Demystify China Economic Matters in Question
Tired of sleepy mainstream comments on China? Try this one instead.
Written by Prominent Ventures (A Member of HCM Capital)
As we read through the news about China from Twitter, NYT, WSJ, or Bloomberg, it feels like the China economy will collapse tomorrow immediately. Then we open WeChat or Weibo and read through articles posted by several official accounts. Suddenly, we become optimistic about the strength of China’s economy, or at least feel the economy is 80% good and only 20% bad. You might notice this difference and would like to have a more objective view of China, but it’s not easy because of language barriers and cultural differences. That’s why we are writing this piece in the first place. We will never try to convince you that we are 100% objective, but we could try to let you know what’s happening in China from a different and hopefully professional perspective.
1. What’s Going on with China’s Economy?
Typically, when we talked about China economy, we tend to pay greater attention to “the troika” for China’s economic growth: investment, consumption, and export, as these three economic variables could largely determine China’s economic state.
1.1 Strong Export or Manipulated Export?
Let’s started with export, as this is the only well-functioned engine in current China’s economy. The latest China’s export is $330 billion with a year-over-year growth rate of 18%, way above the consensus expectation of 16.2%. China’s strong export actually come from the demands of the US, Europe, and Japan, which implement serious sanctions on Russia and have greater import reliance on China. More importantly, the extremely high inflation in most developed countries somewhat beef up China’s export numbers.
It’s important to point out that there are some concerns about the manipulation of these strong export numbers. We could cross-check this number based on the latest US import from China given the US Commerce Department disclosure. As of the post date, the US Commerce Department only discloses the US import from China in June 2022, which is $48.6 billion, while this number is about $56.0 billion from China Customs Department. In addition, the official number of China’s export in June is $330.8 billion, and the US share of export is about 16.9%. Then we could recalculate China's export in June from the data provided by US Commerce Department, and we get $287.6 billion and an estimation error of about $43.2 billion for export data. If the same estimation errors are applied to July export, actual China’s July export will locate somewhere close to $290 billion, a 2.7% growth rate from the last year. Here, we are not suggesting that the estimated number is the “real” export growth rate as we cannot assume the number from the US Commerce Department is 100% accurate. You could refer to our estimation as the lower limit of China’s export. If we average this lower limit with the official number, China’s export growth rate is around 10.4%, a lower but still strong growth rate.
So far, we could say that export is the most important support of China’s economy given China’s weak internal demand, as we are going to discuss later. However, even the only driver will weaken over the next several months. As major economies have greater economic downward pressures and will possibly go through a severe downtime, falling foreign demands will drag down China’s strong export outlook and put greater pressure on China’s further economic growth.
1.2 Internal Bifurcation under Steady Growth in Investment
Now, it’s time for the second pillar of China’s economy, the aggregate fixed asset investment or CAPEX. In July, China has a cumulative aggregate fixed asset investment growth rate of 5.7%, slightly lower than the 6.1% growth rate from the previous month. The aggregate number itself is not that bad, but it indicates the slowdown in China’s investment. If we take a closer look at the structure behind, it’s pretty clear that the most serious pressures come from the weakening of real estate investment. Specifically, real estate investment has a -5.2% cumulative growth rate in July, mostly due to financing restrictions of real estate companies and sluggish real estate sales, which will be covered in more detail in the following section.
In contrast, both infrastructure and manufacturing investments have growth rates above 9% and somewhat offset the slowdown in the real estate market. The high investment growth rate of manufacturing is mostly supported by strong export, while infrastructure investment is financed by government deficits. However, none of them are sustainable in the long term, and we are likely to see a further slowdown in China’s aggregate investment growth rate. Even though we have so many bearish expectations, China’s investment is not going to be 100% bad. At least, we observe the 20% investment growth rate in the high-tech industry. The problem here is the size of the industry is still limited and cannot fully absorb the negative shocks in the economy. However, if we are patient enough, the kids will grow up and become the new pillar of the economy.
