Chinese Economy

DANIEL LACALLE is chief economist at hedge fund Tressis and author of “Freedom or Equality,” “Escape from the Central Bank Trap,” and “Life in the Financial Markets.” Daniel Lacalle

A Serious Problem Facing China

The real estate sector accounts for 29 percent of China’s GDP

few months ago, I wrote that the Chinese slowdown was much more than COVID-19-related and pointed to the challenges coming from the excessive weight of the country’s real estate sector in its economy.

A research paper by Kenneth Rogoff and Yuanchen Yang states that the real estate sector makes up an estimated 29 percent of China’s gross domestic product (GDP). The problems coming from the slow-motion deterioration of the property sector have extended to the financial challenges of China’s local governments and may create a relevant fiscal problem for the nation’s public accounts.

“Sales at China’s largest housing developers fell 43 percent in June from a year earlier, according to China Real Estate Information Corp.,” Bloomberg reported.

This has created an alarming funding gap for local governments, where finances are heavily dependent on land sale revenues, and a significant problem for the financial sector and the government. China’s central bank has promised to mobilize a $148 billion bailout to complete unfinished real estate projects as anger rises among property buyers that haven’t received their homes after advancing significant payments.

The size of the real estate sector in the economy is enormous, and the impact of a slump in sales on GDP may be impossible to offset with other sectors. According to S&P Global, China’s property sales will probably drop by about 30 percent this year because of the increasing number of homebuyers’ mortgage payment suspensions. This could be worse than in 2008, when sales fell by roughly 20 percent, Esther Liu at S&P Global Ratings told CNBC. There’s no sector in China that can mitigate the impact of such a drop in tax revenues and output.

JPMorgan explained the extent of the problem in a recent report, “China’s housing market alarm bell rings again.”

“Since June 30, mortgage suspension requests due to delayed home delivery have expanded to more than 300 projects in different parts of China,” the report reads.

JPMorgan’s equity research team estimates that these requests represent a total value of 330 billion yuan, or $49 billion (or a mortgage value of 132 billion yuan, or $20 billion, assuming a 40 percent loan to value).

Local governments have seen their fiscal revenue decline by 7.9 percent in the first half of 2022, and land sales dropped by 31.4 percent.

There are relevant implications for many sectors and for families. Real estate developers were the largest issuers of commercial paper in China, and millions of savers invested in bonds and debt instruments of property developers to generate stable and safe returns. Many of those are defaulting. According to ANZ Bank, China bond defaults have reached $20 billion in 2022, more than double last year’s total. Out of 19 defaults recorded, 18 came from property developers.

Real estate is also a relevant driver of economic activity in the service sector and other manufacturing sectors. The collapse of many developers is generating ripple effects throughout the sectors that thrive from construction and the activity that real estate incentivizes.

For investors globally, this is largely a domestic issue, and many expect the government to contain it through a series of bailouts and liquidity injections to the financial sector to prevent a credit crunch. From a financial perspective, this may be correct, but there’s no way for the Chinese regime to prevent the macroeconomic implications coming from the burst of a bubble of such enormous magnitude.

Many international analysts expected China to be the first economy to prove that it could navigate a real estate bubble by deflating it through central planification. There was too much hope placed on central planning and too little attention paid to the extent of the problem.

Now it’s evident that there’s no sector that can dilute the effect of a real estate bubble burst. Even if the financial challenge is addressed through bailouts and liquidity injections, the impact will have to manifest itself in the currency, inflation, unemployment, or growth—or all at the same time.

If we can learn anything from this property slump, it’s that inflating growth with a central-planned housing bubble never leads to an easy and manageable solution.

There’s no way for the Chinese regime to prevent the macroeconomic implications coming from the burst of a bubble of such enormous magnitude.

FAN YU is an expert in finance and economics and has contributed analyses on China’s economy since 2015. Fan Yu

The Commotion About Carried Interest Tax

Why has carried interest tax recently become a national talking point?

fter weeks of suspense, the Democratic spending deal formulated by the Senate ditched a provision that would have increased taxes on so-called carried interest income unique to private equity and hedge fund managers.

Sen. Kyrsten Sinema (D-Ariz.) ultimately scuttled the carried interest provision, attracting the ire of certain left-wing politicians.

What’s all the hand-wringing over carried interest about?

It’s a capital gains tax applied to an arcane concept—irrelevant to 99 percent of taxpayers—that has been debated in the halls of Congress for more than a decade. Taxing carried interest at the lower capital gains rate has few backers in Washington, yet it has proven to be hard to kill. Presidents Obama and Trump both promised to increase carried interest tax, but neither president was able to meet that goal.

What is carried interest? It’s the profits that private equity, venture capital, and hedge fund investment managers earn from their investments after certain performance thresholds have been reached (such as a preferred return). Most carried interest is structured as 20 percent after a certain hurdle has been reached by investors (usually 8 percent to 10 percent return). In other words, carried interest is the share of profits the investment manager partakes in for good performance.

The term came from Renaissance Venice ship captains, who were paid an “interest” in a portion of the ship’s valuable cargo for safe passage—carrying the cargo.

That’s a bit of arcane financial knowledge that most people could care less about. But what makes carried interest a national political talking point is the tax rate applied to such gains. Fund managers pay a reduced (usually 20 percent) capital gains tax on such profits, not the usual (and much higher) ordinary income tax rates.

The tax law changes made by the Trump administration in 2017 made it slightly more difficult for private fund managers to enjoy the lower capital gains rate by mandating that funds must hold their investment from one year to three years to enjoy the lower tax rate. But this has had little practical impact because most private equity funds hold their investments for longer than three years.

Mainstream media outlets call it a carried interest “loophole,” as though it were a tax-avoidance plan akin to illegal tax shelters. But there’s no loophole: The capital rates rate is actually written in the tax code. Others say it’s akin to a “subsidy” to rich Wall Street tycoons. But it’s not a “subsidy,” as any tax—even at 1 percent—is still a tax; the government isn’t giving money to private equity managers to encourage investments, in which case “subsidy” would be the right term.

The reason we care about this is because the U.S. government is in need of cash. Politicians believe that the tax rate applied to carried interest income is too low. Increasing the rate applied to this income stream—which only hurts already-wealthy Wall Street investment managers—is a “low-hanging fruit” type of solution to raise this much-needed cash.

After all, everyone hates Wall Streeters, right?

Capital gains on carried interest derived from innocuous origins. It was to reward entrepreneurs and financiers who risked their own money to build businesses that might not pan out. So when there are profits at the end, the tax code rewards these usually long-term profits by applying a lower tax rate.

The American Investment Council, a lobbying group for private equity, attempted to make this argument. It stated that increasing taxes on carried interest could negatively impact private equity investments into small- to medium-sized businesses, which are the biggest drivers of job growth in the United States.

Contrary to what the private equity industry says, its firms actually put up very little of their own capital. If investments turn sour, the third-party investors usually suffer.

I’m not arguing that this is a great set of circumstances, but private equity fund managers are certainly not putting a substantial amount of their own capital at risk. By this argument, carried interest should be taxed at the ordinary income tax rate.

In essence, carried interest is similar to an at-the-money call option. The payoff can be enormous. There’s a cost to failure, but it’s relatively small. And to tax the gains at the capital gains rate is too generous.

Presidents Obama and Trump both promised to increase carried interest tax, but neither was able to meet that goal.