September 23, 2022 | 14:16
China: The Housing Crisis Will (Eventually) End
China: The Housing Crisis Will (Eventually) End
Nearly a year after revelations that one of China’s largest property developers—China Evergrande Group—was on the brink of default, the country’s housing market remains in an extremely weakened state—effectively, a crisis. Numerous homebuilders have defaulted on their bonds (over US$20 bln year to date), housing sales have collapsed (-30.3% y/y in the first eight months in value terms) and construction of hundreds of new housing projects has stalled (Chart 1). We believe it will take time, perhaps well into next year, before the property market gradually recovers. This is bad news for the economy that is already being dragged down by more COVID outbreaks and uncertainty over Beijing’s zero-COVID strategy.
The importance of housing cannot be overstated as it, along with the expansion of the manufacturing sector, have played critical roles behind the Middle Kingdom’s economic boom over the past two decades. Measured as a share of nominal GDP, residential investment has averaged a hefty 13.5% over the past ten years (Chart 2). Housing is estimated to account for a hefty 25% of China’s economy when including all upstream and downstream activities. Compared to some of the more notable housing crashes that recently occurred in Ireland, Spain and the U.S., the scale of housing investment in China is concerning, though much of it is needed to support the urbanization process. However, this process is far from complete as the country’s urbanization ratio just hit 65% in 2021 (Chart 3), which is the original target in its 14th Five-Year Plan (2021-25). Further out, Beijing has stated its ultimate urbanization objective is to reach 75% by 2035, which is closer to advanced economy levels of around 80%.
A Different Type of Housing Crisis
The probability of China’s housing downturn morphing into a 2008-09 U.S.-style housing meltdown that erupts into a major banking/financial crisis remains low. As we have argued in the past, the main difference is that the U.S. housing crisis was driven by weak bank lending standards (buyers could easily purchase housing with small down payments and low incomes), exacerbated by the banking sector’s ability to securitize the mortgages and offload them from their balance sheets. As we all know, this turned into a vicious cycle that eventually resulted in the Global Financial Crisis. In China’s case, bank lending standards were not loose, with maximum loan-to-value (LTV) ratios previously standing at 70% for first-time home buyers and 60% for second homes, nor did Chinese banks securitize and resell their mortgages.
The crux of China’s real estate crisis was that many homebuilders were extremely aggressive, borrowing extensively (via bank loans and, over time, greater bond issuance) and acquiring large land banks and preselling more apartments than they could deliver in a timely manner. We suspect the situation was exacerbated by two other factors: (1) Local governments (LGs) increasingly sold more land and lowered the land/building ratio in recent years to boost revenues. This was necessary after their local government financial vehicles—used to build physical infrastructure (e.g., roads, bridges, subways, etc.)—fell into financial trouble in the early 2010s. And, (2) Beijing’s decision to tighten capital controls (specifically the outflow by residents) after the mini-devaluation of the renminbi in 2015 effectively reduced investment alternatives for Chinese citizens and thereby resulted in more savings being channelled into the domestic housing market. The music stopped when the authorities clamped down harder on developers’ ability to financially leverage themselves by introducing the ‘Three Red Lines’ policy in 2020  and homebuyers’ confidence rapidly dwindled in the aftermath of the Evergrande shock in 2021Q3. It bears mentioning that pressure on the housing market had intensified in the interim after large banks’ outstanding mortgages were capped at 32.5% of total loans and overall lending to the property sector was capped at 40% at the start of 2021.
In retrospect, it seems reasonable to believe that China's authorities did not intend to generate a housing crisis. Nonetheless, it appears that they remain committed to the original objective to curb homebuilders’ leverage. Moreover, the broader objectives stemming from President Xi’s longstanding mantra that “housing is for living in, not for speculation”, are three-fold: (1) Reduce overall financial stability risks by curbing debt of developers and households, which surged in the wake of the Global Financial Crisis (Chart 4). (2) Improve housing affordability. And, (3) divert more financial resources from housing, which is increasingly viewed as an unproductive investment, into more innovative sectors to help the country become more economically/technologically self-sufficient.
Say What… Mortgage Boycotts?
