Investors in China should prepare for a rough patch. The economy is slowing, and regulations are tightening in several industries. The economic cycle turned in June/July, based on the official Purchasing Managers Index readings and other indicators that we track. Heading into 2022, I think GDP (gross domestic product) growth will be considerably lower than the current consensus forecast of around 5%.

Here are a few reasons that lead me to this view :

1. Credit is tight in the real estate market.

Primary real estate sales are about 15% of GDP, and the indirect demand the sector generates makes it even more important to the economy. And credit is tightening in the real estate sector. Home-buying restrictions could be loosened. But, with low inventories and contracting housing supply, any loosening could result in even higher house prices, undermining the government’s key policy objective that “housing is not for speculation.”

Evergrande, the country’s second-largest developer, is likely headed for a managed bankruptcy process. The unwinding will likely involve selling off Evergrande assets project by project to SOEs (state-owned enterprises).

The government’s top priority is to protect those who pre-bought Evergrande apartments, which reportedly amounts to approximately 600,000 buyers. Suppliers to Evergrande are already being “paid” in the form of property that’s been cut in price by 20% to 30%, based on what my colleagues and I have heard from our sources.

But Evergrande is just the most obvious entity in a troubled sector. Dozens of medium-sized developers have weak cash flows and are having trouble obtaining bank loans or issuing debt. Some are slashing prices in order to raise cash. In the past, the larger developers would come in and buy the unfinished projects, but that’s unlikely now.

There’s also the likelihood of a property tax program that will be piloted in some cities. Many middle-class urban households own two properties, and this could dampen consumer demand, depending on the tax rate that may be set and its scope.

China’s economy appears to be weakening¹

2. Consumer confidence is ebbing, and retail sales growth is slowing.

Consumer confidence never fully recovered after China’s initial COVID-19 outbreak in early 2020. And neither did income growth, particularly for lower income groups. Retail sales growth is still positive, but again, the pace of growth is declining. Car sales are also falling in absolute terms though that’s mostly due to supply disruptions due to a lack of components, according to our analysts who cover the sector. Youth employment in urban areas is pushing up, while overall surveyed employment still has not returned to its pre-COVID-19 base.

The government’s Common Prosperity agenda on improving life for the lower middle class could also result in a spate of taxes on property, inheritance, luxury goods and alcohol, which would impact a wide swath of the upper middle class, potentially further dampening consumer sentiment.

3. Heavy industry could see excess capacity, and industrial profits have softened.

The real estate boom of 2018-20 supported high levels of demand for steel. That, plus supply reforms that wiped out old and excess capacity in the mid-2010s, meant that heavy industry returned to health. With end demand contracting now, we could see some excess capacity return. The data is volatile, but the trendline shows that industrial profits are now below pre-COVID levels, which could dampen corporate capital investment in 2022.

 

1. Source: FactSet. Latest available data as of September 30, 2021. An index reading of 50 signals no change since the previous month. Above 50 signals an increase (or improvement), below 50 a decrease (or deterioration). The greater the divergence from 50, the greater the rate of change signaled.

 

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