Dangerous link between China’s real estate, economy and financial system
The spillover impact from failures among real estate developers into the financial system appears to be the most important risk
BURSTING real estate bubbles never occur alone. This was the experience of the US in the sub-prime crisis in 2007, but also that of Spain and the UK slightly later.
Japan also had to pay a very high cost when its real estate bubble burst in the early 1990s, but in a much more protracted way.
China’s situation is clearly more similar to Japan’s experience, because like Japan, China is an external creditor. This means that China’s real estate sector did not expand by borrowing from overseas, but was financed by domestic savings.
In that regard, the risk of a “sudden stop” in a risk-off environment is very limited unless Chinese households decide to sell off Chinese assets. This is even harder in China than in Japan due to capital controls, and this did not even happen in Japan. Hence, the risk of a balance-of-payments crisis in China is very low.
Excess capacity, decelerating real estate prices
For China, the only way out of this crisis is a slow but painful adjustment both in terms of quantity and price.
The process has already started. Fixed asset investment in real estate shrank by double digits due to bleak prospects for housing prices which impinge on the demand for housing. Second, the price channel is also working rapidly with producer prices falling around 5 per cent a year.
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Price deflation is starting to transmit to consumer prices, with negative growth for the first time in July, at -0.3 per cent.
The question then is whether Chinese policymakers can stave off the pain by absorbing the excess capacity in the real estate sector in any way.
The most obvious way is to lift the regulatory constraints that were introduced in the summer of 2020, to limit the leverage by real estate developers – the so-called “three red lines”.
The lifting of such regulatory constraints is well under way with a recent extension of the temporary lifting of the three red lines, but nothing has changed. Such constraints are no longer binding as the demand for housing has fallen so steeply that real estate developers are not willing to invest to build more.
While the ongoing double-digit fall in fixed asset investment in real estate is necessary in order to reduce the supply of housing in the future, it is still not enough to fully absorb the excess capacity in this sector.
This suggests the adjustment has only just started and will take years to conclude.
For this vicious circle to stop, Chinese policymakers need to focus on what is reversible – namely the negative sentiment around China’s real estate sector – but without trying to go against the trend of decelerating prices.
In fact, China’s population is falling, and the average household size is already extremely low; it cannot come down any further. China is also not open to immigration to mitigate the demographic challenges.
Spillover effects
Moving from the unavoidable long-term consequences to the immediate ones, the spillover impact from failures among real estate developers into the financial system appears to be the most important risk.
This question is particularly valid today after Evergrande – the largest real estate developer in China in terms of outstanding liabilities – filed for bankruptcy in the US to protect its assets in the light of a massive restructuring of its debt after it missed payments in June 2021.
As if this were not enough, only a couple of days earlier, Country Garden, China’s largest real estate developer in terms of assets, had announced that it would not pay interest on two international bonds.
Country Garden was considered the darling among real estate developers when Evergrande defaulted on its debt back in late-2021, as it had a much better managed balance sheet. The rapid worsening of Country Garden’s profitability – it posted large losses recently – is a sign of the systemic nature of China’s real estate problems.
Systemic problems can generate systemic consequences, beyond lower growth and deflation which are already bad enough.
The additional channel of transmission is the financial system, given that real estate developers fund their operations through bond issuance and to a lesser extent, bank loans, but also through shadow banking, in particular wealth management products (WMPs).
Shadow banking and WMPs have become more prevalent recently as the most important source of funding for developers. Presales have plummeted as households are much more wary of buying first-hand housing after the many unfinished units due to developers’ defaults.
The dangerous link between the problems of China’s real estate sector and shadow banking has become painfully apparent as Zhongrong Trust, a large asset management company with the equivalent of US$87 billion under management, missed payments on its WMPs to retail investors.
This has generated additional worries about the impact of the bursting of the real estate bubble, not only on the real economy but also on the financial sector.
Thus, financial stability is an additional point of attention for Chinese policymakers trying to navigate the adjustment of the Chinese economy to a shrinking real estate sector.
Measures to ensure financial stability
As opposed to lower growth and deflationary pressures, risks to financial stability operate much faster and with wide ramifications, many of which are hard to control.
For this reason, it would seem important that China’s newly created regulatory authority – with much wider powers – has a plan ready to intervene in the system in the event that a run on deposits or other forms of mistrust in the banking system occur.
This could also apply to other parts of the financial system where direct intervention by lender of last resort is more difficult, particularly in shadow banking.
All in all, while the structural consequences of a bursting of the real estate bubble cannot be avoided (lower growth and deflationary pressures), Chinese policymakers should focus on limiting the potential spillovers into the financial sector which may raise systemic risks.
The longer they wait to do so, the bigger the cost will be.
The writer is chief economist, Asia-Pacific, Natixis Corporate and Investment Banking
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