Odd Lots - This Is the Evergrande Endgame as China’s Property Problems Spread

Episode Date: January 27, 2022

Late last year, the big Chinese property developer Evergrande started running into severe financial distress, as its bonds tumbled and frustrated customers faced delays in getting their homes. Since then, it's gotten worse. Evergrande is still troubled, as are other property developers who have also run into stress. So what does it mean, and what are China's goals here? On this episode, we speak with Travis Lundy, an independent analyst on the Smartkarma platform, who has studied these companies in depth. He explains why things have gotten worse, and what China's goals are with a property sector that historically has been so crucial to its economic model.See omnystudio.com/listener for privacy information.

Thanks for listening to OddLots. Follow the show on Amazon Music for more future episodes or just ask Alexa, play the podcast, Odd Thoughts on Amazon Music. And welcome to another episode of the Odd Thoughts podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. So Joe, it feels like it's another day, another default by a Chinese property developer. And so just today, I should say we're recording this on January 20th. We saw a company called Oyan. I'm probably not pronouncing that right, saying that it won't make payments on four bonds that I think add up to almost $700 million. But here's the weird thing. For a brief moment this week, it seemed like people, investors were getting more optimistic about the Chinese real estate space. We actually saw a pretty dramatic rally in dollar bonds from junk rated property developers

because there were some reports that China would make it easier for property companies to get cash from pre-sales of developments. And then, of course, we saw China lower its interest rates earlier this week, which, you know, obviously monetary easing is going to be good for housing. So there seemed to be these really opposite push-pull factors at the moment, and no one seems to know quite what is going on in the space. I have to say, I kind of missed, you know, in all the, my scanning of the news, I actually kind of missed the optimism period you were talking about because every time. Yeah, I mean, it was only a day. Okay. We're back to pessimism already.

Because I have to say, like, every time I read, like, you know, obviously, look, sort of like Q4 of last year, we were talking a lot about Everground and the trouble they were getting into. And it feels like since then things have metastasized, more developers, is getting into trouble, more fears of default, maybe companies that were perceived as being safer credit risks than Evergrand was getting into trouble. So it really feels that the big story or at least every time I look into it, it's like, this situation is getting worse. Yeah. So we haven't really seen an extreme financial crisis, like a Lehman moment that some people were talking about, you know, late last year. But we have seen contagion in the sense that we have

seen spreads on other junk rated dollar bonds go up quite a bit. But really, I think the question no one quite knows yet is what exactly is the end game here? Like, what exactly is China trying to achieve? Are they going to provide policy support for property developers? Or are they going to reform the market and let the weaker players fail? So today, I'm very pleased to say that we have the perfect person to come on and give us an update on what's really going on in Chinese real estate. We're going to be speaking with Travis Lundi. He's an independent analyst who publishes on the smart karma platform. And of course, we had him on the show last year to talk about China Evergrand, which has since then finally and officially defaulted on its debt.

So Travis, thank you so much for coming back on the show. Thank you for having me. I'm trying to think where to begin because there has been so much going on in this space. but maybe just to start, you can give us an update on, I guess, the current situation around Chinese property developers. What have we seen since we last spoke to you and since Evergrand actually defaulted? Okay. If we take it back a little bit further, back to when we last spoke, and I think we can use Evergrand as a kind of case study for the way other developers have also seen deterioration. And because Evergrand is so large, it effectively encompasses the size of several other smaller developers who might default. The loan interest payments were not made on domestic bank loans,

it appears. Trust loan repayments were not made. Wealth management products have not been repaid at their maturity. At some point in late Q3 to early Q4, something like half of the projects that Evergrand was working on had been had seen work suspended. At that point, we've seen a certain amount of positioning. People are positioning for the fall. Local governments started looking at taking back land. Evergrand was trying to reduce its debt by delivering assets, selling assets to other developers, selling assets to local government affiliated SOEs. Basically, none of that worked. Eventually, Evergrand ran into problems paying its coupons on its offshore debt, paid a bunch of them late. It got an extension on a guarantee on a private debt, which people

