The author is Zhao Jian, president and professor of the Caesar Research Institute.
The logic of this article:
First, the chain reaction triggered by the "three red lines"
Second, the balance sheet soft constraint and the debt explosion
Third, be wary of the Great Recession of the Chinese-style Balance Sheet
(5750 words, reading time about 7-9 minutes)
<h1 class="pgc-h-arrow-right" data-track="12" > the chain reaction triggered by the "three red lines"</h1>
The "three red lines" are triggering a major earthquake for real estate enterprises, and in order to withdraw funds, they have to sell inventory at a low price in large quantities, and reduce land acquisition and investment. Even a large number of projects under construction are closed to reduce capital consumption, and the payment of goods and workers' wages to upstream suppliers can be owed. In short, cash has become the only "life-saving straw" for Chinese real estate developers (especially private enterprises), and all cash-consuming projects must be reduced or even cut down, at the expense of future development - if it goes bankrupt because of default, there is no future to speak of.
Figure: The second half of 2020 began to usher in the tide of credit debt maturity of housing enterprises (unit: 100 million yuan)
It can be said that the "debt-deflation" triggered by the "three red lines" has been formed in the real estate sector and is spreading to the financial sector. Trust companies are the first to be the most affected. In the past few years, due to the narrower and narrower channels for real estate developers to take money in banks, they can only rely on trust companies with flexible operating mechanisms and "exquisite eight-sided" (channel business). Of course, most of the trust companies are only channels, and the ultimate source of funds is still the bank. As a result, the bad pressure on banks is getting bigger and bigger, and several small and medium-sized banks I know are preparing for the upcoming new round of credit risk.
Figure: Growth rate of real estate developers and capital trust balances in 2017Q1-2021Q2 (%): The balance of real estate trusts has entered a negative growth range since 2020
The financial field has long been affected - even the centralized auction of land in Beijing and Shanghai has been auctioned one after another, and other third- and fourth-tier cities can be imagined. Land has two major significances for local fiscal revenue: one is the direct income from land sales, which is conservatively estimated to account for more than 60% of local fiscal revenue; the other is local debt with land as collateral, mainly in the form of loans and non-standards. Many third- and fourth-tier cities have debt ratios of more than 400%, that is, debt exceeds 4 times the fiscal revenue, so it is easy to estimate how much debt issued on land as credit is, and how important it is to local finances.
Beijing and Shanghai are also difficult to escape the withdrawal of cards, and the heat of postponement of transfers has decreased compared with the first round
What is more serious is that the current institutional setup of local governments and the number of public servants are planned and allocated according to the budget when the land finance was hot, resulting in the bloating of institutions (various investment companies, development companies, and industrial parks) seen now, redundant personnel, and huge expenses. Now that the finances are about to be landed, what will fill the huge budget gap? The ratchet effect, how difficult is it to be frugal from luxury, and how to deal with the social instability caused by it?
Inevitably, another drastic housing price decline cycle has arrived, and under a similar taste, many cities have begun to introduce "restriction orders". This is clearly another "ostrich policy". The result is that house prices have stopped falling on the surface and statistical indicators, but the volume of transactions has shrunk significantly. People who desperately need cash flow and need to sell their houses can only trade through intermediary fraud at a lower price, which increases transaction costs and stimulates the popularity of "black market" transactions. Not to mention the concentrated sell-off (selling quickly before the lower limit) caused by the limit decline, and the resulting further panic (buyers almost disappear under the limit price).
Therefore, in the case of increasing fiscal risks, the pressure of "six stability" and "six guarantees" alleviated by relying on external circulation (a record increase in China's exports during the epidemic) may have to return to the scope of the policy level. What I am more worried about here is that the decision-making level has access to and prejudgment of real information. If real estate is placed under collective moral judgment, the resulting systemic risk is not measurable by economic value alone.
