Reaction to the 'Optimist's View' on China
This piece is a reaction to Bob Davis' excellent article in Foreign Policy, laying out an optimistic view of China's current crisis, while grounding the discussion firmly in the facts on the ground.
It is certainly important to explore both sides in a debate, as long as we agree to use real data, honestly, and explain our analysis. We are all touching different parts of the elephant and trying to discern reality.
In China, such open debate is not permitted. Instead, a forced optimism is required. Every statement that could be seen as criticism must be prefaced by positivity, or left unsaid. Too many major business leaders have been disappeared, with little in the way of authoritative explanations. In certain rarefied environments, like elite business meetings, participants may feel less obligated to force the positivity and less afraid for their own safety and (even) personal freedom, but any sense of immunity they once had has been greatly weakened over the last few years.
Blind optimism helps no one, and it is extremely hard to communicate what is happening in reality when one is forced to be positive.
The optimistic view put forth by Davis is that the government has now come to its senses, after a decade of unbridled ideology. The ability of these analysts to accept such a whiplash of policy and ideology is truly impressive. Davis correctly identifies expectations of how the government will act going forward as the critical factor between the pessimistic and optimistic views. I do not believe Chinese market participants will be able to adjust so rapidly to this apparent change.
In many ways Davis proves the pessimists' point. We do have a crisis at this point, implicitly. 'Correcting course' is needed, urgently. The optimists understand that the macroeconomic situation is quite, quite difficult. So there is, at this point, broad agreement.
It is hard to accept that the government has changed so abruptly and so fundamentally. The Xi Jinping leadership has defined itself as primarily ideological. Even if the problems can be seen correctly, the correct policies to adopt are not easy to formulate or to actualize. Yes, the government can correct course, that is certainly true, and it may well happen, eventually. But it is a monumental task.
My sense at this time is that we may not have reached the point where the leadership is forced by reality to compromise its views and approaches. I suspect that the government still wants to have its cake and eat it too. It was only in July of this year that the government unveiled the new security law threatening international consulting companies, after raiding several firms in March and April. The CCDI, itself a radical institution, is still busy with its next victim. If there has been a true change in course, it's not evident yet.
I don't consider myself an optimist or a pessimist, but rather a realist. I do think China can get through this and continue growing. I also think that the headline growth rate doesn't matter overmuch, and that a future China could grow quite happily at 2%, 3%, or even 5%. I do agree that there are opportunities here for the government, if it has the right mindset, to re-balance the economy. But it needs to use social levers that it disfavors, primarily rule of law. Indeed, the destruction of rule of law over the past decade is, in part, how this crisis developed.
The piece certainly soft-sells the housing crisis dramatically. The property developers are merely 'flirting with bankruptcy'. This is an accurate statement within China, (Evergrande has declared bankruptcy in the US), but only because the Chinese government doesn't generally allow bankruptcies to happen. Usually the government will wind up a bankrupted firm without any transparent legal restrictions.
In fact, multiple major developers have defaulted on their offshore debt; they are likely insolvent. There is an argument that these developers might have enough assets to cover their liabilities, but in any event it is unlikely that they would be permitted to do so. Evergrande has total offshore debt of $31 billion at risk. The other property developers owe some $90 billion in total, excluding those that have restructured. Domestically, the situation is just as bad; according to Evergrande's 2022 annual report, deposits have already been seized by banks, and some projects have been transferred to local governments.
Tom Orlik of Bloomberg Economics estimates that China still has about an 18% excess in housing to work through. My rough calculation is that this is equal to about 324 million square meters. The interesting thing about this overhang is that the government, or someone, is going to have to step in and finish some of these housing projects. The buyers, whether they are investors or households, are waiting for their apartment, or certainly some return of the payments they have made.
Additionally, there is a sense of political urgency to this: Leaving all these unfinished complexes, even if the buyers are somehow compensated, seems quite complicated. Of course some of these new concrete towers will remain, which is often a normal part of economic development, while others will be knocked down, which is generally not. But leaving everything in this present state seems untenable, even with a theoretic bailout of buyers. There is also an overhang of jilted buyers, as, again due to the lack of rule of law, this is a problem that has been growing for a decade now.
Evergrande reported it had 1,251 unfinished projects by the end of 2022, to give a sense of the size of the overhang. A portion of these could have a few thousand buyers each.
If we assume for the sake of argument that 50% of these projects will need to be completed, then the question is what will be the cost of completion? This would hopefully not be a bailout of the insolvent firm, but rather an assumption of some of their obligations. This is quite difficult because this is work that has to be completed, not just a payout of money or a canceling of loans. The alternative is to compensate the buyers, which might be worth exploring.
In China houses are generally sold without decoration. So these costs would be things like doors, windows, flooring for the public spaces, elevators and so on. I'm assuming a half-finished construction, any project in an earlier state of development should be sold, possibly back to the local government. If the buyers can receive their apartments in a usable state, they can begin the follow-on process of paying for flooring, appliances, furniture and so on, and the economic cycle can begin again.
This is precisely what the government is doing right now, with the focus on completing construction. But it will cost quite a lot of money, some projects will be undeliverable, and we still haven't talked about the offshore investors, or the illiquid land holdings that the developers certainly have in their portfolios.
Along with this is the issue of deflating the bubble that we all admit exists. Tom Orlik states that housing demand is unsustainably low, and yet the piece seems to elide the issue of concurrent price reductions. Housing is going to contract, prices are going to drop from their unsustainable levels. The government is trying to help people buy by reducing mortgage rates, but also (at local levels) still trying to maintain prices. Everyone in the market knows that a large number of people have bought apartments that are not being worked on, and may never be made habitable. Would you buy an unfinished apartment with that knowledge?
I note one interesting discrepancy in the article, regarding the household savings rate. I agree with the Peterson Institute's Nicholas Lardy that the rate is not necessarily indicative of consumer sentiment towards the government. The savings rate will be responsive to a number of factors. In any case, Andy Rothman in Shanghai says no one was getting a check during the lockdowns, while Lardy says that people had nothing to spend on, so they saved. This likely brings us back to our elephant, and the reality that some people were getting checks while others were not. The categories of workers that may have received checks include financial services, government officials in their private capacities, lawyers, SOE employees possibly, restaurant workers and delivery drivers, and so on. Some slice of workers were paid through some or all of the lockdowns.
If we assume that, in fact, the majority of workers were not paid during the lockdowns, then the increased savings rate becomes quite a bit more interesting. These 'checkless' people would have seen their savings decrease dramatically during those periods. This might lead them psychologically to want to raise their savings accounts back up. Or, we may be seeing an incomplete picture, with some savers increasing while others are stable or falling.
Finally, I would add that the government has shown that it is possible to correct course. We only need to look back one year, to the end of Zero Covid, for evidence of that. Another important policy change from last year was China's permission for PCAOB compliance, which previously was a major sticking point. There are some bright signals, but only some.
Still, the government so far seems to be trying to use its traditional, favored measures to manage this problem, and these measures are very likely unsuitable for the task.