The apparent calm in China’s economy may not be what it seems.

According to S&P Global Ratings, the world’s second-largest economy is in for a fresh wave of corporate defaults as soon as next year.

The reason? The government’s heavy-handed approach to preventing financial risks is distorting the markets and masking the real problem.

“The real thing to watch for policymakers is whether the current directives are creating distorted incentives in the economy,” said Charles Chang, S&P Global Ratings’ greater China lead.

On the surface, China’s business sector seems to be in good shape.

The country’s corporate default rate was just 0.2% in 2023, the lowest in eight years and a tiny fraction of the global average of around 2.6%.

“To a certain extent, this is not a good sign because we see this divergence as something that’s not the result of the functioning of markets,” Chang explained.

He thinks the government is outdoing itself to “discourage defaults in the bond market.”

The problem is that these measures can’t last forever. Chang asked, “What happens to the bond market” when the government no longer directs corporations to avoid defaults?

The ghost of Evergrande

China seem to be delaying the inevitable because the country still hasn’t recovered from a massive property downturn that began a few years ago.

Since the demise of China's largest developer Evergrande in 2021, China’s property market has been in freefall.

Despite efforts to pay back banks and bondholders, a Hong Kong court ordered Evergrande to undergo liquidation. As it turned out, Evergrande was only the tip of the spear.

In 2023, Chinese property developer Country Garden defaulted on roughly $15 billion worth of debt. It joined dozens of other Chinese property developers that had collapsed since Covid.

In total, more than half of China’s former 50 largest developers have defaulted, according to the Financial Times.

So far, government-led efforts to revive the real estate industry have fallen short.

According to the state-run National Bureau of Statistics, new property sales in the first quarter were only equivalent to 29.3% of the sales in Q1 2023.

“The correction in property construction is still in its early stages,” Capital Economics analysts wrote in a research note. They expect property construction to “halve in the coming years, pulling down economic growth over the medium term.”

“China is struggling to strike a balance on its property policy over the past two years—they have been caught between providing too much stimulus or not enough,” Larry Hu, chief China economist at Macquarie, told the Financial Times.

So far, government efforts haven’t been “enough to ease the developer-related credit risk perceived by homebuyers,” Hu said.

Given how much of China’s economy is exposed to real estate, it’s not just developers who are left holding the bag.

“Negative wealth effect”

Before Evergrande, Chinese citizens had roughly three-quarters of their wealth tied up in residential real estate.

So, it was inevitable that the bursting of the real estate bubble would have a profound negative "wealth effect" on the Chinese.

Falling property values “create a significant negative wealth effect, which provides one possible explanation behind weak consumption” China experienced in 2023, said Sam Jochim, an economist at EFG Asset Management.

“What’s more, the situation could get worse” as the property downturn continues to spread to other parts of the economy.

“The decline of the housing market will have a net negative effect on consumer spending,” according to Hanming Fan, an economist at the University of Pennsylvania.

Bad property loans have also impacted some of China’s largest banks, which had massive exposure to real estate before the crash.

For example, the Bank of Communications—the country’s fifth largest bank—reported in March that bad loans accounted for up to 4.99% of its property portfolio at the end of 2023.

Meanwhile, the Industrial and Commercial Bank of China reported that 9.6% of its residential mortgages have gone bad.

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