The Breakdown - A Primer on China's Current Economic Turmoil

Episode Date: August 18, 2023

China has posted some troubling economic data of late, leading many macro commentators to call attention to the concerning developments. In today's episode, NLW provides a primer on the past few years of wobbles, issues in the real estate sector, and the CCP's lack of good options. Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribe to the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Thursday, August 17th, and today we are doing a great big, what the heck is going on with China episode. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link the show notes, we go to bit.ly slash breakdown pod. Hello, friends, we are rumbling on towards the end of the week.

And speaking of rumblings, if you have been watching the macro Twitter sphere closely, there have been growing rumblings about China. You see it pop up a little bit in mainstream media and on YouTube's and certainly now happening on podcasts. And then yesterday, Preston Pish tweeted, Anyone have a really good and recent article or podcast on what's happening with the economy in China right now? Well, over here at the breakdown, that really cinched it that we were going to dig into this.

And before we do, the usual caveats. One, I am not a China expert. Just like basically, I'm not an expert on anything we talk about here. But what we try to do well over here at the breakdown is aggregate sources to help you better understand what's happening at least a little bit better. And number two, to the extent it comes up, apologies in advance for pronunciations, or perhaps I should say mispronunciations. With that, let's try to get a sense of what's happening and why it matters. On Tuesday, the People's Bank of China cut rates on one-year loans by 15 basis points to 2.5%. This is the largest cut since 2020 and was an emergency policy adjustment following the release of some truly dismal economic data.

July data showed weak consumer spending growth, sliding investment, and rising unemployment. Youth unemployment for people between the ages of 16 and 24 hit 21% in June. I know you guys can do the math, but to put that differently, that means one in five young people are now out of work. In fact, this month, the National Bureau of Statistics didn't actually release data on youth unemployment, stating that they needed to adjust their methodology to exclude students seeking their first job. Now, over in currency land, the yuan has devalued by 6% over the course of the year, recently reaching the low point it recorded last October of 7.3 yuan per dollar. That's the weakest exchange rate for the yuan since late 2007.

Data from June showed that China have decreased their holdings of U.S. treasuries for three months in a row, bringing them to a 14-year low. Some analysts believe that these reserves have been mobilized to defend the yuan from devaluing too rapidly. June's CPI data released last week showed that the Chinese economy was an outright deflation. Consumer prices fell by 0.3% on an annualized basis. Manufacturing activity has now contracted for four months straight, and GDP growth this year has been paltry, recording 2.2% in the first quarter and just 0.8% in the second quarter. multiple international banks have now downgraded Chinese growth estimates, forecasting that the economy will fail to achieve the 5% growth targets set by the CCP. And if that target is not hit,

it will be the third year in a row with sub 5% growth, an unprecedented rough patch in the post-Mao era from 1976 onwards. Now contributing to this are debt problems, credit problems, and social stability problems, but before we get to those, let's do a whistle-stop review of the last few years in China to see how things wound up in this position. You will remember that during the pandemic, China ran one of the strictest and longest-running lockdown regimes in the world. And while the impact of the lockdown on the people of China was, of course, immense, the disruption it caused was also a major driver in economic dysfunction. Global supply chains became broken, impacting items from semiconductors to gym equipment.

While the fragility of supply chains based in Chinese manufacturing had long been a talking point for Hawks in the West, the failure of multiple critical supply chains during the pandemic cemented the idea of reshoring manufacturing across the political aisle in the U.S. Since taking office, the Biden administration has pursued major industrial policy with a view to decoupling critical industries from reliance on China. The financial sector has also been discouraged from investing in China over the past few years, with a range of policies and pressure campaigns ensuring that capital flows into China are crimped. And as a little bit of a self-shill, if you want to hear about how this has been impacting the development of their artificial intelligence

