The week of Monday, August 14: China’s slump, climate, taxation, Argentina, and much, much more.
The week of Monday, August 14: China’s slump, climate, taxation, Argentina, and much, much more.
China’s Evergrande, the world’s most heavily indebted property company, has filed for Chapter 15 bankruptcy (a mechanism used in certain cross-border cases) in New York, a step designed to help its restructuring.
The Wall Street Journal’s Alexander Saeedy explains:
China Evergrande Group is seeking a U.S. court’s approval to restructure more than $19 billion in the company’s offshore debts, as the embattled property developer pushes forward on plans to complete one of the world’s largest and most complex debt restructurings…
[The] chapter 15 bankruptcy in New York…would recognize and give effect to the offshore proceedings for three Evergrande companies based in Hong Kong, the British Virgin Islands, and the Cayman Islands, respectively.
Court approval of the debt restructuring would make the deal legally binding in the U.S. and would close the door to any disputes against the plan that could be brought in America. Many of China Evergrande’s $19 billion in foreign bonds are governed by U.S. law.
Evergrande rose to become China’s second largest property developer, but it had built that position on the back of massive borrowing. Evergrande’s outstanding debt of $340 billion is, as Dominic Pino noted on Thursday, equivalent to about two percent of China’s GDP. Against that the company has assets supposedly worth $256 billion, although in situations such as this, assets have a way of being worth rather less than advertised.
Not content with wild borrowing, Evergrande added some wild diversification to the mix. It has just sold a 28 percent stake in its electric vehicle (EV) manufacturer, Evergrande NEV as part of its effort to raise cash. That a heavily indebted property developer should have owned an EV maker in the first place was yet another warning sign, but there were plenty of others. Evergrande also owned (or owns), among other unexpected assets, fifteen “Fairyland” parks, aimed, Business Insider’s Matthew Loh reported back in 2021, “at promoting Chinese culture by using next-gen tech.” Loh links to a Wall Street Journal piece (also from 2021) in which the writers (Yoko Kobota and Liyan Qi) report that the theme parks involved “$100 billion in total investment, according to Journal calculations based on local-government numbers.” $100 billion! Perhaps inevitably Evergrande owned a soccer team. No less inevitable were the increasingly desperate measures taken by the company to keep afloat.
The Financial Times (September 20, 2021):
Crisis-hit Chinese property developer Evergrande used billions of dollars raised by selling wealth management products to retail investors to plug funding gaps and even to pay back other wealth management investors, according to executives of the company in Shenzhen.
Catastrophe had been on the way for a while, but what triggered the crisis at Evergrande was Beijing’s belated introduction in August 2020 of regulations — the Three Red Lines — designed to force a partial deleveraging of the hugely over-borrowed real estate sector (Evergrande was by no means the only culprit). Its other objective was to take some of the air out of a housing bubble which was not only intrinsically dangerous, but, by leaving too many people priced out of the market, risked creating social tension.
Evergrande defaulted on its dollar bonds in December 2021. It has not been the only property company to do so.
Writing in the Washington Post at the beginning of this year, Bloomberg’s Enda Curran looked back at how companies such as Evergrande had ended up in the position they had:
In 1998, China created a nationwide housing market after tightly restricting private sales for decades. Back then, only a third of its people lived in towns and cities. That’s risen to two-thirds, with the urban population expanding by 480 million. The exodus from the countryside represented a vast commercial opportunity for construction firms and developers. Money flooded into real estate as the emerging middle class leapt upon what was one of the few safe investments available, pushing home prices up sixfold over 15 years. Local and regional authorities, which rely on sales of public land for a chunk of their revenue, encouraged the development boom. This also helped the central government to meet its annual targets for economic growth, which often hit double digits.
The property craze was also powered by debt as builders rushed to satisfy expected future demand. The boom encouraged speculative buying, with new homes pre-sold by developers who turned increasingly to foreign investors for funds. Annual sales of dollar-denominated offshore bonds surged to $64.7 billion in 2020 from $675 million in 2009. Opaque liabilities made it hard to assess credit risks. The speculation led to astronomical prices, with homes in boom cities such as Shenzhen becoming less affordable relative to local incomes than London or New York.
Overall, housing prices are estimated to have increased six-fold over the fifteen years leading up to 2022.
