Chief China Strategist
Summary: The PBoC is working to stimulate economic growth by implementing an RRR cut. Positive growth is evident in industrial production and retail sales. However, it's important to note that shadow banking and local government debt continue to present persistent risks. Despite these challenges, the market offers opportunities due to undervalued assets and low institutional investor allocation, especially with some signs of an economic cyclical upturn. Additionally, recent developments in Chinese real estate, such as the lifting of home purchase restrictions in 11 major cities and the milder decline in new home sales volumes, are shaping investor sentiment in the market.
Recent developments in China's economic landscape have significant implications for investors. Despite the People's Bank of China's (PBoC) efforts to stimulate economic growth through a reserve requirement ratio (RRR) cut, there are lingering concerns about shadow banking and local government debt risks. In this comprehensive narrative, we will delve into the key recent developments in China's economy and their implications for investors.
Since the beginning of last week, the Hong Kong/China equity markets have been range-bound, lacking direction despite the PBoC's delivery of the second 25bp RRR cut of the year, effective from September 15th. The reduction brought the weighted average RRR across banks to 7.4%, increasing loanable funds by over RMB 500 billion. The PBoC also injected a net RMB 191 billion when rolling over 1-year medium-term lending to banks. These moves aimed to boost liquidity and stimulate economic growth.
August brought positive surprises in China's industrial production and retail sales figures. Industrial production recorded a 4.5% Y/Y growth rate, surpassing July's levels. The manufacturing sector saw an uptick in growth, reaching 5.4% Y/Y. Retail sales of merchandise also rebounded to 3.7% YoY in August from a mere 1% in July. Notably, the depreciating renminbi contributed to a 7.2% Y/Y growth in retail sales of gold and silver jewelry.
On September 19, the latest data revealed that 11 major Chinese cities, including Shenyang, Nanjing, Dalian, Lanzhou, Qingdao, Jinan, Fuzhou, Zhengzhou, Hefei, Wuxi, and Wuhan, have fully lifted home purchase restrictions. However, restrictions continue to be in effect in megacities such as Beijing, Shanghai, Guangzhou, Shenzhen, Hangzhou, Suzhou, Xiamen, Chengdu, Changsha, and Tianjin. Industry experts anticipate that only core areas of select first-tier cities and a few key second-tier cities will maintain property purchase limitations in the future, while others may opt for a comprehensive relaxation of these restrictions. According to data from WIND, the 7-day moving average of new home sales volumes in the 21 surveyed cities displayed a less pronounced decline of -7.1% year-on-year for the week ending September 17, in contrast to the -16.4% decline in the preceding week.
On September 15th, Zhongrong International Trust confirmed that it was unable to make payments on some trust products, leading to service agreements with the state-owned CITIC Trust and CCB Trust to manage its operations. This incident has drawn attention back to China's shadow banking sector, which has been contracting due to regulatory efforts commencing in 2017 to mitigate systemic risks.
Shadow banking in China encompasses a range of non-bank financial activities that often operate outside the realm of traditional regulatory oversight. These activities include trust products, wealth management products, private equity funds, peer-to-peer lending, and various off-balance-sheet financing mechanisms. Key operators are trust companies, private equity firms, and the investment arms of securities companies.
The growth of the shadow banking sector reached its zenith in late 2016 and early 2017, with estimates suggesting that it reached approximately RMB 100.4 trillion under its broad definition and RMB 51 trillion under its narrow definition during that period. However, regulatory efforts and deleveraging initiatives led to a sharp contraction in the sector. By 2019, it had diminished by 15.5% to RMB 84.8 trillion (broad definition) and by 23.3% to RMB 39.14 trillion (narrow definition) before the onset of the COVID-19 pandemic. Over the past three years, the shadow banking sector in China, as defined narrowly by the China Banking and Insurance Regulatory Commission (CBIRC), has further contracted by an additional 25%, amounting to approximately RMB 25 trillion by the end of 2022.
In August, China’s tax revenues plummeted by 4.6% Y/Y. The decline in tax revenues can be attributed, in part, to base effects resulting from Value-added tax (VAT) rebate schemes. The rebate effect contributed to a meager 1.8% Y/Y increase in VAT in August. Corporate income tax faced a substantial decline of 16.8%, primarily linked to declining exports and reduced corporate profitability. Property-related tax revenues saw a modest 5.6% increase, although when adjusting for base effects, it becomes evident that ongoing fiscal strain persists.
Additionally, land sales revenue, a critical source of income for local governments, dropped sharply by 22.2% in August.
Local governments in China play a significant role in the economy. They actively attract businesses, invest in infrastructure projects, and rely heavily on land sales for revenue. However, they are forbidden from borrowing from banks and restricted by quotas when issuing bonds. To circumvent these limitations, they established local government financing vehicles (LGFVs), which purchased land use rights from local governments and use the land use rights as collaterals to borrow from banks and the shadow banking sector. This resulted in substantial local government debt, reaching RMB 105 trillion or 80% of the nation's GDP.
These LGFVs do not have legally binding guarantees from the local governments; they are set up, owned, and controlled by the local governments themselves. The interest rates LGFVs are paying, averaging 5.4%, exceed the return on investment of their projects, which is around 1%. Many LGFVs do not have sufficient cash flows to cover interest payments and short-term debts, relying on refinancing and borrowing more. While no LGFV public debts have defaulted so far, there are real default risks, and even local governments often rely on borrowing more to make repayments. This situation presents risks, and the state-owned banking sector, which holds most of these debts directly or indirectly through the intermediation of the shadow banking sector, may need to participate in restructuring.
To comprehend China's approach to its current economic challenges, it is imperative to delve into its deleveraging campaign, which has been in motion since 2017. The Chinese authorities initiated this comprehensive endeavor to address the intertwined issues of shadow banking, the property sector, and local government debts.
The ongoing deleveraging campaign underscores China's commitment to addressing financial vulnerabilities and maintaining economic stability. Given this commitment, it is improbable that China will resort to a massive fiscal stimulus package similar to the one implemented between 2008 and 2010.
In essence, the Chinese authorities aim at striking a delicate balance between stimulating economic growth and managing the inherent risks posed by the property sector, the shadow banking sector and local government debts. While short-term cyclical recovery and regulatory easing may provide opportunities in the near term, the government's long-term agenda prioritizes financial stability and prudent economic management.
Understanding China's complex economic landscape and the challenges it faces is essential for investors. While the nation grapples with the property sector, shadow banking, and local government debt risks, there are investment implications to consider. China's medium-term growth rate is expected to be lower amid an aging and declining population and declining productivity, possibly below 5% in the next 2-3 years. However, the short-term outlook suggests a cyclical recovery, coupled with policy tailwinds and regulatory easing. Despite current challenges, China's equity markets offer undemanding valuations. Institutional investors, including global mutual funds, have relatively low allocations to China, presenting opportunities for a potential rally.
As it is not yet a full-blown bull market, investors may opt for top-quality, liquid, and high-beta names, such as mega-cap Internet stocks. For those willing to conduct individual research, certain industrial tech names also appear promising. A-share ETFs with themes centered on technology and innovation could be of interest. These A-share ETFs are available through Stock Connect, accessible at the Saxo Trading Platform.
In conclusion, understanding the recent developments in China's economy, especially regarding shadow banking and local government debt risks, is crucial for investors. While there are challenges, China's commitment to addressing these issues and its potential for growth make it an area to watch closely. However, investors should conduct independent research and remain vigilant as risks evolve. China's economic landscape remains complex, but with careful consideration, it can present opportunities for astute investors looking to navigate this dynamic environment.
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