Written by: Chris Stanford

Publishing date: 9/17/21

Is China's economy the greatest bubble of all time?

Is China's economy the greatest bubble of all time?

 For years almost everybody in the asset management business ignored the facts surrounding China’s economy. Simply because the prevailing sentiment has been that the government will never allow default rates to peak above systemically risky levels.

Evergrande threatening China's economy?

Evergrande threatening China's entire economy?

As a result of the Evergrande crisis, everybody is all of a sudden starting to realize the massive over leverage in the Chinese financial system. The truth is, China was in trouble long before Evergrande! In 2007 I remember writing an economic thesis paper on China, detailing the potential economic disaster that would follow the massive credit build-up. 14 years later and China’s economic growth is finally starting to stall.  For decades the government provided liquidity in high yield markets, but they allowed leverage to surpass untenable levels. 

Chinese government cracking down on debt issue?

Chinese government cracking down on corporate debt ?

In an effort to tighten the overleveraged financial system, the Chinese government is trying to end these too-big to fail policies. The only issue is that a huge portion of their rapid GDP growth can be attributed to easy credit policies.

Corporate default rates in China have reached an all-time high. Even before Evergrande, we saw a series of corporate defaults that nobody was really talking about. Foreign investors are really starting to worry. China isn’t the first government to make this mistake.

There are so many parallels to Japan in the ’80s and ’90s. A few years ago Moody’s published an article that suggested the biggest risk to the global economy is Chinese corporate debt. China’s total private and public debt to GDP is 270. The U.S. was at roughly 240% in 2008. 



China's debt problem

China's debt problem

Growth in the Chinese credit market has far outpaced GDP growth. If you look at all combined private and public sectors debt, China’s debt to GDP ratio is 270. The masses often overlook this issue because most people only pay attention to the national debt to GDP. China’s national debt to GDP is much lower than countries like the United States and Japan. 

I would argue that it is much more sustainable to have a lot of national debt vs. private sector debt. Central Banks have numerous ways that they can delay insolvency. Individuals and companies are far more limited in regards to options in the event of insolvency. 

The countries total household debt to GDP is 61%. This number isn’t terrible when compared to the United States. Our household debt to GDP ratio is 70%. Keep in mind the U.S. household debt to GDP was at a high of 120% in 08. China saw a 100% increase in the last ten or so years.

China's total debt to GDP ratio

China's economic growth slowing?

Last year, China was the only country to have GDP growth. However, in 2021 we are starting to see some cracks in the foundation. The most recent retail sales number was 2.5% vs. 8.5% in the prior quarter. The forecast was 7%. Industrial production saw a slight 0.6% decline from the prior July report. The most recent print was a 5.3% increase vs. 6.4% from July. The total estimated GDP growth is 5-6% for 2021. Property investments grew at the slowest pace in 18 months at a mere 0.3%.

China GDP growth rate

Dollar shortage in China

Dollar shortage in China

China has $3 Trillion in U.S. reserves. However, they have $2 trillion worth of foreign dollar-denominated debt nearing expiration. China needs Dollars/Euros to trade in international markets and pay back foreign debt denominated in dollars. All of the countries major infrastructure projects are funded in U.S. dollars, including the new silk road project. 85% of all exchanges happen in either Dollars or Euros. Only a small single-digit percentage of trade is via the Chinese Yuan. 

Many have argued that the Chinese Yuan will overtake the dollar in the coming years. Part of having a global reserve currency is having a robust global bond market. A lot of FX exchange happens using treasury bonds. China’s bond market outside of its own country is nonexistent.

Another factor contributing to the dollar shortage is wealthy Chinese citizens moving money overseas. Even CCP party members are notorious for storing wealth offshore. By no means is the new phenomenon, it’s been happening for decades. To cut down on foreign money laundering, the Chinese government has placed numerous restrictions that prevent its citizens from moving capital overseas. For example, It’s illegal for a Chinese citizen to transfer more than $50,000 outside of China.

