CHINA Q&A

China’s Economy Is Worse Now Than in

the 1970s, This Analyst Says
By Reshma Kapadia Follow Aug. 26, 2023 2:00 am ET

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8 minutes

China’s property developers are

China’s property market is ailing as the economic recovery
is losing momentum. Here: unfinished buildings in Wuxi,
China.
Qilai Shen/Bloomberg
under duress again, re-igniting
concerns about a debt crisis. But
with a faltering economy and
diminished confidence among
households and companies, China
debt watcher Charlene Chu, senior
analyst at Autonomous Research,
worries the ingredients are there for
a broader financial crisis for the first
time.

The country’s economic recovery from three years of strict Covid restrictions and
crackdowns on its property and internet sectors appears to be losing
momentum. The property sector, which holds 70% of Chinese households’ wealth,
is ailing. Existing home prices slid 9% month over month in big cities in July, the
steepest decline in a decade. Property developer Country Garden Holdings
2007 +5.19% didn’t make a bond payment and financial products managed by
Zhongrong International Trust missed payments to investors, feeding concerns
about financial contagion.

Chu, a former Fitch Ratings analyst, has become a go-to source for understanding
China’s opaque banking system and all things debt. We talked about whether the
country is on the edge of a “Lehman” moment, and why she sees no easy fix to get
China out of its predicament.

Barron’s reached Chu at her office in Washington, D.C. An edited version of our
conversation follows.

Barron’s: How bad is the economic situation in China compared with other
periods of trouble?

Charlene Chu: The macroeconomic climate is much worse than it’s ever been
since reform and opening in the 1970s. It’s not just one issue, like the collapse of
activity in the property sector. We have a cyclical and structural problem with weak
exports, a confidence problem, and local governments, which were an important
contributor of growth for China in the past as they were told to borrow money to
prop up activity, focused this year on managing their ‘implicit debt burden.’
Essentially, they are saying they can’t borrow more because the central
government is pressuring them.

Why can’t the Chinese government come in and bail out local governments?

They definitely have the scope to do it, with central government debt to GDP about
25% to 30%. But there’s an unwillingness to do that. They want to keep the central
government’s balance sheet as pristine as possible. If they drew on the balance
sheet to bail out developers and then the trust products, that scope [to help in the
future] lessens. They have been adamant on this point for several years.

What else differentiates this current economic situation from the past?
The confidence problem is something we haven’t faced at this magnitude in a very
long time. And as we saw in March with the U.S. regional banks, confidence is very
important to the financial sector. The real risk we face in the coming months is if the
macroeconomic situation doesn’t improve—and I don’t think it will—then we are
stuck with confidence problems. Does it at some point spread to the financial
sector such that people say they would feel safer with their money in bank
deposits, not at a trust company?

Then, suddenly investment products—not just trusts—would potentially be in a

run situation where they can’t roll over products because everyone says they want
their money back. Zhongrong International Trust essentially said that it became
difficult for them to issue new products. That is where [China] runs the risk of
confidence in this shadow credit space creating a problem.

Is China vulnerable to a financial run similar to what U.S. regional banks

experienced this spring with Silicon Valley Bank?

There isn’t an ability to redeem most investment products at will like there is with
bank deposits, which is a key reason things remain quiet for now. What we don’t
know is whether recent trust defaults have made investors more reticent to roll their
investments over when they mature. If so, we are likely to see more defaults like
Zhongrong and Zhongzhi. If not, the system can remain fairly quiet and stable.
The most pernicious form of a confidence issue spreading into the financial sector
would be households and corporates not only deciding they would be more
comfortable with their money in bank deposits but rather in deposits at state banks,
which could trigger a migration of funding away from smaller banks akin to what
we saw in the U.S. earlier this year. None of this is happening now, but the
ingredients are there in a way they haven’t been before.

Is China on the edge of a Lehman moment?

We have had six trust companies fail over the last couple years and it didn’t create a
systemic crisis. There’s nothing to say this one will trigger bigger problems. But
Zhongrong is multiple times bigger, the economic climate is much worse, and we
didn’t have the same confidence problem [before] so there are definite
vulnerabilities.

