China’s slow motion financial crisis

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Good morning. US markets wobbled only a bit yesterday, after Wednesday’s oh-lordy-the-Fed-really-meant-it meltdown, so we thought we would take a breath too, and look at some more global stories. Email us: [email protected] and [email protected]

China’s slow-motion financial crisis

For much of last year the biggest story in finance was the real estate debt crisis in China — until Evergrande’s collapse was shoved off front pages by the global inflation panic. Yet Evergrande remains a huge, moving story.

The latest sub-chapter unfolded this week, when a unit of another major Chinese developer, Shimao Group Holdings, defaulted on a loan from a China Credit Trust Co. Shimao’s dollar bonds due this year went from $71 to $48:

Another developer, Guangzhou R&F Properties, said it might miss a repayment next week. Its bonds, already trading at a fraction of par, got hit hard again, too. If you thought all the bad news about China real estate was priced in, you were wrong. We’re still looking for the bottom.

The repercussions of this slow-motion crisis are described beautifully in yesterday’s FT Big Read by Sun Yu and Tom Mitchell. But very schematically, what has happened is this:

  • Over a period of years, the growth of China’s real estate sector became dependent on ever-larger amounts of debt

  • The authorities decided to put limits on property developers’ indebtedness (most famously by setting the “three red lines” in August 2020)

  • The debt limits not only pushed Evergrande towards default, but it left all developers very dependent on property sales for cash

  • But property sales are slowing — in part, presumably, because of loss of confidence caused by Evergrande’s fall — so other developers are nearing default too

  • Infrastructure spending is falling as well, because it is funded in significant part by local governments’ land sales to (now broke) developers

Here is what Caixin reported about the fall in property sales yesterday:

Sales of new homes by China’s top 100 property developers dropped 3.5 per cent to Rmb11.1tn ($1.8tn) in 2021, the first annual decline in more than a decade, data compiled by China Real Estate Information Corp show …

The real estate market has yet to bottom out and will enter a phase of zero growth, CRIC said. Policies restricting financing will be marginally eased in 2022, but the short-term outlook is not promising, it said.

A 3.5 per cent decline in sales may not sound bad, but debt amplifies the impact of lost revenue. And — as we have all learned over the past year — real estate is a very large piece of China’s economy. The consensus (as explained, for example, here) is that fixed investment accounts for more than 40 per cent of the country’s GDP, and that public and private construction projects account for about two-thirds of that. Furthermore, some 70 per cent of household wealth is tied up in real estate, so real estate value declines seem likely to create negative wealth effects.

What this means for economic growth cannot be precisely estimated, but it ain’t good. Craig Botham, chief China economist at Pantheon Macroeconomics, says China’s days of 6 or 7 per cent growth are “gone forever”. The new goal is 5 per cent, which is what will be required to meet Xi Jinping’s target of doubling the economy between 2020 and 2035. “Even that is probably above-trend growth, so they will need to add debt to get there,” he says.

Judging by the official and semi-official response to the Evergrande crisis, more debt is a good prediction. That response has consisted, as far as I can tell, of finding ways to smuggle new debt into the system.

The small loosening of bank reserve ratios is the least of it. Restrictions on developer bond issuance have been eased. State-owned local government financing vehicles are taking the place of developers in property auctions. Developers are issuing commercial paper to evade the “red lines” debt restrictions. Most striking of all, as detailed in the Yu/Mitchell Big Read, local governments seem to have been handed the job of supporting the creditors of broke developers, and seeing that building projects are completed:

Local party and government officials also complain that they, not their bosses in Beijing, have to foot the increasingly expensive bill for Evergrande’s collapse. Wei He, an analyst at Gavekal Dragonomics in Beijing, notes that when central government officials say that all pre-paid homes must be delivered to their nervous buyers, “this responsibility ultimately falls on local governments who may have to pay for construction themselves if developers cannot”. In Huaihua, a small city in Hunan province, the municipal finance bureau recently loaned Evergrande’s local subsidiary Rmb50m to help it complete projects, according to one person familiar with the developer’s operations there . ..

