The first eight days of October are known in China as the “golden week.” Each year on October 1, the Asian giant celebrates its National Day with official ceremonies, parades and massive events. This year was a thermometer for the red dragon’s recovery, and it has scared the markets: the economy did not shine this time. While official data point to a rebound in consumption higher than 2019, it remains insufficient to maintain the level of growth that China is used to.
The cracks in the Asian giant’s economy have incited global terror among investors. The crisis at Evergrande, the country’s main real estate company, as well as the liquidity problems of the shadow bank, which lacks the supervision and control of regular banks, has made investors tremble, after they got excited too early about the Chinese economy’s recovery. The strict intervention of the Xi Jinping regime and the lack of an independent central bank continue to cause doubt about the giant’s true state of health.
Investors are paying attention to the economy. According to data published last October 13, exports fell some 6.2% in September compared to last year, compared to the 8% expected by analysts, and imports decreased 6.2%. Despite ending up in the red, both indicators are more moderate than those of the summer. Inflation, however, remained unchanged. In September it remained at a 0% interannual rate (compared to the expected 0.2%), while the underlying rate increased 0.8%. If they had to give a name to this scenario, the analysts consulted agree on one: deceleration.
This sinkhole of problems is a symptom that China’s growth model, based on exports and capital accumulation, is exhausted. Michael Pettis, member of the Carnegie Foundation and China expert, explains that starting in 1980, the Asian giant implemented a development model based on investment, especially in housing and infrastructure, and high savings. Although it was successful three decades ago, problems began to surface about 10 to 15 years ago. “China increased the level of investment so much that the economy could no longer absorb it productively. Since then, as we have seen in other countries, its growth was boosted by an increase in debt,” he explains. Scope Ratings estimates that Chinese public debt will reach 147% of GDP in 2027.
In recent years, leaders have tried to move away from this model towards one focused on consumption. But the pandemic put a brake on their attempt. Exports had been a key source of growth for the nation during the coronavirus crisis, but cooling global demand dented China’s recovery and market expectations. However, for Luis Pinheiro, an economist at CaixaBank Research, China’s global standing is reaching its limit, especially due to geopolitical tensions with the U.S. and the Eurozone, and they can no longer be the main engine of growth. On the other hand, China’s extraordinary dependence on investments in property and infrastructure represents, today, the greatest challenge.
A real estate crisis
The real estate sector makes up around 15% of Chinese GDP, but indirectly contributes more than 30%. In addition, it accounts for 20% of urban employment and has been the most important investment instrument for the population, since it represents around 70% of total household assets, according to Mali Chivakul, emerging markets economist at J. Safra Sarasin Sustainable AM. But the Evergrande crisis, and the more recent Country Garden crisis, revealed the sector’s limits.
When Evergrande, which was the country’s main real estate company, defaulted in 2021, the first cracks in the sector began to appear. The government at that time tightened access to bank financing for developers with a high level of debt, under the motto of Xi Jinping’s government, “housing is for living in, not for speculation.” Last August, Evergrande officially declared bankruptcy in the U.S. to avoid the embargo of its assets.
Added to this is Country Garden, the country’s main developer, which at the end of August announced losses of $6.345 billion in the first half of 2023. These are not isolated cases. According to Bloomberg, of the 38 state-owned property developers registered in Hong Kong and mainland China, 18 have announced losses in the first half of the year.
The real estate crisis is important for the country’s financial stability, since the sector’s debt represents around 25% of banking assets and approximately half is related to local administrations. Municipal governments, which obtained their main source of income from the sale of land for the development of new housing, are currently heavily indebted. In addition, unfinished buildings worry home buyers who have paid in advance and at the same time drive away potential buyers, undermining confidence in the sector. The data bears this out: sales are down 30%, and new construction has fallen 60% since 2021. Home prices have also fallen 10% to 20% in many cities, according to Goldman Sachs.
Until now, responses have been short-term fixes. The regime has boosted housing demand by relaxing restrictions on purchasing a home, cutting the minimum down payment for first-time buyers to 20%, and to 30% for second-time buyers. In addition, the interest on existing first-home mortgages was reduced.
Along with real estate, the other great current risk lies in shadow banking due to lack of liquidity. Two months ago, one of the largest asset managers in the country, with considerable exposure to the real estate sector, informed its investors of the need to restructure its debt and stopped paying investors. It is estimated that shadow entities move around $3 trillion in China.
The challenge of consumption
The transition towards a consumption-based growth model is one of the main challenges for the red dragon, since it has always been supported by a very high level of household savings. “The most important imbalance is the very weak domestic demand that China suffers from, driven by the lowest proportion of consumption in GDP in history,” says Pettis. The lack of public health and retirement systems has pushed citizens to keep money under the mattress, as they anticipate future turbulence.
