Gao Shanwen's latest analysis: recent economic situation and treasury bond inter

The decline in China's long-term capital returns has driven a broad downward trend in interest rates, which is the fundamental reason for the continuous retreat of the central axis of China's Treasury bond rates.

Discussion on Recent Economic Situation and Market Conditions

Firstly, we observe the proportion of China's constant price trade surplus to GDP. Since 2022, the proportion of China's constant price trade surplus to GDP has surged significantly, reaching the highest level on record.

The last time China's trade account had a substantial surplus was around 2007. At that time, the renminbi exchange rate was undervalued, facing significant appreciation pressure, and the exchange rate formation mechanism lacked flexibility. Concurrently, the economy was at a higher growth level, and inflation was once quite severe.

However, examining the macroeconomic environment around 2022 reveals differences from 2007. The renminbi exchange rate generally faces depreciation pressure, and the exchange rate formation mechanism is more flexible. Over the past few years, the price level has not been satisfactory, and the economic growth rate has remained at a relatively low level.

Next, we compare the actual trade surplus, which excludes price factors, with the nominal trade surplus, which does not exclude price factors. Observing the nominal trade surplus, as shown in Figure 2, it can be seen that the current imbalance in the trade account is more moderate, having retreated by nearly half from the 2007 central axis, and is also slightly lower than the level around 2015.

The significant difference between these two sets of data indicates that in recent years, China's trade conditions have deteriorated severely. That is, the prices of a large number of Chinese export goods have plummeted, while the prices of imported goods have risen sharply. However, from an analysis of the actual economic situation, it may be more valuable to observe the changes in the actual trade surplus after excluding price factors.

The question we need to consider is, why has China experienced such a severe trade account imbalance again in recent years?

An attractive explanation is that during the pandemic, there was widespread lockdown globally, and supply chains were severely disrupted. China's pandemic control from 2020 to early 2022 was quite successful, and economic life was operating normally. Therefore, China's manufacturing production and supply chains were maintained at a relatively normal level.Under such conditions, Chinese goods were exported in large quantities, compensating for the disruptions and suppression of production capacity in the supply chain caused by lockdowns in areas outside of China, thereby driving a significant expansion of China's trade surplus.

This explanation is reasonable, but the issue lies in the fact that from 2023 onwards, global economic life, including that of China, has returned to normal. By 2024, the impact of lockdowns on global supply chains and economic activities is largely invisible.

If the above explanation is correct, as global economic activities return to normal, China's trade surplus should contract significantly. In fact, the actual trade surplus in 2023 did show a slight decline, but since 2024, this figure has risen again. This largely indicates that the impact of the pandemic and lockdowns on the trade surplus is temporary. In terms of the overall performance of the trade surplus over these years, its explanatory power is relatively limited.

The second explanation that is widely accepted by the market is that China's manufacturing investment has generally been maintained at a high level in recent years. Coupled with China's significant technological breakthroughs in areas represented by new energy vehicles, known as the "new three big items," China's competitiveness in these fields has significantly improved, thereby promoting the expansion of the trade surplus.

We believe this explanation has some merit, but relying solely on the enhancement of China's manufacturing capabilities and competitiveness to explain this unprecedented large trade surplus may not be convincing enough.

An important counter-evidence is that the average performance of China's economic growth during this period is relatively low, and the performance of prices and exchange rates is also weak. If the significant enhancement of China's competitiveness had caused a substantial expansion of the trade surplus, the exchange rate should not have shown such a weak performance. Moreover, the economic growth rate during this period may also be significantly lower than the historical normal trend.

Therefore, we attempt to propose a third, and most important, explanation: the significant adjustment of China's real estate market has led to a sharp expansion of the trade surplus. Since 2021, China's real estate market has undergone a significant adjustment, and the demand for the upstream and downstream industries it drives has also declined noticeably. Against this backdrop, with the rapid contraction of demand in these areas, the production capacity originally corresponding to the real estate market was forced to turn to the international market, manifesting as a significant expansion of the trade surplus.

