China’s Red Flags

Jeff Tumolo

A Series of Problems Affecting the World’s Second Biggest Economy Make it a Difficult Place to Invest

By Jeff Tumolo, Managing Director and Chief Investment Strategist

China’s economy represented 18% of global GDP in 2021 and its population was the largest in the world. In the 10 years before December 2021, it contributed more to global GDP growth than any other country in the world with an average growth rate of more than 6% per year. In 2021, China’s stock market hit all-time highs. It was the leading Asian Tiger.

Recently, however, China’s economy has behaved more like a paper tiger. Its global dominance is showing signs of weakness:

  • Its share of global GDP has declined for the last two calendar years and GDP growth, while still positive, has been materially below its ten-year average of 6.14%.
  • GDP growth was 3% in 2022 and 5.2% in 2023.
  • Despite the global economic and capital market recovery from COVID-19, the stock market (Shanghai Exchange Composite Index) is down -45% from its 2021 high on 2/10/2021.
  • And China is no longer the world’s most populous country – it was surpassed by India in 2023.

Hong Kong has lost its relevance as an Asian money center, with fund managers and foreign investment banks moving their primary Asian operations to Singapore, London, or the US. The entire region is starved for capital, as investors, both foreign and domestic, are shying away from Chinese risk assets. This was evident on my recent annual trip to Asia — the tone of my interactions with investment managers there had changed.

The largest issues influencing China’s economy can be described using the four “Ds” :

Demographics. In 2022, for the first time, China’s population declined. The effects of this will be felt by the Chinese and global economies. A declining population increases the average age of the population, putting pressure on social safety nets. This will likely result in a shrinking workforce and declining domestic consumption.

Debt. China central government debt amounts are not high relative to other countries, but it is not representative of the true level of outstanding government obligations. The debt to GDP ratio on centralized government debt is 89%, comparing favorably to ratios of 123% for the US and 254% for Japan. However, this number does not include Chinese provincial and municipal debt, which has been estimated to represent and additional 50% in debt to GDP. On top of that is government controlled and mandated state-owned enterprise debt. When adding this implicitly government sponsored debt, estimates of total debt to GDP climb to close to 200%. In the face of a slowing economy, that is a terrifyingly high number.

Deflation. After decades of steady growth and high inflation going back three or four years, it’s hard to believe deflation is a threat in China right now. But it is and has potentially enormous implications for the Chinese economy and its impact on global growth. The current situation parallels the economic environment in Japan as it entered the “Lost Decade” starting in the early 1990s –a prolonged period of negative economic growth and deflation from which Japan has still not fully recovered. Prior to the Covid pandemic, China’s inflation was running at an annual rate of about 2 to 4%. China’s May inflation rate came in at 0.3%. Some of this may be due to temporary factors related to oversupply, but an increasingly large portion of these price declines may be due to a lack of domestic consumer demand.

Dictatorship. Increased central government control is leaving little doubt that foreign investors are more concerned about doing business in China. Domestic investors have also been hurt by the blunt and uncoordinated manner in which government policy has been implemented. Chinese President Xi Jinping’s administration has focused on closing the wealth gap, a seemingly noble cause — many lower and middle class Chinese citizens believe that too much of China’s growth has benefited too small a number of individuals and corporations, both domestic and foreign. But the heavy handed manner in which President Xi’s government has addressed this concentration of benefits has led to a lack of confidence from investors. The government has placed debilitating restrictions on multiple industries including healthcare, for profit education and private companies listing shares on US stock exchanges. The most high-profile and damaging of these targeted policies is the recent collapse of China’s real estate industry.

Problems in the Real Estate sector began in 2021 with the implementation of the “Three Red lines” policy. The regulations placed new restrictions on how much debt real estate companies could hold, forcing companies to delay construction and shed inventory at reduced prices. Evergrande, the largest Chinese real estate development company, struggled to narrow its financing gap and began a slow decline into eventual bankruptcy. The second largest developer, Country Garden, was also forced into bankruptcy and soon the entire sector was in crisis. Partially completed development projects were abandoned or delayed, not only hurting large investors, but also individuals who had pre-purchased incomplete apartment units.

Real estate and construction businesses represent about 25% of China’s GDP, around twice as high as in the US. Oversupply and a restrictive capital markets environment ground the entire industry to a screeching halt. At one point this year, roughly 68% of issuers and 71% of listed debt issues from real estate development companies were in default. About $125 billion of Chinese corporate debt, from both on and offshore sources, ceased making payments. The central government has been slow to respond, and the response has not been adequate. 70% of Chinese household wealth is in real estate, resulting in a huge erosion of family net worth.

As the rest of the global economy recovered from the COVID Pandemic, draconian Covid restrictions and the length of those restrictions put China on its heels. Then the real estate crisis emerged, destroying significant consumer wealth. Today, China faces a suppressed consumption base, large geopolitical problems pressuring Chinese exports, a declining currency and a lack of investment capital.

The question is: does this present a great investment opportunity, or are their more difficulties ahead for the Chinese economy and its capital markets?

My conclusion is the uncertainty of the regulatory environment and the unfavorable conditions for capital, especially foreign capital, makes this investment difficult to recommend to clients.  Heavy handed policy implementation and unpredictability of which industries the government will target next is keeping investors away. The headwinds are too strong and it’s hard to envision a material and sustained growth recovery in the Chinese markets anytime soon.