In April this year, four banks in the Henan province of China announced that they were
freezing deposits of around six billion dollars while they updated their IT systems.
Depositors worried at first but began to panic in late April when they learned that a major
shareholder of the four banks had been arrested for “serious financial crimes.”
A few months later news hit of a group of homebuyers around China who were threatening
to stop making mortgage payments on apartments in building projects that had yet to be completed.
While Chinese media has portrayed these two stories as minor events that are unrelated
to each other and driven by very specific local circumstances, they might instead be
symptoms of a much greater issue in the Chinese financial system.
The frozen bank deposits led to protests and bank runs.
Then on May 21, a large demonstration was held outside the office of the China Banking
and Insurance Regulatory Commission.
Police stepped in to disperse the protestors, but this only drew national attention to what
was going on.
Municipal authorities even changed the COVID public health codes for people travelling
to the protests, preventing them from using public transportation or assembling in public
spaces.
This abuse of the public health systems led to outrage throughout China, causing the government
in Beijing to intervene.
Local authorities initially claimed that the red health codes were caused by a computer
glitch, but after an investigation, five local officials were punished for wrongdoing.
The protests didn’t end, and on July 10th a larger protest outside the People’s Bank
of China turned violent as the peaceful protestors were violently attacked leading to numerous
hospitalizations.
Videos of the violence went viral, drawing sympathy to the protestors and the local officials
were widely criticized for their behavior.
There are a few interesting things about the Henan banks that froze up in April.
They were all small rural banks that historically had focused on local economic activity in
the rural areas that they serve.
Banks like these are at the riskier end of the spectrum in the Chinese banking system
as they usually struggle to attract deposits from their less affluent rural customers and
they can’t diversify their deposit base or their lending books, as their remote settings
mean that their customers are usually employed in agriculture, which can be a boom or bust
business where either all of their customers are doing well all at once, or are struggling
financially all at once.
This makes for a difficult banking environment.
In recent years, with the advent of new online financial services platforms – or fintechs,
small banks like these worked out that they could attract money from savers all over the
country by offering online deals to customers to deposit their savings.
They might offer higher interest rates of around 4 percent to online customers all over
the country who agreed to lock their money up for a year.
These deals might additionally include the option to extend this interest rate for up
to five years.
And of course, this optionality is valuable too.
Due to government concerns that these online platforms were easy to abuse, many of them
were made illegal in early 2021, but it appears that their use still persisted well into 2022.
By offering high interest rates on these platforms, the four rural banks that eventually froze
up, were able to draw funding from around the province and even neighboring provinces.
For this reason, when things went wrong, it immediately mattered to more than just local
rural communities.
The day after the violent protests, it was announced that members of a “criminal gang”
had been arrested under suspicion of “various serious crimes” related to illegal loan
issuance and transfer of funds.
The gang was said to have gained control of several village banks – including the four
that had frozen up - by illicit means, sold financial products through their platform,
and set up shell companies to hide where the money had gone.
By this point similar problems had been discovered at two more banks in a neighboring province.
Mostly because of the attention the protests had drawn to the issue, financial regulators
began ordering partial payments to local depositors two days later.
Small depositors were repaid first and every week or two repayments were announced for
accounts of increasing size.
On August the 5th it was announced that individuals with accounts of up to the equivalent of 35,000
dollars were to be repaid.
There were (of course) bigger accounts than that still hoping to get their money back.
So, were the deposits insured?
Well, there is supposed to be deposit insurance in China, as a deposit insurance system was
announced in 2014 covering deposits up to the equivalent of around 70,000 dollars.
But the Deposit Insurance Fund Management Company said that the online deposits were
not insured, as they had not been banking deposits.
The money had been invested in other assets and while it’s unclear if the depositors
were aware of this, they should have known that they were earning much higher interest
rates than normal bank deposits – which should indicate that there was additional
risk.
So that is the bank runs, but as this was going on, and perhaps even taking inspiration
from these protests, an online group called “We Need Homes” appeared, and members
of this group began to threaten to stop making payments on their mortgages.
Why were these people upset?
Well, they wanted something done to guarantee the completion of the homes that they had
paid for - in full, which were showing no signs of being built.
