Chinese property developers have serious cash flow problems.  They have relied on escrow funds from pre-sales (housing they’ve already sold) to finance new developments.  As those sales have stalled or faced mortgage boycotts, China’s property crisis has deepened.  Developers have lacked liquidity to finish projects they were already paid to complete.

The reliance on new investors for cash flow to complete existing projects is the classic structure of a Ponzi scheme.  

A year ago, China’s property crisis appeared limited to the China Evergrande Group.  As more evidence of lax escrow oversight came out, however, there appeared to be far more systemic risk in China’s real estate sector.  Like all Ponzi schemes, the question is not if the Chinese government can continue propping it up, but when it will fail.   

Why China’s property crisis is a giant Ponzi scheme

First, let’s quickly review the basics of a classic Ponzi scheme.  We’re very familiar with them in America because Charles Ponzi (the scheme’s namesake) operated throughout North America only to be outdone almost a century later by Bernie Madoff.

The basics include the following: 

• Promises of high returns with little to no risk
• Scheme organizers pay existing investors with funds collected from new investors
• Requires constant flow of new investment and liquidity to survive
• When it becomes hard to recruit new investors or when existing investors cash out, Ponzi schemes tend to collapse

Now let’s apply the basics of a classic Ponzi scheme to China’s property crisis:

• Chinese households allocate most of their savings to real estate.  Approximately 30% of China’s GDP comes from real estate compared to 15-18% in the United States.
• The Chinese government has never let the real estate market fall, and has historically intervened to assist developers and banks.  Accordingly, investment in Chinese real estate promises high returns with little to no risk.   
• It is standard for property developers to sell housing long before projects are completed.  Home buyers in China are required to start paying the entirety of their mortgage before their home is completed and delivered.  
• Developers use these pre-sale proceeds to fund land purchases and to further expand their business.  Therefore, new investment drives liquidity and cash flow.
• Whenever financing conditions have tightened, developers were quick to start new projects, securing more pre-sales and stabilizing cash flow.
• However, as the Chinese real estate market cooled and developers failed to complete projects in a timely manner, less home buyers were buying pre-sales, and existing customers threatened mortgage boycotts when their homes were not completed on time.  
• Therefore, it is only a matter of time before the systemic risk becomes too great, developers do not have necessary cash flow to finish projects or start new ones, and home buyers lose confidence and stop funding pre-sales.  At that point, the Ponzi scheme will collapse.

When it does collapse, the main question will be: who will suffer the economic consequences?  Chinese history strongly suggests an answer, but before we get to Mao and the sparrows below, let’s examine the deeply systemic nature of this property crisis.   

Chinese property developers are the Ponzi scheme organizers

Developers have only delivered approximately 60% of homes sold in advance between 2013 and 2020.  Imagine still waiting for a home you bought almost ten years ago; a nonexistent home you have been paying a full mortgage on for that entire time.

The Chinese government may say that “houses are for living in, not for speculation”, but the actions of developers tell a different story.  In this tale, the municipalities are the enablers, similar to those who helped Bernie Madoff execute the largest (private) Ponzi scheme in history.      

China has laws and regulations requiring developers to set aside enough money in escrow accounts to finish construction on their housing projects, but many municipalities have allowed them to sidestep the rules.  This has allowed large amounts of pre-sale funds to end up in the developers’ personal accounts.  They spend the money as they wish, whether it’s for new projects, land purchases, etc.    

How much developers are required to keep in pre-sale escrow accounts varies by municipality.  There is a lack of nationwide rules on this point.  But importantly, developers by and large have the ability to use funds intended for uncompleted projects to finance new projects.  This cash flow allows Chinese developers to keep their Ponzi scheme afloat.

Nobody noticed a problem until the real estate market started to cool.  When cash flows from pre-sales slowed, developers didn’t always have the funds to complete existing projects.  Existing home buyers were left waiting, or alternatively, received homes in sub-par condition.  Other new projects were simply left empty in ghost cities.

Allowing developers to basically use pre-sale escrow funds at their discretion has caused massive overbuilding and excessive borrowing.     