1.3 Recovery in Consumption? Long Way to Go
Well, let’s turn to the worst part of China’s economy, consumption. In reality, China’s consumption has never bounced back since the pandemic. Worse still, the Shanghai lockdown further depressed consumer confidence and China’s internal demands. Fortunately in July, China’s consumption has a slow recovery with retailing goods consumption growth rate of 3.2%, but the growth rate of catering consumption is still negative, at -1.5%.
Well, there are several reasons behind this weak consumption. One of them is the serious implementation of the zero COVID policy. People in China are afraid of being identified as close contacts with a confirmed case, so they will stay away from crowded places, like shopping malls, cinemas, restaurants, and Disneyland Park, etc. Hence, most of the time, they don’t have a chance to consume at all. In addition, as the country is heading toward a more chaotic and fragile decade, they have a bad expectation of future economic growth. It’s thus more rational for them to save rather than consume against the upcoming rainy days.
So, will China’s consumption bounce back later this year? Before we answer this question, we need to figure out whether China will end its COVID prevention policies and whether it will stabilize the real estate industry. We do not have certain answers to any of these questions, so we don’t have any reliable conclusion about China’s consumption, yet. But if you insist, our best guess is China’s consumption is very unlikely to come back, at least in the short term, due to very shaky real estate industry and economic uncertainty.
Overall, China’s economy is experiencing greater downward pressures with contracting demand and weakening expectations. It’s very likely that China will go through a low economic growth or even a recessionary period, not necessarily bad though but requires greater patience. Now, let’s take a closer look at several interesting topics and news about China’s economy. Please note that we are not the newspaper, and will not waste your time going through the same mainstream comments here. We would like to show you something beneath the ground.
2. What’s China’s Policy Response to the Growing Economic Pressures?
2.1 Is Cut in Policy Rate Helpful?
Given our description of the latest economic data in China, you should notice the massive downward pressures on China’s economy, and so is the PBOC (China’s central bank). To stabilize the economy, China’s central bank decides to step in, and lower the interest rate of reverse repo and MLF (Medium-term Lending Facility) by 10 bps on August 15th. One week later on August 22nd, the 1-year LPR (loan prime rate) was lowered by 5 bps, while the 5-year LPR was lowered by 15 bps.
Before we go any further, you might be confused with so many different rates. What are they? Well, we will try to make them simple. The interest rate of reverse repo and MLF is basically the benchmark rate for interbank lending and borrowing, the only difference between them is that the reverse repo rate is the benchmark for short-term rates, while the MLF serves as the benchmark for long-term ones. The other important rate here is the LPR, the benchmark rate for the loan market. Normally, the borrowing costs of either auto or housing mortgage loans in China are calculated based on LPR.
Now, you might have a basic idea of what these rates are. It’s time to talk about the implications of the cut in these policy rates. Lower policy rates will generally lower borrowing costs and encourage credit and demand expansion in the economy. This is the objective of the move, to reverse the demand contraction in China’s economy and support consumption and investment, especially in the real estate market. Will it work? Very unlikely. Why? On the one hand, the magnitude of this cut is very limited. Both reverse repo rate and MLF are lowered by only 10 bps, while 5-year LPR has the largest cut, still just 15 bps. As a reference, the US Federal Reserve cut its policy rate by 150 bps in two weeks back to March 2020 in response to the pandemic. The point here is that such a tiny cut in China’s policy rates will have very limited effects on the stabilization of the second largest economy in the world.
On the other hand, the latest one-year issue rates for interbank deposits are around 1.9%, already much lower than 2.8% of MLF. Plus, China’s average loan rate has reached its historically low level. Hence, either the interbank market or the loan market already has excessive liquidity and sufficiently lower borrowing costs, so the monetary policy cannot incentivize further credit or demand expansion by simply lowering the benchmark rates.