By the end of July, more than 320 property projects around the country were affected
by this mortgage boycott.
Many of you might be wondering why people would be making mortgage payments on homes
that have not yet been constructed?
Well, the Chinese homebuying market has some peculiarities.
It is not that unusual in hot real estate markets around the world, for people to buy
an apartment off the plans.
But in most parts of the world, this just involves putting down a deposit to reserve
a place.
Home buyers will usually only do this if the developer can show that they have insurance
– so that if the developer goes bust before delivering the home, the buyer can get their
deposit back.
In China however, the homebuyer pays the entire price of the home - in full when they decide
to buy, and they often do this at a point when only the most basic work has been done
to signal the start of construction.
This usually means that they take a mortgage and start making monthly payments well before
the home is completed.
This means that Chinese developers can raise an awful lot of money very quickly – through
announcing sales -, and they often use this money to buy up even more land and expand
their businesses.
The history of private home ownership is quite short in China.
When Mao took power in 1949, the state seized all private property and the state continued
to own all property up until the 1980s, when Deng Xiaoping, began experimenting with private
property ownership in select cities.
Today, all land is still government owned in China, but it is leased out to those willing
to develop the land.
When someone “buys” a home from a property developer, they don’t own the land, they
are just taking over the lease on the land, which for residential property lasts 70 years.
If the lease was granted to developers 10 years ago but the apartment was only just
completed, home buyers might only have 60 years left in the home.
So, what happens when those leases expire?
Well, there have only been a few cases in which this has happened, as this approach
is still quite new.
In 2002, some 20-year land leases in Shenzhen expired, and property holders there had to
pay 35% of the assessed value of the property for a 40-year extension on their lease.
If you didn’t pay for an extension, you would receive only the depreciated cost of
the building materials on the plot as compensation.
China does have laws requiring builders to deposit enough money to complete construction
into government supervised escrow accounts, but local governments and banks often override
this requirement.
There is (of course) a conflict of interest here, as the local governments in China don’t
raise revenue through property taxes, they instead raise revenue by leasing land to property
developers.
Allowing the property developers to sidestep escrow rules, means that the property developers
have more capital and can compete to lease even more land for development – and that
money goes to the local governments.
As you can imagine, preselling apartments is a very cheap source of financing for Chinese
developers, and they have of course made the most of the situation.
What they do is they start projects, announce presales at a rate well beyond what they can
be reasonably be expected to complete in a timely manner.
You can see this clearly on this chart which shows the growing gap between property starts
and property completions in China over the last decade.
Now, in such a situation, home buyers are going to find themselves waiting longer and
longer to get the homes they have paid for, and you might wonder why they would put up
with this.
Well, Chinese home buyers have mostly been happy enough with this situation, as home
prices have historically risen in value at a much faster rate than the rate of interest
on their mortgages, and many of them think of the purchase as an investment, rather than
as a home that they are planning on living in.
So, for the longest time – property developers were able to raise a lot of money through
presales, use it to buy more land for development, and all of this capital raising, and land
purchasing just drove land (and property) prices up in a self-reinforcing manner.
When people saw their friends and neighbors getting rich by borrowing money to buy homes
which were never delivered but inflated in value, they rushed to join the party.
People who were conservative and chose not to participate were financially left behind.
Similarly, property developers who behaved responsibly, completing projects before announcing
new ones, were soon dwarfed in size by their more aggressive competitors, who had bought
up huge swathes of land and had grown unimaginably rich.
The problem with this of course, is that it only works when property prices rise, and
when they fall in value, homebuyers – or really property speculators - find themselves
making monthly payments on a home that hasn’t been built and not only that…
it is falling in value.
We are now left with a situation where property developers have a huge backlog of homes to
build, but they have spent most of the deposits that they have taken on land that is now pretty
much impossible to sell.
The group threatening to not pay their mortgages, according to the Chinese press were not property
speculators hoping to make a quick buck.
They were often working-class people who had bought inexpensive homes in the outskirts
of smaller cities.
These people were actually hoping to live in them, and it is not surprising that this
group were the first to get angry and to take action.
Over the last year, property prices have declined in two thirds of Chinese cities, and the price
declines have been the most severe in the smaller cities.
