Analyzing the Impact of Rising Household Leverage in China

The Investor's Guide to China from Fidelity International takes you deep into the workings of the Chinese economy and its financial markets. Paras Anand, Chief Investment Officer for Asia Pacific, brings you a cast of investment experts working in the world's second largest economy. Hear how they're uncovering this rapidly developing market and avoiding its pitfalls.

Episode 1: It’s an historic time for China's capital markets. Company shares and bonds have are drawing international attention after being included on global indices for the first time. But how open is China really to investors? Exactly how far down the road to liberalisation does China stand today and what should investors watch for next? Joining Paras to answer these questions are Lynda Zhou, a Portfolio Manager based in Shanghai, Bryan Collins, Portfolio Manager and Head of Fidelity's Asia fixed income team, and George Efstathopoulos, Portfolio Manager in the Asia multi asset team. With additional contributions from Alex Zhang, Investment Analyst.

Click here (or below on Apple podcasts) for more episodes from this series.

 

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Transcript

PARAS ANAND

This is An Investor's Guide to China, a new podcast from Fidelity International. I'm Paras Anand, Head of Asset Management in Asia Pacific and I'll be taking you deep into China's economy. What makes the country tick, the areas that are most exciting, and the ones to avoid. Fidelity has built up decades of experience in China and each episode I'll bring you Fidelity's portfolio managers, research analysts, and other specialists who cover the market and can share with you their expertise. The past year has been historic for Chinese capital markets. Company shares and bonds have stepped into the international spotlight, included on global indices for the first time. But how open is China really to investors? Exactly how far down the road of liberalisation does China stand today and what should investors watch for next? To help me answer these questions I'm joined by three of Fidelity's China experts. With me in Shanghai is Lynda Zhou, a portfolio manager who's based in the city. Lynda, you're based here but how long have you known Shanghai? 

 

LYNDA ZHOU

I'm actually Shanghainese. I was born and brought up here but I went to Hong Kong to study and further work. And then the last year, it's basically the opening up of the China market that bought me back. So I relocated the whole family back to Shanghai after almost 20 years.

 

PARAS

And joining us from Hong Kong we have Bryan Collins, a portfolio manager and head of our Asia fixed income team. Brian, how much does China figure in your Asia portfolios?

 

BRYAN COLLINS

China's a significant part of our portfolios directly and indirectly. But you could easily account for half of the exposures that we have and growing. frankly. And, of course, indirectly China has a significant influence on Asia, less the rest of the world.

 

PARAS

And also in Hong Kong we have George Efstathopoulos, a portfolio manager in the multi asset team. George, how close are you to the Chinese market?

 

GEORGE EFSTATHOPOULOS 

In recent years we have found ourselves increasingly participating in China across the cap structure whether it is China bonds - sort of CGBs - sort of the saver part of the cap structure. Increasingly, the past year or so, in China high yield and more recently in Chinese equities, as well. So particular important for us in recent years.

 

PARAS

Thanks George. And thank you all for joining me today. Lynda, Fidelity’s been in China for a decade and a half and you can see that the Shanghai skyline has changed beyond all recognition in that time. But what about the country's financial markets. Where are we in that journey?

 

LYNDA

That's actually a very interesting question for now because we all know that China is still a relatively closed up market. You know we have the capital account is still pretty much closed. The financial markets, just in the past two to three years, the opening up happening… what is really encouraging is in the past one year we do see that speed of opening up actually accelerating quite a lot. It’s probably because it's one of the negotiation conditions of the trade war but we're still very happy to see that process.

 

PARAS

And Brian and George you’re both very frequent visitors to China. But from your vantage point in Hong Kong what's your take on the pace of change? Bryan?

