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China’s Fragile Property Sector Is A Problem For Global Growth

By Speculators Anonymous (Adem Tumerkan)Market OverviewSep 23, 2021 01:13AM ET
China’s Fragile Property Sector Is A Problem For Global Growth
By Speculators Anonymous (Adem Tumerkan)   |  Sep 23, 2021 01:13AM ET
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In early June I wrote an article highlighting China’s increasing fragility and the negative ripple-effects it would have on the world economy. To give you some context: I hypothesized that Chinese authorities would keep tightening credit. And that it’d lead to further debt-defaults.

Now—just a few months since then—and things have only grown more fragile in China (especially in the property-development sector).

And while the mainstream financial media stays focused on the tip of the ice-berg. I’m busy looking at the big-picture. Meaning: there’s a wave of defaults coming in the property sector combined with diminishing returns that will indirectly bog down global growth.

Let me explain. . .

China’s currently dealing with the slow-burning Evergrande (OTC:EGRNY) (HK:3333) crisis (aka the world’s most indebted property-developer) which is nearing total collapse.

And while this is a serious problem—it’s most likely just the beginning. . .

For instance, according to ANZ Research, China’s property developers are facing a wall of dollar-denominated debt coming due over the next few years.

Chinese Property Developers USD Debt To Marture
Chinese Property Developers USD Debt To Marture

To put this into perspective: over $175 billion of debt is maturing by 2026 (with $55 billion due next year).

Now—assuming these firms won’t have that kind-of cash on hand—they’ll be forced to refinance (aka roll-it-over with new debt). But many will struggle (and have struggled) to do so.

And that’s because of China’s ‘three-red lines’ policy. . .

To give you some context: in late-2020, Chinese authorities began trying to gain control of the rising debt burden. So they created guidelines to try and clean up the highly-leveraged property sector. Thus they passed the ‘three-red lines’ agenda (aka three rules that put hard limits on a company’s ability to borrow).

In short, the authorities began forcing developers to deleverage (aka cut back on debt and raise cash instead). Almost immediately these policies began negatively effecting the entire property-development industry.

That’s because—according to S&P Global estimates (as of early-2021)—only 6.3% of all Chinese developers met the ‘three-red lines’ criteria. . .

This implies that over 90% of the developers weren’t able to borrow from lenders until they cleaned up their balance sheets. And while many firms were able to sell assets, cut-back on projects, etc in order to borrow—many others weren’t able to. . .

That's why, in Q1/2021, roughly 27% of all China’s corporate bond defaults came from the real-estate sector alone.

China Bond Defaults
China Bond Defaults

(Keep in mind that property-developer defaults were already on-the-rise before the aggressive ‘three-red lines’ agenda ever began).

Thus – a fragile industry has grown far more fragile.

And while the Evergrande default has captured the mainstream financial media’s heart, there are still hundreds of other firms nearing their own tipping-points. Each with their own potential ripple-effects throughout the global financial system.

But it doesn’t end there. . .

That’s because—besides the financial distress that comes from increasing defaults—there’s significant spill-over effects for the global economy. . .

For instance: China’s economic growth is extremely important to the global economy (especially since 2008). And China’s property sector, which makes up 30% of its annual GDP as-well as a bulk of global commodities demand, has been a key driver for that growth.

But it appears that China’s state-led infrastructure investments and property-sector have already hit the wall of diminishing returns. . .

Meaning: China’s hit the point where each new project costs more while generating less growth.

Just take a look at China’s incremental capital output ratio (ICOR—aka each additional unit of capital needed to produce an additional unit of output) relative to ‘real’ economic growth. . .

Incremental Capital Output Ratio To Real GDP Growth
Incremental Capital Output Ratio To Real GDP Growth

As the chart shows, China averaged between a three-to-four ratio before 2008. (Meaning that new spending increased real growth relatively easily)

But since then China’s found it increasingly difficult to convert new spending into output. . .

In fact, since 2008, the ICOR has more than tripled from three-to-ten while real GDP growth has declined by half. . .

Or, putting it another way: China’s spending more and more on infrastructure that returns less and less.

Making matters worse, recent estimates indicate that China’s ICOR has surged past 11 as late as 2020 (that’s roughly 400% higher than the pre-2008 average).

Imagine hiking into a storm that’s four times as strong as it was a decade ago; it would be a much more painful, slow, and costly hike. . .

Thus, not only is China’s infrastructure-and-property fueled growth suffering from diminishing returns. But the major developer firms are now bogged down by debt.

This means that regardless of any forced deleveraging, China’s growth upside is fading. And quickly.

It’s clear why Chinese authorities want to try and clean-up it’s over-leveraged property sector before it’s too late. But it will come at a steep cost—slower economic growth.

So, in summary, Chinese authorities appear committed to deleveraging its property-sector and keeping credit tighter.

And while it’s commendable—it’ll most likely get far worse before it gets any better.

That’s because the property-sector is a key driver for economic and commodity growth (thus making it pivotal for the world economy).

As we’ve seen time and time again, once credit begins tightening, downside risks significantly grow.

Note that historically easy-money fueled booms almost always lead to waves of unintended consequences. Such as malinvestment, moral hazard, asset-bubbles, price-distortions, etc.

And it’s only after the boom ends when the true distortions and problems show themselves.

But—for now—property firms will continue cleaning-up and raising cash in order to access credit markets. (That is, if they’re able to).

This could spiral into a vicious feedback loop known as ‘debt-deflation’. (Meaning: when a wave of loan defaults lead to creditor insolvencies and falling prices; increases debt burdens in ‘real’ terms, triggering more defaults; repeat).

But at that point I’d imagine the Chinese authorities would step in.

Still, China’s economy remains very unbalanced. So it’s no surprise that the elites want to try and fix things.

The problem? Things like diminishing returns, an ageing population, and slower growth are all structural issues that don’t have easy solutions.

So in the meantime, as China’s property sector deleverages (aka contracts vs. expands), I expect both the global economy and commodity prices to feel it.

As they say: when China sneezes, the whole world catches a cold. . .

PS – for more context, I highly recommend reading Irving Fishers’ classic book ‘Debt-Deflation’ + Michael Pettis’ ‘Trade Wars Are Class Wars’. Both are must reads in the Speculators Anonymous Reading List.

PSS – I remain short-China and commodities as of writing this.

China’s Fragile Property Sector Is A Problem For Global Growth

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China’s Fragile Property Sector Is A Problem For Global Growth

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