The Chinese economy is undergoing a compounding series of crises. There has been a wave of homebuyers refusing to make their mortgage payments over delays in housing construction. The country is facing searing heat and drought. And of course, Covid zero continues to be a source of major strain. So how bad is it? And is it worse than downturns of the past? On this episode, we speak with Tom Orlik, the Chief Economist at Bloomberg Economics, and the author of China: The Bubble That Never Pops, about the situation right now. This transcript has been lightly edited for clarity.
Points of interest from the pod:
How China became so levered to real estate — 3:20
Why homebuyers stopped paying — 6:10
Why China is letting the real estate sector struggle — 9:24
Searching for middleground bailout path — 16:57
The risks to Chinese banks — 19:28
Where the Covid zero policies stand — 27:18
The fundamental imbalances are worsening — 32:18
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Tracy Alloway: (00:09)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:15)
Joe, what is going on in China right now?
Joe: (00:18)
That is a good question. And it's a question we actually haven't been talking about enough. Lots of focus on energy. Lots of focus on Europe. Macro. The Fed. Recession. But my understanding is that things aren't great in China either.
Tracy: (00:32)
I feel like in a normal year, where everyone wasn't distracted by domestic US inflation, and the question of whether or not interest rate hikes are going to spark a recession, I feel like China would be taking center stage with everything that's going on. But it feels like it's sort of been tangential. Like you hear a little bit about what's going on, but people like aren't really focused on it.
Joe: (00:56)
I would say it feels contained in a way. You know, so obviously one of the big stories is the country's ongoing commitment to Covid Zero, which obviously has a negative impact just on economic activity sort of measured broadly. But then there are other things happening. The real estate sector seems very troubled with more and more people basically refusing to pay mortgages on houses that have yet to be completed. I know that's a big story. There's a big drought happening. A really intense heat wave. So they're having their own weather and climate stress. But yeah, I still don't totally get how it all fits together.
Tracy: (01:32)
Right. I feel like people have been warning of a Chinese property bust for so long and it hasn't happened that we've all sort of become inured to the idea that it could actually happen. And maybe we're seeing the beginnings of it, but again, maybe we're not because China is very good at coming in and rescuing particular sectors when it needs to.
Joe: (01:54)
That's the key thing. And of course we've talked about, say, Evergrande a few times on the show. So there are these busts that happen and there are all these troubles, but it always seems like in the past that the government has been able to use its balance sheet to prevent some like wholesale collapse.
Tracy: (02:11)
Yep. But now of course, we know that Xi Jinping is on a mission to pop a lot of bubbles in the Chinese economy. To crack down on certain sectors that he thinks are not economic or efficient. And so maybe it's different this time, but maybe it isn't.
Joe: (02:28)
Let's find out.
Tracy: (02:29)
I have to say, we really do have the perfect guest to discuss this. We are going to be speaking with Tom Orlik he's the Chief Economist at Bloomberg Economics. He is also the author of “China: The Bubble That Never Pops.” So we get to ask him if it is going to pop this time. There is a second edition of the book coming out in September. So it really is a great time to catch up with him. Tom, thanks for coming back on Odd Lots.
Tom Orlik: (02:53)
Great to be here. Thanks for having me Tracy, Joe.
Tracy: (02:56)
So maybe just to set the scene, let's start with the big question, which is, I think most people at this point know that China's economy is heavily, heavily reliant on real estate and property. Something like 30% of total GDP is accounted for by real estate. How did that come to be? Why is China's economy so leveraged to this one particular sector?
Tom: (03:20)
That's a really good question, Tracy. And there's a bunch of factors at work. So the first thing to think about is the strength of fundamental demand. So remember that in the 1980s and early 1990s, China did not have a private property market. If you lived in a city, you almost certainly lived in a dilapidated government apartment or dingy house. And so when the private markets sprung into life in the late 1990s, there was enormous pent-up demand for real estate.
Adding to that, China's households have enjoyed decades of strongly rising incomes. And of course, when your income rises, one of the first things you wanna do is buy somewhere nice to live. And China has had an urbanization boom with hundreds of millions of people moving from the countryside to the cities. So the first reason why real estate has been so important in driving China's growth is just that there's been enormous demand for real estate.
