Richard McGregor
The “controlled demolition” of the debt-laden property giant Evergrande, as Chinese netizens have dubbed the company’s slow-motion collapse, is providing a real-time stress test of dearly held beliefs about China’s party-state.
Super smart officials, bucketloads of money, sheer force of government power: The awesome qualities that many Western hedge fund managers and other China fans ascribe to the ruling Chinese Communist Party (CCP) should ensure, so the familiar narrative goes, that it can manage its way out of this crisis, as it has in the past.
They may yet be right. The coming-collapse-of-China brigade and their willingness to latch onto the smallest hints of trouble in the country have had them crying wolf far too often with predictions of the party-state’s imminent demise.
It was Beijing’s financial regulators, after all, who bought this crisis on.
The central government decided to pop a property bubble years in the making in 2020, ordering developers to cut leverage and debt.
In a country with few outlets for personal investment, property prices have long been the third rail of local politics. The urban middle class who make up the bedrock of party support depend on property as a store of wealth and protest vigorously if prices fall.
By the end of last year, new construction was outpacing the number of estimated future households threefold, according to the Rhodium Group, and a crash lay just over the horizon.
“Bursting the bubble now, while extremely painful, will be much easier than in five years, when the demographic headwinds will be much more apparent,” Rhodium experts wrote in a research note to clients.
But the Evergrande crisis is more than a run-of-the-mill cyclical real estate downturn. The same forces sweeping through Chinese politics, diplomacy, and technology are upending the economy and the vibrant private sector that has been its life force for decades.
Chinese President Xi Jinping’s new policy for the next era of his rule—of “common prosperity”—has the stated purpose of remaking the Chinese economy and society into something fairer and less flashy.
The party always prevails, no matter what, which makes the current standoff with Evergrande all the more perilous, as plenty of middle-class wealth and ambition could go out the window with the winding down of the company.
Companies like Evergrande were firmly in financial regulators’ sights when they began turning the screws with the issuance last year of the “three red lines” policy—which set caps on debt ratios related to assets, equity, and cash on hand—to bring the industry back down to earth.
In its go-go years in the decade from 2010, Evergrande’s business model was summed up in the pithy slogan “Three Highs and One Low”—in other words, high debt, high leverage, high turnover, and low cost.
Evergrande and similar firms prospered by borrowing big to acquire land and then selling units off the plan before construction was even underway. They would then use the money from presales to fund further construction.
The property business made Evergrande’s founder and boss, Xu Jiayin, super rich, which makes him a perfect villain in an era in which the CCP will need plenty.
In his recent book, Red Roulette, an insider’s account of top-level wheeling and dealing in China, the exiled businessman Desmond Shum recounts the methods used by Xu to build relationships with well-connected party figures.
Shum says Xu took Shum’s wife, who was in business with then-Premier Wen Jiabao’s family, to a jewelry store and offered to buy her a ring for $1 million. She declined, but Xu bought two anyway.
“In China, there are several ways to get the attention of those in power,” Shum writes. “Xu’s preferred method was through giving outrageously expensive gifts.”
One can’t blame Xu for wanting to build his contacts list. In China, the government in one form or another technically owns all land and controls all banks. Without connections, developers like Xu can be out of business overnight.
By the time regulators decided to turn off the money tap last year, Evergrande had run up about $300 billion in debts. It owes large sums of money to contractors and suppliers who were finishing its apartments.
The company has also taken down payments on about 1.4 million units that it has yet to finish. But since it has no cash to pay contractors, it has been trying to settle debts with unfinished apartments. All of this in a market that is already oversupplied.
But, to repeat, the government has lots of money and is staffed by hyper-competent officials with all the powers they need to land a jumbo like Evergrande without a crash, right?
As the Chinese state media and their many acolytes around the world keep reminding us, Beijing is at the peak of its powers. The popular slogan in China goes: “The East is rising. The West is declining.”
Such confidence is far too complacent. Chinese growth has been slowing for years, and the country faces a demographic crunch. Even if Evergrande isn’t a Lehman Brothers moment, it symbolizes the start of a wrenching adjustment for the Chinese economy.
The financial officials’ copybook is already stained by allowing the property bubble to develop as it has and with missteps that almost caused a stock market crash in 2015.
Construction and related industries make up nearly a third of China’s economy, and property accounts for 80 percent of household wealth, compared with about one-third in the United States.
The central government is resisting bailing out Evergrande, in large part because it does not want to set a precedent for a private company.
But it will not be easy any which way. Other developers are being strangled by Beijing’s credit squeeze and have been trying to unload properties to raise cash to pay back loans.
In recent weeks, multiple city governments have stepped in to stop developers from discounting their properties too much in fire sales, lest they send the entire market into a death spiral.
“The true systemic risk to the financial system would be large and sustained declines in housing prices and sales,” wrote Wei He of Gavekal, an economics research group.
In the meantime, the financial system will suffer, and growth will slow in an economy already stressed by managing COVID-19.
The timing is touchy for Xi, as late next year he will be demanding a third five-year term as head of the CCP, following his alteration of term limit rules in 2018 to allow him to stay on past a decade. That move bought anger and angst from many of his colleagues—expressed privately, for the moment, but with the possibility of more open dissent in the lead-up to the party congress.
It’s no wonder he is looking for rich villains and greater loyalty. He will need both.
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