In short...
China’s remarkable economic growth has been powered by prodigious amounts of debt
Running above 330% of GDP for Government, Corporate and Household debt combined – according to Bloomberg (quoted by Rabobank) – and estimated at 280% of GDP by the Chinese Center for National Balance Sheets (CNBS) - the debt load might, in a benign view, compare (albeit at the higher end) with the US’s 265% and the Eurozone’s 250% of GDP
The run-up of debt levels immediately after the 2007-2008 financial crisis financed a deliberately aggressive infrastructure program of 4 trillion yuan ($555 billion), about 13% of China’s GDP in 2008
The factors behind mounting debt pools in recent years are more intricate
Powered by interconnected growth engines, the property market and local government investments, egged on by seemingly inexhaustible housing demand, the credit boom took on a life of its own, going unchallenged for years
By putting on the brakes to bring credit back under control, the Chinese central government uncovered inescapable truths about the financial market
- the growth rate of gross debt might fall back - or even reverse - under official diktat, but household (and company) savings, likely to increase in an insecure economic climate, still need to be allocated, preferably to productive ends..which are hard to find
- the concentration of debt which financed immense infrastructure programs weighed essentially on a single category of key actors, local governments - putting their credit worthiness at risk (or worse)
- by diversifying partially regulated sources of credit, from off-shore finance to residential presale, property developers financed breakneck growth with increasing leverage and unsustainable debt pools...and little oversight about true exposure
Gross National Product (GDP), in the expenditure approach, is by definition equal to the sum of all final goods and services purchased over a year by the consumers, by government entities, by business investment and by foreign markets (as net beneficiaries of exports)
The sum of goods and services bought over a single year equates that year's GDP
This puts the sky-high consumer savings rate at the heart of the financial domestic imbalance
At 46% of GDP, gross domestic savings (households, corporate and government) in China are more than double the global world average (20%)
With corporate savings broadly in line with the global average (at approx. 20%), household savings are the drivers of the savings rate differential, at approx. 23-25% of GDP which are more than three times higher than the global average (7-8%)
With below average domestic consumption, China's GDP rebalanced with above average investment (by government and business entities) and net exports
High Chinese consumer savings are here to stay
Enduring structural causes have made it seemingly impossible to entice households to part with their savings
Demographics of an aging society, the one-child policy (1980-2016) and resulting old age insecurity, income inequality and housing affordability all have played, and continue to play, their part
With net exports remaining fairly small at 3% of GDP and stable in the medium term, the slack in purchasing power caused by faltering consumption had to be unwound by the last man standing, the investor (by way of public infrastructure and private projects)
- Net Chinese exports at 3% are much smaller than usually thought - exports represent 20.5% of Chinese GDP but imports weigh 17.5% of GDP
The onus has been on investment to stoke GDP's growth for decades....
Local government rising to the challenge
In China, infrastructure investments are the remit of local governments (Central government investments are estimated at approx. 12% of total)
However, the bulk of liabilities related to infrastructure are held by entities created by local governments during the 2008 crisis to skirt a central government ban on direct state borrowing
More than 3 000 of these investments arms - called local government financial vehicles (LGFVs) - were contracted by regional governments for infrastructure works with often improbable, and certainly delayed, rates of return
On the hook for interest bearing loans, the LGFVs identified what was believed to be a surefire channel to generate income short-term, the sale of building rights on local government land for a limited time period (70 years on average) to real estate developers
At the end of 2022, liabilities accumulated by the LGFVs amounted to 80 trillion yuan (approx. $11 trillion), of which 54 trillion yuan ($7.5 trillion) were interest bearing, according to Reuters, and 60% of the LGFVs (carrying $4.4 trillion debt) may not be able to pay interest
A conveyor belt channeling more and more debt
Domestic savings, intermediated by the financial system, have fueled the investment boom in real estate - a welcome substitute to structurally weak consumption for as long as it lasted
Prodded by anticipated scarcity of land rights (certainly on the Eastern Seaboard), fired by explosive demand of households eager to park their savings in the assumed safety of real estate, the promoters created a 'virtuous' circle driven by shared interests of three parties
- the LGFVs as suppliers of land rights in response to insatiable demand
- the banks (directly or indirectly controlled by the Chinese State) providing credit access to the LGFVs for 62% of their interest-bearing debt of 54.2 trillion yuan - amounting to approx. $4.6 trillion - and to the property developers (representing only 6 to 7% of bank lending)
- Chinese households relying on bank mortgages for their investment (mortgages represent nearly half of real estate-related lending, mainly residential)
In a race to expand their markets, real estate promoters were quick in finding additional sources of credit over the years, especially since the 2017 clamp down on corporate debt
- pre-sale of housing yet to be built - financed by household on stringent mortgage terms (20 to 30% down payment for a first home, even more for a second home and high interest, padding the banks' bottom line)
- special vehicles of alternative financing - issued by the developers and bearing guaranteed interest rates, sold to Chinese non-bank entities
- off-shore US-dollar denominated bonds
So many borrowings in disguise managed to hide the true magnitude of the sector's indebtedness, and probably still do ...
