As China’s economy slows, markets are telling President Xi Jinping exactly what they want from his government: a clean break with the “zero-Covid” era.
The signal from massive market rallies last week is that pulling off a rebound in Chinese growth — and restoring confidence among overseas investors —could be remarkably simple. Beijing’s 20-point move to ease restrictions revealed last week also halted the yuan’s accelerating decline.
China also laid out a 16-point plan to stabilize property markets. It includes property development loans for developers, new home-buying rules for individuals, extending developers’ outstanding bank loans, offering special loans to ensure the completion of projects, market-based approaches including bankruptcy and restructuring, easing of restrictions on banks’ property lending, easier fundraising for acquisitions
Yet if Covid restrictions remain in place, economists wonder if the new real estate policies will gain enough traction. The question still hanging over markets centers on whether Xi’s apparent U-turn on massive lockdowns is real or just a head-fake for global investors.
Since January, there have been periodic reports that Xi’s government might pivot to a “dynamic zero-Covid” crouch — only to revert to shutting down entire provinces. Also, alarm is growing in neighboring Japan as an eighth wave of Covid infections makes headlines.
“Recent market action has shown clearly how investors would respond to a substantial relaxation of Covid restrictions,” says economist Wei He at Gavekal Research. “A property stabilization package, if sufficiently large and convincing, could have a similar impact.”
This latter question has confounded markets all year. The December 2021 default by giant property developer China Evergrande Group left investors fearing additional shoes might drop. To their credit, the People’s Bank of China (PBOC) and Xi’s regulators managed to channel enough liquidity into the sector to stave off more market-shaking defaults.
The yuan’s 12% decline this year, though, makes it harder for over-leveraged developers to make payments on dollar-denominated debt. That fueled speculation of fresh defaults to come.
Talk in markets is that Xi’s economic team is cobbling together a significant rescue and reform effort.
The good news: China is working up a sweeping rescue package to stabilize the real estate market. The central bank and the China Banking and Insurance Regulatory Commission are working up schemes to ensure the “stable and healthy development” of the property sector.
This plan is notable because it includes at least 16 new steps including addressing liquidity shortfalls faced by developers to loosening down-payment requirements for homebuyers.
Again, though, Covid policies remain a question mark.“Today, lower policy rates still look necessary, with the property market in a deep downturn, private-sector credit demand anemic and the October trade data showing a clear downward turn in export growth,” Gavekal’s He says.
Yet, He adds, “while rate cuts will help soften the downturn, they are not the best tool to solve the two big growth problems China faces now: the property-sales slump and financial crisis among property developers, and depressed consumption due to persistent Covid restrictions. While rate cuts might not hurt the currency much, they won’t help it a lot either.”
Hence the need for both increased bailout efforts and a mechanism to dispose of bad debts the way Japan did in the 2000s and the US did in the 1980s. Speculation that Beijing might slash the number of property developers from 40,000 to 2,000 would also cheer investors.
China Evergrande’s scale made it a microcosm of the threat. When put together with related industries, the sector can account for as much as 30% of gross domestic product (GDP). When it defaulted 11 months ago, China Evergrande had roughly 200,000 employees overseeing more than 1,300 developments the company owned in over 280 cities.
Now, China’s deepening property crisis is intensifying strains on a $1.6 trillion section of the nation’s onshore bond market. That has cities and local administrations stepping in to stabilize things. These state-backed bids to cheer investors have generally been successful in the short run.
However, as 2023 approaches, pressures are surfacing more and more. This is putting increased focus on so-called local government financing vehicles, or LGFVs. In early 2022, LGFVs replaced builders as the biggest buyers of land across the nation.
LGFVs also became the top buyer of half-finished projects overseen by China Evergrande and other possible defaulters. This increasing state role in all walks of the real estate sector is ringing alarm bells.