did not know existed. That extension required delivery of certain documentation from a municipal government. That documentation didn't arrive. The bondholders demanded repayment. That came with the end of a grace period of another coupon, and, you know, Evergrand just tossed in a towel and said, you know, we're not paying. That triggered an event of default on the offshore notes, all of them. And since that time, it hasn't made any sense to pay any of the other coupons or redemptions on the offshore notes. And so, you know, people are looking at these and saying, ooh, they didn't pay that coupon or maybe they're not going to pay that redemption at the end of this month. Well, they're not going to. They can't simply decide to start repaying these things

without paying back the other ones. In the meantime, the onshore bonds are seeing pressure. There was an effort to extend the repayment on some onshore bonds last week that was successful, but is not sure how much of that was effectively prodded by local authorities. You either extend or you get nothing. When the Jumbo Fortune Redemption missed, that triggered considerable upset in local circles and a working group was dispatched and they set up a new risk management committee. That working group is very similar to the way H&A group was resolved. in February 2020, after years of debt issues and overinvestment, which had gone sour,

and some likelihood of missed payments in Q1, 2020, the high non-government sent in a working group. And this is, you know, HNA says, we request you to send in the working group. And that's the official story. What really happens is, you know, the local government says, we would like you to request us to send in a working group. And they say, yes, sir. So they send in a working group. and that working group chairman became the new chairman of the company, and the goal was, quote,

to diffuse risks and safeguard the interest of all parties. And so that's the risk management part. And given that the local government in Evergrand's case has been tasked with sorting out all of the claims, financial and otherwise, its involvement is key to safeguard the interests of all the parties. And so if we look at the H&A process, we can look and we can see that there's a possibility that Evergrand turns out roughly the same way. H&A basically went into a kind of suspended animation. Bondholders didn't know what was going on. Non-strategic assets, which could be sold, were sold to non-local parties. That raised a little bit of cash. The local operating businesses continued running and, you know, at a negative earnings rate. The working group spent basically a year

figuring out where all the bodies were buried and what needed to be done. And in February, 2021, the company filed for bankruptcy. That got the court officially involved in the working group managed company could then solicit sponsors to take over the businesses and the assets. And they took all 300 assets and companies, bunched them into a group of four and then said, please bid. And it was the bids which were presented, which proposed breakdowns of how much each of the creditor classes got. And that meant that, you know, people who were, who didn't have money, they were waiting to get repaid, it took them a long time to get repaid.

And I think that Evergrand is going to be in much the same situation. Instead of 300 units, it has, you know, 1,000 units. Right now everyone is quote unquote cooperating. And the highest goal here is to just keep on working, building, finishing projects and delivering them to homebuyers. You know, homebuyers and local governments are the protected classes here. importantly, they're also the way that cash eventually gets back to the onshore real estate parent company.

So without these projects continuing, there's no resolution on the other end. That 50% progress rate is now up into the 90s, and there will be positive news because Evergrand will say, you know, we're doing this, we're doing that. And the negative news simply doesn't come out. So Tracy said something interesting in the beginning and something to the extent of like, well, what is the Chinese government? attempting to achieve here, what is the end game, which to me raises the question of like, okay, how much of what we've seen over the last several months is the result of some policy

aim versus some sort of unintended consequence of something that was not the aim at all? And so when you look at what's transpired and, you know, as we haven't had anything like Lehman, but it's certainly been messy. There's certainly been a lot of pressure on the protected groups of homebuyers and local governments. How much was this a goal versus how much was this a unfortunate side effect of aiming to achieve something else? That's a really good question. I'm not sure I have a good answer for that one. And if I did, I'm not sure I could say it. It's pretty clear. This was not a policy or a group of policies which happened out of the blue. The PBOC started cracking down on excess of debt at financialized developers, which included Evergrand at that time, in 2018.

