Fallout from Evergrande crisis will reach far beyond China
5 Oct 2021|

Australia has a lot riding on the success of the Chinese authorities in containing the fallout from financially troubled developer Evergrande on China’s property market more generally.

China’s property developers account for an astounding 20% of the entire world’s consumption of steel and copper, according to estimates by British investment bank Liberum.

Windows and other fittings in Chinese buildings use a further 9% of global aluminium, 8% of nickel and 5% of zinc.

So any downturn in the Chinese property market can be expected to have sustained repercussions for commodity producers quite apart from the potential financial fallout from defaulting developers.

As the forest of cranes on the skyline of any Chinese city attests, property development is a large component of China’s overall economic growth.

The real-estate and construction sectors account for an astonishing 29% of China’s GDP, comparable only to the levels in Ireland and Spain ahead of the global financial crisis, according to an assessment by former International Monetary Fund chief economist Kenneth Rogoff and researcher Yuanchen Yang.

This estimate is in line with a 2019 Reserve Bank of Australia paper showing that real estate and associated services are responsible for around a fifth of China’s GDP growth.

China’s authorities have long used their ability to manipulate the property market as a principal lever of economic policy. When there are concerns the economy is overheating, restrictions are imposed on the number of properties a person can own and the amount they’re allowed to borrow.

When the government worries that the economy is slowing, loan-to-valuation limits are eased, mortgage discounts are offered, banks are instructed to lift lending and developers are given fresh tax incentives.

But over the past year, the Chinese property market has become a target in a set of policies unleashed under the overall goal of ‘common prosperity’.

An influential report in the Chinese financial daily Caixin by a prominent economist and deputy director of Yuekai Securities Research Institute, Luo Zhiheng, says there have been profound shifts in China’s development philosophy since the plenary session of the Chinese Communist Party’s central committee last October, which launched the latest five-year plan.

‘These include the shift from growth rate to security; from efficiency to fairness; from early prosperity for some to common prosperity; from capital to labour; and from real estate and finance to science, technology and manufacturing,’ he said.

During most of the past 40 years, China had abundant manpower but a lack of capital, so it made sense to build China’s capital strength. But the problem now is a lack of manpower, while capital is abundant.

‘Hence we are seeing the fiscal and taxation policy adjustments on real estate, the antitrust campaigns in the industrial sector and the intervention in intergenerational education inequality caused by the wealth gap,’ Luo writes.

There have been a series of regulatory moves against the property sector, including measures to stop people using real-estate purchases to get their children into elite schools, pilot programs on property taxes and, with particular impact on property developers, new limits on debt levels and growth. According to one count reported in the China Daily, 320 new regulations affecting the property market have been introduced so far this year, 46 of which came from the ministerial level.

President Xi Jinping has frequently declared that ‘houses are built to be inhabited, not for speculation’. The China Daily report says the reiteration of this edict demonstrates ‘the Chinese leadership’s resolve not to make property a short-term economic stimulus tool but to ensure it functions as a long-term ally of high-quality development’.

The curbs on developers, which precipitated Evergrande’s financial crisis, are the first time that the underpinning of China’s economic growth by property development has been challenged.

But the question is whether the authorities can control what they have unleashed. There has been much discussion in both global and Chinese media about whether Evergrande represents a ‘Lehman moment’, referring to the uncontrolled contagion after US authorities declined to save the investment bank from collapse in 2008, precipitating the global financial crisis.

Evergrande’s obscure accounting practice means no one is certain of the true size of its liabilities, or of the exposure of the non-bank financial institutions and the millions of retail investors they represent.

Although Evergrande’s liabilities are vast—the cited number is in excess of US$300 billion—the Chinese authorities likely have the ability to contain a financial crisis by ordering state banks to take on debts and construction companies to complete unfinished projects while guaranteeing retail investors and the deposits of homebuyers. Bond holders would be expected to take losses.

But it may prove a lot more difficult to stop the housing market from falling. The command-and-control instincts of China’s authorities are ill-suited to the management of markets.

Other property developers—already under pressure from the same new debt restrictions that are bringing Evergrande undone—are being squeezed for funds as both the bond markets and the retail retirement products that form the basis of much of China’s property funding dry up.

Developers worried about the impact of Evergrande’s 1.5 million unfinished apartments on property market confidence are attempting to offload their inventory, but local government authorities are banning them from doing so at discounted prices, with references to ‘malicious price cutting’. Despite discounts, property sales were down 20% in August and steeper falls are expected in September.

It is reminiscent of the 2015 and 2016 turbulence in China’s share markets when the authorities attempted to stop shares from falling by halting trade, only for prices to plunge when the ban was lifted.

The share market accounted for a minuscule proportion of Chinese investment, so the broader economic consequences were limited, but housing is massive. The Rogoff and Yang paper reports that housing accounts for 78% of overall Chinese assets, compared with 35% in the United States.

China has a very high home-ownership rate of around 90%, and owners, particularly in the big cities, have enjoyed huge price increases. Since 2002, prices in the major cities have risen six-fold, or about double the increase of prices in Sydney.

The sector carries high debts, accounting for 28% of all bank lending. The household leverage ratio (debt to income) in China doubled to 60% in just four years to 2018 and has continued rising.

A sharp fall in house prices in China would have far-reaching social, economic and political impacts.

It’s striking that the Chinese government’s effort to bring the real-estate market to heel is one of a series of industry battles it has initiated with the private sector over the past year. Others include the concerted campaign to cut steel production, new emissions curbs on the power industry, regulatory intervention in the technology sector, bans on private education providers, new restrictions on wealth management products and controls on cryptocurrencies, entertainment and gambling. When fighting occurs on so many fronts, there’s a lot of scope for five-year plans to go awry.