If one observes the extent of the decline in real estate investment in the total economy and considers its impact on the upstream and downstream industries, and compares this impact with the magnitude of the expansion of the trade surplus, it can be found that the two are relatively close in order of magnitude.

It should be noted that we also emphasize the scarring effect of the pandemic, which has impacted the balance sheets of residents, enterprises, and local governments, thereby dragging down the performance of total demand. This insufficiency of demand is also reflected to some extent in the expansion of the trade surplus.

Overall, we believe that the starting point of the problem lies in the significant adjustment of the real estate market and the demand contraction brought about by the scarring effect, leading to weak economic growth, price levels, and exchange rate performance. At the same time, due to the low demand, the corresponding supply capacity is forced to turn to the international market, thereby manifesting as a significant expansion of the trade surplus.From this perspective, we believe that if there is a significant recovery in China's real estate market in the future, the fading of the scar effect leading to a noticeable increase in total demand, then the current imbalances will be significantly corrected.

We add some recent observations. Since 2024, the trade surplus has been expanding overall. At the same time, the month-on-month change in PPI has been mostly below 0 since the second half of 2022, showing a continuous slight downward trend, as shown in Figure 3.

Against this backdrop, commodity prices have risen significantly in the past few months and have reached new highs since the pandemic. Whether observing the prices of basic commodities within China or the commodity prices of Goldman Sachs, there are similar performances, as shown in Figures 4 and 5.

That is to say, if the impact of upstream basic commodity prices is excluded, the prices of industrial manufactured goods may have actually fallen more in the past few months.

The contraction of the real estate market can explain the trade surplus and the decline in the prices of industrial goods, but it cannot explain the significant rise in basic commodity prices. Although we believe that the adjustment of the real estate market and the scar effect explain the main trends and characteristics in the macro economy since 2021, the changes in the data in the past few months seem to indicate that some new changes have occurred in the economy on this basis.

The important background that has given rise to this change may lie in the fact that China is forming new competitiveness in some emerging fields. The emergence of this competitiveness has promoted the expansion of China's trade surplus, and the economic growth rate has also performed stronger than the market expected before, and it has also driven the rise in the prices of upstream basic commodities. However, the formation of these supply capabilities has further exerted downward pressure on the prices of manufactured goods.

In other words, although the significant adjustment of the real estate market and the continuous impact of the scar effect have been the most important characteristics of the macro economy in the past three years, in the past few months, China's rapid technological progress in the manufacturing industry and the formation of new production capabilities have driven the rise in upstream commodity prices, the decline in the prices of mid and downstream manufactured goods, and the better performance of economic growth relative to expectations. This may also have a marginal supporting effect on the exchange rate to a certain extent.

This supporting effect seems to continue for some time. However, looking at the data performance of the past three years, the factors that play a leading role in the macro environment are still mainly attributed to the real estate industry. Therefore, it is necessary for us to enter the discussion of the real estate market next.

Let's first observe two important data. One is the second-hand housing price index of 25 cities in China, which we believe is representative of the overall real estate market in China; the other is the rental price index of 25 cities. It should be noted that these two data only include residential data, and office buildings are not included.Observe the performance of the housing price index in 25 cities. During 2021, the housing price index once rose above 105 and began to fall sharply after sustaining for 7 months, currently dropping to around 82.8. The decline from the peak to the current level of the housing price index is 22.6%. Although there are differences in the situation of different cities and properties, when combining the national data, this adjustment is likely to be close to the micro-level perception.

Next, observe the rental index. Since the outbreak of the pandemic in 2020, the rental index has started to fluctuate downwards. As of now, compared to the end of 2018, the rental index has fallen by 12.1%.

Combining these two pieces of data contains rich information and is of significant value for understanding the current state and future direction of the real estate market.

