Interview

«China Is Probably the Most Overvalued Property Market in the World. Evergrande is a Symptom of That»

Beijing-based economist Michael Pettis sees the looming collapse of real estate developer Evergrande as a signal that China needs to fundamentally shift away from its investment-based growth model.

Mark Dittli
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Few Western observers know the Chinese economic and financial system as well as Michael Pettis. The American has lived in Beijing for twenty years and teaches financial theory at the renowned Guanghua School of Management at Peking University.

In his view, the crisis of the property developer Evergrande confirms a thesis he has been advocating for years: China's economic growth was based far too heavily on investment. «There is a lot of fictional growth at play in China, overinvestment in all kinds of construction projects has inflated growth for years», he says.

Pettis does not expect a financial crisis; nevertheless, he says, China's economy is facing major upheavals that will affect the rest of the world. In an in-depth conversation with The Market NZZ, he explains what's at stake.

«Nearly a quarter of all apartments in China are empty»: Michael Pettis

«Nearly a quarter of all apartments in China are empty»: Michael Pettis

How dangerous is the looming bankruptcy of Evergrande for China’s financial system?

We have to see Evergrande not as one major event, but as one of a series of events that express the unsustainability of China’s growth model. I would argue that the latest series began in May 2019 with the government intervention in Baoshang Bank. Since then we’ve had a number of interventions, the most important of them being Huarong, where the regulators had Citic take over the obligations of Huarong. Another important crisis company was HNA. And now the rumors are very strong that Ping An would be the next one, which would be much bigger than Evergrande.

Within that sequence, what’s the importance of Evergrande?

Its importance, besides the fact that Evergrande is the most indebted property developer in the world, is that this company represents the excesses in the property sector. Most estimates put the contribution of the property sector to China’s GDP at between 25 and 30%, that’s two to three times what it is in other countries. Property investment alone is about 13 to 14% of GDP. In the US, it’s about 5%. The most worrying statistic of all is that homes represent about 80% of household wealth in China. In Japan, during the property bubble of the 1980s, it peaked at 65%. In most countries, it’s about 30 to 40%.

What does that tell us?

It tells us a couple of things. One, that property prices are very high in China; it’s probably the most overvalued property market in the world. Two, more importantly, it tells us that if property prices go down, there will be a significant wealth effect on households. If your wealth goes down, the way you react is that you spend less and save more.

Just to be clear: Are we talking about a speculative bubble here?

Yes. Because economically, it’s very hard to justify an economy that is two thirds of the size of the US, with having property that is worth twice as much as US property is worth. It’s not as if US property is cheap. It’s probably too expensive in the US too, which means it’s incredibly expensive in China. The amount of income it takes to buy an ordinary apartment in China is several times what it would take even in Switzerland.

You recently tweeted that a speculative bubble never corrects by going sideways. It has to keep growing, or it will collapse.

When you are in a fundamentally sound market, you buy an asset because it has a value to you, and that value is greater than the price you pay. But when you are in a speculative market, you buy an asset because you think its price will be higher tomorrow. In China, the market is extremely speculative. I have students that are 19 or 20 years old, whose parents buy them apartments, because by the time these students are 25, their parents fear they won’t be able to afford an apartment. That is the essence of speculative buying: You’re only buying because you know prices are going up.

What will happen when they stop going up?

When prices no longer go up, two things happen: One, a lot of the demand disappears, because the only reason people bought was because of ever rising prices. Two, many people have borrowed money to buy apartments, which they are not renting out, because rental yields are very low. Don’t forget: nearly a quarter of all apartments in China are empty. So when prices are not going up anymore, these people are losing money on their apartment. What would you do in that situation? You would probably sell it. So you’ll have less buying and more selling, and of course that drives prices down. You know, I was a bond trader before I moved to China, and that was one of my fundamental learnings: Once the market enters a speculative stage, it either goes up or it goes down, but it does not go sideways.

Baoshang, Huarong, HNA: These bankruptcies were all digested rather smoothly within China’s financial system, without triggering a crisis. Is that a blueprint the regulators will be able to repeat with Evergrande?

