Evergrande illusions

12 October 2021

12:43 PM

12 October 2021

12:43 PM

At the height of the 2008 financial crisis I was invited to an off-the-record media lunch with a famous investor. I was taken aback when one of the world’s most successful capitalists announced that the crisis showed the Chinese had a superior economic model.

China has tried something different from traditional capitalism, with its reliance on the ‘hidden hand’ of the free market. Since the first economic reforms in 1978, the heavy hand of the state has grown and modernized the economy with staggering results. If you believe the data, eight hundred million Chinese people no longer live in poverty and China has averaged 10 percent growth a year since reforms began.

China’s success seems to challenge two central premises of our market economics: you can’t have growth without risk, and growth is worth the risk. Economists consider these premises to be as true as the law of gravity. A market economy experiences recession when there’s a sudden shock, or people take on too much risk by lending or borrowing too much or making bad investments. Unemployment, wealth destruction, and then political accountability follow. But the risk of a recession is the cost of a growing and dynamic economy: no risk, no innovation and no sustainable wealth creation.

Sometimes the growth/risk calculus goes wrong, as it did in the crisis of 2007-08. China’s new model of command-economy capitalism appears to ensure steady and high growth with none of the pain. The government hand directs where capital and people flow, and it absorbs the losses too. This is why the failure of the Evergrande Real Estate Group, the second-largest property developer in China, is probably not China’s ‘Lehman moment’, when a bubble of bad debt becomes a market contagion.

Evergrande probably won’t cause a massive recession. It probably won’t cause the over-leveraged Chinese real-estate sector to implode and take household savings down with it. The Chinese government won’t let that happen, and they have tens of trillions of dollars worth of gross domestic savings to throw at the problem.

Evergrande is also why that famous investor was wrong about Chinese superiority. The Evergrande failure shows what happens when capital flows are directed by bureaucrats instead of markets and few pay the price of bad investment. Real estate activities account for 28.7 percent of China’s GDP (compared to 18.5 percent in the US in 2005), and China has enough empty housing stock for 90 million people. Markets don’t always get it right, but when you take risk out of the equation, investors make even worse decisions. As investors assumed that China won’t let developers fail, highly leveraged capital continued to flow to the sector, including from foreign investors and Chinese households with lots of savings and not many places to invest it.

Real estate has caused trouble before. The years from 2010 to 2014 were also a period of highly leveraged overbuilding. The Chinese government headed off a crisis by paying people to relocate into the overbuilt housing and demolishing their older, sometimes poorly built homes. There was no financial disaster in 2014, but this massive intervention worsened the underlying problem: it raised real estate prices and created more moral hazard in the market.

This perpetual near-crisis is a policy choice. The CCP recognizes trouble in the real-estate sector, but is still not comfortable with a free market for capital. Instead it is enforcing discipline through regulation. It recently established the ‘three red lines’, leverage ratios limiting how much debt a property developer can take on. The new regulations hit Evergrande particularly hard, and now it is defaulting on its debt payments.

South Korea and Japan have tried managing risk through industrial policy and capital controls, but not nearly to the same extent as China. It worked for a while for them too, when they were poor countries becoming rich. They also had populations primed to become more productive if you gave them machines and education. But eventually you run out of people, and the only way to keep growing is through innovation.

Industrial policy doesn’t have a great track record with innovation. The best ideas often come from unexpected places: think of the commercial steam engine or penicillin. Markets aren’t perfect, but they tend to be better than governments at spotting innovators and giving them the capital to grow and bring their ideas to market. Eventually South Korea and Japan had to become traditional market economies in order to keep growing.

Beyond the fading possibility that it will allow Evergrande to fail, there is no sign China will embrace markets. The state will probably bail out some investors, most likely Chinese households. The CCP wants to hold on to both the benefits of market discipline and the power to direct capital to politically-favored industries — it has recently interfered with capital markets to hobble the gaming and tutoring industries. Who knows what growth-enhancing innovations this will cost China, and the world?

China’s economic success promised the holy grail of economics: growth free from risk. But sustainable growth requires a market where capital is free to go where it needs to, and where investors and savers are rewarded for good choices and pay the price when things go wrong. The Chinese government is not letting this happen, even if it does let Evergrande fail. That means innovation cannot thrive; that, in itself, will eventually stifle growth. There will be more Evergrandes in China’s future, and the state won’t always be able to bail out its economy, because it can’t sustain this level of growth without meaningful risk. Throw in a shrinking population, and the CCP might not have the means to deal with the next Evergrande.

China may muddle through this time: it is still growing fast, so it still has some margin of error. But its population is shrinking and a distorted capital market is bound to cause more bubbles. This will end badly. It could be a crash that takes down the global economy. Or, if China is ‘lucky’, it could just be a lackluster economy that no longer enriches its citizens.

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