An important piece of information is that the rental price level has been continuously declining for five consecutive years.

Ignoring the impact of the financial crisis, from 2000 to 2018, with the rapid expansion of the economy, the acceleration of urbanization, and the improvement of residents' income levels, the overall trend of urban residential rental prices should have been continuously rising. However, in the past few years, the rental price level has been falling.

If we consider real estate as a very important asset, the cornerstone of its pricing is undoubtedly the cash flow generated by long-term rents. The basis for predicting this cash flow is the performance of rents in the present or over a certain period in the past.

Therefore, from a valuation perspective, it seems easy to conclude that the long-term expected cash flow of this asset has significantly deteriorated. This deterioration inevitably leads to a drastic adjustment in asset prices. We believe this is one of the most important contexts for the significant adjustment in real estate prices.

Observing the rental yield, before the middle of 2021, while housing rents were falling, housing prices were rising. The direction of prices was opposite to the direction indicated by the fundamental rents. Therefore, as an asset, the valuation of real estate was significantly increasing at that time.

The significant increase in valuation indicates that the market at the time believed the decline in rents was temporary, and the market still had optimistic expectations for the future process of urbanization, economic growth, and the rise in rents. So, while rents were falling, housing valuations were rising.

However, after entering the second half of 2021 or 2022, the market's expectations for rent increases began to be revised. Under this condition, the market's understanding of the fundamentals began to align with reality. The result of this alignment brought about a significant correction in valuation and a sharp decline in housing prices, forming a double whammy known as the "Davis Double Play."The valuations in the second half of 2023 have essentially returned to the levels seen at the end of 2018. Alongside the continuous and rapid decline in the housing price index, we believe that the valuation levels represented by the current rental yield have likely returned to the levels between 2017 and 2018.

In this context, let's examine the differences in the performance of housing and rental price changes across different cities. As shown in Figure 7, we can observe a significant positive correlation between changes in rent and changes in housing prices. The less the rent falls, the less the housing prices fall, and vice versa. This indicates that the market price adjustments are not entirely disorderly but are closely tracking the changes in fundamentals.

This pattern is rare in countries where real estate bubbles have burst. The pattern in bubble-bursting countries is that the more the prices rise initially, the more they fall after the bubble bursts, with a weak connection to rent.

Against this backdrop, we further observe the performance of the real estate market adjustment to date.

For housing prices, future rents are the most important fundamental factor. Rents are closely linked to residents' incomes. If residents' income expectations are growing strongly year after year, then their ability to bear housing prices is stronger, and vice versa.

An important fact is that the growth rate of residents' incomes and its expectations have been on a downward trend for a long time, and this trend has accelerated during the pandemic.

The accelerated decline in income growth undoubtedly puts pressure on real estate valuations. However, we find that the decline in mortgage interest rates is synchronized with the decline in income growth. As shown in Figure 8, since the outbreak of the pandemic, the decline in mortgage interest rates has been around 190 basis points, while the decline in income growth has been approximately 290 basis points.

In a simple valuation model, the valuation for long-term growth is calculated by subtracting the interest rate from the profit growth rate and adding a risk premium (it should be noted that the risk premium required by the market may currently be at a high level). While the income growth has declined significantly, the notable downward movement in interest rates helps to support market valuations.

Next, let's observe another important valuation indicator for the real estate market, the price-to-income ratio. The absolute level of housing prices may have already returned to the levels of 2017, or even 2016, while based on the statistical data released by the government, the absolute income level of residents has increased significantly, which means that the price-to-income ratio has shown a clear improvement.

As shown in Figure 9, the current price-to-income ratio may be even lower than the level in 2014. A possible reason is that the early housing price data we use may have flaws and underestimations. However, considering grassroots-level observations, if the absolute level of housing prices has returned to 2017, it is entirely possible for the price-to-income ratio to return to the levels of 2015 or earlier.Taking into account the growth in income, if the price-to-income ratio of housing returns to the level between 2014 and 2015, for most cities, from a longer time series perspective, the housing price-to-income ratio is not at a high level.

