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The fall of the Celestial Empire. For the first time in 30 years, China's economy is on the verge of recession

As the eurozone is fighting record-high inflation and the U.S. is trying to decide whether it should be sad about the technical recession or happy about the rising labor market, China's economy is teetering on the edge of recession, showing its worst performance in 30 years and dragging the rest of Asia down with it. The aftermath of the lockdown has added to an ongoing downturn in the construction industry, and the desire to outperform the U.S. by all means could drive the PRC into more debt.

  • Epidemic vs. economy

  • Construction crisis is dragging economy down

  • Borrowed growth

  • Beat the U.S. at all costs

  • Implications for Asia

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Epidemic vs. economy

China's economy grew by a mere 0.4% per annum in the second quarter, and analysts suspect that even these modest figures were faked by the authorities in an attempt to disguise the crisis. In early March, the authorities set their lowest GDP growth target since 1991 at just 5.5 percent for 2022. But even that target now seems elusive. From April through June, China's GDP already shrunk 2.6% compared to the first quarter. If the shrinkage of the economy continues (which largely depends on the poorly predictable epidemiological situation), that is, if GDP keeps declining for two quarters in a row, the country will follow the U.S. experience and find itself in a technical recession. The International Monetary Fund (IMF) has already lowered its forecast of China's 2022 GDP growth to 3.3%.

The main reason for China's problems is the actions of the authorities - namely the so-called Zero COVID-19 policy, which involves shutting down whole industries, securing complete self-isolation of citizens and effectively bringing the life of entire cities to a standstill. For the Communist Party, it's a matter of principle. The country's leader Xi Jinping is preparing to run for a third term in the fall, and although lockdown is an unpopular measure, he does not want to risk the epidemic spiraling out of control. Because of the underdeveloped health care system, which may collapse from the influx of patients and cause more public discontent, the authorities continue to adhere to strict preventive measures.

In March, due to the Omicron outbreak large-scale lockdowns brought life in several industrial centers to a halt. The most acute problem for both the Chinese and the global economy was the two-month shutdown of the multimillion-dollar Shanghai, the center of international trade and business inside the country. Shanghai, among other things, is the world's largest container port, and the quarantine brought about more disruptions in supply chains. As a result, the city's GDP fell 13.7% year on year in the second quarter, and China's retail sales and industrial production fell in April to their lowest values since the start of the pandemic. Meanwhile, the unemployment rate rose 6.1%, reaching a two-year high.

Even though Shanghai “opened” in early June, further lockdowns in the country cannot be ruled out, especially given the World Health Organization's (WHO) pessimistic forecasts on the spread of the virus for the fall and winter. Already, COVID-19 infection rates are on the rise in many countries around the world. On the European continent, the number of new cases has tripled over the past month and a half, and the number of hospitalizations has doubled.

Construction crisis is dragging economy down

Another headache for the Chinese authorities is the worsening crisis in the real estate market. Developers in China in recent years have fallen into debt and cannot cope with payments for labor and materials in housing construction, as a result of which construction gets severely delayed. As a consequence, the number of buyers refusing to pay mortgages for apartments in unfinished houses is growing. To date, customers have ceased to pay for at least 319 projects in 93 cities – it's the first time the country faces such boycotts by citizens.

The funds of mortgagees and banks are the most important source of liquidity for developers. About 90% of new real estate projects in China are prepaid. According to the investment and banking firm Jefferies, unfinished construction accounts for nearly 1% of total mortgage loans. If all buyers of those homes refuse to pay, the amount of outstanding loans will rise to 388 billion yuan ($57 billion). Such a situation will, in turn, put China's banking system at risk.

Housing prices have been falling for ten months in a row, and no one knows when the downturn will end

Because of all this, housing prices have been falling steadily for ten months in a row, and no one knows when the downturn will end. The construction sector is one of the biggest sectors of the Chinese economy, accounting for one third of GDP, 40% of all bank loans, and half of all municipal taxes. Therefore, the crisis in that segment of the economy will inevitably affect both the financial system and the investment market; stocks and bonds of construction companies have been inexorably losing value.

Some economists believe that the collapse of Evergrande, the real estate developer with the largest debts in the world, prevented by the PRC government and central bank, is just the tip of the iceberg. Its bankruptcy could have caused a domino effect, as in the U.S. after the collapse of investment giant Lehman Brothers in 2008, but Evergrande's bailout does not mean a way out of the crisis; the financial difficulties of Chinese developers already pose a systemic problem.

Borrowed growth

To stimulate fading economic growth, China has moved to relax its monetary policy, while the U.S. and Europe, on the contrary, are cutting asset buyouts and raising interest rates to fight record inflation. That said, China has not been spared from the global trend of rising consumer prices - in June, the country's inflation rate rose to 2.5% year-on-year, the highest since July 2020, but rescuing the real estate sector is now a priority for China.

In late May, the People's Bank of China unexpectedly announced a 15 basis point cut in the key interest rate on five-year loans, to 4.45%. This rate is the key rate for mortgage lending in China. The decision was announced shortly after the release of official statistics, according to which Chinese real estate sales plummeted by 46.6% in April compared to the previous year.

