Is this China’s Minsky Moment?

“The collapse of China Evergrande’s shares upon their return from suspension and a request from fellow residential property developer Country Garden for a grace period on the coupons on a domestic bond, after missing payments on an overseas loan, add to a longstanding tale of woe in China,” says AJ Bell investment director Russ Mould.

“Investors – as well as the ruling Communist Party and the People’s Bank of China – must now assess whether a sudden collapse is coming, or whether the country’s real estate market will endure a lengthy period of subdued growth as speculative excesses are shaken out, and what the implications of either scenario may be for economies and financial markets elsewhere.

“Although Evergrande and Country Garden are grabbing all of the headlines now, their respective share prices speak of a long-term problem that is just reaching crisis point as loans mature, cashflows dry up and China struggles to bounce back from both three years of lockdowns and a speculative bubble in real estate that is now deflating.

Source: Refinitiv data

“The knock-on effects of this bust are now starting to make themselves felt beyond the real estate market, which generates between a quarter and a third of Chinese GDP.

“Finance company Zhongrong, a so-called ‘trust’ specialist that invests savers’ pooled capital across China in a range of assets, has missed payments on maturing schemes to its product holders, be they corporations or wealthy individuals. The liquidity crunch here could in turn be the result of the Chinese residential property downturn as house prices fall, volumes dry up and property companies miss interest payment deadlines.

“The Chinese stock market is still yet to come close to recapturing the peak reached in 2015 and the residential real estate market could also be at the start of a prolonged period of adjustment – similar to that seen in Japanese real estate and equities after a speculative episode there ended with a bang in late 1989.

“China is doing its best to keep the plates spinning, cutting both interest rates and the amount of capital that banks have to hold (thus boosting their ability to lend) but some economists are arguing that the debt numbers mean China simply cannot grow at its current rate for too much longer.

“Some even argue that the country is facing its own Minsky Moment, as its economy reaches the third stage of the debt cycle outlined by economist Hyman Minsky in his 1993 paper The Financial Instability Hypothesis:

• Hedge finance, whereby a mix of cashflow and equity help borrowers to fund interest payments on debt and eventually pay off their liabilities.
• Speculative finance, where debtors have enough money to cover interest but cannot repay the original loan, which must be rolled over.
• Ponzi finance, where borrowers are unable to pay off the interest, let alone the principal debt and resort to asset sales to pay the bills.

“Investors may think this sounds a little apocalyptic, but it might help to explain why the Shanghai Composite index is going nowhere fast – and is no higher now than it was in early 2018, when stock market index constructors such as MSCI and FTSE Russell began to include onshore Chinese A-class shares, and not just Hong Kong-traded H shares, in their benchmarks. The higher weighting given to Chinese equities raised the possibility that a wall of money from passive index trackers would flood into the market and push prices higher. It may have done at first, but not for long, and there is a danger that falling prices and falling weightings prompt a similar reflex, only this time to prompt a wave of passive selling.

Source: Refinitiv data

“Beyond the narrow confines of equity markets in Shanghai and Hong Kong, China’s property pickle begs the question of what it means, if anything, for the global economy and, in turn, global financial markets.

“China’s economy, the world’s second largest, looks likely to slow and state support will surely be required to limit the damage from a housing bubble that is bursting, with fiscal support a distinct possibility.

“This might not be quite as dreadful a prospect as it seems. China runs a trade surplus, so it sells more than it buys. In this respect, the damage to global trade flows may not be quite as big as perhaps feared.

“However, a slower Chinese building market could logically hit demand for raw materials and thus potentially commodity prices, while a squeeze on consumers could have ripples in the international travel and luxury goods markets, especially in Asia.

“How the Communist Party manages to support economic growth without piling up too much debt, or cutting interest rates to the point that the stock market becomes bubbly (as it did in 2007 and 2015) or the renminbi weakens (as it did in 2015-17 and 2019, leading to trade troubles with America) will be fascinating to watch. In the end if feels as if something will have to give – the currency or economic growth targets - especially if Minsky is proven right.

Source: Refinitiv data

Source: Refinitiv data

“If there is any good news here, it may be that less demand for commodities and a weaker Chinese economy and currency take away some of the inflationary pressures that currently bedevil the West. Factory gate inflation in China, as measured by the producer price index, is already in negative territory, after all.”

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