They warned them at the beginning of 2018. They labeled them in a report at the end of 2018. The chairman, Huey went on the tape saying we will reduce debt. He went on the tape again in early 2020, saying he would reduce debt drastically in the next three years. This was a plan. And it only came to the, you know, August 2020, when the, you know, the PBOC, the housing and urban development ministry came out and said, you 12, we need you to abide by these new rules. These are the three red lines. And it never became official policy as far as I can

tell, but everyone knows what they are. And it meant that, you know, those who were triggering two to three of those red lines and Evergrand triggered all three, there was simply nothing to do other than shrink. If you're running a business and you're growing top line, and you have 100 and you're financing at 10, that means in order to roll your financing next year, you need to roll 110. Well, if you've got new assets and new obligations because you bought some land bank last year and you've got an increased number of projects this year, well, you know, to start a project, you pay off the government with the local government with your payment for the land.

You have to go get debt to do that. So you go get some debt. You pay the land. you start pre-selling, you get some cash in the door, some of that has to stay in escrow. But that debt to pay off the land at the start of a building is a kind of a bridge. You have to increase the capacity for that bridge. If you can't have any ability to increase interest-bearing debt, then you have to sell stuff. It's not as much as, you know, buying land bank.

You actually have to sell stuff. And I think the problem is that if you do that for the 12 largest developers, well, that's going to trickle down. It's going to hurt everybody. This was not something which was an accident. There was a real design to reduce over-leverage at developers. There has been efforts to reduce upward price pressure in a bunch of markets. There have been efforts to reduce excessive lending against property. They've put pressure on the banks for years to keep the cap at the allocated level or below. They get really nasty when a bank goes anywhere near that level. So they've been reducing the leverage available in all of the domains until they got

to developers, then they finally pushed it on developers too. This was not a coincidence. Now, you know, the common prosperity theme became very popular in 2021. It existed before that. I think most of us didn't pay quite enough attention to it. But the houses are for living in, not for speculation. That was around for even more. And we, you know, we didn't pay attention to that either. I think that the government has spent a great deal of effort to try and close off avenues of rescue. You know, the banks may find it tough to increase lending because they are at their limits. The central government made it a part of the 14th, five-year plan to increase development and financing for local and regional rejuvenation. urbanization and this was basically you know them putting money into the pot for

growing the the equality of of real estate access to people who didn't have that access before however that's a very small part of the country it's not small in terms of people but the land price starts lower the aspirations are lower the total nominal amount spent is lower if you increase that by 50% but you decrease the major urban centers by 10% is a very large net drop. Now, the other thing is that this is a big part of the economy, right? So it's 25 to some odd percent of the economy, residential real estate is. And that means that if you dampen its growth, you dampen the growth of the overall economy.

And another part, pivot of the 14th five-year plan was they were going to increase quality growth and decrease quantity of growth or emphasize quality versus quantity. That means that they were telling you very clearly, the stuff that we did before to get a high growth rate, we're not going to do it anymore. That's a policy decision. So I think there's a fair bit of effort put into changing the direction here. I think also that it's important to notice that real estate's considered to be like the driver of inequality.

So if you want to decrease inequality, you've got to decrease the inequality embedded in real estate. This is Tom Keane inviting you to join us for the Bloomberg Surveillance Podcast. It's about making you smarter every business day. I'm Paul Sweeney. We bring you complete coverage of the U.S. market open. We cover stocks, bonds, commodities, even crypto, all the information you need to excel. And I'm Alexis Christophers.

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But before we do, you know, you just described the response to the Red Lines policy, which was basically, I mean, it wasn't nothing, but the only thing that developers could really do is try to shrink, sell off assets. I'm wondering, you know, even if they sell off assets, they still have these massive liabilities that they need to fund somehow. And given all the uncertainty in the market, it seems very unlikely that a lot of foreign investors are going to step in to buy those dollar bonds. So I'm curious, how are real estate developers actually funding themselves right now? Evergrands spent much of 2021 extending the terms on its non-interest-bearing liabilities.

