Are disappointing economic news and increasing tension in the South China Sea connected?
A wave of unwelcome economic data from China has troubled investors in recent days. The data represent a reverse just a fortnight after June PMI data showed an uptick to 51.8 from 51.7 in May (for the Caixin General Manufacturing index), with factory output reaching a two year high and output prices rising for the first time in six months.
In news over the weekend, we heard that forty Chinese regional banks, suffering with bad loans from the bloated property sector, are to be folded into larger competitors. In all of 2023, ten such cases were reported.
The structural reorganisation of regional banking may be presented as a reform but it is in practice a necessity given the ongoing deflation of China's property bubble, weak levels of governance and undercapitalisation at smaller banks. The forty in question will probably become branches of larger institutions. The details are scant as yet, but if their non-performing loans are not written down (revalued) then the problem just moves up the chain and infects the larger banks.
Meanwhile, data from China's National Bureau of Statistics show that second-hand home prices in Beijing and Shanghai rose by 0.2% and 0.5% in June compared to May, their first month-on-month increase this year. But in 64 other cities the NBS collects data from, prices continued to fall.
As readers of our Markets Monthly know, China eased residential mortgage lending criteria in May, lowering the minimum deposit for first time buyers to 15% and 25% for second homes, while cutting the mortgage lending rate by 0.25%. The central government also issued debt to set up a $41 Bn facility for local governments to buy up unfinished and finished but unsold properties and rent them out. These policy decisions follow a raft of others reaching back to 2022, but they have all failed to stop the housing market from deflating, only slowing the process. The NBS says that money spent on new homes fell 25% year on year in H1 2024 to RMB 4.7 Tn (about USD 647 Bn) while investment in real estate in H1 this year was down 10% to RMB 5.3 Tn (about USD 730 Bn).
The property market continues to struggle for two main reasons. First, unemployment in the under 30s population remains too high, at more than 20%. The government stopped reporting unemployment among the under-25s for a while in 2023, but that did not make the problem go away. Young people struggle to earn enough to save for a deposit. Secondly, the demographics are against the developers. There are about 64 Mn fewer Chinese aged 2-32 compared to those aged 33 to 53. The number of first-time buyers is drying up. The central government can cut first time buyer deposits to zero if it likes (borrowing a previously tried policy of the last UK government) but if the first time buyers don't exist, the mortgage products will never be sold. And the challenge will grow: last year, there were 9.02 Mn live births in China but 11.1 Mn deaths. As the older generation dies off, there will be fewer young people to acquire their residences.
This is a challenge for President Xi's economic vision, which is that China should become less dependent on exports and more reliant on domestic consumption to drive economic growth. It's hard to grow domestic consumption if the number of young people joining the ranks of consumers by getting jobs, getting married, renting then buying homes, and buying things to put in them, is shrinking. China's services sector is doing better than manufacturing as ageing consumers buy more healthcare and leisure but fewer sofas and TVs. Retail sales grew at their slowest pace in Q2 this year since Q4 2022 when much of the country was in lockdown. Deflation continued for the fifth straight quarter, the longest slide since 1999 as the region recovered from the Asian Financial Crisis.
For now, China's foreign trade is holding up the economy. In H1 2024, exports rose 3.6% to 1.71 trillion while imports rose 2% to USD 1.27 trillion, with rising oil, coal, and iron ore prices contributing to that. Still, the pattern of trade is changing. Trade with Vietnam, Malaysia, and South Korea grew by 21%, 11%, and 4% respectively. Trade with the EU fell 3.7% to USD 382 billion. Exports to the US grew by 1.5% to USD 241 billion, while imports from the US fell 5% to USD 81 Bn.
The nature of China's exports is also changing. Mechanical and electronics exports grew by 5% in H1 this year compared to H1 last year. Integrated circuits exports went up 22% to USD 76 Bn. Textiles and footwear exports fell by 5%. Imports of "automated data processing equipment and parts" went up by 54% in H1. How much of that is re-exported to China's bearlike northerly neighbour which cannot directly buy such items?
Overall, China's GDP grew 4.7% in Q2 compared to a year earlier, underperforming expectations. China faces challenges to its international trade position. Trade wars are looming with the EU and the US, especially if Donald Trump wins the presidential election. In July last year, Mexico overtook China as the number one exporter to the US. Mexico does not have as deep a labour pool as China (despite all the economic migrants from further south), but it does have a trade deal with the US, the USMCA which replaced NAFTA in 2020, under the previous Trump administration. US retailers who stock Chinese goods are said to be building inventory now ahead of anticipated increases in tariffs, with the brought-forward demand contributing to a tripling of trans-Pacific container shipping rates in the last two months.
There are good news stories in the Chinese economy. Domestic EV sales rose 30% year on year in H1 2024 to 4.1 Mn, compared to a 10% rise in the US and Canada, a 1% rise in the EU+EFTA and a 26% rise in the Rest of the World. China's EV and hybrid sales are now over 50% of the monthly total. Chinese vehicle number plates are blue to show internal combustion engines and green to show electric power. Taxis and minibuses are overwhelmingly green plated in Beijing and other large cities. And yet overall new vehicle sales fell 6% in June.
