Evergrande and the end of China’s ‘build, build,
build’ model
Valued at $41bn in 2020, the spectacular unravelling
of the property group exposes deep flaws in Beijing’s growth strategy
James Kynge
in Hong Kong and Sun Yu in Beijing SEPTEMBER 22 2021
A dramatic
video filmed in the southwestern city of Kunming in August hints at the scale
of China’s property bubble. Onlookers can be heard screaming in awe as 15
high-rise apartment blocks are demolished by 85,000 controlled explosions in
less than a minute.
The
unfinished buildings, which formed a complex called Sunshine City II, had stood
empty since 2013 after one developer ran out of money and another found defects
in the construction work. “This urban scar that stood for nearly 10 years has
at last taken a key step toward restoration,” said an article in the official
Kunming Daily after the demolition.
Such “urban
scars” are common all over China, where Evergrande — the world’s most heavily
indebted property company — is suffering a liquidity crunch that could prove
terminal. The crisis at the company, which as recently as two years ago ranked
as the world’s most valuable property stock, highlights both the speed at which
corporate fortunes can unravel and the deep flaws in China’s growth model.
Evergrande,
for all of the high drama of its meltdown, is merely the symptom of a much
bigger problem. China’s vast real estate sector, which contributes 29 per cent
of the country’s gross domestic product, is so overbuilt that it threatens to
relinquish its longstanding role as a prime driver of Chinese economic growth
and, instead, become a drag on it.
There is
enough empty property in China to house over 90m people, says Logan Wright, a
Hong Kong-based director at Rhodium Group, a consultancy. To put that into
perspective: there are five G7 countries — France, Germany, Italy, the UK and
Canada — that could each fit their entire population into those empty Chinese
apartments with room to spare.
The average
size of a household in China is just over three people. “We estimate existing
but unsold housing inventory is in the range of 3bn square metres, which is
enough to house 30m families, conservatively,” Wright says, explaining his
calculations.
Oversupply
has been a problem for several years. What changed is that last year China
decided the issue had become so chronic that it needed to firmly address it.
President Xi Jinping had also run out of patience with the excesses of the
property sector, say observers, and Beijing formulated “three red lines” to
reduce debt levels in the sector. Evergrande is proving to be the first big
victim. While on Wednesday it said it would meet its payment obligations for
one domestic bond, a big crunch point comes on Thursday when Evergrande needs
to make an interest payment on a US dollar bond.
As the
company falters, its undoing raises a fundamental question for the world’s
second-largest economy: has China’s property-driven growth model —
the global economy’s most powerful locomotive — run out of road?
Yes, says
Leland Miller, chief executive of China Beige Book, a consultancy which
analyses the economy through proprietary data. “The leadership in Beijing has
been more worried about Chinese growth than anyone in the west.
“There is a
recognition that the old build, build, build playbook does not work any more
and that it is actually getting dangerous. The leadership now appears to be
thinking that it can’t wait any longer to change the growth model,” Miller says.
Ting Lu,
chief China economist at investment bank Nomura, says he does not expect
Evergrande’s woes to trigger an economic collapse. But he believes Beijing’s
attempts to transition from one growth model to another could significantly
depress annual growth in coming years.
“There is
unlikely to be a sudden stop,” Lu says. “But I think China’s potential [annual]
growth rate will drop to 4 per cent or even lower between 2025 and 2030.”
Wright says
the property sector is becoming a threat to financial, economic and social
stability — it has already sparked protests in several cities. “It is very
difficult to provide a compelling narrative that China’s potential growth will
exceed 4 per cent in the next decade,” Wright adds.
Miller
echoes that sentiment. “We are set for a roller-coaster ride in policy and in
economic growth,” he says. “I would not be surprised if a decade from now GDP
growth was 1 or 2 per cent.”
If such
projections prove correct, the Chinese growth “miracle” is in peril. In the
decade from 2000 to 2009, China’s GDP growth averaged 10.4 per cent a year.
This stellar performance abated during the decade from 2010 to 2019, but annual
GDP still grew by an average of 7.68 per cent.
Any fall in
growth would be swiftly felt worldwide. China has long been the biggest engine
of global prosperity, contributing 28 per cent of GDP growth worldwide from
2013 to 2018 — more than twice the share of the US — according to a study by
the IMF.
“Even if
China avoids a sharp and sudden crisis,” says Jonas Goltermann at Capital
Economics, a research firm, “its medium-term prospects are much worse than
generally acknowledged.”
Crossing
Xi’s ‘red lines’
The risks
that spring from the Evergrande saga encompass both financial contagion —
especially in the offshore US dollar bond market — and the prospect that a
flagging property sector will strike at some of the vital organs of the Chinese
economy, potentially depressing GDP growth for years to come.
The fallout
from the crisis is already considerable. Evergrande’s plummeting share price
has slashed the company’s market capitalisation from $41bn last year to about
$3.7bn now. And concerns around its possible collapse triggered a global
markets sell-off this week. Some 80,000 people in China who hold about Rmb40bn
in the company’s wealth management products are waiting nervously to see
whether Evergrande will honour payment obligations. Offshore bondholders are
bracing for a default, perhaps as early as Thursday, with one bond due to pay
interest trading at about 30 per cent of its face value.
But
potentially longer lasting impacts derive from the broader fall in China’s
property market. It is clear that the real estate sector is in a tailspin, with
sales in 52 large cities down 16 per cent in the first half of September year
on year, extending a 20 per cent decline in August, according to official data.
