Introduction
You may remember the story of Evergrande Group, a property developer that threatened the collapse of the Chinese Financial Sector due to it’s overexposure (Click here to read more about it) – and a year on it seems to have been the tip of the iceberg. While many know China as a manufacturing, industrial, and services powerhouse – this article aims to dive deeper into exploring how a property crisis could affect China’s Economy. An overview of The Chinese Economy can be seen in Figure 1:
Figure 1. Breakdown of China’s Economy
Source:https://www.visualcapitalist.com/visualizing-chinas-18-trillion-economy-in-one-chart/ | Visual Capitalist
According to Figure 1, Real Estate contributed a whopping 7.8 Trillion ¥ (RMB) in 2021 (or 1.2 Trillion USD), making up 6.9% of China’s Total GDP in 2021. However, ever since the Covid 19 Pandemic, the once booming sector has contracted greatly – and as of July 2022, Real Estate Value has fallen by 12% Year on Year (YoY) (Munjal, 2022).
The Context.
Before we explore a potential collapse, it’s important to understand the ‘pre-sales’ mechanism that is the bedrock of the real estate industry where properties are sold before they are built. This was put in place way back when there was a lack of properties in the market (Wu, 2022), hence this mechanism allows property developers to use deposits for construction (leaving demand to create supply). A Senior China Economist at Capital Economics attributes that 70-80% of properties are sold under this mechanism (Tewari, 2022). A majority of individuals pay for mortgages (a housing loan) even without stepping foot on the property.
Chinese Banks and Regulators play a vital role in monitoring how these funds are utilized, however in practice, keeping track of how funds are used is easier said than done – namely if the developer abandons the project due to financial difficulties, there is no safety net in place to ensure the deposits. With economic and financing conditions taking a turn for the worse as a result of the pandemic – the system flaws are beginning to come to light where this system is starting to be questionable as the current state of China’s economic and financing conditions are beginning to tighten…
According to The Conversation, more than 300 groups, as of late August, are refusing to pay home loans with values between 150 billion USD and 370 billion USD as part of their protest against unfinished residential projects (Ou, 2022). These numbers are based on various informal surveys published online, hence, they should only be taken lightly. When the citizens of a nation begin to protest knowing the likely consequences of the actions under an authoritarian government – it’s a telling sign of the direness of the situation. As quoted by The Business Times Singapore, the mortgage payments strikes could have a detrimental effect on the Chinese economy. A recent research report published by ANZ group supports the statement as their findings have shown a payment boycott could affect approximately 222 billion USD worth of home loans sitting in banks, translating to about 4% of outstanding mortgages.
Aside from that, this issue has also indirectly resulted in an overall decrease in demand for properties in China. Consumers have lost the confidence to purchase, in addition to the fact that some have still yet to recover from the economic downturn fueled by the COVID-19 pandemic. The renowned American Credit Rating agency, S&P Global, forecasted a fall in market confidence in July 2022. Their reports have shown that China’s property sales will likely drop by about 30% in 2022, which is supposedly twice as worse than their initial estimates. This forecasted decline can unquestionably be classified as an “outlier” in terms of trends over the past 20+ years as reflected in Figures 2 and 3 below :
Figure 2 shows the Sales revenue from residential real estates sold in China from 1998 to 2020 (in billion yuan).
Figure 2. Source:www.statista.com/statistics/243239/revenue-from-residential-real-estate-sold-in-china/ | Statista
Figure 3 shows the number of apartments sold by real estate developers in China between 2005 and 2020 (in million units).
Figure 3. Source: www.statista.com/statistics/244523/number-sold-in-million-units-in-china | Statista
By analyzing the graphs on sales revenue from residential real estates sold in China (1998 to 2020) to the number of apartments sold by real estate developers in China (2005 and 2020), we can conclude that the trendline shows positive growth – excluding the sharp decline in 2008 caused by the Global Financial Crisis. However, if S&P Global’s forecasts come to fruition, we would see a significant decline in both sales revenue and the number of apartments sold. This would go against the flow of the trend in the past 20 years. The predicted 30% drop would be even worse than the fall in 2008’s property sales in China which was 20% according to Ester Liu, director at S&P Global Ratings (Cheng, 2022).
