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Expert Insights: Keep an Eye on China and the US

Expert Insights: Keep an Eye on China and the US

Evergrande Group is the second-largest real estate developer in China, and the company has debts of USD89bn (AUD122bn). The German financial market watchdog Deutsche Markt Screening Agentur (DMSA) issued a press release on 10 November 2021 advising an interest payment default by China Evergrande Group to international investors and preparations for bankruptcy proceedings.

Evergrande’s financial problems have been known for years, but it was not expected to default on international debts − which may taint China’s economic reputation. Instead, investors and market participants hoped the Chinese government would step in. Market commentary held that there would be a risk of panic sales of Chinese stocks and bonds without the government’s support − much like before the 1997 Asian financial crisis.

Evergrande’s CEO made the USD148m interest payment before the market closed and the company narrowly escaped bankruptcy. It is reported the cash came from a China Construction Bank loan and was collateralised by the CEO’s Hong Kong dwelling and the selling of two private jets.

Another interest payment of USD255m is due on 28 December, which has to be paid by 27 January 2022. But there is no clarity on how the company or the CEO can meet this payment. So following on, there is still a total of USD8bn in interest and principal payments to be made in 2022.

The Chinese real estate sector accounts for 30% of the country’s GDP. However, the boom in China’s real estate sector has materialised in a predicted 30 million residential units remaining unsold and a further 100 million having been sold but remaining unoccupied. And Evergrande is a part of this troubled sector.

The issue seems to be finding demand, with the excess units designed to house 340 million people valued at around USD26trn. As a result, widespread bankruptcy among speculative investors and in China’s real estate sector is expected. The world is still paying for the subprime mortgage crisis of 2008, which caused a global recession that involved debt of around USD10.5trn, with the world’s GDP growth dipping to -1.3% in 2009. Should a real estate debt crisis of such magnitude happen in China, the world economy would be severely affected.

From China to the United States

The trouble is no less severe, but it is not from an overheated real estate sector but inflation. In October, the US inflation rate was 6.2%, the highest since 1990. Moreover, inflation in the United States has been rising rapidly since the beginning of the year, with the average annual inflation rate for 2021 currently at 4.8%. This is a problem because it puts the US economy in a negative interest rate position. This means savers will save less while borrowers will borrow more, which can further propel inflation and thus discourage investment.

The message coming from US policymakers is that high inflation is temporary. Their position is that the current rate is a function of pent-up demand from COVID-19 affected economies, which created global supply chain disruptions. Further comments suggest the Fed will wait until its 25-26 January 2022 meeting before making any moves.

That said, in our view, higher inflation is not temporary and we will likely move into a cycle of higher inflation for years to come. Across the globe, consumers have yet to see real inflation, as producers and wholesalers are still absorbing the rising cost of goods.
For example, wholesale inflation in Japan rose by 8% in October, but consumer inflation was less than 1%. On the other hand, the producer price index rose by 13.5% in China, yet the consumer price index increased by 1.5% in October.

Producers and wholesalers will pass on the higher cost of goods to consumers when the vicious cycle of inflation begins. Higher-priced goods, particularly staples, trigger demand for higher wages. This, in turn raises the costs of production. It is termed a ‘wage-price spiral’. Central banks will have no choice but to deal with these wage-price spirals. To stop this, demand needs to be pushed down, which is done by raising interest rates.

But let’s not panic, as this might not happen. Being a non-market economy, China may manage its real estate debt. And US policymakers may be right − supply chain disruptions will be sorted out, and global inflation may be temporary.

So, the smart move, for now, is to keep an eye on China and the US.

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