Can You Trust Chinese Economic Data? (w/ Chris Balding and Mike Green)

MIKE GREEN: Mike Green I’m here for Real Vision in Los Angeles, and I’m sitting down with Chris Balding, who most people that watch Real Vision probably have heard something about you either on Twitter or in the news, but you and I came into contact over Twitter Your background is as an economics professor who was based in China, and started talking very openly about it First, how did you end up in China? CHRISTOPHER BALDING: The first time I ended up in China was one of the greatest stories My wife had a job here in LA doing homes for rock stars She had a very bad job she wanted to get out of and so I actually pretended to be her sending out her resume She got a US-based headhunter that offered her a job on Wednesday, and she had to be in Beijing to start Monday morning I still remember the conversation telling her, “Honey, I might have found you a job It’s in Beijing.” That conversation did not go super well the first time, but we ended up going to China for 9 years and had a great time MIKE GREEN: When you went over, initially, you went over as a bit of a China file? CHRISTOPHER BALDING: Actually, no I actually went over really knowing even then, after a couple of months in China, knowing very, very little about China As a junior professor, I was focused on knowing the very standard, turn out journal articles and academic books and things like that That’s really what I did for the first, probably almost 5 years of my career there at PKU MIKE GREEN: What started the change at Peking University? What led you to start speaking out and writing about some of the concerns that you had in terms of– whether it was China accounting issues, or whether it was China’s behavior on a national account basis? What was the trigger? CHRISTOPHER BALDING: The first couple years, I would say really 3 to 5 years that I was there, I really felt like I knew so little, that I was just really learning and asking questions and everything like that I remember– and I don’t mean to pick on this guy, but I remember Joe Biden coming to China and writing an article in The Washington Post or New York Times about how China was the future and the US needed to emulate them At that point, having lived there for– I forget the exact timeline, 4 to 5 years, I was like, well, this is what’s being written in the US press and this just isn’t matching what you’re seeing on the ground– whether it was inflation data, or whether it was all the underlying problems that weren’t being addressed That was really the first time I started just blogging At that point, I think it was just my mom and a couple of her friends that were reading what I wrote MIKE GREEN: Your mom obviously liked it, you kept writing Did you encounter blowback in China immediately, or did that build over time? CHRISTOPHER BALDING: Honestly, without any hesitation, I can say I never had the school really push back on anything I wrote about China I’m sure that people at my school got phone calls about what I wrote I can honestly say I never got any pushback The only time that I know of that I got pushback about things that I wrote about China was really involving China only tangentially and that was when there was a case where there was a gentleman in Singapore that hung himself and here was some question as to whether or not it was potentially Chinese military that might have been involved in his death, we still don’t really know to this day He had told friends that he was being pressured to work for Chinese military in high grade microelectronics work I had written about Singapore, and I knew some of the cast of characters that he was involved with, and they were Chinese military industrial companies that their armor, their weaponry is really involved in really almost any hotspot in the world I mentioned them in passing about with this Singaporean death Other than that, honestly, nothing I wrote in China did I get any real official or unofficial request to take anything down MIKE GREEN: When you ultimately decided to leave China– so you worked at Peking University until late 2017, early 2018, and then you came back here briefly, what was the decision process in terms of the decision to leave Peking University? CHRISTOPHER BALDING: The decision went like this In this late summer of 2017, I had started a petition about Cambridge University Press censoring some of their articles on China and I had created petition for foreign universities and academics to just reevaluate their relationship with China I was scheduled to start teaching in November 2017 and the way it worked at our school was they would open up the registration system for students to register for classes about a week to 10 days beforehand I had been in touch with the school in the spring, summer, and early fall about my class

When they opened up the registration system, I started getting emails from students I was going to take your class, Professor Balding, but it’s not listed I emailed the school, and they said, oh, well, we’ll check into that Mind you, this was roughly a week to two weeks after Chairman Xi was reelected for life, and the next day after emailing the school, the school informed me that I was no longer teaching in all of 2017-’18 and my contract would not be renewed at the end of the year I suspect, I don’t know that that was, for lack of a better term, a decision that was taken outside of the school to terminate my contract The school and I had had, like any normal working relationship, there’ve been issues over the years, I don’t think there was anything there that had been significantly outside of ordinary or anything that was unresolvable MIKE GREEN: To the extent that you and I have talked over the years about some of these dynamics, one of the sources for a lot of your information on a lot of the questions that you delved into were your students You had it sounded like you had a very good relationship with most of your students and were well respected certainly as a teacher When I looked up your reviews at Peking University– I’m joking, I didn’t look it up, but it did feel like this is a fairly sudden acceleration in terms of your relationship with China more broadly CHRISTOPHER BALDING: Yeah I think one of the things that even for me, I think it was very informative You really begin to feel China change in 2012 When I first arrived in 2006 and 2009, in relative terms, China seems– looking back now, almost open in freewheeling Things really began to change in 2012 when Xi was there and I think those changes really began to accelerate in, let’s say, 2014-’15 I remember just some of the incidents, I had a journalist call me up