China's "Perfect Storm" Economy

It's Not Just Deflation

While the sudden emergence of problems at Country Gardens and Zhongzhi Enterprise Group has captured much media attention, the prevailing corporate media narrative on China has been one of the equally surprising emergence of consumer price deflation.

Beijing’s economic woes worsened last week after it emerged China had fallen into deflation. The news highlights how the country is struggling to live up to expectations of a strong recovery after emerging from extended Covid lockdowns.

Yet deflation is but one of many problems assailing the Chinese economy at present, as recent events have demonstrated:

• China is facing declining demand on the global market for Chinese exports.

• China has a youth unemployment crisis so bad it simply stopped reporting the numbers.

• China’s real estate market has been in a protracted state of collapse since the summer of 2021 at least.

• China’s $3 Trillion “shadow banking” sector is being roiled with a liquidity crisis when Zhongzhi Enterprise Group began missing payments on wealth management products.

Any one of these issues by itself would constitute a major crisis for any economy. China is facing all of them and a deflationary situation at home. Making matters even worse, these crises are of a sort to feed off each other, complicating efforts to resolve any of them.

Can China weather this economic “perfect storm”?

This much is certain: corporate media is having a difficult time apprehending the scope of China’s difficulties. Despite the constant stream of negative economic data coming out of Beijing recently, much of corporate media persists in believing a “too big to fail” narrative about China.

China had some serious problems even before Covid. It had an ageing population and – despite four decades of rapid growth – was still only a middle-income country. Its growth rate was inflated by often wasteful public investment and subsidies to uneconomic enterprises that would otherwise have collapsed.

All that said, a look around the world suggests authoritarian regimes can hold on to power even when growth is weak or inflation is high. Change in China, if it comes, may be gradual rather than rapid and, if so, we should be grateful. The sudden collapse of the Soviet Union was followed by a global boom. The sudden collapse of China would trigger a global slump.

Note the wording of this assessment: China has to succeed because the global economy needs China to succeed. An economic collapse in the Middle Kingdom would have dramatic contagion effects far beyond its borders.

This view fails to appreciate how global integration is a double edged sword. In China’s case, a global slump in demand is contributing to China’s economic contraction.

As early as the beginning of the year, there have been observations that China’s export engine was struggling in no small part to weak global demand.

China’s export growth percentage is estimated to remain in the “low single digits” this year, with the possibility of a pickup in the second half, according to an outlook by Goldman Sachs that comes amid supply-chain disruptions and sluggish global demand.

Andrew Tilton, chief Asia economist at the American investment bank, said on Tuesday that the global economy is “still rotating back to services to some extent”, rather than trade.

“That’s a relatively soft outlook from China’s perspective. Right now it’s very weak,” he said at a media briefing in Hong Kong. “In the electronics and tech areas, people bought a lot of that kind of equipment during the pandemic, and so you have a sort of overhang.”

When customers stop buying producers are in a bind, and China’s customers are no longer buying, certainly not at the levels they have in the past. Thus we have seen China’s total export volume trend down steadily since July of last year.

Making the drop even worse has been the decline in China’s export prices, which turned downward a few months after export volumes began to drop.

Nor is the decline expected to reverse in the immediate future:

However, exports are expected to decline further over the coming months, the analysts said, citing “wider evidence” that global goods demand is falling as pandemic distortions unwind and monetary tightening weighs on consumer spending.

“The near-term outlook for consumer spending in developed economies remains challenging, with many still at risk of recessions later this year, albeit mild ones,” they said.

For the first seven months of the year, China’s exports decreased 5% from a year earlier. In particular, shipments to the United States, China’s single biggest trading partner, dropped 13%.

China’s exports are a reflection of global demand. If exports are down it is in part because, overall, global demand is down. Twin drops in export volume and export prices starve China of important revenues and pressures to increase employment.

It would be an unwarranted extravagance to say that China’s youth unemployment is being driven entirely by the relative collapse in global demand for China’s goods, but it would be naive to presume the two are wholly separate. That the upward trend in youth employment roughly correlates with the declines in exports at a minimum suggests global demand declines are limiting job opportunities for young Chinese workers.

