Chinese stocks are tumbling and may take a long time to recover. The property developer China Evergrande is on verge of bankruptcy. China Evergrande has the biggest debt of any publicly traded manager or developer of real estate in the world. They are about to default on tens of billions of dollars in bonds for debt holders around the world.
This may be bad for those investors with money in Chinese real estate bonds and maybe for some other Chinese real estate developers, both public and private, but this is not a Great Recession.
For those of you who have heard my China presentations at the Money Show or read my newsletters going back 10 years to 2011, this should come as no surprise.
The Chinese government owns the banks and the land. They set the policy for economic growth and fund it. China’s economy grew from $92 billion in 1970 to $16.6 trillion in 2021. That is a 181 fold increase. In the same time, the United States grew from $1,073 trillion to $22.43 trillion, a 21 fold increase. China grew six times faster than the United States. They had the French Mercantilism model from the 17th century.
But there are problems with the Chinese government’s top-down plan, and they are becoming more apparent as we emerge from the pandemic.
Owning the land, the banks, the work force, and setting economic priorities and policies means that they also own almost all the risk. Some of their risk they passed on to bond holders through companies like China Evergrande. The Chinese government set up to build cities for several million people in places where cities had never existed. Loudi in Hunan province was built using debt as financing. The bonds were valued at $1.5 billion an acre. That is the equivalent of Bellevue, Washington or Winnetka, Illinois. Both those cities are some of the richest in the United States and incomes in those cities were over $250,000 a year in 2011.1
The new residents of Loudi in 2011 were making $2,323 a year, less than one percent of the average income in Bellevue or Winnetka.2
You can begin to see the problem for the investors in China Evergrande and the other builders and developers. And they were put in this position by the Chinese government which itself may be on the hook for significant losses.
In many ways, it is similar to the subprime mortgage crisis that led to the Great Recession. But there is a big difference! In 2007, the world was swimming in credit based on inflated valuations of real estate. Today, it is primarily China. The credit bubble that caused the Great Recession affected North America, the Euro Zone, and Asia. Today, I believe the damage will be limited.
For those of us who lived through the Great Recession, we remember that the stock price of one bank would collapse and that would be followed by another bank and then another and then another. That happened all over the world. Bank after bank, institution after institution fell into the hands of other banks as the Fed and the US government pumped money in to save the financial system from cratering.
Treasury Secretary Tim Geithner was sometimes mocked for insisting that banks and large financial institution do an annual “Stress Test”. That stress test is geared to see if, in the event of an economic crisis, each bank and large financial institution has adequate capital to survive.
The Federal Reserve released the results of the annual bank stress test in June of this year. All 23 US banks remained well above their risk based minimum.3 The European Central Bank announced in July 2021 the EU banks were “robust” after their stress tests.4 Japan’s central bank was set to stress test their five major banks this year.5
According to a November 2020 Fitch report, a third of the large and medium sized Chinese banks would fail even a mild stress test and over two thirds would fail a severe economic breakdown.6
My caution in all of my presentations about China has been “invest at your own risk in China”. Now you can see why I have avoided China.
I am still guardedly optimistic that US companies are going to continue their growth through the next year. As the old saying goes, “A rising tide lifts all boats, but when the tide goes out you get to see who is swimming naked”.
1. Forsythe, Michael, and Henry Sanderson. “China Land Values, Leverage ECHO U.S. Boom – and Perhaps Bust.” The Seattle Times. The Seattle Times Company, July 24, 2011. https://www.seattletimes.com/business/china-land-values-leverage-echo-us-boom-8212-and-perhaps-bust/.
2. Forsythe and Sanderson.
3. “Federal Reserve Board Releases Results of ANNUAL Bank Stress Tests, Which Show That Large Banks Continue to Have Strong Capital Levels and Could Continue Lending to Households and Businesses during a Severe Recession.” Board of Governors of the Federal Reserve System. The Federal Reserve, June 24, 2021. https://www.federalreserve.gov/newsevents/pressreleases/bcreg20210624a.htm.
4. “EBA Publishes the Results of Its 2021 EU-WIDE Stress Test.” European Banking Authority. EBA, July 30, 2021. https://www.eba.europa.eu/eba-publishes-results-its-2021-eu-wide-stress-test.
5. Kihara, Leika. “BOJ to Highlight Climate Risks in Bank EXAMINATIONS next Year.” Reuters. Thomson Reuters, March 30, 2021. https://www.reuters.com/article/us-japan-economy-boj-banks/boj-to-highlight-climate-risks-in-bank-examinations-next-year-idUSKBN2BM0IV.
6. “China’s Banks Remain Vulnerable to Stress in Wake of Pandemic.” Fitch ratings: Credit ratings & analysis for financial markets. FitchWire, November 16, 2020. https://www.fitchratings.com/research/banks/chinas-banks-remain-vulnerable-to-stress-in-wake-of-pandemic-19-11-2020.