China’s Ponzi Problem

The pandemic-inspired lockdown in the large cities in China has triggered the collapse of its housing market. Sales volumes have declined sharply and prices have been falling for more than six months. The epilogue in the seventh edition of Manias, Panics, and Crashes: A History of Financial Crises, published in 2015, described a time-bomb that was expanding in the property markets in several hundred Chinese cities. While China was producing ten million new apartments each year, only six or seven million became occupied. The rest remained intentionally vacant, held as stores of value, because the buyers anticipated that their prices would increase by 8 or 10 percent a year in response to the continued migration of five or six million people annually from the farms and villages to the factories and the cities. As the epilogue pointed out, it was safely predictable that internal migration would decline sharply as a belated result of the one-child policy China adopted in the early 1980s.

China has had thirty-five years of brilliant economic growth since the early 1980s. Then, per capita income was less than $200; currently it is $18,000. China has been in the number one position on the world economic growth rate hit parade for the last several decades; real wage rates have increased as rapidly as per capita income. The Andy Warhol theory of economic growth is that every country grows rapidly for fifteen years—or maybe twenty or thirty—as its industrial sector expands and its agricultural sector shrinks. This is about to become relevant for China because the migration from the countryside to the factories has ended: Since there are so few people on the farms between six and sixty, China’s rate of economic growth will decline sharply.
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Spending on newly built apartments accounted for 10 percent of the country’s GDP alone, and construction has provided employment for more than sixty million workers. Meanwhile, the prices of newly built apartments have increased somewhat more rapidly than China’s GDP; prices in the four major cities—Shanghai, Beijing, Guangzhou, and Shenzhen—are now fifteen to twenty times higher than household incomes.

The jibe is “There are a thousand facts about China. Most are wrong. Unfortunately, we do not know which ones are wrong.” One fact is that the country’s population peaked in 2021. A second fact is that the urban population has peaked or will peak next year. A third fact is that there are now between forty and seventy million vacant apartments, including thirty million owned by property development firms, of which twenty million are in the construction pipelines.

China has more than ten thousand property development companies; some are private, some are public, and some are state owned. Much of the economic news from China in the last six months has centered on the cash flow problems of Evergrande, its second-largest property developer, which owned more than a million apartments in 798 different projects across 234 cities in mid-2021. Evergrande also has invested in electric vehicles, finance, and health care. It donated $12 million dollars to Harvard University to support three research centers. Established in 1996, the company’s indebtedness has increased by more than 15 percent a year to $300 billion, including $20 billion denominated in the U.S. dollar. Moreover, Evergrande owes several tens of billions to the households that made advance payments for the purchase of apartments; some of these funds were to be held in escrow accounts. In addition the firm owes tens of billions to the construction firms that build the apartments that it sells. It’s a safe bet that, until the summer of 2020, all of the money that Evergrande needed for the interest payments on its indebtedness it obtained by selling more of its IOUs.

Several other property developers, including the Kaisa Group, the Sinic Group, Country Gardens, and the Shimano Group, also have defaulted on their bond indebtedness. The popular explanation for their money problems is a shortage of liquidity. The Beijing government has established three “red lines,” and the property development firms have been instructed by the government to limit the increases in their indebtedness, which has in turn prevented them from selling more IOUs to get the cash that they need to refinance their maturing indebtedness.

Why has Evergrande fallen behind in its interest payments to creditors and reneged on its commitment to support the centers at Harvard that carry its name? Remember Hasbro’s Monopoly game, with its purchases and sales of properties in Atlantic City? Firms in financial distress first sell the most attractive assets, in large part because the less attractive assets can only be sold at large discounts from their face values. Evergrande has raised more than several tens of billions from the sale of its projects. The most plausible explanation for why it hasn’t sold more of its properties is that the highest prices that any of the other developers would pay for these projects are below the lowest prices that it would find acceptable. If these projects were sold at the prices offered by other developers, Evergrande would have to recognize an immediate loss.

Evergrande’s cash flow problems reflect both the banks’ and real estate investors’ conclusion that the firm is broke. In reality, Evergrande probably has been insolvent for eight or ten years—it’s the property market counterpart of Bernie Madoff, who is in the Guinness Book of World Records because he managed a Ponzi scheme that operated with negative net worth for nearly twenty years. Madoff could stay in business as long as more money was coming in than going out; he failed during the 2008 credit crunch when cash withdrawals spiked.

