Abstract: The following important trends should be noted from a long-term perspective. First, China’s real estate market may be significantly overshooting, and a reversion to the mean is inevitable, with the timing being the most uncertain. Second, when all statistical calibers of government debt are combined, compared with the rest of the world, China’s debt level is still in a manageable range. The savings rate of Chinese residents is very high, and the holders of government debt are mainly local residents, perhaps magnifying the room for government debt to be freed up. Third, according to the current financial market transactions, banks’ net interest margins may have entered an equilibrium range, and their long-term downward process may be coming to an end. Fourth, as the best part of China’s economy, listed companies do have the ability to generate long-term returns. The main problem with China’s market is the high short-term volatility and investors’ susceptibility to buy at the high end of the range. The factors that amplify short-term market volatility include mainly the lack of stable long-term capital, highly short-term institutional investor appraisals, and generally low dividend rates of listed companies. China has carried out significant reforms in its capital market to address these problems.
Since the beginning of 2023, with the relaxation of the pandemic restrictions, China has witnessed a brief but strong rebound in economic activities, fueling optimism in financial markets for a full-year economic recovery. However, since the beginning of the second quarter, economic indicators have been weakening across the board and beyond expectations. Pessimism began to spread in the equity markets. Despite the successive policy adjustments since late July, the market remains weak.
Pessimistic views hold that due to the interaction of unfavorable trends in population growth, the ongoing adjustment in the real estate market, the difficulties encountered by private enterprises, and geopolitical uncertainties, the household and corporate sectors have begun to lower their expectations of China’s long-term economic growth and have adjusted their economic behaviors accordingly, which has manifested itself in a prevalent reduction in consumption, indebtedness, and investment, leading to a Japanese-style balance sheet recession.
According to these views, it is hard to reverse the situation since the current changes have reflected the continuous accumulation and generalization of many structural contradictions.
These analyses and insights are undoubtedly profound and worthy of our reference and consideration.
However, if we look more closely at the detailed data, we will find the real situation more complicated.
For example, for a long time, manufacturing investment has remained relatively stable, among which the overall share of private enterprises is rising; excluding the impact of the real estate industry, the overall growth rate of private investment has also remained normal, and some new industries have witnessed robust investment growth.
The reduction in mortgage lending by the household sector has been accompanied by a sharp increase in cash-based assets, with reduced risk exposure as a key feature; meanwhile, credit and investment in the corporate sector have been growing normally, different from the performance during the Japanese-style balance sheet recession.
In the labor market, the sparse data showed a rise in the labor force participation rate; the survey data showed a general lengthening of the labor force hours of workers on the job; the unemployment rate dropped faster in small and medium-sized cities than in large ones; in a context of lower economic growth, the unemployment rate of the labor force above 25 years old hit a record low. These changes are hard to explain with a balance-sheet recession.
The remarkable upturn in the propensity to consume in the household sector began during the pandemic in 2020, which, of course, partly reflected the impacts of pandemic prevention and control on consumption activities. However, according to the changes in China and the trajectory in major countries during the pandemic, except the United States (U.S.), the rebound in the propensity to consume after the relaxation of the pandemic restrictions was not a one-time event in most cases, reflecting the consistency of consumption behaviors during the adjustment. The reason behind the unusual performance of the U.S. could be its large subsidies during the pandemic.
Taking all these observations into consideration, with a close perception of the changes in China’s financial markets, we believe that a rather important reason for the current difficult situation seems to be the interaction between the scarring effect caused by the pandemic and the spreading liquidity pressures in the real estate market.
It appears that the scarring effect is at least twofold: first, the shock and damage of the pandemic control to the balance sheets of microeconomic agents; second, the psychological trauma caused by the pandemic, making the population, at least for a while, more risk-averse, more conservative in behaviors, and more inclined to save more.
It is worth noting that the extent and manifestation of the scarring effect varies across countries. Besides the differences in pandemic prevention and control policies, differences in social security systems and fiscal interventions are key reasons. Moreover, while the impact of the scarring effect is not trivial, it can be self-healing over time, and targeted government interventions can undoubtedly accelerate the healing process.
