China: fear or FOMO?
Henry Kissinger, in his 2011 book ‘On China’ discusses China's predilection for realpolitik, where outcomes of a conflict is not an all or nothing clash; multiyear manoeuvres are typical of the Chinese style. Where “Western tradition prizes a decisive clash of forces, common Chinese ideals stress subtlety, indirection and the patient accumulation of relative advantage.” He says this is reflected in China's most enduring game “wei qi” (colloquially known as Go), and translated as a “game of surrounding pieces.” Wei qi is about a protracted campaign and accumulating relative advantage. Chess, closer to the Western tradition, is about total victory. Checkmate. Apropos, is China’s current approach to remedying the state of the real estate sector. As Baillie Gifford recently identified in a market note about China “fear or FOMO?”, focusing on China's risks could lead investors to miss out on plentiful growth opportunities.?
Fear of China is tempered by a fear of missing out. China remains a major global economic player, contributing more to global growth in the past decade than the entire G7 combined. Its stock market is the second largest in the world and China leads in 37 of 44 critical technological sectors, including robotics, energy, and quantum technologies. It also has more 5G base stations than the rest of the world combined, with over 60% of global 5G users. Despite high carbon intensity, China has more renewable energy capacity than the next seven countries combined and dominates global supply chains for electric vehicles, solar, and wind energy.
China is working to improve relations with the West, particularly the US. During the APEC summit in San Francisco, President Xi emphasised peaceful relations and announced plans to invite 50,000 young Americans to China for exchange and study programmes over the next five years. Xi highlighted the importance of fostering people-to-people ties and expressed China’s readiness to be a partner and friend to the US, including cooperation in fighting fentanyl.
Recently fear of missing out is being replaced by just moving out. Credit Suisse, Deutsche Bank, Goldman Sachs, and HSBC reported losses in their China-based units, while Morgan Stanley's profits declined. Only JPMorgan and UBS saw profits rise among seven Wall Street and European banks with investment banking units in mainland China, although HSBC's unit reduced its losses compared to previous years. Western banks have invested in small, often unprofitable operations in China, hoping to establish a presence in the world's second-largest economy. As reported by the FT, US law firms are also closing their offices in Shanghai due to a lack of financial activity and depressed business sentiment. Recently, firms like Sidley Austin, Perkins Coie, Latham & Watkins, and Orrick have closed or announced plans to close their Shanghai offices. A position paper by the British Chambers of Commerce in China noted a 16% decline in foreign law firms with representative offices between 2017 and 2022. Additionally, 70% of professional services firms reported that last year was more difficult than 2022. Other financial groups have also closed their offices in Shanghai in recent years, including the Norwegian sovereign wealth fund Norges Bank Investment Management and UK wealth manager St. James’s Place.
As the US reduces investment in China, Gulf Cooperation Council (GCC) countries are increasing their investments due to improving diplomatic and economic relations. The six GCC nations—Saudi Arabia, Kuwait, the United Arab Emirates, Qatar, Bahrain, and Oman—possess sovereign wealth funds totalling an estimated USD 4 trillion, with less than 2% currently invested in Asia, including China. This is expected to change, with GCC investment projected to grow to USD 10 trillion by the decade's end, potentially allocating USD 1-2 trillion to China by 2030. Some investments may circumvent US restrictions by repackaging through financial hubs like the UAE. Illustratively, The Abu Dhabi Investment Authority (ADIA) is taking advantage of Western investors' withdrawal from China by purchasing stakes in funds managed by Hong Kong-based PAG at a discounted rate. This move reflects Gulf investors' eagerness to acquire discounted assets, with PAG recognised for providing access to Chinese deals. This offers an exit opportunity for investors reducing their exposure to China.
Future investment returns may pivot on one sector: real estate. China faces significant challenges in the sector although it is actively implementing measures to address the crisis. Since late 2023, the People’s Bank of China has increased liquidity to stimulate growth, and in May 2024, Beijing announced a major policy shift to rescue the debt-ridden property sector. The scale of the issue is substantial, with estimates suggesting that at least 2 trillion yuan (￡220bn) would be needed.
