This is Dominic Pino filling in for Noah Rothman filling in for Dominic Pino filling in for Jim Geraghty. Jim will be back tomorrow.
On the menu today: China’s economy. Again. It’s worse than before.
China’s Economic Slippery Slope
In only the past week, since I last wrote this newsletter about China’s economic problems, those problems have gotten worse. China’s struggles are all over the financial press right now, with little crossover into more mainstream journalism. Many American politicians continue to operate under the delusion that China is an economic powerhouse managed by genius technocrats who, despite their authoritarian tendencies, get results. It’s worth countering that narrative. As the economies of the free world continue to recover post-pandemic, China’s is sliding the other way.
The Economist summed it up this way on Thursday: “China’s export boom is long over. Its property slump is not. And, therefore, deflation beckons.” The value of Chinese exports has declined by 14 percent this year, and consumer-price inflation is now negative. Coming back from the most draconian Covid lockdowns in the world has been extremely difficult. Yet again, the short-term “effectiveness” of authoritarianism turns out to be a longer-term curse.
Chinese banks made fewer loans in July than in any month since the global financial crisis, Bloomberg reported on Friday. Forecasters had been expecting 780 billion yuan in new loans in July. China reported less than half that much. That means the interest-rate cuts the Chinese central bank has implemented to lower borrowing costs and increase demand have so far completely failed. And remember, China is pursuing rate cuts while most other major economies are keeping rates higher to counteract inflation.
The Chinese housing market is in deep trouble because buyers are now expecting prices to fall. Why buy now if you think prices will be lower in a few months? That becomes a self-fulfilling prophecy when, a few months from now, sales remain weak and buyers wait a few more months, then a few more, etc. The Wall Street Journal reported that cities have offered “measures including cash subsidies and tax rebates on home purchases, raising limits on how much home buyers can borrow from banks, and removing restrictions on additional home purchases.”
In the past, property developers have also tried to sweeten the deal for homebuyers by offering perks such as free parking and appliances. “Property agents said that has trained people to expect such freebies, and sales decline whenever the deals go away,” the Journal reported. The deals have gone away. China’s property developers are in big financial trouble, and they can’t afford to offer bargains right now.
China’s largest property developer, bucolically named Country Garden, is on the brink of default. Its bonds are currently trading at less than 10 percent of their face value, and the company said this morning it is trying to extend the maturity date on a $537 million payment due on September 2. Bloomberg reports that Country Garden “had 1.4 trillion yuan of total liabilities at the end of last year. To put that figure in perspective, it exceeds the annual economic output of a long list of countries including Kuwait.” The firm has four times as many projects as China Evergrande Group, which is itself a massive property developer and defaulted on its debts at the end of 2021.
Country Garden’s sales were down 34 percent year-over-year in July, and the company missed a major bond payment this month. “Even if Country Garden makes the late payment, it would only be delaying what appears to be inevitable,” reports the Financial Times. According to Morgan Stanley analysis, the company is burning 3–4 billion yuan in cash each month just to stay afloat. Its exposure is worse than that of other property developers because many of its projects are in third-tier cities, some of which are sitting largely empty as a result of central-planning errors.
Then there are the problems with Zhongzhi Enterprise Group. With assets over 1 trillion yuan, it’s one of the biggest “trusts” in China, which are shadow-banking firms that are secretively managed and drive much of the country’s finance industry. The lack of transparency makes it difficult to discern exactly what the firm’s problems are. But we do know it is missing payments on many of its investment products and the Chinese government has created a task force to investigate it.
Zhongzhi is so concerning because of possible financial contagion. Chinese trusts are involved in property development, bonds, equities, and commodities. They pool money from household savings across the country. Major failures of trusts could snowball into much larger problems. The Chinese government is already struggling to restore investor confidence in Chinese markets. Trusts were seen as safe, and if they fail, investors could conclude nothing is safe.
Foreign investors are already leaving. Not because of Biden administration restrictions, which are narrowly targeted at specific industries, but because of poor returns and a weak business climate. Bloomberg reports:
The number of active China-focused hedge funds has slipped for the first time since at least 2012, with only five new funds launched this year as of June, according to data from Preqin Ltd. Another 18 funds were liquidated, the data show.
The contraction marks a major shift for offshore China hedge funds, which accounted for almost half of new funds in Asia as recently as 2021 as investors sought to ride the wave of the once high-flying economy and capital markets. Beijing’s crackdowns on private companies in industries including after-school tutoring and e-commerce, along with growing geopolitical tensions with the US, have led to weak returns since then and sapped global investors’ appetite for China assets. . . .
China-focused hedge funds — stock pickers in particular — are facing an unprecedented second consecutive year of losses, according to Eurekahedge Pte data. More than two-thirds of China-focused hedge funds lost money in 2022, while 36% were down a fifth or more. In the first half of this year, 62% of China funds failed to make money, Preqin data showed.
Another contagion risk comes from local-government debt. The Chinese national government has begun sending officials to the provinces to try and shore up their finances. “One Goldman Sachs estimate puts the total local government debt pile at Rmb94tn ($13tn), including the liabilities of the off-balance sheet entities known as local government financing vehicles,” the Financial Times reported. That debt has been used to build infrastructure and boost GDP numbers in the past, but the bill is coming due now. China’s opaque financial-reporting standards make it difficult for outside observers to know exactly what’s going on. But we do know that slowing economic growth and a shrinking population are going to make it much harder for China to repay its massive local-government debts without significant changes. And there will be plenty of infighting within the Communist Party about which officials will bear responsibility for the failures that are on the horizon.
Much is made of U.S. dependence on Chinese goods, but trade is a two-way street. As the Journal reported on Wednesday, “China has at least a 70% dependence on about 412 items imported from the U.S. and allied countries, at a value of roughly $47 billion annually, according to the analysis. Beijing lacks ready-made homegrown alternatives for many of the items.” The dollar value is small compared to total trade. What matters is that it includes certain key goods, without which entire Chinese industries couldn’t function. For example, China imports nearly all of its silver powder, which is necessary to make solar panels. Nickel powder for batteries and electrical components comes almost entirely from Australia, Canada, and the U.K. A type of traditional Chinese alcohol is made from sorghum, two-thirds of which is imported from the U.S.
Of course, China’s economic problems also pose a downside risk for some U.S. companies that do business there. “The slowdown is registering in earnings results across a range of companies, from chemical giants DuPont and Dow to heavy-equipment suppliers such as Caterpillar,” reported the Wall Street Journal this morning. But some U.S. companies, such as Marriott and Starbucks, are seeing growth in China because the tourism and hospitality sector is doing all right. And large U.S. firms almost always have exposure around the world, so they have the ability to adjust when one country struggles.
The West is facing its fair share of economic struggles, but there’s no Western economy facing anything like what the Chinese economy is currently facing. Relatively free markets, with relatively little government direction, are proving to be better performers post-pandemic than the alternative Chinese model.