China's $6 TRILLION Decline Explained ft. Michael Nicoletos

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0:58is something about to break in China. Welcome to this macro deep dive on China here at Real Vision. I'm Andreas Steno, your host for the next 60 minutes, and I'm pleased to be joined by Michael Nicolettos of DeFi Advisors for this discussion on China. Good to see you, Michael. See you. How are you? Good. I'm not sure we'll be super upbeat after this discussion on China today. Having had initial discussions with you before going on air here, Michael. But I mean, we see loads of stories right now out of China on very weak local consumption, very weak real estate markets. How would you define the current economic landscape in China right now?

1:41Look, I've been worried for quite some time. And if you look at it from a market perspective, I've been wrong in the sense that when you're looking at markets, you need to get the timing right. If I'm crying wolf for like 10 years, I get it right. It's, you know, you're wrong in the market space. So from a market perspective, I think I was early being worried on China because I felt things would break faster. However, in the last few months, and I think in, let's say, the last six months, things are starting to accelerate on the downside. And why am I saying that? I'm saying that because China needs things to stabilize and the real estate market is falling off a cliff.

2:26The stock market isn't doing well. It's lost$6 trillion since 2021. If you put China and Hong Kong together, then you have another$4 trillion or$5 trillion lost in the real estate market. So you're like minus$10 trillion,$11 trillion in the last two, three years, which it adds up. Now, my word has been, they've always managed to build confidence by, I don't want to say printing money by adding liquidity. Okay, so it's an easy way. So how does that work? They add liquidity by increasing M2. So M2 is the money circulating in the economy. The, what you can spend, let's say, you know, for people who don't know what M2 is.

3:14So it's the available money that can be used if you want to say that. So M2 right now in China is around$40 trillion and with a GDP of like$17.7 trillion. Now, to put things in perspective, the US, which has a GDP of like 26 and 7 trillion, something like that, its M2 is 20 trillion. So it's half the M2 that China has. Now, what do they do? They increase the amount of supply. The money cannot leave the country because you have capital controls. So money needs to stay in, if you want to say it. this way. And that money is used to prop up real estate prices to keep the stock market up. But in the past six months, one year, this hasn't happened.

4:02Which means what? It means that the losses are probably more than the money that is being put into the system. So this is what has started to make me worried. Now we're talking about a Chinese economy which is highly dependent on real estate. Housing is like 60 % of the Chinese household compared to 36 % in the US. And housing debt disposable income is just more than 130%. So the Chinese have put a lot of money in that. So that's a big issue right now. The banking system in China when it comes to real estate is a big portion. So I think Chinese assets are around 60 trillion dollars. That's a huge number if you put it in terms of perspective, because this is like 50 % of global GDP, 54 % of global GDP, and it's like 320 % of China's GDP.

5:01Now in their peaks, the US was, I think, around 32 % of global GDP and in Japan in 94 was like 27 % of GDP. So if you take each country at their peaks, how big their banking system was, China surpasses this by a lie. So this fragile situation makes me worry. I fully understand that. And I concur with that view. It seems like China is stuck in some sort of structural downtrend here. Michael, when you look at the path ahead for the Chinese government amidst all this, right? We've been talking a lot about the deficit in the US, but what about the Chinese public deficit? Do they have the coffers to sort of deal with this situation?

5:48How do you view that situation? Well, we talk about the US deficit, which is like 7 % of GDP, if I'm correct. Well, around that number. China's official GDP deficit is 3%. Unofficial is around 7%. The IMF in some reports has it at minus 15%. Now, why that number is different? Why a lot of people find it hard to figure it out? Because in the number which are published, they do not include special government bonds managed under the government's fund. They don't include state capital operation budget. They don't include social insurance budget. They don't include supplementary funds. They've excluded a lot of things.

