Logan Wright
The time to be most concerned about China’s financial stability is when Beijing’s credibility is changing, when investors cannot be sure what assets Beijing is willing to guarantee its support, and when previously protected assets and industries are subjected to new policy-related uncertainties. This was one of the key findings of the CSIS report Credit and Credibility, released in late 2018, and one reason to argue that the current situation in China’s property sector and with its largest developer Evergrande is so meaningful for China’s economy and its future growth trajectory. Markets are now concerned that Beijing will finally be successful in its attempts to rein in China’s property sector after a decade of half-measures. And they are taking that threat to China’s economy more seriously because of the series of policy-led interventions into other industries over the past few months.
The debt problems at Evergrande emerged in the last couple of weeks as the central topic in global financial markets as the company moved closer to default, along with several other Chinese property developers. Speculation about whether Evergrande represents China’s “Lehman” moment obscures the fact that the discussions themselves show that global perceptions of China’s economic trajectory are shifting, and the world is now looking for the most appropriate historical analogy to describe China’s financial trouble. Now, the question is whether there will merely be a temporary slowdown in economic growth in China, a longer-term slowdown in growth led by a drag from the property sector, or a crisis similar to the bursting of the U.S. property bubble.
For Evergrande itself, and China’s other troubled property developers, an interesting and illustrative divide is forming between economic and political China watchers. Economic analysts are claiming that Beijing will simply be forced to step in and rescue Evergrande in some form, either through taking over the company and dividing it into smaller projects or through a temporary cash injection to prevent defaults to its thousands of contractors and suppliers. The property industry, these analysts argue, is simply too large for Beijing to let it fail—it accounts for around a quarter of China’s GDP, perhaps more. Local governments depend upon continued land sale revenues from these same troubled developers. Beijing must step in and prevent a collapse, as it always has in the event of financial stress in the past.
Political analysts, by contrast, are arguing that Beijing’s priorities have changed, and it should not be expected that the broader policy restrictions targeting the property sector will be reversed, even if there are measures to prevent financial contagion from Evergrande’s problems. After all, the campaign against China’s technology giants and education and tutoring companies has basically come out of the blue, and it clearly reflects changing political priorities rather than more traditional concerns about market stability or maintaining economic growth. Beijing’s goal of “common prosperity” appears to be designed to provide different economic outcomes in China than what has been delivered over the past two decades, and controlling the growth of the property sector appears to be one of Beijing’s key priorities.
The Stabilizing Effect of Credibility
The political analysts probably have the better side of the argument right now, because Beijing’s reaction to financial stress has clearly changed. When China’s leaders were focused on maintaining stability at all costs, an issue such as the market reaction to Evergrande’s rising debt would have never expanded to this extent. Usually, Beijing would have already announced some sort of support for the company to prevent a reaction in the rest of the property sector or in global markets. Even though China’s financial system has become far riskier over the past decade, the credibility of the widespread belief among investors that Beijing would always respond to financial stress could by itself prevent financial crises and contagion. Investors did not need to panic and sell securities to reduce risk and protect themselves. They could remain neutral, or even add risky assets to boost returns, while waiting for an inevitable government bailout.
As a result, during times of financial stress, China’s financial markets typically saw “flights to risk” rather than “flights to quality.” During the interbank market crisis of June 2013, it was common to see investors move resources into the highest-yielding wealth management products from some of the riskiest banks, confident that Beijing would prevent any market failures. During the stock market crash of 2015, many investors bought the dip, confident that Beijing itself would intervene and save the market. (That strategy was much less successful.)
One of the reasons that the Evergrande crisis is spreading to global markets is that investors can no longer be certain that Beijing is trying to maintain the same economic growth rates as in the past. The Credit and Credibility report argues it was inevitable that Beijing would stop supporting virtually every asset in China’s financial system. The reduction of state guarantees was an essential part of financial reform, so that markets could price the risk of default and allocate resources within the economy more efficiently.
The Evergrande saga is a prime example of one of the moments Credit and Credibility had anticipated. Investors can clearly see that Beijing intends to restrict financing to the property sector and reduce the industry’s impact on the economy. The campaigns against dynamic private sector firms over the summer and the elevation of “common prosperity” as a key goal indicate Beijing’s relative indifference to the economic consequences of these new regulations. As a result, investors are no longer certain that Beijing will step in to support Evergrande, and if it does not, that would suggest policymakers are unlikely to provide help to other property developers, which has caused banks and investors to pull back in lending and investment to the entire property sector. The change in credibility itself can produce contagion in China’s financial markets, and global markets have reacted as a result.
