China has been growing for decades well above the global average and, of course, the advanced countries. The model for this strong development was first based on a foreign sector that came to generate current account surpluses of 10% of GDP (the largest surplus in the world). With the 2008 financial crisis, this model petered out. Beijing abruptly redirected its policy towards domestic demand (especially investment), a model fueled by massive indebtedness by the private sector (companies and families), generating a debt bubble that seems infinite, but like all of them is unsustainable in the long-term. The paradigm of this ‘exhausted’ model is Evergrande. Now, the Chinese authorities want to deflate that bubble avoiding a catastrophe (a very complex balancing game).
The 2008 financial crisis forced China to look for a new way to maintain remarkable growth, albeit declining. The solution was to stimulate domestic demand through credit to companies and households. Since then, the country’s private debt (especially companies and some families) has skyrocketed to close to 300% of GDP (a large part invested in brick), compared to 117% in 2008.
But the risks of basing growth on mountains of debt are many (bubbles, inefficiency in resource allocation, risk of changes in market perception…). Now, Beijing wants a different, sustainable system, based on internal consumption, more egalitarian, and in which the State regains control of the economy. This is the road to ‘Common Prosperity’, a road where Evergrande is perhaps one of the first major bumps, but the goal is to go much further.
The change that has begun can be seen in the battery of measures and announcements by the authorities that have already had a strong impact on the markets: repression of technology companies, greater credit control, multimillion-dollar donations of great fortunes (largely due to the petition of the government), reduction of emissions and pollution (generating an energy crisis), the non-rescue or refinancing of ‘zombie’ companies… China is leaving behind the policy of continuing to ‘prime’ the bubble to get a few more points of GDP each year, to face the problem head on.
The difficult thing in these cases is to achieve a balance. Reaching the desired point without generating an economic and financial earthquake in between. In the short term, as is being seen, it will be painful. The fall of indebted companies can affect GDP, employment and social welfare. Nomura and other institutions are lowering GDP forecasts for the ‘Asian giant’ once the change in strategy has been seen. Evergrande’s fall may be a reflection of this turning point: pain in the short term, to achieve a more sustainable, inclusive and solid economy in the long term.
For the past year, the Chinese Communist Party has been making an effort to crack down on ‘real or perceived excess capitalism’. It’s all part of President Xi Jinping’s ‘Red New Deal’ agenda, which is within the , which aims to address extreme inequality, reduce high indebtedness and uncompetitive practices and, apparently, rein in some of the tycoons and other influential people,” Erik F. Nielsen, Unicredit’s chief research economist, explains in a note.
The sectors in the crosshairs of Beijing
The new crackdown means tighter regulation across a wide range of sectors, including fintech, social media, e-commerce, entertainment, private education, gaming, cryptocurrency, and real estate. “To assume that all this can be done without consequences for economic growth seems too heroic for my liking… It appears that these strong measures may be a response to growing public discontent over the high cost of living for large proportions of the population, along with with extreme inequality,” says the Unicredit expert.
Alicia García-Herrero, Chief Economist for Asia Pacific at Natixis, explained in statements to elEconomista that the ‘Common Prosperity’ plan “will require a significant transfer of resources from the wealthiest to those who are not, but also a centralization of power in the State. To try to guarantee social peace, especially after the strong impact of covid on the less affluent classes and, with this, to be able to stay in power”.
“In any case, the uncertainty about how this will end and what the government’s ultimate goals are is understandably baffling for markets. After all, we know they are dangerous because they inevitably lead to recession and a relatively slow recovery,” he writes. Nielsen in the note.
It is clear that China wants to change its growth model, but Nielsen questions why it is taking all the steps at once and showing its toughest hand with so many sectors, including real estate, which has been one of the engines of the economy. China in recent years. This expert reveals that there are calculations that show that real estate accounts for up to 29% of Chinese GDP, “a much higher exposure than that of Spain or Ireland before the bubble burst in 2008.”
Red lines for companies
The Evergrande case is the most visible because it is happening now and, above all, because of the size of the firm. It is the perfect company to send a warning to the rest. China has imposed very clear red lines to differentiate between companies that can survive and receive aid. In August 2020, Chinese regulators introduced ‘three red lines’ that companies in the sector must adhere to: (1) a debt-to-asset ratio (excluding pre-sales) of less than 70%, (2) a financial leverage ratio (gearing ratio) of less than 100%, and (3) a liquidity to short-term debt ratio of more than 1 (so that the company can face the closest debt maturities with treasury).
If a company does not meet these red lines, then it will face significant constraints in terms of how much it can increase its debt to continue to ‘survive’. Although these rules will fully enter into force in 2023, the authorities are beginning to apply them progressively. Evergrande is suffering in a certain way from these restrictions: nobody has dared to lend liquidity to the real estate giant so that it does not default. , and perhaps Beijing is taking advantage of it to send a warning to the rest of the economy.
The information that has leaked from the Chinese government speaks of an orderly fall of Evergrande, which would show that the change in the economic model is here. “Beijing seems ready to fire this ‘warning shot’ at other leveraged players in real estate, but we suspect that the authorities are also interested in avoiding systemic contagion, especially as the economy as a whole is weakening,” warns Gille. Möec, chief economist at Axa Investment Managers, in a note on the fall of Evergrande.
housing and inequality
Möec synthesizes the work of his colleagues Aidan Yao and Shirley Shen, from Axa Investment, who point out in a recent article the points where China wants to act with this type of measure: 1 eliminate the risks of the economy (high indebtedness, for example); 2 ensure fairer competition; 3 better control data and 4 promote social equality and address China’s demographic challenges. The common denominator of all these points resides in the Common Prosperity plan, “the search for a more inclusive economic model that supports social stability, which may imply some sacrifice in China’s intensive growth,” these experts explain.
Möec gives the concrete example of China’s real estate boom: “Of course it has boosted growth, but high house prices are contributing to inequality and social tension. Curbing the rampant growth of this sector combines objectives of political stability and financial”. Something similar is happening with the big tech companies, which have become very rich sources of data and have generated new billionaires. Beijing wants to regain control of that data and distribute, in part, that wealth.
A road full of risks
It all sounds great. However, as has been recalled throughout the text, the risks are many. The greater control and repression of the sectors that have been the motor of growth can significantly weigh down GDP and employment in the short term. In addition, there is a risk that these measures will have a more lasting and damaging impact on activity, because as JP Morgan points out, 60% of the wealth of Chinese households is in housing. If the real estate market suffers, so will the price of housing, which will have an impact, not only on developers and real estate, but also on the wealth and consumption of Chinese households.
This is how the wealth of Chinese households is distributed
Finally, it seems clear that these measures aimed at achieving a more egalitarian and ‘fair’ country will also have an impact on China’s competitiveness in the world. This is one of the great dilemmas between politicians and economists, perhaps also in society. Choosing between a high-growth, competitive, but more unequal economy or a more egalitarian, but less competitive, and lower-growth economy. Alicia García-Herrero believes that China is now going to bet on the latter: “Common Prosperity will make China less competitive and, perhaps, even more fair. Both things are good news for the world.”
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