field, go check that out. There continues to be incredible pressure on the Biden administration to even increase restrictions on export of AI-related technology to China, even though many of those restrictions are already in place. Anyway, heading back into the COVID era, as the rest of the world opened up and rolled back lockdowns in late 2021, China continued to be locked down into the strict zero-COVID era. Many times, even when it appeared that things were on the verge of opening back up, some new outbreak would cause another lockdown, leading ultimately to citizens bristling at the continuation of tough track and trace policies. Another big notable event during this time was that in December of 2021, the massive Evergrand Property Development Group defaulted on an

interest payment on its corporate bonds. The property giant had been severely impacted by a crackdown on leverage within the property sector in 2020 and had struggled to refinance its debt. The tightening of credit standards was known as the Three Red Lines Policy and was intended to reduce the credit risk of home builders. When it collapsed, Evergrand had over 50 million apartments left unfinished, leaving homeowners to question whether they would ever receive finished units. The ever-grand failure precipitated further economic problems across China in 2022. Protesters staged demonstrations outside banks, with organized groups refusing to make mortgage payments on unfinished homes. In many cases, mortgages had been taken out prior to construction beginning,

and so you can only imagine the frustration of people who were continuing to pay for homes that had been further and further delayed and who couldn't actually even live in them. In that same time period, multiple banks and wealth management products failed across the country, and Chinese real estate in general entered its most severe downturn in history. Now, the government did step in to manage the ever-grant failure and broader economic contagion. They were, however, in a tough position. Government policy around the restriction of credit to the property sector had been a major catalyst for the problems, but officials were reluctant to wind back the regulations entirely.

President Xi Jinping has been outspoken about reducing the financialization of housing, stating, quote, houses are for living in, not for speculation. Now, diving a little bit deeper into this area of the economy, the property sector is a key part of basically every major economy, but China takes this element to the extreme. China has one of the most overvalued housing markets in the world in relation to income. On average, an apartment cost over 30 times annual income, with major cities like Shanghai bringing this ratio as high as 50 times income. In the U.S., the ratio between housing costs and income is closer to four times on average, and 10 times for major metros like New York and San Diego. Part of the reason housing is so expensive

is that Chinese citizens use housing as a primary store of wealth. Again, this is true globally, but it's particularly lopsided in China. Housing accounts for more than 70% of household wealth in China. Many people invest in property and then hold it vacant to preserve its value as a never-lived-in home. China has some of the highest rates of homeownership in the world, with as many as 90% of households owning at least one property. This skew towards the property sector is largely a function of mistrust in other domestic assets, as well as tight capital controls. The Chinese stock market is notoriously opaque and lacking in the disclosure rules that provide a semblance of investor protection in the West, And while managed investment products are popular, they're often just proxies for exposure to the property sector.

Analysts typically measure the Chinese property sector as representing around 30% of Chinese GDP, which compares to the estimates of around 17% in the U.S. Now, other countries including Canada and Australia, have similar levels of household wealth and GDP contribution from the property sector, but the key difference for the Chinese housing industry is the sheer scale of the market. Chinese real estate is estimated to be worth $42.7 trillion. dollars. This is slightly larger than the U.S. real estate market in aggregate, and even a few trillion dollars bigger than the total market capitalization of the entire U.S. stock market. Many point to Chinese

real estate then as the largest asset class in the world, and it is going down hard right now. Official data has new home prices down 2.4% across China since their peak in August of 2021. Existing homes have dropped by 6% in the same time. This is already a massive drop for a housing market that was generally assumed to go up forever, but these official average figures don't tell the whole story. In China, closing prices for real estate are not public, so the official data is an estimate at best and a political fabrication at worst. The data relies on surveys and has significant smoothing to dampen trends. This makes turning points difficult to capture, and could mean the official data is not telling the full story. Private data from property agents shows major markets like

