China’s Next Decade Looks Grim
In my 2022 piece The Next 5 Years: China, I mentioned “China’s Grand Plan of transitioning from almost an exclusively export economy to a balanced one with a robust domestic consumer market is stalled”. Events in the last two years now lend clarity on the nature of the stall. In a nutshell, export serving as the initial engine of China’s economic flight is distant history by now and investment as the booster engine went horribly wrong, — both domestically and internationally. Now, China’s economic spaceship is stalled and at risk of crashing back down to earth, — before its second booster engine — domestic consumption — has a chance to fire off to give the spaceship escape velocity.
So how and why has China’s investment strategy gone horribly wrong? Well, infrastructure building, both domestically (via the property market) and internationally (via the BRI or Belt and Road Initiative) has been the centerpiece of China’s investment strategy. In both cases, over-leveraged mal-investments and over-investments — facilitated by provincial Local Government Financing Vehicles — have resulted in massive unfinished projects, unserviceable (never mind unrepayable) loans, mass corruption (investors and consumers losing money while intermediaries make billions), and capital destruction. These ills have festered for years, and now have culminated in critical liquidity and insolvency problems in thousands of enterprises (never mind scores of local governments), threatening the personal wealth and jobs of millions. These ills have already translated to domestic social unrest. In the case of the BRI, they have also damaged China’s relationship with its international partners (notice Italy already wisely pulled out of the BRI and openly admitted the mistake of joining it in the first place) and can potentially derail the BRI itself.
The poster children of China’s domestic investment disaster are ZhongZhi or 中植, and EverGrande or 恆大.
Let’s first examine EverGrande, — China’s second largest property developer failing to make interest payments on $23B of foreign bonds issued by more than 235 offshore subsidiary companies, now in liquidation by court ruling at the behest of foreign investors. EverGrande’s total debt of $300B is far greater than its $23B of foreign debt. It is now in negative equity position (i.e. insolvent). EverGrande has 850 subsidiary companies managing thousands of other companies up and down the supply chain overseeing more than 1,850 onshore and offshore projects. Some of these projects are so enormous they are effectively building entire cities. The vast majority of these projects are unfinished (implying the scale of the projects is far bigger than the sunk cost of $300B and operating loss must have been huge to have culminated in negative equity). Some of them haven’t even broken ground yet. It will take a minimum of five years if not a decade for liquidators to comb through the books of these subsidiaries to get to the true status of things under the best of circumstances. And the situation is anything but the best of circumstances because the vast majority of these subsidiaries are inside China and unlikely to have “clean books” let alone forthcoming in sharing them. In the end, whatever remains of Chinese assets will likely be ring fenced because the Chinese authorities won’t likely allow liquidators to close down businesses within China to make foreigners whole. So after five or ten years of liquidator’s costs and fees, there will almost certainly be zero recovery for offshore investors. No wonder Foreign Direct Investment fled China en masse in 2023. And it won’t come flocking back anytime soon because when the dust settles, the EverGrande case will have shown when push comes to shove, China will protect its own businesses and let foreign investors eat all of their losses.
The EverGrande case has already shown that the Chinese authorities are not able or willing to bail out the property sector, despite it being almost 1/3 of the country’s GDP. This can trigger a domino of (foreign) creditors forcing liquidation process on scores of other property developers in similarly dire situations , — including Country Garden or 碧桂园 (China’s largest property developer). Its project in Johor Bahru, Malaysia is a notorious deserted ghost town story. An estimated 20 million Chinese households which have taken on mortgages for unfinished properties will have to wait longer for delivery, if that ever happens. Potential new buyers are now retrenching. So further fall in prices and sales activities — leading to general economic contraction — is almost certain.
