Economist, you've seen it on the cover of Business Week, you've seen it on many Wall Street Journal articles. And yes, it begs the question – is this the reality or is this just a narrative game? 

Now I'll start off with your China plus one because I think it's very important for your listeners to realise this. Today the perception is indeed that the factories are leaving China to go to India, to go to Vietnam, to go to Indonesia and there is no doubt that this is happening. And this is happening mostly with industries at the lower end of the spectrum. Think textiles, think plastic toys etc. 

Meanwhile, what is interesting, what nobody talks about is if you go back six years, when President Trump was beating the drum on how China's trade surplus was too big, beating the drum on how China was competing unfairly with too undervalued in RMB et cetera. Back then China's trade surplus was roughly US $30 billion a month. Now we've had these factories leave. We've had the trade war against China. Guess what China's trade surplus is today? China's trade surplus is now US $80 billion a month. So it's more than doubled. It's almost tripled. So when we talk about China plus one, let's keep this in mind because what's happened really in the past six years is that you've seen China massively move up the value chain in terms of its exports. 

Six years ago China was exporting cotton t-shirts and plastic toys. Today, out of nowhere China is the biggest car exporter in the world. China is the biggest solar panel exporter in the world. China is the biggest battery exporter in the world. China is moving to be the biggest earth moving equipment and telecom switch equipment. So yes, factories are moving into Vietnam, into Indonesia, into India. But so far, this is like the crumbs of China's table. China's trade surplus has still gone from $30 billion to $80 billion. It's the crumbs of China's table— which if you're Vietnam, if you're Indonesia you can feast on these crumbs. This is great news for you. Meanwhile, China has moved from selling plastic toys to cars, where there's a lot more value added.

And electric vehicles. So this is the factory part of it. Tell us about the capital flows. I mean, the numbers don't lie. At least I hope so. We've seen huge capital flight from China and more so in the last six months ago, which seems to be caused also by a political sort of situation in China itself. 

About the numbers not lying, you might remember the quote, ‘You torture the data long enough, and it will confess’. You can take numbers and twist them one way or the other. Now, to your point, there is no doubt that foreign capital has fled out of China. And it has fled for a number of reasons. First, China did itself no favours with the continued lockdowns, the crackdown on Hong Kong, etc. But the bigger part of the equation is, of course, the rising geopolitical tensions. And most of the data that has fled China is, by and large, Western capital. It is capital from US institutions, European institutions…meanwhile, what's interesting is, if you look at money coming in from, say, the Middle East, that's growing very quickly. 

What's happened is most managers of liquid assets – think bonds, equities— have decided the political risk of being in China is too high. So I have to redeploy my capital elsewhere. And I think India has been a massive beneficiary of this. I mean, the Indian markets in general, we can debate whether it's a beneficiary or not because it's not really foreign direct investment inflows. It's just hot money coming in, driving up stock prices. If it comes back out next year, for whatever reason, whether that will have been a big advantage to India is perhaps neither here nor there. What you get for now is a big wealth effect, at the very least. 

But when it comes to China, for me, the bigger question that we should be asking ourselves is right now, China is running trade surpluses of $75-80-85 billion a month, every month. That's a lot of money. If you take China's total trade surplus right now, it's on a par of a trillion dollars a year. So you have to think of it as China is basically sucking in a trillion from the rest of the world. 

To put things in perspective, if China's trade surplus was the GDP of a country, it would be in the G20. China's trade surplus is as big as the GDP of any country except the top 20 countries in the world. So this is massive in terms of flows. 

The question we should be asking ourselves is, where's that money going? In the past, we knew it was recycled back into US Treasuries. Now we know this isn't happening anymore. So is it going to go into gold? Is it going to go to be redeployed in capital spending outside of China, in Africa, across Southeast Asia, across Central Asia? A little bit of both. Is it going into oil inventories? I think there's a lot of signs that this is happening. 

You quoted Bloomberg – Bloomberg's role in the world is to tell people what's happening in financial markets. So they interview people who work in financial markets to tell them what's happening in financial markets at this precise moment. And there's no doubt that what's happening in financial markets is that people are leaving China. Westerners have mostly left. 

But there's a whole bigger picture in terms of global capital flows. What's happening to trade flows, what's happening to the recycling of trade surpluses. These numbers are massive. And to me, that's a more interesting conversation, because we know that foreign flows into equities, foreign flows into bonds, that's always sort of hot money coming in, coming out. 

The other interesting word you used, if I got that right, was it's not deglobalisation, but desinification. Can you dwell on that? 

The reality is that the big buzzword for the past four or five years has been deglobalisation. But when you look through the data, what you see is really none of that. The factories that used to be in China haven't moved back to Detroit or Frankfurt. They've moved to Mexico. They've moved to Vietnam. They've moved to India or Indonesia and global trade has actually continued to expand and the fastest pass of global trade incidentally is emerging market to emerging market trade. That's growing gangbusters.

