The Great Wall of Worry
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TLDR: China’s economy, the great engine of growth, is in a grave situation which will require massive government intervention. The cyclical debt adjustment may last for years, exporting deflation to the world with widespread second order effects across global markets and economies. Moreover, a US & EU recession may arrive sooner than many expect and be profoundly impacted by a persistent material decline in Chinese consumption should it coincide, exacerbating risks for a deeper, more prolonged global contraction.
When Japan, the world’s #2 economy at the time, imploded following their credit bubble in the late 1980’s, a global recession and years of adjustment followed. China may be different, but the shockwaves could be far greater if the correction grows disorderly. It’s not all Doom and Gloom, but a Balance of Risks assessment is critical.
China is moving into a major recession led by a credit contraction exacerbated by secular demographic shifts (aging, urbanization ending), rising endemic youth unemployment, unsustainable local debt, excess supply of and overvalued property, declines in industrial output, declining wealth effect, increasing global isolation (supply chains), and a sclerotic government which some view as near adversarial in its approach to providing economic support.¹
Consumer balance sheets have been decimated by the “dynamic zero” pandemic policies, and major sectors of the economy are all in sharp decline: Consumption, Industry/Manufacturing, Property. The currency has been declining sharply, with SOE banks directed recently to support it, and the financial sector and capital account has been bleeding² while FDI is at a 25 year low.
The property market has been described by one leading Chinese economist as the “cancer of the Chinese economy.”³ Contagion risk has not arced across the credit system yet, however asset prices have fallen and strains are rising. Salient sectors intersecting it, Trust/Shadow Banking, WMPs (wealth management products), Commercial Banks and LGFVs (local government financing vehicles) are discussed briefly below. Federal government measures have been addressing various key areas and issues piecemeal, however to date, with insufficient force. Sentiment is highly and dangerously negative.
The unique way that China’s government has managed its economy and how it developed has now reached a point where the imbalances in its wake have created entrenched negative feedback loops. Fiscal constraints with revenues under significant pressure from the largest sources of income (corporates and VAT) have fallen, while local municipalities land sales which account for about 25% of revenues have declined sharply. Since 1995 local governments have had little control over their own tax income, however they had “fund income” which could sell land or use it as collateral for borrowing to manage their fiscal budget. There are reports recently that local governments have been halting funding of projects, delaying salaries and cutting key services, while the National Audit Office found fraudulent sales of land in 70 cities, selling land to themselves to inflate revenues while hiding debt (mostly at the county levels and below) in repurchase contracts, the same kind listed property developers have used.⁴
Federal growth in tax revenues is far below OECD averages and has been declining.⁵ Current estimates are that 80% of the local government debt servicing is not being covered in the $9T LGFV market (local government financing vehicles — about 50% of GDP, the debt issued by local governments, which supports their infrastructure investment led spending and sold mostly to commercial banks). Banks have reduced lending, while the government has provided 1T CNY in relief, a widespread bailout remains necessary. Local government debt is about 34T CNY on listed bank balance sheets, or about 61% of listed banking assets.
Thus both federal and local government finances are under pressure.⁶ It is notable that the total indebtedness of China, around 284% of GDP⁷ has grown acute.⁸ It took just 10 years for Chinese banking assets to grow to 50% of that of the entire US banking sector (chart below, exhibit 4) which took over 200 years to attain.⁹ This is a stunning statistic, but so too has been China’s ascent.
The efficiency and impact on credit creation to growth has declined sharply,¹⁰ in some ways analogous to the US situation prior to the GFC. For every incremental dollar or RMB of debt being created to fuel growth, the impact has become less and less (chart below, blue lines, exhibit 1).
Now in China, the massive investment spending that has been supporting their growth model for the last 20 years is unlikely to be sustainable going forward, and the enormous debt accumulated will need to be restructured (LGFV’s for example) or forgiven by the federal government.
The so called “fiscal space”¹¹ for the federal government to easily do so is being challenged as mentioned above due to secularly declining revenues. Credit lending rates and consumer mortgage rates will both need to decline precipitously and rapidly as a function of this recalibration and rebalancing needed to avert a systemic economic collapse. Thus the government at all levels may have reduced capacity to provide the kind of wholesale economic bailout necessary to ameliorate the developing crisis, and some China watchers have noted its reluctance to do so on ideological grounds.
