In 2016, Ning Zhu, professor of finance and deputy dean at the Shanghai Advanced Institute of Finance, wrote a book called “China’s Guaranteed Bubble: How Implicit Government Support Has Propelled China's Economy While Creating Systemic Risk.” It analyzed the logic behind China’s economic growth and warned that heavily leveraged conglomerates, such as property developer Evergrande Group, would trigger asset bubbles.

Those bubbles were almost inevitable and could easily burst, Zhu argued, because of how China’s implicit guarantees to institutions and markets have encouraged investors to feel stocks would always gain in value, loans could never be defaulted on, and housing prices would always rise, resulting in massive speculation and financial asset bubbles. 

The Evergrande Group, which specializes in property development, was among the biggest beneficiaries. Founded in Guangzhou in 1996, a year before the Asian financial crisis erupted, Evergrande emerged as a leader in its industry within 10 years, and later branched out into financial products and electric cars and even sponsored a soccer team, all assisted by the dividends of government policy. 

In late 2008, a global financial crisis suddenly upended global markets and economies. China’s central bank poured huge amounts of liquidity into markets to combat the threat, and Evergrande took advantage by aggressively expanding through high-turnover, high-leverage, and high-margin operations to become China’s largest real estate group. 

That speculation has come back to haunt the company, now on the brink of bankruptcy because of its inability to finance and repay debts.

How does Zhu now see the risk to China’s economy posed by Evergrande? How has China’s economy been changing and were those shifts behind the crisis? Here are excerpts of CommonWealth’s interview with Zhu covering these and other questions:

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Q: The Evergrande Group is in danger of defaulting on its debt. What went wrong with the company’s strategy?

A: I think Evergrande’s development strategy was seriously flawed in two areas.

One was its misjudgment of development trends in China’s real estate sector. Some people within the company felt that Chinese property prices would continue to rise exponentially in the coming five years. With that in mind, the company became extremely aggressive in acquiring land and building up land reserves, but its forecast for the market was unrealistic.  

That’s especially true because of Evergrande’s huge land grab in third and fourth tier Chinese cities. The government carried out a plan in 2017 and 2018 to “re-develop run-down areas” that led to the tearing down of old homes and the relocation of residents to new locations. The plan led to a ceiling on demand and housing prices in those cities, substantially weakening property market fundamentals to well below what Evergrande had expected.

The big shift brought by ‘common prosperity’  

Why did Evergrande make such a bet in the first place? One, the real estate sector is a more important driving force in China than any other industry. Two, property is the most important source of revenue for Chinese local governments. Add to that the four aborted attempts over the past decade to regulate the industry and dampen speculation, leaving everyone with the impression that any talk of regulation was simply to scare people. If the economy turned bad or local government finances came under pressure, the conventional wisdom went, the government would loosen up. 

But in the current environment of “common prosperity,” the real estate sector has undergone profound change. Aside from new regulations that have breached the real estate financing’s “three red lines,” what has really led to concerns over the state of Evergrande’s finances has been the relatively rapid weakening of China’s economy in the second and third quarters, hurting property demand. As a result, market trends have clearly been at odds with Evergrande’s more bullish projections. 

The other huge misjudgment was that despite a lack of liquidity, Evergrande thought it could get through any crisis, as had always been the case.

Evergrande has said it has survived “nine deaths” over the past 25 years, having been on the brink of collapse several times. One obvious example was in 2008 when it planned to go public but was unable to because of the severe blow dealt by the global financial crisis. Instead, it was forced to rely on extremely large bridge loans (a type of transitional, short-term loan) and private equity loans to keep the company liquid.

The real estate sector is inherently illiquid because it can be hard to dispose of tangible assets, such as property, in a pinch. Evergrande tried to overcome that limitation over the past few years by diversifying its operations and moving into new businesses, such as car manufacturing, high-end mineral water, and financial products.

Reports surfaced last year that Evergrande had even begun seeing itself as so big and as having borrowed so heavily from banks that if it were to go bankrupt, banks would face incalculable bad debt risks. If true, that thinking mirrored the “too big to fail” mentality of American financial institutions before the 2008 financial crisis erupted. 

The contradictions of a government rescue 

Q: What are the risks brought by the Evergrande crisis?

A: What everybody is wondering related to Evergrande’s debt is whether the Chinese government will intervene and rescue the company. 

Currently, there are a couple of potential risks related to Evergrande. The company has tens of billions of renminbi in financial paper that has reached maturity or is overdue, but is relatively controllable. This part of the portfolio has the greatest impact on society and is the area of most concern to the government. There is little likelihood of a complete default or large-scale losses.My guess is that state-run enterprises or local governments will take over some of Evergrande’s assets or even the entire company and then cover the interest or repayment of the principal. 

But there is an even bigger problem that has yet to have a particularly noticeable impact. Evergrande has received deposits or full payments for housing purchases from customers, but it may have difficulty delivering the houses it has promised because of its cash and debt crunch.

These assets, or Evergrande’s business or company equity, could also gradually be taken over by state-owned enterprises, similar to how Hainan Airlines was handled. It should not have much of an impact on the financial sector, but [founder and chairman] Hui Ka Yan (許家印) and his family could be ousted from the conglomerate.

