Posted: August 2, 2023
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China's Ailing Economy and Real Estate Crisis
Keep China on Your Radar
As we step into the world of investing, it is important to start concerning ourselves with how economies are performing globally. For the past year, much focus has been put on US’ and Europe’s fight against inflation, with the Federal Reserve and ECB raising rates at the fastest pace in recent history.
In case you missed it, China has been going through many issues of its own. Unlike the US and Europe, China has been faced with the reverse conundrum of having to stave off potential deflation. Throughout the whole of 2022, while many parts of the world have reopened their doors and economy in a post-pandemic world, a vast majority of China remained in lockdown — and it did so for 12 to 18 months longer than much of the rest of the world.
Since China’s crackdown on tech companies like Ant Group and Tencent begin in 2020, the Chinese stock markets have failed to recover while its counterparts in the US, Europe and even other parts of Asia made a strong recovery from the Covid-19 pandemic lows.
Figure 1: Global Indices vs. Chinese Indices (%, 2020 – YTD 2023)
As seen above, US indices (S&P 500, NASDAQ), European indices (DAX, FTSE), and Asian indices (TOPIX, NIKKEI, SET and STI) have outperformed the Chinese indices since 2020. This article seeks to outline the issues plaguing the Chinese economy and the policy shifts made by the Chinese government thus far.
Sluggish Growth Plagues the Chinese Economy
GDP grew 6.3% yoy in Q2’23, slower than expected due to low base effects. The Chinese economy grew at a slower pace in Q2 as domestic and foreign demand weakened. GDP grew just 0.8% in April-June from Q1 2023, signalling a slowdown from the 2.2% expansion recorded in the first quarter.
The latest data raises the risk of China missing its 5% growth target for 2023 as economists look to cut estimates as well:
- Citi (5.5% to 5%);
- Morgan Stanley (5.7% to 5%);
- UOB and JPMorgan also cut to 5% from 5.6% and 5.5% respectively.
Figure 2: China’s GDP Growth (%, Q1 2019 – Q2 2023)
China’s manufacturing and housing market continue to slump in July as the Caixin manufacturing PMI declined to a six-month low of 49.2 in June, indicating a contraction in the sector as export demand slumped; the value of new home sales by the 100 biggest real estate developers fell 33.1% yoy, according to preliminary data from China Real Estate Information Corp.
Figure 3: Chinese Manufacturing PMI Shows Signs of Contraction
Deflationary pressures plague the Chinese economy (link). Consumer inflation rate was flat in June while factory-gate prices fell further, fueling concerns of deflationary pressures and adding to speculations over potential economic stimulus.
Both CPI and PPI further reinforced the fact that the Chinese recovery is weakening. For the past few months, consumers and businesses have held back from spending or investing in hopes of lower prices. Commodity prices slid and home demand weakened as a result.
Figure 4: Deflation Risk Persists as CPI and PPI Continues to Decline
Declining exports as the rest of the world (mainly US and Europe) fights inflation and looks to de-risk supply chains. China’s exports have peaked at a record of $340 billion in December 2021, and have since declined to $284 billion in May 2023. US’ efforts to cut China off from supplies of advanced semiconductors and other technologies set to drive future economic growth further exacerbates the problem.
Chinese Real Estate developers show more signs of stress amidst a multi-year credit crisis. Stocks and bonds in China’s real estate industry fell to eight-month lows as fears of a cash crunch at two of the country’s largest developers, Country Garden and Dalian Wanda, deepened woes around the sector. This is a continuation of troubles that first brewed with China Evergrande two years ago.
Figure 5: Bond Prices and Share Prices of Chinese Property Developers Tank
Chinese Consumers Turn Savers as China Hits Record Youth Unemployment
2023 started with optimism that Chinese consumer spending will see a rapid recovery due to revenge shopping, eating out and travelling. However, anxieties over economic outlook have taken precedence as rising unemployment, falling incomes and the negative wealth effect from a slumping property sector forced people to become savers, rather than spenders.
Figure 6: Spike in Consumer Savings Since the Pandemic
Data from the National Bureau of Statistics showed a slowdown in consumer spending growth as retail sales data rose 3.1% yoy in June 2023, down from 12.7% in May 2023.
Extremely high levels of urban youth unemployment rate is also adding to the negative consumer sentiments as youth employment hits 20.8% — four times the national urban jobless rate (5.2% as of June 2023).
Figure 7: Urban Youth Unemployment hits a Record High in China
Towering Local Government Debt
Trillions of dollar of “hidden debt” accumulated. As of May 2023, Goldman Sachs estimated that China’s total government debt is about $23 trillion.About 40% of which are “hidden debt” that do not show up on the local government balance sheets (off-balance sheet financing).
The “hidden” debts are raised using the Local-Government Financing Vehicles (“LGFVs“) to fund the construction of roads, airports, subways and power infrastructure. The IMF estimates that LGFV debts have nearly doubled over the past five years to about 66 trillion yuan ($9.3 trillion).