The reason Lehman spread so fast and [everyone] was pulled in was a loss of
confidence in banks about other banks. Everyone didn’t know how much everyone
else was holding and who was on the verge of not being able to stand up the next
day. We are not on the edge of a loss of that type of confidence of Chinese financial
institutions in each other.

Because the banks are state-owned?

Yes. There are instances where they go down that path and [the government] calls
all the key players into the room and they say nobody is cutting anyone off—
because if they play that game the whole system has a problem.

What’s the risk to the global financial plumbing?

It’s very modest. Western institutions, especially in the wake of what happened in
Ukraine, have all been reviewing what their exposure is and how they would
manage big losses in any key markets.

What impact are higher U.S. interest rates having on China’s financial
situation?

[The People’s Bank of China was] expected to cut rates by 15 basis points on the
one-year this past week and only did 10 basis points. Everyone is focused on
banks’ net interest margins, but the other issue is the very large gap between U.S.
and Chinese interest rates. If China starts cutting rates more aggressively, that gap
widens and [risks] capital outflows and more pressure on the renminbi. That’s
acting as a constraint on the ability of authorities to be more aggressive on rate
cuts.

How could Beijing rebuild confidence?

You could argue they should cut rates more dramatically—a couple hundred basis
points, but this is where things get tricky with how much currency pressure they
want and how much they want to erode banks’ net interest margins. Will they have
problems if bank deposits go to zero and people take their money out and [move]
into trust products and less safe investment products?

The hope is property will bottom and that this inventory destocking cycle [of goods
and commodities] in the U.S. and Europe will bottom, and companies will restock,
increasing export demand in 2024. But property could continue to be very
lackluster. Maybe it flatlines at weak levels. And who knows what happens with
inventory rebuilding in developed markets? If I was a Chinese corporation , I
wouldn’t think about building inventory.

How worried should investors be about Chinese debt levels?

Total credit outstanding is up 8.5 times since 2008; GDP is up 3.9. Debt has risen to
a significant margin, well above its resources. And if growth is going to be slowing,
the resources to repay the debt will get thinner and thinner.

It’s interesting to see what is happening with household debt. People are
prepaying. Chinese households have intuitively realized that they have hit the
maximum amount of debt they can [handle]. Local governments are there too,
especially if the central government is saying they have to work down this implicit
debt. Local government debt didn’t exist in 2008, when it pushed through a $4
trillion stimulus. The real stimulus was that local governments could borrow for the
first time; their debt went from zero to 90 to 100 trillion renminbi in 15 years.

Is China headed to its own version of Japan’s lost decades?

With a Chinese flavor, it is. China is a much bigger country with income levels much
lower than Japan at the time and its demographic profile is deteriorating more
rapidly. We are looking at a very difficult decade unless authorities can come out
with something that is very aggressive on the structural reform side.
How aggressive?

One reason it’s so hard for China to move to a domestic-driven growth model is that
they didn’t take the opportunity when things were going great to build out a
comprehensive social safety net. The population is still bearing a higher cost for
critical things than in the U.S. They have been talking about the need to lift incomes
—and that will lift consumption—but not sure they can do that with all the pressure
on corporations.

Where’s the biggest disconnect you see in the market?

People keep looking at this as a cyclical short-term problem and [think] China will
get back to the growth path it was on, and everything will be fine. Those days are
over. China is never going back to prepandemic growth levels. There are just too
many structural issues. Then, layer on the demographics and it’s going to be
impossible to get close to the growth rates of the past. People don’t understand
that. It’s not clear China’s authorities fully understand that either as they keep
emphasizing that it’s taken every other country time to rebound after reopening so
people just need to be patient.

How bad will it get?

The growth picture has changed dramatically. There will be cyclical ups and
downs when you can make money, but it’s absolutely in a structural decline in
growth and at some point there’s a real risk where it hovers at barely positive levels
of growth. The investment case has gotten much weaker for China, particularly
with all the risks people are taking on when they are investing there.

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Thanks, Charlene.

Write to Reshma Kapadia at reshma.kapadia@barrons.com

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China recovery on the cards: 2023 Asia economic outlook

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China recovery on the cards: 2023 Asia economic outlook

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China recovery on the cards: 2023 Asia economic outlook

NOMURA