One of the highest profile economic risks for the global economy is the pronounced slowdown in China. In order of severity, the key points of distress there are the property sector, debt levels, export weakness, a slowdown in domestic consumption, rising unemployment and poor demographics. We are closely monitoring the situation, as a meaningful decline in the world’s second largest economy could have a pronounced effect on global economic growth.
China’s property sector contributes roughly 30% of their GDP, and there has been a bubble forming for years, most visible in their infamous “ghost cities”. The bubble has sprung a leak, and the days of rampant property speculation in second or third homes, which served as a form of an ATM for the Chinese consumer, have been on the wane for the past three years. Almost two years ago the default of China Evergrande Group, then China’s largest developer, rocked the markets. The latest poster child for the collateral damage is China Garden, who replaced Evergrande as China’s largest real estate developer. According to China Real Estate Information, sales at the largest 100 developers are off 33% year-over-year through July, and China Garden’s were off a stunning 60%. The resulting cash crunch has caused them to miss two recent coupon payments and driven their debt to trade at roughly 25% of face value; a level firmly in “junk” status. China’s response to the weakness has been puny, with their most recent response to the situation being a 0.15% reduction in interest rates. The good news is that Chinese developers have been effectively shut out of global bond markets since 2021, so the damage should be largely isolated to China.
China’s growing debt burden is another reason for concern. Although Chinese data is notoriously doctored and often scant, researchers at JPMorgan Chase estimate a total debt-to-GDP level in China approaching 300% – higher than the 257% ratio in the U.S., yet a fraction of the +1000% level in deeply indebted Japan. As we learned during the Financial Crisis of 2008-2009, though, the combination of a property bubble and the debt market can be toxic, so the situation is serious.
China has been an export powerhouse since it gained membership in the World Trade Organization in 2001, and it has been the primary driver of China’s 6-8% annual economic growth prior to COVID. The lifting of lockdowns in Spring 2020 led to a goods buying binge by U.S. consumers, temporarily boosting the Chinese economy, but with the one-two punch of long COVID lockdowns in China, which put a brake on domestic consumption, and global consumers shifting towards services consumption, Chinese exports declined 14% in July in dollar terms, and economic growth has recently been closer to 3% than its 5% target for 2023 (and that is only if you believe the heavily massaged official statistics). In a nutshell, the government’s plan to shift from an export-led economy to more consumer-driven has hit a major speedbump.
All of the economic challenges that seem to have reached a crossroads at precisely the same time have manifested into an unemployment problem (a bit ironic for a Communist country). Although unemployment for the 25–59-year-old sector has remained stable at roughly 4% (again, assuming you trust the official statistics), youth unemployment for those aged 16-24 has nearly doubled over the past five years, reaching a high of 21.3% in June. In a tragi-comic twist, the Chinese policy response has been to no longer release the data!
The problem of youth unemployment is exacerbating the long-standing demographic problem of an aging and declining population in China; the younger generation is losing hope and is consciously avoiding having children. In addition, the population is skewed towards too many men and not enough potential brides, an unintended effect of the one-child policy implemented in 1980. As a result of these factors, the country’s fertility rate fell to 1.09 babies per a woman’s lifetime last year, which is well below the replacement rate. The authorities are acutely aware of the problem, and lifted the one-child policy in 2016. However, the situation is only worsening and the overall population has recently gone into decline. One need only look to the rapidly aging Japanese for an example of the growth constraints caused by demographic imbalance.
We are not discounting the severity of China’s problems but believe the impact on the global economy (and particularly the U.S. economy) will be muted. Chinese economic growth declined from a COVID-fueled 8.1% in 2021 to only 3% last year, yet the U.S. economy’s recovery has been barely affected. The U.S. simply does not export enough to China for weakness there to really move the needle – our total exports to China are roughly 0.6% of U.S. GDP. Due to lingering hostilities between the U.S. and China that figure is likely to decline on its own. According to The Economist, in the first half of 2023 U.S. trade with Mexico and Canada outpaced that with China for the first time in two decades.
Regarding a possible debt implosion, the bulk of Chinese debt is in the hands of its consumers and local governments. Their federal government has debt levels roughly 20% of ours and is sitting on reserves in excess of $3 trillion. This serves as a ammunition stash for a powerful policy response once they finally acknowledge the severity of the problem. President Xi Jinping is very wary of popular unrest and has reacted with a shotgun approach of a 31-point plan for enterprise, 20-point plan for consumption and a 26-point plan for labor.
We will continue to monitor the situation as it unfolds, which is likely to be a multi-year story. At present, though, we see a bit of an upside in the Chinese unrest; a slowdown in their economy and resulting deflation/currency devaluation should take further edge out of U.S. inflation and allow the Fed to ultimately end its rate hiking cycle. The biggest tail risk we see is that China responds haphazardly with a “wag the dog” response in the form of aggression towards Taiwan. Thankfully the odds appear low at present.
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