Risks had been simmering in the Chinese real estate market for some time. There has been an ongoing debate over whether this will lead to a financial crisis or whether the authorities will be able to manage the decline in a controlled manner. The current backdrop of macroeconomic conditions points increasingly towards the financial crisis scenario, with the growing likelihood of an impending crisis.
There are a few factors that make me think this could be a crisis and it could happen imminently. Energy prices are rising rapidly, cash is evaporating and global bond yields are rising. This cocktail of economic friction is terrible for any asset class in economic weakness, which the Chinese real estate market has been on for some time. Chinese home sales are down almost 50% year-over-year so far in 2022, and the level of debt and investment dependent on a strong real estate market is a significant part not only of Chinese GDP but also of global GDP.
Energy price increases have a well-documented history of triggering financial crisis. Just look at the chart below, and for almost every oil price spike, you can find a corresponding recession/crisis that happened somewhere in the world. The basic mechanism here is that rising energy prices serve as a friction for almost all economic activity, because all economic activity depends on the use of energy. As these frictions increase, not only do they constitute an obstacle to growth, but they also limit the ability of the monetary authorities to react to any slowdown in growth with monetary easing, which would add oil to the inflationary fire.
We certainly see that today. Energy prices have risen to the point of having a negative impact on growth. However, monetary policy easing is not even on the radar of monetary authorities outside of China due to high inflation.
As the world outside of China focuses on monetary tightening, the world’s largest asset class is under significant stress. Stocks of Chinese property developers are at depressed levels and their debt is plummeting with no end in sight:
Meanwhile, all the talk of easing in China has failed to stem the credit downturn that started it all:
And it is against this backdrop that monetary conditions in the United States are tightening at some of the fastest pace in the past two decades.
(spoiler alert: every other time this has happened, significant financial market stress has ensued)
It is important to note that once trust is lost and the wheels of a crisis start to turn, things can go downhill quite quickly. Today I was surprised by this US BBB debt chart. As late as August 2008, junk debt yields were still below 7%, a seemingly benign level in the context it has traded for the past several years. Just two months later, those yields had shot up to over 10% as there was a complete loss of confidence and commercial paper could no longer be trusted.
Speaking of commercial paperThe number of Chinese companies in default on commercial paper payments rose to 1,184 in February, more than double from the 562 companies in default at the end of January.