Shaky Foundations: The Recent Shocks of Evergrande to the Chinese Economy, and What It Means to the World
By Scottie Barsotti
In recent weeks, ripples in the Chinese economy have caught the attention of global investors and governments. Chief among the ripple-causers was the Chinese real estate giant Evergrande, whose default on bond payments caused financial markets to hold their collective breath—with other potential defaults looming. The struggles of Evergrande and other developers are creating a drag on the Chinese economy, which was already showing signs of stress. Are we headed toward another meltdown, like we saw following the collapse of Wall Street players in 2008?
The failure of such a large company, and Beijing’s approach to containing the situation, shines a light on some of the major differences between the Chinese financial system and markets in other countries.
“It’s a real limitation for the Chinese people that the level of government interference in the economy has constrained their ability to acquire household wealth,” said Lee Branstetter, professor of economics and public policy at Heinz College and an expert in the rise of East Asian economies. He suggests that years of restrictions across the Chinese financial system have created a situation in which the real estate market is overlarge, overheated, and volatile—in part because it’s one of the few sectors in which Chinese households can get a decent return on investment.
“There’s a real tradeoff between the government being able to maintain its current level of control on the one hand, and having an efficient financial market that can reliably generate robust returns on the other,” said Branstetter. “You have to choose, and it seems clear at this point which choice Chinese government officials are making.”
We sat down with Professor Branstetter to get a nuanced view of the economic situation in China currently, the impact of the Evergrande default, and what may be possible in the months and years ahead.
This interview has been edited for length and clarity.
Heinz College: We’ve recently seen news reports of multiple large real estate companies in China defaulting, the biggest being Evergrande which has over $300 billion in debts. Thus far, the Chinese government has seemed to take a hands-off approach to that situation, whereas in the recent past they’ve disciplined tech companies—such as e-retailer Alibaba and ride-hailing company Didi—for growing too big, too fast. From your vantage point, what is going on in China’s economy right now and how do you explain Beijing’s positions?
Lee Branstetter: That’s part of the problem. The Chinese regulatory system is pretty opaque. Xi Jinping and his inner circle have an enormous amount of discretion, and over the period of his term as China’s top leader, he has changed his policy approaches across many domains in very significant ways. That creates a lot of uncertainty. It creates uncertainty for investors in China, investors outside of China, and for China’s trading partners. In the long run, that uncertainty is going to be a significant headwind for the Chinese economy. And I say that cognizant of the fact that the Chinese economy has come roaring back from COVID—but it is still a poor country’s economy in many ways, with per capita incomes still very low relative to the U.S. and other countries with advanced economies.
That doesn’t mean China’s economy won’t continue to grow robustly in the short to medium run, or that it won’t become a larger economy in absolute terms than the United States. That’s very likely, given China’s population is so much larger. But for the true “Chinese Dream” to be accomplished, the Chinese government will have to do more than respond to the crises of the moment. Officials need to create the ability for the Chinese people to earn a decent return on their investments. And that’s quite complicated.
HC: Why is that so complicated presently?
LB: If you look at the assets available for investment by Chinese middle-class families, they’re almost exclusively Chinese, because the government maintains very strict controls over the movement of capital inside and outside the country. Americans, for example, are pretty free to invest around the world, and many of us do. That freedom is not extended to Chinese households.
Chinese households work very hard and have a high savings rate, but if you ‘re a Chinese household and you want to invest, what are you going to invest in? You could put your money in the bank, but interest rates are pretty low so, that’s not a great way to build wealth. You could invest in Chinese government bonds, which are very safe but also carry a low interest rate. You could invest in the corporate bond market, but in the Chinese context that market is quite restricted. And if you look at the Chinese equity market, that’s a market that reached its peak value in 2007 before Xi took office. The current level of the Chinese stock market according to the most widely quoted index, is about 40 percent below that peak.
China is a country whose economic size has massively expanded. China has become the biggest exporter in the world and the most important manufacturer in the world. The country has exhibited all this impressive economic dynamism and yet the returns ordinary Chinese people can get from investing in their own stock market are very meager.
HC: What are some of the market controls and regulations from Beijing that make that the case?
LB: The government strictly limits which firms can list their shares, and the firms that are permitted to list their shares have tended to be disproportionately firms that are state-controlled. This is one of the fundamental differences between the way Chinese and American stock markets are regulated. In the U.S., usually there’s a strong and sharp distinction one can draw between the government and the market.
What history teaches us is that authoritarian regimes are giants with feet of clay. They wield enormous power, but are much more fragile than they look. And when they go down, it can be ugly.Prof. Lee Branstetter
But in China, you have many firms listed on the equity market that are effectively controlled by the Chinese government. Historically, Chinese equity markets have been dominated by state-controlled enterprises. And there are a number of important industries where the dominant players are all state-controlled enterprises—the banking sector being one of them. If Beijing loosened these long-standing restrictions and opened that market to all the dynamic and rapidly growing private entrepreneurial firms driving growth in the Chinese economy, many investors would shift their investments to these private firms. That would be good for the economy and for investors, but that shift could generate large capital losses for the state and could create new competition for state-owned players, in turn diminishing the Chinese Communist Party’s influence and control.
