Two Things Drive China’s Economy. One Is In Trouble. – Forbes

Ask any global fund manager why they are bullish on China and they’ll usually give you two reasons, and one has nothing to do with China.

The one that has nothing to do with China is U.S. and U.K. indexes including China securities in major indexes like the Barclays Global Aggregate Bond Index and the MSCI Emerging Markets Index. That means passive index funds benchmarked to those indexes will have to mechanically build their positions to include more China securities. Good for China. More capital will flow into the country, for sure.

The other reason bulls like China is its consumer market. It’s big, needless to say. And the Chinese have been getting richer. Why? Well, because for around 20 years now the economy has been the world’s manufacturing hub, moving up the value chain, allowing them to pay people higher incomes, which those new middle class Chinese used to buy real estate.

So the Chinese consumer and China’s real estate were the two biggest drivers of the economy for the last five years. Only one of them is really worth being bullish about.

China’s growth engine is increasingly relying on the single cylinder of consumer spending, which delivered two thirds of its GDP growth in the first quarter 2019. Consumer confidence has been lifted by rapidly rising incomes alongside a long run in property prices. Both of these drivers now face challenges, but one—real estate—is way worse than the other.

A simple 970-square-feet, two-bedroom apartment located one hour from downtown Shanghai costs around $1,000,000. Shanghai, China, is no San Francisco, California … but its property market sure thinks it is.

China property market is the anchor for a number of areas of the Chinese economy—from commodity demand to lower skilled labor such as bricklayers. China’s housing market is still hot despite years of Beijing doing its darnedest to thrown buckets of cold war on it.

“Real estate and exports are two drivers of consumption that give us cause for pause,” says Sudhir Roc-Sennett, head of ESG investing for Vontobel Asset Management. “Both are important parts of the wealth creation loop that has underwritten the dramatic growth in spending. China’s heated and rising property prices seem unsustainable.”

Real estate plays a key role in China’s economy. 

Land sales have provided significant funding for provincial government budgets. Around 85% of budgeted spending is done through local governments. Home construction has delivered millions of jobs to working-class Chinese, the kind that are not walking up and down Ivy League campuses here in the U.S.  or on spendthrift vacations in Paris.

Property also provides significant collateral, securing much of the debt issued by the country’s banks and even by some publicly traded companies that are heavily invested in land and real estate. 

More importantly, real estate is the Chinese savings account. Most middle-class Chinese have at least one house, as opposed to renting. Upper-income earners have two or more houses, made all the more easy to acquire by generations of single-child households and rising wages translating into few children to spend money on.

Chinese savers cannot invest overseas easily due to the barriers of a closed capital account. Stuck at home, they gamble in the stock market and put their serious money in real estate.

Investors have heard about a China real estate market bust for at least the past 8 years. China keeps defying the odds.

The average price per square meter of a Chinese home has risen from 20% in 2001, to 84% by 2018. But in 2018, Chinese disposable income per capita was just over $4,100, one tenth the $48,700 of average U.S. disposable income. But they are paying U.S. prices for housing.

Alongside wages, real estate prices are clearly an important pillar for the Chinese economy, says Roc-Sennett of Vontobel.  “We assume (Beijing) will do whatever they can to avoid a property sell-off. Given the controls the Chinese leaders have over the economy, they might well be able to stave off a housing bust such as the one the U.S. was unable to avoid in 2008,” he says.

China’s rich housing market comes at a time when the trade war is wearing on the economy. More tariffs are coming next month. And the Treasury Department just labeled China a currency manipulator, giving Washington yet another tool with which to hammer away at China.

Consumers have held up, but they and the index-weighting story are the only things holding the China investment thesis together.

Vontobel warns that the consumer story has little upside from here. 

For now, consumer confidence is holding, helped by recent stimulus including tax cuts to lower income earners. “But the red flags are up,” Roc-Sennett says.

The additional tariffs on $300 billion worth of Chinese goods have increased the downside risks not only for China, but for the U.S. and many emerging markets that are linked to the Chinese economy.

Wall Street may have turned the corner on Tuesday after yesterday’s 600+ point sell-off because the latest trade war headlines reinforce the Fed’s logic for delivering “insurance cuts” to the overnight lending rate, now between 2% and 2.25%.