Even as overall unemployment has trended down in recent months, youth unemployment has been trending up since the beginning of 2021, and while the situation had been improving late last year, around the beginning of 2023, the youth employment outlook took a significant turn for the worse, with now more than one in five Chinese between the ages of 16 and 24 are shut out of the work force.

The extent to which decreases in global demand are contributing to rising youth unemployment might be problematic, but what is decidedly less so is the correlation between declining consumer demand overall and rising youth unemployment.

China has released a raft of indicators in recent months pointing to a slowdown in the country's post-Covid economic rebound, with weak consumer demand making firms reluctant to hire.

"Recent activity data generally came on the weaker side, suggesting that the recovery is stalling," Jing Liu, Greater China chief economist at HSBC wrote in a note this week.

"This has been reflected by the labour market data," she added.

China’s National Bureau of Statistics is doing very little to dispel the gloom surrounding youth employment prospects, and recently took the discouraging step of deciding against publishing youth unemployment data for July, citing a need to “improve” the statistics.

Fu Linghui, a spokesman for the NBS, explained it was because the current statistics “need to be improved.”

The number of students in the age group has grown in recent years and their main task should be to study, rather than to seek jobs, he said.

“Whether the students looking for jobs before graduation should be included … is something that people have different views on. It needs further research,” he added.

Defining the age range of “young job seekers” also needs further study, as young people are now spending more years in school, he added.

The NBS will now conduct “in-depth research” to improve its methodology, Fu said, adding that the data will be released again once the process is completed. He did not give a time frame.

What is not in dispute is the grim reality of China’s lackluster economic performance in July.

Consumer spending, factory production and investment in fixed assets all slowed further in July from a year ago, according to the NBS.

Retail sales expanded 2.5% last month from a year ago, slowing from the 3.1% increase recorded in June. It was the weakest growth in consumption since December, when China scrapped its pandemic restrictions.

Industrial production also came in below expectations. It was up 3.7% in July from a year earlier, compared to growth of 4.4% in June.

Fixed-asset investment rose 3.4% in July, compared to the 3.8% growth recorded in June.

Against this broad backdrop of negative economic data, youth unemployment arguably becomes both consequence and cause of many of the lackluster statistics: without job opportunities for young people, the capacity of young people to spend and consume is constrained, which further constrains factory production and minimizes the need for fixed asset investment. At the same time, declines in these areas hinder job opportunities for young people.

Nowhere has the decline in consumption been more dramatic than in China’s hemorhagging real estate markets.

We got even more dour data today. The Chinese National Bureau of Statistics’ new home price data(opens a new window) for July averaged an annualised seasonally adjusted month-on-month decline of 2.5 per cent for the 70 cities measured, according to Goldman Sachs calculations.

Lower-tier cities saw the biggest declines, but the housing downturn is looking increasingly broad-based, with even tier-1 cities like Shenzhen suffering a slight dip in prices. Kelvin Lam from Pantheon Macro notes that 49 out of the 70 cities surveyed saw new-home price declines in July, compared to just five in March.

Existing home prices are also still falling, with a 0.5 per cent month-on-month decline in July, and analysts are sceptical the PBoC’s rate cut will do much to dent the trajectory. Easier monetary policy “may only lead to an “L-shaped” recovery in the sector in coming years”, Goldman noted.

As home prices have declined, so have home sales, trending down significantly since the market’s most recent peak in 2021.

Yet while sales began slumping particularly in 2021 and 2022, the rate of price growth began trending down at least a year earlier—a leading indicator that the housing bubble was ready to burst.

With price increases slowing by the fall of 2021, the real estate market was already softening when Evergrande’s historic default hit, confirming the bursting of the real estate bubble.

China, The "Sick Man Of Asia"

While Evergrande’s initial default was nearly two years ago, Country Gardens recent missed interest payments confirmed that the real estate crisis was far from over.

Has China's "Lehman Brothers" Moment Arrived?

Since Country Gardens' tumbled into debt default, the bad news has only spread, with now nearly half of China’s listed state-owned developers reporting widespread losses, it is clear the issues with the real estate market extend far beyond the financial imprudence of a few profligate private firms, and indicate problems of a systemic nature.

