How China’s house of cards came crashing down

A full-blown property crisis has exposed broader risks to the wider economy as debt fears grow

In contrast to other major economies, China has been trimming interest rates as it tries to stem the economic effects of its zero-Covid policy and address a growing property crisis.

The country’s traditionally strong housing market has been affected by a funding crunch that has seen development paused and led to buyers refusing to pay their mortgages.

Moreover, the mortgage strikes across China have exposed the risks that have accumulated in the market during the past two decades.

The protests started earlier this year among a group of people that bought homes in an Evergrande development in Jingdezhen city, which is part of Jiangxi province. But similar action has since spread to buyers of other projects throughout the country.

To date, more than 300 groups of homeowners are believed to be refusing to pay between US$150 billion and $370 billion in loans, according to informal surveys published online.

These protesters all have one thing in common – they have been paying mortgages, often at a rate of between 5% and 6%, on homes they have never lived in.

Most of these properties were sold before they were built under what is called the presale system, which is a common way to buy property in China.

The trigger for the buyers’ strikes is a widespread belief that the money homeowners have paid in advance to the builders of these property developments has been misused.

Under the presale system, buyers deposit cash in an account before the property is built.

Chinese banks and local authorities are obligated to monitor developers’ use of these funds. They are not supposed to have access to all of the money until they have hit certain pre-agreed milestones during the building process.

Today’s situation follows a boom in the Chinese property market.

But buyers have complained that many banks – whether or not local authorities are aware is unclear – have been providing loans to developers before the required stage of work has been reached.

They have also argued that, although these funds should have been kept in designated escrow accounts that regulators can monitor, sometimes they are not. In turn, this has enabled developers to evade regulations.

Overall, these buyers believe loose regulation of funds has provided some developers with the temptation and ability to keep investing in new projects, by borrowing more before current projects are completed.

Indeed, a commonly observed pattern in China’s property sector is for developers to purchase land, pledge them to banks to get loans, start projects, begin the presale process with buyers and then use these funds to purchase land for other projects.

In such situations, only a portion of a buyer’s funds might go towards the construction of their own property. As a result, a liquidity crisis in the sector has stalled many projects because the developers involved can’t afford to continue building.

Today’s situation follows a boom in the Chinese property market. The housing market had been enjoying a long rise since the early 2000s, which reached a peak in 2018 before a gradual cooling that ended in a sharp decline in sales in early 2022.

The first chart below shows the change in China’s Real Estate Climate Index, which measures aggregate business activity in land sales and real estate.

Real Estate Climate Index | New House Sales
Chart: Data from China’s National Bureau of Statistics

New house sales have slumped substantially this year, with values dropping by 22% compared to the same time last year.

The weak market has substantially reduced the funding available to developers, as the second chart highlights. This is the root cause of the current situation in which developers have paused construction, causing a homeowners mortgage strike.

Funds Accessible To Developers | Year-on-Year Growth
Chart: Data from China’s National Bureau of Statistics

Tightening credit conditions also play an important role. Among other things, a key policy change is the government’s “three red lines” regulation, introduced in August 2020.

It categorizes developers according to how much debt they hold, which then determines how much more they can borrow annually.

More than 60% of developers have hit at least one of the debt thresholds set by regulators in 2021, as shown by the third chart below.

Government Red Lines Crossed
Red: No new interest-bearing debt is allowed. Orange: New interest-bearing debt growth must not exceed 5%. Yellow: New interest-bearing debt growth must not exceed 10%. Green: New interest-bearing debt growth must not exceed 15%. Chart: Based on reports from China Real Estate Data Academy

Around 10% including crisis-hit Evergrande have breached all three. When this happens, developers are not allowed to raise new borrowing for that year. The resulting credit crunch has pushed many developers into a stressed position, with some even defaulting.

The potential for a wave of developer bankruptcies is the biggest risk to China’s housing market at the moment and could result in a large number of unfinished properties.

This is not an alarmism statement. Chinese developers generally borrow a lot of money to fund ongoing construction. While the industry average debt-to-asset ratio is around 65%, some of the leading companies are even more indebted as the fourth chart illustrates.

Debt-To-Asset Ratio of Listed Developers
Chart: China Stock Market & Accounting Research (CSMAR) Database

The industry has also seen a gradual fall in developers’ ratios or their ability to repay short-term debts as shown by the fifth chart below. It indicates lower overall liquidity and leaves the industry vulnerable to financial shocks.

The risk from the real estate sector could also spill into the wider economy via banks and local governments, which are the two biggest entities supporting China’s growth.

Banks lend both to buyers and developers and so could face a surge in bad debts if the housing market collapsed. The good news is that these loans are a relatively small proportion of their total lending.

Current Ratio of Listed Developers
The ratio is a liquidity measure, calculated by dividing a company’s total assets by its total liabilities. A falling ratio indicates less protection from short-term financial problems. Chart: Figures based on China Stock Market & Accounting Research (CSMAR) Database

According to my own calculations based on government figures, mortgage loans comprised just under 20% of lending by banks by the end of 2021. Major banks, meanwhile, have reported that only about 0.01% of those loans are affected by the homeowners’ strikes.

On the other hand, real estate developments comprise only 6.2% of the loans held by Chinese banks. Even so, major defaults could lead them to tighten lending conditions, causing market liquidity to fall even further.

Local governments are a different story. They often rely heavily on selling land for income and so dwindling returns could affect their investment and urbanization projects.

This would be a further drag on China’s recovery from the pandemic at a time when it is already struggling due to the government’s ongoing zero-Covid policy.

When it comes to global implications, it’s worth remembering China’s “closed” capital account policy restricts the movement of money in and out of the country. This largely isolates the country’s financial market from the international market.

So, unlike the 2008 Global Financial Crisis, these defaults would be unlikely to directly affect the world economy, although nations that trade with China may see a fall in demand from Chinese consumers.

Zhirong Ou is a Senior Lecturer in Economics at the Cardiff Business School at Cardiff University.

This article is republished from The Conversation under a Creative Commons license. Read the original article.

The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy of China Factor.

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