Combining these data, we are inclined to believe that the pandemic has led to a significant deterioration in the fundamentals of the real estate market. This significant deterioration is manifested both in the substantial reduction of rents and in the downward adjustment of long-term income expectations. Against the backdrop of a significant deterioration in fundamentals, if real estate is considered as an asset, its valuation has subsequently undergone a sharp correction.

This correction process includes both the correction of absolute valuation levels and the correction of relative price levels between cities. Moreover, the correction of relative price levels closely tracks the fundamentals. Therefore, we are inclined to believe that this correction is largely a normal adjustment in response to the deterioration of the fundamentals.

After several years of adjustment, the market valuation has undergone a significant correction, and some important valuation indicators appear to have returned to reasonable levels. For example, the housing price-to-income ratio has returned to the earlier levels of 2015; the rental yield may have returned to the position around 2017; and the absolute housing prices may have returned to the levels between 2016 and 2017.

In addition, the downward trend in long-term lending rates has largely offset the impact of declining income expectations (although it should be emphasized that lending rates still need to be further reduced), so the long-term affordability of housing has also improved significantly.

Overall, we believe that after experiencing a deterioration in fundamentals and a correction in valuation, many price-related indicators in real estate have returned to reasonable levels. However, reasonable price levels do not necessarily mean the emergence of a bottom. The formation of a bottom is often complex and random, and bottoms formed entirely by market forces are usually below the reasonable price center.

In the past period, despite significant corrections in many valuation indicators, housing prices have continued to fall rapidly. The deterioration of fundamentals is the reason for the significant adjustment in the real estate market, but not the only reason.

Another important reason for the significant adjustment in the real estate market is the liquidity crisis faced by real estate companies. The business model of Chinese real estate companies is based on high turnover, and this business model has very high requirements for the stability of debt and cash flow.

Due to a series of market and policy reasons, the stability of cash flow and debt of real estate companies has been greatly impacted in the past few years. In this context, there has been a concentrated run on real estate companies by creditors, leading to a liquidity crisis in the real estate industry and a passive and rapid contraction of the balance sheets of real estate companies. This contraction has brought a series of macro-level impacts and is also a key background for the significant adjustment in the real estate market.

An important piece of evidence is that if we compare the primary and secondary housing markets, we will find that the transaction volume of the current secondary housing market in China is roughly maintained at the level of 2019, which is quite high historically; however, the transaction volume of primary housing has returned to the level before 2012. The significant divergence in transaction volume between the primary and secondary housing markets is rare.We believe that the important reason lies in homebuyers' concerns about whether real estate companies can ensure delivery. This concern about delivery risk has suppressed the performance of the primary housing market. The insufficient price adjustment in the primary housing market may also have had an impact.

Therefore, the adjustment of the real estate market is influenced not only by the continuous decline in rental levels, the downturn in residents' income and income expectations, and the associated increase in risk premiums, but also by the liquidity crisis faced by real estate companies.

At this level, we observe the recent performance of several related data.

First, let's observe the stock price indices of state-owned and private real estate sectors in the A-share market. Over the past period, the government has introduced a series of strong interventions and policies to rescue the real estate market. Against this backdrop, the stock price indices of the real estate sector have rebounded significantly.

Looking at the stock performance, in the past month or so, the rebound of the real estate sector index has been close in magnitude to the rebound during the adjustment of epidemic policies.

Observing the performance of the Hong Kong stock market, the rebound of the private real estate stock index was once greater than that during the adjustment of epidemic policies, and the state-owned real estate stock index also showed a rebound of similar magnitude.

This kind of rebound seems to have a similar performance in the high-yield bond market of the Chinese dollar debt. It can be observed that the yield to maturity of high-yield bonds has significantly decreased. Although the decrease is still less than that during the adjustment of epidemic policies, from the bond market perspective, this is already the largest decrease since the adjustment of epidemic policies.

