In autumn 2018, a Chinese blogger, who claimed to be a "veteran in China's
financial sector," sent shockwaves through the business community with an article saying
that the historic mission of private enterprise had achieved all of its goals in China and that
communist ideology would be coming back in full force – the era of private enterprise was over.
The article was so widely shared and caused such consternation that the Communist party spoke out
to calm the nerves of the business community – there was nothing for people to worry about.
Shortly afterwards the crackdowns began. Over the last few years,
President Xi’s administration launched a series of campaigns targeting different
areas of business with the goal of reshaping the business and cultural landscape in China.
The government targeted the fintech industry, private tuition and entertainment as well
as perceived societal ills such as celebrity culture, gaming and effeminate fashion trends.
They also banned the beloved children’s animated character Winnie the Pooh – i dunno,
maybe you are not supposed to say poo. I mean honestly… who named that bear..
The severity of the action taken by Beijing against private companies surprised people
both in China and abroad, and while these attacks on private enterprise were harming the economy,
the real damage was yet to come. The three red line policy in August 2020 essentially sucked
all of the air out of the room for Chinas property developers. This was a big deal as China’s
property sector is estimated to make up almost a third of the country’s total economic output.
A number of developers – unable to refinance - including Evergrande, Kaisa Group,
Fantasia Holdings and Modern Land China have since defaulted on their debt, and the property
market has ground to a halt over the last few months. The problem is bigger than that though,
as local governments in China historically raised about a third of their total revenues
from selling land leases to property developers. That revenue source evaporated in autumn 2021.
Now just to be clear, there was a definite problem of excessive leverage and real estate
malinvestment in China, and this had been building for fifteen to twenty years. My friend Hugh Hendry
has pointed out that there are 55 million empty housing units in China right now and
93 million new homes under construction. Actual housing demand is estimated to be 7 million new
units per year. That is a lot of excess inventory building up. Something did have to be done about
the excesses in the real estate sector, but you have to question if the brakes had to be slammed
on that hard, and if it makes sense to hammer other sectors of the economy at the same time?
The government actions erased billions of dollars of value for both domestic and foreign investors.
It put unprecedented levels of pressure on some of the country’s largest employers,
local governments, and corporate contributors to economic growth. The crackdowns left investors and
Chinese businesspeople wondering if it made any sense to invest in China at all going forward?
So why did this have to happen right now? Well, Chinese officials insist that all is going to
plan. In April 2021, the party’s politburo said China’s strong rebound from the pandemic had
presented a “window of opportunity” to tackle critical structural challenges in the country.
They note that the Chinese economy is on track to exceed the government’s full-year
growth target of more than 6 per cent. They argue that this crackdown is a necessary
element of a larger campaign to eliminate financial risks
that could blow up if not addressed immediately and that these steps are needed to eradicate
inequality and bring about “common prosperity”. There is something to be said for some of these
arguments. Housing affordability in China is right now amongst the worst in the world.
It takes 40 years of income in Shenzhen to purchase an apartment. That compares
to thirteen years in London and eight in New York Cities that are not famed for their affordability.
President Xi has famously said that housing is for living in and not speculation. And he
considers housing policy as the central part of his Common prosperity drive.
China’s trade surplus reached its highest level on record in 2021,
It was 26 per cent higher than the prior year and exports were 30 per
cent higher. China’s manufacturing industry benefited from a shift around the world
from people spending money on services to buying tangible goods over the course of the pandemic.
There was a sudden drop in Chinese Exports in early 2020 at the start of the pandemic,
but Chinese exports of goods quickly took off once domestic cases of the virus fell and lockdowns
were imposed in other countries around the world. It doesn’t make sense to kick the can down the
road as prior administrations have done in China, and it possibly makes sense to
implement reforms at a time when the rest of the economy is experiencing growth,
but it is not clear that a lot of planning went into implementing the three red lines policy.
It would appear that the Chinese government were entirely unprepared for the repercussions.
Since Xi has taken power, two big policy mantras have been put forward by Beijing:
common prosperity and dual circulation. Each is likely to be further emphasized over time.
Common prosperity signifies an intent to raise the living standards
of the approximately 600m Chinese “have-nots”, while dual circulation entails a shift toward
greater self-reliance - avoiding importing goods from abroad – an attempt to achieve
greater localization of China’s supply chain. In an online speech to the World Economic Forum’s
annual meeting, president Xi struck a pro-growth tone in his defense of the common prosperity
policy. He said “The common prosperity we desire is not egalitarianism. We will first
make the pie bigger and then divide it properly through reasonable institutional arrangements.
As a rising tide lifts all boats, everyone will get a fair share from development,
and development gains will benefit all our people in a more substantial and equitable way.”
It doesn’t appear that many of the recent campaigns
have done much to grow the pie as he described, and I struggle to imagine how any of them would.
We’ll have to wait and see how the more equal division goes.
So, China is still growing, but it is growing less than before. By most international standards,
China’s 4 per cent year-on-year growth in the fourth quarter of last year was a
great performance. But while it was above most analysts’ predictions, it was the slowest pace
of expansion for 18 months — a slide from 6.5 per cent growth during the same period in 2020.
