Capitalisn’t: Is Evergrande Really China’s Lehman Moment?

Jim Chanos: This will challenge the whole view in Asia, however, of this be-nevolent, state-sponsored capitalism model, which, up until a few years ago, was being hailed as really something to be emulated.

Bethany: I’m Bethany McLean.

Phil Donahue: Did you ever have a moment of doubt about capitalism, and whether greed’s a good idea?

Luigi: And I’m Luigi Zingales.

Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.

Bethany: And this is Capitalisn’t, a podcast about what is working in capital-ism.

Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?

Luigi: And, most importantly, what isn’t.

Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.

Bethany: China Evergrande Group is one of China’s major real-estate compa-nies, a property developer.

Speaker 8: The company Evergrande is really a household name here. It is the second-largest property developer.

Bethany: Skeptics of China have long said that the property market, which makes up some 30 percent of China’s GDP, is overleveraged and overheated, so bears have been watching Evergrande for a long time. On September 23, Evergrande missed a debt payment.

Speaker 8: And it owes $300 billion in liabilities to various creditors.

Bethany: They have a grace period, but that brought Evergrande into the headlines all of a sudden, because people started to wonder, maybe the bears on China are right, and any kind of problems that Evergrande may have may be the beginning of a wider sell-off in Chi-na’s property sector. Which, because it is so important to the Chinese economy, could then cause a broader problem, both a broader financial problem, possibly, and a broader social problem. And so, people are saying, is this going to be China’s Lehman moment?

Luigi: And, at some level, the analogy with Lehman is very wrong, because one of the problems of Lehman and of the US financial system at the time was that a lot of the in-vestment in housing was directly or indirectly financed through short-term debt. As we know, short-term debt is prone to panics and to moments of runs. I think that that’s not, by and large, the case for the Chinese financial system. In that sense, the risk is limited. However, there are two very important aspects that we need to consider getting into this issue.

Number one, the importance of the real-estate sector in China. Bethany correctly pointed out that roughly 30 percent of China’s GDP, directly and indirectly, is based on its real-estate market. And the real-estate market sector is based very much on the expectation of growth in Chinese GDP. It’s a bit of a chicken-and-egg problem, insofar as they’re now in a very virtuous cycle, but at the moment they slow down, it might work the other way around in a massive way.

The second is, there is a very interesting geopolitical issue, because much of the borrowing done by Evergrande is internal, and, in fact, we’ll hear from some of our guests, it is actually not in the form of loans but in the form of advance payments.

But some of it is done externally through some very complicated system called VIE. VIE stands for variable interest entity. They’re basically saying that people who lent their money to Ever-grande did not really lend their money to Evergrande. They lent their money to an entity in the Cayman Islands whose value is based on dividends that Evergrande pays to this Cayman Island enti-ty. If Evergrande defaults, it’s not like in the United States, where if you default, you can send the police, basically, to seize the assets of the company that defaults. The assets of this VIE entity are basically some claims in China, and these claims are basically nonenforceable.

That’s the dirty secret that nobody wants to talk about, but every investment in China, includ-ing stock investments like investing in Alibaba, goes through these vehicles, and these vehicles are of dubious, at best, legal validity.

Bethany: Another reason Evergrande matters is because it’s actually been the leader in overseas debt issuance, according to a Wall Street Journal piece that just ran in the last couple of days. It’s accounted for six of the 10 largest offshore US dollar-denominated bond deals by Chinese real-estate companies between 2016 and 2021. So, this won’t be a small deal if Evergrande doesn’t pay. I think it will be a sign of things to come. And I wanted to go back to the idea of this being a Lehman moment or not, because history repeats, but it doesn’t repeat ex-actly, right? That’s that old saying: it rhymes, but it doesn’t repeat.

And so, I totally agree with you that the contagion won’t weave through the same channels that the Lehman contagion did. It won’t be through the repo market; it won’t be through global holdings of mortgages backed by subprime loans that are flaring up and like little bombs going off in all sorts of portfolios around the world. But it could be through a different mechanism, which is a loss of confidence on the part of the Chinese people in the property market. And so, the channel of contagion could be different, but there still could be a form of contagion.

One of the guests we decided to talk to is Jim Chanos, whom I’ve known for years, and Jim has been skeptical of China since, I think he said, at least 2009. I interviewed him at a Vanity Fair conference in maybe 2014, 2015, because he was so skeptical of China, and one of the few who was willing to be outspoken about it.

I thought we could start, Jim, you and I had spoken at the Vanity Fair summit about your views on China, your bearish views on China. This is COVID time, and now I can’t remember when that was, but I think it was 2017. Anyway, I thought you could start just by reminding us all of your thesis.

Jim Chanos: We turned bearish on the China economic model and China fi-nancial system at the end of ’09. We began mapping out, quite literally, the amount of real-estate construction that was going on. It sort of stunned us. At the end of ’09, an analyst reported at the time that China had 5.6 billion square meters of high rises under development, half office and half apartments. I sort of chided him for making a rookie mistake by saying, “Well, no, no, no, that can’t be 5.6 billion square meters, it has to be 5.6 billion square feet.”

And he looked at me sort of terrified and said, “I know, I checked three times, it’s 5.6 billion square meters.”

And I said, “Well, if half of that is office and mixed use, that’s a five-foot by five-foot office cubi-cle for every man, woman and child in China.” The enormity of what China was doing was just mind-boggling.

