China update: “Common Prosperity” – what does it mean for credit investors?

The Chinese authorities have announced a wave of new regulations over the last few months, which many commentators have collectively referred to as a Beijing “regulatory reset”. These changes are not to be taken lightly, and, in our opinion, represent a new governance paradigm that, at its core, will look to re-define the Chinese growth model and have a profound impact on global growth.

In order to understand these changes, we have to appreciate the key drivers for economic growth in China over the last 10 to 15 years and the structural changes that have ensued. In the decade from 2000 to 2009, Chinese GDP growth averaged 10.4% a year. This stellar performance abated during the following decade, but GDP still grew by an average of 7.7% a year. Indeed, over this period, China was the engine for global prosperity, contributing 28% of GDP growth worldwide from 2013 to 2018 (according to the IMF).

Real estate: the key growth driver
At the core of this growth engine was the “Build, Build, Build” model, as the Financial Times so aptly put it, with the real estate sector proving a dynamic force. At its height, the real estate sector accounted for close to 29% of Chinese GDP (we estimate this has fallen to 20-25% today). Developers were allowed to borrow almost indiscriminately to buy land, which in turn financed local governments’ capital budgets. This led to large-scale oversupply of property, which was used by Chinese citizens as a wealth accumulation tool. Indeed, the oversupply became so vast that it is estimated that the unsold housing inventory is 3 billion square metres, or enough to house 30 million families (the average Chinese family comprises 3 people). Much of this growth was debt financed, with no company exemplifying this excess more than Evergrande (China’s largest property developer), whose debt ballooned from USD 1.7bn in 2007 to USD 110bn at the end of 2020.

Decline in demand for property as birth rate falls
This unprecedented growth also had profound effects on Chinese society, with the poverty rate dropping from close to 16% in 2010 to virtually zero currently (see chart 1). The largest migration in human living conditions arguably in history, and a stark contrast to India (for example), with only Brazil, under former president Lula da Silva, coming close to achieving such a transformation. However, this improvement in living conditions came at a cost, as China’s population growth stalled, with only 12 million babies being born in 2020. This trend will become more pronounced over the next decade as the number of women of peak childbearing age – between 22 to 35 – is due to fall by more than 30% (a legacy of the one-child policy). Some experts are predicting that the birth rate will fall further, pushing the Chinese population into absolute decline, further dampening the demand for property. In addition to these demographic shifts, there has been a marked increase in social inequality as highlighted in chart 2. Hence, Chinese authorities face a conundrum: How do they invigorate population growth, reverse social inequality and move the economy away from one reliant on debt-fueled property expansion to a more sustainable model?

 

Chart 1: Decade-long journey to eliminate absolute poverty

_{Source   CEIC, Morgan Stanley Research}

 

Chart 2: New policy priorities: social equality, data security and self-sufficiency

_{Source   CEIC, Morgan Stanley Research}

The Chinese Communist party’s “Common Prosperity” campaign goes a long way to address many of the structural issues highlighted above. The policies, at their core, aim to address social inequality, sustainable growth and self-sufficiency. The policies targeting the education sector and property sector are aimed at reducing the cost of raising children and supporting a family, while also removing real estate as a wealth creation vehicle.

What does this mean for credit investors?
It is clear that China will have a lower growth rate over the next decade, and business models will have to adapt to this new economic and regulatory reality (chart 3). This has triggered a vicious repricing of capital, particularly in the high-yield, real estate sector (chart 4), as the market tries to differentiate between the ‘haves’ and ‘have nots’. We feel that, for those willing to tolerate the associated higher volatility, the return profile in Chinese high-yield property bonds looks very interesting, with realizable returns compensating for the heightened business risk.

Chart 3: China GDP growth under different scenarios – China’s regulatory reset could weigh on investment and productivity growth