China’s Debt Crisis Reflects Deep Problems Within

In this month’s Owleye column, only the second since I began writing it last month, I would like to focus on China and its huge debt crisis, which leads to several other problems within its economy. While the debt crisis in China isn’t new (the earliest news reports of its looming debt problem surfaced in 2015-16) the recent spate of debt problems specific to the real estate industry is making even bigger headlines.

That’s because of China’s oversized real estate sector – some estimate it to be around 30% of China’s GDP – and also because most of the debt problems concern its dollar-denominated bonds. The fear, of course, is that the debt defaults if not controlled, can quickly spiral and ripple across financial markets which are quite interconnected around the world.

The most recent debt default is that of a real estate conglomerate, Evergrande, that is also in the business of EVs and banking. It has some US $ 300 billion of debt coming due and from what one read in the news, it has already defaulted on two payments. The Chinese government, while aware of the risk the Evergrande crisis poses to the economy and to financial markets, is trying to control the contagion. No one knows as yet, if Evergrande will eventually be bailed out by the government in order to contain the problem, but that seems more and more likely.

The massive indebtedness of China’s real estate industry is already evident in several other real estate firms facing similar problems. News reports also seem to indicate that the Chinese government has asked Evergrande to prioritise payments to local creditors over foreign creditors. I am not sure how many foreign creditors Evergrande has and who these might be, since media reports seem to focus only on local Chinese banks that appear to be the biggest creditors to the property sector. In the case of Evergrande, the problem is compounded, since it is a company listed in Hong Kong, and it issues dollar-denominated bonds that are also traded there. Besides, media reports seem to suggest that Evergrande’s biggest lenders are trusts and shadow banks, businesses that are already opaque in their operations.

So far, the Chinese government has issued statements saying that the Evergrande crisis is under control and will not spiral into a global catastrophe. Many wondered if a Chinese Lehman moment had arrived. I would not compare it with the 2007-08 global financial crisis just yet, but it did bring to mind the decade older Asian Financial Crisis. That’s because a debt default of this size can rattle the confidence of investors and the financial system. The Evergrande stock collapsed 74% between July 15, 2021 and November 11, 2021, when it was worth HK $ 2.53.

Worse, the planned asset sale fell through, taking the Evergrande stock lower by 12.5% in a single day. Indeed, the fear of an Evergrande contagion has spread through global markets, even as the Chinese government tries to assuage fears. To some extent this seems to have worked, as global investors are still buying loads of Chinese government securities and the country is not yet witnessing a broader sell-off. This is critical, though the Chinese government and Evergrande and other indebted property companies need to come to some kind of agreement soon as to how the crisis will be resolved.

While the Chinese economy and its government securities are not yet seeing a sell-off, the fact that the economy is slowing down considerably is also cause for concern. Another fallout of the Evergrande crisis could be its effect on consumer sentiment and consequently on consumer spending. Not only is the real estate sector almost a third of the country’s GDP, home ownership among China’s urban households is said to be 90%. That is a staggering level of home ownership in any advanced and developed economy I would think, let alone an emerging one.

For now, the most recent economic news out of China as of November 15, 2021 seems to indicate that most macro-economic indicators are still growing. Personal consumption, measured through retail sales, grew at 4.9%, industrial production grew at 3.5% and fixed asset investment grew at 6.1%, all over a year-ago period. Fixed asset investment, of which real estate is a significant part in China, however, did slow down on a monthly basis, thanks to the property debt crisis.

Which brings us to the main problem facing China. Home ownership is not necessarily only to live in, but has become an important investment in China, with plenty of speculation as well in the real estate sector. In fact, China in its building of several new cities, seems to have over-constructed housing units, much of which lies unsold. Media reports of ghost-towns that have come up in most cities and provinces, for which there are either no takers, or the builders have run out of money to complete the projects. There are an estimated 65 million homes in China’s cities lying as unsold inventory, and the actual number might be even more. The reasons are that real estate companies have over-estimated the housing market, while property prices have soared over the past decade or more, putting homes out of the reach of many ordinary urban Chinese.

The deeper malaise lies with China’s over-dependence on the property sector, which is what local governments rely on to raise money. It is a fundamental structural problem that the country must address, if it is to solve the overheated property market, and the over-indebted property companies. China is in many ways, a decentralized economy, according to Arthur Kroeber of Gavekal Dragonomics, in his book, China’s Economy: What Everyone Needs to Know. While he doesn’t write much about the country’s taxation structure or system, and neither does The Economist which mentions taxation reform in 1994 as the reason for local governments in China turning to land sales as the main source of revenue. Which explains why real estate is such an oversized part of China’s economy, why it is so overheated, why there is so much unsold inventory and why companies are drowning in debt.

An important dimension of China’s property crisis, is the local governments’ financial companies that were created to build roads, houses and infrastructure, but with little means to finance them. These LGFVs (Local Government Financing Vehicles) use land and other collateral to borrow from banks, the bond market and consumers to help finance real estate and infrastructure projects.

What is surprising is that a country that has prided itself on its infrastructure building capabilities has not found a viable way to finance them, whether state or private. The country has also not been able to provide Chinese people with enough attractive investment avenues. If it is indeed true that urban Chinese households now have property as accounting for 60% of their total assets and financial assets account for just 20%, then it is quite obvious that the Chinese have few places to park their money, and in relatively liquid form. This, for a country that traditionally had a high savings rate, like India, thanks to the absence of a social safety net.

It is good that China has started allowing local governments to raise money through municipal bonds as that is such an essential part of urban economies’ growth and renewal. The other step that the Chinese government ought to take is to allow local governments to also raise their own taxes and to share them more equitably. This might encourage provinces to compete for more investment and business, and that can only be a sign of a dynamic and healthy economy.

Finally, the Chinese government ought to think of ways that the Chinese household can save and invest their earnings in asset classes that are relatively liquid, and yield good returns. A country with a fairly large affluent class, with many millionaires and billionaires, and a middle-class as well that enjoys relatively high purchasing power ought to have more ways to save, invest and put their money to work than to tie it up in housing. This is also the reason why there are reports of capital flight from China, including investing in Hong Kong’s already overpriced housing market.

President Xi Jinping recently spoke of achieving “common prosperity” for the Chinese people as an aspiration for the country. If that is to be followed up with concrete action, then China needs to prepare a feasible and robust fiscal and financial system for the long term. One that encourages Chinese to pay their fair share of taxes and save and invest wisely while spending to keep their lives and the economy going. The other, to allow provinces and cities to raise their own revenues and borrow to manage and run their economies, without making any one sector the over-dominant one as has become the case with China’s property sector.

Just a thought they might want to consider, as I conclude this piece. Singapore in a sense achieves common prosperity at least in the housing sector, through state-subsidised public housing. That might be the way forward for many of China’s smaller towns and cities, so that housing becomes more affordable, and there is less speculation in the sector. Besides, the Chinese economy itself can then reduce its dependence on property to grow its economy.

The Evergrande crisis is only the tip of the iceberg. It requires the Chinese government to look deeper into the problems that lie within their economy, before it snowballs into a catastrophe of ever-grand proportions affecting global markets.  

The animated owl gif that forms the featured image and title of the Owleye column is by and I am thankful to them.   

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