Welcome to the podcast that shares the views of high-level leaders in the European and global financial services industry.
Nicolas Mackel . – “Welcome to Shaping Finance, a podcast which offers a platform to high level decision makers and shapers in international finance. My name is Nicolas Mackel, I’m the CEO of Luxembourg for Finance and the host of this podcast.
It is a great pleasure to welcome to this new edition of Shaping Finance, a true citizen of the world, Frederic Neumann. Frederic is a Luxembourger who has grown up in Germany, been educated in the UK, in Italy and in Washington DC, where Frederic obtained a PhD at Johns Hopkins University, before going off to teach at various other American universities. And 14 years ago then he crossed the Pacific and started at HSBC in Hongkong where today he is in charge of Asian economic research. We very much look forward to hearing from an expert like Frederic, how the Asian economies are faring in the current context and what he thinks will happen over the next couple of months in this geographic space.
Welcome Frederic. My first question is not directly linked to Asia, but more relates to the worldwide economy. Obviously we are living in extraordinary times and the Covid crisis has brought about not only a major human toll, but also obviously is wrecking havoc among the economies of multiple countries around the world. How do you see the magnitude of this crisis and where do you see this going over the next couple of months?
Frederic Neumann. – “Well, Nicolas, thank you very much first for inviting me and also for the team at Luxembourg For Finance, it’s a pleasure to be with you again. I remember fondly our RMB conference that we held in the last few years and I hope that next year we get to see each other again in person. As to your question, the word that’s being used is unprecedented. And I know that’s become a really overused term, but it’s really true in economic terms we’ve seen a collapse in growth in GDP across the world, whether it’s developed markets, emerging markets, that’s really is on a par with what you’ve seen during the great recession in the 1930s. And it’s come much quicker than that actually. In the 1930s, there was a gradual slide into recession, here it happened within a matter of weeks that essentially we saw a halt in economic activity and that already is very concerning.
You saw the shoot up in unemployment, not just in the US for example, but in India, in Korea, in Brazil. So across the world, a lot of suffering as a consequence, economic suffering, as a consequence of this virus as well. What is different though with this particular pandemic compared to say the global financial crisis or other similar recessions is that it was really caused by a deliberate lockdown of activity. It wasn’t necessarily caused by a collapse in the financial system. We haven’t seen a financial stress develop that we saw, for example, during the financial crisis. And why this matters is because it does give the hope that you might see a faster recovery once the virus has been vanquished, because at that point, banks should be able to lend again and we don’t have the overhang of a financial crisis on top of this.
Now this is the hope that actually with an intact financial system, recovery should happen more quickly. The risk of course, is that if the pandemic were to endure, financial stress becomes inevitable as well, but the hope is with a vaccine towards the end of the year, that really we can avoid the secondary financial stress and therefore recover faster than in the past.
But can we avoid the secondary financial stress that you’re referring to given, as you said, the unemployment levels and the bankruptcy wave that many people are expecting? Is that not going to play out also in financial services?
“It will play itself out with some lag. There is going to be inevitably financial assets that unpair, there’s going to be banks that may have to reduce their lending growth. The question is whether it becomes a financial systemic crisis, or whether it’s just the underlying impairment of bank balance sheets. And there are two questions here that really determined this. The first one is how long will this crisis endure? And that’s a function of how quickly we can find a vaccine and get out of this. And the second one is the response by policy makers. And what’s different now, really even compared to the global financial crisis is extraordinary monetary and fiscal easing you’ve seen. And that provides hope that maybe we get through this without major financial stress occurring.
Asian emerging economies were seen as very attractive for yield hungry investors. Obviously this crisis will be impacting them as well. How will that exactly play out over the couple of months to come or even years?
FN: “Well, that really relates to the recovery prospects in Asia relative to the rest of the world. And there is arguments to be made that Asia on the whole is likely to recover a little bit faster potentially than many other parts of the emerging market world or indeed developed markets. And one of the reasons is that many economies in Asia have been able to reign in the virus quite successfully. So as you know, in China, we’ve virtually no cases now. Domestic life is almost back to normal. You’re seeing even smaller economies like Vietnam, like Malaysia, being very successful in reigning in the virus. And what that means is consumer confidence comes back more quickly, investor confidence comes back more quickly.
