CIO Insights: Reading between the headlines of China’s economic “crisis”

18 September 2023
Stephanie Leung
Group CIO

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A deep dive into the Chinese economy reveals longer-term investment opportunities

The challenges facing China’s property sector have swept headlines in recent weeks. Investors are concerned that the debt-related problems facing the industry could spiral out of control and drag the broader economy down with it.

But is an economic meltdown for China really in the cards? In this month’s CIO Insights, we dive into the challenges – and the opportunities – facing the world’s second-largest economy. 

Key takeaways:

  • Data suggests that China’s economy isn’t quite staring down the barrel of a crisis. Market-based gauges like commodity prices, which tend to be more forward looking, should reflect signs of distress – and so far, they have not. Economic indicators like purchasing managers’ indexes (PMIs) point to an economy that is softening, but not cratering. Liquidity in Chinese banks appears healthy, suggesting that if the situation in the property sector escalates further, risks to the financial system can be contained.
  • But the data does suggest China’s economy is facing a severe slowdown. Downturns in real estate and related industries – which account for as much as 25-30% of GDP – is dragging on investment and consumer spending. Exports, another key economic driver, are being weighed down by slowing growth overseas. Moreover, constraints on the government mean support measures are likely to remain more targeted, versus the all-out stimulus it unleashed in 2008.
  • There are pockets of China’s economy that are still growing rapidly. For example, the electric vehicle (EV) sector, which has been buoyed by several factors: supportive government policies, the rise of competitive Chinese EV manufacturers, and the longer-term global trend of decarbonisation. This may not be enough to propel a rebound in growth in the near-term, but its longer-term potential is worth watching.
  • Overall, while China currently faces near-term growth challenges, fears of a meltdown appear to be overblown. From an investment perspective, it would be reasonable to keep a market-weight exposure to China (over a  longer time horizon), given the economy’s longer-term prospects.

Is China’s economy facing a crisis?

The turmoil in China’s property sector has dominated the headlines recently, but let’s take a step back. It’s important to remember that for years, the Chinese government has been working to rein in excessive borrowing in order to reduce risks to the broader economy. 

The turning point for real estate came in 2020, when the government introduced guidelines for property developers, known as the “three red lines”. This contributed to a slump in the sector and eventually led to defaults among a number of developers, with Evergrande collapsing in 2021, and most recently, Country Garden grappling with its own debt issues.

Investors are now concerned about spillovers from the sector, given its significance. Real estate, together with related industries, accounts for roughly 25-30% of the Chinese economy.

But while several important data points indicate that China may be going through a deep cyclical downturn, others suggest that it’s not quite in a crisis:

Commodity prices: As a major importer, any disruptions to China’s economy should have a large impact on the prices of a variety of commodities, from copper to iron to oil. So far, that doesn’t appear to be the case. Copper and iron ore prices – which did decline in the past 2 years – have since recovered and are relatively stable.

Economic data: Looking at the broader economy, PMIs generally provide a good gauge of prevailing business conditions. Here, the readings for the manufacturing sector have been fluctuating around 50 (which is the mark that separates economic expansion from contraction). Meanwhile, the readings for the services and non-manufacturing sector have been coming down, but remain above that 50 mark – which means they’re still in expansion.

Chinese banking sector: Importantly, if the downturn in the property sector does escalate, the health of the banking sector is key to ensuring that it doesn’t intensify into a full-blown crisis. Overall non-performing loans (NPL) for Chinese banks, as a share of the total, are still manageable  at 1.6%, as of June. That’s relatively low, especially for an emerging market (EM) economy. For comparison, the share of NPLs in India, a fellow EM, is under 5%. In developed markets like the U.S. or the U.K., those stand at about 0.7% and 0.9%, respectively.