So if you look at the interest-bearing liabilities, they actually shrunk from December 2020 to June 2021. If you look at the commercial bills or the trade payables, those increased. So the debt numbers, which was the interest-bearing liabilities portion, that actually shrunk. And they made their target of shrinking debt by 150 billion R&B. But that doesn't help anything. If you put more suppliers on the hook and they stop working for you, then you can't finish your project. And that's what happened in the second half of 2021. If we ask ourselves what can replace the foreign funding, that's a good question.

So far, I think in this year, there's something like $36 billion of redemptions of U.S. dollar debt for Chinese developers. That's a fair bit. That means that that money's got to come from someplace else. It's not clear to me that banks will want to increase their lending in order to repay that. they're already under pressure to not increase. If you look at what the NDRC said as a side note to the 14th five-year plan last year, it was very clear they were going to crack down on the unconstrained growth of local government debt and hidden debt.

And they were going to emphasize prudent fiscal rotation rather than monetary easing in the sector and, in the growth mix of the economy. And Liu Kichang came out and said 6%. People had been expecting a higher number. It had always been a higher number. And he came out with a lower GDP target for 2021. Now, it ended up higher than that, according to the stats. But the willingness to accept a lower target was seen as proof that there was a goal to

crack down on the excesses of the quantity of growth versus quality of growth problem. In this case, it's tough to see who picks up the slack. If you look at foreign markets, you know, the European markets or U.S. markets, when the end user stops buying, usually it comes out to longer, more patient money buying at a discount. Oftentimes that's some kind of private equity venture where people pool their funds together, either incorporated or in a very professional fund, buy the assets and rent them out and hope that they can wait for five years and sell them at a markup. In August of 2021, the government basically ordered the entity which approves funds to stop approving private equity funds in the residential real estate market because obviously housing is

for living in, not for speculation. And that means that you won't see non-developer companies coming in to buy these projects unless they can convince people that the project which they buy is for the betterment of the company. Maybe they buy a project and develop an asset and turn it into dormitories or something like that. And they can convince the local government that is the appropriate thing to do to further, you know, the development of the local economy. But it's basically going to come down to SOEs and SOE developers financing the purchases of assets from troubled developers. And the other place is going to have to be, you know, end users are going to have to step up. And right now, you know, for the longest time, China has had a real estate market,

which was, you know, characterized by prices go up and demand goes up. Prices go down, demand goes down. It's a combination of a Giffin good and a VEblen good, depending on whether your status is, you know, housing is a staple or housing is a luxury. In this case, the government has warned, you know, pretty clearly, we don't want you to speculate. So there goes the Veblen good. They've introduced the concept of a property tax and the property tax means that everybody's ownership gets registered. There are a whole bunch of people out there who don't want to be known as the owner of five different properties. And if you're a communist party cadre in some reason,

city where you purchased a bunch of properties at a very low price and now you're the owner of those properties and it's really great and you are independently wealthy because you, your dog, your three-year-old daughter, they all own properties. You don't want to have the property tax come in and suddenly have to figure out what to do. And if that happens, then that actually creates, you know, another problem. Currently, the developers aren't selling as many properties as they want to. And if luxury buyers and savings buyers, investment buyers, can't buy multiple properties anymore because of a they want to discourage speculation, then that reduces the total, you know, new home sales. And a property tax would invite

increased secondary home sales. That's not a great thing for the market. And it's honestly not a great thing for local governments because local governments make their nut by selling land to new property development. And if new property development stops and the rotation comes from secondary property market where, you know, must sell holders transfer to new people, well, the local government doesn't take a cut of that. So it's not sure where all this money's going to come from. It's so interesting. We just did an episode recently on the lack of inventory in the U.S. housing market and the sort of rise of small landlords, people who might own one to three or four homes.

