Commentary on Political Economy

Saturday 25 September 2021


 As the world’s most indebted real estate company sinks closer to collapse, the optimistic take among global investors​ when it comes to China’s Evergrande Group is that this is a “controlled explosion”​ rather than a “Lehman moment.”

But didn’t Beijing itself light the fuse? The “red lines” on corporate debt the government issued last year all but guaranteed Evergrande’s demise. Still, the bulls say, financial authorities have had plenty of practice at this kind of demolition job. Earlier this year, they placed into bankruptcy administration the HNA Group, one of China’s most acquisitive conglomerates, and on Friday the company announced police had detained its chairman and chief executive.

HNA is one thing. When it comes to Evergrande, though, this explosion can’t be so easily contained. In fact, the developer’s troubles may eventually blow up China’s entire economic growth model.

Protesters outside Evergrande’s Shenzhen headquarters earlier this month.

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Evergrande is the Chinese economy both miniaturized and exaggerated—a debt-fueled construction business that grew on the back of vast migratory flows from the countryside to cities. The company focused on third- and fourth-tier urban centers to which farmers are allowed to move, not mega-cities like Beijing or Shanghai where they are largely excluded.

It was a strategy that spread wealth far and wide. Demand for Evergrande apartments benefited makers of washing machines, refrigerators and other appliances. In China, new car sales became correlated 1:1 with apartments​ as housing projects sprawled from downtown areas to distant suburbs.

And all the housing activity helped fill the coffers of local governments through the sale​ of land. Though representing only 4% of China’s real estate market, Evergrande became an integral part of a pro-growth cycle in which local governments place money gained from land sales into infrastructure—roads, railways, ports and the like—thus encouraging further inflows of workers and businesses, and adding to tax receipts.

Along the way, the alignment of commercial and bureaucratic interests came to define the political economy of China. In smaller cities across the country, the power brokers are the real estate moguls, whose fortunes are entwined with local officials and state bankers. Evergrande now owns more than 1,300 real estate projects in more than​ 280 Chinese cities, making it a big player in governing circles.

But this growth model has always rested on a doubtful proposition: that demand for property is inexhaustible, and therefore prices will​ keep going up.

Covid-19 jolted that idea, slowing property sales. But the most important economic sector in China—and indeed the world—was already being undermined by a more powerful, irreversible reality: Migrant flows are drying up.

A deserted bridge that connects the Hongbaihua Park and the Ruyi Lake Cultural Square in Zhengzhou. China’s growth model has long relied on continued demand for property. Photographer: Yufan Lu for Bloomberg Businessweek

Just about everybody who wants to leave the Chinese countryside has already left. Moreover, the national workforce is contracting as a result of long-term demographic trends. That’s quite a problem when it’s the workers who are​ the main buyers of new homes.

Making matters worse, those workers are getting pickier about where they live, shunning smaller cities with lower growth prospects. According to researchers at the Paulson Institute, 60% of China’s urban population now lives in shrinking cities. Logan Wright, a director at the Rhodium Group, calculates that the entire population of France could fit into empty Chinese apartments. The pro-growth cycle, in other words, is about to shift into reverse.

Beijing has seen all this coming and is rightfully alarmed. The property sector accounts for more than one-quarter of economic output, and some 80% of family wealth is tied up in real estate.

It’s quite likely, then, that Evergrande was intended as a controlled explosion—one big enough to get the attention of other highly indebted real estate firms headed toward insolvency but not so big as to take​ down the entire property sector, and with it the Chinese economy.

That doesn’t mean that China will escape unscathed.

The routes of contagion likely don’t run through the financial system, as they did in 2008, even though Evergrande has more than $300 billion of debt. As the China Beige Book points out, “There is no durable counterparty risk when the state owns or controls all of the counterparties.”

Still, real estate prices are barely rising, and if they start sliding it will crimp consumption, slowing overall growth and further depressing demand for real estate. A decline in infrastructure spending will act as another drag on the economy.

Beijing now faces an awesome challenge. It must shift the drivers of growth while reengineering local governance and its​ entire fiscal system. This may not be a classic Lehman moment. But make no mistake, a systemic threat is looming.

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