FOFO: Fear of Finding Out--Hyper-competition in China with George Magnus

Richard Kramer: Welcome to Bubble Trouble, conversations between the economist and author Will Page and myself, independent analyst Richard Kramer, where we lay out some inconvenient truths about how financial markets really work. Today, we're in conversation with our seventh special guest, discussing hyper-competition in the world's almost-largest economy, China. More in a moment.

Welcome back to Bubble Trouble. We're delighted to have with us George Magnus, someone who's well known to my cohost, Will Page. George, do you wanna introduce yourself to our audience?

George Magnus: Sure, uh, Richard. Thank you. So, my name's George Magnus. I am an associate at the China Center at Oxford University and also at the School of Oriental and African Studies in London, and before I took these a- academic affiliations, I was the chief economist at UBS from about 1995 until about 2012, then a senior advisor for another four years. Yeah, that's kind of who I am. I wrote a book in 2018, '19, called Red Flags: Why Xi's China is in Jeopardy, and, um, that's paying for my lunches nowadays.

Will Page: [laughs] And if I can comment there very quickly, George, maybe just explain a bit about why I'm so pleased to get you on our podcast. Me and you go way back to when you would come up to Edinburgh advising various fund managers there, and I remember round about 2006, 2007, you wrote a paper, which had the words Minsky moment in it. Now, this podcast is called Bubble Trouble, and in your career, you've seen many bubbles lead to many troubles. Could you just quickly reflect on that paper and what you saw when you realized that there's a risk of credit markets drying up? In many ways, you've got kudos in that I told you so first rests with your, with your p-... work more than anyone else's.

George Magnus: Well, thanks, Will. I mean, every dog has its day, you know-

Will Page: [laughs]

George Magnus: ... so, um, that was mine. Yeah, so Hyman Minsky was an American economist who wrote about macroeconomics, and he was famous, really, for kind of identifying, um, how it is that, in complicated financial systems, that the more banks try to create, and, and, basically, financial experts try to create stability, the more they are breeding instability, which one day kind of bites them in the backside and causes all sorts of trouble. Basically, we'd had a couple of dress rehearsals of kind of financial instability. There was the [inaudible 00:02:33] housing crises in the 1980s. There was an Asia crisis in, uh, 1997. There was a Russia crisis in 1998, and it's gone into [inaudible 00:02:42], but when I think, in this particular case, when I started kind of casually reading about subprime mortgages, the extraordinary business term under which mortgages were being given to people that should have never have had them in parts of the United States, particularly poorer parts of the United States, and it just kind of struck me that this was, potentially, the combination of a decade of just [inaudible 00:03:12] regulation in finance and a lot of stuff I saw going on in the bank that I was working for, um, where people didn't really understand what they were doing. Just one example before we move on, I sat next to, uh... well, for a while, my office was next to a group of traders who were trading asset-backed securities, mortgage-backed securities.

Will Page: Mm-hmm [affirmative].

George Magnus: They had data on the housing in the United States going back 10 years, and when I challenged them as to why they only had such a short run of data... This was 2007, by the way... they said, "Oh, it's... you know, that's all we need," and I said, "Well, I've got data going on, you know, on housing markets going back to about 1900. Wouldn't you find that interesting?" and they said, "No," and I knew there was a problem.

Will Page: [laughs] Sounds like a scene from The Big Short. Richard, from one bubble in 2006 to a bigger bubble which could be happening today, let's talk about China.

Richard Kramer: Yeah, George, I wanted to, to get your perspective on how you make sense of a market like China, which publishes its GDP figures two weeks after the end of every quarter and never revises them. So, when you're dealing with what clearly must be imperfect information, and, as you gave us with that UBS example in mortgages, there's no interest to find slightly more perfect information, how should one navigate that sort of environment when you know that the market, to some degree, is going to be distorted by that information assymetry that's baked in?

