Eleven Chinese missiles landed in Taiwan’s waters this past week, including one directly over Taipei, all while Chinese military exercises were conducted in six zones surrounding Taiwan. The demonstration of power was the most recent act of Chinese aggression in an ever-escalating tinder box of conflict — and the largest cross-strait exercise in decades.
The maneuvers come amid other challenges for the nation. For the past few decades, China has enjoyed world-leading economic growth but double-digit economic growth can only go on for so long. And while a cooling of its economy is neither unexpected nor unhealthy, there are domestic power struggles within China that further ratchet up the tension.
Much of China’s growth has been supported by massive amounts of corporate and household debt. And it looks like those chickens are coming home to roost. The chart below compares household debt to GDP for China and the U.S.: China’s debt-to-GDP has increased 256% since 2005; the U.S. ratio has declined by 16%.
Drilling down, you can see that disposable income levels relative to debt have soared 5x since 2006. This indicates that Chinese incomes have not risen nearly as fast as the debt that consumers have taken on. Much of the debt taken on by households in China, the U.S. and elsewhere is mortgage-related.
Fueled by low interest rates, rising equity prices, and strong economic growth, citizens around the world have been loading up on real estate. Recently, however, for many Chinese, real estate projects have not come to fruition. Hundreds of Chinese citizens have taken to state-run social channels like WeChat to voice their displeasure. This has led to a “mortgage boycott,” where many Chinese home buyers are refusing to pay their mortgages.
It’s no secret that many major Chinese real estate firms like China Evergrande are overleveraged. When times were good, they spent frivolously and expanded recklessly; Evergrande even bought its own soccer team.
When crackdowns on lending began to occur in 2020 these developers had to slow down or halt construction completely, even as the buyers had to keep paying their mortgages. Now these homebuyers are refusing to make their mortgage payments on construction projects that are sitting idle.
This triggering effect of crackdowns and failed projects is leading to a surge in Chinese defaults, as shown in the chart below. (Onshore and offshore defaults have been converted to U.S. dollars, in billions.) Default values are touching all-time highs:
You can also analyze the data through the lens of default rates. You can see that issuers, especially offshore bonds, are seeing default rates soar to multi-year highs. In the last 12 months, 27 issuers that hadn’t been in debt trouble in the past, have defaulted. This is an ugly trend that the Chinese government cannot be happy about.
Too Big to Fail
There are a dozen issuers facing debt payments over the next 30 days, which could make the default rate climb even higher. I suspect that the CCP will continue to allow mid-sized “not too big to fail” companies to fail. This sends a strong message for the rest of the group to get their houses in order.
But when push comes to shove, the CCP will likely step in and support the largest of the loans and the “too big to fail” tycoons whose political ties are in line with the establishment. China’s central bank is looking to issue $30 billion worth of low-interest loans to commercial banks. These banks will then be allowed to leverage the $30 billion up $148 billion in liquidity for the property sector. Is this enough you may ask? Well, Evergrande alone has $300 billion in development liabilities…
Make no mistake, the CCP does not want China to become a declining superpower, it will do everything in its power to make sure that doesn’t happen — which is good news for the rest of the world — especially for commodities investors. China has long been a major buyer of commodities such as copper, zinc, iron ore and crude oil. Here’s a chart that shows just how important China is to the global commodity markets.
In today’s world, investors need to be acutely aware of macroeconomic changes. China’s developments should not be taken lightly but just as most market participants took a few months to understand Covid’s impact on China, the implications of current events may not yet be clear.
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