Can Beijing tame China’s housing bubble?

November 2016

House prices in China have soared over the last 12 months, prompting fears of a property bubble. The government is trying to tackle the problem – but has it moved too late to avert a crisis?

 

Happy couples visit registry offices to arrange divorces. Police arrest estate agents for “spreading rumours” to rustle up business. Property developers cower beneath their desks as fisticuffs break out among desperate buyers. Welcome to the strange world of the Chinese housing market.

Over the past 12 months, house prices in the so-called Tier-1 cities of Beijing, Shanghai, Guangzhou and Shenzhen have risen between 20 and 30 per cent. And the trend is not restricted to China’s biggest urban centres: the sleepy coastal town of Xiamen, for example, has seen prices rise by more than a quarter this year.[1]

With memories of the US subprime crisis fresh in the memory, fears have grown that China is facing a potentially catastrophic real estate bubble of its own. Property developer Wang Jianlin, founder of the Dalian Wanda Group and China’s richest man, has gone so far as to call it “the biggest bubble in history“.[2]

This may be an exaggeration – levels of household debt in China remain far below the point they reached in the US prior to 2008,[3] and Beijing has started to introduce measures to cool the market.  Nevertheless, there are growing concerns that a precipitous fall in house prices would bring down heavily indebted property developers and inflict damage on China’s banking and credit markets.

“There is a real concern that smaller developers would get dragged under the water if we get a sharp correction in house prices,” says Sandip Bhalsod, Global Real Estate Analyst at Aviva Investors in London. “That could lead to a contagion-like effect across credit markets in China.”

Top-down growth

The Chinese economy’s reliance on the housing sector – which still accounts for a quarter of the country’s GDP,  despite recent efforts to effect a shift to a more consumer-spending driven growth model – means Beijing tends to step in with support whenever the market shows signs of weakening, as was the case in 2014. That intervention partly explains the recent increase in prices.

“Declining house prices, coupled with concerns about China’s economy, meant there was lots of talk about the need to stimulate the housing market in 2014,” says Bhalsod. “The People’s Bank of China implemented easing policies, such as reducing the size of down-payments needed on second mortgages, and pumped liquidity into the market. It cut reserve-ratio rates so banks could lend more to homebuyers.”

Coupled with new initiatives from the China Securities Regulatory Commission, which lifted restrictions on bond sales by developers, these policies had the desired effect; rejuvenating the market and enabling Beijing to meet its growth targets in 2015 and 2016 (see figure 2.).

Government policy isn’t the only reason for the rise in prices, however.  Some analysts point to a scarcity of land in desirable cities such as Shanghai. Fitch Ratings says China needs to build 800 million square meters of residential real estate each year between 2016 and 2030 to accommodate its growing population – an area the size of Singapore.[4]

Keeping up with the Joneses

But while a lack of supply might explain price rises to a point, it does not account for the way valuations soared so dramatically over the summer of 2016, when the demand for housing reached fever pitch. Riots broke out at an estate agency in Hangzhou when desirable new properties came onto the market.

“I don’t see this as primarily a supply side issue – the rise in prices in 2016 looks more like a consequence of soaring demand,” says Bhalsod. “Supply doesn’t change overnight but demand can ramp up over a couple of months, and that’s evident in the exuberance of the Chinese market. People have jumped on the bandwagon.”

The effects of government policies have been amplified by China’s social dynamics. As prices have risen, potential buyers have seen investors in residential property reap massive gains – and have looked to buy second or third homes to keep up with the neighbours.

“The huge appreciation seen in the housing markets of Tier-1 cities has prompted a wide wealth gap in just 12 months among those who had bought homes a year ago and those who did not,” wrote Mizuho Securities analysts in a September research note. “This may partly explain why buyers are stampeding into showrooms.”[5]

This problem is compounded by the lack of viable alternative investment opportunities in China. The preponderance of retail investors in the domestic stock market makes it extraordinarily volatile – witness the turmoil in mid-2015, when the value of equities traded on the Shanghai Stock Exchange fell equities fell more than 30 per cent over a three-week period in July. Residential property is seen as something of a safe bet by comparison.

Government intervention

Despite its previous interventions in the property market, the rapid rise in prices in 2016 seems to have caught the Chinese government unawares. Now even official sources have started to express fears that the market is overheating: The central bank’s Chief Economist Ma Jun says the growing “bubble” must be tackled.

