Surging real estate prices fueled by ongoing credit expansion are forcing the Chinese government to choose between deflating the housing market and slowing growth. None of its options are ideal as they all present consequences that will further strain some aspect of the Chinese economy and, therefore, the stability of the country’s political system. To understand the tradeoffs the government faces, and the potential fallout from any missteps, this Deep Dive will examine the interrelation between the real estate market and GDP growth, debt growth and Chinese support of state-owned entities. It will also examine the policy tools available to the central government, along with the economic and political repercussions of these tools.
- China has relied heavily on the real estate market to support growth, resulting in surging housing prices, an oversupply of housing and dependence on construction companies as politically important entities to provide jobs.
- On account of its centralized economy and land monopoly, the Chinese government has more tools with which to intervene in the real estate market than many other countries do; however, all of the tools carry implementation risks.
- While China has previously intervened in the real estate market with some degree of success, the combination of declining corporate profitability and growing corporate debt has increased off-balance sheet securities. Furthermore, an increasing housing inventory makes it more difficult to manage rapid changes in housing prices.
- Increased interdependence of the financial system and the real estate market through opaque off-balance sheet instruments has exposed the broader economy to increased risk stemming from downturns in the real estate market.
Geopolitical Futures’ forecast predicts an economic downturn in China that will create significant domestic political challenges. We are observing trends reminiscent of the debt-related problems that drove Japan into a prolonged period of stagnation that began in the early 1990s. The difference between China and Japan is the extent to which each nation’s citizens have benefited from the debt-fueled growth. In Japan, most of society benefited. In China, however, the coasts have prospered while hundreds of millions of people still live in abject poverty in the interior.
This inequality will present China with a choice: transfer coastal wealth to the interior at the expense of trade – which will require compelling unity through international isolation – or risk popular unrest over a growing divide between beneficiaries of coastal trade and the rest of the country. This pattern has occurred repeatedly in China’s past, whereby the coasts grow prosperous from commerce while the interior stagnates and becomes restless. Striking a balance between these poles poses a serious challenge to the ruling party, causing it to become more authoritarian as it attempts to attain that balance. While avoiding an uprising is in the interest of the ruling Communist Party, elites will resist forfeiting their wealth. President Xi Jinping has begun consolidating his power over the country’s ruling structure to mandate this redistribution of wealth.
China finds itself in a difficult position. It has become over-reliant on the real estate industry as a source of growth and has intermingled this industry with the country’s financial system and the health of major state-owned enterprises (SOEs). While the government has frequently intervened to manage property prices, credit expansion is making the economy more difficult to manage overall. So far, despite increasing volatility in housing prices, the central government has managed to avoid a real estate collapse through active intervention in the market. While the central government has been using tools to manage the market, these tools are double-edged swords since actions that can cool the housing market have negative consequences in the broader economy.
Since an economic crisis would have political ramifications, which are discussed in our long-term forecast, this Deep Dive will explore the fine line that China currently walks between slowing growth by deflating the housing market and the repercussions of a misstep.
Rising Real Estate Prices
Chinese property prices have been increasing for the last decade, frequently at double-digit rates. This is partly due to the massive movement of labor from rural to urban centers, which has concentrated aggregate consumer demand in cities. Economic productivity has elevated wages, providing Chinese workers with capital to invest. When seeking places to invest this capital, the Chinese are essentially faced with three options: savings, stock markets and real estate. While overseas investment has historically provided an additional avenue, the central government has imposed increasingly strict capital outflow controls to prevent an uncontrolled fall in the yuan’s value.
The central government has kept savings rates artificially low, allowing the Chinese government to keep inefficient but politically important SOEs afloat by providing a source of cheap debt. Although there is a much greater cultural proclivity to save in China when compared to Western countries, low rates decrease the attractiveness of this option for many people. Investing in corporate stock is similarly unattractive since the government’s debt-based support props up companies that can only offer low rates of return, crowding out private investment. Furthermore, the Chinese public equity markets are volatile, scaring many Chinese who fear that a market swing could rapidly erode their savings.
The combination of fewer corporate investment opportunities and depressed savings rates encourages investors to funnel capital toward real estate as the remaining attractive option. This is true not only for individuals and real estate businesses, but also for companies whose primary business is not real estate. Since rates of return are higher in real estate than in other productive areas of the economy, companies forego investment in their own activities to instead park capital in property for reasons unrelated to their own core business operations. A report by the St. Louis Federal Reserve used data on publicly listed companies to estimate that 45 percent of all non-real estate firms in China invest in real estate for capital appreciation purposes. The Chinese also see real estate as a more secure investment since fixed assets – that is, physical objects – offer some degree of protection against currency devaluation.