However, the Chinese government has been finding ways to counteract mortgage strikes. China has recently made a move to cut down the one-year loan prime rate (LPR) from 3.7% to 3.65%. Moreover, the five-year LPR, which is a reference rate for mortgages, was reduced by 15 basis points or 0.15%. LPR can be simplified as the interest rate commercial banks charge their customers for purchasing the property. The country’s central bank will set the federal funds overnight rate which acts as the basis for these prime rates. Hence, these rates will affect the lending rates for both corporate and household loans in the country. Although the cuts may not seem that significant, a continued trend will reduce the price of mortgages in the long run which should drive up housing demand again.
The Three Red Line Policy introduced in August 2020 reins in property developers to reduce overexposure. The policy states that developers should:
- Have a liability to asset ratio of less than 70%
- A net gearing ratio of less than 100%
- Cash-to-Short Term debt ratio of more than one times
The intended aim of this policy is to control house prices and protect consumers and lead to deleveraging among developers (UBS Asset Management, 2021). Moving on, another key issue that could have contributed to this property crisis in China is the involvement of local land politics as highlighted by Diksha Munjal in The Hindu’s article on China’s Property Market. Dexter Roberts, a senior fellow at the Atlantic Council shared that there was a unique political system behind the growth model of China’s real estate sector (Munjal, 2022). They speculated that local governments worked well with big developers and often gave them the green light to continually develop new commercial and residential properties at breakneck speed. The reason was simple: money. More development projects meant more revenue for the local government council as they would sell more land-use rights to local developers. In fact, the sale of land-use rights is the largest source of non-tax revenue for local governments (Guo, 2022). Thus, with the help of local governments, local developers were able to grow faster and faster, reaching an unsustainable pace where they couldn’t fund their own development projects. This led to breakdowns and abandonment of housing projects, thus finally resulting in angry citizens and mortgage strikes.
Another key factor that may have contributed to this crisis worth examining is the role of local land governments. Dexter Roberts, a senior fellow at the Atlantic Council noted that there was a unique political system behind the growth model of China’s real estate sector (Munjal, 2022). Big developers were given the greenlight by local governments to continually develop new commercial and residential properties at breakneck speeds – and the motivating factor was money. More development projects meant more revenue for the local government council as they would sell more land-use rights to local developers. In fact, the sale of land-use rights is the largest source of non-tax revenue for local governments (Guo, 2022). Thus, with the help of local governments, local developers were able to grow faster and faster, reaching an unsustainable pace where they couldn’t fund their own development projects. Ultimately leading to the abandonment of housing projects and the unrest we see today.
Effects
A development project, be it residential or commercial, does not only involve the developer but many other parties, such as those that supply the raw construction materials and the workers that provide the labor. Hence as things operate in a circular fashion, the stall and collapse of property projects would not only hurt the developer and the citizens paying the mortgage, but also the suppliers of raw materials. For instance, raw materials such as metals and iron ore will experience a decreased demand in China, where the resulting shift of the demand curve would cause prices to fall. Since China is one of the top importers of iron ore, their change in iron ore demand would definitely have an impact of a larger magnitude on the world prices of iron ore. In fact, this was clearly depicted when the property crisis in China worsened in 2022, particularly in July when it slumped by 8% as seen in Figure 4.
Figure 4 shows a graph on Iron Ore (USD/T) in 2022.
Source: https://tradingeconomics.com/commodity/iron-ore | Trading Economics
Adding on, the slowdown in property development would indirectly reduce demand for hard labor. In the long run, this would increase unemployment rates, which would decrease the standard of living and subsequently have adverse effects on consumer demand and purchasing power.
Furthermore, this property crisis would bring about negative effects on Chinese banks. S&P Global Ratings estimated in a worst-case scenario that 356 billion USD of mortgages would be at risk, while Deutsche Bank AG warned that at least 7% would be in danger, triggered by the mortgage boycotts across China (Bloomberg, 2022). Hence, the banks are now stuck at crossroads, where helping or not helping property developers would both bring adverse impacts; helping via cutting loan rates and providing longer grace periods would support the developers but increase the probability of more delayed real estate projects. In contrast, they might end up losing more if they do not decide to provide aid, as the developers would default on debts.