6:34So if you include all that, you get to more than 7%. So now you have a deficit of 7 % and you have an M2 of 40 trillion. So what happens here? The Chinese government has been putting liquidity to fund the deficit action because no external capital is coming in. If you look at the FDI, the FDI is collapsing in China. So that's what they've been doing. We focus on the U.S., which, okay, I'm not saying that the U.S. situation is good. Don't take me wrong. I think the US is in a bad situation. But things are never absolute. They're relative. And the good thing about the US is that it's the biggest capital market in the world.

7:17It's the most liquid capital market in the world. And that attracts capital. So if you're an investor, where will you put your money when you're feeling afraid? You're going to put it in the US Treasuries. Maybe you put it in gold. But you've got to put it in the US Treasuries. Now, the U.S. treasury market, for people to understand, trades around$15 ,15 trillion a month value. China is around$2 trillion or less than$2 trillion. I'd say, yeah, around$2 trillion. So you see the size. The whole world goes into the U.S., who goes into China? And the thing is not that China doesn't want anything, but would you invest your savings in a currency where the currency has capital controls and you might invest in an illiquid market and then not be able to take your money out.

8:08So yes, the US situation is bad, but if you look at it in relative terms, it's much better than what the Chinese economy is right now. Hey everyone, we're going to take a quick pause and hear a word from our partners. We'll be right back. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo. See a trading opportunity? You'll be able to trade it in just two clicks. Feel ready? You can move to real money with as little as$100 once your account is approved.

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9:26Yeah, and your point on illiquidity in Chinese markets is very relevant. I used to travel global central banks a lot, speaking to their reserve managers. And one of the first questions around markets outside of their home markets was also always, is the liquidity good? Because we obviously need to buy some assets with the currencies that we get from each part of the world in the reserves. So you're spot on that liquidity is a key measure for these reserve managers across central banks in the world. Michael, we have a lot of focus on that question right now. because of a very weak Chinese yuan.

10:02So the currency developments are very weak, at least versus the dollar. And we're close to that 7.3 level that they've fiercely defended time after time. So how do you view the path ahead for the Chinese currency amidst this major wave of Chinese debt? Well, China, in my view, there are not a lot of things you can do. They can lower the value of the currency and they're trying to do it in a manageable way. So, you know, you lose like half a percent a month, one percent a month. It's not, it doesn't raise an eyebrow only to people who look at it every day, but it won't make a headline. And I think that's what they're trying to do.

10:46Why do they want to do that? Because China has two ways to accumulate foreign exchange reserves. One is through FDI. One is through the current account. so until now they were focusing on investment and investment was a big part of the economy and now they're trying to shift manufacturing so to shift to manufacturing what does it mean you're going to substitute manufacturing in order to export right the big part of the export so you need to lower the value of the currency given that tariffs are coming and we see that every day we're going to see I think we're at the beginning of a tariff it's not the Chinese thing but people will feel more, they will want to go more inward.

11:31You can see from the elections in Europe, you can see the elections in the US. Everyone's going to try to put their country first and that would be very hard when it comes to trading and doing trade with other countries. So China has two ways to accumulate effective reserves. So if it lowers the value of its currency, it can export more or at least it can balance out the tariff increases. And by doing an FDI, by lowering the price, you can attract more FDI into the country. So now FDI until now was very strong. But if you look at it since 2000, I think 10, it's been from, what was the number? I think the number was 10 % of GDP, and now it's 1.5 % of GDP.

12:25And so in 2003, it was like 80 % lower than in 93. So with the FDI in the US, in China. So they're trying to accumulate money, and they try to increase investments in the country. FDI is overstated, I would say, because there is a lot of money coming through Hong Kong, which is what they call round-tripping. So China sends money to Hong Kong and then it comes back. This is around 25%, according to the IMF, or the World Bank. And that money comes and goes. So if the FDI is that number, it's much worse, in my opinion, than what we see. And they need to lower their value, the lower the value of the currency to attract more FDI and to increase their current account.

