The story of one real estate company illustrates the most troubling fundamental diseases of the Beijing administration.
Ghost Economy
There is one simple fact that even investors in China do not know about the world’s second largest economy: In China, GDP growth is not a measure of economic performance, but a goal. This week we look at how this fundamental problem has become a good excuse for heart attacks among investors in recent weeks.
In most countries around the world, governments set various goals for their economic activity:
- Employment rate in the economy
- Increasing consumption
- Reducing inequality
- Promoting high-tech industry, and more…
The Chinese government does the same, but unlike most governments in the world, it also sets growth targets in terms of gross domestic product (GDP).
The government determines how fast the economy should grow in a given year. This target is used to determine spending by:
- The central government in Beijing
- Governments in provinces across China
- Investment targets for state-owned enterprises
If the Chinese economy is growing at 6 percent annually, this is not a measure of economic health, but a measure of the government’s ability to meet its targets.
What difference does it make whether growth in China is an index or a target?
A slowdown in growth or even a decline in GDP may indicate malinvestment, inefficiencies in the economy, production difficulties, and more. When growth itself is a target, it decouples from the health of the economy and gradually makes the economy inefficient.
For example, when the growth rate is an explicit goal, companies borrow to build more factories and “generate growth,” even though the investment is unlikely to be recouped by building the factories. When this turns out to be the case, the company finds that it must burden itself with more debt and loans to pay off the previous debt.
As Chinese debt grows – much faster than economic growth – the Chinese economy is plagued by inefficiency and flooded with unsustainable businesses. The only thing keeping them afloat is the low borrowing rates that allow them to take out new loans to repay the principal debt and the interest on the previous loans. In addition, the risk is misjudged because people believe that the economy cannot experience a recession.
When the bubble swells
The real estate sector in China is a prime example of these problems. Following the 2008 global economic crisis, the Chinese government encouraged the construction of entire cities — infrastructure, transportation systems, residential buildings, and office towers — to maintain growth. At the same time, it urged banks to lend on favorable terms to companies and individuals. The money flowed into the real estate sector, encouraging more construction. Companies and individuals began buying homes not only in the hope of living in them, but as an investment property.
The result: Today, between one-fifth and one-quarter of China’s homes are empty. People have been investing in real estate for a whole decade because apartment prices have gone up and up. Apartment prices have climbed because people have invested in real estate, and this positive feedback loop has strengthened itself. China is currently “sitting” on a real estate bubble that surpassed the size of the US real estate bubble before the subprime crisis that toppled the world economy in 2008.
The Beijing government is aware of all this. Since 2011 it has been trying to cool the real estate market. In 2020, a new regulation was announced that requires over-leveraged companies – those whose debt exceeds the assets in their possession – to reduce the debt steadily. This move shocked the land on which many buildings are founded.
The immediate threat
Evergrande, a real estate giant that has taken out loans and issued huge bonds to finance its construction projects. When the administration reduced Evergrand’s ability to raise bonds, it appealed to consumers and sold apartments at full or almost full price. As with pyramid scams, Evergrande also used the money to repay loans or to fund other ventures.
This step was not enough. Evergrande began to be forced to sell assets – completed or unfinished construction projects – in order to obtain cash that would allow it to reduce its debt in accordance with government guidelines. Such assets are sold at a discount, because of their condition and because of the necessity to meet the debt reduction targets; And the result is a drop in prices, which could affect the entire Chinese real estate market.
The administration is not willing to rescue Evergrande directly. But it does intend to make sure that the crisis does not spread to the entire economy. Beijing has begun taking over Evergrande Group real estate projects that have not yet been completed. Now handing them over to government companies that will complete the construction themselves.
In the long run this is bad news. It is not clear that if these construction projects are economically justified. Beijing may find that it has simply rolled the hot potato over to government companies, which will have to absorb the losses. The inefficiency of the Chinese economy will continue. And the debt problem will not go away, but will continue to grow.
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