George Magnus: Well, Richard, to be honest, it i-... it is a problem, but I don't think it's the biggest problem in China, and to be fair, they produce copious volumes of statistics-

Richard Kramer: Mm-hmm [affirmative].

George Magnus: ... which GDP is perhaps the worst.

Richard Kramer: [laughs]

George Magnus: But actually, there's... there are a lot of numbers that you can get hold of from, uh, the National Bureau of Statistics, from other statistical agencies, from independent providers of data who, basically, kind of run the rule, really, over all of the available sources of data. So, if you want balance sheet information on companies, if you want, you know, this sort of [inaudible 00:05:23] of different types of steel, if you want to know export data for thousands of categories of products, I mean, that... there's a lot of stuff that you can look at. You're right, though, that GDP numbers are manicured. They are completely devoid of volatility or [inaudible 00:05:42]. They don't really provide any kind of meaningful information. I think people have learned to live with its imperfections because they produce proxies that will do for them in terms of what's going on.

Plus, the government, to be fair, nowadays, is de-emphasizing GDP. We may come onto this, but there is a, um... there's a... the government has kind of re-emphasized an old slogan called [inaudible 00:06:12] prosperity, which is designed to kind of capture the attention of the party and of the citizenry to f-... issues related to income inequality and fairness and more to the quality of growth. It gets [inaudible 00:06:30] investment because of poor allocation of capital in the past. It may well be that China's GDP is nowhere nearly as big as we think it is, and that's something that does have implications in the future.

Richard Kramer: Let me ask about another difference that I really... i- is really striking, to me, looking at tech companies because, in the West, regulation is, is something that moves at a glacial place. Uh, a government agency will launch an investigation into a company. It'll unfold over several years and go into the courts. The courts will opine on it. There might but an appeal, and some eight or 10 years later, there might be a resolution, and we've all forgotten what the issue was in the first place, whereas what we've seen happen in China in the last year is that regulation happens almost instantly, and the companies fall into line and become compliant. Even the Chinese government we see now looking at taking board seats at some of the leading companies. How is regulation so different in China from what we're used to in the West? Is it just a matter of the balance between the role and the power of the state relative to the companies, or is there another explanation that people will need to understand?

George Magnus: I mean, yes, clearly, the role of the state is different, and although there is lots of law in China, and to use kind of a well-worn cliché, China functions according to the rule by law, not the rule of law.

Richard Kramer: [laughs]

George Magnus: And that's, that's an essential different. You know, here, you have a right of appeal. You can, you know, go to the Supreme Court and to the highest, uh, legal authority in the land. You'll, hopefully, get a fair hearing, and if the court rules in your favor, then you've won. It doesn't are work like that in China, particularly if, if you're a private firm in a sector that the government has deemed to be kind of relevant to national security like data collection, storage, and privacy. Yeah, you, you don't really stand much of... you, you basically conform or, or, you know, you get punished.

Richard Kramer: And that seems to happen, that he-... seems to happen almost instantaneously in China.

George Magnus: It does, and I think this is where people make a bit of a mistake, really, 'cause there has been a blizzard of regulation in China since last November, and a lot of these regulations affected fintech companies, technology companies, data companies, platforms, gig company, or, or companies that have a lot of gig workers, logistics companies, private tutoring, and if you look at each case on its own, you'd say, "Oh, well, we might have done that." We're not sure whether it's a good idea for the state to stop kids looking at their video games more than, you know, two hours a week, but actually, Western parents wish they could have the same capacity to do that. So, each case on its own, you can look at it and say, "They're just doing what we would like to do," but actually, that kind of narrow view is devoid of the political context in which this is happening, and the political context is everything.

Richard Kramer: Just to move onto one other topic that's been all over the news, the consequences of a giant property company like Evergrande effectively going bust, and it, it raises the question of don't look too closely, don't ask too many questions, but what's lurking in that Chinese banking system? I mean, you could just as well as the questions of the West, and we do that a lot at Bubble Trouble, thinking about the markets, but are there more Evergrandes out there? Is this the tip of the iceberg, or was this really an isolated incident in a country that just can't build fast enough?