China has so far managed to stay afloat thanks to large cash reserves, pressure on the banking sector and capital flow controls which limit the possibilities of capital flight. However, those measures have been growing less effective. The World Bank has already expressed concerns about it: “There is a danger that China remains tied to the old playbook of boosting growth through debt-financed infrastructure and real estate investment”. The WB experts stress that this growth model is ultimately unsustainable, and the debt of Chinese corporations and local governments is already too high. As a result, China's total debt may grow to 275% of GDP by the end of 2022.

China's total debt may grow to 275% of GDP by the end of 2022

Beat the U.S. at all costs

Behind the traditional - and questionable - methods may be a desire on the part of the Chinese authorities to outpace U.S. economic performance at all costs. At the end of April, there were rumors that Xi Jinping had instructed officials to ensure that the country's economic growth outperform the United States. The PRC leader wants the Chinese economy to look better than that of its main Western competitor, despite all the domestic problems and the shutdown of entire megacities due to the coronavirus policy. That's one of the reasons why many do not believe official Chinese statistics. Western analysts suggest that GDP growth of 4.8% is a sham.

Western analysts think China's GDP growth is a sham

Based on publicly available data on prices in China the British company Pantheon Macroeconomics believes that the real growth is half as much, a mere 2.4%. Adding to the doubts is the fact that the Chinese authorities have never adjusted the GDP target mid-year, and only once did they miss the target - in 1998, during the Asian financial crisis. In short, the reality of China's economy today may be many times worse than the government lets on.

 Nancy Pelosi's visit to Taiwan
Nancy Pelosi's visit to Taiwan

Adding to the problem is the escalating conflict over Taiwan caused by U.S. House Speaker Nancy Pelosi's recent visit to the island. The already tense relations between China and the United States have strained to the limit. The violent protest from the Chinese side escalated into direct threats of military action. Now China intends to hold regular military exercises to blockade Taiwan. Before the 2024 elections Xi Jinping cannot show weakness in any way.

From an economic point of view, escalating tensions in Taiwan could lead to a shortage of semiconductors and a sharp rise in high tech product prices, which would inevitably affect the economies of China itself, the United States and the world. Semiconductors are now key to the production of almost all consumer devices: phones, computers, and car electronics. An escalation of the conflict threatens global supply chains. The Taiwan Strait is the main route for ships sailing from China, Japan, South Korea, and Taiwan to the West, which is used for delivering goods manufactured in Asian factories to markets in Europe, the United States, and other countries.

Implications for Asia

Even without regard to Taiwan, the threat of an economic downturn affects not only China but also the entire Asia-Pacific region (APAC). Economists interviewed by Bloomberg estimate the likelihood of recession in China at 20% over the next 12 months, while China's neighbors, Japan and South Korea, are not so lucky, with the estimated likelihood of recession being 25%. The main reason is the trade deficit caused by sagging exports. China is a key trading partner and market for both countries. It accounts for 27% of South Korea's exports and almost 22% of Japan's. Accordingly, the shrinkage of the Chinese economy will automatically affect them as well. Also exacerbating the situation is a slowdown in the United States and European economies, which are equally important trading partners for Japan and South Korea.

So far, both countries have been coping well with the challenges. Korea's GDP grew 0.7% in the second quarter, compared to the growth of 0.6% in the first quarter. Strong consumption has largely offset meager exports, even despite a series of aggressive interest rate hikes. Japanese GDP fell 0.5% in the first quarter, but rebounded sharply in the second quarter, rising 2.5% due to the removal of covid restrictions and the rapid growth of consumer spending.

However, inflation in Korea and Japan, while not catastrophic, is still record-breaking, just like in the rest of the world. Consumer prices in South Korea rose 6.3% in July, the highest inflation rate since November 1998. In response, the Bank of Korea decided to raise its key rate by 50 basis points at once for the first time in history, and it is now at 2.25% per year. In Japan, which had been largely struggling with deflation for the past 30 years, consumer price growth peaked at 2.5% in May. Although the inflation rate dropped in June, it is still above the 2% target. The Japanese authorities are not planning to do anything about it, they are still focused on maintaining the country's long-standing negative rates.

However, the Japanese authorities have another cause for concern - the rapid depreciation of the yen. The rate of the national currency fell below 136 yen per dollar in July - the lowest value since 1998. The decline was driven by a divergence between the super-soft monetary policy of the Bank of Japan and the expectations of tighter policies from other central banks around the world, including the U.S. Federal Reserve. Goldman Sachs's former chief economist Jim O'Neil admitted that the rate exchange may well fall to 150 yen per dollar. According to him, it may provoke shocks comparable in scale with the Asian financial crisis of 1997.

India is the only major country in Asia-Pacific, which hasn't been affected by economic downturn so far. According to a consensus forecast, the likelihood of recession in the country over the next 12 months is zero. The country's economy today is characterized by the stability of its financial system, an upturn in manufacturing and services and by at least temporary stabilization of inflationary pressures. The rainy season and large grain reserves are also having a positive effect.

India is the only country so far unaffected by economic downturn

It's not everybody's opinion that India will manage to avoid problems. The country's heavy dependence on oil imports could be the main obstacle. High energy prices have fueled inflation, which the government is finding increasingly difficult to control. In June, prices rose 7% - only Thailand had a higher inflation rate among major Asian economies. If the trend continues, it will be another piece of very bad news for everyone, but record supplies of Russian oil at throwaway prices are mitigating the energy component in local inflation.

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