Evergrande – Probably nothing to worry about???

Probably nothing to worry about…

This Evergrande situation is really important for China. And, as we will see, really problematic.

Whilst I sure don’t consider myself a “china-expert”, I’ve casually studied their economy for well over a decade now. In order to understand the problems Evergrande presents (and why they have been completely predictable), it’s important to understand the path that has led us here. With that in mind, let’s start with the modern history of China (the brief, crude version lest we turn this into a 50-page essay).

China as we know it today was born in 1949 when the Communist Party finally won the protracted war with the Kuomintan-led government of the Republic of China that had been going since the 1920’s. The final phase – the Chinese Communist Revolution – came at the end of World War Two and culminated in Communist Party forces overthrowing the Republican forces, seizing control of the mainland and forcing the remaining Republican leaders to flee to the island of Taiwan. Both maintained they were the legitimate rulers of China and sporadic fighting continued until 1979.

The new Communist Party didn’t make a great start in terms of global relations – the year after seizing power around 1 million People’s Liberation Army soldiers filed across the border to fight United Nations troops in North Korea. This resulted in a trade embargo with the West lasting more than two decades.

Economically, the “rise” of China began in 1979 under the leadership of Deng Xiaoping. Prior to then, the Communist Party under the leadership of Mao Zedong maintained a tightlycontrolled centrally planned economy. Most economic production came via State-owned enterprises (“SOE’s”). Private enterprises were basically outlawed, as was foreign investment.

Mao passed away in 1976 with Deng Xiaoping managing to secure leadership in 1978. He inherited one of the poorest nations on earth and a population growing increasingly disenchanted with the Communist Party.

Deng realised that reforms were essential and opening up to the world was an important part. They began to introduce free market principles – starting with moves such as handing more managerial power of SOE’s over to local governments and enabling them to operate and compete under free market principles.

He reached out to the West, in search of technology and know-how to help drag China into the modern era. Their large population was an attraction for the Jimmy Carter administration and a flourishing trade relationship ensued.

From the get-go, the trade relationship wasn’t perfect. China quickly demonstrated that it had no regard for intellectual property rights and the theft of intellectual property was a constant source of tension throughout the ‘80’s and ‘90’s. However, despite a burgeoning trade imbalance, the US was broadly happy with their Chinese customers. During the Clinton administration, after a lengthy process that required US Congressional approval, China was accepted into the World Trade Organisation in 2001… ushering in the “made in China” era we presently live in.

The reforms that began under Deng’s leadership in the ‘80’s certainly didn’t have a goal of ending communism. Their goals were to make their system work better – to introduce greater efficiencies based on free-market principles and an ultimate goal of restoring Chinese prosperity and dignity on the world stage. The pursuit of what’s become known as their “Socialist Market Economy”.

Although a lot of central control was relinquished, the entire country remained – and remains to this day – “centrally-planned”. Throughout this period of reform, key features of the policies pursued essentially sowed the seeds of the problems China faces today.

Economic Growth Model:

It’s helpful to conceptualise China – any country for that matter – to have a certain economic model. What really drives the economy? Developed nations are principally services-based with services being responsible for over 70% of our economy. China is very different.

Under Deng, foreign trade was for the first time in the modern era considered important. Deng knew that trade and trading partnerships with the west would deliver technology and also investment funds. As part of their plans, “special economic zones” were established to grow into major commercial and industrial centres.

China had (has) an enormous population base of extremely low-income people. Putting this labour pool to work could do a lot for the nation.

The Chinese government initiated policies based around mercantilism – policies designed to maximise exports and minimise imports.

Under an open market economy with a floating currency, something rather annoying happens when your economy is growing strongly thanks to exports – the global value of your currency rises.

Thankfully, under their centrally-planned economy, China had a solution to this – have a “closed capital account” – control your currency!

China exports to the world “stuff” and receives money for it in return. Under free market forces, the weight of this money flooding in – often in US dollars – would pressure your currency higher. But a higher currency means that your exports are not as competitively priced on a global basis – that’s not good when you’re trying to maximise exports.

Conceptually, a key feature of China’s economic model since reforms began has been a big virtual customs office at the money border. Virtually all external monetary transactions go through the government. When a huge volume of USD is seeking to be turned into Yuan, the government grabs it at the gate and “issues” Yuan at the prevailing exchange rate that they want. They are then left holding a big pile of foreign currency. What to do with it? US treasury bonds are a good place to park it!

Investment

Investment has been the other major driver of Chinese growth – the “other lever” in their economic model.

If you think about it, China essentially “started from scratch” in the late ‘70’s when Deng took over. They needed a lot of “stuff” – infrastructure, housing, factories… The success of their mercantilist trade policies spurred the need for more stuff – more factories in the special economic zones, more housing in those areas for all the workers migrating to the cities for work.

