The two Ponzis will slow down the Chinese economy and curb its global influence. China will have to find a new economic model to grow.
Glitzy real estate and high profile BRI that were China’s shining beacons, are now debt-fuelled twin Ponzis. In their heydays, both were symbols of China’s growth, wealth and increasing influence in global affairs. As China registers its lowest and slowest growth in recent times (which might actually be in the contraction zone), both these Ponzi schemes threaten to pull it down further. A Ponzi scheme works as long as it is accelerating and its circle/chain is widening. The collapse starts when its input feed freezes. As long as China’s economy grew at an astronomical rate, it was all hunky dory. When the economy slowed, the incoming cash streams fell way short of the increasing arc of cash requirements to sustain these Ponzi schemes.
PROPERTY, THE FIRST PONZI
The property sector is about 30% of China’s GDP and a major driver of its economy. In China, owning a house is a symbol of prosperity, security and wealth. Every Chinese aspires to own a house(s). This resulted in a housing boom, with four players in the arena—the buyer, the developer, the local bank and the local government. In China, property is transacted on a pre-sale model. The buyer places a deposit with the developer, after taking a loan against his savings/estimated earnings from a bank. He begins paying a mortgage on a house that has not yet been built. The developer collects pre-sale cash from an ever-growing number of apartment buyers. He also collects cash from individual investors and banks willing to invest in his mega projects. The developer uses the cash to launch more projects. The local governments become active facilitators for the banks, developers and buyers, since 30% of their revenues come from land transfers and construction related taxes. This spiral drives up costs of land, raw material, cost of housing, etc. This ever-widening circle of debt-fuelled construction creates wealth to induce celebration. The sale of luxury items zooms up. Jobs are created in the construction, steel, cement, and other industries. This looks awesome on China’s GDP graph. So what if all the apartments are not sold or ghost cities get created?
Indication of trouble surfaced last year when property giants like Evergrande, Kaisa and Fantasia started defaulting on billions of dollars’ worth of loans/bonds. Incomplete projects left homebuyers high and dry, with only mortgages to repay. Reflexively, home sales and property prices fell drastically. Developers stopped buying land from local governments. Local governments became cash-starved due to a fall in land sales and taxes. They face shortfalls of up to US$0.9 trillion. As the economy slowed, unemployment and pay cuts increased across the board. Unemployment rates for the youngest and most aspiring 16-24 age group has been the highest irrespective of being educated or not. Appetite for new houses fell. The downslide began with the Evergrande fiasco. Protests in front of failed banks came a year later.
The total asset value of the collapsed Henan banks is about $6 billion, with a customer base of roughly 400,000. It is peanuts for the vast Chinese financial system. Logically, if the issue was local, these customers should have been compensated as it was done when similar small banks collapsed in 2020-21. However, instead of compensating, the Chinese have turned every trick to silence depositors. The Covid test code on the depositors’ smartphones were turned red to restrict their movement to the bank. When the depositors started a protest, local thugs were sent to assault them viciously. Uniformed police officers looked on. Then tanks were lined up in front of the banks to scare off depositors. All these deposits have now forcibly become “investment asset products”. The Chinese are scaring their citizens lest a contagion of protests begin. The malaise is widespread.
The contagion has meta-stated. Across 235 projects spanning 91 cities in 24 of China’s 31 provinces, homebuyers are refusing to pay mortgages on loans since homes are not being delivered. The estimated value of affected mortgages is about $297 billion. That is significant considering that 70% of household wealth in China is invested in real estate. New home purchases account for about 80% of sales. If refusal to pay mortgages continues, the property sector could collapse. People refusing to pay their mortgages are being threatened officially with social credit downgrade.
The drawdown of the property sector is now irrevocable. Unfinished buildings and ghost cities were always the harbinger of things to come. Many of these unoccupied units are investment properties for citizens who already have primary residences. They cannot be sold at profit to trigger a real estate buying spree in a depressed economy. Look deeper. China already has enough empty property to house more than 90 million people. Further, China’s population has peaked and will begin to decline quickly. China’s demography indicates too many aged citizens, a dwindling pension system, decreasing work force, inadequate social security, and low birthrates. Demand for property in future will decrease. Developers owe billions to Chinese bondholders and foreign investors. There are huge backlogs of payment to construction workers. Many listed developers are still facing liquidity problems. Small banks are at risk of collapse. When the going was good, real-estate was the prime driver of Chinese economic growth. Now it is the prime drag.