This would not only affect smaller-scale banks such as state-owned rural banks but also larger Chinese banks. In fact, some major Chinese banks are already showing worrying signs of distress. According to Reuters, 5 of China’s largest banks recorded huge increases in bad debts linked to real estate in the first half of 2022. China Construction Bank Corp (CCB) and Bank of China Ltd reported 68% and 20% increases respectively in bad real estate debts in the first half of 2022, whilst the Industrial and Commercial Bank of China Ltd (ICBC), famous for being the world’s largest commercial lender by assets, recorded a 15% rise in the same period (Tang et al., 2022).
However, in the same report, Chief Liu Jin of the Bank of China states that the state council and respective regulators will continue to push banks to increase lending to the property sector. This would undoubtedly increase the immense pressure and burden that the banks are already experiencing. Bad debts or loans in large volumes would result in banks encountering problems with their capital adequacy and earnings. Unsustainable levels in the long term would lead to bankruptcy. This would indirectly affect the financial stability of China as it could worsen China’s overall debt-to-GDP which is projected to skyrocket to a new record. According to the director of the National Institution for Finance and Development, the overall debt ratio is projected to increase by 11.3 percentage points to around 275% in 2022.
As mentioned earlier on how the property crisis would affect iron ore prices negatively, we can speculate that this property crisis could spill over and bring down other economic sectors in China, such as the steel production industry. According to research by Fitch Ratings, construction accounts for 55% of steel demand in China. Hence a downfall of the property sector might bring down steel producers that are highly dependent on local demand along with them. Sectors that are highly dependent on local consumer demand such as SMEs may also experience similar effects in the long run. The mortgage strike suggests that consumers may be in a situation of financial hardship and hence, may not have the purchasing power to consume as much as before, hurting these businesses. However, in the short run, risks may not be too prominent as Chinese households historically have very high rates of savings. All in all, this property crisis will remain a huge drag on the Chinese economy as quoted by Shuang Ding of Standard Chartered in a recent interview (early August’22 with CNBC).
Although the situation looks pretty bad, a full-blown financial crisis in China and it affecting the world economy significantly is unlikely, given the fact that China has historically pulled itself out of major financial difficulties before and foreign investors do not have much exposure to assets owned by China. Thus a ripple effect in the economy has low chances in the near future. In fact, according to the Guardian, less than 5% of Chinese equities and bonds are held by foreigners (Jin, 2022). However, due to the staggering size of numbers involved in this crisis, the world at large will definitely feel its effects. One example we can look at is furniture. China is now also one of the biggest importers in the world in terms of foreign furniture, thus some pre-sold properties may include fittings of furniture and appliances from foreign countries. So, if the property developers default on debt and are unable to continue with their planned property development, Western furniture manufacturers’ sources of income would be affected, ultimately losing their exports and profitability opportunities in China.
If the property crisis continues to drag China’s economy down over the next few years without any signs of economic upturn, other countries may start to experience adverse effects as well given how the world is interconnected due to international trade. In a 2019 study by the United States Federal Reserve, economists estimated that an 8.5 percent fall in China’s GDP would result in a 3.25 percent drop in advanced economies and nearly 6 percent decline in emerging economies (Power, 2022).
What has been done so far and what should be done?
The property crisis in China has been an ongoing crisis for several years but worsened in 2022. Despite the Chinese government’s introduction of the “Three Red Lines” policy in August 2020, most property developers failed to cope and comply with its terms. However, that was not their only initiative.
The Chinese government has also undergone interest rate cuts and allowed the local councils to relax restrictions on purchasing property in China (The Economist, 2022). The government also rolled out a stimulus worth 44 billion USD in new credit through its state-run policy banks. These steps were taken in the hopes to spur an increase in consumer confidence and stimulate a rise in demand for property. However, these can be considered as temporary, short-term solutions that fail to tackle the issue’s root causes and build-up of past, unresolved crises. On another note, reports suggested that Beijing may allocate a 29.3 billion USD windfall in loans to help complete unfinished housing projects and reduce the burden on parties involved.