Digital Chinese Yuan & money laundering

Digital Chinese Yuan
& money laundering

Part of the reason that China is pushing the digital yuan is so that they can start having better ways to monitor/restrict capital outflows. Chinese banks are running out of dollars. In recent years we’ve heard a lot of speculation that the Chinese Yuan will overtake the dollar. The yuan will never be able to compete with the dollar unless they give up control. For the Chinese Yuan to become a globally used currency, it would take a dramatic 180-degree shift in CCP policies.

Private sector shadow debt

China has desperately been trying to crack down on is shadow banks. Regulators have placed a series of restrictions on shadow banks. These are essentially entities that act as financial institutions but are not formally financial institutions. Therefore they are not subject to the same conditions as such. Shadow bank loans in China have reached an estimated $13 trillion. 

By 2016, shadow bank loans reached an uncontrollable level. The Chinese government wants to be able to control the credit markets. Shadow banks are not formally banks and therefore are not under the same restrictions as banks. This opaque financial system continues to threaten the stability of the financial system.

China shadow debt vs total debt

Increased default rates in Chinese bonds

Increased defaults in Chinese bonds

 In 2021, we’ve seen the highest level of corporate defaults in China. Corporate debt has reached unreasonable levels, and a huge portion of that debt is comprised of high-yield lower-quality issuers. Banks are willing to loan to lower-quality bond issuers because 50% of them are state-owned enterprises. State-owned enterprises are backed by the government. Therefore they are more likely to receive bailouts in a potential default scenario. 

The government created the perception that these companies essentially had no default risk. This has led to a rapid rise in private sector leverage. The government has been trying to tighten the financial system by allowing bonds to default. The issue is that without government intervention, the financial system is insolvent otherwise. The Chinese government faces a major dilemma. The question is, should they let some of these companies default on their debt to prevent any further moral hazards. This scenario would likely result in a massive economic crisis. 

Option 2 is to prioritize short-term growth and keep this game going as long as they can. The downside of option 2 is that you create a slow multi-decade slow unwinding. Japan essentially suffered from the same fate in the ’90s. Billionaire Jim Chanos once said,” We have never seen a credit build-up, of this magnitude, that hasn’t been followed by a major economic crisis”. Liquidity in the high-yield Chinese market has little to no natural buyers.

Noteworthy Chinese corporate defaults

Noteworthy Chinese corporate defaults

Evergrande: Evergrande, one of china’s largest real estate developers, is very close to defaulting on its bonds. This would be one of the largest defaults in the countries history. Until now, they’ve been able to intervene before experiencing any systemic default scenarios. However, the problem is becoming too big to ignore. The company has roughly $350 Billion in outstanding liabilities. I do believe that the Chinese government will have to intervene.

I’ve seen many comparisons to the Lehman Brothers collapse, but I would argue that the Lehman brothers posed a far greater systemic risk. The U.S. investment banking industry naturally has more exposure to other industries. The greatest impact of Evergrande is the change in perception surrounding the Chinese Bond market. People are starting to finally pay attention to issues that have long been ignored/overlooked

Huarong: Huarong is a distressed debt investment firm created by the Chinese government. After increased leverage, the firm received a $15 billion bailout just weeks before the Evergrande default.

Tsinghua Unigroup: Last year, chip manufacturer Tsinghua Defaulted on 1.3 billion RMB in bond. A lot of these recent default scandals often originate from investor skepticism surrounding the companies financials.

Yongcheng Coal & Electricity Holding Group Co. Ltd: A Coal & energy company that defaulted on roughly 1 billion in RMB bonds last year. The company has been aiming to achieve a phase of massive expansion. However, the government is less willing to subsidize that growth than they were in the past.

Jizhong Energy group: They were an AAA-rated state-owned mining company that defaulted on $151 million in bonds. The 2020 pandemic created various supply/demand shocks to china’s coal mining industry.

China Fortune Land Development Co. Ltd: defaulted on a $530 million bond payment in 2021. They are one of the numerous real estate development companies facing liquidity issues.

