The Deloitte Research Monthly Outlook and Perspectives
26 September 2021
Evergrande – no systematic risk but more policy flexibility is required
Over the past ten days, Evergrande, China's second largest property developer, has become a global household name. This is owing to its massive debt (RMB2 trillion), an opaque financial structure, the significant role of the property sector in China's economy and, of course, China's growing impact on the global economy. Initially, some observers compared Evergrande's collapse to the fallout of the Lehman Brother in 2008, which almost brought down the mighty Wall Street.
The notion that Evergrande's spillover effect could rival the "Lehman moment" has been dismissed by most economists and the market, but how China should and will likely deal with Evergrande and its contagion matters a great deal.
Will China's economic growth be significantly affected if real estate companies have lost their willingness to invest? "Homes are shelters, not for speculation" has been a stated policy but should this be implemented nationally, given China's regional diversities? What lessons can China draw from previous boom-to-bust cycles in housing in other countries (Japan, especially)? If property investment grows lower than GDP growth rate, what sectors have to step up in order to fill the gap?
Before we tackle these questions, it is worthwhile to rehash our long-held view on why systematic risk does not apply to China, including the risk that is being posed by Evergrande. Let's begin with some facts: Evergrande, as the second largest property developer in China, has total debts close to RMB2 trillion (contingent liabilities might be another RMB1 trillionn), which more than doubled over the past five years. It has projects throughout the country, with a large exposure in many third and fourth tier cities. This is an important point because China's housing market has seen a pronounced divergence between first tier, second tier and smaller cities in recent years. The demographic factor is compounding the oversupply of flats in many smaller cities but demand is outstripping supply in first and many second tier cities. Therefore, sagging property prices in certain cities could expose local governments' financing needs in future. Of late, some local governments have issued decrees to prevent developers from lowering selling prices. Evergrande's expansion in recent years is controversial because its leverage has ballooned despite the Chinese government's three red lines of curtailing leverage in the property sector (introduced in August 2020). Therefore any bailout, even with an objective of minimizing contagion, could face political pressure. There are many reasons for disputing this as resembling China's "Lehman moment". China has experienced a number of stock market "crashes" since 2015, but the general public has never lost faith in its banking system with the latter playing a far more important role in channeling savings into the real economy. The Chinese government could easily mobilize resources to contain financial sector stress as it has been doing unlike in many other countries. Of course, the Chinese government's superior capability of mobilizing resources is also being underpinned by China Inc's balance sheet. In East Asia in 1996 and 1997, current account deficit was getting out of hand in most countries (Thailand of 8% of GDP while Korea at 6%) and their currencies suffered investors runs and speculative attacks; China, by contrast, has been a net exporter of savings for decades, although its share of GDP (current account surplus/GDP) has come down in recent years owing to a consumption boom, but it seems unlikely that the country will have a current account deficit in the next two years. A closed capital account and a stable exchange rate will allow the People's Bank of China to lower interest rates without worrying about downward pressure on the RMB exchange rate. In fact, we would even argue that China is better off with a more competitive RMB exchange rate for the boost it would provide to manufacturing sectors. The most important reason for us to downplay systematic risk is that Evergrande's financial structure is nowhere near Lehman's convoluted complexity; it essentially relies on trust companies and financing from staff (wealth management products) and credit lines from suppliers in addition to bank loans. To dismiss the notion of a "Lehman moment" does not mean a blanket bailout for Evergrande is called for. In fact, price actions have suggested that equity holders of the developer have been largely wiped out while offshore bond holders have lost about 70% of their capital. In our view, restructuring of the company will proceed soon. In the spirit of maintaining social stability, priority will be given to those homeowners who have paid down payments but not to banks and investors. However, the general guideline should be to minimize spillover.
The property sector itself has played a significant role in driving economic development. Indirectly, the property sector has affected many industries and local public finances in a meaningful way. So far this year, despite the general tone from policymakers in enforcing the three red lines, the property sector recorded impressive double digit growth up until this summer (with a YoY growth of 10.9% in Jan-Aug 2021). However, the outcome of Evergrande will surely impact the investment decisions of major developers. Unlike ratings agencies (e.g., S&P has revised its 2021 growth forecast for China down by 30 basis points to 8 per cent), we have left our forecasts for 2021 GDP growth unchanged at 8.2%, not because Evergrande' economic impact is trivial but mainly due to Beijing's policy flexibility. China has boosted 18.4% of fiscal revenues during the first eight months of this year while interest rate differential between the RMB and the USD has been maintained at 140 basis points. There is therefore ample scope for policymakers to undertake counter-cyclical measures through fiscal expansion and monetary easing.