The adjustment in China’s real estate market reflected the conflict between policy regulation and real estate’s business model. It was supposed to be independent of the pandemic, but during the spread of liquidity pressures, it was shocked by the pandemic.
The pandemic shock and the scarring effect after that exacerbated and spread liquidity pressures in the real estate market; the liquidity pressures worsened economic and financial market adjustments, which in turn amplified and worsened the shocks to the balance sheets of the microeconomic agents, thus forming interaction and mutual reinforcement between the pandemic shock and the scarring effect.
At the beginning of the year, when the pandemic restrictions were lifted, many economic agents had optimistic expectations about what was to come. They believed that the difficulties of the past few years were mainly caused by the pandemic and would soon disappear. It was proved that they significantly overlooked the continuing impact of the scarring effect. Since the beginning of April, as the pent-up demands were fully released, the widespread demand shortage was quickly recognized, and economic expectations were forced to be revised downward, further exacerbating the interactive reinforcement between the scarring effect and liquidity pressures in the real estate market. Therefore, some pessimistic investors even began to doubt the soundness of the fiscal and financial systems. Capital outflows were accompanied by a marked depreciation of the RMB exchange rate, which fell below the lows of October last year.
Since late July, policies have been adjusted one after another. While the central bank cut interest rates beyond expectations, new policy signals were released in real estate, local government invisible debt, and other areas. Regulators launched a package of policy measures to activate the capital market, with an eye to facilitating transactions, balancing the primary and secondary markets, standardizing the reduction of holdings by major shareholders, and guiding public institutions to enter the market with their own funds, while making pragmatic arrangements and positive efforts in expanding and encouraging the entry of long-term funds into the market, increasing dividends from listed companies, and reducing the friction of taxation. While focusing on and digesting these policy signals, the market has also been looking forward to further policy details. However, market performance has remained weak due to short-term pessimism.
Short-term market fluctuations may be caused by temporary factors that are difficult to predict. Furthermore, as seen in trading, investors tend to amplify short-term pessimism and ignore or trivialize the impact of long-term factors, which seems to be more true in China’s market. Successful value investing emphasizes the other way around, encouraging people to endure short-term volatility to reap long-term gains.
Ultimately, the essence of a stock price is the discounting of a listed company’s long-term cash flows. Of course, investors are required to objectively assess and forecast long-term cash flow trends, but it is hard to do so in a world of changes. Difficult as it is to forecast over the long term, it is perhaps even harder to predict short-term ups and downs of the stock price, so it has been jokingly said that predicting short-term stock price is like wrestling with a pig: it’s hard to win, and you’re going to get yourself dirty. Nevertheless, a lot of investors still enjoy it.
From a long-term perspective, we should perhaps carefully analyze several important trends:
First, is China’s urbanization over, and will the real estate market disappear?
We studied the underlying trends in the real estate markets of Japan and the U.S., where urbanization ended a long time ago. We also delved into the real estate market in Northeast China because the population of most cities in this region has shifted to sustained negative growth since 2013, with a population deceleration of 1 percentage point per year. The reality is that real estate development and transactions are still active here, where investment as a share of GDP has stabilized at 6 percentage points or more, and new home sales have remained at about half of their peak levels. Based on this data, it is likely that China’s real estate market is now significantly overshooting, and a reversion to the mean is inevitable in the future, with the timing being the most uncertain.
Second, is the Chinese government capable of controlling the hidden debt and financial risks of local governments?
Despite the large size of local government debt estimated by different statistical calibers, the proportion of central government debt is quite low. When all statistical calibers of government debt are combined, compared with the rest of the world, China’s debt level is still in a manageable range. More importantly, the savings rate of Chinese residents is very high, and the holders of government debt are mainly local residents, perhaps magnifying the room for government debt to be freed up, as Japan’s experience has shown. Furthermore, the government has substantial profitable state-owned assets, urban land that can be liquidated in the long term, foreign exchange reserves, and an excellent credit history that is sufficient to support its own credit.
The current difficulty lies mainly in the prevention of moral hazard, which undoubtedly depends on further reforms of the fiscal system to achieve a better match between the financial capacity and authority of local governments while enhancing market and fiscal discipline. However, in the bottom-line scenario, there is no reason to doubt the central government’s ability to mobilize its finances.