Higher global shipping cost

Due to increased shipping costs/lead times, Chinese manufacturing has become far less profitable for overseas companies. Over the last year, we have seen a hundredfold increase in shipping costs. China is responsible for almost a third of the world’s global manufacturing. They wouldn’t be able to maintain rapid GDP growth without cheap manufacturing. Even before the pandemic, we were already seeing global supply chains shifting away from China. If shipping costs stay elevated, we will see a further acceleration of this trend.

China freight cost increase

Divergence in monetary policy

While the U.S. is tightening, China is easing. Divergence in monetary policies can have much greater repercussions than one might think. Traditional textbooks would focus on trade as the main channel of monetary policy spillovers. The literature suggests that financial channels are more important. Part of the reason that China is reluctant to use QE is that it would only be a short-term band-aid on a much larger issue. QE would provide a boost in short-term economic growth. However, long term it would only further exacerbate their liquidity crisis.


Lack of affordable housing in China

China is now home to some of the world’s most expensive property markets. That’s surprising because they are ranked 79th in terms of GDP per capita. The average cost of an apartment/home in Beijing is about $5,000 per square foot.  The average salary in China is less than $12,400 per year.

 Although they’ve lifted over 800 million people out of poverty, the world poverty standard is only $2.30 per day. If you make $3 per day, you are no longer living in poverty. 70% of the population lives on less than $600 per month. The majority of Chinese property has become far too expensive for the masses. For this reason, you see these huge empty ghost cities. More than 65 million homes are sitting empty nationwide.

China real estate bubble

Lack of rental income

 The rental market in China is extremely small relative to the general size of the population. Roughly only 13% of the population rents property in China. Here is another statistic, 10% of all Americans live alone. Only 5% of the 1.2 Billion Chinese population lives alone. The rental market isn’t nearly as developed as in western countries. Partially due to the family dynamics in Asian Countries.

70% of China's wealth built on real estate

Sources suggest that over 70% of china’s household wealth is attributed to real estate investing. To people that are unfamiliar with the statistics, this can be shocking. When people think of China, the first thing they think of is tech or manufacturing companies. For the last 10-15 years, home prices have increased by double digits in most major cities. Real estate has earned a reputation in China as a safe way to create long-term wealth. 50-60% of American households own stock. Only about 7-10% of Chinese households own stock. Real Estate speculation is much more rampant in China than in developed nations like the United States.

Chinese ghost towns

One of the most shocking statistics is that over 60 million Chinese homes are vacant. Entire cities the size of New York City are abandoned/unfinished. Speculative real estate investing has reached unprecedented levels in China. Real estate investors have been developing these lower-tier cities, preparing for this massive migration from rural villages to sprawling cities. 

Over the last 20 years, we have seen the City populations double. In 2000 the urban population made up about 30% of the total population. Now over 60% of the population lives in cities. In the ’90s and early 2000s, we saw rapid rates of urbanization. Now the degree of change is starting to slow to low single digits.

The most important fact is that most of these newly built apartments are too expensive for the average Chinese Person to afford. The people buying these apartments are often wealthy Chinese property inventors that don’t plan on living in them. A huge portion of these buildings are sitting unfinished and have been for years. 

As a result of these cities being empty, these apartments are unmaintained. In America, real estate investors must comply with GAAP (Generally accepted accounting principles) standards. Based on GAAP principles, if these properties were in the United States, they would be forced to mark down the value of these assets. Property development companies in China do not follow the same accounting principles. Therefore a huge portion of assets are being overstated on their balance sheets.

Our Playbook

There are very few direct ways to exercise our thesis. Shorting Chinese equities has proven to be extremely difficult. The government actively intervenes by placing restrictions on investment activity. Not only that but Chinese equity and bond markets are mostly closed to foreign investors. The best way to directly play this would be short index funds with A & H share exposure to Chinese securities. I prefer plays that are indirect and not so obvious. Like I stated above, I believe China’s slowdown will be very gradual (similar to Japan). However, the most exposed industries will likely experience near-term headwinds. 

Direct index macro plays

($MCHI)iShares MSCI China ETF-This is an index with broad exposure to Chinese Companies of all sizes. MCHI has a total of 601 holdings. The majority of the exposure is to Chinese companies listed in Hong Kong. In the last year, the index has gotten more exposure to the A-shares. I prefer a more direct play on the industries with the most leverage and real estate exposure. Generally, we believe that the broader slowdown will take years to unfold. However, specific industries will see a more immediate slowdown. 