Shanghai and Shenzhen, falling by at least 15% in prime neighborhoods. The real estate surrounding Ali Baba's headquarters is estimated to have lost a quarter of its value. Goldman Sachs economist Wangli Shang said, property weakness is perhaps the most challenging growth headwind amid China's ongoing post-reopening recovery, and thus the momentum and sentiment in the property sector have significant implications for growth and policies. Now, alongside the fall in the housing market, more acute problems in the financial sector have also sprung up recently. At the end of July, Zhang Rong International Trust Company missed payments across dozens of wealth management products. The company is a gigantic player in the Chinese shadow banking sector, which intermediates loans

between individuals and private lenders. They primarily deal in the sale of real estate-backed bonds, and at least 30 products are now overdue, and the company have said they have no immediate plans to make clients whole. Chinese authorities have set up a task force to investigate potential contagion, and banking regulators are looking into risks at the firm's part owner, Zhangji Enterprise Group. Zhangji managed around $138 billion. Jason Su, chief investment officer of Reliant Global Advisors, said, This was one that everyone knew was going to blow up. Overall, there are 106 trust products across the country in default through to July of this year, worth around $6 billion in principle.

Real estate investments have accounted for 74% of defaults by value. Corporate defaults are also up in recent months. June and July recorded missed payments on more than a billion dollars in domestic notes. That's the worst stretch since last December and January, which was punctuated by the default of Evergrand. This time around, the problem seems centered on an even larger property developer called Country Garden. The firm is considered by most to be the largest home builder in China and has more than four times as many outstanding projects as Evergrand. Country Garden has missed payments on its

dollar-denominated bonds and is currently inside a 30-day grace period prior to a formal default. Trading has been suspended on at least 11 onshore notes and payment extension proposals are in the works. Country Gardens' January $24 bond issuance traded at $9.00 dollars' interest week and implied yield of 2,500 percent, just to give you an idea of how the market is pricing the firm's chance of recovery here. Now, as credit risk rips through domestic markets, China's major state-owned banks have been told to sell dollars to buy yuan in both onshore and offshore markets. According to anonymous sources speaking to Reuters, Chinese banks have been propping up the yuan throughout the week in an attempt to control the decline of the currency. Now, standard caveat on quoting zero hedge,

but zero hedge is also reporting that Beijing have urged investment funds not to sell off Chinese stocks. Taking a step back, up until recently, the Chinese reopening was a major narrative for markets. There had been turmoil across China over the last two years, but many investors consoled themselves that China would reopen strong and provide some much-needed growth to the global economy. What's happened is almost the complete opposite. Chinese growth has come in weak and sputtered along since reopening. It now looks like China is headed for a recession at best, if not a full-blown financial crisis. Carnegie Endowment Senior Fellow Michael Pettus wrote, It may seem like terrible luck and amazing coincidence that so many things are going wrong

in the Chinese economy at the same time. But of course, it is not a coincidence at all. This is how systemic imbalances work themselves out. I've often written about the Minskian dynamics of long periods in which market variables move persistently in the same direction. When that happens, businesses, banks, local governments, and households who implicitly or explicitly take too much one-direction risk systematically outperform those that don't, until eventually the operations and balance sheets of much of the economy are directly or indirectly leveraged to those variables. That is why, when that variable finally reverses, the damage can often be much greater than anyone expected, mainly because no one understood the extent of the implicit and explicit

exposures. Decades of surging property prices, expanding liquidity, and contracting credit spreads in China have created an economy in which balance sheets have highly correlated mismatches and distortions. In that case, the impact of an eventual reversal is brutally hard to predict. So what about the response? Well, three weeks ago, wanted to become clear that China was entering another period of economic distress. Chinese leaders vowed to provide more support. The Politburo pledged to spur consumer spending, tackle unemployment, and backstop the property sector. However, details were sorely lacking. The Politburo's statement acknowledged that the economic recovery after reopening was making, quote, torturous progress and that it was necessary to, quote,

actively expand domestic demand and expand consumption by increasing residence income. Julian Evans-Prichard, head of China economics at Capital Economics, lamented the lack of a clear plan. He said at the time, given how bad things are at the moment, it is a bit disappointing that they didn't give us some figures. And while their statement did recognize the risk to the economy, Evans Pritcher said, quote, they are not so desperate that they feel the need to resort to the old school Big Bang stimulus. What he's referring to is that during prior downturns during the 2008 global financial crisis and the 2012 euro crisis, the CCP was eager to dole out massive stimulus on the supply side. The Chinese government directed the stockpiling of commodities and gigantic infrastructure projects

to keep growth ticking over at a fast pace despite global economic turmoil. This time around, as of yet, there is no clear policy, just haphazard emergency interventions. For example, the People's Bank of China has cut rates, but there's a limit to what monetary stimulus can do to support consumption. This time, the problem is deflation, a collapse of demand. Until now, Chinese policymakers have largely been able to keep the economy out of the ditch using only supply-side stimulus. but it's not clear that that will work again.

