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February 8, 2024



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Macro Research Bites #5: the Hang Seng Index (HSI) & Chinese Real Estate

China's equity and real estate market is in crisis. Evergrande, previously the most valuable real estate company in the world, is facing bankruptcy, and the Hang Seng Index is down over 50% since 2018. We explore parallels between China's downturn and the implosion of the Japanese asset bubble in 1989, and offer a hypothesis for what's next.

What’s going on in China?

The Hang Seng Index (HSI) is collapsing. Down over 50% since its peak in 2018 and 27% year over year, the benchmark Hong Kong stock index, widely used as a proxy for Chinese markets, is now approaching levels not seen since the 2008 financial crisis.

Other measures of Chinese market sentiment are crumbling, too. The CSI 300, which tracks the top 300 stocks on the Shanghai and Shenzhen Exchanges, is down over 18% YoY and 15% in the last six months.

Overall, not great. But public opinion is split on what this means for the country. At face value, markets are in turmoil, the Real Estate sector is collapsing, and the country faces a looming demographic crisis. There is evidence to suggest this may be a tipping point for Chinese markets, analogous to Japan’s decades-long turn for the worse in the early 90s after a period of credit-driven market euphoria.

Others see a less dire outlook. This isn’t the first time China sees a downturn, and the inflated Real Estate markets are in dire need of a controlled deleveraging. Evolving news suggests the government may step in to stem potential contagion across the economy. It’s possible we’ve already seen the worst and markets have overreacted.

So how did we get here?

A quick primer on Japan’s bubble

It’s worth briefly reviewing Japan’s boom and bust for clues on how things may play out. In the 1980s, Japan was the envy of the world. Assets prices defied gravity year after year.

Much of this growth was fueled by unsustainable growth in real estate values. To give readers a sense for how crazy things got:

- Land prices in Japan increased 5,000% from 1956-1986, despite consumer prices only doubling over the same period.

- By 1990 the Japanese real estate market was valued at 4x the value of the entire U.S. RE market, despite having a 25x smaller landmass and 200M fewer people.

- The grounds of the Imperial Palace were estimated to be worth more than the entire RE value of California or Canada at market peak.

- In 1989 the P/E ratio on the Nikkei was 60x trailing 12 month earnings.

Japan peaked as the world’s second largest economy with over 18% of global GDP. For comparison, the US today is about 25% of global GDP.

In 1989, things fell apart. After 10 years of explosive growth, the highly leveraged bubble unwound as millions of people lost their life savings. Many investors in the west, betting on Japan’s role as a tech leader into the next century, were badly burned as the country descended into a decades-long recession, or “lost decades.”

The debt to GDP ratio ballooned (263% today), growth slowed (around 1.5% today), and the population aged (over 29% of the population is over age 65). Thirty years later, and the Nikkei has finally recovered its 1990s level. But widespread belief in Japan as a fast-paced innovator is a distant memory.

The Chinese miracle

Let’s return to China. Following Deng Xiaoping’s economic reforms and opening to the west beginning in the late 1970s, China experienced miraculous growth for nearly 30 years. Over 600m people were lifted from rural poverty, moving in droves to rapidly expanding Chinese cities and lifting the country’s industrial output.

In the wake of the 2008 economic crisis, two things happened. First, Chinese growth slowed, dragged by the global financial decline and an already maturing local economy. Second, steep urban housing costs, limited supply, and relatively sluggish activity in other economic sectors focused Chinese policy on scaling housing.

And scale they did. By 2014, China had added 100 billion square feet of floor space, with an average of 5m new apartments built annually. Nearly 30m people (16% of total city employment) worked in home construction at peak.

This real estate boom only drove home prices higher. The growth in land buying, building, and investment fueled a speculative frenzy in the Chinese market, driving home ownership rates in China to the highest in the world. 80% of Chinese households own a home, and 20% own more than one home – even if they don’t live in it. Even millennials own real estate (!); 70% of them are homeowners vs only 35% of their US counterparts. Chinese consumers frequently invest up to 80% of their wealth in real estate.

To fuel this demand, many large real estate development companies sprung up, including now-defunct developer Evergrande. The cumulative value of these companies and related assets over the last decade went parabolic, eventually making them the largest real estate companies in the world. Chinese real estate and infrastructure represent a whopping 32% of the country’s total GDP, compared to around 20% for most G7 nations.

Government intervention in real estate

One of the crucial differences between the housing market in China and the West is the degree of involvement by the state in orchestrating its mechanics. The top six Chinese home sellers in 2023, for instance, were all state-owned or state-backed developers.

Following the 2008 crisis’ drag on the market, policymakers lowered both mortgage interest rates and downpayment requirements for buyers. The market rebounded as a result. Seven years later, seeing another slump in prices, the government once again substantially readjusted interest rate and downpayment requirements. Home prices surged in major cities and stabilised in lower tier ones.

Local and provincial governments also play a role in supporting — and crucially, develop a dependence — on the sector. First, they sell land to developers, a major source of income. Property taxes are then levied on the buildings erected on this land, contributing more income for local governments. As a result, up to 40% of annual government revenue in certain provinces is a direct result of land sales and property taxes. Understandably, these governments have every incentive to prop up both demand for land and home prices.

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The great unwind

After 20 years of parabolic, often credit- and policy-driven growth in Chinese real estate, things are beginning to unwind. Some say an early sign of the market downturn was the report of ghost cities — seemingly infinite stretches of high-rise apartment buildings, built for an expected influx of new residents of mid tier Chinese cities – all ultimately abandoned and never occupied. Such reports were the canary in the coal mine.

