Blog: You, us, everyone

China’s economic recovery has been disappointing so far. There are several reasons for this: the 2nd largest economy suffers

• from low consumer confidence,
• an ongoing stock market rout,
• US trade sanctions on key technologies,
• a record high unemployment rate of 21,3 % in the age category 16- to 24-year-old – and the figure continues to climb,
• private household wealth losses on both the property and stock market, and lastly
• a huge oversupply in the property market that consequently destroyed private wealth and drove multiple developers into critical situation with some gone bankrupt.

For now, the government can’t unlock the situation as it has been towering debt and approaches the progressive society, which the Chinese society is now, with dogmatic and past values.

The broader market is wondering whether the Chinese economy will enter a long and painful period of readjustments as it has enjoyed, at the expense of DM countries, as one of the few countries on the globe, unparalleled economic growth for more than 30 years. If so, the situation would be similar to the experience made by Japan since the stock market bubble in 1991. Let’s develop the issue point by point.     

1. How fast does China’s economy grow? 
According to official statistics, China met its 2023 growth target of 5%. This performance is outstanding given the country has exited its restrictive Zero Covid Policy at the end of 2022. For 2024, the government is projecting a repeat performance of 5%, which is low compared to historic averages. There are two possible scenarios for the Chinese government to publish such a figure: a) a prudent estimate is published so that the actual figure will be higher which should be possible since Covid restrictions have gone and the rather difficult transition is progressively moving ahead, b) knowing that the actual GDP growth will be way below, the growth estimate of 5% is the target it wants to achieve, thereby hoping that people will buy into the story and the economy will go along with it.  

There is however a more nuanced view: The IMF and economists surveyed by Bloomberg expect 2024 GDP to be around 4.6%, declining towards 3.5% in 2028. Research suggests that the situation in the Real Estate market is exceedingly critical and a potential deflation is luring. For the government, avoiding a period of deflation appears a major challenge to overcome. The concern related to an economic slowdown started to appear after the publication of the January trade statistics that showed the fastest drop in consumer prices since the FC 2007/2009! Is there a possible turnaround? The future will tell us!

2. Which place takes China in the world economy? 
China has been playing for the last 30 years or so an overarching role for the world economy. It has acted as the boiler room for all sorts of mass consumer goods. Over the years, its industries accumulated higher competencies and started to penetrate mid-market and specific high-end mass markets such as high-speed trains, aerospace, EVs, and photovoltaic, among others. These competencies were accessed with little R&D, i.e. western companies were required to disclose IP to access the local market, or worse, the entire object set-up got confiscated, dismantled, and reverse-engineered. The Chinese state-owned enterprises are willing to undertake all possible steps to access in an efficient and fast manner a specific technology. For instance, in 2007, a Chinese-owned A320 disappeared, and its whereabouts are still not known. The C919, a single-aisle airliner, that made its first commercial flight in May 2023, resembles in terms of technologies onboarded, range, design, and maneuverability the early version of an A320!

In more recent years, DM companies restricted access to their IP, which in turn resulted in a mandatory exit. At the same time, increased consumer responsiveness about where and how a product is being manufactured, and recent supply-chain bottlenecks, among others, reduced the attractiveness of Chinese-based manufacturing capacities for DM companies. Consequently, DM-based product demand and foreign investments in China started to slump. But on the other hand, the Chinese market is truly important for DM companies. For instance, Chinese-based sales at Apple increased from $12,7 billion to over $ 68 billion in less than 10 years and Volkswagen sold 4.8 million units in 2019 while it was less than 0.5 million in 2007. So, for the major companies, past sales growth didn’t come from DM activities, but rather from their exposure to the South East and Chinese markets. 

According to IMF forecasts, China will remain the top contributor to global growth until 2028. In the years ahead, it is expected to lose global market share to newcomers from Africa. This development is particularly important for countries like Brazil and Australia which built their infrastructure and entire industry segments to cover for exports to China. The oncoming infrastructure challenges and the 2023 market volatility in iron ore and copper prices might be a foretaste of the next chapter for countries with important natural resources.

The slump in the Chinese economy is hitting the entire world economy, from exporters of high-tech goods to standard consumer staples, and wineries in Australia to L’Oreal SA in France. For now, the market advantage is in DM economies where CB policies can be adjusted with limited political dogma. A dogmatic and centralized approach is still prevalent in China, hence compounding the pain for the country.

