Investing in China has been tough lately. Two major regional indices, the Shanghai Shenzhen CSI 300 Index and the Hang Seng Index, have one-year total returns of -15.5% and -16.5%, respectively, as of February 21, 2024. Since markets peaked in 2021, the Shanghai and Shenzhen exchanges have lost about $3 trillion in value. The reason? An emerging economy that is struggling to transition.
Before the Global Financial Crisis began in 2007, the Chinese economy relied on exports to fuel growth. The country was a manufacturing powerhouse, exporting $1.22 trillion U.S. dollars’ worth of goods that year. After the Global Financial Crisis took hold and global demand declined, policymakers unleashed a firehose of financial stimulus on local markets, with an aid package equivalent to $586 billion U.S. dollars. This was comparable in size to the stimulus package the U.S. government provided to quell the damage the financial crisis caused at home, but at the time, China’s economy was only one-third the size of the U.S. The stimulus package resulted in a boom in Chinese bank lending which shifted the primary growth driver of the broader economy from exports to investment in infrastructure and real estate, fueled by massive amounts of debt that led to a real estate bubble. The explosion in debt issuance laid the foundation for today’s economic issues.
Recently, the Chinese government has been intent on deflating the real estate bubble and reigning in the private sector of the Chinese economy. Their view is that there has been too much speculation within the housing market, leading to too much money pouring into the sector, posing issues to investment in other areas of the economy, namely technology, along with a widening wealth gap. Housing price increases in China began to decelerate after Covid hit and regulators tightened lending standards. Soon thereafter, housing prices began to decline. As the Chinese economy reopened after being shut down for a lengthy period due to China’s aggressive response to the pandemic, deflation began to take hold and is now accelerating at its fastest pace since the Global Financial Crisis. This time, however, the government has been reluctant to step in and stimulate the same way it did in 2009 because it doesn’t want to reinflate the real estate bubble.
The result is an economy in a transition phase. With infrastructure spending and housing developments no longer serving as growth drivers, China is looking to consumer spending to fuel the next phase. There is just one problem: consumers aren’t spending. Rampant youth unemployment, declining global demand, and falling home prices are leading to deteriorating spending numbers among Chinese consumers. In turn, the government has been slow to provide direct stimulus because they don’t want to reinflate the housing bubble while attempting to prevent contagion to the broader economy. Small measures have been taken by the government, such as cutting benchmark interest rates, lowering bank reserve requirements, banning “malicious short selling” in equities, and even having its sovereign wealth fund increase equity holdings in the country’s biggest banks, but they have proven widely ineffective thus far.
Zooming out and looking at the long-term prospects of the Chinese economy presents a different set of problems. China faces demographic challenges to future growth. Still considered an emerging economy, they face a challenge usually only seen once economic maturity is reached: a declining population. Almost a decade after dropping the one-child policy, birth rates in China are estimated to be around one child per family, an all-time low and well short of the 2.1 children per family replacement rate estimated to be required for a constant population. Birth rates are declining rather than increasing, and younger generations in China are becoming more reluctant to have children due to the high cost of raising children combined with high youth unemployment, as well as the lasting effects of 35 years’ worth of state messaging about the societal benefits of limiting families to one child. Declining populations are associated with weaker demand for services and infrastructure, threatening prolonged economic challenges. This is especially problematic for the economy long-term, as consumer spending is supposed to drive the next leg of Chinese economic growth. A real-world example of this phenomenon can be seen in Japan, where the population has been on a downward trajectory since 2010. Between 2010 and 2022, the Japanese gross domestic product declined by $1.5 trillion U.S. dollars, and until recently, regulators have been fighting to keep the economy out of a deflationary state. A lack of long-term growth drivers combined with near-term economic issues and regulatory opacity has led to investor dollars fleeing rapidly, wiping out over $3 trillion in value in the process. China has navigated through economic challenges in the past, and the government has the means and the ability to take decisive action. That said, this is a complicated set of circumstances as China tries to allow the problems in real estate to run their course while fighting a larger economic slowdown.
Written by: Brian Sawyer