$CAF: Morgan Stanley China A shares fund: This would be the most direct way to play a slowdown in the Chinese economy. 80% of CAF’s assets are in A-Shares of Chinese companies listed on the Shanghai and Shenzhen Stock Exchanges. The Fund may invest, up to 15% of its net assets, in warrants, structured investments, or other Strategic Transactions. Shares traded in mainland china are hard to get exposure to. They place heavy restrictions around who can and can’t invest in the A-shares. I prefer a more direct play on the industries with the most amount of leverage and real estate exposure. Generally, we believe that the broader slowdown will take years to unfold, however, specific industries will see a more immediate slowdown.

Macau and Casinos

Macau is a region of the southern coast of China. Macau is not a country but essentially governs itself as its own country, similar to Hong Kong. Several years ago, Macau surpassed Las Vegas as the largest gambling destination in the world. A large portion of the countries’ income is attributed to wealthy Chinese tourists. Therefore, the global casino business model is heavily linked to growth in the Chinese economy. 

The casino business in itself is extremely sensitive to economic cycles. To play a Chinese slowdown, you could bet against gaming companies with large exposure to Macau. An example would be Wynn Resorts. Over half of the companies revenue comes from this region. This would be one of my least favorite ways to play this trend. Simply because it’s one of the more obvious trades. The market has already started to severely discount the casino companies that operate in Macau. 

Iron ore producing companies/countries

($VALE)VALE: The Brazilian headquartered company is the largest Iron ore producer in the world.  In 2020, China accounted for 67% of our iron ore and iron ore pellet shipments, and Asia as a whole accounted for 81%. Roughly 79% of the companies revenue comes from iron ore and iron ore products. 

$RIO(RIO TINTO): Rio is an Australian mining and minerals company. 81% of their revenue comes from the production of Iron Ore. Over half of the companies business comes from China. Iron Ore is one of China’s largest imports because they use it to make steel for construction. 

Australia: Australia is one of China’s largest export partners. Also, they are one of the largest producers of Iron ore which is China’s 7th largest import. This is a really good indirect way to play slowdown in the real estate industry. Australia’s Biggest company BHP is an iron ore producer. 


China's largest imports

Our overall thesis

The Chinese economy faces two potential probable outcomes. The first is a sharp, sudden collapse caused by a string of defaults. China claims it will no longer intervene in these life & death default scenarios. To me, this seems to be an empty threat. Without intervention, their financial system is insolvent. 

My theory is that they hope the statements alone will be enough to make corporations think twice before taking on any further leverage. The Chinese government will likely step in and save Evergrande. Although they are taking a tough public stance on this issue, it seems they will have no choice but to intervene. 

The second and most likely outcome is that they continue to intervene by shifting liabilities from company balance sheets to the governments. The problem with shifting liabilities is that it creates the wrong precedent and would likely require quantitative easing. 

China is reluctant to use QE because it would merely be a short-term band-aid for a massive problem. However, I think they are backed into a corner and have no other choice. China has a history of doing anything it can to stimulate its economy. 

China seems to be headed toward the same fate as Japan, after it’s meteoric rise in the 80′ s and 90’s. Japan was closer to economically overtaking the United States than China is now. In 1995 the United States total GDP was 7.5 Trillion. Japan’s GDP was 5.4 Trillion. 

From 1985-1995 Japan’s economy grew by 400%, but almost 30 years later Japan’s economy has not grown at all since 1995. Japan made a lot of the same critical mistakes that China is making. 

Real estate was a huge source of private wealth, and that wealth was fueled by easy lending money policies. Japanese real estate prices have fallen 60 percent since their peak in 1990. 

Japanese banks suffered a credit crisis from low-quality issuance. Instead of restructuring their balance sheets’ they concealed losses and continued to receive government bailouts. Japan never experienced a sharp economic collapse, but it had a decade of no growth. This is the most likely scenario for China, in our view.

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