Li Haitao, Dean’s Distinguished Chair Professor of Finance, Associate Dean for Business Scholars Program, CKGSB

Lin Xi, Research Assistant, CKGSB

The recent problem of unfinished buildings in Chinese cities has attracted widespread attention, as any changes in China’s real estate industry affects the country’s economy. Since 2017, China’s real estate investment has been continuing to rise as a percentage of fixed asset investment. In 2021, real estate investment reached RMB 14.8 trillion, accounting for 27% of fixed asset investment, therefore it is a key driver of China’s economic growth.

Commercial banks in China release liquidity through commercial mortgages. House purchases have been a key source of income for real estate enterprises and local governments. However, in the context of a cooling real estate market, it is important to pay close attention to the impact, which a decline of house purchases has on the income of real estate enterprises and local governments, since it has the potential to create a chain reaction resulting in a liquidity crisis and rapid economic downturn.

China’s real estate industry has entered a downward cycle and not yet stabilized

China’s real estate market is in its worst downward cycle since 2015. Housing prices have continued to decline since the second half of 2021, with second- and third-tier cities experiencing negative year-over-year growth. Meanwhile, in June 2022, the sales area of commercial housing in China was 180 million square meters, down 18% year-on-year.

Will the current fall in house prices continue?

• The current mortgage rates remain high, with 5.03% forfirst-time buyers. This is higher than the average level of 4.4% in mid-2016, which limits people’s willingness to purchase houses.
• The current leverage ratio of China’s household sector is as high as 62%, nearly double that of 2015. In 2016 to 2019 when house prices rose, residents overspent, leaving limited room for additional leverage to buy a house.
• Residents’ willingness to increase leverage has also declined.

Meanwhile, there are a large number of unfinished homes, further reducing the willingness of residents to purchase. Since 2016, sales of commercial housing have significantly outpaced completion: the cumulative sales area has reached 10.3 billion square meters, while only 5.9 billion square meters of housing has been completed. In the next 12 years, real estate developers will focus more on completion and less on land acquisition and starting new construction projects.

In fact, housing companies have recently struggled to acquire land. In first half of 2022, land transactions halved compared with the same period last year. Only 74.91 million square meters of residential land was traded in 100 large and medium-sized cities, a cumulative year-on-year decrease of 57%. The cumulative value of land transaction prices this year was RMB 204.3 billion, a cumulative year-on-year decrease of 46%. The decline in land transactions has brought downward pressure on subsequent new construction projects, as well as the revenue and expenditure of local governments.

China’s real estate risks remain manageable

The key is to ensure that systemic risks do not occur in the future. So far, the risks in the real estate market are under control, with no large-scale crisis in sight for the time being. This is because:

-Firstly, the current downward cycle of interest rates means that the probability of large-scale mortgage defaults is relatively small. Falling interest rates will reduce pressure on household mortgages, lowering the risk of defaults. Although the US Federal Reserve interest rate hike have limited the easing of China’s monetary policy to some extent, there is still space for further easing considering China’s low CPI and the downward pressure on the economy.

Secondly, housing prices in second- and third-tier cities in China have fallen by less than 5%. Chinese residents generally pay a down payment of 20% to 30% on purchases. Thus, it is hard to see large-scale defaults when the decline in house prices is less than the down payment ratio.

Commercial housing is the most important asset for Chinese residents. If there is no large-scale unemployment and loss of repayment sources, the risk of homeowners defaulting is relatively low. The current unemployment rate in urban China is 5.5% and 5.8% in 31 major cities, below its peak. Moreover, unemployment has declined recently under the improvement of the COVID-19 situation.

The risk of China’s real estate, such as that of unfinished buildings, are mainly concentrated in the capital chains of small – and medium-sized enterprises. Risks of contagion are relatively small.  

As for banks that have high credit rating, real estate only accounts for less than 5.5% of their assets. As of June 2021, the total debt of Chinese real estate developers was about RMB 20 trillion, including loans, bonds and trusts. Compared with the total assets of China’s banking industry of RMB 371 trillion, the risk is more manageable.

Also, Chinese banks have accumulated several impaired assets (those valued at less than book value) in the past several years. Even if there is a partial default, the risk of contagion will be controllable. The current banking industry has a high margin of safety with a provision coverage ratio of 200% and a non-performing loan ratio of 1.7%.

In addition, bank loans to real estate companies are collateralized, and large- and medium-sized banks are fully capable of dealing with the debt problems of individual real estate companies. If there is a contagion risk, these small- and medium-sized banks can be taken over by a regulator and file for bankruptcy. Thus, the bank’s debt exposure should be manageable.

Furthermore, the Chinese government is expected to take measures to prevent the crisis from spreading. In response to the risk of unfinished buildings, the government may consider setting up a real estate fund and may introduce a nationwide policy involving issuing special bonds for shanty reform to prevent further deterioration of the real estate market.

Despite the manageable risks in China’s real estate market, it is clear that China’s real estate hey day is over, and it will be difficult for the sector to turn around as quickly as it did in 2016. This is due to the following:

• First, the policy of “houses are for living in, not for speculation” will not be relaxed.
• Second, real estate has entered a stage of oversupply. Increasing real estate investment will only exacerbate oversupply, while doing little to promote employment.
• Third, households have essentially lost purchasing power due to a high leverage ratio.

Implications of current real estate risks in China

China has experienced a downturn in real estate prices in 2012, 2014 and 2018, all of which correspond to a slowdown in economic growth. This time, the price of commercial housing is expected to decline for a longer period of time than in the past.

Also, since 2010, the driving effect of real estate on the overall economy has become less significant, mainly due to an increase in household leverage, but also because the capacity to drive economic growth through fixed asset investment has reduced.

In the future, China will lower its economic growth target, focus on stabilizing employment and prices, and rely on internal consumption to achieve longer-term economic development. This means that China will have to put an end to its reliance on real estate infrastructure.

The impact of the current real estate downturn on broad asset classes will involve the following:

• The real estate crisis is expected to be manageable and will not trigger a rapid economic collapse or a stock market crash.
• China may sacrifice short-term economic growth and take the initiative to burst the real estate bubble in exchange for longer-term and higher-quality economic development. In the future, China’s economic growth will rely more on manufacturing and consumption.
• Industrial commodity prices could face a crisis. The slow decline in real estate sales and investment will make it difficult to boost the demand for downstream industrial products.  The production lines of cement, rebar and others will likely face a loss of production capacity. The crisis in some real estate related industries (glass, cement, steel, etc.) may continue for a long time, even up to 35 years. Downstream companies should increase inventory turnover and expand cautiously.

This article first appeared in Chinese in http://ai.alphainfo.com.cn/collect/dnns_showCollectInfo.do?identify=6&mid=8a9983118245236c0182570b981837e2