The flow of bad news surrounding China’s deeply troubled real estate market is unrelenting. Hui Ka Yan, the multi-billionaire founder of Evergrande, the world’s most indebted property developer, has been put under investigation for unspecified suspected crimes. His company, which has been on life support for at least two years, can now only be restructured or liquidated. His own fate is uncertain, but as a crisis over financial liabilities acquires a cloak of potential criminality, this will only further undermine confidence in China’s housing market.
We don’t know what Hui is alleged to have done. He certainly didn’t endear himself to Beijing when Evergrande filed for so-called chapter 15 bankruptcy protection in a US court last month, and hired a US law firm to represent it in financial restructuring talks with foreign bond holders under US law. Under current geopolitical conditions, and given the significance of property to the Chinese economy, you can see why the Chinese Communist Party might prefer to deal with this case at home, under its own close control.
Geopolitical sensitivities aside, the sheer size of the broadly defined real-estate sector – between a fifth and a quarter of China’s GDP – merits a laser-like focus from the Chinese leadership. It is materially bigger than the UK’s entire industrial sector, and there simply isn’t anything else nearly as big in China to compensate for a sustained downturn in the property market. The problem here is more systemic than it is cyclical. In other words, near-term ups and downs aside, the market is likely to shrink for years to come.
We know from direct experience in the 1980s, and more especially after the 2008-09 financial crisis, the damage that large property busts can inflict. The economist, diplomat and raconteur JK Galbraith, suggested a formulation that is relevant for a post-Evergrande China. He wrote about “bezzle”, or the gains from embezzlement during periods of financial euphoria that evaporate when things eventually unravel. Bezzle can be ill-gotten gains but it can also be the gap between the actual and market value of homes or other asset prices that is revealed to all when boom turns to bust. In China, the size of the bezzle is remarkable.
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The pace of that unravelling can be spectacular, as it was with Lehman Brothers, with a virtuous circle in which optimism, home prices, construction and wealth all rise together, transforming into a vicious circle when they all go into reverse. But this process can also unfold over a longer period of time. In China’s case, where the government owns and controls the financial system, assets and liabilities can be moved around at will, and so a protracted, painful reordering is more likely than a sudden financial eruption. China has unquestionably started down this path.
The largest Chinese banks have little direct exposure to Evergrande, but other developers with large liabilities, and local governments with even bigger debts, mean that the financial system as a whole now confronts direct risks. It is also affected indirectly to the extent that land and real estate constitute a high proportion of the collateral in many loan agreements. There are risks to the real economy too. Weak activity and falling home prices are already having adverse effects on construction materials, home appliances and furniture, and creating significant debt service difficulties for already strained local governments, a handful of which have had to resort to layoffs, and reducing publicly provided goods and services. The property downturn is also undermining the confidence of households, whose wealth is held mostly in the form of real estate, further depressing already subdued consumption in the economy.
Chinese officials have been busy trying to prop up the market, rather than allowing losses to be taken, and insolvent firms to fail. This is consistent with their past approach of using housing as a tool to mitigate economic weakness, and so it may not work for long. This summer they lowered mortgage rates and deposits, as well as providing liquidity and balance sheet assistance to developers to help them start or complete projects. This is particularly important given the common “pre-sale” model of home buying in China, where households often take out mortgages on homes that have yet to be built. Some cities have also allowed previous mortgage holders to be treated as first-time buyers and benefit from more favourable financing terms, with about a dozen cities lifting all mortgage restrictions.
An initial spurt in home sales in August quickly fizzled out, but it is possible that these and other measures will have some effect in stabilising the market for a while. This process could be aided by the huge declines in construction volume and sales in recent months: between 40 and 60 per cent below levels recorded in 2019 and even in 2021. Nevertheless, the sector undoubtedly faces years of shrinkage as it absorbs chronic over-supply of homes, and adapts to much lower household formation due to a decline in the population of first-time buyers and a sharp fall in the number of marriages.
There is a risk of financial contagion to the rest of the world but this is fairly low if, as expected, large Chinese banks are not allowed to fail. The yuan may weaken further, as capital tries to leave China, but that could lower prices of Chinese goods sold into Europe and elsewhere. Bigger risks loom over countries and firms that rely on selling commodities for the property sector. Lower economic growth means many import categories will be more subdued. The fabled rising Chinese middle class is unlikely to be as spendthrift as foreign firms have hoped given the weakening property sector and restraints on incomes they now confront.
China has relied on the real estate sector to mitigate its economic downturns for the last 15 years, creating a bubble in the process, and a financial system underpinned by moral hazard. The world enjoyed the euphoria, but it’s now time to pay the piper.