some time, I want to say it was 2016 or so, saying, hey, I need a pro-China commentary on this specific issue This was something that would have been pro-party, pro-Beijing, this wasn’t looking for an activist position and I called up a couple of colleagues saying, hey, there’s this journalist, would you mind doing this? The couple of colleagues that I called up said, no, I’m not going to comment You can’t comment in China today Don’t ask me again It was very interesting to me that there was such even– and this was a couple years, this was probably two years before I left– of how much the environment in China had changed that people didn’t even want to say pro-party things publicly MIKE GREEN: Well, one of the things that you and I have discussed somewhat ad nauseum is the dynamic that began to emerge with Xi’s ascension, I would phrase it as, in particular, there seems to be an obsession with the decline of the Soviet Union and the advent of Perestroika and the opening up that occurred in the Soviet Union prior to its dissolution roughly 1990 From what I understand and from what we’ve talked about, that seems to be a very key focus in terms of the CCP and in particular, Xi Is that consistent with how you think about it? CHRISTOPHER BALDING: Absolutely I think that is probably one of the biggest things that is missed in everything that’s being discussed about China is Xi is almost, in my estimation, singularly focused on not just the collapse of China, but the accompanying numerology that is there right now One of the ones is– and I might be wrong on the name of the plan, but I believe leave it was the Soviet Union was on its 13th 5-year plan, and China is in the middle or near the end of its 13th 5-year plan right now, and the Soviet Union did not see a 14th . Xi is singularly focused on not just having a 14th, but on making sure that he does not replicate what he sees as the errors of the Soviet Union that led to its demise, specifically, opening and liberalization MIKE GREEN: That’s consistent with the discussion we’ve also had, which is my contention is that this is also very true that Xi is very focused on this dynamic of 13th to 14th plan, the mistakes of 1989 The way I look at it is that if you were working assiduously to avoid the mistakes of 1989, you’re almost guaranteed to repeat the mistakes of 1936-’37, which was when Stalin was made Emperor for life or appointed for life as both head of the party and head of the Politburo The equivalent cultural reformation that accompany the time period in which the Soviet Union

withdrew from the West and ’36-’37 ultimately culminating in the Ribbentrop, do you see it similarly, or do you think there’s a different dynamic at work here? CHRISTOPHER BALDING: No, I think you’re seeing a very similar dynamic play out One of the things is the people I continue to talk to in China is you hear things about how much sentiment there is to retake Taiwan You hear about, well, Hong Kong should be grateful to China You hear all of these types of things Well, we’re just turning Xingjian into China We have to do this There’s this cultural imperative to make China great again, for lack of a better term I think there’s a very similar dynamic I don’t think, when we talk about the US or other countries working with China, I think there’s a very static understanding of how China views itself domestically and how China views itself in reasserting itself and taking its place as an equal or looking down upon the United States Part of that is this like almost cultural cleansing that they seem to be going through right now to elevate China again MIKE GREEN: Yeah Unfortunately, I see these dynamics playing out very, very similarly One of the alternate takes, so I would argue two primary narratives Three One is China’s the future This is the Joe Biden articulation, which is difficult to square with many of the facts on the ground, but certainly remains, I would argue, the consensus view The second one is that no, China is not the future, but it’s going to manage it similarly to Japan, that it’s going to have a step down in growth, that it’s going to age and therefore have deflationary pressures, and probably an appreciation of the yuan as they seek financial power and global power in terms of the financial sphere as compared to the manufacturing or outright growth Then the third one is the China collapse model What do you think about that middle one, the idea that China can gracefully go the route of Japan? CHRISTOPHER BALDING: I was talking to someone a couple years ago in Beijing, and I was talking about the debt pressures that China was facing I was unconvinced that Beijing even understood the severity of debt problems I asked this person I said, do you think they understand the severity? He said, absolutely, they understand the severity, but you’re looking at it as if there’s a problem there to be reformed I was like, what do you mean, of course, they have to reform? He said, no, no, their goal is to just become Japan, not Thailand I think internally, in the bureaucrats’ minds, debt is not a problem as long as they can essentially always stay one step ahead of a plate that might fall off However, that is becoming even the Japan model, more and more difficult Not to say that they’re going to become Thailand, but the greater the debt pressures become both on domestic debt and on foreign debt, you have to elevate it one step above Japan if you’re going to make sure that you don’t become Thailand and what that requires is almost going the DPRK model of financial repression I think more and more, that is what you are seeing is that level of financial repression Just as an example, we’re seeing a lot of evidence that there are essentially price mandates on real estate prices Just this week, we’re seeing– just over the past couple weeks, we’re seeing evidence of financial repression with regards to pork sales and subsidies, and you need identity cards to purchase pork I think what you’re seeing is for- – they’re realizing it and it’s going to be more and more difficult for them to even become Japan and if they do that, to make sure they don’t become Thailand, they have to become more financially and socially oppressive at every step of the escalation MIKE GREEN: Well, it’s also interesting, because I think there’s a bit of a misunderstanding of what Japan is Japan became rich, flirted with the idea of do we want to become a global superpower? Do we want to challenge the United States? They somewhat rationally looked at it and said, no, and therefore chose a path that allowed them to benefit from the assets that they had accumulated abroad, somewhat of the cost of domestic production