In the worst-case scenario, where distressed developers – about half of the total – default on all of their debt, we estimate the hit to bank assets would be below 2%. This is due to Chinese banks’ relatively limited exposure to property developer loans. And given that these banks’ overall capital adequacy ratio (CAR) stands at 14.7%, such a hit would not bring that ratio below the 10.5%-11.5% levels required by the government.

Still, China faces near-term economic challenges, both at home and abroad

Having said that, the downturn in China’s property sector is placing significant downward pressure on the broader economy. As mentioned, real estate comprises a large chunk of China’s GDP, and a decline in property investment (-10% in 2022 and -8.5% for the year to end-July) is a direct hit to the country’s growth.

China also faces pressures in terms of exports, an important engine of growth that accounts for about 20% of GDP. As we shared in our mid-year market outlook, slowing demand for goods from the US – China’s largest trading partner – removes an important source of support for the economy. As of August, China’s total exports contracted 8.8% from a year earlier, following double-digit declines in June and July.

China’s government is working to contain risks, but “bazooka” stimulus is unlikely

Encouragingly for investors, the Chinese government has taken a series of targeted steps to support the sector and prevent a wider downturn. These have included: lowering property down-payment requirements, relaxing home purchase restrictions, and encouraging lenders to lower existing mortgage rates (which should be helpful in encouraging broader consumption).

In recent months, the country’s central bank, the People’s Bank of China (PBOC), has also stepped in to increase liquidity in the financial system – with cash injections in August totaling an outsized 3.3 trillion yuan (US$509 billion).

However, we think the likelihood of large-scale “bazooka” stimulus – similar to what it deployed during the Global Financial Crisis in 2008 – is quite low. Since then, the government has made it a long-term goal to deleverage the private sector and prevent asset bubbles from forming; it’s unlikely it would return to its previous tactics.

Looking longer term, China is transitioning to new growth drivers

One of the reasons behind the current cyclical downturn: China is focusing on transitioning to new areas of growth for the longer-term. Take its growing EV industry, for example.

China laid the foundations for its current EV ecosystem in the late 2000s, when the government threw its weight behind the sector. Fast forward to today, and Chinese carmakers produce affordable, high-quality EVs and components that are competitive in the world market. As a result, UBS estimates that China’s automakers will almost double their share of the total global auto market by 2030, to 33%.

EV adoption is also growing rapidly within the country itself. About 33% of domestic car sales now come from these vehicles – a share that could rise to 67% by 2030, according to BloombergNEF. And currently, home-grown Chinese brands like BYD account for more than 80% of these domestic sales.

That said, rapid growth in EVs won’t be enough to offset China’s other near-term economic challenges. Currently, China’s global EV sales account for about 0.6% of the country’s GDP. Using industry projections of it tripling by 2028, that would still  only represent under 2% of GDP.

While that is a significant figure, it’s still relatively small. That’s not enough to do the heavy lifting for the economy, especially when you compare it to other major economic growth drivers: the property sector at 25-30% of GDP, and the digital economy at roughly 40%.

As an investor, what does China’s slowdown mean for me?

From a market perspective, valuations of Chinese equities remain relatively reasonable. The forward price/earnings ratio for the MSCI China index has picked up from a dip in August, and as of early September stands at around 11x, still a discount relative to the ten-year average of 12.5x. That’s also cheaper relative to the forward P/E of the broader MSCI Emerging Markets index, which is currently around 13.6x.

Looking through a longer-term lens, we think maintaining a market-weight allocation to China makes sense. This means keeping an exposure that’s roughly in line with the market capitalisation of Chinese equities relative to global equities. Within our ERAA®-managed portfolios, we’ve kept exposure to Chinese equities in the low- to mid-single digits across our General Investing portfolios, via EM and broad-based global equity ETFs.

Overall, China is facing a cyclical slowdown, putting pressure on company earnings in the near-term. But when you dig into the details, fears of a meltdown appear to be overblown. As is often the case, a deeper dive presents a more nuanced picture – and for investors and observers alike, it’s a reminder to remain grounded in data, rather than in headlines.

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