China: Contagion or Contained?

China's economy may have spillover effects on global economic and earnings growth, but it's unlikely to lead to global financial contagion and send stock markets materially lower.

China is having a tough year. In contrast to post-lockdown pent-up demand driving solid and steady economic growth this year, a surge in the first quarter was followed by a stall in the second. Our analysis of China's national data shows a country mired in deflation, plunging exports, youth unemployment climbing above 20%, a consumer pullback and an unstable property sector leaving developers to miss bond payments and a trust company to fail to repay investors.

A stalled economy and concerns about a property market crash have reinvigorated questions about the impact of China's slowdown on the rest of the world. The world's second-largest economy has typically been closely tied to global demand. Historically, China's inflation has dipped into negative territory only around global recessions (2001, 2008-09 and 2020), as you can see in the chart below. Although China's consumer price index (CPI) has once more moved negative, we don't believe a "Lehman moment" involving a housing crash and global financial contagion is a likely outcome. We do expect lingering slow growth in China and potential spillover effects on global economic and earnings growth.

China deflation and global recessions

What happened?

Although official statistics from the People's Republic of China report the real estate sector directly accounted for 7% of GDP in 2020, the growth in activity across the many industries driven by property activities is estimated to contribute as much as 29% of GDP, according to a research paper published in August 2020 by Harvard Professor of Public Policy and Economics Kenneth Rogoff and International Monetary Fund economist Yancheng Yang. To curb speculation and the buildup of leverage, the government's "three red lines" were created in 2020. The criteria of property developers specified a 70% limit on the ratio of liabilities to assets, a 100% limit on the net leverage ratio, and a minimum coefficient of 1 in the liquidity ratio for property developers. By 2021, most developers were able to comply with these restrictions. But some, like Evergrande and Country Garden, have struggled.

Although the Chinese government sought to curb what it saw as overinvestment, the pendulum has swung to the other extreme. Developers seem to be starved of capital both in terms of debt issuance and cashflows from new property sales. Chinese homebuyers make down payments years before delivery of completed units, and concerns about losing down payments and making mortgage payments on properties not yet built have increased.

Because property comprises about 70% of wealth for Chinese households (according to analysis of data from China's National Bureau of Statistics), worries about the housing market have seemed to erode consumer confidence and the pace of spending on goods. This weakening has also reduced land sales revenues for local governments and may have contributed to a trust company missing payments to investors on some investment products.