Consumer balance sheets are under enormous pressure, with about 70% of household assets tied up in real estate. Additionally about 70% of RE sales are new construction. Note that buyers start paying on mortgages to the banks before completion, while banks pay developers in stages based on key milestones before delivery, a very opaque process. About 30% of developers funding is counted as deferred revenue in the liability side of the balance sheet.¹² Post Covid, the household sector’s pent up savings, and the will to spend should have been enormous, yet data on household consumption has been weak and housing/RE data much worse than officially reported. Household balance sheets are a trainwreck, and at the end of 2021 China had a clean and solid banking system (with a couple outlier problems but on the whole in good shape) but the RE sector meltdown and Covid zero crushed them.
There may be no easy way to get back with the unemployment ratio being out of proportion, and wage deflation combined with a negative wealth effect from prosperity dropping so much. There’s been a forceful reduction of wages and government mandates have demolished pay in the financial sector as government employees make the same as in other industries (for example senior bank managers (PBOC, CSRC, etc) get the same salary as senior management in a reclamation company. This has resulted in the reversal of a 20 year trend, which is deflationary, and many white collar workers are transitioning to blue collar workers. Expectations arising from a lack of consumption, translate into broader deflation with the cost of production going down.
Why are the RE developers in so much trouble? Their balance sheets had sufficient margin to absorb losses with a property market correction but government forced price caps have not allowed property prices to fall. Without the market being able to clear, the private developers have effectively been mostly bankrupted as housing became illiquid with sharply declining demand with real prices falling and projects incomplete and credit unavailable.
Interest rate projections are far more extreme as well. Mortgage rates were 5.6% in 2022, to 3.5% now, and will be 3.2% or lower projected by year end by some banks. The sector needs to get to the point where the capital rate is low enough to make sense to buy vs rent, and rates need to get to 1.5–2% for that. The RE sector presently is viewed as non recoverable in its current form. Price to rent is 70:1 compared to 17:1. in the US. Property developers have about $1T in debt, of which about $292 bn is due in 2023. Sales have fallen over 40% to about $1.1T (end 2022) and buyers are reluctant due to many factors as mentioned (household budgets, unemployment, wealth factor, sentiment, artificially high prices, etc.). The government has prioritized delivery of existing sales.
Overall RE supply has declined, credit is still flowing in places, SOE’s have gained marketshare, and credit spreads and NPLs have not deteriorated much yet in the wider economy, hence the crisis has been contained to date. The property crisis doesn’t affect the mid/lower class as much given less ownership of property, but still will be very difficult to resolve.
Trust companies comprise $3T in assets in the shadow finance business, out of the $60T+ financial sector. China’s trust industry typically organizes capital from corporates and individuals rather than banks and is overly exposed to RE. Trust companies issue funds under the guise of subscription based trust product investments transitioned from wealth management companies to companies’ FHG, then directed to companies under their control. It is also the source of lower quality lending to many SMEs who cannot obtain direct bank financing. The trust sector has been insolvent for a year and combines different asset classes, some risk bearing, some non risk bearing.
Trust companies co-invest into their own products, which is dangerous and risky.
Typically they take the subprime tranche, leverage it, then create a15% loan structure product around it to yield 10% for prime tranche investors. Their level of insolvency is high because of this co-investment and they take 100% of losses paying out to investors (despite losses on underlying assets), which are heavily skewed to RE. On balance sheet bad assets are made as loans to a 3rd party, who then invests back to the trust who books these as NPL’s on the balance sheet. Thus where the RE sector goes, so too does the trust bank/companies and the situation is toxic.
About 1/3 of the $3T Trust sector¹³ which has been in the headlines recently is deemed bankrupt. One leading company, Zhongzhi Group, with CNY 1T (c. $137B) in assets, has been unable to make payments from its 4 wealth management subsidiaries due to investors, many of whose investments are tied to the property sector, and made more pernicious by their underwriting and participating in their own trust products, as above.
Importantly however, there appears low risk of contagion from these products as they are typically held up for 3 years and investors constitute a minor subset (100’s of thousands, compared to millions in WMPs). However, the WMP industry, a 25T CNY market (20% of GDP) sold by banks, is heavily reliant on the property market and developers as well, which represents another source of concern in the overall 100T CNY (about $16T) asset management industry. It is estimated that 10% or more of WMP’s are tied to the RE sector.
Thus there may not be direct contagion risk from the Trust sector, but certainly there are huge risks systemically and when combined with trade, industry, capital flows, weaker currency, deflation, and aggregate demand pressures, the situation is grave.¹⁴
Lastly, Banks WMP business has about 7–10% of assets in trust products (c. 2.5T CNY or about 20% of the trust sector). Trust products are about 1% of large bank assets but smaller banks comprise a much larger proportion of around 10% or higher. If there was contagion from this sector, this is the place it seems likely to materialize.
