China Q&A: Top 5 Questions

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, 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