Of course, all that property has been built and then some sort of 3x since 2009, and it got us to look deeper into the nature of the Chinese economic model, and the symbiotic relationship be-tween the Chinese banks, which are all predominantly state-owned and state-controlled, and the economic model, and how massively dependent it was on construction, both then and now. Con-struction—or investment, take your pick—is almost half of GDP. And it was in ’09 and it still is.

Bethany: Can you explain what you mean by that symbiotic relationship be-tween the real-estate sector and the Chinese banks?

Jim Chanos: Yeah. One of the reasons that this model has been embraced by all levels of the Party is because the local governments and the local parties basically earn their money—because they don’t really have a property-tax system—by selling land to developers. Of course, in order to do that, the developers need to be able to develop the land into high rises, and so, they go back to the banks for loans, because everything is pretty much bank-centric still in Chi-na today. Even though they have a nascent bond market, banks are the purchasers of most of those bonds, so it all comes back on bank balance sheets in China.

In effect, you’ve got these giant state-controlled and state-owned banks, and they’re the largest in the world, that are extending credit to developers, who then pass the money on to the local governments. Instead of taxing consumers with a property tax, you’re in effect overcharging them for real estate. That’s how the system is jerry-rigged to avoid taxation on assets or on property, as we do in the West, but economically, there’s still taxation. It’s just been deferred.

Luigi: But the amazing thing about China is, until basically the late ’90s, there was no private property of houses, and so, in a little bit more than 20 years, they have increased home ownership by a huge amount, and they increased supply by a huge amount. And you said in 2009 you started to be negative. Hopefully you didn’t short too much, because you would have lost your shirt many times in the meantime.

Jim Chanos: Au contraire, China has been the best short of all financial mar-kets in the past 12 years. The Chinese market has gone down since the end of ’09. The FXI, which is the US-traded China ETF, was $41 at the end of ’09. It’s now, I think, $37 or $38. It’s been the best single short that any bear could have wished for in this global bull market.

Luigi: So, the real-estate prices in China have gone down since ’09?

Jim Chanos: No, no, no, I’m talking about the financial markets.

Luigi: I see.

Jim Chanos: I traffic in the financial markets. You can’t short individual apartments.

Luigi: No, no, I understood. But your prediction—and maybe I’m missing a step here—but your prediction was linked to oversupply of construction that eventually would lead to a drop in house prices, and we have not seen that drop yet.

Jim Chanos: But the markets, obviously, the financial markets are discounting the profit streams of Chinese corporations—both the banks and real-estate developers, as well as others—because I think they see the same thing, ultimately, that we see, that this is not sustaina-ble. The stock prices of the developers, the stock price of the banks, anybody related to the lever-aged economy, has gone nowhere or gone down over the past 12 years, despite the GDP almost tripling since that time.

Bethany: Can you explain that disconnect a little bit more and why that isn’t highlighted more in the narratives of China’s takeover of the world? And is there a comparable that we could look to in US markets where you’ve seen a disconnect like that, between one sector do-ing one thing and the signal coming from the market for such a long period of time telling you something else entirely?

Jim Chanos: Obviously, there are mixed signals that come out of China. If you’re focused on GDP growth and prosperity, there’s no doubt that that has happened. The prob-lem becomes, just how much debt has been incurred in more recent years to keep the game go-ing? That’s number one.

Number two, the Chinese banks have just continually traded at lower and lower prices to tan-gible book value. Right now, they’re the cheapest in the world. They’re trading at 0.3 times tangi-ble book, which tells you that the market doesn’t trust the balance sheets, and it’s making it diffi-cult for Chinese banks to issue equity.

Conversely, healthy banks trade over one times book, as most of the big Western banks do now, but China, of course, is trading at only 10 percent of those levels. And so, there’s a healthy skepticism in the marketplace about this model, and also about agency risk, right? In that the prof-its in the system, to the extent there are true economic profits, don’t really derive to shareholders in the Chinese system. They derive to insiders in the Party. Now, for four or five years, this was all forgotten as China brought its tech giants public in the West, like Alibaba, and Tencent, and Baidu. Then, of course, Western investors flocked to those.

But we now know, as Xi has begun to tighten his control politically, he’s gone after the tech giants, and they’ve suffered as well recently. There is this sense that China has cutting-edge tech-nology, it’s going to challenge the West, it’s going to challenge America in terms of growth and productivity, but the brutal fact of the matter is the economic model is still dependent upon stick-ing shovels in the ground. And I think that’s the thing that Evergrande has brought back to the fore, just how dependent China is on investment.

Luigi: Some people have used the analogy that this is a gray rhino rather than a black swan—something completely unexpected—it’s a rhino that everybody expects to charge, and so there is no surprise to that. Is this reassuring in the sense that because it’s so expected, you wouldn’t see a major impact on the economy, and particularly in the economy outside of China? Or, in spite of the fact that this was highly predictable and predicted, is it still going to have a ma-jor impact? If so, what are the channels?

Jim Chanos: I mean, I think we’re with the majority on this view that we don’t see an international systemic risk, although with debt crises you never know. But because of the closed nature of the Chinese system and financial system, this is basically going to be a Chinese problem. Now, what are the implications cross-border? Well, certainly, if Chinese GDP growth truly slows, despite what they might print, it has an impact on what we call Greater China, which are the countries that touch upon China, that trade actively with China, as well as commodity providers. People that are shipping iron ore, copper, and whatever to satisfy China’s voracious appetite.

