Exclusive Interviews
Jeffrey Tang on the Asian Markets and the Coming Deflation in China
By Anthony Wile - February 09, 2014

Introduction: Jeff Tang is the founding partner of ACF Capital Advisory LLC in Boston, which focuses on Asia economies and markets. Jeff previously managed Clough Capital's Asia long/short equity portfolio for six years after working as an Asia Equity analyst at Evergreen Investment. Jeff holds a MBA degree from the Booth School of Business at the University of Chicago, and BS degree from Peking University in Beijing, China. Jeff Tang can be reached by email at jytang001@yahoo.com; find him at LinkedIn here.

Daily Bell: Thanks for sitting down with us. You're an investment specialist in Asia and China so we'll direct our questions mainly to that area. First, please, give us an overview. What's going on in Asia? Emerging markets were just hit hard. Was that an expected occurrence?

Jeffrey Tang: Asia, and more broadly the whole world, is affected by what is going on in China and in the US. China's growth has peaked. While slower growth in China is a consensus now, I think the potential severity and duration is under-appreciated. Demand of commodities other than food/energy has peaked and will go down. Whoever sells to China will suffer, especially if they have used leverage to build capacity. Hence, you will see Indonesia, Australia and Brazil suffer for a long time. Other nations that have over-expanded based on the low cost US$, will also suffer, the process of which depends on how the Fed wants the dollar to behave. If our call on the dollar is the dollar credit cycle has peaked, then we will see countries such as India and Vietnam go back to their natural status, which is low, single-digit growth after the credit rebalance, and export sectors in Taiwan, Japan and Korea lose money on excess capacity.

China's growth in the past decade was based on two sectors. In the first half of last decade, the economy was export driven. The 2007 US meltdown put an end to the external demand. On top of that, the fast-rising labor cost put China's unit labor cost at 3.9% above South Korea and 5.4% below Japan, which by now should be substantially higher (World Bank data 2010). These two developments put China's export at a severe disadvantage (which makes one wonder where all the export growth has been coming from). In the second half of the last decade until now, the growth has come from infrastructure build-up and property development, which is also showing signs of stress. When the unit labor cost is so high, income growth is probably going to be hard to get. In the meantime, when property decline starts, negative wealth effect will start to drag discretionary spending lower, as Japan experienced. So the much talked about domestic consumer spending will not come to the rescue, either. It is not going to be pretty.

Japan, as a pioneer financial experiment for the monetarist/Keynesian model, has reached its end. Abenomics is not a choice made by Abe; it is a predestined outcome of decades of policies. The deficit spending model reached the point of no more savings left to buy the government debt. Bank of Japan is the buyer of last resort.

Daily Bell: Give us some insight into the smaller markets like Cambodia, Thailand and Vietnam. Would you invest in these markets – privately or publicly?

Jeffrey Tang: Cambodia is a protectorate of China. It has been this way for hundreds of years. When China is healthy, Cambodia is an okay place to invest. If one is bearish on China, stay away from Cambodia.

Thailand is a country torn between the traditional elite and the coalition of peasants and capitalists. The elite privileged intend to maintain its status, while the capitalists want to take a bigger share of the economic pie with the help from the underprivileged peasants. This has been ongoing and will continue until one side wins dominating power. The end is predetermined, while the process may have many twists and turns. This is about history and geopolitical struggles. It is important to pick the winner and invest accordingly. But stay away from Bangkok for now.

Vietnam benefitted from both the US credit expansion and China commodity boom. Northern Vietnam supplies commodities to China. South Vietnam has deep ties with the US. So watch the perfect storm when the two tides turn.

Overall, Thailand is a good place in the long run.

Daily Bell: Any views on India?

Jeffrey Tang: India is a basket-case of developing country disaster, a repetition of the early '90s Asia Crisis. You have a country with no infrastructure, an under-educated population, highly entrenched bureaucrats, an economy controlled by a handful of groups, a 10% fiscal deficit, a 5% trade deficit, foreign oil dependency, foreign coal dependency, sky-high residential property prices and over-build and a highly spoiled consumption style. That is a combination of the worst aspects of pre-Asia Financial Crisis in Indonesia, South Korea and Thailand. On top of that, you throw in a government subsidy-dependent agriculture, a US financial service sector-dependent IT service export industry and 10 times the population of Thailand and South Korea combined. Granted, the currency has already reflected some of the negatives. But watch out for the next oil price move. The rule of thumb is, when the oil price goes above $100 and stays there for a while, crisis will be triggered.

