There are two diverging views on what the economy in China could do after the 38% fall in the Shanghai Composite in the last two months. One view is that the share market has little interaction with the real economy and thus there’s no need to worry. The other has the two heavily interlinked, with the economy and the share market both moving down. The key to which view will ultimately prevail is what links exist and how strongly the changes in one flow over to the other.
In order to show what the links might be and how the problems could spread I’ve mapped out a ‘hard landing’ scenario. This isn’t a prediction, but rather an attempt to show that a hard landing is possible and not unforeseeable.
Stage 1: Equities fall hard
The equity sell-off began in June, with initial falls only halted when the government intervened, banning large owners from selling and forcing securities groups to buy. Towards the end of August, the Chinese government temporarily withdrew its direct support of equity markets. Once the sell-off began it accelerated quickly, as unusually high levels of margin debt forced many to liquidate their positions. The government re-entered and compelled more buying, as it could not stomach a collapsing stock market raining on its grand military parade on 4 September.
To stabilise the market at this point would require a combination of (i) the end of forced sales from margin debt unwinds, (ii) the ‘get out while you still can’ sentiment of retail buyers fading and (iii) institutional investors seeing value and beginning to buy as the P/E ratios reach levels similar to or below those of developed markets. None of these factors appear likely in the near term. Whilst government intervention continues, relative stability can be maintained, but if that stops then the dominos start to fall.
As investors digest that there is no longer a government safety net for equities, they assume this applies to their other investments. As a result, a wave of selling hits property markets and wealth management products. Some investors need to sell other assets and deleverage after their equities fall, whilst others sell out of fear.
Stage 2: Collapse of shadow banking
Prior to the falls in equities, losses on property and wealth management products were both limited, and in a number of cases, had been papered over by government organised bailouts. However, as the equity-linked defaults mount and the Chinese government chooses not to intervene, investors refuse to rollover their investments in wealth management products. As almost all of these trusts have investment periods of six months or less, a liquidity crisis rapidly compounds. Chinese peer to peer lenders also find that their investors are no longer willing to supply capital. Loans made to small and medium businesses, local governments, and equity and property investors are called in.
As a result of credit being cut-off, forced liquidations of property investments begins. Developers lose access to funding and halt construction on existing developments leaving many investors out of pocket and without a habitable property. The glut of empty properties, with little prospect of finding tenants, means investors have no cashflow generation to point to when seeking finance or when offering their property for sale. A second wave of equity selling begins as providers of margin loans call in their debts in order to repay investors and protect their positions.
Many intermediaries collapse with senior management fleeing, leaving their businesses in disarray. Investors are horrified to learn that their money was used to fund defunct property developments, mining companies and steel companies. After investing based on the brand name of the bank that sold them the product, they learn that the underlying businesses have long been unprofitable.
Courts are swamped with insolvencies dragging out the recovery proceedings. Provincial governments are too busy cleaning up their off-balance sheet activities to be able to assist. Guarantee companies drown in a sea of claims, failing to do the very thing they are supposed to do at their first major test. The recovery rates of defaulted wealth management products and other shadow banking investments is minimal.
Stage 3: Collapse of the banking system
The lack of trust in governments and financial institutions exacerbates the panic sentiment. Bank depositors withdraw their funds en masse, creating a liquidity crisis for banks. Whilst the Chinese government provides liquidity to meet the outflows, it cannot stop the defaults and destruction of capital reserves at many banks. Decades of ‘extend and pretend’ lending finally comes unstuck with banks forced to reveal their losses as bad loans are sold off to asset management (restructuring) companies at a substantial discount to face value.
The Chinese government is forced to recapitalise banks and takes full control of the banking system. Government debt to GDP skyrockets as a result. Depositors are left with some losses but many bondholders and equity investors receive nothing. Investors now assume that nothing is safe, other than physical gold and investments outside of China.
Stage 4: Credit crunch and recession
Banks are overwhelmed with problem loans and new lending grinds to a halt. Only buyers with sufficient cash reserves are able to purchase businesses and properties with prices of both severely depressed as a result. International investors have pulled their capital out and won’t be back anytime soon after suffering heavy losses. Many businesses close down completely and others have to lay off most of their staff. Business and consumer demand craters with only government stimulus to offset the damage.
Due to the losses on other investments and the widespread lack of trust, investors are unwilling to buy government bonds and the Chinese government is forced into quantitative easing. The Yuan collapses with hyperinflation taking hold. After years of urbanisation China sees large flows of young people returning to their home villages. There simply isn’t enough work in the major cities to support current population levels.
Property and infrastructure construction plummets taking down the demand for electricity and steel. The demand for imported goods dwindles as many Chinese simply cannot afford them with their reduced wages and the decline in the Yuan. Widespread public protests are crushed with military force with citizens now fearful of their lives as well as losing their remaining wealth. Affluent citizens use all means available to get their money and families out of China.
Conclusion
This is obviously a bearish scenario, but it has been put forward to illustrate a possible (but not necessarily probable) outcome for China. As well as the future being unknown, there is much about China’s economy and markets that is currently unknown to outside observers like myself. Low levels of disclosure raises the possibility that much of what is generally thought to be known about China may subsequently be discovered as untrue. How the Chinese government reacts to changes at each stage will have a big impact on future levels of growth or decline.
In the face of such uncertainty, consider several key facts on China. It is an emerging market that has averaged 10% growth per year over the last 30 years. Official debt levels have more than quadrupled in the last eight years with widespread mal-investment. By most valuation methods its equity and property markets are overpriced compared with global peers. China is now such a large economy that it can no longer export its way to high growth levels. Its workforce is shrinking and its population is aging. Just as trees don’t grow to the sky, China’s ability to record high levels of growth is unsustainable, with the possibility that a hard landing occurs in the medium term.
Jonathan Rochford is Portfolio Manager at Narrow Road Capital. This article was prepared for educational purposes and is not a substitute for professional and tailored financial advice. Narrow Road Capital advises on and invests in a wide range of securities.