Get ready for rough weather in China and the world — that’s my takeaway from a chat with Joyce Chang of J.P. Morgan

You know that China’s place in the world has truly changed when the Global Head of Research for J.P. Morgan talks about the Communist Party’s “principle contradiction” when she tells you about China’s economic prospects.

Joyce Chang has more than three decades of experience at investment banks. I chatted to her by phone on May 13. This is an edited, abridged transcript of our conversation, part of my Invited to Tea interview series.

—Jeremy Goldkorn

It’s really quite remarkable, the negativity I’m hearing out of Shanghai and other parts of China, from business people and investors, people that I’ve never heard speak in such terms.

What’s your macro outlook for China’s economy with the spread of Omicron and under the strict lockdowns?

The escalation of the COVID zero policy, including partial, and full lockdowns in a number of cities has led to disruptions in economic activities that are the most significant we’ve seen since March 2020 at the onset of the pandemic. If you look at the high frequency data for the second quarter, we’re actually looking at GDP that’s tracking a contraction quarter on quarter of one and a half percent.

There’s a number of indicators that we’re looking at. The lockdowns are now affecting the mobility that is equivalent to about 25% of GDP. Taking a look at some of the high frequency numbers, we’ve seen retail sales down as much as 26% in some parts of China. So we do think that this is more severe than our earlier forecasts. We are really looking at the continuation of some of the supply chain disruptions, and I think that will continue to have reverberations beyond China.

We have actually taken down the full year China forecasts to 4.3% GDP growth. That is more than one full percentage point below the official government target of five and a half percent. And if you look at just the history of China’s growth over the last decades, it is only the second time that we think the government will miss its official targets. The last time being 2020, the year that the pandemic broke out. So this is a fairly serious slowdown.

We also took our Hong Kong forecast for the full year down to a small contraction of the Hong Kong economy.

That’s grim enough. So add to it the Russian invasion of Ukraine and fears of secondary sanctions. Can you talk a little bit about the effects you’re seeing of that?

We have seen significant portfolio outflows from China since Russia’s invasion of Ukraine. They’ve been very sizable because China had received record inflows from foreign investors in 2020 and 2021 into Chinese government bonds when they entered into the benchmark bond indices. During 2020, China received a record $576 billion portfolio flows from foreign investors. We’ve seen outflows over the last two months of more than $30 billion from China bonds. And that is a real reversal of the trend that we saw over the last two years.

$30 billion?

Yes. We’ve also seen, with the sell-off in the equity market, about $10 billion of outflows from equities. Since COVID-19, China had been one of the outliers getting consistent capital inflows from investors who were looking at the yield differential to U.S. Treasuries, with China going into the mainstream indexes, and China’s growth being better than many of the other countries with the 8% growth that they had last year and the only country with positive growth in 2020.

There’s also the threat of secondary sanctions that is weighing on investor sentiment although there are so far no signs that China is helping Russia to evade the sanctions. But it’s made a lot of people rethink whether they are comfortable increasing investment allocations to China. So we are actually seeing significant outflows in the last two months.

And then there’s a third thing in the mix: The government’s “common prosperity” slogan and campaign. I don’t think we’re 100% sure what that means exactly but it seems to mean the government is going to emphasize a fairer distribution of wealth more than it will allow some of the most profitable companies to continue making enormous profits.

And there are possibly related moves against big technology companies and the real estate industry.

The common prosperity agenda has really been in the works since 2017. It was actually the 19th Congress of the Chinese Communist Party in 2017 that was, I think, a watershed moment for China.

The media, the markets’ attention was largely focused on the change in the leadership transition scheme. But the notion of “principal contradiction,” which is central to how the Party sees the economy, politics, and society was raised at that meeting. The “principal contradiction” was defined as the tension between “unbalanced and inadequate development” and the “peoples’ ever-growing need for a better life.”

The “principal contradiction” is a tension between what the Chinese Communist Party saw as unbalanced and inadequate development, and people’s ever-growing need for a better life.

So this to us, foretold a long road of tightening. It was basically radically altering the way that the Party characterizes China. It’s no longer a low-income economy, challenged by the need to generate millions of jobs to maintain social stability. It’s a rising middle-income nation, aspiring for a better quality of life.

And all of this has implications for the longer term macro outlook. It has implications for the growth trajectory going forward. We have growth at 4.3% this year, but we’ve taken down potential growth quite significantly. We have potential growth going down to a three handle in the 2030s. And that’s largely because of the demographics.

Common prosperity has prompted a number of regulatory changes. It was in 2017 that Xi talked about housing being “for living, not for speculation.” They no longer wanted to use housing or the property market as a counter-cyclical policy instrument.

And you’ve also seen just the regulatory tightening that has come into sectors where they feel that perhaps the growth was too high, too uneven. This is impacting the tech sector and we also saw the alterations to education policy. All of this was foretold to some extent by the priorities set in the 19th Party Congress.

Even though there’s a lot of downside risk to growth, I think that these policies on the regulatory side are unlikely to be reversed. There could be some easing of macro policies, but I think it’s a longer term framework that China’s putting into place.

How gloomy does this make people in the financial world?

Russia’s war on Ukraine has been a catalyst for tail risks becoming reality. There are many factors beyond common prosperity driving investor sentiment toward China, with attention now on the U.S. focus on “friend-shoring” and “worker-centered trade,” and its desire to align economic trade and investment objectives with geopolitical alliances.

I think that the U.S.-China strategic relationship is the key relationship that will really define the global economy going forward. If you look at the last couple of years, the trade between the U.S. and China has actually been very strong. Looking at the supply chain concerns, I would really divide this into two and separate the manufacturing supply chain from deep tech.