This raises the question, as Xi seeks a third term later this year, if the
economic consequences of his common prosperity campaign are beginning to spiral out of control.
The three main factors putting a drag on the Chinese economy right now are:
Number 1. the crackdowns on businesses like in the tech sector and education sector. Number two,
the collapse of the property market. And number three, China’s “zero Covid” strategy which goes
far beyond social distancing and wearing masks. It involves people being confined to their homes,
closed roads, suspended transportation services and it has left citizens short of food and other
essential supplies. It is almost as bad as Canada… China appears to be taking this action
partly to prevent disruption to the upcoming Winter Olympics, trading
economic growth for international prestige. China’s slowdown is, to a certain extent,
self-inflicted. But it doesn’t look like Beijing will relax any of the policies
affecting these three key areas as they appear to reflect a strongly-held official conviction.
On top of these problems, Chinese companies are facing a number of additional headwinds.
US Tariffs are still in place, and there are new investment blacklists
relating to human rights abuses. So, what is happening on the ground in
China due to these policy-led slowdowns? Well, in December China’s State Council accused the local
government in Bazhou, of violating government orders by going on a fee-collection spree
from small and medium-sized businesses to make up for its declining land-sale and tax revenues
from the property slow down. The local government ordered officials to collect $47m in new revenues,
through the imposition of arbitrary fees and fines on the local community. A factory owner
describes being forced by the local meteorological office to buy an expensive lightning rod from a
government-designated supplier at a highly inflated price. The central government,
while outraged, said nothing about their own policies that had forced the municipality
to scramble for revenues in this manner. Local party and government officials in China are
complaining that they, not the central government in Beijing, have to foot the increasingly
expensive bill for Evergrande’s collapse. As I mentioned in a prior piece, they are being asked
to complete Evergrande projects that buyers have already paid for, but they do not appear to be
receiving any government funds to get this done. An executive at a construction firm,
told the press that his firm is refusing to do any work on Evergrande projects for the
local government unless he is paid in advance – he is already owed money for work he did for
Evergrande. In other cities local officials are trying to auction their Evergrande problems away
by selling off the developer’s uncompleted projects in their jurisdictions.
There are news reports of Chinese people who have seen their home prices half, offering to give
away their partially paid off homes to anyone who will take over the remaining mortgage payments.
There are other problems cropping up too. In China developers often force
their suppliers to accept commercial paper – a form of IOU - instead of cash payments.
They promise to pay this off by a future date. The supplier is then able to use this commercial paper
to pay its suppliers, provided it endorses the document by stamping a company chop or seal on
it. This commercial paper can easily be endorsed ten times before it ends up with the final holder.
If a company like Evergrande is unable to pay upon maturity, the holder can sue every company
that endorsed the document — potentially freezing assets worth many times more than
the original debt. This is a big problem. In 2020 the total amount of commercial paper
issued by Chinese companies came to 3.5 percent of Chinese GDP. Evergrande alone accounted
for more than 60 per cent of commercial paper issuance by the top-20 real estate developers.
So is the government doing anything to ease these problems? Well, so far, they are not doing much.
China lowered its one-year loan prime rate by 10 basis points and the five-year rate
which is used to price mortgages was reduced by 5 basis points, the first cut since April 2020.
The party’s year-end economic planning conference reiterated that the government would continue to
refrain from “flood-like stimulus” and would continue its battles against “the disorderly
expansion of capital” — party-speak for the various crackdowns on private-sector
businesses — as well as speculation and high leverage in the real estate industry.
What about the mostly state controlled Chinese banks? Well, Chinese banks rushed to meet their
state-required lending quotas last month by buying up low-risk financial instruments rather than by
issuing loans. They bought banker’s acceptance bills, which are technically classified as loans
and yield close to zero per cent. Chinese banks’ have a cost of capital of around 2.5 per cent.
This means that they preferred to lose money on low-yielding banker’s acceptance bills
rather than risking greater losses by issuing their own loans at higher rates of interest.
Many of the problems being faced by President Xi were in place when he took office, but it could be
argued that better planning was needed in order for these problems to be unwound in an
orderly manner. Before implementing the three red lines policy that would force Chinese developers
to deleverage, the government could have made plans for funding local governments that were
reliant on selling land leases to developers to fund their operations. A lack of planning can
also be seen in the growing contagion that is happening in Chinese commercial paper markets.
It would appear that under these policies, Chinese property prices will be in structural decline,
and local governments will have to deal with tight finances for the foreseeable future.
The technology, education and entertainment industries in China
will also have to deal with growing regulations. For several years, China has contributed more
to global GDP growth than any other country and, before the coronavirus
pandemic struck, it often accounted for close to one-third of the world’s economic growth.
Last year, China contributed about one-quarter of global GDP growth
as its property sector collapsed, birth rates declined, and debt levels rose.
These headwinds are unlikely to dissipate any time soon.
If you enjoyed this video, you should watch this one next. See you again soon, bye.