The 21st century had been one of triumph for the Chinese Communist Party.
As governments in the U.S. and Europe mishandled one calamity after another — from the 2008 financial crisis to botched efforts to contain COVID-19 — even champions of liberal democracy looked on with envy as China’s policy makers navigated the same troubled waters with apparent ease.
But the cracks of China’s governing model are beginning to show as its real estate sector deals with the ramifications of a bust in the property market and as its zero-Covid policy falters in the face of fast-spreading new variants.
“There has been a certain sort of envy in the West of what appeared to be the extraordinary competence of China’s policy makers, but at the moment the emperor has no clothes,” said Jeremy Mark, a senior fellow at the Atlantic Council and an expert on Asian economies.
As Chinese President Xi Jinping looks set to secure a precedent-breaking third five-year term when the Chinese Communist Party holds its 20th Party Congress starting Oct. 16, the coming months could be pivotal for the country and its efforts to achieve the status of a world-class power.
The end of China’s miracle growth
The importance of the Chinese economy to global growth was made apparent in the years after the 2008 financial crisis, when the U.S. and European economies were straining under the weight of a badly wounded financial sector, declining real estate prices and rising unemployment that sapped consumer demand.
China’s economy was not only kept safe from financial contagion — it barely lost any steam all, growing at nearly 10% per year from 2008 through 2011 as local governments borrowed heavily to fund a massive new wave of infrastructure development.
Even as Western demand for Chinese manufactured goods evaporated after the financial crisis, its economy powered ahead on the strength of a $575 billion fiscal stimulus package — which equated to 13% of China’s GDP at the time — that was largely spent on infrastructure projects and encouraged easy lending to the property sector.
The stimulus package and subsequent policies built on the success of the three prior decades when the government was able to encourage double-digit economic growth through much needed infrastructure spending. It also set the stage for another decade in which China’s economy would outperform the West and provide the global economy with the lion’s share of its growth.
But these policies also papered over a serious problem: China was running out of ways to productively invest in roads, bridges and other infrastructure. Michael Pettis, a professor of finance at Peking University in Beijing, argues that this reality posed a fundamental problem for Chinese policymakers that they have yet to solve.
After China had “closed the gap between the investment it had and the investment that the economy could productively absorb … China should have dramatically lowered the share of production it reinvested,” Pettis wrote in a recent essay for the Carnegie Endowment for International Peace.
Rebalancing the Chinese economy from one led by investment to one dominated by domestic consumer spending ran into political opposition, however, as vested interests in maintaining the current model have blocked necessary reforms.
“Political priorities are central to understanding the decisions made by the Chinese Communist Party,” the Atlantic Council’s Marks said. “Politics have taken precedence over other considerations in economic policy making.”
A slow-moving debt crisis
Real estate bubbles are common in economic history, and the bubble that formed in China’s property sector does not look all that different than the ones formed in the U.S. and Europe in the 2000s.
In the U.S., homebuyers and builders feasted on easy credit provided by investor demand for supposedly safe mortgage-backed securities, and rising home prices eventually triggered a bout of speculation that drove those prices ever higher until the bubble burst.
In China, easy credit to the property sector was provided by the government as it sought to spur economic activity to hit unsustainably high GDP-growth targets, according to Pettis.
An added wrinkle to the story is the widespread practice by Chinese developers of pre-selling homes that have yet to be constructed and using those funds not to complete the promised home, but purchase more land.
“As real estate prices [in China] rose year after year, it changed businesses’ behavior in ways that in turn distorted prices,” Pettis wrote, adding that rapidly rising prices benefitted companies that took on the most risk by snapping up as much real estate as they could to anticipate future needs.
Just as the real estate market in the U.S. became dominated by speculators in the 2000s, so too was China’s in recent years.
Bursting the bubble
Chinese officials have long recognized its real estate bubble, and the growth in debt that fueled its inflation, as a problem demanding serious attention.
In 2020, Beijing introduced new regulations that significantly restricted access to credit to the property development sector, which prevented developers from borrowing to mask cash shortages and led to some being unable to complete projects that homebuyers had already paid for.
Property developers like China Evergrande Group EGRNF, -2.73% have been struggling to meet commitments to buyers and lenders over the past year, and stresses in the real estate sector have hit speculators hard, with real estate prices in China declining for the 11th month in a row in August.
Brad Setser, a former senior advisor to the U.S. Trade Representative and a fellow at the Council on Foreign Relations told MarketWatch in an interview that it is unlikely that troubles in China’s real estate crisis will pose a risk to the financial system because it is already state run and the Chinese government has shown a willingness to recapitalize banks in the past.
But the bursting of the real estate bubble may be a serious headwind for the Chinese economy even absent a financial crisis, given how important property development is to the Chinese economy.
“Property investment was a much larger share of the Chinese economy than in the U.S. context,” Setser said. “It’s as if the entire economy were Nevada and Arizona and some of the booming and construction states before our crisis.”
Cleaning up the mess
The task facing Chinese policymakers is to somehow arrest the cycle of declining real estate prices and sales and to stabilize property development companies so that they can finish the homes they’ve promised to build.
Tom Orlik, chief economist at Bloomberg Economics estimates that the value of mortgages attached to unfinished properties in China amount to about $230 billion, or 1.4% of the country’s GDP. If homes continue to be completed at their current rate, that amount will rise to $632 billion in 2024, a whopping 4% of GDP.
A growing number of Chinese have begun to boycott mortgage payments on uncompleted homes where developers have halted construction, according to Houze Song who leads research into the Chinese economy for the think tank MacroPolo.
Song said in an interview with MarketWatch that it’s difficult to know how widespread these protests are because the Chinese government has worked to stop the spread of information about the boycotts, in traditional and social media, though there’s evidence the government is taking the protests seriously.
Beijing recently announced $29 billion in loans to troubled developers, though Song warned that “the size is probably not sufficient to solve the problem.”
The regime is in a difficult position because officials want both to stabilize the property sector without sending the message that private actors will be bailed out by the government if they take on too much risk, Song added.
That means the government is likely to roll out support slowly and will look to force real estate companies and local governments to bear as much of the burden as is practical.
The current stimulus plans “will only be sufficient to muddle through,” but uncertainty and declining real estate problems will continue to weigh on consumer and business confidence and economic growth, Song said.
Another headwind for China is its so-called zero-COVID policy, entailing rolling lockdowns of major cities in an effort to rid the country entirely of the virus.
“Without relaxing zero COVID there will be no stabilization of the housing market,” Carl Weinberg, chief economist at the High Frequency Economics and veteran China watcher told MarketWatch.
The policy is defensible on moral grounds, especially when compared to the U.S., where more than a million COVID deaths has contributed to a nearly unprecedented three-year decline in average life expectancy.
But it does lay bare that China’s vaccine production and roll out has been less successful in the West, while betraying the Communist Party’s authoritarian tendencies at a time when its international reputation has been harmed by events in Hong Kong and Xinxiang.
Recent polls from Pew and the Eurasia Group show a growing share of the global population have negative views of China, while countries from India to Nigeria and Brazil say they prefer the U.S. over China for the role of leading superpower.
China’s biggest decisions are ahead, however. The standoff between the Western powers and China over the fate of Taiwan will define perceptions of China’s economic and political strength for decades to come, Weinberg said.
“A successful repatriation of Taiwan would give it control over the global chip market and a louder voice on the international stage,” he said. “The stakes are really high.”