It’s not so much that the system was able to digest them, it’s that their debt was absorbed into larger balance sheets. As the regulators reduced the risk of the individual borrower, they increased the riskiness of the entire system. One of the bad consequences of rescuing these companies is that the government reinforced the idea that you don’t have to worry about lending money to anybody important. Because if anybody important gets into trouble, you get bailed out. Hence why should you care? This is the definition of moral hazard.

With Evergrande, the government seems to be willing to teach the market a lesson. What do you make of that?

First, remember that what we see with Evergrande is the result of the attempt by the government to reduce the economy’s overreliance on debt. A year ago, they introduced the so-called three red lines, which specifically aimed at slowing the debt-fuelled property market. Evergrande is a victim of that policy. What they want to do with Evergrande is teach the market not to trust in moral hazard. Of course, they have said this before. But every time the going got tough, the government backed away and things got back to normal. With Evergrande it looks like they are a little bit more serious. The point is that the cost of letting things fall is quite high. The cost of not letting things fall is also quite high, but typically these costs only occur in the future, while the former occur today. So in the end it’s a question of when you are willing to take the pain.

Seeing that other property developers also are in distress: Is it fair to say that Evergrande is a symptom of a wider crisis?

Yes, Evergrande is clearly a symptom of a systemic problem for China. The whole property sector is overleveraged and overly speculative. The problem, of course, is that it also represents a substantial share of Chinese growth to date.

Do you see a genuine willingness by the Party leadership to accept short term pain now in order to get the economy on a more even footing?

My friend Logan Wright at Rhodium Group said something that I thought was a very useful way of framing it. He said Beijing has a coherent understanding of what is wrong with its current economic model. What they don’t have is a coherent understanding of the alternative.

What do you mean by that?

The big problem in China is that its economy is over-reliant on investment. This wasn’t a problem 20 or 30 years ago, because China was hugely underinvested back then. It became a problem once China began overinvesting, and its reliance on continued investment meant that debt exploded relative to debt capacity, for which GDP is a rough proxy. This overinvestment in the real estate market and in all kinds of infrastructure projects artificially inflated GDP growth in the past years. Many of these projects are of little economic use, so the debt that is associated with them is unsustainable. The Party leadership knows this, they know they have to bring down this kind of bad investment. But if you bring down bad investment, you have to replace it with something else, or else economic growth will stop.

What can they replace it with?

In theory, you could replace bad investment with good, economically viable investment. But this is easier said than done once the country is already full of world-class infrastructure and abundant housing. So what else could they do? They could increase their external growth, through a rising trade surplus. If China was a small country like Singapore, it could do that and nobody would notice. But the second largest economy in the world simply can’t do that, because the world already has difficulties absorbing China’s surpluses. They would have to double their current account surplus next year and grow it by 2 to 3% of GDP every year. The world can’t accept that. The last thing they could do if they want to keep growth rates high and want to bring down bad investment, is replacing it with domestic consumption.

The Party leadership has been talking about that for years, haven’t they?

Yes, they have been talking about this rebalancing since 2007. The problem with consumption in China is that it’s very low, the lowest in history in relation to GDP. And that’s because the households' share of GDP is very low, the lowest in history. So if they really want to fix that, they have to increase the households' share of GDP. That would mean a massive redistribution of income. So, I have given you four alternative paths: One, keep on doing what they are doing in terms of bad investment, which is unsustainable. Two, replace bad investment with good investment, which is hard to do. Three, replace bad investment with a rising trade surplus, which the world can’t accept. Four, replace bad investment with consumption, which requires a massive redistribution of income.

Couldn’t they just choose to get rid of bad investment without replacing it?

Absolutely. But if they did that, growth rates would drop significantly, probably to below 2 to 3%. This has happened to every country in history which has followed this development model. Growth dropped significantly, and it dropped much more than anybody expected.

Even General Secretary Xi Jinping, in an essay in Qiushi, has talked about getting rid of fictional growth and concentrating on genuine growth.

Yes, and I thought it was very important that he acknowledged that.

So when China talks about an official GDP growth rate of 6%, we know there is a fictional element to it. What is its genuine economic growth rate?

