Category Archives: EM

Toto, I’ve a feeling we’re not in Kansas anymore

03 Tuesday Mar 2020

Posted by in Asset Allocation, China, EM, Equity, Monetary Policy, Politics

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This worked out quite well. Too well given the G7 “strong and coordinated response”. Let’s not kid ourselves, unless they can build a hospital in six days, this is going to be highly inadequate.

As if rates going negative was not enough of a wake-up call that what we are dealing with is something else, something which no one alive has experienced: a build-up of private debt and inequality of extraordinary proportions which completely clogs the monetary transmission as well as the income generation mechanism. And no, classical fiscal policy is not going to be a solution either – as if years of Japan trying and failing was not obvious enough either.

But the most pathetic thing is that we are now going to fight a pandemic virus with the same tools which have so far totally failed to revive our economies. If the latter was indeed a failure, this virus episode is going to be a fiasco. If no growth could be ‘forgiven’, ‘dead bodies’ borders on criminal.

Here is why. The narrative that we are soon going to reach a peak in infections in the West following a similar pattern in China is based on the wrong interpretation of the data, and if we do not change our attitude, the virus will overwhelm us. China managed to contain the infectious spread precisely and exclusively because of the hyper-restrictive measures that were applied there. Not because of the (warm) weather, and not because of any intrinsic features of the virus itself, and not because it provided any extraordinary liquidity (it did not), and not because it cut rates (it actually did, but only by 10bps). In short, the R0 in China was dragged down by force. Only Italy in the West is actually taking such draconian measures to fight the virus.

Any comparisons to any other known viruses, present or past, is futile. We simply don’t know. What if we loosen the measures (watch out China here) and the R0 jumps back up? Until we have a vaccine or at least we get the number of infected people below some kind of threshold, anything is possible. So, don’t be fooled by the complacency of the 0.00whatever number of ‘deaths to infected’. It does not matter because the number you need to be worried about is the hospital beds per population: look at those numbers in US/UK (around 3 per 1,000 people), and compare to Japan/Korea (around 12 per 1,000 people). What happens if the infection rate speeds up and the hospitalization rate jumps up? Our health system will collapse.

UK released its Coronavirus action plan today. It’s a grim reading. Widespread transmission, which is highly likely, could take two or three months to peak. Up to one fifth of the workforce could be off work at the same time. These are not just numbers pulled out of a hat but based on actual math because scientist can monitor these things just as they can monitor the weather (and they have become quite good at the latter). And here, again, China is ahead of us because it already has at its disposal a vast reservoir of all kinds of public data, available for immediate analysis and to people in power who can make decisions and act fast, vert fast. Compare to the situation in the West where data is mostly scattered and in private companies’ hands. US seems to be the most vulnerable country in the West, not just because of its questionable leadership in general and Trump’s chaotic response to the virus so far, but also because of its public health system set-up, limiting testing and treating of patients.

Which really brings me to the issue at hand when it comes to the reaction in the markets.

The Coronavirus only reinforces what is primarily shaping to be a US equity crisis, at its worst, because of the forces (high valuation, passive, ETF, short vol., etc.) which were in place even before. This is unlikely to morph into a credit crisis because of policy support. 

Therefore, if you have to place your bet on a short, it would be equities over credit. My point is not that credit will be immune but that if the crisis evolves further, it will be more like dotcom than GFC. Credit and equity crises follow each other: dotcom was preceded by S&L and followed by GFC.

And from an economics standpoint, the corona virus is, equally, only reinforcing the de-globalization trend which, one could say, started with the decision to brexit in 2016. The two decades of globalization, beginning with China’s WTO acceptance in 2001, were beneficial to the USD especially against EM, and US equities overall. Ironically, globalization has not been that kind to commodity prices partially because of the strong dollar post 2008, but also because of the strong disinflationary trend which has persisted throughout.

So, if all this is about to reverse and the Coronavirus was just the feather that finally broke globalization’s back, then it stands to reason to bet on the next cycle being the opposite of what we had so far: weaker USD, higher inflation, higher commodities, US equities underperformance.

That’s my playbook.

Corona Virus market implications

29 Saturday Feb 2020

Posted by in Asset Allocation, China, EM, Equity, Monetary Policy, Politics, UBI

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Following up on the ‘easy’ question of what to expect the effect of the Corona Virus will be in the long term, here is trying to answer the more difficult question what will happen to the markets in the short-to-medium term.

Coming up from the fact that this was the steepest 6-day stock market decline of this magnitude ever (and notwithstanding that this was preceded by a quite unprecedented market rise), there are two options for what is likely to happen next week:

  1. During the weekend, the number of Corona Virus (CV) cases in the West shoots up (situation starts to deteriorate rapidly) which causes central banks (CB) to react (as per ECB, Fed comments on Friday) -> markets bounce.
  2. CV news over the weekend is calm, which further reinforces the narrative of ‘this too shall pass’: It took China a month or so, but now it is recovering -> markets rally. 

While it is probably obvious that one should sell into the bounce under Option 1, I would argue that one should sell also under Option 2 because the policy response, we have seen so far from authorities in the West, and especially in the US, is largely inferior to that in China in terms of testing, quarantining and treating CV patients. So, either the situation in the US will take much longer than China to improve with obviously bigger economic and, probably more importantly, political consequences, or to get out of hand with devastating consequences. 

It will take longer for investors to see how hollow the narrative under Option 2 is than how desperately inadequate the CB action under Option 1 is. Therefore, markets will stay bid for longer under Option 2.

The first caveat is that if under Option 1 CBs do nothing, markets may continue to sell off next week but I don’t think the price action will be anything that bad as this week as the narrative under Option 2 is developing independently. 

The second caveat is that I will start to believe the Option 2 narrative as well but only if the US starts testing, quarantining, treating people in earnest. However, the window of opportunity for that is narrowing rapidly.

What’s the medium-term game plan?

I am coming from the point of view that economically we are about to experience primarily a ‘permanent-ish’ supply shock, and, only secondary, a temporary demand shock. From a market point of view, I believe this is largely an equity worry first, and, perhaps, a credit worry second.

Even if we Option 2 above plays out and the whole world recovers from CV within the next month, this virus scare would only reinforce the ongoing trend of deglobalization which started probably with Brexit and then Trump. The US-China trade war already got the ball rolling on companies starting to rethink their China operations. The shifting of global supply chains now will accelerate. But that takes time, there isn’t simply an ON/OFF switch which can be simply flicked. What this means is that global supply chains will stay clogged for a lot longer while that shift is being executed. 

It’s been quite some since the global economy experienced a supply shock of such magnitude. Perhaps the 1970s oil crises, but they were temporary: the 1973 oil embargo also lasted about 6 months but the world was much less global back then. If it wasn’t for the reckless Fed response to the second oil crisis in 1979 on the back of the Iranian revolution (Volcker’s disastrous monetary experiment), there would have been perhaps less damage to economic growth.  Indeed, while CBs can claim to know how to unclog monetary transmission lines, they do not have the tools to deal with supply shocks: all the Fed did in the early 1980s, when it allowed rates to rise to almost 20%, was kill demand.

CBs have learnt those lessons and are unlikely to repeat them. In fact, as discussed above, their reaction function is now the polar opposite. This is good news as it assures that demand does not crater, however, it sadly does not mean that it allows it to grow. That is why I think we could get the temporary demand pullback. But that holds mostly for the US, and perhaps UK, where more orthodox economic thinking and rigid political structures still prevail. 

In Asia, and to a certain extent in Europe, I suspect the CV crisis to finally usher in some unorthodox fiscal policy in supporting directly households’ purchasing power in the form of government monetary handouts. We have already seen that in Hong Kong and Singapore. Though temporary at the moment, not really qualifying as helicopter money, I would not be surprised if they become more permanent if the situation requires (and to eventually morph into UBI). I fully expect China to follow that same path.

In Europe, such direct fiscal policy action is less likely but I would not be surprised if the ECB comes up with an equivalent plan under its own monetary policy rules using tiered negative rates and the banking system as the transmission mechanism – a kind of stealth fiscal transfer to EU households similar in spirit to Target2 which is the equivalent for EU governments (Eric Lonergan has done some excellent work on this idea).

That is where my belief that, at worst, we experience only a temporary demand drop globally, comes from, although a much more ‘permanent’ in US than anywhere else. If that indeed plays out like that, one is supposed to stay underweight US equities against RoW equities – but especially against China – basically a reversal of the decades long trend we have had until now.  Also, a general equity underweight vs commodities. Within the commodities sector, I would focus on longs in WTI (shale and Middle East disruptions) and softs (food essentials, looming crop failures across Central Asia, Middle East and Africa on the back of the looming locust invasion). 

Finally, on the FX side, stay underweight the USD against the EUR on narrowing rate differentials and against commodity currencies as per above.

The more medium outlook really has to do with whether the specialness of US equities will persist and whether the passive investing trend will continue. Despite, in fact, perhaps because of the selloff last week, market commentators have continued to reinforce the idea of the futility of trying to time market gyrations and the superiority of staying always invested (there are too many examples, but see here, here, and here). This all makes sense and we have the data historically, on a long enough time frame, to prove it. However, this holds mostly for US stocks which have outperformed all other major stocks markets around the world. And that is despite lower (and negative) rates in Europe and Japan where, in addition, CBs have also been buying corporate assets direct (bonds by ECB, bonds and equities by BOJ).

