The case against China

Lots of lazy headlines about China at the start of the year. About how it was going to dramatically reopen after the lifting of stringent Covid-zero lockdowns, fueling an economic surge akin to when it emerged out of the global financial crisis (GFC). 8% to 9% GDP growth. Spillover effects lifting the rest of the world, including the U.S. A vast appetite for resources supporting EM markets. Well, we’ve moved past halftime into the third quarter and the reemergent China story has yet to pan out. After a solid but unspectacular Q1, built on a sugar high in services as residents emerged from their Covid caves to travel and go to movies and restaurants, the data has disappointed. Q2 growth slowed, manufacturing is contracting and to date, foreign visitors largely are staying away. Contrary to my esteemed equity colleague, I don’t have a lot of confidence that a pro-business pivot from authorities can rapidly turn this situation around. Maybe it can give a lift to beaten-down stocks, but bonds? I’d rather look elsewhere.

A big problem is China was getting sick even before Covid. It had issues with demographics—it’s getting older, its working-age population is shrinking and there’s a jobs-skills mismatch (it needs engineers and technicians to meet its tech and AI ambitions); with policy—far different from his modern-era predecessors, President Xi Jinping has been almost antagonistic to the private sector and has consolidated power from all centers of government, steps that discouraged entrepreneurship; even with the economy itself—for a long time, Chinese growth centered on very heavy fixed investment in commercial, industrial and residential structures that required unsustainable growth in debt to support. Now, growing trade tensions with the U.S. and slowing growth in Europe are cutting into exports, as is “friendshoring” that has customers looking to Mexico and other sources of supply closer to home. Xi’s “Common Prosperity” initiatives focusing on the quality rather than quantity of growth also were moderating China’s economic outlook before the pandemic hit. Covid—and China’s response to it—made it all much worse. When entire cities like Shanghai were shut down for 90 days, or 10 city blocks without warning, it was psychologically scarring. Confidence remains shot. Consumers aren’t spending as much even though their savings are high. Their main sources of wealth—the Chinese stock market and real estate—have been battered, and at 22-23%, youth unemployment is double pre-Covid levels.

This environment has left China with limited options. Its focus on monetary policy to goose growth confronts weakened avenues for transmission. China is still an EM country, and at 292%, its total debt to GDP provides little incentive for consumers or local/regional governments to borrow more, or debt markets to step up. The central government isn’t in bad shape, but there’s a misconception that China is a highly centralized state when it’s the regional and local governments that do the heavy lifting. And they’ve already borrowed heavily, using land sales as a major source of revenue. With real estate in the doldrums, that door is largely closed. For bondholders, the whole sector is uninvestable—Evergrande casts long shadows. This means fiscal stimulus faces limits, too. Local governments are stuck with a lot of debt and few options to pump out a lot of new spending. A central government bailout seems unlikely. Remembering the fallout from the GFC spree, they want to avoid the moral hazard trade. Tax cuts are possible but would have to be funded. In short, there’s little prospect of anything like 2008’s $560 billion stimulus. There are no quick fixes.