Lehman to Evergrande: The long shadow of real estate-led economic crises

China economy

Karl Marx (1818-1883), the German-born philosopher, economist, political theorist, and revolutionary socialist, is said to have remarked, “History repeats itself. The first time as tragedy, the second time as farce.” He forgot to add that it is equally applicable to economics too.

The 2008 Global Financial Crisis (GFC) was the most severe worldwide economic crisis since the 1929 Great Depression. Its roots can be traced back almost two decades to a US legislation passed to encourage financing for affordable housing. It sparked a multi-decade financial bubble that quickly devolved into banks and financial institutions selling predatory financial products to low-income, low-information homebuyers without the income or means to pay those mortgages, packaging and down-selling these poor-quality credit loans as securitised mortgage-backed securities (MBS) in financial markets, and pocketing their fees and commissions. The runaway success of this originate-package-selldown model, unchecked by regulators, resulted in excessive risk-taking by global financial institutions. Until the US housing bubble burst, precipitating a "perfect storm" of an international banking crisis. September marked the 15th anniversary of the iconic Lehman Brothers bankruptcy, which symbolised the GFC.

The same GFC prompted China to abandon Deng Xiaoping's "Tao Guang Yuang Hui," or "keep a low profile and bide your time," which the chief architect of China's economic success first articulated as foreign policy in the 1980s. In fact, the roots of China’s global assertiveness, including its subsequent infrastructure-led Belt and Road Initiative and offering its “Chinese model” as an alternative form of development, trace back to the GFC and the troubles of the Western markets and democracies-led world order.

The GFC took a heavy toll on China. Its main economic driver, exports to the United States and Europe, were hit hard, even as foreign investments fell as global financial markets were thrown into turmoil. It had to find an urgent substitute for this engine of its economic growth. China's wealth and income concentration within a narrow base of affluence, combined with its historical household reluctance to spend, ruled out significantly increasing domestic consumption in the short term. As a result, China turned to the other side of the equation — its high household savings rate — to fund the firing-up of two other primary growth engines in real estate and infrastructure.

Real Estate Boom

China’s land and real estate boom began nearly three decades ago, in 1994, when local governments were given monopoly ownership of urban public land. This was a result of the reorganisation of the fiscal distribution system between the central government and local governments, which saw local governments' share of tax revenue decline to less than 50 percent, despite no change in their expenditure burden. Between 2002 and 2006, their tax revenues were further reduced as local fees, and then the millennium-old agricultural tax was abolished. This deprivation of tax revenues at the local level sparked the rush by local governments to monetise urban land rights. Local governments increasingly relied on land leasing revenues to even fund basic budgetary expenditures and, as the only source of revenue under their control, to bridge budget deficits. Since then, sales of land use rights have been a primary source of revenue for local governments, including unprecedented borrowings against these rights through Local Government Financing Vehicles (LGFVs).

In the seven years following the GFC, between 2009 and 2015, China's governments generated more than $3 trillion through land sales—the equivalent of selling Manhattan twice over. Land sales in China accounted for roughly one-third of total fiscal revenue. Land enabled the construction of projects that would not have been possible if they had been required to be funded by Chinese taxpayers. Local governments, however, ended up abusing this privilege by treating land finance as if it were free money. They built whatever they wanted—subways, airports, roads, bridges, new cities, and districts—without regard for underlying needs, productivity, recoveries, returns, or financial implications. Worse yet, it became an addiction with no efforts to develop alternate and sustainable fiscal revenue sources like house taxes, etc. Land sales raised 31 times more money for local governments in 2014 than they did in 2001.

However, the stimulus, usually intended as a temporary measure, never ended in China.  Massive land sales and correspondingly large infrastructure public works projects became almost routine for over a decade and a half. According to Ba Shusong, one of China's most influential economists, "if land markets cool, land prices fall, and the volume of land sales falls, not only will funding of some projects be difficult, but it will likely produce financial crises."  Following the GFC, land sales aided the Chinese economy by funding an increase in public works. Now, as the economy slows, a drop in land sales may exacerbate the slowdown.

New Style Urbanisation

When China's then-fifth-generation leaders, Xi Jinping and Li Keqiang, took power in 2012, it was widely expected that they would undertake a course correction on the real estate and infrastructure-led stimulus and emphasise increasing domestic consumption as the alternate and sustainable engine of continued economic growth. Instead, their "new-style urbanisation" strategy for continued economic growth continued to rely on real estate. New-style urbanisation sought to focus on small and medium-sized cities, increasing the number of urban residents by liberalising the hukou (China's resident permit system) for new rural migrants and allowing cities to focus on service-sector economic activity rather than relying on industry and export production.  This stage of urbanisation was expected to result in the formation of a secure, permanent, and consuming urban middle class to support a target annual growth of 7 percent. With a massive oversupply of real estate, looming defaults, faltering confidence, and poor long-term demographics, the feasibility of this strategy remains uncertain.

For multiple reasons, including limited alternative investment opportunities in China’s tightly controlled and skewed financial system and higher returns offered by shadow banks through predatory “wealth management” financial products, a significant part of the savings of Chinese households are invested in real estate in China. Real estate sector activity accounts for around 29 percent of China’s GDP. In fact, China’s real estate market has been called the most important sector in the world economy. Valued at about $55 trillion, it is now twice the size of its US equivalent and four times larger than China’s GDP. 

Any significant changes in China’s real estate sector will affect not only real estate companies, millions of Chinese households, investors, and banks, but will also have a direct impact on the resources of local governments, which have long relied on land bank monetisation to fund not only investments but also budget expenditure for its social sector commitments like pensions, hospitals, and education to citizens.

Unlike the GFC and how it played out in Western economies, Chinese markets are nominal, and the Chinese Communist Party effectively operates a unitary, nation-size balance sheet.  Spectacular defaults and uncontrolled bankruptcies like Lehman are therefore unlikely as China corrects its course and undertakes deep debt restructuring, as it has in the past. And from which it will emerge. Except that the challenges are more difficult this time, the alternatives are fewer, and the environment, both internal and external, is less conducive. It will be a long, painful, and complicated road to resolution.

Sandeep Hasurkar is an ex-investment banker and author of `Never Too Big To Fail: The Collapse of IL&FS’. Views are personal, and do not represent the stand of this publication.