Alicia García Herrero (Natixis)| China’s real estate crisis has lingered for over two years. While the recurring headlines from Evergrande to Country Garden have dampened foreign investors’ sentiment on China-related assets, the brewing spillovers have dragged domestic consumer and business confidence. What is new is that policymakers seem to believe that the problems have reached a tipping point recently. Although many policy changes have largely fallen short of expectations, the tone is changing from supporting demand to supporting developers. This is, thus, a vital moment to assess the status of China’s real estate sector on the chance of stabilisation, if not a turnaround.
In this note, we start with a macro analysis of the impact of the real estate crisis, followed by the linkages in five major channels: households, local governments, property developers, other corporates, and financials. With our economic and sectoral findings, we offer more granular implications of China’s real estate crisis on the country and the rest of the world.
Regulation is only a trigger with structural deceleration behind
While the regulatory changes appear to be the biggest shock, the structural pressure on China’s real estate emerged as early as 2016. As slower long-term economic growth drags income growth, the higher youth unemployment rate and falling population also reduce potential housing demand. The cyclical factors of cautious monetary policy stance and disinflation also offer limited incentives for home purchases. We estimate that the contribution of real estate activities to China’s GDP falls from over 5 percentage points during 2003-2007 to 0.4 percentage points from 2018-2022. And the contribution is negative in 2022 and 2023. Still, the negative contribution from real estate may diminish if Chinese government boosts public housing. But such growth will not come from the private sector, and it will not grow as quickly as before.
Household exposure is limited with potential consequences on wealth effect
Unlike the Global Financial Crisis (GFC), the impact of China’s property slowdown on households is limited. China’s household debt-to-GDP ratio is 61.4% in 2022, a moderate level globally. Only half of the Chinese household debt is property-related, and mortgage loan growth has decelerated. The trends may not be positive for economic growth, but it is helpful for households to manage its real estate exposure. Still, the high concentration of wealth in real estate can potentially lead to a negative wealth effect with the broad decline in asset prices, such as equities. Passive income of China’s households is now growing slower than wages and business income.
Local governments to face structural transition
Other stakeholders are not as lucky. Local governments are in a dilemma with plummeting land sales and the pileup in off-balance sheet debt, posing challenges to fiscal sustainability. Due to weak property investment, China’s government revenue from land sales is likely to decline for two consecutive years, namely 23% in 2022 and 21% YTD in October 2023. However, the more severe challenges may come from local government financing vehicles (LGFVs) as one-third of the entities are involved in property-related activities and the general return on assets (ROA) is falling. China’s central government will probably have no choice but to play a bigger role and widen its budget deficit, meaning a significant fiscal transition may be on the way.
Most developers face a liquidity crisis
Unlike local governments with long-term stresses, the impact on property developers is a matter of survival with severe cash flow pressure. State-owned developers are the survivors who can continue buying land for future investment, with the share of land purchases growing from 47% in 2020 to 91% YTD in October 2023.
While the situation is alarming, most developers can keep operating cash flows reasonably stable, and the main problem is financing. Developers have tapped into cash reserves for debt repayment and expenses, especially for private firms. With the pressure in home sales, the debt coverage ratio (net operating income / total debt) fell from 8% in 2020 to -5% in 2021 and stabilized at -1% in Q2 2023, a sharp deterioration of repayment ability. More liquidity to private developers will be an important band aid to credit risks, but policy implementation and home sales will still be key.
No massive spillover to other corporates yet except for a few related sectors
One of the concerns about the weaker repayment ability of developers is whether there will be a negative spillover towards other sectors. Our analysis using data from 3000 listed Chinese firms shows there is no massive spillover from real estate developers yet, but the impact can be more severe for some sectors. With closer connections to property developers, only firms operating real estate services and construction materials see higher account receivables and provisions to total assets, showing more payment delays. It shows that the current stress from real estate developers is worrisome but far from exerting a wide spillover effect in all sectors.
Financial sector becoming a shock absorber
With challenges coming from all fronts, China’s financial sector is the last resort in absorbing the losses and banks have been an important policy transmission tool in China. For banks, the exposure to developers, mortgages, and LGFVs are 3%, 10% and 14%, respectively. The NPL ratio for real estate corporate loans surged from 2.28% to 4.45% for the same period. Mortgages, the safest loan type for many years, also saw the NPL ratio rising from 0.31% to 0.46%. Banks can stomach the costs as the exposure to developers remains small on relative terms.
Still, the ambiguous definition of LGFVs can be an issue if local governments do not have enough resources to guarantee all repayment, should the fiscal situation worsen. And the pressure from mortgages may lead to slower asset growth. Beyond the strong ability of the state to mobilize resources, China’s high saving rate and low foreign debt ownership are the two factors explaining why China has plenty of resources and limited risks in the financial sector to absorb the losses in the real estate sector.
Implications on China and the world
All in all, China’s real estate crisis will bring economic consequences, but it is about both regulatory changes and structural slowdown. It all depends on whether there is a sector that is big enough to equal the demand driven by real estate. While there are spotlights in the economy, such as electric vehicles, the size is simply not comparable to the contribution by real estate. For the world, China is the second largest economy and the biggest importer of key commodities and intermediate goods. The deceleration of the Chinese economy – in part stemming from the poor performance in real estate – is bad news. Still, it is unlikely to see cross-border financial transmission given the limited linkages between China and the world. The main reason is that China’s real estate crisis has been financed with its own savings. There is no aggregate financing constraint with the rest of the world that can make the crisis more acute.
