‘I’ve been a long-term bear over the past several years on the China real estate sector and it has hugely underperformed. Investors are now fretting that the housing/fixed investment/leverage perpetual motion machine can’t be sustained much longer – property developers in China offer bond yields in the 7-10% range (despite wide dispersion in fundamentals – not all are pursuing the Evergrande shell game by diversifying into with EVs etc.).China’s housing market has proved remarkably impervious to endless policy tweaks meant to slow it down – home prices across the 70 major cities rose 4.8% in April y/y, the fastest monthly pace since last September which puts the pressure on the government to impose even more draconian measures as housing affordability is a very tangible and embarrassing manifestation of extreme inequality hanging over the Communist Party’s centenary this year. Ironically, it’s exacerbating the looming demographic implosion which may be the one force that can finally end the ‘concrete deposit box’ mentality. Indeed, housing costs on most social surveys are a key factor in the plummeting fertility rate… ‘ – ‘China Goes Childless…‘ Weekly Insight, May 21st 2021
Mark Zuckerberg’s cringeworthy 4th July stunt holding an American flag while hovering over a lake on an electric surfboard looked an act of hubris after Facebook won its FTC antitrust case and would never have been attempted by his jittery mainland peers. There are broad parallels between the Biden Administration’s latest attempt to limit corporate concentration (as a factor in rising inequality/suppressing wage growth) in tech and China’s assault on its tech giants. The unconstrained agglomeration of data analytics and hence market share ultimately undermines growth and competitiveness. The difference is in the exercise of power, which as with the pandemic response last year is far more decisive – the US is debating regulation within an updated anti-trust framework for the network effect digital platform era (i.e. that looks beyond a very crude consumer welfare calculation), China is implementing one at breakneck speed. Monopolistic rent seeking and regulatory capture have become a global economic phenomenon far beyond tech, but it’s hard to see any other country being able to tackle the now widely accepted negative economic and social externalities as decisively. The investor pain of this realignment of political versus corporate power is being front loaded in mainland names, but will be protracted in the US and Europe…
There is a pressing global need to rebalance power between state, network effect tech platforms that defy conventional consumer welfare based anti-trust analysis and consumers whose behavioural data is the ‘product’. China has hugely lagged even inadequate Western regulatory and anti-competitive laws and institutions – the legal framework is only now being built and anti-trust sanctions have extended far beyond tech e.g. logistics and concrete companies have all come under scrutiny/been fined for price fixing. There has been popular discontent with price discrimination practices, working conditions and with merchants being forced to pay for online traffic and their products copied by a generic version if successful. With the top-down policy focus now on the enterprise/industrial software space to leverage the 5G rollout and boost productivity, the fact that so much consumer data is siloed off in closed ecosystems is detrimental, while the sheer dominance of a handful of companies has slowed the number of new Chinese start-ups; any that show promise are swiftly crushed or acquired, similar to chaebol dominance in S. Korea or FAANG+ in the US.
There is a level of long-term policy coherence that many foreign investors are overlooking. Firstly, as it achieved in 5G, China is aiming to set global standards in platform regulation and anti-trust enforcement. Secondly, there is a ‘crowding out’ aspect – the policy focus for economic development is now on hardware (particularly semis) and enterprise software innovation, not incremental value extraction in consumer platforms. Reducing the attraction of the latter is therefore partly about shifting the incentive framework for Tencent, Alibaba etc., but they remain crucial to Beijing’s global value chain/digital currency ambitions and there will be closure on the regulatory deluge over the next 3-6 months (and a relative mean reversion trade versus US peers). The country has vertically integrated cleantech supply chains over the past decade to become a global leader in alternative energy (from lithium and cobalt to advanced batteries in EVs, polysilicon to PV modules in solar, rare earth metals for magnets to finished wind turbines etc.) and it would be dangerously complacent to underestimate its leapfrog potential, from quantum communications to RISC-V open source architecture and next generation compound semiconductors. It has used FDI and technology transfer to accumulate strategic process knowledge and then build indigenous national champions in one sector after another, although leading edge chip fabrication has unique bottlenecks via EUV lithography.
Demographics are the clearly the main driver for the demolition of the online education sector, and China’s ominous population trajectory was highlighted back in that may note (including the highly suspect official fertility rate), and the focus in the latest five-year plan is less on GDP than population growth. There is now a degree of official panic about falling birth rates and a determination to make child rearing more affordable. Once the first regulations came out about limiting tutoring hours, it was a clear warning about the direction of travel. I ran a China education thematic stock basket in 2019, but closed it on regulatory tail risks, which even then were growing after repeated official warnings. Every shopping mall I’ve ever visited in China has an upper floor dedicated to Western sounding tutoring outfits, from kindergarten math schools to cramming exhausted teenagers for the brutal university entrance exams. With about 80% of children ages 6-18 enrolled in some form of extracurricular academic tutoring, those malls will now face empty units. Indeed, they were often the busiest floors, particularly at weekends and in the evenings, but perhaps world leading levels of childhood myopia might improve with more time spend outdoors.
Beijing has decided that allowing households to follow the Korean model and end up spending 12-14% of disposable income on private education services was socially regressive, as well as exacerbating the fertility implosion covered earlier in the year given the soaring expense of rearing a child. The $120-150bn revenue sector will likely see revenues shrink 60-70% with massive lay-offs, not least among foreign tutors who have been singled out as unwelcome. Again, the US faces similar issues with private education costs running out of control and creating economic distortions (including delaying household formation), albeit the problem is more at college level where fees and housing are now $75-100k annually and student debt has topped $2trn. Cheaper housing via Singapore style HDB blocks or developer build to rent schemes is another policy priority to boost cut child rearing costs rather than speculative ‘concrete deposit boxes left empty in their millions. That backdrop is important to the latest duration mismatch/margin call panic on Evergrande’s ~$90bn debt pile; we’ve already seen a sharp slowdown in the real estate market in Q2, from bank funding to floorspace sold and started.
The big question is whether it has made itself too big to fail – real estate investment across the whole supply chain is 25% plus of Chinese GDP while real estate loans also make up around 28% of outstanding bank loans. Recently, China’s financial regulator instructed banks to conduct a stress test around an Evergrande failure so the endgame to this saga should finally be getting close. We will soon discover whether Beijing is willing to let it implode as a cautionary tale to the rest of the sector and a means to end moral hazard. A liquidation process that is more or less orderly would ultimately be a net positive for credit risk pricing on mainland capital markets. The implication of recent events is that China is now on a very decisive policy path to reduce inequality, boost CCP legitimacy and underpin technological decoupling from the US and hence the geopolitical challenge to it across wider Asia.