Daily Bell: Are the smaller countries in Asia offering more market freedoms? Is this a trend?

Jeffrey Tang: The smaller countries like Singapore, Indonesia and the Philippines are certainly moving toward more market freedom compared to their own history. With a democratically elected government, it is inevitable, for now. You can say that is a trend.

Daily Bell: Is there a regional "Asia" market now? Are there plans for some sort of Asian market similar to the EU?

Jeffrey Tang: Yes and no. Geographical proximity makes a regional common market inevitable. But it will not be like the EU. In the EU, you have three major powers so there were negotiations and compromises. In Asia, one power dominates, or will dominate. Because of the presence of the US, small countries can make some noise. But when the US gradually reduces its influence, Asia will have only one voice left, i.e., China. It will be much less chaotic than Europe.

Daily Bell: There are military tensions in Asia these days. Are the smaller Asian countries and their leaders fearful of China?

Jeffrey Tang: The military tension is probably exaggerated by the press. China will not engage in open conflict unless it cannot lose. Japan is not an independent country, not really. The leaders in the smaller countries are fearful of the inevitability that Asia will be dominated by China.

Daily Bell: What about North Korea? Is that country going to open up or are we going to see continued authoritarianism?

Jeffrey Tang: North Korea is very unlikely to open up peacefully. The fraction that has ties to China and to its common citizens has recently been brutally executed. No sign of changes.

Daily Bell: Is China worried about North Korea and its new regime?

Jeffrey Tang: China seems to be upset with the recent brutal events in North Korea, the group being executed being China-friendly. However, North Korea is a small country of a population of 20 million. Not a big issue for China, just an inconvenience. Even if North Korea breaks down overnight, which could happen any morning when we wake up, life will go on unchanged in China.

Daily Bell: What is the end result here? Does North Korea eventually fall in line with what the ChiCom leaders desire?

Jeffrey Tang: The end result in the short term will probably be the same as before – the young Kim will eventually realize he cannot afford an open confrontation with the hand that feeds his mouth and make reconciliation with China. China's interest in North Korea is for it to stay out of China's face. That is certainly achievable.

Daily Bell: And what about the ChiComs? Will they even be in power in the near future?

Jeffrey Tang: Haha. This is a sensitive question. There is no sign that the leadership of the Communist Party is being challenged.

Daily Bell: Is China a cohesive country or a series of fiefdoms each ruled from its own power center?

Jeffrey Tang: Historically, China is a very cohesive country. Beijing controls the military, the money printing and the media. It is very hard to imagine there can be any power center other than Beijing that has these basic elements of controlling the masses.

Daily Bell: We've argued that the top men in China work closely with European and US banking powers. True? False?

Jeffrey Tang: Just look at the paper wealth that China has accumulated. That is the hip joint.

Daily Bell: If there is considerable cooperation from a financial standpoint, doesn't this mean military tensions are exaggerated?

Jeffrey Tang: There is no real military tension in Asia.

Daily Bell: Here's what the BBC wrote recently, "The borders in Europe are settled. Not so in Asia. China is flexing its nascent naval muscles. Japan is figuring out how to respond." What do you make of this? Are we going to see the evolution of these tensions?

Jeffrey Tang: The longer it remains an issue the better for the leaders on both sides. But real action defeats that purpose. So it will pop up once in a while, but with no real effect.

Daily Bell: Prime Minister Shinzo Abe seems to determined to expand military tensions to incite Japanese nationalism. He is also a kind of hyper-Keynesian, from what we can tell, having embarked on an aggressive campaign of money printing. Who's behind Abe? Are his policies coordinated? Is the monetary expansion linked to the military one? It seems to mimic the worst aspects of Western macro-economics. Comment?

Jeffrey Tang: Abe is sinking in public opinions on domestic issues, so he uses foreign relation issues as a distraction. Anyone who takes leadership of Japan will probably do what he is doing. The Japanese economy is dominated by a handful of industrial groups. The political and economic policies are designed in the best interest of these groups. Coordinated or not, the printing press is the route of least resistance until it is not. Now is not the "Not" moment yet (JGB yield has not spiked.)