At the end of the day, the key issue here is the lack of confidence in the strength of China’s economy, at least in the short term. Hence, the monetary policy could not do much here, as people are unwilling to buy cars, houses, or stocks no matter how low the borrowing cost is because they are not certain whether China’s economy has bottomed out. You might still wonder if this cut is not really useful, and why did so in the first place. Well, our best guess is that China’s central bank is trying to send some positive signals to the market, to relieve the concerns about the economic downturn and pave the roads for further fiscal stimulus.
2.2 Fiscal Policy is Strong in Will but Weak in Power
So, as monetary policy is ineffective, you might wonder why don’t China try fiscal stimulus measures instead. In fact, China tried and unfortunately failed. Since early 2022, China’s central government has very active financing from government bond issuance and thus implements strong fiscal policies, to smooth out the economic cycle. So far, China’s fiscal efforts have focused on the infrastructure sector and stimulates the investment growth rate to at least 8% since early 2022, which was only 2% on average in 2021.
However, the active fiscal policies do not achieve the expected outcome, as China’s economic situation is not any better before these fiscal efforts. Why? The most important reason is that other restrictive policies offset the supporting policies. One of these restrictive policies is the zero COVID that blocks the recovery in the domestic demands. Even worse, the Shanghai lockdown further disrupted the operations of factories and supply chains across the country. Then, even after this tail risk, the normalized nucleic acid tests put additional burdens on the fiscal budget, and in fact, distract the fiscal resources from supporting the economy.
Another fact is that the implementation of fiscal support has so many restrictions. For instance, fiscal expenditures should not be redirected to support the property market, which is the core issue of the economy. At the same time, the central government actually asks the local governments to be careful about their leverage ratio and indirectly constrain the fiscal efforts of the local governments.
Finally, the Chinese government has a very tight fiscal budget. Land selling had been using to be the most important source of fiscal income, but now it is not reliable due to regulations on the property market. The alternative tax income is also limited due to the low revenue growth of enterprises and the tax relief requirements.
So during most time of 2022, the Chinese government has more expenses than revenues, and the only way it worked is to finance the deficits by selling government bonds. Is this sustainable? Absolutely no. But the current leverage ratio of its book is only around 46% (v.s. the US, 118%, by the end of 2021), so it’s too early to be concerned about the fiscal pressures in China. It’s also important to point out that even in the worst scenario, any government could solve insolvency by printing more money, though it will be super unfair to creditors and depositors, or let’s say most of us.
3. What is Really Going on with China’s Real Estate Market?
3.1 What’s the Current Outlook of the Real Estate Market?
Well, you might have heard a lot of news and reports, talking about the bubble in China’s real estate market. The conclusion of that news and reports is basically that China’s real estate market will collapse eventually. Now, China’s housing market has not collapsed yet, but it is in the middle of a really tough period.
Let’s take a closer look at China’s property sales over the last several months.
It’s obvious that China’s commercial housing sales have plunged significantly across the country over the last 12 months. More specifically, even the first-tier cities have experienced an average 10% decline in housing sales, while the situation for other cities is much worse.
Worse still, the weakening in the real estate sector actually has the greatest negative impact on China’s economic growth.
In fact, the -13% contribution to the GDP growth rate is a minimum estimation. Remember, the property sector is in the middle of a large value chain and has so many connected industries. The upstream of property sector include steel, cement, heavy equipment, and glass production, while the downstream covers furniture, TVs, air conditioner, refrigerator, microwave, lamp, house decoration, and property management. On average, the property sector has a 20% to 30% contribution to China’s economic growth, and it’s reasonable to believe that it will same level but opposite effects on the economy as the industry is sinking.
So, that’s how bad China’s property market is!
3.2 What Makes this Market that Bad
Well, the most obvious reason is the series of regulations on the housing price and financing activities of real estate corporations, including the “three red-line”, principle that “houses are for living in, not for speculation”, centralized land supply, etc. You might not be interested in any specific details of these policies at all. In fact, you don’t have to. At this point, you just need to notice that these regulations put extra operational burdens on real estate corporations.
