Yves here. We’ve pointed out from time to time with respect to China that no large economy has ever made the transition from being investment-led to consumption-led without suffering a financial crisis. Here, short-seller Jim Chanos, who has been too early with respect to China longer than Nouriel Roubini was with respect to the global financial crisis, argues that the Chinese real estate bubble has gotten so out of hand despite repeated efforts by the government to let air out of it that bad outcomes can’t be put off much longer. But while Chanos had earlier worried about financial outcomes, he’s now alarmed about political repercussions.
Note that despite the scale of the Chinese real estate mania, a 2008-style blowup is highly unlikely. Japan had a proportionately much larger bubble than the US did, even factoring in our financial system leverage due to derivatives, but their banks didn’t fall over (at least not until 1997, when the BoJ unwisely thought the crisis was over and started tightening) but instead underwent zombifacation, which resulted in a lost two-plus decades.
Recall that even right after the global financial crisis, Ambrose Evans-Pritchard was regularly pointing out that China was having to resort to higher and higher proportions of debt to generate and extra dollar of GDP. As of 2009, his sources pegged the ratio as 4-5 in borrowings to 1 of GDP increase. It can’t have gotten better since then.
To add to Chanos’ sobering overview, Bloomberg recently wrote about supply chain financing as another major source of leverage in China:
At over 1,100 listed companies in China’s industrial and manufacturing sectors, receivables are piling up; cash conversion cycles are getting longer (that is, the time it takes to turn inventory investments into cash); and net short-term debt levels are becoming increasingly volatile, a Bloomberg Opinion analysis shows….
Chinese suppliers wait a long time to get paid by their customers, which squeezes their working capital. Even in the pre-pandemic good times of 2019, it took almost 92 days on average, compared with 51 in the U.S. To bridge that funding gap, companies increasingly have turned to supply chain financing — instead of waiting to get paid, firms go to a third party that hands over cash sooner. A big benefit is that companies struggling to borrow can use their assets as collateral, which helps break the vicious cycle of weak creditworthiness.
That’s what eventually caught up with Evergrande. Inventory makes up a big portion of its working capital, and as that deteriorated, bills piled up…. In addition to the debt the company took out from mainstream financing channels, Evergrande leaned on vendors and other parts of its supply chain — apartment buyers and customers. It even roped in its employees, who were told to invest in the company’s wealth products…
Companies across China’s industrial landscape have turned to similar arrangements to alleviate their funding troubles. Supply chain financing has exploded over the past few years, ballooning to 17.4 trillion yuan ($2.69 trillion) by 2019, at a compounded annual growth rate of 10.6% since 2015. Banks, along with trust companies, insurance firms and other non-bank financial institutions, play an active role.
Now consider the impact of substantial backlogs at US ports and the impact of China’s energy crisis. On the latter, per the Financial Times:
Factory owners in China and their customers worldwide have been told to prepare for power supply disruptions becoming part of life as President Xi Jinping doggedly weans the world’s second-biggest economy off its dependence on coal.
Months of shortages have cut power to households in China’s north-east and caused outages at factories across the country. But energy demand is still surging amid record demand for Chinese exports, and the problems will be compounded by the prospect of freezing temperatures in winter…
Trueanalog Strictly OEM, a factory producing loudspeakers near Guangzhou, is emblematic of the crunch already hitting exporters from frequent outages. Owner Philip Richardson said his company was stuck “playing catch-up”.
“It’s the domino effect when you cut electricity: it directly affects the glues in the production line, we have to reset the jigging, it removes 20 to 30 per cent of productivity from the day . . . It’s really a hassle,” he said.
Will Jones, chief operating officer for the British Home Enhancement Trade Association, said a third of members in the DIY and gardening sector reported that suppliers had extended their lead times.
PlutoniumKun provided this tidbit about Chinese real estate in comments:
Chinese construction quality is pretty horrifying by any standard (with the exception of a few very high income areas). The reasons for this are quite straightforward – financial suppression means that the only real way Chinese people can save is by investing in property, which is seen as much safer than the stock market or the shadow banking area. So houses become a little like bitcoin – their notional value is very different from the objective value of having a home. In China, people quote prices per square metre. I remember my surprise when Chinese friends would ask me ‘how much is an apartment in Ireland?’ They wanted the answer in per metre terms – of course I had no idea.
So apartments in particular (because it’s hard to buy land or many forms of commercial property) become commodified. Nearly all are bought off the plans a few years before they are built. Buyers aren’t particularly interested in the quality as they assume the government will maintain high prices (probably correctly) and they are rarely interested in rental income, as tenants can be too annoying. So there is zero incentive for developers to do anything but a bare minimum construction standard. Add to this the widespread fakery of products, and you have a massive malinvestment issue.
By Lynn Parramore, senior research analyst at the Institute for New Economic Thinking. Originally published at the Institute for New Economic Thinking website
Renowned short-seller Jim Chanos, founder of Kynikos Associates, is what you might call the “ever-bear” of China. For more than a decade, he has warned that the country was building a real estate-driven economy on a feeble house of cards. He spoke to the Institute for New Economic Thinking’s Lynn Parramore about how he views the chickens coming home to roost as the property giant Evergrande – now the world’s most indebted property developer — teeters on the verge of collapse.