A way to express the difficulties endured by the Chinese society is to look at the fast-changing GDP composition. Example: The property sector and infrastructure sector, which was the government’s darling, has lost, in the last 5 years, close to ¼ of its weight, and the trend is not reversing. China’s $18 trillion economy has been struggling across all sectors with three common areas of concern:  

1. Recent data suggest that manufacturing activity has been down for almost half a year. More precisely, manufacturing activity peaked in October 2023 and is now down to the level of 2016. At the outbreak of Covid exports to DM markets soared – in the meantime, these markets were hit with strong inflation and higher interest rate charges. One can’t expect that cost-conscious consumers will return to the spending spree excelled in 2020 and 2021, hence Chinese-based manufacturing will not kick in to absorb the available capacities. 
2. The US cut China off from supplies of advanced semiconductors and other technologies that drive economic growth. The strategic competition implemented by the US appears to be reaching out further with some unexpected ramifications, in particular in the housing market.
3. Through China's initiated Silk and Belt Road initiative, the country implemented a soft-power strategy and allocated cash-strapped entities and foreign countries' off-the-book loans. The program allocated most of its resources to infrastructure investment with floored minimum dividend payments interconnected with the capacity utilization ratios.
   
   Major failures include Colombo’s Airport infrastructure, designed for an annual passenger capacity of 35 million people where the present usage is less than 6 million passengers. The airport operator went bankrupt shortly after its inception as the planned tourist flow never took shape. A second project included the Hambantota port, a newly built and truly oversized infrastructure for the capacity of the island. All-in-all, Sri Lanka defaulted on over US$50 billion in foreign debt in April 2022, with China being among the main creditors.
   
   Another pharaonic project engineered under the patronage of China is the railroad between Mombasa and Nairobi. For US$3.6 billion it was among Kenya's most expensive infrastructure projects. The prime contractor was the China Road & Bridge Corporation - CRBC. According to sanctioned data, 25,000 people were working on the project. Officially, the project was completed by Kenyans, but research suggests the labor force mainly came from China. CRBC contracted China Communications Construction Company to operate the line for its first five years. As of 2020, while utilization ratios were above expectations, the project was still generating negative cash flow and it became a burden for the local government.
   
   For China, most of these foreign revenue streams have not materialized which comes on top of the local housing downturn and the stubbornly high level of inflation across the globe. Many cash-strapped entities and foreign undertakings face bankruptcy which generates not only a shortfall of liquidity but also a political headache. 
   

4. What did happen to the consumers after Covid? 

In late 2022, when China exited the pandemic restrictions, the optimism was high. The government expected that the reopening of its borders would see a rapid recovery in consumer spending fueled by mass product shopping, eating out, and traveling. However, the anticipation was wrong. Chinese consumers were fretted by the rapid rise in inflation, weak growth, lower factory activity ratios, and rising unemployment. While there were no official statistics, research suggests that, after the Covid period, every larger family knew at least someone not being re-hired or made redundant. 

On top of this, because of the slumping property sector — people felt their homes were worth less which in turn has prompted people to save rather than spend. 

The low level of confidence also impacted the Chinese tourist industry. Holiday bookings for the lengthy February Lunar New Year were low, despite an overall lower price tag, signaling the consumption rebound still has a long way to go. 

Regulator crackdowns on big technology companies is adding negativity to overall concerns in the industry. As a result, many lucrative career paths for many young and ambitious graduates have vanished. 
  

For years, property investments were considered by many Chinese as a sure-bet investment that never can fail and that would serve as a store of value for the future. The downturn has however taught them a different lesson and the pain is expected to continue in 2024. Prices of new and second-hand homes continue to drop, a trend that has been well entrenched since early 2022.

To reduce risks to the financial system, the government attempted to restructure the heavily indebted real estate developers in 2020. It didn’t succeed as passive corruption is still highly present. 

In the meantime, several key companies have defaulted with over ten million housing units not being terminated. Moreover, because of the liquidity crunch, many developers, while not being out of business, stopped building homes they sold earlier on. This in turn prompted people to stop making their down payments since the prospects to relocate evaporated. 

To untangle the situation, the government has unveiled a long list of measures centered on boosting equity, bond, and loan financing for developers to alleviate the liquidity crunch. For the time being, this strategy has failed as developers like China Evergrande Group and Country Garden Holdings Co., once the country’s largest developer by sales, continue to suffer from rampant liquidity crunch.

6. Central Bank Policy?

Here we have a binary situation. Firstly, the People’s Bank of China (PBOC) is highly intertwined with the international monetary exchange. Secondly, the PBOC has to manage, maintain, and satisfy a complex fixed exchange mechanism with its main trading partners directly impacting its citizens.  

As of now the People’s Bank of China policy is one of the largest single US Debt holders. While the amount has been declining ever since 2018 - this coincides with the US/China trade war initiation - it is still holding the equivalent of $ 816,3B as of January 2023.

