The Journal. - The Big Short: China Edition

Episode Date: May 30, 2024

For years, China’s real estate market was booming. Developers, home buyers and Western banks rushed to invest. But the boom turned into a bubble, which eventually burst. WSJ’s Rebecca Feng reports on the warning signs that were ignored and we speak to two people who saw the collapse coming.  Further Reading: -The Folly of China’s Real-Estate Boom Was Easy to See, but No One Wanted to Stop It-Evergrande Was Once China’s Biggest Property Developer. Now, It Has Been Ordered to Liquidate.  Further Listening: -China’s Property Market Crisis  -China’s Evergrande Crisis  Learn more about your ad choices. Visit megaphone.fm/adchoices

In 2015, a New York hedge fund manager named Parker Quillen went to China to visit a new property development near Beijing. Can you sort of paint a picture of what you saw? Well, the first thing we saw from a long way away was a huge tower. You could see it from miles and miles away. So there was almost this kind of enthusiastic anticipation of, wow, we're going to come to something big. That tower was due to be China's tallest building. It was part of a huge luxury development called Golden Metropolitan. Parker saw office and residential buildings, expensive villas, and a high-end members club. There were even plans for an opera house. The style was neoclassical, and the developer said it aimed to convey a sense of an aristocratic

lifestyle. So it kind of looked like a mini-? It's definitely a mini city. Okay. Absolutely. Parker was on a fact-finding mission. At the time, China's property market was booming. All kinds of money was flowing in. But Parker didn't believe the hype, and he wanted to see what was going on for himself. That's what brought him to Golden Metropolitan. And I remember speaking to our guide or our host, a nice woman who was oddly dressed in a riding costume, the stretchy pants with the leather and all that. And I was asking her business questions like, how do you plan to get this whole place occupied? Right. You have a study you could show me that shows, you know, subway lines

going in or, you know, there's a tax holiday for 10 years. What is, what's the reason for people to come here? And at which point a smile cracked on my host's face and there was a pause and she nodded slowly and kind of held back for, I guess, a dramatic effect. We were walking and discussing this and as we turned the corner, she says, behold, polo. Polo, as in that sport with horses. And I just remember looking at my, I was traveling with a couple colleagues, and I just remember looking at them, and I don't want to say any curse words, but we were mouthing, like, what the heck is this? Parker realized that the developer thought that polo would attract buyers to the Golden Metropolitan.

And he wasn't convinced by that or by a lot of what he saw on this trip to China. So when he returned to New York, Parker bet against Chinese property stocks. He was certain the real estate market was a bubble that was ready to burst. And it did burst, but not for another five years. Today, the real estate sector in China is in a long and painful deflation. And the story of everything that happened up to this moment is full of froth, a lot of denial, and accusations of fraud. Welcome to The Journal, our show about money, business, and power.

I'm Kate Leinbaugh. It's Thursday, May 30th. Coming up on the show, the collapse of China's housing market and the people who saw it coming. When it comes to smart water, alkaline 9.5 plus pH with antioxidant, there's nothing to overthink. So, while you may be performing mental gymnastics over whether the post-work gym crowd is worth it, if you'll be able to find a spot for your yoga mat, or if that spin instructor will make you late for dinner again, don't overthink how you hydrate. Life's full of choices. Smart Water Alkaline is a simple one.

Parker was so convinced that the Chinese real estate market was a bubble that was ready to burst that he kept betting against it, essentially predicting that the stock prices would fall. But in 2016, he learned a hard lesson. The stocks had a rally, and then the stocks kept going up, and we lost money. The stocks just had so much momentum that we decided to cut bait and come back another day. And so we exited with losses. Parker lost millions of dollars on these short positions because despite all the empty apartments that he saw, Chinese developers were still building and people were still buying. And to finance all this growth, developers were borrowing a lot of money, hundreds of billions of dollars. Here's our colleague Rebecca Fung, who's based in Hong Kong. The developers needed capital, so they were, you know, selling a lot of bonds in Hong Kong

to raise that capital. And then international investors and international banks like Goldman Sachs, Morgan Stanley and JP Morgan, they were all in it. These banks were helping sell the bonds to offshore investors. Global investors like BlackRock, you name it, like Fidelity, Invesco, just every sort of major U.S. and Western asset manager were buying these debts. For the investors, the bankers, the developers, business was good, real good. One banker told me that he always went to the lobby of the Hong Kong Four Seasons Hotel,

where I went and I realized one highball cost about 23 US dollars. And, you know, that's where they sort of discussed deals. And many of the investors' family offices were hedge fund managers. You know, they recall attending parties at least once a month at, you know, yachts owned by Chinese developers or their chairman, usually with champagne and female escorts. So it was a luxury lifestyle that they were living. was a luxury lifestyle that they were living. Watching all of this was Gillum Tullock, who, like Parker, had doubts about the Chinese property market. Gillum runs a small financial firm in Hong Kong. As a firm, we're three aged analysts with 30 years experience who probably couldn't

find a job anywhere else, but quite enjoy pouring over financial statements. And we focus on identifying companies where the economic reality is different to that that is presented in the financial statements. Gillum's firm researches companies in Asia, and they sell that research to clients and investors. And they sell that research to clients and investors. Okay, so let's go back to when you first started thinking something weird was going on with real estate in China. Yeah, so the first time I thought something was very odd was back in 2011 when this Al Jazeera reporter produced,

