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Financial Instability in China: A Real Estate Crisis Long in the Making

Financial Instability in China: A Real Estate Crisis Long in the Making
 Philippe Aguignier
Senior Fellow - Asia

China avoided the worst of the 2008-2009 Great Financial Crisis (GFC) largely thanks to a massive debt-financed investment plan. Since then, however, it went through periods of financial instability which have required State intervention, often at a great cost. So far none of these episodes evolved into major financial crises, but their recurrence is not only a major source of concern for Chinese authorities, but also for the world, given China’s economic weight in it. It is hence key to understand the causes at the heart of China's financial stresses, as well as the probability that authorities find themselves unable to manage a financial blowout.

This paper is the first of a blog series analyzing the mechanisms generating financial instability in China: how they are dealt with, why they reoccur, and whether and how they might spread to the rest of the world. China’s property sector, which has been hitting the headlines since last year due to its extended financial difficulties, will serve as our starting point. 

The collapse of the real estate developer Evergrande is the latest financial accident, and perhaps the most dangerous one, that China has faced in recent years. The Chinese authorities have been successful so far in containing the immediate financial impacts of this collapse, but they have not managed to prevent the domino effect: the crisis has spread to other developers and to the real estate sector in general. After Evergrande had defaulted on its own bonds, at least six publicly listed developers (some of them among the top 10) have defaulted on USD bonds, and the total sales of the listed players in the sector have declined by almost 50% Year-on-Year (YoY) in the first four months of 2022. We are talking about a sector that has almost always gone up in the last forty years and has been one of the main growth engines of the Chinese economy. Therefore, this could mark the beginning of a structural downturn. Evergrande’s troubles, as we will see, are emblematic of the entire property sector, which exposes the difficulties of Chinese economic development model as a whole.

Evergrande’s troubles are emblematic of the entire property sector, which exposes the difficulties of the Chinese economic development model as a whole.

Evergrande is one of the largest property developers in China, catering mostly to the urban middle-class, with more than a thousand projects in hand in more than 600 cities in China. It accumulated a gargantuan debt of at least ¥2,000 billion (around $300 billion), which it is incapable of honouring. It defaulted on its USD international bonds in November 2021 (around $20 billion), and is currently in the middle of a vast and complex debt restructuring exercise led by the Chinese authorities, which jumped in to contain the risks of a disorderly collapse of Evergrande. Work had stopped on many projects because Evergrande was short of cash.

A comprehensive restructuring plan has been announced for this autumn. The management of the group has been taken over by a "risk committee", formed mostly with Guangdong provincial officials or representatives of state-owned large conglomerates. However, very little has transpired about this exercise, and the actual situation on the ground remains obscure. 

Although an event of default has been called on Evergrande’s international bonds, no default has been declared in the domestic market. To date, not a single Chinese bank has broken ranks and attempted to seize or dispose of collateral assets. This has been possible because most of Evergrande’s debt is domestic, and Chinese authorities exercise an extraordinary degree of control on the banking system, which is vastly composed of state-owned banks. The domestic nature of the debt also explains why the crisis has not spread beyond China, despite initial fears that it might.

Both volumes and prices of property transactions have been impacted, the former more than the latter. So far, developers have refrained (or perhaps have been forbidden from doing so by the authorities) from offering for sale massive amounts of unsold flats at substantial discounts. Purchases of land during public auctions, which are the main channel of land acquisition for development and also a major source of financing for local governments, have also plummeted. The few land purchases that have occured in the past months are made by state-owned players, not private ones, reflecting the lack of market confidence. 

The recent Covid lockdowns affecting various cities in China further worsened the situation, although they did not cause the present problems. Potential buyers refrain from buying, fearing that market prices may go down and that developers may default. evelopers, already highly leveraged, become even more cash-constrained as their sales contract. This creates a vicious circle. The situation is far from stabilised and may still morph into a deep and far-reaching economic crisis.

A golden era of forty years

The current real estate market downturn is caused by deep structural factors, which have been at work for a long time. This downturn may signal the end of a "golden era" that lasted almost forty years, characterised by continuous flat building, uninterrupted sales growth, and soaring sale price: average prices in major cities rose from at most a few hundred RMB per square metre in the late 1980s (the time when residential real estate emerged as a market) to ¥40,000 or ¥50,000 per square metre today in ​​first tier cities such as Beijing or Shanghai, or between ¥5,000 and ¥10,000in smaller cities. 