Pictured: Chinese banks are shifting more loans from real estate to industrial enterprises
Our strength is strong state control, but that doesn't mean local governments have the capacity to govern in a match. The implementation of "circuit breakers" for the collapse of the market is a common practice in the stock market, and there is a lot of controversy, but it seems to be able to play the effect of "time for space". That is, press the pause button at an irrational time when investors are extremely panicked, so that everyone can calm down and return to rationality and common sense. However, it is not clear whether the "freezing" of the sharp decline in house prices can have the same effect. However, according to the experience of previous years (2013-2014), after the local government "froze" house prices, the next step was to relax the control policy of restricting purchases and loans, and then reduce the interest rate lending limit and relax the credit policy, and even accelerate the "helicopter money" - the currency issued by the last round of shed reform currency was as high as 4.5 trillion yuan. Eventually, there was a huge rebound in house prices, and house prices in most first- and second-tier cities almost doubled in 2016.
What is different this time is that the supply of real estate has suffered unprecedented damage. In order to meet the "three red lines", housing enterprises have almost stopped normal investment and development activities. The strict price limit order in the previous stage also made housing enterprises have to cut corners, and even violated the spirit of the contract to fake school district sales, resulting in the quality of real estate delivered in recent years is very poor, and group incidents have broken out one after another, which has seriously affected social stability.
So I am worried that after this big reshuffle of housing enterprises, there will be a serious crisis of "inventory shortage" of new houses in the short term. This has appeared in many supply-side reform industries, such as the environmental protection governance of the pig industry last year, which led to a crazy rise in pork last year, and after re-encouraging breeding, it led to overcapacity, and meat prices fell sharply in the second half of this year. Taking Beijing's data, due to the high rate of auctions (known as "postponement"), the first batch of new housing for land supply may only be sold for 5 months, not to mention other cities with higher streaming rates.
If such a story plays out, house prices will soon re-enter uncontrollable fluctuations, and the credibility of local governments may suffer another huge criticism. However, if the policy is not relaxed, continue to be red line high pressure, house prices can not be stabilized, into a sharp decline range, the consequences are not only the survival and development of the real estate industry, but also lead to credit crisis, bank crisis, and finally the local financial crisis. Perhaps many years later, looking back, all this is just a chain reaction triggered by a small "three red lines".
<h1 class="pgc-h-arrow-right" data-track="98" > second, balance sheet soft constraints and debt explosion</h1>
Why should we clean up the debts of housing enterprises? The fundamental reason is that China's real estate enterprises have been alienated into a kind of "land bank", that is, a "shadow bank" that uses land as a credit generation mechanism and operates liabilities. Of course, it cannot directly create money, but it can form loans in banks through real estate development loans and property mortgages, which in turn create deposits, that is, the broad currency M2.
Once enterprises begin to operate debt-oriented like banks, there is a huge "negative externality", and the risk caused by debt default cannot be digested by itself, and the whole society will bear it together, which requires supervision. Compared with the hard constraints such as market demand (profit constraints) and technical curves (supply capacity), the expansion of the debt side is relatively simple, especially in an environment with too low interest rates and monetary easing, and the balance sheet is full of brutal expansion impulses under the temptation of low cost on the liability side.
So can debt really "grow to heaven"? Can money really be created out of thin air? This depends on the constraint mechanism of debt and currency issuance, of which the balance sheet constraint is one, which means that assets and liabilities belong to the same person. If the assets formed by debt belong to themselves, but the responsibility for debt repayment can be passed on in whole or in part to others, then the balance sheet lacks constraints, or "soft constraints".
Each country is unique, but the basic principles of economics, finance, and accounting are universal. Debt is an overdraft of future resources, and the increase in debt can certainly bring about economic growth, because it concentrates future resources on the present: what cannot be bought on its own income can now be bought, projects that cannot be invested can now be invested, demand increases, and GDP can easily come up. This is a more magical mechanism for economic growth creation: demand is created out of thin air by debt, and then supply is mobilized under the drive of demand, and the economy grows. From the perspective of the balance sheet, it is to create assets through liabilities. This process is full of temptations for businesses, individuals, and governments.
Theoretically, a reasonable debt-driven mechanism is that assets formed through debt have a reasonable rate of return to ensure that the net cash flow (profit) realized in the future can be repaid on time, which is the first financing state described by Minsky. How to ensure that this benign state emerges and continues depends on a sound budget constraint. This constraint is not only a constraint of the current period, but also a long-term dynamic intertemporal constraint. Speaking of popularity, the debt is repaid (current liability), and the father's debt is repaid (intertemporal liability). As long as there is such a constraint and a clear repayment expectation is formed, the debt will be in a reasonable growth range, and the irrational "debt explosion" will basically not occur.
