China’s property sector is undergoing a severe contraction. Given property’s large size and interconnectedness, the sector’s woes are raising a series of concerns about local government finances, banks’ balance sheets and even about the risk of a deep recession. We find these concerns overblown and argue that the risk of a disorderly adjustment in housing with damaging knock-on effects on the rest of the economy is low.
What is the state of China's property sector?
China’s property sector is undergoing a severe contraction. Buyer sentiment has been materially impacted by the Zero COVID Policy (ZCP), while indebted property developers have come under stress from the government’s “three red lines” policy that aim to constrain borrowing and to reduce debt ratios. The government has responded to the slowdown by introducing measures including cutting mortgage rates, providing tax rebates, and reviving the PBoC’s Pledged Supplemental Lending (PSL) facility for cash strapped developers to complete unfinished housing and for shantytown development. While these measures could provide some partial relief, housing activity is expected to stay depressed for as long as ZCP and the three red lines policy for developers remain in place. With the housing sector accounting for some 25% of GDP, with broad linkages and multipliers running through key sectors in steel, cement, raw materials and consumer durables, its continued slide will be a drag on China’s future growth 1.
Will China's housing lead to a wrenching economic adjustment?
The risk of China’s housing downturn occurring in a disorderly fashion with damaging knock-on effects on the rest of the economy is likely limited, in our view. First, the housing sector had already peaked some time ago. After experiencing exponential rates of growth in the 2000’s, housing activity has been flat to declining since the second half of the 2010’s (see Exhibits 1 and 2). The initial drivers of the housing boom – rapidly rising incomes as China entered the WTO and pushed out its production possibility frontier, widespread access to home financing, and redevelopment of shantytown and the rising importance of state housing had already begun to fade before the current downturn (see Exhibit 2). As a result, based on data from the National Bureau of Statistics (NBS):
• Sales volumes peaked near 1700 million m² in 2017 and have been flat
• Housing starts peaked at 2200 million m² in 2019 and have been declining
• Home completions peaked at 1000 million m² in 2017 and have been flat since then
And because real GDP growth was still expanding, construction intensity per unit of GDP has long been on a declining trend. In short, TRG believes that there is nothing new about the housing sector exerting a drag on growth - the adjustment to a non-housing growth model had already been in the making for the last five years.
Second, the China housing market has experienced several cyclical periods of regulatory tightening in the past. These tightening measures have let air out of the property bubble when the market was running hot and have acted to discourage households from over-extending leverage and to align housing price increases closer to household income growth. For example, the introduction of property and credit tightening caused housing sales to fall by about 20% during the 2011 and 2014 tightening episodes, NBS data shows, before recovering once these measures were relaxed upon signs of cooling (see Exhibit 3).
Is there a housing bubble that will pop?
Traditional valuation metrics suggest that risks do not lie in household balance sheets. China’s household loan to value (LTV) ratio is extremely low at 30%2. TRG believes there is little risk that a fall in housing prices will precipitate forced selling as homeowners become unable to raise cash to restore their LTV ratio. It is worth noting that despite the sharp fall in housing activity in the year to date, nationwide house prices have fallen by just 5% over year ago levels as of September (see Exhibit 2).
Housing affordability ratios remain well behaved too. Much attention has been paid to elevated house prices in Beijing and Shanghai, with home price to income ratios of Tier 1 cities near 18X. But the top cities represent a small share of total sales values – at the national level, the home price to income ratio is much lower at 7X. These ratios compare with 3.2X in India, 8.2X in the US and 8.6X in Japan, all according to JP Morgan Research. However, risks lie on the supply side. Property developers have been significantly impacted by falling revenue from sharply lower housing sales and a liquidity crunch from tighter borrowing restrictions. Unsold inventories have risen to about 12 months in Tier-1 cities and 15 months in Tier-2 cities, SouFun-CREIS data indicates. Continued weakness in housing sentiment and little scope for an easing in the regulatory regime would likely lead to more distress and insolvency amongst over-levered developers.
“The risk of China’s housing downturn occurring in a disorderly fashion with damaging knock-on effects on the rest of the economy is likely limited."
Will a slowdown have a big impact on land sales and local government revenue?
An often-quoted statistic is that land sales account for 40% of local government revenue, finance ministry data shows; accordingly, a weaker housing market would severely impact local government finances. However, the figure is quoted on a gross revenue basis and does not account for property related costs that are borne by local governments, such as compensation for existing landowners and related construction costs on infrastructure. On a net basis, land sales account for a considerably lower 10% of local government revenue, with transfers from the central government and direct revenue collections making up the bulk of the total.
Do banks and capital markets face systemic risks from distressing property developers?
Yields of USD-denominated bonds of property developers have risen to 25% or more, according to Bloomberg data. The government is unlikely to provide any form support to the offshore market, in our view. By contrast, authorities are providing support to property developers in the RMB bond market, as loan payments continue to get rolled over and refinanced.Further developer stress will increase non-performing loans and will worsen asset quality in the banking system. However, TRG believes that bank systemic risk remains low. China’s deleveraging policy began in earnest in 2016. Debt ratios have been reduced, riskier parts of shadow banking wound down, small and medium banks recapitalized and non-performing loans either restructured or written off. With the banking system mostly funded by a stable retail deposit base and with reduced exposure to less stable sources of funding, we believe the banking system today is in a much better position to withstand potential negative effects amongst distressed property developers. A gradual deleveraging process is thus a more plausible scenario than a sudden stop in banking system funding.
1 Rogoff, Kenneth, and Yuanchen Yang. 2022. “A Tale of Tier 3 Cities.” IMF Working Paper 2022/196, International Monetary Fund, Washington, DC
2 Li, Hao and Wu, Jing and Xu, Mandi, Estimating the Leverage Condition of China’s Urban Households: Evidence from the Housing Sector (May 29, 2020). Available at SSRN: https://ssrn.com/abstract=3613442
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