Why China Is on the Brink of Its Biggest Crisis in Decades

China is known for being the factory of the world. Its economy is based on the manufacture of cheap products that are then sold abroad. Toys, mobile phones, tools, appliances... All of them are the products that allow China to have one of the most thriving economies in the world. Well... At least, this has been the story we have always been told. But what if I told you that this story is... false? What if I told you that the main driver of China's economy has nothing to do with manufacturing or even foreign trade? In fact, since the mid-2000s, the weight of exports in China has plummeted.

Not only that, but many Western companies began to leave the country to produce in other cheaper and safer places such as Vietnam or Malaysia. China is no longer what it was and the famous “made in China” is in the doldrums. But, if this is so... If factories are no longer the main activity... What is it then? Or rather, what has been China's true economic driver in recent years? The answer is the real estate sector. The Chinese real estate market, together with all its related activities, currently generates between 20 and 30% of the country's GDP. This is practically double that of other places such as the United States, the European Union or South Korea, and it is undoubtedly the most thriving sector of the Asian giant's economy by far.

Real estate construction has not only had benefits in terms of economic growth, but also in terms of human well-being. For example, in the 1990s, living space in urban China was about 7 square meters per person, or 75 square feet. Basically, people lived in small concrete closets. However, thanks to the growth of the sector, this space has grown to match that of other developed countries. In short, we could say that China has gone from being the world's factory to being a major builder of commercial buildings, homes and all types of public infrastructure. That's great, it has created a lot of jobs and a lot of economic development in recent years.

Still, I fear that now, in 2023, this strategy could blow up the entire country: (China's real estate bubble burst will shake the economy for years – India Times) Just a year and a half ago, a major real estate company Burst the

crisis

in China. A

crisis

that still continues to this day. This is something many of you will no doubt have heard about in the news with the bankruptcy of developer Evergrande. This crisis is turning out to be something similar to what happened in 2008 in Western countries, but... With one big difference: in China, the real estate sector has become much more important than in the West.

In other words, a crisis of this type in China is a crisis that affects its main economic engine. And as you can imagine, this poses a serious systemic danger to global economic stability. (As the real estate crisis in China grows, is the global economy at risk? – Al Jazeera) In this video we will talk about the situation of the Chinese real estate crisis, its possible consequences and, above all, its causes. Because what if I told you that, in reality, it was the Chinese government itself that caused this whole disaster? Yes, that is correct. The Chinese government has caused its own crisis.

But, to understand the details, let's go directly to this story. Let us begin. To understand all aspects of the new Chinese crisis, one must first answer a key question: and that question is: why has the Chinese real estate market become so large, even twice as large as that of other countries? To find the answer, we must go back to 2008. At that time, China was at its peak as the world's factory. Its level of exports was almost double the current level and its factories were working at full steam. However, as everyone knows, the financial crisis broke out in the West that year.

Countries that used to buy Chinese products had huge economic problems and because of that, they reduced their purchases from China. As a result, the Asian giant's economy suffered, they were no longer selling as much as before, and that was something the government could not tolerate. The Chinese government was not going to allow its economy to go into recession and that is why it decided to intervene and give the country an economic boost. And how did they do that? Well, giving a huge boost to the real estate sector. More specifically, starting in 2008, the government increased housing loans, reduced interest rates, and provided all kinds of fiscal support for real estate development and promotion.

In fact, this way of boosting the economy, through the construction of real estate, was common in China for many years. It wasn't until 2008 that they went all out. And in the end, it was a pretty sensible way to do politics. In short, China was a country with a gigantic population and few homes, with growing urban centers and many developing companies. All of this requires a lot of construction of homes, offices and infrastructure. However, the truth is that the boost to the real estate market went far beyond good intentions. And what began as a way to improve the economy and people's lives ended up becoming a spiral of perverse interests and incentives.

For what reason? Well, stay tuned. (THE LOCAL SPECULATION CYCLE) To understand the perverse incentives of the Chinese real estate system, we must first understand how taxes work in China. You see, until 1994, each region of China collected and spent taxes largely autonomously. The central government was primarily responsible for collecting taxes for common expenses such as the military or foreign affairs, but it was the local institutions in each region that administered most of the taxes. The problem is that this decentralized tax system weakened the central government's ability to control, which in turn raised major political concerns for leaders in Beijing.