George Magnus: Well, I think Evergrande is... okay, for people that might not know, it's China's second-biggest property developer, and in... not alone. It just happens to be the biggest property developer in the world, but there are other Chinese property developers, smaller companies, that are equally in trouble. But within the private sector, it's probably in the worst sector, and I think that property, in a sense, really is a metaphor for, uh, the wider issue of over-indebtedness in China, which pri-... predominantly resides in local and provincial governments, and in state enterprises, and... well, mainly there. Household debt is pretty big, grown very quickly, five times the last 10 years, or two to 10 trillion dollars, but to look... the property sector has problems, endemic problems of its own, which actually are going to become more of an issue during the next kind of 10 years 'cause I think the fundamentals are now turning very strongly against property in China. And it's a big sector. If you kind of broadly define property to include housing services like buying, renting, managing, and developing, and you include inputs like copper, steel, and glass, consumer durables that go into new apartments or... property's about 29% of Chinese GDP.

Richard Kramer: Wow.

George Magnus: If 29% of GDP doesn't do very much for the next [inaudible 00:11:39] years, you know, they're gonna know all about it.

Richard Kramer: But I guess, you know, tell us again, from your peers of being a global economist specializing in China but understanding things that go on in the U.S. and the UK, we hear about councils in the UK that are... that have run out of money. We, we know that many of the state pension funds of the U.S. states are effectively bankrupt. We see this problem of debt piling up at the local level everywhere. Is China really so different? Or, are we singling it out because it's so once removed from our personal experience that we wanna ascribe it to, to being in a worse state?

George Magnus: G-... I wouldn't say it's unique. It's different because it's accumulated an awful lot of debt in a very, very short space of time.

Richard Kramer: Right.

George Magnus: So, in 2000, debt to GDP was about 100%. It's now 330, 340%, and it's not even the number, really, that matters that much. It's the fast that so much of the debt that has been accumulated in the last 10 or 15 years is uncommercial and-

Richard Kramer: Hmm.

George Magnus: ... a lot of the local governments can't pay the... their debts back, and so they have to be effectively bankrolled, or they have to resort to accounting trickery to, to stay current on their payments. And I think that it's because China has adopted this reliance on debt. I mean, the fact that a lot of state pension funds in the United States may be dysfunctional or have more liabilities than assets, I mean, it's a problem, obviously for them, and more so it's a problem for their, uh, beneficiaries, but actually, it's not going to interfere with the functioning of the American economy. It's gonna cost somebody somewhere something, but we're talking about in China's case is a growth model that's been dependent on credit creation over the last 12 years, and now that looks to be drawing to a stop.

Richard Kramer: So, the stabilizers are off?

George Magnus: Mm-hmm [affirmative].

Richard Kramer: And then, I think that the other thing to follow up on there, when you talk about going from 100 to 330% debt to GDP, that's in the context of GDP going up fivefold or sixfold-

George Magnus: Absolutely. Yeah. Absolutely.

Richard Kramer: ... which didn't happen in the West.

George Magnus: Exactly so.

Will Page: And maybe bringing it to a close for part one, this is what... my lasting memory. You said that GDP is the most important number that's out there, and it's the least trustworthy of all the [laughs] government statistics that China produces. Presumably, debt is easy to calculate and verify, which makes me wonder what the true debt-to-GDP ratio actually is.

George Magnus: We'll, that's, that's a great point. Well it's... you've heard s-... I mean, w- one of the biggest proponents of this argument is the, uh, economist who, uh, teaches at the [inaudible 00:14:23] University, Mike Pettis, and he basically says that a substantial proportion of China's GDP is fake-

Will Page: [laughs]

George Magnus: ... basically. That's... you know, that it... In other words, you know, if you build something that ends up polluting a river, and you then have to unbuild it or rip it down because of that, or if it doesn't make money, you know, you've built a third or fourth method of access to an urban co-... a- agglomeration, and nobody uses it, it, it adds to GDP when it's built. Nobody actually discounts it. That doesn't happen in China, so GDP is, I don't know, 80% of what it is or 75% of what it is, and of course, your suggestion about true debt-to-GDP ratio is, is going to be on the [inaudible 00:15:07].