They seated share but gained income That seems to have changed under Abe, and so there’s this debate about whether Japan still looks like Japan under that context, I would argue, Japan is one of the countries that has the most exposure to China in terms of the value of the Japanese yen that seems underappreciated on the street That does seem like a really difficult path for a country that is fundamentally quite poor China has $3 trillion in reserves, but that’s $2,000 per person It’s just not that much money If they’re looking at that type of difficulty, where they think it’s really hard to become Japan, do you think they go the DPRK or North Korean route? CHRISTOPHER BALDING: I think if you just look at the evidence right now of where Xi is taking them socially and financially, I think you have to believe that yes, that is the direction they’re going If you just take one example, I think there’s pretty strong evidence that over the past, say, year or so, they’re working very, very hard to lower their import bill Specifically, one example of this would be– a lot of their import bill comes from two primary areas– imports for processing and imports for natural resources that they use as inputs One of the areas where they seem to be working very hard to lower their import bill is in iron ore How they’re doing that is they’re essentially shifting to domestically produced iron ore that is let’s say anywhere from 10% to 20% premium, but at this point, at least, they don’t have to expend FX reserves I was talking to someone, they actually ran the calculations, well, if China has enough cobalt reserves, turn out batteries, what is the payoff period for them to essentially go all electric with batteries and lower their import bill through lower oil purchases? They said within five years, it’s not crazy to think that that is on their to do list to essentially shift away from international transactions in oil, because we see that happening right now with iron ore If they can essentially say, we’re going to cut our natural resource import bill significantly, it’s not crazy to think that they are essentially going to that model in the international trade We see that happening already in the social realm of how much they continue to tighten up and control speech on financial matters I stay abreast of Chinese language, IB research, and even a lot of the IB research has censorship mandates about they can and can’t say That DPRK model is clearly something that they’re at least trending towards, even if they don’t go quite that extreme MIKE GREEN: It’s interesting, because this is the thing that you would expect to see and it can have two outputs Over the course of 18 months, if you decide that you’re going to deemphasize imported iron ore, seaborne, primarily, and emphasize domestic production, the immediate reaction from most purchasing managers is I’m going to buy as much seaborne ferrous with higher iron or content, the 62% plus stuff as fast as I possibly can so I get ahead of these purchasing restrictions It shows up as a positive impulse into the global iron ore markets We saw this, we saw the prices rise, and now they’ve been falling as this import substitution takes hold The other thing that’s interesting about that type of behavior is it ends up increasing pollution, destroying productivity, because you can’t run the higher technology, steel foundries, with lower iron ore content, lower purity domestic sources They’ve depleted their highest iron ore content, ores, and now they’re using lower and lower which leads to tremendous amounts of slag build up, et cetera in their product, they just can’t do it Paradoxically, they’re going to end up in a less productive, weaker position through this choice, but it is a choice for autarky basically, they want to reduce that import bill CHRISTOPHER BALDING: Yes I think that seems to be the direction that they’re very clearly moving I think fundamentally, the backup issue is that they’re quite worried about their foreign exchange position because even as reserves have essentially stagnated for a couple of years, money has continued to grow relatively significantly, such that if there’s any problem, that is going to put a real dent in their FX position, especially with all the foreign denominated debt they have coming down MIKE GREEN: Well, when you say money has been growing, what you’re really referring to is the broader credit system, not the actual currency in circulation, per se? CHRISTOPHER BALDING: Yeah The currency in circulation has been growing in the low mid-single digits and credit has

been continuing to grow, let’s say at 11% to 13% range over that time MIKE GREEN: 13% seems right When you think about where there’s an endgame here, what can cause a reckoning in China? CHRISTOPHER BALDING: The way that I always think about a reckoning is people always talk about– well, they can keep printing money and this type of stuff I think of it less as a direct credit type of event What I mean by that is, they can always print more money, and they can always close themselves off more When you talk about what is going to do that, you’re typically looking for– and I hate this term, but some type of Black Swan event, types of things that we’re not expecting When you think about China, the types of scenarios that you would say, okay, what would be an unexpected type of event? The types of things that you would not expect is people say, well, real estate is heavily overvalued, and that’s an accurate assessment But generally speaking, the loan to value ratios on those accompanying loans, unless you’ve bought within the past 2 to 3 years, are such that it’s not going to cause a banking crisis Any significant fall in real estate, however, may prompt people to take to the streets, but it’s not going to cause a banking crisis People have such faith in real estate that they just expect it to go up by double digits every year, no questions asked When I lived in Shenzhen, the apartment I lived in would have sold for probably $2.5 million It was roughly 1500, 1400 square feet and the average wage of the person who lived there and worked for the electrical company as the developer was probably capped out at $20,000 to $30,000 in official terms, so you can do the math from there at what is that roughly 100 times down That is an astounding– that’s an absurd ratio One of the things we’ve seen is cities and provinces that have been instituting essentially price floors, where they won’t let transactions take place if it’s beneath a certain price threshold That gets to the really the societal fear, even if there’s not a significant financial risk for most of the broader economy is that they don’t