Buildings under construction near the People’s Bank of China in Chongqing, China. China Photos/Getty Images
Risks Bubbling Up
In December 2016, real estate prices had declined slightly in some of China’s Tier 1 cities on a month-on-month basis (decreases of 0.1 percent in Beijing, 0.2 percent in Shanghai and 0.4 percent in Hong Kong). Overall, however, they were still up on a year-over-year basis (28.4 percent, 31.7 percent and 23.8 percent, respectively). Prices also continued to rise in the rest of the country. Despite these rising prices, China’s housing inventory continues to grow, an indication that construction has outpaced demand. Vacancy rates have also grown in tandem with both property prices and rates of return on real estate. The aforementioned report from the St. Louis Federal Reserve estimates that vacancies in Chinese cities could be as high as 22.4 percent, which includes properties that have been purchased but are nevertheless empty. While this seems counterintuitive since property can provide rental income, many owners are indifferent because returns on property are currently so high relative to other opportunities that even empty properties are a better option than the alternatives of saving and investing in corporate stock. The result is an unusual combination of rising inventory, growing vacancy rates and increasing prices.
It will be difficult for demand to catch up with supply. China’s existing housing supply is large and continues to expand while GDP growth continues to decline. Pressure from declining exports gives little reassurance that China will be able to reverse this trend anytime soon. As demand persistently lags supply, prices will fall in an attempt to clear the accumulated inventory. Despite vacant properties being purchased as investments, the supply has increased at such a pace that unsold housing inventory nevertheless continues to grow.
If China were to see sufficiently high price declines, developers would begin facing challenges. Since developers frequently receive large construction loans, their projects are highly susceptible to even slight price declines. If a project’s collateral value declines below the loan amount, the lender would seek compensation for the increased risk of loan loss, often in the form of partial payback or higher interest rates. Worse still, developers unable to sell their projects at a profit would face project failure and bankruptcy. This would not just happen to one developer at a time, but to many at once. Banks would be threatened with insolvency when loans stop performing, which would threaten bank runs if depositors become worried.
How China Has Avoided a Housing Contraction Thus Far
This is not the first time real estate prices have surged in China as they become artificially inflated by debt – a situation that could cause prices to drop and ultimately collapse the housing market as demand fails to catch up with supply. Analysts and economists have been predicting the imminent collapse of the housing market since 2005. But it hasn’t happened. Why?
Due to China’s centrally planned political system, the country has unique ways to control housing supply and, to a lesser degree, demand. In addition to traditional monetary policy tools such as reserve rate requirements, loan-to-deposit ratios and various interest rates, the Communist Party owns all land in the country, giving it monopoly control. The government does not sell land. Rather, it allocates land to municipal governments that then auction the development rights. In the event of a precipitous decline in prices, the government could attempt to cushion the fall by restricting the supply of land to the market. This might prevent a real estate collapse, but it wouldn’t solve the problem of slower economic growth resulting from diminished development activity. The decline would impact construction companies and others that provide goods and services to the construction industry. In addition, restricting the supply of land would fail to address the oversupply of existing inventory; it would only prevent new inventory from being added to the market.
The central government also has some control over demand. It has eased regulations on foreign ownership of property while at the same time restricting capital outflow, in part to control the decline of the yuan’s value. This prevents money from leaving the country and forces it to seek returns domestically, maintaining upward pressure on prices. In late 2016, the government also imposed transaction controls such as requiring buyers to make larger down deposits in certain urban centers and limiting the number of properties individuals can own.
What’s Different This Time?
Despite new controls on home ownership that went into effect late last year, credit continues to grow – not just in construction and real estate, but across all sectors. This growth has led China’s central bank to use tools that it hasn’t implemented for several years. Since the beginning of 2017, the central bank has raised the rate on several interbank lending facilities through which it provides liquidity to banks. As a result, interbank borrowing costs increased. Among the lending facilities affected are the medium-term lending facility (MLF) and the standing lending facility, which offers a shorter-term rate than the MLF. The central bank also raised rates on reverse repurchase agreements, which banks use to provide short-term liquidity, by conducting open market operations. These moves are intended to both restrain rising prices and contain real estate and corporate credit expansion.
