The global economy is entering an interesting phase where one of its two motors has started to cough and splutter as speculation mounts that China could see a Lehman-style banking and property meltdown.
Property developers are back on the rocks, this time Country Garden (HK:2007) serving as the late-arriving sequel to Evergrande’s default in 2021. It is not yet in default, but is facing a 6 September deadline to find enough cash for a coupon payment on two of its bonds.
The net result of the slowdown is that more developers stand to fall behind with debt repayments, leaving thousands of unfinished apartments on which owners have already taken out mortgages. With more of the government’s statistics going dark – apparently, youth unemployment is no longer worth counting in its current form – a sense of gloom surrounds China’s prospects, along with UK-based companies that have large dealings with Chinese debt and equities.
The extent of the default rates cannot be underestimated. JP Morgan recently upped its forecast for Asian market high-yield defaults to 10 per cent of total loans, up from 4.1 per cent, with China providing the vast majority of the default risk. Indeed, it is estimated that the Chinese property market is currently the largest single asset class in any large economy in the world.
Lots of indirect information reveals that new-build property in China is topping out rapidly, with the government’s own department for housing calling for a change in direction. BMO Capital Markets reports that the minister for housing, Ni Hong, wants developers and local government to focus on the quality of existing stock, more affordable housing, conversion of existing unused commercial stock and the renovation of shanty towns. What is not clear from the ministry’s statements is whether any further action beyond interest rate loosening will be taken to prop up the housing market. The People's Bank of China can also cut existing mortgage rates, which could help household budgets. Consultancy PRC Macro said last week that a 50 basis point cut to existing mortgages could boost retail sales by 1.3 per cent.
The shadow banking risk
Analysts have been warning for years that China’s shadow banking system, which consists of trust companies investing in shares, property and loans on behalf of wealthy individuals and companies, poses a systemic risk to the country’s financial system.
As long ago as 2019, the Bank for International Settlements concluded that the shadow system drives up the risk for all banks as it stands outside the regulatory power that governs the M2 money supply – that is the sum of all short, long deposits as well as total money in circulation. In essence, they are not subject to the same regulatory framework or oversight as banks. With shadow banking trusts making up an estimated $2.9tn (£2.26tn) out of an $18tn economy, the potential for them to do serious harm to the system is substantial.
And there are signs that some shadow trusts are suffering serious pain due to China’s collapsing property market. For example, it was recently reported that a trust closely linked to Zhongzhi Enterprise Group – Zhongrong International Trust – started missing payments on some of its high yield investment products. Zhongzhi manages $137bn of funds and regulators have stepped in to prevent contagion with the help of KPMG, according to Bloomberg.
What this ripple effect means for companies outside of China can be gauged by the performance of shares with strong links to the economy. HSBC (HSBA), as we reported in our analysis of its latest results, is seeing more of its China loan book going into impairment as developers default or delay payments.
The shares, despite being up 8 per cent over the past 12 months, have been on a consistent losing streak since the results as more worries over Chinese credit have emerged. The bank has an estimated $21.3bn exposure to Chinese developers, measurable tranches of which are now under water. As a historical note, rather than a parallel, HSBC was the first major bank to sound the alarm over US sub-prime debt in early 2007.
Another interesting case is emerging market asset management specialist Ashmore (ASHM), which has been buying distressed property debt such as Evergrande since 2021. Its most recent trading update in July gave little away other than that it had experienced modest outflows and that some emerging market asset classes were starting to recover on the back of a weaker dollar.
Since peaking above 280p in March, the shares have suffered consistent attrition ever since, but its own buying seems to reflect the realities of market distress. Back in February, its corporate bond manager, Adrian Petreanu, said the company had been buying distressed debt at around 20¢ on the dollar on the basis that a restructuring period of up to three years was needed before a recovery kicks in. "We want to give these companies two years of runway of minimum requirements in terms of liquidity for them to support their debt," he said. "So, we are pushing maturities five, seven years out into the future."
In the July trading update, Ashmore said it had done well in "local currency, equities and investment grade strategies, and underperformed in other external debt, corporate debt and blended debt strategies". It saw outflows of $2.9bn in the three months to 30 June, or 3 per cent of total assets under management, taking the 12-month outflow to 13 per cent.
Overall, there is little the markets can do except wait and see, but a world economy coping with a recession-wracked China would be living in interesting times indeed.