And the same issue of like in states, California being the big one, where there isn't much of a tax on property, you just get incentivized to hold. And how places where there's higher taxes that match the value of the home, you sort of create that churn and greater inventory. So it's interesting to hear the same dynamic. I mean, it makes sense. But it's interesting to hear the same dynamic in China. So the thing I wanted to focus on, though, is, you know, it seems to me when we talk about like

debt. You know, there's sort of like the financial debt and the real debt. And of course, the financial debt are the bonds and the various payments that these companies have to make. And then the real debt is, of course, the housing units that the companies owe to people who have put down a down payment. And it's a very big deal if those aren't delivered in a timely manner. Talk about the connection. Like, what is it that has made the actual like process of creating new units, creating new homes. What caused the sort of like the physical process to slow down such that the real debt has been difficult for some of these developers to fulfill? Well, that comes down to a financial debt, actually. I mean, the process basically is developer says, I got a project. I want to

go bid for this land. He bids for the land. He doesn't have to pay for it usually on day one. Instead, he pays for it in a year. Or he's got a time limit says you must develop this within three years. So You know, two years and a half later, he goes and starts developing. And developing means that they probably have to break ground and put a foundation in. There are different definitions depending on the different contract. The developer signs with the local government when the local government sells a land. However, you know, land prices go up 10% a year. If you don't have to pay until year two and a half, you can promise to pay 100.

And land prices go up, you know, 10% a year, let's say. and in year two and a half, that 100 is now worth 125. And all you got to do is now you've got to go fund 100 to pay the local government. And it's worth 125. It's on your books at 125. Then you go out and pre-sell it. And because it's worth 125 and you only paid 100, the bank will give you a small loan to start, you know, construction. And you pre-sell it.

And once you get to a certain level of construction, then you can take the full payment from the mortgage and that will all go into an escrow account. And, you know, different, different localities have different rules on how much money can be taken out at what point in the process. Some of them are extraordinarily detailed schedules. You know, if you have a height of the building of 40 meters, then when you get to seven meters, then you can take out 15%. When you get to 12 meters, you can take out a different level. And that money is meant, you know, to fund the work in progress so that at the end, the money is out and the delivery is made. A lot of these processes or projects were perhaps less well supervised than they should have been. And this is one of the things we're going to see,

I think, in Evergrand. What we saw last year was that when it came out that Evergrand had taken money out of the escrow account faster than it should have, a bunch of local governments came in and started suing Ever Grant to get money put back in. And they were successful and Evergrand put the money back in. But that was, you know, again, part of the Q2 problem last year where things started going south for them. As a result, you know, with the government cracking down on banks saying you have to be more prudent, you have to make sure you're not lending more, they went in and did line by line on all the exposure to the major developers, including especially Evergrand. And all the local governments were, you know, brought in to cooperate. And that meant that they had to,

you know, excuse my French, but do a CYA exercise. And that meant that they got very strict. And one thing we've seen here very recently is that there's been a proposal in the past week or so, which says that the national government will come out with a new rule on escrow accounts to supersede. the local rules because perhaps the local governments have now been too strict in releasing funds. So you've got this problem where it was loosey-goosey and now it's much less loosey-goosey. And so there's been a swing from kind of over the curve to under the curve. And developers use that money to go speculate. Like Evergrand has a soccer team.

It's building a stadium or a bunch of stadiums. It owns this, that, and the other thing. there have been some large dividends paid out over years, and there's certainly been some luxury spending on expenses. And if you look at some of that, the money just disappeared. There's just not enough money in the pot. And when the local governments start restricting the amount of money coming out, you start being unable to pay your suppliers. And instead, you pay your suppliers with a note, which says, rather than pay you cash, now I'll pay you, you know, 10% more cash in three months. Well, that starts, that's a financial liability.

because if you actually have to go pay that guy in three months, well, now you need to source that cash from someplace else. And they just don't have that. They just started basically creating non-interest-bearing, but premium payout liabilities, which they couldn't keep up with. So suppliers didn't get paid and they stopped work. And then what really happened was the government stepped in

and said, you will pay your suppliers in order to start these things working again. And whatever you need to do, do it to pay your suppliers to start working again. On April 4th, 2020, around 2 in the morning, a man was found stabbed multiple times on a sidewalk

