China’s Economy is decelerating, casting serious doubts on the reopening strategy despite Government’s efforts. There is now probably no alternative for #China other than to move decisively to stabilize its traditional growth driver: #Property.

“Looks like we got ourselves a Mexican stand off here boy

And I ain’t about to run

Put your gun down boy

…”

Robbie Williams

Is China Heading for a Balance Sheet Recession?

In a recent tweet, Alicia Garcia Herrero gave us the lowdown on the current credit growth in China. The latest data for June shows that credit demand isn’t bouncing back—it’s actually going downhill, causing people to stash away their extra cash. This whole credit slowdown and the rise in savings could be a sign that China is stuck in a balance sheet recession !

China’s credit data for June was basically a rerun of the inflation data. The official sector is giving a big push to boost credit, but there’s no pull from households or companies. Simply put, the demand for loans is seriously not coming back.

And consider this—according to the People’s Bank of China (#PBoC)— Chinese households managed to save a mind-boggling 11.9 trillion yuan ($1.7 trillion) during the first half of 2023. That’s a whopping 15% increase compared to last year! It seems like all the effort put into the reopening strategy to boost consumer spending is falling short of success.

On top of that, inflation is taking a nosedive. Both the Consumer Price Index (CPI) and the Producer Price Index (PPI) are going down faster than a rollercoaster. This is bad news because it’s making people worried about deflation and it’s bringing down their overall confidence. It comes as little surprise that there is a growing discussion surrounding the potential measures the government may undertake to revitalize the economy.

Despite the roll-back of the three red lines and the extension of 16 easing measures for developers, the real estate market shows no signs of relief. Transactions remain notably subdued, as illustrated by the chart below.

Let’s face it! If it looks like a balance sheet recession, quacks like a balance sheet recession, then it’s probably a balance sheet recession.

But how did we get to this point?

Why is China’s quest for innovation failing?

Despite the Chinese government’s heavy investment in research and development (R&D) and human capital, the country’s economy continues to decelerate, raising concerns about the effectiveness of its innovation pursuits. Four key bottlenecks contribute to this challenge. First, the increasing complexity of the institutional bureaucratic framework hampers progress. Second, a changing society has led to shifting career preferences among the youth, with civil servant jobs gaining more appeal than private sector careers, even with a high youth unemployment rate of 20% after full reopening. Third, the US push to technologically contain China, particularly in semiconductors, exacerbates the situation, amplifying the impact of the ongoing trade war. Fourth, China’s strategy to change their growth model away from property and private-led tech was too abrupt, and they did not fully consider that triggering a balance sheet recession would make it virtually impossible to recalibrate the country’s growth strategy. This additional bottleneck further adds to the complexity and challenges faced by China in navigating its economic trajectory.

What does a China Pivot really mean?

Objective Function

I don’t think that the a China Pivot means that policymakers are going to switch their objectives. That ain’t gonna happen! But here’s the deal: for policymakers to reach their long term objectives they need to tackle excessive risk aversion among financial institutions and investors in terms of real estate financing! I don’t think there is a way around it!

But there is more to it, it is crucial for China to amplify its efforts in providing substantial support to the private tech sector. It’s high time to ditch the current crackdown approach. A more market-oriented approach will be instrumental in sustaining the momentum and fostering a thriving environment for growth and innovation.

Constraints

For real estate developers they have extended the 16 easing rules but that does not mean the demand will be back. The solution in 2015 was a stimulus but the fiscal space now is much more limited with China’s public debt having reached 100% of GDP. High debt to GDP, the the biggest hurdle right now!

Size of the Stimulus

Constraints loom large in the form of high national public debt and colossal debts incurred by local governments. However, I hold a different perspective from the consensus. While most pundits expect China to continue with its gradual support approach, I am increasingly convinced that a significant shift is imminent. China is poised to bring back its economic “bazooka” into play. Such measures are necessary to overcome the balance sheet recession and ignite the economy. Incremental steps alone will not suffice, and I believe President Xi Jinping now comprehends this reality. Hence, his recent efforts to extend an olive branch to the private sector signal a policy U-turn in the making.

Collateral Damage

Who is going to then bear the brunt of the cost of financing the cash-strapped property developers? Chinese banks! which are clearly facing increasing risks from rising non-performing loans (NPLs) and diminishing returns, making them a lightning rod for investors’ worries about the world’s second-largest economy.

Investment Conclusions

The China Pivot is expected to have significant ripple effects on investments throughout emerging markets. These effects are anticipated to particularly benefit emerging market corporates, rather than sovereign entities. In my opinion, emerging market corporates are likely to outperform sovereign entities due to certain challenges faced by the latter. In the EMBI (Emerging Market Bond Index), many countries are grappling with a logjam of credit defaults or restructurings, which can hinder their performance.

CEMBI corporates spread vs. Sovereign are not wide on an historical basis, but they are still attractive.

source: JPM

The only catch is that all the pick-up is in the HY space as IG issuers are already trading near the tights. No risk no gain, that’s why this is not a market for EM tourists!

source: JPM

Based on this analysis, the following conclusions can be drawn:

# Conclusion 1: Consider adopting a long position on CEMBI (Corporate Emerging Market Bond Index) to take advantage

of potential opportunities in emerging market corporates.

# Conclusion 2: Explore long positions in traditional emerging market commodity plays and key trading partners with China to leverage the potential benefits arising from the China Pivot.

# Conclusion 3: Implement a barbell portfolio strategy by allocating 10-20% of the portfolio to distressed credit names (3-4% to China developers. you don’t need more!). Diversify carefully the remaining 80-90% across regions and issuers to mitigate idiosyncratic risks. As said, this is not a market for EM tourists!

By implementing these investment approaches, investors can position themselves to potentially benefit from the ripple effects of the China Pivot on emerging markets.

Inflection Point Team

Disclaimer

All views expressed on this site are my own and do not represent the opinions of any entity with which I have been, am now, or will be affiliated. I assume no responsibility for any errors or omissions in the content of this site and there is no guarantee for completeness or accuracy. The content is food for thought and it is not meant to be a solicitation to trade or invest. Readers should perform their investment analysis and research and/or seek the advice of a licensed professional with direct knowledge of the reader’s specific risk profile characteristics.