China’s changing growth model, not Evergrande, is the top threat to prosperity

The new emphasis on redistribution plus re-regulation strikes at the heart of the reform that has underpinned China’s growth since the 1980s
The Evergrande crisis will pass, but a regulatory clampdown in conjunction with a push to redistribute wealth could rewind the Chinese miracle

Stephen Roach

Published: 1:30am, 29 Sep 2021

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All eyes are fixed on the dark side of China. We have been here before. Starting with the Asian financial crisis of the late 1990s and continuing through the dotcom recession of the early 2000s and the 2008 global financial crisis, China was portrayed as the next to fall. Yet, the Chinese economy has defied gloomy predictions with a resilience that took many observers by surprise.

Count me among the few who were not surprised that past alarms turned out to be false. But also count me in when it comes to sensing that this time feels different.

Contrary to many, I do not think Evergrande Group is the problem, or even the catalytic tipping point. Yes, China’s second-largest property developer is in potentially fatal trouble.

And yes, its debt overhang of some US$300 billion poses broader risks to the Chinese financial system, with potential knock-on effects in global markets. But the magnitude of those ripple effects is likely to be far less than those who loudly proclaim that Evergrande is China’s answer to Lehman Brothers, suggesting that another “Minsky moment” may well be at hand.

Three considerations argue to the contrary. First, the Chinese government has ample resources to backstop Evergrande loan defaults and ring-fence potential spillovers to other assets and markets.

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Angry protest at headquarters of China Evergrande as property giant faces liquidity crunch

With more than US$7 trillion in domestic savings and another US$3 trillion in foreign exchange reserves, China has more than enough capacity to absorb a worst-case Evergrande implosion. Recent large liquidity injections by the People’s Bank of China underscore the point.

Second, Evergrande is not a classic “black swan” crisis. Rather, it is a deliberate consequence of Chinese policy aimed at deleveraging, de-risking and preserving financial stability.

In particular, China has made progress reducing shadow banking activity in recent years, thereby limiting the potential for deleveraging contagion to infect other segments of its financial markets. Unlike Lehman and its devastating collateral damage, the Evergrande problem hasn’t blindsided Chinese policymakers.

Third, there are limited risks to the real economy, which has entered a soft patch. The demand side of the Chinese property market is supported by the ongoing migration of rural workers to cities.

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Few workers at China Evergrande’s half-built Guangzhou FC football stadium amid financial crunch

This is different from the collapse of speculative housing bubbles in other countries where supply overhangs were unsupported by demand. While the urban share of the Chinese population is slightly above 60 per cent, there is still plenty of upside until it reaches the 80 to 85 per cent threshold typical of advanced economies.

Notwithstanding recent accounts of shrinking cities – reminiscent of earlier claims of a profusion of ghost cities – underlying demand for urban housing remains firm. This limits downside risks to the overall economy, even in the face of an Evergrande failure.

China’s most serious problems are less about Evergrande and more about a major rethinking of its growth model. Initially, I worried about a regulatory clampdown, writing in July that the new measures took dead aim at China’s internet platform companies, threatening to stifle the “animal spirits” in some of the economy’s most dynamic sectors.

That was then. Now, the Chinese government has doubled down, with President Xi Jinping throwing the full force of his power into a “common prosperity” campaign aimed at addressing inequalities of income and wealth.

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Moreover, the regulatory net has been broadened, not just to ban cryptocurrencies but also to become an instrument of social engineering, with the government adding to its ever-lengthening list of bad social habits.

All this compounds the concerns I raised two months ago. The new dual thrust of Chinese policy – redistribution plus re-regulation – strikes at the heart of the market-based “reform and opening up” that have underpinned China’s growth since the 1980s.

It will subdue the entrepreneurial activity that has been so important in powering China’s dynamic private sector, with lasting consequences for the next, innovation-driven phase of Chinese economic development. Without animal spirits, the case for indigenous innovation is in tatters.

With Evergrande blowing up in the aftermath of this sea change in Chinese policy, financial markets have reacted sharply. The government has been quick to counter the backlash. Vice-Premier Liu He, China’s leading architect of economic strategy, was quick to reaffirm the government’s unwavering support for private enterprise.

06:54

Is cryptocurrency too risky for China?

Capital market regulators have likewise stressed further “opening up” via new connectivity initiatives between onshore and offshore markets. Other regulators have reaffirmed China’s steadfast intention to stay the course. Perhaps they doth protest too much?

On one level, who wouldn’t want common prosperity? US President Joe Biden’s “Build Back Better” agenda includes many of the same objectives. Tackling inequality and a social agenda at the same time is a big deal for any country. It is not only the subject of intense debate in Washington but also bears critically on China’s prospects.

The problem for China is that its new approach runs counter to its most powerful economic trends of the past four decades: entrepreneurial activity, a thriving start-up culture, private-sector dynamism and innovation. What I hear now from China is denial – siloed arguments that address each issue in isolation. Redistribution is discussed separately from the impact of new regulations.

There is also a siloed approach to defending regulatory actions themselves – case-by-case arguments for strengthening oversight of internet platform companies, reducing social anxiety among stressed-out young people and ensuring data security.

As a macro practitioner, I was always taught to consider the combined effects of major developments. Evergrande will pass. A regulatory clampdown, in conjunction with a push to redistribute income and wealth, rewinds the movie of the Chinese miracle. By failing to connect the dots, China’s leaders risk a dangerous miscalculation.

Stephen S. Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China. Copyright: Project Syndicate