Red Chinese Real Estate Dominoes

In 2021, the Red Chinese real estate market started making world headlines when the real estate titan Evergrande Group defaulted on some of its massive debts. As that country's second-largest real estate developer, the risk of financial contagion was - and remains - high. Evergrande is deeply indebted and as Red China's property market was purposefully "cooled," it ran into serious trouble.

When Evergrande started stalling, there was some worry about the other gigantic Red Chinese real estate majors. There are none larger than Country Garden, the top dog in the country. The loss of another real estate major will compound the contagion risks in and beyond Red China, and that looks like it might be in the early stages of happening. This month, Country Garden started missing debt payments. They aren't technically in default yet - they are in the grace period - but it's a very bad sign. The Red Chinese real estate economy has been teetering for years, and the failure of a player as big as Country Garden would mark the fall of another major domino.

The potential consequences for their economy are profound. The country has long depended on real estate development to generate GDP growth. More construction, more employment, more sales for intermediate companies and manufacturers, more banking activity, more revenue, more everything. Real estate is awesome, but only on the way up. On the way down, it wreaks havoc and when it represents between a quarter and a third of your entire GDP, the consequences are profound for everything from government to individuals to the vast industrial complex. What isn't geared toward export is often geared toward real estate, at least in some fashion.

It's even worse in Red China because of the unusual way real estate works there. All land is owned by the state, and tracts are leased out to "buyers" at auctions. The leases are for 70 years and the money goes to the local government. Land finance is a primary local and provincial government funding mechanism. Unlike countries with a proper property market, a real estate downturn there has huge consequences on all government operations - including financing massive infrastructure projects, which are another enormous chunk of Red China's GDP.

Another distinctly Chinese consequence of declining real estate is how it is financed. There is a pre-sale system for new developments, where the buyer gets a mortgage and buys the house or apartment before it exists, and repayment starts immediately. The money is transferred to the builder to build the development and when finished, units are handed over to the buyers. The money is ostensibly held in trust and is to be used for construction, but there is a lot of fraud and corruption and a lot of the money goes to other things like buying more land and greasing Party members. When this breaks down, the buildings don't get finished and they become "rotten tail" projects. The buyer still has to pay the mortgage because if he doesn't, his social credit score collapses not just for himself but for his children. The buyers are left holding rights to unfinished buildings that the developer can't finish, and they must keep paying or be punished by the government. Generations' worth of a family's accumulated wealth vanishes or ends up locked up in finished properties that can't be profitably sold, putting still more downward pressure on the economy.

The banks, of course, are also hit. The Red Chinese banking and real estate sectors are deeply entwined, and cascading failure is a meaningful risk. People and businesses are caught in the crossfire, their money gone and the government unable or unwilling to bail them out. The government is probably unable - it's simply too much money.

This all matters for two reasons. First, there is a huge amount of foreign capital - including American capital - tied up in Red Chinese real estate. It is unlikely to cause a crisis over here, but it could result in major losses for those who gambled on it. Much more important, however, is that this is going to continue deeply stressing that country, adding more strain to an economy that is likely already in structural decline. Some consequences of this will be positive, because Red China will have less money to throw at things like the belt-and-road projects and it will be less able to dictate terms around the world. But compounding, all-levels economic decline also has the potential to make the country - and its ruling party and emperor - increasingly desperate.

A desperate Red China may also be a reckless Red China, and that may have extremely significant consequences both inside and outside its own neighborhood.

posted by Joe Mannix at 03:45 PM

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