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Podcast: China – from power shortages to power play

Podcast: China – from power shortages to power play

26-10-2021 | Podcast

In our latest podcast, we discuss China’s challenges – from property to power shortages. We also zoom in on China’s ambition as it moves from a trade war to a tech war with the US. "The rivalry will only intensify," says Jie Lu, Head of Investments China. Tune in for more fascinating insights.

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Transcript

We do not guarantee the accuracy of this transcript.

Male voice: This podcast is for professional investors only.

Jie Lu (Jie): Evergrande is probably not too big to fail, but the property sector is. So that's why I think in the base case scenario, China will step in.

Erika van der Merwe (Erika): It seems inconceivable today for any investment discussion not to consider the implications of the Chinese economy, as well as its tremendous domestic opportunities. The most recent events in China have once again caused commentators to recalibrate their growth forecasts and their investment outlook.

Male voice: Welcome to a new episode of the Robeco podcast.

Erika: We invited Jie Lu, he's Robeco’s Head of Investments for China, to help us make sense of it all. Thanks for joining me, Jie.

Jie: Thank you for having me, Erika.

Erika: Jie, there are so many topics that we could discuss here, and to a large extent, I believe they're all interrelated. Ultimately, I want us to get to that topic of the opportunities presented by China's ambitious drive towards global tech and innovation leadership. But let's start with the energy situation in China. I believe around two-thirds of China's provinces have experienced power blackouts or rationing over the past month or so. What's behind these large-scale power cuts?

Jie: Just to have a small correction: when you say something like two-thirds of China is in blackout, you make people think that it's a very serious issue. But you have incidents in these provinces that are happening, that doesn't mean you have a two-thirds of impact. Because that's always the news headline that gives us such an impression. But I want to make sure as we see all this news, they tend to exaggerate a lot of things. So for these power shortage situation, yes, it has been ongoing. And if you look at the root cause of it, there are several reasons. One, of course, China has had very strong demand for power this year, especially driven by a first half of strong export orders. And we're also going into the holiday seasons where orders start piling up. At the same time, at the supply side, we do see the significant coal shortage. One reason is over the last few years, China has been doing the supply side reform, cutting down these high-polluting coal mines over the years. And this year, and especially when we see a strong demand, the coal price has been surging dramatically. At the same time, if you look at the coal power plants, which take coal as the main cost, their pricing has been heavily regulated. So for a lot of these coal-fired plants, they have not been able to make money on a cash basis. So that leads to a shortage of power. At the same time, China also had this carbon-neutrality push starting last year, so there are more KPIs focused on the so-called dual control, which is the energy intensity and energy consumption. And this year in particular, we are seeing all these measures on a quarterly basis instead of an annual basis. So a lot of the provinces have seen their KPIs really lag behind and they kind of scramble towards the quarter end to shut down this factory to control these power consumptions. So that makes things even worse. So that's the root cause. I think it’s due to the shortage of coal, but the environmental control makes it a little bit more serious.

Erika: Of course, the other aspect of the Chinese economy, that's much in the news, certainly in the West, is its property sector. It's a cause for huge concern right now. Now, it's still unclear at the time of this recording what Evergrande's fate will be and how exactly the government will intervene. But beyond those specifics, Jie, what lies at the root of this problem in the property sector?

Jie: Yeah, I think the property sector has been under the radar for the last few years already. So China mentioned this terminology called ‘our great rhino’, meaning something pretty big and obvious, but it's relatively slow moving. But eventually it could happen. But China, you see, from a government point of view, they started to contain this sector from years ago, but occasionally in order to support economic growth, they need to relax the policy a bit. That's what we’ve seen in 2016 and also briefly during the Covid situation. And last year, actually, China already started to set out this new regulation rule, its so-called three red line rules, for all the developers to try to improve their balance sheet. And Evergrande actually is not as huge a surprise, because Evergrande has been on top of the league table in terms of the balance sheet risks. And then, if you add all these scandals related to the wealth management products that they sold to their employees, so that might make things even worse. But nevertheless, I think the property sector tightening has been ongoing for years. This is just that we are reaching the point that Evergrande is the biggest problem, that starts showing the problem.