I think it was a short sort of, you know, documentary on a city in Inner Mongolia, which was a ghost city. And I think they had built this city, but it was pretty much completely empty. Welcome to the city of Ordos, a city of the future, brand new and built in just five years and meant for one million residents. But no one's moved in. Gillum wanted to know if there were other ghost cities in China. And it turns out, Gillum's not the kind of guy to bury his curiosity. He's the kind of guy who spends hours zooming in on Google Earth, checking out cities around China at the street level. And from this research, he counted seven other ghost cities.

What it essentially showed was that they were building well in excess of demand and consumers were buying it well in excess of demand. You know, both consumers and producers were just, you know, they were transacting well ahead of when they were actually going to use these properties. So most of the properties in these ghost cities were bought as a store of value. What Gillum means by store of value is that many of these properties weren't being bought to be lived in. They were investments, places for people to store their money with the hope that it would eventually grow. For Gillum, this was a red flag.

So he and his colleagues decided to go see what was happening on the ground. In late 2016, I tootled off to China and with Nigel and our poor assistant, and we hired a Buick car from another company that we thought was a fraud just to test out, you know, just to see whether or not it actually existed, which it did. And then we went off to see Evergrande's projects.

Evergrande was China's largest private developer. Evergrande had about 400 projects on the go, so we only visited about 10%. But, you know, we tried to visit mature projects and young projects. And what we found was staggering. Tell us about it. What did you find? I remember the first project we went to, it was primarily housing residential, and they clearly sold the houses, but they were beginning to fall down. And then they had this park where they were piping out music from, you know, the ground level. I think it was Shakira and the Hips Don't Lie was one of the songs that was on the loop. And then on the right, there was this Olympic-sized sports complex with a hotel.

And it was all unfinished. They clearly stopped building it many years ago. And it was filling up with water. It was, you know, when it's been sitting there for a while, it turns black because of the mold and whatever it is. So, you know, it's kind of rotting. And you're looking at that. And we found this repeatedly

at a number of the developments, the sort of similar failure to complete the projects. Gillum and his colleagues visited 40 Evergrande projects in 16 cities. A lot of the buildings they saw were unfinished and unsold.

But Gillum says that wasn't reflected in Evergrande's books. If you looked at their financial statements, everything had been a wonderful success up to that stage. Evergrande has defended its accounting and business practices, saying its financial results were audited. practices, saying its financial results were audited. After their trip, Gillum and his colleagues published a report that concluded Evergrande was insolvent and its equity worth nothing. It said the company had to borrow money just to pay the interest on its existing debt. They called the report Auditors Asleep. So we thought that the auditors, when approving Evergrande's financial statements, hadn't exercised due professional skepticism. And so we published the report, I think, in about November 2016.

Years later, Evergrande's auditor, PricewaterhouseCoopers, would resign, in part because it wasn't able to get documents to support the company's sales numbers. But as sure as Gillum was that Chinese real estate would come crashing down, the markets didn't agree. In 2017, the year after Gillum and his colleagues put out their report, Evergrande's Hong Kong-listed shares surged more than 400%. It was absolutely dreadful. If anyone had shorted it then, you know, they would have been wiped out. Right. So, yeah, it was a bit horrific.

And so at the end of that stock market rally, I turned around to Nigel and I said, we're never writing on this ever again. But Gillum would eventually be proven right. That's next. With Smartwater's pure, crisp taste, there's nothing to overthink. So while you may be spiraling over double texting your crush, whether your skincare routine is working because you look the same or is doing nothing because you look the same

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Look for new value programs when you shop at Loblaws in-store and online. One reason Chinese property stocks kept going up had to do with the Chinese government. Here's our colleague Rebecca again. Everyone was operating on a, you know, seemingly sort of bulletproof assumption that the Chinese government would never let the property market to crash.

And everyone was just making a lot of money, riding the bubble, despite very clear warning signs. That's because property is a really important part of the Chinese economy. For decades, most people in China lived in housing provided by the state. That changed in the 1990s, when the government allowed homes to be bought and sold for the first time, creating a real housing market. The government encouraged people to buy, and they did, fueling one of the biggest property booms in history. Some economists have estimated

that real estate and industries related to it at one point accounted for a quarter of the country's GDP. And then it was all well until 2015, 2016, when there was sort of a downturn in the property market. And, you know, even then, economists were warning of a bubble and people were seeing signs of a bubble too. But because of property's sort of importance to the Chinese economy, whenever there was sort of, you know, the market would show signs of faltering and the government would step in and therefore the confidence would be restored. Beijing rolled out new policies to stimulate the market, like lowering interest rates. And confidence was restored.

