Financial markets have been firmly focused on the interest-rate implications of a resilient, even robust US economy, but investors may not have been paying enough attention to China’s economic and financial news.
Despite the dire state of the economy, global markets have been like the Chinese saying, “loud thunder, little rain”. It is easy to see why, but also why we should remain on our guard.
The application by Evergrande to seek Chapter 15 bankruptcy protection in New York this week was hardly news, and markets have been digesting this firm’s decay for a long time.
More significant was the financial demise of another large property developer, Country Garden, and the financial disturbance in a large trust (shadow) bank, Zhongrong, which defaulted on payments to investors on some of its products.
The waves of distress emanating from the crisis in the real estate sector, as they roll into the finance sector, are now discernible, raising, for analysts, at least, the threat of contagion.
There is no question that the outlook for the property sector is grim. It isn’t the only drag on the Chinese economy, and joins other systemic weaknesses, such as a wider debt burden, weak consumption, productive and governance, and a business environment that is overwhelmingly about politics and the needs of the Chinese Communist Party.
Property is the proximate cause of distress, though. The sector is adjusting to overbuilding, and excessive indebtedness through a collapse in transactions volumes. Floorspace built, and sales are about 40-50% below 2019 levels.
The problem is more complex, though, because while prices have fallen, official data based on survey evidence, has been modest. However, existing-home sale prices are about 15% lower than in 2019, and new home sales are being discounted by comparable amounts to attract reluctant and unconfident buyers, many of whom have their wealth and mortgages tied up in uncompleted homes.
The combination of falling transactions and prices is typical of a self-feeding real estate bust, and a mirror image of the boom, when everyone’s balance sheet was being extended and managed as though the upside in property was a one-way bet. Now the tune has changed, and the herd has changed direction.
The trust bank news is worrying but only at the margins. Trust banks are not hugely exposed to real estate, and the authorities can probably stabilise disturbances in individual firms. However, if multiple asset managers ran into liquidity shortages, not to mention if primary bank lenders were suddenly confronted with deposit withdrawals or a spate of non-performing property loans, things could get messy very fast.
These are then tricky times, and people are expecting or hoping that the government will soon announce measures to boost the economy and consumption, ease rules and regulations for home owners and developers, and try and buy some time. Perhaps markets will be momentarily relieved, but the reality is that property faces years of shrinkage as it adjusts to weaker demand for home construction for both economic and demographic reasons.
See: Global investors expect China to deliver a massive fiscal stimulus. Here’s why it may never arrive.
Reflecting these and associated phenomena, China’s equity markets have, at best, marked time, and bond yields have fallen as monetary policy has been eased in the face of the threat of deflation. The central bank has tried this week to slow or stop the depreciation of the renminbi, also known as the yuan, which recently fell to its lowest level since 2007 when it was appreciating steadily.
The effects on global financial markets and investors for the moment have been fairly limited. Indeed, the empirical evidence is that global market contagion emanating from disturbances in China’s economy or financial market is generally quite small.
Investors outside China typically still own quite small proportions of Chinese assets. The less than 5% weighting that foreign asset managers have in Chinese equities and fixed income on average doesn’t suggest investors are, by and large, at huge risk. If anything, they have cut back further this year. Despite the investment industry’s constant urging that investors lift China exposures to something approaching China’s proportion of global GDP, that is around 18%, most investors have wisely opted to stand well clear.
Global contagion is limited by two other factors. First, few money managers outside the country have exposure to Chinese property assets now. Second, it is generally believed that China will not only attempt to stabilize its economy and limit global spillover, but also, importantly, use its control over the financial system to shift liabilities around as necessary to buttress major financial institutions.
See also: China Evergrande collapse shows need for $1 trillion Beijing rescue plan, says Clocktower strategist
These conditions, of course, may not always hold, especially the preservation of financial stability, and so investors will have to pay close attention, regardless.
Even in the event that Chinese and global markets remain largely uncorrelated, foreign investors should be alert to other risks and opportunities. For example, while the macro-contagion effect might be dull, there is no question that the consequences for commodities and commodity firms will be much more remarkable. China’s voracious appetite for energy, metals and minerals to feed into its industrial economy and its oversized real estate market is legendary. As conditions stumble or stall, these areas will no doubt be adversely affected.
China’s other challenging economic and financial conditions might also act as triggers to accelerate or influence the recalibration of supply chains that has already begun, especially regarding technology and national security-sensitive products and processes. Investors should certainly be tracking these developments to identify companies and countries in non-China Asia and among ‘friendly’ nations that are the beneficiaries of new investment and commerce.
The weakness of the renminbi is also worth watching, as it can be viewed as a bellwether of the bad news flow and easing of monetary conditions. The People’s Bank of China was compelled to step in last week, and did. A weak Renminbi offers cheap goods and services to those buying in other currencies, but it reflects a flagging economy and weak imports from the rest of the world.
See: China sets yuan fix at biggest gap to estimate on record
For investors, though, Renminbi depreciation is also an indicator that might be conveying information about a deterioration in conditions at home, and or porous capital controls as smarter or more nimble investors attempt to get their money out of China. The signals of under pressure earnings, tightening credit conditions, and financial stability risks might then be more consequential globally.
George Magnus is a research associate at Oxford University’s China Centre and at SOAS University of London and is a former Chief Economist at UBS. He is author of ‘Red Flags: Why Xi’s China is in Jeopardy‘.
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