You may remember back in the 1960s a US television show called ‘Rowan and Martin’s Laugh In’. This was a weekly satirical look at largely American politics with a global flavour when required. It was at a time of huge upheaval in America, with the Vietnam war and civil rights movement creating enormous amounts of tension between different sectors in society. For those of our younger readers who think we live in a frighteningly divided and dangerous world today, please refer to the Cuban missile crisis for a bit of perspective.
In the show there was a spot featuring Henry Gibson as ‘The Poet’, who would recite a short, sharp, satirical poem whilst dressed as a hippie. One of the most memorable poems was, “Marshall McLuhan, what are you doin’?” Marshall McLuhan was a Canadian philosopher who coined the expression ‘the medium is the message’ and the term ‘global village’. He also predicted the World Wide Web 30 years before it was invented, so he was not only well ahead of his time but also widely thought to be not quite firing on all cylinders.
We thought this month we would focus on China, as the inexorable rise of that nation continues to have a significant bearing on the rest of the world, even before the effects of its leaky labs. There are two types of economic growth in China (and elsewhere), the good and the bad. Often categorised as ‘genuine growth’ and ‘fictional growth’. High quality, genuine growth comes from innovation, increasing market share, rises in productivity, improvements in sustainability and so on. On the other hand, fictional, bad economic growth arises from too much lending to unviable companies, too much government spending, propping up inefficient organisations, etc. It has always been a problem with assessing the Chinese economic miracle of the past three decades that we simply don’t know how much genuine or fictional growth there has been.
You may have noticed in the news recently that a property company called Evergrande has caused great financial distress in China, spreading faster and more forcefully than Beijing’s financial regulators expected. Policymakers in Beijing are in a tough position on what to do about Evergrande, the most indebted property developer in the world, whose total liabilities could amount to an enormous 3% of China’s annual GDP.
For the past several years, Chinese regulators have worked hard to reduce the economy’s over-reliance on debt. As part of this regulatory push, regulators implemented what became known as the three red lines for property developers last year. These reduced the availability of credit and immediately began to affect the operations of all highly indebted developers, not just Evergrande. Because they were no longer able to borrow, and in many cases were forced to pay down debt, they had to liquidate assets, often in fire-sale conditions, and were sometimes forced to cut back on their operations. The resulting losses often only worsened their balance sheets and put further pressure on them to cut back.
It is easy to understand why policymakers have been so worried about real estate debt - and debt in general. China’s official debt figures have soared by 45% in the past five years, leaving it with among the highest debt ratios for any developing country in history. The property sector is notorious for its addiction to debt. This addiction has expressed itself not just in borrowing from banks and bond markets but in a variety of other ways. All this borrowing has enabled the property sector to become one of the main engines of economic activity for the Chinese economy, accounting for as much as 25% of the country’s GDP, considerably higher than is typical in other countries.
Borrowing for large Chinese companies like Evergrande had never been a problem in the past. It was widely assumed they would never be allowed to default on their obligations. Local governments and regulators were expected always to step in at the last minute to rescue the borrower, no matter the cost. This is why Chinese regulators have decided to have a showdown with creditors over Evergrande. By convincing lenders that they will no longer stand behind large Chinese borrowers, they are trying to transform the country’s financial system by making Chinese investors more reluctant to fund non-productive investment projects.
Regulators are right to worry about the important role moral hazard plays in generating overall leverage within the Chinese economy, but it isn’t an easy problem to resolve. If they intervene to support creditors, they will reinforce moral hazard and lose credibility. If they do not, and effectively force the borrower and its creditors to work out their disputes using just Evergrande’s internal resources, there are at least three important subsequent problems the regulators would face. These include the closure of credit markets so that no companies, good or bad, would be able to borrow money to expand, widespread financial distress, and the role of debt in propping up China’s fictional/genuine GDP growth.
The problem is that this could provoke a vicious circle. Bankers wouldn’t know how to lend until they understood what the restructured market would look like. But if all lending in China stopped, even temporarily, the consequence could be the type of financial contagion with which global investors have become all too familiar in recent years. This leads to the risk of financial distress spreading throughout the global economy.
The good news is that the Chinese government doesn’t mess about with democracy and all that malarkey and therefore doesn’t need to obtain consensus across the political divides before it can act. The Chinese economy is already benefiting from this totalitarian process in action. Contractors, developers, lenders and customers have slowed down their activity and the Chinese government has started to realise that the routine of them publishing annual growth targets for the economy each year and then meeting these exactly by whatever means possible is both nonsensical and harmful and that they should instead allow growth to fall to whatever level the economy can sustain.
It won’t all be plain sailing of course, not least because Evergrande has 200,000 employees, not to mention hundreds of thousands of employees at other property developers. But before financial distress spreads further throughout the economy, most analysts expect – correctly, in our opinion – that Chinese regulators are capable of addressing this as rapidly as possible by drawing clear lines about what will and what will not be rescued so as to suppress the uncertainty Evergrande has created in the economy. So, no need to panic Captain Mainwaring.
Elsewhere, the global recovery from the pandemic continues rather more slowly than we would all like and the world continues to change at an increasing rate. But at least we have Emma Radacanu now.