Changes in government credibility are specifically important in China’s property sector. As noted in The China Economic Risk Matrix released a year ago, this is one industry where there are so many market participants that it makes it difficult for Beijing to use its array of administrative tools to control market outcomes. Beijing’s state capacity is more limited in sectors where investors respond to market signals rather than administrative orders and where there are conflicting incentives between Beijing and local governments. As a result, if investors and homebuyers suddenly change their beliefs that Beijing will always support the property sector, it is probable that home sales and prices will decline, since a significant proportion of property demand is from investors betting that prices will rise over time. That reversal seems to be underway now, as nationwide housing sales have dropped by 8 percent in July, at least 16 percent in August, and around 32 percent in major cities so far in September.
A Long-Term Problem, No Easy Solutions
The problems now surfacing in China’s property sector, exemplified by Evergrande, have been in the making for over a decade. China saw the largest single-country credit expansion in modern history, adding a whopping $42.2 trillion in bank assets since 2008, equivalent to around half of all global economic output. A significant proportion of that new borrowing has funded property construction or mortgage finance, and property has been the investment of choice for Chinese households for the past two decades. Property-related lending is thought to comprise around 30–35 percent of all lending in China’s banking system.
Credit growth started slowing meaningfully in China in 2018 as part of a direct effort by Beijing to reduce financial risks. From 2007 to 2016, a broad measure of China’s credit growth averaged 18.1 percent. Since then, it has averaged only 9.2 percent. Under any similar circumstances, one would expect an industry that had benefited from credit expansion in the past to face pressure, as some borrowers are cut off from financing and must change behavior. Property developers were able to avoid some of the worst effects of this credit slowdown for a while, partially by increasing their reliance upon pre-construction sales of houses, which essentially provided financing to developers, funding construction scheduled for the future in advance.
But with Beijing’s new restrictions on developers’ financing announced last year, the so-called three red lines, there is nowhere to hide for developers in China’s imbalanced property market. New housing starts hit an all-time high in 2019, well beyond the peak of fundamental demand (determined by urbanization and growth of household formation). Home ownership rates are already very high, over 80 percent according to most household financing surveys. Household debt levels have risen sharply, by over $6.4 trillion since the end of 2015, which will limit homeowners’ ability to upgrade their housing in the future. And China’s looming demographic headwinds will significantly slow the pace of new urban household formation.
A slowdown in housing construction activity appears inevitable, but the timing remains uncertain. The current market tension over Evergrande, which is restricting financing to many developers, may have accelerated the property market’s confrontation with its weakening fundamentals, leading to declining prices and slowing new construction.
There are no easy options for Beijing from here. It could choose to quietly bail out Evergrande and provide credit to its contractors and suppliers so they can complete the projects Evergrande has promised homebuyers. But doing so quietly would likely mean that bonds and equities of other developers continue to drop and banks limit future lending to the industry, while property sales themselves continue to decline. Publicly bailing out Evergrande and its investors and shareholders would reflect a sharp reversal of recent policy trends and may encourage a short-lived bout of speculative fervor in the property industry again, with markets suddenly believing that the sector truly is “too big to fail.” Doing nothing is not an option either, as the longer that Beijing waits, the more likely it is that contagion will spread to other property developers and continue to weaken property sales.
Beijing is likely to prioritize the interests of current homeowners awaiting unfinished apartments and construction contractors and suppliers. There are already media reports that local governments are preparing to take over some Evergrande projects to ensure that construction is completed (but no indication yet where they will obtain the money to do so). But Beijing must treat bond and equity investors, and the banks who lent to property developers, carefully as well. Dismissing their interests too cavalierly or directing some loans for state purposes could exacerbate the funding pressure on the sector, as investors could then easily anticipate losses in financing other distressed developers in the future.
It seems unlikely that Beijing will try to ramp up property construction once again; after all, the apparent purpose of these financing restrictions is to reduce the property sector’s role within the economy. Consider the plight of a hypothetical Chinese official trying to encourage China’s leadership to change course at this juncture. Making the case that policy needs to change on a dime is risky for one’s own career, and to do so, an official would need a lot of evidence that markets are truly distressed and China’s economic future is at stake. As a result, even if the property sector reaches a truly dangerous point and the economy is slowing, Beijing is more likely to be reactive to financial market stress, rather than proactive in preventing it. The most probable result is a considerable slowdown in property construction and China’s economic growth over the next three to five years.
This year’s events in China’s economy, from the crackdown on technology and education firms to the turmoil in the property sector, is likely to mark an inflection point in how the rest of the world thinks about China’s economic trajectory and policy credibility. Lower growth expectations over the next decade will naturally reset expectations of China’s international influence and perceived inevitability. And credibility lost is difficult to restore.
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