Evergrande more Greece than Lehman

The Evergrande saga is intensifying daily. The firm’s equity is all but gone. Its debt barely trades. Its sales and assets are crashing in value. Its brand damage is ruinous:

Moreover, we have now reached a point of open crisis for the entire Chinese property development sector. Funding spread blowouts are indistinguishable from being frozen. Good and bad equity is being priced for calamity. Market confidence is gone. Rumours of bailouts and hare-brained schemes for saves are rampant:

However, the signals coming from policymakers are serene. The “common prosperity” rhetorical umbrella that is covering a wave of regulatory interventions in China enables Bejing to justify hammering rentier billionaires, and no bailout for developers appears imminent.

Indeed, on Friday, the state-sponsored Global Times troll-in-chief declared that no support is coming:

The editor-in-chief of state-backed Chinese newspaper Global Times warned debt-ridden property giant Evergrande Group (3333.HK) that it should not bet on a government bailout on the assumption that it is “too big to fail”.

It was the first commentary to appear in state-backed media casting doubt on a government bailout for the country’s No.2 property developer, whose shares fell on Friday for the fifth consecutive day amid concerns it is heading for default.

Evergrande is scrambling to raise funds to pay its many lenders and suppliers and investors, with regulators warning its $305 billion of liabilities could spark broader risks to the country’s financial system if not stabilised. read more

Global Times’ editor-in-chief Hu Xijin said on his WeChat social media account on Thursday that Evergrande should turn to the market for salvation, not the government.

The base case for the Evergrande crisis has thus shifted to an enduring shakeout for Chinese property development. But of what variety?

Ruin or reform?

You could hardly be blamed for being reminded of other financial crises like the Lehman Brothers moment that triggered the Global Financial Crisis. The underlying imbalance is an immense property bubble. The leverage is terrifying. The players are too-big-to-fail and policymakers are wedged between moral hazard and catastrophe.

Or, is this the case? There is another way to look at this latest Chinese reform episode. This is the fourth instalment of Chinese attempts to rid itself of its troublesome property development sector. The first began in 2011. It was ramped up again in 2015 and 2019. Each time, the failing growth that followed has spooked policymakers into more stimulus.

China keeps returning to this program for one reason. Its property market excesses are the key threat to its economic development path. Property is both the source of its enduring catch-up growth and its doom if allowed to run too far. No other Chinese sector misallocates capital and kills productivity on such a massive scale. If not restructured it will drag China into the middle-income trap of weak income, stalled growth and declining efficiency.

If so, the key to understanding this crisis is that it is more deliberate than the Lehman Brothers episode. It probably doesn’t threaten the financial system. China owns its banks and can liquify credit any time it likes. It could bail out Evergrande and its property sector tomorrow if it wanted to. It has oodles of monetary space to play with and can, at any time, stimulate more property activity by loosening macroprudential controls. It is choosing not to.

That is not to say that no financial crisis is ahead. It is. But it is not so much for banks (which will see turbulence) as it is property developers specifically.

The implications of this are still very material, and in some ways even more so. A deep recession for Chinese construction will be a significant hit to overall Chinese growth, more than anybody is expecting in Q4 and 2022. This is owing to two factors:

  • First, the direct impact of less construction will be exacerbated by a bad debt shock that will curtail some lending, and falling property prices (in some areas) will crimp consumption.
  • Second, infrastructure will not rebound in its place as hoped. It is too closely linked to property in local government balance sheets.

Moreover, if economic restructuring is the goal then the recovery will look different as well. Stimulus will be slower to come than usual. And when the shakeout is complete, the recovery won’t be v-shaped. It will be L-shaped as property development grows via quality not quantity from a greatly diminished base.

Lehman or Greece?

If we’re seeking a historical analogy to make sense of such an intentional campaign of economic restructuring around the GFC period, then there is another episode to consider. In 2010,  Germany took advantage of the post-GFC boom to lead Europe into a deleveraging and structural reform episode. The European debt crisis was allowed to run unabated by German authorities to reform economies running twin deficits. The “PIIGS” as we knew them.

That crisis could have been ended at any time, too. But it was only when Teutonic states were satisfied that the message to stop the waste have gotten through to the “PIIGS” policymakers that the ECB was allowed to print and restore order to yields.

Analogously, China has built out its urban environment sufficient to support its ongoing people movements up to 80% urbanisation in the 2030s. Doing more of it will only strangle the economy with unproductive debt. China only has another 200m people to shift and roughly 60m empty apartments have them covered already.

The breaking of Evergrande and its peers can thus be seen as an admirable undertaking to clean up wasted capital; a long-delayed but essential step if China is to springboard its economy beyond the middle-income trap via higher value-added growth.

The fallout

Yet, for everyone else, it is still the end of the greatest phase of Chinese catch-up growth.

If the Chinese reform effort base case transpires then it augers a global economic adjustment that will encompass everything from crushed commodity prices, challenged EM export-dependencies, competition with China on value-added output, a deflation tsunami akin to a global recession, and a reckoning for overvalued developed market assets.

Policymakers will be incrementally supportive in the form of a slow-motion restructuring of Evergrande and other distressed developers without obvious bailouts. Anne Stevenson-Yang summarises how it will likely happen.

There will be deep RRR and rate cuts in due course, as well as more fiscal support, though not in property.