Erika: And Jie, the consequences for Chinese consumers, Chinese investors and also even the regional and global property sector? But before you answer, here's Cathie Wood from Ark Invest, speaking this week on a client webinar specifically on this topic of the Chinese property sector. 

Cathie Wood: They have had a few liquidations before Evergrande, so they're getting the hang of it and maybe they've been emboldened because nothing really bad seems to have happened. But real estate accounts for at least 75% of consumer savings in China. And if the consumer feels that his or her biggest investment is starting to deflate, just like with inventories, they might want to get out of the way and sell into that, exacerbating the problem. So that would be a big problem for China. I think China knows it. Clearly, they feel that real estate has gone too far. There's too much speculation, there's too much debt associated with the speculation. And I have a feeling that's why the government, the central government, is examining the financial regulators as well as the financial institutions. But as I said before, I think that's playing with fire.

Erika: So Cathie is warning investors regarding the situation.

Jie: Yeah, I think she's right in the sense that this could be a very serious spillover effect. Not just the supply chain that is relevant to the property sector, but also the consumer confidence, because after all, property is a big part of the consumer's assets. And that actually leads to my view that Evergrande is probably not too big to fail, but the property sector is. So that's why I think, you know, in the base case scenario China will step in to contain this risk, because they cannot afford not to do so, because of all these implications, the numbers, the weight, the property sector put on the whole economy. So, China has been seemingly slow in reacting to this issue; China is really wanting to avoid the moral hazard situation. Because even though the property sector has been tightened over the years, you’re still seeing some developers have been not able to reduce the risk on the balance sheets, such as Evergrande. And also for a period of time, they also think they are too big to fail. So China wants to avoid that. So there will be a structured, managed restructuring process, led probably by local government, and a group of SOEs or high-quality developers, trying to take over the project and to liquidate in the rather slower fashion, to avoid the fire sale, because that would lead to the drop of the price expectation of the property. And that would lead to a snowball effect. So I think it would take a bit longer time for them to unwind this property sector’s project but at a project level, government does still allow them to operate, to fulfil the demand from the home buyers where they put the deposit in, then will be the suppliers, the supply chain stakeholders and then will be the wealth management of product investors. So the bottom line for China is really to try to avoid social instability and also the systemic risk.

Erika: Now, that aspect of social instability and ensuring that there aren't great imbalances also links to the government's recent clarification of its common prosperity policy. How should investors view this policy evolution?

Jie: It's interesting that you mention the word evolution, because the common prosperity, the word itself, is not something really new. Actually, the first mention is probably, at the beginning of China, the current People's Republic of China. And even when Deng Xiaoping started this reform and opening up, he mentioned that we need to have a smaller group of people to get rich first, then will bring the rest of the society, and then we all reach the common prosperity. But over the years, we see the China economy booming, at the same time to lead to this problem of the huge wealth gap. So that's why President Xi Jinping, when he started his leadership, he particularly mentioned the quality of the growth, rather than the growth number itself. So that's the evolution of so-called common prosperity. It’s really to try to shrink this gap by growing the middle class, the middle part of the population, bigger. And I believe in the longer run, this probably will support a more sustainable growth in China's consumption story.

Erika: Jie, moving on to the trade war and the tech war, which most visibly is playing out between the US and China. It didn't end under Biden's administration, so to what extent would you say that this rivalry that we're seeing is causing the chips-and-ships shortages and bottlenecks that are now bedeviling global supply chains?

Jie: When trade war started in 2018, we mentioned that there's no winner in a trade war. Because the global supply chain has been so complicated as it’s been built over the last few decades; to unwind it, to decouple, it's hard to imagine. And then you can see the recent situation in the chips, semiconductor industry or manufacturing that have had all these disruptions. But I think if you look at the US/China, we are now at a stage that we already went beyond the trade war itself. We’ve evolved to a tech war, or even a conflict between ideologies. So we have to look at it in a holistic way. The thing here, what we see, is the trade war itself and the trade between US/China has become less and less strategically important between two countries. So that's why when China started their renegotiation with the US recently, I think they paved the way to unwind some trade tariffs in certain areas that are not that critical, because that's no benefit between US and China. But at the same time, for the longer term, I think the rivalry in the technology sector, especially this critical technology sector, semiconductor, AI, et cetera, will only get more intensified because that's strategically important between the US and China. I think one lesson China learned over the period of the trade war, is that China really needs to solve this problem of a technology dependency on this critical part, especially. So if you look at the recent five-year plan, technology independence is on the top of the agenda, because China thinks they need to be self-sufficient on this critical technology. And that's the way if they later on need to compete with the US as a second superpower on the global stage.