Which begs the question what makes US stocks so special? Is it the preeminent position the US holds in the world as a whole? The largest economy in the world? The most innovative companies? The shareholders’ primacy doctrine and the share buybacks which it enshrines? One of the lowest corporate tax rates for the largest market cap companies, net of tax havens?… 

I don’t know what is the exact reason for this occurrence but in the spirit of ‘past performance is not guarantee for future success’s it is prudent when we invest to keep in mind that there are a lot of shifting sands at the moment which may invalidate any of the reasons cited above: from China’s advance in both economic size, geopolitical (and military) importance, and technological prowess (5G, digitalization) to potential regulatory changes (started with banking – Basel, possibly moving to technology – monopoly, data ownership, privacy, market access – share buybacks, and taxation – larger US government budgets bring corporate tax havens into the focus).

The same holds true for the passive investing trend. History (again, in the US mostly) is on its side in terms of superiority of returns. Low volatility and low rates, have been an essential part of reinforcing this trend. Will the CV and US probably inadequate response to it change that? For the moment, the market still believes in V-shaped recoveries because even the dotcom bust and the 2008 financial crisis, to a certain extent, have been such. But markets don’t always go up. In the past it had taken decades for even the US stock market to better its previous peaks. In other countries, like Japan, for example, the stock market is still below its previous set in 1990.

While the Fed has indeed said it stands ready to lower rates if the situation with the CV deteriorates, it is not certain how central bankers will respond if an unexpected burst of inflation comes about on the back of the supply shock (and if the 1980s is any sign, not too well indeed). Even without a spike in US interest rates, a 20-30 VIX investing environment, instead of the prevailing 10-20 for most of the post 2009 period, brought about by pulling some of the foundational reasons for the specialness of US equities out, may cause a rethink of the passive trend.  

The best portfolio diversifier (cont.)

01 Friday Nov 2019

Posted by in Asset Allocation, China, Debt, EM

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…is (actually) Chinese bonds

When speaking to investors, the two most common questions I get asked, given rather extreme levels and valuations of (most) asset classes, are:

1.Should my asset allocation change dramatically going forward? and

2.What is the best risk diversifier for my portfolio?

I have previously opined on this here. Very broadly speaking, on the equity portion, one should reduce exposure to US equities and increase allocation to EM equities (unhedged). On the fixed income side, one should move completely out of the long end of UST and put everything into T-Bills to 2yr UST; exposure to EU-denominated sovereigns should also be reduced to zero at the expense of EM local (unhedged) and hard currency bonds. In the normally ‘Others’ section of the portfolio, one should include soft commodities (or alternatively, scale everything down to make space for them). Finally, in terms of FX exposure, apart from EM currencies through the unhedged portions of the bonds and equities allocations, one should hedge the USD exposure with EUR.

Here I am adding some more general thoughts on what I consider to be the best portfolio diversifier for the next 5 years, possibly even longer. To my knowledge, ‘noone’ is invested in any meaningful way in Chinese bonds (I am excluding the special situations credit funds, some of which I know to be very active in the Chinese credit space – but even they are not looking at Chinese government or bank policy bonds).

The big fixed income funds, the pension/mutual funds, the insurance companies have zero allocation to Chinese bonds. Some of the index followers started dipping their foot in the space but most of them are either ignoring China’s weight or are massively underweight the respective index. Finally, a sign of how unloved this market is, on the passive/ETF side, the biggest fund is just a bit more than $100mm.

Let me just say here that we are talking about the third (possibly even the second, by the end of this year) largest fixed income market in the world. And no one is in it?

Chinese bonds merit a rather significant place in investors’ portfolios. They offer diversification thanks to their low correlation and superior volatility-adjusted return relative to other developed and emerging markets. In addition, Chinese bonds are likely to benefit significantly from both the passive and active flows going forward: I expect up $3 trillion of foreign inflows over the next decade on the back of indexation.

Bloomberg Barclays Global Aggregate Index (BBGAI) and JP Morgan Global Diversified have already confirmed Chinese bonds inclusion in their respective indices. FTSE Russell WGBI is likely to do that next March. This inclusion is a big deal! It will have huge repercussions on the global bond industry. It is a much more important and far-reaching development than a similar inclusion of Chinese equities in global indices last year. And the market is not only not ready for this, but it is also underestimating its impact overall.

China is a highly rated sovereign with a much better risk/return profile than other high-quality alternatives.  Chinese bonds offer a significant scope for portfolio diversification because they have very low correlation to global interest rates which means lower return volatility.

Therefore, China sovereign bonds offer a much better volatility-adjusted return than Global Bonds, EM Hard Currency and Corporate Bonds, US HY and Equities, Global Equities and Real Estate.

Among the plethora of negatively yielding sovereign bonds, China sovereigns offer a good pick-up over other DM bonds while yielding not too much lower than EM bonds. In addition, they offer much more opportunity for alpha generation than both DM or EM sovereign bonds. This alpha partially comes from the fact that Chinese fixed income market is still not so well developed and partially from the fact that there are not many sophisticated foreign players in it, as access to it is still not that straightforward.

However, things are rapidly improving on the access side. Bond Connect has already started to revolutionize the onshore market. Before the setting-up of CIBM, and especially Bond Connect in 2017, access to the China bond market was extremely cumbersome through a lengthy process requiring approvals from high authority (QFII and RQFII). Bond Connect, on the other hand, does not require domestic account and custody while following international trading practices. In addition, not long ago, it started real-time settlement and block trading. As a result, Bond Connect volumes doubled.

Moreover, in September this year, SAFE decided to scrap the quota restrictions on both QFII and RQFII, while Euroclear signed a memorandum of understanding with the China Central Depository & Clearing to provide cross-border services to further support the evolution of CIBM. That opens up the path for Chinese bonds to be used as collateral in international markets (eventually to become euro-clearable), even as part of banks’ HQLA. Such developments are bound to make access to the Chinese bond market much easier for overseas investors.

September proved to be a very important month for the China bond market also because the authorities finally delivered on the interest rate reform agenda. The central bank eliminated the benchmark policy loan and deposit rates in favor of a more flexible reference rate. This should be positive for yield curve formation and the continued expansion of interbank liquidity.

China does not have some of the weaknesses typical of emerging markets. On the opposite, it has very little sovereign FX debt, has large FX reserves, and it is a net creditor to the world. Moreover, some of the foreign debt is most likely offset by foreign assets.

Corporate-sector leverage, however, is still high, though default rates, despite lots of recent media focus, are still relatively low. On the other hand, the recovery rates are high, while the official, banking and household sectors are in relatively strong position which, reflects degrees of freedom to deal with these challenges. China has large amounts of debt with implicit state backing and a culture averse to defaults. In effect, the government controls both the asset and the liability side of the domestic debt issue thus a debt crisis is much less likely than in a fully free-market economy. The fact that China has the ‘fiscal’ space to deal with the private debt issue is one big advantage it has over DM countries with similarly high private debt burdens but which have also already used the option of shifting that debt to the government balance sheet.

The high debt issue and the authorities’ attitude to it, the structure of the economy (export-driven) as well as the potential transition from an extremely high growth rate to a more ‘normal’ one, makes China’s situation very similar to Japan’s in the late 1980s. Yet, there are also major differences. China’s urbanization rate is much below Japan’s before the 1990 crisis, the real estate bubble is only in the top tier cities as opposed to country-wide as in Japan, the Renminbi is more likely to depreciate going forward than massively appreciate which is what happened to the Yen after the Plaza accord.  

The high debt issue is a problem China shares not only with Japan but also with most advanced countries in the world. Similar to them, China is fully sovereign (the government has full control of the overall economy balance sheet; the currency peg is a “question mark”, not a real issue given China’s large positive NIIP). Of all these advanced economies with similarly high non-financial debt to GDP, only China has not reached the zero-bound*. It is, therefore, likely for the Chinese policy rate to continue to move lower until it eventually hits 0%.

Similar to Japan, it has a high household savings rate and a rapidly ageing population. Yet, Chinese households have relatively low exposure to financial assets and especially to bonds. Given the policy agenda of financial market reform and the life-cycle savings behavior (i.e. risk-aversion increases with age), Chinese households’ allocation to bonds is bound to increase manifold. Moreover, with the looming of the property tax law (sometime next year), I expect the flow into bonds to start fairly soon.

This flow aspect makes the case for investing into China bonds much stronger. Given the size of the Chinese fixed income market, its rapid growth rate and the reforms undertaken most recently, global bond indices had ignored Chinese bonds for too long. However, last year BBGAI announced that it would include China in its index as of April 1, 2019. Purely as a result of this, China bond inflow is expected to reach $500Bn by 2021 as the weights gradually increase from 0.6% to 6%. By then China will be the 4th largest component in the index (after US, Japan and France – and bigger than Germany!)

Before BBGAI’s inclusion, there had never been a bond market that large, that was not included in an index, as the Chinese bond market. In fact, China already represents the third largest bond market in the world, growing from $1.6 trillion in 2008 to over $11 trillion now.

And there is much more money flowing into Chinese bonds, for example, than into Chinese equities for the first time in history.