There might also be some knock-on effects on the One Belt, One Road Initiative, which is Chi-na’s geopolitical attempt to recreate the Silk Road using debt for developing economies. But, for the most part, I suspect this is an issue that China will have to deal with internally through recapi-talization of the banks, various bailouts, limited or otherwise, and they’ll muddle through.

Let me just point out, historically, there is a blueprint here, albeit at much, much reduced lev-els. In 2000, 2001, China had to recap its banking system before it entered the WTO. At the time, in US dollar terms, China had a GDP of about $1 trillion US. They had a banking system with assets of about $1 trillion U.S, and 40 percent of those assets were bad.

So, they had to recap the banks somehow to the tune of about $400 billion, or 40 percent of GDP, and they did so through a variety of methods. They raised equity, they set up these asset-management companies that the state implicitly guaranteed to take bad debts off the banking sys-tem, replace them with bonds of the asset-management companies. Today, we have a Chinese economy that is $15 trillion US, and a banking system that is about $60 trillion.

Bethany: Wow.

Jim Chanos: So, you can see that this is a magnitude of much, much different proportions.

Bethany: Can I challenge that sanguine view that it’s not going to necessarily leak outside of China, and not from the standpoint of any knowledge, but just from the standpoint of, how in this world can China keep it closed? How can they manage to do that? And let’s take just a few little signs that maybe there will be leakage from the debt holdings in Evergrande by firms like BlackRock and Fidelity, to the Secretary of State today coming out and telling China to please handle this responsibly. What does all that mean?

Jim Chanos: Don’t forget, some of the supranational banks like HSBC and Standard Chartered that have 40 percent of their loan book in what they call Greater China. A lot of that is cross-border, and a lot of it is hidden Chinese exposure.

Bethany: Yeah, how is there not leakage?

Jim Chanos: Oh, there will be some, but when you tend to have these runs, it tends to be on the liability side of the balance sheet. We know the assets are bad, right? But what made ’08 so hair-raising was that suddenly no one would fund each other, and so you had a liquidity issue that then made the insolvencies even worse, and it became a spiral. That part of it, the deposit side and the funding side, is quite a bit different in the Chinese banking system than it was in the Western banking system in ’08. But look, I mean, arguably the asset side is worse. The problem in ’07, ’08, was residential real estate, which, when all was said and done, went down, but not to the extent that commercial real estate and the overvaluation of Chinese property could go down.

Luigi: What is your forecast for the drop in commercial real-estate prices in China in the next year or so?

Jim Chanos: I don’t know. All I know is that valuations in terms of rental in-come for commercial or national income, per capita income, in China right now are at all-time highs. I mean, higher than we saw in Tokyo in ’89, higher than Spain in ’06, higher than Ireland in ’07, so you’re at pretty rarefied levels in terms of the overvaluation of the real-estate sector rela-tive to incomes. Can it keep going? Maybe, but it sure seems like that’s not the way you want to be positioned. At some point, you get to the point, like Evergrande, where you can’t manage all of the debts, and you do have to start giving people some haircuts.

And what does that do for confidence? What does that do for the marginal apartment buyer? Keep in mind that right now there is enough housing to house all of the people in China’s cities, so the new construction is basically being bought by people for speculative investment purposes. These apartments are empty. When you see row upon row of apartment buildings in China where there are no lights on, it’s not as if the apartments weren’t sold. They were. It’s just there’s nobody in them. And when that pops, I think the risk, Luigi, is much more residential construction than it’s commercial construction.

Luigi: I think you made it very clear that the liabilities of Evergrande are dif-ferent than the liabilities of Lehman, and there is not so much short-term debt, so there wouldn’t be a run as we experienced in the United States in 2008. However, you said that the problem is on the asset side, and the moment you mentioned that scares me is Tokyo 1989. Also, in that case, we didn’t see a financial crisis in the American sense, but after that we saw two decades of a poor-performing economy.

Jim Chanos: The zombie banks. Yep.

Luigi: Exactly. Do you expect something like this to take place in China?

Jim Chanos: To me, that is a more likely scenario than smoking ruins in the banking system. One thing I will mention, though, that I think the authorities are concerned about is, in the case of the developers, a huge chunk of the liabilities are what we, from an accounting point of view, call deferred revenues. In the West, property developers get paid typically at the end of the construction process. In China, it’s the opposite way around. The buyers finance the construction. So, one of the largest liabilities on the Evergrande balance sheet, as well as the other developers, is what they owe to customers, i.e., they owe them an apartment, and right now, it is very clear that Evergrande can’t deliver on those promises.

This is where confidence comes in. In the West, in the Lehman crisis, it was commercial confi-dence, it was lenders lending to each other overnight and not trusting each other’s balance sheet. In this case, it’s small, individual retail speculators and investors who put money up to buy their second or third apartment, and suddenly are being told you might not get it. And so, that’s why I’m so worried about transmission into the economic model, that if the model depends on ever-growing groups of people buying apartments, and you scare people about that, then you’ve got possibly a unique problem.

Bethany: In effect, China has to manage not just the near-term economic fallout of this, but the longer-term social fallout of the loss of confidence. And the latter may be harder to manage than the former. Is that a fair summary?

