China – can the car get back on the road?

By early autumn, China's economic situation had reached a critical point demanding drastic action. In fact, conditions were probably worse than expected, with many ordinary citizens becoming increasingly frustrated about their financial circumstances. We have heard that some of the European luxury brands are reporting sales down by more than 50% year on year. Clearly this is not a good measure of the average consumer, but it does reflect the extremely poor sentiment in the country.

Throughout the year, we have seen a steady drip-feed of stimulus measures that have ultimately fallen short. Our perspective is that the Chinese leadership has now recognised the need for deeper, more profound measures to address the problem. The challenge, however, is that there are many fundamental issues to resolve before the classic consumption stimulus would work. For instance, offering consumption vouchers won’t help someone who is worried about losing their job.

China’s approach has been to tackle each issue systematically, starting with the backbone of the economy. In other words, the car was about to break down completely, but before you can get it back on the road, you have to change the engine, check the chassis, refuel it (or better yet, recharge it), and finally, repaint it. This is no small task—it takes time and patience.

From a Western perspective, the obvious solution is a stimulus package worth around RMB 5 trillion (USD 702 billion), which is why some observers have been disappointed by the lack of concrete figures from Beijing. The Chinese view, however, is more of an acknowledging that the car needs repairing, and while the cost is uncertain, the priority is to get it back on the road as soon as possible.

However, it is clear that most of the people we speak with believe that the government has made a clear pivot and realises that ‘things have to change’. The jury is still out, but we can see the potential for an overhaul of issues that are crucial to address if China is to return to a decent growth trajectory.

Fixing the chassis

China consists of 34 provinces with populations ranging from 4 to 126 million. In terms of size of population and economic size, they are comparable to European countries. While some provinces are well run, around half are likely grappling with significant debt burdens. It is difficult to get concrete information on how this affects the overall economy, but a typical example would be a company providing services to the regional government in a particular province. The cash-strapped regional government simply defers payment to the company, resulting in delayed wage payments to employees or, in the worst –case, bankruptcies. Recent estimates we’ve seen suggest that overdue payments from local governments total around 10% of GDP.

On top of these challenges, regional governments are also expected to invest in new areas prioritised by Beijing. This task now appears overwhelming, leaving some local governments in desperate need of a cash injection. The issue is twofold: first, to ensure that there is enough liquidity in the system to fund ongoing projects and, more importantly, to have the capacity to invest further. How local governments support businesses is often opaque. While it can involve direct subsidies, it is more commonly indirect—such as providing free land for a new factory or offering tax breaks for five years.

A key source of the problem for local governments is their heavy reliance on land sales, which previously accounted for up to 80% of their revenues. In short, local governments sold land for real estate development and used the proceeds to fund operating expenses. With the real estate sector now in crisis, this model is no longer viable. Local government debt has ballooned to RMB 40.7 trillion (USD 5.6 trillion).

Recently, the Ministry of Finance announced a one-off increase in the debt ratio to help restructure local government debt, describing it as “the largest in recent years”. This debt swap could allow local governments to catch up on late payments to businesses. We’re also likely to see more financing funnelled from banks and the central government to the provinces.

If China’s economy is to recover, addressing local government debt is crucial; otherwise, the economic "chassis" simply won’t hold.

Changing the engine from ICE to electric

Replacing the "engine" of China’s economy is perhaps the most challenging task. Real estate and infrastructure—depending on the definition—have accounted for up to 35% of GDP and have been key drivers of China’s growth miracle. This era, however, seems to be coming to an end. Real estate prices have fallen for three consecutive years, and new housing starts are down 70% from their peak in 2019. Real estate has long been seen as a guaranteed path to wealth in China, with 80% of household wealth tied up in real estate, compared with just 30% in Europe. However, prices have fallen significantly—by about 40% in tier 3 and tier 4 cities, and by around 25% in Shanghai and Beijing.

While the timeline for market stabilisation is complex and uncertain, we estimate it could occur within the next 12-18 months. The government’s latest measure—a RMB 4 trillion (USD 550 billion) loan support package for "white-listed" developers—signals its intention to address the crisis. There are also initiatives aimed at reducing supply, such as buying up existing apartments on the market. Affordability is starting to improve, with prices for new apartments in some areas falling to RMB 7,000 per square metre (less than USD 1,000 per square metre) in some areas.

On a recent trip to Beijing, we met with Beke, the largest real estate broker in China, and they also believe that the government has pivoted and is actively working to resolve the oversupply issue. Local governments are being permitted to issue special bonds and use the proceeds to buy up unsold apartment inventory. Many more measures have been announced, but tackling the oversupply is clearly the key. Encouragingly, transaction volumes for both primary and secondary home sales have doubled on a weekly basis year-on-year since the recent Golden Week holiday, signalling some early signs of recovery.

Fixing the real estate market is crucial not just economically, but also psychologically, given the vast amount of household wealth tied up in property. Put simply, people are less likely to spend if the value of their homes continues to fall.