 

BRYAN

I would say it's a little mixed. I mean it's very rapid. I very much look at the domestic capital markets in China and see them as not developed but rapidly developing. So in some respects the rate of growth - the size of the market, for one - has been impressive, immense. We've never seen this before in terms of the growth of a debt capital market or a capital market more generally. The good thing for China is that it's got large established developed markets around the rest of the world which it can effectively mirror or at least reflect or take the best of, if you will. We've seen some good improvements with the regulatory oversight especially around the banking system and around regulating shadow banking, for example, and shadow financing channels over the last couple of years in particular. Yet on the other hand there are some aspects, little things, which still have a long way to go. One of the obvious ones that we feel is significant for the onshore domestic bond markets is simply allowing greater use of really basic derivatives like bond futures, government bond futures, for example, which are available and they're used, but for example as international participants we're not yet able to use that as some other participants. Now we feel that that will change and will obviously continue to develop and there's always this balance between making sure that the development of any capital market is measured, it's controlled, it's not excessive or creating any kind of systemic risks. But on the other hand, given the size, the fact that the bond markets is 13 or so trillion US dollars in size, we expect within the next five to six years that number to be easily 30 trillion US dollars in size - that's as big as the US debt capital markets. So if you think about it in size terms they're going to equate each other very soon but when you think about the depth and breadth and the sophistication of the two markets, China's well behind. So it's got lots of room and opportunity to continue to grow.

 

PARAS

And we're seeing that same sort of development also in terms of the A--share market as well when we think about index inclusion. George, when I look at the Chinese market, despite the sort of the development of it the depth of it liquidity of the market the volatility of the market still gives me the impression that it's still a very immature or sort of developing market. What's your perspective on that?

 

GEORGE

I think it is a more retail-driven market. So retail investors onshore in China, they're responsible for roughly about 80 per cent of trading activity, of turnover, when they hold about 20 per cent of the outstanding. These numbers are slowly changing with the inclusion that we saw we are seeing a little bit of those dynamics change, it's still very early days. I think about 10 per cent now of the outstanding is held by foreign investors so this will gradually change dynamics and will have a positive impact on volatility. But having said that, I'd also like to mention inclusion. Typically what happens when a country gets included in an index you tend to have the ‘buy the rumour, sell the fact’, that's what happened with UAE, Qatar, and even going back with Taiwan and Korea many years ago. And this time around, with China, it's been the exact opposite. We knew there was going to be inclusion sometime earlier this year - we didn't particularly know the extent of it - but last year, despite decent earnings growth in China, we saw a huge compression of multiples. So we didn't really see this buying the rumour, selling the fact, that then created a very interesting buying opportunity on the back of very attractive valuations.

 

LYNDA

After the valuation compression of last year the market is definitely becoming more interesting. And last year it was because we got multiple surprises from both inside and outside. I think the outside one - the trade war one - is probably still going on, but inside-wise the financial market deleverage has almost come to the end. So it does look more interesting from now.

 

PARAS

And let's stay with trade wars for a bit. Obviously we're in this environment now, tariffs being imposed by the US on China and the retaliation that we're seeing. George, how serious is this and how much of an impact is it having on your asset allocation views, as you’re thinking through the portfolio. Is this a short term situation or something that you see extending for quarters ahead of us?

 

GEORGE

The key thing that we're monitoring on trade wars is: what is the impact on the Chinese economy? And from our perspective we've done a lot of work trying to understand from the bottom up what does it really mean and the impact it has and today versus 10, 15 years ago, the impact today is very different because today the Chinese economy has managed to transition from an export driven economy to one [where] a big part of GDP growth is driven by the consumption story. So trade wars 15 years ago would have had a much bigger impact than what it has today.

 

PARAS

I'd like to I'd like to come in on currency though because I think one of the things that I'm finding particularly surprising is how weak the currency was as we went through 2018. But despite all of these headlines around trade wars, when you actually look at the currency, yes - we see a little bit of weakness but really it's been more resilient maybe than one might have expected as we look through 2019. Bryan are you seeing value in the currency or do you feel that there's further weakness to come?

 

BRYAN

The RMB is an evolving currency. For all intents and purposes it's a managed trade-weighted currency. And especially you can start to see how domestic monetary policy in China is playing a bigger role in the direction of the currency. So you mentioned that it was weak during 2018 which was the reverse of 2017 versus the US dollar because monetary policy growth trajectories are actually diverging, so that's what currencies should do. In 2018 the PBOC was easing monetary policy, the US Fed was actually starting to hike. Growth trajectories between the two were actually starting to diverge: the US was stronger, China was starting to moderate. So you should see a currency behave that way, like a natural stabilizer. That's what they do. That's one of the great things about having a currency.

 

PARAS

But I want to bring out this point on value though. Lynda, when you look at the currency do you see value?

