Amy Xie Patrick: The market’s getting excited about China again, but it may be premature

A new signal from China caused excitement among investors this week. AMY XIE PATRICK explains what it means

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THE latest message from China’s top decision-making body caused a stir this week when investors noted softer language on property.

For the first time since 2016, President Xi Jinping’s signature slogan that “houses are for living, not for speculation” was missing from a note that followed the Politburo’s July meeting.

That caused excitement in the market about the potential for a meaningful stimulus push via the property sector.

China’s property industry accounts for up to 20 per cent of GDP once related sectors are added.

But the market is getting ahead of itself.

The line has likely been dropped because it’s simply no longer needed.

Buyers are no longer speculating. They are actively selling in an attempt to exit the property game altogether.

In fact, one of our investment themes here in Pendal’s Income and Fixed Interest team, is that there will be no silver bullet from China to turn around its economy.

Deleveraging leads to fire sales

Beijing’s attempts to de-leverage property developers effectively shut them out from official channels of funding in 2020.

The unofficial channel relied on off-the-plan pre-payments from buyers – but relying on this channel alone is a bit like a Ponzi scheme.

Developers need to keep selling properties they promise to build in the future, to secure the funds to finish what they’ve already pre-sold.

As defaults among Chinese property developers started to snowball last year, buyers soon came to the realisation that they may never get delivery of properties they’d made down payments on.

To cut their losses, owners of partially completed apartments started to list them at discounts on the secondary market.

Indicators suggest property prices are now falling as fast as they did during the initial outbreak of the pandemic, with no relief in sight.

Breaking bad

It is impossible to understate the extent of this shock to the Chinese psyche.

The economic model has had property at its core for the best part of a generation.

Every crisis has been met with property sector stimulus. This spurred consumer spending on all things related to buying a new home.

It gave local governments revenue from selling plots of land.

It spurred borrowing from Chinese households to get on the property ladder because as far as they knew, Chinese house prices only ever went up.

Confidence in the property sector has now been shaken to the core.

It forces Chinese households to recognise the real state of their balance sheets. At the margin, income will be directed towards balance sheet repair rather than new consumption.

I have some sympathy with commentary that draws parallels between Japan’s bubble bursting in the late ’80s.

In the long run, this is a good story for China.

It allows the economy to break away from its addiction to building endless apartments and move on to find healthier alternatives. What those alternatives might be is yet to be determined.

Economic debris

The bad news right now is that the debris from the current property carnage is clogging up China’s economic engine.

Policy response has so far been limited.

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Interest rates and reserve ratios have been cut. But what use is making the price of borrowing cheaper in a system where there is no appetite to borrow because of shattered confidence?

Clearing this debris requires either allowing developers to borrow again or someone to absorb losses.

The former is unlikely given the pain endured to come this far down the deleveraging path. The latter is unpalatable given the sheer extent of losses that potentially exist.

As an example, Chinese property developer Evergrande recently wrote down US$52 billion of losses on the value of its assets – and faces a $44bn funding gap for completing its construction pipeline.

If that funding gap can’t be bridged, further write-downs will follow.

The extent of unrealised losses sitting within this sector may simply be too big for the private sector to bear.

But the state also faces a moral hazard dilemma if it tries to share the burden.

Against this backdrop, it is easier to understand why stimulus efforts have been so lacklustre to date.

What it means for markets and investors

Chinese asset prices have largely priced in a soggy growth story from here.

The rest of the world has had the luxury of ignoring China’s woes because strong consumption supported by excess savings has more than offset China’s drag.

What happens when those savings run out has most certainly not been priced into global asset prices.

The Politburo meeting also highlights a renewed focus on currency.

Beijing dislikes extreme moves over a short period of time. But in the absence of a property-driven growth engine, Beijing probably doesn’t mind a weaker currency.

Since domestic demand is hard to lift, a weaker yuan should at least help to channel some international demand in China’s direction.

Here are some broad-brush implications for positioning:

• Lean against yuan strength. Volatility can be smoothed but the trend can’t be stopped. A cheaper currency would help Chinese growth at the margin by lifting exports.

• Avoid betting on lower Chinese yields. Slashing interest rates won’t work to stimulate the economy when no one wants to borrow. Near term, the Chinese rates market may have priced peak pessimism.

• Maintain a long duration bias in global duration. When excess savings run out, China’s drag will become more evident on global growth.