Insurers also invest in trust products¹⁵ and are also large direct investors in the property market, another area of concern.¹⁶
“Insurers also invest in trust products. We estimate that non-standard fixed-income assets — including trust products, asset- and wealth-management products, and infrastructure debt schemes — constitute around 6% to 44% of Fitch-rated Chinese insurers’ invested assets.”
“We consider non-standard assets as higher risk than bonds and equities. They may resemble credit in substance, implying that the exclusion of such investments in banks’ balance sheets could distort financial reporting”
“Fitch applies higher capital charges on such non-standard assets in assessing insurers’ capital adequacy. The revised capital framework launched in 2022 also imposes higher capital requirements in the solvency calculation for insurers with non-standard investments with opaque underlying assets, including trust products.”
Conclusion:
It appears that all primary sectors of the Chinese economy are at risk of further adjustment; property, consumption, manufacturing/construction, and finance. For example, about 25% of GDP (about 3x the US) is estimated to come from the construction industry; without the spending growth, cash flows and balance sheet constraints will be negative, coincident with reduced capacity due to demographic shifts (diminishing urbanization — 100’s of millions migrated from the countryside to the city, and this is now over, and with it the huge infrastructure and housing development needs). This will take multiple percentages off the growth rate in the years to come as up and downstream impacts are realized (glass manufacture, steel, etc. etc.), with both direct and second order effects.
In short, infrastructure and housing development has matured, or reached overcapacity for the time being. Associated government spending which has fueled China’s investment led growth while supporting local government revenues, in turn tied to the property market growth, in turn fueling private asset formation, bank credit growth and consumer balance sheets, will no longer be the drivers of growth — likely impediments to it for the foreseeable future as the aggregation of imbalances gets worked off through the economy. The government and corporate sector is highly leveraged, the consumer less so, and we don’t know how high shadow banks and related parties are.
Deflation is likely to be exported in multiple channels, including the global goods cycle, as cement, iron ore, copper, etc. will see less demand given China’s outsized consumption role. Capital flows will be key to understanding interrelationships between disparate asset pricing as capital flight abroad fights against repatriation and formation needs domestically.
Global macroeconomic effects could be severe depending on the nature of the adjustment which will require a sustained policy response to mitigate the cyclical contraction domestically and the deflationary impulse across multiple channels abroad.
Historically there are three ways out of a debt bubble — growth, inflation or haircuts. China’s debt bubble may be the most vulnerable now, but they’re not alone. The West may find inflation a better alternative, with foundational growth restorative in time, while China’s growth and inflation prospects appear more limited in period ahead, leaving further indebtedness and write downs as more likely prospects given the lack of open capital markets. The wildcard is the currency, which could be a useful if dangerous lever.
¹ A number of China experts (and friends, especially Dr. E. von Pfeil) made significant contributions to this note for which I am most grateful as well as from the presentation,“Post Evergrande: China Real Estate Market Challenge” at the University of Chicago, 31st August, 2023. Credit and thanks to Professors Zhiguo He of UChicago, Matthew Lowenstein of Stanford and Joseph Gyourko of Wharton for some salient data points from that discussion used here.
² 29bn in July per Goldman Sachs
³ Dr. Zhiguo He of University of Chicago, 31/8/23 “Post Evergrande: China Real Estate Market Challenge”
⁴ Ibid 1, 31/8/23 University of Chicago, “Post Evergrande: China Real Estate Market Challenge”
⁵ https://rhg.com/research/the-myth-of-chinas-fiscal-space/
⁶ While outside the scope of this brief market oriented note, all supporting data come from a wide variety of reliable sources and are available on request.
⁷ https://en.macromicro.me/collections/31/cn-finance-relative/33510/cn-macro-leverage-ratio
⁸ Overall credit growth from 2009–2015 by my calculation stood at over 1500% of that of all G7 countries, combined.
⁹ Ibid 1, 31/8/23 University of Chicago, “Post Evergrande: China Real Estate Market Challenge”
¹⁰ AFRE Chart below, and data, and here
¹¹ ibid, 1 above
¹² Ibid, Dr. Zhiguo He of University of Chicago, 31/8/23 “Post Evergrande: China Real Estate Market Challenge”
¹³ Estimated by a leading China expert
¹⁴ Gavekal estimates 1.1 T RMB of 23T RMB in RE, with the real figure probably a lot higher. There is no data on trust lending to LGFV, though it's probably very high as well.
¹⁵ https://www.fitchratings.com/research/banks/heightened-risk-in-chinas-trust-sector-may-have-wider-effect-on-financial-institutions-20-08-2023
¹⁶ Some of the leaders such as Ping An are very well capitalized and likely to weather the crisis without too much fallout (they’re also heavily involved in the trust industry however)
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