The second contributing factor is that speculators got in on the game. China's investors don't have brilliant options. There isn't much of a kind of retail financial market. There aren't a lot of money market funds and things like that that you can park your cash in. If you put your money in a bank deposit, very often the interest rate is below the level of inflation. So you are essentially losing money. If you put your money in the stock market, it's a roller coaster. So a lot of investment funds went into real estate and that speculative demand added substantially to the fundamental demand. By some measures, as much as 30% of property in China is sold to speculators who hold it empty, hoping for capital gains. So those factors together drove China's real estate boom and pushed its contribution to GDP taking account of all the construction activity, all of the impact on steel and concrete and home electronics and furniture and a car to put in the garage up to that 30% number, which Tracy mentioned.
Joe: (05:28)
So my understanding, and this is just that we've had, you know, we talked about Evergrande a few times last year, but my understanding is that there's this broader problem of real estate developers essentially running into financial trouble, running into operational trouble, having a difficult time delivering on houses that they pre-sold essentially.
And now the people who bought those mortgages are saying, ‘Look, you haven't delivered the house that I bought. I'm not sure the timing of when you're gonna deliver those homes. So I'm not gonna pay.’ Is that an accurate characterization of it? And how big is this movement that we're seeing where people are saying we're not paying our mortgage right now?
Tom: (06:10)
Yeah, I think that's completely right Joe, but the last few decades, given the very strong demand, given the continually rising prices in China's real estate sector, the best strategy for real estate developers was just to build as much as possible, as quickly as possible. And in executing on that strategy, many of China's real estate developers engaged in some sharp practices. One of those sharp practices was selling homes off the plan. So not selling a home they'd already built, but selling a home they were promising to build and then taking the funds from those pre-sales. And instead of using them to complete the project, using them to buy land, to start another project. Now, as long as the demand was there, as long as they could sell that second project and as long as they could get access to bank finance, as long as the banks were willing to loan the money to fill in any short term shortfalls, that strategy worked really well.
But what's happened in the last two or three years, is that the government has stepped in and said, ‘no, this is not a sustainable trajectory for the real estate sector. We need real estate developers to get their finances in order. And we're gonna cut off sources of finance for real estate developers that we think have engaged in too many sharp practices that have borrowed too much money that have too much leverage at the same time.’
The fundamental demand story, which has driven China's real estate boom has kind of come to an end. China's demographics have become a drag. And of course, when you have less people, you need less accommodation. China's urbanization story is not quite over, but it's not delivering the same impetus that it was 10 years ago. Certainly not the same impetus it was delivering 20 years ago. And what that means is that real estate developers who took money to build a project and then use that money to start another project now, find they don't have enough funds to finish the houses they promised to finish.
Tracy: (08:21)
So this actually leads into a question I wanted to ask. So we have this situation where's something like 70% of all Chinese property sales are presales. So for units that are going to be constructed, and people have pinpointed to that as a source of weakness for a while. And even the Chinese government, as you just mentioned, basically started cracking down on it and saying ‘this is problematic.’
So how much of the current situation where you have this mortgage boycott — people refusing to pay the money that they owe to developers for houses that are under construction and you have house prices, deteriorating, and you have property developers under pressure — how much of that is engineered by the Chinese authorities themselves as part of property sector reform versus things that are maybe a little bit more macro, maybe outside of their control, such as the impact of the pandemic or, you know, interest rates and things like that?
Tom: (09:24)
So it's a complicated picture, Tracy, and I think you have to give China's government some of the blame for allowing the situation to get to the point which it has. And also some of the credit for attempting to move ahead of a crisis, right? To try and tamp down the problem before it really blows up. And of course like all governments in the world, they've been the victims of bad luck.