Despite the setback of FTSE Russell postponing its decision to include Chinese bonds into its index to March next year, JP Morgan did follow through with the inclusion. The FTSE Russell decision to wait for the inclusion happened literally a day before Trump announced that he is considering banning all investments into China on the back of the escalating trade war. Tensions since then have been substantially reduced and I do not expect Trump’s warning to materialize regardless. I expect foreign flows into Chinese bonds, therefore, to continue to grow substantially (probably by another $150Bn combined on the back of the FTSE/JP Morgan inclusions).

And that’s just from index accounts. I expect substantial inflows also from accounts outside of the passive investment universe. In addition, CBs and SWFs (which so far have been the largest investors in Chinese bonds) are also likely to keep increasing allocations. Bottom line is, as the liquidity and transparency improve, unconstrained bond managers and sovereigns are also likely to start allocating money in this space.

And even after these inflows, China bonds are still likely to remain relatively under-owned by foreigners as they would represent just 5% of China’s total bond market (currently foreign ownership of the overall bond market is around 3%, PBOC expects it to reach 15%). Foreign ownership of China sovereign bonds (CGBs) is slightly higher, but even at around 6%, it is materially lower than in other major sovereign bond markets. This under-ownership is even more pronounced relative to the emerging market (EM) universe (the ranges there are between 10% and 50%).

Compare this potential foreign involvement in Chinese bonds with those in Japanese bonds (the second largest market currently in the world, one which, actually, China is likely to surpass very soon): 40% of the traded volumes there are by foreign entities. Foreigners own about 13% of the market there – this may indeed seem small but it is still larger than local banks ownership, plus one has to take into consideration that Bank of Japan owns majority of the issues. The Chinese bond market, on the other hand, is completely dominated by domestic institutions (more than two-thirds is owned by commercial banks).

Domestic commercial banks have very much a ‘buy-and-hold’ mentality but liquidity in Chinese bonds is expected to increase substantially as local insurance companies and asset managers start becoming more active. In the sovereign bond market, for example, there are 45 primary dealers. Auctions are regular with single issue sizes varying between $3bn and $17Bn and maturity up to 50 years. On-the-run bonds (there isn’t a well-defined yield curve which actually provides opportunity for surplus alpha – see above) have bid-offer spreads normally around 1-3bps. In terms of liquidity, bonds stay ‘on-the-run’ for at least a year, in some cases longer.

Finally, foreign investors are expected to continue to get very favorable treatment from the Chinese authorities. The government has an incentive to make things easier as they need the foreign inflows to balance the potential domestic outflows once the current account is liberalized. For example, the tax changes implemented last year allowed foreigners to waive the withholding tax and VAT on bond interest income for a period of three years.

I am still frankly shocked how little time investors have to discuss these developments above but, at the same time, how eager they are to discuss the Chinese economy and the trade tensions. From one hand, they acknowledge the importance of China for their investment portfolio, but on the other, they continue to ignore the elephant in the room being the Chinese bond market. I understand that this choice is perhaps driven by investors’ inherent negative bias towards any Chinese asset, but the situation between asset and asset is much more nuanced.

In the fixed income space, one can be bearish select corporate credit and bullish CGBs or bank policy bonds (in fact, the more bearish one is on corporate credit, the more bullish sovereign bonds one should be). Finally, I do acknowledge that the big unknown here is the currency. But even there, the market has become much more sophisticated: one can now use a much longer CNY/CNH forward curve to hedge.

Bottom line is that if you are still looking for a fixed income alternative to diversify your portfolio and you are not looking at Chinese sovereign bonds as an alternative, you are not being fiduciary responsible.

*For more details, see JP Morgan’s economics research note, “China’s debt: How will it evolve?”

The best portfolio diversifier

24 Thursday Oct 2019

Posted by in Asset Allocation, EM

≈ 2 Comments

Given low, and in some countries negative sovereign rates, are sovereign bonds still the best portfolio diversifier in the long run? 

Yes

Because the portfolio optimization function has also changed. We are moving away from a world of profit maximization to a world of loss minimization.

Given persistent and large output gaps and surplus capital in the developed world, the expected return on future capital investment should be negative.

If Japan, Switzerland, Sweden and Denmark are any guide, their respective stock markets are down or flat since rates hit 0%. US is still a massive outlier (buybacks) but that is also fading (SPX buyback index is down YTD).

From a long-term point of view, I would still own sovereign debt as it has superior risk-adjusted returns even at these low yields. For example, in the last bear market for bonds, 10yr UST went from 1.95% in 1941 to 14.6% in 1982. Annual real total return for the period was 0.4% (annual nominal return was 5% with Sharpe ratio of 0.54). There were 10 years of negative returns (24% of the time) with the largest drawdown of 5% in 1969. In the bull market that followed, annual real returns were much higher but that was only because of disinflation (nominal returns were only marginally higher – around 6%). We still had 6 years of negative returns, but the largest drawdown was 11%.

‘Bond bubble’ is an oxymoron. The best value on the curve now: T-Bills. If you could be bothered to roll them, they would have a similar return to the long end but much lower volatility. The Fed just announced it is in the market buying T-Bills (as it ‘should’: the Fed is massively underweight T-Bills vs both history and the market). Despite heavy Treasury issuance net supply of T-Bills is expected to be negative next year.

US retail is massively underweight USTs: about 3-5% of all financial assets and about 2% of their overall assets.

Is gold a better portfolio diversifier when sovereigns yields are negative? Perhaps, in the short term and only for retail. Long-term, expected return on gold should also be negative (as long as sovereign yields are negative). For institutional investor gold is an inferior option from a liquidity and regulations point of view.

Is there a better portfolio diversifier at the moment, short-term? Perhaps soft commodities which trade below production costs (for some, like cotton, wheat – substantially below) – compare to precious metals which trade 50% above marginal cost of production. 

Soft commodities might be the exception among the major asset classes, whereby expected return is actually positive in a negative sovereign yield world, given that they already experienced negative returns in the past 10 years and their zero (negative?) weights in institutional or retail portfolios (mean reversion).

One can go even fancier here, up the risk curve, and allocate to hard currency emerging market debt, which has had even better risk-adjusted returns than USTs over the last 3 years. And, depending on currency views, go even further into local currency (unhedged) emerging market debt. USTs do not need to be negative, just to hover around 0%, for emerging market debt to really outperform, assuming no major market dislocation.

Finally, on the equity side, some allocation to emerging markets equity is also probably warranted given their massive under-performance specifically to US equities and my projected negative returns of the latter going forward. Unlike their developed market counterparts, emerging markets are not running negative output gaps and therefore, capital is still expected to earn a premium there.

Bottom line: if we are indeed in a loss-minimization type of world when it comes to investment returns (note, this does not assume any kind of market crash) one is still better off staying in sovereign debt, even when it yields negative as every other liquid asset is bound to return even more negative on any reasonable time scenario.

The jeepney: decentralized trust in practice

21 Thursday Feb 2019

Posted by in Decentralization, EM

≈ 1 Comment

Have you ever ridden in a jeepney? Chances are that you haven’t, for even if you have visited the Philippines, unless you are a backpacker, you would have stuck to taxis. In our travels, we met expats who had lived there for years but had never been in a jeepney.

Well, you are missing on a practical lesson how decentralized trust works.

The jeepney is actually the most popular public means of transportation in the Philippines. It was originally made from the American jeeps left over from WWII. It is also the cheapest way to travel because of its open rear door design, the jeepney can pick up and drop off passengers anywhere. Having said that, it is not the safest way of transport, either mechanically (too old), or because of its seating configuration (a long bench with no seat belts, very low ceiling, combined with constant and sudden stopping).

What was fascinating for me was actually how its payment system works: it is all based on trust. Decentralized trust in fact. As it is not optimal to have a ticket collector, the jeepney driver is also tasked with collecting the money for the trip. The problem is that the entrance is all the way in the back. Not only the driver cannot collect the fare in advance, but he has to rely on other passengers to pass on the money to him. Many times he has to pass back change. The fare also depends on the destination which is shouted as the money changes hands, which adds an additional variable to keep track of. All this while driving, so obviously the driver cannot possibly follow up on all this!

But the system works. Passengers can see who has paid and who has not and they have an interest to keep its integrity in check not because of a fear of a fine (light regulation with minimal monitoring) but the realization that if it breaks, it means everyone has to take the more expensive and less convenient bus. Of course the system can also be ‘gamed’: if ‘majority’ of the passengers agree to cheat but the level/cost of cooperation is too high.

As societies become more complex it is basically suboptimal to rely on a centralized authority. An additional complication is if those societies do not have a strong institutional infrastructure, like in most of EM, or the traditional sources of authority start to be mistrusted, like in a lot of the developed world.  Decentralized trust then becomes a necessity and a prerequisite for maintaining the proper functioning of society. It seems to me that EM has the first mover advantage here and is likely to leapfrog the developed world.

China’s credit expansion in perspective

28 Friday Dec 2018

Posted by in Debt, EM

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There seem to be three aspects of the recent debate about China’s private credit build-up:

1) Is it excessive? Yes, but it is not extreme.

2) Has it been misallocated? Probably yes, but not necessarily more than in other countries now or in earlier stages of development.

3) How will the authorities handle the inevitable credit burst? That remains to be seen, but due to its unique political system, China seems to be more in control than other countries which have undergone a similar fate Question is whether this control will result in a positive outcome.

