September 22, 2021
Paul Christopher, CFA, Head of Global Market Strategy
China liquidity crunch roils global markets
- A developing financial crisis at large, a Chinese real estate developer has prompted fears of contagion across China and into global markets.
- Beijing has the cash and the know-how to prevent a crisis, but questions remain about some of China’s policies in the longer term.
What it may mean for investors
- As we have written repeatedly this year, the global economy is in an expansion of above-average strength, particularly in the U.S. We tactically favor the U.S. over international equity markets and are most favorable on U.S. Large Cap and primarily cyclically-oriented sectors. Bouts of volatility are likely to continue, but we prefer to manage exposure via a disciplined plan that puts cash to work incrementally.
Since last week, a large, Chinese real estate developer and China’s largest non-investment-grade debt issuer has appeared likely to miss payments to bondholders, due on September 23. This episode occurs as Beijing attempts to rein in China’s conglomerates. In particular, this real estate developer is the largest in its industry, with $110 billion in 2020 real estate sales and $355 billion in housing assets across 1,300 housing developments. The company has expanded into electric cars, insurance, sports, and bottled water.1 The financial difficulty comes after the central government instituted its “three red lines” policy last year to force property developers to shed debt.2
So far, selling in global risk markets indicates concern, but it is likely that worries about fiscal and monetary policies in the U.S. and elsewhere may be magnifying that concern. Notably, the more limited spillovers in Chinese financial markets suggest no immediate threat to China’s economy. Importantly, the risk to the Chinese banking system seems small. The loan balances of China’s real estate developers are almost all below 0.5% of the total value of loans at individual Chinese banks.3
The contagion to global markets so far has been limited. There has been no surge of buying in perceived “safe havens”, such as U.S. Treasury securities, the Japanese yen or the U.S. dollar. The reaction in Chinese equity and bond markets also seems narrowly focused on real estate and particularly on non-investment-grade debt. The Chinese equity market (proxied by the MSCI China Index) has been weak in recent weeks but has not declined in tandem with the equity real estate sector during this latest bout of stress (Chart 1).
The recent performance difference is even greater in the bond market, where an index of high-yield Chinese bonds has sold off much more sharply than its investment-grade counterpart (Chart 2). Considering the limited impact on the banking sector and the equity markets until now, the risk seems to have landed mainly on high-yield debt, which aligns with the exposure of the particular company.
Looking ahead, the company could restructure its debts but continue in operation, or it could liquidate. In either case, the investors in the company’s financial instruments, as well as suppliers of materials and buyers waiting for homes likely will suffer at least some losses. In the event of a liquidation, however, Chinese and global investors could decide that the contagion could spread beyond China. This appears to have been a concern in the global equity market indices on September 20.
Housing represents approximately 25% of the Chinese economy’s annual output, but it means much more. Dramatic urban housing expansion has allowed people from rural areas to move to where the jobs are. Even more fundamentally, housing –not the financial markets– historically has been the principal way for households to build wealth. At the same time, limited arable land in the eastern third of the country has made land expensive, and speculators buy multiple homes to sell as prices rise.
The high price of housing is, in our view, precisely what catches the attention of government regulators. During China’s great urban migration, regulators repeatedly have raised down payment requirements, limited land sales, and imposed other restrictions as a way to curb speculation. Chart 3 shows the effect of policies that start and then stop incentives to buy housing. After the 2008 global financial crisis, Beijing injected large amounts of credit into the economy. Housing starts soared in 2009-2010 before prices escalated and prompted new restrictions. The cycle repeated from 2013-2015.
The 2021 downturn follows post-pandemic price inflation that triggered new restrictions to limit debt-fueled speculation, including among the developers. These constraints include the three red lines policy and are consistent with Beijing’s more recent efforts to regulate perceived predatory practices in after-school tutoring, private health care, and online gaming, to name a few. These policies are part of Beijing’s goal of common prosperity.4
Put another way, these policies all target an affordable middle-class lifestyle and appear to have continuity and staying power. According to the United Nations, China’s population is set to peak during this decade, and the aging work force should reduce worker productivity and, inevitably, wage growth.5 Beijing appears to be targeting reduced middle-class living costs as a way to promote social stability in the short-term and raise the population growth rate in the longer run.