Erika: I'd love to go deeper into what you've just touched on. But first: technology, China and the US, Jie, have all been key themes in your personal history. You've studied and worked in both countries. You started your career as a software engineer, worked on the world's first 3G mobile phone. You went on to complete an MBA at Northwestern Kellogg School of Management. So it's such a wonderful combination of how things can work between China and the US, and doing business. How have all these experiences shaped your personal perspectives, but also as an investor in China?

Jie: This is a long story. I think, first of all, I'm really the beneficiary between the improved relationship between China and the US, and China's opening up, right? When I studied biochemistry and was able to do a PhD study further in the US, at that time people always say the 21st century is a century for biological sciences. I think looking back on that, that was like two decades too early. But if you look at now, my fellow classmates who went to the US to study this field, all started coming back to China to start up their own ventures and companies because they gained all this knowledge and experience that China has provided, a very good environment for them to further prosper. And also, another experience, if you look at the technology side, things are changing so rapidly. When I was at Motorola as a software engineer, we had quite a lot of cooperation with Huawei, which at that time was a very tiny company in China, but we all know they are working very hard. So never underestimate China's entrepreneurship because there are people that are so keen to absorb this knowledge and try to make the advancement. So at the same time, if you look at the technology, nothing really lasts forever, the company Motorola does not exist anymore. So you need to constantly reinvent yourself to avoid being obsolete. So that's why I think, if you look back at the past few decades, how China has started gaining a more and more stronger position in the technology field, you can see that happening because China is learning things very fast.

Erika: So you are now based in Shanghai. What’s the best part of living in that city with a young family and at such a time of great change in your nation, and rapid change, as you say?

Jie: I think Shanghai itself has been growing very rapidly, especially the last few decades and especially the last few years, when China was opening up. So Robeco has recently just got the private fund management license, so we are ready to launch our first fund serving Chinese investors. So we see all this wealth accumulation from Chinese consumers, and they also need to invest in the various fields, including overseas, including domestically. So this is a very strong trend and for Robeco as a company, I think there's a great opportunity for business development there, and I’m happy to be part of it.

Erika: Wonderful. So Jie, we were talking about this time of great change for China, great ambition. The government is clear about its intentions to move towards global tech leadership, as you said, towards tech self-sufficiency, and it's using the full might of state funding to do so, which to the West can be problematic. So what are the implications of this relentless drive, this push?

Jie: The implication, of course, when China is moving trillions of dollars to invest in certain critical areas for investors, you really need to see where the money goes. Put it in a simple way: just follow the money. Because the last year or so we see structural changes from where China wants to focus on in terms of driving growth. We see the crackdown on the internet sector. Because China thinks there are issues for data security and data privacy, as well as for common prosperity; it just really has needed to deal with a lot of the social costs by this fast-growing sector. At the same time, they really want to direct their focus and the funding towards areas such as renewable energy, AI, semiconductors, which they think is strictly important. So we are seeing a tremendous shift in terms of the structure. So we need to follow that kind of shift because these changes really represent a lot of opportunity for us. And if you look at China, I think China does have a lot of advantages to make tech successful, even though I think China is still lagging behind and China knows that. First of all, China as a country, it has a really high savings and a well-developed capital market that really can support this innovation. And also, it has a large domestic consumer market that actually enables future global leaders to first gather strength in their home base market. Given this rising tension in the geopolitical, you know, with the western world. So they can grow within China first, so then eventually they can look abroad to do the further expansion. And finally, the country also has a vast pool of highly educated professionals and as well as the people that really have extensive experience overseas nowadays. Like I mentioned, my friends that are coming back to China to step up their own ventures. So China has all these advantages to grow their technology sector.

