Chancellor: Evergrande is all China’s woes in one

LONDON, Sept 30 (Reuters Breakingviews) - Former Chinese Premier Wen Jiabao called China’s economy “unstable, unbalanced, uncoordinated and unsustainable” 14 years ago. Whether he foresaw that China would one day be beset by a massive real estate bubble, over-investment, excessive buildup of debt and a wobbly credit system is not known - but it has come to fruition. China Evergrande (3333.HK), the stricken Chinese property developer, has long existed at the intersection of these imbalances. read more By setting up Evergrande to fail, President Xi Jinping has shown that he intends to grasp the nettle. As China’s bubble economy deflates, it will be replaced by a new economic system under Xi’s absolute command.

Before the global financial crisis, China’s growth was propelled by surging exports and related investment in factories and manufacturing. After Lehman Brothers went bust, Beijing launched a massive stimulus plan, financed by borrowed money. Over the following years, China’s economy was driven by ever-larger doses of investment and credit. The country’s property market was at the centre of this boom. Having survived numerous setbacks, Chinese real estate gained a reputation for invincibility. As the title of a recent book put it, it was the “bubble that never pops.”

Unlike most senior Chinese politicians Xi was not entranced by the soaring property market. Real estate booms deliver low quality or “fictional” growth, he said. In recent years, returns on investment in China have collapsed and productivity growth (output per capita) has fallen to half its 2007 level. Xi also branded the property boom as socially divisive. Land development fueled public corruption, which Xi was trying to stamp out. Rising home prices worsened inequality – around half of the world’s real estate billionaires come from the People’s Republic – and priced younger people out of the market. Millions of properties owned by investors have been kept vacant.

Last year, the pandemic sent China’s housing market into overdrive. At which point, Beijing issued its “three red lines” limiting developers’ use of leverage. These new rules ultimately brought Evergrande to the brink. Housing sales have recently collapsed. This is a risky move. The value of China’s housing stock is around 3.7 times GDP, according to Stewart Paterson of Capital Dialectics. Much of China’s debt is secured against real estate. Nearly a third of economic activity is exposed, directly or indirectly, to property development.

No country has ever deflated a real estate bubble without experiencing a severe economic slump, often accompanied by a financial crisis. There are parallels with the Japanese bubble economy that burst three decades ago. The total value of Chinese property (relative to GDP) is roughly on par with Japanese real estate at its 1990 peak. Credit growth in China has been more extreme than Japan witnessed in the 1980s. After Tokyo jacked up interest rates to burst its speculative frenzy, a severe banking crisis followed, and the economy suffered a “lost decade.” At the same time, the decline of Japan’s working population exacerbated the deflationary forces unleashed by the bubble’s collapse. China faces a similar predicament today.

Beijing, however, believes it is better placed than Tokyo was to manage the fallout. State-controlled developers and local governments will probably take over housing projects from Evergrande and other private developers. Contract law won’t determine how bad debts are sorted out. Instead, non-performing loans will be shuffled around China’s opaque credit system with the authorities deciding who absorbs the losses. It helps that the People’s Republic has relatively limited exposure to foreign creditors.

China’s economy is almost certain to slow as the bubble lets out air. It is often said that the legitimacy of Communist Party rule depends on the party delivering economic growth. But the party’s current general secretary is more interested in “resilience” and “common prosperity” than in meeting GDP targets. His primary aim is not economic but national “rejuvenation.” In pursuit of those goals, Xi is prepared to sacrifice immediate economic growth. His political position is strong enough to take on the vested interests that will be suffer most from the collapse.

Besides, Xi has a vision for the future. His China 2025 economic development plan aims to establish Chinese predominance in a variety of new technologies, from artificial intelligence to robotics. A system of social credits, which rewards and punishes citizens’ behaviour, will supplement conventional credit. There’s no place for cryptos in this world. Instead, a digital yuan issued by the central bank will supplement, and perhaps even replace, conventional money. The country’s economic structure, currently built on bricks and mortar, will become more digital. Big Data, fed by the internet and the hundreds of millions of public cameras, will support Xi’s surveillance society.

Western investors have plenty to chew on. The immediate impact of the real estate downturn is deflationary. China’s shift from investment-driven growth will reduce global demand for raw materials. If the PBOC prints money to ease debt problems, as seems likely, the yuan could take a hit on the foreign exchanges. Capital flight may put further pressure on the currency. But if China dumps cheap surplus goods on the rest of the world, trade tensions are bound to resurface.

China is becoming a more dangerous place for foreign investors. Beijing’s recent treatment of technology companies and listed education enterprises shows that every Chinese company must put the state’s interests ahead of shareholders. As bad debt problems surface, foreign creditors will find themselves at the back of the line. Tellingly, when Evergrande last week missed a payment to foreign creditors it was reported that interest due on its domestic debt had been renegotiated.

The period of “reform and opening” that started with Deng Xiaoping’s reforms in the late 1970s revived the “China Dream” – the longstanding notion that demand from the country’s enormous population would generate vast profits for foreigners. That dream is now dead. In its place, Xi talks about the “Chinese Dream”, a collectivist project that exalts the nation state and places the party he leads in total control. Socialism with Chinese Characteristics is starting to look a lot like old-fashioned communism. Except this time, its technology is more advanced.

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