Amid China’s persistent housing slump, previously immune state-owned enterprise builders are now grappling with financial losses.

An analysis of corporate filings by Bloomberg reveals that 18 out of 38 such builders listed in Hong Kong and mainland China have reported preliminary losses in the six months leading up to June 30. This represents a significant increase from the 11 that had forewarned of full-year losses in the preceding year.

At the same time, Evergrande, the company that sparked the crisis itself, filed for bankruptcy protection in US courts, as part of its ongoing efforts to restructure its dollar-denominated offshore debt. That grim reminder of Evergrande’s tortuous and ongoing demise is does not bode well for Country Garden’s future, nor for the future of real estate in China—a sector which has accounted for as much as 30% of GDP in recent years.

It’s hard to overstate the importance of the property market China. The industry accounts for as much as 30% of the country’s economic activity, and more than two-thirds of household wealth is tied up in real estate.

But nearly three years of “zero Covid” restrictions sapped China’s economic growth, and consumers have been reluctant to buy new homes in the face of higher unemployment and falling property values.

The twin failures of China’s preeminent private developers, coupled with the struggles of nearly half of state-owned firms, are compelling indicators that China’s real estate markets are going to be depressed for the near future at least, and that it will be years before they will be a significant contributor to China’s GDP in the way they have been in recent years. That is no small loss.

The decline in home values also represents a significant level of wealth destruction for the average Chinese household, which will further sap consumer confidence as well as consumption, leading to a decrease in job opportunities particularly for young people.

The collapse of the real estate sector has brought with it a dreaded word: contagion.

Because so many real estate transactions are tied up with various forms of debt, there is always a potential for a bursting real estate bubble to cause chaos in financial markets as well. The crises represented by Evergrande and Country Gardens has been no different, as was demonstrated last week when Zhongzhi Enterprise Group, as well a partially owned subsidiary Zhongrong International Trust, defaulted on trust and wealth management products.

The privately owned manager of more than 1 trillion yuan ($137 billion) and its trust-company affiliates are under intense scrutiny after halting payments to thousands of customers. Underlining Zhongzhi’s importance, regulators have formed a task force as they seek to prevent contagion. Behind the scenes the firm has hired KPMG to carry out what is likely to be a protracted restructuring process. Potential asset sales threaten to weigh on broader markets.

While it is unknown if either Zhongzhi or Zhongrong’s wealth management products were tied up in any way with specific Country Gardens assets, with some $300 billion invested in real estate (roughly 10% of Zhongrong’s entire portfolio), the sector’s overall weakness has undeniably impacted China’s $3 Trillion “shadow banking” sector of wealth management companies.

In recent years, even as rival trusts pared risks, Zhongzhi and its affiliates, especially Zhongrong, extended financing to troubled developers and snapped up assets from companies including China Evergrande Group.

The real estate investments soured after a crackdown on property lending and a slump in sales during the pandemic led to a flurry of defaults. Even developers like Country Garden Holdings Co. that survived the first wave of failures are under pressure as the slowdown continues. China’s home sales tumbled the most in a year last month, and Country Garden is on the verge of default after it missed coupon payments.

The property woes created a cash crunch for trusts like Zhongrong, which count on investments and loans to pay depositors. An estimated 10% of all trust assets — some $300 billion — are tied to the property sector, according to Bloomberg Economics.

As we have seen within the US banking sector, even having 10% of assets impaired is enough for a financial company to find itself in a liquidity trap, which is what appears to be the case with Zhongrong.

How Safe Are Bank Deposits?

With developers under increasing stress, it was perhaps inevitable that wealth management companies such as Zhongrong would run into liquidity problems, as the ongoing delays, as briefly happened to the US banking sector this past spring.

In the case of Zhongron and Zhongzhi, however, there is also an apparent lack of oversight and investor discipline, as some of Zhongrong’s products became little more than “cash pools”, where new cash inflows were used to pay premium levels of interest to existing investors.