Let’s next examine ZhongZhi, — China’s bankrupt shadow banking giant with $36B of negative equity now under criminal investigation by Chinese authorities. In recent decades, unregulated shadow banks have been attracting capital by offering Chinese savers (who have scant few investment options) “wealth management products” carrying attractive (typically 5–10%) yields. The shadow banks then turn around and lend that money — with a lot less stringent terms and conditions — to companies associated with property development that can’t otherwise get funding from traditional banks. An estimated $3 trillion of capital has been invested by Chinese savers into shadow banks over the last 15 years. A lot of that investment is now underwater if only for the huge fall in real estate value over the last 5 years. This poses a real danger of “run” that can quickly bankrupt shadow banks because their capital is tied up in illiquid property projects. ZhongZhi is the canary in the coal mine. A domino of liquidity crises will likely arise in Chinese companies reliant on this $3 trillion sector of the Chinese economy. Meanwhile, an accounting firm will be placed in charge of ZhongZhi’s bankruptcy proceedings to recover as much of its assets to repay investors. Sadly, after the accounting firm’s expenses and fees, there won’t be much recovery, if any. Many mom-and-pop investors will have lost a big chunk of their life savings.
The poster child of China’s international investment disaster is its grandiose Belt and Road Initiative or BRI, — a $1.34 trillion investment in 2,985 projects and 146 countries in Africa Asia, Oceania, the Middle East, Latin America, the Caribbean and Central and Eastern Europe. Its stated goal is to establish two new trade routes under China’s control (rather than that of the U.S. navy). Per this report, the initiative is more about extracting natural resources from the target countries, particularly energy and industrial metals, — both of which China needs ongoing. A lot of money has also been invested in the construction of infrastructures like power stations, airports, roads, railways and ports. Early BRI projects in Central Asia seemed successful (i.e. mutually beneficial to China and the “Stans”). Then, state-owned creditors went on a lending spree, issuing thousands of loans to fund mega-infrastructure projects all over the developing world. Today, we see the ill effects of that over-expansion.
Except for loans in US dollars in the early years, China has been extending loans secured by collaterals only in Chinese Yuan (CNY). So the host countries can only spend the money on Chinese contractors and employees doing the actual work or to buy stuff from China. Around 80% of all loans carry variable interest rates. China also charges penalty interest rate of 1.18% for non-compliance with the original terms and conditions. These conditions obviously put the host countries — mostly low-income/high-risk 3rd world economies — at high risk of losing control over assets in their own countries, — hence the bad rap of the BRI being a “debt trap”. The poster child here is the Hambantota International Port in Sri Lanka. When the Sri Lankan government failed to keep up repayments, China took a 99-year lease over that port, now has full control and ownership of it, and has abated access to it.
As of 2023, the vast majority of BRI projects are incomplete and 79% of them are in countries in financial distress. 94 projects representing $56B of debt has already been cancelled or suspended. More will follow suit in the coming years due to China’s domestic economic slowdown, thus lack of further investable capital. Whatever available capital will be deployed to save critical projects that China cannot afford to shut down. As this report shows, emergency (i.e. bailout) loans for critical projects now make up 58% of the total BRI loan book, far exceeding normal project lending. The BRI has become a horrendous cash sink beyond the $1.34 trillion already invested. Currently, 44% of BRI loans have reached their repayment date. By 2050, every single loan will be due for repayment. There is no way all the projects will be up and running, generating sufficient cash flow to enable the issue of foreign bonds to repay China. Will China just take over the assets in all of these host countries, effectively colonizing them? The international community may have a serious problem with that.
Besides BRI, giant Chinese developers and investment groups also speculated heavily in major international metropolis. For the same over-leverage and over-expansion reasons, they have suffered setbacks and losses beyond recovery. These are examples in London alone.
At the big picture level, one can ask “China is running an $18 trillion economy, what does $1.34 trillion of BRI, or even $3 trillion of shadow banking exposure matter?” Well, nearly 1/3 of that $18 trillion GDP is the property sector which is in deep distress and has a huge knock-on effect on banks, shadow banks, consumers, and local governments alike. That matters. For a period of around 10 years, the property market was a literal feeding frenzy. People were sleeping on streets to get into developers’ offices to get their picks in a new development. People were buying multiple properties, paying 100% of the purchase price with borrowed money upfront before the building had even broken ground. Both regulated banks and shadow banks fed this frenzy. Then in August 2020, the Chinese authorities decided much belatedly to put the breaks on, by imposing the “three red lines” (guidelines which should have been in place all along), abruptly tightening credit. That’s like abruptly stopping supply to an addict after allowing him to OD for decades. Virtually all of the big property developers immediately breached at least one of the requirements. For lack of additional credit from banks, they had to increasingly pre-sell properties to raise cash to continue operation. That is an unsustainable Ponzi scheme, as illustrated by EverGrande. Shadow banks overextended their loan books and quickly became illiquid, as illustrated by ZhongZhi. Many more like them have similarly impaired balance sheets and are staring down the barrel of bankruptcy. Meanwhile, excess inventory (enough to house 1.4 billion people) and diminished demand (from more weary and cautious, never mind financially impaired potential buyers) is causing prices, transaction volumes, and new constructions to drop, — all contributing to economic contraction. Further bankruptcies will only accelerate the process.
