Earlier in February, I did a podcast with David Kimberley of Kepler Trust Intelligence in the UK and talked about economic issues in China after the dropping of Covid restrictions. The full thing is online; the below is an edited transcript of the more substantive parts of the discussion. I’ve cleaned up the speech for easier reading but haven’t changed any of the content.
David: Before we get started, I’ll just start with a small anecdote. So I went to Malaysia about six months ago, and a friend of mine from Hong Kong happened to be there at the same time. We met up and went out for dinner. And over the course of dinner, he kept complaining about things that were happening in Hong Kong and China at the time. Every time he was complaining about something, I would say, Why are they doing that? Why is this the policy? And and it went from mundane things to more serious things. And eventually he said, if you try to understand these policies, you’re just going to go insane. So it’s better to just accept them as they are and live your life accordingly.
Maybe to get started you could you talk a bit about why you think Chinese policy for Covid was so restrictive and also why there was this sudden change? I think for most people who are not keen watchers of the country, it felt like there was this really strict policy that was hard to understand, and then a very quick reversal that was equally hard to understand. So maybe you could talk a bit about both.
Andrew: Sure. I think the reversal is probably easier to understand because they had no choice, right? They were forced into changing policy. The Covid controls were breaking down. And they could either insist that people, local governments and companies continue to follow these extreme measures which weren’t working, or they could recognize that they weren’t working and tell people, okay, fine, we’re not gonna do it anymore. The reversal was basically forced on them by the realities of what was happening with the pandemic, which is that the virus had become so infectious that it was extremely difficult to control even with the very strict measures that China employed.
The local governments that were in charge of actually enforcing these measures had different levels of competence and enthusiasm for enforcing these measures. Some local governments were quite good at it and then others really weren’t that good at it or really didn’t want to do it for whatever reason. Because some local governments weren’t that good at restricting the spread of Covid, Covid spread. And so the weak parts of the system undermined the strong parts of the system, and then eventually the whole thing came crashing down.
So yeah, for the policy change, it’s not something I think was really decided in a considered way at the top. Of course they try to portray it that way, but if you look at the sequence of events, that’s not actually how it played out. They were trying to retain the Covid systems, but they basically just fell apart. And so they had no choice but to give up and say, okay, we’re done.
For the first part of the question, why did they do all this stuff in the first place? I think a lot of it is just path dependency. They got trapped into a certain set of a certain set of policies, a certain set of preconceptions that were difficult to get out of. In 2022, it was very popular for people to criticize China’s Covid policies and everyone’s like, oh, why are they doing this crazy stuff? But if you think back to the first half of 2021, actually China’s policies were looking pretty good.
The lockdowns in 2020 had effectively stamped out Covid. There was no domestic transmission of Covid in China, unlike everywhere else in the world. They had substantially reopened domestically, so for many people daily life had returned to normal. The economy was booming, and they had gotten this economic boom without having to borrow and spend in the way that a lot of Western governments were. They had low inflation and not a big increase in government debt. They didn’t overstimulate the economy. So actually the set of trade-offs that China made at that point in time was looking pretty good.
I think their strategy was essentially to say: okay, we’ve kicked this thing, but we are still going to stay closed off from the outside world because we want to prevent new infections from coming in. But basically what we’ll do is have a vaccination campaign that will achieve herd immunity. And then once we achieve herd immunity, we can gradually open up and then everything will be fine.
And of course what happened is that the SARS-CoV-2 virus continued to evolve into new variants, and these variants were so transmissible that herd immunity became impossible. And I don’t think they were prepared for that. There wasn’t an alternative strategy to achieving herd immunity. Because they had this this set of restrictions, the only thing they could do was to continue with them in order to not have a massive wave of Covid infections and deaths. Which of course is what they have just experienced.
David: That’s all very interesting. I think you did have some protests, which seems, again to someone that’s a casual observer, something that’s quite unusual in China. So did those things have any role to play or are those misconceptions?
Andrew: I do think that the protests had a very clear impact on Covid policy. At our firm, we put together a daily indicator of Covid policies. My colleagues did this heroic work of looking every day at the actual measures announced by 100 different city governments and then classifying them according to how severe they were.
If you look at the data series that we compiled, you see that the restrictiveness of Covid policies begins to immediately decline after the protests, before the central government had officially announced any change in policy. So it’s clear that the actual implementers of Covid policy, which are the local governments, responded to the popular discontent.
Another way you can see the same thing is just to look at the test results. What’s kind of counterintuitive is that immediately after the protests, the number of Covid cases plunges. This of course doesn’t reflect reality because the pandemic was spiraling out of control at that point. But what it means is that a lot of local governments simply stopped doing tests. Mandatory tests were a key part of the whole Covid control system.
So you can see very clearly in the data that the government immediately began to back off from the most restrictive policies in the face of these popular protests. I think there’s no question that they had a real impact.
David: To touch on something else people have been concerned about, which is the real estate sector. As far as I’m aware, most Chinese have their savings in real estate. Is that a bubble that’s about to burst? Is there a huge amount of risk there? Can you just talk about what’s happening in the real estate sector?