How so? Well, on the one hand, the regulations intended to limit the demand in the housing market, either through higher mortgage rates or limits on second home buying. The restricted demand will directly depress the housing price and thus the revenue of real estate corporations. Therefore, real estate corporations cannot create sufficient revenue and cash flow to pay back their operational and interest costs.
What should they do? They have to rely more on financing activities to support their operations. Unfortunately, this is not a feasible solution as the regulations have already closed this possibility in the first place.
So basically, real estate corporations cannot generate sufficient cash flows from either revenue or debt. What's left? Well, if the real estate corporations have a certain amount of cash reserves, which they normally don’t, they could complete the unfinished projects, endure this cold winter with slow destocking, and eventually de-lever their balance sheet. If not, then they have to go bankrupt! This is a “real” situation faced by the property sector in China.
If you would like to see specific data and check our arguments, here you go! The latest growth rate in sales in the housing market is -23%, and the aggregate investment growth rate in this sector is -5.2%, the lowest level since the 2020 pandemic.
At the same time, this lousy market outlook will cause a vicious cycle. As sales in the housing market keep plunging, the value or price of the housing market will decline continuously. With this bearish expectation, home buyers will keep postponing their demand, and the demand in the housing market will become weaker and weaker, making housing prices even more depressed. Such a vicious cycle will be there until either the collapse of the whole market or the government’s step in.
It’s worth noting that the recent reports of unfinished housing projects are directly related to the sales plummet in the property sector. Since real estate corporations cannot create revenue from the housing market and have limited access to the capital market, they have very limited cash flows after interest payments. Thus, they are unwilling to make investments in unfinished projects, as they are no longer cost-effective in such a depressing market. Very unethical but economic rational decision-making, but it will only work in the short term. The negative news about this sinking industry will only make it collapse even faster.
Though the regulation did make the real estate market worse, we should note that this market will fail even without the government’s interruption. In fact, China’s property sector has an unsustainable business model.
Specifically, the prosperity of this sector is highly dependent on credit expansion and the assumption that housing prices will increase forever. A real estate corporation generally starts by buying several valuable lands from the local governments, and using the lands as collateral to finance the housing construction. Then, the real estate corporation could either sell the properties or use them as collateral to borrow from the banks, buy more lands, and construct more properties. This loop can continue over and over as long as the price of properties keeps growing and inflates away the fixed borrowing costs.
However, things will not be the same forever. Once the value appreciation of the property cannot catch up with the debt accumulation of the real estate corporations, the whole sector will bust. Unfortunately, that’s exactly what’s happening in China, where the average debt rate of the real estate industry is close to 68%, while the sales growth rate drop to -23%.
Before we move on, we have to yell for another factor behind the property sector: the population.
In fact, the current problem of the housing market is not just political or economic problems but implies the issues associated the China’s population structure. And we could even say that the population is the long-term determinant of the real estate market. If you take a closer look at Figure 13. The growth rate of the Age 15~64 population is directly related to the sales of commercial properties. It’s no surprise to observe this pattern as people at this age are more likely to demand independent living places.
The other thing we learn from this figure is that the population at the age between 15 and 64 has declined since 2016, a side effect of China’s family planning policies. Such a decline in working-age people directly depresses the demands in the housing market. More importantly, as long as there is no reverse of population ageing, China’s property sector will never have a real bounce back.
3.3 Will the Depressed Real Estate Market Cause a Subprime Mortgage Crisis?
You might notice that we are bearish on China’s property market. Indeed, this is the largest but the most ineffective industry in China. In fact, they need a recession to reallocate the capital from this industry to more productive and innovative ones, and that’s why the government is trying to regulate this industry in the first place.
Well, there are some concerns that the further depression in the real estate market will cause China’s subprime mortgage crisis, very similar to the 2008–09 financial crisis that happened in the US.