 

LYNDA

It’s a tough question because as an as an insider people are always trying to diversify because we see the credit expansion speed - it's so much faster than your nominal GDP growth. That's why internal-wise, domestic people always have a fear of the currency depreciating, that's why they're willing to put money into things like property or even hard liquor. But just not keep cash.

 

PARAS

But in the context, George, of your portfolios you can be hedging out currency. Are you hedging the currency at the moment?

 

GEORGE

We have been hedging the currency for the past month or so. I'd say roughly two weeks before the trade war shenanigans came back to surface. And the reason for that is we thought that the currency had gone a long way so far this year, it was pricing in a lot of good news.
The hedging cost as a result had come down quite significantly. Last year, hedging cost we're about three and a half to four per cent - almost the entire coupon you'd be getting from the bonds. On the other hand, a month ago they had gone down two basis points. So from our end, pricing was very good news and hedging costs were very low, we thought that was a good opportunity to reduce some of our renminbi exposure.

 

BRYAN

The interest rate differentials have completely converged between China and the US. So those hedging costs are negligible now. I wouldn't say there's value in the currency only because there are downside risks. There are psychological barriers if you will, particularly for the domestic consumer and domestic confidence that seven is an issue. But frankly it should be able to break through that. If China needs to be able to adjust to a relatively high level of debt to GDP, if it needs to use that as a tool within the trade war negotiations, maybe, but currencies need to go up and down to be a natural stabiliser and the problem is with a closed capital account, with a managed currency, its ability to do that has both very strong pros and cons.

 

PARAS

Just turning to the economy more broadly. One of the things that international investors really struggle with, Lynda, is actually trying to get a read on the Chinese economy. From inside the country, what's your view on where we are in the business cycle? How do you get a read on the economy?

 

LYNDA

It's also not very easy even for a domestic person because the volatility in the GDP number is very low and to some extent doesn't really reflect how the economy changes. So we do have some better indicators, things like power generation and things like discretionary spending on some of the key items. I think these are more close to the reality, [these] types of parameters. And also I have some personal channels.

 

PARAS

Tell me?

 

LYNDA

I’m based in Shanghai so I take taxis - [it’s a] shared car system - twice a twice a day.

 

PARAS

So you take taxis twice a day?

 

LYNDA

Yeah. It’s actually quite good value because we still got a lot of internet giant subsidies on shared car services. So I talk to the drivers twice a day. The interesting thing is these taxi drivers, they are not full time taxi drivers, most of time they have another job and [often] they're actually SME owners. So in their leisure time they can earn some additional money.

 

PARAS

SMEs - small companies?

 

LYNDA

Small medium enterprises. They can give you really first hand information of what's happening on the ground. Like, for example, one of the drivers last year, he raised pigs. He told me it was very tough last year, in his business. And he was thinking that he may close down his business and switch to another one. That's typically a signal of the trough of the cycle of the pig market.

 

PARAS

And how did you act on that? What did you do on the back of that information?

 

LYNDA

Usually it will give you some idea of a kind of turning point and also it just gives you an idea. So after that I need to prove that. So I talked to the really big scale pig raising companies to see if it's really close to the downcycle of the market. I think that probably gives me some of the information earlier, you know quicker, before I really picked up some news from Bloomberg or from a sell-side report. It's really first-hand information.

 

PARAS

One of the things that I'm really interested in at the moment is the role that monetary policy is playing. Bryan, I don't know how effective you think the Chinese authorities have been in terms of their use of monetary policy to manage the economy? Should the folks at the People's Bank of China - should they be talking to the pig farmers as well?

 

BRYAN

For what it's worth I'm certain they are because that's an important component of inflation. Food in particular is a big part of the consumer price index and it's just a big part of the disposable income. And I think what we've noticed with the PBOC is that their monetary policy framework, their formalised open market operations, have really stepped up quite meaningfully in the last couple of years - officially from November of 2015. So monetary policy is now becoming a much better tool and you can monitor that through, again, the formal open market operations, you can look at it with short end funding costs. So this is actually a much better indicator, we would say, of what the central bank is actually doing rather than just what they're saying. And so you can actually start to see over the last couple of years that tightening of monetary policy. The easing of monetary policy over 2017 and ‘18 respectively were very clear to see and that helped us with our positioning, it helped us get conviction, it helped us to add risk at the end of last year. And the other thing that I think is very relevant to that - it's all very interconnected as you can imagine - is obviously the currency and interest rate differentials (we talked about that before). But then it's even just looking at the credit impulse, that credit growth within the economy. This is critical in assessing and evaluating the cycles and the mini cycles that we see within China, all very related to each other, because monetary policy is not just credit growth, we also need to add things like fiscal impulse or local government spending, for example.

