China - Eternal boom or the beginning of the end?

In our last Capital Market Outlook from October (which you can find here), we used the German residential real estate market as an example to show that an investment form that has shown strong growth in value for over 10 years and has been classified as too expensive by the German Bundesbank, among others, can nevertheless be undervalued.

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However, when the US Federal Reserve warns in its semi-annual stability report in October that a crisis could arise in the Chinese real estate sector, which has also been booming for years, and could spread to the US, we should take a closer look. In contrast to the European Central Bank, which was still heavily influenced by the German Bundesbank at the time, this central bank printed money quickly, massively and successfully during the 2008 financial crisis, thereby stabilizing the financial markets worldwide after the collapse of Lehman Brothers.

In addition, China is now the world's largest economy, at least in terms of purchasing power of national income (see figure 1a below left). According to sport.de, the old rule "they never come back" has not applied to heavyweight boxing since 1960. For world powers - both military and economic - it has applied for thousands of years, with just one exception. This one exception, China, has already recovered several times after a massive loss of importance, for example after the Mongol conquest or the relative decline in the 19th century.

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The reason for this was not only that the Chinese have always been large in number, but also that a thousand years ago their level of education and science was far superior to the rest of the world. Several centuries before the Europeans, the Chinese already had the printing press, compass, gunpowder, paper money, state offices for old people's homes and nursing care, public libraries, porcelain and an "assessment center" for future top civil servants, in which candidates had to pass comprehensive examinations in scientific and cultural subjects. Free trade was also practised within the Chinese empire, something that the Germans only became familiar with in the 19th century and learned to appreciate in view of the subsequent economic boom.

As economic output has grown since the change of course towards a market economy in 1978 under Deng Xiaoping, the Chinese have also increased their military spending. In this context, two hotbeds of conflict have emerged. Most of China's Asian neighbors are allied with the USA and feel increasingly under pressure from China. The USA is responding to this by increasingly turning its military attention to the Asian region.

Taiwan, from a Chinese perspective a Chinese province, is particularly threatened. The country is the most important producer of modern computer chips of a quality that China cannot yet produce itself.

China's government is wise enough to avoid an open military conflict, as the economic damage would far outweigh the benefits, even for the victor. Nevertheless, the global capital markets could occasionally be burdened by these conflicts and China by its high military spending.

The gap between the USA and China is narrowing, but the USA still has military superiority (see Figures 2a-b below).

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However, Nicolas Chaillan, the head of software at the US Department of Defense, resigned in autumn 2021 in protest at the slow pace of digitalization in the US military compared to China. He sees China as superior to the USA in 15 to 20 years (source: Financial Times).

In terms of education, China is successfully building on centuries-old traditions. As in other Asian countries, great value is placed on mathematical education, which is important for the development of modern technologies and thus for prosperity. This is to a considerable extent linked to mathematical skills, which have been above average in Asia not only since 2005 (see Figures 4 and 3a-b below).

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Up to this point, China's rapid rise looks like an unprecedented success story. Nevertheless, political uncertainty in China is growing faster than in the rest of the world (see Figure 5).

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This is not only due to the military tensions in Southeast Asia, but also to the Chinese government's increasing intervention in the economy, for which the Communist ruling party believes there are social reasons, namely the sharp rise in inequality since the opening-up in 1978 (see Figure 6 below).

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This is no longer acceptable, as the middle class in China is coming under increasing pressure from several sides. Despite the abolition of the one-child policy, the birth rate plummeted by 18% in 2020. One reason for this, according to the government, is that families are burdened with particularly high costs, e.g. for private tutoring, which is almost indispensable for passing university entrance exams. Tutoring companies have therefore been forced to drastically reduce fees and their business model has been destroyed.

In addition, condominiums have become almost unaffordable (see Figure 7a).

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The strong overvaluation is also evident from the strikingly low rental yields in China's major cities (Figure 7b).

Only in China have homebuyers had to significantly increase their debt in recent years (Figure 8a), because house prices in Chinese cities are now on a par with those in major German cities, but incomes are less than 25% of the level in Germany (Figure 8b).

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To make matters worse, home buyers in China must have 30% equity. In large Chinese cities, this means that on average you need at least 9 times your annual income to obtain a loan (Figure 9a). In Germany, people resort to grandma and grandpa's savings account to raise non-existent equity, but China's grandparents were usually desperately poor. In view of the relatively high interest rates in China and the significantly lower rental savings, the remaining income is halved after "only" 70% debt-financed home purchases in Chinese cities, while in other major cities around the world the rent saved is greater than the interest expense, meaning that the remaining income increases (Figure 9b). The Chinese are therefore likely to soon lose the desire to own their own home.

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Not only the high costs, but also the rapidly declining number of potential buyers (see Figure 10b, comparable to Japan 30 years earlier) will reduce the demand for residential real estate.

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Especially as China's vacancy rate of 22% is only exceeded by Italy (23%) and the former real estate boom country Spain with 28% (Rogoff/Yang 2020). The USA is at 13%, Germany at 8% and the UK at just 2.5%. Chinese homeowners, who have so far only been fixated on price increases and often do not rent out their apartments to keep them in mint condition, are likely to soon discover that there are fewer and fewer buyers and tenants.

The supply situation also points to falling prices. The above-mentioned record vacancy rate in Spain is due to the construction and real estate boom there until 2006, when this part of the economy accounted for almost 30% of the total economy (see Figure 11a) and too many apartments were built. This figure has also been reached in China for some years now; too much is being built there too.