From the data we have, it’s relatively unlikely. From the latest survey, the average mortgage down payment is around 50%, this number is between 40% and 60% for the second mortgage. More importantly, 50% of China’s households own houses without mortgage loans, and 30% of them rent apartments instead. Therefore, the market has risk exposure to only 20% of China’s households with at least 50% mortgage down payment.
Plus, the average household leverage ratio is only around 62%, while this number is above 99% before the 2008–09 financial crisis in the US. You got the point here. The credit risks from mortgage loans are relatively limited.
However, we do not imply that there are no systematic risks from the property sector. In fact, the default risks of real estate corporations might cause ripple effects on the whole economy, including these closely connected industries, such as steel, cement, furniture, home appliances, etc. Fortunately, China’s central government is trying to prevent the worst scenario from happening and will step in to recapitalize the industry if necessary.
Remember, the world never offers free meals. The slow recapitalization of the property sector will push China to endure a low economic growth rate of 1%~2% for an extended period. At the same time, China could not solve the debt problems without printing money, which directly devalue Chinese households’ wealth. Ultimately, if China is patient enough, it could complete its industrial structure transformation and bounce back with stronger economic growth. But before that, China will have to try its best to prevent some tail risks during the upcoming tough periods.
4. Clarification of Some Mainstream Comments on China’s Economy
4.1 Is Sichuan Electricity Rationing an Energy Crisis?
In the last several months, there are so many twitters discussing the commodity and energy supply shortage around the world, especially in Europe, while China is the least mentioned in the discussions until the news about Sichuan electricity rationing. Once Sichuan declared electricity rationing for factories from August 15th to August 20th, extended to August 25th later, and suddenly the tweets about this news are like:
So here, the question is will a ten-day electricity rationing become more serious than 37.2% PPI in Germany and eventually lead to an energy crisis. Let's figure it out. First, let’s look at why Sichuan has this electricity shortage. The biggest reason is the most extreme heatwave in six decades and causes temperatures in the province to hover around 40–42 degrees Celsius (around 104–108 degrees Fahrenheit). Such high temperatures will stimulate soaring demands of electricity for air-conditioning. At the same time, China suffers from severe droughts from the heatwaves, and this leads to low river water levels, thus limiting the electricity production output from hydropower. It’s important to note that Sichuan province has significant reliance on hydropower, 85% of Sichuan's electricity production output comes from hydroelectric power. Together, these issues cause a significant electricity demand-supply gap, and as there is no feasible workaround solution, Sichuan has to shut down factories to support the residential electricity demand.
Now, it’s time to answer whether this power rationing will cause a systematic risk or even a crisis. The answer is probably no. Honestly speaking, it is hilarious to make an analogy of a 10-day regional electricity rationing with an energy crisis. If you would like a more comprehensive analysis, then here you go. First and foremost, China doesn’t count on hydropower for electricity production as China has a sufficient supply of coal and could always rely on thermal power for electricity supply. The only reason that China does not rely significantly on coal-fired power generation is the incentives to accelerate energy innovation and further support the development of renewable energy. Therefore, in the extreme electricity shortage, it’s very unlikely that the Chinese government will do nothing with the backup coal-fired power generation.
Moreover, the insufficient electricity production from hydropower is due to extreme seasonal effects, and the summer and extremely high temperatures will be gone. Thus, the inefficiency of hydroelectric power is transitory.
Well, some of you might point out will the shutdown of factories further drags down China’s economic growth. The answer is yes, but the negative effects are quite limited. According to CICC (China International Capital Corporation), only 0.6% of publicly listed companies are affected by this round of electricity rationing. More importantly, it’s important to note that the work ethics of China’s factories could even catch up with the production deadline even with these 10-day shutdowns.