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this is Foundering, the Killing of Bob Lee, beginning April 16. So you mentioned the possible change in escrow rules. And I think this was one of the things that sparked that very, very brief rally that I was talking about in the intro in property bonds. And of course, this week we also saw China cut interest rates. And, you know, it seems to be embarking on some sort of easing cycle, which presumably would help the property sector. I guess my question is, how do we feel about the policy response right now? Does it seem like the authorities are,

are maybe trying to calibrate their crackdown and their efforts to reduce leverage in the opposite direction. So maybe they think they've gone too far and they need to start to roll back some of these measures. That's a good question. I think that we will continue to see statements from the PBOC, from the CBIRC, from the Financial Stability and Development Commission, who's the, you know, the top financial regulator. I think we'll continue to see statements from all of these bodies saying that China will not return to aggressive growth of real estate to bail out the economy. They've said that constantly.

I think it's going to be the mantra for a long while. The question I think we have to get to is, and I think I mentioned this the last time, was, you know, China's teaching a lesson. And the question is how hard and to whom are they teaching this lesson? lesson. And I don't think we've answered that yet. The beginning question here was, what is the end game? I think the end game is a 2030 to 2050 outlook, where we have a China is a moderately prosperous society in 2030 and is a leader in global and regional markets and has common prosperity for all. And if you look at what Xi Jinping has said with regard to his common prosperity, this is not a

2022 thing. This is a long-dated thing. So we really have to look at where the long-dated endgame is. And the long-dated end game for common prosperity means a reduction in inequality. And I think the question has to be asked because China has a Fuji system where you have a, you have your effective household registration or, if you will, local citizenship based on where you live. And that really comes out to where you were born. And the question is, should Chinese people have their relative wealth and prosperity determined by where they were born. And that is a particularly un-Shijimping kind of attitude. So I think that he's looking at that and saying, no, that's not the way it should be done.

And if you look at, for example, the changes in the education sector in the past year, that's very clearly, you know, let's not give excess advantage to those who happen to have excess funds right now. Let's make education something accessible to all. And I think that he's looking at real estate much the same way. And the question here is, well, is that unfair to the people who bought all the property? Well, then the question is, is that unfair to all the rich people? And I think his answer might be, well, you know, that's just one of those things.

So I think if we look at the end game, the end game is clearly a very non-capitalist, non-libertarian socialist view of the way assets should be distributed across an economy. and if I look at that, that means that there's a bunch of people who are going to hurt. And if you think about what the developers really represent, and all of us, you know, there's been something like $80 billion of value lost in the offshore bond markets or Chinese developers in the past year. Great. Well, most of the developers are still functioning and building houses.

Contract sales are down, but they are still out there every day building houses and delivering houses to their homes, to their homebuyers. What has been lost has been the capital ownership of those end. entities. Those operating entities continue to operate and will continue to build. And as long as they fulfill a social function, then that's what the end goal is going to be. Now, capital owners and capital providers are going to take a big hit here. They already have, and I don't see it getting much better. But you don't see such pain that they have to backtrack. And so you talk about a 2030 or what the end game looks like in the year 2030 to 2050. And real estate is not such an important

part of the economy and the wealthy who bought up multiple homes early of taking it ahead. Can I mean, I guess the question is, can they get there without having to backtrack? Or would there be so much acute pain in the meantime from people who do have equity in their own home or so forth such that it becomes untenable to go all the way through without further easing or without further sort of like juicing the sector again? I think this comes down to what is acceptable and what is not. acceptable as a response. And if you look at what the PBOC and CBIRC have said specifically about Evergrand, it's almost exactly the same wording they used about HNA. This company exercised

poor management and took blind risk for expansion. And this is the chickens coming home to roost. And there's no pity for them here. And what that also tells you is that, you know, there will be heads will roll on this. There will be, as John Galbraith put it in, when you described the bezel and we're, you know, Michael Pettis and I have both described this as the downside of the bezel, the discovery phase of the bezel. Audits are penetrating and meticulous. People are assumed to be dishonest until they're proven otherwise and commercial morality improves when the truth comes out. I think we're going to see that. And I think that's what that's what the goal is here. So the trick is what is acceptable and what is unacceptable.

