Just as a personal crisis can lead you to dig deeper into yourself, so the rapid-fire events in China - with trillions of dollars of business and investment on the line - have led us to (finally) go deeper into how China works – and to come to grips with uncertainties caused by Xi Jinping’s recent moves to reshape the Chinese economy and the Party’s social contract with the Chinese people.

• The latest upheaval – the likely default and restructuring of Evergrande – has generated some excellent analyses of how China’s property works and doesn’t work.

There are more these than I could cover in ten issues.

• So today I bring a few that I found to be especially useful.

All the best,

Malcolm

1 | How China's Capitalists Define 'Luck'

I am in the camp that Evergrande will not be China’s ‘Lehman Moment’ – more like a ‘Bear Stearns Moment,’ a signal that a crisis may be brewing.

• As Liqian Ren of WisdomTree ETF writes in ‘What’s the Likely End for Evergrande?’:

‘Although its debt of $300 billion is high, the problem has not arisen suddenly like Lehman Brothers.’

• ‘During the Lehman crisis, the confusion over “who owes what with how much leverage” is what led to contagion.’
• ‘In fact, the Chinese government has generally had some idea of how much risk Evergrande and other highly leveraged real estate companies pose since last year.’

Also overlooked in the handwringing among institutional investors is that:

• ‘The government also has had experience restructuring and winding down a few very large firms, such as Suning, Anbang and HNA Group.’

So what is Evergrande’s fate? Dr. Ren says: ‘Evergrande as a company likely will go bust, depending on how you define “bust.” ’

• ‘It could be broken up and sold off like the insurance conglomerate, AnBang.’ In that situation, the brand name was lost and the CEO was convicted and sentenced to 18 years in prison.’
• ‘Or, it could also end up like HNA Group, where the founder’s equity was completely wiped out. In that case, the government proclaimed that “it is what free market should be.” ’
• ‘It might be lucky and continue to exist, like Suning, whose founder was able to quietly keep some money.’

And, my favorite line:

• ‘In any case, the founder’s best hope is to stay out of prison and keep some money while Evergrande is re-structured.’

Chinese capitalism at its best, in a nutshell.

2 | The Impact of Chinese Homebuyers' Psychology

In ‘Evergrande on the Brink’, MacroPolo’s Dinny McMahon in a Trivium China ‘Flash Talk,’ moderated by Andrew Polk, gives one of the best analyses of Evergrande’s and the property sector’s threats to the Chinese economy.

• A 55 minute-video and well worth watching
• Here’s just one part from Mr. McMahon.

‘There is real potential for things to go seriously wrong and for there to be real contagion emerging from an Evergrande default.’

• ‘The potential for contagion doesn't necessarily come through the banks and the bond markets of the wealth management products.’
• ‘It comes from Chinese households pre-paying property developers for their apartments.’

‘Evergrande has something like 800 projects spread around the country.’

• ‘The New York Times printed the figure that something like more than a million people have prepaid for apartments that are still under construction by Evergrande.’

‘Pre-payment has become an incredibly important source of funding for most major developers in China.’

• ‘It's become even more important for those developers that are in violation of either all three red lines or, or two red lines [put into place by the Chinese government to limit borrowing by already heavily-leveraged property developers].’

‘The risk is that Chinese households will look at what's happening at Evergrande. And we’re seeing it with how they treat Evergrande.’

• ‘Over the last three months, month on month, people are being less willing to buy Evergrande apartments on contract, precisely because they're not sure whether if they buy them today, they will ever receive their apartment in the future - or even if they do receive it, will it be on time.’

‘So the real risk of an Evergrande default is that there is a shift in the psychology of Chinese consumers – that is they start looking around for who could potentially be the next Evergrande.’

• ‘Looking at developers that are having trouble repaying their contractors or their suppliers on time and going, “You know, I'm not quite sure how bad this company's finances are, but I think probably the best thing I can do at the moment is maybe not buy an apartment from them in advance today; maybe I'll give it a year.” ’
• ‘ “Or maybe rather than buy it from this company, I'll buy it from a Vanke or a company that I know is genuinely secure in its finances." ’

‘And it's there that you get the potential for contagion because the effect would, in some ways, be akin to a run on a bank.’

• ‘And a vital source of credit and financing for the weaker developers will just start to dry up.’
• ‘Ultimately you can end up with more defaults.’

‘What starts off as a problem exclusively with Evergrande today can start to snowball to take in other, relatively weak, developers tomorrow.’

3 | Magnifying the Impact of an Evergrande Default

‘Three sources of uncertainty could greatly magnify the negative impact of an Evergrande default on the rest of the Chinese economy,’ writes Shang Jin-Wei, professor at Columbia Business School and former Chief Economist at the Asia Development Bank in 'Preventing an Evergrande Confidence Crisis in China.'