The Covid pandemic hasn't made anything easier. It certainly hasn't made dealing with a real estate crisis any easier. So it's not easy to put a sort of size and scope on this problem. China's government has clearly decided that the mortgage boycott is a sort of extremely sensitive issue. And so they're actually making it rather hard to get a handle on it. There aren't good numbers from private real estate information companies, for example, who would be positioned to tell us exactly how many delayed projects there are, but we've put a super smart team on the ground and they've done some fancy footwork with the data that is available to try and put a magnitude on the size of the problem.
So the starting point of their calculations is the fact that on average, it takes about three years to finish a property project. And if we look at the historical data in general, if you have a hundred projects started in year one, then in year four, three years later, 80 of those projects will be completed. So three years in there's an 80% completion rate.
But when we look at the data for ‘21 and 2022, what we see is that completion rate has dropped all the way down to 50%. And because we know how much it costs to build a house, and because we know on average, how much of house purchases are paid for with mortgages, we can then use that drop from an 80% completion rate to a 50% completion rate to calculate the magnitude of the problem. And what that calculation tells us is that the value of mortgages attached to unfinished properties right now is around 1.6 trillion yuan. That's about 1.4% of China's GDP.
Now that's already really big, certainly big enough to make this a systemic issue for China's economy and financial system. If the problem is left unaddressed and that 50% completion ratio holds until the end of 2024, the size of the problem's gonna go up to 4.4 trillion [yuan], which will be close to 4% of China's GDP.
Joe: (12:03)
Wow. Why is the completion rate so low? How much is the change in finances and how much, you know, I don't know, are Chinese developers, are they also facing supply chain and commodity constraints like basically everywhere else in the world?
Tom: (12:21)
So I think it is a substantially a financing issue for China's developers. In 2020 China's government introduced something. They called the three red lines policy, right? Essentially a set of constraints on access to credit for China's property developers. One of the red lines, for example, was if you don't have enough cash or liquid assets to cover all of your short-term debts, you're not allowed to borrow any more money.
And that clamp down on access to finance for developers, it kind of made it really hard for them to continue with that game where they sold projects on plan and then used the funds to start another project. But that was okay, because they could always go to the bank to borrow any extra funds they needed to make sure everything was completed. So I think access to finance has been a really big part of it. But of course there are other factors coming into play as well. Covid Zero — China's insistence on keeping the sort of Covid rate right down in the sort of low single digits — obviously means that at different points in different parts of the country, it's just hard to get things done because you can't leave your apartment.
Joe: (13:33)
Just real quickly though, so if it's largely a finance problem, what are the drawbacks of yet another sort of government intervention — having the banks open the taps and say ‘here's the money, get the apartments built.’
Tom: (13:49)
So I think there's a couple of things going on, Joe. The first is a kind of a recognition that the fundamental demand story in China's real estate sector has changed. The demographics, the end of the urbanization boom, mean we're just not gonna go back to the years of rapid growth in real estate construction contributing to rapid growth in China's GDP. So that's the first reason China's central government are reluctant to turn the financial taps back on. The second reason is that in part the real estate boom has been underpinned by moral hazard, the belief by real estate developers and investors in real estate that they can take any risk they like and if it pays off, they're gonna make massive profits. And if it doesn't pay off, don't worry, the government's gonna be in there to backstop our borrowing and make sure we stay solvent.
So China's government is very keen to address that problem of moral hazard. That's why they allowed Evergrande to go into default. That's why they've allowed another quite large set of property developers to go into default. That said, China's government are not crazy. I remember reading Timothy Geithner’s book on his experience in the financial crisis. And he says, people who worry about moral hazard in a financial crisis are like people who would allow a house to burn to the ground without calling the fire brigade, to teach people about the importance of not playing with matches.
And I think China's government very much sort of pulled to that general philosophy. They don't see this as a one-round game. They see it as a multi-round game. They've imposed a bunch of pain on China's property developers and China's property investors by allowing the defaults which have taken place so far. I don't think they're gonna pursue their campaign against moral hazard so far that they tip the entire Chinese economy and financial system into crisis. They’re not arsonists.