Jim Chanos: I think it’s a fair summary, and it forces them to reevaluate this whole economic model, right? I always joke that China was the only advanced economy that knew its annual GDP on January 1 of that year. Because, if you have an economy driven by investment, you literally can dial up what you want your growth to be if you never write off the bad debts. I mean, for God’s sake, China grew 2 percent last year. You’ve got to rethink this.

I don’t know if Xi Jinping is that forward-thinking, but maybe a lot of the political crackdown, the saber rattling in the Taiwan Straits, may also just be aimed at creating a set of enemies, domes-tic and foreign, to blame when growth inevitably has to downshift. He wouldn’t be the first author-itarian ruler to do that.

Bethany: Can we back up a little bit to what you thought when you started to see Xi’s crackdown on capitalism in China? And is there a connection between that and what’s happened with Evergrande, or would the latter have happened without the crackdown? Is there anything relevant about that that has then affected the Evergrande situation?

Jim Chanos: Well, the way in which they’re connected, Bethany, is via West-ern investors, but the interesting nexus was then the rise of financing in the West via the VIE struc-ture, and we’re now going to go full circle to our Enron days. There has been this gigantic govern-ance fraud that’s been foisted on Western investors who have been investing in the Alibabas, and even the Evergrandes, in their offshore entities, by the use of the so-called variable interest enti-ties or VIEs. This is something that our mouth has been agape on, because when you invest as a Western investor in a Western-listed Alibaba, you own a holding company that’s based in the Brit-ish Virgin Islands or the Caymans.

You do not own the assets in the People’s Republic of China. You by law cannot own those as-sets, so they get around this by using a variable-interest-entity structure, where the holding com-pany that you are the owner of has its asset and offers a piece of paper in a safe in a lawyer’s office in the Caribbean that says you will share into the economics in some specified or unspecified way of the operations, somehow, in the People’s Republic, but you do not have ownership and you do not vote. It’s bizarre, and then, to make it even more bizarre, the Chinese Communist Party and the Chinese courts, which are controlled by the Party, do not recognize these VIE structures as le-gal.

And, if you read the prospectus for Alibaba’s IPO, or even Baidu, I think, in a recent debt offer-ing put it on the cover of the prospectus, you do not have a claim on the assets in the People’s Re-public. And so, people will espouse whether they think Alibaba or Tencent is cheap or expensive based on cash flows, and price to book, and whatever metrics the analysts want to use, and some of us would raise our hands and say, “Well, that’s all well and good, but it doesn’t really matter if you can’t get your hands on or claim the cash flows.” This will challenge the whole view in Asia, how-ever, of this benevolent, state-sponsored capitalism model, which, up until a few years ago, was being hailed as really something to be emulated.

Bethany: That’s fascinating. Well, thank you so much, Jim, for your time. It’s always wonderful to talk to you, and this was great.

Luigi: Yes, indeed, Jim. Very helpful.

Jim Chanos: My pleasure to both of you. Thank you.

Bethany: I think one of the things Jim laid out that strikes me as rational is the amount of these property developers—not just Evergrande, but all of them—that are financed by prospective sales that then are liabilities on their books, but people have paid the money for the apartments that haven’t been built yet. And so, if they don’t get their apartments because these companies can’t deliver them, that starts to cause a massive crisis of confidence in this whole setup that then is both a financial mess for the government to deal with, but also a political mess.

Luigi: Yeah. I don’t see a state of the world in which the Chinese government will not intervene to protect these guys. If you have put all your life savings into buying a house and the house does not materialize and you’re left with nothing, you are ready to start a revolt. That’s not good for the stability of the Chinese political system or the financial system, so the Chi-nese government will intervene to protect them. And two-thirds of the liabilities of Evergrande are of this nature. Only one-third are bonds issued in the international market or sold in the national markets.

Bethany: I think so, but it’s interesting, there’s a piece that just ran in the New York Times. It’s titled “As Evergrande Teeters, Chinese Media Walks A Fine Line.” And it points out that, weirdly, there are these videos of protesting homebuyers in China that are flooding social media with people asking for help and asking what this means, and there’s just noth-ing on the country’s front pages. The name Evergrande has barely been mentioned by top state-run news outlets in recent weeks, and it was only once that the country’s central bank commented on Evergrande and basically just said, “We’ve got it under control.”

I wondered, when I read that, do they have it under control the way China usually has it under control? Or do they have it under control the way Ben Bernanke had the subprime-mortgage crisis under control in 2006? I don’t know, what do you think?

Luigi: It’s hard to tell, because central banks have always said they have the situation under control, because if they were to say we don’t have it under control, there would be a panic, right?

Bethany: That’s a very fair point, Luigi.

Luigi: I think that they are bound to present it that way. Now, in part, this situation has been prompted by the Chinese authorities, so the Chinese authorities do understand that the real-estate boom market has gone too far. What they’re trying to sell—and there is an el-ement of truth in that—they’re trying to sell that this is a controlled bursting of the real-estate bubble. What we know by experience is it’s much easier to burst the bubble than to control the bursting, so there could be two potential effects on the West.

What is the effect of the slowdown of the Chinese economy, which has been a big engine of growth for the entire world in the last 20 years? And a major slowdown could have a sneak-away effect, and two, that would be the most dramatic one, as you mentioned, is the idea of either pan-ic or lack of faith in Chinese investment overall, that would lead to a race to the door. And that could have potential impacts because, surprise, surprise, we’re going to find a lot of places where the investment is made in China, and we don’t know.

