China update: Could real estate market risks spread?

December 2 | Market news

China experienced decades of dramatic economic growth as the nation opened its doors to free trade and economic reforms in the late 1970s, catapulting China to a position of significant investment importance.

China’s economy grew at a rate of more than 13% per year (as measured by Gross Domestic Product or GDP) in the two decades through 2020.1 China now ranks as the second largest economy in the world, just behind the U.S. (see chart). Many project that given its large population and strong economic base, China as measured by total GDP will become the largest economy in the world in a matter of years.

China is now the world’s second-largest economy
Based on GDP at year-end 2020

Source: Work Bank National Accounts Data and OECD National Accounts data files.

Despite China’s rapid growth in both economic terms and investment cache, several recent issues have raised investor concerns. One issue centers on recent challenges facing China’s fast-growing real estate sector. Continued trade disputes and geopolitical tensions between the U.S. and China are other areas of focus.

The state of China’s real estate market

China’s building boom is illustrative of the nation’s economic emergence in recent decades. Debt capital, much of it raised overseas, helped to underwrite the construction of residential and business properties. Yet global markets flinched in September 2021 when word spread of the possible financial failure of Evergrande Group, a major Chinese development firm. Amid speculation that Evergrande would default on some of its significant debt, the company did make payments shortly after the threat of default emerged. Evergrande is reported to have more than $300 billion of unpaid debts.2

This led to concerns that the problem may not be isolated, might reflect weakness in China’s real estate sector, and could potentially hamper economic growth nationwide. “Residential and commercial property development represents somewhere between 15 to 25% of China’s GDP, depending on how you calculate it,” says Eric Freedman, chief investment officer at U.S. Bank. “Naturally, investors need to contemplate the potential financial tributaries that could flow out of Evergrande’s problems.” Offshore bondholders who invested in Evergrande’s fixed income offerings would feel some of the immediate fallout.

While Evergrande is reportedly the most indebted property owner in the world,2 other Chinese-based developers may be facing challenges with debt payments. This level of indebtedness could create a dilemma for China’s government and the nation’s economy. “The Chinese government has indicated potential debt defaults pose a limited threat to the global economy due to a constrained number of bondholders,” says Freedman. “But it’s hard to be confident that property market challenges are behind us.”

Problems may extend to other property companies in China. It’s not clear the extent to which the Chinese government might intervene to help resolve financing issues that affect the real estate sector.

If the problems confronting Evergrande and other developers persist, the next question is whether that will detract from China’s overall economic growth. With real estate development representing as much as one-quarter of the nation’s economy, those problems could significantly dampen the rate of economic expansion in the near term. That could spill over to the global economy, particularly given China’s greater influence on the world scene.

An opaque environment

While China has experienced impressive economic growth, Freedman notes “it isn’t always easy for outsiders to understand how to extract investment opportunities from China. We pay close attention to the potential wedge effects between what may be an area of opportunity like Chinese consumption trends and how an investor can actually harness those opportunities.”

Among those wedge effects are considerations like rule of law, faith in government-based statistical and data releases and financial reporting standards. “We think about rule of law and clarity with accounting,” says Freedman. “While no country is perfect, recent Securities and Exchange Commission (SEC) viewpoints about Chinese accounting standards and what they may mean for Chinese companies listed on U.S. exchanges bears watching.”

Could global real estate be at risk?

Fears about potential debt defaults in China are reminders of the global financial crisis that developed in full force in 2008. In a period when real estate values have been expanding rapidly in many parts of the world, investors become cautious about the potential for excessive valuations. Freedman attributes much of real estate’s rally to the interest rate environment. “When you have real interest rates (interest rates minus the inflation rate) at all-time lows, that drives the value of assets higher. Real estate has been one of the most significant beneficiaries of this phenomenon.”

Freedman believes the direction of U.S. real estate prices from this point may be dictated more by interest rate trends rather than problems facing real estate developers in China and other markets. The persistence of higher inflation through much of 2021 put pressure on the Federal Reserve (the Fed) to consider raising the short-term interest rate it controls – the target Fed Funds rate – more quickly than it originally intended. Fed chair Jerome Powell has indicated for some time that the Fed would hold off on rate hikes until 2023. Freedman thinks circumstances may alter the Fed’s policy stance. It has initiated tapering of its monthly bond-buying program and is scheduled to completely end it by mid-2022. It will put a stop to significant liquidity that the Fed added to the market for U.S. Treasury and mortgage-backed securities. Freedman thinks mid-year 2022 may also mark the point where the Fed begins to raise its target Fed Funds rate. He anticipates two rate hikes as a distinct possibility in 2022.

Growing U.S.-China tensions

China’s economy appears to be undergoing a transformation under President Xi Jinping. After a period where capitalistic ventures were encouraged to strengthen and modernize China’s economy, the government has been tightening controls under President Xi. This trend has manifested in the Chinese state government exerting more oversight of Internet content, making it illegal to transact business using cryptocurrencies, demonstrating a firmer hand over the once British-held territory of Hong Kong, and detaining top executives of major companies.

Tensions between the U.S. and China have escalated in recent years. The Trump administration implemented tariffs, which strained relations between the two countries. The Biden administration followed that with expressions of concern about human rights abuses in China and support for Taiwan’s self-governance, contrary to China’s stance. As a result, the divide between China and the U.S. appears to be widening which contributes to investor unease about what the ramifications could be for the economy and markets.

In early November 2021, two positive steps occurred that appeared to temper those concerns. The U.S. and China presented a joint statement related to the COP26 Climate Change conference being held in Glasgow, Scotland that demonstrated a degree of cooperation. Shortly after that, President Biden and China’s President Xi held a virtual summit, their first in-depth discussion since Biden took office in early 2021. Both expressed a desire to maintain a strong working relationship.

“China has interests, the U.S. has interests, and the two are often diametrically opposed on economic policy,” says Freedman. “But they also have common concerns like limiting nuclear proliferation and military activity. Markets want to see less saber-rattling on those fronts.” Freedman believes the market finds it constructive that there’s been some discussion about hotspot issues like Taiwan. Tensions remain, but communication between the leaders of the two largest economies in the world is considered a positive step.

Investment strategy considerations

China is the largest of the emerging market economies and will remain a force in global investment markets. As the market’s short-term negative reaction to news surrounding Evergrande demonstrated, events in China can have implications for investors around the world. We will continue to closely monitor this situation and other issues related to China and provide our best guidance for investors.

Consult with your wealth professional to discuss how your investment portfolio is structured and take steps to ensure it’s consistent with your risk tolerance level.

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