The extreme heat engulfing parts of China is a painfully apt metaphor for the economic temperature in Beijing.
The headlines of recent days can smack of cooling. Case in point: Asia’s biggest economy grew just 0.4% in the April-June quarter from a year ago. It was below forecasts of 1% and a world away from the 5.5% 2022 target.
But it’s the overheating risks emanating from China’s debt markets that are dominating investors’ attention. Some of the most extreme heat is being felt by China Evergrande Group and other property developers facing a mutiny among homeowners.
The problem: many Chinese took out huge mortgages for properties that remain unfinished. Homebuyers are either refusing to make payments or threatening to. This bubble has a number of economists worried China is giving off strong Lehman Brothers vibes as growth grinds to a halt.
Minxin Pei, China expert at Claremont McKenna College notes that confidence in the stability of mainland banks has been “badly shaken” by the failure of several small banks in Henan Province in April.
Since 2008-2009, when the Lehman crisis rocked the global financial system, China has been on a debt binge to support growth. Lots of it was issued by local governments far away from the real seat of power in Beijing. “Many have wondered how long the party could go on,” Pei explains.
Diana Choyleva at Enodo Economics points to another warning sign that things are amiss the globe’s biggest trading nation: mass bank protests in the city of Zhengzhou, the provincial capital of Henan, in recent months to accounts being frozen.
This pushback by “bank depositors demanding their life savings back and condemning government corruption is another manifestation of the huge challenges Beijing faces at present,” Choyleva says. “In China, whose citizens have no chance to express views through the ballot box, domestic bank runs can signal falling confidence in the system Xi tops.”
Clearly, investors betting on Japan-like reckoning in China haven’t made money these last 13-14 years. Time and time again, Communist Party leaders managed to steer China away from the rocks. Beijing did so by pushing China’s debt-to-GDP ratio to the verge of 265%.
Short-sellers who stepped forward to bet against Chinese government debt or the yuan over the last dozen years ended up closing those trades. Here, think hedge fund manager Kyle Bass, founder of Dallas-based Hayman Capital.
But China’s debt challenge is now colliding with two big threats, one from abroad and one homemade.
The first is a global inflation surge forcing the Federal Reserve to make its biggest tightening moves since the early 1990s. The second is President Xi Jinping’s “zero-Covid” lockdowns, which are backfiring—and fast.
For China, any gross domestic product reading under 4% arguably puts the economy in recession territory. Not only is a new Covid-19 wave weighing on China’s outlook, but so is a diminishing returns dynamic that could reduce the power of fresh Chinese stimulus.
More than a decade of generating growth with massive infrastructure projects, many funded at the local government level, has left China with fewer productive projects to order up. Over time, the economic payoff weakens, increasing the costs to broader society.
As Xinquan Chen, economist at Goldman Sachs puts it: “Funds are less of a constraint for infrastructure investment this year, while the bottlenecks lie mainly with project pipelines and government incentives.”
And then there’s Charlene Chu, an economist well known for spotlighting China’s bubble troubles when she was with Fitch Ratings. Now with Autonomous Research, Chu has two big worries about Xi’s economy.
The immediate one is another cycle of Evergrande-like defaults as growth flatlines. The People’s Bank of China could surely try to open the monetary floodgates to avoid contagion. At some point, questions about which companies are too big to fail will pivot to whether they’re too big to save.
The longer-term problem is how debt becomes an intensifying headwind for China’s $17 trillion economy. In a recent appearance on the One Decision Podcast, Chu said “we continue to be in a climate where the Chinese government is growing credit at very, very rapid rates. And longer term, this does have a cost.”
Even if China doesn’t crash anytime soon, Chu says, the debt burden “does start to squeeze overall economic growth. The more you saddle households and businesses with debt the more each dollar or RMB of revenue or income they get from wages is going to repay debt. And that’s not going to consume goods, it’s not going to new capital expenditure to drive growth and business.”
China, Chu notes, “is in a situation now where the debt bubble continues to grow and it is I think one of the structural issues that is weighing on Chinese growth.” She adds that it’s “one of the reasons why we think we are entering an area here where we are going to be looking at low to mid-single-digit growth in China at best as the country really starts to slow down from this.”
Many bearish short-sellers will attest that Xi’s government is skilled at confounding the naysayers. Yet his financial rescue team really has its work cut out as Lehman comparisons make the rounds in investment circles.