 

PARAS

And if we turn to macro prudential measures more broadly. George, again, to ask the same question: despite lots of different economies and governments talking about macro prudential measures, you could argue actually that China's been one of the most effective at using macro prudential measures to control the economy. Am I right in thinking that?

 

GEORGE

Last year we have had the deleveraging campaign and that has been working but at the same time it has also had some unintended consequences. And actually that links up very much to what Bryan talked about - the credit cycle and the credit impulse. What happened last year was that companies that needed liquidity, that needed credit flow the most, these sort of private companies, small and medium sized enterprises - these companies did not have access anymore to lending. And as a result we started seeing an increase of defaults, more spread volatility in the onshore bond market, and that's important because small and medium sized enterprises in China, private companies in China, they make up a big part of China's employment - about 70 to 80 per cent of urban employment. And if we think of China and the political spectrum in China, they key objective here is, I would say, social stability. How can we relate that to the economy and something more tangible that we can monitor? I would argue that that is employment, essentially not seeing unemployment rising. If private companies are having issues - and not issues because they've been poorly managed but issues because they're not finding access to liquidity - then that is a bad thing because it can lead to rising unemployment. Now that was identified as an unintended consequence by the PBOC middle of last year, they started stepping up on that front. And as a result, from our perspective, that was a catalyst to start adding to risk especially in Chinese corporates.

 

BRYAN

The macro prudential policy that we've also seen, which I think is a little bit mixed but I think you're right Paras, it's been a pretty good example of how it can work, certainly at scale, that's for sure. Clearly, we've seen over many years quite extensive policy controls around the property market, around lending standards, that's actually created some distortions frankly, it’s a mixed result if you will. The other macro prudential policy - it's probably torturing and stretching the term and the definition a little bit - has just really been about the cost of funding. So the overall cost of funding, the allocation of capital within the economy, has been very heavily skewed towards state owned enterprise and with good cause - through decades of rapid development this is a necessary, very valid way to create capital, to generate fixed asset investment, infrastructure and everything that goes with it. The problem however is over time, if the cost of capital is not priced correctly you then get a misallocation of capital. And one of the nice things that we see about the development of a domestic bond market is that it starts the process of pricing capital better. And when you price capital better you get a much higher chance of that capital being allocated more efficiently. It's not perfect. It just means that good quality companies get rewarded with a lower cost of funding and vice versa. It's a work in progress. The bond market helps you do that. But that's, I would argue, the number one financial market reform for China: the efficient pricing and allocation of capital, and the bond market helps with that but there's still a lot more to be done.

 

GEORGE

And not just the bond market, also the inclusion of China into the Barclays indices etc which will slowly find international institutional investors coming into the market and again helping with pricing that risk more efficiently.

 

LYNDA

Just on that misallocation of capital point: this round of easing I got a very different feeling because from the recent April PBOC monthly commentary you already feel that they started to tighten a little bit after the first big scale of easing. So this time round their mentality is very different. They want to just control the liquidity enough to support the economy, not [let it] collapse, but they don't want to really pump the system with abandoned liquidity and create a lot of bubbles or in another words, allocate capital in a very inefficient way. So I think it's also a kind of mentality, an attitude change towards the easing and definitely that brings more credit financing to direct equity financing or bond financing.

 

PARAS

And Bryan you mentioned property and traditionally property is where up to 70 per cent of Chinese household wealth is tied up. And my colleague Richard Edgar has hit the streets in Shanghai to see what's happening in the property market and what that could actually mean for the broader economy.

 

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RICHARD EDGAR

Paras, I'm in downtown Shanghai, the centre of the Pudong business district, in fact just outside our offices. You can probably wave and I'd see you. But I'm about to go on a ramble to see some rather different areas, different neighbourhoods and the story they tell about China's economy today. My guide is Alex Zhang, Fidelity's real estate analyst here in China. Alex welcome to you.

