Thread by @travislundyasia

I just finished listening to the always excellent Odd Lots podcast with @tracyalloway and @TheStalwart - this time about the macroeconomic implications of the Evergrande situation with @michaelxpettis.

A great listen. Worth your time.

https://twitter.com/tracyalloway/status/1447476656214462465?s=20

Professor Pettis lays it out quite cleanly, noting (in an opinion I agree with) that Evergrande did not start the fire, and that the overarching policy aims meant this was going to happen at some point. Evergrande is the poster-child because of its presence in USD debt markets

but the situation is following the model of previous cleanups starting a few years ago (Professor Pettis mentions Baoshang Bank as one model (tho I prefer HNA as the model because it will likely be a local govt-organised restructure rather than a regulator-driven restructure))

and the larger issue is really about the impact of the overarching policy on the economy. If excess speculation in real estate is largely dampened, that will reduce the amount of savings applied to "low quality GDP growth", leading to lower nominal growth, which causes the

imbalance to be re-directed to other places.

As he points out, the potential size of the 'escape valve' allowing deflation of this particular balloon is small compared to the problem, to a great extent because as he notes, there are no good solutions, just bad or worse.

Adding a few comments...
1) One of the really interesting aspects of Chinese households having so much of their household wealth in residential real estate is that the NPV of the asset is partly high because there is relatively little friction. In many other countries, property

taxes and maintenance and insurance (especially of single family homes) present a meaningful drag, adding an expense of a couple percent per year against the value. With so much of the property market being newbuild multifamily (which presumably means lower maintenance) units,

lacking the drag of property tax, it makes sense that the asset/income multiple be higher. Perhaps not as high as it is, but higher, certainly. The home purchase price is higher because the NPV of the property tax is paid up front in the land purchase premium (where the developer

buys the land). Furthermore, because the developer has to carry the land bank for years, that means debt financing costs to carry that land bank mean breakeven profit levels are quite a bit higher than land purchase cost.

If land were auctioned and property taxes were a known

cost, and the real estate transfer price were post-paid (effectively financed at the local govt's borrowing rate rather than the developer's borrowing rate), all this would lower the upfront cost to a homebuyer. That means, ceteris paribus, less debt, less savings embedded in it,

and lower Day1 home price/income multiples. Of course, property tax just means the drag is added to future household income rather than accumulated savings.

One way for the transition to be made would be for LGs to start charging property tax (leasehold payments / "land rates")

on newbuilds while allowing existing owners (who paid a higher price on the land upfront) to "earn out" their property tax through the end of the lease. Then, when they renew the lease, they start paying property tax.

This would allow a dual secondary market where some property

trades with a leasehold payment obligation, and some trades with no obligation til end of lease.

This would effectively allow the secondary market to become more relevant compared to newbuild (natural now that a lot more of the cumulative housing stock is recent), and it would

anchor the secondary market price to an NPV which could be calculated based on a homebuyer's own borrowing cost. And it would mean LGs have to earn less from land sales because they are getting a stream of PT payments going forward.

2) resi real estate and CRE can be bifurcated

and stay that way for decades. CRE is eventually covered in consumption as consumers pay the seller's costs in the product price. Something which reduces the speculative element in resi markets need not kill off CRE. Yet.

3) Michael Pettis noted 5 ways for the imbalances to

resolve themselves, pointing at increasing the trade surplus as one possibly unpalatable way of allocating capital from bad productivity to better productivity endeavours. MP points out that trade partners are unlikely to be excited by a larger trade surplus. I'd argue another

version of this could include currency depreciation, which would effectively reduce the dollar value of nominal wealth, debt, and household income, but because right now China is effectively insulated because the trade surplus is what it is, but the household sector isn't

exporting savings through travel and the corporate sector is not exporting savings through foreign asset purchases, those who would get hit are companies with significant foreign currency debt (like property devcos), which, surprise surprise, are already getting hit hard.

While I have not been a proponent of a sudden devaluation, it would be a way to create nominal inflation with real world default against foreign investors AND against the populace (through declining value of household RMB wealth as denominated in global currency). The trick is in

managing the disappointment which will come when the nominal real estate price does not grow with other inflation. In Japan from the early 1990s onward, purchasing a home was better than renting because the monthly payment was slightly lower and rates would reset lower as

long-term rates fell. But it was "homes are not for speculation but for living in" because home prices just didn't go up.

Japan had a lost decade (or two) but came out of it remarkably well. Banks had to be recapitalised. And the central govt effectively took the load through

increased central govt debt, kicking the can very far down the road, but it created credible long-term fiscal irresponsibility which would be softened through the fact that savings assets (in Japan, home ownership, life insurance, and prodigious amounts of bank deposits) earned

very low income for years. That was the effective default vs expectations as far as a generation (or two) of Japanese people were concerned.

I expect China may find itself in the same boat. It may be uncomfortable given China's image of its future self but as a well-known

Japanese saying goes, perhaps "it can't be helped."