Another 1/3 of China’s $18 trillion GDP is the manufacturing sector. That also matters. Short of critical mass in China’s consumer economy (only 10% of total GDP), the vast majority of China’s manufacturing is for export. Thanks to China’s much higher standard of living now, its exports are no longer that cost competitive on the international market. As well, post-Covid global reshoring out of China has now diminished China’s manufacturing base. Also, “it takes two to tango” the export dance: The party to whom you export must be willing (and able) to accept your export. Weary of China’s overt aggression, the West is clearly much less welcoming for China’s exports these days. (Government subsidized) export — amounting to predatory dumping in foreign markets — is (now facing significant pushback and) a spent rocket in China’s spaceship, not to be reused to gain altitude from current levels.
When the “three red lines” was imposed (with intent to cool down the over- invested property sector by restricting credit availability), the Chinese government encouraged investment in the EV sector instead. And investors complied. In a short three years, China now dominates the EV market, up and down the supply chain, — threatening not only Tesla but the German automaker giants. Unfortunately, severe quality issues like this and this are hampering order rates, just as EVs are going out of vogue (for all kinds of reasons — not the least political — beyond the scope of this article), China now has another over-invested sector (think excess inventory and capacity) to worry about.
Officially, China’s financial sector is 10% of its GDP, most of it insolvent (doesn’t matter, because the whole sector is state-owned) due to the collapsing property sector. China’s consumer economy is retrenching due to lost savings and confidence. China is plum out of engine for growth, — evidenced by double digit youth unemployment expressed in the “let rot” and “lie flat” sentiment (擺爛 and 躺平). Printing trillions will not help because credit demand is not there and the money printed will only be trapped in the financial sector but with a lot of leakage in China’s multi-tiered bureaucracy, — especially in the area of taxation (witness the much publicized prosecution of tax evasion by China’s rich celebrities). China’s tax receipts to GDP ratio is only about 1/3 of similar size Western economies. It is simply not generating enough cash for service and repayment of debt, never mind spending on military buildup and other programs at the central level. In sum, China’s economy can only shrink from here. This is not even taking into account its significant demographic headwind, — women are simply refusing to bear more than one (if any) child despite government incentives. Just like “let rot” and “lie flat”, this is an expression of pessimistic outlook. Finally, there is the prospect of food and (hydro and nuclear) energy shortages from China’s water crisis, — a subject for another time.
The “China miracle” was so labeled because China was able to accomplish so much and so vastly in such a short time. That “miracle” has now proven to be “the eyes are bigger than the stomach”. China’s economic growth beyond the initial export stage was by this simple formula: Provincial governments sell land (via their Local Government Financing Vehicles) to developers to get tax revenue. Developers then borrow money (both domestically and overseas) to massive build (keeping employment high and meeting GDP growth target set by Beijing). Problem is, all these provinces massively overbuilt “bridges that lead to nowhere” and “ghost cities” for which there is no consumer demand, — just to satisfy Beijing dictated GDP goals. For lack of cash flow from the end products, this growth model was an unprofitable one that destroys capital from the get-go. Had China been a free market system, stomach upset would have appeared a long time ago. But China’s central planners kept administering pepto bismo (i.e. State owned banks kept absorbing mal-investments onto their own books in further rolling bad debt) to make everything appear fine. Well, now the miracle is stalled — both inside China and internationally — and the stomach pains have just begun.