China’s recent credit build-up is indeed big: its recent private credit-to-GDP gap (a BIS indicator measuring the speed of credit creation now relative to its long-term trend) is currently the largest in the world. 

China’s credit build-up seems to have accelerated especially so after the great financial crisis in 2008. 

However, private credit creation growth in China reached a top (using four quarters MA of the credit gap as an indicator) sometimes in 2015 and has been decreasing since then. 


Indeed, China’s absolute private credit to GDP ratio is nowhere near some other countries’ extremes. 

It is the corporate sector which has levered… 

…with households still relatively unlevered. 

And of the corporate sector, most of the debt is concentrated in the SOEs. Finally, its government sector is unlevered,  leaving the total (private + public) credit to GDP even lower relative to majority of other countries. 

 

Bottom line is, China seems to have a lot of credit space left, giving it some room for “a beautiful deleveraging”.

The fact that most of the credit is in CNY gives a lot of flexibility of how that deleveraging is done – on China’s own terms (there is some foreign currency debt but a lot of it is either matched by corporate foreign currency assets or covered by the country’s own FX reserves).

Having travelled extensively throughout the whole country, I can confirm that there are ghost cities but the state of the overall infrastructure, pretty much everywhere, is first class, probably on par, or even better than most of continental Europe while putting US/UK infrastructure to shame. Having travelled also through all of Central Asia and after spending a month in the Philippines and now in Malaysia, I can also attest that the alternative, not spending so much on infrastructure, is infinitely worse.

So, by investing in real estate and infrastructure projects, and given its large population which is emerging from decades of under-development, is China misallocating more capital relative to:

  • the developed world, particularly, UK and US, where since the 1980s majority of credit created was against existing (unproductive) assets like residential real estate and financial assets for speculative purposes, leaving current infrastructure in a crumbling state? That’s in sharp contrast to the period between WW2 and the 1980s when credit was allocated to the production of goods and services and infrastructure projects like the interstate highway system in the US (a period more comparative to China’s developments now, and one largely heralded as the golden stage of economic growth).
  •  the developing world, which similar to China now is also in need of massive infrastructure development but instead national capital has been syphoned off to offshore wealth centres? Yes, there has been private capital outflow from China as well but it would have been much bigger had the capital account not remained closed.

It would take time before we know for sure whether the decisions Chinese leaders are making are beneficial for the country or not. It is fairly likely, though, that this credit expansion is not sustainable. Should this boom be followed by a bust, we could be fairly certain that the situation would be carefully managed by the authorities, unhindered by either hostile domestic political opposition, like in the majority of the democratic Western world or by foreign creditors, like in the majority of the developing world.

How would they handle it? If history is any guide, they did a pretty good job both during the Asian crisis in 1997/98 and the great financial crisis of 2008. Third time lucky?

I expect the authorities to continue building up the social safety net – pension and health care system – alongside expanding and improving the financial assets universe. They could simultaneously deflate the real estate bubble, by starving it of additional capital and inflate financial assets by encouraging diversification into them. Unlike, developed world countries where household wealth generally collapses during crises, Chinese households could come out unscathed from this as they are unlevered. In addition, any losses on their real estate portfolio could be offset by gains in their financial assets portfolio. Finally, with the right social safety net in place, they would also feel more secure for their future than before and therefore welcome such an outcome.

 

Note: All data used above is from BIS

Silk Road (8): China West to East

27 Thursday Dec 2018

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I speak and speak, … but the listener retains only the words he is expecting. … It is not the voice that commands the story: it is the ear.

~ Marco Polo to Kublai Khan

 

Xinjiang

We had to stand in a single line even before entering the China border control building, with the border patrol officers strictly making sure the line is not broken. Everyone, except us, on that bus from Kazakhstan was either Kazakh or Chinese but we were not asked any questions by the
authorities – almost as if they were expecting us. However, after passing
through passport control I was pulled on the side and an officer went through my mobile phone pictures.

We did not know it then, but we ended up getting used to officials in Xinjiang province asking to check our identities and taking photos of us holding the passports open on the picture page. At the border crossing
they did that three times: first, on entering the building, second, during
‘official’ passport check, and the third time, at the exit of the building.

Once in China, we got picked up by one of Max’s friends and driven to the nearest town of Khorgos. The first thing that struck me there was how modern the town looked (given that it is a relatively small border town in
a undeveloped part of China). The second thing that surprised me was how high the level of security was. Even though we were aware of the Uighur ‘situation’ there, I had never seen anything like this on any of my previous travels (including the Bekaa Valley on the border of Lebanon and Syria when I visited it in 2000).

There were metal detectors and heavily armed police on the entrance of any public building. In fact, there were security on any building entrance. There were also military checks pretty much everywhere on the streets. Despite this we never felt unsafe or worried. The people did not speak
any foreign language but were extremely polite and accommodative.

We stayed in Khorgos for about a couple of hours, literally: just enough to get something to eat and get on the overnight train to Urumqi, the capital of Xinjiang. Incidentally, in Khorgos we discovered one thing that made our travel in the rest of China much less stressful: one can buy train tickets in the local post offices which are all over town!

Anyone who has traveled in a self-organized way in China would know that securing train tickets could generally be a hassle: foreigners cannot book online (easily and instantly – there are agencies which could do this, but it takes a few days and still need delivery of physical tickets), cannot use the ticket machines (need passport details which machines are not
designed to handle yet) and therefore, the only way to do it (until we discovered the post offices) is at the train stations.

In our experience most train stations, especially the ones for the super fast trains as they were recently built, are far out of the cities. Buying train tickets in advance, which was for us a necessity in the case of some of the most popular destinations, would have been we a waste of time and money if we had to go to the train station and back.

Moreover, the problem with train station ticket offices is that they are crowded and the officials do not speak much English (and find it very complicated to enter non-Chinese identify details). While one has those
same issues at the post office, there, at least they do not have the pressure of hundreds of Chinese travellers getting impatient and hustling because it takes longer than usual.

The other thing we realized immediately is that the only way we could participate in the local economy was through cash. For example, we
attempted to buy train tickets for our next destination once we arrived at
Urumqi train station from Khorgos, but couldn’t, as our credit cards were not accepted, we did not have enough cash and the only ATM machine there was out of order.

Away from top hotels and restaurants, non-Chinese credit cards, indeed, are not really welcome and everyone uses WeChat/Alipay otherwise. At least ATM machines would generally accept non-Chinese debit cards which meant that, as usual on this journey, we ended up travelling with a
decent amount of cash (we are four people after all).

China is not cheap. Part of it was due to our unwillingness to put up with the risks associated with real cheap lodging and food in a country where, we had heard, hygienic and safety standards might not be as
strict as ours. Part of it was due, though, to the demands of an intense local tourism business which must be pushing the prices of train, restaurant and hotel, more or less, on level with those in Europe. How is this possible, I thought at first? How can the average Chinese afford a $60 train ticket and a $100 hotel room? Well, because, the actual Chinese tourist is not of average income but their sheer size allows for that economy to flourish. When one considers that the Chinese middle class is
equal to the size of EU’s total population, then suddenly buying that $60 train ticket does not sound that crazy (and also explains that all the trains we took, without exception, were full).

We arrived in Urumqi in the very early morning with the ground covered in freshly fallen snow. We could not immediately check in our hotel but we left our luggage there and went around looking for something to eat. That’s when we discovered another peculiarity of China. Away from the really big cities, like Shanghai and Beijing or tourist centers like Hangzhou, generally speaking, there are no Western-style cafes. There are, of course, Chinese pastry shops, but they do not seem to start baking anytime before they open (around 9am or later) which means no pastry or bread before lunch time.

Coffee is not really a Chinese thing (the default is instant coffee), but the really big surprise, for us, was that restaurants in Western and North China do not serve tea. What is customary, though, is to be served plain hot water. In fact, there are hot water facilities everywhere but especially so in the trains and at train stations. It is very common to see people in that part of China carrying their special hot water bottles around with them everywhere. Georgia loves her tea and eventually she also bought a hot water bottle to enjoy everywhere we went.

We continued to notice heavy military presence everywhere in Urumqi as well. I don’t know whether it was related to the recent events, but all public parks were closed. There were military drills in the streets as well. In another flashback from my life behind the Iron Curtain, we witnessed
early morning police exercises including stretching and running in a circle in the public squares.

As we walked around the city (and we walked everywhere), we saw the police/military teaching common shop owners how to defend themselves
and what to do in case of riots. But, just like in Khorgos, we did not feel
unsafe at all. We stopped to observe these drills and the police did not seem to mind, apart from scolding the people they were teaching every single time they got distracted looking at us and not following their commands.

Despite its natural beauty and because of its remoteness, and especially because the government discourages travelling there, Xinjiang region is not popular with foreign tourists. In fact, I don’t think we saw any Western-looking foreigners in Urumqi. So, everywhere we went we were greeted
both with curiosity by the locals and with special attention by the authorities: double checking passports and taking more photos. In each case, though, done in a very friendly manner. If at first we found this special security attention amusing, after only three days there though, we had a bit too much of it. I was both happy to get on the fast train to Dunhuang and somewhat disappointed that we did not have a chance to venture out of the city to explore more of the natural beauty this part of China has on offer.

