The key piece that many western economists and investors fundamentally missed about China in trying to analyze its markets and grab a piece of its meteoric rise, is that it is historically and fundamentally departed from being compatible with many of the business and market principles that have been used to build the industrial and corporate behemoths of the west. Outcomes are the end goal of the semblance of capitalism that exists in China, and when that outcome is growth, the process to achieving that end becomes largely irrelevant.
In China, organizations are built differently because the thinking and the process is fundamentally different. The Chinese word for logic is actually borrowed — the Chinese believe the world is far too complex to be understood by deterministic processes. The ideas of truth and logic literally are different than the western understanding of truth and logic. Truth in China isn’t something that is necessarily proved, only suggested. Absolutist understanding really has no place in a world that embraces relative ideas of the truth.
The applications of these ideas need to be a pillar of understanding when investors seek to be part of the Chinese economic jamboree. As market’s were rocked last week upon the news of Evergrande’s default on a $83 million interest payment, marking one of the first major tremors of the Chinese debt bubble bursting. For those who were paying attention, it’s not hard to see how we got here.
In 2009 while western economists were busy explaining and seeking to understand how our own age of leverage spiraled into a financial global crisis China was setting the stage for a new era of leverage-driven growth and another financial crisis, a crisis that has only just begun. Back in 2009, China had a problem, its economy had a serious dependence on one thing that left it particularly vulnerable: western consumer demand. The United States at the dawn of the crisis represented 19% of China’s exports.
In 2008 as the financial crisis in the west was playing out during the collapse of Bear Sterns and Lehman Brothers, employers in the United States shed 2.6 million jobs. In China, by February of 2009, that jobless figure was said to be anywhere from 20 million to 100 million.
A Growing Problem for the CPC
The CPC has been left with a giant problem, a huge population that it needs to keep busy with its biggest trade partner facing a potentially decade-long credit crunch. In the United States, policymakers are content with adding 1 million jobs per year, China, on the other hand, has to create 1 million jobs every single month. The CPC has a desired outcome, but now, it needs a new method to drive that growth away from export-driven demand. It shortly became evident how China would achieve its outcome, on a year-to-year basis, bank lending to firms increased by 5.6 trillion renminbi in 2009 (about $815 billion), more than twice the average increase observed in the previous two years. Simultaneously the government-funded 4 trillion RMB (about US$650 billion) in stimulus during 2009 mostly towards infrastructure. The CPC met the challenge of unemployment and growth with the only real tool in its arsenal, leverage. At some point during the crisis, China’s central bank, The Peoples Bank of China, gave its state-owned banks the nod to open the credit floodgates launching a building bonanza unlike the world had ever seen. At the end of 2010 real estate made up 20% of China’s economy.
Something that has also been lost on the world is how quickly China’s slowdown started coinciding with its meteoric rise. The greatest deception of China was convincing the world was that the end of its peak hadn’t even happened. By 2011 China’s hot economy began to cool dropping from double digit growth at 10.9% in 2010 to a forecasted 7.4% for 2011 according to World Bank estimates. After 2 years of propping up the economy with debt in response to the great financial crisis, the Eurozone debt crisis was again putting the squeeze on Chinese exports, comprising of 20% of China’s exports. Again, facing an evaporation China doubled down on leverage and state funded infrastructure projects at figures estimated to exceed $1.8 trillion.
While many economists continued to laude China’s growth as an economic miracle, others weren’t quite so convinced. In 2012 Controversial short seller Andrew Left wrote a report claiming that Evergrande, China’s largest property developer would soon be insolvent — nine years ago. As a result, he was banned from trading securities in Hong Kong.
Since then, it would seem Left has changed his tune although being completely correct with Evergrande, he now fully understands the nature of the beast that is China. He approaches the impending crisis from the Chinese frame — outcome oriented. “I believe China has a plan to unwind this. It might not be pretty, but it is a long time coming and they will save the system from the bottom up”. Said Left in September 2021. In 2014, evidence of Left’s 2012 Evergrande prediction was proved to be completely “reasonable”, which we now know was unequivocally accurate. According to Evergrande’s 2014 earnings report, debt to equity ratio was 85.9% if perpetuals were classified as debt that debt to equity ratio becomes 292%.
