China’s Wobbles Could Throw the Global Economy Off Its Axis

About the author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was previously a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

Today, a Hong Kong court ordered the liquidation of Evergrande, a Chinese company that was one of the world’s largest property developers. After years of fruitless negotiations between the company and its creditors over the restructuring of its $300 billion debt mountain, a Chinese court said that “enough was enough.” In a blow to an already troubled Chinese housing market, it ordered that the company’s assets be liquidated to pay back its creditors.

How mainland China handles Hong Kong’s court order could have major implications for Chinese property prices and foreign investor confidence. If it enforces the court’s order, that could see an acceleration in Chinese home-price declines by adding to supply in an already glutted market. It could also heighten social tensions by disappointing around 1.5 million Chinese households who have put down large deposits for homes that are yet to be completed.

If it ignores the Hong Kong court’s order, it risks dealing a further blow to waning investor confidence. Questions would arise about China’s willingness to abide by the rule of law and to offer a safe economic environment for investors.

The Evergrande liquidation comes at an awkward time for the Chinese economy. It is already in deep trouble and could be headed for a Japanese-style lost economic decade. The news also suggests that China will disappoint the consensus view that the Chinese economy is headed for only a minor economic slowdown this year. This could have major implications for the U.S. and world economic outlook, considering that China is the world’s second-largest economy and until recently was its main engine of economic growth.

Even before Evergrande’s liquidation order, a whole set of indicators suggested that the former Chinese economic growth model was dead. Chinese home prices have been falling for more than a year; both wholesale and consumer prices have been falling; stock prices have plummeted as foreign investors have taken fright; and youth unemployment has risen to around 20%.

There have also been questions about President Xi Jinping’s economic stewardship. First, his disastrous zero-tolerance Covid policy contributed to the country’s slowest economic growth in 30 years. Now his increased economic intervention is undermining the underpinnings of the Chinese economic growth miracle unleashed by Deng Xiaoping’s economic reforms in the 1980s.

Chinese stocks rose last week on news that authorities are taking steps to stimulate the economy. But anyone thinking that the Chinese economy will respond favourably to yet another round of policy stimulus has not been paying attention to the size of that country’s housing and credit market bubble that has now burst. Nor have they been paying attention to the troubling degree to which that country’s economy has become unbalanced.

According to Harvard’s Ken Rogoff, the Chinese property market now accounts for almost 30% of that country’s GDP. That is around 50% more than that in most developed economies. Meanwhile, over the past decade Chinese credit to its non financial private sector expanded by 100% of GDP, according to the Bank for International Settlements. That is a larger rate of credit expansion than that which preceded Japan’s lost economic decade in the 1990s and that which preceded the 2008 bursting of the U.S. subprime and housing market.

The overall Chinese economy is highly unbalanced in the sense that it has become overly reliant on investment demand. The Chinese investment-to-GDP ratio is over 40%, according to the Organization for Economic Cooperation and Development. That’s sharply higher than the more normal 25% ratio in most other developed and mid-sized emerging market economies.

The consensus forecast is that Chinese economic growth this year will continue at a 5% clip. Anyone relying on that forecast should reflect on the many failures by the U.S. Federal Reserve and other central bankers to foresee the grave problems of the subprime housing market in the U.S. in early 2008. It would seem that most economists are downplaying indications of major Chinese economic problems that are plain sight. Chinese economic problems could unleash serious deflationary forces for the U.S. and global economy. The Federal Reserve would be ignoring them at its peril.

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The Reserve Bank had little choice but to raise interest rates again this week.

Inflation was already proving stubborn before the latest Middle East instability added further pressure to energy prices and supply chains.

Housing inflation alone has averaged six per cent over the past year, remaining one of the single biggest contributors to CPI.

But while the focus remains on rates, the deeper problem is structural and far more dangerous.

Australia is not building enough homes, and the conditions required to fix that are deteriorating simultaneously.

Construction costs remain elevated. Builders are increasingly unwilling to absorb contract risk. Labour shortages persist.

Capital is becoming more expensive. And as borrowing capacity weakens and sentiment softens, fewer projects are becoming financially viable.

The result is a self-reinforcing cycle.

The RBA raises rates to fight inflation. Higher rates reduce development feasibility. Fewer projects start. Housing supply tightens further. Rents rise. Inflation persists. The RBA raises rates again.

The only long-term solution is supply, yet Australia remains nowhere near the National Housing Accord target of 240,000 new dwellings a year.

Completion continues to lag approvals, meaning many projects approved on paper are simply never making it out of the ground.

That gap matters enormously because housing is not just another sector of the economy.

Around two-thirds of Australian household wealth is tied to property, while the sector underpins millions of jobs and related industries. Weakness here quickly spreads beyond real estate.

We are already seeing signs of stress. Auction clearance rates in Sydney and Melbourne have softened, borrowing capacity has declined, and parts of the market are experiencing price corrections as confidence weakens.

At the same time, policymakers continue to debate tax measures such as changes to negative gearing and capital gains tax discounts, despite fears that such reforms could drive private capital out of the rental market at precisely the moment when supply is most constrained.

This is the paradox at the centre of Australia’s housing crisis.

Demand for property remains extraordinarily high, yet the economic conditions required to actually build new housing are worsening.

The Reserve Bank cannot solve that problem alone.

Monetary policy cannot accelerate planning approvals, reduce construction costs or create more tradies. It can only raise the cost of money until something eventually breaks.

And increasingly, that “something” looks like the development pipeline itself.

Paul Miron is the Co-Founder & Fund Manager of Msquared Capital.

China’s Wobbles Could Throw the Global Economy Off Its Axis

Rising rates, construction inflation and shrinking investor confidence are pushing Australia deeper into a dangerous housing spiral that monetary policy alone cannot fix.