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In Ireland, the construction and real estate industry's 22% share of national income was enough to drive the country to the brink of national bankruptcy due to the collapse of project developers, mortgage banks and home buyers. Between 2007 and 2009, the Irish government had to increase the national debt from 25% of national income to five times that amount in order to save the banks.

Figure 11b shows real estate investment excluding the construction industry, which accounted for around 6% of national income in the USA at the end of the subprime boom. This had brought the USA a severe financial crisis from fall 2008 (Lehman Brothers bankruptcy). The comparable figure in China is more than twice as high at 14% and the demographic future is significantly worse than in the USA.

In China, a number of project developers, who have often built huge, largely empty ghost towns, have their backs to the wall or are already bankrupt; the now prominent Evergrande is the largest of these, with others following close behind.

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The long-term consequences of this foreseeable tipping point in the Chinese real estate market due to falling demand and far too much supply can be illustrated using Japan as an example (Figures 13a-b).

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At the peak of the almost 15-year real estate boom up to 1990 (Figure 13a), real estate in Japan was absurdly overpriced; at 0.5%, rental yields in Tokyo were even lower than in major Chinese cities today and lending rates were 7.5%. The main argument of the euphoric buyers was that 7.5% lending rates were completely irrelevant because the annual rates of price increases were much higher. Much too late, the then head of the Japanese central bank, Mieno, realized that even a senior employee in 1990 could at best afford a two-bedroom apartment - two hours away from the center of Tokyo - and that the real estate boom had to be slowed down. Today, Xi Jinping also wants lower prices because more and more Chinese people can no longer afford a small apartment. Mieno was successful, but at the cost of exploding national debt (see chart above right) because the banks had granted huge amounts of credit at high interest rates. When prices fell, many property owners had to sell and often owed the banks the interest and part of the loan amount. The state had to prop up the banks for years and since then has been by far the most indebted country in the world (top right chart) with the weakest demographic development (see p. 5 above). China's demography follows Japan's with a delay of around 30 years.

After reunification in 1990, we Germans also made the mistake of doping the economy from 1990 until after the Bundestag elections in December 1994 by massively stimulating real estate investments in depressed East Germany. After the tax concessions were abolished - i.e. from a point in time comparable to the current situation in China - countless West German "high earners" lost so much money that Germany was the "sick man" of Europe for the following 10 years. The main reason was weak consumption, because many formerly wealthy people could hardly afford anything.

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Finally, the question naturally arises as to why the Chinese government, which otherwise often acts wisely, made this mistake of stimulating the economy by inflating the real estate market, even though it was clear that this always led to major damage in other countries. One understandable reason is the fact that the provincial governments in China have been generating a high proportion of their income from fees for the transfer of land use rights for over 10 years (see following chart) and did not want to do without them. Incidentally, people in China do not acquire land ownership - the land remains state property - but residential purchases are made in a form comparable to the German leasehold. Against this backdrop, the overvaluation of Chinese real estate is particularly absurd.

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Another reason is that many close relatives of top communist politicians are involved in real estate project developers. Lobbying and corruption always and everywhere lead to major damage.

Conclusion

China has achieved breathtaking growth since opening up its economy and establishing a fairly good education system - real per capita prosperity has increased for many hundreds of millions of inhabitants to an extent never before seen in the world. The country has even managed to at least catch up technologically with the long-established industrialized countries. However, growth rates over the next 10 years will be significantly lower than we were used to in China. The main reason for this is the fact that the growth of the Chinese economy as a whole has been doped, particularly after the financial crisis, by the real estate sector, which has been stimulated by the state through the generous provision of loans - as was the case in Germany 30 years ago. The housing market in particular is facing a significant slump, which, given the importance of this sector, will probably even trigger a recession according to Rogoff / Yang (Aug. 2020, p. 36). Consumption is likely to suffer significantly as a result. Increasing foreign policy tensions will also have a negative impact on future economic growth due to high military spending and growing economic isolation.

However, the dangerous situation of the real estate market in China does not mean that the Chinese stock market is unattractive, because unlike the double bubble of real estate and stocks in Japan from 1990 onwards, the stock market is not overvalued. The government's intervention in the environment of some sectors such as the now dead-regulated tutoring providers, the real estate project developers in difficulties due to government-imposed debt ceilings or some online giants (Alibaba, Tencent) has put pressure on the stock market, but has also normalized valuations.

This means that the earnings expectation for the next 10 years is in the upper single-digit range (see Figures 15a-c).

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Moreover, the coming real estate crisis will not only have negative consequences for the country. Since the end of 1995, there has been an equity index for China (from MSCI) compiled according to international standards and associated fundamental data (profits, dividends, cash flows, etc.). In these 26 years, economic growth has reached around 12% p.a., which is higher than in any other industrialized country, but the stock market has only achieved a performance of 5.1% p.a., which is far less than the 8.6% p.a. of the global stock market.

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One of the reasons for this is the high level of investment activity, which has not only proved to be a gigantic waste of capital (empty ghost towns), but has also used up the excess liquidity of savers. This was then no longer available for share purchases. A decline in investment activity, particularly in the capital-intensive real estate sector, therefore helps share prices in the long term. In addition, the real estate crisis will necessitate state financial injections and interest rate cuts, as in every other ageing industrialized country. The economy has been growing at a slow pace for a long time, but share prices are constantly reaching new record highs.

An article in WirtschaftsWoche about the future of the stock markets by the then editor-in-chief Manfred Gburek already had the timeless headline around 35 years ago: "Long live the debt crisis". This now also applies to China (and its stock market, which has become more "industrialized country-like" in recent years, see Figure 16), which has thus joined the world of established nations.

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