Chart: The property sector has played a significant role in driving economic development
Chart: China's monetary policy could buck the trend of global tightening thanks to relatively high rates
Is growth for 2022 at risk? One of key questions confronted by policymakers is how to make up the likely shortfall in 2022 should exports begin to taper off in 2022. Domestic demand is the obvious answer but can domestic investment sustain its current pace? This makes a speedy resolution of Evergrande's current situation indeed important. In our view, "homes are shelters, not for speculation" is likely to remain as the long term objective, but there is room for policymakers to tinker with the three red lines in the short term. This will be a delicate balancing act. Anecdotally, there are signs that housing markets in large cities have cooled off on the back of the Evergrande saga. Bear in mind that most cities have seen a rapid run up in prices since 2000 (currently national average house prices are as much as five times higher than in 2000). A mild pull-back of house prices is unlikely to dampen consumer sentiment. Yet, how to avoid the profound impact of asset deflation to the real economy following a prolonged period of booming house prices is a valid question (as was the case in Japan in 1990) beyond the short term. On September 29, Yi Gang, PBOC Governor, said that China's sustainable growth rate is between 5% to 6%. Such a pledge ought to be more than an assurance on economic growth, but also a pragmatic approach of using economic growth to deflate bubbles gradually. Of course, there are many lessons from Japan's experience of dealing with property bubbles. Avoiding overly tight monetary conditions should be one of them. The power crunch that is currently affecting both China's manufacturing sector and consumers suggests that electricity price liberalization is long overdue. Such liberalization means greater tolerance for inflation and necessary fiscal subsides to firms that are being plagued by COVID-19 and high commodity prices.
A return to the ‘essence’ of education
The new "Double Reduction" policy reshapes the education and training market
In order to reduce the study burden of primary and middle school students, the Ministry of Education has issued a policy entitled “Opinions on Further Reduction of the Homework Load for Students in Compulsory Education and Out-of-school Training” (known as “double reduction”). On the basis of this paper, pilot projects were rolled out in August 2021, profoundly changing the after school off-campus education and training market. The policy clearly stipulated that all localities will no longer examine and approve new off-campus tutoring academies targeting the teaching of school subjects to students in the compulsory education age group. In addition, it stipulated that existing tutoring institutions were to be registered as non-profit organisations, and hence could not raise capital by listing themselves on the equity market. Furthermore, services of those institutions would be standardized, and online tutoring institutions would have to pay special attention to the issue of training duration and put an end to bad teaching methods that put a great deal of stress on students.
Under the policy of "double reduction", the sector will return to the ‘essence’ of education, i.e. developing the mind and heart of a human being. As a result, a shift is currently underway from trying to teach children the ‘right’ answer in an exam towards developing their individual strengths and learning abilities. More significantly, the “double reduction” policy has led to a withdrawal of capital from the extra-curricular tutoring industry, and the relationship between schools and off-campus tutoring academies has changed fundamentally.
Capital withdrawal and decrease in number of training institutions.
The “double reduction" policy has been something of a gamechanger, turning after school education in China from a ‘high growth, high profit industry’ into a standardized semi-social service, effectively ‘de-industrializing’ it. According to data collected by Tianyan (a company focusing on business registration inquiries), as of September 1, permits for more than 160,000 education and training-related enterprises have been cancelled or revoked because they did not meet government standards. China's active pursuit of the goal of fair education means that in the future, the market of academic subject tutoring will no longer exist. So, where will investment and growth go? The next capital flow will probably focus on self-improvement education, especially character-building, development of personal interests and/or vocational skills.
The relationship between on-campus and off-campus has changed. The "double reduction" policy makes parallel efforts both inside and outside schools. In addition to strengthening control over off campus scholastic training institutions, it also puts forward requirements on training within school campuses such as improving teaching quality and arranging homework in a scientific and reasonable manner. What this will do in the medium to long run is to stop the on-campus- off-campus rivalry and force tutoring institutions and schools to collaborate. For example, off-campus tutoring institutions could become "strong auxiliaries" to the on-campus education by focussing on integrating quality-oriented education and enriching students' extracurricular knowledge.