During the National Day holiday in early October – considered an auspicious time to buy a house – local government officials worked overtime to expedite new rules designed to rein in runaway house prices. Down-payments of at least 30 per cent are now required from most first-time buyers and this figure is higher for second homes; in Beijing, Guangzhou and Shenzhen, the minimum down-payment on a second home is now 70 per cent. Shanghai has introduced outright restrictions on the number of properties couples can buy, which has had the unintended consequence of spurring a wave of ‘fake divorces’ among couples keen to circumvent the rules.

These regulations are being introduced at a local level partly because of the two-speed nature of China’s housing market. While Tier-1 cities and other fast-growing urban centres see rapid price rises, some poorer towns to the West are still struggling with weak demand and massive oversupply. Long-delayed reforms to the hukou system, which imposes restrictions on where citizens can live, work and claim state benefits, are needed to enable rural families to start populating these provincial ghost towns.

Credit crunch?

Tightening measures are likely to affect developers’ sales volumes and, eventually, help bring prices down. The more pressing issue, however, may lie in the linkages between China’s property and credit markets. While household debt in China stands at a manageable 45 per cent,[6] property developers are taking on escalating levels of leverage. Academic research shows that the total liabilities of China’s real estate sector doubled from 30 per cent to 60 per cent of GDP between 2008 and 2015.[7]

This year, developers have already raised three times as much capital in the bond markets as they did in the whole of 2015 to finance a construction spree. The government has cracked down on new bond issuance by developers on the Shanghai and Shenzhen exchanges, but while such measures should put a ceiling on debt levels, they may merely postpone an inevitable reckoning.

“Many developers have bonds maturing in 2018 so they need the market to open for their refinancing needs,” says Joyce Bing, Credit Research Analyst at Aviva Investors in Singapore. “If house prices drop sharply, their credit profile will face challenges. Some of the smaller developers would be in trouble, especially if they have not yet been able to monetise their property projects and were unable to sell during a downturn.”

Problems among China’s indebted property developers could, in turn, produce unwanted effects in the financial sector, as Chinese banks are major players in the onshore bond markets. In its October Financial Stability Report, the International Monetary Fund highlighted the risks of China’s looming credit overhang – which indicates the deviation of credit growth from its long-term trend – and cites the booming real estate market as a contributing factor.

“[China’s] credit overhang, a key cross-country indicator of potential crisis, is estimated somewhere in the range of 22-27 per cent of GDP, which is very high in international comparison,” the report said. “Continued rapid credit growth in China and expanding shadow banking products pose mounting risks to financial stability.”

The report cites the risks of ‘spillover’ effects to the wider economy if borrowers face a liquidity crunch. Research from brokerage DBS Vickers Hong Kong quantifies the potential damage: If house prices were to fall 30 per cent, banks would face bad loans worth upwards of $600 billion. That’s far less than the $1.4 trillion of losses faced by US banks in the wake of the financial crisis, but enough to prompt a likely government bailout. Such an intervention would weigh on financial stocks and push up Beijing’s borrowing costs.

Balancing act

Fortunately, this scenario looks unlikely, at least in the short term, given that monetary policy remains broadly accommodative and most property developers will have built up ample liquidity buffers during the recent boom. Nevertheless, the government will have to tread carefully as it seeks to smooth the housing market’s transition through its next cycle.

“China needs to control overheating prices in top tier cities and to continue destocking in lower-tier cities,” says Bing. “The government needs to balance the two objectives carefully as China’s housing market is a key driver of the economy. It affects many other sectors: construction, machinery, steel, cement, capital goods, local government revenue and so on. It cannot afford a collapse.”

 

Figure 1. Average year-on-year house price increase, Shanghai

 

Figure 2. Relationship between house prices and bank reserve requirements

 

[1] JP Morgan, ‘China: Property market tightening, or monetary tightening?,’ October 2016

[2] http://money.cnn.com/2016/09/28/investing/china-wang-jianlin-real-estate-bubble/

[3] Data from The Economist shows that household debt in the US in late 2007 stood at over 120 per cent of income; in China in 2016 this figure is approximately 45 per cent.

[4]Fitch Ratings, ‘China housing demand to stay resilient through 2030,’ August 2016

[5] Mizuho, ‘China Property: The Madness of Crowds,’ September 2016

[6] This is significantly less than regional neighbours including Japan (132 per cent) and South Korea (160 per cent), according to OECD data.

[7] ‘China’s debt challenge,’ Australia-China Relations Institute, February 2016

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