Gansu

The Gobi desert rises just outside of the city. I use ‘rise’ here intentionally as the Gobi is unlike any other desert I had ever seen and resembles more a small mountain: the sand dunes are massive.

Dunhuang used to be an important stop on the Silk Road, but was pretty much abandoned in the middle ages. It is not a big city by Chinese standards at all and nowadays is famous for the Mogao Caves, the first of which was built (yes, they are artificial) more than 1,000 years ago. The legend has it that an Indian monk, after wandering in the Gobi desert for days, had a vision of a thousand Buddhas (surprise, surprise!) and decided to stop and dig a cave there in dedication. Eventually, more and more caves were built at the site.

The caves are dug out in the rocks in the desert. There are hundreds of them but not all of them are open for visitors: we managed to see only 8. The caves obviously have a lot of archaeological significance (the largest collection of Buddhist art in the world on their walls) and carry a lot of history (the Library Cave, walled off until recently, contained thousand of
documents, among which, the oldest printed book, in more than a dozen different languages – most of these documents are now in museums in India and Britain, by the way).

The Mogao Caves complex is very well organized. On arrival, visitors are ushered in a very modern building and shown a 3D video of the history of the caves. Then they get on special buses which take them deep in the desert where the actual caves are. There, they cannot just wander off
unaccompanied by a guide. Finally, special high tech makes sure the air
pressure and consistency in the caves stay constant to ensure the longevity of the art there. Visitors cannot take any pictures inside.

There is some irony in all this. The archeological significance of the caves was only recognized fairly recently. For example, even in the early 20th century they were unguarded and anyone could go in unhindered. During the war, the government decided to use the caves as a prison for captured Russian soldiers, who vandalized a lot of the art in the caves. And even a couple of decades ago, the public could visit the caves without a guide. Definitely worth visiting if you are in the area, yet somehow, I think the Necropolis in Shiraz is more impressive.

Yet, it was the Gobi desert that I was really looking forward to visiting. On our way back into town for some street food for lunch, we struck a conversation with a young family, a rare occurrence as people generally do not speak English (or any other foreign language in that part of China).
They were so nice that they went out of their way to pick up their car and give us a lift to the desert on the outskirts of the city.

I have to say, nothing prepared me for the majestic sight of the Gobi desert. When I think of desert I imagine flat land but the sand dunes in Dunhuang suddenly rise out of nowhere as the city end approaches. It looks almost surreal. To top it off, among the sand dunes there is the so
called Crescent Lake: a real oasis in the desert, shaped like a crescent, thus the name. We took the whole afternoon and well into sunset to climb up and down the sand dunes. The kids had an awesome time sliding down, pretending they are on a ski slope.

The Chinese clearly enjoy spending time in the outdoors but, at the same time, they somehow seem to prefer to have as little contact with nature as possible. Not sure whether it has to do with a (convoluted) idea of
modernization and urbanization whereby the average Chinese thinks he has ‘made it’ coming out of the village with its agrarian lifestyle, but we saw it on numerous occasions visiting Chinese natural landmarks. For example, on the foot of the dunes here in the Gobi desert, you can rent special boots which protect your own shoes and socks from the sand. We, on the other hand, went the opposite way: even though, it was rather chilly, we took off our shoes and socks and went barefoot!

That evening, as we were wandering the streets of Dunhuang in search of an ATM we stumbled across a tiny family restaurant. It literally felt it was their living room as there were no other customers and the family’s two kids were doing homework on the table. The mother was helping the younger son while the father was in the kitchen. The kids were very curious to start a conversation as, it turned out, the older one was actually studying English. Still, their English was not on the level to allow us to order food (no menu and no pictures), yet we had already been well prepared for this language barrier. We had brought along a “Point It” book which had hundreds of photos separated by category: one could simply point to in order to have a basic communication.

It was a lovely evening during which there was a genuine connection between us despite the language barrier. Our kids read their English
books, while the Chinese kids, on the other hand, helped with Chinese
pronunciation.

Dunhuang is, unfortunately, not on the fast train line, and one has to take a 2h drive to the nearest “connection” – a strange choice by the Chinese as that fast train station is literally in the middle of nowhere. Anyway, from there we headed to our next destination of Zhangye.

This city is is much bigger than Dunhuang, and just like it, was
an important outpost along the Silk Road. So much, that Marco Polo decided to spend one year there – for which they erected a statue of him in one of the city’s squares. Apparently, the Mongol emperor Kublai Khan was born in the Dafu Temple in the city. What the latter is actually famous for is the longest wooden reclining Buddha in China.

We arrived in Zhangye in the evening, quite exhausted and hungry. We could not find proper transportation from the train station into the city and had no choice but to take one of the touts. Throughout Central Asia, that had never been a problem and we had taken many of them, but in China, we had heard many unpleasant stories. Anyway, we managed to negotiate a reasonable fare and we set on. As usual, I would follow the navigation on my phone, more out of curiosity than anything else, but this man would have none of it and was obviously irritated that I was doing it. We were communicating through the translation apps on our phones, which are not always right, but his comment was something like this, “I am a former China special forces, you should trust me!”.

Throughout our trip into town he was trying to convince us to take us to the Rainbow Mountains, another must see sight in the region, the following day. I had to politely explain that we would think about it and get back to him (I did take his number). When he dropped us off to the hotel he hanged around waiting for us to check in while discussing something with the receptionist. When he even requested to take a picture of our daughter, we did get a bit worried and we all grouped on it instead. We almost expected he might pop back at the hotel the next morning and were relieved that it wasn’t the case.

The hotel was in the town center, but the best way I can describe it is “dodgy”. There was this big neon sign in front of it which stated the room rates per night as well as per hour! The receptionist was smoking profusely all the time (disregarding the non-smoking sign) while checking us in. On the upside, however, he spoke decent English and was rather
polite.

We left our luggage and, despite the late hour, we hurried out to find something to eat. Normally, there would be lots of choices of
street food but in this case we could not find any. There were the usual
Western fast food places (KFC, McDonald’s, etc.) and the Chinese fast food ones (local joints which normally are better than the Western, but in this case they were infinitely worse as people were smoking inside). Eventually, we came across a second floor, decent looking, non-smoking, and rather inexpensive restaurant.

We sat down at a table and a couple of people came over to take our order (because of the late hour, the restaurant was rather empty). Of course, none of them spoke English and there was no menu with pictures. The “Point It” book turned out to be of no much help either. We slowly realized, that this was a ‘hot pot’, a typical restaurant for this part of China. The way it works is they put a pot with a specific sauce on a “fire” in the middle of the table and then customers choose vegetables and meat to go along. Sometimes, in the West, this is called “Chinese fondue”. They were very nice in that restaurant. To explain all this, they took Georgia to the kitchen and throughout our meal they were super helpful: it felt that we had a private dinner!

The following morning, we took off to see the natural beauty of the Rainbow Mountains but not before we stopped by the post office to buy the tickets to our next destination, Xi’an. In the bus to the mountains we struck a conversation with a Filipino who had a business in China and who
suggested that we should also visit Binggou Danxia, a rock formation, on the way to Zhangye Danxia (which is the Rainbow Mountains). It was a great choice! The place is amazing – in 2000, Binggou Danxia Landform was nominated by National Geographical Magazine as the world’s top ten magical geographical wonders. What was surprising, as we would soon discover on our subsequent tourist stops, was that it was deserted. We did, however, catch a sense of the Chinese “Disneyland-fixation” as they play loud music, the walking paths are well designated and everything is groomed.

We were so glad we had literally stumbled upon this natural wonder, that we stayed as long as we could before rushing to pick up the alleged bus to the Rainbow Mountains. The problem was that that bus never materialized. Not knowing when the next one would arrive we tried to hitch hike. After a few cars passed by with only a look of utter surprise on the face of the driver (and/or passengers), eventually one stopped a few meters afterpassing us, turned around and came to us. The driver was really nice and, I believe, genuinely wanted to help us but the problem was that we did not understand each other. We thanked him anyway but were getting worried a bit as it was getting late as well.

Luckily, just when we started to despair, a bus arrived, strangely going in the opposite direction, or so we thought. A couple of college kids inside spoke broken English and reassured us it would take us to our destination, so we boarded and after half an hour we were at Zhangye Danxia. This is the more popular tourist site in the region and it showed: hordes of Chinese tourists organized in buses to take them to see the colorful mountains. The scenery is spectacular, true, but somehow the way the trip was organized took a bit off the excitement being there: you get on a bus that takes you onto the first sightseeing spot, you get off, follow a well trodden path, take some pictures and get on a bus to go to the next spot. Can’t wander off, can’t go off the path as you are under the watchful eye of many officials always nearby.

The whole experience was more like going to the movies: if anything, everything was so efficiently done to limit any interaction with nature. Which makes me think that the Chinese would be perfectly happy and very open to the arrival of VR. It seems to fit nicely their culture and society. It was partially this, partially the fact that the evening was fast approaching and we needed to take a bus back into town, that we spent a rather short time there.

Back in Zhangye, we finally repaired my son’s phone, the one he broke in Yerevan which made him very happy! We were off to Xi’an the next day – to an extent this was kind of the end of the really exciting part of the Silk Road journey for me, as I and Georgia had already in the past visited all the cities, until Huangzhou, which we were about to visit again.