13:12So it works both ways for them. The only thing they don't want to do is scare people. So they do not want to do this abruptly. And they don't want to do it in a fast way. So they're doing it the way you see it. So it's been from 7.20 to 7.30, like five months, six months, something like that. Yeah, a very slow move, but a small smidge each and every day. And Michael, in relation to that, I mean, we obviously often get questions on Chinese ambitions in the foreign exchange market all the time. the potential for a BRICS currency. So this current regime where the Chinese yuan is at least somewhat linked to the US dollar, at least they manage it within some sort of bandwidth against the US dollar.

14:03How do you view that link versus the dollar and the potential to create some sort of reserve currency out of the yuan all the time? It clearly wants to become a global reserve currency. And it wants it not only for mercantilistic reasons, but for functional reasons. Because if it manages to succeed and get from, I think, 7 % of global transactions to, let's say, 40 % or 50%, then foreigners will accumulate FX reserves in Airbnb, which will then need to deploy it in their local bond market, which then all that M2 that is shut down in China will be able to get out, if you want to say that. Because if you look at the US, the biggest weapon of the US is the euro-dollar market.

14:53The euro-dollar market, I mean, the dollars created outside the US, to put it, not the euro for people who don't know. So what does the US do? The biggest weapon the US has is the US dollar. It's like 80 % of global transactions. They have the euro-dollar market outside the US. Everyone needs dollars. So every time the dollar gets stronger, everyone gets squeezed. So they come back to the U.S. one way or another, asking for the equity. And then the U.S. facilitates. And I'm pretty sure they don't. So something comes by. Now, China wants for sure to become a global reserve currency. But in order to do that, it has to do two things.

15:31It will have to open the capital account. because with capital controls, it will be very hard for someone to accumulate a currency that they might get stuck with it. And they'll need to make their market more transparent and more liquid. Of course, it's a chicken and egg problem. So you need to do a bit of both. And it's a positive loop as the currency becomes more freely traded, the local market becomes more liquid, and vice versa. So I think that's the main issue China needs to do, and they want to do it. However, they're faced with a dilemma. If they open the capital account, with a$40 trillion in M2 and$3.2 trillion in FX reserves, which is 12.7 times more than their FX reserves, China might not have external debt, which is usually the problem.

16:25But it has too much money in the country which wants to leave. So if that money that wants to leave decides to leave, your 3.2 trillion is nothing compared to 40 trillion M2. I'm not saying if 40 trillion are going to leave the country, but it's 12 times more. The Asian tigers in 1997 collapsed when that number exceeded four times. So just to put the number. But because of capital control, because it's China, because everyone thinks that China has it under control, it's still manageable. But if they were to go for a global reserve currency, they would have to open the capital account, which means that money would leave.

17:03They would have probably a big devaluation. And if you look at the banking system you just mentioned earlier, which is like around$60 trillion,$57 trillion worth of assets. Now, with all the real estate and the stock market having these issues, and the banks have taken less than 2%, have shown their balances less than 2 % of NPLs. So imagine that number being bigger. They would need to be recapitalized. That would be the magnitude of 5 to 10 trillion. You see the numbers get up again. The numbers are down. So it's very hard for them to open it. so they want it, but they can't have it. And when we talk about the BRICS currency, Russia has capital controls.

17:54India has capital controls. China has capital controls. You cannot have a collective currency with half of them having capital controls. Who's going to have what? If they don't trust each other, how will this work? Yes, it's nice to say it in words. It's really, really nice to have it as a headline. People get really excited. People who think the dollar is dying tomorrow morning. But these things take a bit more time. I'm not saying the U.S. dollar is not doing things it shouldn't be doing or the U.S. government. But I'm saying it takes much more time for all this to play out. And usually it takes 10, 20, 30 years.