This rebound indicates that the market has a positive expectation for the real estate policies introduced in the past month. The new round of real estate policies, while relaxing home purchase restrictions and adjusting mortgage interest rates, have begun to intervene and rescue the liquidity of real estate companies in a targeted manner, such as purchasing some commercial housing and repurchasing land.

The liquidity pressure faced by real estate companies is an important reason for the continuous decline of the real estate industry. Therefore, when the policy tries to solve this important issue, the market price index has rebounded significantly.

We believe that the market's interpretation of the policy and real estate situation is objective. This round of real estate policies has found the key to the problem and tried to solve the liquidity problem of real estate companies, and along this line of thinking, the implementation of these policies has the possibility of gradually promoting the market to bottom out and reverse. However, the execution process of the policy is full of uncertainty and requires us to closely track.Further Discussion on Long-Term Interest Rates

In our mid-term strategy meeting in June 2021, we discussed the long-term rate of return on capital in China. The fundamental view was that after 2010, China's rate of return on capital began a long-term downward trend, which is expected to continue at least until 2030. The long-term decline in China's rate of return on capital will lead to a downward shift in the entire interest rate center.

At that time, we believed that by 2030, the interest rate on China's 10-year government bonds might fall to a level near 2%. The reason is that as China's economy successively crosses the first and second Lewis turning points, the law of declining marginal returns on capital begins to play a leading role.

During this transitional period, the decline in long-term capital returns is irresistible until the economic growth rate falls to around 3% or lower, and technological progress can counteract, reverse, and balance this trend. We have observed similar patterns in the transition processes of other East Asian economies such as Japan and South Korea.

Figure 13 includes two indicators: one is the Incremental Capital Output Ratio (ICOR), which is the marginal rate of return on capital. The other is the rate of return on existing capital. Both indicators show that since 2010, China's rate of return on capital has been continuously declining.

The decline in the rate of return on capital will pull the entire economic interest rate center continuously downward. Against this backdrop, although the long-term interest rate in 2021 was still above 3%, we believe it will fall to around 2% by 2030.

Over the past year or so, the downward trend in long-term interest rates has exceeded market expectations. We believe that the technical explanation is reasonable for phased transactions, but it may not be comprehensive enough when viewed from a longer historical perspective. The fundamental reason for the significant downward trend in interest rates is the decline in long-term capital returns.

Based on this discussion, we further analyze the balance sheets of banks. Banks' assets include loans and government bonds, etc. We calculate the difference between the interest rate on bank loans and the interest rate on government bonds held by banks, which is the risk premium, as shown in Figure 14. Banks holding loans require more risk compensation compared to holding government bonds, as loans are less liquid and carry more risk.It can be observed that from 2011 to 2024, despite fluctuations in between, over the course of more than a decade, this risk premium has generally trended significantly downward in a one-sided manner. The high point in 2012 was around 4.5%, and now it is only about 1.5%, having declined by approximately 300 basis points.

In the financial markets, this significant and prolonged downward trend of this key risk premium indicator is noteworthy. What has caused such a phenomenon?

According to financial textbooks, this would indicate that over the past decade or so, the risk in China's credit market has significantly decreased, liquidity has markedly improved, and economic growth has become stronger. Therefore, relative to government bonds, the risk compensation for credit has substantially decreased. However, this does not align with actual observations.

Some argue that changes in China's money supply mechanism have created this discrepancy. However, differences in money supply affect both loan rates and government bond rates. If loan rates are too low and the risk compensation is insufficient, banks can adjust their portfolios and increase holdings of government bonds, which would also lower the bond rates, preventing a significant decrease in the spread. Thus, the difference in money supply is also hard to use as an explanation for this phenomenon.

What is the core reason?