Daily Bell: Are Abe's policies going to work? Will the Japanese back them? What does this mean for Japan as an industrial power?

Jeffrey Tang: Since the burst of the real estate/credit bubble in the early '90s, Japan has adopted the policy of deficit spending to shift private sector credit onto the government balance sheet. The policy has succeeded in maintaining the overall size of credit and disguised the problems. The general population was fooled into believing the problems are at least manageable and can continue. The negative impact is waste of savings in government spending. Now at 200% of GDP, and a shrinking savings pool, this game cannot continue anymore. Abe has no choice but to monetize fiscal deficit while fooling people into believing it is an active policy move to revive the economy. It will drive up asset prices and thus raise government revenue while the monetization continues. It certainly lowers cost in the manufacturing sector for exports as the yen weakens. The short-term effect is a positive boost to the economy but when the QE stops due to a shrinking deficit caused by rising asset prices, the effect dissipates. Then they will go into recession again, and then again, until finally the market realizes it will not work and long-term yield blows off.

Daily Bell: What about the Fukushima problem in Japan? Is the radiation being overstated or is the plant an intractable danger?

Jeffrey Tang: I was in a Tokyo hotel when the earthquake hit. Tokyo Electric kept telling the public there was no breach of the cores, which turned out not to be true. So I would take it with a grain of salt when I read the news announcements coming out of Tepco.

Daily Bell: How do the Japanese feel about their government at this point? Do they trust the system – and the stock market? It doesn't seem so. The Japanese birth rate keeps plummeting, as if an entire nation-state is in the throes of suicide. Why is it so bad? What can help?

Jeffrey Tang: From my understanding of the people, the Japanese may not trust their politicians, but they do trust their system. The calm I saw after the earthquake was impressive compared to what happened in New Orleans.

Birth rate is a problem for not just the Japanese. You see the same phenomenon in South Korea, Taiwan and China. For the leisure and extra spending power from not having kids or having fewer kids, the middle class has chosen a path that makes sense for each individual but not for a whole population. Everyone wants a free lunch. That was why socialism failed. What can help? Nothing in this cycle.

Daily Bell: Let's return to China. Is China headed for a significant bust?

Jeffrey Tang: China has overbuilt the residential property market for a long time. China has also overbuilt its infrastructure, but that is a derivative of the housing boom. The extent of overbuilt is unprecedented in any other major nation in the world. We have seen some smaller cities run into trouble, Erdos and Wenzhou. The housing price dropped 50%-70% within a span of a few months and then stayed dead. It has started to spread into the resource-rich cities. Nobody pays attention to that because those are small cities. Prices in the large provincial capital cities are still going up, as the population there relies more on property sectors. When those places start to have problems, we will see even faster price drops as the property price feedback loop reverses.

Daily Bell: It seems as if the price inflation created by central bank printing is increasingly intractable no matter what the Chinese do. Your take?

Jeffrey Tang: Total wealth on the household balance sheet compared to the household income is already high. For the asset side of the balance sheet to remain stable, the expectation of future income growth has to stay high. But real economic growth has peaked and the growth rate is trending down. Gradual controlled inflation is needed so that people hold onto their property. Hence, the 14% credit growth with 7.6% GDP growth. But that seems to be wishful thinking, too late already. Daily necessities such as food and clothing are at least twice the price compared to similar quality goods in the US, if not higher, and still rising. RMB is over-valued, which means when it corrects, inflation for necessities will be even worse.

Daily Bell: What is the point of building so many empty cities and skyscrapers – or has this been exaggerated?

Jeffrey Tang: Since the one-child policy took effect, the traditional family structure of two parents raise 2-3 children was outlawed. The expense that would have/should have been spent on raising a child, which is usually 20% of a family's expenses, has been forced into savings and invested in expectation of future returns. The savings done by the national government were invested in infrastructure and the US Treasury. The part saved up by the households is mostly put into property as the only conduit of saving to fight monetary inflation. So you have demand, much higher demand for property than normally would be.

Land is government property in China. To raise revenue for infrastructure spending or any kind of spending, selling land is the quickest way. Infrastructure spending is loved by all government officials in the world. So they sell land. Now we have supply.

High investment demand coupled with high supply gives them empty cities. We have seen property bubbles in other countries, which were caused by either loose monetary policies or foreign capital inflows. But the one in China is well over and above your average property overbuild.

