Tremors in the East
#67: China's property woes are far from over.
Over the past several months, headlines have signaled trouble in the world’s second largest economy. The great China reopening has sputtered, the yuan is tanking, imports and exports have flopped. After surging on hopes of a post-COVID revival earlier this year, Chinese equity markets on the mainland and in Hong Kong have slumped yet again.
Now, China’s property woes have resurfaced as massive property developer Country Garden warned it may default on its debt, Evergrande filed for bankruptcy in the U.S.1, and investment firm Zhongzhi froze payments on real estate linked products, sparking fears of contagion. But haven’t we heard all of this before?
We have been reading about China’s property failures for the past two years, and despite ominous headlines, there have been few knock-on effects internationally. For global markets, it is easy to assume that concerns are overblown. But I don’t think they are.
Two years ago, at the earliest stages of the Chinese property crisis, I fell into a rabbit hole of research, tracking bond prices of little known developers and writing impassioned screeds on Twitter (endorsed by Michael Burry).
I wasn’t drawn to the subject because some big company overseas was going bust, but rather because the largest industry in the world was going bust. The estimated value of the Chinese property market exceeded that of the U.S. stock market and had served as the primary engine of economic growth in China for two decades. Enormous sums of debt were backed by speculative and unsustainable property prices.
By clamping down on over-levered and arguably insolvent property developers in an effort to rein in the property bubble, regulators risked spurring mass contagion in the property sector. Given the massive exposure to property across Chinese banks, this even risked a new financial crisis. In my view, it was nearly impossible to overstate the potential impact both for China and the rest of the world.
I was right about certain things. For one, the collapse of Evergrande in the summer of 2021 did indeed lead to mass contagion, freezing financing channels and property sales, and leading to 17 consecutive months of property price declines2. As predicted, the entire offshore bond market worth tens of billions collapsed in short order3.
And yet, the transmission to the onshore financial sector did not happen as quickly as I thought. It became clear that the wider effects would take years to play out.
Now, two years later, Country Garden’s default and Zhongzhi’s liquidity crisis are merely a continuation of a process that began with the Three Red Lines4 in 2020. Neither event is surprising nor globally impactful, in isolation. But that doesn’t mean that we should dismiss them as inconsequential.
Rather, we are witnessing the ongoing deflation of the Chinese property bubble and a fundamental rewiring of the engine of growth in the country. This tectonic shift is still underway and the conclusion has yet to be written.
The Property Engine
The property engine works like this. The government invests in infrastructure, building roads and utilities which enable large scale residential development of previously underdeveloped or rural areas. Local governments with limited tax revenue raise critical funds via land sales to property developers. Developers fund their land acquisitions by property sales to citizens, as well as financing from banks, shadow banks, and offshore investors. Meanwhile, property construction generates significant economic activity including wages for citizens and business income for a slew of related industries.
At the core of this process, land (and property) is monetized and supports money creation via credit expansion. Credit flows down from the central bank, the People’s Bank of China (PBOC), and through state-owned major banks, to smaller banks and the shadow banking system. The real economy receives a steady flow of new money, while lenders receive debt obligations inherently backed by the value of property.
So long as land and property values appreciate, this cycle is virtuous. Local governments receive more land sale revenue, rising property values support the growing debt obligations of property developers, and increasing consumer wealth supports confidence in the sector and the recycling of savings into more real-estate purchases.
Property appreciation and credit creation are both chicken and egg. Higher prices provide the basis to extend credit, while the flow of credit allows prices to appreciate.
During the early days of private property ownership and urbanization, there was seemingly unlimited demand to build and unlimited room for housing prices to rise. Even after the market was likely oversaturated compared to primary demand for living space, real estate remained the most popular and profitable investment. Ironically, the necessity of rising property prices for economic stability made the asset appear safe to many. It was assumed that the government could not risk and would not allow property prices to decline.
But this flywheel structure is inherently fragile. If property prices fall, this virtuous cycle becomes vicious5. Local government revenue falls, citizen wealth is destroyed, developers and contractors go bust, and the vast sums of credit that were written against property go bad.
While the development model was clearly unsustainable, the precarious state of the property developers at the center of the web made the situation much worse. Most developers were reliant on a constant stream of new financing and pre-sales of unbuilt apartments in order to pay off old debts.
Recognizing the precarious and unproductive path of development, central authorities tried to rein in the bubble by establishing buyer restrictions on multiple properties and famously warning “houses are for living in, not speculation”.
In 2020, the Three Red Lines regulations - aimed at curbing property developer debt - did what stern warnings could not. By halting the expansion of credit, regulators popped the property bubble.