The lax oversight of pre-sale escrow accounts was somewhat curtailed in 2021 following Evergrande’s debt problems, but as cash flow became a serious concern for other developers, many municipalities backtracked earlier this year.  They eased restrictions again on escrow accounts, although it did not resolve the property crisis for two main reasons: 

(1) less people are buying homes, and 

(2) existing customers have threatened mortgage boycotts.  

Both are necessary to keep cash flow dependent developers operating their Ponzi scheme.  

When the Ponzi scheme collapses, municipalities may not be able to help

Most Chinese municipalities are strapped for funding.  They can’t afford to bail out developers, even as more of them default on debt obligations (30 so far).  Lower revenues and pandemic lockdowns have limited their cash flows.  And municipalities are the primary regulators of the real estate market in China.  

Instead they have tried to incentivize economic activity.  From tax rebates and cash rewards to reducing interest rates and lowering down payments, local governments have tried anything to keep the Ponzi scheme afloat.  

Real estate funds have also been set up to quell the property crisis.  Their mission is to:

“Solve the urgent difficulties of developers’ broken funding chains, alleviate the social problems and possible systemic financial risks caused by the mortgage boycotts and construction suspension of housing projects, and boost confidence.” 

When they say “broken funding chains”, they mean “Ponzi scheme.”  After all, land sales accounted for 30.8% of local government revenue in 2020.  Of course it’s in the municipalities’ interest to aid and abet the developers’ scheme.

But it’s doubtful that these real estate funds can fix an endemic, systemic risk in the Chinese property market.  Developers need cash flow to keep their scheme alive.   

Someone will have to eat the costs 

Like any autocrat, Chinese President Xi Jinping values economic stability above all else.  He will do anything to avert economic disaster, even if that means sacrificing his own people.  

And there’s historical precedent for it in China.  

In the 1960s, Mao Zedong embarked on the Great Sparrow Campaign.  The government mobilized citizens to eradicate all sparrows in China.  They were eating too much grain.  What they didn’t realize, however, was that sparrows also ate insects.  When the sparrows were killed off, insect populations boomed.  Locusts in particular ate every crop they could find, starving millions of Chinese in the process.  

Today the Great Sparrow Campaign is censored in China and not only because millions starved.  Many Chinese resorted to cannibalism in an effort to survive.  Other dissidents lost their lives for speaking out.

The worst part of it all was that the Communist central government had enough food stored in grain silos and warehouses to feed the entire country.  They simply chose not to.  Despite the fact their policies led to the crisis.

The current property crisis and Ponzi scheme may not be nearly as brutal, but it foretells who will likely suffer the consequences of any economic downturn.  It will not be the local governments, developers, or banks.  It will be the people.

Home buyers who purchase pre-sale properties bear the financial risk.  It’s unclear what type – if any – disclosures they receive on how their money might be used in escrow, but in the end, the financing risk is theirs.  Whether they know it or not.

The moral hazard created by the Chinese government has fueled nonstop investment and buying in real estate.  They have signaled throughout the past decades that real estate effectively guarantees high returns with little risk because it has been government-backed and subsidized.

Until the government or market decides it isn’t.

Home buyers will then be left holding the bag.  The Chinese government cannot afford to have too many developers go under.  They need them to continue building, furthering the Ponzi scheme, in order to reach GDP goals.  Real estate is simply too important to the Chinese economy to let any of the main stakeholders fold.

The easy target is the same one from the Great Sparrow Campaign.  The working class and lower to middle class residents of secondary or tertiary cities.  They might even be told it’s for the good of China.

The Chinese property crisis Ponzi scheme will not end well

Chinese home buyers have figured out the government does not want the real estate market to fall.  This has led many Chinese to pile their life savings into real estate.  

That’s not to say they cannot afford what they have purchased.  In fact, Chinese banks have a very low bad debt ratio, and they have become even more restrictive on extending home loans.

The tighter financing requirements may be difficult for buyers, but it is catastrophic for Chinese developers.  As noted, developers depend on a steady stream of new cash flow to finance existing projects.  Without it, many will experience solvency issues absent support from the government.  Any financial pain felt by developers could have systemic ripple effects throughout the real estate sector to banks who underwrote loans to buyers who prepaid for uncompleted apartments. 

This would all be fine if real estate prices always increased.  But like all Ponzi schemes, there is always a day of reckoning.  It is not a matter of if, but when.         

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