Will Page: Amazing. Well, that brings it to the end of part one, but I should remind listeners that people in glass houses shouldn't throw stones, and George, me and you have discussed many times in pitted rounds, we have a bit of fake GDP in our own accounts as well, but, uh, back in part two, and we're gonna look at the fear of finding out.

Back with part two of Bubble Trouble, where we're joined by a very, very special guest, George Magnus, uh, the former chief economist at UBS and author of several books, including a recent one, where he takes a rather cynical view on the Chinese economy, and that's what we've been discussing. Evergrande reminds me of Enron, reminds me of that Who song Won't Get Fooled Again. So, Richard, we've been discussing FOMO as a driver of bubble troubles for the past few episodes, but you've come up with a new acronym, FOFO. Try saying that after three pints of strong lager. Tell us about FOF and how we can get to squeeze George like a sponge to explain what FOF might mean for China.

Richard Kramer: Well, one thing I've noticed with the markets is not only are, as we've discussed many times, people willing to believe narratives which otherwise would sound incredulous coming from all sorts of companies, but they just turn and run a country mile from any real due diligence into those narratives. I guess my question for George is, is around this FOFO, fear of finding out. How many investors have bought into China without really having done the cultural or financial due diligence they should have, where in classic investing fashion, on should invest in things you have a familiarity in or have a good sense of, uh, understand the demand-supply characteristics? But with China, it's a, it's a market where a lot of investors buying the shares would not speak the language, would not use the products, would not understand the cultural backdrop. How do you think about that concept of FOFO and the trillions of dollars that are put to work in the Chinese economy by Western investors?

George Magnus: I was kind of laughing to myself when you were asking the question, really, 'cause first thing I thought of when you were talking about that was crypto, actually. How many people-

Richard Kramer: [laughs]

George Magnus: ... understand what they're doing with, like-

Richard Kramer: [laughs] That's a se-... that's a whole nother struggle we haven't donee yet.

George Magnus: There's another program.

Will Page: The answer isn't and minus one.

George Magnus: [laughs]

Richard Kramer: Yeah.

George Magnus: But I don't really know. As long as I've been sort of treading the boards in, you know, financial services both inside and outside, so to speak, bank commercial intermediaries have constantly been telling investors they underweight China. You need to get it up. You need to, you know, build up your exposure. It hasn't really changed that much in the last few years. I can remember not all that long ago when maybe, you know, 1 or 2% of global portfolios were allocated to China. Nowadays, it's probably about 4 or 5, and the, you know, experts, quote unquote, keep telling us it should be around 15 or 20, in other words, something aligned with China's share of the global economy. I don't think that's ever gonna happen, not for the foreseeable future. China may not be the biggest bi-... part of their portfolios by any means. It's the passive ines-... investment, which people may not even be aware they're making because of the inclusion of China in, uh, global indices like wo-... MSCI emerging markets index, so when you buy a, a fund, you are just buying the fund, and you look at its overall performance, but you have no idea, really, or could if you did the due diligence, but you... most people have no idea how that [inaudible 00:18:47].

You basically are trusting in the veracity of the portfolio manager to know the asset and the valuation of that asset much better than you could ever know it. That might be true, but it might not be true, and I think that's the problem now because, when it's just business risk, good old-fashioned business or financial risk, you know, we can kinda trust the financial professionals. They don't always know what they're doing, but many of them are pretty well trained, but we're talking about very different kind of risk here. This is political risk, regulatory risk, and it's political risk in a very feisty global context. So, I think people need to be very careful about what they're... how much they're paying or what they owe-

Richard Kramer: Mm.

George Magnus: ... and make sure they've got a, you know, a good discount on, on any price that they are being shown.

