China Still Behind the Property 8-Ball

A reminder that nothing has changed in China. I have reduced focus on China because the government successfully kicked the can enough times. The big bust is still looming, but timing it is impossible because it will only happen by choice (a political decision) or because they lose control. The latter will be global in scope, it won't happen in a vacuum. The important point: China is in a worse position that the U.S. was in 1929. It is not a market economy, even if they do use the market quite a lot. It is a command-economy that uses real estate development to hit growth targets. This model broke in 2008. They created a tsunami of credit in a restart attempt. They failed. The economy has been in a permanent slowdown since 2011 and they have intesified their reliance on real estate in every way imaginable. Most critically, to keep local government debt levels down, those local governments shifted heavily into "land finance," selling public land to finance infrastructure development to hit GDP growth targets.

Evergrande isn't some outlier company. It is the engine of the Chinese economy. In the quote below, Chanos explains how credit flows through the system: it begins with homebuyers! It also highlights the point I've constantly drilled home: China cannot increase credit growth without it flowing into real estate, a mirror of the Federal Reserve's difficulty in getting capital flowing into the real economy instead of financial assets. Neither country is willing to face the bust or enact the major reforms needed for sustainable, organic growth.

Xi's consolidation of power should be seen in light of this reality: China is in worse financial shape with respect to the size and clearing of the bubble. The U.S. let financial asset prices collapse and rebuild its economy. The ruling class won't survive, but the U.S. has a process for their removal. China will have forests of unused apartment buildings. Households debts are backed by real estate. There will be mass bankruptcies and the banks will own the forests. As globalization retreats, factory cities will lose their export markets. China has greater power to control the fallout, but it cannot eliminate the costs. I still expect the final destination will be the currency.

ZH: Jim Chanos: China's "Leveraged Prosperity" Model Is Doomed...And That's Not The Worst Of It

LP: So with Evergrande, everyone came to expect a bailout?

JC: I think we’re at that crossroads. The problem is that these companies are so much bigger than they were in 2015 or 2011. Can you bail everybody out? In the case of the developers, you have an additional problem. The biggest amount of liabilities is not necessarily to banks and bondholders. It’s to apartment buyers. Here’s why: the Chinese real estate finance system is exactly the opposite of ours. In our system, when there’s a new development, you’re typically required to put 10% down to sign a contract, with the balance due on closing. You go get your financing and your mortgage proceeds pay for the rest of the house or the apartment. In China, you pay upfront. You are extending the developer a loan. So, of the $300 billion in liabilities Evergrande owes, I think the biggest chunk, last time I checked, is basically what we would call a deferred revenue item. It’s money that you took in from people, and you owe them an apartment. And the apartments aren’t done, but the money’s been spent. So the problem is not just bailing people out, but the question of who is going to put up more capital to pay off the retail people that have bought apartments that haven’t gotten anything.

These numbers are big, and Evergrande is not the only one. There are a handful of developers that are missing interest payments and have their bond prices reflecting distress.

LP: Is this only a problem with the real estate sector, or is it more extensive?

JC: Based on our analysis of the numbers – and you have to take the Chinese numbers with more than a shaker of salt – we’ve long thought that residential real estate was probably 20% of GDP and that all in, real estate construction and related services was about 25%. Ken Rogoff came out with a study last year that said it was 29%. That’s already a huge amount compared to other countries.

Well, the numbers that the Wall Street Journal just put out were staggering, implying that there were 1.6 million acres of residential real estate under construction. If you do the math, it’s the equivalent of 72 million apartments. We believed that they were selling 20 million a year, but the WSJ story seems to imply that the numbers are actually much, much bigger. That tells me that our numbers and Rogoff’s numbers regarding GDP are probably on the low side. It could be a 30-40% problem, not a 20-25% problem. It’s just magnitudes bigger. We’ve never seen anything like this. And there’s no game plan, no historical analog. Maybe Tokyo in ’89? But this is worse than that. It’s worse than Spain in ’06 or Ireland in ’06. We’ve just never seen an economy this dependent on putting up apartment buildings — apartments that nobody is residing in. Everybody already has an apartment! These additional ones are second and third apartments at this point, and only for people who can afford them because they’re extremely expensive.