Why do macroeconomists care about the fate of a single Chinese company?
I mean sure it is absolutely massive!!! with assets equal to roughly 2.2% of China’s GDP…. but it is the losses on those assets that matter for GDP and those will surely be much less.
What’s more China’s GDP is typically growing around 6-8% every year…. So, China’s economy should easily be able to shrug this one off ….. right?
Welllll there is one economic problem that Western economists found about out about the hard way in 2008 and that is …. contagion….
After all, in a complex system, such as the economy, everything is interconnected… and if a single hub company fails it could spread to others….
In a way, this is what happened with the fall of the American bank Lehman brothers in 2008…. It’s fall triggered a panic in financial markets leading to a freeze in interbank lending and a subsequent stop of lending to the economy…. accelerating its collapse…
But the thing is, even though media like to make this comparison, the Chinese economy differs from the US economy in a crucial way….
it’s financial system is not a free market.
In fact, most of its banks are owned and operated by the state…….
So, no risk of interbank market lending freezing up and no risk of contagion then right?
Well… no, because there are other ways that financial problems can quickly spread through the economy…. and in this case the two relevant factors are debt and property prices….
And this is where the macroeconomics comes in.
We typically measure how well the Chinese economy is doing by looking at its Gross Domestic Product… and this can be split into four parts: government spending, investment spending, consumption spending, and net foreign spending…. on Chinese exports …
Now, the problem is that economists fear that the managed collapse of Evergrande will spill over into property prices because it will need to sell its massive property portfolio to repay its massive debts…..
And a fall in property prices might have massive ramifications for all parts of GDP…
Let’s talk about the most obvious one first… investment spending…
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Investment
If property prices fall, there will obviously be less investment spending from the property development sector and related industries. Now, the problem is that these sectors are much bigger in China than they are anywhere else. In fact, economists estimate that real estate excluding housing construction accounts for a whopping 7% of GDP.. while related industries such as raw materials account for 17.2%….
but , perhaps consumer spending can come to the rescue?
Consumption
Well… That is unlikely, because property prices are deeply connected to consumer spending in China in two ways. First, because the property sector and industries that rely on it, employ a lot of people…. that might loose their job… and stop spending… making consumption drop as well. The second connection is that Chinese households have invested heavily in properties. And this is where we come to what economists call a ‘wealth effect.’ The idea here is that, if people perceive themselves to become poorer because the value of their house drops, they will cut back on spending.
Government spending
So, what about government spending? This is where people have high hopes… just like with the financial sector… the Chinese central government is well aware of the Keynesian solution to halt macroeconomic contagion…. increased government spending…
But, here there is one aspect that is again pretty crucial to China and that is that local government spending … which is much higher than central government spending… and depends heavily on the proceeds from land sales and these could start falling rapidly along with property prices….
Debt
And for each of these sectors debt comes in as an amplifying mechanism… the more indebted in property developers are the faster they are forced to cut back spending. Similarly, the more debt in the household sector and the harder the wealth effect kicks in… the same for local government debt…. the only exception might be the central government. But, since China’s official debt-to-GDP ratio has increased by almost 45 percent in the last five years, it now has one of the highest debt ratios for any developing countries in history.
The foreign sector
So, what about the the rest of us…. well it is unlikely that exports will increase enough to make up for domestic spending since the rest of the world is still dealing with another type of contagion…
what is more China’s reduced imports might actually reduce its exports as well since the proceeds from its imports were often used by commodity reliant trading partners such as Australia, Africa and South America…. to buy…. Chinese products…
Again … contagion…
Conclusion
So, that is why macroeconomists care about one single company… it is all about contagion…
But, just as with a virus… or politics… it is impossible to predict precisely what will happen next…. We all know that China’s central government doesn’t like contagion… and it could very well be that it will step in sooner rather than later… ending contagion…. preventing depression…. and ushering in an era of economic stagnation … but that is a story for a future video… so make sure to subscribe … and if you want to discuss further with me and my awesome Patrons… consider supporting the channel of Patreon.
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