Big Trouble in Little China

China’s been the subject of a lot chatter over the last couple of months. Everything we’ve been reading and hearing about is ambiguous. But what’s not ambiguous at all is that the country’s growth measures are no where close to where they should be and we’re seeing economic data decline with every reading.

As if that wasn’t enough, we’re seeing JPM, Citi and Barclays all drop their forecast for GDP growth to below 5%. For China, that’s a massive downward revision since their average GDP growth has been over 8% for the last 30 years.

As I see it, there are four major problems that China faces, plus a fifth geopolitical threat.

1 - Consumption - Savings

When China was about to re-open, we heard a lot of stories about how they had pent up savings and that would create a massive level of consumption. Unfortunately, things did not pan out that way and the savings continue to grow. It’s not a problem of having things to spend on but rather a problem of faith. People are worried and don’t want to deplete their savings right now.

2 - The Property Market

China's property sector is shaping up to be a major headwind for the country's growth prospects. According to BBG, China's real estate developers have debt worth 12% of the country's GDP at risk of default. 48% of the total borrowing held by the 186 listed developers are either on the brink of default or already in default.

People are not investing in properties and property developers are struggling with cash flow and debt repayments. China had a tagline that said “Homes are for living, not speculation” and during the recent Politburo meeting in July, this was removed. That’s supposed to be some sort of encouragement for people to go out and buy property!

3 - Local Government Financing Vehicles (LGFV) Debt Burden

The massive infrastructure projects done in China was through “Local Government Financing Vehicles” or LGFVs for short. These financing vehicles took on the debt in the forms of loans and bonds and the Government helped pay the interest on these. But now, the Government is trying to move away from that.

To make matters worse, the slowdown in the economy means that cash flow is scarce. This is at a time when they are faced with a huge maturity wall on their bonds. They will have to refinance these bonds or at least get the Government to intervene to restructure them.

4 - Youth Unemployment

Youth Unemployment is a problem. So much so that China is pulling the data from circulation now. There are a few views to consider here - firstly, this could lead to a potential revolt. Secondly, younger people are meant to be the most productive (supposedly). And finally, it’s lost income and a generation with little savings.

But until China opens up more of their tech and stops suppressing new initiatives, this is not going to change a whole lot. I doubt most of these young people want to work in factories or farms.

All these issues are interlinked to a large extent but the overarching issue is “faith”. The people have lost faith in the government and are fearful of what’s next. I’m no psychologist but, the damage from Covid lockdowns and almost whimsical measures is sure to leave a scar.

One could argue… oh but the government is doing something. Just not enough. Most of the measures announced in the last two months have been mostly “all talk” and we’re not seeing a lot of tangible measures come through. It would seem like every time negative economic data is released something is announced just to placate the market but, there really isn’t any implementation. The last thing the government needs is an uprising and so there’s just enough communiqué to make sure people remain hopeful.

But, the market has also started to call their bluff. On Tuesday (Aug 15), the PBoC cut rates but, the market’s response was lackluster at best. The slew of negative economic data released earlier in the data seemed to trump any kind of enthusiasm.

The problem with the rate cuts?

They were simply not enough. A 0.10% cut to the 1-year loan prime rate (LPR) does nothing to stimulate real demand in the economy. Furthermore, they left the 5-year LPR unchanged.

One reason that rates are not being cut aggressively is the currency. China has already seen the Yuan depreciate quite a bit and easing could exacerbate the situation. The PBoC has been propping up the Yuan with aggressive rate fixings in an attempt to keep the currency stronger.

The other reason not to cut rates is to prop up the local banks. With property defaults looming, the banks need to make money to cover these defaults. Defaults hit the bottom line directly and with lower rates, banks make less money, particularly long-term rates.

This also has a negative impact on stocks. As long as rates are high and the currency continues to remain strong, they will continue to see pressure on equities. When you consider that GDP growth is slowing, consumption is slowing and unemployment is rising, you can conclude quite easily that this can’t be great for the markets.

So what do we see for Chinese equities?

I still find it hard to be constructive without clarity in terms of policies. I know China has always been somewhat of a mystery when it comes to government intervention. But, now it feels like the Government is just standing by and watching things go from bad to worse.

A part of it could be that the Government sees the trouble that we’ve talked about with the currency and is trying to strike the right balance. The other part could be that they still have their GDP target at 5% and as long as that is not threatened, they don’t see reason to intervene.

Equities have been chopping in a range for China. The Hang Seng is no different except the range is a bit wider, quite possibly because more of the property stocks are listed there.

It’s almost as if every time the market drops, there’s some announcement and the market goes back up again. There will be a floor to the market - the point where stocks get so cheap that people can’t help but buy.

However, in terms of an outsized rally, I can’t see that happening unless China fixes their problems. It was reported that CNY10B left the market - so basically much of the investments that came after the Politburo announcements.

There are some companies I like - Pinduoduo (PDD), Miniso (MNSO), Yum China (YUMC). I’m sure there are more. Although I wouldn’t look at Alibaba (BABA) until their restructuring is done. Who knows what the company will look like afterwards.

Closing Thoughts

As always we will be keeping an eye on the situation. I report on China every morning through Breakfast Bites, we put out our Dashboard with our views and when & if the time comes, we can think about investing. In the meantime, there are so many other place that we could put our money and get a good night’s sleep!