Similarly, Evergrande expanded its production of apartments at a rapid rate because it needed the cash from the down payments for the purchase of apartments on Tuesday for the payments to the construction firms for building the apartments that it had sold on Monday. Tuesday’s buyers were told that the cash would remain isolated in escrow accounts, but somehow the money leaked from these accounts. Evergrande was the winning bidder in many of the auctions for land that local governments were selling. If it had not acquired the land, it would not have been able to sell new apartments, or to receive the cash that it needed for the interest payments on its outstanding indebtedness.

Evergrande had the property market counterpart of small pox during most of 2021. As word got out that it had fallen behind in its payments to contractors, its sales receipts declined sharply because households became super cautious about buying its apartments. Skepticism about other property developers’ promises has surged. The prospect of insolvency has become self-fulfilling; as sales of new apartments slow, property developers have developed larger inventories of unsold apartments than they had anticipated.

The quip is that property developers in China—like those in most other countries—borrow as much money as they can. As apartment prices decline, hundreds of property developers (including many previously believed to be well managed) will have fire sales on unsold apartments in their scramble for cash. A price tumble of 15 to 20 percent will cause most of these firms to become bankrupt. The would-be buyers will move to the sidelines as prices fall.

The Xi Jinping government may provide a burst of liquidity to paper over the insolvency of the property developers, but it cannot paper over the demographics of a declining population and forty or sixty million vacant and overpriced apartments. The current market value of Chinese residential real estate is three to four times China’s GDP. (By comparison, the market value of U.S. residential real estate is slightly higher than U.S. GDP.) If property prices decline to levels commensurate with household incomes and rents, Chinese household wealth will decline by 60 or 70 percent—two to three times China’s GDP, or eight to ten times larger than the annual expenditures of the Beijing government. Some in Beijing may recognize that if they kick this can down the road for a year or two, all of the Humpty Dumpties will not be able to restore the belief among apartment owners that they will be bailed out by the greater fools who would pay higher prices for these apartments. The DNA of a real estate bubble is that prices do not plateau when they stop increasing; rather, they fall.

Fast forward to 2050. China’s population then will be smaller by sixty to eighty million; there will be a slightly larger decline in the labor force unless the retirement age is raised. These declines are already baked into the data, and will lead to a dramatic fall in the GDP growth rate. The service sector will be a modestly larger share of GDP as the industrial sector shrinks. The most optimistic view is that productivity in the service sector—education, health care, transportation—will be about 3 percent a year and the GDP growth rate will be about 2 percent a year.

The more near-term implication is that Chinese GDP growth will decline as new house spending starts to fall. The demand for construction labor will shrink. Each decline of one million units in housing equates with five or six million fewer workers being needed for construction; it also equates with a GDP growth rate decline of one and one-half percentage points. Moreover, because construction of apartments has absorbed 25 percent of private savings, spending on automobiles and other durables and tourism will fall. The government can increase spending on infrastructure, but it will have to create a financial vehicle to capture more of household saving than originally led to the purchase of apartments. The fiscal deficit of the Chinese government will surge, because the large banks will need to be recapitalized and the provincial governments will seek cash from Beijing to offset the decline in revenue from land sales.

The contagion effect will come into play. Property prices in Hong Kong will fall. The number of Chinese students at colleges and universities in the United States, Great Britain, Canada, and Australia will decline. Some U.S. colleges and some public schools in Great Britain will consequently close. China’s imports of copper and iron ore will plummet, and its purchases of petroleum will decline. China’s manufactures exports will increase sharply; the price of the yuan will tend to increase as import payments fall and export receipts increase; but the People’s Bank of China may become a large buyer of dollar securities to limit the decline in the competitiveness of Chinese-produced goods in foreign markets. The increase in China’s trade surplus will limit increases in the goods price levels of its trading partners by a modest amount.

China is becoming more mercantilist and seeks to reduce its dependence on foreign goods. Moreover, it appears to be experiencing another major convulsion, with a governmental squeeze on wealthy entrepreneurs. Smart Chinese will want to stash more of their money in the United States, Great Britain, and Singapore.

The challenges for China continue as far as the eye can see.

Robert Z. Aliber is professor of international economics and finance emeritus at the Booth School of Business, University of Chicago. He is co-author of the latest edition of Manias, Panics, and Crashes: A History of Financial Crises (2015).