In September, shock waves reverberated through global financial markets on news that Evergrande Group, China’s second-largest real estate developer, was on the verge of defaulting on its U.S.-dollar bonds. For a brief moment, stock prices all over the world dropped as nervous investors wondered whether Evergrande’s collapse would be China’s Lehman Brothers moment, and the trigger of a major global financial disaster.
Western media is busy debating whether Evergrande is too big to fail and if the Chinese government will rescue it from creditors. While the jury is still out on that front, investor fear has abated. Stocks have recovered, and most investors have concluded that Evergrande’s problems are containable and not likely to create significant collateral damage for China or other global economies. While we don’t disagree with the market’s assessment, there are important insights, lessons and possible longer-term implications worth considering.
The first thing to appreciate is that there is a material difference between the U.S. government’s attitude toward Lehman Brothers prior to its 2008 bankruptcy and Evergrande’s recent woes. The U.S. government wanted to save Lehman Brothers, yet failed to do so, whereas the Chinese government purposely created the policies that precipitated Evergrande’s financial difficulties.
Among other things, the Chinese government is concerned about inequality and excessive leverage and speculation in their real estate market. The issues are related, and they are also common problems in much of the world. Dealing with them will cause economic turbulence in the near term, but a little short-term pain might be the right recipe to build a stronger economic foundation and sustain a brighter future.
To understand the present issues in China, it’s important to acknowledge the magnitude of its real estate boom and its significance to their overall economy.
Up until the 1990s, Communist Party rules prevented most Chinese citizens from owning their own homes. That changed in 1998, when the government moved toward private homeownership over the traditional employer-allocated housing model. People were encouraged to buy their homes from government-owned or controlled businesses, which were sold at heavily discounted prices. This created a huge transfer of wealth from the state to its people, seeding the growth in the residential housing market as homeowners reinvested their gains back into the market by buying bigger and better homes. This fueled the mother of all housing booms, with an estimated 95% of urban households owning at least one home by 2019.
Indeed, over the last three decades, the massive movement of workers from farms to cities, together with enormous real estate and infrastructure development, helped create China’s economic miracle. Real estate spending accounts for 14% of China’s GDP today, compared to just 3.5% when the homeownership rules changed in 1998. Factor in all the other activities like home furnishing that are indirectly influenced by construction and it’s estimated that real estate-related activities account for 25% of the Chinese economy.
The real estate bonanza has been a virtuous cycle, with rapidly rising home prices driving tremendous wealth creation for developers and citizens alike. Government tax revenues have exploded in lockstep with the expanding economic base, and much of the country’s amazing infrastructure has been funded by selling land to developers, who have erected entire cities knowing that the speculative environment makes it easy to sell homes before they are built.
Unfortunately, China’s real estate boom, like most, has been fueled by debt. According to the Bank of International Settlements, China accounted for two-thirds of the world’s $12 trillion increase in household debt between 2009 and 2019.
We have long worried about the sustainability of the debt-financed building frenzy in China, pointing to ghost cities and empty shopping malls as reasons for concern. But the boom continued, and many of these developments have filled up over time. While booms often last longer than expected, it seems that the Chinese government feels that this one has gone on too long.
It’s estimated that 20% of homes in China sit empty, which is massive compared to the less than 1% of U.S. homes that are unoccupied. With the price of the average Chinese home nearly 10 times the average income, housing is a leading contributor to inequality and a considerable source of political unrest.
The Chinese government tried to moderate home price inflation and the associated buildup of financial leverage with regulatory initiatives, including higher down payments, limiting purchases to first-time buyers and restricting demand in some cities to residents only. But, like similar initiatives around the world, they failed. This year, the government changed its focus and implemented policies aimed at limiting developer debt as the primary means of moderating speculation and leverage in the real estate sector. We believe the authorities knew that Evergrande and other highly leveraged developers would be casualties of these policies. Moreover, we think they appreciate that tackling this problem will hamper the country’s growth in the near term, but that it is a necessary action to put their country on a healthier and more sustainable growth path.
Rising inequality in the world is our biggest concern, as it stokes social unrest that may ultimately undermine economic progress and the value of investments. While globalization and technology have contributed to rising inequity, we believe well-intentioned yet misplaced monetary policies have been the primary cause of the growing gap between the haves and the have-nots. In recent decades, central banks have responded to each economic crisis with progressively lower interest rates and more and more money printing. The wealthy benefit the most from these policies, as they disproportionately own the real estate and other assets that get inflated by accommodative monetary policies.
These policies have been a boon for investments, yet we worry that they are not sustainable. There is already considerable discontent and political unrest in the world, which will only get worse if central banks continue to flood the economic system with cheap and easy money at every sign of trouble. Moreover, these policies have encouraged greater and greater debt in society, and history teaches us that excessive leverage is ultimately destabilizing.
While China has plenty of policies that we don’t support, efforts to moderate debt leverage is a very desirable initiative, in our view. The Western world would be wise to consider doing the same. There is no doubt that lessening societies’ appetite for debt will slow economic growth in the near term, but we believe some short-term pain would lead to long-term gain.
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