But having acted too slowly, Beijing then (arguably) did too much too quickly. While the Red Lines were somewhat more flexible than their name might suggest (restrictions on further borrowing depended on how many Red Lines were crossed), the crackdown on borrowing created a liquidity squeeze (made worse by the Covid slowdown) that left many over-borrowed property companies with no chance of finding a way out, should one have ever existed. Adding to the misery has been the way that some property companies used preconstruction sales to finance current operations (that’s not unusual in this sector, but in China it was much less strictly regulated than elsewhere). Faltering new sales have meant that, in some instances, there has been no money to complete properties that had already been paid for in whole or in part.
Back to Curran:
Across China, millions of square feet of unfinished apartments have been left to gather dust. Economists at Nomura International HK Ltd. estimated in mid-July that Chinese developers had delivered only about 60% of the homes they pre-sold from 2013 to 2020. (Buyer protections commonly used abroad, such as escrow accounts and installment payments, have tended to be weak.) By mid-2022, wildcat mortgage boycotts by owners of unfinished homes had spread to over 300 housing projects in about 90 cities. The protests later subsided. But with more than 70% of urban China’s wealth stored in housing in some parts of the country, many livelihoods are at stake and the threat of popular unrest lingers.
Ambrose Evans Pritchard, writing in the Daily Telegraph:
China’s $60 trillion property edifice is by far the largest asset class in the world.
It accounts for half of the world’s entire property sales, an astonishing figure given that China’s workforce is already contracting and net migration from the countryside has stopped.
The developers have debts of $5 trillion. By comparison, this is six times greater than America’s $800bn subprime property debt on the eve of the Lehman crisis.
In January, Beijing moved away from the Three Red Lines.
The Financial Times (January 11, 2023):
Beijing is now easing constraints on developer credit and even rolling out potential loans following a severe downturn that saw housing and land sales collapse, threatening a major pillar of an economy already ailing from coronavirus lockdowns.
Officials at multiple state-owned banks said they had effectively shelved the leverage curbs — whose three red lines refer to targets for debt, equity and assets for individual companies — in their assessment of borrowers. Late last year, state-owned banks announced hundreds of billions of dollars of potential new lending to property developers.
The authors of that report wondered whether this relaxation would be too late for Evergrande. Now we know.
The next domino may be Country Garden (China’s largest house builder), which, as Dominic Pino noted, is teetering on the brink of default.
Country Garden is renowned for its huge projects in China’s second- and third-tier cities. The firm’s debts are smaller than those of Evergrande, a big, heavily indebted company that defaulted in 2021. But at the start of the year Country Garden was building four times more homes than Evergrande was before it defaulted. At the rate Country Garden was delivering them in the first half of 2022, at least 144,000 buyers will not receive homes they were promised by the end of this year. A sudden debt meltdown at the firm would leave even more families out in the cold.
That won’t delight a regime forever worried about its grip on power.
The Economist:
Until recently, most thought that Country Garden was immune to default. Since late last year officials have sought to calm the market by drawing up an informal list of healthy developers, including Country Garden, which investors could feel comfortable funding and Chinese citizens could trust.
The calculation has changed in recent days. Country Garden’s issue is not one of over-leverage in the style of Evergrande. Instead, it is a victim of a loss of confidence among regular folk—a sign the government is losing control. After a short rebound following the lifting of covid-19 controls, the property crisis has intensified. Prices are dropping. Sales among the 100 biggest developers fell by 33% in July compared with a year earlier. Country Garden’s tumbled by 60%. The firm’s decline is forcing market-watchers to confront their deepest fears about the property sector.
One is that property supply chains collapse. Over the past three years suppliers of materials, along with the engineering and construction firms that build homes, have often not been paid on time by developers. But so far this backbone of the sector has withstood the pressure. That could change as developers grow shorter on funds. The decline in payments to suppliers is already noticeable. Between 2021 and 2022, Country Garden’s transfers to such firms fell from 285bn yuan ($44bn) to 192bn yuan, according to S&P Global, a rating agency. They are all but certain to fall further this year. Although the biggest contracting firms will probably survive with help from the government, it is not hard to imagine widespread collapses among the myriad smaller engineering and materials companies that do the work on the ground.
The Economist’s writers, singling out Sino-Ocean, also speculate that the trouble could spread to state-owned builders, up to now seen as safe. They also suggest that Country Garden has the money ($22.5 million) to pay the debt that fell due this month by the end of a grace period that expires in early September, but that it is signaling a desire to eventually restructure as a way of putting pressure on the government to step in and help.
