- A hard landing in China is possible but not necessarily probable, with a road map for a hard landing laid out below
- Four phases are envisioned for this scenario: equities fall hard, collapse of shadow banking, collapse of the banking system, and credit crunch and recession
- Much is unknown about China making it difficult to predict the future, but five key facts point to the possibility of a hard landing
There’s two diverging views getting media coverage about what the economy in China could do after the 38% fall in Shanghai Composite in the last two months. One view is that the share market has little interaction with the real economy and thus there’s no need to be worried. The other end of the spectrum has the two heavily interlinked, with the economy set to follow the share market down. The key to which view will ultimately found to be correct is what links exist and how strongly the changes in one flow over to the other.
In order to show what the links might be and how the problems could spread I’ve prepared a “hard landing” scenario. This isn’t a prediction, but rather an attempt to show that a hard landing is possible and not unforeseeable. With that said here’s my attempt to map out a hard landing scenario.
Stage 1: Equities Fall Hard
The equity sell-off began in June, with initial falls only halted when the government intervened, banning large owners from selling and forcing securities groups to buy. Towards the end of August, the Chinese government temporarily withdrew its direct support of equity markets. Once the sell-off began it accelerated quickly, as unusually high levels of margin debt forced many to liquidate their positions. The government re-entered and compelled more buying, as it could not stomach a collapsing stock market raining on its grand military parade on September 41.
Here’s where the scenario begins. To stabilise the market at this point requires a combination of (i) forced sales from margin debt unwinds conclude, (ii) the general sentiment of retail buyers of “get out while you still can” fades and (iii) institutional investors see value and begin buying as the P/E ratios reach levels similar to or below those of developed markets. None of these factors appear likely to change in the near term.
As investors digest that there is no longer a government safety net for equities, they assume this applies to their other investments. As a result, a wave of selling hits property markets and wealth management products. Some investors need to sell other assets and deleverage after their equities fell, whilst others sell in fear of a panic.
Stage 2: Collapse of Shadow Banking
Prior to the falls in equities, losses on property and wealth management products were both limited, and in a number of cases had been papered over by government organised bailouts. However, as the equity linked defaults mount and the Chinese government chooses not to intervene, investors refuse to rollover their investments in wealth management products. As almost all of these trusts have investment periods of six months or less a liquidity crisis rapidly compounds. Chinese peer to peer lenders also find that their investors are no longer willing to supply capital. Loans made to small and medium businesses, local governments, and equity and property investors are called in.
As a result of credit being cut-off, forced liquidations of property investments begins. Developers lose access to funding and halt construction on existing developments leaving many investors out of pocket and without a habitable property. The glut of empty properties, with little prospect of finding tenants, means investors have no cashflow generation to point to when seeking finance or when offering their property for sale. A second wave of equity selling begins as all providers of margin loans call in their debts in order to repay their investors and protect their positions.
Many intermediaries collapse with senior management fleeing, leaving their businesses in disarray. Investors are horrified to learn that their money was used to fund defunct property developments, mining companies and steel companies. After investing based on the brand name of the bank that sold them the product, they learn that the underlying businesses have long been unprofitable. Courts are swamped with insolvencies dragging out the recovery proceedings. Provincial governments are too busy cleaning up their off balance sheet activities to be able to assist. Guarantee companies2 drown in a sea of claims, failing to do the very thing they are supposed to do at their first major test. The recovery rates of defaulted wealth management products and other shadow banking investments is minimal.
Stage 3: Collapse of the Banking System
The lack of trust in governments and financial institutions exacerbates the panic sentiment. Bank depositors withdraw their funds en masse, creating a liquidity crisis for banks. Whilst the Chinese government provides liquidity to meet the outflows, it cannot stop the defaults and destruction of capital reserves. Decades of “extend and pretend” lending finally comes unstuck with banks forced to reveal their losses as bad loans are sold off to asset management (restructuring) companies at a substantial discount to face value.
The Chinese government is forced to recapitalise banks and takes full control of the banking system. Government debt to GDP skyrockets as a result. Depositors are left with some losses but many bondholders and equity investors receive nothing. Investors now assume that nothing is safe, other than physical gold and investments outside of China.
Stage 4: Credit Crunch and Recession
Banks are overwhelmed with problem loans with new lending grinding to a halt. Only buyers with sufficient cash reserves are able to purchase businesses and properties with prices of both severely depressed as a result. International investors have pulled their capital out and won’t be back anytime soon after suffering heavy losses. Many businesses close down completely and others have to lay off most of their staff. Business and consumer demand craters with only government stimulus able to offset the damage.
Due to the losses on other investments and the widespread lack of trust investors are unwilling to buy government bonds and the Chinese government is forced to embark on quantitative easing. The Yuan collapses with hyperinflation taking hold. After years of urbanisation China sees large flows of young people returning to their home villages. There simply isn’t enough work in the major cities to support current population levels.
Property and infrastructure construction plummets taking down the demand for electricity and steel with it. The demand for imported goods dwindles as many Chinese simply cannot afford them with their reduced wages and the decline in the Yuan. Widespread public protests are crushed with military force with citizens now fearful of their lives as well as fearful of losing their remaining wealth. Affluent citizens use all means available to get their money and families out of China.
This is obviously a bearish scenario, but keep in mind it has been put forward to illustrate a possible (but not necessarily probable) outcome for China. As well as the future being unknown, there is much about China’s economy and markets that is currently unknown to outside observers like myself. Low levels of disclosure and trust raises the possibility that much of what is generally thought to be known about China may subsequently be found to be untrue. How the Chinese government reacts to changes at each stage will have a big impact on future levels of growth or decline.
In the face of such uncertainty I return to several key facts on China. It is an emerging market that has averaged 10% growth per year over the last 30 years. Official debt levels have more than quadrupled in the last eight years with mal-investment known to widespread. By most valuation methods its equity and property markets are overpriced compared to global peers. China is now such a large economy that it can no longer export its way to high growth levels. Its workforce is shrinking and its population is aging. Just as trees don’t grow to the sky, China’s ability to record high levels of growth is now unsustainable, with the real possibility that a hard landing occurs in the medium term.