- Restructuring, not liquidation should limit near-term global market downside: We believe Beijing has the cash and the know-how to prevent a crisis. (The government successfully managed a 2019 bank default that was similar in breadth of liabilities.6) And the developer in question reportedly already has legal and financial consultants to advise on a restructuring.7 Of course, it is a truism that governments can and do miscalculate, but we believe Beijing has the means and the experience to manage a restructuring and to prevent a liquidation and a broader crisis.
- Common prosperity may mean more China market volatility: If the new regulatory measures are indeed part of a plan to limit speculation and lower household costs generally, then more regulatory surprises may follow, possibly targeted to Chinese equities that have high current valuations. Chinese equity market volatility should continue. In the coming years, it may prove difficult to promote efficient economic growth while (perhaps unpredictably) directing lower prices at some companies.
- China’s economy and housing market should stabilize for 2022, but more challenges lie beyond: We believe additional government spending and lower borrowing costs at banks are likely to steady China’s economy in 2022. New credit infusions into mortgage markets should follow early next year to reverse the construction contraction (Chart 3). Such measures should ease conditions for developers but, beyond 2022, Beijing still may struggle to promote home ownership but discourage speculation and, ultimately, prevent episodes like the current one.
- Our conviction remains for equities, and with a U.S. preference: As we have written repeatedly this year, the global economy is in an expansion of above-average strength, particularly in the U.S. We target an S&P 500 Index range between 4,900 and 5,100 by year-end 2022. More specifically, we tactically favor the U.S. over international markets and are most favorable on U.S. large-cap and primarily cyclically-oriented sectors (Industrials, Energy, Financials, and Communication Services). We continue to favor holding fixed income but prefer a defensive approach that includes favoring intermediate- over longer-term maturities.8
This bout of market volatility may linger with fears of a broader financial crisis, but we anticipate a restructuring, not liquidation, for the Chinese company in focus. Nevertheless, other bouts of volatility are likely to arise through 2022. We favor staying invested along these equity and fixed income preferences and particularly favor putting cash to work in incremental and disciplined steps.
1 “How China Evergrande’s Debt Woes Pose a Systemic Risk”, Reuters, July 27, 2021.
2 The three red lines are conditions under which Beijing will continue to allow developers access to financing, namely, a liability-to-asset ratio (excluding advance receipts) of 70%, net gearing ratio of less than 100%, and cash-to-short-term debt ratio of more than 100%. See “What China’s Three Red Lines Mean for Property Firms”, BNN-Bloomberg, October 8, 2020.
3 “China Strategy”, Macquarie, September 15, 2021.
4 Common prosperity is neither a new term nor a new policy for China. It was originally a 1950s program to lift the country out of poverty. The term returned in the 1970s to signal an opening up of the economy to international markets. Today, the term is really about easing the costs facing middle-class families, as a way to extend prosperity. For more on the latest incarnation of “common prosperity”, please see, “CPC Sets Path to Common Prosperity”, September 6, 2021, published in the China Daily, an official paper of the Chinese Communist Party.
5 Source: United Nations World Population Prospects, September 20, 2021.
6 “China allows first commercial bank to go bankrupt in almost 20 years”, Financial Times, October 8, 2020.
7 “China Evergrande Hires Financial Advisers as Protests Erupt at Its Offices – Update”, Bloomberg, September 14, 2021.
8 For more details on portfolio implications of a defensive position, please see our report 2021 Midyear Outlook: Fuel for Growth, June 2021.
Forecasts and targets are based on certain assumptions and on views of market and economic conditions which are subject to change.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.
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