Sales took off again. rates, and confidence was restored. Sales took off again. So after 2016, after the government stepped in, I think the investors and the developers and home buyers sort of saw it as almost like their conviction being reaffirmed. Like, you know, the government will not let the market fall. So it was sort of after 2016, 2017, when the bubble really took off. Like, if you look at the debt levels of certain developers, 2017 was like a moment when I think people realized, oh, okay, like the property sector was too big to fail. By 2019, Chinese people had almost 80% of their wealth tied up in residential property. But the tide was about to turn.

China's leader Xi Jinping had repeatedly said that homes are for living in, not for speculation. And on the first day of 2021, the government imposed a policy for developers known as the Three Red Lines. So with the new Three Red Lines policy, a lot of developers, they cannot borrow anymore. So effectively kind of cut one of the lifelines of these property developers.

And as Gilliam and Nigel said in their report, these developers need to depend on borrowings to survive. After this, banks and investors began to slow their lending. And within months, Evergrande, China's biggest property developer, was unable to pay some of its suppliers. In August 2021, Evergrande stopped construction at hundreds of projects. Gillum and his colleague Nigel were watching all of this play out. Nigel put out another report at that stage, I think about August 21, saying, you know, this time it could be for real. This time it's different.

The bubble was finally about to burst. Parker was watching from New York. And despite his previous losses shorting Chinese property stocks, he was ready to gamble again. And we shorted it then because at that point it was clear that the Chinese government was no longer enabling the bubble, that they in fact were concerned about the bubble. I think the bubble really burst when Evergrande defaulted in December 2021.

Evergrande, big news of course, officially labeled a default. There could be global economic fallout after one of China's largest real estate developers defaulted on its debts. And then what happened? Basically, the investors suddenly realized, oh my God, if Evergrande was not too big to fail, maybe others were not either. So they stopped lending to these developers. So what happened to those developers?

They felt like dominoes. Sunak is just one of many developers that has been struggling for more than a year now. Giant Chinese property developer Country Garden could be on the brink of default. Fantasia, Scenic, as well as China Properties Group, all defaulting on debts in recent months. Ultimately, more than 50 Chinese developers defaulted, and that had a knock-on effect. If things go in chain, right, it's like a chain reaction of construction workers were not paid, so construction halted. So the homes that these developers sold to home buyers, they remain unfinished. And the home buyers saw that, oh my God, my homes could be left unfinished.

So they stopped buying. And that took away more money from developers. So the fear was contagious. In January, a Hong Kong court ordered Evergrande to liquidate. Trading in its shares was suspended. A few months later, China's security regulator said Evergrande had committed fraud by overstating its sales in 2019 and 2020 by more than $78 billion. Evergrande's demise was good news for the people betting against it, people like Parker. Yes, I ended up ahead. That obviously worked out.

yes, I ended up ahead. That obviously worked out. Parker won't say how much money he eventually made, but he did say he regrets his bet wasn't bigger. As for Gillum, the research analyst in Hong Kong, did you feel vindicated? Well, you know, it's sort of a pyrrhic victory. It's a pyrrhic victory because, you know, we've been saying for a long time that, look, the Chinese property sector investment bubble is unsustainable. And

we knew that if the bubble burst, it would essentially derail the Chinese growth story and turn that would hurt our business. So, yeah, I mean, it's nice to have got it right. And we picked the right company. But you know, I mean, financially, we've not made any money out of it. You know, on the contrary, you know, the clients have left China, some have gone into India, but into Japan, but most of the money has gone home. You may have read it right, but you also are bearing the cost. Yeah, we're bearing the brunt of it as well. What has the economic cost been?

As we said at the beginning, like property and related industries took up a quarter of China's GDP. So when this whole 25% is not doing well, China's economy is not doing well at the moment because it's sort of lost one key pillar of growth. And, you know, since the bubble burst, the Chinese government has been trying to find sort of an alternative to fill growth. But I think economists were telling us that it's in the short term, there's no alternative.

So maybe, you know, going forward, like global investors and domestic investors would just need to sort of accept a slower growing Chinese economy. That huge tower that Parker saw back in 2015, it's now in the Guinness Book of World Records as the tallest unoccupied building in the world. And its developer is bankrupt. That's all for today. Thursday, May 30th. The Journal is a co-production of Spotify and The Wall Street Journal. If you like our show, follow us on Spotify or wherever you get your podcasts.

We're out every weekday afternoon. Thanks for listening. See you tomorrow.