China is a broad and very popular topic among investors. That isn't surprising given that the country is the second-largest economy in the world and is home to three of the top 10 stock market exchanges. We provide our answers to the top five questions we are currently being asked about China.
1. Why is China cutting interest rates when the Fed is hiking?
China is battling deflation, while the rest of the world battles inflation. Deflation and the continuation of weaker-than-expected economic growth are the country's main economic risks. Both core and services Consumer Price Inflation (CPI) are below 1%. Property prices are also in decline. China needs lower interest rates and a weaker currency to battle deflationary pressures which can depress spending and weaken the economy while worsening repayment burdens for borrowers. In contrast, the main problem for the U.S. is elevated inflation, requiring higher interest rates and a stronger currency.
Inflation in China is going in a different direction
Source: Charles Schwab, Bloomberg data as of 8/27/2022.
Last week, in addition to rate cuts by the People's Bank of China (PBOC), Premier Li announced a series of growth supportive measures. These fiscal measures could help offset the sharp contraction in government revenue and support infrastructure investment growth in coming months. They may also help to weaken the Chinese currency; a look at the spread between the U.S. and China's three-month interbank rates points to the potential for China's yuan to drop 10% against the U.S. dollar. While these actions may aid China's efforts against deflation, it could reignite tensions with the U.S. over currency moves in an environment of weakening export growth.
Chinese yuan to depreciate further?
Source: Charles Schwab, Macrobond
Source (continued): China Foreign Exchange Trade System (National Interbank Funding Center), Intercontinental Exchange (ICE), data as of 8/26/2022.
2. Is China experiencing a "Lehman-like" real estate crisis?
China's property market is making headlines. Sales have slowed and borrowers are boycotting mortgage payments. For the first time since 2015 newly built home prices are down, falling every month since last September at an average pace of -0.1% per month.
China home prices have fallen every month since September 2021
Source: Charles Schwab, Bloomberg data as of 8/26/2022.
How did we get here? In August 2020, the Chinese government began a deleveraging campaign for property developers, called the "three red lines." To help control home prices, it reduced credit to the property sector in an effort to ensure a more stable financial system. This created a liquidity squeeze on some property developers, who fell behind on project completion. The COVID-19 lockdowns and restrictions from March through May contributed to a standstill in the property market, particularly for new sales, since consumers' mobility was hindered and construction activity was impeded.
In response, China's policy makers have put forth efforts to get developers the funds they need to restart construction. Latest reports indicate the PBOC and finance ministry have instructed policy banks to lend up to 200 billion yuan ($29.3 billion) to ensure previously sold homes are finished, according to people familiar with the matter. While China's economy and stock market could remain volatile, we don't see any signs that a housing or Lehman-type crisis is imminent.
There are a few key differences compared to what happened with Lehman:
- Leverage – In China, there are no zero-down payment "NINJA" loans (no income, no job applicant) that were popular in the U.S. in the lead up to the housing crisis. Rather, a down payment of at least 30% for first-time buyers had been the standard in China until earlier this year. This up-front cash was the largest source of funding for Chinese property developers, even though delivery of units wouldn't be made until one to three years later.
- Small share of market affected - Estimates by Bloomberg Intelligence indicate only about 4% of pre-sold housing property has been stalled in the construction process due to a lack of funds by developers and the rising cost of materials.
- Small impact to portfolios - Lenders who have reported indicate less than 0.01% of their residential mortgage portfolios have been impacted by the mortgage payment boycotts, according to Fitch Ratings.
3. What should investors consider regarding an invasion of Taiwan by China?
The recent flare-up in tensions is related to trips by members of the U.S. Congress. China has been clear that if Taiwan were to declare independence, China would take military action. However, that scenario seems highly unlikely because the Taiwanese don't seem to want it. The latest survey, published in June, from Taiwan's National Chengchi University, provides details on Taiwan's sentiment on independence.
Taiwanese favor status quo, not independence from China
Source: Election Study Center, National Chengchi University, Taiwan. Survey data as of July 12, 2022.
