The company is feeling the pain of President Xi Jinping’s regulatory drive to tackle inequalities and financial risks in the system by addressing the long-simmering debt problem in its real estate market, which has grown aggressively thanks to a easy access to capital. The latest toll comes as China’s economy is already slowing amid efforts to contain the latest Covid outbreaks, the one-time increase in exports last year due to pandemic disruptions is waning and businesses face regulatory crackdown and s ‘adapt to a more state-controlled approach to capitalism.

The Evergrande crisis may not trigger a Lehman Brothers-type financial crisis, but Rogoff has for years warned of the dangers of China’s dependence on its real estate market. Barron met with the economist to discuss the possibility that Evergrande could become a systemic crisis, issues related to China’s dependence on its real estate sector, and risks to its economy. Here’s a condensed and edited version of the conversation.

Barron’s: How worried should investors be about contagion?

Kenneth Rogoff: Some believe they have the ability to act very quickly and cauterize even the biggest financial problems.

There are strengths and weaknesses in the Chinese system. One strength: the government can deal with bankruptcy very quickly and very efficiently, without problems with the courts and they have deep pockets. Western debt crises are so problematic in large part because it takes a long time to resolve them. This has not been tested in large cases, but there is a view [China ] could do it better. They had a lot of bankruptcies in 1999 and did so quite efficiently. It’s still a financial crisis, but it wouldn’t swell in the system.

What weaknesses are you concerned about?

They have become very dependent on housing for their growth. [Real estate] was the target of stimulus measures after the global financial crisis. Real estate products and services represent 29% of GDP. Ireland and Spain may have reached these levels before the [global financial crisis]; the United States at the top was 15%. And they’ve already built a lot of housing. While they may have a per capita income about a quarter of that of France or Germany, per capita housing is about the same.

So they can’t get out of this crisis?

In the third and fourth tier cities, they try to keep the housing engine running but run out of steam. Same [if real estate] contracts 20% is a lot [unemployed construction workers] to reassign. Their objective was to gradually ensure that the real estate market [as a share of the economy] go from 29% to 15% or less. But if the economy slows down, which it is, then that puts pressure on prices and amplifies the mechanism.

What about from the point of view that they have vast reserves and many tools to manage it?

They have a lot of tools. But the problem is not just a single lender; the whole Chinese growth model is so dependent on real estate production. They have known this for a while. Let’s say the economy over the next 12 months slows down by 6% without the housing boost to 4%. Housing could lower it further from 1 to 2 [percentage points]. It is an economy that is growing at 2%; it’s painful !

What does China need to do to deal with this?

The world has learned to respect the competence of the Chinese in managing their economy. But they’ve painted themselves a bit in a corner – and it’s coming at a bad time. They have tried to tackle it but can no longer push back. They cannot get around the fact that they have to downsize real estate, construction and services. If the prices are low and the economy weak, a gradual decline can be difficult to imagine.

This isn’t a Lehman time when they are going through a financial crisis, but it could be just as painful if you look at longer term growth. They could provide other kinds of stimulation, but it’s not that easy for an economy to move on.

What is the overall impact?

It’s very difficult for commodity exporters like Australia and countries that export heavily to China, including Germany. There is also the question of whether this is something that has a deeper psychological effect. If there was a significant slowdown, would that undermine one of the certainties investors around the world have about the progress of the global economy? It’s unclear if this could turn out. It is clear that stocks, housing markets and crypto markets are very high. They took in the low rates, but maybe not so much the low growth. We’ll see.

Write to Reshma Kapadia at [email protected]