Lynn Parramore: Back in ’09, when you started looking at China, your real estate analysts alerted you to the mind-boggling amount of real estate overdevelopment there. You warned that this overdevelopment would end badly. After Xi Jinping became president in 2013, you expressed the then-minority view that a different kind of leader had arrived on the scene. What’s your take on what has happened since then?
Jim Chanos: In 2013, we put a slide in our presentation for investors and talks that was very controversial – especially for Chinese nationals. It showed President Xi Jinping in emperor’s garb. People thought we should take it out, that it was offensive. At the time, Xi was widely seen as just the latest in a series of technocrats who had risen through the ranks — one who would follow along with Deng Xiaoping’s reforms. It’s “capitalism with Chinese characteristics.” It’s okay to get rich as long as the country prospers.
But a few things made us think, no, this guy is different. His first speech in China after becoming president was critical of the Soviet Union for being soft on perestroika. They should have crushed it when they had the chance, he said. Xi then set up an institute to study the Soviet Union’s collapse. That was a red flag to us that he was going to be more hardline than people thought. He went on to do an anti-corruption drive, which people dismissed as a typical settling of scores that Chinese leaders do. But it actually extended beyond that. A couple of years later, he began talking in Puritanical terms about social issues. Again, that was different. Nobody had cared about that stuff for 20 years. Do what you want as long as you don’t question the party. Next, we had the book collecting his speeches and writings, which people could be seen carrying around. He started showing up in military events dressed in Mao jackets. This symbolism isn’t lost in China.
We noticed all this, but the real switch occurred in 2019 when he started going after celebrities like Jack Ma [co-founder of Alibaba]. At that point, it was clear that this president was not stepping down at the end of 10 years. He was taking a much harder line on the “flowers of capitalism,” if you will, than past presidents. In 2021, all of this exploded into the open. There’s been initiative after initiative. Redistributing wealth to the masses. Going after other leaders. Overlaid on top of this is the Evergrande saga.
LP: Let’s talk about Evergrande, the Shenzhen developer whose crisis has got everybody worried. How did things get so bad?
JC: Last year, as the tech crackdown was gaining momentum, Xi’s administration put down a set of rules called the “three red lines.” They were sort of balance sheet financial tests. It was an attempt to deleverage the real estate developers.
LP: Which means he knew something was wrong.
JC: Well, here’s the problem. I always joke that when you have an investment-driven economic model, you know your annual GDP on January 1st of that year, because you can stick shovels in the ground to make your growth numbers. That’s how the model works. It’s not a consumption-based model. As we now know — and the Wall Street Journal just had some phenomenal numbers in a recent piece – that real estate construction is now larger than it was when he took office. I would always hear, well, don’t worry: these are smart guys, technocrats who see the problem and will wean themselves off this apartment construction-on-steroids. But they haven’t.
LP: Why haven’t they been able to slow it down?
JC: Since we started following China at the end of ’09, this is the fourth time that they’ve attempted to slow the real estate market down, because they do know that this is going to be basically too big to deal with if it keeps growing at the rate it’s growing. But every time they’ve done it, the economy has hit stall speed very quickly, and they panicked. They went from hitting the breaks to hitting the accelerator. That’s why we’ve seen higher levels of real estate. The idea that “I can’t lose buying apartments” became ingrained with bankers, real estate speculators, and the public.
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: How much has corruption played a role in this mess?
JC: That’s a problem with their economic model focusing so much on real estate. Because they don’t have a local tax system, like property taxes, the local governments sell land to pay for local services. But whenever you have private developers buying land from municipalities controlled by one party, yeah, it’s ripe for corruption. We know that’s rampant in China.
LP: How do you view the policy reaction to Evergrande?
JC: So, what do the policymakers do? It’s not a Lehman moment in that there’s not a lot of cross-border interbank lending here. The Chinese system is still pretty much a closed financial system. That’s not the risk. During the Global Financial Crisis [GFC], what brought us to our knees was the liability side of the banks’ books. They couldn’t roll over the loans to each other because no one trusted the assets. Here, it’s the assets. I think that if they try to inflate it again, if they try to bail it out again, we’re only going to be right back in this soup in another two or three years, with even bigger problems.
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.
I think the Chinese government has convinced themselves that by borrowing lots of money from their own citizens and elsewhere, that there’s ongoing activity that is sustainable. But as we find out in every real estate bubble that bursts, when your activity is constructing real estate itself and you’re taking capital and turning it into income by paying construction workers and real estate brokers and everybody else, when that activity ends, it goes poof! And there’s no income from the asset you’ve just financed. It’s not like building a factory where you have demand for your products. It’s just apartments sitting empty in Beijing or Shenzhen.
LP: How does this problem relate to Chinese politics?
JC: As all of this is happening on the financial and economic front, along with the crackdown on business elites, we’ve seen a commensurate rise in bellicosity, in saber-rattling toward Taiwan, India, and Tibet. We’ve seen a much more aggressive posture from Xi in relating to the West. Now every day there’s a warning in one of the Chinese Communist Party organs threatening Australia if they come to Taiwan, threatening Japan. I don’t know if the Party is preparing the citizenry for a “them.” Someone to blame.
