Hey everybody. Peter Zeihan coming to you from Colorado. The big news over the weekend is that a Hong Kong court has ruled that China’s largest property development group, Evergrande, is bankrupt and needs to be broken up. This is something that the Chinese government has spent a lot of effort on the last two years. Not happening because. Well, let me give you a little back story.

So there’s two big things that dominate the Chinese economy. The first is something I call hyper financialization. The idea that the government both de facto confiscates the savings of the citizen population so it can only go into projects funded by Chinese state banks, as well as massively expanding the money supply to the tune of like almost triple what we have here in the United States in order to make sure that there is plenty of cash sloshing around in the system so that banks can loan anything in any amount at low terms to anyone at any time, because if they can do that, they can expand, expand, expand and hire, higher hire.

And people who have jobs don’t go on long walks in large groups together. It’s a public stability, political control approach to finance. It’s not about profit. It’s about throughput, because throughput requires a lot of bodies anyway. That’s the goal. In that sort of situation, you get two things. Number one, you get companies like Evergrande who gorge on all this bottomless supply of debt to build, build, build, build, build, even if there’s no demand.

Second, you get a population who knows that their private savings is almost worthless because the Chinese government is forcing them to keep it in the state banks and they want to put it into a hard asset that preferably the state can’t control. And if they can’t get their money out of the country, then the next best thing is a hard asset in the country, which typically is property.

So you get people pooling their private savings in order to buy condos, and each condo is typically owned by a different consortium of private individuals making untangling it. Also, you have somewhere probably in the vicinity of 1.5 billion units in the country that have never been lived and never will be lived in. So you’re talking about 100% overbuild conservatively.

Some estimates say it’s as high as 3 trillion, which is just so far beyond stupid. Anyway, Evergrande going down means that their debts aren’t going to be serviced anymore and the physical assets they have had to be parceled up. And foreign investors are going to come in and see what bits that they can get. None of these things are things that the Chinese Communist Party would normally allow to happen.

So there’s a couple of ways that this can go. None of them are good. Option number one is we follow a Western style bankruptcy and restitution program where this system is broken up and a lot of their assets are sold at pennies, maybe dimes on a dollar, and it just goes away. If that happens, we will have a very clear idea of just how much the oversupply in the market is.

And you can count on private citizens being up in arms probably. I mean, the best estimate I’ve seen out of China is that 70% of total private savings is wrapped up in real estate. And most of these assets are worth no more than $0.10 on the dollar. So if you have a fire sale of the single largest player, which controls one sixth of the market, holy shit, things are going to get real very, very, very quickly.

Option number two is that the Chinese step in and abrogate the Hong Kong ruling. Now, legally this cannot happen, but the Chinese Communist Party is not really big on legal details when it comes to Hong Kong in particular. And I have no doubt that they could stick their noses in that. If that happens, that Evergrande goes on some sort of state drip and everything with the system just kind of limps on with the understanding now that Hong Kong has no legal authority over its own holdings, which will start an exodus of what few international firms are still there, regardless how this goes.

Don’t expect anything in the market to get better. This is not like, say, the TARP program that the United States put into place back in 2008 at the bottom of the subprime crisis, which kind of froze the market and put a Florida things and allowed for reforms and economic growth to eventually heal the damage of the subprime crisis.

This is this is a one off decision that is not just holding back one rock from rolling down the hill. Evergrande may be the biggest player in this market, but it is by far not the only one has been doing stupid things like this building condos that have no demand or running that like a Ponzi scheme. Every development company in the country basically operates this way, and the second and third largest players in the industry are state owned.

So you can count on the Chinese government not using this as an opportunity to break with the old model and put into place something sustainable. And even if all of a sudden this place were run by a bunch of Austrian economists, it’s too late. Housing demand, legitimate housing demand, housing demand for houses that people actually live in is dominated by people age 20 to 45.

People who are starting out well. 45 years ago, the Chinese government instituted the one child policy. You combine that with the most rapid urbanization program in human history and there are no longer enough people under age 45 to do anything that is consumption led, including home buying. So there is no path out of this that follows any pattern that we have established in a market environment which leads us to political and social outcomes, where the market economics are just atrocious and getting worse by the day with a government that is becoming ever more nervous about the state of the economy and the loyalty of its population.

I don’t want to say anything overly dramatic is like this is where it all starts to fall apart because we’ve had a lot of things like that go down in the last 18 months. But this cuts to the core of what enables the average citizen to actually support the government. And there’s no way we move forward from this without a lot of side damage.

Hey everybody. Peter Zeihan here comes to you from Colorado. A lot of you have been writing in and asking for scenarios of what the Chinese system will look like as it collapses. And Chinese history is rich with how it’s all going to hell. So putting my finger on one specific scenario I don’t think is very useful, but a lot of you have also written in asking about the Chinese housing market, and I think kind of exploring these two things hand in hand is worth a little bit of time.

So the Chinese follow a capital intensive investment model. There are there’s three types of economic growth. You’ve got consumption. Like you go out and you buy a home or you buy an iPod or whatever it happens to be. In the United States, that’s about 70% of total economic activity. Private consumption. Then you have exports. So, you know, you make something like Boeing and you sell it to the Indians.

Export led economic growth that is a system that is more popular in a place like, say, Korea or Germany. And then you have investment led economic growth, which is the building of stuff where regardless of where you get the capital, you get you build a road, you build a factory, something like that. And this has always been the method that has been favored in China and to a lesser degree, all of East Asia, because it’s something the government, for the most part, can control.

And it tends to be directed towards things that the government feels needs to be done. So roads, bridges, industrial plant and all of the East Asians have followed this pattern to a certain degree. The problem with this pattern and this type of growth is if you do it enough, you start to distort the economy and you absorb more and more capital and more and more labor and more and more resources.