Pino also noted concerns about wobbles in the shadow-banking sector, which is, inevitably, heavily exposed to property. Trouble there would be another potent source of financial contagion. And then there is the matter of massive and often murky local government debt. Coping with that burden won’t be made any easier by the collapse in land sales, which (as mentioned by Enda Curran above) have been a useful source of revenue for local governments. One way or another, real estate may, on some estimates, have accounted for nearly 40 percent of local government income in recent years.
As Pino relates, the full extent of local government indebtedness is hard to quantify, but as Marc Joffe noted in an article for Capital Matters, the IMF estimates that, after adding in off balance sheet items, it stands at around 53 percent of GDP, and there are additional liabilities on top of that (at least one estimate suggests that the real number is running into the 70s). The central government is again sending out inspectors to work out how much that debt really amounts to, prior, presumably, to cobbling together a solution that avoids the social, political and economic risks of local governments running out of money. According to the finance ministry their income fell by slightly more than a fifth in the first half of the year, a number that, given the Chinese state’s way with statistics, may well be an understatement.
The ratio of China’s central government debt to GDP is (according to the IMF) 77 percent. Total Chinese debt (households, companies and the government) has been estimated by JPMorgan Chase at 282 percent, somewhat more than the average for developed economies (256 percent). The figure for the U.S. is 257 percent. But what distinguishes China is how rapidly this debt has grown. According to the New York Times’ Keith Bradsher, it has more than doubled when compared with the economy in the past fifteen years. A rapid accumulation of debt is a red flag under many circumstances. To be sure, there can be in a jump in the “good” debt that helps finance the growth of a rapidly developing market, but it’s not unusual for that to be accompanied by a surge in “unproductive” debt, something that China now has in enormous amounts.
Under the circumstances, it’s not surprising that Xi has been signaling to the private sector that the government will be handling it with a lighter touch than in the recent past. It would be foolish to believe him. In particular, foreign investors, who can easily take their money elsewhere, have watched the regime’s tightening grip and, finally, it seems, prompted in part surely by China’s slowdown, have been coming to a sensible conclusion. In the second quarter (Bloomberg reports) foreign investment in China fell to its lowest level in twenty-five years. Growing worries about a possible economic crisis are not going to help Xi’s efforts to lure them back, which is no bad thing. The West needs to do much more to loosen its unhealthily close trading relationship with China, and if the profits to be made in that market fall, so will the incentive to do business there. Falling rates of foreign investment will also hit China’s ability to, uh, innovate. As economist Kenneth Rogoff notes, “foreign companies build plants and they copy them. That has been the Chinese model. The slowdown in FDI [foreign direct investment] will also imply a slowdown in innovation.” Good.
How deep a crisis lies ahead is impossible to say. The stock market is at a nine month low and the yuan has come under pressure. The latter may mean trouble for those businesses — many of them in the U.S. and Europe — that compete with Chinese imports, as well as for those already struggling to sell their products into China’s sluggish economy.
Beijing now faces the challenge of reversing the deepening gloom, a challenge made all the more difficult by the interconnectedness of its woes. However, unlike its democratic counterparts, the regime has tools at its disposal that enable it to, so to speak, insist on calm. And it could always throw cash at the problem. Bloomberg reports that one prominent adviser to the Central Bank has called for direct payments of $551 billion to households to stimulate demand, an approach that an unenthusiastic Communist Party leadership has in the past denounced as “welfarism.” On the other hand, if writing large checks, whether to its citizens, its local governments or its embattled companies, or to all of them, is what it takes to maintain social peace, that’s what a Beijing leadership eager to hang onto their jobs will do. But even if such moves defuse the crisis for now, returning to the growth rates, however unsoundly based they may have been, of the last decade or so is going to be tough. Morgan Stanley is forecasting that China’s economy will grow by 4.7 percent this year. We’ll see. Capital Economics is predicting that (real) trend growth in the later 2020s will be 2.8 percent.
All emerging markets have smash-ups along the way, and China is still, whatever some of its boosters may claim, an emerging market. Nevertheless, the Daily Telegraph’s Ambrose Evans Pritchard observes that China is “no longer on the same trajectory as Japan, Taiwan, and Korea at a comparable point of development.” There’s a lesson there.
Adam Smith 300
All year, the Adam Smith 300 essay series from National Review Capital Matters has been celebrating the tercentenary of the birth of the father of modern economics. Each month, a new essay has reflected on Smith’s legacy from a different perspective.