Tracy: (15:56)
So just on this topic, I mean, we have seen China announce quite a few stimulus measures just in the past week. And I should mention, we are recording this on August 29th, and I think it was August 24th, or something like that, hey announced, I think 19 new measures to stimulate the economy that are worth more than 1 trillion yuan, which is about $150 billion. And one of the things that's in there is allowing local governments to raise more money, issue more special bonds, raise more money and allowing them some more leeway to potentially allocate that to housing, to try to figure out this presale problem. So how effective will that measure be? And to the point of this tension between stimulating the economy and reinflating a bubble, is there a possibility that local governments just start unleashing a torrent of credit that makes the problem worse?
Tom: (16:57)
Maybe one way of thinking about this is thinking about two extremes, right? So one extreme is do nothing — allow the mortgage boycotts to continue increasing, allow more and more real estate developers to go into bankruptcy. Allow that to spill over into a massive increase in non-performing loans in the banks and allow that ultimately to sort of metastasize into a Chinese version of the US subprime crisis and great recession, right? So that's one extreme.
At the other extreme, you've got something which looks like China's response to the Great Financial Crisis, the global financial crisis in 2008, where they opened the credit taps and delivered that massive stimulus, which got the Chinese economy going again and got the global economy going again, but put them on this unsustainable trajectory where they had to keep on borrowing more and more money to pay for more and more overcapacity in real estate, overcapacity in industry.
So neither of those extremes is a particularly attractive. What’s China trying to do right now? They're attempting to find a kind of a middle path between the two. And that's why we are having this sort of drip, drip of what I would call sort of relatively small stimulus announcements. The PBOC cutting interest rates, a little bit local governments being able to issue a few more bonds to pay for infrastructure and perhaps provide a little bit of support to the real estate sector. It's not what the market wants to hear. They want to hear that kind of shock and or stimulus announcement like they heard from when Wen Jiabao at the end of 2008, they're not going to get that shock or stimulus announcement. China doesn't want to restart another unsustainable boom, but neither is the kind of nightmare scenario of a ‘do nothing’ Chinese government, which allows the real estate sector to melt down going to play out.
Tracy: (19:03)
You mentioned the banks. What position are the banks in to recognize these types of losses? And one of the things that I occasionally hear from people in China is that, ‘oh, it's not such a big deal because a lot of the presales lending was done by regional banks, or a lot of the property lending I should say, was done by regional banks, which no one ever really regarded as safe anyway. So it's not that much of a issue.’
Tom: (19:28)
So this is a potentially a big problem for China's banks. If we think about the history of financial crises, real estate often plays a very significant role. It was real estate which kicked off the 1989 meltdown in Japan's economy, which ended Japan's development miracle and pushed them into that lost decade of low growth and falling prices. Of course it was the subprime crisis here in the United States, which kicked off the great recession and real estate also played a big role in the Asian financial crisis back in 1997. So problems in real estate do have a track record of spilling over into the financial system. And China's financial system is heavily exposed to real estate. There are a lot of loans to households to buy homes. There are a lot of loans to property developers and a lot of loans, which are not directly to the property sector are collateralized by property or land, which means a drop in property prices or land prices would affect those loans as well.
So there's a substantial risk there. How should we think about how that risk is going to impact? I think it's useful to think about two different types of Chinese banks. At the top of the kind of chain you've got the big state-owned banks, the ICBCs and CCBs and ABCs of the world. They are extremely well funded and they have a huge capital buffer. They’re also diversified around the country, which means that problems in a particular city or a particular province, aren't going to be good news for them, but they're not going to affect their entire loan book. I don't think we're going to see problems for China's big state-owned banks.
At the other end of the spectrum you've got small city banks. Now, small city banks tends to have a much less stable funding base. They tend to have a smaller capital buffer and they tend to be heavily exposed to lending in their own city. And that means it's pretty easy to imagine a scenario where you've got a city with a bunch of stalled property projects, with a bunch of mortgage boycotts going on, with a city bank that doesn't have good funding, that doesn't have a strong capital buffer and which runs into problems. We're not quite there yet, but I wouldn't be surprised if in the next one, two, three years we saw a bunch of small city banks that needed a capital injection.