According to the results of the survey, only 5% of the population of Taiwan is in favor of "Independence as soon as possible"—similar to the share seen each year going back decades. The top response at 29% was "Maintain status quo indefinitely"—which was tied with a similar response: "Maintain status quo, decide at later date." Together, summing to 58%, they make a majority for the status quo. Only if we combine those who want to move immediately toward independence with those who want to maintain the status quo now but move toward independence over time can we get to about 30% of the population, a significant amount but nowhere near the overwhelming majority it would take for Taiwan's democratically elected leaders to declare independence. Therefore, it seems the likelihood of an imminent invasion is low.
However, there is a related risk: A Chinese consumer boycott of American-branded products, such as cars, due to escalating U.S.-China tensions. Last year, China contributed about half of GM's vehicle sales and a third of Tesla's, so a consumer boycott could be significant. It has happened before. U.S. automakers reported that sales in China tumbled 28% over a nine-month period after President Trump announced tariffs on Chinese goods in 2018. So, a possible boycott might be a more relevant risk for investors to consider rather than a war suddenly breaking out in Asia.
4. How is de-globalization impacting China?
Efforts to curtail foreign investment and onshore manufacturing production domestically haven't made much progress. According to China's Ministry of Commerce, investment by businesses into operations in China from Korea, the United States, and Germany soared 37%, 26%, and 14%, respectively, in the first half of this year from a year ago. In fact, the pace of net new business investment in China has been exceptionally strong as China finally outpaced the U.S. to become the world's largest exporter over the past two years.
Trend of foreign direct investment into China
Source: Charles Schwab, Bloomberg data as of 8/27/2022.
5. Will Chinese companies' U.S.-listed shares be delisted from exchanges?
Last week, a deal was struck between China and the U.S. on audits that averts a mass delisting of Chinese companies from U.S. stock exchanges.
To review, Chinese companies listed in the U.S. have always had to comply with certain audit and financial disclosure requirements which apply to all companies listed on U.S. exchanges. U.S.-listed Chinese companies are audited by global accounting firms used by many U.S. companies. When the Holding Foreign Companies Accountable Act (HFCAA) was passed in December 2020, the process changed by requiring that all companies' audit work papers be inspected by the U.S. Public Company Accounting Oversight Board (PCAOB). In other words, the U.S. law required an audit of the auditors for foreign companies. If these companies became non-compliant for three years, they would be delisted. For companies with December fiscal years, 2021, 2022, and 2023 would be the years under scrutiny, and so the filing of 2023 statements (usually around March-April) in 2024 would be the trigger.
Last week's deal allows for full and complete access to the audit work papers. PCAOB officials will be dispatched by mid-September to Hong Kong to start the reviews. The PCAOB will have access to unredacted documents, while more sensitive materials that might be considered state secrets would be available on a "view only" basis.
China has resisted granting access to audit data that may compromise security such as revealing government military assets or the movements of key leaders. The announcement earlier this month that five government-owned companies would be voluntarily delisted was likely the last step towards resolution of this issue. Those five companies trade relatively few shares in the U.S. (less than 1% of the shares traded in Hong Kong or the Chinese Mainland stock market) in contrast to widely followed Chinese companies like Alibaba which sees trading in the U.S. equivalent to about half of the volume traded in Hong Kong.
Shares traded by market for Chinese firms delisting in U.S.
Source: Charles Schwab, Bloomberg data as of 8/16/2022
The risk of delisting has not been completely removed; it is still contingent on the actual results of the audit inspections over the next several months. U.S. Securities and Exchange Commission (SEC) Chairman Gary Gensler said that officials would be able to assess if they are getting sufficient access by December. The best option for holding these stocks may be through a diversified exchange-traded fund (ETF) or mutual fund, where the investment managers can make any needed transition between U.S. and Hong Kong listed shares of a company. Our research has uncovered that many ETFs have already started to convert their holdings from U.S.-based shares to Hong Kong shares in anticipation of this rule change.
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