A fundamental principle of this budgetary constraint, or the "first principle" of indebtedness, is that whoever pays the money, the debtor and the person who repays the debt should be guaranteed to be the first person. This constraint, which we call a dynamic budget constraint, is a dynamic budget constraint. And the same balance sheet, the person responsible for the liability and the asset should be the same person, because the balance sheet itself is two sides of the same coin. This constraint is the "balance sheet constraint."
If there is a dynamic budget soft constraint, one person borrows money, and when it comes to repaying the money, another person can repay it, then what will the borrower do? The money borrowed by an enterprise can make the whole society repay; it is the current who borrows the money, the next person who repays the money, and the next term, so what will the executives of the enterprise and the officials of the local government do?
More seriously, if the two sides of the same coin are forcibly separated, the assets belong to themselves, and the liabilities are passed on to others, what will the boss of the enterprise do at this time? In this wave of debt, we have seen too many such stories of "flower transfer", its magic, its absurdity, its cruelty, and people have to lament that the drama of reality is much higher than the drama itself. This phenomenon is called "balance sheet soft constraint".
Are these issues unique to China? Definitely not. Looking at the economic and financial history of the United States a hundred years ago, it also experienced such a barbaric and absurd process, which is described in the classic best-selling book "The Great Game". This is the basis of history, and from the theoretical basis, from the perspective of the balance sheet, modern growth can be examined from two lines. One is the asset side, which is the main line of the traditional model (neoclassical model), that is, the economic growth is mainly driven by physical assets and the real economy; this is also depicted by the classic production function: capital, labor, technology, and the indescribable total factor productivity (TFP). This can be seen as the "yang" side of economic growth.
The other line is the liability side, which can be called the "Minsky model", which some scholars call the "modern model", corresponding to modern monetary theory (MMT). Minsky is generally classified as a post-Keynesian, and his most prominent contribution was the discovery of financing constraints in economic growth and volatility. Before Minsky, neoclassical economists believed and studied only "real growth," saw only the "yang, and basically ignored the impact of money, credit, and even the entire financial system on the economy. Now, we finally understand that "finance is the core of the modern economy", which basically grasps the core characteristics of the modern economy. The debt side can be seen as the "yin" side of modern economic growth.
Since finance is the core of the modern economy, grasping finance is equivalent to grasping the bull nose of the modern economy. Looking at the world, the strongest financial competitiveness is the United States, Wall Street controls and determines the lifeblood of the global economy, the fundamental reason is to seize the operating center of the international financial system. From industrial capitalism, to financial capitalism, to the fund manager capitalism described by Minsky, from the perspective of the balance sheet, it is essentially the story of driving real economic and wealth growth through the operation of liabilities. This is a testament to the energy of the debt explosion and the balance sheet expansion, which has been maximized by national finance departments and central banks after the subprime mortgage crisis a decade ago and after today's pandemic crisis.
However, after all, debt cannot replace real growth, and debt can only create demand but cannot directly form supply. When the debt swells to a certain extent and begins to be difficult to maintain (generally speaking, the energy of liquidity cannot sustain a sustained increase in entropy), an extremely cruel and painful process in contrast occurs, that is, the Great Balance Sheet Recession.
<h1 class="pgc-h-arrow-right" data-track="99" > third, be wary of the Great Recession of the Chinese-style balance sheet</h1>
Whether it is a traditional model or a modern model, the main consideration is flow (investment, financing are flow). When Japanese economist Koo Chaoming studied the long-term recession of the Japanese economy, he found the impact of stock contraction on the modern economy, the so-called "Great Balance Sheet Recession". The main idea is that when the asset price bubble bursts, huge loss write-downs occur on the asset side, but the repayment obligation on the liability side still exists, which will occur in two situations: the first is that the asset price declines very largely, to the extent of insolvency, accompanied by the bank's monetary contraction and liquidity crisis, and finally have to go bankrupt and liquidate, the balance sheet becomes nothing, the enterprise disappears, and the personnel lose their jobs. At this time, it will create a crisis situation of the Great Depression at the macro level.