This leads us back to its policy. The People’s Bank of China cut interest rates twice last year. The use of this traditional tool did little to help growth. 

At the beginning of 2024, the central bank disappointed investors once more by not cutting its key policy rate. In lieu, the PBOC has eased monetary conditions, i.e. a less stringent reserve requirement ratio and a record reduction to a key lending rate. 

To go forward, the fiscal stimulus is expected to play a larger role this year — especially given constraints the central bank faces from a strong dollar, still-high US rates, concerns about domestic capital outflows, and a net foreign investment balance. 

So far the central government has announced plans to issue 1 trillion yuan ($139 billion) of ultra-long special central government bonds in 2024, along with aims for similar issuances in the coming years. Lately and to promote local consumption, the appearance of buzzwords like “New Productive Forces to Drive Growth”, Worry-Free Spending for Consumers”, and “Common Prosperity” occurred; it appears there is a government entity that acts as a sponsor. 

While psychology plays an important role during times of stress, the use of such buzzwords could incite people to do the opposite, i.e. a belt-tightening exercise on big-ticket purchases.

Multiple examples of dead-born government stimulus programs provide evidence that the funds seldomly reach the actual destination, but rather evaporate somehow on the way to it. We wouldn’t expect this to be different in China. Hence the use of direct subsidies is of little help to undo the deep routed property crisis.The housing market suffers from an oversupply that will take multiple quarters, probably years, to resolve thereby more pain should be expected in the construction sector. 

We expect the present property market crisis to likely initiate a profound change to the entire economic set-up. With fewer structural factors driving the market, for instance, the population is shrinking and there are fewer foreign investment projects, the economy may adjust faster than expected to a service economy. 

But this change does not come for fee. The country could face an extended period of weak growth while it works on its transition and fixes its debt problems. This is a scenario similar to the one experienced by Japan after the property and stock market bubbles burst in 1990. In fact, in the case of Japan, history books teach us about the lost decade. 

Weak growth coupled with structural challenges could result in a lost decade for the nation too. Given the likelihood of this scenario, we doubt that China can overtake the US as the world’s biggest economy, a milestone that the Chinese government wanted to achieve by 2030, is happening any time soon.

History tells us that supremacy never lasts! Major civilizations were built within a few generations and have lasted in some cases several centuries while others vanished relatively quickly.

When looking back through the corridors of time, we also learn that rising empires ushered in an era of religious tolerance, global free trade, technological advancement, and equal opportunity for commerce. It is fair to say that China does not tick all the boxes and that there is room for improvement in many areas. 

Historians fail to explain and assign a specific cause for an empire to collapse. Whether we look at the historic Empires or today’s construct, they seem to have emerged from well-setup foundations, built grand cities, large expensive armies, complex communication systems, and complex regional trade networks. A complex setup comes however with costs. While at first sight complexity is a good thing, i.e. it increases competition, it requires more and more energy, it creates administrative disruption, and other forms of friction. Without realizing it, empires become fragile as points of failure multiply.

That fits well with our own zeitgeist where we find several poly-crisis among others. We have some overlapping issues with the past, from geopolitical polarization, inequality, and overarching issues such as climate change, war, pandemics, and mass migration which we fail to address. More importantly, we do seem incapable of simplifying things.

Researchers such as Tainter and Cline suggest that a partial disruption of the global supply chain could be devastating for all of us. By disrupting the flow of semiconductors, the world will stop functioning. In contrast with the past, we understand the feedback loops in the system we rely on.

To put today’s concern into the context of humanity, if there is a collapse of an Empire, then it is not the end but rather part of a perpetual evolution with seeds of renewed human grandeur. 

The major long-term challenge China is facing consists of transitioning its economy from an infrastructure-based economy to a service-driven economy. This evolution involves not only economic aspects but also enforces social and cultural facets. This might include plans to create pension plans, full social security, antipoverty programs, and a progressive personal tax system, among others. While the implementation of these improvements will take decades, investors need to remain vigilant and ready for rapid changes. 

For now, the government is expected to deliver measures and strong policy execution to fix issues related to its infrastructure. In the absence of palpable results and as direction is lacking, the Chinese equity market is expected to face greater volatility. 

Investors are advised to adopt a barbell strategy by holding onto recovery beneficiaries in sectors such as consumer, materials, and industrial sectors, alongside strong balance sheet stocks in defensive sectors including utilities, telecom, and insurers. We would advise reducing the exposure to banks as the fallout from the credit bubble may not be accounted for in full.

Overall, policy support may fall short of expectations and therefore it would be opportune to skew to the portfolio to the defensive.