And that brings me to my next point. What's quite interesting is I think when most people think of deglobalisation they think, ‘okay Apple is going to shut down its factories in China and open up new factories in India’. The way things work though is somewhat different. A lot of this desinification – because again deglobalisation isn't the right word – is driven by Chinese entrepreneurs themselves. If you're a Chinese entrepreneur today you think hold on, do I want to build my next factory in Hangzhou or in Shenzhen? When I see those geopolitical tensions unfolding? Maybe I'm better off opening it in Saigon. Maybe I'm better off opening it in Mexico. And that is what's happening. 

I have a colleague, Tom Miller who wrote a series of papers last year going around the maquiladoras (low-cost factories) of Mexico and to his big surprise so many of them are now Chinese owned. And interviewing the Chinese managers of these businesses they said, well look, at this point the workers in Mexico are basically the same price as the workers in China and they're just as hardworking and we're obviously much closer to our end markets of the United States and we don't have any political risk in producing. You know in most people's conceptualisation of deglobalisation it's American multinationals deciding to move abroad. But the reality on the ground is actually much more complex.

Which links to the next point which is de-dollarisation. You talked about the south-south trade which is growing or expanding quite rapidly. It's a favourite theme in India as well. I mean the banking regulator has put out a paper on de-dollarisation. There is discussion and of course there are sceptics, including me to some extent, because I feel that we shouldn't jump the gun here even in thought. How do you see it? 

First, de-dollarisation is a very loaded word and it means very different things to different people. The first point I'd make is – most people want to see a date or a specific event. Let's say the recent BRICS summit. Everybody got very excited. The reality is de-dollarisation is a process that can go more slowly or more quickly, but it's a process. And the reality today is that we are living in a world where a growing percentage of south-south trade is now occurring in currencies other than the US dollar. 

And you have really two massive events that have contributed to this. The first of course is the Russia-Ukraine war. The Western world decided to kick Russia off the US dollar system for violating international law and invading Ukraine. And the direct consequence of this was that Russia had no choice but to start selling its commodities in other people's currencies. 

Now, if you're India, for you that's a game changer. It's an absolute game changer, because India has always run trade deficits, always run budget deficits, and always had basically unlimited infrastructure spending. India needs to build railways, ports, roads, power plants, you name it. The constraint was always, how can we fund this in a world where all the commodities we need to buy are priced in US dollars? If tomorrow we can't get our hands on US dollars, the dollar funding market shuts down, or if the price of oil shoots up, our economy implodes. And here comes Russia and says, hey, you can buy oil from me in rupees. So now, all of a sudden, if you're India, your biggest constraint to growth disappears.

It's not a coincidence that today ISM surveys are below 50 in Europe, below 50 in the US, below 50 in China, all announcing recessions. While in India or in places like Indonesia, Latin America, Middle East, etc, the ISM surveys are at record highs. And that is all linked to the fact that the biggest constraint to growth, which for India was always accessing US dollars, has just abated massively. So that's your first massive shift in the de-dollarisation trade. 

The second massive shift, which I think people massively underestimate, goes back to what I was saying about how China has moved up the value chain in terms of exporting cars, earth moving equipment, solar panels, telecom, switches, etc. Because China now comes to you and says, hey, India, you used to buy Caterpillar Machines for 100. You can now buy Long Home Machineries for 60 instead of 100. And I can give you credit through ICBC, through China Construction Banks or whoever …Communications Bank, whoever, I'll give you credit for it. And that means that if you're an Indian company, all of a sudden your working capital needs have collapsed, because instead of having one supplier with one source of funding, you now have two suppliers with two sources of funding. So your need to keep precautionary savings just collapses. So China's rapid industrialisation and the fact that it's now turning to the rest of the emerging markets and saying, I can help you industrialise on the cheap and on credit means that the need for dollars collapses. And so I think those two things are really driving de-dollarisation today. 

I see what you mean, and I think the part about funding is cheap in Africa or parts of Asia, even the Pacific islands, and we've seen some interesting examples, but also of those examples going sour. So is that something that could continue? Maybe the glory days are already over. 

Going south, no. Yes of course you've had bad loans along the way. But if you're China, I think you're first and foremost a mercantilist country. So you might say, okay, we've had some bad loans along the way, but it's okay. Our trade surplus is $80 billion a month, and again, that pays for a lot of broken pots. So vendor financing, trade financing is a risky business, there's no doubt about it. Every now and then you get huge blow ups. You saw this in the 1970s, the US vendor and trade financed Latin America, and in the 1970s or early 80s, Latin America blew up and then almost blew up the US banking system. They had to do the Brady bonds, the government had to intervene, et cetera. 

