China, Real-Estate & Evergrande. Operation Damage Limitation.

Situation

At the time of writing, whispers grow that Evergrande, the Chinese real-estate developer, will default on $82.5 million in interest payments. Al-Jazeera notes how the failure to make the payments on a public bond would “trigger cross-defaults on all the company’s about $19 billion of bonds on the international capital markets” earning Evergrande a place in the history books as China’s largest ever defaulter to date, obviously sending ripple effects across the economy. Understanding those ripple effects, and their channels and mechanisms is the purpose of the article, and unravelling why the Chinese real-estate market poses a stern challenge to local, national and monetary officials.

Threat to the wider Chinese economy

It comes not as a surprise that the Chinese economy is heavily intertwined with the Real Estate Market. The Role of the real estate sector is distortionary in many ways, but the counterargument is that given the increase in the steady income growth, and the otherwise limited investment opportunities and the huge demand of over a billion citizens, there is no Chinese equivalent to the Japanese property bubbles and concerns about oversupply, stemming from the early 1990s. At that time, the land surrounding the Imperial Palace in Tokyo was worth more than California. However, the balancing forces keeping the effect of a clear property rise of prices in China have become muted, which raises the sceptre of a potentially painful readjustment period.

Why would the readjustment period be painful? This is because real estate has become an extraordinarily powerful driver of the economy – contributing 5% of GDP in 1997 to over 13% in 2019 (Rogoff, Yang, 2021). More importantly, all Chinese citizens will likely be affected. Over 70% of annual real estate development is now for housing, and fuels 23% of household consumption (Ibid). Thus, it becomes apparent that the housing market is intertwined closely with the rest of the Chinese Economy. But in what ways? In terms of output, the numbers are historical – in 2016, the combined value of the Real Estate and the construction business amounted to 29% of GDP (Ibid), on par only with pre crisis Spain and Ireland.  Meanwhile, in terms of employment, the numbers are equally significant – over 20% of non-urban private sector workers are employed in the combined real-estate and construction industry. Large regional and national firms have significant influence over the tax revenues for local governments – land sales compose 40% of local revenues. Evergrande may be the biggest indebted real estate developer, but it is ultimately a piece in a larger puzzle.

Additionally, the real-estate market which has boomed over the past 20 years in particular, is also significantly distortionary. Given how the vast majority of loans for real-estate development is taken from state-banks, the portfolio of these banks is such that they are increasingly holding land holdings and real estate as the collateral, implying that they are preferring real-estate developers as creditworthy, crowding out others in due process. Additionally, rising property prices above the real value of the asset class is distortionary since it leads to an apparent arbitrage opportunity, ultimately causing the transfer of resources and other investments from other sources detached from the land business – including the technology sector. The threat to the wider Chinese economy also arises due to the social dimension, which is understandably harder to unravel. Nevertheless, it is clear that young men are increasingly encouraged to buy property as a social-status symbol, especially for marriage. Given the historic performance of real-estate, and the belief that the prices will continue to rise (hence causing a self-perpetuating increase in the prices as a result of remaining in the trade despite valuations being above the real value), this together means that Chinese private consumption will be affected in an outsized manner by declines in the housing market (Rogoff, Yang, 2021).

Source: Rogoff, Kenneth, and Yuanchen Yang. 2021. “Has China’s Housing Production Peaked?” China and the World Economy 21 (1): 1-31.

How is Chinese Monetary Policy set to cope with this?

On December 6th 2021, the People’s Bank of China (Henceforth PBC) announced the decision to inject liquidity into the financial system by cutting the required reserve ratio by 5 percentage points, effective December 15th, reducing the weighted required reserve ratio to 8.4%.

Onlookers have drawn the relationship between the implementation of a slightly more dovish approach and the perilous state of Evergrande. It is reported that given the already perilous state of the State banks, this provides room for manaeovuring which ensures that lending to state developers who will likely take over the Evergrande empire, will be able to access credit. This is significant – since Evergrande’s total debts sum to $343 million. For now, the strategy appears to slowly wind down the Grey Rhino of Evergrande, such that its major projects are taken over by the already-burdened State real-estate developers, all the while ensuring that Evergrande will remain a shell of what it used to be – the world’s largest property developer in the world.

Eswar Prasad states that the strategy of Chinese monetary policy is to “support growth but without a broad expansion of credit that could fuel a resurgence of financial market imbalances”. In that sense Messrs Prasad appears correct – the same press release from the PBC also noted that its measures will set the stage for a “favourable monetary and financial environment for the high-qualilty development”.

Mathematical Modelling and Predictions

Rogoff and Yang use the following input-output modelling, whose purpose is to estimate the impacts of positive or negative economic shocks and analyse the ripple effects across the economy.

As noted, there are direct and amplifying effects as a result of the fluctuations in the Chinese property market.

Direct:

  1. A Massive reduction in house prices is likely to put real-estate developers out of cash, and thus force them to default on payments and eventually go bankrupt.
  2. A surge in insolvencies will cause people to lose their jobs, or at least part of their income, which once again puts a downward pressure on housing demand (Ibid).
  3. The financial accelerator means that house price movement determines credit growth and financial stability.

Meanwhile the amplifying effects include on ancillary industries affected by a change in the house prices.

What they noted, alongside researchers at the Kansas City Fed, was that the magnitude of real-estate activity was 22% of total GDP. In addition, a 10% reduction in investment in real-estate would have a -2.9% amplified effect on GDP.

Conclusion

In summation, it is evident how big the real-estate market is to the Chinese economy, and how sensitive total output is to fluctuations in investment and house price. The strategy for Evergrande is to try and mitigate the fallout of the indebted developer, through tweaking the central bank reserve requirements for banks and additionally putting in place Party officials to try and inspire public trust. Evergrande appears to be gone – the Communist government could yet save the empire and its shareholders, but it appears keen to bring the housing market, and all its speculations and distortions, to heel.

This article was written by: Ishan Kalia, currently a student at the London School of Economics, pursuing BSc Economics.

Published by Ishan

Hi everyone. I am an incoming Economics undergraduate and enjoy writing on foreign policy, political economy, monetary policy etc. All views expressed are my own. Please get in touch at ishankalia03@gmail.com for any comments/ queries/ etc.

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