The LGFV is a funding mechanism used by local governments in China to finance real estate development and other local infrastructure projects. They exist in the form of investment companies that borrow money to finance these projects.
LGFVs were originally established to skirt around a ban on municipal authorities borrowing from banks or selling bonds directly in the market.
LGFVs borrow money from banks or individuals by selling bonds known as “municipal investment bonds” or “municipal corporate bonds”.
LGFVs rarely generate enough returns to cover their debt obligations despite the immense amounts of money used to finance these infrastructure projects.
Hence, they require injections from municipal funds to stay solvent. The inability for the infrastructure projects to be self-sufficient has caused a drag on local government’s cash balance.
Signs of stress despite no default. While none of the LGFV have defaulted on their publicly issued bonds, many have started to show signs of stress as debt-income ratios across China have gone off the rails:
- In Kunming, a LGFV dragged out a bond payment until the last minute in late May, spurring speculation that it was having difficulty raising cash to meet its obligations.
- In Guizhou, one of China’s poorest and most-indebted provinces, officials stepped up their pleas for aid in April to draw Beijing’s attention to a sever debt crunch. A separate LGFV from Guizhou asked banks to extend its loan obligations for two decades to avoid a default.
- In Shangqiu, a city of 7.7 million people in China’s central Henan province, the only bus service came close to shutting down.
- In Wuhan and Guangzhou, proposed cuts to pensioners’ medical benefits prompted rare street protests earlier this year.
- Wealthy cities have not escaped the brunt of China’s debt problem either – civil servants in cities like Shanghai are reportedly having their pay slashed.
- Some cities have resorted to unusual measures to raise cash – in Wuhan, local authorities publicly named and shamed hundreds of debtors in local newspaper article to demand payment.
Figure 8: Heatmap of Debt Risks and Refinancing / Repayment Pressures in China
Dwindling government revenues from a slowing housing market adds pressure on local government funding. Government revenues have also dwindled due to a housing market downturn, adding to pressures and concerns of this $9 trillion debt problem. Land sales, a key revenue source, have slumped due to a dwindling appetite from cash-strapped developers.
Consequently, LGFVs and state-owned developers have stepped in to fill the void by snapping up more than half of the residential land sold last year.
Figure 9: Revenue from Land Sales Decline as LGFVs and State-owned Developers Fill the Void
Then-Premier Li Keqiang warned in March that regional governments’ debts were a key threat to financial stability, and authorities have sent delegations from richer regions to collaborate with those in poorer cities. Assuaged by the signals, the bond market has remained relatively calm, with the risk spreads on LGFV yuan bonds narrowing by as much as 72 basis points this year, according to data compiled by Bloomberg.
Mounting credit stress in China. Bloomberg’s China Credit Tracker showed signs of added stress domestically as onshore credit stress rose to level 4 in June (from level 3). The worsening was caused largely by a pair of builders failing to make a combined 4.4 billion yuan ($608 million) of bond payments, the largest monthly total this year.
Large domestic banks halt purchases of local notes issued by LGFVs in the Shanghai free-trade zone. China state-owned banks step up. LGFVs could face liquidity tightness and have to seek alternate financing channels.
As LGFVs lose a potential financing channel from domestic banks, it finds some reprieve as China’s biggest state banks are offering some LGFVs 25-year loans and temporary interest relief to prevent a credit crunch in the sector.
China’s Real Estate Crisis - How We Got Here
Real estate has been a key economic growth driver in China for over a decade, mostly debt-fueled. Rapid urbanization presented a vast commercial opportunity for construction firms and developers in urban cities. Money flooded into real estate as the emerging middle class hopped aboard the bandwagon and invested in what they considered as one of the few safe investments available.
This fueled a property craze whereby developers pre-sold new homes and collateralized these sales to get additional debt while turning towards foreign investors in bond issuances to finance new projects. This led to a debt-fueled property boom. Annual sales of dollar-denominated offshore bonds surged to $64.7 billion in 2020 from $675 million in 2009.
Crackdown on heavily indebted real estate developers to reduce systemic risks with the introduction of the “three red lines”. In August 2020, the Chinese government introduced the “three red lines” policy to regulate the borrowings of property developers. This policy sets the limits on the amount of new borrowing that property developers can raise each year by placing caps on their debt ratios.
The three red lines refer to three specific thresholds that developers must meet to refinance their existing debts:
- Liabilities-to asset ratio of less than 70%, excluding advance proceeds from projects sold on contract;
- Net debt-to-equity ratio of less than 100%;
- Cash-to-short-term borrowings ratio of at least 1.
The move was aimed at (1) setting borrowing limits, and (2) to prevent distressed developers from selling assets to healthier firms to raise cash as potential buyers ran the risk of breaching the red lines. This move was sparked by fears of another housing bubble after home prices surged sixfold over the past 15 years, making cities like Shenzhen less affordable than London. The debt binge by Chinese developers was a key contributor to rising prices as they are forced to charge more to cover swelling interest burden.
