Last week, a Hong Kong court ruled that the largest indebted property developer in the world, Evergrande, would be liquidated, two years after the company defaulted on its debt in late 2021.
Much of the media reporting on the decision focused on whether foreign creditors would ever recoup their losses from Evergrande, as the Chinese government has already said it will prioritize completing the group’s existing projects, though how this will happen is less clear. But beyond the question of who will get repaid, Evergrande’s liquidation opens up a slew of larger and more profound questions about the future of the Chinese economy, especially the relationships between the central government, local governments, the private sector and households. The liquidation of Evergrande is not an accident. It is part of a larger crackdown on the private sector and government collusion that President Xi Jinping launched at the very start of his term, beginning in 2013 with the Anti-Corruption Campaign, which has become one of the most consequential and longest-running campaigns in the history of the People’s Republic of China. Taken as a whole, this crackdown has fundamentally changed the relationship between the Communist Party and the business community, creating deep distrust and fear, while leading to capital flight and a deep downturn in confidence. The Anti-Corruption Campaign was followed by other policies that put the private sector on notice that old patterns of behavior would no longer be tolerated. Xi’s “new normal” would include more discipline and oversight. Xi’s confidence in the ability of his government to implement this crackdown expanded enormously in late 2020 and early 2021, coinciding with the regime’s successful management of the COVID-19 pandemic before the arrival of the incredibly infectious omicron variant. Xi made numerous speeches and statements at the time about the importance of “common prosperity” and the need to crack down on “disorderly capital,” while also emphasizing his dislike of real estate development as investment, epitomized by his oft-quoted mantra that “houses are for living in.” The “three red lines” policy, which reined in debt-fueled property development and directly targeted firms like Evergrande that were enormously leveraged, dates back to this period. In addition to launching the attack on the over-leveraged property sector, Chinese authorities canceled the IPO of Ant Financial, forced the rewinding of Didi’s listing on the N.Y. Stock Exchange, banned private tutoring and nationalized gray rhinos, as large firms that create systemic risk, such as Anbang Insurance and HNA, are known. At the same time, in his speeches on “common prosperity,” Xi vaguely alluded to new forms of taxation and redistribution so that China would eventually become an “olive-shaped society” with a large middle class and relatively few rich and poor. But crackdowns alone cannot substitute for the deep structural reform that the Chinese economy desperately needs. Any viable solution to the property crisis and to local government’s fiscal health requires that China’s central government take on more responsibility and more accountability. Xi must shift from being a disciplinarian to accepting that these problems are not only rooted in the bad behavior of corrupt officials, greedy capitalists or overextended households. All of these actors were responding to incentives set up by China’s development model, which grew increasingly dependent on real estate and land development for growth. So while Xi talks frequently about high-quality development as the “hard truth” of his administration, this is unlikely to be achieved without a fundamental shift in responsibility upward toward the central government. In other words, it’s not just local governments and private entrepreneurs who must change their behavior—the central government must as well. Given the scale of the current crisis—over 1.5 million home purchasers are still waiting for residences that they have already paid Evergrande for—it’s possible that local governments will still be held responsible for finding other viable real estate developers to take over the unfinished projects in their regions. But local governments are themselves deeply in debt for both related and unrelated reasons. Local governments were caught up in the same frenzy of real estate development and land sales for years. But they are also reeling from debt related to COVID-19 management and testing, as well as from the basic structure of their fiscal relations with the central government, which leaves them with many mandates to fund social security and public goods like education, but without enough resources to do so. This fiscal imbalance is one of the primary reasons that local governments became so reliant on land speculation and real estate development in the first place, because in a period of ever-rising property prices, it provided much-needed revenue. It was also, not coincidentally, an excellent mechanism for local officials to collude with real estate developers to become personally wealthy. As a result, local governments are implicated in the accumulated problems of overinvestment and corruption. But any long-term solution will require changes to the tax system, so that they have sufficient tax revenue to pay for the disproportionate amount of governance they are tasked with. This will by necessity include more directly taxing both the wealthy and property, and directing more tax revenue to localities instead of the central government. Requiring local governments to find “viable developers” to take over Evergrande’s unfinished homes also ignores how Evergrande’s problems are only the tip of the iceberg of real estate development debt. It is not even clear which developers are viable enough to take on the burden of finishing the homes Evergrande has already been paid for, while also attempting to make money on new development, given China’s significant overbuilding and declining property values. A new International Monetary Fund report on the Chinese economy estimates that China’s fundamental demand for housing will decrease by 50 percent over the next decade, even as media reports indicate a current oversupply in excess of 50 million homes. The real estate sector cannot deal with these problems alone, but most local governments are in no position to help. An effective solution will require that the central government allow for substantial restructuring of existing firms and perhaps direct bailouts to households currently left holding the bag. The IMF estimates that such measures will cost about 5 percent of GDP but will be offset by avoiding longer-term losses. For households, the real estate sector’s unraveling is hitting their pocketbooks directly. Because of China’s presale model of development, households have already paid for the promised properties, so they cannot be expected to pay more, especially when the value of these future properties are going down. Meanwhile, investments in existing property are the most important source of wealth for China’s urbanites, representing about 70 percent of household wealth. So the contraction in the real estate sector, while necessary, will make many Chinese poorer. Employment opportunities have also worsened, as the real estate decline affects not just construction, but everything else tied to property, from landscaping to interior design. All of these impacts will exacerbate the problem of consumer confidence, inducing households to save rather than spend, an incentive structure that is already reinforced by China’s weak social safety net. This in turn means that China will be forced to look to external markets to absorb excess capacity in everything from building materials to electric vehicles, further exacerbating imbalances that are complicating China’s relations with trade partners. Once again, any effective policy to address the problem of consumer confidence will similarly require more support from the central government and improvements to China’s underfunded and shallow welfare state. The risk of social unrest is still low due to strong state capacity to repress street protests. But Chinese households have already shown ingenious ways to express their displeasure through inaction, such as not paying mortgages and not seeking employment—the practice known as lying flat. Beijing has accomplished much with Xi’s dramatic crackdowns as he seeks to shift China’s development in a new and more sustainable direction. But the crackdowns are only the first step. They need to be followed by increased support for local governments from the central government. So far, Xi has deftly yielded sticks. Much will depend on whether he can now do the same with carrots.
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