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Evergrand continues to haunt the Chinese market

 It has been more than six months since Evergrand defaulted on $300 billion in bonds.  Since then things in China have not improved.  The pandemic brought a massive slowdown to the construction sector and for the past year those who bought "planned" real estate projects have largely stopped paying their advance payments (these are often termed mortgage payments in China, but it's really a secured loan on a construction project).  

Over the past 10 years, Beijing has been aggressively supporting the construction sector with cheap loans and debt forgiveness.  It has been widely reported that the margin return on capital has been below 1 for at least a decade -- every $100 dollar invested only generates $70 of economic growth, and the rest is wasted, compared to 30 years ago when every $100 dollar invested generated nearly $300 in economic growth.

Over the past 40 years, local governments have relied on real estate taxes to grow their operations.  These are not recurrent revenues, but "one-offs" that arise when a new project is being built.  100s of local authorities have borrowed aggressively against "future revenues" but these are now failing to materialize, partly because the construction boom has stopped and partly because lenders will not advance new funds because of directives from the Bank of China.  These local governments are broke and are now aggressively cutting services, creating additional economic uncertainty.

Nearly 80% of all Chinese wealth is in real estate (directly or indirectly) and so a collapse of the real estate market in China is UNTHINKABLE (in the US13% of all wealth is in real estate, double that level in Europe).  The question is, what will Beijing do?  They really have no option but to take some form of action to secure the real estate market.  The Chinese government is acutely aware of the problem, and far from sticking their collective heads in the sand, they have been looking for solutions.  There was a strong push a few years ago to "export their way out of trouble" but that road is no longer feasible, first China's economy is too large, and its own geopolitical needs interfere with that strategy.  Western companies that had for the past 20 years relied on off-shoring to reduce costs, are now on-shoring to reduce the risk of supply chain disruption. Everyone has seen how Tesla has a massive economic advantage in having vertically integrated its automobile manufacturing.

China has for the past several years contemplated territorial wars as a way of distracting its populations, its aggressive activities in the South China sea were the precursor event, but now, after the massive failure of Russia to quickly and painlessly take control of Ukraine, a small country with a tiny army, that shares a land border with Russia  The Chinese government idea of invading Taiwan must be on the back burner, the logistics of invading an island is complex, and although China has a massive army, unlike Taiwan it is not a professional one, but one based on conscription.  Finally, China's aggressive activities in the South China sea has been vigorously met head-on by Vietnam, the Philippines and Japan and there too its ambitions have been thwarted.

The fear has to be that without reasonable exit strategies, unreasonable ones will be contemplated.  The Chinese President's position is at risk, the decision process here is directly from Xi Jinping office.  Yes he's been elected for life (something Trump would really really like for himself) but that too could end suddenly, it would not be the first time that a leader "dies from a sudden illness".  

China's leaders need to find solutions; debt restructuring, forgiveness or even transformation into equity has to be contemplated and Evergrand is the case study for how things will proceed across this highly indebted sector.  However, the numbers are huge (trillions), the impact on the financial sector is unpredictable, and the knock-on effect on other parts of the economy is probably impossible to quantify.  President Xi has a massive challenge before him, and his administration.  However, even if the problems of Evergrand are resolved, the eventual solution will result in losses for investors, management will be replaced, fraud will be found, but more importantly, confidence in the real estate market, China's largest source of wealth, will be at the very least shaken and at the very worse destroyed.  The government will need to be sensitive, sensible and lucky!

That's a tall order


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