From Country Garden to Systematic Defects (Part II)
Side-effects of the Three Red Lines and Excessive Reliance on Fiscal Restrictions
Date: 22 September 2023
The Chinese flag flying in front of the Oriental Pearl TV Tower, Shanghai.
In the previous part, the focus is placed on providing a brief overview of the Chinese property sector debt crisis and possible solutions the government can deploy to decelerate investors’ loss of confidence in related industries. However, simply by looking into the process of debt accumulation itself within the industry is not sufficient to explain the sudden crash of Evergrande in 2021. Many external reasons affect the market, one of which is state regulations and macro-readjustments. Therefore, to explore root causes of the liquidity shortage experienced by multiple real estate developers, it may be useful to examine long term state policies.
Systematic Failure?
A primary reason why I refer to the incident as mismanagement is because the series of property corporation crises is directly correlated to the Three Red Line policy enacted by the Chinese state in 2020. The Three Red Line was issued to prevent the continuous growth of debt in the property sector, which amounted to around 15% annually in 2020. Regulators are to assess the financial position of property corporations according to the following three criteria: (1) whether corporates have a liability-to-asset ratio of less than 70%, (2) whether their net gearing ratio is less than 100%, and (3) whether their cash-to-short-term debt ratio is less than 1x. If corporates’ balance sheets have records that go beyond the stated quotas, the state and regulators would limit their ability to acquire new debt, with those breaching all three red lines being completely cut off from borrowing services in the following year.
While certain foreign observers at the time considered the policy to be ‘credit-positive’ as it encourages firms to reduce leverage, the policy directly generated at least 3 problems. First, it results in liquidity problems in the sector. By limiting credit to developers who rely on high leverage to finance construction projects, the government is effectively curtailing the developers’ ability to deliver currently planned properties. By not being able to profit and repay existing debt, corporations cannot obtain new credit, creating a vicious cycle of debt problems.
To avoid liquidity shortage, developers would turn to obtaining debt through unconventional methods, for instance, by drawing on private bonds as well as funding from trust companies. Nevertheless, the use of off-balance sheet debt makes it difficult for regulators to track liability within the sector, while at the same time allowing the financial risk to spread through unclear channels. Last but not least, it directly impacts the revenue of the local governments.
After enacting the Three Red Lines, local governments’ land sales declined by close to 50% in the first half of 2021 when compared to the same time in 2020. The rapid drop in land sales put the local government into a more difficult economic situation, which pushed them to limit their cooperation with developers that had already been in serious financial distress. The reluctance of local government to work with, let alone finance, troubled developers makes it even harder for them to increase their revenue and pay off debt. Again, this creates another vicious cycle of indebtedness.
Evergrande Headquarters in Shenzhen fenced by the Police.
Courtesy of Nyra (2022).
While this case may be understood as an individual policy failure with unfortunate consequences, the use of central directives dictated by the central government to curtail economic and social problems is a distinct characteristic of the Chinese model of governance. When examining the uses of slogans and policy in China, China expert Prof. Zeng Jingxian proposed that the central government often issue policies that are poorly defined and opaque, leaving it to local authorities and experts to work out the practicalities. This situation emerged as the central government considered its role to be primarily refined to setting general directions in policymaking.
In the case of the Three Red Lines, the message that the central government attempted to deliver was that it would no longer be tolerable towards high-leverage operations that may result in a burst of economic bubble and financial collapse. This is a rational direction to undertake, considering the US subprime mortgage crisis in 2008 was precisely triggered by the burst of housing bubbles. Therefore, having the perception that the bubble burst should be curtailed before it occurred is reasonable.
Nevertheless, I suspect that the central government did not properly evaluate the bearing capacity of both the housing corporations and the local authorities before executing the policy. According to Bloomberg, in the entire property sector, only around 30 companies were able to comply with all the regulations listed in the Three Red Lines. Hence, most of the corporations in the property sector did not endure the effects of the policy well.
Following the defaults of Evergrande and Fantasia Holding Group, several pillar companies in the property sector such as Sinic Holdings, Modern Land (China) Co., Yango Group and Kaisa Group declared themselves in financial difficulties. If the central government had planned to endure such loss and were clear that such a situation might occur, it would be difficult to explain why the regulating departments planned to ease the assessment process and criteria of the Three Red Line policy in January of this year. The local authorities also seemed to be unaware of the impact of such a policy in the first place, not excluding the possibility that they were not informed beforehand at all, as they were forced to fund new companies to buy new plots of land to avoid a financial deficit. In this case, the central government may have undermined the negative effects of its policy, and left private corporations and the local governments to deal with the aftershock.
Construction workers on site in Beijing.
Courtesy of Joe Tym (2023): https://flic.kr/p/e8VZJ7.
Nevertheless, the use of central directives is by no means a one-time measure to deal with a particular problem. A similar mixture of fiscal policy and related propaganda was also used to boost the stock market from 2014 onwards, which resulted in an economic bubble and a market crash. At the outset, a possible reason why the state had taken an active role in supporting and promoting investment in the stock market in the first place is that it attempted to prevent the accumulation of bad debt in the banking sector.