Challenges in the transformation of training institutions.
In order to survive, subject-oriented training institutes will have to shift attention and concentrate instead on taking a more people-centred approach focused on the student. But this transformation of the existing structures will be very challenging. Remaining issues that need to be addressed include the reorganization of the teachers' teams and the reconstruction of the curriculum and teaching system. Moreover, the character-building education market is so scattered and segmented that it is very difficult to scale. Turning to vocational training, the biggest challenge for off-campus training institutions is to cater to a completely different customer group and acquire customers. Even transforming to an after-school educational nursery and home tutoring is fraught with issues of a small customer base, low profit, and high cost.
Three development opportunities for training institutions
Training institutions can focus on using their experience and successes in the examination field to help design programs that complement the work done on campus during school hours. They could gain more development space by transferring the learning scene to the schools or going abroad.
Empowering IT system construction on campus. Off-campus training institutions, especially some online training institutions, have helped their students achieve good results in school examinations by using the internet, big data, cloud computing and artificial intelligence technologies. Instead of competing with schools, they could make schools their primary clients, using their experience in obtaining good results and their tech knowledge to design IT based teaching systems for school. For example, they could provide schools with online and offline integrated learning systems, teachers' homework correcting systems, learning situation analysis and diagnosis systems, teaching quality evaluation systems, and teacher and student personalized matching systems. For example, the learning system of Netease Youdao built in 2021 can generate intelligent homework, do homework correction and make personalized student reports. At present, cooperation has been carried out in some primary and secondary schools in Beijing's Haidian District.
Providing character-building oriented education classes. According to government requirements to build a high-quality education system, off-campus private training institutions can consider changing the kind of courses on offer and including more courses on aesthetic education, art, sports, scientific creation (STEM based), and crafts to gradually meet the needs of schools to produce high quality individuals. In particular, sports have been included in middle school examinations, and sports scores have been improved year-on-year. For example, New Oriental has seized this trend to open a physical education cram school for primary and middle school students, and restored 1:1 physical examination sites which have achieved positive results.
Expanding education training to foreign countries. Training institutions can spread Chinese culture by providing Chinese language learning for foreign learners. More than 70 countries have incorporated the Chinese language into their national education systems, and more than 4,000 foreign universities have opened Chinese language courses. Chinese language education has a broad and solid foundation in China, whereas overseas the Chinese language education market is beset with the "double shortages" of courses and teachers. Domestic training institutions can seize the opportunity to solve the problem of supply and demand with the help of online Chinese language education models.
Membership stores gain popularity
Since Costco entered the Chinese mainland in 2019, warehouse-type membership stores have been a bright spot in the consumer industry. After HEMA took the lead in the warehouse-type membership store model, domestic retailers in the traditional retail format have been accelerating their entry into the warehouse-type membership store industry. Recently, Yonghui, Renrenle and Beijing Hualian have successively announced their entry into the business of warehouse membership stores.
Figure ：major brand of membership stores SKU and membership fee
When discussing warehouse-type membership big-box stores, it is impossible to ignore the contributions of Costco and Sam’s Club which created this model of retailing in the US and introduced it to China. Walmart opened its first Sam's Club stores in China as early as 1996. But in the early stages, because Chinese consumers were extremely price conscious, the opening of Sam's Club stores was slow. As of 2016, Walmart has opened only 16 stores, which are mainly concentrated in first-tier cities and provincial capitals. In fact, warehouse-type member stores are not an entirely new concept in China. Apart from Walmart, foreign supermarkets including Metro made similar attempts more than a decade ago, but their efforts did not pay off either. By 2019, however, the scene had changed. Costco had settled in Shanghai, and the popularity of warehouse membership stores had been rekindled. The main reasons for this renewed popularity are:
- Increase in quality consciousness of the Chinese consumer because of the rapid progression of consumption upgrading. Economic development and significant increases in per capita disposable income has meant that consumers' consumption behavior has changed. Consumers no longer simply pursue low prices and larger categories. They are now opting for more refined and higher quality products.
