Xi Jinping’s New Political Economy: Part 2

François Godement

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The Risks

As explained in Part 1 of this analysis, the move against real estate, the tightening of budget and credit policies, and the new social policies all point to some very grand ambitions. China’s political economy under Xi Jinping is at a turning point. These changes come with a cost, yet, many other measures are said to be under consideration.

It appears that Xi Jinping is ready to incur risks beyond anything his predecessors had been willing to accept since Mao’s death. Indeed, one should look at the trade-off between the benefits of moving against existing financial risks, and the new risks that could come from the bubble-bursting policies and other regulatory moves put in place.

Perhaps the biggest risk faced by the new "common prosperity" set of goals, from bubble bursting to limiting inequality and fighting a market society, is that they might end up not being implemented at all, due to China’s multi-layered bureaucracy and its special interests. There are, after all, many recent examples. Xi Jinping’s 30/60 (2030 and 2060) targets for capping CO2 emissions and carbon neutrality have immediately been contradicted by actual trends. Coal consumption and thermal energy, steel production and the entire construction sector in 2020 and 2021 have made the official targets even harder to reach. In 2021, we can see the actual public budget cutting the very expenses that should be central to welfare and "common prosperity": education, health, agriculture and forestry. Despite Xi’s authoritarianism, or perhaps because of it, actual trends and events in China can still defy government-stated intentions. Let’s look at the real estate sector again: concentrating public land auctions in a few massive events was meant to create a supply shock and dampen price speculation in large cities. In practice, it has had the reverse effect, given the realtor companies’ voracity for land. Ultimately, the impact of such a policy is limited when in almost all second and third tier cities, real estate companies are offering massive discounts to unload their stock as fast as they can, or to collect advance funds and solve their short-term liquidity crisis.

Another reality is that, contrary to their international reputation ("in China, when the government talks, banks listen", a well-known expert of the Chinese financial system once quipped), financial actors have become used to going around rules until they literally face a wall. To use the case of Evergrande: the company, which by now is famous for its use of insider connections to China’s power centers, faced the credit restrictions in 2020 by escalating its risk strategy. It invested even more and launched an aggressive price cutting policy that could only be emulated by its competitors. In typical Chinese fashion, market share became the key to future survival. When it could no longer deny its debt problem, it pretended to reimburse some of it by issuing short-term promissory notes to suppliers and builders. In August 2021, it was still claiming sales of real estate equivalent to 2020 - roughly 82 billion euros or the equivalent of France’s entire real estate sector.

But if Evergrande’s practices are now in the spotlight, it is the entire real estate sector that evaded the 2020 credit tightening measures and warnings. Investment in real estate, which is cyclical, actually rebounded in 2020 and the first half of 2021.

Homebuyers - often middle-class investors buying multiple units - kept their blind belief that prices could only go up, and simply began borrowing instead of using their own savings for deposits towards purchases. In March 2021, loans to individuals, largely driven by real estate, increased by 12.6% YoY. The strict credit rules for real estate lending, promulgated in December 2020 by the PBOC, had clearly very little effect on the housing bubble.

It is therefore clear that the government has had to choose between ineffectiveness leading to even higher future risks from a debt bubble, or teaching a lesson that may backfire, create snowballing defaults and a deflationary cycle. This is exactly where things stand in September 2021.

Xi’s rhetorics cost the five largest international luxury companies 67 billion USD of stock value in 48 hours.

Beyond these implementation risks, it is the scale and dynamics of the financial risks created by the new policies and their psychological impact that are striking. Certainly, revolution isn’t a gala dinner, as Mao said. Xi Jinping has indicated how little he cares about collateral damage with his recent tirades against "good guys" who serve no purpose or actually root for enemies.

The breakage is already very large. Since October 2020, Alibaba alone has lost 378 billion USD of capitalization, and the lesser known Tencent has lost 308 billions. As mentioned before, China’s private tutoring sector was worth 120 billion USD. Xi’s rhetorics cost the five largest international luxury companies 67 billion USD of stock value in 48 hours. By comparison, the 27 billion USD loss within two weeks for international investors in Didi Chuxing’s IPO appears to be pocket change. Whatever happens to Evergrande, an outright bankruptcy or a restructuring with a huge "haircut" on promissory notes and debts, the 300 billion plus pile of debt of the company will impact three categories of creditors: the home buyers who plucked down their money in advance, said to be currently 1.2 million households, the Chinese investors who bought stock offered for sale by the company and by its officers, including in the months before the crash, and the international owners of VIE shares listed in the Cayman island or Hong Kong.

