Evergrande Accelerates China’s Long March to Net-Zero Growth

The collapse and imminent bankruptcy of Chinese property company Evergrande is not and never was the country's Lehman's moment. This false depiction is a classic example of the financial markets' favourite trope and behavioural economic sin, referencing the straw man. The straw man provides displacement to distract from the real question: if Evergrande is not Lehman's, what is it? The answer is considerably longer than the thousand words afforded by this website, but in summary, I believe that the collapse adds momentum to China's inevitable long march towards net-zero growth. China's economic miracle will not end with a bang but with a whimper.

There are superficial comparisons between Lehman and Evergrande; both were over-indebted companies involved in over-inflated property markets, both were companies brought low by authorities application of moral hazard. The best depiction of moral hazard "Dans ce pay-ci, il est bon de teur de temps un admiral pour encourager les autres", or since most of us philistines don't read French "in this country, it is good to kill an admiral from time to time, to encourage the others".

The country referred to in Voltaire's quote is Britain, which executed Admiral John Byng on his quarterdeck for the heinous crime of failing to relieve the siege of Minorca. Lehman Brothers was a mercy killing by the US Treasury. It was supposed to follow the path of another investment bank Bear Sterns, which collapsed into the willing arms of JP Morgan. Lehmans was supposed to fold into Barclays, but in the weekend before the collapse, UK Treasury officials baulked at the deal, and the US Treasury found to its dismay that British bureaucrats do not answer the phone on a Sunday. The whole affair can be ascribed to the cock-up theory of history. After the collapse, it wasn't about property leverage but the inability of the market to value the collateral underpinning this lending; it was not until the US Treasury stepped in with an unprecedented bailout of the banking system that markets stabilised.

Evergrande is not a cock-up; it is state-sponsored corporate assassination. Evergrande had evaded the controls on corporate leverage that have been in place since 2015 because of the importance of the property sector to overall prosperity and, most importantly, the growth target. As a result, Evergrande's on-balance sheet debt has more doubled over the period to the equivalent of more than $300bn, which represents more than 2% of Chinese GDP, while estimates of the more opaque off-balance debt suggest as much a 3%. It was too big to live under the new policy of reducing inequality and better quality growth. 

President Xi is a great student of history and is determined not to repeat the mistakes of the past. His admirers claim that this knowledge will enable banking officials to unwind Evergrande with the minimum of fuss. These officials will not let the value of property collateral decline, which would turn this drama into a crisis. Moreover, they say that secondary demand for property remains strong despite the restrictions on new builds. This optimism is best described as Big Brother masquerading as the Wizard of Oz, pulling the levers of state to achieve strong and sustainable growth.

However, Evergrande and China's property bubble represent a case of a good idea taken to the extreme because of propaganda. China's four decades of continuous growth were driven by a model based on exports and investment, which necessitated constraints upon consumer demand to drive the high savings economy. However, this reliance upon foreign demand is threatened by US recessions. Fortunately, the consumer of last resort suffered short-lived and mild recessions in 1990 and 2000. The Chinese authorities stimulated domestic demand during these periods. As soon as US growth resumed, domestic demand was reigned in, and the export-led model continued. This fortuitous pattern ended with the Great Financial Crisis. The crisis of capitalism that authorities had long predicted led to the largest ever fiscal stimulus. As a percentage of GDP is was more than twice as large as the US stimulus, and since it was largely channelled through local governments, who derive 35% of their incomes through land sales, the property bubble grew alongside the public investment boom. The resulting doubled digit growth led to the tantalising prospect of doubling real GDP in a decade. Growth, therefore, had to average 7% per annum over the period. This target became growth for growth's sake, regardless of the economy's underlying productive potential. The property sector share of GDP rose 5% in the wake of the GFC and has remained high ever since. Indeed, Ken Rogoff and Yuachin Yang estimated that property represented 28.7% of GDP. Amongst the major industrialised economies, only Spain on the eve of GFC has come close to this level.

As Herbert Stein famously noted, "trends that can't continue, won't". Chinese Premier Xi has belated recognised this, having achieved the pyrrhic victory of doubling growth. Evergrande is a state-sponsored corporate assassination. The authorities set three controls to reign in the property sector. They specified that; a property developer's ratio of liabilities to assets must be below 70%, its ratio of net debt to equity below 100%, and cash to short-term debt at least 100%. Evergrande fell foul of all three restrictions, but in a veritable rogues gallery, only one of the top fifteen largest property developers is fully compliant with the rules. Failures were inevitable, and once investors rapidly concluded that none were too big to fail, attention turned to resolution, assuming that it would be similar to previous corporate sacrifices such as HNA. However, while the authorities have provided guidelines and liquidity, emphasising stability, they have been slow to react. Inaction is a reaction to prior clampdowns on property, which, while aggressive, didn't last long enough to change corporate behaviour. The longer the delay to resolution, the greater the risk of policy error.

There is many a slip betwixt cup and lip, and with 27% of all bank loans emanating from the property sector and housing wealth representing 78% of household wealth, Rogoff and Yuan estimate that a 20% decline in real estate activity could result in a 5-10% contraction in GDP. This represents the downside risk of contagion and policy failure; neither hope nor failure are optimal investment strategies. We have to look at the consequences of the satisficing muddle through policy. As the World Bank has sadly demonstrated, forecasting Chinese growth is highly political, which means that official and investment bank forecasts will inevitably be too high. Most are currently centred between 4-5% for 2022 and 2023.

The productive potential identity, measuring the sum of the working-age population (declining) and long-term productivity growth (slowing), suggests an underlying rate of less than half these Panglossian forecasts. 

We also have to factor in the legacy of the malinvestment over the past decade and the deflationary impact of more subdued growth and property inflation expectations. I think China will march towards zero growth over the next few years, and Evergrande is the catalyst. It will not be pretty for the rest of the world, which will lose its largest and previously most reliable contributor to global growth. The current inflation scare will last long enough to stretch the boundaries of transitory, prompting policy errors from Western central banks and risking further policy reversals from China, but China's long march to net-zero growth is a necessary element to my forecast of deflation by the middle of the decade.

Stuart Thomson is an independent economist and portfolio strategist. His writings reflect his personal views and are intended for the reader's entertainment and to elicit debate. They are not intended to constitute investment advice