Richard Kramer: I think what you've seen in the past is clearly a lot of stocks in China traded at a premium because they had this vast 1.4 billion-person market to sell into, and that was seen as so attractive. There was so much green field growth for them to, to address, but you said something there that I really wanna tease out, which is be careful what you own because, in China, do you own anything? Aren't most of the those companies you're going to be investing in actually providing you a vehicle, which is a variable interest entity sitting in some offshore financial center, which mirrors the assets you have in China but doesn't actually give you any right to those assets because those assets in China are all, obviously, owned by the state?

George Magnus: I suppose we would... uh, if it's not too nerdy, we should probably distinguish a little bit between what we might call onshore assets and offshore assets.

Richard Kramer: Mm.

George Magnus: So, the offshore assets, which are, for example, stocks that you can buy in the NASDAQ Golden Dragon index or on the Hong Kong, uh, technical index, technology index, I mean, these are high-risk companies by in large 'cause these are the ones that have mostly been affected by the regulatory changes that have been introduced. There are many private companies that are... if you're m- manufacturing electric vehicles, or if you, uh... making, I don't know, Chinese washing machines or e-... whatever it happens to be, I mean, these aren't necessarily in the kind of government's crosshairs at the moment, certainly not in the, the kind of national security Venn diagrams. So, it's not to say that all assets in China are at risk, but, but some clearly are.

If you're going to go for, you know, or if you're going to kind of look at onshore listed equities, for example, then you've got also to be aware about liquidity risk and about, uh, uh, all sorts of other kind of issues that might affect functioning of foreign companies. That may be something else because you'd have to worry about them where they're listed at, at home. But the regulatory thing can, actually, go a lot further. I mean, said before, regulations are affecting education, logistics, fintech, technology, gig companies, but I would have thought that other things that might be in the process would but, like, medical care, pharma, housing. You know, these things match a lot to household projects and to household welfare and might be in the frame in the not-to-distant future.

Richard Kramer: Mm.

Will Page: George, if, if, if, I can just keep working on this newly found acronym from Richard Kramer of fear of finding out, FOFO, it seems like an apt point to twist this conversation back to your [inaudible 00:22:30], that is fear of finding out if you did the right due diligence in China is [inaudible 00:22:35]. What might a reader of your book find out if, you know, they were a standard investor in passive markets in China, digested your book, how do you think the book would make them behave differently with regards to China?

George Magnus: I mean, the book is... you know, it's not just sort of a doom-and-gloom predictor about the collapse of the Communist Party, or civil war, or America-China, although these things are, you know, alluded to in the various place because, honestly, who can tell what the future portends? What I try to do, really, in the book is to try to explain to readers we've reached, in China, the end of extrapolation. You cannot predict or know what's going to happen in China by saying, "Well, this happened over the last 20 or 30 years."

Will Page: Love that.

George Magnus: "We're going on the straight line here. This is how it's going to end up in 2040 or 2050." I mean, that doesn't work, really, in any country's case, but for some reason, people are prepared to believe that the, you know, the i-... the inevitable rise of China is inevitable. It isn't.

Will Page: Three cheers for that because, uh, after speaking with Richard Kramer, so much investment analysis seems to be holding a ruler and saying, "There's your future."

Richard Kramer: Not that was endorse that.

Will Page: [laughs]

Richard Kramer: We do not endorse that here, Will.

George Magnus: The thing is that every investor knows... actually, they don't know. They should know that, in the small print of the documents they sign, it says something to the effect of [laughs], you know, the future may not look like the past. The future performance may not replicate past performance. They did that inlay from a compliance point of view after the financial crisis. This is the same thing with China. I mean, you have to be able to say, look backwards and say, "That narrative was really good for 35 years, and this is why," and actually, it doesn't hold. It doesn't work looking forward. We have to set a new narrative, new condition, new circumstances. That's, that's point number one, and point number two is, when Xi Jinping came to power in 2012, everything changes. Right? It's not the China that our parents and grandparents grew up with, with or watching. Um, and the governance system which China under Xi Jinping has adopted and is evolving is not the governance system under which it erupted the way that it did in the '80s, '90s, and 2000s. It's very much totalitarian. It's controlling. It's state leads everything. The party leads everywhere. That's not thee environment that we knew about or thought we knew about when we were looking at dynamic private Chinese companies that were blazing a trail in lots of different places, and so that's kind of what I want people really to take away.