Now, we’d like you to join us in person to hear from some of the leading voices on Smith’s thought. January author Dan Klein of George Mason University and October author Anne Bradley of TFAS will talk with NRI Rhodes fellow and Capital Matters contributor Dominic Pino about Smith’s continued relevance today. May author Samuel Gregg of AIER will give a keynote address, followed by a conversation with NRI trustee David Bahnsen.
Whether you’re already a Smith expert or only loosely acquainted with his works, this event is a unique opportunity to celebrate the life of the author of The Theory of Moral Sentiments and The Wealth of Nations. More than a mere symbol of free markets, Smith possessed deep insight into human interaction, and his analysis of what he called the “system of natural liberty” still holds up today. With free markets under attack, it’s important to return to intellectual foundations, and remember why William F. Buckley Jr. wrote in the mission statement for National Review that “the competitive price system is indispensable to liberty and material progress.”
If you are interested in attending, more details here.
The Capital Record
We released the latest of our series of podcasts, the Capital Record. Follow the link to see how to subscribe (it’s free!). The Capital Record, which appears weekly, is designed to make use of another medium to deliver Capital Matters’ defense of free markets. Financier and National Review Institute trustee, David L. Bahnsen hosts discussions on economics and finance in this National Review Capital Matters podcast, sponsored by the National Review Institute. Episodes feature interviews with the nation’s top business leaders, entrepreneurs, investment professionals, and financial commentators.
In the 132nd episode, David takes on Gretchen Morgenson’s horrific new book, These Are the Plunderers, an embarrassing assault on private equity (though now published thanks to private equity, hysterically enough). Understanding the innovation of private equity and its net benefit to society is facilitated by some general understanding of financial vocabulary, a deeper appreciation for private property and the rule of law, and, of course, the adoption of first principles that embrace risk and always ask the question, “Compared to what?”
No Free Lunch
Earlier this year, David Bahnsen launched a new six-part digital video series, No Free Lunch, here online at National Review. In it, we bring the debate over free markets back to “first things” — emphatically arguing that only by beginning our study of economics with the human person can we obtain a properly ordered vision for a market economy…
The series began with a discussion with Fr. Robert Sirico of the Acton Institute. Later guests include Larry Kudlow, Dennis Prager, Dr. Hunter Baker, Ryan Anderson, Pastor Doug Wilson, and Senator Ted Cruz.
Yes, the six-part series now has seven parts.
Enjoy.
The Capital Matters week that was . . .
Taxation
Aharon Friedman & Joshua Rauh:
Sovereignty means respecting the right of each country to make its own rules. However, the Biden administration, as reflected in a recent article by former Treasury officials Natasha Sarin and Kimberly Clausing, in defending its efforts to enact a Global Tax Code advances a novel explanation of sovereignty and the Constitution: that the agreement negotiated by the administration expands American sovereignty by giving Congress the freedom to choose higher tax rates.
The fact the Biden administration feels it necessary to craft a formal agreement with the rest of the world to impose minimum-tax rates proves that not all countries prefer higher taxes. Forcing other countries to enact one’s own policy preferences in order to make it easier to enact those policies at home is not sovereignty but imperialism…
The Internal Revenue Service (IRS) announced in late July that it will stop its practice of making unannounced personal visits to the homes and businesses of delinquent citizens to collect taxes. The change focuses only on the practice of Revenue Officers (ROs) making such calls, as explained in more detail below, and it will not affect other agents of the IRS. The sole job of an RO is to collect delinquent taxes, and in some cases to secure unfiled tax returns…
The Economy
Here’s Kevin Hassett on Fox discussing inflation: “It’s going to look like the seventies.” Braver readers might want to click on the link to see what he meant by that.
Population
You’d think that, after the Industrial Revolution melted the Iron Law of Wages, 21st-century intellectuals wouldn’t issue calls for population control. Think again. Apparently unaware of Paul Ehrlich’s humiliation after population growth failed to precipitate global famine, Jane Goodall decided to torpedo her own reputation in a similarly Malthusian manner…
The Debt
Speaking of the small community of budget scholars trying to draw attention to our fiscal problem, Cato Institute’s Romina Boccia has been writing about a well-designed commission, modeled after the Base Realignment and Closure Commission (BRAC), that could help with the political inability to reform Social Security, Medicare, and Medicaid. I don’t need to remind the Corner’s readers that these three programs are the drivers of our future debt. Addressing their insolvency is key to putting the U.S. on a sustainable fiscal path.
