Global Economic Woes Part 2: China

This is part 2 of a 3 part series about economic issues in the world’s largest economies.

Fox Article

First off, yesterday the IMF announced that China has overtaken the U.S. as the world’s largest economy. China is on pace to produce $17.6 trillion of goods and services this year compared to $17.4 trillion in the U.S. In real terms, the Chinese economy now accounts for 16.5% of the global economy with the U.S. coming in second at 16.3%.

With that said, let’s turn our attention to some significant downward pressures facing the new #1.

  • Housing Prices

International Business Times Article

Chinese home prices fell for the second successive month in October from a year ago, official data showed, logging their steepest annual drop since records began in 2011.

The October reading was double the fall anticipated by the markets, and followed a 1.3% year-on-year drop in September.

The decelerating property market, which accounts for some 15% of China’s economy, has intensified concerns that a softening housing sector will restrain growth.

Bill Adams, senior international economist for PNC Financial Services said in a note: “…China’s housing market is still on the way down in its correction. In addition to prices, construction activity and manufacture of the steel and cement used in the construction industry are also falling, a major headwind to real GDP growth. Real estate corrections can persist for 5-7 years, meaning this slump in China is likely to persist into 2015 and 2016 at least.

Property investment, which impacts over 40 other sectors from cement to furniture, grew 12.4% between January to October from a year ago, its slowest pace in over five years.

  • China’s Banking System

Financial Times Article

In some ways, China today resembles Japan in the early to mid-nineties or the US in 2007 to 2008 on the eve of their respective financial crises, both triggered by overvalued property.

It is not only that property companies are huge borrowers (in the case of China both domestically and in the offshore US dollar high yield bond market), it is that many other borrowers in China can only take out loans if they have property to serve as collateral.

Chinese domestic bank loans were just under 100 per cent of gross domestic product in 2008 but by August of [2014], they had swelled to 139 per cent of GDP, growing at a 6.7 per cent rate per year – by far the fastest pace of any emerging market…

Meanwhile, interest rates are high. The average lending rate in September was 6.97 per cent, and the real, one-year interest rate is now 4.3 per cent – a five-year record.

“Leverage is at an all-time high (7 times) while interest coverage is at an all-time low,” [Morgan Stanley] analysts conclude. Indeed, many developers who are seeking funds today are proposing structures that involve repaying their debts with more securities since they lack the means to repay in cash.

My opinion: The first bullet point above deals with a dwindling housing market in China. And just like in the U.S. before the recent financial crisis, much of China’s credit market relies heavily on real estate prices maintaining certain levels. The silver lining of this issue is that right now housing prices in China are decreasing at a slow pace. This will allow investors and the government to respond (hopefully) at a calmer rate.

However, if the bubble were to pop all of the sudden then a financial crisis could ensue. Upon researching the Chinese shadow banking sector a little further, I came across a few recent articles that talk about runs occurring on small non-banking institutions. Falling housing prices has caused “non-financial guarantee companies” to become unable to meet their promised returns.  As of now, these issues appear to be isolated within this particular category of investment company (which I don’t know much about). Although the problem they face is one that broader credit markets will soon confront if housing prices continue downward.

CNBC Article on these Non-Financial Guarantee Companies

So what can China do? Well, China still has a lot of breathing room at this point. They have a substantial buildup of foreign reserves they can tap and interest rates are still high enough for them to affect liquidity in a conventional manner.  As a matter of fact, on November 21, 2014 The People’s Bank of China lowered their interest rate again to 5.6% from 6%.

Reports regarding China’s housing sector for November 2014 should come out in the next couple weeks. Given the recent decrease in interests rates though, I wouldn’t be expecting any sort of positive turnaround.

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