by Thomas Kirchner, CFA
No Lehman or Minsky moment in sight.
China's real estate market to crash.
Domestic repression and international conflicts will cover up economic problems.
The Evergrande default on $2 billion of Dollar-denominated foreign bonds itself, or the broader collapse of the Chinese real estate market, poses little threat of contagion and certainly is no Lehman moment. However, we see risks of indirect contamination of the global financial system.
No Lehman moment
Whether you call it a Lehman or Minsky moment after the late author of “Stabilizing an Unstable Economy,” the idea is that large losses in one part of the financial system will cause panic among investors who fear that other market participants will suffer similar losses. During the Global Financial Crisis, the wide distribution of MBS gave some credence to the notion that losses from U.S. real estate would spread to financial institutions that are not normally involved in U.S. mortgage lending. With the Chinese property market in contraction, there have been similar fears, mainly because the numbers are so large – we will discuss the extent below. However, what is missing are the transmission mechanisms of losses in Chinese real estate into the broader global financial system. This is not only due to the lack of convertibility of the Yuan into dollars, but also due to the protectionism of China's financial industry, which prevents foreign financial institutions from competing with domestic players. As a result, Chinas mortgage market is hermetically insulated from the rest of the world. Evergrande is one of the exceptions in that it has issued $2 billion worth of foreign bonds; however, the amount of dollar bonds issued by all Chinese corporate remains a minuscule slice of the overall global bond market, so that any losses will not spiral out of control. Therefore, we doubt that the Evergrande problems or even a greater real estate crash in China would have a direct systemic impact. However, we do see risks in indirect transmission mechanisms.
Hong Kong is the weak link
With direct contagion out of the picture, we can see only two transmission mechanisms.
The first is through the Hong Kong real estate market. Unlike mainland China, Hong Kong has no currency controls and its financial markets are integrated with the world. Although geographically small, Hong Kong has a sizable mortgage market due to the exorbitant cost of its real estate: the average home costs the equivalent of US$ 1.2 million [i]. UBS considers it to be a bubble risk [ii]. Two of the top mortgage lenders are actually British banks, HSBC and Standard Chartered, while most other lenders are Chinese banks. Aggregate outstanding residential mortgage loans are a relatively modest $200 billion, some of which have been securitized. However, given the overall limited amount, it is unlikely that home mortgage losses in Hong Kong would threaten the global financial system. In contrast, commercial mortgages are more likely to spread losses widely. Banks are allowed to lend only 40% on the value of a building, but mezzanine and other non-bank lenders will provide financing to bring the total to the 80% level typically seen elsewhere in the world [iv]. Their financing, in turn, shows up elsewhere in the financial system. With values of commercial buildings substantially lower due to Covid, any selling by Chinese banks in Hong Kong real estate or lending products could accelerate a downturn and spread around the world.
The second transmission mechanism takes longer to play out: a recession induced by the collapse of China's real estate bubble would reduce demand by Chinese consumers and would impact profitability in China-dependent industries in the West such as automotive or luxury goods.
Importance of China's real estate market
Real estate is the backbone of China's non-export economy, representing anywhere from 10%, if we believe Statista [v], to as much as 29 percent of GDP, if we believe Ken Rogoff [vi]. Moreover, home ownership rates are high at 90% [vii], so that changes in house prices and affordability have a much stronger impact than in Western countries with lower home ownership rates. Housing represents 79% of household wealth, although that percentage may have increased recently as households lost about $1 trillion in tech stocks after the recent clampdown. Housing is important not only for the economy overall, but, in the absence of pensions and social security, also serves as a retirement savings plan.
The housing sector is at risk of not just a pullback, but an outright crash. In 2020, the PBOC and Ministry of Housing issued the “three red lines” directive which limits leverage for developers. This year to date, more than 400 new regulations [ix] have been issued. 27% of all bank loans [ix] are tied up in real estate projects, so capping leverage feels like a logical step to reduce financial fragility.
Except that it seems to be counter-productive. Evergrande is the poster child of the failure of these regulations. The company completed a $13 billion debt-to-equity swap in 2020 to reduce its debt load, yet is in a worse shape now. Relative to a total debt load of $300 billion, $13 billion in extra equity capital is just a drop in the bucket when the market turns south. The only accomplishment of this move was to highlight the risks inherent in China's highly leveraged developers, without actually reducing this risk by more than a token amount.
Therefore, a real estate crash in China seems inevitable to us. The question is to what extent it will reduce consumer demand and by extension, demand for imports.
Risk of unrest and war
The other significant risk from a recession in China is political. The Chinese Communist Party has built its legitimacy since Tiananmen on progress and wealth creation, a theme President Xi perpetuates with his “common prosperity” campaign that appears to take China back to stone-age communist principles. If a real estate crash were to threaten prosperity, the CCP will have to act. For Xi personally, this presents a challenge. Although he made himself President for life in 2018 by abolishing term limits, he still needs to be elected to a third term in the 20th CCP National Congress that is scheduled for the fall of 2022. Xi has eliminated many rivals, in some cases executing them on corruption charges, but his clampdown on tech and entertainment industries have doubtlessly made him many enemies recently. We would expect increased domestic repression in the runup to the congress, with many more business leader disappearing who may be deemed insufficiently loyal to Xi.
Of greater concern is China's already aggressive foreign policy. If Xi's position were threatened at home because of an economic crisis, there would be no easier way to stay in power than to drum up nationalist favor through a military adventure. Taiwan is the first target to spring to mind, but the collateral damage would be significant. An easier target would be an expansion of the border skirmishes with India. This conflict has recently de-escalated, but the underlying differences remain. The conflict is remote enough that it would have little impact on the large population centers, making it ideal for achieving political goals. Similarly, Xi could reignite conflict over the various disputed atolls in the Pacific, including the fake islands that China created when it poured concrete on submerged rocks and installed flagpoles in 2015.
[i] “Hong Kong Holds Spot As World's Priciest Residential Property Market” CBRE, June 8, 2020.
[ii] “ UBS Global Real Estate Bubble Index” UBS, September 2020.
[iii] “Mortgage Market in Hong Kong” EconomyWatch, May 18, 2021.
[iv] Claire Jim: “Hong Kong's commercial lenders on edge as building values tumble” Reuters, July 29, 2020.
[v] Daniel Slotta: “Real estate in China - statistics & facts” Statista, April 21, 2021.
[vi] Kenneth Rogoff: “Can China’s outsized real estate sector amplify a Delta-induced slowdown?” VoxEU.org, September 21, 2021.
[vii] Youqin Huang, Shenjing He, and Li Ganc: “Introduction to SI: Homeownership and housing divide in China” Elsevier Public Health Emergency Collection, PMC7546956, October 10, 2020.
[viii] Yu Xie, Yongai Jin: “Household Wealth in China” Chin Sociol Rev. 2015; 47(3): 203–229, January 1 2016.
[ix] “Evergrande Debt Crisis Is Financial Stress Test No One Wanted” Bloomberg, September 22, 2021.
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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.
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