Of course, the ideal situation is to utilize the current difficult situation to accelerate the reform of the fiscal system and better rationalize the fiscal relationship between the central and local governments.
Third, is China’s banking system robust, and is its long-term profitability a concern?
As the real estate market fluctuations over the past few years, among others, have shown, the balance sheets of China’s large banks have been overall robust when facing large shocks, reflecting the tremendous improvement in commercial banks’ risk management ability in market-oriented reforms and the precautions accompanying the long-standing concerns about the real estate bubbles. The financial pressure generated by the real estate market has mainly concentrated on the shadow financial system, making the transmission process significantly different from that in Japan and the U.S.
Moreover, over the past decade or so, the net interest margins of China’s commercial banks have continued to narrow, return on capital has fallen sharply, and share price performance has been overall weak. These unfavorable factors have adversely impacted the long-term performance of the capital market. With a closer look at historical data, it’s not hard to find that the interest rate spreads of commercial banks were unusually high around 2010, mainly reflecting the policy design of the financial reform at that time, which was aimed at helping banks absorb plenty of historically accumulated bad loans. With the success of this reform, spreads began to decline normally. According to the current financial market transactions, banks’ net interest margins may have entered an equilibrium range, and their long-term downward process may be coming to an end.
Fourth, can China’s capital market generate long-term returns?
According to long-term data from the past, as the best part of China’s economy, listed companies do have the ability to generate long-term returns. The main problem with China’s market is the great short-term volatility and investors’ susceptibility to buy at the high end of the range, which adversely impacts the investment experience.
A prevailing belief attributes this market behavior to the dearth of stable long-term capital in the Chinese financial landscape. Notably, this trend affects significant investors, including public equity institutions and insurance companies, who tend to adhere to short-term appraisals. This practice, in turn, fosters a speculative culture characterized by the pursuit of market trends and amplified by the trend investment of fundamentals. As a result, market volatility is exacerbated.
A noteworthy concern centers around the relatively modest dividend distributions from Chinese listed companies. This aspect assumes significance as investors often stand to profit primarily from surges in share prices, given the unreliability of stable dividend returns. This dynamic further fuels a culture of short-termism in investment behavior.
Another critical consideration pertains to the alignment of expected returns with value creation. When the anticipated rate of return from reinvesting a listed company's profits falls below the opportunity cost of retaining funds for investors, the imperative arises to return these profits to the investors. Neglecting this principle risks value destruction. This pressure gains prominence as the economy matures.
In practicality, listed companies have grappled with maintaining consistent and substantial dividend payments, attributed to an array of reasons. This predicament, in turn, has undermined the bedrock for stable capital market operation.
While this challenge is unquestionably linked to complexities in corporate governance, including insider control and monitoring limitations for smaller investors, state-owned enterprises (SOEs) provide a notable counterpoint. In numerous large SOEs, the government holds ultimate control, wielding significant managerial oversight. Paradoxically, certain international comparisons expose that dividends provided by SOEs to the government remain notably low.
While comprehensible and even commendable during periods of robust economic growth and abundant high-return investment opportunities, this approach becomes problematic during phases of medium-to-low economic expansion.
Apart from the imperative for corporate governance reform, the establishment of a robust equity culture becomes equally pivotal. This demands not only changes in attitudes but also the nurturing of constructive financial habits.
Significantly, while extending the assessment period for institutional investors and encouraging long-term investment, regulatory departments reform also have undertaken other pragmatic efforts to incentivize company dividends and buybacks. If numerous state-owned enterprises can genuinely enhance their dividend disbursements to shareholders, including the government, this would undoubtedly trigger a shift in perspectives and the cultivation of a more constructive ethos.
This critical juncture is underscored by significant reforms within China's capital markets, notably addressing the discussed challenges.
In conclusion, despite persisting investor skepticism regarding short-term economic performance and the attendant market volatility, the adage that "there is a rainbow after the storm" remains a poignant reminder.
The article is translated by CF40 and has not been subject to the review of the author himself. The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations.