According to the estimation of CLSA, a financial service enterprise based in Hong Kong, in 2015, the non-performing loan (NPL) ratio in the Chinese bank sector could have reached 19% according to Western accounting standards. Meanwhile, the corresponding figure for the US was merely 1.5% in the same year. The high NPL ratio implied that many borrowers failed to repay their debt on time or in full to the banks, which increased the financial risk bared by banks when they borrowed. Therefore, the state encouraged companies to finance their operations directly through the stock market, instead of through the banking system.
A series of policies and speeches were made to boast the support for the stock exchange. As early as 2012, the China Securities Regulatory Commission (CSRC) released restrictions for foreign investment in China, with the amount of capital that foreigners could invest in Chinese securities increased from $30 to $80 billion. On 17 November 2014, the Shanghai-Hong Kong Stock Connect channel was established, which allowed investors to trade in and out of shares from both stock markets through their local brokers. The People’s Daily and Zhou Xiaochuan, the president of China’s central bank at the time, both advocated participation in the stock market, with the latter stating that ‘investing in the stock market is essentially supporting the real economy’.
The problem arose when this series of fiscal policies and official rhetoric over-encouraged Chinese and foreign investors to engage in the stock market, which allowed the Shanghai Stock Market to surge by over 150% from July 2014 to June 2015. Instead of supporting the real economy, the growing bubble demonstrated the investor’s desire to escape the declining real estate market and gain further profit through equities investments. A particular issue was that a huge amount of such growth was fueled by marginal debt, which increased the risk of financial collapse in case of a bubble burst.
Sensing a potential threat, the Chinese regulators enacted a policy to stop short selling and to limit marginal lending in areas such as fintech. Nevertheless, investors promptly unloaded when they sensed tightening market policies, which might limit their access to further loans or to sell off their shares. This situation resulted in the collapse of the Shanghai Stock Exchange index from its high point of 5166.3501 in mid-June to the lowest point of 3507.1919 at the start of July. The market only fully recovered from the crash at around December.
Both the 2015 crash and the 2020-23 real estate debt crisis reflected the ambivalent, at times conflicting, goals of the Chinese government when it comes to its economic development. While the government desired to liberalise its stock and real estate market to allow in flow of capital and facilitate economic growth, at the same time, it attempted to remain in control of the market economy through fiscal policies and macro readjustments. Moreover, it is often in favour of using strong and direct policies to set restrictions upon the free flow of capital in the market to prevent bubble bursts and redirect investments. While some consider such policies and measures helpful in strengthening market growth, that is not necessarily the case.
As seen in both cases, while the state had clear targets in mind that it wanted to achieve through fiscal policy and regulations, boasting up stock market trade in the former and better regulating the real estate market in the latter, it often failed to deliver. This is partly due to the dependency of the market on state support, to the extent when the state attempts to impose certain regulations and limits, investors and corporations may perceive it as a sign that the state is withdrawing its support for certain types of economic activities and industries. As a result, they will sell what they hold or refuse to invest in those activities and industries, which aggravates the scenario. The same could be said for the opposite account when the state openly demonstrates its support for a certain sector. Therefore, it is extremely difficult for the state to predict market responses.
Interior of the Shenzhen Stock Exchange.
Courtesy of Stang, W. M.
Final Remarks
Temporary Success and Long-Term Instability of the Chinese Economy
It is true that the mixture of state-directed policies and limited economic liberalisation helped China to transform its economic structure in the early 1980s and resulted in astonishing economic growth. Under the state-directed reforms of Deng Xiaoping, China was able to increase its GDP by more than 9% per year over the first three decades of restructuring. Nevertheless, one should note that Deng’s success was largely due to him using his authoritarian power to gradually adopt liberalisation policies, not upholding Party control. By allowing foreign investments to enter the country and developing regulations to protect ownership rights, Deng was able to stimulate economic growth to a degree far beyond initial predictions.
However, as seen in the two cases above, the Chinese state practice in economic management has not evolved throughout the decades. With the state not gradually strengthening non-arbitrary regulations and favouring direct fiscal interference instead, it is rather difficult for the market to develop maturely into an independent socio-political institute. Constant state intrusion would result in people buying and selling according not to market dynamics, but policy directions. This would hinder market competition and the ability of the market to readjust itself in times of excessive or insufficient supply or demand.
This is not to say that complete privatisation and liberalisation are the best set of policies in every given scenario. However, in China’s case, by constantly undermining market dynamics and operating above regulations, the state is eroding the fundamental protection for market operation and property rights. The inability to perceive market trends makes it harder for investors to react to changes in the market, which not only furthers distrust towards the Chinese stock market, but its economic operation as a whole.
‘Development is the only way’ -Deng Xiaoping.
Courtesy of Brücke-Osteuropa (2010).
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