So, the basic idea is that Sichuan electricity rationing is nothing close to Germany’s tough energy position, or an energy crisis. However, it does not mean that China does not have any concerns about energy shortage. At this point, China is still in the early stage of the development of renewable energy, and it has to maintain a tough balance during the transition from traditional fossil fuel to new but still inefficient energy. Overall, China may not have concerns about the energy crisis at this moment, but it will have to deal with structural energy shortage over an extended period.
4.2 Should China be Concerned About the High Youth Unemployment Rate?
Well, the reason why we include this section is that we notice a lot of misleading comments on the high youth unemployment rate in China. Let's take a look at this shocking number before we go any deeper.
As you could see from Figure 15, China’s youth unemployment rate is somewhere close to 20%, where the specific number is 19.9%, the highest level since this survey data is available. This is absolutely not a good indicator for these young adults who feel really hard to find a job. But it will be reckless to make any specific conclusion according to this number.
One type of misleading report will start with this number and become sympathetic to the fresh graduates who have fierce competition in the school but could not find a job with their hard-working. But ironically, this survey data does not take fresh graduates into consideration in the first place. The data represents the employment market for a group of young adults who enter society relatively early with possibly less sophisticated skills, and the opening positions for them might be totally different from those for fresh graduates.
Here, we are not trying to suggest that the employment market for fresh graduates is good, which is actually not. But we cannot make a reckless conclusion about this based upon less relevant data in the first place.
The other type of misleading comment is that this historically high youth unemployment rate is the signal that China’s employment market has collapsed. Still, let’s look at the overall picture before we make any reckless comments.
So, China’s latest overall unemployment rate is 5.4%, slightly higher than the average level before the pandemic. But this level is still acceptable considering China’s demand contraction, weakening property sector, and global macroeconomic pressures. At least, we will not have the conclusion that China’s employment market has collapsed.
Now, let's come back to the question if we need to be concerned about the high youth unemployment rate in China. The answer is yes, but not that much.
The obvious reason behind the high youth unemployment rate is China’s economic slowdown, especially the weakening of the property sector used to create a great number of employment opportunities.
The other constrain behind the employment market is the strict COVID prevention policies that depress the consumption in the whole economy and put extra pressure on normal operations of restaurants, shopping malls, fitness centers, extracurricular activities, and other service industries, which used to offer desired positions for these young adults. Another side effect of the COVID policies is the restriction on the mobility of young adults across the cities, so they could not easily transport to other cities with the demand of labor.
Overall, the problem inside the employment market is the consequence rather than the cause of the current economic slowdown, and if China could deal with the risks in the property sector and the zero COVID policy properly, the employment market will bounce back for sure. At the end of the day, China’s priority is to figure out how to stabilize the property sector, prevent a systematic crisis, and allow productive and innovative firms to flourish.
5. Final Thoughts
Well, we have covered a lot of topics about China’s economy, and we tried to provide our perspective, hopefully objective and professional, on these issues. Before the end of this article, here are the summary and the final thoughts of what we have discussed:
- 1) China is heading toward a period of recession with weakening investment, contracting consumption, and strong but unsustainable exports.
- 2) China’s cut in policy rates will provide limited support to China’s economy as the core issue here is the contraction in demands.
- 3) China’s fiscal stimulus does not work out due to disruptions of the Shanghai lockdown, and with excessive expenditures, China’s local governments are now facing burdens from fiscal deficits.
- 4) China’s real estate market has obvious negative growth due to regulations, demand contractions, weakening expectations, and population ageing.
- 5) Though China’s real estate market has certain default risks, it does not resemble to the subprime mortgage crisis in 2008–09.
- 6) Sichuan power rationing is a regional, transitory, and seasonal issue, and it has nothing to do with an energy crisis.
- 7) High youth unemployment does not directly associate with the employment pressures of fresh graduates and is not necessarily indicating the collapse of the employment market in China.
- 8) With the inefficient industrial structure and public health policies, China will endure an extended period of low economic growth, and it has to wait for the growth of those really productive and innovative industries to have a more sustainable bounce back.
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