Shenwan Macro Zhao Wei: "Anti-Inner-Wrap", markets may have misunderstood something.

The market's emphasis on "anti-inner loop" has significantly increased, but there is a great deal of disagreement on the understanding of "inner loop"; most viewpoints are based on the mindset of supply-side reforms, but there are small differences and huge mistakes; besides production control and self-discipline talks, there are also many "hidden means" in "anti-inner loop". Misunderstanding of the "inner loop meaning": Is "anti-inner loop" equal to "anti-surplus"? Different causes of demand: "Surplus" is when demand declines, supply passively exceeds, while "inner loop" is when supply actively increases in strong demand sectors. Before the supply-side reform, real estate and infrastructure demand weakened, with the capacity of high-energy-consuming industries passively exceeding; currently, external demand is stronger, but the fixed asset turnover rate of external demand industries has fallen to the lowest level in history (below 2.6), while the fixed asset turnover rate of domestic demand industries, though declining, is still at the historical median, indicating that external demand industries are more overburdened than domestic demand industries; the delivery service industry (non-trade sector) does not have an overcapacity problem, but is also overburdened. Different price performance: "Surplus" is when companies lower prices in response to demand decline, while "inner loop" is when companies compete disorderly by lowering prices due to strong demand. Before the supply-side reform, real estate and infrastructure demand weakened, leading to a sharp drop in CPI for sectors like coal and steel, and a corresponding downward trend in manufacturing industry investments; in the current inner loop sectors, profits are weak and investment in manufacturing industry has significantly expanded, with higher investment growth in external demand sectors (13%). The prices of exported goods (below -5% year-on-year) are even lower than the prices of the same goods sold domestically (between -1% to -2.5% year-on-year), reflecting a proactive price reduction in the inner loop. Different supply issues: Before the supply-side reform, there was an oversupply in the upstream and midstream, while this round of anti-inner loop is more focused on the midstream and downstream, with private enterprises being more overburdened. Observing the historical percentile of fixed asset turnover rate, in 2016, upstream mining and raw materials industries were at historical lows, currently around 30%-40% historical percentile. Midstream machinery and equipment sectors and downstream sectors were at historical percentile of 40%-60% in 2016, but are now at historical lows; looking at the nature of enterprises, the fixed asset turnover rate of private enterprises is at its historical lowest level, while state-owned enterprises are near the historical median (50%). Misunderstanding "targeting sectors": Does "anti-inner loop" mean "significant contraction of supply in midstream and upstream"? High-energy-consuming industries have completed capacity consolidation, and most traditional backward capacities are not actually backward. Since 2020, the growth rate of high-energy-consuming industries, represented by steel, has been around 0, while the growth rate of fixed asset investment has temporarily exceeded 20%, indicating large-scale energy-saving transformations in capacity; in recent years, the fixed asset turnover rate of high-energy-consuming industries has declined but is still at the historical median level; since 2024, the growth rate of value added in high-energy-consuming industries (4%) has been consistently higher than the growth rate of electricity consumption (1%), indicating a significant reduction in energy consumption after large-scale capacity transformation. Policies are aimed at controlling industries with excessive growth in the midstream and upstream, but the perspective is relatively more focused on the midstream and downstream. Policies are only targeting industries with "excessive production," such as pork, coal, and photovoltaics, to address the problem of "excessive price declines". In terms of coal, electricity demand is weak, but raw coal production has increased to over 5%, leading to a sharp drop in coal prices, prompting policies to moderately control production; in terms of pork, excluding base effects, the growth rate of pig inventories (2%) has risen to a high level in recent years, causing pig prices to continue falling, indicating significant room for pork supply control in the future. It is important to avoid excessive contraction of supply in the midstream and upstream which could lead to "overpriced" situations, limiting the effectiveness of anti-inner loop policies and affecting employment. During the supply-side reform, while the prices in the upstream rose significantly, benefiting business profits, profits in the downstream significantly weakened. This round of inner loop is in the midstream and downstream, where increased investment has led to rising fixed costs. A sharp rise in upstream prices will exacerbate cost pressure on the downstream; calculations show that a 10% increase in metal prices could reduce downstream profit growth by 1.9 percentage points; the recent abnormal price increases in industries like potassium fertilizer in the chemical industry have prompted policies to focus on "ensuring supply and stabilizing prices". Misunderstanding "policy levers": Can "anti-inner loop" only rely on self-discipline talks? Experience shows that encouraging industry mergers and acquisitions, raising industry standards, enhancing industry self-discipline, and matching corresponding support policies may be a viable policy combination. 1) Japan and South Korea experience: The Japanese government has implemented policies to promote cross-shareholdings between companies to avoid excessive competition and the influence of foreign companies. 2) UK and US experience: The US steel industry has adopted a market-led reform strategy in the face of surplus capacity. 3) German experience: The German beer industry faces fierce market competition, but persists in a high-standard brewing system and the differentiation of regional flavors, creating a "non-price competitive" ecosystem. Anti-inner loop does not mean stimulating demand in surplus sectors, but developing demand in non-surplus sectors (such as the service industry), and guiding the transformation of supply structure in line with the long-term demand structure. Stimulating demand in overburdened sectors will only exacerbate the situation. Anti-inner loop measures should address the differentiated demand structure at its root. Developing demand in other sectors, balancing the demand structure, and guiding the supply structure to adapt to demand transformation; the service industry has huge potential in terms of demand, and employment in the supply side is insufficient, the development of the service industry can take on employment from the manufacturing industry, breaking the cycle of overburden. Addressing the issue of "regulatory arbitrage" in equipment upgrades is also an important means, with minimal negative impact on employment. In industries purchasing new equipment, there has not been an equal reduction in old equipment, thus resulting in overcapacity export; equipment upgrades do not affect the balance of fixed assets, but the fixed asset growth rate in external demand industries has significantly increased; while the growth rate of equipment purchases has surged, the growth rate of the disposal of waste from old equipment has plummeted by nearly 10 percentage points; it is necessary to force the elimination of old equipment, and since new equipment has been purchased, the reduction of old equipment may have limited impact on production and employment. Risk warning The economic transformation may face short-term constraints, policy implementation effects may fall short of expectations, and household income growth may not meet expectations.