Supply-side disruptions and real estate developer defaults have been in the news since last year, but the world has been busy with the Russia-Ukraine war and global inflation. Economists and fund managers have so far been mainly concerned about a recession in the US & Europe and the debt crisis in smaller countries. Well, China may just deliver a nasty shock. Nothing seems to be going right and the troubles are just getting bigger.
Economists have been concerned about a recession in the US & Europe and the debt crisis in smaller countries. Well, China may just deliver a nasty shock.
Last year, China’s largest real estate company, Evergrande, with a debt of nearly $300 bn, defaulted on its bond repayments. Real estate is now sinking the whole country.
There was a record withdrawal of $43 billion by foreign investors in the first quarter of 2022 as the interest differentials widened. With the ‘Zero COVID’ policy, the economy will continue to shrink, risking further flight of capital.
Since last week, homeowners have been refusing to pay mortgage EMIs in 91 cities involving more than 300 projects, as developers have failed to deliver homes. China may be heading for an encore of the 2008 subprime crisis.
Local governments are broke. They have a borrowing of $7 trillion by way of outstanding bonds and borrowings, in addition to a funding gap of $1 trillion.
China’s total debt is bursting through the seams, standing at 264% of its GDP (corporate and individual debt included).
How Real Estate Has Crushed the Economy
Last year, China’s largest real estate company, Evergrande, with a debt of nearly $300 bn, defaulted on its bond repayments. Real estate is now sinking the whole country. The sector contributes more than 25% to the Chinese GDP. Over the years, China has created a structurally imbalanced economy with large exposure to real estate. As much as 78% of household wealth is in the form of real estate holdings. Families pool in resources to buy homes, and thus house ownership has a huge significance for the Chinese people. Since last week, homeowners have been refusing to pay mortgage EMIs in 91 cities involving more than 300 projects, as developers have failed to deliver homes. China may be heading for an encore of the 2008 subprime crisis.
The total banking exposure to real estate stands at a whopping $9.2 trillion. Default by homebuyers and developers will spin up major banking stress in China, which is likely to have a global impact. For a couple of months now, rural banks in Henan have frozen the deposits of the public as they are unable to pay. Local politicians are protecting the defaulting banks amid charges of diversion of funds. Shockingly, the Bank of China has declared these deposits as ‘investment products’ and they can’t be withdrawn.
Local Governments are Broke
China is behaving like a classic socialist economy, where no one owns anything and everything belongs to the state. The People’s Liberation Army (PLA) has deployed tanks on the streets to keep away people whose deposits have been frozen by the defaulting banks. The military and the police are protecting the defaulting banks and developers against citizens, who are now at risk of losing their life savings.
However, the bigger news is that local governments are broke. They have a borrowing of $7 trillion by way of outstanding bonds and borrowings, in addition to a funding gap of $1 trillion. The governments have run out of funds as real estate, i.e. the selling of land use rights, was their main source of earnings.
The central government is in no position to help as China’s total debt is bursting through the seams, standing at 264% of its GDP (corporate and individual debt included). Local governments are borrowing funds at 10%, while the bank rate for savings accounts is under 1% as such these 10% interest bonds would qualify for junk bonds.
China’s ‘Zero Covid’ policy is ruining the mental well-being of individuals and the economic well-being of the nation. Frequent lockdowns have resulted in a GDP growth of only 0.4 % in the last quarter. Entrepreneurs and businesses are suffering on account of supply disruptions and production schedule breakdowns. Post-COVID-19, many global manufacturers have exited China and the world is looking for new suppliers. The global auto industry has had to cut production on account of semiconductor shortages.
China, projected to be the next superpower, has a long way to go, though it has done remarkably well to have become the second largest economy with a formidable global presence. However, the world has deep trust issues with Beijing, which have worsened after the COVID-19 pandemic. It is increasingly being seen as an aggressor. The US no longer shares the same bonhomie it did for the last 35 years, and Quad members are actively working towards reigning in the Chinese economic and military expansion.
India, too, recently cracked down on Chinese telecom companies citing massive tax evasion. The Indian government has rejected quite a few Chinese FDI proposals in the last couple of years.
Sino-Australian trade has taken a hit post the COVID-19 pandemic. And Rishi Sunak, in his manifesto as a candidate in the UK prime ministerial race, has unequivocally stated his anti-China stance. De-globalisation and a growing anti-China sentiment may adversely impact Chinese trade and investments in the medium term.
China Is Doling Out Loans, But Its Own Economy Is Struggling
Chinese entrepreneurs are also growing disillusioned with the communist regime. Many millionaires are in a hurry to leave the country. The Xi Jinping government is gunning for capitalist entrepreneurs. It looks like there is growing confusion over political ideology – should China work towards becoming the numero uno economic power or go back to its hardcore communist practices? The demographics isn’t in favour of China either as the working population is shrinking. In the next 15 years, as much as 45% of the Chinese population will be over 60 years of age, and thus, government spending will increase massively to provide for an ageing population.
To prop up a sagging economy, the Chinese government announced a stimulus package of $200 billion to fund infrastructure and construction activities. The only problem is that China is already reeling under huge debt and the local government debt crises are further stressing the system.
China is pursuing an expansionary monetary policy contrary to the Fed policy. It went for rate cuts while the Fed is and will be raising interest rates. A stronger dollar will also put pressure on the Yuan and the Renminbi. There was a record withdrawal of $43 billion by foreign investors in the first quarter of 2022 as the interest differentials widened. With the ‘Zero COVID’ policy, the economy will continue to shrink, risking further flight of capital.
While China is actively working on de-dollarisation for now, it’s a long road to playing a meaningful role in the global currency markets. At $336.1 billion, only 2.79% of global forex reserves are held in Yuan.
China has been pursuing a global expansionary policy and is doling out loans to smaller countries and funding international projects, but its own finances back home seem to be in the doldrums. With struggling banks, real estate collapse, supply-side disruptions, flight of capital, rising current account deficit and fiscal deficit, nationwide public outrage and broke local governments, it looks like the Chinese story is over for the time being.
Will China Deal the Death Blow?
Expect China to show below-average growth rates in the next few years. One doesn’t know the exact magnitude of the financial and political stress in China, but it is very evident that it is on the brink of delivering a rude shock to the global economy. The world is likely to slip into a long recession as the top six economies, excluding India, account for 60% of the $100-trillion global economy. With China also getting into a flat or negative growth, things look bleak. Besides, many countries are staring at severe debt crises, which are likely to get worse with rising interest rates and a strong dollar. I doubt if the world will achieve the projected growth of 3.6% for 2022. The next year is likely to see a much lower number.
The world is already reeling under a slowdown and the last thing it needs is an economic and banking crisis in China. The country is one of the biggest consumers of commodities, and with a collapse in Chinese demand, the world may see a major deflation in asset and commodity prices. Sell recommendation on global equities continues.
(The author is Managing Partner at Alquimie Advisors. This is an opinion article and the views expressed are the author's own. The Quint neither endorses nor is responsible for them.)