China’s Economic Distress and its Implications
What happened last week?
- The S&P 500 dropped by 2.1%
- The Dow Jones fell 2.2%
- The Nasdaq was off by 2.6%
For the month, the Nasdaq is now down by 7.4%, as investors have been grappling with rising bond yields. 10-year Treasury yields rose to their highest level since late 2007 on Thursday before settling in at 4.25%.
Higher yields are working their way into other areas of the economy, too. Fannie Mae reported an average mortgage rate of 7.09%, the highest in 20 years.
3 Things to Know
The Trouble with China
With local equity markets down 20% this year and 54% since Feb 2021, global and domestic investors are wondering what caused China’s major change of fortune and what can be done to reverse it.
No major economy pivots from high growth to low growth in a flash. From 1990 – 2022, China’s national infrastructure development, real estate to support the migration of 619 million Chinese to urban centers and financing to export manufacturing companies capable of competing on the world stage led to real GDP growth averaging 8.9% per annum.
Unless policymakers get ahead of deflationary expectations and ease forcefully, a hard, painful deleveraging becomes likely. This would cause healthy parts of the Chinese economy to be dragged down along with the industries in need to fundamental restructuring.
We believe any procrastination in stimulating China’s economy risks self-reinforcing negative economic effects.
If China stays on its present course of slow and insufficient stimulative action, we would view consequent strength in the US dollar, weakness in Chinese demand and falling export prices to be a global disinflationary force. Chinese export prices have already fallen 7% over the past year. Many have argued that the disinflationary impulse of Chinese exports on US consumer prices during the past two decades had already run its course. If China does not turn around, it would be another strong factor weighing against the popular view that the US is facing a higher long-term trend rate of inflation.
Control over Growth
The current administration has been willing to derail national champions in the name of “common prosperity”. From e-commerce to online education to carhailing, China has impacted corporate decision-making, sacrificing rapid growth in revenues and profits for greater state control.
As suggested by the weak trade growth numbers in July (exports -14.5%y/y, imports -12.4%y/y), domestic demand is contracting at a fast-than-expected pace, while external demand for Chinese goods continues to fall.
Central government fiscal support for provincial governments, infrastructure and real estate restructuring could amount to between 5%-10% of nominal GDP though 2024. The spending would also boost hiring and consumption.
While this seems large, it would be significantly less than US COVID-related spending in both 2020 and 2021.
Finally, ending much of the regulatory clampdown, including constraints on platform tech companies, education and other sectors, would help restore business confidence. In recent months, policymakers and major government officials, including President Xi Jinping, have emphasized that reviving the private sector is one of top policy objectives. Bold actions need to follow the statements.
China’s Real Estate Crisis
Real estate has historically played a major, positive role in the growth of family wealth for the Chinese. Rather than investing in stocks, homes have been a rising, safe store of value.
The current housing downcycle began in 3Q 2020 and has just entered the 12th quarter, the longest downturn on record. The long and deep contraction has had material impact on the Chinese economy which relies on real estate for about a quarter of China’s GDP.
The recent escalation in China’s real estate crisis revolved around Country Garden, once China’s largest developer by contracted sales between 2017 – 2022.
The company has 3,121 developments in China and maintains a large landbank that covers 1,425 locations of which 90% are in China’s most overbuilt Tier 3 & Tier 4 cities. Fixed asset investment in China is more than 40% of GDP.
With exports down and consumer spending cooling, China’s economic outlook is highly dependent on a turnaround.
China will either stimulate broadly again as it did in 2008 and 2020, or fall behind in a way that is reminiscent of Japan from a macroeconomic policy perspective.
See our weekly CIO Strategy Bulletin for more details