Adam Smith
Amidst the celebrations of Adam Smith’s 300th birthday, an examination of Smith’s attitude on interest regulation offers insight into his approach to public policy, especially for those, including the present writer, who have argued that understanding the Calvinist and Newtonian natural-theological backgrounds to his thought are important. Interest-rate restrictions are one of many exceptions to his generally free-market approach. Other exceptions include limited Church privileges, the Navigation Acts (which restricted trade to British ships), and limited arguments for tariffs on foreign trade. When considering these exceptions, we need to remember that 18th-century Britain was a very different environment from contemporary America and that Smith had a keen awareness of which reforms were politically feasible.
State Intervention
To say that the adoption of a less naive approach toward trading with China is the largest example of a revived belief in the power of government is a stretch. That dubious honor belongs to the West’s climate policy, an exercise in central planning on a gigantic scale. And (surprise, surprise) it will be a disaster for everybody other than the central planners, the rent-seekers who feed off them, and the West’s geopolitical adversaries. But that’s a discussion for another time…
Argentina
On Monday, Argentines woke up to shocking news: Javier Milei, a libertarian presidential candidate who, among other promises, has pledged to dollarize the country’s faltering economy, won 30 percent of the total vote and surpassed all other candidates in a key primary held before the general election in October. That morning, markets opened in panic mode and local ADRs saw declines of up to 14 percent, before making a partial comeback. On the same day, the government devalued the national currency by 22 percent, and in just two days, the unofficial exchange rate rose from 600 to 780 pesos per dollar.
So, what happened? How is it that the victory of a pro-market candidate caused markets to fall?
There will a lot to say over the next few months about what’s going on in Argentina, but it’s a sign of the depth of the crisis that the country is now facing that in the first round of voting for this year’s presidential election, a self-described libertarian, Javier Milei, came top of the poll, with a little over 30 percent of the vote, far better than the roughly 20 percent that was expected…
Libertarianism has not, shall we say, been a major part of Argentina’s political tradition…
Climate
I talked about this on The Editors podcast on Tuesday, and reporting since then continues to point toward my conclusion: Focusing on climate change at the expense of every other environmental issue is bad for the environment.
This is in the context of the wildfires in Hawaii, which are the deadliest wildfires in the U.S. in over 100 years. Based on media coverage of wildfires, you would likely think that they just happen as a result of hot weather, but that’s not how they work at all. About 85 percent of wildfires are human-caused — not by carbon emissions raising the planet’s temperature, but by failing to take adequate precautions around fire sources.
The world is careening toward a climate crisis, and by that we do not mean nasty weather or impending human extinction. The real challenge lies in adapting to a changing climate without undermining an already stressed global order, not to mention imperiling democracy.
The West’s current policy agenda, based almost entirely on the promotion of “renewable” energy, seems likely to produce only marginal gains while (according to McKinsey) costing $6 trillion annually for the next 30 years, equal to a quarter taxes collected and half of all annual profits worldwide. The question is not so much how we can “fight” climate change but how to do so in a way that does not create other, arguably more disruptive, changes in society and the economy…
China
NR’s editorial this morning was on China’s economic woes. Right on cue, China Evergrande Group, formerly China’s largest property developer, filed for bankruptcy today.
The company defaulted on its debts in 2021, and its prospects haven’t improved much since then. After not releasing financial results for two years, last month it announced an $81 billion loss. The filing also said its debts totaled $340 billion, equal to about 2 percent of China’s GDP, against $256 billion in assets. Its shares have been suspended from trading since March of last year. Creditors seized one of Evergrande’s largest assets, a $1.6 billion tower in Hong Kong, last year. They still haven’t found a buyer, and market prices suggest that when they do, they could take a loss of $1 billion…
Front page of the Wall Street Journal today: “Investors Fear China’s ‘Lehman Moment’ Is Looming.”
It’s about the Chinese firm Zhongzhi Enterprise Group, which I wrote about in the Morning Jolt on Monday. It’s one of China’s largest “trusts,” which are shadow banks involved in real estate, commodities, equities, and bonds. Several Zhongzhi investment products have been missing payments in recent weeks, spurring investor concern that the firm might collapse.
As always with China, it’s a bit tricky to figure out exactly what’s going on…
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