Q: Why do you think the Evergrande crisis will not create systemic risk for the financial system? 

A: The outside world thinks this could be China’s Lehman Brothers. But I’m much more optimistic.

Lehman Brothers’ transactions were in the subprime mortgage market, where prices can easily reflect capital markets. Evergrande’s main assets are land and its property development business. Prices and liquidity in those areas are not that transparent. 

There’s also an important difference between China and the United States. The Chinese government’s influence on the economy is particularly deep. If state-owned enterprises take over Evergrande, while they may not be very efficient, they can get low-cost and secured financing.

My own opinion is that this will be an imperfect solution. The crisis can be defused in the short term without having too much of an impact on the market, but there will still be two big problems in the medium and long term.

First, we all know that the management of Chinese state-owned enterprises is not as efficient as that of elite property developers. If they take over Evergrande, will they still be as efficient in developing new properties and controlling costs?

The second uncertainty is the “too big to fail” mentality. If Hui Ka Yan’s family is not removed from the company, other property developers will realize that they can do what Evergrande did and still be rescued [by the government]. It could be an extremely dangerous signal.

I also want to add one thing. I think China’s overall real estate market will increasingly be led by state-owned enterprises to effectively control prices in the real estate market.   

The threat of soaring real estate prices

Q: So what you’re saying is that China’s real estate market will move toward socialism in the future?

A: Real estate is indeed a special product and has social and political significance.   

Right now, Chinese housing prices have risen to a level far above the level seen in Japan and Taiwan at the same phase of development. If you look at China’s house price to income ratio, it is far worse than that seen at the same development stage in Japan, Taiwan and South Korea.

At the same time, China’s low-birth rate and aging trends are far more serious than they are in Japan, South Korea, and Taiwan, mainly because of Beijing’s one-child policy. The two trends have sharpened the contradictions embedded in China’s real estate market.

There are also many other factors. One, for example, is that China does not have property taxes – the main source of revenue for local governments is the sale of land. That has distorted incentives by encouraging local governments to sell land and drive housing prices higher, to almost as high as those in Hong Kong. I think this has been a very regrettable and mistaken historical choice. 

How can this be solved? It can’t only be looked at from the perspective of a financial and economic bubble, but also from the perspective of social and political stability.

Even though I think it may be a little late, a more effective approach would be to quickly introduce property taxes.       

Right now, restrictions on buying and selling have already been imposed in many parts of China to manage “demand” in the real estate market. On the supply and price side, activity in China’s real estate market is bound to weaken, whether through the provision of more long-term rentals, low-rent housing, or affordable housing, or through state-owned enterprises getting directly involved in the property development market or the government regulating prices. 

(Source: Shutterstock)

This is closely related to the concept of “common prosperity,” but many investors and families have not yet realized such a shift has occurred. 

Q: You have said the Chinese government implicitly provides policy, capital and investment guarantees. After the Evergrande incident, can we say based on your analysis so far that these guarantees have been shattered? 

A: I think they have been. The three guarantees have actually changed over the past five years.

First, the policy guarantees. China’s targets for economic growth have become increasingly flexible. In 2019, the economic growth target was in the range of 6 to 6.5 percent, but in 2020 it did not set any target because of COVID-19. This year, many believe China’s economic growth will exceed 8 percent, but it has set a very low target of 6 percent. That reflects Beijing’s desire to gradually move away from the rapid growth of the past and adopt a more sustainable development model. 

But I feel the biggest change may be the investment guarantee [that investors at the very least should not suffer investment losses]. In real estate, for example, regulations announced in 2018 indicated that China ultimately wants to move toward a system where the buyer is responsible for the outcome of a purchase and the seller is accountable for the product being sold.

Government taking control, regulating prices

Q: If you look at the Evergrande case in the context of the overall Chinese economy or private sector development in general, are we at a critical juncture?

A: Over the past five years, if you look at the scale of state-owned enterprises in the economy or their share of bank loans, the trend toward “the state advancing and the private sector retreating” has been obvious.

Whether it was the Alibaba incident last year, the Didi incident this year, or the retrenchment of the education and training sector, they all reflect a major trend, known as opposing “the disorderly expansion of capital.

What does “disorderly” mean? It’s very hard to define, but it symbolizes the adjustment in the relative importance of the public and private sectors.

Vice Premier Liu He stressed at the beginning of September that the private business sector contributes more than 50 percent of China’s employment, innovation, and tax revenue, or even higher. For the vice premier to come out and say this suggested that people at the grassroots level were speculating or having doubts over the status and role of private enterprises and entrepreneurs.   

The real estate sector reflects this trend. State-run enterprises are already controlling what they can control in the huge physical economy, and financial institutions are moving away from private control. Real estate is sandwiched between the physical economy and financial system.

That’s why I think the next step for the Chinese real estate sector is for more state-owned enterprises to get involved, and for housing prices to no longer be completely determined by market mechanisms.  

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Translated by Luke Sabatier
Uploaded by Jane Chen