Joe: (22:24)
I want to pivot off of real estate a little bit and talk about, you know, the story of the world right now is clearly commodity scarcity. And most of the attention is focused on Europe and the soaring price of power there. But it's really, it's not just a Europe story, a lot of developed markets every day there's stories about some sort of rationing or export curbs or rolling blackouts or the surging price of price of food. I feel like, you know, just sort of big picture, what is China's commodity position? How much is that story affecting the Chinese economy right now, or to what degree is China insulated from it?
Tom: (23:04)
You know, Joe, I would almost flip that question round and think about how what's happening in China right now is impacting the global commodity story. So let's imagine that China was running a repeat of its 2008 massive stimulus play and getting the economy back growing at 6% a year. Now, if that happened, it would drive enormous demand for energy, enormous demand for metals, enormous demand for agricultural commodities. And the biggest problem for the rest of the world right now — high inflation driven in part by high commodity prices — would be a lot worse. China's not running a repeat of its 2008 stimulus play. That means growth is very weak. Second quarter, we had actually a contraction in GDP. Most people think the rebound in the second half of the year is gonna be tepid at best. And what that means is China's commodity demand just isn't where the markets expected it to be a few months ago. That's one of the factors weighing on energy prices, metals prices, agricultural commodity prices. So that's actually making the biggest problem for the rest of the world right now, the inflation problem, a little bit easier to grapple with.
Joe: (24:18)
Tracy, you know, to Tom’s point, something I've been thinking about is all these US retailers talk about how much excess inventory they have right now. And in a way, you know, these hard lockdowns that we saw in China, it almost kind of comes almost at a fortuitous time in the sense that this is not a time where retailers want to have a lot of inventory or stuff coming in from China.
Tracy: (24:42)
Well, this was actually gonna be my next question, which is how does the Fed's inflation fight and the fact that they seem to be even more explicitly now trying to take a chunk out of consumer demand to bring down prices, how is that going to impact the Chinese economy at a time when it's already quite fragile?
Tom: (25:02)
It's a great question. I think you kind of hit it in your introduction to the whole podcast. In normal circumstances, if China's economy contracted like it did in the second quarter of the year, if China's real estate sector was in crisis like it is, then we'd all be waking up every day and seeing that on the, you know, top of our Bloomberg terminal and the front page, right?
Tracy: (25:22)
Checking the yuan fixing, all of that.
Tom: (25:25)
Right. Exactly. And we're not, right? We're wondering what Jerome Powell's gonna say at Jackson Hole. We're wondering if the European Central Bank's gonna deliver an outsized hike. So at least on the sort of the PR front, the sort of the inflation challenge which the US and the rest of the world is facing, which is absorbing all the attention of the global financial markets, is actually doing China a bit of a favor. They're in a crisis no one's watching in a broader sense though. It is not good news for China.
China's gonna spend certainly the rest of this year and very likely several years ahead working through the problem of overcapacity in the real estate sector, also grappling with Covid Zero and how ultimately to exit from Covid Zero. All of these things are going to be bad news for domestic demand. Now, what do you want when domestic demand is weak? You want external demand. You want export demand to be super strong to provide a buffer. Clearly that's not going to happen. The Fed is very aggressively focused on tightening to bring inflation under control. Very likely that's going to tip the US economy into recession. Same story in Europe. China's two biggest export destinations are both going to be contracting at exactly the moment China really needs them to be booming.
Tracy: (26:44)
Talk to us a little bit more about the Covid Zero restrictions, because I feel like these are the things, the backdrop against which all of this economic drama is actually happening. And this is a choice made by the Chinese authorities to have very restrictive Covid Zero policies to prevent free movement of goods and people, to be very gung-ho when it comes to lockdowns and things like that. What's the motivation there? And at what point would you expect those to start to ease off a bit?
Tom: (27:18)
So if we were having this conversation at the end of 2020, or the end of 2021, China would look pretty clever on its management of its domestic Covid outbreak. They contained the virus, saved a bunch of lives and they got the economy growing again. They were the only major economy in the world to have a V-shaped recovery.