BRI, THE SECOND PONZI
China’s Belt and Road Initiative (BRI) was launched in 2013. The vast collection of development and investment initiatives—railways, highways, ports, energy projects and industrial estates—spanned all continents to expand China’s economic and political influence. BRI was to establish China as a superpower. More than 60 countries signed on to projects. The $62 billion China-Pakistan Economic Corridor was the flagship of BRI. China has already spent an estimated $200 billion on BRI projects. The outlay was to reach $1.2-1.3 trillion by 2027. The BRI started off in a frenzy. Countries were engaged in closely guarded bilateral contracts. Enticing loans were extended by large Chinese banks. Excess Chinese capital and capacity was deployed overseas to boost the economy. Chinese merchandise was to flow in outbound streams. Inbound traffic was income, food grains, energy, and resources to drive the Chinese engine. BRI would create and consolidate a Sinocentric world.
The first hiccup came at Hambantota. In December 2017, an indebted Sri Lanka signed the port over to China on a 99-year lease. The debt trap had closed and misgivings about the BRI started surfacing. By 2019, some participating countries sought renegotiation on loans and terms of projects. Others started to explore ways to terminate unviable projects. However, many poor countries, considered high risk due to weak economies and corrupt political systems, continued with the BRI. The BRI ecosystem continued to expand with more countries joining in. China went on a lending binge to expand the BRI. Now, China has more loans outstanding to low-income countries than all the members of the Paris Club combined. The Ponzi trap was set.
The Covid put brakes on most BRI projects due to physical lockdowns, stressed economies and changed political scenarios. In places like Pakistan, BRI is struggling due to security threats. Breaks induced in the BRI cycle meant that many countries could not repay either the loans or the interest. The global economic downturn due to the Ukraine war weighed in alongside Covid. China is now fighting debt fires in many countries. It is extending “rescue loans” that allow debtor countries to service their loans and avoid default, which amounts to throwing good money after bad money. Countries receiving “rescue loans” include Pakistan, Argentina, Zambia, Belarus, Egypt, Mongolia, Nigeria, Turkey, Ukraine and Sri Lanka. Pakistan and Zambia are addicted to repeated “rescue loans”, which China is now forced to part with. All these countries have a credit rating of “junk”, with a high chance of default. Large Chinese banks which lent tens of billions to these countries as part of BRI funding are at risk. A significant portion of their credit portfolio is likely to become nonperforming as the borrower countries cannot service the debt. In many BRI projects, debt is being converted into equity. It means that China now partly owns unviable projects like Hambantota, or is a partner in a project which it built for profit with substandard specifications, but is now responsible to operate and deliver as per public expectation in that country. This represents a dead loss. The BRI has become a financial white elephant.
Combine the two Ponzis and a mega problem pops up. China has about 4,000 small and medium-sized banks with nearly $14 trillion assets. If more small banks fail, a chain reaction could threaten the stability of the larger financial sector. Big Chinese banks are also troubled due to rising nonperforming loans and assets of BRI. The entire banking system of China is stressed. The question is will there be a financial crash? No. The government controls the banking system: the central bank, the big four state-owned commercial banks and the so-called “bad banks”, which absorb bad loans and small banks. A financial crisis is ruled out. The government will simply order the People’s Bank of China and the big four banks to do whatever it takes to stabilise the situation. Defaulted loans will be exchanged for equity stakes. Pension funds will buy shares and bonds of failing companies. Local governments will be forced to complete property projects. A special fund will be set up. However, the two Ponzis will significantly slow down the Chinese economy and curb its global influence. China will have to find a new economic model to grow based on a fundamental transformation. Debt fuelled infrastructure models—internal or external—to pump growth, are over. There is economic pain and internal weakness ahead. China might seem to be a fire breathing dragon while being a sick lizard.
Lt Gen P.R. Shankar PVSM, AVSM, VSM (Retired) is a retired Director General of Artillery. The General Officer is now a Professor in the Aerospace Department of Indian Institute of Technology, Madras. His articles are available at www.gunnersshot.com