The boom, bust and future of China’s real estate sector

SINCE the global financial crisis in 2008, the real estate sector has emerged as one of the most important engines of growth in China’s economy, contributing more than even external exports. A huge investment binge in infrastructure and real estate resulted in a policy push away from external product demand.

Housing prices consequently shot up at the speed of light. China’s well-known high savings ratio, together with capital controls, have been instrumental in channelling funds to finance the real estate bubble.

Chinese households invested up to 80 percent of their wealth into real estate, and many bought several property units, depending on their ability to do so.

As a result, Chinese real estate developers became the largest in the world – that is, until the bubble ended abruptly some 18 months ago.

This decade-long real estate boom had several consequences.

First and foremost, it contributed as much as one third of the growth in fixed asset investment and GDP (gross domestic product) growth in China between 2010 and 2019.

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Second, it provided large amounts of cash to Chinese local governments through the sales of land to developers. This meant that they could fund many other projects such as international acquisitions of technological parks through their local champions.

Finally, as the price of land continued to increase and real estate developers were cut from bank financing in an attempt to rein in their increasing leverage, they had to find creative ways to finance themselves.

This, together with local governments’ own need to finance infrastructure projects, led to the rapid emergence of China’s shadow banking.

Shadow banking and the related risks to financial stability proved to be a headache for regulators. Chinese leader Xi Jinping first attempted to regulate the property market’s excessive leverage in mid-2017.

This proved counterproductive as it once again pushed real estate developers to find alternative sources of funding, leading them to the offshore bond market in Hong Kong and, most importantly, pre-sales from Chinese households.

Chinese households’ savings and wealth became intertwined more and more with a bloated real estate sector which was four times as big – in terms of developers’ assets – as anywhere else in the world.

The fragilities of China’s real estate sector were buried over the years thanks to ample liquidity in the financial sector and high economic growth.

These suddenly became visible when Chinese regulators began to react to the ever-increasing housing prices and the related deterioration of housing affordability and income distribution.

It was not until the summer of 2020, during a period when China seemed to have won its war against the pandemic while the rest of the world was struggling, that an emboldened regulator decided to introduce the so-called “three red lines” guidelines to limit developers’ leverage.

These financial guidelines relating to the ratio of debt to cash, equity and assets proved to be a risky move.

It was clear that some developers, including China’s Evergrande – the largest in terms of assets, would not be able to withstand the pressure.

This came as a shock to investors, both in China and globally. Evergrande had as much as US$300 billion in outstanding debt, 10 per cent of which was with overseas investors.

The ripple effects of Evergrande’s default on its external debt in the summer of 2021 resulted in several other developers defaulting, and there was a collapse in housing transactions. This progressed into negative double-digit growth and a rapid correction in housing prices.

In addition, mortgage boycotts emerged in the first half of 2022 as a direct consequence of households having deployed their savings for large downpayments on projects that developers with payment difficulties did not complete.

While such mortgage defaults have remained rather subdued so far, financial stability has become a key risk that China has to monitor down the road.

Chinese policymakers have decided to go back to square one and lift the regulatory restrictions on real estate developers, such as the “three red lines”. The irony is that the zero-Covid policy and its negative impact on the Chinese economy might be the reason why.

In other words, simultaneously dealing with Covid as well as the demise of the real estate sector ended up being too much for China to swallow, paving the way for a recovery of the sector.

It goes without saying that the structural weaknesses of China’s real estate sector remain in place. Households are likely to remain wary of this and will probably not invest money as easily as in the past. This suggests that housing transactions will probably never recover to previous levels.

Still, the lifting of regulatory pressure should offer some support for the sector in 2023, attracting speculative investors.

The consequence of all of this, though, is that there will be more leverage to clean up eventually. Housing affordability will not improve as quickly as expected, which does not bode well for the Chinese government’s objective of achieving “common prosperity”.

The writer is chief economist, Asia-Pacific, Natixis CIB.