Because China’s economic spaceship is stalled (refer to the opening paragraph), it is impossible for China to organically grow out of its gigantic debt overhang. China’s huge and cheap labor force — a tailwind for growth during the export years — is now a huge unemployment pool and a headwind for growth. The gigantic debt overhang can only be resolved in a three-stage process. First, orderly deleveraging or disorderly default. Clearly, disorderly default has already happened. Next, deflation will ensue from credit contraction at all levels: Government, enterprises, and households, curtailing investment and spending all at once, inducing mass exodus of foreign companies. This is the “debt deflation spiral” that is happening as I pen. Last, depression (i.e. prolonged economic contraction), or China’s “giant leap backwards” will come. In dealing with the three-stage setback, China will likely devalue the Yuan at some point, thereby exporting deflation to the rest of the world. Unlike inflation which is somewhat self-correcting (“the best cure for high prices is high prices”), deflation has a self-reinforcing spiraling (down) effect (Japan's lost decade actually lasted almost 3 decades).
Manufacturing deflation is already obvious:
Consumer price deflation (which is self-reinforcing because “why buy now if things will only get cheaper tomorrow?”) is obvious as well:
Part of this is due to wage deflation: Unlike the West, when tens of millions of Chinese return to the big cities from the countryside post-COVID, wages went down, taking consumption with it. Depressed consumption — at both enterprise and household levels — will only accelerate in the face of rising fear from the draconian anti-graft crackdown right now (not that anti-graft is bad, just ill-timed), which is tightening “financial conditions” when they disparately need to be eased:
China has unquestionably entered prolonged recession, — or depression. This is always caused by supply exceeding demand. Besides oversupply of capacity (per earlier discussion of overinvestment), China has gross oversupply of labor (from property construction going bust and foreign enterprises leaving) and not enough jobs (witness double digit youth unemployment so bad that statistics are now being suppressed). The lack of dispensable income — exacerbated by mortgage payments from overextended property investment — has resulted in consumption slowdown in a doom loop: what little dispensable income goes into savings out of insecurity which further depresses the economy and creates more insecurity. In turn, this induces price wars, profit squeeze, more companies going out of business, and more layoffs. The automobile industry exemplifies this. Of course, plummeting property prices — creating “negative wealth effect” — only exacerbates this doom loop.
The festering depression was telegraphed by China’s stock market, — now at a 5-year low after free-falling for three straight years. As a leading indicator for the economy, China’s stock market is loudly raising the specter of fall after stall. While companies like PDD take market share away from companies like BABA on the low-end, the entire pie (of a belt-tightening consumer market) is shrinking. Realizing this, western investors like Michael Berry (of “Big Short” fame) sold all their China shares in one fell swoop in late 2023, essentially giving China up for dead. So on top of mass exodus of Foreign Direct Investment, indirect access to foreign capital via stock valuation has also dried up in China.
It is important to remember, however, that unlike the United States (which cares about its equity market first and foremost), China first cares about its currency, then its bond market, then its equity market. Only 15% of China’s populace owns stocks and China’s economic growth is funded predominantly through its banking system, not its equity market. At the end of the day, the CNY is the best gauge for China’s strategy “after stall”. China’s current situation is reminiscent of the disastrous 1997 Asian Financial Crisis that started in Thailand. That crisis was all about EM (judged by GDP PER CAPITA, China is really still an EM country) in the face of rising USD (induced by rising U.S. interest rates) coupled with FDI capital flight. Should the CNY experience free fall (due to lack of USD reserve to defend the CNY, as in the current case in China and the Thai Baht case then), debt deflation will quickly turn into hyper-inflation, turning what already looks like fall after stall in 2024 (a lot of government agencies are running out of money and cannot pay civil servants) into The Great Leap Backward.
Last but not least, the prospect of economic growth for any country lies in availability of affordable energy. This is especially true if the growth “engine” is AI, — which is dependent on big data centers and extremely energy intensive. China is disproportionately reliant on hydro power:
And it appears to be running out of water.
Above and beyond all the factors thus far discussed, China’s social fabrics are falling apart, making fall-after-stall increasingly likely as rulers tighten control to the point of breakage.
