URSABLOG: China Crisis

There are troubling signs in China at the moment – at least as far as I can see – that a moment of reckoning is coming. The signs are not great: manufacturing activity contracted for the second month in November, with the purchasing managers’ index (PMI) coming in at 49.4, lower than a median forecast of 49.8 in a Bloomberg poll and slightly below a reading of 49.5 in October. A reading below 650 signifies a contraction. And although the non-manufacturing PMI came in at a positive 50.2 it marks the lowest reading since last December, when following the abrupt lifting of lockdown restrictions, COVID swept through the land. More worryingly perhaps, the services industry activity component registered a contraction at 49.3 points. And it is in services where we are expected to see signs of growth. Not encouraging news.

And neither is actual industrial growth: profits at China’s industrial companies rose 2.7% slowing down markedly from 11.9% per cent in September and 17.2% per cent in August. Frederic Neumann of HSBC, quoted in the Financial Times,is still banging the stimulus drum:

“I think the market is expecting signals for more support measures. Is it going to be more fiscal stimulus in the pipeline, what’s the thinking around monetary easing? Because there is a sense that without further policy support, the economy will struggle to reach 5 per cent next year organically.”

I remind you that there has been no significant fiscal stimulus, and monetary easing has been confined to various tweaks in borrowing rates to maintain liquidity in the banking system rather than make life that much easier for those that are currently trying to pay off debts, or borrow more.

And, again reported by the FT, Nomura analysts are expecting the economy to “dip” again at the end of this year and into early next year, pointing towards a weakening property sector further restricting growth. External demand for Chinese goods is also expected to remain weak. “The pain of another dip may finally convince Beijing to play the role of lender of last resort to rescue some major troubled developers and fill the vast funding gap for building and delivering those pre-sold homes,” Nomura said. I think that they – and many others – are still living on hope that China must do something, but as we know, hope dies last. China doesn’t have to do anything of the sort, until it has to.

Consider the draconian Chinese laws concerning personal bankruptcy. Defaulters are blacklisted, and therefore blocked from a range of economic activities, including purchasing plane tickets and making payments through mobile apps such as Alipay and WeChat Pay. The blacklisting process is triggered after a borrower is sued by creditors, such as banks, and then misses a subsequent payment deadline. This happens in months, and although debtors are taken off the blacklist once the debt is settled, it is the courts that police this process, and keep the records. It won’t help debtors’ social ratings in the future either.

And despite all the talk of common prosperity and an effort by President Xi to change the thinking of the Chinese, this growing crisis has happened on his watch. Household debt as a percentage of gross domestic product almost doubled over the past decade to 64 per cent in September, according to the National Institution for Finance and Development, a Beijing-based think-tank. And the numbers are not small. It is the highest since the initial outbreak of COVID: 8.54 mill people, most of them between the ages of 18 and 59. This is now about 1% of the working-age Chinese adults, and up from 5.7 mill defaulters in early 2020.

The proportion of blacklisted defaulters as part of the working population is not so great in overall terms, but it is the fear of bankruptcy that will maintain a drag on the consumer economy. Consumers do not know when they will need their savings so will continue to hoard them. After all, the Chinese government was not so generous as western economies during COVID, instead using the opportunity to develop new technologies to restrict and control the population further rather than relieve their suffering and recognise, let alone compensate for, their loss of income. And remember that the end of lockdown came only after the social fabric was breaking down after unprecedented protests against restrictions and censorship were threatening the legitimacy of the Party. It was in the end nothing to do with health, mental or otherwise, or even the economy. The Party was losing control.

Whilst inflation in the western economies – which peaked due to too much money in the system – is now being brought under control by higher interest rates, China is hovering on the edge of disinflation, whilst consumer activity in the west is being tempered by the higher costs of living, affected in part by those higher interest rates, restricting the ability of China to profit from exports.

