The Great Fall of China?

By Portfolio Manager, David Ruff

In correction mode since mid-Summer, global equities slumped 10.12% for the three months ending October 27th.  This exceeds the downturn earlier in the year from February 2nd through March 15th when the MSCI ACWI IMI Index fell back 7.81%.  Of course, Israel’s War declaration, in response to Hamas’ terrorist acts of October 7th, and a potential widening of the conflict, put the markets on the defensive over the past few weeks, but equities started their downward trek earlier.  The initial trend reversal in late July rested on many of the same reasons for the earlier decline.  Notably, another interest rate spike induced renewed concerns about US economic resiliency and banking system health.  With this adeptly addressed in ACM’s latest quarterly commentary by Chief Investment Officer, Dr. Charles Lieberman, I’ll focus on the newer equity market worry expressed by several market pundits, namely, the lack of meaningful recovery in China’s economy signifying a much deeper problem.  Specifically, they warn the troubled real estate market heralds a Chinese financial system melt-down, causing another “Lehman Moment,” with the resulting turbulence bringing down the global economy.  Our answer?  Succinctly put, no, we will not see a “Great Fall of China”.

This concern of many is understandable.  Although it’s the world’s second largest economy, China contributes most to global economic growth.  Accounting for more than 28% of global manufacturing output, countries depend on China’s large import demand for a wide range of items ranging from commodities to integrated circuits.  For example, the country processes over 55% of the world’s aluminum and copper, 40% of the world’s semiconductors, and 18% of the world’s pharmaceuticals.  Also, despite all the talk of decoupling, de-risking, and diversifying supply chains, global dependence on Chinese exports continues to grow in key areas.  Specifically, being the world’s “refinery”, with the most extensive and scaled processing infrastructure, few alternatives exist outside China for many newer industry inputs and components.  Examples include pulverized cobalt for electric vehicle batteries (70% supplied by China), refined graphite for advanced aerospace (90% supplied by China), and processed rare earths for semiconductors (95% supplied by China with several exclusively supplied).   Easy to flip away from China in areas such as toys, clothing, and furniture, creating alternative supply chains for these more advanced industries will be a much greater challenge.  Extensively integrated through trade and investment in these advanced areas, foreign jobs dependent on China are likely to grow from the currently estimated 38 million.  Clearly, a sputtering of this economic engine could cause extensive damage to world economic development. 

It’s fair to say a mini-real estate market crash already occurred in China.  Back in 2021 several prominent developers went into distress, including Evergrande Group.  To understand this situation, we should go back to the beginning.  Landmark law changes in 1994 altered China’s real estate development landscape forever.  The central government took away local governments’ abilities to tax and issue bonds, but granted them the right to issue long-term land leases.  Selling land-use rights became the primary source of revenue for local governments, and with developed land much more valuable than raw land, local officials became powerful drivers of development, attracting industrial and commercial companies to build factories and infrastructure such as roads, bridges, and hospitals in their jurisdictions.  Beginning in 2008, the industrialization craze gave way to residential development, and many local governments became joint venture owners in those businesses.  In effect, local governments became equity owners, actively seeking venture capital financing for commercial and residential development.  Developer profits exploded, utilizing inexpensive construction materials, low-cost labor, and cheap financing.  In partnership with the local government, developers were able to ignore the risks of over development because officials purposely limited land sales to keep existing values high.  Land values in some jurisdictions increased eighteen-fold, and of course, residential home prices soared.  Unsurprisingly, this gold rush bred undisciplined and even unscrupulous behavior. Developers hoarded land and construction materials even before the announcements of new projects.  Not wanting to be limited by bank lending, they skirted lending limits by using local government financing vehicles (LGFVs), known as shadow banking.  They used this debt to expand into unneeded, high-end property projects and aggressively invested in non-real estate areas.  With increased debt loads, which seemed to be a matter of pride, they became the most indebted companies in the world and lost focus on their primary businesses.  Enter the central government with a pronouncement in late 2020 that homes are to be lived in, rather than built as speculative investments.  Although not everything about LGFVs has been bad, Beijing identified the long-term risks of this unbridled debt accumulation and imposed new restrictions which reduced the speculative demand for property.  Predictably, and, amplified by Covid, property sales turned down, declining 2.59% in 2021, but a number of tier-1 cities saw sales decline even more steeply, ranging from 30 to 60 percent. 

This, of course, fueled the “Great Fall” debate, with many pessimists arguing China’s government needed to do more to help these developers, even suggesting China may lack the necessary resources.  I believe this shows a lack of understanding.  In terms of resources, with over $12 trillion in net assets, China’s central government has one of the strongest balance sheets in the world.  The question is not whether Beijing can bail out these developers, but whether it’s willing to do so.  Beijing believes that it’s best to let these firms fail in order to curtail the shadow banking sector and remove moral hazard in the process.  That is, signal to investors they need to do due diligence.  Don’t count on the state to save them from poor corporate management.

