China’s property-driven economic crisis is real but it’s not facing a ‘Lehman moment’

While the acute risks in China’s real estate sector should not be downplayed, their effect on global markets is prone to misinterpretation and exaggeration
Stability is the overriding priority in China’s state-controlled financial system, and more aggressive stimulus are available if needed

Nicholas Spiro

Published: 3:30pm, 21 Aug 2023

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Nomura has been bearish on China for some time. Even by the standards of its own bleak outlook, though, its latest research report published last Friday makes for particularly grim reading.

Not only did the bank cut its growth forecast for this year to 4.6 per cent – even lower than the government’s modest target of 5 per cent – it warned of a dangerous “chain reaction” stemming from the government’s failure to stem the crisis in the property sector.

“Slumping home sales may lead to a rising number of developer defaults, a sharp contraction of government revenue, falling demand for construction materials, declining wages of employees in the property and government sectors, weaker consumption and faltering financial institutions,” Nomura warned.

As recently as a month ago, such a dire prediction would have been treated by global investors as either overly pessimistic or a risk not worth paying too much attention to. Yet by the end of last week, investors had become far more sensitive to vulnerabilities as another China scare began to take hold.

For the first time since China Evergrande Group defaulted on its US dollar-denominated debt in 2021, fears are growing about widespread financial contagion. A cash crunch at Country Garden Holdings – a top developer with heavy exposure to smaller cities that missed payments on two offshore bonds earlier this month – is being exacerbated by mounting losses among previously stable state-owed developers, imperilling their ability to take on unfinished projects by their distressed private peers.

Just as worryingly, the property-induced troubles of Zhongrong International Trust have fanned fears over China’s vast shadow banking industry, exposing a prime conduit for contagion.

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“That all this is happening after further policy easing begs the question of whether things could actually be a lot worse than many fear,” said Jim Veneau, head of Asian fixed income at AXA Investment Managers in Hong Kong.

Last week, there were signs that vulnerabilities in China were shaping global sentiment. The FTSE All-World Index, a gauge of global stocks, had its worst week since the US banking crisis in March, while foreign outflows from Chinese equities matched their longest streak of net selling since Bloomberg began tracking the data in 2016.

Moreover, there has been a noticeable shift in the tone of the market commentary on China. JPMorgan said Country Garden’s default would be “the final nail [in the coffin] for the China high-yield property sector”. Bank of America said the “risk of a China ‘credit event’ is spooking global markets.” Gavekal Research, meanwhile, went so far as to say that “the worry is that a ‘Lehman moment’ beckons”.

While the acute risks in China’s real estate sector should not be downplayed, their effect on global markets – and markets’ effect on the response by Beijing – is prone to misinterpretation and exaggeration.

Workers walk past a construction site of residential buildings by property developer Country Garden in Kunming, Yunnan province, on September 17, 2019. Photo: Reuters

First, it is important not to overstate the impact of China’s property crisis on Wall Street. The sell-off in global stocks last week had more to do with the sharp increase in bond yields the world over because of investors’ belated realisation that interest rates will remain at high levels for longer than anticipated.

The findings of Bank of America’s latest global fund manager survey showed China did not even figure among the biggest “tail risks” in markets. Tellingly, respondents deemed US commercial property as a more likely source for a “systemic credit event” than Chinese real estate.

Not only do international investors not perceive the fallout from the downturn in China’s housing market as a Lehman-type situation – a crisis that could trigger a system-wide collapse on the scale of the disaster that followed the demise of Lehman Brothers in 2008 – there are no telltale signs they are positioning themselves for a China-induced meltdown.

China’s property sector, not falling prices, is its top economic worry

This is mainly because the Chinese property market’s linkages to the global financial system are not on the same scale as a major Wall Street investment bank, but also because of the advantages of a state-controlled banking system and capital controls in forestalling a full-blown financial crisis.

Second, it is doubtful whether more intense pressure from markets would force Beijing’s hand. It should be clear to investors by now that stability is the overriding priority in housing policy. This does not preclude more aggressive stimulus should market conditions deteriorate more sharply, but the fact this has not already happened given the damage incurred says a great deal.

Nomura believes the most markets can hope for is “policies that finally stem the downward spiral and stabilise new home sales at slightly above current levels”. However, such support would be dictated by concerns about social unrest rather than market instability.

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Third, even if pressure from markets intensifies, it is unclear whether Chinese policymakers know how to respond. This is because of long-standing policy differences within the government and factors related to the sensitivity and flow of data at a critical moment for China’s economy.

Anything that suggests the post-Covid recovery is weaker than feared risks further undermining confidence in the eyes of Beijing. This is partly why the government has restricted the release of sensitive economic and financial data. It also adds to concerns that more aggressive stimulus could backfire if it is taken as a sign policymakers are more worried about growth than previously assumed.

China is not facing a “Lehman moment”, and neither is it likely to given its state-owned financial system. This helps explain why global investors are not overly concerned. The crisis is a structural economic one, which no amount of market pressure can resolve.

Nicholas Spiro is a partner at Lauressa Advisory