The Chinese government has attempted to restrain credit growth in the past, but those attempts weren’t completely effective and debt has continued to increase. To achieve greater credit restraint, the government must now use tools that either haven’t been used in the past or were only used before greater amounts of debt accumulated in the economy. For instance, the central bank raised interest rates on the MLF in 2017 for the first time since the facility’s 2014 debut. The increase also marked the first time the central bank had raised interest rates on reverse repurchases since 2013. The 2013 rate hike led to an even sharper fall in housing price growth than the hike in 2011, the last time rates were raised prior to 2013. Furthermore, declining prices in 2015 led to a rapid loosening of monetary policy to prevent a crash in real estate prices. But volatility in these cycles has been intensifying, and it is becoming increasingly difficult for the central bank to anticipate how the market will respond to each of these tools. This raises the risk of an overcorrection.
China has learned from Japan’s past and knows that raising rates too far too quickly comes with inherent risk. After Japan left its debt balloon unchecked during most of the 1980s, its discount rate was raised from 2.5 percent in May 1989 to 5.25 percent in March 1990. This increase was the straw that broke the proverbial camel’s back and tipped Japan’s economy into decline and chronic torpor. China’s central bank is moving far more cautiously and only raised the MLF and reverse-repo rates by 10 basis points. It has not yet changed its base rate.
China’s corporate and real estate debt have continued to rise. With corporate debt growing to 169 percent of GDP in October 2016, corporations are becoming less profitable. This makes it increasingly difficult for them to service debt. The increasing amount of debt makes it more difficult to predict the economy’s response to contractionary policy, especially if the government implements policy tools that are infrequently used and have been avoided due to fear of a system-wide impact.
In recent years, banks have become more exposed to the real estate sector. In theory, China’s financial system is sequestered from certain industries that suffer from greater volatility risk, including companies in sectors related to real estate (for instance, steel, construction and cement). Banks have skirted this restriction by offering off-balance sheet investments, the most popular of which are called wealth management products (WMPs). WMPs are securities owned by trusts with complicated ownership structures that often lead back to banks. This way, banks technically do not carry these assets on their balance sheets (hence “off-balance sheet”) but are ultimately still exposed to them. This has increased the financial system’s exposure to the unpredictability of the real estate market.
Chinese savers invest in WMPs because they offer higher yields than deposits. Many believe that WMPs, like deposits, offer guarantees from the federal government. However, they are not guaranteed even though the government has covered many losses from WMPs that have failed to date. WMPs and other off-balance sheet securities carry greater risk than deposits for several reasons. In addition to lacking a government guarantee, they fund riskier projects. There’s also maturity risk, meaning that many WMPs have shorter-term maturities than the projects they fund, requiring the debt to be rolled to prevent the project from default. While China has taken steps to make off-balance sheet products more transparent and require banks to carry additional reserves against them, the financial system remains exposed to real estate nonetheless.
As China continues to contract monetary policy as a way to control credit growth, real estate prices will decline. This will put pressure on projects and companies that are funded by WMPs. China will carefully manage rate hikes, knowing that too great of an increase will bankrupt developers and impact WMP investors, risking a liquidity crunch that could trigger a system-wide crisis. This doesn’t mean that investors will escape losses as rates rise – investors will suffer losses, especially those that have invested in higher-yield, higher-risk WMPs. However, China will attempt to spread the damage out over time to avoid causing too much pain at any given moment.
Risks and Implications
As it has attempted to transition from an export-based to a consumer-based economy, China has developed an increased dependency on real estate to support growth. In 2015, approximately 15-20 percent of China’s GDP was dependent on real estate (including construction, sale and outfitting of homes). It is therefore impossible to think about Chinese real estate in isolation since it is deeply tied to corporations that provide related goods and services. These companies are often politically important SOEs that struggle to maintain profitability and are supported by government policies that funnel them cheap debt.
Revenues are declining in industries with real estate ties. In the absence of government bailouts, declining revenues require cost cuts that eliminate jobs. This is already happening; China has announced that millions of jobs will be cut in the steel and coal industries in an attempt to reduce overcapacity. Although the construction companies have thus far been kept afloat by government debt, declining real estate revenues mean that they are also at risk for job cuts in the future. The construction sector is of particular political importance since many rural migrants have moved into cities to find construction jobs; 16 percent of China’s urban workers were employed in the construction sector in 2014. If the construction sector falters, concentration of unemployment will increase, which could lead to social unrest.
Debt risk is not shared equally across all companies. (Debt risk is defined as the ratio of debt with an interest coverage ratio below one relative to total debt outstanding, where interest rate coverage is the ratio of operating profit to interest expense. In layman’s terms, companies with greater debt risk struggle to repay their debt, which puts pressure on banks.) Debt risk is highest for local SOEs, especially in the manufacturing sector, which produces a number of goods used in real estate construction. Any slump in the real estate market will affect SOEs that cater to real estate. According to a paper published by the International Monetary Fund (IMF) in October 2016, 15.5 percent of commercial bank loans are potentially at risk of default. Another IMF report estimated that “total debt at risk could rise to about a quarter of total debt of listed firms in the event of a 20% decline in real estate or construction profit.”