And therefore if Asia outperforms again, in terms of the growth rates going into next year, that will continuously then attract capital. And we’ve seen already in the last few months, very strong capital inflows again into regional fixed income markets, equity markets, on the expectation that there is macroeconomic stability and that there is still positive growth momentum. In fact, we have three economies in Asia that will actually deliver positive growth this year still, which is quite unusual, but that’s China, it’s Vietnam and Taiwan, very likely to have positive growth rates still. That’s quite an achievement in this world.
And what about India in this?
FN: “Well, India is a slightly different position for two reasons. One is that you’ve seen a much sharper proliferation of the Covid-19 virus in India than in other Asian economies. And that takes a terrible human toll, but it also took an enormous toll on the economy. And in many ways, India doesn’t have the defenses to really deal with that economically. And so you’ve seen a much deeper contraction. In fact, the deepest economic contraction of any economy this year so far has been India minus 20% year-by-year. And that is a major shock. And it’s likely to last because we still haven’t seen the virus pandemic there peak. The second challenge for India is that it entered this crisis already slightly weaker than other economies. The banking system there was already challenged going into the crisis. And so the crisis only added to this and India is perhaps one of these examples of economies where an impaired banking system will constrain the recovery. And so India may take longer to really get out of this very quickly.
FN: “Korea actually has done quite well compared to other economies in Asia. Korea, for example, has gotten on top of the virus proliferation relatively quickly. There was a secondary wave, but really has been able to contain the virus broadly speaking. And that meant that the domestic economy never had that big hit. There was never a massive lockdown. The estimation right now is that the economy for the full year might contract by 1%. That compares to maybe Europe at minus 8%, the US at minus 8%. So it’s a mild recession for Korea, but Korea of course suffers from weak exports because with the world economy week, that hurts an export dependent economy like Korea.
You mentioned China as a country where the sanitary crisis seems to be relatively managed at this point in time, as there are no new cases appearing, but the Chinese economy is certainly facing other challenges amongst which probably the most prominent one is the ongoing trade war with the United States. Especially now on the technology players side, what’s are you making of this increase in a hostile rhetoric between these two countries? What will it exactly mean for the opening up of China’s economy and more importantly, also from our point of view, what does it mean for China bound investments from Western countries?
FN: “So, the US China trade tension clearly poses a headwind for economic growth for China, but so far not as large as one might expect. For example, the tariffs themselves have meant that China has lost market share in the US but actually China gained global market share more than any other economy over the last two years. So China remains very competitive and it’s compensated other markets for the loss in the US. What is a bigger challenge for China’s economy are the tech restrictions that have recently been tightened actually with regards to semiconductors, for example, as of September 15, certain semiconductor sales can no longer be undertaken. And that is a big challenge for the Chinese economy because China imports significantly more semiconductors than crude oil. We tend to think of crude oil being very important. China imports about $230 billion worth of crude oil every year, a massive amount, but it imports over $350 billion worth of semiconductors.
And so if that flow is interrupted, that has implications for growth domestically in China, in terms of rollout of certain 5G technologies, for example. So that is a bit of a headwind, but regarding how does China then respond in terms of openness and paradoxically, what is perhaps paradoxically, what’s happened is that as a result of the pressures from the US China trade tensions, China has actually accelerated its opening, particularly with regards to capital inflows. If you look at the last 18 months, China has a significantly reduced barriers to inward equity investments, inward fixed income investments, liberalized insurance flows is talking about liberalizing wealth management flows, for example. All really to attract more capital. China has also really rolled back a lot of restrictions on foreign direct investment, because it wants to sort of remain open and signal that it remains open to global business.
So rather than closed down, China has actually gone out of its way to open itself up. Interestingly, in 2019, China had another record year of foreign direct investment, including a pickup in foreign direct investment from US companies that are looking to go into the Chinese market. The reason why foreign investors still keep going into China, despite external tensions, is really that China is an enormous market, is one of the few areas in the world promising growth. And if you were to take a survey, imagine among European companies, German companies in particular, they would all tell you that they remain keenly interested in the Chinese market. Actually it has encouraged some opening, by the Chinese economy.
Frederic, you have been living in Hong Kong for the last 14 years. And of these, the last couple of years have seen some level of disruption first by various protests, and then obviously now with the COVID crisis, how will this affect Hong Kong’s role as an international financial centre and how do you see it’s future in this role?
