Podcast: Is this China’s “Lehman Brothers moment”?
Emerging markets economist David Rees joins the pod to discuss what's going on in China and whether it could be the country's “Lehman Brothers moment”.
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[00:00:07.930] - David Brett
Welcome to the Investor Download the podcast about the themes driving markets and the economy now and in the future. I'm your host, David Brett.
[00:00:24.970] - David Brett
There's trouble brewing in China's economy.
[00:00:28.490] - News Clip
China's huge spending power is critical to global financial stability. But the country is now experiencing some evidence of an economic downturn.
[00:00:37.170] - News Clip
The trouble in China continues. New home prices in the world's second largest economy fell in July for the second month in a row. Adding to concerns a growing property crisis will further slam a struggling economy.
[00:00:49.990] - News Clip
The real estate sector represents anywhere between 15% to 30% of GDP, depending on estimates.
[00:00:55.990] - News Clip
Cash flow problems in China's real estate sector had some investors worried. They're concerned it could spill over into multiple sectors of the country's economy.
[00:01:06.050] - David Brett
Recent economic data has done little to calm fears about the health of China's economy.
[00:01:12.220] - News Clip
In May, youth unemployment was almost 21%. That's a record high. And exports dropped year on year by 7.5%.
[00:01:21.230] - News Clip
Domestic demand is a major bottleneck. We are losing the recurring momentum very quickly.
[00:01:26.990] - News Clip
While the UK is struggling to get inflation under control, China's economy is suffering from the opposite deflation.
[00:01:33.890] - David Brett
In response, China is taking emergency measures.
[00:01:38.430] - News Clip
China's central bank cutting key rates for the second time in three months, as this new eco data there comes in weaker than expected.
[00:01:44.590] - News Clip
The central bank had reduced the one year medium term lending facility by a bigger than normal margin of 15 basis points.
[00:01:54.000] - News Clip
We do expect more action not only on the monetary side, but also on the fiscal side.
[00:01:59.510] - David Brett
But will it be enough to prevent a full blown crisis? Or is this China's Lehman Brothers moment? Stuart Podmore will be your host for today's pod? He'll be chatting with emerging markets economist David Rees. They'll discuss what the implications might be for future common prosperity and political intervention in China. They'll also look at what it might mean for the rest of the world and the 3D reset. But first up, Stuart asks David directly could this be China's Lehman Brothers moment?
[00:02:34.370] - David Rees
That's a question I've had quite a few times, both from clients and fund managers during the past couple of weeks. And there are some parallels clearly, given that we seem to be having financial problems emanating from the housing market.
[00:02:49.000] - News Clip
Real estate giant Evergrande is still trying to sort out a deal with its major creditors after hitting a liquidity crisis and it filed for bankruptcy protection in the US last week. Another huge group, Country Garden, has announced losses of over $7 billion for the first half of the year and will be delisted from the Hong Kong Stock Exchange.
[00:03:09.780] - David Rees
That's causing stress amongst some major property developers, which want where one time appear to be the gold standard, certainly in terms of Country Garden. And we've also seen some wealth management companies get into trouble who have been deriving at least some of their returns from the property sector. It's not entirely clear how those linkages work. And of course, the lack of transparency just feeds this kind of panic about the state of what's going on in China. That said, I think it's worth stepping back, remembering that these issues in the housing market are really actually well known. So the government sort of decided to shake up the sector a couple of years ago now by clamping down on the amount of leverage in the system, clamping down on speculative purchases of property, which seemingly had become the main source of demand and risk to store up systemic problems in the future. And so a lot of bonds, certainly offshore of these developers have been trading at distress levels for quite some time. Many have been dropping out of the sort of benchmark indices, et cetera. So clearly there's a problem going on, it's causing some pain, but it's well known and so it doesn't necessarily have that element of surprise that the Lehman Brothers sort of situation did as we went into the global financial crisis.
[00:04:31.990] - Stuart Podmore
And if you could just expand that a little bit to the wider economic situation in the markets as well as the second part of that first question.
[00:04:39.770] - David Rees
Yes, absolutely. So I think there's probably two strands in terms of what it means for the economy. So in the short term, one of the key transmission mechanisms for policy support getting out into the economy in China in recent years has been through the housing sector. So you've typically seen an expansion of credit lending. People have taken that money, bought houses that supported construction, which is a pretty big part of the economy, and then it's also been followed up by purchases of household goods. And so that method of policy transmission is clearly broken. And actually we see that because the financial system in China is awash with cash, actually. Interbank rates are very low because of excess liquidity stuck in the financial system. But it's not getting out into the broader real economy, in large part because housing isn't an avenue for that to happen. So short term, that's kind of created a bit of a plumbing problem in terms of policy support getting out. And in the longer term there will clearly be a negative impact on the economy's potential rate of growth. I mean, there's a huge amount of debate about how large the real estate sector actually is as a share of China's economy.