Richard Kramer: So, George, the name of this podcast is Bubble Trouble, and I've got to ask you. When you look at the trillions of dollars that are represented by the Chinese market on global stock markets, not just in China or on Hong Kong but in the U.S., are we looking at a bubble given what you've seen in, in debt, in the hostile environment facing China, and in some of the structural issues facing their companies? Or, do you think the weight of demographics and the growth of the Chinese economy overcome all those challenges?

George Magnus: I, I don't think that the Chinese financial markets themselves are chronically overvalued. I'm not saying they wouldn't go down in the event of some shock or macroeconomic problem, and obviously, since the regulatory blizzard happened, you know, the prices of many Chinese stocks and their... kind of the digital and modern sector have come down, you know, 40, 45%, so there's been a big kind of valuation slump, um, which I don't think is going to reverse, uh, very quickly or, or even at all. But I do think that, if people around the world, and in other countries, and active in other equity and financial markets are assuming that China can go through the next few years... I mean, next year, 2022 may be a special year because of the party congress. They'll pull all the stops out to make sure there's no accidents, but if people think that, uh, markets will survive China becomes a much more pedestrian, low-growth, perhaps even recessionary for a while place as the property market'll come down, I think it'll be a big shock to people's expectations, I think.

Will Page: I'm tempted to ask, is there a sequel to your book, but there's a pertinent-

George Magnus: Mm.

Will Page: ... question to ask you, which is something was ask on this show called smoke signals. It's obviously a big year for Chinese politics in 2022. Is there a couple of smoke signals you can give our listeners for perhaps signs of some of the warnings you make in the book are gonna come to fruition?

George Magnus: Yeah, amongst several, okay? I think, first of all, people need to pay a lot of attention, always, to Chinese politics because the party is central to everything, whether it happens inside China's boundaries or in the rest of the world, Taiwan, South China Sea [inaudible 00:27:44] Europe, or wherever it happens to be. So, watch the politics, and in particular, watch [inaudible 00:27:50] in the long run-up to the 20th party congress here 2022-

Will Page: Mm.

George Magnus: ... when Ping expects to be crowned for a third term for the first time since, since Mao Zedong by the way. There may be one or more countries prepared to boycott the Winter Olympic diplomatically. The Chinese will not like that, and, uh, there could be, kind of ruction swelling from that, and I'd say, kind of last but not least, and obviously 'cause I'm an economist, and I watch the economy very closely, and I think that China's ability to project power in the world is based on its economic heft, so anything that interrupts China's economic heft, I think, is consequential. And, um, property markets, lack of alternative development model, and growing headwinds that China is running into during the next 10 years, I think, are all going to be telling in their own ways.

Will Page: Well, I'll make sure my agent listens to this and gets you that sequel to your book. That wraps it up for this episode of Bubble T-... I'm honored to have George Magnus on as a guest, a mentor to me for f-... over 15 years, and my thanks to Richard Kramer, not just for his contribution but for introducing a hot new acronym to the alphabet soup of financial speak, from FOMO in the West, fear of missing out, to FOFO in China. That's been Bubble Trouble, and see you next time.

Richard Kramer: If you're new to Bubble Trouble, we hope you'll follow the show wherever you listen to podcasts. Bubble Trouble is produced by Eric [Nussen 00:29:22], Jessie Baker, Julia [Nat 00:29:23] at Magnificent Noise. You can learn more at bubbletroublepodcast.com. Will Page and I will see you next time.