Tiger Head, Snake Tails
is the title of a book about China written by journalist Jonathan Fenby. It is a metaphor for what he learned about the country as an author and editor of the South China Morning Post. He suggests that one has to take into account not just the China that hits the headlines, or the top-line economic statistics or the straight-line projections to a future that may or not come to pass, but also a host of down-to-earth factors which actually determine how the country functions and where it is going. Your team at Ledyard has been working to understand these factors because they will help us manage your portfolios. China accounts for almost one-fifth of the world’s economy and about 1.4 billon of the 7.9 billion people on this planet. China’s path and decisions have implications for investments across the globe.
We have been very fortunate to be able to access the perspectives of many talented individuals in the Ledyard network. Sarwar Kashmeri is an international relations specialist, author and commentator. He joined us recently for a conversation focused on China’s grand strategy and its relationship with the United States and other countries (please let us know if you would like a copy of the video). We have also considered the views of accomplished members of our Investment Advisory Board and other China experts. In this article, we would like to share our thinking about several concerns about China that have been in the headlines.
China’s Regulatory Crackdown
The Chinese government has introduced an unprecedented number of regulations over the past year. They target specific sectors such as internet platforms, educational services and residential real estate. Investors are questioning whether China intends to undo decades of market-based reforms. This concern has wiped $3 trillion from the market value of the country’s biggest companies.
We do not believe the Chinese government is moving to squeeze out capitalism. China’s private companies have driven new job creation and lifted hundreds of millions of its citizens out of poverty. The government is unlikely to reverse this. Instead, China is doing what it articulated in its 14th Five-Year Plan. It is trying to promote more sustainable and responsible growth. Policymakers are tackling many of the same concerns that major democracies have. These concerns include income inequality, unequal access to education, anti-competitive behavior, the impact of gaming and social media on children and consumer data security. While new regulations will hurt the near-term outlook for some companies, these changes will make the Chinese economy more resilient in the long-term.
While the government has singled out some sectors for restrictions, it has stepped up support for others. China wants to strengthen its consumer markets and become a self-reliant technological powerhouse. As such, it is moving rapidly to build its innovation ecosystem. The country now accounts for one-fifth of the world’s spending in research and development, second only to the United States. It has increased its investments in semiconductors, artificial intelligence, biotechnology, aviation, health care, cloud computing and clean energy. The results are significant. For example, China is the world’s largest producer of electric vehicles. New and larger pools of investment capital combined with a well-educated workforce will support more innovation. This will promote growth and engender more robust capital markets.
China’s Real Estate Bubble
Home prices in China have increased six-fold over the past 15 years. As the chart on the left shows, the price of homes relative to annual household income levels is extremely high in major Chinese cities. Real estate and related services account for about one-quarter of China’s annual GDP. The chart on the right shows that total debt of Chinese real estate development companies. Debt has surged from $100 billion to $1 trillion dollars in ten years.
There are many other reasons why economists believe this $50 trillion asset class – the largest in the world - is a bubble. The important question is what will the implications be when it deflates? Our base case is that it may cause a deflationary shock to China’s economy, but it will not lead to contagion that will cause markets to drop across the globe.
The Chinese government has introduced measures to control the debt levels of property developers. These changes have pushed developers such as China Evergrande Group to the brink of bankruptcy. The headlines are evocative of the US housing downturn that led to the 2007-2009 global financial crisis. But there are important differences. Because China has a semi-closed system, global banks do not have much exposure to real estate loans in China. As a result, there are fewer linkages to the global financial system. According to Goldman Sachs, loans to real estate developers account for 6% of Chinese total bank loans. Unlike the loans made before the financial crisis, these loans are not packaged into opaque securities tied to derivatives. These loans are straight-forward and defined clearly - secured by land and local development projects. Lenders will force borrowers to sell properties at a discount, but these loans will be easier to restructure.
Twenty-eight percent of Chinese bank loans are mortgages. Chinese homebuyers must put down 30% of the value of a home in cash. The average outstanding mortgage is about 50%-60% of each home’s value. This means home prices would have to decline significantly before there is not enough collateral for banks to cover their loans. These mortgages are quite different from those that caused the global financial crisis of 2008. During that period, banks were providing mortgages to homebuyers with loan-to-value ratios as high as 125%. Home buyers often did not have to put any money down or provide proof of income.
Residential real estate has long been an engine of growth for China. Beijing’s aggressive campaign to reduce excesses in the housing market will thus have a meaningful negative impact on its economy. Chinese policymakers will likely ease monetary and fiscal policy to offset some of this weakness. They have room to do so because they eased policy modestly compared to other central banks to cushion the impacts of the coronavirus. Despite this, we expect China’s 2022 GDP growth to be below the consensus expectations of 5.5%. Because China has accounted for about 30% of the world’s economic growth, this will have implications beyond China’s borders.
Where We Stand
Ledyard’s exposure to China-based companies is just 2-3% of the equities in most of our investment strategies. We are reviewing our positions in US companies that have a high percentage of sales to China. These companies might be impacted as China’s economy slows and it continues to become more self-reliant. Revenue growth in other fast-growing regions such as India and Africa may be a counterbalance. At the same time, we are confident that China’s current challenges will lead to promising investment opportunities in the future. Although counterintuitive, it is important to remember that bull markets are born of pessimism not optimism. The US bull market we are experiencing now sprouted from the economic shock from Covid, and before that, from the ashes of the financial crisis more than a decade ago. Chinese equity valuations have fallen as pessimism has increased. But they have not yet reached the bottom of their range.
Over time, investors may increase their investments in China. The country represents 17% of the global economy but only 4-5% of institutional investors’ portfolios. China’s Five-Year Plan reiterates its commitment to open its markets to more international investments. While China’s regulatory changes should ultimately improve China’s investment landscape, there is plenty of work to do. To attract more capital, China needs to address corruption, intellectual property theft and human rights issues. Residential real estate has been the primary investment choice for many Chinese investors. This will change. If investors decide to put more of their significant savings in stocks, Chinese public markets will have meaningful upside.
As always, we welcome your thoughts and questions. We are grateful to those that have provided input as we investigate and interpret China’s many complexities.
Chief Investment Officer