China’s Property Bubble: Will it Stabilise or Burst?
Long-sustained housing investment has been consistently observed in China over the last decade, which has prompted both fear and trepidation amongst economists, analysts and governments globally. The signs of overbuilding are apparent. The debt levels are high. At the peak of the last U.S. property boom in 2007, approximately $900bn a year was being invested in residential real estate. In the 12 months to June 2020, about $1.4trn was invested in housing in China. What might tip a late-stage industry cycle into finally bursting China’s property bubble? Or will such calamitous events never materialise, given the CCP’s far-reaching regulatory strength? Towards the end of 2020, China announced new measures to reign in debt levels amongst housing developers in the nation, which will improve financial health for the real estate sector as well as drive a wave of credit re-ratings for developers and open up opportunities for bond investors. Domestic property investor’s capital, however, must stretch further afield to foreign markets in search of stronger yields from property.
China’s Housing Market
Each year, China releases approximately 15 million new homes to its domestic market — which is five times the rate of the US and Europe combined. Housing investment directly contributes to 10% of China’s GDP annually, whilst the cumulative, indirect investment in other sectors such as materials, mining and home furnishings bring housing’s contribution to total 25% of China’s GDP. Major tier one cities have vacancy rates as low as 10%, which is low in international standards. The demand stems from all over China and internationally to buy trophy apartments in Shanghai and Beijing, making its markets as buoyant as those of central London and Manhattan, New York. Yet the vast majority of the lower-tier cities face the complete opposite issues, with a glut of housing supply from years of sustained housing investment causing vacancy in these regions to be as high as 22%, according to data from the China Household Finance Survey, showing a saturation of the markets which have reached the late-cycle. Hegang, a small town located close to China’s border with Russia, suffers from such glut and dwindling local economy that it found widespread attention from its advertisement of new-build apartments for just 20,000 yuan, which is shy of a single square metre of real estate in tier 1 Shanghai. Between 2000 and 2010, house prices on average in China doubled, whilst in Beijing and Shanghai they increased fourfold.
Debt Financing and Development Activity
As recently as the 1990s, it was illegal under China’s communist system for most citizens to own residential property. A State Council decision in 1998 banished the country’s old system of employer-allocated housing, and the new era of homeownership began. The total value of Chinese residential properties and developers’ inventory reached $52trn in 2019, according to Goldman Sachs, which is even larger than the value of the entire U.S. bond market, at $44trn. With sustained price growth over decades, it is clear that the Chinese government will not allow prices to tumble with a bubble burst, as doing so will be economically and socially detrimental to millions of Chinese citizens whose largest financial asset is held within their properties. Buyers purchase safely in the knowledge that prices are highly likely to continue to move in one positive direction and have been incentivised by plentiful opportunities to affordably lend. Citizens may worry about China’s currency depreciating during global economic slowdowns, which drives even more investment into housing as a haven. Between 2007 and 2015, credit markets supplied approximately five times more M2 cash (a liquid form of money), whilst the price of other investments fell, suggesting savers looked for safe harbour places to position their savings following the 2007-08 Global Financial Crises.
Today, corporate bond repayments amongst Chinese property developers total $100bn, according to Moody’s, whilst 10% of global debt to non-financial sectors can be attributed to China’s property sector, across both mortgages to satisfy the demand-side or towards construction financing for the supply of housing. China’s largest developer, Evergrande, has debt levels worth $120bn. A highly-leveraged industry signals warnings of an impending bust period within a cyclical market, though these concerns have been sounded repeatedly for over decade. The majority of financial crises in the modern global economy can be traced to their origins within real estate bubbles — 1991 Japan Asset price bubble, 1997 Asian financial Crisis, 2007 US Great Financial Crisis. Japan’s economy has yet to fully recover since the bursting of its asset bubble in late 1991. Real estate is a significant part of China’s economy with strong, systemic linkages to numerous upstream and downstream industries, and may be managed carefully to prevent an impending bust.
