Kenneth Rogoff, the Harvard economist who has spent years studying financial crises and debt bubble, sees plenty of reasons to worry about the fallout from the debt travails of
China Evergrande Group
one of the country’s largest property developers.
Evergrande on Wednesday said its flagship business would pay the interest on an onshore bond that is due but questions persist on whether the company pays the coupon on its dollar-denominated debt due Thursday. Evergrande has accumulated more than $300 billion in debt after years of aggressive debt-financed expansion across the country.
The company is feeling the pain of President Xi Jinping’s regulatory drive to address inequality and financial risks in the system by dealing with the long-simmering debt problem in its property market, which has grown aggressively thanks to easy access to capital. The latest reckoning comes as China’s economy is already slowing amid efforts to contain the latest Covid outbreaks, the one-off boost in exports last year from pandemic disruptions wanes and businesses face a regulatory crackdown and adjust to a more state-controlled approach to capitalism.
The Evergrande crisis may not trigger a Lehman Brothers-type financial crisis, but Rogoff has been warning about the dangers of China’s reliance on its property market for years. Barron’s caught up with the economist to discuss whether Evergrande can become a systemic crisis, the problems with China’s reliance on its property sector and the risks to its economy. Here is a condensed, edited version of the conversation.
Barron’s: How worried should investors be about contagion?
Kenneth Rogoff: There is a view that they have the capacity to act very quickly and cauterize financial problems, even big ones.
There are strength and weaknesses to China’s system. One strength: The government can process bankruptcy very fast and very efficiently, with no problem with courts and they have deep pockets. A lot of why Western debt crises are so problematic is because it takes a long time to resolve them. This has been untested in large cases but there is a view [China ] could do it better. They had a lot of bankruptcies in 1999 and did it fairly effectively. It’s still a financial crisis, but it wouldn’t balloon out in the system.
What are the weaknesses that concern you?
They have become very dependent on housing for growth. [Real estate] has been the target for stimulus after the global financial crisis. Real estate products and services account for 29% of GDP. Ireland and Spain may have touched those levels before the [global financial crisis]; the U.S. at the peak was 15%. And they have already constructed a lot of housing. While they may have per capita income of roughly a quarter of France or Germany, the per capita housing is about the same.
So they can’t build their way out of this crisis?
In the third and fourth-tier cities, they are trying to keep the housing engine going but are running out of steam. Even [if real estate] contracts 20% that is a lot of [unemployed construction workers] to reallocate. Their goal was to gradually have the property market [as a share of the economy] come down from 29% to 15% or less. But if the economy is slowing down, which it is, then that puts pressure on prices and amplifies the mechanism.
What about the view they have ample reserves and lots of tools to manage it?
They have a lot of tools. But the problem isn’t just a single lender; it’s the whole Chinese growth model that is so dependent on producing real estate. They have known this for a while. Let’s say the economy over the next 12 months slows from 6% without the housing amplification to 4%. Housing could take it down another 1 to 2 [percentage points]. That is an economy growing at 2%; that is painful!
What does China need to do to manage this?
The world has learned to respect the competence of the Chinese in managing their economy. But they have somewhat painted themselves into a corner—and it comes at a bad time. They have been trying to tackle it but can’t put it off any longer. They can’t get around the fact that they have to shrink the size of real estate, construction and services. If prices are weak and the economy is weak, a gradual phase down may be hard to engineer.
It isn’t a Lehman moment in that they get a financial crisis, but it could be just as painful if you look at the longer-term growth. They could provide other types of stimulus, but it isn’t that easy for an economy to shift into other things.
What’s the global impact?
It’s very difficult for commodities exporters like Australia and countries that export heavily to China, including Germany. There is also the question of whether this is something that has a psychological effect that is deeper. If there was a significant slowdown, would it undermine one of the certainties investors around the world have on how the global economy is progressing? It’s difficult to know if this could spin out. It’s clear stocks, housing markets and crypto markets are very high. They have priced in the low rates but maybe not so much low growth. We’ll see.
Write to Reshma Kapadia at [email protected]