China – when one risk may hide another!
Hervé Goulletquer
Senior Economic Adviser, Accuracy
When we look at the Chinese economy, in this early autumn, two dynamics emerge. First, from a macroeconomic perspective, we can note very disappointing GDP growth during the third quarter of the year. As was forecast by Bloomberg’s economic consensus, one of the most viewed forecast aggregates, performance barely got off the mark (+0.2%, quarter on quarter). This phenomenon may not last long, however, and from the fourth quarter, the country may return to its previous performance level (around 1.5%, quarter on quarter). But even if we accept the forecasts, is there not a risk of being taken by surprise again in the near future?
China: the slump may not last
Second, and this time from a microeconomic perspective, we have the Evergrande issue. It is the country’s largest property developer, which, over time, has transformed into a type of conglomerate. It is unable to pay its debts and coupons that are falling due. And it is fair to say that its debts are high: over 300 billion dollars in total or almost 2% of the country’s GDP, including 90 billion in financial debt (bank loans and bonds), 150 billion in commercial debt (including deposits from off-plan buyers), and 80 billion off balance sheet (essentially investment products issued by the company). Available cash would only cover 40% of its short-term debt (maturing within 12 months). Before starting a carve-out process for some of the assets, it was estimated that a fire sale would involve a debt haircut of some 50%.
We should note that the Evergrande case, however iconic and high profile the company may be, is not unique. Other developers are putting themselves in defaulting positions, even when they are able to pay what they owe. They use the toughening regulation, which hinders their business development considerably and try to ensure their creditors are the ones with the losing hand. Or, to put it another way, they try to create enough scandal or public difficulty to force the public authorities to revise their attitude.
Evergrande: asset prices clearly falling
A major credit event in a suddenly deteriorated economic environment gives us a more worrying outlook: what if China was no longer a centre of stability in a world that very much needs one?
The Xi Administration (based on the name of President Xi Jinping) has started a restructuring/consolidation phase for the country’s economy, with the aim of reinforcing its fundamentals. It no doubt considered the international environment to be favourable to such an action. The decline of the COVID-19 pandemic, the return of global growth and a theoretically more cooperative US president should create sufficiently promising external demand conditions to compensate any ‘blunders’ in domestic spending that the reforms (even if conceived and implemented well) would doubtless cause.
However, as is often the case in life, things have not gone exactly according to plan.
The Beijing government started with three areas: real estate, debt and inequality. Work on all three must be reduced.
Let us start with real estate. Its total weight in the Chinese economy, taking into account upstream and downstream effects, is estimated at between 25% and 30%. The scale is reminiscent of what we saw in Spain or Ireland before the Great Recession in 2008. Might we do well to take this similarity as an invitation to prevent rather than to cure, after the real estate bubble bursts? Moreover, real estate needs have become less significant (apart from the considerable wave of migration from the countryside to cities), whilst prices have skyrocketed. An average of 42 m2 per person in a dwelling is perfectly comparable to what we can see in major Western European countries. However, the ratio of property prices to average household income is over 40 in Beijing or Shanghai (2018 figures). Though comparable to the ratio for Hong Kong, it is significantly higher than its equivalent for London or Paris (around 20), not to mention New York (12). This level observed in large Chinese cities is only understandable if economic growth and demographics remain sufficiently strong to justify a highly dynamic demand for property and therefore to maintain expectations of property price increases. We know that the demographics are not heading in this direction, and we sense that the potential GDP growth is slowing…
Preventing the formation of a real estate bubble could be seen as a pressing obligation. First, is it not necessary to preserve the financial system’s ability to take the initiative at a time of structural change in the economy? The system’s exposure to the real estate sector is significant, between 50% and 60% of total bank loans granted. Second, less investment in real estate would facilitate, all else being equal, increased investment in capital goods or intellectual property products. Measures of both productivity and economic growth could find themselves improved
Credit exposure in real estate sector
Chine: heading towards a new breakdown in fixed investment?
Now let us talk about debt. Debt in non-financial corporates is high; in fact, it is among the highest in major countries around the globe. It represents 160% of the country’s GDP. Of course, we can highlight the much more reasonable levels noted for households and public authorities and therefore talk about a very ‘presentable’ average. But embarking on economic reforms, which will most certainly create losers as well as the expected winners, starting from a situation with a high level of debt in the corporate sector is uncomfortable. This is even more so the case when we consider the ricochet effect on the financial system of the difficulties facing a certain number of companies.
We must therefore understand that the importance given to greater stability in the financial system risks weighing on economic growth. As we highlighted previously, this is another reason to ensure more efficient investment signposting – towards where there is the greatest potential for long-lasting and inclusive growth.
Debt of non-financial Chinese companies among the highest
The thread that runs from real estate to debt leads to inequalities. These inequalities are too great, and Beijing is aiming to reduce them. The Chinese real estate ‘adventure’ described above, in addition to the development of the technology sector and its consequent outperformance of the market, has contributed to an increase in inequalities, now putting them at the same level as in the United States. The richest 1% holds 30% of the wealth of all households in China, a proportion that doubled in the 20 years from 1995 to 2015. For Beijing, this development seems to carry the risk of challenging political stability. Is it not understandable then that the middle class should call for a reduction in these inequalities?
China: inegality becoming a political matter
No sooner said than done, we might wish to say; after all, President Xi is not one to dawdle. A large number of measures have been implemented to effect this triple ambition. Many relate to the technology and real estate sectors and encourage greater moral standards from the country’s citizens. The table below provides a summary of the changes.
China: a significant catalogue of party/government initiatives
But all this has a destabilising effect! Ensuring parallelism between the impact of decisions that will suppress growth (real estate, finance and technology) and the impact of those to come that will boost it (aim to increase added-value content of the Chinese economy, less dependence on foreign countries, and ‘healthy’ stimulation of domestic demand, to mention what we currently understand) will require significant skill in economic policy. Even in what remains a relatively nationalised system, it will be quite a challenge. Benefitting from a favourable external environment is certainly a ‘pressing obligation’ for Beijing today – never mind if, at least at first, it flies in the face of the ambition to become more autonomous from the rest of the world. Are we there yet?
Not really – with such a complicated international environment (from the COVID-19 pandemic, which has not yet disappeared, to persistent Sino-American tensions, not to mention a global economy that is still recovering), it will be necessary to arbitrate between the desirable (domestic reforms) and the possible (degrees of freedom offered by the economic context and external policies). That will mean accelerating when possible and slowing down when necessary. It will be an arduous task for the person in charge of economic policy, not to mention ensuring that the business community falls in line. It will not always be easy!