From Project Syndicate, Yu Yongding – In the two decades since China’s State Council officially classified the real estate sector as a “pillar industry”, the sector has seen rapid development, fueled GDP growth and inspired millions of Chinese to dream of owning their own home. But the sector is now beset by problems ranging from high prices to massive debt, threatening to undermine growth at a time when China cannot afford to.
Although there is no private ownership of land in China, households aspire to own their own houses to improve their living conditions and accumulate wealth. The Chinese cannot easily buy foreign assets because of capital controls, and China’s stock markets have not performed well. China doesn’t tax residential property, capital gains or inheritance – and promises big gains in value. As a result, real estate becomes the most attractive form of asset to own.
From 2005 to 2021, China’s real residential property price index increased by 28.5%, from 87.95 to 112.99. Although the price index has fallen several times over the years, it has always rebounded strongly, giving the Chinese the impression that when it comes to accumulating wealth, home ownership is practically a sure bet.
But like expectations of rising property prices and speculation cause real prices to rise at a rate well above the growth in household disposable incomehousing is increasingly unaffordable for young Chinese, not to mention migrant workers who do not have the same rights as permanent residents of the city. In some prime cities, housing costs more than 40 times the average income.
The Chinese government has repeatedly tried to control property prices, notably by limiting the number of property purchases a single household can make and even by introducing administrative controls on property prices. However, these measures have proven to be largely ineffective and sometimes even counterproductive. While this is partly due to buyers and sellers finding ways around the restrictions, the underlying reason is that the real estate sector has effectively hijacked China’s economy.
The real estate sector has a very long value chain, so whatever happens has deep implications, both upstream and downstream. Slower growth in real estate prices leads to slower growth in real estate investment. Since these investments and related activities account for a significant share of China’s GDP – averaging more than 10% over the past decade – this weighs on overall economic growth.
For years, whenever this happened, the Chinese government responded by relaxing or removing all measures that had held back price growth, setting the stage for a strong recovery in property investment and house prices. After the 2014-2015 crash, home prices soared – and continued to rise for the next six years, marking the longest (mostly) continuous run of price increases since 2003.
So in 2021, the Chinese government intervened again by introducing three “red lines” for real estate developers. If a developer had a liabilities-to-assets ratio above 70%, a net debt ratio above 100% or a cash-to-short-term debt ratio above 100%, they would lose access to a bank loan. Unsurprisingly, the property price index began to fall rapidly, followed by an increase in property investment.
The extent of the decline was surprising: in 2022, real estate investment fell by 10% year-on-year. And although the government quickly relaxed its restrictive policies considerably, the usual recovery never materialized. On the contrary, during the first ten months of 2023, the growth of investment in real estate further decreased by 9.3% year-on-year and the volume of unsold premises increased by 18.3%.
Currently, a growing number of real estate developers are on the brink of insolvency due to a combination of high debt-to-asset ratios and lack of liquidity. And some – especially Evergrande, China’s second-largest developer — has already fallen. While Chinese regulators insist Evergrande’s failure is a one-off event that will have little impact on the market, there is no denying the growing risks in the property sector. China has always managed to get away with it in the past, but this time may be different.
To be sure, defaults by developers, even the largest ones, are unlikely to cause a systemic financial crisis in China. At the end of the third quarter of this year, outstanding bank loans in China totaled 234.5 trillion yen ($33 trillion), with mortgage loans accounting for only 39 trillion yen (16.6% of the total) and real estate loans. developers accounted for ¥13 trillion (5.6% of the total). Due to the high standards placed on borrowers and high deposit requirements, the quality of mortgages in China is high.
The problem facing banks is not the prospect of widespread borrower defaults, but rather the growing desire of borrowers to pay off their mortgages early. Although China’s bank NPL ratio is currently very low at less than 2%, it could rise sharply if the government fails to address the deteriorating finances of developers (and their upstream and downstream businesses).
In addition to the liquidation and restructuring of bankrupt real estate developers,The Chinese government can limit financial risks by placing insolvency-risk developers under tighter government control, eitherthrough trusts or temporary nationalization. It could also provide liquidity to creditworthy developers who need it and buy the assets (financial or physical) of developers who are under pressure to offer “flash sale”.
With a relatively strong fiscal position and a central bank with room to adopt a more expansionary monetary policy, China should be able to facilitate the resolution of debt problems in the real estate sector. Here’s hoping the Chinese government gets away with it once again.