In Shaoyang, another city in Hunan, local officials are trying to auction their Evergrande problems away. On December 24 they announced that they would sell off the developer’s four projects in their jurisdiction. “Neither the government nor Evergrande has money,” one local official told the FT. “Someone else needs to fill the vacuum.”

This is a long way from an orderly and transparent liquidation process in which an order of creditors is established and losses are assigned. Instead, it looks like an improvisational effort to kick the can, creating the appearance that no one — with the exception of offshore bondholders — is taking a hard loss.

How much does all this matter to global investors? Because the Chinese authorities have chosen ambiguity and pain later over transparency and pain now, it is hard to know who will bear the inevitable losses.

But one point, from Pantheon’s Botham, is worth bearing in mind. The cyclical supply of credit in China — the so-called “credit impulse”, or contribution of debt to GDP — has been tightening for more than a year now. Many observers are expecting the loosening of credit to lead to a rebound in China’s economy. But unconventional forms of credit are already flowing, and all they are doing is filling balance-sheet holes left by Evergrande’s collapse, not creating new capacity or output.

More debt may buy China more time, but it won’t buy it much growth.

Kazakh politics are investors’ problem

The protests ripping through Kazakhstan have brought the Central Asian frontier market to the world’s attention. We won’t feign expertise on the domestic or global politics. But we did have a look at the market implications.

One market where Kazakhstan matters is uranium, where Kazatomprom, the state-owned mining company, is the world’s biggest supplier. The company, which is listed on the London Stock Exchange, reassured investors that protests had not led to production stoppages and work would continue apace. Yet the unrest pushed prices up 8 per cent.

Why? One analyst explained the situation to Bloomberg like this:

Given Kazakhstan’s role as the world’s No 1 uranium supplier, “it’d be like if the Saudis had issues in oil,” said Jonathan Hinze, president of UxC, a leading nuclear fuel market research and analysis firm. “Even if there isn’t a shortage right now, the potential for this to create a shortage is what people now are trading on.”

It is actually worse than that, according to Amir Adnani, CEO of Uranium Energy. Kazatomprom controls 40 per cent of primary uranium production — more akin to a one-country Opec than to Saudi Arabia.

Moreover, mine closures and the lack of new mines have choked off production just as more countries are embracing nuclear power. That has left uranium supply some 50m pounds short of demand each year, sending prices to a nine-year high in September. The gap is being filled by fast-depleting above-ground inventories, which are at decade lows. Here’s Adnani:

The market was already in a structural deficit between supply and demand. And the market had quite a bit of concentration in one country, which would’ve created geopolitical risk exposure prior to [Kazakhstan’s protests]. 

And now you have a situation [that] illustrates how risky a highly concentrated industry can be — especially when there’s a lot of concentration and geopolitical risk that is all of a sudden manifesting itself.

We relay all this not because it is a catastrophe in itself, but because it is a microcosm of the risks that can emanate from markets that rarely command investor attention. Domestic politics in far-off countries increasingly matter. What if these protests came in a future world that relied on nuclear to solve renewables’ intermittency problem? Or if similar protests broke out in the Democratic Republic of Congo, which holds 70 per cent of the world’s cobalt (which is indispensable in electronics such as electric vehicles and phones)?

Simon Quijano-Evans, chief economist at Gemcorp Capital Management, put it nicely in an email:

No matter what the reasons for the turmoil are, the current situation in Kazakhstan comes as a surprise to everyone, political pundits and neighbours included.

But, as we have seen in the past two years in both emerging markets and developed markets, with the very bastions of democracy threatened at times, governments and indeed electorates everywhere need to remain aware of these risks.

The global economy, it is sometimes claimed, is deglobalising. That may be true on the margin, but don’t discount how integrated the world already is. The next big commodity shock could come from somewhere most investors barely understand. (Ethan Wu)

One good read

Elsewhere in the FT, Alphaville’s Jemima Kelly takes Matt Damon to task for his crypto shilling. As Kelly points out it took the actor just a decade to go from narrating anti-bank tirades to pushing crypto.

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