LP: As we’ve seen with the pandemic already.
JC: Yes, and in the way they’ve treated the West’s outrage about the concentration camps in Xinjiang province. That’s the classic authoritarian move. We know it from our own country. Blame someone. “It’s their fault, not our fault.” We need an enemy. I don’t know how real the saber-rattling is. Is it a distraction from domestic belt-tightening that’s coming? Planting the idea that we’re going through hard times because the whole world is against us? We’ll see. It’s an incredibly interesting time to be watching China.
LP: What does it all mean to the rest of the world?
JC: Again, I think it’s not a financial transmission issue reverberating through the financial systems and markets. I do think that it will affect global growth. China was a full point of the 3% global real growth we’ve had since the GFC. Without China, it’s 2%. So China itself, by growing 7 or 8% a year was a disproportionate amount of global growth. It’s also going to impact what I call Greater China, which is Taiwan, South Korea, Singapore – the areas that trade very actively with China. And it will definitely impact commodity exporters. In this massive build-out, China has continued to suck in iron ore and copper and all kinds of things from a variety of different countries like Brazil and Australia. But I think that the impact might be more political than financial. That’s what worries me.
LP: How would you characterize these worries?
JC: It’s the rise of bellicosity, the rise of a more militant China as the economy and the financial situation has gotten more precarious. That’s a 1930s kind of problem. We know that a rise in authoritarianism and statism around the world was one of the upshots of ’29-’32. You had leaders saying, “I’m the one that can get us out of this problem” and “They are the ones who got us here.” This situation in China is a little bit frightening to the student of history, because there’s no doubt, whether you’re flying over Taiwan airspace or coming close to ships in the South China Sea, that there’s a rise of tensions in and around China. I don’t think it’s a coincidence.
LP: To touch on Xi’s crackdown on the tech industry, how do you view that in the context of the need to lessen this dependency on the real estate sector? Certainly, we can see in our own case with Silicon Valley — Facebook and so on — that poorly regulated tech is a problem. But what does Xi’s stance mean in the context of his desire for China to be a leader in innovation, on the cutting edge of technology?
JC: That was always one of the responses to our concerns about the investment-driven model. People said, well, everyone does everything on their smartphone in China. They’re far more advanced in social media than we are and more advanced in payment systems, and so on.
The problem was that, number one, it gave rise to these global tech celebrities, and number two, I think China, or the Party, realized a little bit later than they might have that the control of databases and information that these companies have is certainly a power center. And the one thing that the Communist Party cannot brook is a threat to its control. There are no other political parties, no free press. The only thing that could challenge control is the thing that people said would liberalize China – the internet. Access to the internet, access to ideas, access to global media. People thought these things would democratize China, but Xi is saying no: we’re going to put up a Great Firewall and we’re not going to allow Alibaba to have as much power as the Party.
LP: And it looks like he’s going after the banks next.
JC: The real estate system is so big, and so levered – the banking system has grown with it, of course. It seems to me that Xi is basically going through all the power centers — technology, finance, etc., and cracking down. He’s making sure his people are completely in charge and that there’s no interference, no other power centers. And it makes me ask why. What’s the end game? I mean, the Party has control of the country for the most part. The citizens understand that. So why? What is coming that he feels he needs to make sure that all of his people are in control? I can’t help but think of Stalin. The end game puzzles me the most. Is it to prepare for a takeover of Taiwan? To be more forceful on the international stage? I don’t know.
LP: What is distinct about China’s vision of capitalism in the context of a one-party system? What are its particular features and challenges?
JC: What distinguishes China and what makes it so unique from my perspective, putting on the financial historian’s hat, is that the speed at which they developed was unprecedented, and the amount of risk they have taken to do that is unprecedented. Their banking system is now the largest in the world. The amount of real estate construction is just completely insane, and until, perhaps, this past 12 months, we haven’t seen a real, serious effort to say, “Maybe we should rethink this fantasy where everybody is going to have six apartments. Maybe we need to do other things in our economy to balance it out.”
How are they going to deal with the transition? Because they’re going to have to do it at some point. I think it’s going to be fascinating to see how they try to get out of it. Do they switch spending to defense spending? Do we get an arms race? Can they keep a closed currency? There are a whole lot of big questions.
They’ve got to make some tough decisions on how the economic model is going to work going forward. In the late ‘80s, everybody thought Japan was going to surpass the U.S., but they had the same problems – a banking system that was bloated, real estate prices too high, too dependent on exports, and they’ve had 30 years of muddling through. The idea that China is going to be growing 6 or 7% while the rest of the world is growing 2% just has to be revisited. It’s not gonna happen. That realization is going to be the bucket of cold water that’s going to force them to rethink next steps. The population has been used to this leveraged prosperity, and everybody has borrowed money to buy real estate. What are the next steps? It’s otherworldly what they have done with real estate. Whatever happens, it’s going to be severe somehow. Whether it’s politically or financially — whatever it is, it’ll be severe.