In my opinion, I believe that the structure of China’s property system is fundamentally flawed and needs to be redesigned. There should be some form of restriction or introduction of tighter policies on pre-sales of property in China in order to protect the purchasers of that specific property. For instance, relevant government agencies and authorities could perform thorough background checks, in terms of the developers’ liquidity, efficiency and stability during the specific period of time in which they decide to launch a new property project. This should be followed up with frequent checks to ensure the developers’ financial ratios and level of financing remain at a sustainable level and that there is a low risk of project abandonment. Also, the Chinese government could take the initiative to undergo a property market reform. One of the first few steps that can be taken is to approve and implement a property tax, tax paid on property owned by a specific individual or any other legal entity to the local government. This is relevant as China remains one of the few countries that do not impose a property tax on private residential property ownership. However, I believe that property tax will help improve the deformation of the economy of properties in China as it will discourage citizens from seeing properties as “investments”. At the same time, it will increase revenue for local governments, thus expanding their budget and reducing their dependence on selling land use rights to local developers. If the local government’s said dependence decreases due to an increase in tax revenue, it would place less pressure on the local government to sell them to local property developers; hence, decreasing the overpopulation of development and allowing sector growth at a sustainable pace. This reform would also align with President Xi JinPing’s idea of property as he often quotes that “houses are for living in and not for speculation”.
References:
Bloomberg. (2022, August 1). China banks may face US$350 billion in losses from property crisis. The Edge Markets. Retrieved September 16, 2022, from https://www.theedgemarkets.com/article/china-banks-may-face-us350-billion-losses-property-crisis
Cheng, E. (2022, July 27). China’s property sales are set to plunge 30% — worse than in 2008, S&P says. CNBC. Retrieved September 16, 2022, from https://www.cnbc.com/2022/07/27/chinas-property-sales-set-for-a-worse-plunge-than-in-2008-sp-says.html
The Economist. (2022, September 15). China’s property crisis hasn’t gone away: it is getting worse. The Economist. Retrieved September 17, 2022, from https://www.economist.com/leaders/2022/09/15/chinas-property-crisis-hasnt-gone-away-it-is-getting-worse
Guo, Y. Z. (2022, July 7). China’s plunging land sales threaten local governments. Nikkei Asia. Retrieved September 16, 2022, from https://asia.nikkei.com/Spotlight/Caixin/China-s-plunging-land-sales-threaten-local-governments
Jin, K. (2022, August 23). China’s property market is in freefall. What does this mean for the world economy? | Keyu Jin. The Guardian. Retrieved September 17, 2022, from https://www.theguardian.com/commentisfree/2022/aug/23/china-property-market-world-economy
Munjal, D. (2022, 8 30). Explained | How bad is China’s property crisis and how did it get here? The Hindu. Retrieved 9 11, 2022, from https://www.thehindu.com/news/international/explained-how-bad-is-chinas-property-crisis-and-how-did-it-get-here/article65826898.ece
Ou, Z. (2022, August 23). China property crisis: why the housing market is collapsing – and the risks to the wider economy. The Conversation. Retrieved September 11, 2022, from https://theconversation.com/china-property-crisis-why-the-housing-market-is-collapsing-and-the-risks-to-the-wider-economy-189082
Power, J. (2022, August 30). As China’s property crisis grows, is the global economy at risk? Al Jazeera. Retrieved September 17, 2022, from https://www.aljazeera.com/economy/2022/8/30/what-chinas-property-crisis
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Tewari, S. (2022, August 9). China property crisis: Why homeowners stopped paying their mortgages. BBC. Retrieved September 11, 2022, from https://www.bbc.com/news/world-asia-china-62402961
UBS Asset Management. (2021, January 11). China’s Three Red Lines Policy on Property. UBS. Retrieved September 16, 2022, from https://www.ubs.com/global/en/assetmanagement/insights/thematic-viewpoints/apac-and-emerging/articles/china-three-red-lines.html
Wu, S. (2022, 7 14). China’s Housing Presales Model Needs Fixing as Many Projects Go Unfinished, Experts Say. Yicai Global. Retrieved 9 11, 2022, from https://www.yicaiglobal.com/news/china-housing-presales-model-needs-fixing-as-many-projects-go-unfinished-experts-say-
Researcher(s): Edwin Oh Chun Kit
Reviewer(s): Nasir Ali
Editor(s): Maryam Nazir Chaudhary (Article), Julia Yazid (Infographic)
