The China Question: Mother of Dragons or is Winter Coming?



Over the past few days, American financial markets have experienced significant volatility. Many market observers are blaming China, specifically regarding recent developments about Evergrande, a major Chinese real estate company that may be defaulting on its loan obligations. While Evergrande is dominating the news currently, now might be a better time to assess why China is where it is today.


Chinese GDP has grown around 9% per year for the last 25 years. Impressive to say the least and something no other country in the world has ever been able to achieve. But how do you grow a country by 9% a year for 25 years? Measures of output like GDP really come down to two major factors: growth in the labor force (hours worked) and growth in productivity (output per hour.) On both fronts, the Chinese have been blessed in recent decades.

The best prescription for unprecedented productivity gains is simple:

  1. Do nothing for thousands of years.

  2. Then borrow everyone else’s technology.

It’s not due to communism. In fact, it’s the exact opposite! China’s rapid growth was only possible because Deng Xiaoping decided in 1982 to move China to more of an open, market-based economy. Because of that decision, hundreds of millions of Chinese have been brought out of poverty. Was it truly a free market? Not even close. But it was a massive change and it allowed China to adopt the world’s technologies resulting in massive productivity gains.

Think of China over the last 30 years as a Ford Model T with a rocket engine strapped to its back. It’s been great as it has continued to move forward in a straight line, with the rocket of capitalism speeding the country forward. But because of this, the Communist Party’s power has been weakened over the decades. It now looks like President Xi Jinping is responding forcefully, trying to reverse the trend and move back to a more centrally controlled economy to regain lost power to the detriment of the people. And when you try to make a left turn in a Ford Model T with a rocket engine strapped to its back, the results can be disastrous. The Model T eventually hits a wall and blows up into thousands of pieces. Think Wiley Coyote and his ACME-powered mishaps. But this rocket-powered Model T status is exactly where China finds itself in these early stages of President Xi’s efforts to move power back to the state.

We are witnessing examples of President Xi bullying private companies into serving the Chinese Communist Party’s agenda everywhere. Earlier this year, the government halted the Ant Financial IPO, which would have been the world’s largest. Xi has gone after China’s tech sector, where lots of money and power exist, launching numerous probes and investigations, imposing heavy fines, and blocking mergers. The top six Chinese tech stocks have lost $1.1 trillion in value in the past six months. And it doesn’t stop there. The $120 billion private tutoring sector has been wiped out with a single administrative order. No one knows where the regulation will stop. Political risk in China is infinite. Influential billionaires routinely disappear.

One of the most popular theories over the past quarter-century was the idea that it was simply a matter of time before China supplanted the U.S. on the world stage. You may recall some similar conversations back in the 1980s about Japan. Back in those days, Japan was the “big new thing” much like China is today. It was going to beat the U.S. You couldn’t go to a good business school and not read book after book about what the Japanese were doing. And that brings us to demographics and China’s labor force.

Japan’s stock market famously peaked in 1989. Less well known is the fact that 1989 was also the year when Japan’s working-age population peaked. Japan still has not come back, and its working-age population is still on the decline.


According to the United Nations, China’s working-age population is currently hitting its peak as well and is set to decline by over 40% by 2100. The Communist Party is directly to blame. Such is the inevitable impact of their centrally planned one-child policy. The undeniable fact is that China needs to advance further toward free-market capitalism, not reverse course. Communism has never worked and never will.

But instead of recognizing this, the Communist Party has doubled down and expanded its crack-down efforts by now focusing its crosshairs on Chinese real estate. President Xi is now targeting real estate as an example of visible wealth inequality as part of his policy of “Common Prosperity.” Over the past decades, Chinese real estate and property investments have boomed as the Communist Party has mostly barred access to global financial markets to its people. With most investment options being unavailable, real estate was the asset most normal people were able to buy that felt safe and reliable. In fact, owning property in China denotes a higher status in society.


As the Chinese saved hand over fist, money continued to pump into real estate leading to ever-rising prices, causing many areas to be over-built and leading to lots of poor investment choices. In fact, over 70% of Chinese household wealth is tied up in real estate. Much of this over-building and funneling of money into real estate was a direct result of poor, centrally planned policies, with the most notorious example being the “ghost cities” without a soul living in them.


Now, with more avenues for investment and a shrinking population in the future both hurting demand for real estate, this bubble seems to have burst. Other private real estate companies, besides Evergrande, may also default or go under. But will that bring contagion to the U.S.? Probably not.

Banks in the U.S. have very little exposure to Chinese real estate. There may be some hedge funds that have exposure, but no major banks. A “default” has been considered a dirty word ever since the mortgage crisis in 2008, but that was due to “mark to market” accounting which turned a fire into an inferno. Companies were forced to mark assets to illiquid market prices, which, in turn, made them look insolvent on paper, even if the underlying mortgages were still paying on time. We do not have mark-to-market accounting in place in the U.S. today.


Nor will an economic slowdown in China harm the U.S. in any significant way. S&P 500 revenues coming from the Greater China area, which includes Hong Kong and Taiwan, accounted for only about 2% of revenues in 2019. Remember, U.S. growth accelerated in the 1990s when Japan started stagnating. Back in those years, Japan represented a much larger share of our GDP than China does today.

The idea that China is the driving force behind recent market drops ignores all kinds of other issues: Serious immigration problems, the potential for politicians to pass $4.5 trillion in new spending and big tax hikes, an apparent desire to move toward socialism in the U.S., inflation, a potentially tightening Fed, the Delta variant, the debt ceiling, or simply the fact that it’s been so long since the last market correction could also be spooking the market. The bottom line is that China is not anywhere near the largest of our worries.


Sincerely,


David A. Pickler, Esq., CFP®, ChFC®, CDFA®

President

Pickler Wealth Advisors

75 views