“We need to figure out a way to help individual defaulters rise up again,” Liu Junhai, a law professor at Renmin University who helped draft China’s corporate bankruptcy law, said in the FT. But a lack of transparency concerning personal finances is a large part of the problem. Policymakers have made little progress in passing regulations on individual asset disclosures due to a backlash from government officials and other interest groups who fear the rules may reveal corruption. This is structural not cyclical: servants of the state not willing to make the situation better because they fear the dead hand of the anti-corruption police on their shoulders.

And apparently they too are still hard at work. Zhongzhi – the troubled shadow banking company that recently warned it faced a US$ 36 bill shortfall, admitting that it was “severely insolvent” after management “ran wild” after the death of founder Xie Zhikun – has reported two of its’ executives missing, days after Chinese authorities said they were opening an investigation into the sprawling conglomerate. Ma Hongying and Ma Changshui, executives of two with significant shares owned by Zhongzi, could not be reached, and Zhongzhi reported that they had no knowledge of their whereabouts. Such an announcement by a company usually precedes another at some point in the future by the anti-corruption forces, acknowledging and confirming their detention. This has become an all too familiar process in the last ten years.

Which leads us to the elephant in the room: Evergrande. Tomorrow, Hong Kong’s High Court will rule on a winding-up lawsuit brought by offshore investor Top Shine Global last year, alleging that Evergrande has failed to honour claims of around US$ 110 mill, small change in the grand scheme of Evergrande’s debts, but in the absence of any meaningful or workable restructuring proposal, Judge Linda Chan has said it was “very likely” she will grant an winding-up order. If awarded, it is feared in the bond markets that this order will lead to Evergrande Group’s “uncontrolled collapse” leading to a “catastrophic effect” on other Chinese developers, one of those effects being the inability to raise money again in the international capital markets.

Evergrande had put together a restructuring plan, but in September, Evergrande itself cast doubt on the plan, saying it could not issue new notes because its mainland business, Hengda Real Estate, was “being investigated”. Days later it was announced by Evergrande that Hui Ka Yan – once Asia’s richest man – had been placed under “mandatory measures” on suspicion of involvement in unspecified “crimes”.

There is little money to be recovered by bondholders from Hong Kong: the majority of assets are in mainland China. It appears that despite how close Hong Kong has become to China in the last few years it is highly unlikely that Chinese courts will allow international investors to recover their debts from the wider group, or authorise the seizure of assets by foreign bondholders on the back of a winding-up order issued in Hong Kong. In fact, little or no money is expected to flow back to bondholders. According to the FT:

Last month a lawyer for some bondholders said in court that in the event of a liquidation, they might expect to receive less than three cents on the dollar. The outlook could be even worse. The process could take a decade or more…: “They may be looking at zero recovery.”

A moribund consumer economy shackled by structural problems that admittedly predate Xi Jinping’s tenure as President, endemic corruption – past and present – that is obstructing legal reforms, the arrest of executives from companies connected to problem shadow banking and property construction groups – which have a deep symbiotic relationship with each other – on anti-corruption measures all point towards a financial and political crisis that has been building up slowly and inexorably over months if not years. It is like – literally – watching a train crash in slow motion, and one that not even the all-powerful Party can prevent.

Is it any wonder that recent US-China relations are showing some kind of thawing? Is it all that surprising that new cold war rhetoric has lost its shrillness in recent weeks? I am not usually one for indulging in conspiracy theories, but joining the dots is sometimes useful. Even if the predicted collapse, orderly or otherwise, of Evergrande doesn’t take place, the problems affecting the Chinese economy remain. China will need to at least to keep the lines of communication open with the world, however self-contained the Chinese economy has become, which by the way is not so much. Expect stormy times ahead as the world’s second largest economy starts to deal with problems built deep into its foundations, that will need to be dug out to mend, not just in the property sector, but across the board. This will require not just a stimulus – fiscal or monetary – but fundamental and swift reconstruction. It will need decisive action, not just increased control. And it is anyone’s guess what the outcome will be once the dust settles. China reaching 5% GDP growth next year will be the least of our worries.

Simon Ward