China-focused investors are breathing a sigh of relief this week thanks to a rally driven by solid earnings in the tech sector. Beijing has ceased fire after blasting salvos at Big Tech, e-commerce platforms, after-class tutoring, video game makers, food delivery and ride hailing services, crypto miners and e-cigarette makers. That cessation of fire has provided shell-shocked shareholders of Internet companies a chance to collect the dead and wounded in their portfolios.
But bigger problems may await the broader Chinese economy. This short-term bounce in stocks may mask uncertain business prospects over the medium term, risks that are not fully recognized.
"Markets have become so focused on the regulatory storm that they ignore the elephant in the room," Nomura's Asia economics team said in a note to clients here on Wednesday.
There are "unprecedented" curbs in the property sector, according to authors Ting Lu, Lisheng Wang and Jing Wang, and that's where the crisis would unfold. Real estate is the most-important element of the Chinese economy, accounting for one-quarter of the entire GDP.
The Beijing government is willing to sacrifice near-term economic growth to tame home prices. They accept the need to divert financial resources out of the real estate sector. As a result, the Nomura team wonders if China is about to have its "Volcker moment."
"Markets should be prepared for what could be a much worse-than-expected growth slowdown, more loan and bond defaults, and potential stock market turmoil," the China economists say.
They're thinking of the punishingly tough anti-inflation measures started in October 1979 by Federal Reserve Chairman Paul Volcker to combat Carter-era stagflation. In a radical move, Volcker caused interest rates to shoot through the roof, peaking at 20%, in an ultimately successful bid to tame runaway inflation that crested to 14.8%.
That's not to say the regulatory risk from Beijing has vanished. Investors should still be very worried about it. The Chinese Communist Party has proven particularly unpredictable in its efforts to push change on a tech sector it clearly felt had grown out of control.
Efforts to rein in tech-sector pay and unseemly profits from Chinese consumers, all in the name of social reform and greater income inequality, have disadvantaged investors in a way that's highly unusual to see in the West. Those shareholders have no recompense.
This week, investors have been encouraged by good numbers from JD.com (JD) , the e-commerce rival to Alibaba Group Holding (BABA) . Standard & Poor's suggests that JD's revenue could rise above C¥1 trillion (US$154 billion) this year. That's judging from second-quarter sales that rose 26% year over year. What's more, the number of active customer accounts rose to a record 532 million.
The strong showing for an e-commerce behemoth put a shine on Chinese shares this week. The CSI 300 index of the largest mainland stocks is up 3.5% since last Friday afternoon. It is the tech sector leading the way; the Hang Seng Tech Index has advanced 10% in the same time frame. It represents Hong Kong-listed Chinese tech stocks, which are the outward-looking companies that attract the most attention from international investors.
However, real estate stocks dropped 3.7% on Wednesday. The pipe supplier Yonggao SZ:002641 said China's largest homebuilder, China Evergrande EGRNY and HK:3333, has stopped paying some bills, casting fresh doubt over the fate of the world's most indebted developer. Yonggao declared the situation in a stock exchange filling and said it may sue over C¥195 million (US$30 million) in overdue commercial bills. The construction supplier stopped delivering pipes to Evergrande in May as a result.
Evergrande's problems are on a grand scale. But other property companies are also experiencing a cash crunch.
The Beijing government has not yet delivered a concrete long-term plan for the property sector. Instead, it has just mandated rapid forced deleveraging. It has imposed "three red lines" that all property companies will have to satisfy. They must have a liability-to-asset ratio of less than 70%, net gearing of less than 100%, and cash to short-term debt of more than 1x.
China announced those changes in August 2020 and developers are still struggling to comply. Only 6% of developers met all three criteria as of the start of this year, according to S&P.
The tightening on property, intended to make housing more affordable, comes at a time that China is still contending with the Delta variant of COVID-19. While that's currently under control, there have been snap lockdowns in many heavily populated cities, which is sure to knock businesses off track.
Wealth disparity worries
The Communist government is incredibly concerned about China's worsening wealth inequality. President Xi Jinping spoke last week at a party congress about the need to "adjust excessive incomes" and redistribute wealth away from the super-rich in a bid to achieve "common prosperity." The government, he told the party's Central Committee for Financial and Economic Affairs, must "regulate excessively high incomes and encourage high-income groups and enterprises to return more to society."
Housing, healthcare and education are the "three large mountains" that Chinese families say they must climb. That's why we are seeing Beijing try to tackle private-sector education, which has become a bit of a tiger-parent nuclear arms race. Drug companies and online health clinics, which get most of their revenue fulfilling prescriptions, are also facing government action to curb price inflation.
A property tax is a likely method to spread some of that wealth around. Because Chinese stocks are effectively just an option on a company that might have its entire business model upended by the government overnight, many wealthy Chinese people prefer to put the bulk of their money in bricks and mortar. The Chinese Communist Party can tap that by expanding a tax that it is testing in the cities of Shanghai and Chongqing.
Its efforts to force developers to cut back on credit are a new tack from inside the financial system. The government previously attempted only to block buyers from acquiring investment properties. There are likely to be developers that collapse.
The Nomura economists note that property is the single-largest component of the economy in China, at 25.0% when you include land sales. Selling plots generates 44% of total government revenue. So these curbs will cut to the quick.
China's GDP growth will decelerate fast from 7.9% in the second quarter to 5.1% in the third quarter and then 4.4% in the fourth quarter, Nomura forecasts, a big change in short order. At best, Chinese growth is looking at 5.1% in 2022 with risks to the downside, the economics crew said.
Investors counting on the "China growth story" may need to recalibrate their sights. If developers start going under in large number, the picture for the Chinese economy and its stock markets could turn very bleak indeed.