I think that the U.S. realizes that in the manufacturing supply chain, they really can’t change the model. That model has been in place for a long period of time where China really took over that engine and many of the exports are not strategic in nature. The focus is on critical infrastructure on the tech side to ensure U.S. competitiveness in AI, semiconductors, life sciences, aerospace, etc.

Almost like separate two economies?

I think the question really is, can you separate the two? When you talk to a lot of the companies that operate on the manufacturing, the consumer side, they haven’t been impacted that much. But the threat of secondary sanctions [from the sanctions on Russia], if it were to materialize, is a new risk factor.

And there are bills in the U.S. Congress under discussion related to competition with China that are targeting the security of the U.S. supply chain. There are some components of the bills related to approvals of outward bound investment to China, if passed as drafted, that really could negatively impact investor sentiment.

Can we talk about the outlook for the property and housing market, which is obviously related to everything we’ve just been discussing, but has its own unique features. Is the general slowdown going to stall deleveraging, and what’s your sense of housing policy? What’s coming down the pipe?

I do still look at the housing market in the property sector as really the biggest near-term macro risk for China to manage. So maybe I can just start by going through some of the numbers so that everybody has an idea of just the importance of the housing and the property market in the China economy. In 2021, China’s property sector contributed 14% of GDP (including both construction and real estate services), real estate investment accounted for 20% of total Fixed Asset Investment, and land sale revenue represented 27% of total local government funding. Around 40% of total bank loans are property related. And that includes 6% in loans to real estate developers, 20% to 25% in mortgage loans, new construction loans…

Sorry to interrupt Joyce. The mortgage loans, does that refer specifically to consumer mortgage loans?

Also housing mortgage loans and remember that housing is still the most important asset in household wealth. It accounts for nearly 60% of household assets. That’s compared to 30% in the United States.

So a housing price collapse would create a much bigger social political problem than a housing price spike.

Housing prices are still seen as a proxy for wealth, particularly as home ownership is relatively high. Housing wealth has long been considered a cushion that supplements a weak social security system in China. If you take a look at this from a macro perspective, our economists estimate that a one percentage point decline in housing prices tends to drag down household consumption by about 0.2 percentage points.

And China has experienced historical episodes of housing tightening over the last 15 years. You actually had a peak for housing demand around 2017. Some of the demand is falling partly because the demographics are shifting as well. China is seeing lower birth rates, the decline in new marriages, slowing urbanization, the end of some of the financial subsidies that were provided to increase home ownership.

And there has been more of a crackdown on speculative housing transactions. But property remains a very big component of the overall economy at the equivalent of 15% to 20% of GDP. So, it’s a very fine line that China has to balance in managing the China property market sell-off so that it does not spread into the housing market, given the implications for household wealth.

And how does this problem show up in financial markets?

Big implications: China’s real estate sector makes up about 25% of the overall China bond stock outstanding. If you look at what happened with valuations with credit spreads, they went in excess of 3000 basis points pricing in a 50% default rate. So I think that you’ve had a lot of fear that was driving that market last year.

How is the government going to handle this?

Do they have the capacity to handle this? Yes — I do think that China can handle a property market downturn. They had started really tightening policies before last year’s property market sell-off, starting back in the fourth quarter of 2020, because the housing market rebound after COVID played a very important role in China’s post-pandemic recovery. Real estate investment really leads the Fixed Asset Investment recovery.

But that also triggered a new wave of housing tightening that the government started putting into place at the end of 2020. The “three red lines” that the government gave the real estate industry limit the liability asset ratio, the net gearing, the cash coverage of short-term debt. And there is also the two red lines, the ceilings on the property exposure and the mortgage limit exposure to contain bank exposure in the property sector.

The rapid deterioration of Evergrande, which is the largest and the most indebted property developer in China, raised concerns about the overall outlook for the real estate sector. It has total liabilities of $300 billion. The market has focused on the industry-wide problems that have resulted from the high debt growth model.

I do think that the policymakers have the levers to contain this risk, but it is just one of the confluence of factors that we’re watching in China now: Omicron, the slowdown, the U.S.-China relationship, the discussion on sanctions, and also the property sector. So I think the government, what they have done is that they’ve tried to fine-tune the housing policy.

What are they doing?

Last November they stepped up fiscal and monetary easing to stabilize growth. And they continue to do more fine-tuning to strike the right balance in the housing market. Some cities have started to ease local policies regarding mortgage rates and some of the home purchase restrictions that had been put into place. But we’re seeing wide variation, and the relaxation of city-level housing policy has been pretty modest. And I think there’s more scope for policy action. For example, the government can also use fiscal and monetary resources to boost the development of affordable rental housing because that’s a big problem in China as well.

Questions remain on whether the funding stress for developers will continue to persist. We upwardly adjust our 2022 Asia default forecast to $35 billion (or 10% default rate) from our original forecast of $25 billion (7% rebased to year end 2021). This accounts for recent developments, in particular some large cap developers, and we now expect 29 defaults (including distressed exchanges). This would still be lower than the $49 billion (13% default rate) recorded in 2021, even though the number of defaults would be higher than last year’s tally at 26.

Our default forecast is highly concentrated in the China property sector where we expect $32 billion of defaults or 31% default rate. Including last year’s casualties, that implies half of China HY property bonds will have defaulted by year-end 2022.

That sounds very scary. Joyce, can I ask a dumb question? Who holds most of this debt?

Asian bonds are largely held by regional investors, meaning local investors in the Asia region. So this has not been a global systemic problem or a Lehman-like moment.The fears last fall of a systemic threat were really overblown but this has serious implications for China’s bond market at a point where there are other stresses impacting the overall macro outlook.

Invited to Tea with Jeremy Goldkorn is a weekly interview series. Previously: 

Exactly how pessimistic are you about the Chinese economy? — Q&A with Anne Stevenson-Yang