Paper Tiger

China and the U.S. have agreed to a temporary ceasefire in the tariff war, but things are not as they seem. Will the Asian behemoth be forced to capitulate?

For years, China’s economy has been under severe strain. We're now a few years into what’s shaping up to be a historic correction, and despite efforts by Beijing to engineer a soft landing, the property sector is still stuck in a rut. Prices are falling, developers are scrambling for cash, and the broader economy (especially the financial sector) is starting to feel the drag. These economic undercurrents are forcing China to come to the table to discuss tariffs- something we’ll get into later in this piece.

I first started covering the Chinese slow-motion train crash in pieces like China Teeters, where I pointed out the fundamental issues plaguing the real estate sector, like overbuilding, ghost cities, financial derivatization, and excessive leverage. All of this had contributed to the economic boom enjoyed by China in the 2000s and 2010s, allowing the country to experience an average GDP growth rate of 8% from 2005-2024, a staggering figure even by developing economy standards. However, this had come at a cost- blowing a bubble of biblical proportions in their real estate and financial sectors.

The economic activity from this housing bubble had flowed into construction, manufacturing, auto + truck production, and other adjacent areas of the economy, and as long as the developers had access to easy credit, and globalization kept stuffing more factories into Chinese cities, everything worked. As you can see in the above chart, the bubble accelerated in the mid-2010s.

It’s important to understand that the way that policymakers in Beijing view credit, growth, and wages is functionally different from how we do in the West. In China, just like Japan, economics is downstream of the state- meaning that if some initiative might undermine fundamental growth but prop up state interests, it is generally viewed as the right option. This has been the case for decades, ever since Mao’s Great Leap Forward and the subsequent economic turmoil that followed.

The citizenry knows this- that’s why they’ve been hesitant to invest in their own domestic economy, and recalcitrant when it comes to capital controls. As Peter Zeihan pointed out, a few years ago China opened up a foreign investment program and within a year elites had moved over a trillion dollars (in USD terms) overseas. The government promptly shuttered the program.

Equities had long been manipulated, and without a strong regulatory body, corporate scams were commonplace. In fact, the main index , the SSE composite, has still not reclaimed its 2008 highs, as you can see here. An entire documentary called the China Hustle was made about the rampant financial fraud in their markets- it’s a great watch.

This is why real estate became such a valuable tool for monetary authorities to goose economic growth. Since it was a tangible asset, many Chinese were much less cautious about investing than they were with equities or bonds- and since it was stable, banks were able to lend against it and use it as collateral when securing financing. Much of the Chinese business order is based on a social concept of guanxi; this translates loosely to relationships in English, but the practical idea is much more of a tit-for-tat reciprocal favor system. This meant that a banker would give a favorable loan to a developer to build a high rise, in exchange for early entry into their pre-built home fund. You can quickly see how this system can spiral out of control, especially once asset prices are climbing.

By 2015, China’s leadership was staring down a slowing economy. The breakneck double-digit GDP growth of the 2000s was already fading - manufacturing was losing steam, exports were far off the highs from a decade earlier, and policymakers needed a way to keep the economic engine humming. So they doubled down on real estate.

Local governments loved it- real estate had long been their golden goose; selling land to developers was one of the easiest ways to raise revenue. In fact, ​as of 2021, land sales were making up for approximately 30% of their total income, and when combined with property-related taxes, this figure rose to about 38% of total local government revenue.

Developers, in turn, borrowed like crazy to gobble up that land and start building. It was a self-reinforcing cycle: cheap credit fueled land grabs, which pushed up prices, which kept investment flowing. And the demand was real, at least on paper. Urbanization and industrialization was still in full swing. The cultural obsession with property ownership was strong, and investors started treating apartments less like places to live and more like leveraged assets.

But by 2017, warning lights were starting to blink. Prices in top-tier cities like Beijing and Shanghai were skyrocketing, sometimes by over 20% a year. People were taking out multiple mortgages, empty homes were multiplying, and “ghost cities” were making international headlines.

The developers at this time began engaging in what we can lightly term “unorthodox business practices” like selling pre-built homes or leveraging funds raised from investors to borrow even more money. In effect, these were ponzi schemes that relied on new investor capital to pay for the construction of buildings they had already promised previous investors.

The government, to its credit, noticed the bubble forming, and they began rolling out cooling measures, including higher down payments, tighter credit, purchase restrictions for second homes. But it was too little, too late. The bubble had already grown to gargantuan proportions, and was getting bigger by the minute.

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This is the context that leads into the Evergrande collapse and the slow-motion crisis we’re living through now. The seeds were sown during the boom years between 2015 and 2020, when short-term growth was prioritized over long-term stability. Now it’s time to pay the piper.

With the advent of the COVID-19 pandemic and the subsequent lockdowns (China was especially extreme, since the CCP was afraid of losing control of the narrative of government control), economic activity slowed meaningfully. Initially, there was an economic freeze as sales stopped, manufacturing slowed, and construction halted. But very quickly, Beijing reversed course. To keep the economy from falling off a cliff, they reopened the credit spigot. Developers were once again able to borrow in large quantities, and many did. But underneath the surface, cracks were widening.

By the end of the pandemic, China’s real estate market was bloated and rapidly deflating. Developers were sitting on mountains of debt, families had sunk their life savings into pre-sold homes, and local governments had grown addicted to land sales. Everyone knew the model was unsustainable, but no one wanted to be the one to break the cycle.

As of late 2024, average home prices in major Chinese cities dropped by nearly 6% compared to the previous year. In 2022, revenue from land sales dropped to 6.7 trillion yuan, a 23% decrease from 2021, falling to 5.8 trillion yuan in 2023, and by 2024, land sales revenue further decreased by 16% to 4.87 trillion yuan. Last year, China’s Mortgage-Backed-Securities (MBS) market fell by two thirds as borrowers rushed to repay loans early, due to uncertainty about future economic conditions.