9 mins read . 29 Aug 2023
The general assumption was that once the pandemic restrictions were done and dusted, China would lead the global growth. That is not what is happening. China may have made its own set of mistakes like trying to get too insular and taking the US head-on. However, that is just the symptom of a much deeper crisis that has currently enveloped China. Real estate companies are becoming a major embarrassment for China and Evergrande may just be the proverbial tip of the iceberg. Consumer credit is tight. Banks with cash are not willing to lend. The more aggressive financial players are not being allowed to lend by the Chinese government to avoid a credit bubble. But at the base of all these apparent problems, there is a more structural challenge that China faces; but more on that later.
These analogies have been going on for a long time since, like Japan, the Chinese growth was also led by the real estate sector. However, that is where the comparisons may end. The biggest challenge that China is facing today is a squeeze on credit. Look at the contrast with Japan in the 1990s. In Japan, during the 1990s, most of the large and mid-sized companies paid down their debt to improve their chances of survival. In contrast, Chinese companies and even retail households are cutting borrowings due to a lack of confidence in the growth engine. Look at the numbers. Yuan loans fell by 90% in July 2023. This is the antithesis of a credit bubble and in terms of impact on jobs and income, it can be a lot worse. Today, what China is facing is a debt-deflation loop, where weak credit demand has notoriously combined with a low-risk appetite.
For the last 25 years, and especially since 2008, China was the undisputed driver of global growth. It not only contributed the most to incremental dollar GDP but also offered the biggest global market for almost every conceivable consumer and industrial product. That is what is hurting since scores of countries across Asia, Latin America and Africa had literally made their fortunes exporting commodities to China. In June 2023 quarter, the yoy growth in Chinese GDP was 6.2%, which is misleading due to the low base. QOQ growth, which is more reflective, has faltered in Q2 from 2. A better picture would be the QOQ growth and that is where the GDP numbers faltered from 2.2% to just 0.8%. Even as India flaunts its demographic dividends, China is facing record levels of youth unemployment. The PBOC, the Chinese central bank, can cut rates to boost growth, but it is worried that in reality it may just end up triggering another credit binge and worsen the current crisis.
Why does the real estate sector have an oversized impact on the Chinese economy? That is because its contribution to the Chinese economy is also oversized. Even today, about 30% of China’s GDP is accounted for by real estate and that is not a very comforting feeling. In fact, a major chunk of household wealth in China is parked in real estate. With real estate prices slumping, most loans are already facing negative equity (where the outstanding principal on the loan exceeds the value of the property). When this happens to commercial property, it is the tipping point for defaults.
There have been several large defaults in the China real estate market. Evergrande was the first big casualty and not another big Chinese realty name, Country Garden, has already skipped coupon payments. Most of these troubled realty names have typically raised funds in China via high yield (junk) bonds where the probability of default or renegotiation is very high, ab initio. Even if you look at countries like Japan and Korea (which had such problems in the past), real estate is less than 20% of GDP. So, Chinese real estate still has a lot of corrections pending. In short, the Chinese economy is going to see a lot more pain in the coming months. PBOC, meanwhile, finds itself in a dilemma. It needs to cut rates to rescue the realty sector and boost growth. But that would worsen the credit binge.
Let us cut to the gist of the point here. Realty and liquidity may be the apparent problems in China but there are deeper structural issues.
China plus one and broadening supply sourcing look positive for India. The Western world wants to spread its bets and this uncertainty is going to benefit India. However, the crisis in China does bring 2 major risks for India.
A weak China could be bad news for India, but a volatile China could be worse. Apple, Tesla, and Boeings making a beeline for India feel good. But a weak China may be a lot worse.