Investment Strategy Brief:
China on the Ropes

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

After China relaxed its zero-COVID policy last December, many anticipated that a strong recovery in economic activity would shortly follow after a period of normalization. However, the rebound has proved rather lackluster so far, punctuated by an all-time high in China’s unemployment rate for those aged 16 to 24. It got to the point last week where Chinese officials just flat out decided to pull this dataset from circulation and announced it would no longer publish youth unemployment stats.

So what exactly is going on? Several broad measures of economic activity, like industrial production, have failed to generate anything resembling the V-shaped recoveries that many other countries experienced after lifting pandemic restrictions. Economists were getting increasingly upbeat on the prospects for robust real GDP growth in China this year, but consensus estimates have begun to back off as more evidence of tepid growth has started to emerge.

The property sector in particular has been getting a lot of attention. For example, new construction of residential properties has been flagging for much of 2023 as measured by the total floor space of new construction starts and sales. Each are running at levels roughly half that observed right before the pandemic began at the start of 2020 despite efforts to normalize. This matters, because a large portion of China’s economy is driven by fixed investment – 43% vs. 18% in the U.S., for comparison.

Much of the capital used to finance China’s construction boom over the last decade appears to have come via “shadow” banking channels. The term “shadow bank” may sounds sort of ominous, but it isn’t necessarily a bad thing by definition. It simply refers to institutions other than banks that extend loans, such as insurance companies or, in China’s case, property management firms. It’s an important distinction from a risk management perspective though, because these entities often don’t face the same regulation than do traditional bank lenders. That sort of lending has exploded in usage since the Great Financial Crisis in China, ballooning from less than 1% of GDP in 2008 to more than 60% as of the end of last year. In this case, concerns have mounted that, if a significant portion of these loans transition to non-performing status, it could run the risk of financial contagion throughout the Chinese economy.

It is often easy for U.S. investors to focus on domestic economic issues given America’s status as the world’s largest economy. With that said, economic troubles in China cannot be ignored, as it is now the world’s second largest economy and responsible for almost one-fifth of world GDP. Any sustained weakness could have direct implications for its major trading partners, not to mention any indirect effects that could arise from a decline in aggregate world demand.

For the U.S. specifically, China is the single largest origin of imports and a sizable destination for exports. However, the post-COVID era may have begun a decoupling of that trade relationship, as China’s shares of imports and exports have both begun to decline. But that decoupling is likely to be a long, gradual process. As a result, the flagging Chinese economy could be one of several catalysts that could lead to recession later this year or early next and is worth watching for investors.

So to summarize, the post-COVID lockdown recovery in China hasn’t quite lived up to expectations so for, especially in the property sector which is responsible for a large share of Chinese economic activity. This has led to concerns about non-performing loans in the Chinese shadow banks, which face less regulation than traditional banks. This is an issue that can’t be ignored since China is now the second largest economy in the world. Even though the U.S. has begun a gradual decoupling of its trade relationship with China, this could have implications for U.S. growth. Specifically, it could be one of several catalysts that may contribute to recession later this year or in early 2024.

Thanks for listening! And please don’t hesitate to reach out with any questions.