WORTH A LOOK #8 “Explaining China’s Financial Crisis”

Worth a Look

February 19, 2024

Explaining China’s Financial Crisis

 

Last week, Chinese indexes hit a five-year low and have lost $7 trillion in value since 2021. Chinese equities have become uninvestable for many after declining for 3+ years despite record low valuations. 

Recently I was reading Tencent’s 3rd quarter earnings and was shocked to see the valuation had dropped so low considering the company is still growing more than 2x faster than China’s GDP. Using napkin math, Tencent is selling for roughly 6.8x 3Q annualized operating earnings excluding its stakes in public and private companies (which are also probably very undervalued). 

The level of extreme negativity for China has led me to re-think what could be an unusual opportunity to own a handful of the very best companies that in some cases have never traded this cheap. That said, China is facing hurricane-like economic headwinds that could always get worse.  For example, a new US administration could put additional pressure on Chinese imports as a bargaining chip to secure a new trade deal.

The list of reasons to avoid investing in China are well-known and well-rehearsed by money managers who for the most part seem to repeat the same simple narratives, without having taken a deeper look at the crisis or opportunities. 

With China on my mind again, I wanted to share an excellent interview with three Goldman Sachs China-experts on China’s financial crisis. The interview breaks down the history and scale of China’s property boom/bust and why the collapse of large Chinese property developers might not trigger a deeper crisis in their opinion.

What does China’s struggling property sector mean for the global economy?

Speakers:
Yi Wang – Head of China real estate, Goldman Sachs
Hui Shan – Chief China Economist, Goldman Sachs
Kenneth Ho – Asia credit strategist, Goldman Sachs

Summary of my notes:

 

Background

  • “We are living through the aftermaths of one of the largest ever recorded credit booms”
  • Past housing crisis in the US and Europe has caused investors to fear a broader banking crisis in China.
  • China’s economy is close to 20% of global GDP.  China’s property sector accounts for 30% of the economy vs 15% in the US.
  • Property has more linkages to other parts of the economy in China than in other countries. Local governments sell land which drives GDP, commodities, consumer wealth effect, spending and investing.
  • Home ownership in China is over 80% vs ~60% in the US, most urban households own their own apartment, 60-70% of Chinese consumer net worth tied up in home ownership. 
  • Chinese households save 30% of disposable income and invest in properties or bank deposits. Other investments like stocks are a very small percentage of household net worth.

History

  • The property boom started in 1998 with household reform. Rapid urbanization led to a housing boom, turbocharged by China entering the WTO and trading more with the US. The property sector expanded dramatically from the early 2000 to the 2010s.
  • In 2016, the government started worrying about speculation, and housing was becoming unaffordable in big cities. Consumers were often making trading in properties than investing in the economy or even their jobs.
  • The 2018-2019 trade war with the US slowed Chinese growth and exposed cracks. The government could not tighten policy fast enough.
  • During the 2020 COVID shutdown, the government decided to use the situation to curb property activity because exports were booming. By 2021, the Chinese economy deteriorated quickly, and property values started to decline. 2021 marked the peak in prices.

Today

  • New construction starts are down 50-60% from peak, land sales down 40% from peak, property prices down 20%. 
  • Of the top 100 developers, which constitute 50% of the market, 70% are private. The majority have liquidity problems or have defaulted on their debt.
  • From 2009 to 2019, China’s non-financial debt to GDP rose from 150% to 260% in less than a decade, with property development debt being a significant part of that
  • Development debt + mortgages went from 10% of GDP in 2006 to 55% in 2020. The property sector got out of control; total developer debt outstanding estimated at $8.4 trillion. 

Will we see a bigger fallout from the developer credit crisis?

  • We think not. Chinese consumers are not leveraged like US consumers were and will not walk away from their homes. China is in worse shape than the US was in 2008, but consumers are not losing their homes. Loan-to-value (LTV) is very low, savings rates are high, with second homes requiring a 70% down payment, many paid with cashNot seeing waves of foreclosures and banks are losing credit.
  • Parallel with US/Europe GFC but it’s not the same. Chinese private sector started deleveraging several years ago.
  • Banks need to clean up non-performing loans, and Goldman Sachs does not see a crisis because the Chinese government controls the banks and policymakers are on top of the issue.

Why are we not seeing more China government stimulus?

  • Past stimulus seen as the reason for the mess today’s property bust. The 2008 stimulus was enormous, followed by 2015-16 again. They’re not doing this again; they did too much.
  • The government has injected some liquidity to developers (16 measures) and relaxed mortgage or home purchase restrictions to boost demand. However, it’s much slower than past stimulus programs.
  • They’re trying to avoid a huge collapse down the road. There’s a risk around the secondary market for homes; they can’t control price declines. We are seeing a rising supply of homes and further deterioration.

Implications for growth / risks

  • Goldman Sachs estimates that the total property market had a 2% drag to GDP in 2022 and 1.5% in 2023. The future impact on growth will be sizable. 
  • China GDP should settle out at a 4% growth rate with the property sector holding back further upside. It will take years to get back to normal. 
  • The property crisis explains declines in copper and commodities, and deflation.
  • Downside risk in around unsold housing stock and non-performing loans.
  • Y4 trillion funding gap over next 2 years for developers, big liquidity issues on the developer side.
  • Undeveloped homes ~30% of total housing stock.

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