Chugging along on the conveyor belt, debt levels bounced ever higher between the LGFVs, the banks and the households, equally demanding but driven by very different agendas
Outside - and beyond - direct oversight of monetary regulators, focused on the banking system and protective of the households, real estate became the primary driver of economic growth in China
Because house prices – in yuan per square meter – were on the march (doubling over the decade since 2010), the high savings of Chinese households were naturally directed to real estate investments...
As long as it lasted....
Who now is too-big-to-fail ?
The real estate sector, that is who
Although with a margin of uncertainty, the sector is thought to represent at least 23% of Chinese GDP, up to 26.3% according to economist Kenneth Rogoff's 2021 estimates
From the perspective of households, exposure to real estate goes even deeper
- A central bank (People's Bank of China) survey of urban households conducted in 2019 revealed that the value of housing composed 59% of households’ total assets, while mortgage loans stood at 12% of total assets (similar to the US on the eve of the subprime mortgage crisis in 2008 and to Japan before the bursting of the real estate bubble)
- Deposits and pre-sales have been the largest source of income for property developers for 90% of the projects - raising 6.6 trillion yuan (approx. $1 billion) in 2020 - 34.5% of primary sources - construction slow-down in June 2022 led homebuyers in at least 100 cities to threaten to halt mortgage payments...
Slamming into reverse....
A Reuters report - dated September 26, 2023 - is a roll call of a deeply troubled sector
China's second largest builder, Country Garden, has under development the equivalent of two times the area of Manhattan...
China's largest, Evergrande, goes down with liabilities of $340 billion (2% of total China's GDP)
As of August, an estimated 7.2 million homes (based on an average size of 90 square meters (approx. 970 sq.feet) remain unsold
Uncovering yawning political challenges, large numbers of pre-sold projects are not being completed by cash-strapped developers
Indicative of the magnitude of the shortfall, special purpose loans of 400 billion yuan ($55.2 billion), rolled out by the central authorities since 2022 with urgency, allowed delivery of a third of unfinished presold houses
...leaving on hold two-thirds of the households caught up in the crisis, with wide regional discrepancies
- In southern China, 56% were completed, 40% in the east, but just 15% in the southwest and 16% in central China...
When the music stops...
With falling house prices, China's families see their nest egg dwindle before their eyes
With falling land prices, the banking sector as major lender to LGFVs will not be refunded anytime soon - if ever
With massive overstock in housing (yet to be finished), the real estate sector has lost its premier role in driving the Chinese economy
“Finally, There’s More Money Than Fools in China” ...says Bloomberg,
As of August 2023, household deposits totaled a record 132 trillion yuan ($18 trillion), blowing past China’s entire gross domestic product last year and people keep on putting money into banks even as the People’s Bank of China cuts deposit rates
With real estate investments brought to a grinding halt, money not spend on consumer goods or not allocated to investments is effectively frozen out of circulation
Loss of confidence in the economy is not a temporary backlash, to be remedied by central government policy
Trapped in a vise, China's economy is experiencing a generational reversal, as potent on the way down as its decade-long performance had been on the way up