18:32We might see the first signs, but we're not changed. So from a trading perspective or from an investment perspective, this is not an issue for me right now. it's something to look at it but we're far away from you know from going from seven percent and overthrowing the government the u.s which is 87 or 80 percent more it will take a lot of things for this to to to switch yeah that's how that's the way i see it i don't know if you agree i don't know what your thoughts are on this but it feels to me that it's It's very tough. Well, it's not an imminent discussion. I agree. I guess I get quite a few questions from, say, that you're a millionaire or potentially even a billionaire, and you want to sort of protect yourself against a scenario where the US dollar loses value versus, for example, a BRICS currency.

19:26Is there a way to sort of mitigate that risk from an investment perspective? What would you buy to alleviate that risk? I can ask you the question. I may have a few inputs on it after that. But the way I view the world is the dollar. And if I have to buy anything else but the dollar, and I'm talking in size now, I'm not saying Bitcoin or anything. Because I'm in favor of Bitcoin, but I would not put all my money into Bitcoin. I'm not a maximalist. And I don't think one should not have any Bitcoin. I think everyone should own some Bitcoin. and I think it's something which makes sense. Now, if I don't own dollars, my view is to own gold.

20:09And why do I say? So my personal, and I'm in Europe, so that will help explain what I'm thinking. Being in Europe, I hold dollars and gold. I don't hold any euros. Or I hold as many euros as I need to live my life, but I don't hold any euros from a perspective. Because what happens? If the dollar strengthens, gold usually falls, but sometimes, as we can see, it rises as well. But when dollar falls, gold goes up. So why not have an asset with no counterparty risk when I get the same effect as I would have if I hold another currency? Now, I'm talking about trading right now. I'm talking about an asset allocation.

20:53Now, okay, if we see extremes, I'll trade them. If you see the yen going through the roof, maybe I'll buy some. But this is not something I would do right now. And then I like Bitcoin, I like gold, as I said. I like hard assets, which yield something. So you need to be, you know, high quality investments. And I think the US, with its bads and all its wrongs, it's still the favorite place to invest. The structure of the market is such that it can't be compared to something else. That's my view. I don't know if you agree or not. Hey, everyone. We're going to take another quick break and hear a word from our partners, and then we'll be right back.

21:40Well, I guess in that ultimate tail risk scenario where China will try to open its capital account, it's hard not to see gold performing versus the local currency out there, right? So I agree with you that it's a strong hedge against that scenario. and I mean in relation to that discussion Michael why is it even possible right now to to to measure the amount of capital flight that we see from China because I often go to Singapore I haven't been to mainland China for a while and I meet a lot of Chinese entrepreneurs leaving the country for Singapore and and obviously they've brought their money abroad to a certain extent they they typically have to pay to leave but but uh is it possible to measure how many of these exits we see from from wealthy chinese people it's very hard and i'm saying it's very hard because even if the information that you find you can see you can see the signs that it's happening but it's very hard to to know the number i'll give you an anecdotal information how do the chinese take their money out they have a company in hong kong they're over invoice they send a portion to hong kong and then that money leaves.

22:51But that way is not available to everyone. Okay? So the ones who can do it, they do it. But if someone goes to the PBOC and one goes to the HKMA, which is the Hong Kong Monetary Authority, and you look at some numbers, okay? Look at exports and imports to Hong Kong on both central banks. The numbers should be the same or at least should be close. the discrepancies in the billions of dollars they don't have the same number the numbers are no i deviate by i don't know how many billions so and i'm saying okay it shouldn't be exactly the same but they're not even close which tells me that things are moving towards getting out of china now another thing you can look at gold in hong kong trades at a premium I think it's been written.

23:47It's been, you know, you can see it everywhere. In China, it's still allowed. You're still allowed to buy gold. And it's still a privilege. So if you're a Chinese and you feel you're not safe in the banking system, you feel you cannot keep your, you take your money out, what do you do? You either buy gold or you buy Bitcoin. Bitcoin is very hard for someone to buy because they've made it very hard. But gold still is the only way to do it. So people buy gold, they don't care if there's a premium for it, they'll buy it. They'll buy it in order to protect themselves from a systemic issue. That's how I see it.

