Not Just Another Recession
Why the Global Economy May Never Be the Same
In March 2021, analysts projected that revenues at Evergrande Group, China’s second-largest real estate developer, would grow by 70 percent this year. In September, however, the property behemoth—with some $300 billion in outstanding debt—missed $131 million in interest payments. When Beijing didn’t come to its rescue, shocked investors were caught flatfooted.
Frothy real estate markets and aggressive corporate borrowing have driven much of China’s growth over the past two decades. Real estate and construction now account for 29 percent of the economy—twice the levels prevailing in developed countries. Other Chinese sectors depend heavily on property values; nearly one-third of the country’s local-government revenues come from land sales, and soaring home prices have spurred the recent growth in consumer borrowing. At the same time, levels of corporate debt have soared. Since 2008, Chinese firms have borrowed a larger share of national income than those of any other major economy, with debts now topping 160 percent of GDP.
For years, the government intervened to rescue companies on the brink of default, particularly those deemed of strategic importance. These have included Sinosteel, China Eastern Airlines, solar-panel maker Suntech Power, and manufacturing giant Baoding Tianwei. Not this time, however. When the COVID-19 pandemic hit Chinese property sales last year, triggering a cash crunch for Evergrande, Beijing stayed on the sidelines. Newly enacted borrowing restrictions on property developers, moreover, thwarted the company’s efforts to raise new capital.
Now that Evergrande is missing debt payments, Beijing is using its plight to warn other developers against risky borrowing. China’s central bank governor has publicly disparaged “mismanagement” at the company, and President Xi Jinping himself has condemned the property mania underlying the firm’s growth. “Homes are for living in,” he scolded, “not for speculation.”
The Evergrande crisis isn’t the first time Xi has attacked overborrowing. In 2016, China took measures to cut corporate leverage (that is, debt), which it redoubled two years later. Perhaps, then, Evergrande’s fall from grace marks a turning point—the end of debt-fueled growth in China. After all, China set up dozens of new bankruptcy courts across the country just two years ago; and last spring, the chairman of the China Banking Regulatory Commission warned of bankruptcy risks from rising corporate leverage. The government even listed reducing debt as one of its “five major tasks” for this year.
Xi, a recent New York Times piece concluded, is trying to “send a warning that no firm is too big to fail.” Studying his earlier bouts with the debt demon more carefully, however, one finds that borrowing is actually more likely to shift to other sectors than to fall. The political hazards of weaning China off debt are simply too great. The Chinese president, one might say, is a modern-day Augustine, exhorting God to make him chaste—just not yet.
In a normal market economy, home prices and corporate lending tend to move in tandem. When the economy is strong, banks increase lending to firms, and consumers use rising incomes to buy property, pushing up prices. When the economy turns down, incomes fall, defaults rise, and these trends reverse. Indeed, as the figure below shows, this is what has happened in the United States over many decades.
In China, however, everything is different. Since Xi took power in 2012, Chinese home prices and bank lending to corporations have been negatively correlated, as shown in the figure below. When one moves up, the other moves down, and vice versa.
So what is going on here? Lending in Xi’s China is ultimately a slave to the government’s GDP-growth target, which is six percent for this year. When growth looks set to lag below that target level, Beijing juices borrowing and lending to boost the numbers.
In principle, the government would like to tame debt-fueled overinvestment in both housing and corporate sectors. Yet a downturn in either sector consistently spooks Beijing. So, when the government pumps the brakes on housing speculation, it simultaneously pumps the gas on corporate borrowing to temper the growth hit. Then, as corporate defaults threaten, the government does the reverse. Debt levels continue to rise.
This dynamic confronts Xi with an unenviable choice. He can finally crack down on excess credit growth across the economy. This path leads toward longer-term economic stability. If Beijing lets overindebted companies fail instead of propping them up with still more credit, lenders will reallocate capital to more productive uses, boosting the prospects for long-term growth. But doing so also means an end to the ambitious short-term growth targets that Xi has relied on to cement his political legitimacy.
What will Xi do? The answer seems obvious. Given that he will be bidding for an unprecedented third term in power next October, there is no reason to expect these historical trends to change. Growth must take precedence. Xi will therefore meet the current downturn in housing prices and construction with renewed efforts to funnel cheap credit to state-owned enterprises. Overall production will rise, many will proclaim Xi’s economic genius, and the Party will reanoint him—after which he will renew his rhetorical assaults on speculation and leverage.
This path means a continued march back from the era between the country’s former leader Deng Xiaoping and Xi—the glory years of the Chinese economy. Between 1995 and 2005, China converted two-thirds of its state-owned enterprises to private ownership, boosting productivity and generating robust sustainable growth. Instead, China will keep funneling underpriced credit to unproductive firms that can’t repay their loans, continuing the country’s decline in productivity and rise in debt. These trends mean a greater likelihood of a major financial crisis and longer-term economic stagnation.
To be sure, Xi would love the current shock to cure China’s debt woes. But Evergrande is merely a thread in a much larger tapestry of debt—a thread Beijing dare not pull on further.