The second is that although the fair value of assets has also been greatly reduced, even to the point of insolvency, the cash flow statement is OK, the liquidity crisis has not yet occurred, there is cash flow on the account to repay debts and pay wages, and the company can maintain daily operations. However, due to the serious damage to the balance sheet, unless it is a hundred years into bankruptcy, the debt repayment obligation of the enterprise will always exist. If the company still wants to survive, in the long years to come, there may be only one task left: to make money and pay off debts.
Imagine if a business, a household, is stuck in a state of debt repayment for a long time, then what additional expenditures do they have to expand reproduction and increase new consumption. Instead, companies will cut wages and lay off employees, reducing all unnecessary expenses to save money to repay debts. The same is true of families, where all members, under a heavy debt burden, have to cut back on their debts. Why is that? Because the balance sheet is broken and the debt ratio is climbing sharply as asset prices shrink, only shrinking debt can make the balance sheet look healthier. At this time, although the crisis does not look so serious, it will fall into a long-term recession and rigidity.
Similarly, asset prices are broken, american companies and households generally choose to go bankrupt and clear, while Japan chooses to resist debt repayment. This may be related to the cultural traditions of the people and the philosophy of the company. The United States advocates market liberalism, and Japanese companies have a traditional family culture and a culture of loyalty, so they pursue a lifelong employment system, and they are very face-saving, preferring to choose to silently repair the balance sheet rather than be liquidated. This is also the root cause of Japan's loss of the "two decades" of the long great recession and the prevalence of zombie companies. In this "lost twenty years," they have put in a generation of efforts to "fill the pits" and fill the asset impairment losses caused by the bursting of the real estate and stock market bubbles. At this point, the profits are used to supplement the damage on the asset side, and of course there are no resources to support expanded reproduction and "real growth". From the statistics, we can clearly see that Japan has been close to two decades, and the balance sheet of the entire country, except for the government, has shrunk.
Chart: Japan's balance sheet recession in the 1990s
Under this principle, if the sharp decline in China's housing prices leads to a sharp revaluation of the fair value of the assets of banks, residents, enterprises, and local governments, it will inevitably lead to the damage of the balance sheet. That is, the asset side shrinks, but the liability repayment obligation cannot be less than a penny, and a large number of "impairment losses" will be formed in accounting (belonging to the owner's equity loss, and the bank side is a non-performing asset). At this time, Chinese companies will also face two choices. The first is bankruptcy liquidation, and the second is slow digestion after freezing. Judging from the government's preferences and handling habits, it is generally chosen to freeze the balance sheet and then gradually digest the bad debts through restructuring. At this time, it is likely to enter a Japanese-style balance sheet recession. The economy is also likely to enter one of the most frightening conditions of the modern economy: people no longer want to borrow to expand consumption and investment, but are bent on repaying money.
Chart: Discussion of "stagflation" (via @DavidInglesTV)
There is an old Chinese saying (ghost valley): a gentleman conspires against the yin and becomes a yang. For an economy, as a negative liability, it should be to serve the assets of the yang side, the so-called financial services real economy. For a healthy economy, it should also rely on yang qi to survive like a healthy human body. But now the global economy is in a state of dependence on the yin of debt, and such a balance sheet is certainly unhealthy. When the accumulated lesions will erupt clinically may only be a matter of time. For China, the courage to take the initiative to break the abscess is certainly commendable, but the ultimate goal should be to treat the disease and save people, rather than simply three red lines "excessive" treatment. After all, the illness comes like a mountain, the illness goes like a silk, and the governance of financial risks should have the patience and meditation of "drawing silk".
China and Japan have similar cultures, but the difference is that under the strong goal of social stability, the government generally does not take an extreme approach when dealing with bad debts, but uses monetization to supplement the "black hole" created on the asset side during the crazy expansion of debt through freezing and taking over. Because China's commercial banks are also state-owned, this means that the government can issue not only base money, but also more broad money. This strong monetary and financial control ability can avoid the huge financial tsunami and economic recession caused by the Great Depression and the subprime mortgage crisis in the United States, but it will pay greater fiscal costs and public credit resources, because this treatment is nothing more than a redistribution of debt and risk. Minsky's time is constantly delayed and blunted by the space of great power superiority, but the distorting effects of structure and institutions cannot be completely eliminated, but exist in a more stealthy form. It's either a zombie economy or a massive stagflation, all of which are typical of the Great Recession on the balance sheet.