want prices to fall, because that’s going to create, for lack of a better term, a real societal risk There’s people that track where riots or conflicts take place in China and one of the more common reasons that riots or conflicts take place in China is a developer will sell 50% or 75% of a development and then they’ll lower the prices for the remaining 25% of units or something like that The people who’ve already bought come out and riot asking for the same price cut Those are the types of things that keep Chinese technocrats and Chinese politicians up at night is if they ever have to announce broad based falls in asset prices, like real estate MIKE GREEN: When you think about something like that you think about that type of environment in which that’s a risk and levels are 100 times income, the United States put it in contrast in an urban environment, you’re typically going to see 8 to 10 times with much lower levels of homeownership It tends to reflect a wealthy individual in New York City or Los Angeles being able to afford a home when many people can’t and therefore live 50 miles away and commute in When you talk about a place like Shenzhen in those types of multiples, what’s enabling that? What’s allowing that to be serviced at this point? How do people actually afford to do this? CHRISTOPHER BALDING: What you will typically see is that basically, families or extended families, et cetera will basically pool their money to purchase an apartment I had a student that he and his fiancĂ© were pooling their money, and then their parents, each parents on each side were pulling their money This all went into purchasing an apartment for this new family This actually generally matches household wealth data that we see because even though in China, there’s this fabled myth that household have a 40% savings rate, the implied rates are actually much lower Actually Chinese household savings rates, they have household liquid financial wealth numbers that are much more in line with Mexico, Brazil, Russia, which have significantly lower household financial wealth numbers, and have also seen lower rates of return over time

Either China is saving much less, or the rates of return that they’re seeing on financial assets is much lower, you simply can’t reconcile this 40% savings rate number with the rates of return that they’ve claimed unless that number, unless those financial assets are being consumed in household savings MIKE GREEN: Well, this is one of the things that I think people struggle with, and the difference between household accounting and national accounting In a household accounting basis, you and I think of our savings as the dollars that we don’t spend, that we put into the bank or into another investment account In a national accounting system, it’s really a solution set for how much money has been spent on investment, in particular, capital investment, but other forms as well By definition, in national accounting terms, savings equals investment, and therefore, the Chinese are saving a lot because investment is give or take 40% of GDP Is that a fair characterization? CHRISTOPHER BALDING: Yes, I think that’s a fair characterization Yes MIKE GREEN: If I were to look at the actual cash flow dynamics of an individual Chinese household, what would you guess the actual savings rate is? CHRISTOPHER BALDING: I think, if we can take like a little bit of a range, I would say that the number is probably somewhere between about 15% and 25% of income You really can’t justify based upon other implied data that it’s any number really above 25% and it’s difficult to argue that it’s, let’s say in the high single digits or low teens To take a range, I’d say 15% to 25% MIKE GREEN: When we stop, and we think about, again, their system of national accounting and the way we account for it here in the United States, we don’t include in our savings numbers things like social security or Medicare, which is money that is theoretically being taxed and set aside for future consumption, i.e. savings It’s invested in the form of government bonds that are purchased by a government entity These are actually very similar levels If I take the US 6%, and I add roughly the 15% Social Security and Medicare burden combined between households and corporate sector, they’re basically like us CHRISTOPHER BALDING: Very, very similar, yes Because one of the things is, is that in China, even though they have a technical guarantee of medical care, that really provides for very little There’s a lot of pre-emptive savings, where a lot of that savings is essentially set aside for cancer or other medical care, things like that, other transitory shocks being out of work One of the one of the reasons why those household financial asset levels are much more in line with your Mexico’s and your Brazil’s, is because there’s a lot of consumption of that preemptive savings for medical care, Social Security, et cetera, et cetera MIKE GREEN: When we think about– so there’s more vulnerability at the household level and as you’re saying, where we’ve seen incidences of effectively writedowns, developments, that’s been a cause for demonstrations and an attempt to get the developer to refund the difference or to rescind the price decreases CHRISTOPHER BALDING: Yes, that’s correct MIKE GREEN: How had the state responded to those types of events? CHRISTOPHER BALDING: In most cases, they urged the developers to try and negotiate and there’s typically some type of arrangement where everybody gets a 10% discount or something like that There’s also cases where they call in the riot squad and clear it and everybody that had a contract is forced to buy and they just delay those sales of those additional units for another couple of years when people are already locked in or something like that However, generally speaking, it just goes on a case by case basis as long as the problem goes away MIKE GREEN: When we think about some of the developments that are currently in play, so the African swine fever has resulted in pork shortages, we’re seeing this in wholesale price, pig prices beginning to surge in China in advance of the Chinese New Year and I guess, the traditional time for making pork soup, which is turning into an issue How do they think about the capacity of the population to rise up similar to what we’ve seen in Hong Kong, or the increased resistance we’re seeing from Taiwan? Is it more will come to an accommodation, or is it more, we’re going to bring out the water cannons or the actual cannons? CHRISTOPHER BALDING: This is just speculation on my part, nothing more, but they are very smart in Beijing One of the things you have to keep in the back of your mind as a possibility is that they know that the economy has been stressed for a couple of years, since 2015 They know that there are significant stresses in the economy, and so one of the things that