 

ALEX ZHANG

Welcome to Shanghai.

 

RICHARD

Thank you very much. What an exciting time to be covering real estate. I know that you think that Shanghai is a little bit like China in miniature - if you could call a city like this of 26 million people in any way mini - but tell me about the development here in this business district, what are we looking at right now?

 

ALEX

Sure. We are now standing in the very centre of Lujiazui financial town and there are around 40 buildings in this area and in those buildings we have over 200,000 people working for the financial industry.

 

RICHARD

And 30 years ago what was here?

 

ALEX

Fields and some very shabby neighbourhoods. And when the Chinese government decided to develop the Pudong area as the starting point of opening up we started to see a lot of building. Some of them were built in the 1990s but also some of them are what built in 2010.

 

RICHARD

So this is possibly the scene that most people think of - most foreigners certainly think of - when they think of Shanghai. But you're going to take me to a rather different place.

 

ALEX

Yes of course. For the residential community in this Lujiazui area there are two camps. One is about five to 10 minute walk from our office. And the other is around 20 minute walk from the office. I'm actually living in the 20 minute camp.

 

RICHARD

It sounds like we've got some exercise to get on with, why don’t you lead on.

 

ALEX

Yes, of course.

 

RICHARD

Right, Alex, not an awful lot of exercise. We've only been walking about seven or eight minutes and here we are in the area that you were telling me about. It’s much more residential, it’s leafy - we've got lots of trees down this street, very attractive and helpful on a very sunny day here in Shanghai. Tell me about the shops that we can see around.

 

ALEX

As you can see the most popular are property agents, restaurants, coffee bars, juice bars. And I think all of these represent the fast-growing service industry in China. So definitely it's a structural trend. However, we can also see with all of these tenants the turnover rate is very high.

 

RICHARD

The turnover rate?

 

ALEX

Yeah - or the churn rate, which means a lot of people are trying to open their own shops. However, some people succeed to survive but some people just have to close down just after the tenant lease period.

 

RICHARD

This is your neighbourhood. You walk up and down the streets every day. How often do you see new shops here?

 

ALEX

I have to say very often. Actually, in front of us these three shops, I didn't find them during the last weekend.

 

RICHARD

Really? They’re brand new?

 

ALEX

Yeah.

 

RICHARD

And how long do you think they'll last?

 

ALEX

It depends. I think the property agents probably could last quite a period because they are the experts about demand. And these dumpling shops, I think they mainly serve the mid to low end customers, they can actually also survive quite a long time. But this one which is a stewed meat kind of shop is quite a specific demand, so I'm not quite sure how long they can survive.

 

RICHARD

So dumplings - yes; stewed meat - maybe not.

 

ALEX

Yeah.

 

RICHARD

And how important is property as an investment to people here in Shanghai?

 

ALEX

The property price went up about 30 per cent in 2015 and another 30 per cent in 2016. But after two years of skyrocketing the Chinese government came in with interventions to curb the property bubble in late 2017. So since then we’ve seen a 15 per cent drop from the peak and which bottomed in February this year and edged up 6 per cent since then.

 

RICHARD

It’s been edging up 6 per cent? I mean that's a pretty good edging up, isn't it. Has that government intervention and the slowing of the incredible racing away of prices, has that changed the way that people think about property?

 

ALEX

Definitely property has become less attractive as an investment.

 

RICHARD

And this is something close to your heart as well? Not just professionally.

 

ALEX

Yeah because I bought my apartment in this area in early 2016 so I enjoyed the rally in 2016. However, I also experienced the drop in 2017 and ‘18. But definitely I don't view that from an investment angle, I more treat it as a living purpose. I think one of the purposes for the government to control the property bubble is also to prevent property from crowding out too much consumption. So I think there will definitely be a structural trend for the Chinese household to allocate their assets out of property and gradually into other types of assets like equity, fixed income, and other type of things. And also on the other hand you have more disposable income to be allocated to consumption. So that's definitely both good for the capital markets and consumption for the next decades.

 

RICHARD

Alex Zhang here on the leafy streets of almost central Shanghai, thank you very much indeed.

 

ALEX

Thanks very much.

 

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PARAS

Lynda, I want to explore this point that Alex raised on consumer trends a bit more. Does what he said really chime with your own outlook?