Reform and Regulation
With the Chinese Government’s strong control over its markets and financial system, the CCP has the ability to reform the debt-fuelled drive into this asset-class. China’s land system is an additional channel by which to control the capital markets, as the supply and use of land is controlled by the government and can be considered exogenous to the nation’s monetary system. Constraining or relaxing land supply controls house price inflation and the cost of capital, thus the demand for loans. Other regulations to curb the insatiable demand for housing include imposing allocation lotteries within the markets of high-tier cities, whereby lotteries allocate a limited supply of homes — first time buyers are prioritised, as are local residents who hold “hukou” permits, as well as newly divorced citizens or those who have owned their current homes for at least five years. The odds of winning the lottery, meaning getting chosen and offered the chance to purchase a home of choice can be as low as 1 in 60 in major tier one cities. Increasing down payments to 30% of the property price, serves to reduce debt levels as well as incentivising buyers to increase their personal financial prudence to avoid defaulting on their loans, given their higher equity stake.
Since the last quarter of 2020, China has implemented a “three red lines” policy to reduce the amount of debt amongst domestic real estate developers, which in turn reduces cyclicality within the sector. Access to financing going forward will be predicated on developers’ adherence to strict corporate financial criteria including liability-to-asset ratio (excluding advance receipts) of less than 70%, net gearing ratio of less than 100%, and cash-to-short-term debt ratios of more than 1x. If the developers fail to meet one, two, or all of the ‘three red lines’, regulators would then place limits on the extent to which they can grow debt. Only 11 out of 100 of China’s largest property developers pass all three measures with no curbs on debt growth. In an attempt to raise their cash assets and shed levels of debts on balance sheets, developers have held fire sales of newly-built homes at heavy discounts as much as 30% of original market values. Another method is to attract new equity investors or by spinning off subsidiary businesses, such as vertically-integrated property-management arms.
Beyond Borders: Chinese Capital in Foreign Markets
The struggle for domestic investors who are used to investing in this real, tangible asset class will exacerbate. With global central banks’ likely continued quantitative easing and a low interest rate environment through 2021, more and more investors are looking towards foreign, private markets, such as property, to seek greater yield. A sign of this capital in search of higher yields is the cyclical upswing in US Treasury Bond yields — the fact that their yields have risen above 1% for the first time since March 2020 last year when the pandemic fully took over, with bond prices falling, signalling the decreasing demand as capital searches for higher-yielding investments. By late last year, about 96% of China’s urban households already owned at least one home, according to a Chinese central bank survey released in April, far exceeding the 65% homeownership rate in the U.S. In China’s tier one cities, real estate has become not as profitable as before, and owning it entails a lot of bureaucracy. Rental yields — the proportion of a property’s value made annually by renting it out — are below 2% in major cities like Beijing, Shanghai, Shenzhen and Chengdu, less than can be made buying Chinese government bonds. The country also uses a leasehold ownership system, making any property a depreciating asset. All this points to the flight of capital from China, as investors look towards foreign markets for offshore assets.
The macroeconomic Mundell-Fleming trilemma (also referred to as the “impossible trinity”) explains the restriction of free movement of capital from China’s borders. Outflow control measures were introduced to preserve China’s $3.2trn in foreign exchange reserves, by ensuring that capital flows are either balanced or that more capital flows into the country than leaves it. China retains a $50,000 personal allowance each year for foreign exchange purchases, which is more than most people need for overseas travel purposes, but constraints investment. Chinese citizens and neighbouring countries have resorted to creative ways of transferring capital. For many years, insurance products sold in Hong Kong attracted rich customers from the mainland, who bought policies worth hundreds of thousands of dollars using Chinese credit cards, only to later cash them out in Hong Kong Dollars. In Macau, plastic watches sold for $10,000, whereby buyers purchased using their Chinese cards and received the cheap timepiece along with a stack of dollars. Regulators have continued to clamp down on outbound deals following an unprecedented flood of offshore acquisitions in 2016 that drained China’s foreign exchange reserves. These capital flows contribute to the blockbuster acquisitions and market fundamentals seen in property markets across many of the developed economies, including the US property markets and in UK and European real estate.