The Taiwan Banker

It was the government itself which originally started the fire. Its “three red lines” deleveraging policy, setting thresholds on liabilities to assets, net debt to equity, and cash to short-term debt, caused lending to Evergrande to dry up. Deleveraging has been a priority of the government for several years, and for good reason as corporate debt surges past 160% of GDP. As the world’s most indebted real estate developer, Evergrande was naturally first in line. It is not clear exactly what firewalls financial regulators have prepared. Other developers are also being targeted by bond markets, which may be a rational response to the original crackdown. In particular, the government has made it clear that it will not bail out foreign bondholders. It does not take long for liquidity problems to become real problems on the asset side of the balance sheet. The larger systemic risks involve the banking and governmental sectors. Banks rely heavily on real estate for collateral. Furthermore, local governments use land sales as a direct revenue source. Beijing is standing by in case of any need for rescue. Even though it retains the power to do so, however, the use of that power constrains the scope of its reform ambitions. One response by local governments has been to impose price floors on real estate sales. This makes sense in the short term as a crisis prevention measure, but it also reflects deep cultural and institutional attitudes which are coming under challenge. Over the longer term, lower prices are precisely the natural resolution to China’s persistent economic imbalances. A cultural shift To understand the pressures the government faces here, it can more be instructive to look at previous cases of protests against real estate prices. Rather than targeting price appreciation to some of the highest levels in the world in relation to local wages, such incidents have apparently been solely directed at price drops, after buyers have been suckered into deals at higher prices. Despite being mocked inside and outside China alike, “fangnao” (or “housing trouble”) protests show that the price floor mentality is not just limited to crisis management. In fact, analyzing some specific reasons for such protests provides useful insights into current issues. Clearly the sunk cost fallacy plays a major role, which the source of the derision. Nevertheless, one could also surmise that price declines would not provoke such a reaction if they were more common in the first place. The entire market – from individual home buyers to economic planners – is psychologically conditioned to believe that housing prices only move in one direction, and reacts accordingly when events violate this belief. More to the point, such protests sometimes work. The legal culture in China has yet to develop to a point where a contract is viewed as a final transaction document. Here too, however, there are further subtleties. Many of these protests in fact target not the handover of the house, but rather pre-sales payments. Developers frequently accept full pre-payments for houses, even years before they are built. Giving fangnao the benefit of the doubt here, even though pre-sales may superficially seem like a matter of property transfer, perhaps they should be considered more like a financing channel – and shadow financing at that. The current crisis is forcing regulators to better define this practice. Pre-sales became more common in the past few years as an off-balance-sheet workaround to the increased difficulty of fundraising through official channels. Evergrande left 1.2 million homebuyers who had made down payments – and the lenders who had provided their mortgages – in the lurch. The government has pledged to rescue these claimants, but it is less clear what will happen to the pre-sale model in general. Because developers receive money for assets which have already been used to obtain on-balance-sheet financing, it is a form of double collateralization. If the government is serious about addressing leverage and moral hazard, it will need to substantially reform the practice. Missing price signals The scope of the problem also extends to monetary policy itself. China’s macroeconomic policy stance tends to alternate frequently, but mainly transmitted through channels outside of interest rates. Instead, China has a system that might be called a “land standard” (with reference to the alternative system of the “gold standard”). With extensive control over capital markets, China has a number of unique policy levers, one of which is land supply. When it wants to heat the economy, it releases new land and lends money to fund construction on it. Conversely, deleveraging means restricting supply. According to statistics by Rhodium group, land sales are down 43% on the year; this connection between land supply and liquidity means that prices are never allowed to drop substantially. This use of real estate as a store of value explains why the government is so concerned with price stability in both directions – perhaps even to a greater extent than social stability. By taking on the real estate sector, therefore, Beijing is not just crushing a powerful industry, but creating a new economic model. The scope of this change is quite deliberate. Xi Jinping’s vision of “common prosperity” has upended a number of sectors relevant to capital markets, including education and video games. For real estate, the focus is on public housing. “During the 14th Five-Year Plan period (2021-25), we will take the development of government-subsidized rental housing as a key task, improve the integrity of the housing security system, and increase the supply of government-subsidized housing, so that all Chinese can have their own place in which to live,” said Wang Menghui, minister of housing and urban-rural development, on August 31. This news is good to the extent that the government is recognizing its housing problem, but the real estate sector was already controlled to a great extent by the availability of financing, and thus by government policies. Its current problems indicate that the problem is not excessive profitability, but rather something upstream. The key question remaining to be answered is whether the price of land will be allowed to fall on a sustained, finally breaking its multi-decade growth streak. New financing methods are indeed coming online, helping facilitate a transition away from land-based liquidity provision. Efforts are being made to improve secondary markets in provincial government bonds, and a sorely-needed stock exchange for SMEs is being planned for Beijing. These are welcome developments, yet without the signal of declining prices, the transition away from the real estate driver will never be complete. Admittedly, if any country could adopt quantitative controls and ignore price signals, it would be China, but an administrative approach will still be challenged either by shadow financing, or by intrusive controls. An important example of distortions from a lack of price signals is the housing rental market. Public housing could potentially put more rental units on the market by government fiat, but the scale is unlikely to match the potential of existing empty units. The psychology of sales prices that never go down is an important factor behind the reluctance of homeowners to become landlords. Without that expectation, they would either need to sell or earn cash flow directly. Breaking the social contract Behind the Evergrande crisis, therefore, lies a number of deep and complex issues. Further rolling crises may be expected as the financial system gradually adopts to the new model. It is clear that the old stimulus pattern is no longer sustainable, but less clear what comes next. China has so far resisted the consumer-oriented stimulus policies which have become favored in the US and elsewhere, which would provide a way to address price-to-income ratios without risking a hard landing. The success of this transition will determine whether or not the country falls into a middle-income trap. Its total factor productivity has declined precipitously over the past decade, for the simple reason that inputs, particularly capital, have increased so dramatically. Productivity is the ratio of output to input, so it declines when more capital is used to produce the same output. The next stage of China’s growth must involve more intensive use of the capital assets already available. Regarding stability, due to the basis of China’s real estate market in equity, rather than debt, it has survived imbalances that might result in catastrophic failures in other countries. Current homeowners however mostly acquired their properties at lower prices than those available today, when the economy was also growing faster. Going forward, mortgage financing will become more widespread, and with it even further systemic issues. The other stakeholder worth considering is the consumer. High prices for housing put a damper on consumption growth – which, in a vicious cycle, is precisely what’s needed to stimulate the economy. This is of course not the only factor to do so: education and healthcare costs are also substantial, but housing is the only one of the three which is also a capital asset. Meanwhile, it is also vital to consider the role of the home in Chinese culture as a prerequisite to marriage. When young people cannot afford a home, they put off marriage and procreation. This can help explain why China’s working-age population has been declining for several years now. It also helps answer where the missing protests against home price appreciation have gone. They are silent, but much greater in consequence.