Late on Monday, Kai Fang, a member of the Monetary Policy Committee at the PBOC, warned that emergency rate cuts would not be enough. He said, The most urgent goal now is to stimulate household consumption, and it is necessary to use all reasonable, legally compliant, and economic channels to put money in residence pockets. Fang joins a growing chorus of economists insisting on direct transfer payments to consumers in order to support spending.

This option has been controversial with senior Politburo figures, however, and so far Beijing has ignored the suggestion. Many have suggested instead that tax and fee cuts for companies were the most direct, fair and efficient way to stimulate the economy. Senior party members also have a history of warning against the, quote, trap of welfareism, wanting to ensure that Chinese citizens accumulate wealth through hard work rather than government handouts. Of course, the concern is that the underlying problem might be a simple lack of capacity. China's government resources are distributed through numerous local governments. These governments typically raise funding through land sales, but with the property sector in trouble, this line of revenue is less viable.

There has also been an ongoing dispute between the Central Party and provincial governments. During the turmoil of the last few years, Beijing has been reluctant to come to the aid of over-indebted regional governments. Estimates vary wildly due to the large amount of off-balance sheet liabilities, but Goldman Sachs analysts think there could be as much as 13 trillion in debt held by local governments. China's GDP is around $17 trillion annually, so there could be significantly less fiscal space for stimulus than the publicly disclosed figures imply. Liu Chow, Professor of Finance at Peking University, said, The debt problem of some local governments is relatively serious now.

The primary issue to consider at this time is not the moral hazard, but rather stimulating economic growth, repairing the balance sheets of local governments, and gradually restoring the ability of local governments to repay debts. Now, as you might imagine, overarching all of these economic problems are the very real political considerations. Tensions around the rule of President Xi Jinping have started to come to a head around the financial turmoil of the last two years.

For the first time, we've seen evidence of open protest against she on the mainland. Now, of course, it's impossible to tell how widespread the antipathy towards she is, but it's hard not to view at least some of the events of the last couple years as cracks emerging. And so really where we're left, to do a very brief summary, is a situation in which a set of challenges are converging all at the same time. And there are a set of challenges not necessarily easily solved by old techniques. Officials are caught between wanting to run back the old playbook and trying to figure out if there's a new playbook that'll work better.

Michael Pettis again wrote, What got China into this mess has been over a decade of massive amounts of investment in unnecessary infrastructure and empty apartments. If this investment had been economically justified, rising debt would have been more than matched by rising productive capacity in GDP, which means local government debt would have never become the problem it has clearly become. I understand why many policy advisors are so worried about China's economic slowdown, that they are turning again to the old policies that boosted GDP in the past.

but more of the same won't get China out of the mess that more of the same got it into. Now, of course, outside of China, the big questions are how a Chinese recession or slowdown or even financial crisis will impact the global economy. One thing that some observers have noted is that we haven't had a normal business cycle recession in so long. In other words, we haven't had a downturn precipitated by anything other than a financial crisis for so long that we kind of don't know how to handle it. We don't really have a playbook for what to do with it. at least not one that's been updated recently. To some extent, I wonder if the not-knowingness

of the situation is contributing to the anxiety around it. But as with any macro topic, it is an extremely dense, complex, nuanced, intertwined set of issues, and so the best we can do is keep trying to keep track of it and re-contextualize as new events teach us more about what's happening. Hope this was a helpful primer, at least a little bit, on what's going on. Until next time, peace.