You know, speculators losing money, that's acceptable. Homebuyers in the streets, that's unacceptable. 40 million migrant laborers involved in the real estate construction sector out of work and not getting paid and not being able to eat. That's a real problem. And so I think that there's a difference between what is deemed to be an acceptable risk and what is deemed to be an unacceptable risk. In this particular case, there's obviously a path risk. And I don't think that China has adequately prepared to the ground for that financing path. And the financing path, in the end, comes down to the local governments.

So this is something that you and I have discussed previously. And one way I like to think about the housing market and the way it fits into China's financial system is sort of like a supply chain. And I think you said this, but a supply chain of capital, right? It's moving in a straight line and one disruption at one end of the capital supply chain is going to reverberate and have consequences for other things further down the supply chain. So maybe you can walk us through those connections and how a disturbance in the housing market, lower inventory, lower prices might actually have a knock on effect to things like local governments,

Chinese banks, SOEs, state-owned enterprises and things like that. If we look at the status, if we think about this as a shooting star, it shot up. There was a lot of profit under the curve, a lot of spread taken out by different parties. And growth, nominal growth, which was quantity of growth rather than quality of growth. The pivot point in all of this is the supply of land. The government of China owns all the land. In the early 90s that the decision on who sold land to whom was then delegated to the local governments and the local governments could raise revenue because they were

not allowed to issue deficit bonds. They could raise revenue by selling land. And they would sell land and then the developer would develop it and then they would earn a developer tax from the developer's sale of the land and property to buyers. If we look at the local government funding sources, something like 38 to 40% is across all of China is in the sale of land and the special taxes which come from the development. That's a very big portion of local government funding. And that has been growing, you know, roughly in line with GDP because it's a big part of GDP. When we look at this supply chain of capital, you know, the people providing capital, those people providing capital. They provide it to a developer who buys the asset. Then the asset is rotated

into savings capital, which is purchased by the new home buyer or the investor. And if you think about these, there are a bunch of flows going on. If the local governments have sold a lot of land, and that is going to decrease, that means that the grade of growth that they are able to raise money at will drop. We can look at this and say, you know, in 1995 to 2000, there was no such thing as a land bank. Governments were starting out from scratch. Developers were starting out from scratch. And then we ran into the, you know, the late-naughties problem, the GFC. And then there was suddenly a burst of financing, but the burst of financing allowed developers to build land bank. So if we take the idea of a land bank, from 2010 to 2020, developers have grown land bank to be,

you know, on average, something like three years worth of land on their books. And that means that local governments have sold 13 years worth of land in 10 years. If we look forward and we say that the developers aren't going to be able to carry that because, you know, their high funding costs and the lower sales rate means that they simply can't hold it, they will burn through their inventory. But over the next 10 years, basically the local governments will sell, you know, eight years worth of land bank to the developers who will then spend 10 years worth of land bank. So they were, you know, earning at 13 years out of 10, so 130% of what they probably should have.

And now they're going to melt back down to eight years out of 10, let's say. That's a 40% drop versus your straight line growth. And a 40% drop is a lot of money to be taken out of the flow into local government coffers. And that's where the pivot point comes. If we look at all of these, the logistics here, you know, real estate is a local government funding source. It is a GDP source because all of the development creates jobs. It creates construction jobs, financing jobs.

Mortgage spread is the single biggest contributor to the bottom line of most Chinese banks. There's a clear, you know, incentive for everybody to have. this all go well. But when it doesn't go well, you know, volume drops, spread drops, volume drops on the sales, land sales, and local governments find themselves unable to fund their other infrastructure products. And that means fewer jobs. And it means that savings assets are not created at the same rate they were created before. In the end, I think that people are okay with the idea that savings assets, which are heavily levered, aren't created because it's a relatively low spread asset. A lot of these assets aren't earning any money. People are financing

them, but they're just held empty. So it's a relatively inefficient way to create a gross levered financial asset. But all of the stuff between then, you know, local government financing, GDP, jobs, bank health, it's all connected. And when you put a stop on one end of it, that means, you know, the block cascades through the chain. I'd like to point people to Michael Pettus's odd lots back in October. He really addressed this issue of expansion and contraction and local government as a place where it was going to hurt. I think that is part and parcel of where we're going to see the problem.