Shaanxi

As we had travelled from West to East along the Silk Road, a thought was reemerging. This is how, in general, ‘information’ flowed in
antiquity: the monks who travelled from India to China to spread Buddhism, for example. And then beyond China: we found out, actually, that the city of Kyoto in Japan was modelled after Xi’an.

I realized that there was very little I remembered from the last time I was in Xi’an in 2007: this was how much the city had changed. Our hotel was very close to the Bell and Drum Towers (after the experience in Zhangye, we decided to treat ourselves and stayed in a really fancy Art Hotel).
I did remember those but everything was different around them: two massive Starbucks, a KFC etc. and an array of high-end Western shops along the avenues leading to the Bell Tower.

Our ‘goal’ in Xi’an was to show the kids the Terracotta Warriors site. No doubt the extreme commercialization which we had started witnessing in all Chinese tourist attractions was in full swing there s well! Ok, the actual
site is still impressive, but everything around it was too much for me: the
buses, the stands selling everything, the overpriced restaurants. I would say, if you have never been there, it is worth going but some of the charm is definitely gone.

Yet, one can still learn something new and interesting in Xi’an. This city is old, one of the few cities, still standing, around the world to have a history spanning three millennia. For example, we spent almost a full day just walking along its city wall. The city is also the site of the tomb of the only female emperor in Chinese history, Wu Zetian. A former concubine, she was ruthless – actually deposing her sons from the throne to become Empress. Bu she was also efficient – allowing for advances in education,
improving taxation, and encouraging trade by reopening of the Silk Road.

Xi’an is also considered the ‘buckle’ that ties the belt together in the One Belt One Road idea thanks to its extensive rail network (the dark side of this industrialization is that usage of coal is still predominant which makes the city one of the worst polluted in China). But the Xi’an is also a pioneer in the digital sphere by becoming the first one in China to have its metro accept cashless QR code tickets linked with Alipay mobile payments. In fact, Xi’an has a New Software Park where Alibaba is planning to build its ‘Silk Road Headquarters’ to cover all of Western China (the name Xi’an, actually means “peace in the West”). Finally, Xi’an is also the home of
China’s space exploration program: it is planning to be the first nation to
reach the dark side of the moon!

 Beijing

The kids were actually really excited to visit the capitol. They had studied about China but the fact that China, aka ‘Beijing’, has been constantly in the news this year on account of the trade frictions, was a factor.

Beijing would turn out to be the most expensive city on our Silk Road Journey, so we had to resort to even more budgeting and planning carefully. For example, the hotel we booked was walking distance to the
Forbidden City and had amazingly considerate concierge (I am kidding, the hotel concierge did indeed help us order delivery for dinner and paid with their own personal Alipay account – we, of course, paid them back – but we did not plan this!).

Not that transportation is necessarily expensive in the city. The Metro is very affordable while DiDi, the taxi sharing company, supposedly the only large start-up in which all the three Chinese giants, Alibaba, Tencent and Baidu have stakes in, is infinitely cheaper than normal taxis. There are also the city bikes, which are the epitome of true sharing: they can be left anywhere in the streets as they can only be unlocked by QR codes on WeChat.

For all the talk in the media, Beijing, itself, is actually not really polluted if it was not for the industrial zones around it (for example, Shandong Province) and the proclivity for the wind to blow in its direction. Also, despite Shanghai considered the financial capital of China, there are more Fortune 500 companies headquartered there than anywhere else in
the world except Tokyo!

We spent a day enjoying the splendor of the Forbidden City, majestic as ever (and how I remember it – very big – as big as 28 football fields), lingering the streets in Hutong (massive change – I think it has shrunk by half from the last time we visited – and definitely lost its charm) and wandering the little shops (and antique tea houses) around Houhai lake. It
was in Beijing that we first saw such delicatessen as scorpions and snakes for sale in the street food markets.

The Great Wall of China was another day trip. Beijing is already very well strategically located, mountains on the north and west, with the Great Wall an added bonus for protection. We got unlucky a bit as the weather that day was bitterly windy but we toughened it up for the kids. Otherwise
nothing has changed much from before – only the hordes of Chinese tourists, and their inconsiderate behavior (littering, pushing, being loud, etc.), has increased.

On the way back into the city we stopped by the Beijing Olympics Stadium – our son really wanted to visit it. Unlike other former Olympics stadiums which may have been left derelict, the Bird’s Nest (as it is called) is as glorious as ever, especially at night with the lights on – it has a truly futuristic feeling. That Beijing will be the first city in the world to host both the summer and winter Olympics maybe has something to do
with the fact that the stadium and the Olympic village next to it have been kept in pristine condition.

The third day in Beijing was devoted to the Summer Palace, which is more like a massive garden and where the emperors spent their…summers. There, you would still see impressive buildings and pagodas but one should visit with the idea of immersing in their splendor and just relaxing and letting time pass by. In the evening, we visited Tiananmen Square and Mao’s mausoleum. While the latter was lit up, ceremoniously guarded and
full of couples taking selfies in front of it, the former was left dark and was
off limits for tourists. This prompted some questions from my son about
postmortem fairness in history.

The next morning, we got on the fastest train in the world and headed to Shanghai…

Silk Road (7): Free-roaming camels and wild horses

09 Friday Nov 2018

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,

A note for clarity:

I set up this blog as a diary for my thoughts on the financial markets about a year ago. As we embarked on our Silk Road journey, my son wanted to share his travel experiences and I allowed him to use beyondoverton.com.

So now, you may have noticed that there are two entries per each country we have visited: my perspective (beyondoverton) and his (g88kboy). Additionally, because of the lack of reliable internet connections in most countries and our (Georgia and I, not necessarily the kids) desire to experience the real life as much as possible, our country posts come with delay. For example, I am about to post on Kazakhstan but we have been in China for almost a month already.

Connectivity being the issue has also meant that some posts have appeared in strange writing style – I don’t know why – could be because we upload from our mobile phones. It is for this reason that there are very few photos, in general. We have thousands, but uploading photos takes forever.

I have been also posting general footnotes on the journey, from time to time, with the latest being on China. That may increase the confusion as the timeline now, with this Kazakhstan post, seems to have been ‘broken’. A proper post on China will come soon!)

——————————————————————————–

We entered Kazakhstan twice. The first time when we crossed the Caspian Sea from Azerbaijan, and the second time, after Uzbekistan. The fact that we do not need visa to enter helped substantially in organizing our trip that way (all the visas we had to get so far for the other countries have been single entry only).

The two entries were also totally different experiences. During the first, we literally got taken for a ride by a local, whom we met on the boat from Baku. During the second, we met some of the nicest people (thanks to a good friend of mine: Nurik, if you are reading – a whole lot of gratitude) who not only showed us Almaty from a local point of view but also helped us cross the border into China!

We did neither know how to get from the port of entry on the Caspian Sea to the nearest town, Atyrau, nor really how to go to the border of Uzbekistan from there (about 6h drive). We thought we were in luck when one of the drivers on the boat from Azerbaijan, Mohammed, offered to take us to Beyneu, one hour away from the border. He had been to Georgia where he had bought a bus and was driving it back to his home in Aktau.

By the time we managed to get through passport control, and after waiting for a few hours for Mohammed to pass through customs with his bus, it had already become 10pm. I had checked that there was a train from Beyneu to Nukus, Uzbekistan at 4 am, so I thought, “Perfect timing”.

The bus driver had already agreed to take an American solo traveller, Michael, and a few of the locals along. At the last barrier before exiting the border area, the officers, for some reason, did not let us through. Mohammed turned around and asked me if he could borrow $30 (he said he had no cash) equivalent in Tenge, the local currency, because he had forgotten to pay for some document. It was lucky that I had exchanged that much money as, normally, exchange rates at borders are the worst.

It turned out, that he did not have the license to drive this bus (I have no idea how he had driven it so far!). I don’t know what the money I gave him was for, or how they let us through but now we needed to find someone else to drive the bus once in Atyrau, which meant that we could not go to Beyneu immediately.

We picked up more locals on the way, one of whom was kind enough to direct us as there did not seem to be a proper road for probably something like 10-15 km.

A small diversion here. This was a brand new port, which had opened literally two weeks ago. The facilities were excellent. Nothing compared to what they were in Azerbaijan and more like any modern European port of entry.

We stopped at a petrol station and the driver asked each of the locals to contribute some money for him to fill up the tank. That’s when I started to get suspicious; but still, he was a devout Muslim – he wouldn’t be a cheat and a liar, would he?

We were in Atyrau by midnight. We stopped at a parking lot just outside of town where all the locals disembarked and we waited for two people, one of whom was the new driver, the other, a friend of Mohammed. There was a new problem: they needed to arrange insurance, and, of course, that could not be done in the middle of the night. So, we needed to find a place to sleep…and somewhere to exchange money to pay for it.

Mohammed’s friend managed to arrange a flat for $40 for the night for all of us (including Michael) and I got in his car with him to find some Tenge and pick up the keys. (Everyone else stayed in that parking lot to wait for us).

When I look at this whole experience in hindsight, it seems surreal. I had no idea who these people were, we had just arrived in a foreign country in the middle of the night, I had left my family on a deserted parking lot and embarked on a trip across town with a stranger looking for a flat to sleep in and a place where to exchange money!