- On the flip side, of late, brick-and-mortar retailers have been suffering from a decrease in traffic and supermarket retailers have been losing business as e-commerce continues to make inroads into offline categories. Similarly, new retailers have forced their way into the market selling products such as vegetables and fresh food that were being supplied by traditional supermarkets. Yonghui, Renrenle and Beijing Hualian which recently joined the fray either saw their sales fall or even lost money during the first half of this year.
Faced with a growth dilemma, warehouse membership stores seem to have become the key avenue for physical retailers to retain consumers. Competition among domestic warehouse membership stores hinges on three areas: supply chain capabilities, the ability to select and define products, and digital capabilities. An analysis of the industry participants - multinational corporations, local supermarkets and new retailers – shows that their development depends upon the following characteristics:
- The first is the multinational warehouse club brand, led bt Sam’s Club and Costco. As the pioneer of this model, multinational warehouse-type club stores have solid first mover advantages. Their strong global supply chains, their ability to develop a self-owned, popular product, and their capability to select products and manufacture popular models are well ahead of the rest. The streamlined SKU not only effectively reduces transportation and display costs, but also makes it easy to scale up, effectively improving the bargaining power of enterprises on the upstream supply chain. From the perspective of digital capabilities, there are great differences among multinational enterprises. At present, Walmart leads in digital abilities amongst the multinational warehouse club stores. Since the launch of "speedup service" in 2018, Sam’s stores are now to be found in 22 cities, and they have set up nearly 100 cloud warehouses which cater to a much larger region. Moreover, the average daily order volume has increased by more than 10 times compared with that in 2018, becoming a new source of sales outside Sam's Club warehouse stores. In contrast, Costco's digital progress in China has been relatively slow. After years of market education, Chinese consumers have become accustomed to the consumption form of online and offline integration. Additionally, multinational warehouse operators also face fierce competition from domestic peers, direct-to-consumer fresh produce e-commerce and community quality-product supermarkets. Therefore, for multinational warehouse-type membership stores with slow digital penetration, the key to improving their digital footprint is to select SKUs for real-time consumption, build a digital warehouse for real-time distribution and increase the capacity of free or third-party real-time distribution.
- The second is the entry into warehouse-type membership stores by local operators of traditional retail businesses. Local enterprises have a great advantage in terms of local supply chain capacity as they are deeply rooted in China. However, in terms of direct purchase of imported goods and private brand building capability, local traditional operators still come up way short. In terms of digital capabilities, there are also great differences amongst local traditional formats. Yonghui, which has earlier transformed into digital and quickly laid out the "home mode", is an enterprise with better digital abilities among the local entrants into the business. According to its 2020 annual report, Yonghui's online sales reached RMB 5.91 billion, jumping 147% year-on-year. For new entrants such as Beijing Hualian, the development of online sales and home mode is still relatively slow. Therefore, for the traditional supermarkets and local enterprises that want to rush into the warehouse-type membership stores, they should first strengthen their global supply chains and purchasing abilities. At the same time, when the high-quality commodities directly purchased from abroad cannot meet the demand of low price and high quality, they should be quick to create their own domestic brands to fill this void.
- Finally, the new retail up-and-comers such as the Freshippo x membership store. As the first local enterprise to get into the warehouse-type membership store model, Freshippo x membership store shows strong advantages in its supply chains and digitalization. In terms of supply chains, since Freshippo x membership store piggybacks on the source supply chain of the HEMA ecosystem, it has stronger global direct purchasing abilities than its local peers. In addition, the self-owned products of Freshippo x membership store currently account for more than 40% of its total SKU. Since R&D, design, production lines and prices are independently controllable, a higher share of self-owned brands can help enterprises control costs better and pass on their improved margins to consumers while ensuring quality. In terms of digitalization, relying on the advantages of online and offline integrated operations, Freshippo x membership store also launched a 30-minute delivery to destinations within 3 kilometers of the stores, and its distribution scope also covers a 20 kilometer radius around its stores. Nevertheless, at present, membership stores are tending towards homogenization in the selection of products. For example, roasted chicken, Swiss rolls, croissants and sweet potatoes which have been hot selling items in multinational warehouse membership stores have become the "standard" items across all such stores. To solve the problem of homogenization, in the future, enterprises need to enhance product R&D capabilities, rely on the advantages of consumption big data, and launch more differentiated categories and commodities to improve their category barriers.