And that is where the mortgage boycotts have been concentrated.
The market for new homes has collapsed in China, and news of bank runs, and mortgage
boycotts have only made the situation worse.
The Chinese press reports that in the first two weeks of July – in thirty major cities,
in terms of floor space, new home sales have more than halved – partially driven by the
news of mortgage boycotts.
The situation is so bad that several property developers have advertised that they would
accept food - including peaches, watermelons and garlic - as down payments on new homes.
The threatened mortgage boycott got the attention of authorities, with some officials initially
warning that a failure to pay mortgages would result in serious long-term consequences.
The authorities were concerned that if a boycott on unfinished homes was successful, that the
boycott strategy might spread to other homeowners who had received their apartments but were
upset because their property prices were falling.
That would be much more of a problem.
Authorities eventually responded by allowing homebuyers to temporarily to halt mortgage
payments on undelivered property projects without incurring penalties, but eligibility
and the length of the grace periods would be decided by local governments and banks.
They also took steps to expedite the completion of building projects around the country, where
local governments were asked to take steps to push the uncompleted projects forward and
China’s banking regulator urged banks to increase lending to make these completions
happen.
It is rumored that local state-owned enterprises will take control and ownership of uncompleted
projects in order to get them completed.
The problem with this solution, is that many of these local governments are struggling
with tight budgets, as they typically raise money by leasing land to real estate developers,
and demand for new land leases has dried up.
Both the bank runs, and mortgage boycotts are symptoms of the significant strains in
the Chinese financial system after years of soaring debt, nonproductive investment, and
a property bubble.
The fall in property prices is causing these problems, but also highlighting weaknesses
in the financial system – like the issues with deposit insurance.
The problem in the financial system is not a liquidity issue, that can be worked around.
There has been a huge growth in debt to fund malinvestment in both real estate and unnecessary
public infrastructure – which is worth less than the debt that was taken on to pay for
it.
The core issue is that this rise in debt has been well beyond the growth of the borrower’s
ability to service that debt.
Most of the solutions being put forth for the problems in the Chinese financial system
don’t actually solve any problems, they are mostly just ways of postponing a painful
situation by restructuring and extending these losses further out into the future.
Economies that follow these types of loss deferral strategies tend to recover much more
slowly than economies that face up to their problems allow necessary bankruptcies and
move on.
There are huge losses sitting there in China due to decades of malinvestment that are only
now being recognized by the state, and eventually some sector of the economy will have to absorb
those losses.
These losses are real and can be absorbed by the central government in Beijing, the
banking sector, the local government sector, the business sector, Chinese households or
some combination of that list.
The wealth transfers required to fill the holes that exist can come from increased taxes
– on either individuals or businesses, defaults, currency appreciation, inflation or wage suppression.
There are many ways that this situation can resolve itself, but one way or another it
will be a political decision where the central government decides who the winners and losers
are going to be.
The losses can’t be erased, the only question is - which sector of the economy will be forced
to take the loss.
The decision as to who takes these losses will of course have huge long term economic
implications.
Due to the Chinese Communist Party’s upcoming National Congress in mid-October, Chinese
regulators are likely to prioritize stability between now and then.
Any additional financial issues that crop up will be quickly dealt with by local government
borrowing and the bigger banks – the same sort of thing that we have seen so far.
There is a chance that we see a lot of economic stimulus to kick-start the property market,
and increase confidence amongst lenders and bank depositors.
It doesn’t seem likely that the costs of these losses will be pushed to the business
sector through higher taxes or lower subsidies, as this would likely grind growth to a halt
in China.
It’s equally unlikely to see these costs being allocated to the agriculture or mining
sectors, as it would appear that the government is aiming to grow these sectors to make the
country more self-sufficient.
That leaves us with the government sector, and large government owned banks as being
most able to absorb both the costs of these losses, and the cost of rebalancing the economy
away from real estate and infrastructure investment which make up a huge percentage of Chinese
GDP.
It is very hard to predict what will happen though as this will be very politically driven.
If you found this interesting, you should watch my video on the international consequences
of Chinas slowdown next, as China makes up a very large percentage of global growth.
Have a great day, and talk to you again soon, bye.