Chief China Strategist
Summary: In this market pulse, we delve into the complex terrain of China's property debt overhang, examining the challenges faced by giants like Evergrande. We also assess the current economic momentum, highlighted by positive indicators and upcoming Purchasing Managers' Index (PMI) data releases. Moreover, we emphasize the pivotal role of impending crucial meetings, including the Third Plenary Session and the 6th National Financial Work Conference, in shaping China's economic policies.
China Evergrande's ongoing financial troubles and defaults have once again taken center stage, casting a dark cloud over the equity market. Meanwhile, China's economic recovery is showing signs of life, with attention turning to key economic indicators like the Purchasing Managers' Index (PMI). In addition to these economic developments, several crucial meetings on China's economic and financial policies are on the horizon. This article will delve into these topics, providing an analysis of the current situation and what lies ahead.
China Evergrande, one of the nation's largest property developers, has recently made headlines due to its inability to meet regulatory qualifications for issuing new debt. This situation escalated when its mainland unit, Hengda Real Estate Group, failed to make a scheduled payment of RMB4 billion in principal and interest.
The broader issue here is the massive debt overhang in the Chinese property sector, totaling RMB60 trillion. A significant portion of this debt, RMB40 trillion, consists of mortgage debts that are relatively less risky for banks as long as the pre-sold units are completed and delivered to buyers. The focus for Chinese authorities is to resolve these pre-sold units to ensure contractors get paid and homebuyers receive their properties. The completion of unfinished housing projects requires substantially additional funds, estimated to be over RMB2 trillion, which may be shared by state-owned enterprises that take over the projects, local governments, and the central government.
However, the more problematic area is the RMB20 trillion in property developer debts. It's highly unlikely that China will bail out insolvent property developers. Instead, these developers and their banks will likely sell encumbered projects, along with their loans, to stronger entities, often state-owned enterprises with government backing. The recent regulatory easing on housing demand may stabilize the housing market to some extent. Still, the overhang of housing inventories in lower-tier cities facing population decline will persist for several years. This will lead to more headlines about defaults, restructuring, and liquidation of insolvent developers, causing losses for shareholders, bondholders, banks, and investors in trust and wealth management products tied to property projects.
Some trust companies and private equity funds in the shadow banking sector may be subject to losses detrimental to their financial viability. While the banking sector, which holds around 75% of the RMB20 trillion developer debts, has sufficient capital buffers to absorb losses, the extent of the impact will depend on the successful liquidation of housing inventories by insolvent developers to stronger entities, likely brokered by local governments. This process is expected to negatively affect the profitability of banks in China.
Recent economic indicators have shown signs of improvement in the Chinese economy. The Citi China Economic Surprise Index (Figure 1) has rebounded, indicating fewer instances of economic data falling below expectations. As discussed in last week's Market Pulse note, retail sales, industrial production, trade, and inflation data improved in August.
The release today of a bounce in August industrial profit growth to 17.2% YoY (Figure 2), the first monthly year-on-year growth since June of last year, provides additional support for the pick-up in growth found in the industrial production released last week.
Looking ahead, investors are closely watching the upcoming PMI data releases. The National Bureau of Statistics (NBS) is set to release Manufacturing and Non-manufacturing PMI data on September 30. The Emerging Industries PMI's rise to 54.0 in September, up from 48.1 in August, has boosted expectations for a Manufacturing PMI above 50 for the first time since March to 50.1. Non-manufacturing PMI is also anticipated to show growth, increasing to 51.6 in September from 51.0 in August, driven by infrastructure construction which was supported by larger volume of local government bond issuance.
The Caixin Manufacturing PMI and Services PMI are scheduled to release on Sunday, October 1. Bloomberg's survey is projecting the Caixin Manufacturing PMI to increase to 51.2, up from 51.0 in August. Having a higher weight in exporters in the eastern coastal regions of China, the Caixin survey tends to be influenced by the export trend in China. The first 20-day trade data in Korea showed a rebound in trading activities with China and pointed to the potential of a positive surprise in this data. But the fact that the Korean data this September had 2.5 more working days might caution such a conjecture. The Caixin Services PMI is expected to tick up to 52 from 51.8.
These PMI indicators serve as timely barometers of economic activity and provide insights into the pace of recovery of the Chinese economy. If they come in higher, it will tend to confirm our base case for a gradual recovery in progress and a tactical rally in the making for Chinese equities. Nonetheless, if the majority of them come in lower than expected or even fall, the equity market will be at risk of making new lows. The upcoming PMI data will be pivotal for the near-term direction of the Hong Kong and mainland Chinese markets.
It's worth noting that during this period, the Stock Exchange of Hong Kong will be closed for the National Day holiday on Monday, October 2, while mainland bourses will be closed for six sessions to observe the Mid-autumn festival and the National Day holidays from Friday, September 29 to Friday, October 6, 2023.
Looking beyond the immediate economic data, several crucial meetings are on the horizon that will significantly impact China's economic and financial policies.
The Third Plenary Session of the 20th Central Committee of the Communist Party of China is expected to convene in late October. This session will address critical economic policies and set the strategic framework for economic development over the next 5 to 10 years.
Another important meeting is the 6th National Financial Work Conference, which guides major financial system reforms and addresses critical issues in the financial system. It is held every five years, and the last one was held in 2017. While it was initially slated for 2022, it was postponed and is widely expected to be held in Q4 this year. This conference is likely to cover topics such as deleveraging in the property sector, shadow banking, and local government debts. Additionally, it will likely shape the financial system in ways that focus on serving the real economy, the government’s industrial policies, and comprehensive national security.
Additionally, the Central Economic Work Conference in December will review the economic performance of 2023 and begin formulating policies for 2024. These meetings come at a crucial juncture for China's economic trajectory and provide an opportunity for policymakers to address pressing issues and shape the country's economic future.
In conclusion, the situation surrounding China Evergrande and the broader property developer debt overhang remains a significant concern. There is no expectation of a policy bailout for property developers, and the focus is on clearing housing inventory and completing pre-sold units. Deleveraging efforts will continue in the property sector, shadow banking, and local government financing vehicles.
Recent economic data show tentative signs of a recovery in the Chinese economy. The upcoming PMI data releases will provide further insights into the sustainability of this recovery. Beyond that, the forthcoming critical meetings, such as the Third Plenary Session and the 6th National Financial Work Conference, will play a vital role in shaping China's economic and financial policies.
In light of these developments, the base case remains a gradual economic recovery. However, it's important to monitor the evolving situation and be prepared for potential market volatility based on the outcomes of these meetings and economic data. For now, a tactical trade to go long on China and Hong Kong equities for Q4 is intact, but investors should remain vigilant and adaptable in the face of uncertainty.
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