This guy was huge, a former Kazakhstan bench weight lifting champion…and he turned out to be super nice. If I had any fears, they quickly disappeared once I got talking to him in the car (by the way, unlike the other former Soviet Republics we passed through, Kazakh people not only speak perfect Russian but are also happy to).

He obviously knew his way around town. We stopped first in a secluded alley, where the ‘exchange bureau’ was an iron door with a small opening in the middle where you handed your dollars and hoped you would get some Tenge back. Then we drove to a really dilapidated block of old Soviet-style flats where a lady handed us the keys (she insisted on keeping my passport for ‘deposit’ but eventually settled for 2,000 Tenge – about $5).

The bizarre did not finish there. We picked up the family and Michael from the parking lot and drove to a brand new, very modern, but half-built ‘skyscraper’ on the Caspian Sea waterfront, where, I think, no flats were inhabited. The fact that there was a guard at the door who looked at us worryingly and warned he would call the police confirmed my suspicion (he did not).

The following morning, we got on the bus again and we left for the border town. I began to wonder whether I would ever get our money back. It was not so much for the actual money but a question of trust. Moreover, we had run out of Tenge and I was still relying on the money we were owed.

At our first stop we needed to buy water and I asked Mohammed when he was planning to give us the money back. He laughed back at me and said something like, “You were not thinking you were getting a ride for free, were you!?” Of course we were! The bus was going empty in our direction anyhow, and he had never mentioned money. His reply was, “Sorry, I must have forgotten to tell you, I expect you to pay for taking you to Beyneu”.

The situation became hilarious when, half way, we stopped at another petrol station and he asked to ‘borrow’ more money under another pledge that he would give it back. We were shocked after our previous exchange. Did he really think that we would trust him again?

Eventually, we got dropped off at the Beyneu train station but with a sour taste in our mouth.

Incidentally, while this drama was going on in the bus, the scenery outside was a vast steppe (most of it, hundreds of meters below sea level) where camels and wild horses were roaming free.  The other thing I noticed was, once past the Caspian Sea, people start to look much more Asian. In any of the countries so far on our trip, I could have possibly passed as a local. No such chance here.

We arrived in Almaty on the train from Tashkent. Almaty was really special: the unusually cold (below freezing, snowing) weather was contrasted with the amazing warmth of the people we met there. Nurik, my friend from University, who is also originally from Almaty but lives in London, put us in touch with his friends, Max and Daniar.

Max waited for us at the Almatyi train station, helped us to exchange money and get a SIM card and eventually took us to our rented flat. He was pretty much ‘on call’ all the time we were there with suggestions what to do and where to eat. And of course he organized our trip to the Chinese border.

Daniar took us for lunch where we tried some Kazakh delicatessen, among which camel and horse milk. Afterwards, he showed us Medeu, the most popular ski resort in Central Asia, just half an hour drive from Central Almaty.

Otherwise, the weather was totally ‘uncooperative’: miserably cold. We had planned our trip with the idea to avoid the coming winter in Central Asia/China, both as it is less pleasant to travel from place to place, backpackers’ style, when it is cold, and for practical reasons (fewer things to carry).

Georgia and my son had already bought winter jackets in Uzbekistan, and now literally the first thing we did in Almaty was buy hats and gloves in a mall. Then we went to the ‘Green Bazaar’ and bought these special waterproof ‘socks’ which go on top of the normal socks (we brought only one pair of shoes with us on this journey, the special Vivo Bare Foot, which had served us extraordinarily well so far, but were no match for the slush and snow in Almaty). And then we bought camel-hair and bamboo socks to keep warm. Finally, we still wore pretty much every single piece of clothing we had brought with us – this is how big the shock to the system was the cold we encountered in Almaty!

The upside of the bad weather was that we spent some time in Almaty wonderful cafes (I was very happy that I was finally able to drink some proper coffee!), restaurants (we had amazing Korean – it turns out that Almaty has a large Korean diaspora stretching all the way to the 1930s – the first mass transfer of an entire nationality!) and, of course, Bania Arasan (the Arasan Baths). This latter was heaven for Georgia and my son; I and my daughter, on the other hand, were just fine.

Arasan Baths were finished only in 1982 and are a typical example of Soviet modernist architecture. Rumor is that they were built to compete with the oriental baths in Tashkent (we did not see the latter because they were demolished a few years ago). Inside, the baths are not only really exquisite – a blend of oriental and modernist style architecture and materials; but they are also quite practical – everything was designed with a specific task in mind. Men and women bathe separately but, apparently, the two sides are exactly symmetrical. The choices are Russian Bania, Finnish sauna and Turkish steam room with the temperature in each decreasing in that order (if you are a first timer, like me, you would not
be able to stay more than a minute in the Russian Bania – it is that hot!).

We had chosen the rental flat right next to both the Arasan Baths and the Panfilovets’ Park the other must-see attraction in Almaty. The park is named and dedicated to the 28 soldiers of an Almaty infantry unit who died fighting the Nazis outside Moscow. We had to visit it despite the extreme cold. It was definitely worth it as the memorial is really magnificent.

On our last day we left Almaty very early in the morning for our drive to the Chinese border. Max came to pick us up from the flat (he gave us a few of the city’s famous apples for the road!) and then one of his drivers took us to the border.

The scenery was very much as I remembered it on our first encounter
with Kazakhstan in the east: steppes with wild horses (did not see camels;
don’t know if it was because it was so cold).

The difference was that this time the land was covered with snow, and with the majestic Tien-Shan mountains in the distance, it looked like a scene from one of those Russian ‘skazkis’ (stories) I had read as a child.

The border! Again! It all started well. We got dropped off where the car could go no further, picked up by one of Max’s people and taken, like VIPs, to the Kazakh border control. The appearance of a family on a deserted border crossing so far had caused some commotion and excitement. Here, though, it caused also some suspicion.

That was probably caused by my son mentioning he was from Italy while handing his British passport to the border officer, and my Eastern European name (and looks). Not only, it took the border officers an usually long time to process our documents (especially the kids’), but also, after passing through, we were separately, and casually, asked few questions (to the kids, what is the name of their mother; to Georgia, what is her name and to confirm her husband was from Ukraine!?!). We couldn’t
figure out if it was pure curious chit-chat from a group of bored officers or
digging deeper into our identities, but we thought it amusing.

The actual problem was what happened after we finally cleared the Kazakh border control. We started walking towards the Chinese side, when we were stopped by a screaming loudspeaker and asked to return back: apparently, you are not allowed to simply walk in no man’s land to the Chinese border – you have to be ‘transported’ there.

The issue was that the only transportation is a public bus, that not only arrives from time to time (no one knows when) but you need Tenge to pay for it (the same rate as if you had picked it up from the departure point), and we had not kept any.

We found ourselves in a bind. What do we do? Do we take our chances and wait for the bus? What if it is full? Would the driver take dollars instead of Tenge? Do we go back in Kazakhstan and attempt to board that bus at its starting point?

We decided to wait. Eventually, the Kazakh border officers warmed up and we started talking (I think they were bored – no one passed through the three hours we waited for that bus!). One of them promised he would talk to the driver and make sure he would take us on board, and for free! It was indeed a relief when the bus eventually arrived with enough spaces for us to board and cross into China. However, not before waiting for an hour, in the bus, while the Chinese border was closed for lunch break!

Silk Road Footnote

05 Monday Nov 2018

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(Bull on the Bund, Shanghai)
We’ve been in China for less than a month as part of our Silk Road journey by land, a time, highly inadequate to make any strong conclusions. Yet, within that time, we’ve crossed the full country west to east, taken only public transport, stayed and dined in ‘everyday’ hotels and restaurants (a lot of street food as well!). All this gave us a chance to engage with locals on a completely different level than by only visiting the financial sector in Shanghai or government officials in Beijing (and staying in 5-star hotels – the way I used to do it as a professional investor). All this is obviously anecdotal ‘evidence’ but what struck me is:

1) the service sector is absolutely booming

2) prices are generally on the same level as in Europe/US

3) the locals can afford them

I consider myself a practical economist (UPenn/Wharton but having acquired 90% of my ‘economics’ from the markets and from tons of reading), so I am not making any claims, but it is actually possible, despite misgivings in the West, that China may indeed be growing at the official rate they have been reporting.

We, ourselves, in the West, are grappling with the accounting of an increasingly digitized service economy. Well, the size of Chinese e-commerce is multiple times that of the US, which means a lot more data. Moreover, because of the structure of society (centralization) they have managed to gather and analyze that data, and perhaps, make better conclusion than we could possibly make.

So, it is possible that we are indeed looking at Chinese growth too pessimistically, which does not negate the fact that all this may indeed be built upon a credit bubble. That would be hardly a surprise given that US growth has been built on a huge private credit bubble since the days of financialization in the early 1980s. Indeed, the locals we spoke to, think there are currently three big bubbles in the world: US stocks, Japanese bonds and Chinese real estate.

My point is that China could be shifting to a consumer-based society much faster than we anticipated and thus is also becoming much less dependent on exports and foreign growth – China does not need to rely on the rest of the world that much anymore. That was more than obvious on our travels in the country: foreign tourists, at best, are tolerated – the local Chinese tourist industry is very well developed and is flourishing. This is a big change from 10 years ago, for example, during which living standards have more than doubled.