Bethany: I think there’s also a third possibility that maybe all of what China is doing to crack down on capitalism actually means, and that’s something that for sure is happening. Whether it’s Chinese companies going public outside of China, the crackdown on tech billionaires, the crackdown on property developers, it’s very, very clear that China is a different China than we all thought it was a year ago or two years ago, than it was supposed to be in the popular imagina-tion of the West. And so, I think that very clear—not just possibility, but probability or actuality—accompanies either of those other two possibilities. And it’s interesting, it leaves the world in a very different place vis-à-vis China than I think we all thought we were.

Luigi: As an alternative to Jim Chanos, we decided to interview a colleague of mine, Zhiguo He. He is a professor of finance, he’s the director of the Becker Friedman Institute for Economics in China. He is a Chinese native and a China expert, and overall, in general, a pretty strong bull of China. The argument he makes is that houses are a really special good in Chinese cul-ture and mentality, and people are willing to pay special prices for that. The second argument is that China is strong enough to weather this storm quite effectively.

Many people compare Evergrande to a Lehman moment, of course, referring to the failure of investment bank Lehman in 2008, and the consequences this brought to the US economy. Zhiguo, you don’t seem to agree that that’s a Lehman moment for China. What is your reasoning?

Zhiguo He: There are several logics behind this statement. The first and big-gest one is that the so-called housing developers are very fungible. Basically, they are not even building the houses. There are other construction companies, which are very specialized construc-tion companies and typically state-owned, building these houses. These developers are the guys who are really like intermediaries getting the land from the local governments, figuring out a way to get the license to build houses, finding the people who work on the building, and then sell-ing.

Which means that, right now, if Evergrande goes down, then the other bigger companies are now starting to take over parts of the projects that Evergrande is leaving on the ground. So, that’s the first point, it’s very fungible.

The second one is that the interconnections among these developers are very small, not like Lehman, where all these complicated financial contracts, once you open the book, you are really shocked as regulators. That’s the second point.

The third point is that there was an email among our colleagues saying that Evergrande is only 4 percent of China’s housing market. Even the top 20 only have like 30 percent of the total housing market. In that sense, it’s just very diversified, very equally distributed, so I make the assertion that Evergrande will not get too much of a bailout based on these facts. Even if Evergrande goes down, the contagion effect is not as large as typically people think of Lehman.

Bethany: But is Evergrande the canary in the coal mine, in the sense that it tells a larger story about the other property developers, too? So, while there may not be conta-gion, there is a broader issue?

Zhiguo He: What’s interesting was that there was another big, gigantic wave of housing prices increasing right after COVID, when China contained the virus in a fairly successful way. And you see that everywhere, in bigger cities like Shenzhen, Shanghai, Beijing, the housing price doubled again, and a lot of the reason behind it is a lot of rich families decided not to send their kids here, and then they started to buy more houses, et cetera.

Luigi: If I understood correctly, you just said that prices doubled in a year. Is that right? Did I understand you correctly?

Zhiguo He: For the top cities, yes.

Luigi: Yeah. This is in the context—and you might disagree, and feel free to disagree here—but what we heard from Chanos is that there is an oversupply of houses. Twenty percent or something of the houses are sitting empty. How is it possible that house prices double in this context, number one? And, number two, how can you assume that prices will not fall if 20 percent of the houses are empty?

Zhiguo He: I’m not sure I will be able to convince you, just because there are many different moving parts around these types of calculations. Housing prices in Shenzhen, in Bei-jing, in Shanghai, they’re actually lower than market demand. However, the demand for this hous-ing, especially for Beijing and Shanghai and Shenzhen, is coming from the billionaires or million-aires from outside the region, and this is why everywhere you see that prices are too high, too high, and the government is cracking down, like pushing the high-price cap on the one hand—

Luigi: The millionaires and billionaires are not buying houses for themselves. They’re buying houses in the expectation they can rent them, so the key variable here is, what is the expected rent? If you do a rent-to-price ratio, how does it look?

Zhiguo He: It’s very, very high, as is being said. You’re going to ask, why don’t we just rent the house? You don’t need to own it. However, all these public resources—schooling, everything, for instance, like you go to the hospital—are linked to house ownership, and that ex-plains the huge difference.

Bethany: But if the renters can’t afford to buy, then isn’t it still speculation on the part of the people who are buying and renting it out, even if there’s demand?

Zhiguo He: Rental is rising very, very fast nowadays. Amazingly, on the price side, the government is still trying very, very hard and using all these possible visible hands to just push down the market price. For instance, they set a rule saying this year’s price cannot go more than 5 percent above last year’s price. That’s still there in Beijing. And then, you might wonder, where is all the demand? It must be because of the expectation, so I totally agree with you, and that’s very dangerous. I totally agree with you.

Luigi: I’m a little bit puzzled, because it reminds me a lot of the discussions I had with some people in 2005, 2006, in the United States, where they said, “Oh, but house prices cannot drop, because there is this, because there is that.” And, sure enough, eventually they dropped. Now, that doesn’t mean that I’m right.

Let me try to summarize to make sure I understood correctly. You’re saying that we agree that most of the buying is done for speculative reasons, and so, the ultimate question is, will people in the future be able to afford houses, not at the current prices, but at the future prices?

By and large, it’s a huge bet on the continuous growth of China, so it has the characteristic of a bubble because it’s fed by expectations. And the moment these expectations go down, it does be-come self-fulfilling, because if the growth goes down, people cannot afford to buy. So, how likely is that scenario?