Andrew: What happened in the real estate sector last year was basically the biggest correction in housing, sales and construction in the history of the modern Chinese property market. You had something like 50% declines in new construction volumes, and 30% declines in housing sales volumes. We’re not in a situation where we’re waiting to see if bad things are going to happen. Very bad things have already happened. The question is whether bad things continue to happen or whether they get less bad.
This extraordinary collapse in the real estate sector is kind of a confluence of things that people expected and things that people didn’t expect. You’ve had this regulatory crackdown on property developers underway since about 2017. Basically the central government had decided, I think quite correctly, that property developers were a major source of financial risk because they were running highly leveraged business models and were incentivized to build too much housing. The government and financial regulators have been trying different ways to try to constrain the risk-taking behavior of property developers over the last several years.
The first two or three years of this campaign from 2017 to 2019 was partially effective, but did not really change property developers’ behavior. Then of course we have the Covid interlude in 2020 and 2021, and then this campaign comes back with a vengeance. They came up with some very tough, very restrictive measures that really reduced property developers’ access to finance and started to have pretty serious effects on their business.
And as the industry was feeling the effects of this in early 2022, it got this exogenous shock from the Shanghai lockdown. The Covid restrictions that had been fairly light up to that point became extremely strict all over again. And this created a lot of uncertainty among people. Everyone in China was like, oh, we thought this thing this stuff was over, we thought all these restrictions were going to gradually go away, and now it seems like they’re never going to go away and are going to be here forever. And this is terrible.
You had a collapse in property sales that happened in part because of the the lockdown and the collapse in household confidence. It’s difficult to disaggregate these things, but at the same time it was also driven by the deteriorating financial state of the developers, where they became unable to complete projects. And that made people understandably reluctant to hand over a lot of their money to developers.
This sharp collapse in property sales was basically a death blow for developers who already had extreme financial stress from the loss of external financing. It’s one thing to be finding it more difficult to borrow from banks or to issue bonds. But the main way that developers finance their business is by selling houses. If they’re not selling houses, then they really don’t have any money. And they didn’t have any access to external finance to make up the gap.
That imposed huge financial stress on developers. They not only had to stop work on existing projects, but they massively cut back all the new construction or purchases of land for future construction, simply because they didn’t have any money. They had no money from sales coming in the door and they couldn’t borrow it.
What’s happened over the last few months is that, simultaneously with this relaxation of Covid policy, the government has come around, slowly and I think somewhat reluctantly, to the view that it overdid things by trying crush the developers with financial regulation and that the macro effects of this were just too severe.
The priority now is to get housing sales going again, and restore normal funding channels for developers and prevent a further collapse in the sector. That’s where we are now. What the market is going to be looking for over the next weeks and months is some indication that property sales are going to normalize. They may not ever go back to their pre-Covid levels, but if they increase a little bit, that will make a big difference to the financial situation for developers and help halt this free fall in construction activity.
David: To finish off, I think most people listening to this will be individual investors who are not in China, and they are probably pondering whether or not they should be invested in Chinese companies. I think that after Russia invaded Ukraine, a lot of people had this realization of what it means to be invested in a country that is governed in, let’s say, a less transparent, more authoritarian way.
If I’m investing in Russia, you could talk about how great a company like Yandex is, or Gazprom’s dividend, but actually it is kind of irrelevant if in a single day all of that can just be wiped out. And you can’t predict whether or not that is going to happen. Many people were starting to wonder whether actually exactly the same thing applies to China. So I’m curious if you have any kind of thoughts around that. Do you think that China’s going to be able to lure back foreign investors?
Andrew: The short answer is apparently yes, because inflows from foreign investors into Chinese domestic stocks had their biggest month of all time in January. So there’s been a pretty big change in foreign investor sentiment, at least in the short term. But let me try to give you a little more thoughtful answer on this.
Over the years, talking to our clients, who are mainly institutional investors, a lot of them were very interested in finding a way to benefit from the long-term growth story of China, but also avoid what they saw as the political risks and lack of transparency involved in the Communist system. A lot of investors came to the conclusion that the way to do that, to achieve both those goals, was to buy shares in the Chinese private-sector internet companies.
These were companies that were clearly in a growing part of the economy. They were targeting consumer demand rather than government spending. And crucially, they were run by profit-seeking entrepreneurs. They were run by guys who wanted to make tons of money by providing internet services to a billion people. And it seemed that generally the government was okay with that and had given them space to do that. So from a Western investor’s perspective, this is the best of all possible worlds. You have all of the Chinese growth potential, and then you have none of the weird China stuff of state intervention and Communist Party jargon.
What really what happened in that regulatory crackdown, or whatever you want to call it, in 2021, is that this thesis was proved to be wrong. That, in fact, there wasn’t a special sector of the economy that was immune to government influence, and where you didn’t have to worry about Communist Party slogans or state intervention. The internet sector was also vulnerable to these issues just like every other sector of the Chinese economy. And I think that was a pretty big shock for a lot of people who had hoped that the internet sector was going to be different.