The bigger challenge, however, is to replace the economic "engine." Real estate will no longer be the primary growth driver for China. Instead, sectors like electric vehicles (EVs), solar panels, batteries, and advanced machinery could become the new pillars of growth. This transformation, though promising, is fraught with challenges. As we’ve already seen in industries like solar panels and battery manufacturing, too much capacity has been built too quickly, leading to issues of oversupply.

Transitioning from a real estate-driven economy to one powered by these emerging sectors will be complex and require careful balancing to avoid repeating past mistakes.

Trying to recharge

China’s banking system is vital to keeping the economy running. However, state-controlled banks have often financed various government projects and companies that have failed to repay their debts, simply rolling them over instead. As a result, the banking system has struggled to increase lending where it is genuinely needed.

This issue has been addressed by lowering the reserve requirement ratio by 50 basis points, theoretically freeing up RMB 1 trillion (USD 140 billion), and cutting the key interest rate by 20 basis points. More importantly, there has been a core Tier 1 capital injection of RMB 800 billion (USD 110 billion). Collectively, these measures indicate that the "charging station" is now operational.

The pressing question, however, is whether there will be any "cars" to fuel. Currently, demand for loans is quite weak, as both businesses and individuals perceive fewer investment opportunities. A clear indicator of this is that households are sitting on RMB 110 trillion in time deposits, nearly double the level before2020. Additionally, bank lending to households has been steadily declining, with annual growth currently at just 3% (Figure 1).

What can make a difference are the so-called demand-side measures, which include fiscal stimulus designed to boost confidence and stimulate the economy. Several concrete initiatives have already been announced, including the removal of restrictions on home purchases, resales, and pricing, reducing the down payment ratio from 25% to 15%, and implementing a 50 basis point interest rate cut on existing mortgages.

It is highly likely that the government will introduce additional measures if the initial initiatives prove insufficient, but we shouldn’t expect a massive wave of changes all at once. The Chinese government typically approaches these situations differently; they prefer to test a few measures, evaluate their effectiveness, and then implement further actions as necessary.

Polishing the interior

While a beautiful interior may be nice to have, it’s not essential; after all, it’s only visible to those inside the car. There are 250 million retail investors in China, and during the recent Golden Week holiday, an additional 3 million accounts were opened. This clearly shows that these investors care about the stock market and their investments.

In the West, retail investors must accept the risks of potential gains or losses, without expecting the government to be responsible for those losses. In China, however, the approach is somewhat different. Although the government bears no official responsibility for potential losses, it still aims to maintain a stable stock market. A recently announced plan to allow insurance companies to borrow RMB 500 billion (USD 70 billion) should be seen as a measure to stabilise the market.

When asked by a reporter whether the People’s Bank of China (PBOC) would take further steps to support the market, Governor Pan simply smiled and said, "If RMB 500 billion is effective, we can do another 500 billion. And we can do yet another 500 billion..." This illustrates that the government is committed to maintaining stability in the A-share (domestic) stock market. While it may not be the highest priority, they certainly want to avoid a sharp market correction.

Repainting the car

There’s no point in repainting the car until you’ve repaired the chassis, replaced the engine, and polished the interior. While a shiny new paint job can make the car look beautiful, it should come last. The engine and chassis, though often unseen, are the true cornerstones of the vehicle. This may reflect how Chinese leadership views the current situation: direct stimuli for consumption, akin to a fresh coat of paint, should come after the fundamental issues have been addressed.

A person is unlikely to be satisfied with a consumer voucher if he’s just lost his job. As a result, most of the measures announced so far focus on tackling deep structural problems. This process will take time, and only after these issues have been addressed will more direct stimulus measures be introduced. That said, some small initiatives to stimulate consumption have already been implemented.

When will the car run at full speed?

Fixing all the various components will take months, but by the end of the year, the car may begin to accelerate again. The upcoming US election, along with the possibility of more trade tariffs under a Trump administration, introduces significant uncertainty. If Trump wins, it’s likely that the Chinese government will announce additional measures to navigate these challenges.

However, it’s important to recognize that without addressing the structural issues mentioned earlier, it will be difficult for China to return to significant GDP growth. Many of these problems are long-standing and will take time and effort to resolve.

So, how should we drive on the road ahead?

Well, most people would probably say they are good drivers. We are probably more cautious than most, trying to avoid danger and crashes. Our stock picking has been focused on sectors of the economy that we think are still growing, such as education and dental care. A somewhat better economy would benefit technology companies with attractive growth valuations, such as Kuaishou, which trades at 10x earnings and 75% EPS growth.

Finally, our focus has always been on corporate governance, with a somewhat new theme being the large number of buybacks launched by Chinese companies. For example, while consumer lender Qifu might not operate in the most attractive sector, good management led to a 31% profit increase in Q2. The company also announced that 80% of profits will be used for cash dividends and buybacks. The Chinese part of our GEM portfolio has a PEG ratio of 0.31 for 2024.