Dear Eoin, I am one of your long term subscribers from Singapore from back when David started the service. I have been shared this hypothesis regarding the reason why China is keeping to the zero covid measures and it is less to do with the disease but something else. Firstly with the reason for covid, they have managed to track the movement of all individuals in China with the Green Code, which coupled with their country wide camera surveillance, allow the state to monitor constantly all citizens. This is especially important in the fight against corruption. Secondly and more importantly, China is still trying to deflate their large property bubble which is 30-40% of the countries economy. Besides Evergrande, there are systemic risk to the over investment in real estate which is a huge Ponzi scheme. Fortunately most of the debt are on-shore, and China needs to keep its borders closed. This is because if re-opened, the increased spending from in-bound and outbound tourism will cause inflation, and this will force The Central bank to raise interest rates. China Central Bank wants inflation to still be low so that the economy can be stimulated and the growth in local jobs help keep the confidence for the population to invest in the property market. If inflation rises, then interest rates have to increase and it will delay the clean up of the property market which has so far been very well controlled. China is doing far more in the real estate cleanup then the US did with Sub-Prime Crisis in 2007-2008. Due to the trade offs, the real estate recovery is more important that the risk to public health although China could simply mandate all citizens especially the elderly to be vaccinated which they have not. It cannot be due to the lack of vaccines or preparation for the hospital and ICU beds capacity as China could have allowed Moderna and Pfizer to be registered locally without asking for the IP to be disclosed. Hope to hear from you. Thanks

Eoin Treacy's view

Thank you for this informative email and your long-term patronage of the Service. At a time when many consumers are taking a hard look at expenses, I want to give special thanks to every one of our subscribers.

I have discussed this exact issue in the big picture long-term videos on several occasions, most recently last Friday. Let’s address it from first principals. China’s is a single party state, so they have the luxury of equating the Party with the country. Whatever is good for the Party is therefore considered good for the country.

So, what’s good for the Party? Control is the overarching concern. In a single Party system any form of dissent must be discriminated against in a radical manner. The sanctity of the Party takes precedence over every other concern. All other factors are secondary.

When economic growth in the early 2000s was surging and the building boom was delivering wealth and capital to everyone, the Party was in a position to be relatively relaxed. That ended in 2013, not so much because Xi took power but because growth became predicated on debt.

China had reached the point where the benefit from infrastructure expansion was no longer a net contributor to economic growth. Wages had jumped so low end manufacturing was no longer competitive.  

Nevertheless, the building boom persisted and millions of new units were constructed as investment vehicles. As the quality of growth deteriorated, the government became uneasy at the prospect of a housing bubble disrupting social cohesion and threatening power. The efforts to cut liquidity off from the property development sector have been ongoing for years. However, there were significant obstacles to unwinding the infrastructure dependent nature of growth.

China does not have a property tax. Therefore local governments rely on property sales to fund their operations. State owned banks issue loans to property developers to buy land and local governments deposit the cash at the same banks. This was the norm for decades and allowed local party officials to become very wealthy on the back of infrastructure development. They also represented the biggest threat to reform of the sector. The anti-corruption pogrom was more about enforcing control over this group of Party officials than any other factor.

The cozy relationship between banks, property developers and local governments led to significant leverage in the banking sector and the government has been at pains to stop it. Property developers then raised cash from everywhere they could get it. When domestic sources were cut off they issued $500 billion in US debt. That number is the thin end of the wedge when we think about how leveraged the Chinese property sector is.

The decision was made during the pandemic to finally tackle the property overleverage issue because it represents a systemic risk to the longevity of the Party. Prices had risen to levels where regular people could never hope to own their own home regardless of how diligently they saved. From the Party’s perspective that’s a recipe for social unrest. Crashing the housing market is also a recipe for social unrest and so is failing to build units people have already fully paid for.

In short, it is practically impossible to perform a managed property market contraction and most particularly because property is by far the most favoured asset for Chinese citizens. Many outsiders believe Xi successfully secured his longevity in power because he promised to take over Taiwan. That’s certainly an ambition that distracts from the central policy of squeezing leverage out of the system to ensure the health of the economy for the future. The Party comes before the economy and the property market.

It is well understood that China has the internal resources to manage its debt issues. However, it will mean lower asset prices. That’s why they have to clamp down on the potential for capital flight. If the border were open, currency would exit the system en masse and the economy could crash. Nevertheless, the Renminbi is still susceptible to medium-term weakness in what is likely to be a managed devaluation.

Investors are selling out of Hong Kong shares in a rush. Both the Hang Seng and China Enterprises indices are accelerating lower. It is not unusual for shares to sport P/Es of 4 and dividends of around 6%. That’s reflective of the risk premium attached to investing in China.

CK Hutchison was prescient in selling out of China several years ago but the decision to bet instead on European telecoms is proving problematic at present. The share is back in the region of the 2008 low but will need a clear upward dynamic to check the slide.

Tencent is wholly dependent on the domestic market and its social media venue is now under the control of the government. The go-go days of growth are over and the much reduced valuation reflects that.