FN: “Well, it’s clear that Hong Kong had fair economic challenges over the last two years. First, obviously the tourism industry was impacted because of local political tensions. Then you had some certainty around US China trade tensions as well. If you look at how the financial centre has actually evolved, it’s been actually surprisingly resilient. And to some extent, some of the bigger geopolitical trends have not been all negative for Hong Kong. One example is that we’ve seen a flurry of listings by Chinese companies in Hong Kong. Partly this was to replace listings in the US, partly just because Chinese companies themselves have decided to diversify their listings outside of mainland China, and then also in Hong Kong. So actually the equity market has been a vibrant part of the financial sector here with lots of new IPOs coming through. You see capital flowing into Hong Kong, actually the Hong Kong dollar trades at the strong end of the band because of these inflows. So that is I think, one example where the resilience comes through.
The second thing relates to the openness of the Chinese economy. And if we just take a step back, China is the second biggest financial market in the world in terms of the equity market, in terms of the credit markets, in terms of the savings pool sitting in China. It’s actually been never integrated with the rest of the world, but we’ve seen in the last two years is there’s an acceleration in the opening of China on the capital flow side, and a lot of these flows are going through Hong Kong. Hong Kong remains the gateway to China for equity flows, for bond flows. And from that perspective, Hong Kong has also benefitted as a financial centre actually, in this regard.
The third element is the RMB internationalization that you and I have talked about a lot. I know it’s a keen topic being followed by Luxembourg for Finance as well. We have seen actually a pickup in the use of the RMB for denomination of assets, for trade settlement purposes, and a lot of that flows still through Hong Kong. So from that perspective, actually, despite all the challenges that you read about, the financial centre has been quite resilient.
If we take a little hop across the sea from China to Japan, where there obviously was some major news recently, Prime Minister Shinzō Abe has stepped down and his successor has been appointed. What future do you see for Japan and where will it go after Abenomics?
FN: “Yeah, it’s a critical moment now for Japan because Abenomics has been the game changer in many ways, not just because of monetary policy or fiscal policy, but the structural reforms that Abe-San has actually introduced in Japan. I’ll just give you one example, which is the role of women in the workforce. Abe-San has been a big supporter of getting women back into the workforce, which has helped to alleviate for example, demographic challenges in Japan. So a lot of social and political changes as well. Now will these stay? Will these stick with Abe’s departure? His successor, Sugo-San, is actually somebody who comes from the same school of thought and the broad expectation is that he will continue to pursue Abenomics. He’s already indicated that monetary policy will remain unchanged. Fiscal policy will remain unchanged, but structural reform is really something he wants to drive forward.
He has promised, for example, an overhaul of the telecommunications sector. He’s very keen to overhaul the bureaucracy, all still missing elements in Abenomics. One of the key challenges really will be whether Suga-San can remain Prime Minister for a considerable time. And that’s partly because Japan has a record of having quick succession of Prime Ministers. Abe-San has been in power for quite some time, therefore able to pursue these reforms. And the next Prime Minister will need to stay in power for quite some time to continue with the agenda. Quick successions just wouldn’t be very conducive to continue to implement Abenomics. That’s going to be the key challenge here.
If you look for instance, at Japan’s public debt to GDP ratio, it stands at a whopping 230%, according to Fitch, how are we to understand a country as Japan can have a debt level of 230%? In Europe we look at this as something absolutely extraordinary and unacceptable. Luxembourg has a public debt ratio of 21%, Germany of 60%. And yes, some in Europe have a hundred percent or a little bit over a hundred percent. If it gets too further than that, it really is seen as very, very problematic. Why is it not a problem with Japan?
FN: “Well, Japan is pushing the boundaries in terms of what’s acceptable or possible. And it looks like everybody else is now quickly following in the tracks of Japan. The crisis certainly has elevated a lot of these measures. There were some specific circumstances that applied to Japan that don’t necessarily apply to other countries. The first one is Japan buys its own debt. It saves so much money that it can fund its own debt, and that’s not necessarily true for other economies. Many other economies rely on foreigners buying the debt and that is a much harder proposition. Japan never had to convince any rating agency overseas or any investor overseas to buy its debt because there was enough Japanese savings. That’s a key difference, and that’s why Japan could do it. The second is that the Japanese themselves prefer to buy their own bonds than other countries bonds. Now they still buy other countries bonds, but there’s a home bias.
