After the Great Financial Crisis, China was universally admired for its apt handling of the economic fallout caused by the implosion of the US real estate bubble and the ensuing global collapse of the entire financial industry. China pulled it off by doubling down on real estate. Having relied on the real estate sector as a catalyst for growth since the 1990s, China again funnelled its entire $586 billion crash stimulus programme into property development.
Dutifully it generated half of China’s emergency growth and still constitutes 29 per cent of China’s GDP. When last month China’s biggest private developer Evergrande slid into insolvency, markets began to worry. After all, we are used to and depend on China growing smoothly.
China’s construction industry, as it became apparent, had done very little to increase the wealth of the nation in any meaningful way. Ghost cities of gleaming but unoccupied apartment towers disfigure the outskirts of many rural towns which have little use for them beyond boosting municipal coffers by means of land sales to developers and the fulfilment of economic target figures.
Unfinished construction sites, monuments to pointless economic activity, have been lately brought down by demolition squads – unspoken admission of value destruction on a large scale.
The dangers of making a country predominantly rely on real estate developers should resonate with us in Malta too, which obstinately barters passports and tax benefits for overpriced property ‘investments’. This too may come to an end one day. Take note: rural land conversion to urban use is rampant in China.
There are enough empty apartments idling about all over China to house 90 million occupants, according to consultancy Rhodium Group, and yet construction continues, despite the fact that 90 per cent of urban households own apartments already and 87 per cent of all new sales go to second-home owners betting on ever-rising prices.
These retail speculators are oblivious to the fact that China has a dwindling birth rate, hence a population which has not only stopped growing, but will soon start to shrink. Attempts to curb abortions and the cancelling of the infamous one-child policy will do very little to persuade women to grow their households against their will, one can assume.
China’s real estate bubble relies today entirely on financial speculation, causing a deficit boom in central areas and unneeded housing elsewhere. This has reached the ear and attention of the new Great Helmsman, Xi Jinping, who declared that “houses are for living, not speculation” and should underpin “common prosperity” – meaning that he does not want oligarchs getting rich by spinning pyramid schemes which threaten to destabilise a country with an ever more fragile debt mountain.
‘Three red lines’ were therefore postulated by Chinese Communist Party (CCP) policy makers: debt-to-asset ratios, debt-to-equity ratios and cash-to-short-term-debt ratios have to stay well within levels considered safe. Bank lending to the sector was thus throttled.
This deprived developers of the means to keep the ball rolling and is now endangering a main pillar of the economy: real estate activity represents an astounding 29 per cent of China’s total output. An estimated 40 per cent of bank assets are held in the property sector, part of a total sector debt of $2.8 trillion, which employs 20 per cent of urban labour.
The dangers of making a country predominantly rely on real estate developers should resonate with us in Malta too- Andreas Weitzer
Real estate constitutes 60 per cent of household assets in China, their wealth tied to real estate prices and to saving products pitched by developers. It is hard to fathom how China’s economy can be decoupled from this, despite the urgency.
Evergrande (EG), the world’s most indebted developer and the biggest issuer of junk bonds in Asia, epitomises China’s obsession with property development in perfect detail. The script of EG’s demise, written now in real-time by the CCP, is exemplary for things to come. To finance its relentless building tsunami, EG depended not only on bank finance and domestic and international bonds.
Cash flow was also generated by delaying payment to suppliers and the issuing of high-yielding ‘investment’ products marketed to gullible retail investors. The major part of its funding, more than 50 per cent, derived from pre-sales of planned construction. An estimated 1.6 million flats have thus been sold to buyers who may never see them completed.
To preserve cash, construction was stopped. Retail investors were duped to sell their expiring, high-yield debentures to EG’s cronies at a discount, who were then paid in full. Parking lots were offered in lieu of money due. Completed flats were sold off at steep discounts, unnerving existing homeowners who saw their wealth steeply diminished. The Communist Party, habitually railing against expensive real estate, was now compelled to label these fire sales “malicious price cutting”.
As it looks, shares in Evergrande, suspended on stock exchanges in China and Hong Kong, will be worthless. International creditors and bondholders will face the brunt of losses. But what to do with all the customers who had paid in advance; homeowners who all of a sudden are seeing their wealth diminished; tricked retail investors; unpaid suppliers; and millions of workers facing redundancy?
And what to do with the financial industry so intricately enmeshed with Evergrande? My guess is when the problems start to get out of hand the Chinese leadership will yet again reverse course and postpone all necessary financial reform to die another day.
China’s handling of this malaise is consequential. It is the playbook written for all other Chinese developers, for the country as a whole, and for us investors. The real estate sector was a reliable growth contributor to an economy which could not possibly grow exports at the same pace anymore as we have witnessed in the last three decades – trade wars and labour cost inflation have put a damper on this.
Alternatives to real estate will be hard to find. Electricity blackouts which recently hit many parts of China and ballooning energy prices make green investments, however necessary, a politically risky proposition. (We will see how western democracies fare in this expensive transition). Consumption as a growth tool can only work when inequality is meaningfully reversed – hence the billionaire bashing and the new Mao- slogans of “common prosperity”.
Until such goals miraculously become reality, the wealthy will consume less. New high-rises, long considered a tool to break up village communities and ethnic minorities, have created an atomised populace exclusively dependent on the CCP. This makes the Communist Party in turn exclusively at fault. Missteps risk social unrest. Increasingly brutal control will intensify, hurting growth.
Our retail investments over the last two decades rested on the assumption of China’s unwavering, economic expansion. It profited exporters of machinery, commodities and consumer goods from the rest of the world. As illustrated, neither export, nor consumption, nor public or private investment can guarantee China’s continuous growth we have long taken for granted. It is time to examine our portfolio.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com