Click here to watch a short video on the demolition of one of these cities.

This early sign of oversupply and overgrowth in the market has burst into markets more broadly. In the last weeks, things have come to a head as Evergrande, the nation’s second largest real estate developer, was forced into liquidation on January 29th, 2024. The company has lost over 99% of its share price in the last four years, with the most recent cataclysmic event its debt default in late 2021.

And Evergrande isn’t the only part of the real estate market facing troubles. This follows on the heels of what was once the nation’s largest non-state owned developer, Country Garden, narrowly skirting default at the end of 2023 when investors agreed at a meeting with Shenzhen Stock Exchange to forego a put option on the company expiring Dec. 13th. Property values as a whole have plummeted nationwide, and new property starts and sales have struggled since topping in 2021.

Source: Haver Analytics, Goldman Sachs Global Investment Research

Now, many fear this shock to the real estate market may spill over into the rest of the Chinese economy. China is already experiencing deflation – usually a sign of economic woes – much in contrast to the inflation plaguing western economies. As mentioned at the start, the Hang Seng Index is down nearly 30% YoY on generalized Chinese economic fears.

What does this rapid deleveraging means for the future of the Chinese real estate market and economy as a whole? We have a few hypotheses.

China lost decade(s) incoming?

While the west remains focused on fighting inflation, China is more worried about entering a deflationary spiral à la 1990s Japan, which popped its real estate bubble in 1989 and sent the economy into deflationary collapse for decades. The decline of Evergrande and China’s equity and real estate markets have led some to speculate China too may go the way of Japan.

Declining Chinese consumer confidence: down tremendous

First, the similarities. Japan and China's economic growth stories share striking resemblances, particularly in the magnitude and impact of their rapid expansions. Both nations achieved impressive GDP growth rates during their high-growth periods — Japan seeing rates often exceeding 10% in the 1960s, and China averaging around 9-10% annually from the late 1970s into the early 21st century. These sustained periods of growth propelled both countries to become the world's second-largest economies in their respective eras with significant influence on global trade and manufacturing. Both shared a model of leveraging state policy to spur industrial and technological growth.

But this is where the comparisons end. China's economic ascent, unlike Japan's, has been characterized by its unprecedented scale and duration, affecting the global economy on a much larger scale. Much of the later-stage boom in Japan was paper wealth driven by unrealised gains from real estate and stock market investments when corporate operating profits were actually falling. With a population over ten times that of Japan, China's transformation has lifted hundreds of millions out of poverty, a feat unmatched in human history. Its integration into the global economy has made it a vital link in global supply chains, significantly more so than Japan ever was.

Unlike Japan's earlier reliance on exports, China has focused on developing its now-enormous domestic market and integrating itself into the global economy through trade and investment. China's broader impact is visible not just in economic metrics but with strategic projects like the Belt and Road Initiative, a scale of ambition that Japan's economic policies never reached.

China’s bubble was also nowhere near the scale of Japan’s. Today, the HSI is trading at a P/E of 10x, previously peaking at a high of 24x. The Nikkei, by contrast, peaked at a P/E of 60x. The yen appreciated around 45% against the dollar from 1985 to 1990. Meanwhile in China, the yuan has depreciated 10% against the dollar during the past five years.

This year’s rapid deleveraging may in fact be welcome for China’s long-term growth. It’s only natural that China’s growth stabilise as it catches up to and surpasses most of the world. Xi Jinping has himself reiterated his desire to focus on “high quality growth.” Clues into the CCP’s next approach to the crisis will be revealed in the Two Sessions, the country’s annual parliamentary meetings, which begin next month on March 5th.

So what’s next? Despite these differences, China does face a real risk of Japanifying, albeit for different reasons than those that drove Japan’s decline. Since the mid-2010s, China has witnessed a significant shift towards greater centralization of power and increased state intervention in economic affairs, marking a contrast to the more market-oriented reforms and liberalization trends of the previous decade. This shift has been characterized by actions aimed at strengthening the role of the state in the economy, tightening control over various sectors, and enhancing the CCP’s influence across the board. Examples include:

- Crackdowns on tech, particularly in the edtech sector

- Power centralization under Xi, including the abolition of term limits in 2018

- Expansion of digital currency and government-controlled electronic payments

- Enhanced scrutiny and control over foreign investments

- Promotion of state-owned enterprises (SOEs) as “national champions”

Much of China’s real estate bubble, declining foreign investment, and certainly its impending demographic issues can be directly attributed to state meddling.

In our view (NFA!), excess focus on short-term Chinese central bank policy is misguided. While rate cuts may help temporarily alleviate the decline in asset prices, the more important question of whether China continues its parabolic growth or follows in Japan’s footsteps is largely a function of core economic drivers like demographics and economic policy. We like short term stimmy, too, but there are more important factors at play.

The Japanification of China will hinge on whether it continues down its current path. Its pivot towards increased state meddling in market affairs need to be thoroughly re-examined if it wants to pursue Xi’s stated goal of “high quality growth.”

To conclude, we don’t think China becomes Japan, but whether it becomes the ‘old’ China again depends on how seriously they shift away from excess economic intervention in the next years. Our view is China ends up in an extended period of slower growth and manages to steer through deflationary threats – but we don’t expect China to boom like before. That mantle will need to find a new home. Maybe India?

Listing HSI on Ostium

P.S. Finally, we’re thrilled to announce that Ostium will be the first DEX to support trading of the HSI/HKD pair. We’ll be live on testnet this month, with more news shortly. Register for our waitlist, follow and join our Discord for priority access!

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