There were valid reasons as to why this "golden era" lasted for so long: the overall population grew roughly from 600 million people in 1978 to 1,400 million in 2019, and during the same period the urbanisation rate grew from 20% to almost 60%. This represents an urban population growth of 17 million people a year for forty years. By all measures, this has been a formidable growth driver for housing demand, especially as the stock of available housing at the beginning of the reforms was very inadequate in terms of quantity as well as quality, and even taking into account that some urban residents like migrant workers may reside in factory dormitories rather than in dwellings they own.

There were other drivers as well, beyond the purely "physical" demand for housing: real estate assets progressively became the preferred financial assets of most households. There are many reasons for this. Bank deposits are the safest and most widespread form of financial assets, but interest rates on deposits have for a long time been regulated and voluntarily fixed at very low levels, even below the rate of inflation for long periods of time. From a macro standpoint, this was meant to keep the banking sector profitable while still capable of providing funding to enterprises and corporates at relatively low cost. 

There were other drivers as well, beyond the purely "physical" demand for housing: real estate assets progressively became the preferred financial assets of most households. 

This has naturally pushed individuals to look for assets offering better returns. This simple fact has triggered a series of consequences going beyond real estate.

However, China’s financial markets are still relatively underdeveloped even today, although they are among the largest in the world given the sheer size of the Chinese economy. The overall value of stock and bond markets in China is well below the value of real estate assets, whereas the opposite is generally the case in most major economies. Property assets today constitute 60% of Chinese household assets. This is more than in any other major economy (the comparable figure for the US is 31.5%).

The equity market in particular is very volatile and open to all kinds of manipulation and distorsions. As a result, many households are reluctant to invest a material part of their savings in it. This is where the real estate market came into play. For most Chinese, their experience of this market has been predominantly positive. Prices always go up, except for very short periods of limited decline which are quickly erased by long periods of growth. Over time, no other type of asset offered a return that comes close. In addition, many people believed that the government had so much at stake for economic, social and political reasons in avoiding a prolonged period of price decline that it would always come to the rescue if problems arose. This is how houses became tools for investment or speculation as much as places to live in. This also helps explain why there are so many empty flats and houses in China today (up to 20% of the stock): while some of these empty flats are unsold inventory held by developers, many are investment assets for households to park their savings by lack of more attractive opportunities. 

The real estate sector progressively took a prominent place in the economy. According to a recent study, its weight in China’s GDP was approximately 10% in 2000, 20% in 2008-2009, and is now 29%, taking into account all impacts, direct and indirect (such as induced demand for steel, cement, etc.). In other major economies, the overall weight of real estate in GDP is estimated between 15 and 20%, a major exception being Spain where it had also reached almost 30% just before the onset of the GFC in 2008-2009.

The real estate sector progressively took a prominent place in the economy. Its weight in China’s GDP was approximately 10% in 2000, 20% in 2008-2009, and is now 29%.

The rise of real estate as a major economic activity has been welcomed by many stakeholders. Purchasers satisfied a basic need and were happy to see their investment grow in value. Banks saw an opportunity to grow their business by lending enthusiastically to developers, home purchasers, and ad-hoc vehicles set up by local governments to raise financing by offering land as guarantee (real estate related loans account for at least 30% of total loans). Economic planners came to see the property sector as a major source of economic growth, and a lever they could pull on every time some stimulus was needed to boost GDP. 

Accelerated urbanization and the development of small and medium-sized cities were important components of all stimulus plans, and especially of the massive plan that China launched to counter the impact of the GFC. What is usually described as infrastructure projects in these plans actually comprise a fair dose of housing construction. 

Real estate also became a major source of financing for local governments, and this added fuel to the fire. A major fiscal reform in the 1990s redefined the rules of sharing of major categories of expenses and revenues between local and central governments, and left local governments in a difficult fiscal position, as they are responsible for a share of public expenses larger than the share they receive from public revenues. Part of the difference is compensated by transfers from the central government, but local governments are nevertheless faced with a structural deficit. Proceeds from land sales, however, were among the revenues that could be kept at local level, and came to represent a substantial part of local revenues, equivalent to between 30 and 60% of local general budgetary revenues. This provided local governments with a powerful incentive to offer land for sale and facilitate real estate projects, sometimes based on very optimistic assumptions about the future level of demand for housing.

The beginning of the end?

All good things must come to an end. Signs of stress have kept on accumulating during the last decade.