Fast-forwarding to the present, home sales and construction activity are likely to remain depressed until many of the (300+) stalled housing projects get moving again. In tandem, many homebuilders still face the risk of defaulting because housing sales have become their only funding channel as they can no longer issue bonds or borrow from banks. Such developments explain the rather bizarre phenomenon of ‘mortgage boycotts’ that erupted in July. Essentially, new homebuyers have been refusing to service their mortgage liabilities in an effort to accelerate the completion of the homes they bought. Note, homebuyers in China begin servicing their mortgage upon the initial purchase of the home, not after the final delivery of the completed home as in Canada and most countries. Thus, the vast majority of boycotters do not intend to default on their mortgages and walk away from their home purchases (especially given the high down payment!), they simply want their home to be completed. Of the Chinese banks that have reported their boycotted mortgages, most show them accounting for well below 0.5% of total loans.
The inability of developers to deliver finished homes has placed Beijing in a big predicament: how to get all the stalled projects finished without exacerbating moral hazard (i.e., directly bailing out homebuilders) and, at the same time, prevent housing prices from falling sharply (and creating a negative wealth effect). Getting the homes completed should be fairly straightforward, but the bigger question is who will bear the cost. The latest news indicate that a few key government agencies will provide CNY200 bln (or 0.2% of 2021 GDP) in special loans that will be channelled through policy banks. LGs will then borrow the funds and likely provide them to healthier developers in their respective jurisdictions to finish construction. The reality is that the amount of funds needed to complete all unfinished homes is small in the bigger picture (less than 2.0% of GDP).
Preventing home prices from falling is trickier, as much depends on supply/demand dynamics which vary immensely from city to city. It appears that higher-tiered cities are not currently saddled with a glut of unsold completed homes as opposed to fourth- and fifth-tiered cities. To be clear: the current problem is that developers are having trouble finishing pre-sold units. Thus, the prospect of the country being stuck with a large stock of unsold completed housing is limited, compared to the early 2010s, when numerous lower-tiered, smaller cities were swamped with excess supply (Chart 5). Or put another way: it’s too early to decisively conclude that China will follow Japan’s footsteps after its housing market burst in the early 1990s, with existing home prices holding up fairly well, especially in major cities (Chart 6).
Meanwhile, LGs are exercising their longstanding power to control prices by placing a floor on the price that developers can sell new homes at. Note the vast majority of housing transactions in China are new, as opposed to existing, home sales. This is a double-edged sword as LGs are likely setting prices too high to allow developers to quickly clear their inventories (Chart 7). At the same time, keeping pre-construction sale prices higher than would otherwise be the case may provide confidence to potential and existing homebuyers that housing is still a good investment. However, LGs may be on the verge of relenting as the city of Guangzhou reportedly cut the selling price of new homes by as much as 20% the previous week.
Otherwise, one should expect Beijing/LGs to implement more measures that make buying houses more affordable, such as lowering borrowing rates and LTV ratios or perhaps easing the hukou/household registration system . The latter would allow more citizens to move freely around the country with equal access to public services, which would accelerate urbanization. Nonetheless, we suspect the authorities are mindful that completely tearing down the hukou system carries its own risks as it could result in many people rushing to the more vibrant bigger cities, further exacerbating problems for smaller, less dynamic city centres. But change may be afoot as the city of Zhengzhou, which has witnessed among the most mortgage boycotts and protests, announced that it was ending its residency requirements in an effort to stabilize its housing market and also attract more skilled workers.
Key Takeaway: China’s housing market will eventually recover, though it is unlikely to experience the boom years of the past. Viewed from a broader global perspective, the country’s extended housing crisis is helping to temper commodity prices (e.g., bulk commodities like iron ore, and base metals) and, moreover, dampen views that the world has entered into a new commodity supercycle.
 The Three Red Lines policy mandates real estate companies must have: i) a liability to asset ratio (excluding customer deposits) of less than 70%, ii) a net gearing ratio (net debt/equity) of less than 100%, and iii) a cash to short-term borrowing ratio of at least 1x. Different limits would be placed on a homebuilder’s ability to increase debt if one, two, or three of the red lines are breached. [^]
 A hukou/local household registration provides an individual/family the right to live, work, own property and benefit from basic public services (e.g., schools) in a specific city. In practice, many (larger) cities allow individuals (i.e., migrant workers) to work but deny them access to public services or the right to buy houses. [^]