In most years, I would say genuine growth is probably 2 to 3%, not more. In other words, there is an awful lot of fictional growth. Mind you, I don’t mean fictional as in that they’re lying. Many people say that they are lying about their data. They may be, but I don’t think they are. But for me that’s not the issue. The issue is that if you build a bridge which is widely used by everybody, and then you build another bridge that nobody uses, clearly the first bridge is economically valuable, while the second bridge is worthless. The first bridge would contribute genuine growth, while the second bridge would contribute fictional growth. But during construction, both boost GDP in exactly the same way. And I would say in China it’s been more and more of the second type of growth in the past years.

So the Party leadership knows that their development model is not sustainable. But all the alternatives are either impossible or painful in the short term. Aren’t political leaders always tempted to keep the show going and push the old model for a little longer?

Yes, that’s always the political problem. You can say it’s the same in the US with the Fed’s monetary policy. We all know that Western central banks are pumping up the value of assets too much. But it allows us to avoid short term pain, while we can ignore the long term costs. In China, remember that next year we have the very important 20th National Party Congress. This means that as long as the Party leadership thinks they have the ability to prevent a slowdown, they will prevent a slowdown. But we know what the economist Herb Stein once said: If something is unsustainable, eventually it will stop. That’s true of any unsustainable process. Unless you believe that China has an infinite debt capacity, you know that this growth model must stop. And it will stop. It can stop in the form of a crisis, or it can stop in the form of government intervention to restructure the economy.

Which way is better?

In some ways, a crisis is worse, and it definitely inflicts more pain in the short term. But in the long run, purely economically speaking, a crisis is probably better than a Japanese-style, decades-long grinding away of the problem.

What should the Party leadership do, in your opinion?

The way for China to get out of this situation is by redistributing income to ordinary households and thereby increasing consumption. The party leadership recognizes that this is a distribution problem. In May of this year, Xi Jinping revived this phrase, Common Prosperity, which is an old phrase from Mao’s times in the 1950s, and he gave it a new meaning. They are pushing what’s called tertiary distribution, which means donations, by forcing the rich and businesses with excess profits to donate money to ordinary Chinese.

Will that do the trick?

At best, it will help at the margin. The fundamental problem is that Beijing is trying to solve the American problem in China. What I mean by that: In the US and Europe, where households retain 70 or 80% of GDP, it’s reasonable to say that if there is a distortion in the distribution of economic income, it is within the distribution of household income: the rich have too big a share, the poor have too small a share. In China, there also is huge income inequality. But in China, household income is only 55% of GDP, which means the real problem is not that the rich have too much. Rather, it’s that the rich have too much of a small share. The government, including state-owned enterprises, retains 20 to 25% of economic income. So the real distortion in China is the very high government share of GDP which is responsible for the low household income share of GDP. If you really want to solve that problem, you would have to distribute income from local governments to the household sector. And that is politically very difficult to do. Powerful vested interests are against this.

How would an income transfer from local governments to the household sector work?

There are many ways. They could fund a stronger social safety net. They could build cheap housing and give it away to the poor. They could eliminate residency requirements, the hukou system. They could allow stronger labor unions that protect workers and raise wages. They could lower VAT taxes and fees for non-luxury goods. They could make public transport or utilities cheaper or free. Basically anything that makes ordinary households richer at the expense of local governments would work, but each of these solutions has difficult political implications that make it hard to implement.

For years, the argument was that China needs this kind of high-powered growth of 6% or more in order to create enough jobs for its population. Is that not the case anymore?

No. The baby boom generation of the post-1949 years is retiring, there is a big demographic shift happening. The working age population started to shrink five or six years ago. Plus, 60% of all Chinese live in cities today, so there is not this huge movement of rural workers to the cities anymore. So while in the 1980s and 1990s it was all about growth, today it is all about the distribution of income.

Millions of Chinese have stored their wealth in property. The Party takes its legitimacy in ensuring social stability. If the real estate bubble deflates, many people will lose a lot of money. How can the Party handle this without risking upheaval?

The problem is that if they don’t do anything and prices continue to rise, that also creates social unhappiness. Remember that the wealth of a country is not the value of its real estate, but the total amount of goods and services that it produces. China in aggregate doesn't get richer when the price of real estate goes up. But somebody got richer, therefore in real terms somebody else must have gotten poorer. When you think about it that way, you realize that rising property prices are a transfer of wealth from younger and poorer people, who don’t own apartments, to people who own multiple apartments. That also creates a big social problem. So the Party is basically weighing the two problems. In a way, they're damned if they do, but they're damned if they don’t. So at some point you just have to bite the bullet and do it.

