The China meltdown?

Despite significant challenges in its real estate sector, the financial markets are sending contradictory signals

It has become fashionable to bash China lately. The Western media is going after the country with an endless stream of negative articles and commentary. From the Financial Times to The Economist and The Wall Street Journal, every week seems to bring a new negative cover story or podcast about the impending meltdown in China. Even global investment banks are now getting in on the action. Bloomberg Economics has just published a report arguing that China might never overtake the US economy, contrary to previous expectations of a crossover in the early 2030s.

So what is going on? Are things really that bad? Is China the next Japan, doomed to a lost decade or two as it undergoes a debt/deflation bust and a balance sheet recession, or is this wishful thinking on the part of the West?

First of all, there is absolutely no doubt that the Chinese economy is in trouble. The problems seem to be centered on the real estate sector. Property has been a huge driver of China’s growth, accounting for over 30 per cent of the economy, and it has been its most important sector. To get a sense of relative scale, while in India, 350,000-400,000 apartments are sold per annum, the figure for China is 10 million. Property investment is why China is the largest consumer of commodities in the world, and its debt is over 300 per cent of gross domestic product (GDP), second only to France and Japan.

It is also clear that the property sector is in serious trouble, and its decline is slowing the overall economic growth, causing stress in various pockets of the economy. Since April, property sales have started to decline and are now at 50-60 per cent of 2019 levels (last year of normal activity). The decline has been driven by a general lack of confidence among consumers in both the developer’s ability to deliver projects on time, as well as the state of the economy. It is well-known that youth unemployment in China is running at over 20 per cent and wage growth is subdued. The government, led by Xi Jinping, has consistently maintained a tough line on property speculation, emphasising that property is meant for living, not for speculative purposes. Ensuring housing affordability is a core part of his common prosperity narrative. It is not lost on the homebuyer that the prospects for property price appreciation are limited, as the government wants property-price stability not appreciation.

Weakening demand is further causing prices to drop. Existing home prices fell by 9 per cent month-on-month (annualised in July) and are still showing no signs of stability. A credit crunch, weakening sales, and pricing issues have combined to severely restrict new project launches. New construction starts have declined to 40 per cent of the 2019 run rate.

Property developers are in severe stress. Of the 50 developers who have issued overseas bonds, 34 have already undergone some form of debt restructuring. The case of Evergrande and Country Garden and their effective bankruptcy are well -known. The China high-yield debt market is dislocated with benchmark yields hitting 20 per cent.

The property slump is at the heart of nearly every negative headline on China and it is fair to say that the economy cannot recover in a sustained manner without some stability in the real estate sector. To compound the property slowdown, we are also seeing negative exports growth for China, linked to geopolitical concerns, supply chain diversification, and a general slowdown in the West. Thus, China may not be able to export its way out of trouble this time.

Markets want to see policy support from the government to save the property developers and boost demand for housing. While we have seen steps to reduce down payments, fewer restrictions on existing homeowners buying another property, and a lowering of rates, markets want more. The Chinese authorities seem determined to reduce the dependence of their economy on property and appear willing to let this rebalancing play out gradually, even if it means weaker, highly leveraged developers are wiped out  as the sector slowly rebuilds credibility and its balance sheet. They seem unwilling to bail out the developers. This approach is fine as long as we don’t see financial system contagion, as local government financing vehicles linked to land sales are struggling and high-yielding wealth management products sold to retail investors have seen defaults.

The collapse in the property markets will be a large deflationary shock. Combined with the poor demographics of China, the 300 per cent debt-to-GDP ratio, and the need to deleverage, one can see why the comparisons with Japan and the risk of a debt/deflation spiral are being discussed.

If the government truly lets this crisis play out, it may take years for the economy to fully recover. Even after recovery, growth may never fully normalise, as has been the case in other geographies that experienced large property busts.

One can see where the China implosion thesis comes from and why the Western media is happy to paint a picture of severe doom and gloom. Western commentators have been stressing about the unsustainable leverage and over investment in China for years now.

However, the markets are sending less bearish signals. As an example, if China were imploding one would expect the shares of its banks to be in free fall. The share price action of the financial sector is a good leading indicator of an impending economic bust. However, contrary to what you would expect, over the last five years, the Chinese banks have actually outperformed US banks and are trading at approximately 2019 levels. While they have done poorly on an absolute basis, they do not signal an economic collapse. You get a similar message when looking at long-term Chinese government bonds. Since Covid, China sovereign bonds have outperformed US treasuries by 35 per cent. Chinese yields have also remained stable. As noted by Gavekal, when has an emerging market supposedly on the verge of a crisis outperformed US treasuries? It has never happened.

Even in commodities, where China is the largest buyer, there is no sign of a collapse. Oil is breaking out, and other industrial commodities are, by and large, stable. Again, not consistent with the message that the Chinese economy is imploding. Luxury brands, where China is a major buyer, are not seeing share prices collapse either. 

It is clear that the Chinese economy is going through a major slowdown, however it may not be a systemic collapse as some in the West predict. It will be a gradual process. The days of heady growth for China are over, but it may be too early to write off the country entirely. China’s slowdown presents a real opportunity for India. However, we cannot be complacent and assume that it is our right to take on the growth mantle. We need to continue making incremental reforms to improve productivity and governance. We are in pole position due to demographics, geopolitics and government policy, but nothing is guaranteed. We cannot be complacent and let this opportunity slip away. It will not come again.

The writer is with Amansa Capital