Erika: Jie, for a Western investor or an investor outside of China, into this economy, is this a long-term play? Is the payoff only going to come over time, given all the structural and massive effort required to move this huge entity?

Jie: Yes. We have identified actually three major investment themes that are worth considering for investors. One is the relentless rise of EV, which is the electric vehicle. And then the rise of the automation driven by the Industry 4.0 push in China. And the third one is the increasing focus on localization for the supply chain. And first of all, the rise of EV is quite obvious if you look at China being the world's largest EV market. But at the same time, it also goes beyond just electric cars or OEMs. Because from a technology perspective, China also manages secure leadership in various areas of the EVs’ entire supply chain. Take the battery as example. The battery is the critical part of the EV industry. China has the largest battery manufacturers, as well as a lot of the components, such as anode-cathode separator, for example. At the same time, if you look at the upstream of the EV supply chains, China has also been able to secure the large resources in lithium, cobalt. That's actually very strategically important. Another area is the automotive software, because the EV will make cars smarter and more connected. So there's a huge demand for the software that’s installed in the EV cars. The second one, is China does not just want to be the world's largest factory, China also wants to be the world's smartest factory. That actually leads to the combining of traditional production with novel digital technologies such as the Internet of Things, AI, robots, drones, etc. And the Chinese factories face a lot of the upgrade because of that labor shortage and rising labor cost. So this fourth industrial revolution actually will drive automation needs tremendously. And then the third one is, because of the rising geopolitical tension between China and the US, Chinese companies nowadays increasingly consider localizing their supply chains whenever possible, therefore offering a lot of new opportunities for investors. So it's not just, for example, the semiconductor foundry, but also software and the critical components in the machinery, renewable energies, et cetera. So that's really beyond just the semiconductor, as I mentioned, because this is the push that is also driven by carbon neutrality, and this also will incubate a lot of the local champions in China along this strategic push.

Erika: Jie, in closing, what would you say is the biggest myth about China that Western investors need to overcome?

Jie: A couple of them, I think. One: don't oversimplify China. I think the Western world tends to use some ideology to look at China. China is neither socialism nor capitalism, in my view, it is a mix of both. And also, government is really a big stakeholder. In the western world we all want to have the free economy, which means the government will play as little role as possible. But in China, the government plays a huge role here. Whenever that happens, you also need to understand the government has very strong implementation, execution capabilities and a lot of things can be overshoot at any stage. And this kind of overshooting will lead to volatility. But at the same time, China is very much long-term driven. So China likes to make planning, such as the five-year plan. But if you look back to history, all these five-year plans mostly are realized. And China has the luxury, in my view, to stick to the long term, to tolerate some short-term volatility because they know where they want to go. So the recent situation in property is a good example of that. Also the example of the intended crackdown is also a good example, because even in the western world, the regulation is increasing in the internet sector because of data privacy, et cetera. But China is able to do it in a very fast way. But I think to a lot of Western investors it becomes very shocking because I think that's the style of the Chinese government. In a way it's very extreme, but if you look at the longer term, that's the direction they want to go. What China can improve is communication, to let the Western world understand better their intention. Otherwise, there's always volatility, but for us as investors, if we can stick with the long-term view, sometimes the volatility really also gives us opportunities.

Erika: Right. Well, much there to think about. Thank you so much for your insights, Jie.

Jie: Thank you very much.

Erika: And thanks also to listeners. Thanks for being part of this conversation. We'd love to hear from you, so please do send us your comments, feedback and suggestions to podcast@robeco.com. You'll find all of our podcasts on your favorite podcast platform, as well as at Robeco.com.

Male voice: Thanks for joining this Robeco podcast. Please tune in next time as well. Important information: this publication is intended for professional investors. This podcast was brought to you by Robeco and in the US by Robeco Institutional Asset Management US Inc, a Delaware corporation, as well as an investment advisor registered with the US Securities and Exchange Commission. The podcast is intended only for institutional investors. Robeco Institutional Asset Management US is a wholly owned subsidiary of ORIX Corporation Europe N.V., a Dutch investment management firm located in Rotterdam, the Netherlands. Robeco Institutional Asset Management B.V. has a license as manager of UCITS and AIFS for the Netherlands Authority for the Financial Markets in Amsterdam.