How serious is the current economic crisis in China?

20 Aug 2023 , 09:13 AM

Firstly, there were the sanctions and the counter sanctions between the US and China under Donald Trump. This was followed by the pandemic, where China suffered a big economic hit as its growth engine faltered. Its performance as the nucleus of the global supply chain did not leave too many nations pleased. Then there were the first signs of a crisis when Evergrande, the Chinese real estate giant, came close to imploding under a pile of bad loans. Now, there is talk of a prolonged slowdown and growth squeeze in China. In reality, a lot of this could be speculation since China has never been too transparent with its data. However, China is the second largest economy in the world and a crisis in China is nothing short of a global worry. But first, a look at how the crisis evolved in China.

Problems in China credit data and GDP numbers

In the last few days, the Chinese credit data and the GDP numbers have been rather disappointing, indicating that the problem is gradually getting bigger. Credit released last week by China showed a plunge in new loans amidst fears of a major property crisis. In fact, the credit data showed a slump in demand from businesses and households to borrow money for the future. Experts believe that the property bubble in China today may be similar to Japan in the late 1980s. however, there is a difference in how individuals and businesses have responded to these concerns. In Japan, during the 1990s, corporates paid down their debt to improve their chances of survival. In contrast, Chinese companies and households are cutting their borrowing due to a lack of confidence in the growth engine.

Some of the credit numbers from China indicate a sharp squeeze. For instance, new local currency bank loans fell 89% in July 2023, compared to June. This is the lowest level since the aftermath of the global financial crisis in 2009, which shows how serious the problem of weak loan demand is in China. It is said that if credit bubbles are bad and can be inflationary, then weak credit demand is worse, as it can be deflationary. That is a risk which even Morgan Stanley has highlighted in its report. According to a Morgan Stanley note, “China faces a high risk of falling into a debt-deflation loop.” It is often a lethal combination when weak credit demand is combined with low risk appetite. 

Let us turn to the other data announcement of GDP growth. For the June quarter (Q2), China’s GDP grew by 6.2% yoy, but that is misleading as it is on a very low base. A better picture would be the QOQ growth and that is where the GDP numbers falter. If you compare QOQ GDP growth, then Q2 is just 0.8%, compared to 2.2% in Q1. China has more problems as youth unemployment in China is touching new highs. There is also a policy dilemma that China is facing. One way to boost the economy is through a series of rate cuts but the Chinese central Bank (PBOC) is wary of such a move as it would again lead to a credit binge and result in exacerbating the debt crisis, already rampant in China. 

Real drag is not GDP but real estate debt

In a sense, the weak GDP growth is just a manifestation and not the problem. The real problem in China is the crisis in real estate sector. Here is why. Much of household wealth in China is parked in the real estate sector. With a slump in real estate prices, loans are likely to end up with negative equity. That is normally the tipping point for a slew of defaults by borrowers. That could virtually drag the entire Chinese economy down. Evergrande was the first big realty name in China to totter and now another premier real estate developer, Country Garden, is also in trouble. Country Garden has already skipped coupon payments on two dollar-denominated bonds and has just suspended trading on 10 of its yuan bonds to avoid the volatility in pricing. Most of the real estate developers have raised funds in China through high yield (risky) bonds where the probability default or renegotiation is very high.

The real estate sector predominates the Chinese economy. Nearly 30% of the Chinese economy is accounted for by the real estate sector. It was much higher about 3 years back, but if you look at benchmarks, then even 30% is too high. Both, Japan, and South Korea, which have gone through a real estate valuation crisis in the past, today have real estate that is about 20% of the economy. If you use that as the benchmark, then there is more of valuation downgrade that much happen in China. However, that will come with a lot of pain and substantial collateral impact on household wealth and solvency of banks.

Why real estate is the Catch-22 for China

As the real estate sector finds itself in the midst of a crisis, the Chinese government finds itself in a real Catch-22 situation. In 2020, Beijing began a serious crackdown on developers with high reliance on debt for growth. However, that triggered a crisis, including Evergrande, and forced the Chinese authorities to go slow. To ease the problems for the real estate sector, the government has since slowed down on such crackdowns. However, that has not been sufficient. To give a boost to the real estate sector in particular and the economy in general, the PBOC needs to cut rates aggressively. 

And therein lies the Catch-22 situation for the Chinese government. It can revive the economy with easy lending and a liquidity boost through rate cuts. However, while that will provide some temporary relief for the economy, the lower rates and easy credit will also result in a credit binge. Considering the proclivity for the Chinese to borrow when rates are low, it could exacerbate the very debt crisis that the government is trying to solve. For the Chinese authorities, it is really a very tough choice. Either ways, it is likely to only worsen the economic crisis. The irony is that the more the government tries to help the real estate industry, the longer it would take for the industry to find a reasonable bottom.

But, there are structural problems too in China

Economists and journalists are gradually around to the point of view that the problems in China are not just about real estate or liquidity. It is a lot more structural in nature. For a long time, China became the factory to the world and was the nucleus of the global supply chain. It played that part to perfection. In the last 4-5 years, China has been becoming increasingly insular and unilateral in its decision making. That has not gone down too well with the global markets. That, in a way, has triggered a host of structural problems for the Chinese economy. 

1. Some of the major structural changes that China faces today is an ageing population, a shrinking work force and sharply falling productivity. These are structural problems, irrespective of what the world is doing. This has been worsened by the restrictions on transfer of technology by the US and the consequent insular approach adopted by China. Clearly, China does not look like it is returning to 10% growth (like during the 1980-2010 period), anytime soon. 

    

2. Ther is an unwillingness to spend among households and companies in China. Not only has household consumption growth slowed, but even the corporate spending, especially on capex, has slowed considerably. That has been a major trigger for the tapering growth in China. Above all, trade which was at the centre of the China story, has fallen sharply in the aftermath of the pandemic.

    

3. China is faced with falling consumption and rising savings. That means, the Chinese households and companies are going to be left with a lot of spending power in the coming quarters. But that will translate into spending and productivity only if the consumer and corporate confidence in the Chinese economy comes back. For now, that appears to be missing in the China story.

    

4. Many economists feel that China finds itself in a classic pre-deflation trap. Here is why. The falling retail prices may force households to postpone consumption on expectations that goods would become cheaper tomorrow. That reduces consumption and economic growth. Deflation expectations are very strong. Also, inventories at most businesses are at peak levels, so the investment outlook is still ambivalent.

In short, the problems in China are not just about real estate and macro policy. It is about larger issues like productivity, demographic challenges, and deflationary expectations.

What does the China story mean for India?

The emerging situation in China can actually be a mixed story for India. Here is why.

• On the positive side, this is likely to reinforce the China Plus One story. India has already seen companies like Apple and Boeing, and even Tesla, looking at India as a manufacturing alternative to China. The developed Western world wants to spread its bets and this uncertainty is going to be a major advantage for India.

   

• However, China is not just the producing factory of the world, but also the consumption factory. Today, China accounts for 50% of the global demand for steel, aluminium, and copper. A weak China would mean the prices of these metals could fall sharply and that would hamper the profitability of the metal and mineral companies in India.

   

• Last, there is a more geopolitical concern. India has been surrounded by volatile neighbours and the last thing that India wants is an economic unstable China. After all, even today, China contributes the maximum to absolute accretion in global GDP

To sum it up, a weak China could be bad for India, but a volatile China could be worse. If China slows, as it looks likely, India may not have too many reasons to celebrate.