Is China facing a Lehman Brothers moment?
China's property market is overheating. And one of its biggest developers, Evergrande, is in struggling to repay its debts. John Stepek looks at what's going on, and ask: is this something you need to worry about?
Like almost every other country in the world, China has a persistent problem with bubbly house prices.
Unlike most other countries, China is quite keen to pop this bubble.
The danger is that defusing house price bubbles is the financial system equivalent of juggling nitroglycerine.
Which is why a lot of investors have been fretting about the fate of a property developer that some are already calling “China’s Lehman Brothers”.
The trouble with property bubbles
As with every other housing market in the world – whether or not they operate under nominally communist regimes – Chinese house prices are mostly a function of how much money is sloshing around the system to buy them.
When money is tight, prices go down; when money is loose, prices go up.
The availability of money is in turn a function of how worried the authorities are about economic growth at any given point.
After the 2008 financial crisis, China opened the floodgates and spent lots of money on infrastructure, for example, to keep growth rising. Many of these projects didn’t make any returns (in other words, they were wastes of money rather than productive investments – “mal-investments”, as the Austrian economists would put it).
But as long as they keep people busy and they keep the GDP figures rising, that’s what matters.
Anyway, there’s a problem here. As we’ve seen elsewhere in the world, when house prices rise beyond the reach of young people and the aspirational classes, populations get angry. There is no more visible symptom of wealth inequality than soaring house prices.
That’s hard enough to tackle in a liberal democracy; in a nation whose social contract is based on the idea that if they tolerate a centralised authoritarian government, everyone will get richer at roughly the same pace, it’s actively quite dangerous.
So, as Matthew Brooker notes on Bloomberg, China has always flip-flopped about ways to control speculation in the property market.
Now, however, as analysts at Nomura put it, Beijing is showing “unprecedented determination” to cool the housing market down. This is all part of Xi Jinping’s crackdown on visible wealth inequality, branded as “common prosperity”.
The stress is showing in the system. The most obvious red flashing light is around Chinese property developer Evergrande.
The company has been in trouble for a while, but things really seem to be coming to a head now.
To cut a long story short, Evergrande’s sorry tale is the same as all the other sorry tales around property going bad – including the Great British classic, Northern Rock. It over-reached itself and then got caught swimming with no trunks on when the tide went out.
Put very simply, Evergrande relies on money from advance sales of the properties it develops to actually build the properties in question. But because of a crackdown by China’s authorities, sales have dried up. So it can’t finish its properties because it can’t pay its suppliers and so it can’t raise more cash – it’s a vicious circle.
Credit ratings agencies have lined up to downgrade the developer, and the price of its bonds has collapsed, indicating that investors believe it will default. Obviously, its share price has collapsed too.
The risk is that this spreads to other property developers. Evergrande just happens to be the largest canary in the coalmine, but there’s an aviary full of them.
This is “contagion”. Property developers go bust, the banks and investors who loaned money to them lose out, and you get a big credit crunch. We’ve seen this film before, which is why some people have been describing Evergrande as “China’s Lehman Brothers”.
This is probably a chronic crisis rather than an acute one
So is this something you need to worry about? It’s a good question and I’ll warn you right now that I don’t have a strong view as to the answer.
However, it’s worth thinking about what might happen. First, it’s always worth remembering that, after 2008, the world knows what the response to a banking solvency crisis is: you print lots of money to keep the system from collapsing and you recapitalise the banks or bail out whoever you need to. Would the Federal Reserve, America’s central bank, ever let Lehman go bust today? You have your answer.
Second, the Chinese authorities have even more leeway to do this sort of thing than governments in the developed world. So, in theory at least, the system should be underwritten. It shouldn’t be a Lehman Brothers moment in terms of creating unstoppable waves of panic.
Indeed, even as I write this, I’m seeing reports on Twitter that Evergrande will be allowed to “reset” its debt terms to avoid a cash crunch. In other words, it’s getting bailed out, just as China stepped in previously to bail out a bad bank – Huarong.
So we know the authorities will abide by the post-2008 rulebook.
Will it work? That’s the other question. The problem is that defusing these things is not simple; there are a lot of moving parts. Even in a centrally-controlled financial system whose overseers have no qualms about stepping in (which to an extent is every financial system today, not just China’s), there are side-effects and consequences.
China once again faces the big problem: all of that past malinvestment means that it can’t calm down its property sector without slowing the economy. So the juggling act has to be based on which issue causes the most social upheaval: high house prices or weak growth?
Meanwhile, on a global basis, China is a more important driver of the global economy than it once was. Does it matter if it slows down as long as the rest of the world is picking up the slack? Probably not, but I’d keep a close eye on what unfolds rather than feeling very confident about that.
Finally, when you’re facing internal economic strife, there’s nothing like an external enemy to give you a focus. I’m not keen on getting melodramatic about geopolitics here, and I do think that the rush to highlight Taiwan as a global flashpoint is perhaps a bit too hasty. But again, it bears watching – will China resolve its internal conflicts by trying to get its citizens to focus on external ones?
So sorry – not very conclusive this morning. All I can say is that this doesn’t call for any obvious changes to your asset allocation and I’m pretty sure it won’t be a Lehman moment (though I wouldn’t be surprised to see some assets having a turbulent ride if someone needs to liquidate to cover losses elsewhere at some point).
But do keep an eye on China.
We’ll no doubt be covering all of this in future issues of MoneyWeek magazine. Subscribe now to get your first six issues free.