Let’s assume the Party leadership stays the course and cools down the property market. Will that trigger a financial crisis?

I will never say there can’t be a financial crisis, but I would say that it is unlikely in China as long as the banking system is still largely closed. It has opened up a bit recently, but foreigners as yet play a very minor role in the Chinese financial system. Also, a crisis is unlikely as long as the regulators are very credible and powerful, which they are. I think at least for the next few years a crisis is very unlikely, because in the end a crisis is always a balance sheet problem. The regulators can always resolve it by forcing everyone to restructure their liabilities.

That would mean there won’t be any big spillover effects to the world economy?

That depends on your definition of spillover effects. On a purely financial level, because China’s financial system is rather closed, there are few contagion links to the world financial system. However, the big issue is that China today consumes more than 40 or 50% of almost every important industrial commodity. That’s because of the huge investment-driven nature of Chinese growth. So if we assume that China moves away from its bad investment-driven growth model, I would say that this would cause a sharp fall in the price of commodities in the medium term. Is that good or bad for the world economy? It depends. For Switzerland it’s a good thing, because you are an importer. For Brazil it’s probably a bad thing.

But if China slows down, won't the world lose its growth engine?

That, in my view, is not quite the right way of looking at it. We can learn a lot by looking at Japan. As you know, Japan during its boom years before 1990, was growing its GDP at 5% per annum. After 1990, when its property bubble had deflated, it grew by 0.5% per annum. Now imagine that in 1989, you had predicted that Japan would grow by 0.5% for the next 20 years. People would have told you that this would be a disaster for the world, because Japan was the world’s growth engine, and if you turn that engine off, the world stops growing. Well, that did not happen. I would argue that it’s partly because the Japanese growth rate was never as high as we thought it was in the 1980s, as there was a lot of fictional growth, driven by its property bubble. But the most important thing is this: Japan underwent a slow rebalancing of its domestic economy. And because its trade surplus slowly shrank for the following ten to fifteen years, that was mildly positive for the world economy, because Japan added demand to the world. So it really depends on how the burden of the adjustment is shared.

In the past months, we have seen a crackdown on private enterprise in China. What's behind this?

What we are seeing today is the Party leadership having recognized that the old debt- and investment-fuelled development is not sustainable anymore. And they are answering by intervening much more directly in the economy, thereby hoping to achieve a rebalancing. Will they succeed? We don’t really know yet. Is a highly centralized, autocratic government better at generating advanced growth than a highly decentralized, democratic system? Maybe it’s because I’m American, but I assume that for the advanced type of growth what you really need is bottom up development. That doesn’t mean a centralized system is always bad: I would argue that in the 1980s, when China was massively underinvested in everything, and there was a clear objective to invest, it was probably more efficient to have a highly centralized system. But it’s at this last stage of growth where I don’t think it’s a coincidence that the most advanced economies are all democracies. You can argue that they’re rich because they’re democracies, or that they’re democracies because they are rich, we don’t know the answer to that. It's clear that Beijing is choosing the other path now. We will find out in the next ten to fifteen years if it worked.

Michael Pettis

Michael Pettis is professor of finance at Peking University's Guanghua School of Management. He has been living in China since 2002. Before that, he taught at Columbia University's Graduate School of Business from 1992 to 2001. Before he entered academia, he was an investment banker for Bear Stearns and Credit Suisse First Boston, specializing in emerging markets. In an advisory role, he has worked for the governments of Mexico, South Korea and Macedonia on the restructuring of their banking system. His latest book, which he authored together with Matthew C. Klein, is «Trade Wars are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace».
Michael Pettis is professor of finance at Peking University's Guanghua School of Management. He has been living in China since 2002. Before that, he taught at Columbia University's Graduate School of Business from 1992 to 2001. Before he entered academia, he was an investment banker for Bear Stearns and Credit Suisse First Boston, specializing in emerging markets. In an advisory role, he has worked for the governments of Mexico, South Korea and Macedonia on the restructuring of their banking system. His latest book, which he authored together with Matthew C. Klein, is «Trade Wars are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace».