How the Evergrande debt crisis could force China’s hand on reforming government

An Evergrande collapse would be unlikely to bring down China’s financial system, but unresolved problems could still threaten social stability
Bloated government, dependence on land sales revenue, shadow banking and inefficient urbanisation are among the issues in need of urgent reform

Andy Xie

Published: 6:45am, 1 Oct, 2021

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Beijing is likely to handle the collapse of the Evergrande bubble in a controlled manner, as it did in cases like Anbang or HNA before. That might not be enough to secure China’s financial long-term stability, however.

The best option would be to dismantle the debt bubble as a whole, wean the government off property money, and rebalance the economy towards household consumption and away from investment. But Beijing will probably settle for minimising contagion from the crisis and wait for the next Evergrande.

Chinese cuisine is famous for working many different ingredients into a mouthwatering dish. Evergrande’s debt story seems to have more ingredients than any stir fry: offshore and onshore, local and foreign currency, private IOUs and loan funds, bonds and bank syndicates, delayed payments for contractors and workers, and wealth management products for unsuspecting investors.

In 2008, Wall Street banks formed a suicide pact with complex derivatives linking them together. China’s debt issues have laid a trap for a wide section of society, even the powerful mandarins in Beijing. Could Evergrande be China’s “Lehman moment”?

Since 2008, China has shaped its financial system to avoid such a moment. The shadow banking system, including wealth management products for the retail market, has grown rapidly to take on the risks that banks shun.

02:25

Unpaid by Evergrande, supplier sells car and home to rescue his business

As such, an Evergrande collapse would be unlikely to bring down China’s financial system. However, a host of other problems – such as protesting investors and prepaying homebuyers – could still threaten social stability. Dumping risks on unsuspecting households carries its own version of financial chaos.

Even without the shadow banking system as a cushion, China can avoid a Lehman moment because creditors cannot foreclose and liquidate quickly without government approval.

To some extent, relying on an unwieldy shadow banking system to cushion the banks has made things worse. Risk management in the shadow banking system is much worse, exacerbating the overall risk level.

Beijing is trying to contain the debt bubble by limiting overall leverage for a business group. That exposes businesses that rely on rising leverage, not sales, to stay liquid. Evergrande is one of those, and there are more to come.

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Angry protest at headquarters of China Evergrande as property giant faces liquidity crunch

The next wave of bankruptcy candidates will come when falling land prices expose the hot air in their equity base. The rampant expansion of the shadow banking system has increased liquidity flow into the land market. As land prices surge, it increases the room for more debt.

The rapid expansion of the shadow banking system, which was estimated to be about 86 per cent of China’s gross domestic product last December, is the driver behind China’s massive and long-lasting property bubble.

Capping leverage will lead to reduced liquidity in the land market. The land price would then fall in the coming months or years and more developers will find themselves in negative equity.

China’s trajectory in handling its debt bubble is similar to that of Japan three decades ago. The Japanese banking system did not allow snowballing from rapid liquidation and held onto non-performing assets for a long time.

In China’s case, the banking system might need to swallow assets from the shadow banking system for the sake of stability. The clever idea of dumping risk into the shadow banking system was just self-deception.

Could China become like Japan as its property bubble deflates, albeit in a controlled manner? There are two main differences. First, China’s per capita income of US$10,500 is less than a third of the OECD average while Japan’s was well above the average when its bubble economy popped. China still has room for improved efficiency.

Second, China does not face significant competition for its place as the factory of the world. Japan faced competition from South Korea, Taiwan and mainland China, generating pressure to shed uncompetitive industries. India and Southeast Asia – two potential challengers for China – are not yet organised enough to compete.

China will become more dependent on being the world’s factory in the coming years as Beijing is unlikely to shift income to the household sector to boost consumption. Local governments have been supplementing their budgets with revenue from land sales and taxes on the property sector, but as land prices cool they will face severe fiscal pressure.

Shenzhen’s second land sale of the year fetches government US$7 billion

Resulting measures to raise revenue would put more pressure on households and dampen consumption. Thus, exports would become more important.

A prolonged collapse in demand would force real changes in China. The top issue is the size of the government, which is already too big and getting bigger. Government consumption is more than 15 per cent of national GDP.

Most investment, other than the property sector, is from the government or state-owned enterprises. The odds are that the government will boost its investment to support the economy as the property sector cools.

The second big issue is urbanisation efficiency. Policies that favour urbanising small cities have failed. People need to live where they can get good-paying jobs, and only big cities with efficiency of scale can offer that.

China needs to concentrate on developing megacities, but the political winds are going the other way. Just when the government will follow the efficiency route rather than its own instincts is anyone’s guess.

Finally, boosting consumption is only possible when the government and investment are efficient. The resulting gains could be shifted to households to encourage consumption. While increasing consumption is a government goal, it will not happen unless fundamental reforms elsewhere happen first.

China is not like Japan three decades ago. It can still improve its external competitiveness. If it wants to become like South Korea after 1997 and restructure to raise efficiency and income, it needs fundamental reform in the government sector.

The only scenario that forces China to change is a prolonged collapse of demand. The survival instinct will make the government change despite the pain.

Andy Xie is an independent economist