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Summary
- Investors are not expecting any meaningful impact of Evergrande or other regulatory clampdowns on Chinese growth or stability. We disagree.
- The end of the property boom, authorities clamping down on the private sector and China’s COVID policy all suggest significant downside risks to China growth
- Commodities, certain Asian equity markets and commodity FX could all suffer. Meanwhile the CNH has tended to perform well during periods of instability. China sovereign yields should head lower after the commodity FX part and before CNH.
Punch Line
A clear consensus has emerged. The failings of China’s second-largest real estate developer, Evergrande Group, and other broader clampdowns will lead to neither a Lehman-style financial crisis nor even a growth slowdown. Chinese financials outperformed the overall index in recent weeks even as Evergrande teetered on default (Chart 1). And on the growth front, many expect some form of stimulus, which will keep growth on track. Consensus forecasts of Chinese growth for 2022 and 2023 have barely budged in recent months (Chart 2). While a financial contagion event is unlikely, a growth slowdown or even a 2015-style China crisis is on the cards.
For us, China has now crossed three crucial red lines. First is the country’s own ‘three red lines’ introduced in August 2020 for major property developers: caps on debt-to-cash, debt-to-asset and debt-to-equity rates. This marked a crucial step in curbing its property sector. And it will hamper a large segment of the economy and impede the typical channel through which authorities stimulate the economy.
Second is China’s assault on the private sector. Whether pulling IPOs of private companies, banning private education companies or controlling content on private platforms, the assault will likely hinder the private sector’s growth and benefit the state-linked sector. The problem is the private sector is much more efficient, productive and less credit intensive than the state sector.
Third is China’s handling of the COVID crisis. It suggests authorities are unconfident in their vaccine strategy. Consequently, they continue to pursue a zero-cases approach. This means still using lockdowns to manage renewed outbreaks such as the Delta variant. The strategy is hindering the recovery and normalization of the economy.
Credit Context
Underlying these three red lines, China has been experiencing an unsustainable credit boom. China’s credit growth has been exceptionally high since the global financial crisis (GFC) – much higher than other EM countries (Chart 3). Yet growth has been relatively weak. This means China’s credit intensity is very high – that is, increasingly more credit is needed to generate a unit of growth (Chart 4). Indeed, before the GFC, roughly one yuan of credit would generate one yuan of growth. Since then, it has been closer to four yuan on average and as high as 12 for one yuan of growth.
Authorities recognise this and are therefore forced to deleverage the economy. Timing-wise, COVID has given authorities more control of the population and greater awareness of the power of private tech. Meanwhile, next year President Xi Jinping will likely see his second term renewed for an unprecedented third, giving a political imperative to push through many of these reforms. Ultimately, almost every country that has experienced the unravelling of a credit boom has either suffered a major economic slowdown, a financial crisis, or both. China will likely be no different.
The Three Red Lines in More Detail
(1) The End of the Property-Growth Cycle
China has seen one of the largest property price booms in the modern period. From 2000 until the GFC in 2008, China property prices rose 94% in real terms – this was comparable to Spain (+86%) and Ireland (+74%, Chart 5). Since 2009, China property has continued to rise by 160% – versus declines in Spain (-28%) and Ireland (-7%, Chart 5). Valuation metrics such as property prices to household income also show major cities in China at worldwide extremes.
Unsurprisingly, this has skewed the Chinese economy heavily towards property. Recent academic work finds 30% of the economy is somehow related to real estate (Chart 6). This is similar to the height of the Spanish property boom in the 2000s and much higher than comparable economies. Real estate companies, such as Evergrande, have become overleveraged and dependent on continued property price rises. Meanwhile, China’s assets and wealth are heavily biased towards property. The value of China’s housing is worth more than the US and Japan’s combined (Chart 7).
The demise of Evergrande and the attendant policy restrictions will probably significantly impact the property sector and so the overall economy. It will also dent authorities’ ability to stimulate the economy without the property channel. Therefore, any stimulus will likely have a much smaller impact on growth than ever before.
(2) Curtailing the Private Sector
Higher-income individuals and companies have been able to access underpriced credit and boost their wealth. This has contributed to widening income inequality. Authorities have responded by promoting the concept of ‘common prosperity’. As part of this, they have targeted the private sector. Aside from the haphazard nature of implementing these policies, a common thread has been to limit companies from accessing foreign capital, limit data held by private companies, control content (whether on platforms or in the education sector) and encourage hardware development while downplaying consumer software.
Constraining such a large swathe of the private sector will likely negatively impact growth. We must remember the private sector has much higher productivity and uses less credit than the state sector (Charts 8 and 9). Meanwhile, welfare support for poorer households remains low, especially versus other countries (Chart 10). This constrains domestic consumption. Moreover, reforms of the bloated state sector have been much less aggressive. A notable consequence will likely be China tech continuing to underperform versus US tech (Chart 11). Ultimately, authorities are hampering the economy’s most productive part in their drive for common prosperity, which lowers China’s growth potential.
(3) The COVID Factor
The COVID-19 pandemic likely partly explains the timing of both policies above (as well as Xi’s likely third term at next year’s National Party Congress). The pandemic led to border closures, higher population tolerance for aggressive state actions and a growth windfall from China’s exports of COVID-related equipment (Chart 12). In some ways, this parallels the early 2000s when China’s entry into the WTO allowed a restructuring of domestic banks.
A striking feature of China’s COVID strategy is authorities’ lack of confidence in its vaccine plan. This could be due to lower actual vaccination rates than officially published figures or the lower efficacy of Chinese vaccines. The upshot is that China continues to use lockdowns to manage new waves of the pandemic. Other countries like the US have relied on vaccines to exit lockdowns. The economic consequences are clear. During the Delta wave over summer, China locked down again and saw its service sector activity plunge. Meanwhile, US services activity has continued to be stable despite the Delta wave (Chart 13).
COVID’s prevalence gives authorities significant control over the population, which allows aggressive reforms to continue. It also means domestic economic activity may recover more slowly than other economies. China will therefore be heavily reliant on exports, which are unlikely to remain as high as now. Again, this should pull down Chinese growth.
Market Implications
Already, our preferred measure of the China growth cycle shows a notable decline in growth. This measure incorporates hard data such as new orders in business surveys, electricity usage and freight rates and better captures the China cycle than official GDP data (Chart 14). As for markets most sensitive to Chinese growth, looking at correlations in levels and changes versus our growth tracker reveals the following:
- Commodities: iron ore, copper and oil all have strong correlations to growth (Chart 15).
- Equities: Korean stocks show the most correlations. Chinese stocks have a weak correlation (Chart 16).
- FX: EUR, AUD, NZD, ZAR are tied to the cycle. Notably, CNH tends to appreciate during downturns (Chart 17).
- Rates: China 10-year has the strongest correlation (Chart 18).
If our view is correct, we expect all these markets to come under pressure. Iron ore has already fallen sharply, but both copper and oil could follow. In FX, scope exists for further weakness in AUD, NZD and ZAR, and China rates could rally further. Meanwhile, CNH could end up stronger than many expect. We would this is a medium-term theme as it will take time for markets to come grips with the slowdown theme.