Home prices fall amidst slashed prices and increased financial stress during the pandemic. Following the introduction of the “three red lines” (三道红线), a number of weaker companies started defaulting on their debt obligations as they lost the ability to refinance or secure new funding.
Developers with weaker balance sheets were forced to slash home prices to boost sales and shore up cash. This was evident in Evergrande’s campaign to offer discounts of as much as 30% in 2020. When covid cases surged and large cities went into lockdown, housing sales were frozen and prices started declining in August 2021.
Cash-strapped developers unable to finish construction, prompting mortgage boycotts and protests by buyers as the Covid-19 pandemic gripped the locked-down cities. Many developers stopped building houses that they had already sold, but had yet delivered, prompting homeowners to stop paying their mortgages. According to Bloomberg, Economists at Nomura International HK Ltd. estimated in mid-July that Chinese developers had delivered only about 60% of the homes they pre-sold from 2013 to 2020.
Beijing sets up bailout fund worth up to $44 billion and $29 billion of special loans for unfinished projects to restore confidence. In July 2022, the government set up a $44 billion Real Estate Bailout Fund. According to Reuters, the fund was initially funded with 80 billion yuan by the People’s Bank of China (PBOC) through the state-owned China Construction Bank, with the aim of raising up to 200-300 billion yuan from other banks.
In August 2022, the Chinese government backstopped stalled housing projects, which have been sold but yet to complete, by channelling the special loans through policy banks like China Development Bank and Agricultural Development Bank of China. Many analysts warned that this move might be counterproductive and set a floor for a downward spiral which adds more new debt.
Relaxation of the “three red lines” at the start of 2023. In January 2023, the Chinese government relaxed its stringent “three red lines” rule and unveiled measures centered around boosting equity, bond and loan financing for developers. According to the Financial Times, officials at multiple state-owned banks have effectively shelved the leverage curbs in their assessments of borrowers. Deleveraging by developers has proven to be a tall order amidst slowing housing sales.
China property recovery remains short-lived as the sector declined 1.2% in Q2 2023. Despite the support measures rolled out by the government, housing sales continue to fall. In fact, prices of new and second-hand homes had fallen every month for the past year.
The state of China’s property sector remains in focus as about 30% to 40% of developer’s total debts will fall due by the end of 2024. Currently, developers have outstanding bonds of about 2.9 trillion yuan ($401 billion) on their balance sheet, with nearly 1 trillion yuan coming due within the next 12 months and a maturity wall expected in the third quarter.
Government Policy Shifts Thus Far - Property Sector
Easing of lending terms to property developers by encouraging negotiations to extend outstanding loans – (1) mainland Chinese financial institutions must extend existing loans to developers that are due by the end of 2024 by another 12 months; (2) commercial banks can classify project-based special loans provided to developers before the end of 2024 as “lower risk” category. The aim is to ease liquidity constraints faced by developers and to support the delivery of homes that are under construction.
Chinese State Council has called on cities to introduce policies to ensure continued support and the healthy development of the property sector. The Politburo signalled softer language on the property market as Xi’s signature slogan, “houses are for living, not for speculation”, was omitted for the first time since 2019.
Easing of home-buying restrictions in tier 1 cities – including scrapping mortgage rules that require higher downpayments and have more restrictive borrowing limits for homebuyers who have owned properties before.
Some cities have lowered down-payment requirements and removed restrictions on buying multiple properties to help revive the property market. Homebuyers who had paid off previous mortgages will be considered as first-time buyers.
Government Policy Shifts Thus Far - Deleveraging Local Government Balance Sheets
Chinese State-owned Banks are offering long-term loans of up to 25 years to LGFVs to ease credit crunch. The deteriorating balance sheets of local governments is in desperate need for financing as Covid spending coupled with dwindling land sales and poor tax collection rates caused large budget deficits. Much needed relief is being extended by state-owned banks to relief financial pressures.
Thus far, the central government have not signalled any willingness to take on these debt onto their own balance sheets. However, measures taken in the property sector should be viewed hand-in-hand with measures to relief debt pressures of LGFVs as a recovering property market will help boost land sales as well.
That said, Chinese state pension fund had sugested its asset managers sell some of the bonds issued by the riskier LGFVs and private developers following a review.
Government Policy Shifts Thus Far - Economic Stimulus
- Key policy interest rate cut by the PBOC in June 2023 for the first time in nearly a year, signalling looser monetary policy.
10-step plan to increase car purchases released by the NDRC – targeting new-energy vehicles, including lower costs for electric-vehicle charging and extending tax breaks.
Pumping the brakes on a multi-year crackdown on tech firms as China vowed to treat private companies the same as state-owned enterprises.
Top internet regulators also loosened restrictions around ChatGPT-style services that was proposed several months ago.
More loan support for businesses to spur economy. China has pledged to boost credit to private companies and extend other funding measures to small firms to shore up confidence.
Expansion of a relending quota by 120 billion yuan ($16.5 billion) to 1.76 trillion yuan in a bid to encourage banks to grant loans to support the transport, logistics and storage sectors, which were hit hard by the pandemic