China is over-producing and under-consuming many goods including steel, cars, photovoltaic cells, diesel, and of course housing. The government has announced many initiatives to shut down inefficient manufacturing and promote high-tech industries including AI, robotics, medical instruments, renewable energy machinery. Several reforms of the property market have been announced since Evergrande's collapse in 2021 and eventual bankruptcy last year.
This week, China's Communist Party leaders are meeting in their so-called Third Plenum to set the terms of the next five year plan. Chinese state media have been trailing economic reforms focused on "common prosperity" and a popular "sense of gain", with announcements on tax reform, advanced manufacturing, domestic consumption and support for private sector job creation all expected. Famously, back in the 1970s, Deng Xiaoping used a Third Plenum to announce the economic reforms which were the first step in the long march to economic superpower status. I doubt that this year’s Third Plenum can match that. It is more likely that the next Five Year Plan will provide the details of any further reforms.
The trouble is, Beijing announced major reforms on an increasingly frequent basis with few visible results. For instance, the National Development and Reform Commission, the polit-bureau level economic agreement team, announced in April that it would take steps to manage steel output. This is the fourth year it has done so and indeed steel output was 1.1% down year on year in H1 2024 at 531 Mn T, in data announced on 15 July. But this is still far too much. Steel rebar prices fell below RMB 3300 on the news, off from a RMB 5884 peak set in October 2021.
My hypothesis then is that, as China's political leadership ossifies as party cadres await orders from the very top, China's economy slows. State owned firms fall increasingly under political control; private firms cannot easily flourish. Manufacturers rely on exports to increasingly antagonistic trading partners.
The more China's economic control is centralised around President Xi, the more I have a sense that reform is not being enacted on the ground. For many Chinese this is not a major issue. They have jobs, homes, disposable income, medical care. For those old enough to remember the 20th century, living standards are almost unimaginably better. But for China's top politicians, this is a problem. Local vested interests, inertia or even fear of the regime and its anti-corruption purges could lead to officials reporting what they think their superiors want to hear. Private industry and entrepreneurial endeavour are in decline in China. At January's CPP convention, Premier Li Keqiang vowed to support both; little has been enacted since then to do so.
There is little evidence of widespread political dissatisfaction. Protests tend to be local and directed at local officials. In 2023, 61% of protests were labour related and 17% housing related, according to China Dissent Monitor, which notes a rise in protests from around 225 a month to over 300 a month in Q4 last year. In a country of 1.4 Bn people, that is a manageable total. Xi will remember the widespread Covid protests of 2022 and in the context of slower economic growth, he may look for themes to unite the nation under him.
Fortunately for Xi, the US Presidential election could hand him a nation-unifying challenge. Zhang Jiadong, a researcher at Fudan University’s Centre for American studies, told the South China Morning Post that a Trump presidency would make "countering China" militarily a foreign policy priority. This month the US Republican Party has been discussing revoking China’s “most favoured nation” trading status.
If China is to achieve its aims in the South China Sea, including reunifying Taiwan and controlling the ocean within the nine-dash line, should Xi not take his chance while President Biden is trapped in party infighting over his cognitive decline, and before the less predictable and more hawkish Donald Trump takes over?
China may be testing this theory out in its interactions with the Philippines. Bilateral tensions are rising, as our Macro Macchiato and follow up from last week reported. In June, the US ambassador to the Philippines, MaryKay Carlson, warned that “the chorus against threats to peace and stability in the South China Sea is growing louder and stronger each day” and called for freedom of navigation in the South China Sea for all ships. The US is bound by a 1951 treaty to protect the Philippines.
After recent clashes between their coastguards, Chinese and Filipino officials met in Manila to discuss the situation, with no resolution other than to continue the dialogue. But at the same time the Chinese have announced that they consider the Sabina Shoal, aka Escoda Shoal, part of their territory. The shoal is 75 miles west of Palawan, the most westerly island of the Philippines and within the Filipino exclusive economic zone. China has sent its navy to the shoal and says that its actions are in accord with domestic and international law.
Just today, 15th July, the Philippine Former Supreme Court Judge Antonio Carpo said that Manila and Hanoi should combine in an arbitration case against China’s unilaterally imposed control of the Scarborough Shoal. His remarks related to fishing rights but their significance is in tying Vietnam and the Philippines more closely together. China’s neighbours cannot hope to counter China individually but ASEAN has taken a doveish approach to relations via dialogue and standing committees on the equitable division of the South China Sea’s resources, rather than insisting on where borders lie.
It suits China’s interests to achieve what it can before November’s US election, but I doubt this will amount to more than further sabre rattling and stern official pronouncements aimed as much at China’s domestic audience as at China’s international interlocutors. Nonetheless, as China’s economy struggles to find a gear, it looks inevitable that Xi will play the nationalist card.
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