Population growth has slowed down and now even started to reverse, which will have a progressively adverse impact on overall demand. Urbanization in small and medium-sized cities can still be a growth driver, but at a 60% urbanization rate the room for growth is no longer the same as when it was 20%. The ownership ratio among the Chinese population is now around 90%, and the average surface of housing per head, at 40 square metre, is comparable to the level of more advanced economies. There are therefore strong limitations on the growth potential of demand for houses as a physical asset.

The ratio of multiple house owners, at 20%, is also particularly high. This ratio has been trending upwards, and especially in the last two years, multiple owners have represented the majority of house buyers: in 2008, 70% of buyers were first-time purchasers, in 2018 they were less than 20%. This means that, in recent years, demand was increasingly driven by purchases for investment purposes.

With the rise in prices, housing has become less and less affordable: in major cities the home price-to-income ratio is now above 30 times, which is much higher than in any major city in the world, including Paris, London or New York. The ratio is more reasonable but still very high (around 10 times) in smaller cities.

With the fundamentals driving demand weakening, maintaining the growth rates that would allow "the show to continue" has required more and more leverage. This can be seen in at least two ways. First in the leverage ratios of developers, Evergrande being a prime example, and second in the ratio of household debt to GDP, which rose from less than 30% in 2010 to 61% in 2021 (with 70% of loans to households being mortgage loans). In absolute terms and in comparison with other countries, this ratio is not particularly high, but the rate at which it has been growing is. A similar pattern had been observed in Spain or in the US in the years leading to the GFC.

With the rise in prices, housing has become less and less affordable [...] much higher than in any major city in the world, including Paris, London or New York

The risk of an overheating real estate market has been a major source of concern for political and financial authorities for many years. Already in 2016, Xi Jinping famously pronounced that "houses are for living in, not for speculation". The financial authorities, and especially the banking regulator (CBIRC), have also been worried about the impact of a property crash on the banking sector for a long time. Increasingly tight measures have been introduced to curb banks’ exposure to the real estate sector: banks have been in particular discouraged (or even forbidden during some periods) from providing mortgage financing to non first-time buyers, who are required to provide a much higher level of down payment in cash than first-time buyers. Various measures, ​​such as the requirement of a minimum holding period before resale, have also been introduced periodically in large cities to curb the rise of home prices, with limited success.

Financial regulators also became increasingly concerned with the financial situation of developers and introduced various types of restrictions on their ability to raise financing from the banks. This incidentally pushed developers into looking for alternative sources of financing which are often more risky as they involve the general public. By 2020, pre-sales had become the main source of finance for developers. Evergrande had yet to deliver more than one million pre-sold houses or flats when it defaulted. The regulators’ efforts culminated in the introduction of a new regulation called "three red lines" in August 2020, basically preventing developers which were not meeting certain financial criteria from obtaining new loans as well as renewing their existing loans. This was more than over-leveraged developers could take, and marked the beginning of the end first for Evergrande, and then for many others, as we saw above. 

The property sector will be a drain on the economy in the coming years, as the level of construction will have to adjust downwards to reflect the changes in the fundamentals driving demand. 

The irony of the situation is that the regulators may have precipitated the very events they tried to prevent. It can also be said however that the housing bubble was ready to burst at any time, and that the longer it took for it to burst, the more extensive the costs of fixing it. In any case, the property sector will be a drain on the economy in the coming years, as the level of construction will have to adjust downwards to reflect the changes in the fundamentals driving demand. In addition, it will also be a source of potential financial instability due to the high leverage taken by key actors during the boom years, be they developers, banks or home buyers.

The temptation will be great for the authorities to provide some kind of stimulus to the market as it has done many times in the past every time a crisis looms, but this may well end up in adding fuel to the next crisis.

This rapid survey of the situation in the real estate sector illustrates a classical case of asset bubble: it built up when economic actors did not react in time to signals of deteriorating fundamentals, and it was allowed to extend due to the abundance of liquidity in the economy and the availability of financing without due consideration for risks or economic rationality. This is a recurrent pattern in recent years in the Chinese economy. 

It also illustrates the challenges that the Chinese authorities and financial regulators have to deal with: on the one hand, they are well aware of the potential dangers facing them. Their capacity to avoid an immediate blow-up in the Evergrande case and many other cases in the last ten years show that they have at their disposal formidable resources, managerial as well as financial, to deal with emergencies. On the other hand, even though they anticipate them and try to manage them proactively ex post, they seem powerless at preventing the occurrence of crises. 

We will turn to these issues in the next episodes of this blog series.



Copyright: Hector RETAMAL / AFP

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