[00:05:49.110] - David Rees
Most sensible estimates seem to put it around a fifth to a quarter. Now, if we think that a lot of the speculative demand that was driving that has now gone more or less permanently, then we're going to have to mark down potential growth rates. So maybe, whereas potential growth for the next decade looked like it could be 4% to 4.5%, maybe now it's somewhere in the ballpark of 3% to 4%. So it will add to that structural slowdown in the economy. Albeit we could make an argument that by cutting off unsustainable debt fuelled growth and accepting a slower rates growth is actually kind of a healthy development in China, rather than just setting lofty growth targets and meeting it through unsustainable means.
[00:06:34.110] - Stuart Podmore
Yes, that's a really good point that last point. Especially as going into April, the reopening trade post COVID, you had estimated, I think, that there was going to be something like 6.5% of growth, GDP growth in China this year. So the fact that we're trimming that, or very likely to trim that in our next forecast, is not necessarily all negative.
[00:06:53.420] - David Rees
Yeah, I mean, I've clearly been caught offside. Up until April, I felt quite smug myself because it seemed like things were all on track and the Chinese growth data were going to be strong. But then from April onwards, we've seen a double dip in housing sales, and that has also been sort of accompanied by a general declining confidence, which is then passed through the economy. So there are pockets that are doing well. The kind of reopening services sector, travel related services seem to be doing okay, but that hasn't translated into broader growth in the way that I thought it might do.
[00:07:26.160] - Announcer
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[00:07:33.490] - Stuart Podmore
And moving on to the second question, which is about that political intervention, the idea of when we last saw the People's Party Congress, there was plenty of talk about common prosperity, self sufficiency. This particular episode with big names like Country Garden, for example, in trouble, what does that mean for the relationship between those businesses over in China and its ruling Communist Party?
[00:07:56.470] - David Rees
Well, look, China's clearly a different system. It's run in a different way. You know, it's not for us to say whether that's right or wrong, and we could argue all day about the relative strengths and weaknesses of the Chinese economic model versus what we're more used to here. I think we have to accept that in China political interference or political intervention, however you want to cast it, is something that's never going to go away. I guess certainly with the direction of travel on the political front in China, where we've got consolidation and centralization of power at the top of the party, that is not going to go away. And it's a fact of life, and it's been a fact of life for quite some time. State run banks are effectively an organ of the government. We've seen things like telecoms companies essentially become organs of the government, and probably now we're seeing a similar thing with the housing market. Whereas we had a huge number of pretty bloated, as we're now finding out, real estate developers, it looks like there will be some consolidation and a greater role to play for state owned enterprises in the real estate sector.
[00:09:05.290] - David Rees
So that's not going to go away. We can also make the argument that actually this intervention is positive. As I said, if the government is willing to accept slower growth but is taught quite often about improving the quality of growth and trying to reallocate resources from a sector which is clearly on an unsustainable path, causing a lot of leverage to build up oversupply of property that could potentially lead to systemic financial problems in the future. If actually what we're seeing is an effort now to clamp down on that and reallocate the resources, labour and capital to other sectors, sort of higher technology sectors, energy transition, et cetera, which are more productive and can sort of try to arrest this underlying structural slowdown growth, then you could actually make the argument that what we're seeing in terms of intervention is positive, albeit it's clearly very painful at the moment.
[00:10:03.250] - Stuart Podmore
Yeah, so actually, that different system, without making a value judgement on that at all, actually allows for perhaps a government that can move in a more nimble fashion and is perhaps not constrained by the political cycle, the electoral cycle.
[00:10:19.390] - David Rees
[00:10:20.630] - Announcer
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[00:10:31.510] - Stuart Podmore
That sort of takes us to the final question then what does all this mean for the rest of the world, and Asia in particular? And how does that affect our regime shift narrative that we've constructed so successfully for our clients?
[00:10:43.230] - David Rees
So what does it mean for the world? Well, clearly, China is quite a big part of the global economy and so slower growth in China mechanistically reduces global growth. In our forecast spreadsheet, China's weight is about a fifth of global GDP. So if, for example, you knock one percentage point off Chinese growth, then you automatically knock about a fifth off global growth. So clearly, slower growth in China equals slower global growth. In terms of the spill overs, though, the story is quite nuanced. So there are countries and there are sectors that rely on China. Obvious examples are emerging markets that derive quite a lot of GDP growth from exporting commodities to China. You think of countries like Chile, where copper exports are essentially to China, essentially worth about 8% of GDP, something like that. So it's quite significant that if China is reducing its direct demand for commodities, which I would actually make the point at the moment, it's been holding up quite well, it seems to be demand for commodities from the rest of the world, which is soft at the moment. But if China's demand goes down in the future and or what's going on in China causes prices to fall and then those emerging markets that do a lot of trade with China, or just rely on commodities trade, then will suffer.