you have to consider is that they have been building up this surveillance capacity They’ve been building up this censorship capacity for preparing for exactly these types of scenarios So whether it’s pork, whether it’s real estate development, whether it’s making sure that news about Hong Kong is sold in the way that Beijing wants to be sold, you have to consider that they’ve been preparing for exactly these types of scenarios, so that they can keep any types of dissent from getting out of hand And if it does, they can respond in almost real time to a gathering of people in this part of town, a riot in this part of town, complaints about the price of pork in this WeChat group so that they’re ready for all those types of scenarios MIKE GREEN: This is a theme that I’ve expressed as well The deal since Deng Xiaoping has been don’t protest don’t complain, we’ll make you rich, the natural conclusion from that is if you conclude, you can no longer make people rich, you need to install the surveillance systems that prevent them from protesting It feels like that’s what much of the development that you’re referring to has been focused on It’s a realization that things are going to be less good going forward and so you need to be prepared with crowd surveillance and instantaneous response CHRISTOPHER BALDING: Yes I think, even for us, living in China, we always knew that we were going to be monitored and expected that and we never posted pictures of Tiananmen Square on WeChat, for instance, but I think even in the last year we were there, my wife comes home sometime in the spring of 2018 and there was this intersection where she would take my son, and she’d get on the bus– and my son liked getting on the bus She comes home one day, and she’s like, oh, my gosh, this bus stop, which is not even in a major intersection She’s like, they put up a massive bank of security cameras so that it basically just on one corner, everything on the intersection from 10 different angles would be covered, and of course, it had facial recognition and could zoom in on different people Just even within the past, let’s say two years, the level that they have gone to, I think by any standards, even by Chinese standards, is quite surprising MIKE GREEN: When you think about the local reaction, your wife, obviously, as a foreigner is attuned to this, the local reaction from your students, from others that you were in contact with, how did they think about this rise in surveillance, or is it it’s just something they can’t escape? CHRISTOPHER BALDING: It’s something that they can’t escape but I will say I think there are people– I think there’s a good number of people in China that are worried about this, because I think they’ve always known that they lived in an authoritarian state but it also is not lost on anyone that they are just barely ahead of the DPRK in being able to access information I was talking to someone that I would consider in China, a relative political and financial elite and this was in the spring of 2018, I was at a conference This was somebody that was in the system They weren’t a party member I was talking to them, and they said there’s a lot of worry about the direction that China is heading and they went to one of the elite schools in China, and they said at a recent reunion, this dominated the conversation about people being worried If you go to an elite school in China, you are part of the system to some degree You may not be a party member, you may not be an elite civil servant or vice minister, but you’re in the system to some degree You’re vested in the system To hear people talking like that definitely gives me some hope that there is some valid concern and I’ll give you one more story About 18 months ago, I forget the exact timeframe, a senior Chinese tech official made a joke on WeChat that the CEO of WeChat could read all of his text messages It prompted quite the outpouring of concern all throughout China, it’s like a damn released all throughout China about people talking about being concerned that basically anybody at WeChat can read their messages at any time, and the government being able to read what they say This is definitely something that’s bubbling under the surface of people having this concern about privacy, whether it’s on WeChat, whether it’s out in public, and so I wouldn’t call

it let’s say, I wouldn’t call it a hot button issue It’s definitely bubbling beneath the surface that people are very aware of MIKE GREEN: It’s one thing to be bubbling and aware of Is there a prospect of it boiling over? Is there a realistic prospect of anything challenging the direction that it seems to be going? CHRISTOPHER BALDING: I don’t think in reality that that is possible yet We haven’t had one of those events within China that we know of We haven’t had one of those events The way that I think helps me think about it is there’s definitely enough bubbling discontent about Xi and the CCP that you will hear people talk very privately and quietly with phones stowed very far away but it’s still not anything that people will say with any degree of public statements The word that I would use to think about it is, there’s a lot of very fragile support for what’s happening in China, so that as long as there isn’t a significant downturn, as long as there isn’t that event that makes Xi look weak, for lack of a better term, there’s going to continue to be support for Xi and the CCP If there is, for instance, a 25% drop in real estate prices, if there is a significant downturn in the economy, something like that, that could change very rapidly However, I would not expect that to happen anytime soon MIKE GREEN: A historical example I believe we’ve talked about is the German stock market under the Nazi regime, which was viewed as a point of national pride It was perceived as bad Some other administrations might think this as well, if the stock market went down, and so a rule was put in place between 1933– I think it was actually ’34 that it was put in place– in the end of World War II in which transaction could only occur at an all-time high price The German stock market only went up in a similar fashion What you’re describing is something identical, where they’re basically saying, the only transaction that can ever happen is one at a higher price, and so we’ll see falling transaction numbers But prices remain elevated, and nobody has a cause to believe that their property is worth any less Does that feel accurate? Is that what you