In the great opera that are often financial crisis’s, the fuse and timer may take some time to burn out but as soon as the ignition point is hit the chain reaction happens quickly — inevitably resulting in explosion, it then becomes a matter of blast containment. By the end 2015 China’s household debt levels had risen to $6.4 trillion. A nation that sought to solve a crisis with leverage now found itself drowning in it, with the primary savings asset of Chinese households being real estate. In short, the PRC solved its employment crisis with a credit-driven building bonanza and a consumer credit tidal wave to bolster domestic demand, an economy built almost entirely on western export demand and debt. What’s worse this tidal wave of leverage-driven construction vastly outpaced natural demand resulting in entire “ghost cities” with enough vacant housing to shelter the entire population of Germany. Now across the ocean in America, China’s next problem was beginning to take shape — agent orange 2.0.
The United States while seeing unprecedented wealth accumulation during this period neglected its beating heartland and a new presidential candidate was answering its populist call. Among the main platform issues, China’s manufacturing rise and its complacency in the erosion of the American middle class. The result upon Trump’s election in 2016 would lead to some of the most stringent trade tariffs enacted in nearly a century, further hobbling an unsuspecting China. Again, China would turn to the only remedy in its arsenal in the face of a margin squeeze on its exports, leverage and stimulus. However, Beijing now more than aware of the fragility of the situation begins to pressure some firms to cut back their debt piles with Evergrande in 2017 “vowing” to cut debt for the first time.
After three years of a now aggressive White House finally cracking down on intellectual property theft and seeking to decouple from its dependance on china for exports critical to national security, in 2019 China’s real estate market now made up 30% of its economy. While the leading theory that with all this debt, the CPC was always presumed to step in when the time would come to pay the piper, however as the world was concerned with a global pandemic that had originated in Wuhan, Chinas banks balance sheets began to swell with bad debts accounting for a reported 22%. The average ratio of bad debt among the four banks rose 0.14 point from the end of 2019 to 1.54%, marking the first uptick in four years. Losses from bad debt rose 16% collectively, which put downward pressure on earnings according to Agricultural Bank of China. In the same year, according to Refinativ data, Evergrande began ramping up its bond sales, selling $3 billion in bonds on a single day in January in 2019, Asia’s largest for the year. UBS was among the joint coordinators of the bond sale.
In 2020 the five largest Chinese banks at least a 10% profit decline in the first half of the year, the cause, bad loans. Beijing’s senses now heightened to the systemic risks begin to introduce controls and caps for debt ratios, with regulators meeting with 12 major property developers, Evergrande among them. In line with Beijing’s overarching crackdown on “private companies” on the heels of the August summit Evergrande slashes its property prices by 30% in hopes to bolster sales, however, China has another looming problem, inadequate demand.
According to the Rhodium Group, future urban household formation rates in China are predicted to be around 5 million to 7 million per year over the next decade, compared to around 9 million to 10 million a decade ago and declining over time. Urbanization rates are slowing, and annual marriages declining by 40% from their peak in 2013, according to China’s Ministry of Civil Affairs. The leading drivers of demand for housing were primarily based on speculative demand and asset parking. With the housing market outlook now grim, price-cutting for a market held together by buyer profiles with no intentions to occupy becomes largely meaningless, and likely was just a tactic of appeasement for Beijing.
Today as western markets are now digesting and unpacking Evergrande’s insolvency in the face of its now $305 billion debt pile, eyes should be turned to the larger issue: Assessing the contagion and debt exposure of China’s other property developers, the infamous 12. As far as Evergrande goes western markets should rest easy as its outstanding offshore debt pile is currently only estimated to be $20 billion. Among its biggest creditors are HSBC, Blackrock, UBS, RBC, and London-based Ashmore. The vast majority of China's property liabilities are internal, and that poses the questions of systemic tail risk on how a further contraction will affect China’s employment, growth, and furthermore, political stability. With real estate composing 30% of the economy, domestic spillage into other areas of the economy is inevitable. In the end, it boils down to one thing that has been a long time coming for a decade, crisis.