24:25So there are a lot of signs which show that the Chinese are taking the money out. It's very hard to quantify it. But look, if the real estate is going down, if the stock market is not doing well, if the government keeps pumping money and the deficit is at 7 % or more, where is all that money going? Why isn't there asset inflation in China? What do they do with the money? There's some leakage. With these kind of numbers, you would expect the growth rate to be through the rules. And I think last year, growth was like 5%. Official growth was 5%. Now, investment is like 40-45 % of GDP. And it was flat last year.

25:21How do these two numbers reconcile? So the important thing to understand about China, the GDP number is an input number, where the rest of the real world is an output number. So they put a goal at the beginning of the year and the local governments need to achieve it. So they'll do anything to achieve it. And the rest of the world is what you produce. That's the output number. That's your GDP. So the two numbers are not comparable. So when we say that China grew 5%, it's not the 5 % we understand. What we have as a common denominator in the West. So you cannot have the 5 % growth number and when 45 % of your economy is flat.

26:07How does that happen? When FDI is at its lows, when the current account is not doing anything tremendous, so I need to reconcile the numbers. Something has to get. And I'm pretty sure that if the numbers were better, the Chinese government would do anything in its power to build confidence and show that it's better. So my view is that the numbers we see are the best case scenario. Numbers are likely worse than what we see, which are bad as they are. Yeah. I track some satellite data. I think it's from NASA in the U.S. So tracking the amount of light over industrial complexes in both Beijing and other cities in China.

26:57I also track some data on air pollution in China. So two non-mollipulative numbers on the industrial activity. And it was absolutely on the floor in 2023. So obviously there was a recession. They just didn't report it. So you have it year by year? You have that data on a year by year? Yeah. And I mean, it looks like a 10 % recession, something like that. Obviously you cannot exactly say that it's a nominal. You get a feel for it. But you get a feel for it. The direction of travel was certainly negative in 2023, But it's actually improving a bit this year, but from a very bad level, right? And I guess that's an interest.

27:36We've gotten a few questions from the audience already. Can we say something positive around China? And in relation to that, I'll start with a question on the strategy in relation to the Chinese holdings of U.S. treasuries, because we get a few questions in wondering why are they actually offloading U.S. treasuries in this scenario? Is that in preparation for a future where the Chinese yuan is decoupled from the U.S. to a larger extent? Or how do you view that situation where they're actually offloading U.S. treasuries in this scenario? That's what I thought. And then I came across some research which suggested that China is accumulating U.S.

28:18FX reserves through Luxembourg and Belgium. So actually the number is flat and is not being reduced. So it makes a nice headline. China is offloading US Treasuries. The news writer, people start saying the dollar is dying and all that. While at the same time, to another vehicle or another form, they are accumulating through Belgium and Luxembourg. And the data that I saw, it was that the last year it's been flat. I wouldn't say it's offloading, but it's flat. So I think that made a lot of sense. and the research was quite compelling. So I'll take that. I can't see how that happens and the US Treasury market is flat.

29:05So it hasn't done much in the last year. So I'd say that I wouldn't buy it. I don't think the Chinese are selling. And if they're selling, it's because they don't have any dollars and they need them. So they sell them because they have to stop the currency from falling faster. So that would be my case if it were for them to drop. But I don't think it's dropping. I think they're managing a stable devaluation in order to make it more compelling for those workers coming. Yeah. It's a good point on the accumulation outside of Chinese shores. I obviously referred to the official data from SAFE, the investment arm of the Bank of China.

29:50And when we look at the gold reserves of SAFE, the investment arm of People's Bank of China. They've been buying a lot of gold, also officially in China. They made an announcement in May that they halted the purchases of gold in May. We don't know whether they've bought in June yet. But what do you read into that official buying of gold also in China? It's not only unofficial, it's also official. Is that important? I think it's important because I'm always trying to think scenarios. So what happens if this happens? What happens if that happens? So let's play out the scenario and see if you find any flaws and we can discuss.