Its therefore totally understandable that the last 40 years has essentially been a non-stop construction boom. However, the key problem they have created is that the economy has become incredibly reliant on “building stuff” for economic activity and employment.

There’s also very powerful “vested interests” keen for this model to continue. It’s hard to get rich in China if you’re not “one of them” – one of the Communist Party, that is. Although current leader Xi Jinping is incredibly powerful, he can’t run the country by himself solely according to his principles. When many of the Chinese elite have gotten rich off their economic model, Xi has his work cut out for him trying to convince them they need to make some radical changes for the good of the nation.

In the simplest sense, that’s the Chinese “economic model” – exports and building stuff. It’s become engrained in their economy largely thanks to the actions of their government.

“GDP targeting”:

We all know that GDP is basically a measure of the size of the economy – the sum of all the goods and services produced in a certain period. In most nations, its merely an “output” – our Australian Bureau of Statistics tallies up all the numbers at the end of the period and then reports “the size of the economy was $XYZ representing an ABC% increase from the prior period”.

Not in China. Since the ‘90’s, a feature of the Chinese governments’ periodical “5-year plans” has been a certain level of GDP growth. GDP has been an input, not an output.

This has had a major impact on the economy and the cementing of those “drivers” of growth. Recall that reforms included handing greater responsibility and autonomy over to regional governments. A feature of these GDP targets resulted in this sort of hypothetical exchange between state and local governors:

Central Governor: “7% GDP. That’s our target for this year. What are you doing to help achieve that in your area?”
Local Governor: “We’re well on track with that new subway project and we’re in the final planning stages for a new soccer stadium.”
Central Governor: “Excellent work! Keep it up!”

Residential property played a major role in this sort of activity also. This hypothetical exchange seems typical of many:

Property Developer: “We want to build a big new residential development on that parcel of land over there.”
Local Governor: “Yes! Great idea. I grant your project development approval. We will begin the arrangements to sell you the land… and then we will hastily tell the peasants currently living on that land to find a new place to live! And then we will begin with plans to extend infrastructure such as roads and train services to your new development”.

GDP targeting seems to have ended in recent years under the stewardship of current leader Xi as he seems to realise it’s now causing more harm than good.

What pays for this?

People see images like this of the Shanghai skyline…

… and often gush “look at China… wow they are so rich!”

But how does all this development get paid for? Seriously – the workers, the steel producers, plumbers, glaziers, the architects… engineers – how do they get paid? Where does the money come from?

If that hurts you head a little, it should – it’s a rather abstract idea that few people ever really stop to think about… let alone seek to understand.

The economic concepts of capital formation and deployment are long and complex so we’ll skip over all that today. But to a large degree, the answer to how all this development is paid for is simple:

Debt.

When China “started from scratch” about 40 years ago, this basically included its debt burden. But in the last 20 years in particular they have been busy piling on the debt:

China-watchers agree that the debt-fuelled development model is past its “best-before” date. Respected China watchers estimate that debt has been increasing by 20 to 25% per year in he recent couple of years. Against GDP growth of maybe 5%.

The debt situation has to an extent been exacerbated by China’s closed capital account. With Chinese citizens being unable to get much money out of China, their only investment options are internal.

An important driver of China’s debt burden has been financial repression. Recall that in many years over the past decade or two, we’ve been used to hearing about China’s GDP growing at 7%, 8%, even 10%. During much of this period, inflation has been running at a similar sort of clip.

And yet interest rates during much of these periods might have been 5%, 6% or 7%. In other words, in “real” (inflation-adjusted) terms, interest rates have been negative.

Economically, this basically means a transfer from savers (the general population) to borrowers (big corporates and SOE’s). Borrowers being subsidised by savers. And when interest rates are negative, the more you borrow the better your prospective returns. This is important in the context of the imbalances that have manifested as well as the incredible debt burdens being shouldered by many organisations.

Lending Standards:

The way in which lending decisions are made in China has been massively distorted by their special form of “socialist market economy”. You’ve had a central government pushing the nation to create activity – to a large degree via capital-intensive investment. Many of the entities creating the activity are local governments or state-owned enterprises. Banks, in turn, are in some way pressured to extend credit.

When you think about that, it’s understandable that what’s developed is a system whereby banks don’t so much lend based on the economic merits of the project being planned or the creditworthiness of the borrower…

They lend based on the strength of the perceived government guarantee extended to the borrower.

The offices of Harbin Pharmaceuticals are a famous example.

