China's Economy: In Recession? | Read Now

Authored by Sandeep Rao

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Near the beginning of the year, the Chinese government laid out a projection of what its economy would attain, despite not fully emerging from a restrictive pandemic-driven lockdown regime: a GDP growth in excess of 5%. As the year is poised to end, many China watchers hold that this will simply not be met in fact.

A lot of this is being attributed to the change in the operational style of (arguably) the world’s largest “command economy”. The relative “economic liberalism” of the two decades preceding Xi Jinping was alleged to have been rife with often-hidden chaos with murky local government finances, commercial bank loans of questionable quality and an over-indebted property sector, with a vast network of state-owned enterprises and their own relative non-transparency often leaving practically any consideration of China’s economic prospects and investabilty often uncomfortably balanced against the buying power and enterprise of its massive populace.

As of 2022, the International Monetary Fund’s Global Debt Monitor indicates China’s overall debt-to-GDP ratio has increased fourfold since the 1980s. Over half of the increase in the entire global economy’s debt-to-GDP ratio since 2008 is solely due to an “unparalleled” rise in China, according to the IMF.

It is expected that China might have overtaken the U.S. in debt-to-GDP terms in 2023.

Almost two-thirds of the country’s total debt is in the private sector (both companies and consumers) although there is a level of murkiness here, given how some local government debt is repackaged into a vehicle in the private sector. Under President Xi’s rule, the emphasis was laid on bringing about “stability’ at all costs. One example of this was the “three red lines” regulations brought on the real estate sector in 2020. The “three red lines” – signifying the debt, equity and assets for individual companies – was meant to provide a framework to deleverage the over-active property sector. This steadily worsened the property sector’s viability to the point that the Chinese government was forced to begin reconsidering the framework.

The real estate sector was long the harbinger of GDP growth. However, the collapse of some of the country’s (and the world’s) largest property development companies in the year lays bare the shakiness of the sector as a whole. A year where more and more developers turned to offshore bond markets to access financing also turned out to be a year where developer bond defaults so far is currently north of $130 billion since 2020.

Unsurprisingly, Chinese developers now report facing increasing difficulty in accessing financing via this channel. In 2022, apartment and commercial property sales nationwide plummeted by 27%. S&P Global Ratings forecasts for the negative scenario sees the sector’s activity rescind to 2015 levels when China’s economic output was about half its current size. Overall, it is estimated that it will be a multi-trillion dollar slump in sales over the next few years.

If the real estate sector were smaller, this wouldn’t be as grim a problem. In fact, it could be argued as being a net positive since it frees up people and capital for more productive sector. However, China’s real estate sector – as per well-known macro analyst Ren Zeping, former chief economist of China Evergrande Group – is vast: the spillover effect is seen to affect “upstream” industries such as resources and building materials to “downstream” ones including home appliances and leasing. Thus, the sector has gone from contributing 1.6 percentage points to China’s 7% GDP growth in 2015 to pulling down 1.3 percentage points in 2022.

In the current year, even as per the Chinese government’s own statistics, the sector is a net negative in standalone terms.

The drop in sales has even led to the drying of government coffers at the local level. Local governments’ revenues from real estate had already fallen by 23% in 2022. This shrank another 18% in the first 11 months of the year, relative to the same period in 2022.

Through most of H2 this year, foreign investors – typically institutional and advisor-led high net worth players – have been pulling their assets out out of China’s domestic stock market at a rate of $5-8 billion on a net weekly basis for most of the second half of 2023. Note: There are multiple share classes in China. The U.S.-listed companies best known to Western investors are not considered to be part of the “domestic” market.

There have long been doubts in the official statistics released by Chinese agencies. Key towards a consideration of China’s prospects by offshore investors was “empirical” data (i.e. personally experienced fact patterns) or proxies such as ancillary actions. Key among those ancillary actions that triggered a negative outlook on the Chinese economy was the decision by the Chinese government to start debt repayment measures against borrowers of the Belt and Road Initiative (BRI) – mostly impoverished countries unable to access in-demand bonds for global investors as well as a decision to expand fiscal deficit at a time when solid growth was being reported. In 2023, the Chinese economy experienced negative foreign direct investment for the first time since the end of the Cold War and strong reported and unreported capital outflows (the fastest in seven years).

A less direct (but perhaps more relatable) “empirical” data point would be in the likes of the publicly-traded Swiss luxury goods company Compagnie Financière Richemont SA which owns brands such as Buccellati, Cartier, IWC, Piaget, Panerai, Dunhill and Van Cleef & Arpels. Early in November, the company cautioned that economic worries and global tensions were weighing on consumer spending as after the group’s first-half profits missed forecasts . This cautionary note was issued after widely-reported expectations that a post-lockdown China would see luxury goods companies witnessing a surge in revenues. Richemont was purported to be a net beneficiary, given how 30% of Richemont’s sales are in China. In reference to the potential impact of high-end Chinese buyers, chairman Johann Rupert said , “They’re not going out to bust their credit cards”.

All in all, it’s a time for caution when it comes to China. As asset mixes shift away from the “Middle Kingdom”, U.S. equities in particular might be assumed to witness some spikes. However, a resilient fixed income market with particularly favourable rates is empirically seen to be to the detriment of most mid- and small-cap companies’ valuation. Like most of 2023, it can be assumed that such spikes will likely have very little breadth since they will favour the likes of the Magnificent Seven and certain consumer discretionary companies (as an earlier article about S&P 500 trends indicated).

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