Some recent data for people to ponder: In January 2014, home prices in the top 100 cities rose 11% year-over-year to Rmb 10,901; that is US$ 200/sf for a bare-bones apartment. Land sales in the top 33 cities was Rmb 180bn, up 26% year-over-year, 30% of which is financed by off-shore sources. We may think there is a property bubble in China. The Chinese property developers certainly don't think so, not in the big cities, which will make the adjustment that much harder when it comes.

What is ominous from the January data is that 37 cities reported month-over-month price drops, compared to 32 in the previous month. This may well be the beginning of the end.

Daily Bell: We've argued a downturn is inevitable and that when it happens the Chinese Communist Party itself will face significant challenges. Your view?

Jeffrey Tang: The struggle that is going on inside of the leadership group may well have been the preparation for the inevitable downturn. Someone has to be the scapegoat. It is better to have it ready for the blame.

As long as the leadership can point fingers at those corrupted officials while maintaining a reasonable food supply, the situation can be managed following the Japanese model, i.e., shift the loss of the banks to the central government while letting the households take the hit on their property value.

Daily Bell: Do you think average Chinese people are content with the consumerist model that is now prevalent in China?

Jeffrey Tang: The average Chinese have enjoyed the prosperity coming from the low cost of raising a family due to the one-child policy, increased productivity from Western technology and non-stop credit expansion courtesy of PBOC and the Fed. The party keeps getting better and better as long as one does not play stocks in the Shanghai Stock Exchange. There is no reason for people not to be optimistic and buy more and more unnecessary items.

Daily Bell: What happens when the Chinese middle class finds out their real estate investments are not worth what they thought they were?

Jeffrey Tang: If Japan is any guidance, when the property value deflates, the discretionary spending will get hit hard. But people will stay calm if there is no significant food inflation when the RMB depreciates. That is of course a big IF.

Daily Bell: What does the future hold for China economically? Any chance of a more free-market approach taking hold? A private gold standard? A removal of monopoly central banking?

Jeffrey Tang: As free-market believers, we believe a free market is the only solution, which I think will happen in China. But I would not be surprised that in the immediate aftermath of what will be coming in China, the free market will be suspended for a short while in trades that involve essentials such as food. When the property market deflates, the balance sheet and income statement of almost everyone will be wrecked. Interest will go down, businesses will go bust and capital flight will arrive in earnest at the anticipation of capital control, which surely will be self-fulfilling and shock the yield chasers. The RMB will weaken. Prices of imported commodities will rise, which will put more businesses out of business while the price of food and energy will go up depending on the how much RMB weakens. That means there need to be government managed food and energy distributions. Because there are 300 million unskilled migrant workers, maintaining law and order will be difficult. The arrival of the free market will be delayed. But there is a short window of opportunity before the demographic disaster becomes unmanageable for a smooth transition to a free market.

So there will be difficult times. With the massive amount of bank deposits, the future purchasing power of the RMB is destined to go down significantly. That will become obvious to the depositors when food inflation starts to kick in. Gold could become the ultimate safe heaven for the Chinese people.

Daily Bell: What about the Internet? Will China be able to continue blocking the 'Net or is it changing things regardless?

Jeffrey Tang: China will continue to block the 'Net. Free-flow of information means the end of the government in the current form.

Daily Bell: Give us an update on Hong Kong, where there is considerable resistance to the mainland Chinese sociopolitical and economic structure. Will Hong Kong continue to be quasi-independent from mainland policies? How much independence does Hong Kong really have?

Jeffrey Tang: Hong Kong is a business hub. The main driving forces in Hong Kong are the businessmen. Their interest lies in Beijing.

Daily Bell: Will the Hong Kong model win out in the end?

Jeffrey Tang: Political control and economic freedom may work for a short period of time on a small scale, such as in the pre-1997 Southeast Asia countries, which led to disaster in the end. The same model has been tried in Mainland China. We are already seeing the results. Singapore seems to be an exception. Hard to say whether it is a sustainable model.

Daily Bell: Where is China headed? Can you sum it up? More nationalism and militarism to take the focus away from a failing economic model? Or do you think the economy can be rehabilitated and continue as is?