problem addressed. In the end, the biggest savior here will be probably local governments selling land to local government financing vehicles who will then build low-income housing. That will create jobs. It will create spread. And perhaps they will rent those to low-income households on a kind of a rent-to-own basis so that people are building a certain wealth and basis of future prosperity for their household, and it will, in effect, dampen the pain that we're seeing. But I don't think that we're going to see a return to people buying five or six apartments in a project because they can and expecting, you know, property prices to rise 15% a year for the foreseeable future. I don't think that that's coming back.

Travis, that was a fantastic explanation and update of what's going on. really appreciate you coming back on all thoughts. Thank you. All right, Travis, thank you so much. So it's always great having Travis on because he's immensely knowledgeable about pretty much any space you throw at him. But I thought in particular what was interesting in that, well, I thought the thing that stood out in that conversation was the emphasis on changing the quality or the makeup of China's

growth. The idea that you don't want to have financialized growth anymore or not as much of it, you don't want growth that's driven by asset price inflation and debt and leverage. And so you're taking leverage out of the system. I mean, China has been pretty direct about doing this. If you're taking leverage out of the system and saying that you don't want housing to be purely for speculation, then inevitably those prices are going to have to fall and funding is going to fall too. And that's the big question for me. Like, where does the money actually come from and how much of it will be available? because that's also going to dictate where house prices actually end up.

Right. Yeah. And this idea that or the goal, like, can you sort of hurt the capitalists, the investors, the bondholders, while also maintaining a healthy pace of volume growth in homes, like building more homes or making more homes available? Because obviously, that's still a multi-year priority and there's a lot of development yet to be done. And as he described it, like the existing system was very friendly to capital. There were all these ways to, I don't know if game is the right word, but let's say make easy money.

And the example of, okay, you buy land from the government at X, but you don't have to pay it for a while. And then by the time you do pay it, it's up 25%. And then you can take money out of the system by the time you've like done a little bit. And so essentially, like, there's the leverage. And the question is, can you keep up that same pace of home creation? while making it less capital-friendly is like a really interesting thing to watch. Yeah, well, I thought the idea of China sort of killing two birds with one stone by building low-income housing that will hopefully replace some of the lost inventory, that's a really

interesting notion. And it makes a lot of sense from a policy standpoint. So it'll be interesting to see whether or not we actually see that now. It's kind of interesting that like in any economy, anywhere around the world, like, especially these days, it's like whether the U.S. or China, like, there is this demand for more house, like more home volume, like people want. And yet, you know, you don't really see modern governments talk, at least in, you know, at least in the West, talking about like the number of new homes built as a major measuring stake. You know, in the U.S.

are talking about like wages and job creation, et cetera. But no, I've never heard like a politician say like, oh, well, we built two million homes under my watch. Or we were. build a million, you know, but it would it be intuitive. And so it'd be interesting if China, with its more sort of top-down policy can just sort of like manufacture homes in a way that's separate from the capital markets process. Totally. It makes a lot of sense from a policy standpoint. But yeah, you're right. Historically, it just hasn't been emphasized. Although I think in the UK politicians do make housing supply quite a talking point. But maybe that's, yeah, maybe that's a conversation for another day. Shall we leave it there? Let's leave it there. All right. This has been

another episode of the Odd Lots podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Jill Wisenthall. You can follow me on Twitter at the stalwart. Follow our guest, Travis Lundy. He's at Travis Lundy Asia. Follow our producer, Laura Carlson at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy at Francesca today. And check out all of our podcast at Bloomberg, under the handle, at podcasts. Thanks for listening. April 29th and 30th, Bloomberg House arrives in Miami at the Formula One Grand Prix. Set against one of the world's most electrifying sporting events, Bloomberg House brings business, investment, and culture together, powered by Bloomberg journalism, real-time data,

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