By John Richardson
WE ALL know, or at least we all should know, just how important is the Chinese economy to the global economy.
Assume significantly weaker-than-consensus Chinese demand growth in everything from base chemicals to autos, smartphones and TVs, and there is no statistical basis for believing that strong growth in other regions can steer us away from a very deep global recession.
That’s what the numbers say. There is quite simply no argument against this proposition.
What should be of further concern is the extent to which Chinese growth depends on just one domestic sector – housing – and the economic stress of the housing sector.
How many chemicals and polymers companies have game-planned a collapse or a sharper-than-expected slowdown in the Chinese housing sector and what it would mean for their global sales?
I haven’t been able to find public evidence of any discussions amongst senior executives of the risk that the Chinese property sectors represents.
This might because the analysis is being held behind closed doors as no CEO wants to be the first to sound the alarm in case her or his company’s share price leads a sector-wide downturn. Or alternatively the risks are being ignored.
Let’s quantify the risks, thanks to a useful summary of recent research by Aviva Investors, the global asset manager:
- If current housing activity in China fell by 10%, the total decline in China’s output over the next few years would be around 2.2% of GDP growth.
- This would have major global implications as in 2018 18% of the world’s total GDP emanated from China, when adjusted for purchasing power parity.
- If China’s output was to fall by 2%, Oxford Economics predicts that world GDP growth would decline to 2.5% by 2020 from its baseline forecast of 2.7%.
China reduces high-risk lending by $2 trillion
History teaches us that major investment bubbles usually explode and the bigger the bubble the larger the shockwaves from the explosion.
Another lesson from history is that we should entirely ignore conventional thinking about the timing of a particular explosion and the damage it will inflict. We should instead crunch the data ourselves and look for the kind of outliers who are prepared to challenge the conventional view.
The sub-prime crisis is the standout example of this. Ben Bernanke told a Senate committee in July 2017 that total subprime costs would be up to $100bn. The final cost to the US economy was $22 trillion.
With the wonderful benefit of hindsight, the kind of outlier we should have been listening to was Steve Eisman of “Big Short” fame.
He was one the few people who bothered to read collateralised debt obligations in detail and, in so doing, discovered that they were stuffed with large amounts of toxic debt.
Getting the same level of detailed access to data on Chinese debt is impossible because of lack of transparency and the poor quality of Chinese data in general. But we have credible-enough information to sound the alarm bells.
China’s government has long recognised the dangerously inflated nature of real estate. This explains why it has reduced shadow bank lending by $2 trillion over the last two years, according to Caixin. High- risk shadow lending went into the property sector.
This startling numbers helps explain the 2018-2019 slowdown of the overall Chinese economy.
Guo Shuqing, chairman of the China Banking and Insurance Regulatory Commission, when announcing this figure, warned that a large proportion of households had seen debt ratios “grow to unsustainable levels” because of property speculation.
As much as two-thirds of household wealth is tied to property with many people buying third homes as investments, estimates wealth manager Noah Holdings.
China’s property developers have sidestepped the shadow-banking squeeze by borrowing more money offshore. In Q1, Chinese developers issued a record $24.4bn in overseas bonds, up 32% year-on-year.
These offshore bonds carry high yields with repayments also at risk from of a further devaluation of the yuan.
As I shall discuss in detail in a later post, discussions between between Presidents Trump and Xi at the G20 meeting at the end of this month are the last realistic chance to avoid a major escalation of the trade war.
If the talks were to fail the value of the yuan versus the dollar would very likely fall well below the key number of seven, increased dollar repayment costs would place a lot of strain on China’s property developers.
The air will seep out of the bubble
The good news is that the vast majority of Chinese real estate borrowing is onshore. But analysis by Standard and Poor’s indicates that high risk debt in general, including offshore, has left lower-rated property developers highly exposed.
There are 52m vacant residential units in China, representing 22% of total urban housing stock, according to Southwestern University of Finance and Economics.
But this doesn’t take into account what Ting Lu, chief economist at Nomura International, says is “the true amount of properties under construction”. Residential building projects can sometimes take 15 years to complete, as these delays help prop-up prices and keep people in jobs.
If you predict a crisis for long enough you are bound to eventually be right. But with the risk of a major acceleration of the trade war very high, and with China possessing very limited means to re-stimulate its economy, the risk of the housing bubble going pop by the end of this year cannot be entirely discounted.
Or, and I see this as more likely, we have to get used to air merely seeping out of the bubble. This would in itself have a major negative effect on chemicals demand as house price inflation slowed down and as some property developers went bust.
Confidence is a crucial factor in housing sales. You are not going to buy a house when you are worried about the economic future.
And when you buy a house, which in itself contains a lot of chemicals and polymers, you are also more likely to buy a shiny new auto to sit outside your brand-new home.
You will also want to equip your home with a washing machine, a refrigerator and TV etc. All of these finished goods again of course contain lots of chemicals and polymers. China’s auto sales were down by a shockingly-bad 16.4% in May, the biggest-ever monthly decline.
We next need to obviously consider how quickly the air will seep out of the bubble. Very rapidly of the Trump/Xi meeting results in no deal, with, as I said, a tail risk of an outright property crisis.
I think it’s more probable that Trump will drag the trade war out to closer to next year’s presidential election. He will then come to an arrangement with China in order to order to gain the maximum electoral benefit.
But let’s instead assume that I am wrong and a deal is done at the G20. We still have to accept these two things:
- The scale of China’s debt bubble makes the same levels of property inflation, and so wealth creation, that we have seen since 2009 simply impossible.
- Demographics also make this impossible. China is running out of enough young people to maintain property inflation at recent levels. Old people already own most of what they need, including houses.
Quantifying the impact on chemicals
One of the dangerous weaknesses of the Chinese infrastructure-led growth model is the heavy indebtedness of provincial governments because of their post-2008 spending binge on bridges, roads and new factories etc.
Most of this spending was paid for by land sales. If land sales slowdown so will spending on infrastructure. This will be especially bad for China’s poorer inland provinces and their “catch-up” growth ambitions.
Data from the same Aviva report also show that some 12% of China’s overall GDP growth is directly dependent on the property sector, never mind the knock-on benefits of higher autos, washing machine and kitchenware etc. sales that can accompany the purchase of a new home.
When these secondary effects are taken into account, such as the effects on steel, cement and retail sales, this rises to 20% of GDP.
Clearly, we must therefore conduct research into the exposure of chemicals demand to the housing sector. It is bound to be huge. As with the global GDP exposure I quoted earlier, we then need to put this into the context of the exposure of the global chemicals industry to a significant slowdown in the Chinese economy.
I will later on provide some estimates of the downsides for both Chinese and global chemicals demand under several scenarios or the Chinese property sector.
Meanwhile. take a close look at the chart at the beginning of this blog post. What you can see is our business as usual as usual estimates of Chinese demand growth for a group of polymers, the growth of which are directly or indirectly tied to real estate.
We expect moderating demand growth for these polymers in China in 2019- 2025 because of a maturing economy, but no collapse in growth.
A collapse does however need to be planned for in the event of the property bubble exploding, along with no collapse but a sharper-than-expected slowdown.