The financial sector’s heavy dependence on real estate exposes the entire Chinese economy to systemic risk. This connection means that a downturn in real estate could quickly spread to other areas of the Chinese economy if banks face liquidity shortfalls. Additionally, decreasing housing prices could result in more non-performing loans (NPLs). While NPLs officially account for only 1.75 percent of all Chinese loans, it’s likely that the government is understating the figure. BMI Research, a financial consulting firm, estimated in a 2016 report that NPLs could be close to 20 percent of loans.
As banks have extended additional credit to real estate developers and buyers, their profitability has stagnated. China’s economy is not technically based on capitalism and therefore doesn’t revolve around profitability in theory; in practice, however, money needs to come from somewhere. A company that doesn’t generate profit can’t sustain itself in the long run. The Chinese government can’t afford to let banks fail since doing so would threaten both the financial system’s health and the critical lifeline to SOEs that provide jobs.
Providing liquidity to the banks that could keep SOEs afloat – a bailout – poses a different set of risks. The Chinese government could fund bailouts in two different ways: by printing money or borrowing it from abroad. Printing money wouldn’t actually create value; it would just redefine the store of value (currency) such that one yuan would be worth less tomorrow than it is today. Depreciating the yuan would amount to a tax on Chinese citizens by devaluing savings. However, this wouldn’t solve any underlying problems; the Chinese government would be solving one political problem (banks losing deposits through insolvency) by creating another one (people losing savings through devaluation). Although the Chinese government could minimize the effect of currency devaluation by selling a greater portion of its foreign exchange reserves, its supply of dollars is finite.
The other option, borrowing more from abroad, just delays the inevitable consequences. More external debt will handcuff the Chinese government when it reaches the upper limits of what global markets will lend. At that point, the government will have to resort to option one: printing money. Since currency devaluation makes it difficult to pay external debt, borrowing additional money before reaching this point provides even less room to maneuver.
Taxes would also be affected in a downturn. China’s local governments derive substantial revenue from land taxes. In some years, land-use conveyance fees and other property taxes account for up to 40 percent of all fiscal revenue collected by regional governments. Unlike in many Western economies, real estate taxes in China are levied on transactions, creating an incentive for local governments to encourage greater deal volume and construction. While local governments need to forward most types of tax revenue on to the central government, revenue generated from land-use right conveyance fees are an exception. This creates a mismatch between local governments, which want to maintain real estate development, and the central government, which is attempting to prevent the housing bubble from evolving. A collapse in the real estate market would therefore squeeze local governments of tax revenue that they use to fund infrastructure investment and other projects.
China is walking a fine line. To avoid a housing collapse, it needs to reduce credit expansion and put downward pressure on property prices. But the very policy tools that are available to the government for intervening in the real estate market risk impacting the financial system and politically important corporations – and, therefore, growth in the broader economy. Reduced growth means fewer jobs and greater popular dissatisfaction, which the Communist Party knows is a recipe for social unrest.
When faced with a liquidity crunch, the Chinese government will be forced to print more money. This will amount to a transfer of wealth from savers to laborers. While this will penalize those who have saved more, it will nonetheless affect all savers and not just the wealthy. However, China knows there is a limit to how much it can devalue people’s savings and still maintain order, so the country is doing what it can to avoid pulling too far on this lever.
Ultimately, there are only two viable scenarios. The first is a managed transition to slow growth that will be painful but not disastrous. The real estate market might not crash if the government can manage it carefully. Given that China has avoided a major collapse thus far by actively intervening in the market, and has Japan as a case study that demonstrates how to not handle interest rate hikes, this is the more likely scenario. Even so, political risk would still be present if China manages a smooth transition to a state of slower growth. China’s massive, poor interior population, facing a Japan-like period of stagnation, would not be content at having missed out on economic prosperity that the coast experienced during prior decades.
However, if the government overshoots with its contractionary policy, China would face more than a mere transition to slow growth. This second scenario, while somewhat less likely due to the degree of control China has over the economy, is more agonizing. A rapid decline in property prices would risk a recession in real estate that the government is carefully trying to avoid. Instead of a gradual transition to lower growth, this shock would package the hurt into a shorter time period, risking a destabilization not only of the economic system but the political institutions of the country as well.
China is between a rock and a hard place. All roads point to popular discontent.