Zhiguo He: This is exactly, exactly what Beijing worries about. Beijing in 2020 put up the slogan, which is for real, which says that housing is only for living, not for speculation. So, I do think that Beijing really worries about it, together with the more important economic fun-damental, which is population. You didn’t mention population, but if population goes down, even-tually the housing demand will go down after old people pass away, and that explains the policy-making.

Now, I do not think that there are more and more developers getting in. Every research report will tell the businessmen—successful, young, and very energetic businessmen—not to get into the developer side anymore. So, as a result, naturally the market force will persuade these people from getting into this business, and hopefully that resolves the supply issue. So, hopefully, if China still can grow, let’s say, 4 percent, 5 percent, which seems to be very reachable nowadays, in the next five years, at that time, whatever we have, the inventory, maybe can be absorbed.

Bethany: Can we back up to something you said at the beginning, which maybe I’m misunderstanding, and I want to make sure I’m interpreting it correctly? But when you said that the developer is separate from the company that actually constructs the homes, one of the points Jim Chanos made is that if you have the bankruptcy of Evergrande, then people don’t get their homes. Is that a misunderstanding of the way it works?

Zhiguo He: It is the biggest headache right now for local governments: the coordination of local government that has started to try to finish some of the houses on behalf of Evergrande. Basically, local governments are backing up the potential future payments. This is di-rectly attacking the whole core issue of the Chinese social unrest that potentially could be caused by the Evergrande default. And this is exactly because there’s a difference between China and the US. In China, you basically pay for your home when you’re just signing a contract, and the home is not there yet.

It’s just a crazy thing. I did that, too, because my mom forced me to buy a house. And I said, “OK, fine, what do I need to do?” She said, “No, you just need to wire the money and quick, quick, quick, because otherwise, next year it will be going up another 20 percent.”

Luigi: But to what extent will this have repercussions for the banking system? Because the banking debt is on the order of, what? $60 trillion for GDP of $15 trillion US. If you start to have a serious amount of default, this can be an expensive proposition to bail out, even for a country as solid as China.

Zhiguo He: Definitely, and the banking system is what Beijing is most worried about. So, everything on the banking side is state-owned, and I’m not saying that state-owned means it’s safe. I mean state-owned means that they know the books, they know the real books. I can tell you that at the time that Beijing pushed out these three lines, three red lines, this is something—

Luigi: Can you explain the three lines?

Zhiguo He: Yeah, the three lines are very, very important. If you talk about Evergrande but don’t talk about the three red lines, it’s just impossible to understand what’s going on. The first of the three red lines is just leverage ratio. That’s understandable, but we know that leverage ratio can be easily twisted. The second red line, which is very, very important, is the short-term debt. Cash cannot be below 100 percent, so you have to have enough cash to cover one year of debt. That’s the second one already hitting Evergrande. The third red line is the key, which is that whenever you calculate your assets, you should not count these advance payments that I was talking about. Yes, that’s the killer.

Bethany: And did Beijing also understand when they pushed out the three red lines what the effects would be and what the knock-on effects would be? In other words, they already had a game plan. So, if you were, again, comparing this to the US subprime crisis, where the government had no clue what was happening, is this an entirely different situation, in your view?

Zhiguo He: This is the part where maybe Luigi will disagree with me. I think the guys at the top there, especially on the economic side of it, are very smart people. Talking to the relevant people, I was in China this summer at that time that Evergrande had the issue, and there were a lot of rumors around, like—

Luigi: Sorry, when were the three red lines introduced?

Zhiguo He: August 2020. That’s in response to the rising prices after COVID, and some real-estate developers reacted. Evergrande wasn’t that active. You can see the books, right? Okay, so, to Bethany’s question, partly just because there’s some even more interesting and more weird stuff revealed recently that was to my surprise, Evergrande borrowed a lot from their own employees. Basically, this is what’s going on, this is a very interesting story. Whenever a lend-er, let’s say, a big bank, was lending to Evergrande, the lender would ask Evergrande’s top CEO or manager to put in their own stake.

So, as a result, Evergrande built up this fund, and that fund basically raised money from em-ployees and typically, in order for you to get the bonus, you have to contribute to blah, blah, blah fund. And now that things get revealed saying that, oh, Evergrande is borrowing a lot from their employees, and what’s more is that in July, there are some departing CEOs or departing higher-rank officials, and when they left, they got the money. They got the contribution to the fund without telling all these retired employees who also had some stake in the fund. So, that gets into another tricky issue. This is a trigger, a catalyst, to the whole mess, which sounds very fun to watch, but I’m not sure that people are enjoying it.

Luigi: That sounds like Wall Street. So much for socialism.

Zhiguo He: We’re learning from the United States.

Luigi: Yeah, of course. No, but one thing that I actually am impressed by, to some extent, what you’re describing of the policy of the three red lines is what we call in the West macroprudential regulation, but done very aggressively at a difficult moment because, of course, this is not popular. So, my question is, what it is in the political economy of the Chinese system that allows this to take place?

Zhiguo He: People in China are basically saying, if there is something that is good for the life of the society, they will support it, and that kind of mentality seems to be, in Bei-jing’s mind, that’s the perspective they’re taking. And once they decide on it, it’s about the im-plementation.

Bethany: What is it that that bears like Jim Chanos get wrong about China or misunderstand about China? What’s top on your list?