Gilded ceilings. Luxury amenities. The company is partially state-owned. If such an entity wants to borrow some money for basically any reason, a lender won’t knock them back. It doesn’t matter whether they are profitable (and most SOE’s are known to be unprofitable)– the perception is their loan is implicitly backed by the government. And remember, even a silly, unnecessary project like the above consumes a lot of man-hours… creates some good GDP!

Leader Xi understands that Chinese debt levels have gotten unsustainable and the government has been working hard in recent years to reduce the excessive reliance on debt (unsuccessfully to date). He has even called this sort of unproductive investment “fictional growth”.

The role of property:

We can begin to apply a lot of the above to the residential property market. A large population with few investment options available to them. Financially repressed via negative interest rates. A central government actively encouraging construction activity in the interests of GDP growth. Local governments heavily reliant on land sales to developers to meet their revenue targets.

Is it any wonder Chinese property has gone crazy?

Respected China-watchers (including some within China) are very comfortable calling Chinese residential property “a bubble”. Who am I to argue?

Some of the statistics about the market are incredible. Estimates suggest that the real estate sector is around 30% of the Chinese economy – close to double most countries. Further, investors in China are prone to leaving properties empty rather than living in them or renting them out. Estimates are that perhaps one quarter of Chinese housing stock may be empty. Incredible – empty houses capable of housing tens of millions of people!

Investment in property comes in various forms. Property developers generally need to raise funds before the can get finance for a project. Two sources are pre-sales (often demanding 100% of the sale price upfront, not just a tiny deposit) and issuance of “wealth management products”.

These wealth management products are basically corporate bonds aimed at retail investors. Some of the names of these products are hilarious – things like “super lucky fortune”. Apparently, it’s very typical for developers to solicit investments from staff as well as prospective buyers. So, for some investors they have significant exposure to the developer.

Evergrande:

Finally, after all that we can now explore this Evergrande mess and understand the very difficult problem it presents to the government.

Evergrande is the most indebted property developer in the world. Many billions (roughly $304bn USD) in debts with estimates being that their total debt may be 3% of Chinese GDP. They employ circa 200,000 people with many, many more people providing services upstream or downstream. Hundreds of projects on the go across dozens of cities.

It’s been a bit of a slow-motion train wreck – festering away since last year. But actions by the government aimed at trying to reduce leverage in the sector have seemingly helped push it over the edge – reliant on a constant stream of financing in various forms to meet its obligations, the threat of default has caused lenders to back off.

Recall that the creditors involved here will be in all shapes and sizes – sure, banks will be on the line. Corporate bonds including foreigners. And also individuals via wealth management products as well as pre-purchased apartments… a lot of stakeholders stand to get burned. Surely at least a few being wealthy Communist Party insiders.

Recall how we discussed that debt-fuelled investment is a key driver of economic growth – evolving from the economic policies China has instigated. Debt is known to be rising unsustainably and the government knows they need to stop this. And a lot of asset allocation decisions are made not based on what makes economic sense but who people see as “safe” – backed by the government.

Understand that the Chinese government has the know-how and financial means (“credibility”) to make this whole Evergrande situation go away. They can bail out everyone.

But they don’t want to. This will only re-enforce the perception that all investments/loans to large businesses are “risk-free” because the government will always bail them out. Pure moral hazard.

But Evergrande is so significant that a complete failure would result in major losses and major disruption in the property market…

The realisation by investors of all kinds that “shit, we can actually lose here” would reverberate throughout the country – paralysing the property market…

A market we discussed is a major part of the economy, a key driver of economic activity, employment and store of wealth for the entire country…

And the broader corporate bond market would likely seize as well…

That’s quite a pickle!

It’s probably nothing

When you understand the above, you understand that this Evergrande matter is very significant. It really could sink the Chinese economy. But I don’t think it will.

Again, the Chinese have the know-how and “credibility” to stem any major fallout. Could they mis-manage it? Absolutely they could. They won’t want to simply bail out everyone – they will want to inflict some pain on some stakeholders in order to try and send a message to the nation “we won’t just bail everything and everyone out”. In doing this, there’s risk things get out of control.

Despite my confidence in them managing this debacle, it’s a solid dent in their economy which has finally exposed the vulnerabilities of letting this economic model go on too long. There will be an impact on growth going forward.

None of this is new. For years now, we’ve been discussing that “what can’t go on forever won’t go on forever”. Debt – now a huge percentage of GDP – can’t continue to go up by even 10% per year in an economy barely growing.

It must be more than 10 years ago now when I was watching videos of outspoken British Hedge Fund manager Hugh Hendry strolling around brand new, empty business parks in China looking for tenants. I’ll end this with a quote of his from those days:

“I don’t know if there’s a Confucius saying about this or not, but if there is its wise man not invest in overcapacity.”