 

LYNDA

I think it's quite common to think in that way but from my kind of experience I actually do feel the opposite way. I think that having your property price rising actually creates a lot of wealth effect and increases your consumption power. And second, it also increases your expectation for future growth. So I do think that the wealth effect takes a big part from the property price. It's probably quite good for consumption. And also I did experience a very big drop in the Hong Kong property price back in 1987 when the property price dropped 70 per cent. So that's definitely going to decrease our consumption not increase.

 

PARAS

One of the things that I discovered meeting Chinese companies over the last year is that it seems as if local brands are starting to resonate with consumers arguably more than international brands. And we're very used to this idea that international brands like Nike have global resonance. But what's really surprised me is the prominence and growth and appetite for local brands. Is this is a real shift that we're seeing?

 

LYNDA

It is a very strong phenomenon that’s emerged in the past decade. I think there are two reasons behind that. First one is you have local brands that have really had a quality improvement. In terms of value for money it can give you a better utility. So there is fundamental reasons why the local brands are emerging. And second, also from the consumer perspective, we’ve got a young generation - their consumption pattern is very different from my generation. They're very focused on tailor-made demand and also very focused on experience. And also they’re quite focused on a kind of interaction or feedback. Sometimes the local brands are really good at that, they're very fast at changing their models, their designs, to better tailoring the younger generation customers. Whereas international brands - for example, it's a very typical example, is like a P&G, when they want to launch a new product and try and fit into the younger generation they need tonnes of process approval from their US-based R&D centre but the local cosmetics or FMCG brands they change really, really fast.

 

PARAS

But one of the emerging stories really though is about increasing household leverage. On the credit side, Bryan, is increasing household borrowing a concern for you?

 

BRYAN

The level of household debt is always something we need to be thinking about in any economy, particularly around the rate of change. Someone's property or properties plural as is often the case within China and the mortgage associated to that is typically the largest part of that household debt. That wealth effect and everything that we've talked about is obviously an important part of that. The good thing is generally speaking we don't see excessive levels of debt in the household sector other than the investors and even then it's been difficult to have excessive amounts of debt within the household sector. But as we start to think about things like auto leasing, for example, if we start to think about the use of consumer credit, this is a much trickier part of the household debt problem because usually it's a higher cost of funding, it usually brings forward consumption and of course it's harder for that to sustain rapid growth. And that actually is what brings about cyclicality within more developed economies like the US, for example, which is very much domestic driven with a large amount of domestic credit focus and household debt focus. The development of China’s credit scoring systems or social scoring systems is clearly a way to try and rein in and self-regulate if you will. But I guess I'm not concerned about household leverage at this point of stage but my goodness it's increased quite significantly over the last few years so it's definitely something we need to be watching and mindful of.

 

GEORGE

One more thing to add to sort of link up to that is you know monitoring household leverage levels but simultaneously monitoring savings rates which historically and continues to be one of the highest globally. If that starts deteriorating at a time when household leverage is moving upwards that would be a more worrying dynamic. Haven't really seen that yet happening in a meaningful way.

 

LYNDA

I agree with Bryan. It does rise very, very quickly. But my feeling is that it’s still pretty much linked to the mortgage. So mortgage debt is still so far the largest part of the household leverage. So again it links back to the question of property prices. My view is property prices are going to be stable, not collapsing. And as long as that’s the case I don't think the mortgage-type of household leverage is going to be a big problem.

 

PARAS

Well that's a really helpful insight. If I wanted to bring this all together: what we've really learned today is that the Chinese market, the capital markets, are continuing their process of opening up but really we've seen the pace really accelerate over the last 12 months. Also really interested to hear that our view on the management of the economies by the Chinese authorities, we're giving a lot of credibility for both the efficacy of monetary policy as well as the macro prudential measures. And that whilst we're seeing a maturing real estate cycle and potentially a kind of a more mixed outlook for real estate that in fact the consumption story continues apace. And of course we'll be keeping a very close eye on pigs.

 

That brings us to the end of our show today. I'd like to thank my guests Lynda and Alex in Shanghai and Bryan and George in Hong Kong. The producers were Richard Edgar in Shanghai and Neil Gough and Seb Morton-Clark in Hong Kong. If you like what you've heard today do subscribe, rate and review us on your podcast app. Until next time, thanks for listening and goodbye.

 

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