‘First, there would be a psychological spillover to many other property developers that, like Evergrande, use debt to finance their operations.’

‘If potential lenders to these companies are worried about the property sector’s demise, many firms may find that their funding dries up.’

• ‘As fears of a chain of bankruptcies in the sector become self-fulfilling, a large number of these firms will go under, too.’

‘Then there is the spillover from Evergrande to China’s financial system.’

• ‘While the extent of the firm’s borrowing from banks and non-bank financial institutions is easy to discover and document, the channels and the size of various indirect effects are more uncertain.’
• ‘For example, if Evergrande goes under, many of its steel, cement, and equipment suppliers also may have trouble repaying their bank loans. Banks’ outstanding loans to other property firms could become non-performing as well.’

‘Separately, Evergrande has also aggressively tapped into China’s shadow banking sector to finance its operations, and some of this borrowing is managed by non-listed parts of the group that do not disclose their balance sheets fully.’

• ‘There is no transparent and audited account of the size of these borrowings.’

‘The third and perhaps most important source of uncertainty is whether the Chinese authorities can prevent a full-blown financial meltdown if the Evergrande problem develops into a systemic crisis.’

• ‘Evergrande’s total liabilities are estimated to be about CN¥2 trillion(roughly $300 billion), which is equivalent to approximately 2% of China’s GDP in 2020.’
• ‘Because China has a much lower government-debt-to-GDP ratio (about 70%in 2021) than the United States (133%), Japan (257%), and France (115%), the government still has the fiscal capacity to deal with a potential crisis.’
• ‘And the People’s Bank of China has the tools and ability to inject liquidity into the economy to address any potential credit freeze.’

‘What is less certain is whether the authorities have the will to take such steps.’

• ‘Evergrande is not a state-owned entity, and the government might be reluctant to help the firm’s multi-billionaire founder and controlling shareholder, Hui Ka Yan, in view of its current “common prosperity” campaign.’

‘The Chinese authorities can take two steps to prevent a bank run and calm capital markets.

• ‘The first is to communicate clearly that they can save Evergrande’s many stakeholders (other than Hui). These include its lenders and employees, and households that have paid the company for an apartment but have not yet received one. This can be accomplished by facilitating other firms’ purchases of construction projects and other assets from Evergrande.’
• ‘Second, the government can announce a contingency plan involving quick and decisive steps to stop the various spillovers in the event that Evergrande goes bankrupt.’

4 | Property's Outsized Role in China's Economy

For years, I have said that if I could only track one thing in the Chinese economy it would be property.

• For most years, that meant tracking Beijing’s regulators putting on the foot on the gas when it needed to juice the economy and on the brakes when the sector was overheating.

Why I chose property is its outsized role in the Chinese economy.

• There’s the direct input from construction and sales as well as related industries from concrete and sale to equipment to furniture and appliances to services.
• But also the impact on commodities: iron, zinc, copper, and so on. [When China was making a major push to build low-income housing, a hedge fund analyst asked me if these millions of units would have air conditioners. Air conditioners use copper and demand like that would drive copper prices up.]
• And of course employment: real estate and construction alone employ nearly 20 per cent of China’s urban workforce.

And that role is outsized in comparison to most other economies. As Kenneth S. Rogoff of Harvard and Yuanchen Yang of Tsinghua found in their 2020 analysis, ‘Peak China Housing’ (you will see this study referred in just about every article on the issue) real estate and related industries, as this chart shows, accounted for almost 30% of China’s GDP in 2016.

• And, according to Paola Subacchi in 'A Made-in-China Financial Crisis?' 'real-estate value added contributes about 6.5% to China’s GDP. (If indirect contributions, such as fixed-asset investment, are considered, the sector’s contribution to Chinese growth is even larger.)'

The Rogoff report concludes that ‘a 20% fall in real estate activity could lead to a 5-10% fall in GDP, even without amplification from a banking crisis, or accounting for the importance of real estate as collateral.

• And this of course if why Beijing is worried about an Evergrande and the impact its default could have.

5 | Build, Build, Build

As James Kygne and Sun Yu of the Financial Times in ‘Evergrande and the end of China’s ‘build, build, build” ’ model, point out:

• ‘Evergrande, for all of the high drama of its meltdown, is merely the symptom of a much bigger problem.’

‘China’s vast real estate sector is so overbuilt that it threatens to relinquish its longstanding role as a prime driver of Chinese economic growth and, instead, become a drag on it.’

• ‘There is enough empty property in China to house over 90m people.’
• ‘Five G7 countries — France, Germany, Italy, the UK and Canada —could each fit their entire population into those empty Chinese apartments with room to spare.’