And eventually you get to the point where there’s diminishing returns because you only need so many roads, you only need so many factories. In the case of Japan. They reached this point in the 1980s and they went from having stratospheric growth because this generates a lot of economic activity to just kind of a stall out. And they were left with a stack of loans worth about 50% of their GDP, $2 trillion at the time that was invested into assets that probably should have never been built in the first place.

And it took the Japanese system 30 years to churn through that, and that was 30 years of basically not having economic growth at all. Eventually, they realized the debt burden was so bad that they needed to focus what they could do on more productive stuff. And that turned out to be stuff that was not in Japan. And so we started this generation long outsourcing, the sourcing, whatever you want to call it, to countries that had better demographics and better debt profiles, most notably the United States.

And here we are now, 35 years after that process started. And the Japanese economy is more or less back in health. But it’s happened as the demographic situation has turned inside out. So consumption led growth in Japan will probably never happen again. They’re just too old. Something similar went down in Korea, but the Koreans attacked it with a fervor that the Japanese couldn’t muster, and they decided to deal with it by investing more, but going further and further up the value added chain.

And this could work in Korea because they were already among the most highly educated populations in the world, and they eventually generated things like the Samsung and the Daewoo and the Hyundai that we know today. It came at a cost. Extraordinary levels of turnover in the corporate world as entire chaebol, which are kind of giant industrial conglomerates, would go bust, which would generate a huge surge of unemployment and credit risk, which the government had to step in and assume the risk of itself in China.

It has done something similar to both of these as well as a third one. So first, building bridges to nowhere. The Chinese absolutely reached that level probably back in the early 20 tens. And most of the construction we’ve seen across China is of questionable economic use and the debt has been building up. Corporate debt has basically doubled since 2010 and it started at a level that was already in excess of American debt.

So, you know, we’re talking about a huge amount of money that has been put into things that probably are never going to have a return. They tried to follow the Korean model as well, but what they discovered is that their workforce was already fairly unproductive. And while overall productivity for the Chinese labor forces have gone up by 50 to 100% in the last 10 to 15 years, the debt load has gone up by a factor of five.

So from a cost benefit point of view, Chinese labor has actually decreased in terms of its overall productivity once you consider the cost, because in that time frame, the cost of Chinese labor has gone up by more than a factor of five or six. And then there’s a third model, unlike Japan, unlike Korea, which are, for the most part, private enterprise driven systems, the Chinese are absolutely state centric and in China and excuse me, in Korea, in Japan, the people always had options for where to put their own personal money to make their bets on their futures, prepare for their own retirements, expand their own wealth.

The Chinese don’t have that. Capital flight is strictly regulated, in many cases forbidden. And every time that the people find a new way to get money out, the Chinese government changes the law and so it all gets bottled up at home. Now, for the Chinese development model, this has proven successful at keeping the Chinese citizens money as part of the process that then funds all of that investment.

So whereas in Japan, it’s a mix of corporate and creates a mix of corporate and government. In China, the average citizen in many ways is being forced to help underwrite all this bad debt, and the Chinese citizens don’t really appreciate that, as you might expect. And so they’re always looking for outlets. Now, they can’t send their money abroad, so they looking for outlets at home.

And so China is famous for massive speculative bubbles that happen in commodities or gold or anything. And the one that has proven the most problematic and the one that has generated the most economic growth to this point has been housing. The government does allow you to own your own home. So people do that with gusto. And then they started buying apartments.

And second apartments and third apartments and fourth apartments. And basically we got an Enron style financial boom driven by growth in construction of the housing sector. Now, the new news that has come out in just the last few days that kind of crystallized this all for me was a dude in China by the name of he king, great name, who used to be an uppity up in the Chinese Statistics Bureau.

And his estimate now is that there are more there’s more housing units available that are unoccupied in China, so many available that they could house the entire Chinese population. So we’re talking an overbuild in excess of 100%. Do you kind of put that into perspective? The American subprime crisis at its peak had less than 5% overbuild because of subprime, probably closer to 3%.

And it was only because we bound up those mortgages with more healthy real estate investments and asset backed securities that it actually turned into the crisis. And we all know how that felt here. Ultimately, we had a financial crisis that lopped 5% off of GDP. If in China, you’re talking 100% overbuild in a country that is suffering from the advanced stages of terminal demographic decline and is already experiencing massive population losses against in the United States, where we had less than a 5% overbuilding, we still had population growth and inward migration.

The mind reels in coming up with a historical precedent here because there isn’t one in time. The Korean or the Japanese models were able to mostly recover from the overbuild, in part because private citizens were not wrapped up in the damage this time around in China. This specific aspect of the overbuild, which is the biggest in human history, isn’t even reflected in the debt data because a lot of Chinese have been able to pay for these apartments with cash and they now have invested for the most part, their total life savings in an asset that is probably worth at most a quarter of what they paid for it.

So in China excuse me, in Japan, in Korea, national coherence, public support for the very existence of the government was never damaged because people’s finances were only hit indirectly because of economic growth issues. But in China, you’re talking about a complete wipe out for what, for most Chinese citizens is their primary and maybe even only method of savings on top of a failure of the Korean style expansion to improve productivity on top of a failure of the Japanese style program to improve public infrastructure.

This is going to hit them from every possible angle when it breaks, and it’s going to do so by ripping the heart out of public support for the entire system and the CCP and the government in particular. So no, I am not particularly optimistic about how this is going to shake out. Quick addendum. I did a quick fact check before we went to print with this one print release, whatever on Mr. Hes data that he estimates that there are sufficient empty apartments to house the entirety of the Chinese population.

That was wrong. He says there’s sufficient spare housing to house twice the Chinese population. So everything I said before stands just underline most of it.