An even
more consequential trend for China’s political economy is the collapse in land
sales by local governments, which fell 90 per cent year on year in the first 12
days of September, official figures show. Such land sales generate about
one-third of local government revenues, which in turn are used to help pay the
principal and interest on some $8.4tn in debt issued by several thousand local
government financing vehicles. LGFVs act as an often unseen dynamo for the
broader economy; they raise capital through bond issuance that is then used to
fund vast infrastructure projects.
“We expect
land sales revenue to get much worse,” says Nomura’s Lu.
This
dwindling ability of local governments to raise finance to spend on
infrastructure has the potential to depress Chinese growth considerably. Fixed
asset investment, which last year totalled Rmb51.9tn ($8tn), constitutes 43 per
cent of GDP.
Distress is
already evident in an offshore US dollar bond market, where some $221bn in debt
raised by several hundred Chinese property developers is trading. Big chunks of
the market are currently priced for default. “A full 16 per cent of the market
is trading at yields of over 30 per cent and 11 per cent of the market is
trading at yields of over 50 per cent,” Wright says.
Yields of
over 50 per cent suggest defaults are likely, he adds.
Ultimately,
the fate of such bonds, and almost all other offshoots from the malaise in
Chinese property, depends on Beijing. The Chinese state owns almost all of the
country’s large financial institutions, meaning that if Beijing orders them to
bail out Evergrande or other distressed property companies, they will follow
orders.
In some
overseas markets the idea that Evergrande’s distress may presage a “Lehman
moment” — recalling the chaos that followed the collapse of US investment bank
Lehman Brothers 13 years ago — has gained traction. But given Beijing’s
influence and vested interests, the analogy does not easily fit.
Security
personnel form a human chain outside Evergrande’s headquarters in Shenzhen,
where people gathered this month to demand repayment of loans and financial
products © David Kirton/Reuters
“Unless
China’s regulators seriously mismanage the situation, a systemic crisis in the
country’s financial sector is not on the cards,” says He Wei, an analyst at
Gavekal, a research company.
Indeed, the
main cause of Evergrande’s crisis and the downturn in the broader property
sector is Beijing itself. The “three red lines” that the Xi government
announced last year stipulate that developers must keep debt levels within
reasonable bounds.
Specifically,
it says that the ratio of liabilities to assets must be below 70 per cent, the
ratio of net debt to equity must be below 100 per cent and the ratio of cash to
short-term debt must be at least 100 per cent. In June, Evergrande was failing
on all three metrics and was therefore forbidden from raising additional debt —
triggering its current crisis.
‘Common
prosperity’
If it is
true that Beijing is the main cause of Evergrande’s predicament, then it stands
to reason that it can end the current market meltdown by taking its foot off
the property sector’s throat.
But deep
structural forces in the economy have convinced China’s policymakers that
property can no longer be a reliable dynamo for sustainable economic growth,
analysts say. This is not only because of Xi’s famous phrase that “houses are
for living in, not for speculation,” made in a 2017 speech.
For one
thing, the demand picture has changed utterly from when Beijing pushed through
free market reforms in the late 1990s that touched off the biggest real estate
boom in human history.
China’s
population is hardly growing. In 2020, only 12m babies were born, down from
14.65m a year earlier in a country of 1.4bn. The trend may well become more
pronounced over the next decade as the number of women of peak childbearing age
— between 22 to 35 — is due to fall by more than 30 per cent.
Some
experts are predicting that the birth rate could drop below 10m a year,
throwing China’s population into absolute decline and further dampening demand
for property.
Houze Song,
an analyst at Chicago-based think-tank MacroPolo, says the situation is
exacerbated by the phenomenon of “shrinking cities”. After around three decades
during which hundreds of millions of people left their rural villages to settle
in cities, the biggest migration in human history has now dwindled to a
trickle.
About three
quarters of the cities in China are in population decline, says Song. “A decade
from now, even assuming that some people will leave for growth cities, more
than 600m Chinese citizens will still live in shrinking cities.”
China is
faced with a risky transition. It is starting to shift its growth model away
from an over-reliance on real estate to more preferred engines of growth such
as high-tech manufacturing and the deployment of green technologies, analysts
say.
Here again,
the impetus comes from Xi. A list of eight priorities released following an
economic planning meeting in late 2020 not only denounced the “disorderly
expansion of capital” — understood to have been code for speculation in
property — it also advocated technological innovation and the pursuit of carbon
neutrality.
Such a
transition may take several years to achieve, analysts say. But it is clear
from Xi’s recent exhortations on the need for China to follow “common
prosperity” that he is serious. The propensity of real estate to leapfrog in
value in sought-after areas while remaining undercooked in low-rent districts
has been blamed for widening the inequality gap between rich and poor.
“The slogan
of ‘common prosperity’ is a narrative change that paves the way for a shift in
the growth model,” says Miller. “It clarifies that a drop in GDP growth is not
a failure for the Chinese Communist party.”
Yet,
ordinary people across China are suffering the pain of the country’s property
market meltdown. Xu, 36, who asked not to be fully identified, lives in the
central city of Xinyang and works as a secretary at a local factory. Her mother
bought a high-yield investment product from Evergrande to help cover the
medical bills for her late-stage lung cancer.
But the
promised 7.5 per cent returns from the investment, which cost Rmb200,000, have
not materialised. Instead, Evergrande is refusing to pay out as it conserves
cash to stave off potentially huge defaults.
“My parents
have put all they have into Evergrande,” says Xu. “This is no longer just an
economic issue,” she adds, “this is absolutely a huge social issue. There will
be serious consequences if the issue doesn’t get properly solved.
“If my
mother’s health situation deteriorates because of this,” adds Xu, “I am going
to fight Evergrande every day.”
Additional
reporting by Thomas Hale in Hong Kong
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