One proposed measure involves the government acquiring unfinished projects from developers and transforming them into social housing. This initiative, managed either by the central government or supported by local authorities, aims to withdraw inventory from the private housing market and increase social housing availability. By leveraging the government’s access to cheaper funding – the central bank will offer cheap loans worth up to 300bn yuan (￡34bn) to banks which will then lend to city-owned enterprises, which in turn will use the funds to purchase finished but unsold flats from property developers which can then be sold or rented at below-market rates to low-income buyers – this strategy not only addresses stalled construction projects but also increases affordable housing stock, providing relief to low-income families and potentially stabilising the housing market by reducing the oversupply of private homes.
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Another strategy includes converting unsold properties in the secondary market into rental housing. Cities like Suzhou, Taicang, and Zhengzhou have already explored this approach, with local governments purchasing these properties from homeowners, who are then required to reinvest the proceeds in larger homes. The government repurposes these properties into rental housing using low-cost funding from the central bank or government, aiming to ease pressure on homeowners to reduce prices while increasing rental housing availability. This strategy helps stabilise the market by shifting inventory from homeowners to the government.
Stabilising the real estate market is essential for China's overall economic health. Addressing surplus inventory and increasing affordable and rental housing can support both developers and homeowners while providing relief to low-income families. In the long term, these measures could lead to a more balanced and sustainable housing market. The focus on affordable and rental housing aligns with broader social and economic goals, such as improving living standards and reducing inequality. Involving SOEs and local governments could provide a stabilising influence, mitigating the boom-and-bust cycles that have characterised the sector in recent years. If successful, these strategies could provide a model for the West facing similar issues.
The stakes are high. S&P warns of the possibility of China's growth plummeting below 3% if the property crisis worsens. Property sales have already dipped 30% below the peak reached in 2021. This decline, coupled with high leverage, is straining cash flow and increasing the risk of defaults among Chinese developers. Moreover, reduced land sales are negatively impacting the fiscal profiles of local governments, creating a negative feedback loop.
The pain in the property sector is hindering China's economic recovery, thereby exacerbating the downturn in property sales—a scenario that perpetuates a negative feedback loop. S&P's downside scenario, which carries a 1-in-5 probability, anticipates a further 20%-25% decline in property sales in 2024 compared to 2022. Such a decline could cause China's real GDP growth to plummet to 2.9% in 2024, significantly lower than the base case projection of 4.4%.
China's growth is slowing amid weakening consumer and business confidence, subdued exports, and high corporate and local government leverage. A dimmer growth outlook could exacerbate these challenges. Given China's substantial share of global trade and demand, its slowdown could reverberate across multiple regions. Furthermore, China's already high debt-to-GDP ratio is expected to worsen as authorities aim to restore confidence, likely through additional stimulus measures.
UBS are more optimistic, arguing that the default cycle in China's real estate sector has largely run its course, with most privately owned real estate issuers in the midst of restructuring. They suggest that some select credits within the sector offer appealing potential upside due to distressed valuations and anticipated policy support.
As of the end of November 2023, the China real estate sector accounts for only 1.9% of the overall Asia credit market and 7.0% of Asia high yield, according to J.P. Morgan data.? Looking ahead to 2024, J.P. Morgan’s forecast for default rates among high-yield corporates within the J.P. Morgan Asia Credit Index is 11%, driven primarily by defaults in the real estate sector in China.
Sun Tzu’s most famous work, “The Art of War,” is considered one of the most influential military treatises ever written. He famously wrote "Water shapes its course according to the nature of the ground over which it flows; the soldier works out his victory in relation to the foe whom he is facing." Identifying the range of issues is half the battle. Solving the problem (real estate over supply) by fixing an underlying fault line (economic malaise), albeit by fiat, is sensible.