Zhiguo He: I think that China’s economic growth will slow down, but it will not be anything called a crash. That’s my perspective. And on the consumption side, investment side, everything, you will see a huge amount of heterogeneity, and that’s what we’re always, al-ways emphasizing. I told you the housing prices in Shanghai, Beijing, Shenzhen, and you guys quot-ed some numbers about some houses that were empty. These empty houses are not in Beijing, Shanghai, Shenzhen, just totally different places. This heterogeneity, if managed properly with the strong government in moving around the resources, has another 20 years to support China’s growth.

That’s the first part. The second part is a very, very important question that as an economist I see in the cracking down. What I want to point out, one slightly positive thing which I’m very, very strong on, because I talk to so many people who probably are 15 or 20 years younger than me. Af-ter college, they are well connected, and I just ask them, are you worried about it? What are you going to do? Are you going to the government agency or not? Because they could. Their outside options are very high.

Interestingly, they firmly believe that as long as they pick the right industry, they are able to become the next richest guy. I don’t know what is driving that, but that’s just a very important in-gredient to your question, I think.

Bethany: One of the things I found really interesting about our guests is they actually agreed more than I thought they did. I think they both agreed on this VIE structure as be-ing something potentially quite dangerous, at least for foreign investors, and it’s going be really interesting to see how that plays out. And, if foreign investors don’t get paid, will it be a big deal that changes the future of geopolitical relationships and investing flows around the globe?

Luigi: I think where they disagree is whether the real-estate market itself will collapse as a massive, overvalued collapse, because I heard Jim saying that this is a bigger bub-ble than Japan in 1989. And I heard Zhiguo say, be careful, because some of the numbers are not that great, and there is this uniqueness of China. Now, I have to say that once I read the minutes of the Fed Board at the beginning of 2008, and they were saying exactly the same thing, that the numbers are not very reliable, we shouldn’t check, et cetera, but he might be right, this is a reason why forecasting the future is so hard.

Bethany: At this point in the market, you can cite whatever you want to make whatever argument you want. It’s only once the dust is cleared that you see which argument was actually correct. Or maybe I’m too through a glass darkly, but at least that has always tended to be my perspective. And then the ones who did call it right look like they were brilliant, and they must have understood before it happened, but not necessarily. Maybe they didn’t even understand any better than the ones who got it wrong. It’s just that history is determined by the victors, right?

Luigi: Definitely, definitely. I don’t like autocratic regimes at all, but I have to say autocratic regimes do have a comparative advantage in dealing with financial panics. In 1933, Italy went through a bank panic and there was a fascist regime, and the fascist regime dealt with it very expeditiously and very effectively. And one is because the news is controlled, as you were de-scribing, so it’s more difficult to have panic if you don’t have news. Now, with social media, it’s a bit tricky, and of course, in 1933, there was hardly the radio, let alone social media.

The other is that you can deploy a lot of money fast without too many people complaining. Remember, when TARP was under discussion in the United States, the first version was struck down by Congress, and then they had to go back, and this clearly created a lot of uncertainty. The fascist regime presented a solution already done. I can see the Chinese government doing exactly that as far as the domestic financial system is concerned. The big question mark is, what do they want to do with the international financial system? How much do they want to dump this stuff onto foreign bondholders?

And, again, for fairness, when GM when bankrupt, Obama basically structured stuff so that the bondholders took the hit, and the unions were in part bailed out. That was really a political deci-sion that violated absolute priority. What I’m saying is, if even in a democratic regime that follows the rule of law, you have this violation of absolute priority, you can only imagine what is going to happen in China. And the question is whether they have a willingness to do something for the for-eign investors or whether panic will start.

Bethany: You know, that’s a really good point about GM, and I had forgotten about that. Because, at the time, there was a widespread hue and cry that this meant capitalism was dead and nobody was ever going to trust the sanctity of bankruptcy and where bonds are sup-posed to rank in the capital stack ever again. And clearly, it turned out not to matter, given that I didn’t even think about it until you just brought it up. So, yeah, the fact that something along these lines can happen in a democratic, supposedly capitalistic society also, it does tell you some-thing.

But I disagree with you a little bit about the rest of it. Whether autocratic regimes are or aren’t better equipped to handle financial panics—and I’d agree that they were—I still think that’s beside the point of the fact that China is, with this, with the crackdown on tech giants, I do think that this is a different China than we all thought it was. I think, for a long time, there was a temptation to believe, and I think it goes back to people’s faith, blind faith in the VIE structure.

People believed that China was following a model of capitalism where it would be controlled capitalism, but entrepreneurs were going to be able to get rich and companies were going to be able to do what they want, as they do in the US, and I think we’re seeing very clearly that’s not the way it’s going to go. And the extent to which China retreats into itself is the question, right?

Luigi: Yeah, but let me take the opposite side, just for the sake of it. If China succeeds in dealing with this financial crisis well, thanks to the autocratic power and what we said earlier, and if it succeeds in reining in the power of big tech in a way that the United States is una-ble to do, maybe at the end of the day it comes out as a better capitalist system than the United States. Because the United States did not deal particularly well with the financial crisis, especially with the spillover on ordinary Americans. They protected the banks, but they didn’t protect home investors very much, and so on and so forth. They’re not particularly good at reining in big tech. What I fear is, at the end of this, people will look up to China saying it’s a better capitalist sys-tem.

