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Is it like Lehman, is it like LTCM? I'm struggling to stay afloat in this flood of hot Evergrande takes.
The only thing to add today is that it looks more like Enron to me, especially when you look at this corporate structure 👇
I'm going to make some assumptions about the future based on my personal experiences and observations.
I fully expect to be called out for this if anything reaches too far.
Let's crack on!
I lived and worked through the Spanish real estate boom and bust.
Although China's situation is clearly different, I see some striking similarities, particularly in the way people view property as a one-way bet and tie their identity and status to property ownership.
And that's really what I want to focus on.
People, and how they behaved in the past as a guide for the future.
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Back to Spain's boom...
Everyone was leveraged to the nuts & snapping up every property they could.
People would constantly buy off plan and flip for 20%+ gain two years later and then do it all again.
But this wasn't just a buy one, wait two years situation. This was a continuous process of overlapping purchases and sales.
At the individual level, people would sign contracts for multiple units, flip them before completion, and use the profits to buy one or two outright..
Businesses were taking their spare cash and lumping it into property speculation.
In many cases, they'd sign up in bulk to get some discount, then flip dozens or even hundreds of properties before completion.
The most sophisticated even had their own resale networks within the business.
It wasn't uncommon for employees to spend more time flipping properties for their bosses than doing the main job...
An entire meta-economy was running parallel to the main business.
Much of the speculation in Spain was also fuelled by banks pushing 100%+ mortgages and very easy personal loans.
Most lending was still approved at a local level so if you knew the right people you could borrow your down payment with an unsecured loan and then roll that into an interest only mortgage on completion (or paid it back when you successfully flipped the contract for a tasty profit).
Every trick in the book was used to secure finance, lever up and get in on the action.
People rarely kept much in the way of un-invested savings, and nobody was investing in the stock market...
Why would they?!
Just keep pumping money into the property machine and watch it keep paying out year after year, surrounded by others doing exactly the same thing.
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Due to the opacity in the Chinese financial system it's impossible to know if this has been playing out in exactly the same way.
That said, I think it's fair to assume that many of the same dynamics are in place, especially the big story of property being a perpetual cash generator, and levering up so that you're not 'left behind'...
That's the key driver.
As we are talking about people and how they behave (rather than systems and data), here's a semi-anecdotal example 👇
- ¥20,000 is about £2,250 / $3,000
- ¥100MM is roughly £11 million / $15 million
The couple in this example are the absolute definition of asset-rich, cash poor.
And this is where I start to worry for China.
I couldn't care less if Evergrande gets bailed out, restructured, if they default on their bonds, or if equityholders lose money.
Nope, my big concern is what it means for future Chinese consumer demand and confidence.
Real estate investment is such a huge part of the economy... 👇
I'd say it's near impossible to unwind this without causing some serious issues...
And to do it in an 'orderly' way?
I'm unconvinced. This sums up what happened in Spain... 👇
As soon as the 'property only goes up' narrative was exposed as a lie, demand for property disappeared, prices plummeted, and the downward spiral began.
Competition to sell became just as fierce as the buying competition that preceded it.
Many of these private owners lost deposits (either through their refusal to complete or due to developer bankruptcy) & lost their jobs to boot.
The majority of their savings were invested in the property market so there was nothing to fall back on...
The glut of empty properties meant that these reluctant landlords became ultra-competitive, pushing prices lower in their desperation to sell up and bring some money in.
Developers were under pressure from banks to do the same.
The unemployment situation worsened as so many jobs were tied to construction.
Many tenants stopped paying their rent.
These reluctant landlords just couldn't catch a break.
Their ideas about the future were shattered, this new reality was depressing.
Even if some of the properties owned were mortgage free, if any carried debt, the entire portfolio was at risk.
When people couldn't pay those mortgages, the banks would renegotiate rather than repossess, but the falling prices meant that the debts needed to be secured against more assets.
Mortgage-free properties were now mortgaged. Asset rich no more...
Debt burdens weighed heavy, spending dried up, wages stagnated...
By many standards people remained wealthy due to home ownership, but they didn't feel it as their net worth continuously fell and they had no 'upward mobility'...
The middle-class bore the brunt of the crisis.
Michael Pettis wrote about this today and it all sounds so familiar:
The Chinese economy is already seeing this process in action. Property developers there have long claimed that the success of their business is driven by the three carriages—high turnover, high gross profit, and high leverage.
But all of these proverbial carriages are breaking down as the effects of Evergrande’s crisis spread throughout the economy. Potential homebuyers, for example, frightened about what they read in the news, are becoming reluctant to close on homes, resulting in an already sharp decline in home sales.
What is more, they are likely to refuse to prepurchase unfinished apartments or put down deposits, except at large discounts, thereby squeezing liquidity and raising financing costs for the developers.
At the same time, sales agents and other employees are likely to be highly distracted during working hours, worrying about their employment prospects and in some cases the loss of their savings in wealth management products. Such circumstances can cause a sharp decline in labor productivity.
What’s more, contractors have been suspending construction work until their payment prospects have been assured, while suppliers, similarly, are less willing to accept commercial paper as payment for their deliveries.
The result, as Evergrande has already announced, is that construction projects are rapidly falling behind schedule.
Full article is well worth a read 👇
None of the above even accounts for Xi's aggressive policies to achieve 'common prosperity'.
From a 'people' perspective, who's going to take risks in this environment? 👇
“Xi does think he’s moving to a new kind of system that doesn’t exist anywhere in the world,” said Barry Naughton, a China economy expert at the University of California, San Diego. “I call it a government-steered economy.”
A number of countries closely regulate industry, labor and markets, set monetary policy and provide subsidies to help boost their economies. In Mr. Xi’s version, the government would have a level of control that would allow it to steer the economy and industry along a path of its choosing, and channel private resources into strengthening state power.
The big risk for China and Mr. Xi is that the push winds up suppressing much of the entrepreneurial energy that has powered China’s boom and years of innovation.
Xi's rhetoric about 'domestic demand' and 'dual circulation', is dependent on an increase in household incomes to boost consumption.
Perhaps this is all planned out meticulously, and the digital yuan will be launched to incentivise spending at just the right time.
Personally, I wouldn't bet on it. Central planners don't have a great track record...
A depressed Chinese consumer is a very real possibility. And it's one that I think markets will increasingly start to discount once the 'excitement' of Evergrande fades and the layers are peeled away...