HC: How do those economic conditions and controls feed into some of the things we’ve seen in the news recently, such as the defaults of large Chinese real estate companies like Evergrande?
LB: If you’re an investor in China, and you can’t make money by putting it in the bank, or investing in stocks or bonds, what can you invest in? Real estate. For the past 30-40 years, real estate investment has been the most important means of building wealth for Chinese households. Over time, the “real estate/construction complex” in China has grown to truly gargantuan proportions. It’s hard to know precisely because of the opacity in the system, but some economists suggest that real estate construction and speculation is connected to as much as 30 percent of Chinese output, much greater than was ever the case in the U.S. at the height of the housing bubble.
If the real estate/construction sector has become that important in the Chinese economy, then if it were ever to hit the wall and suffer a significant and persistent downturn, the Chinese economy would face a hard landing. There would be a decline in GDP, and because much of the financial system is invested in this real estate boom, there could be widespread bankruptcies. In addition, local governments in China have come to rely on revenue from the sale of land and land use rights. What happens to local government finances when the boom ends?
If a slowdown were to persist for a long time, then the legitimacy of the CCP—which is largely based on the promise of continued economic growth—would be called into question, and that could be a scary moment.
HC: Scary how?
LB: This is a really big economy that matters in the global scheme of things. It is also a nuclear-armed nation that has strained relationships with its neighbors, some of whom are important U.S. allies and trading partners. The nightmare scenario is one in which an economic downturn leads to a political crisis or civil conflict, and the impact of that on the region and the world would be massive.
I see that as an unlikely scenario. Even a significant downturn that lasted a while would probably be survivable by the regime with their current mechanisms of control. But what history teaches us is that authoritarian regimes are giants with feet of clay. They wield enormous power, but are much more fragile than they look. And when they go down, it can be ugly.
HC: If the risk of systemic failure is so high, why would Beijing resist bailing out a company like Evergrande?
LB: The Chinese government understands that the real estate/construction complex cannot continue to expand as a fraction of the Chinese economy without limits. It’s gotten too big, and there needs to be rebalancing. The challenge is how to take this bubble and gently deflate it without causing it to precipitously pop. If market participants believe the real estate boom will continue forever, investments will be profitable and failure will be bailed out, then it will be very hard to deflate the bubble.
The way the Chinese government is approaching this situation (and there’s some wisdom in this), is that they want to change that inclination and place some market discipline on firms that have over-leveraged. On the other hand, they don’t want those consequences to lead to a collapse, which is a really hard line to walk. In the U.S., when the government allowed Lehman Brothers to fail, Washington insiders thought the damage would be contained. In hindsight, it’s clear the Lehman Brothers failure precipitated a much broader collapse.
HC: What levers do policymakers in other countries have available to them to prevent the collapse of a large Chinese company like Evergrande from causing more widespread harm?
LB: I’ve criticized the policies that make it hard to move capital from Chinese financial markets to other markets, because it depresses the choices available to the Chinese people. But on the other hand, those limitations on capital movements help to partly insulate other economies like the U.S. from major downturns in China.
The Chinese stock market took a serious tumble in 2015. The repercussions in the rest of the world were fairly limited due to the barriers Beijing has created and maintained. The contrast is that when the American equity market declines sharply, it impacts the entire world. That’s a reflection of the fact that the U.S. is deeply interconnected to other international financial markets. That’s helpful because it creates a lot of choice for investors, but it also creates a certain amount of financial interdependence that the Chinese have consciously avoided.
If the Chinese system prevents the people of China from realizing their potential, then the progress of the entire human race is held back very substantially.Prof. Lee Branstetter
One response to the uncertainty created by the capriciousness of the Chinese political system is to isolate yourself from it—but Beijing has done that for us. The other strategy is to integrate China more into a global financial system whose rules we have played a role in drafting.
HC: Why should Heinz college students pay attention to what is happening in China?
LB: It’s important to understand just how big China has become and how important it is to the global economy. I’m critical of the Chinese financial system, but I want to pay appropriate respect to the entrepreneurial energy and dynamism, hard work, and thrift of the Chinese people despite the shortcomings of that system. They have built an enormous amount of economic growth and productive capacity.
China is educating more scientists and engineers up to the first university degree level than the top technological powers of the Western world put together. A huge fraction of the human race’s capability to innovate, invent, and produce resides within the political boundaries of the People’s Republic of China. If that human potential can be fully realized, then it will vastly expand the human race’s ability to confront the major problems we’re facing in the 21st century, including climate change, health security in the face of pandemics, and social innovations that combine the ability to develop new technology with the ability to equitably distribute the wealth it creates.
At the same time, lack of faith in the current political system to create opportunity in the long run is driving some of the most talented people in China away from a country that desperately needs their talent and energy.
The bad news is that the system that governs all that human potential has some clear deficiencies. If the Chinese system prevents the people of China from realizing their potential, then the progress of the entire human race is held back very substantially. So, we should be playing close attention, because the potential for good that can come out of China is enormous, but the realization of that potential is far from certain.