Xi Jinping’s government has been reluctant about the possibility of introducing a welfare state and granting any type of state aid or subsidies to citizens, as it prefers to support companies to generate employment and indirectly increase household income.
However, in official speeches, the regime is implying that it will assume a lower level of growth — like the current 5% objective — but of higher quality. Last March, Premier Li Qiang declared that “most people do not monitor GDP growth all the time. What matters most to them are the things that happen in their daily lives.”
The international market
The consequences of China’s economic slowdown leave no doubts among analysts. The weakness of the country, which contributes 20% to global GDP, will cause a slowdown in global growth. The latest official estimates suggest that each point less of growth in China would imply a drop of between 0.1 and 0.4 percentage points in growth in the Eurozone. Carlos Casanova, chief economist for Asia at Union Bancaire Privée, adds that the slowdown would also affect international trade, and would drag down other economies that depend on Chinese demand for their exports, such as Germany.
Added to this are investors’ expectations about the income prospects of large multinationals that obtain part of their profits in China and which could see them reduced. This would translate into a drop in asset prices in the markets, as has happened in recent months with the European luxury sector.
On the other hand, experts are still debating the consequences of the crisis in the real estate sector. The most optimistic consider it a “local crisis” with a moderate direct impact on the markets. Despite being the second largest global economy, China does not have a very close connection with global financial markets unlike, for example, the United States. “It is estimated that Chinese investors hold 5% of global assets and liabilities, a level far from the size of its economy,” explains Pinheiro.
Likewise, the economist recalls that the Evergrande crisis is nothing new and has not yet created significant turbulence in the markets. “The international bond market in China, particularly in the construction and real estate sector, is already discounting a very high probability of this default in a large part of the developers,” he explains.
Investors should not worry about the crisis catching on internationally, since the current scenario is very different from that experienced during the financial crisis of 2010. At that time, in Spain, banks financed mortgages by issuing debt abroad and suddenly found themselves without liquidity due to lack of investor confidence. In China, on the other hand, the financing of the real estate sector comes from families, some banks and the issuance of debt, but it is not external financing, according to Alicia Herrero, Asia-Pacific chief economist at Natixis. “The drop in housing supply is slower than in Spain, because while here no one could finance a single project, in China the State developers buy the land and have liquidity,” she says.
Pettis also rules out a financial crisis in China. What’s more, he believes that it will face a “slow and prolonged adjustment” like the one Japan experienced after 1990, with a limited but uneven impact on the markets. “Countries and sectors that benefited from high levels of investment in China, such as producers of capital goods or industrial raw materials, will be severely affected by the sharp drop in investment, while those that benefited from Chinese consumption, like producers of consumer goods and agricultural raw materials, will perform well,” he concludes.
Some pessimists do think that the bursting of the bubble could have serious consequences. Virginia Pérez, investment director of Tressis, believes that Evergrande’s bankruptcy could infect the sector and cause financial problems in the industry. In addition, it would generate greater risk aversion and a loss of confidence in the markets.
Investors’ eyes are on China’s latest macroeconomic data. It will suggest whether the red dragon is on its way to becoming a black swan.
The Japanization of China
Investors eagerly awaited the end of China’s zero-covid policy and the recovery of international travel. But the Asian giant’s momentum has not improved. Given data that points to a slowdown in the economy, analysts point out the possibility of a Japanization of China’s economy, which would mean a period of low growth and depressed interest rates, as occurred in Japan in the 1990s. Vladimir Oleinikov, analyst senior at CFA, and Christoph Siepmann, economist at Generali Investments identify the similarities.
The real-estate market: The contraction in the level of real estate investment, property sales and housing prices have contracted significantly, as occurred in Japan. However, the estimated defaults in the sector so far seem more acceptable to the banks, and the Chinese government exercises much greater control over prices, developers, banks and deleveraging needs.
Inflation: In July China’s CPI fell 0.3%. Although it rose 0.1% in August, in September it remained unchanged at 0%. Analysts interpret these data as a symptom of a long-lasting deflation problem, like the one Japan has experienced in recent decades.
Demography: The proportion of people over 65 years old was 12.7% in Japan in 1991, similar to that in China today. Just like Japan, China is facing a rapid decline in its working-age population and, therefore, a drop in the productivity of the economy.
Debt/GDP: The debt/GDP ratio of China’s non-financial private sector reached 220% of GDP by the end of 2022, and exceeds that of Japan in 1990, which reached 202% of GDP.
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