There’s an extreme gravitation towards buying your own debt in Japan, which is also very unusual because in other countries, investors just go for yield. They don’t necessarily have a home bias. And those two measures, the amount of domestic savings and the home bias explains why Japan could push it so far, essentially. And then having a very aggressive central bank as well. I don’t think it’s necessarily a strategy we should emulate everywhere in the world. So Luxembourg I’d like to commend with it’s 21%. I wouldn’t recommend going to over 200% in an instant because ultimately, it doesn’t solve any economic problems. Growth is derived not by spending more, it is through productivity gains, through having a dynamic corporate sector, through having favorable demographics. And those are the things that Japan is still working on to this day.
What would be very interesting also to hear from you is how Asian investors are viewing what is happening in the rest of the world in particular in Europe and in the US? Are there any trends emerging from these investors that it would be useful for us to understand and to know?
FN: “Well, I think the first thing is Asian investors are very rational. They make their analysis like everybody else and invest where you have the best yield potential with diversification. So therefore they look at Europe, the US, as much as they look at Asia. Having said that though, there are some emerging trends which I think are interesting, which is that there is increasingly a sense that maybe there’s a somewhat hostile, perhaps, environment for certain types of investments. So if you think, for example, a Chinese company investing in the US, maybe that could lead to certain political backlash or might not be seen well. So there is I think a bit of an image problem, if you will, where hesitancy increasingly where investors, particularly companies, are evaluating a little bit more, what the sustainability of that investment is. It’s probably less of a portfolio investor issue, but certainly companies I think are very receptive to this idea that perhaps there’s been some barriers thrown up or their investments is less welcomed than was several years ago.
And what that might mean is that you might see less acquisitions for example, by Asian companies in Europe and the US. In fact, the data shows that already, that you’ve seen a decline in Asian companies buying US companies. Now, maybe it’s just a cyclical blip, but to the extent, and I don’t think European and US policy is necessarily just aimed at China. I think it’s just a general protectionist trend that is emerging, and that could be fueled by further populism that raises some concerns about Asian investors. And I think that’s just a fair thing to say. There’s a lot of political uncertainty now in Europe as well in the US. And that certainly impinges on how investors here look at putting extra dollars to work in Asia or Europe.
Somebody with your depth of understanding of Asia should definitely be writing a book, but until you do that, you probably mostly read books. And so please let me ask you a question we have now come to traditionally ask at this stage of the podcast, namely, which book have you recently read and would recommend to our listeners?
FN: “There’s so many books that I’d love to recommend readers, but maybe if I may two, if I may just pick two, one is Lingling Wei And Bob Davis at the Wall Street Journal have written a book, which is entitled Superpower Showdown, which is really about US China trade tensions and how they’ve come about. And so they’ve not just looked closely at the last 12, 18 months of the Trump presidency, but really looked at the last 20, 30 years and what you can beautifully see in that book is that a lot of these tensions we talk about now, the seeds were set over the years and is really broader than just about President Trump or President Xi Jinping not getting along. It’s not about the personality, it’s more systemic clash, if you will. And so it gives a deep understanding of that, and they do it with a journalistic flair, but at the same time it cites a lot of academic work. So I think it’s an excellent book that helps understand that relationship.
On a more personal note, I’ve been trying to get away from US China trade tensions, I’ve dived into the biography of Lyndon Johnson by Caro, Robert Caro. And this is a masterpiece. It’s about 3000 pages, which should not dissuade any listener from reading it, because it reads like a breeze. And the interesting thing is that there are so many parallels between the politics of the 1940s and ’50s in the US and what you see today in the US. And sometimes you despair at the antagonism that you see on TV in the US but you’re reminded that, maybe we have had challenges before and we’ve overcome those. And that’s a book that encapsulates that in one biography of one very fascinating President, which is Lyndon Johnson.
NM: “A biographer himself has also written a book about how he works on such biographies and which itself is already a very interesting book to read. Well, Frederic Neumann, thank you very, very much for this fascinating tour de raison of Asia. This is obviously something we could be discussing for hours on end, but thank you so much for this. Thank you also to our listeners who have tuned in again to our podcast. Then in the next episode we will be switching continents, crossing the Pacific in the other direction and listening to Jennifer Reynolds from Toronto, who will tell us a little bit what is happening in Toronto in the tech sphere, but not only, also more generally as regards to the investments going on there. Thank you very much to all of you and talk to you soon.”