Are you impatient? I am guilty of not having a lot of patience. While I understand the notion of “good things come to those who wait”, I generally focus on minimising the waiting time. Looking at the Covid-19 pandemic waves in China, it feels like investors, businesses and policymakers across the globe are also becoming increasingly impatient with slow progress on re-opening the Chinese borders and the implementation of regular lockdowns to maintain the zero-Covid policy.

Today, faced with two significant sources of uncertainty – the implications of zero-Covid policy in China and the fallout of the Russia/Ukraine war – it appears that investors are more puzzled by potential solutions to the former than the latter. Over the years, we have learned to allow for a different pace of decision making out of China. In the past, we have seen in numerous instances a thoughtful and measured approach when it comes to dealing with crisis situations, rather than a panicked, rushed response. But this time round, the prolonged pause in engineering a way out of zero-Covid policy risks taking a bigger toll on the economy and future growth prospects than China has faced in the past.

This was the response of a policy official in China when providing a rationale for the current Covid policy during our conversation a few days ago. While it is worth reflecting on this profound difference in philosophy, in today's world, several sectors inside and outside of China have been directly affected by the country’s Covid policies.

Continuous lockdowns are disruptive for any economy and China is no exception. Lockdowns create material supply bottlenecks across the world – a full lockdown of one Chinese city can lead to a 50% drop in shipping volumes in and out of that city during the lockdown period. Both foreign and domestically-owned businesses in China are suffering – 23% of European businesses (the highest number in 10-years) recently announced that they are considering moving operations out of China as they urge authorities to move away from lockdown policies.

Having historically been one of the key drivers of Chinese growth, the sector has suffered a double whammy of tighter liquidity (given China's focus on deleveraging) and much weaker property demand in the wake of the zero-Covid policy. Real-estate sales volumes are down more than 40% year-to-date from the peak at the start of the pandemic, with volume drops being most pronounced in lower-tier cities, while unsold inventories spiked to the highest level since May 2008. The need to de-lever the sector, which relied primarily on debt funding given the lack of alternatives, was widely acknowledged. However, a sharp tightening of liquidity, starting in late 2020, combined with the zero-Covid policy and continuous lockdowns, led to a scenario where over half of the sector went into financial distress. 52% of the companies’ publicly traded debt went into default over the last 12 months and another 27% is expected to default between now and year-end, based on BoAML estimates. Defaults have been almost indiscriminate, including high-quality investment grade names, with only a handful of developers out of over 100 issuers with USD250bn+ of bonds outstanding continuing to trade above 50 cents on the dollar.

A lack of policy response risks changing a liquidity problem into a solvency problem for a strategically important sector in the Chinese economy. This also has implications for other sectors. Companies ranging from steelmakers to cement producers are starting to feel the pinch, with cement and steel volumes down 12% year-on-year and 8% year-on-year respectively in 1Q22.

Over the last few weeks, we engaged in a fact-finding mission, revisiting a number of real-estate projects across China to evaluate the state of play and prospects for recovery on the defaulted bonds. Some of the findings confirmed our expectations and some raised eyebrows. As expected, most developers continue to work on completing existing projects. However, the focus is on building, not selling. In some cases, sales offices were shut or developers didn’t have any sales representatives available to show the properties following mass redundancies ranging from between 20–80% of personnel. For some developers, construction activity had also halted, as they were unable to gain support from local governments to continue with their projects. There were also instances of questionable dealings, with one developer trying to sell residential projects that were not approved by the government at a big discount, albeit without much luck. Overall, the sense of optimism that is usually ingrained in sales teams was notably absent.

While it’s not surprising that the government’s focus has been on completing existing projects, the cash flow problem in the sector is not being solved and is only growing as lockdowns continue. For real estate developers, time is money and a lack of sales is not only a lost opportunity cost, but translates into a further rise in operating costs. We saw this chain of events play out in other countries where a steady accumulation of municipal and other operating liabilities over time left investors empty-handed.

Yet so far, the Chinese government doesn't seem to exhibit a sense of urgency in providing sector support or revitalising economic growth by following the Western model of exiting from the pandemic. Ironically, when responding to crises in the past, governments of large market-oriented economies have not provided market solutions but, fearing the consequences, have opted for bailouts (e.g. the US during Global Financial Crisis in 2008 or European Crisis in 2011).

One can argue that China is the first large economy that has taken a market approach to dealing with a crisis of this significance. However, this approach has a cost to it. At 6.1%, the recent unemployment print in China was already close to the five-year highs and, in our view, with real estate and construction accounting for 20% of urban employment, this rate is going to increase further with the current policy mix. Employment is a core pillar of social stability in the country, something which remains one of the government’s key overarching goals.

China was arguably exemplary in dealing with the Covid crisis at the outset, but this cannot be said about the aftermath. We believe that at this stage, zero-Covid policy is a political decision detached from economic and social rationale. This is unlikely to change until the 20th Party Congress in autumn 2022, where we could see some key personnel reshuffles in the Politburo Standing Committee (PSC). With that said, the cost of waiting should not be underestimated. Until people are free to move within and outside the country, any monetary or fiscal stimulus is likely to be less effective. It would follow, therefore, that longer-term growth projections are likely to be meaningfully below the current consensus, as will future investor interest in the country.

While the focus on “lives over freedom” is understandable, during a crisis a lack of policy response can often create even more imbalances and ultimately trigger a much bigger adjustment down the line, with this sector (including construction) accounting for a third of Chinese GDP, 35% of total local fiscal revenues and 28% of total banks’ loans in China. And this is without mentioning that housing wealth accounts for close to 80% of all Chinese financial assets (including equity and bonds), making Chinese private consumption very sensitive to house price decline.

Only two years ago, China’s demographics and urbanisation trend were delivering 7% growth in real estate sales volumes, given continuous growth in the urbanisation rate and the need for home improvement, as well as limited alternative investment opportunities. At that time, pent-up demand for property translated into a 20% price premium in the secondary market compared to the primary market, where the government had more influence. A revival of this trend is heavily dependent on the actions and priorities of policymakers.

But investor patience will soon run out. A lack of timely action by the government can have long-term consequences. However, the larger potential damage does not lie in recovery levels for bondholders and future investor interest in China, but in those areas that are top priorities for the government, such as social stability, employment and prosperity.

While construction is ongoing (see left), the state of the showroom (see right) reflects the (lack of) sales focus.