From where we are heading in further into the second half of 2022. China's looking much less clever. Here in the US and in Europe, at enormous expense in human life, the population has a measure of immunity from the virus, partly because many people have got sick and then recovered. So they have natural immunity, partly because we have the sort of more advanced and effective mRNA vaccines. So normal life has resumed. I'm recording this Odd Lots podcast from the Bloomberg office. I dropped my children off in school this morning. In China because the population hasn't experienced a wave of Covid infections, and because they've stuck with their domestic vaccines and not imported or developed their own version of mRNA, the population is Covid naive.
That's just a really big problem for China's government. For now, the decision has been to prioritize public health. So they're sticking with the Covid Zero strategy. Even when they see a handful of cases break out in a particular city, that city is locked down. That's pretty successful at saving lives, even it's a bit of a catastrophe for the economy.
We saw a contraction in the second quarter of this year. It's entirely possible looking into the second half that we'll see more cases in more major cities. Those cities will be locked down and we'll see a further blow to growth looking forward. I think the kind of the consensus expectation is that at the Party Congress, Xi Jinping will get a third term in charge of the country.
And at that point, with that third term secured, the attention of the government will shift towards how to exit from Covid Zero. One reason to kind of query or have some questions about that consensus view is what's happening with vaccines? As far as I'm aware, China, hasn't moved to secure the 1.4 billion mRNA doses it would need to give its population the maximum protection ahead of opening up. Neither do they seem to have their own domestic alternative. And that failure to sort of move ahead aggressively on the vaccine front raises some questions about what their end game is on Covid Zero.
Joe: (29:52)
How long can it be sustained? Just the economic damage that comes from retailers or restaurants or anything in person in major cities, seeing their demand get crushed the way it is. Or to have so much uncertainty, does this do permanent supply side damage to the Chinese economy to have like such a long, I mean, we're facing it in the US. And as you mentioned, we took a major loss of human life and a lot of people got sick. But because we sort of made the choice to reopen very quickly and we're still feeling the shocks, it would intuitively seem like a very long-term damaging thing to have this much supply side degradation and the halt of so many businesses.
Tom: (30:36)
Yeah, I think that's completely right, Joe. So when we think about sort of China's economy kind of broadly understood, we think about a bunch of imbalances that have to be addressed. So too much emphasis on industry, not enough emphasis on services, too much investment and exports, not enough consumption too much debt. The state sector is too big. The private sector, small private sector firms are too small. Covid lockdowns make all of those imbalances worse. Covid lockdowns are a disaster for the services sector, Covidlockdowns hammer consumption whilst they leave industrial output to broadly untouched. Covid lockdowns require an increase in debt to keep businesses solvent and state-owned enterprises, which tend to be bigger and have better access to finance are better placed to survive Covid lockdowns than their smaller private sector rivals.
So is the Chinese go economy going to fall over tomorrow because of Covid lockdowns? I don't think so. I think one of the lessons of the last two or three years is that actually it’s pretty resilient, it can be locked down and reopened. But certainly the longer this goes on, the worse those imbalances are going to get and the higher the cost ultimately of unwinding those unbalances will be.
Tracy: (32:03)
So I have a big picture question based on that, which is how much of the problems that we've been discussing — so the impact of Covidrestrictions, the impact of lockdowns and Covid Zero policies and the influx of money that has gone into the real estate sector, as you described at the beginning of this conversation — how much of that could be fixed by strengthening China's social safety net, such that people didn't have to put all their savings into property if there were a government-funded retirement option or national healthcare and things like that, or stronger healthcare services, I should say.
Tom: (32:44)
So one of the fundamental imbalances in China's economy is the imbalance in the drivers of demand. Consumption plays a relatively small role in driving demand. Investment and exports play a substantially larger role in driving demand. Now, why is consumption weak? Well, an important reason, as you suggested Tracy, is because of the absence of a social safety net, because Chinese households feel like they need to protect themselves against the risk of unemployment or illness, or provide some funding to fall back on. When they retire, they save a substantial share of their income. That saving goes into paying for investment. And it also means they have less money to pay for consumption. Now, there are other factors at work as well. The one child policy has been an important driver of that imbalance. If you have only one child, you just spend less because you don't need such a big house.