think is happening? Because we are seeing transaction volumes fall fairly sharply, even as prices remain elevated CHRISTOPHER BALDING: Yeah If you take the example of real estate, and I haven’t looked at this in about six months, but there were cities that were at, by my calculations, 100-year turnover rates, and their prices were still going up MIKE GREEN: Just to be clear, when you say 100-year turnover rates, that’s a measure of turnover relative to the stock of housing? CHRISTOPHER BALDING: Yes Basically, if you had 100 units of housing and you started with unit one and went down the line, and then started back at the beginning, it would take 100 years to psych to it before you got back to the first housing unit In like 2007, I think that number was like at six years in the United States You had very high turnover rates 100-year turnover rates is just absurdly high The lowest number that I found in China, I think, was at roughly a 30-year turnover rate, which is still quite high This gives you an idea that there’s just not the transaction volume even though prices continue to go up MIKE GREEN: That’s one of the things that happens under our command economy In a market economy prices, higher prices signal higher activity They encourage new supply, they encourage people to take their existing properties and sell them In a command economy, perversely, you end up with a bimodal outcome, where prices are set at an unsustainably high level, demand is much, much lower, and therefore there’s very little clearing between the two effectively, activity stops Is there anything that could force liquidation? CHRISTOPHER BALDING: That’s part of what they appear to be stopping and they seem to be trying to address in a couple of ways For instance, one of the things is, is that even though the Chinese household supposedly saves almost 45% of their income, they’re now one of the most indebted households in the world They’re more indebted than US households It presents a real paradox, how does a household save 45% of their income and simultaneously become one of the most indebted households in the world? That’s a real puzzle

One of those things, it’s very difficult to believe that both of those things are true and accurate On the flip side, we’ve seen a real clamp down on transactions that don’t meet city or provincial levels for price for instance One of the other things on that command economy is you’re now looking at a housing market in China where 25% of apartments sit empty and the one sector in China that is continuing to grow at double digits is real estate and steel inputs to build those apartments It seems quite paradoxical that they’re continuing to channel credit to a sector of the economy which is at 25% unused and is essentially deadweight at this point because of population they’re never going to fill MIKE GREEN: Well, it seems paradoxical until you break it down and say, wait a second, the sale of land to developers and the building of those properties is the only way you get credit It’s also the only way you generate financing for local governments This is the 19th century variant of the United States where the funding for local municipalities came from the sale of public lands CHRISTOPHER BALDING: If you look at whether it’s households or corporations, virtually all of their security in loan documents is related to physical assets, primarily either land or real estate If you have that, even if the value, even if nobody lives there, you can very easily go and get a loan on that unused apartment I know a couple people that found themselves in situations where they would go rent an apartment, and then at some point, they would be living in that apartment and they would come back, and then there’d be police tape across the door They’d go to the landlord and say, oh, well, I have to roll over my loans Come to find out, what would happen is they would have an apartment free and clear and they would go to a bank and they would get a loan on that apartment They would take that loan, go purchase a second apartment, either free and clear, or maybe with a 10%, 25% loan on that apartment They would then go to a separate bank and get a loan on that apartment They would until they had 10– MIKE GREEN: Effectively laddering their positions CHRISTOPHER BALDING: Yes, until they had 10 apartments on essentially one underlying asset That is essentially what you frequently see, because people are very, very– financial institutions in China, very happy to lend out on a specified physical asset MIKE GREEN: Ultimately, there’s another variant of this, which is multiple rehypothecation We tend to think of China as this extraordinarily organized and disciplined bureaucracy but as I understand it, there’s no Uniform Commercial Code, there’s no centralized database of who owes money to whom, that assets are multiply encumbered This is stuff we’ve talked about in the past, do you think that still continues to hold? CHRISTOPHER BALDING: I’ve heard multiple stories, so it’s very, very difficult to pin down what exactly is happening with regards to purely financial credit What I mean by that is, if this is one reason why people use different banks I can tell you, there’s even been court cases in China, where there’s been actual recognized financial bank fraud as a source of conflict For instance, there was a case in Shenzhen where there was going to be a purchase of a real estate asset, the price that was listed to the bank was different than the actual transaction price, and there was going to be a kickback There becomes this dispute, and it goes to the courts Even though the courts recognize that there was actual bank fraud that took place, nobody was actually prosecuted for the actual bank fraud, because there’s such paucity of documentation between the bank and the listing that gets recorded at the city These are the types of problems that– that’s why you go into title and you sign all these different documentation, signed the loan documents, you signed the title documents, et cetera Everybody, there’s transparency in that transaction and it doesn’t happen that way in China MIKE GREEN: Well, that’s one of the things that I think people tend to forget is that the systems that have grown up around credit accommodation in the western regime or the developed market regime, things like title insurance Those, by and large, don’t exist in China It feels very much if I’m digging into my financial history, or economic history, like a 19th century variant of the United States where wildcat banks have no method of communicating with other banks in terms of a property that they’ve lent money out against As a result, credit claims multiply relative to the underlying assets, which again, in a system of national accounting, until everyone writes it off, shows up as positive savings CHRISTOPHER BALDING: Yes, absolutely I can tell you a story of a bank that they were on third position in a company that they

