September 16, 2022 | 16:14
China: A Different Type of Housing Crisis
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 in the 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. 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.
On the flip side, the probability of it 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 essentially 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 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 via the introduction of the ‘Three Red Lines’ policy in 2020 and homebuyers’ confidence rapidly dwindled in the aftermath of the Evergrande shock.
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 really 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.
The inability of developers to deliver completed 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 stuck with a large glut of unsold housing as opposed to fourth- and fifth-tiered cities. Meanwhile, LGs are exercising their longstanding power by placing a floor on the price that developers can sell new homes at. This is a double-edged sword as LGs are likely setting prices too high to allow developers to quickly clear their inventories. At the same time, keeping pre-sale prices higher than would otherwise be the case may be providing 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% this past 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 could accelerate urbanization. This process is still not complete, though it has entered the latter stages with the urbanization ratio hitting 65% in 2021.
Key Takeaway: China’s housing market will eventually recover though it is unlikely to experience the boom years of the past. The authorities appear increasingly committed to President Xi’s longstanding mantra that “housing is for living in, not for speculation”, which should result in financial resources being redirected into high-tech sectors to help the country becoming more economically self-sufficient and competitive.