As fears around inflation abate, China is fast becoming a dominant theme in risk markets. If the situation worsens further, we are likely to see sizable flight-to-safety trade. At its peak in the early 2000s, the Chinese economy was growing at more than 10% per annum. This boom was largely driven by debt-fuelled infrastructure and fixed asset investment. The expansion in credit during this period was enormous – monthly total social financing (TSF) growth in dollar terms was at times greater than the annual GDP of Greece or Portugal1. A few years down the line and, as with many debt-led booms, we may now face a bust.
A lot of assumptions were made about China at the start of the year. Many investors hoped the opening of the economy following the end of zero-Covid curbs, would fuel an economic surge similar to when China rebounded from the 2008-09 global financial crisis, lifting the rest of the world.
At the mid-point in Q3, the China rebound story has yet to play out. After a solid but unspectacular Q1, built on the ‘sugar high’ of resurgent demand for services as people emerged from lockdowns, the data has disappointed. Growth slowed in Q2, manufacturing has contracted and foreign visitors have largely stayed away.
Figure 1: China annual investment in real estate development
China’s current predicament can be summarised by the four Ds: defaults, debt, demographics and deflation.
The real estate sector constitutes about 30% of China’s GDP2 .The defaults by domestic property giants Evergrande and Country Garden after they failed to honour Eurobond coupon payments have added to pressures on China’s credit market. Many retail investors in China are exposed to the rise in defaults through trusts and wealth management products, hitting consumer confidence at a time when it’s already flagging.
The problem is that China was getting sick even before Covid. It faces a demographic shortfall. The working-age population is aging and shrinking. There is a jobs and skills mismatch as China seeks to become a tech superpower. Unlike his direct predecessors, President Xi Jinping has been antagonistic to the private sector and has consolidated power from all centres of government, which has discouraged entrepreneurship and weighed on the economy. This is despite the fact that Chinese growth has long relied on significant fixed investment and ongoing debt expansion.
Figure 2: China annual fixed-asset investment growth
Meanwhile, trade tensions with the US and slowing growth in Europe have cut exports and companies have been restructuring supply chains away from China.
China’s heavy-handed handling of the Covid-19 pandemic – which led to entire cities being shut down for months – has psychologically scarred the population. Consumer confidence remains shot, despite high levels of savings. Many people’s capital is tied up in wealth management products, Chinese equities and real estate – which have been battered. Youth unemployment is at record highs of more than 20%3.
One misconception about China is that everything is highly centralised. Regional governments actually do a lot of the heavy lifting in terms of investment and economic growth delivery. And they’ve already borrowed heavily, using land sales as a major source of revenue. With real estate in the doldrums, that door is largely closed. For bondholders, the whole sector has become un-investable.
For bondholders, the whole real estate sector has become un-investable
The Beijing government has been left with limited options. Tax cuts are possible, but they would have to be broad-based and funded. The monetary policy moves we have seen so far are not enough. But central government has thus far been hesitant to bail out local governments and embark on large-scale fiscal stimulus. It could still pull out the big bazooka, but the clock is ticking and the longer they leave it the bigger the costs. The Politburo and State Council have at least acknowledged the problem. In the aftermath of the 2008 financial crisis, the fiscal spree totalled US$586bn4. A repeat would be unlikely and poses significant additional risks. The country’s debt-to-GDP ratio of 282%5 limits the scope to ramp-up borrowing.
For all the reasons outlined above, our view on China is as far as credit investors are concerned is to approach with extreme caution – at least for the time being.