Jeffrey Tang: China is heading for major restructuring. The twin engines of growth, export and construction, have both hit the wall. When major internal events happen, it will be so overwhelming that no external events will be able to distract attention. The economy will be re-oriented. Growth will go down to low single digits and stay there after some negative years. People will have to find a new way of life, a life of less material consumption, a life of cleaner air and water and food.

Daily Bell: Our feeling regarding Western markets is that there is a strand of globalist banking that is seeking what we call a "Wall Street Party" intended to send the markets much higher. Would Asia and China benefit from this?

Jeffrey Tang: I don't think China markets can go much higher even when the US market goes up. The divergence is quite clear already after two years of underperformance. The markets with more US exposure such as Korea and Singapore may have a better time. But China dependant markets such as Australia and Indonesia will not. The China super cycle has passed its peak.

Daily Bell: What happens when this party ends? We think it will be a tremendous bust that could be worldwide and usher in yet more globalist consolidation including perhaps a kind of bancor and even a worldwide central bank. Your thoughts?

Jeffrey Tang: I am of the view that after the next major credit reset, people in each of the major countries will be more inward looking, as they realize they have to solve their own problems on their own. There will be no need for a worldwide central bank.

Daily Bell: Should people be investing in Asia now? In China? How should they be doing that?

Jeffrey Tang: China is a consensus underweight now. This time the consensus may be right. Stock picking will be the way to go. Investing is about putting capital in projects that will better deliver goods and services. In Asia, China in particular, there is massive misallocation of capital, which means there are areas that are under-invested where capital can be profitably invested. Just have to be very careful.

Daily Bell: What about commodities, especially gold and silver?

Jeffrey Tang: When the 1.3 billion Chinese start to buy something, you need to buy it before it runs away from you. We have seen it in iron ore, coal and Vancouver properties. When properties start to collapse, the Chinese people will need to find something to buy. There is an old Chinese adage: "When society is prospering, one toys with antiques. When there is turmoil, one stacks gold bars." Have you seen Christie's auction in Hong Kong lately? Imagine when the Chinese liquidities go into gold.

Daily Bell: Does the Chinese central bank hold a lot of gold and silver? Why? Does it belong to the bank or will it eventually find its way into private hands?

Jeffrey Tang: I don't have substantive knowledge now. The rumor was at one point before the gold price crash, the PBOC did a purchase in the open market and the price responded promptly so they stopped. Relative to its reserves, PBOC has very little gold.

Daily Bell: Where are you advising people to put funds if they want to invest in China and Asia?

Jeffrey Tang: Industries that makes things the people need for daily living.

Daily Bell: Any other thoughts, either optimistic or pessimistic ones?

Jeffrey Tang: I am a long-term optimist. China has a chance to get through the restructure if the right decisions are made and tough actions are taken. It will take some time and there will be good investment opportunities in Asia.

Daily Bell: Thanks for spending time with us today.

After Thoughts

Jeff Tang really seems to understand Asia. And we were pleased to see his analysis is along the lines of what we've been explaining over the past four to five years.

We were among the first to note China's empty cities, the insane money printing and the misallocation of capital generally. This was at a time when the Chinese "miracle" was generally being reported on. The idea somehow was that the innate creativity and industry of the Chinese people had been released once the ChiComs had adopted "capitalism" as their main economic model.

Also, we were told that China would avoid a monetary meltdown because they had restricted economic development to industrial zones and thus foreign companies would suffer most of the damage in the event of a real downturn.

We never believed any of this. China's development, we noted, was just as ruthless as that of the West's because the Chinese system essentially depended on tremendous overprinting of currency and not much else.

It's well known by now that the West's capitalist system is severely centralized, with very few firms controlling most of the significant industrial and economic development.

China's system is surely even more centralized. The "competition" that observers note is mostly at a lower level. At the highest level, the main levers of the economy – the financial ones – are operated by only a few.

Eventually, China is going to have a terrific bust (which may already have started), though it may be a kind of rolling one that doesn't happen all at once. The timing of this is fairly critical, as we tend to believe that before China's current cycle collapses, the West's Wall Street Party will be in high gear. In fact, a China "bust" could merely force more cash into Western – US – markets to begin with.

In the long term, the deflation of the Chinese economy will spell the end to any kind of global "recovery," in our view. And that is when a more globalized economic reset could be implemented that would involve an international central bank, currency, etc.

Stay tuned! And thanks, again, to Mr. Tang for this insightful interview.

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