You don't need to buy so many clothes. You don't need to buy so much food. You don't need to spend so much money on tutoring and so on. And because you only have one child you're worried they won't be able to support you in your old age. So you also save more. Financial repression has played a role as well. So we mentioned earlier on that interest rates were often lower than the level of inflation. That's been a kind of deliberate government policy aimed at making it cheaper to invest, but it also meant that Chinese households needed to save more if they wanted to reach their target for retirement. So all of these factors are at work, the lack of a welfare state is one of them. To Chinese government's credit, over the last 20 years, they have been kind of progressively moving into place, the kind of the elements of a welfare state. So education is not perfect, but it is now free and universal up to the end of high school. The entire country has at least basic health insurance provided by the state. So it's still a problem, but policy, at least in that respect, is moving in the right direction.
Joe: (35:26)
I brought up the commodity and power question earlier. And as you noted in a way, the world is fortunate that Chinese demand for a lot of industrial or energy commodities, or even ag commodities is not as high as it might have been in an alternate policy scenario. One commonality, however, and this seems to, this is a story that's getting a lot more attention, is the effect of simply extreme weather on the production of energy itself. And that also is worsening things in Europe, and there's a terrible heat wave and drought, or certainly a heat wave happening in China right now, how much is this adding to the pain? How significant is this? How much are you watching the effect of extreme weather and climate change on China's own ability to provide for itself?
Tom: (36:15)
So China is one of the countries in the world which is most at risk from climate change. Most of the population or the plurality of the population live on the east coast, which means they're exposed to the risk of rising sea levels. A large share of the population still work in agriculture. Agriculture of course is one of the sectors which is most at risk as temperatures rise. So thinking on a kind of multi-decade trajectory, China faces some significant risks from climate change, and that's why climate change is one of the few areas where China still wants to do business with the United States and get some stuff done.
The situation right now with very high temperatures, meaning that there's not enough water supply to power hydroelectricity, and that's contributing to power shortages. That's an additional negative for China's economy at a moment where with real estate in crisis with Covid Zero imposing some costs, they don't need an extra problem to deal with. I wouldn't say it was the kind of the dominant narrative or the biggest problem that they're facing right now.
Tracy: (37:28)
So there is a very big event coming up, which is the National Party Congress, that big gathering of China's policymakers. And traditionally when that happens, you often see the government start to say or do things that would be expected to boost the economy and push up stocks so that everyone is fairly happy going into this big event. What do you expect from this year's Congress?
Tom: (37:55)
So Tracy you were out in Hong Kong at the same time as I was in Beijing, so you know as well as me that ahead of these big political events, what China's policy makers want, what the communist party wants, is stability. They want stability in the economy. They want stability in the financial markets and this time around, they're not going to have it. The real estate crisis, I think, is going to run for certainly months. And the drag from real estate is going to last for years. There's no sign so far that the government is willing to exit from Covid Zero. And when they do ultimately exit from Covid Zero, that's going to be a very messy and very costly process. So my expectation ahead of the Party Congress is that we're going to see sort of a continued drip, drip of stimulus measures. The government is going to want to bring a measure of stability to the real estate sector, a measure of stability to the bond and equity markets, but they're not going to be able to deliver the kind of massive stimulus which would be needed to kind of significantly turn the situation around and create that kind of feel good factor, which they normally like to have heading into these big political events.
Joe: (39:10)
I'll just ask one more big picture question, but your book “China: The Bubble That Never Pops” and the second edition is coming out, and of course people have been talking about the China bubble collapsing for years and years — certainly for as long as our careers, me and Tracy’s. Andas your book notes, it never seems to happen. I mean, does it feel different this time? Or is this like, look, China has these periods where there's lots of stress, like many other countries, like Europe, like the US, and, you know, eventually it muddles through and finds way out. Does it feel different this time? How does it feel compared to other periods of stress and turmoil for China's economic history?