It is amazing, in fact, the magnitude of Chinese middle class growth. When combined with the digitalization of society, totally embraced by the government, and the Great Leap Forward may finally happen.

(*Overtake England in 15 years”, 1958, Shanghai Propaganda Poster Art Centre)

The fact that some of these trends are developing much slower in the West due to a lot of private legacy interests, which stand in the way, and governments which imagine they are running out of money, increases the risk that this latest trade ‘war’ would prove to be a spectacular own goal.

Silk Road (6): Chevrolet Land

03 Saturday Nov 2018

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I know probably you would not believe me, having also said that every second car in Georgia is a Toyota Prius, but in Uzbekistan, pretty much every new car is a Chevrolet. Ok, I looked it up: thanks to a joint venture between GM and the government, apparently 95% of the new cars in Uzbekistan are Chevrolets.

Because of Uzbekistan’s vast resources of gas (and no oil), majority of those cars are adjusted for methane and propane, which are half the
price of oil. It was strange the first time we took a long-distance taxi and it
had to refill: the driver stopped about 200m away from the gas station and
asked us to get out of the car for safety.

I was really looking forward to visiting Uzbekistan. The country was a major destination along the Silk Road and I had heard so much about the magic of Samarkand already in my school days in Bulgaria. I was also very curious to see a country which was literally locked up for so many years after the breakdown of the Soviet Union: Uzbekistan’s borders were pretty much shut down until 2005 – during and until the end of Islam Karimov’s reign, the first president after gaining independence.

In fact, developing deep and meaningful international relations are still in their early stages. For example, the tourist visa regime was only recently simplified, and only a couple of months before our visit, Uzbekistan finally introduced e-visas. But also, because the country was closed off for the majority of the world for so long, it actually learned to produce a lot of goods locally. Ironically, the joint venture with GM was both an example
of this (locally produced cars) and an exception (foreign joint venture).

One could say that we entered Uzbekistan through the “back door”, from Beyneu, Kazakhstan. In fact, Uzbekistan is one of only two double land-locked countries in the world – these are countries which border land-locked countries themselves – yet another curious feature which made me
eager to visit it..

“Back door” is also in reference to the way tourists travel when they visit the country: they normally fly into Tashkent, go to Samarkand, and then Bukhara. Some of the more adventurous may go to Khiva as well. And
then back. We did it the other way around: Khiva-Bukhara-Samarkand-Tashkent.

We encountered a peculiarity about Uzbek culture already in the
border town there: vodka. When it comes to liquor, restaurants seem to offer a large variety of vodka, and pretty much nothing else (and people do drink their vodka – and it shows!). I seldom saw beer, and when I ordered it, it was not particularly good.

What is surprising, though, is the lack of wine. Uzbekistan has different varieties of amazingly sweet grapes but, as far as I know, not much of a choice when it comes to wine. We did try a bottle of wine in Nukus,
the only one on the menu; it was OK, but it turned out it was sweet (what a
surprise!).

But while we may have gone ‘against the tourist traffic’, so to say, we definitely went with the local traffic. The train left Beyneu,
the last stop before the Uzbek border at 4am. We had ‘camped out’ at the train station for the night which was full of people; in fact, at some point one could barely even stand there. There were traders selling all kinds of stuff outside along the railway line. It was incredibly busy!

The kids by now were used to such an experience and promptly fell asleep on the chairs, their heads resting on their knapsacks. As our trip has progressed, it is actually interesting to see how they finally started to grasp the concept of different kinds of comfort. For example, before
this trip, they were used to staying in 4 and 5 star hotels where their concern would normally be if the facilities include a swimming pool. Now they worry not only about the availability of Wi-Fi but sometimes, as in the case of Beyneu, also of a bed!

Around 2 am, a kind officer in the train station, with whom I struck a conversation about football, informed us that we could actually board the train. What was our surprise when we found out that we did not have any assigned seats, it was ‘first come, first serve’ kind of service, and people had already taken any seats where one could lie down! Eventually we managed to find two bench-seats for the kids.

As usual by now when crossing land borders, majority of travellers were ‘traders’: we were asked several times whether we could take some of their stuff in our bags. Overall, however, people were very nice and we
were simply treated as a curiosity. The border crossing was fast and
straightforward. The customs officer did ask us though whether we were bringing any history books!

We arrived in Nukus after 17 hours, travelling through mostly desert-like terrain. There, at the train station, trying to figure out a way to get to a hotel (we had no booking) I encountered another peculiar feature of Uzbekistan culture: they don’t seem to like to negotiate. Having travelled through all the other countries, but especially Turkey and Iran, where negotiating was part of the process, I found this strange. The taxi drivers in Nukus, for example, had very strict rules, one could say, the equivalent of taxis in the West with meter machines: 5,000 Soum (that’s the local currency) for the first 3km and 500 for each after. They would simply
zero out their odometers on every ride.

Even in the bazaars, Uzbek people did not seem to engage in negotiations. They were a bit more flexible there, but they would almost get offended if it went for too long and eventually refuse to sell you the product at any price if “pushed”. I don’t know if this is a specific Uzbek
characteristic or it is a vestige of the Soviet system but I had to respect that this is the way it is.

Our first planned stop was Khiva, a 3h drive from Nukus. The day we drove to Khiva, the temperature dropped from almost 30C, from the day before, to half that. We did not expect such a big change in weather that
soon, and definitely did not welcome it!

Khiva’s old town is surrounded by a wall, inside which old residential houses stand next to centuries old mosques and madrases. Both Uzbekistan’s history and culture are interlinked with those of Iran (and, later, Turkey), so the structure of the mosques is somewhat similar. Yet, unlike Iran, Uzbekistan is famous for its madrases, Muslim religious schools. Samarkand’s Registan, for example is composed of three madrases (but there is one small mosque in one of them).  

Despite this, Uzbekistan did not strike me as a particularly religious country. We barely saw women wearing hijabs (actually they were predominant only in Tashkent’s old town). We even had pork in a restaurant in Nukus (the proprietor was Korean) and in a cafe in Tashkent.

As we advanced more eastwards, the arid land gave way to some green vegetation, orchards and grapes. Along the roads, there were people
selling fruits and vegetables at almost any time of the day and (probably)
night. What was amazing to see was the melons: apparently Uzbekistan has the biggest varieties of melons of any country in the world (and the ones we tried were exceptionally sweet – it is a shame they do not juice them like in Iran).

Uzbekistan has plenty of cotton fields. As we were in the country right at the time of harvesting it, we could see people picking up the cotton and piling up the bags in massive containers along the road. We were told that students had to help with the harvest as well (i.e. no school for a month!). I remembered with fondness that we had to do the same in Bulgaria when I was a student there in the 1980s.

Unfortunately, the weather refused to ‘cooperate’ and it got progressively colder. So much, that we had to buy my son a winter jacket in the local market in Bukhara (he had lost his warm jacket somewhere along the
Silk Road before!). We were also forced to wear pretty much all our layers just to keep warm. Yet, that did not seem to help Georgia who fell ill and had to stay one full day in bed! The next day, while feeling better and able to walk around the streets, she also bought something to keep her warmer: a traditional long Uzbek coat. She looked different in it, and enjoyed the curious (from some, the older ones, obviously approving, from the others, the younger generation, amusing) gazes of the locals as we passed them by.

Another reason I wanted to visit Samarkand was Timur the Great, the legendary local leader I had read about as a kid. He created an empire which spanned a vast area, going deep into Persia and all the way to Delhi. However his reign was a one-off, i.e. there were no successors who could maintain his expansions. Timur was peculiar in a sense that he was illiterate himself, but he believed in the power of knowledge and appreciated the beauty of art. Legend has it that when he first ransacked Samarkand ,he killed the majority of the population but he spared the lives of architects, teachers and generally, people of knowledge. Then, under his guidance, Samarkand was rebuilt with the focus exclusively on madrases and other places of knowledge (Ulug Beg, the famous astronomer lived approximately at the same time).

Our last stop in Uzbekistan was its capital, Tashkent. I did not expect much of Tashkent, especially after visiting all these other places before that. Still, I was looking forward to being there because a friend of mine from both university and Morgan Stanley, whom I had not seen for decades, lives there. Unfortunately, he surprisingly had to go to New York the same week we turned up there. It was a shame, not only because I was looking forward to reconnect with him but also because speaking to a local, who I knew previously,would have enriched massively our view of Uzbekistan. As it was, Uzbekistan, after Iran, was a bit of an anticlimax.

However, we managed to get the best of our visit nevertheless. In fact, I enjoyed Tashkent, if not for anything else, for the blast from my ‘Soviet’ past that it provided, more than any other ex-Soviet capital I had ever been to.

So, a lot of things reminded me of how it used to be in Bulgaria in the 1980s: the monuments, the old block of apartments, the local market (where people would still offer to record music for you!), the circus. Even the main department store in the town where I went to high school was called ‘Tashkent’. We took the metro a lot (by the way, there was no metro in Bulgaria back in the ’80s). Some of the metro stations had very interesting decorations, the way I remember the Moscow metro when I visited it in the late 1980s.

The one thing we struggled with in Tashkent was knowing which restaurant was worth going to. In fact, that is one of the things we missed the most on our travels – after eating ‘street food’ most of the time, we were craving some variety…some
vegetables. Luckily, our next stop, Almati, would offer plenty of it.