We saw it in Europe. Germany, to a large extent trade and vendor-financed Greece, Spain, Portugal, sold them a bunch of BMWs and Mercedes and told them it's okay, you'll pay us back later. And then when the Greeks said, actually we won't, we're not going to pay you back later, that almost blew up the euro. And so there are big risks to this.

This is what China is doing right now. It's lending money to the Sri Lankas of this world, lending money to the Pakistans, lending money to the Burmas, to the Indonesias, to the Thailands, and saying, it's okay, you can pay us back later. You could say, oh my God, I've seen this movie time and again. The reality is we're just at the beginning of this movie, and I agree with you that eventually it might blow up. But the numbers relative to the Chinese economy are still small enough, and more importantly, the numbers relative to the size of the Chinese trade surplus are still small enough that we're still very far from the part where this blows up the Chinese system. We're in the first inning of this. This has just started. This is like saying, if you were saying in 1999-2000, when the Euro really got going, saying: Oh my God, Greece is going to blow up, it's taking on too much debt, you were eventually right, but you were wrong by twelve years, which in financial markets means you were wrong. 

Obviously, there's a real estate problem in China, and depending on who you ask… the figure that I have is that there's developer debt of almost $1.9 trillion at risk.

13 trillion renminbi (REM). 

Yeah, that's the problem. Now, depending on who you read or who you ask, either Xi Jinping is running it cold or running it hot. So we don't know. Is China in control here and therefore are things playing out the way we're seeing it, or have they lost control and therefore are things playing out the way we see it? Does it impact how things could evolve or play out in terms of how global trade and global capital flows will go at least after the next six months or in the next year? 

I don't know who's saying he's running it hot, because he's not running it hot. He's been trying to crack down on Chinese property developers for the past five years, and he's successfully done so. I don't think that the problems that Chinese real estate is facing today is a bug. I think it's the feature. That's what they were aiming for. And it was both because they wanted to curtail speculation in property, number one. And number two, because it's a way for them to regain control over local authorities that were getting too much power by being able to fund themselves through selling land, et cetera. 

Now, you're absolutely right. The numbers I have is that there's 13 trillion RMB potential losses of exposure to property developers in the Chinese banking system. And that's a very big number. But to put things in context, that's 6% of total outstanding bank loans. And conceptually, that's primatic because banks obviously run a leveraged business model. Having said that, it's also a number that's small enough that you can exercise some kind of regulatory forbearance…sort of sweep it under the rug and work it out over four or five years of bank margins, which is how China's always dealt with banking problems in the past. 

You know what's interesting to me is everybody has spent the whole summer worrying about this Chinese issue. And people called me up and clients and we discussed it, and I always said, look, why do you worry about this? What's the trait here? How does this impact your portfolio? And I think deep down what the reality is is that most people look at this and think, ‘oh my God, I've seen this movie before. This is 2008 all over again’. You've got falling real estate prices, property developers in trouble, shadow banks going bust, and everybody's got PTSD from 2008. So everybody harks back to this. 

The reality is the Chinese financial system is completely different from the US financial system. So everybody's running around saying this is China's Lehman moment. No, it is not. This isn't to say that there's no problem, but you can't use the same template, it just isn't. 

And the best example of this, the best illustration of this, is the fact that if you look at Chinese bank shares, they're actually flat for the past twelve months. Now, if you look at US bank shares from January 1, 2007 – July 2008, ie, two months before Lehman went bust, they were already down 60%, and then Lehman went bust and they fell another 50%.

China is confronting a real estate problem that will hamper growth for the coming years, but it's not really hampering Chinese banks’ ability to lend. And against that, you have parts of the economy that are doing fine. What all this means is you have weaker growth in China for the foreseeable future, but then you come back to what you do about it in portfolios.

Maybe you go long Chinese government bonds because bond yields are going to continue to come down. And I agree with that. Do you want to go short a currency that's running an 80 billion a month trade surplus with the currency now two standard deviations undervalued? I don't think so. Do you short the Chinese stock market? I think that's a pretty courageous trade to put on, given how cheap it is, and given that the government is now trying to crank it up. So you look at all this, you torture your mind like, this is massive. And how does this impact my portfolio? I'm not sure it does. 

Speaking of portfolio, let me bring you to present times, as it were. Two things that have happened recently. One is that Wall Street stocks have fallen because there's fear that interest rates will rise again, or there's been a hint that they will rise. And the second is oil, which is now heading to $100 a barrel and surely above $95. Putting that as the backdrop, how are you seeing two, three things? One is capital flows in general. Secondly, emerging markets and the role of interest rates and oil. 

Well, to be honest, I think your fact number two oil going up is one of the key drivers of your fact number one, markets going down. Yes, markets are going down. Yes, interest rates are higher. When you look through history, you find that whenever you have mortgage rates that go up more than 200 basis points over twelve months, which is what we've just had, and I'm talking about the US here. Plus old prices that go up more than 30% year on year. That's a tough combination. 

