Opinion : The prospects for China’s real estate sector are bleak, but they are not the only drag on the Chinese economy

Financial markets have been firmly focused on the interest rate implications of a resilient, even resilient, US economy, but investors may not have been paying enough attention to China’s economic and financial news.

Despite the desolate economic situation, the proverb “Loud thunder, little rain”, as the Chinese say, prevailed on the world markets. It’s easy to see why, but also why we should stay alert.

Evergrande’s filing for Chapter 15 bankruptcy protection in New York this week was hardly news, and markets have long digested the company’s demise.

More significantly was the financial collapse of another major real estate developer, Country Garden, and the financial turmoil at a large trust bank (shadow bank), Zhongrong, which defaulted on payments to investors for some of its products.

The waves of distress emanating from the crisis in the real estate sector and spreading to the financial sector are now being felt and are increasing the risk of contagion, at least for analysts.

There is no doubt that the outlook for the real estate sector is bleak. This is not the only drag on the Chinese economy and joins other systemic weaknesses, such as a larger debt burden, weak consumption, weak manufacturing and poor governance, and a business environment dominated by politics and the needs of the Chinese Communist Party.

However, property is the immediate cause of distress. The sector is bracing for over-build and excessive leverage due to a slump in transaction volume. Built-up area and turnover are around 40-50% below 2019 levels.

The problem is more complex, however, because although prices have fallen, the official data, based on survey results, is modest. However, selling prices for existing homes are about 15% lower than in 2019, and new home sales are being offered comparable discounts to attract hesitant and uncertain buyers, many of whom are tying up their assets and mortgages in unfinished homes.

The combination of declining transactions and prices is typical of a self-sustaining real estate downturn and a reflection of the boom when everyone’s balance sheets were stretched and managed as if the real estate uptrend were a one-way bet. Now the mood has changed and the herd has changed direction.

The news about trust banks is worrying, but only marginally. Trust banks aren’t particularly dependent on real estate, and the authorities can likely stabilize disruptions in individual companies. However, if several wealth managers ran into liquidity problems, not to mention primary bank lenders were suddenly faced with deposit withdrawals or a spate of bad housing loans, problems could arise very quickly.

These are difficult times then, and people expect or hope that the government will soon announce measures to stimulate the economy and consumption, relax rules and regulations on homeowners and developers, and try to buy some time. Markets may temporarily calm down, but the reality is that the housing market has been contracting for years as it adjusts to weaker housing demand for economic and demographic reasons.

See: Global investors expect a massive economic stimulus from China. Because of this, it may never come to pass.

In the face of these and related phenomena, China’s stock markets have seen, at best, time and bond yields have fallen as monetary policy eased in the face of the threat of deflation. The central bank this week attempted to slow or halt the depreciation of the renminbi, also known as the yuan, which recently fell to its lowest level since 2007 when it was steadily appreciating.

The impact on global financial markets and investors is currently quite limited. In fact, the empirical evidence is that global market contagion, stemming from disruptions in the Chinese economy or financial markets, is generally quite small.

Investors outside of China still tend to own fairly small amounts of Chinese assets. The average weighting of Chinese equities and foreign asset managers’ fixed-income securities of less than 5% does not suggest that, on the whole, investors are exposed to a large amount of risk. If anything, they’ve cut even further this year. Although the investment industry is constantly urging investors to increase their China exposure to around China’s share of global GDP, or around 18%, most investors have wisely chosen to keep their distance.

Global contagion is limited by two other factors. First, few wealth managers outside the country currently have exposure to Chinese real estate assets. Second, it is widely believed that China will not only seek to stabilize its economy and limit global spillovers but, more importantly, will use its control of the financial system to shift liabilities to large ones as needed support financial institutions.

See also: China Evergrande collapse shows need for $1 trillion bailout plan for Beijing, says Clocktower strategist

Of course, these conditions, particularly the preservation of financial stability, may not always be present, which is why investors need to pay close attention in any case.

Even if the Chinese and global markets remain largely uncorrelated, foreign investors should be aware of other risks and opportunities. For example, while the macroeconomic contagion may have weakened, there is no doubt that the fallout for commodities and resource companies will be far more remarkable. China’s insatiable appetite for energy, metals and minerals to fuel its industrial economy and oversized real estate market is legendary. When conditions falter or falter, these areas will no doubt be affected.

China’s other difficult economic and financial conditions could also serve as a trigger to accelerate or influence the supply chain recalibration already underway, particularly with regard to products and processes critical to technology and national security. Investors should definitely follow these developments to identify companies and countries in non-Chinese Asia and among the “friendly” countries that will benefit from new investment and trade.

Renminbi weakness is also something to keep an eye on as it can be seen as a harbinger of bad news and easing monetary conditions. The People’s Bank of China felt compelled to intervene last week and did so. A weak renminbi offers cheap goods and services to those buying in other currencies, but reflects a flagging economy and weak imports from the rest of the world.

See: China sets yuan fix at widest gap on record

For investors, however, the renminbi’s depreciation is also an indicator that could shed light on deteriorating domestic conditions or loose capital controls as smarter or more adept investors try to get their money out of China. The signals of squeezed earnings, tightening credit conditions and risks to financial stability could then have a bigger impact globally.

George Magnus is a researcher at the China Center at Oxford University and SOAS University of London, and a former chief economist at UBS. He is the author of Red Flags: Why Xi’s China is in Jeopardy.