Polina Kurdyavko hits the road, reflecting on her observations from around the world while tying in fresh investment perspectives related to emerging markets. For investors that are both armchair travelers and road warriors, these insights will open your eyes to the opportunities abroad. Subscribe to receive her latest note.
Key points
- Most recent Chinese economic data have been weaker than expected
- This has been mainly driven by deterioration in the real estate sector, the weaker performance of the banking sector and the marginally softer export data
- We believe the government needs to introduce structural tax reforms as new solutions to address the issues
Are you a workaholic? I grew up with both of my parents putting great emphasis on a strong work ethic. Indeed, competitive spirit and resilience were the foundation of the Soviet upbringing. While there are undoubtedly benefits to a strong work ethic, a constant ‘overachiever’ mindset also has its downside and limitations.
In a visit to China last week, the latest buzzword, 'involution', came up repeatedly. Most people in China work from 9 am till 9 pm six days a week (so-called ‘996’) or virtually 24-hour shifts, seven days a week (so-called ‘007’). Many claim this has led to a number of challenges, including exhaustion, anxiety and increased incidents of mental illness. The old English proverb, ‘All work and no play made Jack a dull boy’ might need rewording a ‘dull boy’ into an ‘ill boy’ in today’s context. Notwithstanding the benefits the strong work ethic has yielded in China over the last twenty years, recently, this hardworking attitude has not translated into a continuous improvement in growth and consumer confidence.
Weaker data disappoints
Looking at the most recent Chinese macroeconomic data, the GDP print of 6.3% year-on-year in 2Q23 was below market expectations, with most analysts now expecting growth to slow further to a low of 4.8%-5% in 2H 2023. This is a modest outcome in the context of a post-Covid recovery, especially compared to developed countries. It is also notable that China has room, both monetary and fiscal, to stimulate a recovery, given the policy rate of 2.65%, zero inflation and a modest fiscal deficit of 3%.
The weaker data has been mainly driven by a further deterioration in the real estate sector, the weaker performance of the banking sector and the marginally softer export data compared to the recent peak in 2022. Combined with three years of lockdown due to the Covid pandemic, this has translated into an unprecedented crisis of confidence within China. What is the path to recovery? The Covid pandemic is hopefully behind us and the export slowdown is largely a result of a global slowdown and deterioration in the US/China relationship. However, the rehabilitation of the real estate sector, which has created a meaningful dent across all sectors of the Chinese economy, appears more questionable.
The ongoing property price decline
Property sales in China are down over 50% since peak levels of 2021. Moreover, most private developers are still in a ‘frozen’ state with no construction activity, given the lack of funding and liens on completed projects that forbid developers to conduct sales. In late 2022, the government introduced several measures to help jump-start the developers’ sales, but these measures do not appear to have yielded results, with new sales down 37% year-on-year as of 17 July 2023. While the government can inject liquidity into the banking sector, the policy objective of making housing more affordable means it can’t/won’t force the banks to lend to the developers.
In our view, this translates into a slow and gradual property price decline balanced against a slow release of property supply. Meanwhile, despite being flush with liquidity, banks are not lending to the real estate sector. They are struggling with profitability, seeing their net interest margins (NIMs) barely above 1%. The status quo is also putting a lot of strain on local government balance sheets, given that traditionally real estate sales accounted for approximately half of their total revenues. We know that, for now, the government is allowing local governments to sell land to LGFVs (Local Government Financing Vehicles) and use this as security while LGFVs raise funding through the bond market. This approach is a short-term tactic that is not sustainable in the medium or longer term. The government is also allowing some ‘policy banks’ to put equity in the state-owned enterprises (SOE) infrastructure companies to enable funding for land purchases. However, we understand that the scale is small.
New solutions required
What is the solution to avoid local governments following the path of real estate developers? Longer term, we believe the government needs to introduce a structural tax reform, including the introduction of property tax, capital gains tax and a personal income tax filing system that would allow local governments to broaden their revenue base and reduce reliance on the real estate sector. However, there needs to be a stimulus in the short term to grow demand. The government’s overarching policy objective focuses on affordable housing and house improvements, i.e., shantytown renovations. Given these objectives and the acknowledgement that real estate accounts for 80% of consumers’ wealth, it is keen to engineer a gradual slowdown in property prices. The government can achieve this by managing the supply in the market, which explains why we haven’t seen a meaningful increase in stimulus to the sector so far.
The current property oversupply is striking. During our trip, we visited several projects sold in Tier 1 cities over the last few years. Even these projects were only 40% occupied, with the majority still left unfurnished. Given the anticipated gradual price reduction and currently low rental yields of 1%-1.5%, this market is unlikely to attract new investors. Therefore, we would expect sales volume to gradually decline further. In this environment, how do local governments gain revenues and do real estate developers have a chance for survival?
One solution could be a revenue-sharing agreement between private developers and their SOE contractors, restoring confidence in the banks to lend to new projects. In this instance, some private developers may at least have a chance of a turnaround, benefitting from the low cost of funding and low leverage of their SOE partners once the property market recovers in the medium term. Without such strategies, no matter how attractive various restructuring proposals might look today, only a handful of private real estate developers will likely remain a going concern in the long term.
All eyes on policymakers
While the real estate crisis has been in the eye of the storm, other developments give us hope. The government is prioritising focus on technology and consumption, a move that requires the participation of the private sector. We are encouraged by the recently appointed Prime Minister, Li Qiang, who is known to be pro-business and supportive of reducing bureaucratic interference in the market. We are also encouraged by the social aspects of the Chinese workforce, in particular its gender diversity. Most of the senior officials whom we met on our trip were women. In some cases, such as the Ministry of Finance, women account for more than 50% of the workforce. We also note that although the Western press has focused a lot on China’s pro-Russia stance during the war, a strong argument can be made that China has tried to maintain a neutral official position throughout.
Trust is a rare commodity in times of geopolitical tensions and economic downturns. The market is also oversensitive to news flow, second-guessing the validity of sources and questioning hidden policy agendas. Recent rules that include onerous procedures for foreigners interacting with policymakers and broadening the anti-espionage policies raise more questions than answers. The dynamic surrounding these concerns can quickly lead to a further deterioration in trust and become a self-fulfilling prophecy. This would be a shame, given the many economic and political advantages achievable through global cooperation.
Finding the balance
Interestingly, during my trip, the Chinese work ethic was definitely a bonus for our schedule, permitting eight meetings on Friday and six on Saturday – no questions asked. With that said, one does have to wonder about the bigger risks of excessive workload creating more challenges for Chinese individuals, regardless of the marginal impact on productivity. The West is also grappling with the notion of work/life balance, especially following the pandemic and growth slowdown.
Evolution of our priorities to find the right balance -- individually, as a society and from the position of a policy maker -- is needed to deliver broad personal well-being and sustainable economic growth.