The Chinese “Evergrand” crisis may be worse than the American collapse


The world is watching with concern the Chinese real estate market, after the Evergrande Group faced the possibility of default. Market observers have been making comparisons between what is happening in China today and the real estate crash and real estate crash in the United States in 2008, and some even compared the real estate crash in Japan two decades ago. However, despite some similarities, the situation in China today is fundamentally different from the two previous events.
The most obvious comparison to a potential Chinese real estate crash appears to be the US housing bubble that burst in the wake of the Lehman Brothers collapse. We now know that real estate bubbles are particularly harmful to the economy, because they involve a lot of debt. And when these bubbles burst, they usually tend to bring the financial system down with them, causing lenders to back down, fearing bankruptcy and illiquidity. Indeed, this is precisely what happened in the US, but as commentators have been quick to point out, China does not really risk this type of scenario, given the government’s control of the banks. And if President Xi Jinping asks Chinese banks to continue lending, they will certainly do so, no matter how bad the situation with other institutions is like the one facing the Evergrande.
Indeed, Japan’s real estate bubble, and its bursting in the early 1990’s, is an example that relatively few outside the country understand. However, some may instinctively be quick to associate it with what is happening today in China, given that both countries are located in East Asia.
In the late 1980s, Japan’s efforts to catch up with the West paid off, but the country’s economic growth was slowing. In an attempt to maintain the level of growth to which they are accustomed, Japanese banks have stormed into the realm of mortgage finance in a big way, helped by the easing of regulatory restrictions, low interest rates and a strong currency.
So far, this situation looks somewhat similar to what China is experiencing today. It is worth noting here that every time the Chinese economy is in danger of slowing down, banks are ordered to provide loans, and banks often extend their loans to real estate and related industries such as construction. This sounds like a slower version of what Japan did, but the incentive to maintain rapid growth probably remains the same in both cases.
Another factor contributing to Japan’s real estate bubble is its financial system. Unlike in the US, most companies borrowed from major banks, rather than issued bonds. In order to obtain loans, companies needed collateral, and it was land that the banks were most eager to accept. This increased demand for urban real estate, exacerbating the price bubble, and at the same time exacerbating the collapse when the value of corporate guarantees fell. Accordingly, the banks refused to provide more loans to companies, forcing the latter to reduce their activities.
Again, such a matter is unlikely to be a problem for China, although it certainly does carry a lot of debt on Chinese companies, if real estate is not part of their core activities, the depreciation of the value of the land they hold may not matter in terms of Bank borrowing operations, as the government will still be able to direct the loans to the destination it desires.
At the same time, companies that rely on real estate or construction and local governments that finance themselves through the sale of land are sure to take a major hit if the real estate sector declines. However, firms in manufacturing and other areas are likely to be safe, unlike in Japan.
Herein lies the good news. Essentially, both the US and Japan have been characterized by capitalist financial systems, where lenders can withdraw when real estate collapses. On the other hand, China misses this weak point.
However, in all respects except for financial stability, the Chinese economy appears more vulnerable to a real estate crash than either the US or Japan. It is worth noting that the real estate industry and other related industries account for nearly 30 per cent of China’s gross domestic product, a much larger share than was the case in the US at the height of the real estate boom.
And if Xi is serious about pushing the Chinese economy away from real estate and toward industrialization, as he has announced, this will certainly be a painful shift. If the fall of the Evergrande and the collapse of the real estate market is exploited to carry out this structural transformation, the pain will increase, because it will be concentrated within a short period.
To make matters worse, Chinese citizens are exceptionally dependent on real estate. The ownership rate is 90 percent, and it is estimated that Chinese living in urban areas own more than 70 percent of their net wealth in real estate. In fact, this is something Japan has not had to deal with, because Japanese homes tend to fall in value, not rise, as the government tends to rebuild them now and then. So, when land prices collapsed, it didn’t kill the middle class. The middle class in the United States has been hit hardest, but if land prices in China fall, the masses of the population will suffer massive financial damage.
Finally, a long-term property meltdown would significantly reduce China’s ability to respond to macroeconomic shocks. For their part, Japan and the US use traditional monetary and fiscal policy to fight recessions, while China has long relied on ordering banks to lend. Without real estate, there will be far fewer profitable companies for Chinese banks to lend to, which means that China will be hit hard by the next recession shock.
Thus, it becomes clear that the real estate situation in China is somewhat different from that of the United States and Japan in terms of the real estate collapse experienced by the countries, but it is worse in many ways. Although China is not as financially fragile as capitalist countries, its middle-class wealth and long-term stability and growth policy are all more dependent on real estate. Any company that invests in China, or makes a living from exporting to China, must be seriously nervous about the potential fallout from the Evergrande crisis.

* In agreement with Bloomberg


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