Zhou Yue, a bond analyst at Zhongtai Securities, notes that LGFVs have little experience with construction. If poor quality undermines sales, both cash flows and solvency worries could shake China’s financial system anew.
Analyst Ivan Chung at Moody’s Investors Service says that “LGFVs in economically weaker cities already carry higher credit risks. If halted projects there have big cash holes to fill, it may bring further risks to the LGFVs overseeing their deliveries.”
That could hurt the credit profile of state funding agencies. While there are no known LGFV defaults to date, missed payments that send shockwaves through bond markets remain a clear and present danger. For example, average credit spreads on some of the shakier LGFV local bonds nearly doubled since January to roughly 10 percentage points.
The upshot is that LGFVs may be running out of ways to mask growing cracks in their portfolios and, more broadly, in China’s financial system.
“We think that it will become increasingly hard for weak local governments to use LGFVs to artificially increase land sales revenues and improve budgetary performance,” says analyst Zoey Zhou Qianyun at CreditSights.
“This in turn would restrict their ability to apply for local government bond quotas from the provincial and central governments for 2023 and weaken their capacity to support their LGFVs. As a result, we continue to caution against going down in credit quality of LGFV dollar bonds,” Zoey said
The longer Xi’s government delays bold action to increase trust in China’s economic outlook, the more the yuan might be under downward pressure.
“The depreciation pressures on the renminbi will continue in the short run, until policymakers send a clear and credible signal of stronger support for economic growth,” says Gavekal’s He.
The US dollar, He adds, “has had a historic rally against many major currencies, but the yuan has generally depreciated. Markets are worried about China’s growth. I’d argue that as long as the dollar is still strong, it will keep pushing down the renminbi until policymakers can show they have stabilized China’s growth outlook.”
As much as anything, this requires a more flexible and nuanced approach to Covid-19. Here, investors will have to see if Beijing follows through this time on signals of a more pro-growth approach.
Economist Lauren Gloudeman at Eurasia Group notes that “while the updated measures do constitute significant easing, authorities made a deliberate effort to frame them as ‘science-based fine-tuning’ rather than ‘relaxation’ or ‘lying flat.’ This characterization likely reflects a desire from the senior party leadership to continue distinguishing its Covid-19 governance as superior to the Western approach.”
Yet economist Carlos Casanova at Swiss private bank Union Bancaire Privée says recent data offer Xi’s inner circles ample evidence of the damage caused by rolling lockdowns. Case in point: a 0.7% year-on-year drop in imports in October.
This is what happens, Casanova says, when “over 300 cities have implemented varying degrees of virus containment measures which inevitably exert downside pressure on domestic consumption, both via sentiment channels as well as due to disruptions to domestic mobility. A weaker yuan has also driven up the cost of imported commodities, reducing demand.”
Covid easing measures announced on November 11 included shorter quarantines for inbound travelers and people having close contact with infected people.
Economists at Goldman Sachs are taking a wait-and-see approach to this apparent about-face. They worry the pivot will be “marginal in terms of economic impact.”
Nor are economists at Australia & New Zealand Banking Group getting too excited about tweaks to Beijing’s terminology on what constitutes serious infection risks.
Case in point: researcher Wang Liping at the Chinese Center for Disease Control and Prevention saying that “as new virus variants keep coming, while our knowledge of the disease deepens and the epidemic situation changes both at home and abroad, we don’t rule out the possibility to further optimize and adjust our quarantine measures.”
To ANZ economist Raymond Yeung, this just “means the immune system can develop antibodies to combat the virus. However, policymakers are still concerned about the impact of long Covid and the burden on medical facilities.”
Others see reason for optimism amid reports that German Chancellor Olaf Scholz and Xi are in talks to make BioNTech’s Covid shots available to foreigners in China. It would mark a crucial step toward wider offerings.
Either way, markets have stated very clearly to Xi’s inner circle what they desire from China. Regaining global trust may be just a simple pivot away.
Follow William Pesek on Twitter at @WilliamPesek