A lack of ring-fencing appears to be a key cause of Zhongrong’s default. For instance, the 30 million yuan trust product Nacity Property Services had bought was supposed to be similar to a money-market fund, with an expected 5.8% return. But it turned out to be a so-called “cash pool.” Nacity’s money was put into a common pool, which the trust could use to repay older, existing investors.

By the end of 2021, Zhongzhi’s cash pools, not including that of its trust affiliate Zhongrong, had reached 300 billion yuan. They were backed by about 150 billion yuan worth of underlying assets, reported financial media outlet Caixin. No surprise then that, when new fundraising dried up, Nacity’s money was not returned at maturity. 

The government, of course, frowns upon this practice. A polite description is excessive leverage, while a more crude one is a Ponzi scheme. However, because of their complex nature, regulations covering cash pool products have only been loosely enforced, according to CreditSights. Officials don’t get to see the lending documents — they are, by definition, private. They don’t have the resources to sift through and understand the tailor-made borrowing terms either. 

With the entire real estate sector under severe distress, the question is not how badly willl Zhongrong and Zhongzhi default on their various wealth management products, but how far beyond the two companies will the contagion effect spread. Moreover, with Zhongzhi working on restructuring its portfolio, and anticipates selling assets to resolve outstanding debt, the potential for that restructuring to add further stress to China’s finance and banking sectors is elevated.

The crisis in the shadow banking system is worsening a sell-off in Chinese financial markets, which are already under pressure from disappointing economic data and the slumping property market. While the nation’s top leaders have vowed to boost domestic consumption and support the private sector, they have yet to announce any new stimulus measures. Adding to the stress, Chinese local corporate bond defaults are running at the highest levels since the beginning of the year.

The MSCI China Index fell as much as 2 per cent on Thursday in a fifth day of losses, before erasing declines. The offshore yuan is near a record low against the US dollar.

Financial markets are already pricing in the potential for defaults among China’s shadow banks, including the potential for the rot to spread to other shadow banks and “investment trust” firms, with China-related indices and Exchange Traded Funds having declined precipitously since August 1st.

While any of these crises is significant in its own right and could, by itself, derail China’s economic growth plans, what makes China’s problems particularly troublesome both for Beijing and for the rest of the world economy is the degree to which these problems feed off each other in a series of transitory but highly destructive positive feedback loops: The liquidity crisis among shadow banks threatens to make the real estate crisis even worse, and adds to a crisis of confidence among Chinese consumers, which in turn feeds youth unemployment.

What the corporate media has been overlooking about these individual crises and challenges is this synergistic effect each is having upon the others, aggravating each one and doing even more economic damage.

Will these crises by themselves spell the end of the Chinese economy and, by extension, the Chinese economy? Probably not by themselves, and certainly not right away. However, these crises are enough by themselves to put China into an extended period of economic malaise, and that could be enough to end Xi Jinping’s ambitions of global or even regional economic hegemony.

Additionally, there is the potential for these problems to trigger widespread social unrest. With some street protests already occurring, the potential for widespread violence and chaos is undeniable.

The sensitivity of the government to the problems at Zhongzhi is highlighted by a Bloomberg report that investors who put money into the shadow banks had been visited by police at their homes advising them not to join public protests.

Earlier this week, about two dozen people in Beijing gathered outside the company’s offices demanding to know why they had not been paid the money they were owed.

According to the Bloomberg report, “dozens of people” who had invested in Zhongzhi received “what they described as cordial visits from police in recent weeks.” The visits covered a large area including Beijing, the southwest province of Sichuan and the coastal area of Jiangsu and Shandong.

China is not the old Soviet Union, however, and economic distress does not automatically translate into political chaos. Still, as challenges and issues are layered onto the Chinese economy, the likelihood of political chaos rises. As challenges and issues are layered onto the Chinese economy, the likelihood of future prosperity for the Chinese people declines.

China’s challenges are, at the moment, a good deal more than simply Japan-style deflation, with each challenge making the deflation that much worse, and drawing it out that much longer. That will likely not be enough to collapse either the Chinese economy altogether or collapse the Chinese Communist Party’s authority within China. It may be enough to limit China’s future economic potential.

We are not, in all probability, looking at the imminent end of the Chinese economy. We are, in all probability, looking at the high water mark of that economy.