[00:12:06.730] - David Rees
Similarly on a sectoral basis you could imagine that if construction is going to be less of an engine of growth in the future, then Chinese demand for diggers and trucks, et cetera, and maybe machinery from Germany, for example, is going to be smaller in the future. But I think the more fundamental point for me is that if you look at China's external position it runs large structural external surpluses and it has done basically since it joined the World Party as a manufacturing base for the rest of the world. What does that mean? Well, that means that in aggregate terms China is a net drain on activities, not a source of aggregate demand for the rest of the world. And so even if you mechanistically knock down global growth, the actual spill overs to the world in aggregate, quite limited in terms of weaker Chinese demand. And so, you know, you've got to be careful with that nuance because the risk from China growing not as quickly is often guess. You know, actually the greater risk probably comes through confidence shocks and worries that China's about to implode and people just sort of retreating a bit from risky assets. That's a really flows but that's a different point.
[00:13:23.890] - Stuart Podmore
Yeah, I mean I think that the point you make on the nuance there is really important though and understanding the implications for global growth and actually when you put it like that, it doesn't sound as negative as perhaps one might have imagined. And certainly I'm immediately thinking to then move to the idea of regime shift, I'm thinking back to some of the very relevant points we made about deglobalization, for example, and that process of deglobalization and what you say about Chinese demand and Chinese supply for the global economy. I'm thinking actually the deglobalization narrative continues and actually that could be positive still.
[00:14:01.740] - David Rees
Well, I mean it seems pretty clear to me the deglobalization narrative continues. I mean we're going to go into the US election year where you assume Donald Trump is going to be pretty hawkish on China and Joe Biden's not going to give him a free luncheon, is going to continue to also be pretty hawkish on China. So that's not going away. But we are seeing real evidence in some of the incoming data. You say US construction of factories is starting to accelerate rapidly so we are starting to see snippets of this kind of reshoring, et cetera, deglobalization going on. And I think probably what we're seeing in China in terms of the government's desire to fundamentally reshape the economy also fits that narrative. As I said, rather than pouring resources in terms of capital and labour into property, which is not really generating any long term benefit to the economy, there is an effort and we can argue again about whether it's going to be successful or not. But there is an effort to reallocate those into sectors that are going to help China to become more self sufficient as and when it loses access to more intermediate goods that it relies.
[00:15:12.300] - David Rees
Obviously we've already seen a big clamp down on semiconductors and who's to say what's going to be next? And so this all does fit into that regime shift story that we've been telling. The flip side, of course, could be that the rest of the world starts to lose some Chinese supply as well if the trade war really gets ugly. And we've already seen during the pandemic what that can do to inflation elsewhere. So these things run both ways.
[00:15:39.450] - Stuart Podmore
Indeed they do. So thank you very much indeed for that, David. I think I'm going to try a summary now and you've got to point out whether or not I've got this right. But I think when we think about this being the Chinese version of Lehman Brothers, I think you are not going for such hyperbole there. Actually, I think what you're saying here is that this is nowhere near as sudden or as unanticipated. I get the sense as well, when you think about the Chinese government, that actually the Chinese government would, through the lack of constraint on its power, be searching for that almost a property pivot, a pivot away from property to broaden out or diversify the strength of that economy as it's moved towards self sufficiency. And that actually, that self sufficiency plays into deglobalization regime shift, but from a Chinese perspective as much as the rest of the world. So, overall, I'm taking some positives here, whilst accepting the fact that we're going to be taking maybe a quarter, if not a fifth off Chinese GDP forecasts and probably doing likewise on a global basis. Would that be fair?
[00:16:44.290] - David Rees
Yeah, I think so. I mean, I wouldn't say I'm feeling particularly positive, but maybe within the current pain that we're going through, there will be some positives in the long term in that problems in the property sector that we've been worried about for a long time are being dealt with. They're being dealt with quite harshly and abruptly, but they are being dealt with and maybe that can sort of start to stem this structural slow down in China's economy that we're seeing. There's a huge amount of scepticism about that and we won't find out for quite a number of years if it's successful, but at least they're making a stab at it.
[00:17:25.130] - David Brett
Well, that wasour show. We very much hope you enjoyed it. If you want to find out more, please head to Schroders.com/Insights. And we're endeavouring to record as many of these shows in the studio, on video. And if you want to watch them in their full, unabridged version, then go to Schroder's YouTube channel. If you want to get in touch with us, it's email@example.com. And remember, you can listen, subscribe and review the Investor Download wherever you get your podcasts. New shows drop every Thursday at 05:00 p.m. UK time. But above all, keep safe and go well. Cheers.
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