CWS Market Review – August 22, 2023

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China’s Growth Model Hits the Wall

Americans have been unnerved by the recent rise in mortgage rates. According to Freddie Mac, the average 30-year fixed-rate mortgage is now over 7%. That’s a 21-year high.

On Tuesday, the existing-home sales report said that sales in July were down 2.2% from sales in June. Compared with one year ago, sales are off by more than 16%. This was the slowest July since 2010.

Last month, there were only 1.11 million homes on the market. That’s tiny. For context, that’s about half as many homes as were on the market before Covid, and it’s the lowest number in nearly a quarter of a century.

As rough as those numbers are, they’re peanuts compared with what’s happening in China. That country’s real estate sector appears to be going through a full core meltdown, and the damage isn’t limited to real estate. It’s starting to get folks to wonder if China’s entire model for economic growth is flat-out wrong.

The Chinese economy used to be the gem of the Far East and a global growth superpower. Not anymore. The country is mired in debt, and it’s addicted to overbuilding.

For four decades, the Chinese economy roared ahead. We heard countless stories about China’s emergence as a global superpower. We even heard from some observers in the West that China provided a blueprint for future development. Soon, we were told, China would replace the United States as the world’s largest economy.

The old playbook was simple: borrow and build. When in doubt, borrow and build. That was followed by even more borrowing and even more building. To help spur all the borrowing, Chinese state banks set rates artificially low. Now China has millions of apartments with no tenants and cities with no people. Even some small cities have multiple airports.

Don’t get me wrong. The borrow-and-build model is a great idea, but it needs two things. One is tons and tons of Western money pouring in. The other is rising prices. As long as you have those, there’s nothing to worry about.

Once the reverse happens, then things get bad. Really bad.

On Monday, the People’s Bank of China (i.e., the Chinese Fed), responded to the real estate mess by, what else, cutting interest rates. The problem was that the cut was only by 0.1% which was less than expected. In fact, a lot of observers ignored it as a token gesture, which it is.

The benchmark for one-year corporate loans fell from 3.55% to 3.45% while the benchmark for five-year loans was unchanged at 4.2%.

That’s not enough to do the trick. The ultimate judge on any policy is how the markets react, and traders didn’t like the puny rate cut. The Hang Seng Index, which is based in Hong Kong, fell 1.8%. It’s now down more than 12% this month. The yuan recently hit a 16-year low.

The real estate mess is bad and it’s getting worse. Country Garden is the latest to run into trouble. The developer “has hundreds of billions of dollars in unpaid bills,” and it just got booted off the Hang Seng.

Not that long ago, Country Garden was hailed as the model company. The New York Times notes that, “More than 50 developers have already defaulted or stopped paying on overseas bonds.” They’ve simply run out of money.

So much of China’s economy revolves around real estate. In July, new-home sales in China were down by one-third from last year. In June, new home sales were off by 28%.

For years, millions of Chinese citizens moved from rural areas into big cities. In response, the country built massive amounts of urban housing. They struggled to meet demand. They built way too much and now demand has plunged.

It’s not just housing. The government has spent billions of dollars trying to make a world-class independent semiconductor industry. That hasn’t worked out. In terms of sophistication, their chips are still way behind Taiwan’s.

China’s problems don’t end there. Two weeks ago, I told you about how the American and Chinese economies are being decoupled. That’s threatening China’s foreign investment and trade. Now economists are concerned about China’s future.

What will the future look like? The International Monetary Fund puts China’s GDP growth at below 4% in the coming years, less than half of its tally for most of the past four decades. Capital Economics, a London-based research firm, figures China’s trend growth has slowed to 3% from 5% in 2019, and will fall to around 2% in 2030.

In 2020, President Xi Jinping said his goal was to double China’s economy by 2035. That looks like it won’t happen. Nor is China about to dethrone America as the world’s largest economy.

Normally, if you want to get an economy moving, you can try boosting credit and leverage your way forward. China is at the point where it can’t do that anymore.

Truthfully, cracks have been showing in China’s economy for some time. Covid just sped things up. China’s explosive housing market helped masked the problems that had been growing just beneath the surface. Now the housing bubble has popped.

The outlook has darkened considerably in recent months. Manufacturing activity has contracted, exports have declined, and youth unemployment has reached record highs. One of the country’s largest surviving property developers, Country Garden Holdings, is on the cusp of a possible default as the overall economy slips into deflation.

The big fear is that China won’t merely slow down but that it will enter a multi-decade period of low growth similar to what Japan’s been through. There is, however, one major difference. When Japan hit the wall, it was already rich. China isn’t nearly as developed.

800 Million Have Been Lifted Out of Poverty

Another fear is that a weaker economy might lead to a more aggressive foreign policy. That may already be happening. President Biden recently said that China’s economy is a “ticking time bomb” that will cause it to do “do bad things.” That didn’t exactly go over well in Beijing.

Youth unemployment is so bad that the government has stopped reporting the numbers. The last report was for June. It said that the jobless rate for urban 16 to 24-year-olds was 21.3%.

The growth story dates back to 1978 when Deng Xiaoping opened China’s economy to free enterprise. It’s hard for us today to imagine how poor and backward China was. Millions of Chinese lived as peasants, not very different from how their ancestors lived.

According to numbers from the World Bank, since the free market reforms, China’s per capita has increased 25-fold, and 800 million people have been lifted out of poverty.

Forty-five years later, China has massive ghost cities. It’s estimated that 20% of China’s urban apartments are vacant. That’s 130 million units. They’ve built cities that no one lives in, and airports and rail networks that no one uses.

The borrow-and-build philosophy has already picked the low-hanging fruit. Now the return on investment in China is far lower. Instead of facing the problem, the government has encouraged even more borrowing. In ten years, China’s total debt has grown from 200% of GDP to 300% of GDP.

Here’s a chart of the yuan to the dollar:

There is an obvious solution to China’s problem: make the economy more balanced. For that, it needs to promote its consumer sector. That means that Chinese consumers need to spend more and save less. The problem with that is that the government would have to give up some control over the economy and replace it with individual choice. That kind of thinking doesn’t come easy to the Chinese Communist Party.

The big worry is that China’s problems will spill over into the United States, but for now, I think that’s very unlikely.

This may sound odd, but the U.S. economy really isn’t heavily exposed to China. Of course, we’re talking about very large sums.

The U.S. currently has about $215 billion in direct investment in China and about $300 billion in portfolio investment. Paul Krugman points out that U.S. office buildings are worth about $2.6 trillion which is about five times our total investment in China.

What about demand from China? That’s not that big, either. Last year, China bought about $150 billion worth of goods from us. That’s less than 1% of our GDP. That means a downturn in China will barely be felt in the U.S. As troubling as the mess in China is, we don’t have much to be fearful of.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

P.S. If you want more info on our ETF, you can check out the ETF’s website.

Posted by on August 22nd, 2023 at 6:51 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.