Although these declines impacted the general property sales data, the developers had focused mainly on the tier-1 cities, a relatively small proportion of China’s population and area.  The latest 2023 GDP figures show property investment down 9.1%, but overall GDP still grew at a 4.9% annualized rate.   Many fear, however, that real estate weakness could broaden and cause the entire economy to stumble.  They argue the rapid home property price appreciation produced an overbuild, which will proliferate into a classic real estate bubble similar to those suffered in Spain, Japan, and the US.  They highlight, for instance, that although slowing over the last 10 years to a more modest 6.6% per year, tier-one city home prices quadrupled in the 10 years ending 2013.  This made Beijing and Shanghai home prices comparable to those in Boston, but these Chinese city residents earn vastly lower incomes, averaging just 30% of Boston resident levels.  In response to the price surge, the country added residential housing stock at an annualized double-digit growth rate over the last two decades. 

Unsurprisingly, property assumes greater importance in China, impacting all the major actors – consumers, companies, and the state.  Property accounts for 43% of household assets, compared to 28% in the US and 19% in Japan.  Importantly, real estate plays a major role as collateral for financing, not just mortgages, but corporate debt and shadow banking (off balance sheet) loans for businesses activities outside real estate.  Further, as mentioned above, land sales serve as a crucial revenue generator for local governments.  Although not reflected in the official data, indirect impacts suggest that construction accounts for 30% of China’s GDP, compared to 16% in the US and 12% in Japan using the same methodology.  China’s total real estate value measures almost twice that in the US, reminiscent of Japan’s property market in the early 1990s before its housing bust.  Now, Japan’s real estate market value totals 42% less than that of the US.  Due to corporate financial linkages, and extensive international trade linkages, doomsayers warn a comparable crash in China’s property market heralds an ominous development for the world.

Before we assume financial Armageddon, we need to know whether all this construction, and related price increases, constitute a housing bubble that may burst at some point. A look at the details shows that the market’s growth has been fairly closely matched to income growth in most of the country. And because residential real estate is five times larger than commercial and office real estate put together, we need just look at those markets.  First, we need to remember that China’s property market was born just 25 years ago when the final pieces of the legal framework for private property ownership were put in place.  Previously, most city dwellers worked at SOEs (state-owned enterprises) which allocated no-frills housing to employees.  Given the early stage of the market, a significant resale market has not yet developed, so price statistics almost completely reflect new builds. This makes country-wide house price statistics misleading in comparison to developed markets.  Once property rights were established, developers understandably focused on the most lucrative neighborhoods first, such as the east side of Beijing.  The increase in reported house prices reflects this choice, but it does not capture price changes on comparable properties across time.  Moreover, researchers, looking at micro-level mortgage data from the period 2003 to 2017, a period registering China’s fastest home price appreciation, discovered that although home prices appreciated on average 350%, the proportion of mortgage loan value to home buyer annual income remained relatively steady.   While it is the case that in the top four tier-1 cities of Shanghai, Beijing, Guangzhou, and Shenzhen, property values outpaced income levels, the population in these cities amounts to only seven percent of China’s total.  Approximately 58% of the population live in lower-tier cities where property values-to-income ratios either stayed flat or even fell.  This is not surprising, given these lower-tier cities experienced faster growth in affluent households (net worth over $900,000).  Thus, the bubble condition of insufficient home buyer income relative to the size of the mortgage, which helped lead to the US Global Financial Crisis and Japan’s price bubble burst, does not currently exist in China. 

Cultural factors should also be considered.  China citizens save at higher rates than in many other countries, and this raises their ability to service mortgage debt.  Using this mortgage debt serviceability metric, China ranks second best in the world, and multiples better than the US, Japan, and Spain before their real estate crises.  Also note that while China’s home ownership rate at over 90% is considerably higher than that in the US (67%), China’s rate reflects the alternative of bare-bones government housing.  Residents want to move out of these cramped quarters, and this has added to the incentive to save a high proportion of income.  Additionally, demographics and the one-child policy increased the importance of owning a home.  Because families restricted to one child preferred boys (believing this gender would be better able to support the family), the resulting gender imbalance gave women more bargaining power in the marriage market.  A male courting a bride had better own property, or she’ll say “I don’t”.  Consequently, potential grooms, and sometimes in a joint effort with their future spouse, strive to save to accumulate a down payment, which can be 35% of home value in some major cities.  This also led to the “six-wallet” home phenomenon: couples, who could not afford the down payment on their own, asked the in-laws for help.  In short, owning property, even for young adults, remains a quest in China, much more than millennials in most other countries, and this will likely sustain demand for residential real estate.

Going forward, China’s home price appreciation rates will fluctuate, and will certainly slow longer-term, but they are unlikely to collapse, given the strong underlying fundamentals for most of the nation.  The tier-1 cities mentioned above have seen little home price growth over the last 12 months, because they are already at high levels, but their cosmopolitan status and perceived aspirational destination by Chinese and foreigners alike, suggests low probability of a meaningful price dive.  Finally, with over 490 million people still living in rural and small communities in China, we look for the urbanization trend to continue, providing ongoing support for property development and home prices overall.

Finally, we’ve heard these gloomy predictions regarding China’s property market before.  More than two decades ago in 2001, Gordon Chang published “The Coming Collapse of China” where he predicted a property implosion ending China’s modern state within 10 years.  There have been regular articles warning of systemic risk from an impending property bubble, looming banking crisis, or shadow banking debt mountain.  This commentary moniker, “The Great Fall of China”, was first coined by the Economist in 2004 and reprised in 2015.  It may be a catchy title, but it hasn’t been prescient, as a full financial crisis has failed to materialize, and remains unlikely to for some time due to the unique aspects of this political market economy.

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