To address this, in 1994, the Chinese government reformed the country's entire tax system and centralized it. Thereafter, the central government began collecting most of the taxes and then redistributed the revenue to local organizations. However, this in turn caused another problem. After the reform, local bodies remained responsible for most expenses, such as health and education of citizens, but of course they depended on the central government to obtain the money to finance all these expenses. So what was the conclusion? Local agencies found it very difficult to formulate new policies or make investments on their own. But there was an exception in this story.

There was a way for local bodies to raise money for themselves without having to deal with the government - we're talking about land charges here. Local institutions owned the land in their region. And one thing they could do was sell the rights to use that land to real estate companies to build properties. So, said and done. Local institutions began to make a lot of money by selling land to construction companies. But be careful, because it doesn't end there. It turns out that the more expensive housing is in a region, the more money real estate companies will pay for the land and, therefore, the more money local authorities will be able to make.

And it was at this point that the cycle of local speculation took shape: first, local agencies invested heavily in roads, hospitals, and infrastructure of all kinds. Thanks to these investments, more people wanted to live in regions with better infrastructure. This caused the price of housing to skyrocket, and with it, the price of land. And all of this, in the end, translated into more income for local entities, which, once again, were able to invest in new infrastructure, returning to the beginning of the cycle. As you can see, the objective of the local agencies was very clear: to increase the price of housing by any means necessary.

In fact, many of them began to cheat more, such as using state-owned companies to issue debt, buying land and keeping the money generated from the subsequent sale. More specifically, some reports claim that more than half of all land sold in Chinese cities was acquired by state-owned companies. Basically, the huge Chinese real estate boom was manipulated from the beginning. In any case, that wasn't even the worst of it. The worst part of this whole story was in the real estate companies themselves. (THOSE WHO GO TO SLEEP WITH DEBT END UP IN BANKRUPTCY) To build the houses on the newly acquired land, the real estate companies needed money, a lot of money.

And where did that money come from? Well, mainly from two places. The first is the pre-sale of real estate. That is, the real estate agencies sold the houses long before they were built, and once they were all sold, they began to build them with the money from the sales. This led many families to start paying mortgages on their homes even several years before they could live in them. In any case, the second way in which real estate companies obtained the money necessary to build was through loans from the financial system. Mainly bank loans. To give you an idea, taking into account all the debts, real estate companies currently have a debt-to-asset ratio of 80%.

A real debacle, practically the entire Chinese financial system is neck-deep in the real estate market. So knowing everything we just told you, we are sure that a crucial question has arisen in your mind. Why did Chinese banks decide to lend so much money to the real estate market? Didn't they learn the lesson from what happened in the West with the 2008 crisis? Well, let's see, on the one hand, we must take into account that the large Chinese banks belong to the government. And as we explained at the beginning of the video, since 2008, the government began to issue credit wildly, using precisely its own banks.

But, on the other hand, many private banks that had no reason to enter the real estate market were bought by real estate companies. Yes, that is correct. Chinese real estate companies bought up entire banks to get cheap money to finance their construction projects. For example, Evergrande, the well-known company that went bankrupt at the beginning of this crisis, bought part of a Beijing bank called Huaxia Bank. . However: It is clear that perverse incentives prepared the real estate market, it is clear that the financial sector was up to its neck, but... What really triggered the crisis? What caused the system to completely explode?

Well, as we said at the beginning, the cause was the Chinese government itself. Listen! (ORCHESTRING THE DISASTER) The road to hell is paved with good intentions. And in the case of the Chinese crisis, this is truer than ever. You see, back in 2020, China's government realized that the country's real estate market was over-indebted and overheated. So, to avoid a financial crisis, he gathered the major real estate developers and asked them to do three things. The first was to reduce its debt levels to 70%. Secondly, they needed to have a capital cushion to withstand possible losses. And third, they would need to have enough cash to cover their short-term debts in the event of a crisis.

Basically, the government wanted real estate companies to reduce their enormous debt. But, to ensure this happened, the government also turned off the tap of cheap credit from banks to property developers and home buyers. By doing this, the government would not only reduce debt, but also curb excessive construction of new housing. Now, remember that the road to hell is paved with good intentions. And the problem is that when the government implemented these new restrictions, added to the pandemic that slowed economic activity, the result was that, overnight, home purchases in China plummeted. And think about it: If home sales plummet, real estate companies will stop making money.