We believe that before 2011, in order to digest the non-performing assets formed historically and to successfully complete the commercialization reform of state-owned banks, policy designs consciously maintained a higher credit spread arrangement. Under this design, commercial banks could easily digest historical burdens, clear non-performing assets, and replenish capital through profits.

Operationally, these designs meant suppressing deposit rates and raising loan rates. The method of raising loan rates involved, on one hand, limiting the downward movement of rates, and on the other hand, controlling the availability of credit. The scarcity of credit allowed market rates to be maintained at a higher level.

From the banks' perspective, restrictions on credit allocation caused excess funds to flow back into the government bond market, leading to a downward trend in bond rates. This force would also feedback into the deposit market, putting downward pressure on deposit rates as well.

Therefore, before 2011, the spread between credit rates and government bond rates was at a higher level. The higher credit spread enhanced the profitability of banks, leading to higher valuations. However, as the commercialization reform of banks continued to advance, policies began to guide rates back towards market-oriented levels.

The continuous lowering of the loan rate floor and the gradual easing of lending constraints for banks, coupled with credit controls that stimulated the shadow banking system to issue a large amount of loans, have resulted in the spread between loans and government bonds gradually moving towards an equilibrium level over the past decade.In terms of government bond yields, they are influenced by two forces. The first is the marketization of interest rates, where the regression of spreads exerts an upward influence on government bond yields; the second is the decline in the long-term rate of return on capital, which pulls interest rates downward.

Under the influence of these two forces, compared to loan interest rates, the downward trend of long-term government bond yields from 2010 to 2020 was relatively mild. In contrast, loan interest rates have declined significantly due to the dual impact of the downward trend in the long-term rate of return on capital and the relaxation of regulations and marketization of interest rates.

However, can we extrapolate the mild downward trend of long-term government bond yields from 2010 to 2020? We believe that considering the marketization of interest rates may be nearing its end, complete extrapolation may be unreasonable.

Therefore, in the next decade, the downward movement of government bond yields will be more influenced by the decline in the long-term rate of return on capital, with a weaker influence from the reversal of interest rate liberalization. Consequently, there is significant room for long-term government bond yields to decline substantially by 2030 compared to 2020.

Of course, the impact of short-term cyclical factors exists; the deterioration of the real estate market, scarring effects, and overcapacity are also conducive to the downward movement of interest rates in the short term. As the influence of short-term cyclical factors fades, interest rates may experience cyclical rebounds driven by economic conditions, but the central trend of interest rates should be in a downward channel.

Why do we believe that the process of interest rate marketization is nearing its end but has not yet concluded?

The most natural observation is that the prohibition of manual interest subsidies since April has had a significant impact on the market.

Inferring from the extent of manual interest subsidies at the grassroots research level, there may still be a gap of 25-30 basis points between the wholesale deposit rate and the equilibrium level at the time of interest rate marketization.

Analysis of Japanese Companies Going Global

Going global has been a highly focused investment theme in the domestic capital market since last year. Against the backdrop of long-term economic stagnation in Japan, the large-scale international expansion of Japanese companies provides us with a case study for learning and reference.The overseas expansion of Japanese companies has many contextual backgrounds. Internally, the significant appreciation of the yen weakened the competitiveness of export products, the collapse of the real estate bubble led to long-term weak domestic demand and sluggish growth in the domestic market, and the aging population and declining total population growth had a long-term negative impact on Japan's economic growth.

Externally, with the initiation of reform and opening up in China and the end of the Cold War, the world entered a period of peace and stability, and economic globalization accelerated. At the same time, a series of technological innovations in fields such as information technology, aviation, and maritime transportation also provided important technological conditions for companies to go global. Under such conditions, Japanese companies have been continuously exploring overseas markets for decades, achieving impressive performances.

