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22 September 2021

Why China’s Evergrande debt crisis is the tip of an iceberg

The woes of the world’s most heavily indebted property developer could soon mean problems for Xi Jinping, China’s economy and beyond.

By George Magnus

As Covid-19 spread across China at the beginning of 2020, some commentators dubbed it as China’s “Chernobyl moment” – an event that would undermine the legitimacy and rule of the Communist Party. A much more likely candidate has emerged, though, in the form of the debt crisis enveloping Evergrande.

China’s second biggest property developer and the most indebted developer in the world with over $300bn of liabilities is out of cash, and unable to meet interest payments due to both banks and foreign bondholders — though it was reported on Wednesday 22 September that some deal has been done to meet an interest payment to domestic bond holders. Evergrande is also a kind of metaphor for the wider debt crisis in the country’s economy. Material consequences for both China and the global system are sure to follow. 

The most immediate dilemma is the unravelling of Evergrande, which owns more than 1,300 projects in more than 280 cities across China. Until now, the Chinese government has refrained from stepping in, choosing instead to make an example of the debt-ridden company’s “capitalist excesses” to banks and others as a way to encourage more conservative financial behaviour. 

Yet some sort of state bailout or restructuring is inevitable, at least to buy time. Otherwise, the financial contagion, and economic and social instability consequences of a messy default, would be catastrophic for Xi Jinping, especially ahead of the important 20th party Congress in November next year. Consider that much of Evergrande’s liabilities comprise pre-sale deposits by almost 1.5 million households, all of which would see their savings lost. The company’s employees and others bought financial products that it issued to help fund itself, and they too would risk losing money in a worst case default. The government will not want unhappy citizens to be on the hook. I expect that rather than a spectacular Lehman-type crisis, China will go through a period of financial distress, which will squeeze growth hard.

[See also: Why there is no solution to our age of crisis without China]

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China’s property market, valued at $52trn or four times GDP in 2019 by Goldman Sachs, has for some time been the most important market in the world, helping drive China’s economy. It still is but now for all the wrong reasons. Xi Jinping and other leaders have for some time warned that property is for living in, not for speculation. To curb the runaway debt accumulation, they have subjected mortgages and second home ownership to tougher rules, and in 2020, regulators introduced “three red lines” restrictions to limit the growth in both debt, and the supply of new homes. About a fifth of China’s real estate units are empty, and in the last year or so, chronic overbuilding — based on the erroneous concept of “borrow, build and they will come” — has been exposed. 

This year’s regulatory crackdown to impose tighter control over private companies may extend to housing, where high costs are deemed excessive and a disincentive to bigger family size. A recently revived slogan called “common prosperity”, designed to address the country’s staggering wealth inequality, has called for greater taxation of high incomes and capital, including a long discussed nationwide property tax. Shifting demographics, especially the shrinking cohort of prime age, first-time homebuyers, is also expected to sap construction in years to come. 

All real estate booms go bust eventually, and China’s turn may have come. Yet the country has never experienced a meaningful decline in property prices, which have risen by almost 50 per cent since 2015 alone according to Bank of International Settlements data. Lower prices would undermine Chinese consumption, and in turn investment. They will also have adverse implications for banks as loan losses rise and the value of high real estate collateral in loan agreements declines. Local governments, which depend heavily on land sales to fund their spending would become even more financially stressed and be less able to meet obligations.

Exactly how this crisis will be resolved is murky but it is inevitable that losses will somehow be allocated among creditors, investors and depositors. This will be a painful process that is likely to cost growth and jobs, and in extremis, it could give rise to social or political instability too. 

[See also: The nuclear tinderbox: why the Indo-Pacific is the new arena of great power rivalry]

The Evergrande timing is poor, too. China is still struggling with its zero Covid-19 policy and faces a cocktail of medium-term economic headwinds along with the harshest commercial and geopolitical environment since the Mao era. Under other political circumstances, a reboot of China’s development model would be hastened to breathe new life into “reform and opening”, income and wealth redistribution, deregulation of service industries and the productive private sector. Yet, none of this is on Xi Jinping’s agenda. On the contrary: The prior market-oriented reform and opening era is over, displaced by a more totalitarian governance system, the restoration of state firms to “commanding heights” and a sharp leftward political lurch.

Unlike the Lehman Brothers collapse, it’s doubtful that the world’s economy or financial markets will suffer much immediate harm from the Evergrande turmoil if, as expected, it is contained within the property sector. Angst though has already upset equity and commodity, especially metals, markets and producers, and may persist intermittently. 

[See also: Lithium will be as era-defining as oil, and China is dominating its supply]

More importantly, though, much of the way the world currently works depends on uninterrupted and elevated Chinese growth. Think of global supply chains, exports and growth, as well as China’s own geopolitical leverage and narrative; its ambition and global presence, which depend on its economic heft, might be compromised in unpredictable ways. All of this could be in jeopardy in coming years from the iceberg whose tip bears the name Evergrande. 

George Magnus is a research associate at Oxford University’s China Centre and at SOAS, a former UBS chief economist, and author of “Red Flags: Why Xi’s China is in Jeopardy”

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