That implies a big drop ahead for the yuan. This will export a lot of economic pressure to emerging market external balances as commodity prices crash and their competitiveness versus China erodes. If the Fed tapers at the same time and adds pressure to EM capital accounts, then an EM crisis looms as the greatest risk of international contagion.

Finally, there are two other risk scenarios to consider, one downside and one upside. It is still entirely possible that China loses control of the shakeout. China’s fantastically opaque daisy chains of finance may unravel and draw in the financial system. Policy error remains the outstanding risk of our time.

If that happens, and Chinese house prices follow Evergrande into the abyss, then the global economy may be witnessing the beginning of the end of the post-COVID cycle.

Which leaves us with the second risk case. That Evergrande panics policymakers into another round of broad stimulus and we do it all again in 18 months’ time!

Houses and Holes
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  1. Jumping jack flash

    Mortgage debt was framed by the banks as being a fundamental and absolutely necessary driver of the New Economy of debt (unnecesary in China, but people are people).

    The “wealth effect” was invented by the banks and seriously made no sense. The wealth effect was simply people getting used to taking on more debt after taking on an enormous mortgage.

    If nothing else, the last few years since 2017 have shown that mortgage debt doesn’t actually make its way into the wider economy to be used for consumption. Instead it just sits there locked up in houses and collects interest. If the debt doesn’t grow fast enough to pay most of the interest, the interest is taken from consumption!

    Is China the first country to realise that and chop the cancerous tumor of trillions of dollars of nonproductive mortgage debt weighing heavily on the economy off?

    As long as consumption was protected there is no reason not to do it. In a properly functioning economy based on transforming raw materials into useful goods to sell to the world for profit, banks and their debt is completely unnecessary. We are only in this situation because banks have inserted their debt into the economic cycle and made it essential to own.

    • My greatest fear is that China will find someone to blame for their homegrown misfortune.
      In many ways it was a debt crises which usurer in an era of ultra-nationalism following the excesses of the 1920’s
      In Germany the boogieman was a Jewish banker and before long anything Jewish was fair game for the nationalists. It couldn’t possibly be their fault and it certainly wasn’t the fault of the Germanic peoples, they were pure, they were Aryan!
      Similar nationalist sentiments are the cornerstone of Chinese culture, so whatever happens here you can be certain of one thing, it’s not China’s fault! By extension it’s not the fault of the Chinese, but obviously someone is to blame, someone caused this, someone is intentionally hurting the Chinese peoples.
      You don’t need to spend much time exploring this rabbit hole before you find the US’s fingerprints all over the place, it also doesn’t take a genius to link Taiwan to the US …the story becomes somewhat self fulfilling, as the only possible solution emerges.
      I’m certain that China doesn’t want to go to war, but I’m equally certain that they don’t want to really take responsibility for their own stupidity. Even if they do somewhat take responsibility, what form does this correction take?
      This is the junction where China’s own Military Industrial complex comes up with its own solution. The solution starts with developing China’s military capabilities but ends with them using these capabilities.

      • The CCP will blame Australia! That said the Chinese people are smarter than that, they could see through the BS, at least they where a few years ago. Back then it seemed as though any major disaster could spark a revolution. Now with nationalism running rampant the vast majority, like in Germany, may choose to follow the narrative that it was the west that done it!

        • No matter how smart people are, analysis requires information. The information flow is very tightly constrained. To an outside observer it was clear just how serious this was going to be when the CCP outlawed any adverse financial commentary a couple of weeks ago. It’s all the fault of foreigners. Unleash the wolf warriors!

  2. As far as entertainment goes, this is up there.
    daily episodes, potential plot twists here and there, plenty of bad guys interspersed with a few sad stories and an ending were just not sure of.
    Now this IS reality TV

  3. One other factor I’ve not heard anyone mention is demographics and how these forces are different from what we have seen in other markets China should already be well past peak earning according to demographics, the point at which Japan real estate bubble collapsed. Of course Japan didn’t have 20% odd of empty apartments or 200m people still to enter the cities, I am not sure how these people can enter the expensive cities or how the empty properties are sold for profit to these people. What happens when the group think of property investment being magic ends? Will it even? Are there really 200m productive people to enter the cities or are they mostly old & uneducated, is it worth leaving their small holding to labour in the city?

  4. Japan and the USA. Time to find out if China really is different! Seeing all those empty apartments coming down suggests something different. However, I’m not convinced. Average Jo-China must love their property and gambling almost as much as Aussies. Both will be seen to have taken a hit by the govt at the end of the day. No fear of being voted out might save them but surely there are a few ‘Henry Paulson’ types doing the rounds on the developer’s behalfs over there?

  5. With all this panic can you tell me where the money is going ?
    It’s certainly not bonds & if it’s running to the USD there must be a lot of selling here because it’s not going up much ?
    You’d think with AUST probably most affected from a China contagion our bond yields would be falling & why isn’t the AUD falling today ?

    You’d think copper futures would be falling ? Not even moving at all

    Feels like a capitulation in commodity miners at the bottom

    Feels like capitulation from long positions in panic

    You’re all tapping away with your articles preying for a global crisis & only iron is moving & I wouldn’t be surprised how many shorts are building up in iron ore too

    Looks like you are trying to push everything down & hoping

  6. The whole episode is so far reasonably benign. I wonder if the risk is that the central agency overplays their hand on the next one