Tom: (39:51)
So it feels worse, Joe. I think there's a confluence of factors, which are sort of coming together right now and which will also weigh on China's growth going forward. So we've talked about real estate. China has had real estate busts in the past, but this one looks more severe. We've talked about Covid Zero, that's already a drag on growth, and there's the big unanswered question of how they exit from it. One thing we haven't talked about, but which is also really important, is China's kind of growing international isolation. China's a big exporting country. China is a net beneficiary of technology transfer. A big driver of China's growth has been learning from — or if we're less charitable — stealing advanced technologies from other parts of the world, that's just going to be much more difficult in the years ahead as hostility to China in the US, in big European countries, increases.
So all of these factors are sort of hitting China right now and threatening to weigh on China in the years ahead. At the same time, I think it's important to recognize that China retains pretty significant resources for resilience. China is at a relatively low stage of development. GDP per capita in China is still just a third of GDP per capita in the United States. That means China has continued and substantial room to grow, not by sort of doing anything particularly innovative or inventive, but just by continuing to kind of move up a technology ladder, which you can already see in front of it.
Don't forget that Japan fell over in 1989 when its GDP per capita was 80% of the level in the United States. So China has a long way to go before it reaches that level. Secondly, because China's policymakers remain ingenious in their capacity to think about inventive solutions to economic and financial problems, they continue to have a certain amount of space, certainly less space than they did in the past, but still some space for maneuver as they address those problems. And philosophically China's policy makers don't want to see everything burned down, right? They would sooner see a bit more imbalance than a lot of collapse.
Tracy: (42:23)
All right, Tom Orlik, Chief Economist at Bloomberg Economics and the author of “China: The Bubble That Never Pops.” Thank you so much for coming back on Odd Lots. That was great.
Tom: (42:32)
Great to be here. Thank you.
Joe: (42:33)
That was great, Tom.
Tracy: (42:50)
So Joe, clearly a lot of things to pull out of this conversation, but I think the overwhelming one is just this tension between solving the problem versus recreating the problem in some respects, or accepting those imbalances that Tom was describing. There does seem to be that fundamental tension there.
Joe: (43:09)
That was actually the most interesting, or one of the interesting ideas that I hadn't thought about before. The degree to which Covid zero policies push back reforms. The degree to which they favor SOEs over smaller companies, the degree to which they favor industry over services, the degree to which they force the private sector into deeper debt, the degree to which it diminishes consumption. I hadn't thought about, like, all of these structural imbalances that we've talked about for years with several guests, the degree to which Covid Zero is this huge setback on those.
Tracy: (43:43)
And Covid Zero in exacerbating the economic problems that we've just described seems to be creating this double whammy, right? So on the one hand, it stops some of the reforms that the Chinese government might want to see like the shift to services. And on the other hand, it also means that you have to enact stimulus measures and most of Chinese stimulus, you know, it tends to be large-scale infrastructure projects, or more credit to build more houses, which is problematic in the current situation.
Joe: (44:15)
You know at the end he gave I thought of a follow-up podcast that we should do with someone that I don't think has gotten enough discussion, is the long-term or medium-term effects of geopolitical isolation for China, which I hadn't really thought of. But as he mentioned, whether it's technology transfer, however you want to use that term, other aspects of just being a country that's heavily dependent on exports, etc. Like what does it mean for China in five, 10, 15 years to have this sort of, you know, basically deglobalization in a sense from the Chinese perspective?
Tracy: (44:52)
Yeah. I would be totally into that. I think it's an interesting question because on the one hand, yes, it's an export-based economy. They don't want to be completely disconnected from the global economy. But on the other hand, there are ways in which isolation could benefit China's economic reforms — by building up technology self-sufficiency, as we just mentioned, or, you know, even keeping capital more in the country versus having outflows. It's a really interesting question.
Joe: (45:18)
Yeah, let's follow up on that.
Tracy: (45:19)
All right. Shall we leave it there for now?
Joe: (45:21)
Let's leave it there.
You can follow Tom Orlik on Twitter at @tomorlik.