Many of the current contexts in China are similar to those in Japan at that time. Internally, many believe that China is experiencing a process of long-term insufficient demand after a significant adjustment and the bursting of the real estate bubble, enduring the impact of rising domestic labor costs, environmental protection costs, and other factor costs on product competitiveness, and will also face the long-term impact of a declining total population and working-age population. Externally, China is facing the impact of geopolitical uncertainties on supply chains and capacity allocation, while many countries are also focusing on the localization of manufacturing and attracting capital backflow.

Therefore, analyzing the performance of Japanese companies going global has reference value for our understanding and prediction of the future overseas expansion of Chinese companies.

First, observe the performance of Japanese companies going global at the aggregate level. In Figure 15, the denominator of the red line indicator is the total capital stock in Japan, including factories, machinery and equipment, subways, airports, etc., and the numerator is the stock of Japan's direct investment abroad. Japanese companies have a large number of joint ventures abroad, and the shares of these joint ventures form the capital stock of overseas direct investment.

The blue line in the figure is the broad-sense stock of overseas investment, which not only includes direct investment but also credit, stocks, foreign exchange reserves, etc. The claims accumulated abroad through financial markets and credit markets are also part of Japan's overseas capital. From this indicator, as of 2022, Japan's total overseas investment stock accounts for 40% of the capital stock. Among them, overseas direct investment accounts for about 8% of Japan's capital stock, and about 20% of the total overseas investment stock.

Next, observe the sales revenue of Japanese overseas companies. The sales revenue of Japanese overseas companies is not equal to but roughly comparable to GDP. It has similarities with GDP statistics, but it is not exactly equal. As shown in Figure 16, as of 2021, the sales revenue of Japanese companies invested abroad is equivalent to a level slightly more than 50% of Japan's GDP.

Therefore, in terms of the total volume of overseas investment and the proportion of overseas revenue, many people say that Japan has recreated half of Japan outside its territory.

Observe the returns on Japan's overseas investments. By comparing the investment returns of Japan abroad with those domestically, it is found that since the pandemic, this ratio has increased significantly, perhaps because the overseas economy has expanded significantly.

Looking at the period before the pandemic, Japan's overseas direct investment accounted for less than 8% of the capital stock, and its returns accounted for a little more than 10% of the operating surplus of domestic companies. Therefore, the return on overseas direct investment is somewhat higher than that within the territory. In terms of total overseas investment, its returns accounted for more than 20% of the operating surplus of domestic companies before the pandemic, and the capital stock accounted for about 40% of Japan's capital stock.In this context, we compare the rate of return on direct investments outside of Japan with that within Japan over a certain period. For most of the time, the rate of return on direct investments outside of Japan has been higher than that within the country.

From a micro perspective, Japanese companies possess excellent management capabilities, technological levels, and business networks. Overseas investments can take advantage of relatively cheap local labor, favorable tax policies, and other environments, to bring them closer to customers, expand market space, and also avoid trade frictions. These factors make overseas investments more likely to achieve higher returns. In contrast, within Japan, factors such as economic stagnation and population decline make it more difficult to obtain returns domestically.

Therefore, it seems obvious that the return on overseas investments is higher than that of domestic investments, and growth abroad is faster than within the country. However, going overseas is selective; if the companies that choose to go overseas are already very competitive domestically, their rate of return in Japan is already high. After going overseas, the overseas rate of return is higher than the overall domestic rate of return, which does not necessarily indicate that going overseas has improved the profitability of the companies.

If this explanation holds, then the impact of going overseas on the company's stock price and valuation is limited, because going overseas does not increase the rate of return. However, there is also a possibility that going overseas has indeed increased the rate of return based on the favorable factors mentioned earlier, in which case going overseas would lead to better stock performance and higher valuations. The key is to distinguish between these two explanations.

Before distinguishing these effects, let's observe some aggregate performances. On the horizontal axis, we measure the degree of going overseas in different industries by the proportion of overseas sales of companies in the industry (considering data availability, we used the proportion of the market value of overseas companies to the total market value of the industry), and the vertical axis is the rate of return of these industries. It is easy to see that the higher the degree of going overseas, the higher the rate of return, and this conclusion also holds for the industry's net profit margin and the growth rate of sales revenue.