Even more importantly, it is the psychology of domestic investors and consumers alike that is impacted. Perhaps this is precisely the end that was sought. There has been enough assault on the interests of the urban upper middle classes as to warrant that assumption. Like learning English with the help of private tutoring or preparing for university entrance, or traveling abroad, buying real estate as a hedge for retirement extends beyond these upper middle classes. In 2020, only 0.53% of private employees had any corporate retirement plan beyond the basic national pension system.

The signs of an economic downturn, and not merely a slower growth that was anticipated for months, are now multiplying. In August, retail sales growth YoY slowed down from 8.5% a month before to 2.5%. The most impacted sectors were communication appliances, automobiles, house electronics, clothing, and catering . In early September, real estate figures are dropping like a stone: high-frequency data reveal that in the first 11 days of September, sales of new homes dropped by more than 26% YoY, with sales of existing homes down by 46.6%. In value terms, land sales are plunging by 90% year-on-year this month, after a drop of 65% YoY in August.

The signs of an economic downturn, and not merely a slower growth that was anticipated for months, are now multiplying.

The requirements for capital bail-out in the form of ensuring continued interest payment or restructuring are therefore growing day by day, as other real estate companies and their suppliers are likely to fall under, and as consumers grow ever more cautious. The small resumption of delta variant Covid cases and the sledgehammer approach to their eradication is not helping China’s stock market either. This had seen increased transaction volumes in the summer as domestic investors began shifting their money away from real estate. It is now down as defiance is taking over.

As of now, none of the above portends a broader financial crisis, as the government holds many levers over the market. But the balance between teaching a hard lesson and risking a crash is getting more delicate, as the amounts necessary to restructure debts and preserve at least a modicum of the financial assets of real estate companies and builders is growing quickly.

In this dark perspective, there is a persistently shining light: China’s exports. The bonanza that the Covid pandemic started - with other Asian producers partly inacapacitated, and exports slots that match global demand - has kept on giving throughout August 2021.

Future gains can be guessed from the following example: since August 2019, China’s auto parts exports (which do include batteries) have been multiplied by nine as of August 2021.

It is evident that Xi Jinping and the financial authorities chose to break with the domestic debt spiral, a large part of which is associated with the real estate bubble. Given the Chinese connected entrepreneurs’ and individual investors’ taste for speculation, their belief in implicit guarantees for businesses that have delivered over the years, a hard lesson is being taught. It chimes with other publicized measures against some of China’s billionaire class, as well as the sudden limits placed on the lifestyle of the upper middle class. In China, the joke goes: you never own a share, you merely take care of it for the Party-state…

All of this has international implications, including for foreign investors. Depending on the source, we find that foreign holdings of domestic bonds, whether public or private, have kept increasing, or on the contrary that the acquisitions have begun to slow down over this summer. Much short term investment advice will be to forget about present losses and to focus on the sectors that the Party-state now prioritizes. But these - whether IT hardware or biotech - have very high price-earnings (P/E) ratios. And the lesson being taught is also about uncertainty, not only about heeding government orders. To this day, China has seen increased capital flows from abroad, regardless of the so-called "trade war" or of Western tech purchase restrictions on Chinese companies. Will this hold true for much longer?

In the short term, there is a benefit to the international economies that do not have a large energy or material export component. A large dip, if not a crash, in China’s housing sector should evidently end China’s thirst and dampen prices for these commodities. It also benefits CO2 emissions - whether this was one of the intended targets or not.

Several trends should give us food for thought: the priority given to the "stability" of the financial system over GDP growth, the narrative about national security, the move towards ever higher self-sufficiency while exports are being strongly promoted, the shift from a more cosmopolitan middle class towards populist policies.

Not only has regime security been reconfirmed by Xi’s new political economy, but economic and societal decoupling is bound to accelerate from its various components and from the ideology that underlies it.