And if they stop making money, who pays their huge debts? Exactly... Nobody. (Chinese real estate giant Evergrande admits a debt crisis as protesters besiege its headquarters. – The Guardian) To all this, there is an additional element to take into account. Do you remember that real estate companies used to sell houses before they built them? When they ran out of money, they were unable to complete the construction of the houses they had already sold. As a result, many families were left without their homes, but had to continue paying their mortgages, all without knowing if they would ever have the home they were promised.

Absolute chaos. The underlying problem with this whole story is not only that the real estate crisis could plunge the country into a serious recession, but it could also end up destroying the entire financial system. The government wanted to avoid that possibility and, before the crisis worsened, it implemented a shock program with three key components: first, access to credit was restored and facilitated for real estate companies to avoid bankruptcy. Secondly, assistance was provided for the completion of half-constructed buildings for families who had already taken out mortgages. And third, healthier real estate companies were encouraged to buy troubled companies and thusavoid its fall.

So what was the result of all this? As a result, the government managed to stop the decline of the real estate market. In the first quarter of 2023, real estate investment practically stabilized, although still at very low levels. But does this mean that China managed to avoid the crisis? What exactly does the future hold for you? Well, VisualEconomik viewers, things are much worse than they seem. (BETWEEN THE WALL AND THE WALLPAPER) It is true that, at least so far in 2023, the Chinese real estate market seems to have stagnated, without getting better or worse, it remains stable. Even so, several experts point out that this could be the calm before the real storm, and that the Chinese crisis still has a long way to go.

On the one hand, the COVID recovery may have helped curb the crisis. After all, people were going out to buy houses again. But on the other hand, there is good reason to believe that when this COVID recovery is over, the housing crisis will unleash its full potential. So let's take a look at the clues that lead us to believe that the worst is yet to come: The first clue is that the number of empty houses in China is skyrocketing. It is true that countries like Spain and Italy surpass it, but in these two countries there are many holiday homes that are empty most of the time.

However, in China there are many empty houses simply because there are not enough people to occupy them, and many of the buildings are in rural areas that are losing population. Apart from this, another factor to consider is that home purchase prices compared to citizens' income are out of control in China. To give you an idea, in cities like Beijing or Shanghai, the price of a house is equivalent to 50 years of income for the average citizen. Meanwhile, in San Francisco, one of the most unaffordable cities in the US, the price does not even reach 10 years of income.

So real estate prices in China are wildly disproportionate. And the question is: If there are not enough people to occupy all the houses, but at the same time everyone was building houses... How come the price has increased so much until now? The answer lies in real estate speculation. You see, unlike other countries, China does not have a highly developed stock or investment market. That is, people with money don't find it as easy to invest in stocks or bonds as they do in places like the United States. So instead, they invest the money in the real estate market.

In China, people buy real estate for speculative reasons, and that has contributed disastrously to skyrocketing prices. But that's not the end of the story. Remember the local authority speculation cycle? The fundraising strategy of these local institutions was the sale of land. But there is a problem, and that is that the land is running out. This means that overnight many Chinese regional governments could lose a large amount of revenue, they will have problems paying their debts and that could even collapse the country's social services, which, let's not forget, are managed by local bodies and not by the central government. (A poor province in China splurged on bridges and roads.

Now it faces a reckoning – WSJ) In short, the housing crisis could be much worse than it has been, it could destroy its main economic engine, affect the financial sector , and bankrupt their governments. It's not such a nice image, is it? Yes, it's a pretty bleak outlook. To which, by the way, we must add one last factor. When banks started giving loans to real estate companies, they stopped giving money to companies in more productive long-term sectors, such as the technology sector. This caused Chinese companies to have more problems growing and developing, all to fully fuel a real estate sector that is now on the

brink

of collapse.

Or put another way: China not only fattened a monster that could destroy it, but it also killed many companies in other sectors that, now, could have saved it from disaster. Although, as we always say, at VisualEconomik we do not have a crystal ball to see what will happen in the future, so we will be attentive to what develops. And for now it's up to you: Do you think that the worst of the crisis is yet to come or do you think that the containment measures will save the country? What would you do if you were the Chinese government?

And, above all, who do you think has been the main culprit in this whole matter? You can leave your answers in the comments. If you liked the video, give it a like, subscribe, hit the bell and as you know, see you in the next video. See you soon.