felt quite strongly was going to go under, and so if they being in third position, they were behind two very large banks, they were going to face significant problems recovering any assets, and they were going to wipe it out They actually went to their client and said, let’s put together a deal where we can essentially buy out two banks ahead of us, we can spin this off into a private equity type of entity where it also goes off of our books and so they actually got one of the two banks ahead of them to essentially participate in this “private equity offering” Both banks ended up with the loan being officially taken off of their books, where their clients participated in the private equity offering so they listed it as a financial asset, and the loans went off of their books Technically, it’s no longer in the financial system and both of these banks come out looking cleaner The purpose of that is, is that the banks now are able to boost their overall balance sheet even though they essentially are still backing these products and loans MIKE GREEN: This is a mortgage, what you’re describing here is just a contingent liability It’s the exact same underlying dynamic of structured products in the United States where a large portion of it was sold off, a fraction of the asset was retained but there was a contingent liability associated with fraud or anything else This is the same underlying dynamic, it’s a thing to quote, Disney, it’s a tale as old as time When you face challenges, speaking, either to Western investors, or to global investors who might have a different view of China, don’t see it with the more rose colored view of China is the future, it represents a pool of 1.4 billion possible consumers What’s the reaction to your message? CHRISTOPHER BALDING: The people that have been there for any significant amount of time, they know all these stories I’ve never met anyone that hasn’t been there for a few years and doesn’t know all of these stories I think in the West, you come to the United States, you come to Europe, and people have some idea that some of this is happening but then you relay some of these stories, and their eyes just get wide like this I have this friend in China, and he had this great line He’s like, the problem with China is you tell people stories here, and they’re so wild and crazy that they don’t believe you People just don’t believe you at first until you’ve come over and you’ve experienced some of what happens in China and you’re like, wow, these things are actually are actually true I think especially for financial investors, this is why the largest flows that you’re seeing right now, are the passive mandate money, because the active investors I think are a lot more, generally speaking, reticent now, having seen some of the problems There’s a lot less activity in the active mandates to really dive in, because there’s so much concern about the unknown unknowns MIKE GREEN: Well, we’re definitely seeing this on the corporate side Foreign direct investment into China in terms of primary has collapsed We are definitely seeing dynamics associated with things like MSCI rebalancings that is pulling institutional money in They’re looking to match an MSCI all country exUS passive benchmark, which requires them to put money into fixed income, it requires them to put money into equity This is purely mechanical, it’s contained in the 401ks of Americans, it’s contained in the pension plans and endowments of America and the rest of the world for that matter With no real analysis of the underlying other than it’s big, it’s a market and therefore, we should have some exposure to it feels like that’s the only source of capital that’s going in at this point CHRISTOPHER BALDING: Yes I think what is so amazing to me is– especially on like the fixed income side, there’s so little understanding of China that people aren’t even looking up the IPO prospectus is and going through them and looking at the bond offering document Some of the things you’ve heard international investors take out with regards to provincial bond offerings and things like that are just astounding to me, knowing where some of these places are and hearing some of the things that they’re going to be doing with this money To this day, it never ceases to astound me that you have people putting in this sum of money into some of these places, they couldn’t even find out a map MIKE GREEN: They’re doing it for a very simple reason They don’t know they’re doing it

What I’m saying is the marginal investor is somebody in a target date fund that has exposure to a Vanguard, or BlackRock or capital that are just plowing money into an international bond index or into an international equity index with no real knowledge, it just comes out of their paycheck Ultimately, the fiduciary responsibility is offset by, well, we’re just market, we’re calculating everything As long as somebody else presumed somebody else is doing the work in setting the price, it seems rational until you realize the scale of these flows that are unmanaged Let’s wrap up and talk very quickly about what you think is going to happen with the trade negotiations CHRISTOPHER BALDING: My expectation is I would be very surprised if there was any type of deal before the election MIKE GREEN: Is that driven from the US in the intransigence of Donald Trump, or is that driven by China in your view? CHRISTOPHER BALDING: My primary complaint about a lot of the analysis that looks at the trade war, that starts in the United States is not that we shouldn’t look at Donald Trump and all that comes with that I think there’s too many people that are not looking at, okay, who is my counterparty? If I’m in a negotiation, there’s two people or two sides in a negotiation so I need to look at, okay, who is my counterparty? I think there’s, there’s a lot of people that are not looking at what is the Chinese side Let’s just look briefly at the Chinese side, I think it’s pretty clear for many reasons that China is really not going to make any changes to their economic model of any materiality or significance If we look at just how they recentralized the economy, really over the past, let’s say 5 years– 3 to 5 years That’s the entire focus I also think, fundamentally, Chairman Xi can’t make any significance Let’s ignore the political side, it would be politically fraught for him to make any significant concessions But economically and