So, personally, I don't really worry when I see oil prices going up in a vacuum and interest rates not following. And I don't really worry when I see interest rates go up in a vacuum and oil not following. But when you have the two of them, it's like a one two punch. I think most people, most businesses and most consumers are strong enough on their feet that they can take one punch. But if you take two punches, the risk is you're going to get knocked out. 

And that's what we're going through right now. You have rising interest rates plus rising oil prices. And that's a very, very tough combination. You can look back through history, it's a tough combination for markets to withstand. And I would say it's an all the more tough combination for markets to withstand that markets today are not really priced cheaply. It'd be one thing if markets were super, the stock market was trading at a ten times PE. 

But again, you look at the US today, you look at Apple trading at 30 times earnings when sales and profits really haven't grown for the past four or five years, all Apple's been doing is gearing up the balance sheet to buy back stock. And that's one thing in an environment where oil is at $50 and interest rates are at 2%, it's a completely different can of worms when mortgage rates are at 7% and oil is at $95. 

Now, my big fear is that oil prices continue to go up. They continue to go up because for the past decade, we've massively mal-invested in our entire energy infrastructure. We've made a big bet that we'd pour money into wind and solar and that that would deliver tremendous productivity gains and cheap energy for the foreseeable future. 

And the reality is, it hasn't. We've poured 4 trillion with a T US dollars. And when I say we, I mean the western world, $4 trillion into wind and solar. And for that, we've moved our carbon use from 83% to 81%. So it hasn't moved the needle. You have a bubble right now that's imploding. And that's the bubble on alternative energy. Go look at your share prices of your wind, of your solar, et cetera. It's all imploding. The bubble on alternative energy is collapsing in front of our very eyes out of the realisation that these guys over promised and under delivered. And we're left with 4 trillion capital misallocation that we have to digest. And the way we're going to digest this, unfortunately, is through higher energy prices for the foreseeable future. 

So how are you advising your clients on asset allocation? Asset could be geography as well. And the second is, you were telling me that you were in India quite recently, last month actually. What have you taken away? And I mean, if there's good news on investments, what are the kind of areas that you're looking at? 

I'll start with India and then I'll work my way to the asset allocation. So I hadn't been to India since pre-Covid, since it had been like five years that I'd last gone to India. And there's no doubt that in those five years, India's roads have gotten better, very nice airports. The whole myth that: Oh my God, India can't build infrastructure, I think is collapsing in front of our eyes. India has gotten a lot better on that front. And I think that's part of the re-rating you're seeing in Indian assets today. 

When you go there, it's hard not to feel an enthusiasm for the future, a sense of belief that India is going places and a certain sense of optimism…so that is there. And obviously, foreign investors are massively overweight India on the back of it, which is perhaps the one vulnerability, I would say that India has right now is: I think you've had a lot of hot money coming in, partly leaving China, going to India. So that means that India in itself is sort of somewhat dependent on the news cycle. If for whatever reason, you get some bad news. As far as foreign investors are concerned, and I don't want to get involved in Indian politics, but as far as foreign investors are concerned, they put a lot of this success down to Modi's administration. And so there's a feeling that, Oh my God, if Modi doesn't get reelected, the market will tank, et cetera. There is that sort of Damocles Sword, maybe today a higher political risk because of all this foreign inflow of hot money. 

To your point on asset allocation, I think the starting point of any asset allocation today is the acknowledgement and the realisation that we are no longer in a deflationary environment, for a lot of the reasons we discussed today but we are now in a structurally inflationary environment. And in an inflationary environment, asset allocation becomes much more complicated. Portfolio construction in a deflationary environment is easy. You buy 60% equity, 40% OECD government bonds, and you can go to the beach. You know that if ever there's a shock to the system, US Treasuries will take the hit for you. 

Fast forward to today and for the past three years, US treasuries have not done that job. Past few days, again being a proof of that. Past few days SMP has been down one and a half a day and US bonds are down 2% a day— long dated treasuries. So bonds no longer diversify equity risk. And so that means that you have to go back to the drawing board and say, okay, I still like my equities, I still like my Alibaba, I still like my Microsoft. What do I do to diversify away from that? 

I know in India the default mode is gold. The problem with gold is it's a highly volatile asset class. I happen to like gold, to be very clear. But adding gold to your portfolio seldom reduces the volatility of your portfolio. So I think you can have some gold for sure, but you probably need something else as well. And as we just discussed, the big risk on portfolios today is that energy prices continue to go up. So for me, the ultimate portfolio diversification today is no longer bonds. It's actually energy positions. And that could be energy companies, that could be long dated futures on oil prices. It could be any one of many things. But I think any portfolio that does not have a substantial energy position right now is cruising for a bruising.