However, these only indicate a correlation between the degree of going overseas and profitability, not a causal relationship. To infer a causal relationship, we introduce statistical analysis based on a two-way fixed effects model. Simply put, we control for the effects of both industry and time, and observe the impact of factors that change simultaneously in industry and time dimensions on profitability.

Looking at the statistical results from Figure 22, we can generally determine that, based on some of the mechanisms we described, companies going overseas have indeed increased their profitability, sales growth, and net profit margin.

If companies going overseas can increase their profitability, then in the long term, it is meaningful for the capital market. Next, we observe the performance of long-term stock prices in Japan. We set the index at 100 in 1995, the red line represents the stock price performance of 50 large-scale overseas companies, and the blue line represents the performance of 50 companies with revenue concentrated in the domestic market. From 1995 to the recent past, we see that the red line has risen from 100 to about 800, while the blue line has only risen to less than 200. Even focusing on the period before the pandemic, the long-term performance of the red line is significantly better than that of the blue line.Many people believe that before the pandemic, Japan's stock market had been stagnant for a long time, and after the bubble burst, it remained at a relatively low level for an extended period. This observation is correct for the Nikkei index, but the overseas segment of the Nikkei has not performed poorly over a 20-year period. From 1995 to before the pandemic, the overseas index rose from 100 to a level of 300-400, which is a considerable increase for an economy like Japan that is almost non-growing.

If we focus on the period from 2003 to before the pandemic, the gap between the domestic demand index and the external demand index has narrowed, but overall, the external demand index has still performed slightly better than the domestic demand index. After the outbreak of the pandemic, the external demand index has been significantly stronger than the domestic demand index, and there is a similar performance on the profit level.

Combining the above analysis, we believe that in an economy with weak internal growth, competitive companies that go abroad on a large scale can improve their return on investment, and the performance feedback to the stock price is reflected as the external demand index performing relatively better than the domestic demand index in the long term.

Summary

This article discusses three aspects of content.

Firstly, the significant adjustment in the real estate industry and the resulting severe imbalance in the trade account are key characteristics of China's economy in recent years. After the deterioration of the fundamentals and the correction of valuations, many price-related indicators in the current real estate market may have entered a reasonable range, but this does not mean that housing prices have completely bottomed out. The formation of the bottom is often complex and random, and the bottom formed by the market's own forces is usually lower than the reasonable price center.

In addition to the deterioration of the fundamentals, the liquidity crisis faced by real estate companies is also an important reason for the continuous deceleration of the industry. The recent real estate policies are aimed at the root cause of the liquidity crisis, and if implemented along the current thinking, there is a possibility that the policy will gradually push the market to the bottom. However, the implementation process of the policy is full of uncertainties, and we need to closely track it.

Secondly, the decline in China's long-term capital return rate has led to a downward trend in broad-spectrum interest rates, which is the fundamental reason for the continuous decline in the central level of our country's government bond interest rates. Over the past decade, the process of interest rate liberalization has partially offset the impact of the decline in long-term capital return rates, making the decline in government bond interest rates relatively minor compared to loan interest rates. Considering that interest rate liberalization is entering its final stage, future government bond interest rates will be more affected by the decline in long-term capital return rates, and there is room for a significant downward trend.

Thirdly, against the backdrop of the gradual maturity of information and transportation technology, the acceleration of globalization, and the long-term lack of growth in the domestic economy, Japanese companies began to go abroad on a large scale from the 1980s. Going abroad on a macro level has formed a large-scale overseas capital stock, creating sales revenue close to half the size of the domestic GDP. On a micro level, going abroad helps companies improve their profitability and competitiveness, which in turn leads to a significant increase in stock return rates. This provides a useful reference for Chinese companies to go abroad.