Bethany: I don’t know if I would call it a capitalist system then, it’s a some-thing system. I’m not sure it’s a capitalist system, but I think that’s actually a fair point. That it’s a different model and different way of doing things. Because China isn’t just copying the US, because they actually are doing things their own way, it could become more of a threat to US dominance than it would be if it followed a US model. And that’s going to be the interesting question going forward, right? How is this crackdown on tech going to play out?

Are entrepreneurs going to start leaving China and starting businesses elsewhere? And is China going to be able to control this financial crisis? And I think you raise a really good point, which is that it has these really big, broad repercussions for who’s perceived as the world leader. And if China does come out of this well, that may be more of a threat to the US way of doing things than anything else we can imagine.

Luigi: Our producer, who likes to keep us honest, just sent me a message say-ing, “But wait a minute, you have always advocated on this podcast that you cannot have capitalism without democracy. And now you’re saying that China can do a better job than the United States. Aren’t you in contradiction?” And the answer is, no, it’s not in contradiction, because it’s precisely the lack of functioning democracy in the United States that creates this space for somebody else, and some other model, to do better.

It is a lack of representative democracy that created this fracture, the deterioration of the US democracy into a plutocracy that makes an autocratic system, for whatever reason, seem to be bet-ter able to resist this pressure more effectively. And seeing the faults of American democracy is not necessarily celebrating an autocracy, but it’s recognizing we need to fix our democracy fast, be-cause otherwise another system might become more attractive.

Bethany: I think the descent into, whether you call it plutocracy or crony capitalism, is hugely troubling in America, but I think that’s a different question than whether you could have capitalism without democracy. And I think that’s why I would push back on the idea that what China is doing is capitalism. If China comes out in the end with a different model that appears to work better than what we have allowed our supposedly capitalist democracy to deterio-rate into, what they’re doing, I don’t think it will be capitalism, or it will be a different brand of capitalism, where the state can step in at any moment and control it in a way that I don’t think we would stand for in America.

Regardless of whether we should have tighter rules on what corporations are allowed to do and better macroprudential regulation than we have, I don’t think we would stand for the persecution and prosecution of billionaires that has been seen in China.

Luigi: But I think that if you look at the history of the United States, in the ’30s for example, the state came back pretty aggressively, and many rich people, starting with the DuPont family, cried wolf and said that this was communism, and they were expropriated and blah, blah, blah, blah, blah. But I think that the system turned out to be much more resilient than we expected. So, I don’t think that the Chinese are unique in intervening, and sometimes changing the rules ex post. In fact, I think that the United States has a long tradition of doing that. Now, it has a tradition of doing that with more of a discussion in the public domain. So, it seems a little bit less arbitrary, but some people at the time thought it was very arbitrary.

Bethany: I think you’ve just convinced me. I think you’ve actually won this round, because as you were talking, I was thinking about the trustbusting at the end of the 1800s, early 1900s, right? You could argue that that is the United States just coming in and changing the rules, and changing the rules in a pseudo-legal way with the Sherman Act. But I’m sure some of the people who had their trusts broken up would say that the Sherman Act was political maneuvering in order to put the gloss of legality on something that was simply expropriation of assets.

It’d actually be really interesting to do a comparison of that time in US history with what’s hap-pening in China now, and really think through it and decide if there’s a fundamental difference, or if the two are actually quite similar.

Luigi: We should invite the listeners to do this research and send it to us.

Bethany: That sounds like a great idea. And do we need anything else?

Matt Hodapp: No. Unless we want to do “is” or “isn’t” for this episode.

Bethany: Oh, I guess we should.

Matt Hodapp: Well, we have a lot of stuff.

Luigi: I think it’s actually great to say, in part we’ve already discussed wheth-er what we observe in China today is Capital-is or -isn’t.

Bethany: Yeah, it’s funny, before our conversation, Luigi, I would have said, “Well, it’s Capitalisn’t. Look at all these things they’re doing, denying foreign investors their bond payments, putting lies in documents that make things into shams that people are willing to believe with these VIE structures, cracking down on technology billionaires.” But now I think, well, that’s not so different than the way the US grew up. And so, then, I guess you could ask, is the US really as capitalistic as we think it is? Or is it capitalist on the fly, capitalist when it suits us, and not capital-ist when it doesn’t?

Luigi: I agree with you that the VIE are the worst example of capitalism, the one that we would like to not deal with, but they’re present everywhere, and so they’re not uniquely Chinese. I think that the crackdown of China on the rampant capitalism, I think the jury is still out whether this will go down in history as they’ve been able to put on a restraint that the West has not, or they are a centralized economy, and all the power is in five families, and they get all the money. But it is interesting that the founder of Evergrande was very well connected with the Chinese Communist Party, as everybody is who succeeds in China these days, but in spite of that, they went ahead and they put a kibosh on him. So, it will remain to be seen.

Bethany: Yeah. I think it shows more than anything that China has changed. As we all know by now, this is the new regime, and which way it goes will be interesting. And, yes, per your points, I think you could argue that the way in which the US has allowed its tech giants to be monopolies run amok is a Capitalisn’t, as much as you can argue that China’s attempts to re-strain them and crack down on them could be a Capital-is.

I think you and I have discussed many, many times that there is no such thing as a truly free market. It’s all dependent on what rules you put in place. And then, we just have to argue about the rules. But you can’t have anything, you can’t have a functioning economy, without rules. So, the question is, what are the rules?

Luigi: And, most importantly, who enforces them?

Bethany: Fair point.