financially, the Chinese economy is such right now that any significant changes to that model could create very significant financial risks and I think they know that Whether it’s the banks, whether it’s the heavy industry that they’re subsidizing, that they’re keeping afloat these other aspects, I think there’s an enormous financial risk to Beijing to making any significant financial changes I don’t think you can expect Beijing to make any financial economic concessions If we zoom back out now and look at, well, how does that change how Trump is going to be negotiating? If you’re going in a negotiation and you can look at the other side and say, I don’t expect them to make any concessions really, or any changes to what that I would be asking– and the other thing is just politically, Beijing has said, look, we’re great again You’re going to have to deal with that That puts the Trump administration in no matter really, what they ask, is it’s probably going to be no Everyone talks about how Trump is going to cave or he wants agricultural purchases I’m not even sure at this point, China is willing to make those very low level basic concessions Because if it was, it would seem that maybe they’ve agreed to it, maybe they haven’t, but they certainly haven’t followed through on those pledges that they’re going to do that Regardless of what we have with the Trump administration, I think it’s pretty clear that China is unwilling to make any changes to their economic model of any significance MIKE GREEN: I lean towards there’s probably a component of detente, and if there’s going to be, it’s going to be in the agricultural purchases area I think China signaled something with the tariffs in particular, on pork at this point in time It’s the equivalent of Briar rabbit saying, please don’t throw me into the Briar Patch We’re going to prevent you from importing pork to China when the majority of people are looking at it like well, wait, the African swine fever is destroying the Chinese pork herd, the swine herd, and so they should be doing the exact opposite It feels to me that it’s a very transparent move to say, this is something that’s really important to us to protect, and we’re willing to take that much pain, when the reality is, is that the imports that are coming in are from companies like Smithfield, which is a Chinese company anyway They can very easily refund the tariff back to the corporate entity if they choose to do so This is going to be a fascinating time I agree with you with the under explored part and I think it’s in part because people are

so– the media in particular is so negative Trump, that they’re very focused on the CPI impact, who bears the cost of the US tariffs? They’re spending very little time thinking about the implications of these tariffs in the context of can China even accommodate any former tariff? It feels to me like China is very close to– the technical term is broke and any meaningful change would just accelerate that process The easy answer is, let’s say no, and push it off on the United States and say they’re the bad guys CHRISTOPHER BALDING: I think there’s two broader themes here which seemed to be happening The Trump administration seems to be saying, I’m going to get material significant change from China and if I don’t get that, I’m willing to essentially decouple and essentially move that manufacturing to other parts of the world In fact, what you’ve seen is that US imports from the world are essentially growing pretty much on trends, a little bit lower this year than the boom year we had last year, where there was maybe some frontrunning of imports, but they’re growing pretty much on trend What this seems to indicate is that those imports that would be coming from China are slowly being dispersed to other parts of the world That seems to be one of the gambits that Trump is making is, if I can’t get significant change, I’m at least going to cause the pain so that it has to go to other parts of the world China, on the other hand, I think what we’re seeing which I think is an enormously underreported area, is that people say global trade is slowing down because of the trade war No, that’s really what’s happening You’re seeing imports into China across the board, regardless almost of product, regardless of geography, imports into China are falling quite significantly What they seem to be doing is exactly what we talked about earlier, they seem to be saying we need to, first of all, lower our import bill in total and we seem to be essentially becoming more focused on self-determination, whether it’s iron ore or whether it’s chips and we’re going to do that You’re seeing this entire trade slowing with all of Chinese trade partners, not just the United States That seems to be marking a major shift in not just the trade war, but the global economy, where China, in some cases, was responsible for 50% or 75% of global growth in trade in some of these areas and that’s essentially been cut off MIKE GREEN: Yeah, I see it very, very similarly and we’re just to highlight that if that was actually happening, paradoxically, it would be seen as a rising manufacturing surplus for China It could be potentially perceived as China is winning, but the reality is, is that happens, it’s just the same description as a contract manufacturer has positive cash flow once their business starts to die off, because they no longer buy any inventory, they run off their working capital, they convert that into positive cash, and that seems like a real win It also goes to this idea that China is going to dump its Treasuries Going back to the 1936-’37 model, the Soviet Union held on to US Treasuries and any foreign reserves that it could get very fiercely because they had no prospect of generating them through efficient trade dynamics That was made easier because of the Soviet Union’s raw commodity exposure It’s much harder for a manufacturing entity like China As we look forward to the next year, you’re going to be heading back over to Vietnam, where you’ve been teaching for a while, we’re going to get you back to the States so we can check on this in 6 months to a year I’d love to have you back on CHRISTOPHER BALDING: Yes, absolutely I can tell you, in places like Vietnam, they are actually actively cheering on the trade war It’s actually putting them in some industries bumping up against capacity constraints, they still have port space, but some other things are being built out as fast as possible Yes, I’ll absolutely be coming back in the next 6 months to a year MIKE GREEN: All right, fantastic Can we get you back on then? CHRISTOPHER BALDING: Absolutely MIKE GREEN: Thank you very much, Chris I appreciate it