China’s crackdown on its highly indebted real estate sector has caused the number of defaults to rise since late 2020, inflicting a deflationary shock on the economy. This episode of financial stress has also caused investors to worry that if the property market crashes, it could trigger a systemic crisis, since the property sector accounts for about one-third of China’s economy.
China’s property market is highly leveraged. The average total debt-to-asset ratio exceeds 80% and its average cash reserve ratio has been well below the level of short-term debt since 2017. The sector’s ‘debt-addiction’ has created a vicious circle, with an insatiable need for fresh funding pushing it to fall afoul of the government’s regulatory thresholds.
All this has blocked many property players’ access to domestic bank financing, forcing them to use shadow financing and to rely on account payables to contractors and suppliers for short-term funding. However, Beijing’s debt-reduction policy has significantly squeezed these sources of funding, aggravating investor concerns over a possible property market crash.
Even so, the probability of such a crash triggering systemic risk remains low, in our view, thanks to the fragmented nature of China’s housing market and its strong bank balance sheets. No single major developer accounts for more than 5% of the country’s property sales; even the RMB2 trillion (roughly USD300 billion) total debt of the second-largest developer, which is currently in trouble, equates to just 1% of China’s total bank loans.
The International Monetary Fund has estimated that Chinese banks have an average tier 1 capital ratio of 12%, which suggests that the system has a large financial cushion for potential shocks.
Conventional wisdom assumes that China’s housing market is in a massive bubble. This is not true, in our view. Its fragmented nature means that there is not one amorphous property market, but many smaller ones. So, there are some pockets of local bubbles. Macroeconomic policy tools such as interest rates cannot address this. Instead, Beijing needs structural policies to tackle the individual bubbles.
Home prices are indeed high in major cities; affordability in the lower tier cities has also worsened since 2015 (see Exhibit 1). This has become a major source of social discontent, prompting Beijing in recent years to tighten policies from land sales and construction to developer financing and home purchase restrictions.
The government has used a differentiated approach: measures are tougher for major cities with market bubble conditions than for others where there are no property bubbles. However, home prices have continued to rise, especially in large cities.
Many observers have pointed to sensational media stories of ghost towns’ and ‘see-through’ buildings in many parts of China as being evidence of a supply glut that could soon cause the housing bubble to burst. However, in our view, the persistent rise in home prices points to a shortage of houses, not a surfeit.
The demand-supply imbalance is especially acute in large cities such as Beijing and Shanghai where residential construction has dropped in recent years (see Exhibit 2). Given China’s large population, rising income and continued urbanisation, housing supply does not appear to be excessive at the national level.
The point is that China’s property market has large regional divergences, meaning that bubble pockets and ghost towns could coexist. At an aggregate level, it is likely that supply shortages rather than gluts have boosted house prices. The government’s property crackdown will inflict a deflationary drag on GDP growth in the short term, but a property market crash triggering a systemic crisis is unlikely, in our view.
The world, especially Asia, is worried about a property market crash because the resultant shock to Chinese growth could dampen global growth and inflationary pressures due to the weight of Chinese global demand. Evidence shows that the pace of growth in Asia is more sensitive to GDP growth changes in China than it is to changes in European and US growth (see Exhibit 3).
This suggests that if growth in China were to slow sharply, even strong growth in Europe and the US might not be able to offset the impact on Asia. The rest of the world also could feel the cooling effect from a slowdown in China’s growth. This, in turn, would put a dampener on regional, or even global, inflationary pressures.
Also read Part I: Credit events in China (I) – The macroeconomic impact
Senior Market Strategist at BNP Paribas Asset Management
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