From this, Martin Sandbu of the Financial Times in ‘The real meaning of China’s Evergrande problem’ makes an interesting argument:

• ‘Given the signs of oversupply, one has to wonder about the actual economic value of those contributions to GDP: China’s past growth may not be all that it seemed.’

‘On Rogoff and Yang’s numbers [in ‘Peak Housing,’ discussed above], real estate’s share of GDP increased by almost 10 percentage points (or about half the starting share) in the five years following the global financial crisis, and then stayed flat near 30.’

• ‘On a rough approximation, that means these activities contributed nearly half of China’s strong GDP growth in those years, and a continuing near-30 per cent or so of growth in the ensuing years.’

‘Did all this activity really add value — something that constitutes Chinese prosperity? Or was some of it more what we may call “pseudo-income”, which shows up in the numbers but does not reflect anything that is actually valuable so to speak on the ground?’

• ‘The stories about Chinese “ghost cities” that have circulated for more than a decade — and more recently, reports of demolition of never-occupied buildings — suggest the answer is no.’
• ‘And given the sheer size of real estate’s importance, China’s real prosperity may be much lower than what growth rates and GDP levels have measured.’

How much indeed?

• Many years ago, Patrick Chovanec of Silvercrest contended that much of China’s GDP came from the equivalent of digging big holes and filling them back in.
• China has at least advanced to building tall buildings and then tearing them down.

6 | A Little Context

‘For much of this year commentators have been warning that falling yields suggest the bond market is increasingly irrational, out of touch with a rapid global recovery and misled by heavy central bank buying or the ebbs and flows of the pandemic,’ writes Morgan Stanley’s Ruchir Sharma.

• ‘Now, events in China suggest the bond markets are far from clueless or crazy.’  

‘The world’s most indebted real estate developer, Evergrande, is on the verge of default.’

• ‘Its troubles are reverberating across China’s property sector and the world, revealing a very rational reason why long-term interest rates would not rise too far: the global economy is heavily indebted and too financially fragile to handle tighter credit conditions.’

‘We are caught in a debt trap.’

• ‘China is stuck in the deep end of this quagmire.

'Since the global financial crisis of 2008, China has led the debt binge:’

• ‘private debt held by households and corporations has risen by nearly 100 percentage points to 260 per cent of gross domestic product in China, accounting for nearly two-thirds of the global increase.’

That's a bet I'm not sure I would take.

‘By early 2016 China was on the financial brink.’

• ‘Default rates were rising rapidly. Capital was rushing out of the country.’
• ‘To stave off another global financial crisis, the US Federal Reserve had to abandon plans to tighten monetary policy and Chinese authorities had to inject massive amounts of money into the financial system.’  

‘Over the next five years, China slowed much less rapidly than one would expect given the debt levels, thanks to the meteoric rise of its tech sector.’

• ‘The new economy, led by digital technology companies in the private sector, was virtually debt-free and grew explosively.’
• ‘The tech sector now accounts for a staggering 40 per cent of the Chinese economy, up from 20 per cent in 2016.’

‘In the background, however, the debt bomb was still ticking.’

• ‘After 2016, private debts rose another 20-plus percentage points as a share of GDP, with households taking on mortgages at a record pace.’

‘Much of it went to further inflating the property bubble.’

• ‘About 40 per cent of the Chinese banking system’s assets are now tied to the property sector.’  

‘In many ways, China follows the same deformed model of capitalism as most western countries, only more so, taking on ever increasing levels of debt to generate less and less growth.’  

• ‘The result is growing financial fragility.’

‘Like its more advanced rivals from the US to Japan, China has created a financial system that is in constant need of government support and stimulus.’

• ‘Policymakers keep economic growth going at any cost, and repeatedly back down from tightening policy at the slightest hint of economic or financial trouble.’
• ‘Whenever a company of any consequence gets into difficulty, authorities have stepped in with a bailout.’

‘That’s especially true in China, where in recent years default rates have run far below the very low global averages.’  

• ‘Conditioned to expect the government to intervene in time to stave off any crisis, global investors have not pulled money out of China, yet.’
• ‘But if Xi were to depart from the past, by purging debts and letting defaults spike, it could trigger a nervous breakdown in the world’s financial system.’

‘What we are likely to witness over the coming months is an epic clash between a leader with supreme powers determined to change the course of his nation, and the economic constraints imposed by gargantuan debts.’

• ‘For now, the markets are still betting that the stakes are too high, even for a leader as powerful as Xi, to wean China suddenly off a debt-fuelled form of capitalism the world has been practising for years.'

That's a bet I'm not sure I would take.