It is no secret that the Chinese property market is in trouble. After decades of extreme price appreciation, housing prices are falling quickly this year. The official data shows a single-digit price drop, but the actual price drop is much higher.1 For decades, buying a home whenever you had cash was the surest investment for Chinese citizens, but that sentiment is long gone.
The property/debt-fueled growth model was a big driver for China’s gross domestic product (GDP) growth over the last 15 years. This is a low-growth model because high real estate prices and leverage in the economy caused misallocation of capital and planted the seeds for a financial crisis.
Now, the government policy is to divert capital away from real estate and into artificial intelligence (AI) and renewable energy to foster high-quality growth. As a result, we are starting to see major property developers teetering on the edge of default.
Policymakers have two choices to support growth. The first is to go back to the old growth model: big fiscal stimulus, allow local government to leverage further and boost housing prices. The second is to accept slower growth as the price to change the growth model. This can be accomplished through small fiscal stimulus and monetary easing to keep the economy from a deep recession, while giving the economy time to find a new growth engine.
China is likely taking the second approach, and in the long run, I believe it should be better this way. In this scenario, interest rates will likely stay low in China for a long time, and the yuan will fall further. A weakening yuan will make the Chinese economy more competitive and support growth.
China had 15 years of a booming property market driven by fiscal stimulus. The U.S. had 15 years of a booming stock market driven by monetary stimulus. The challenge in the U.S. is that long periods of extremely low interest rates has allowed households and corporations to lock in low interest rates. This dramatically reduced the effectiveness of monetary tightening. In previous cycles, it was usually how high the federal funds rate would go that mattered, but in this cycle, it is all about how long the fed funds rate stays high. We have to wait for the low-interest-rate borrowers to refinance for the tighter monetary policy to flow into the economy. This is likely due to all major central banks emphasizing “higher-for-longer.”
The end result of “higher-for-longer” interest rates in the U.S. and a weakening Chinese economy that needs low interest rates creates an argument for a lower Chinese yuan. Even though the yuan is trading at its weakest level over the last 15 years, there is room for further decline. Of course, there is the risk of a recession in the U.S., which could give the yuan a short-term boost. If that happens, it might be good to consider initiating or adding shorts. Still, the long-term picture is unchanged despite the cyclical downturn risk in the U.S.
China faces challenges as it moves away from a housing/debt-fueled growth model and faces the risk of deflation. This means interest rates will stay low for longer in China. In the U.S., the Federal Reserve‘s “higher-for-longer” policy means front end interest rates will stay high. The supply/demand dynamics means the interest rates for the long end will stay high as well. Together, these circumstances argue for a stronger dollar and a weaker yuan.
1Bloomberg – China’s Housing Slump Is Much Worse Than Official Data Shows; 9/16/23
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