Is China Heading the Same Way as Japan?

Positive news this month includes the peak of Omicron being passed, and the one billionth vaccine being given on 16th January according to the World Health Organisation. We may not be home and dry when it comes to getting out of this pandemic, but we could be home and vigorously towelling ourselves down.

Stock markets expect a recovery in economic activity as the pandemic is declared over and the virus becomes endemic – a flu-like illness that will prey on the weak and the old just as flu does. Governments are hoping that this uptick in activity will do them a political favour, improving their credibility and popularity, even if they did in some cases attend too many parties during lockdown.

Stock markets have been wrong in the past. The saying goes that they have predicted nine of the last five recessions.

This time, the great global economic engine that is China is not accelerating. Chinese GDP grew at its slowest rate in six quarters in Q4 of 2021, at just 4.0% year on year, according to data released on 17 January by the National Bureau of Statistics. In Q4 2020 the number was 6.5%. For the full year 2021, growth is estimated to have been 8.1%. That looks like a great performance, but it also reflects a rebound from a very weak 2020 when large swathes of China were in lockdown for much of the first half.

The NBS has of course spun the news positively, saying that China is following a sustainable recovery, leads global growth and epidemic prevention and control, while admitting a ‘triple pressure of demand contractions, supply shock and weakening expectations’

On 17th January, the People’s Bank of China has cut interest rates on one year policy loans by 10 basis points to 2.85%, the first reduction since April 2020. It also lowered the rate on the 7-day repurchase rate and put Yuan 200 Bn (about USD 31.5 Bn) in cash into the financial system to prop up liquidity. These measures follow a five basis point cut in the one year prime rate in December. Retail mortgage rates remain unchanged.

Why are there liquidity problems? Partly because of China’s imploding property sector. Evergrande is merely the visible sin-eater in a construction sector that is massively over-built, over-leveraged and over-priced. A surplus of 30 Mn homes – enough for 90 Mn people basis the average family size – may never be overcome, especially as birth rates are collapsing, falling 12% year on year in 2021 according to the NBS.

There is no official measure of the multiple of house prices to average earnings in China, and a regionalised market would arguably make a national average meaningless, but Nordea Bank estimates that prices are 25 times incomes in Beijing, 19 times in Shanghai, 14 times in Tianjin, Nine times in Chongqing and 13 times national average income.[1]

If property developers and off-plan buyers cannot sell on homes, the whole pyramid will collapse. There is added danger as financing limits (the “Three Red Lines”) that the PBOC announced last September are now starting to bite. Evergrande, Sunac China, Greenland and Zhongliang are not allowed any increase in debt this year. Sunshine City is only allowed a 5% increase in debt. Country Garden, China Vanke and Seazen Holdings are only allowed a 10% increase in debt, basis data from Ping An Securities and Caixin. Without sales and with no access to working capital, the property Ponzi scheme will collapse. Property sales in China rose 4.4% in 2021 but fell 7.7% year on year in the final quarter.

The Japanese property bubble burst in the 1990s and led to 20 years of minimal economic performance, with the drag of negative demographic growth making ever greater policy actions inevitable (such as the ‘Three Arrows’ of Abenomics). The danger that China might follow a similar trajectory has been well-known for some time. But policy actions on financing limits for developers will not only affect them, but also their suppliers, bond-holders, stock-holders and wider markets.

In all our models, we acknowledge that a credit crunch is due in China sometime this decade. It feels like it is now drawing closer. We aren’t forecasting negative GDP growth within our forecast horizon, but clearly our forecasts are very sensitive to any underperformance of Chinese economy, so we suggest keeping a close eye on economic news and policy announcements in the Middle Kingdom.

An alternative, more optimistic view is that the Three Red Lines have contained the problem, which now has a value, and that the PBOC is starting to loosen lending rates to cushion the blow to the wider economy. Let’s not forget that the PBOC is not independent in China, where monetary policy is government policy. The CCP will doubtless try to manoeuvre out of a property bubble without bursting it. Maybe it will be successful. Maybe not.