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Why China’s property market matters

A credit-fuelled property bubble enabled China to maintain its incredible run of growth through the global financial crisis (GFC). However, now China has to deal with a massive excess supply of property that is causing construction activity to contract along with a range of other linked sectors in the Chinese economy, as millions of homes lie vacant.

Background to China’s property bubble

In 2007, China was constructing around 1.5 billion square metres of gross residential floor space per year (or approximately 15 million housing units) to support urbanisation, to replace old housing stock and to meet the investment needs of Chinese households. By 2013, despite a fall in the rate of urbanisation, the construction rate had reached 2 billion square metres, resulting in several million more housing units being constructed each year than new households being formed.

A serious geographic mismatch also developed between housing supply and demand. Although urbanisation generated strong housing demand in Tier 1 and 2 cities, a disproportionate share of property development was concentrated in smaller cities. Subsequently, Tier 1 cities such as Beijing and Shanghai generally suffer from housing shortages, while Tier 3 and 4 cities hold most of the excess supply.

The excess supply problem is compounded by a lack of affordable housing for domestic migrant workers who account for the majority of new urban households. Almost 60% of migrant workers live in company dormitories or on work sites, most of whom cannot afford to buy homes, even if the ‘hukou system’ allowed it. China’s government has directly contributed to the property glut, having built an estimated 46 million low-cost subsidised housing units from 2010-2015.

Moreover, unfavourable demographics are putting downward pressure on property demand. China’s working age population (aged 15-59) peaked in 2012 and is currently declining by several million people each year, while the main property buying demographic, the population aged 25-49, is expected to peak in 2015 and decline thereafter.

Most of China’s excess housing supply is vacant stock held by private investors, with the remainder sitting on the books of real estate developers, many of whom are highly-indebted. According to the China Household Finance Survey, 22% of urban housing in China is vacant.

What does this mean for China?

A build-up of unoccupied properties will ultimately lead to a major contraction of construction and linked sectors in the Chinese economy. Indeed this process is already underway. National house prices have fallen 6% in the past year and urban housing completions are down 13% so far in 2015. Electricity consumption increased by 1% over the year to April 2015, compared to 8% growth per annum in 2012 and 2013. Steel production, cement production and rail freight traffic are slowing significantly while imports are contracting, which may reflect domestic macro weakness.

A property fire sale by investors or developers could lead to large falls in prices and capital losses, rendering many developers insolvent. China’s property industry is highly leveraged, and closely linked to the shadow banking system, creating potential financial system risks. Local governments are increasingly buying land from themselves, via local government financing vehicles (LGFVs), using money borrowed from banks and shadow lenders. Many Chinese households have effectively lent to LGFVs via trusts and wealth management products (WMPs).

Real estate accounts for more than half of household wealth in China. If prices fall dramatically household consumption will follow, and some overleveraged households may be forced to sell. Household debt, around half of which is mortgage-related, has risen strongly from around 8% of GDP in 2000 to around 38% in 2014, but remains relatively low. Interest rate liberalisation, capital account opening, and the availability of alternative investments (e.g. WMPs) could also undermine property market fundamentals.

To work off the excess supply it is possible that China’s residential property construction activity could fall by as much as 50%. Real estate and related industries account for 20-25% of GDP. The housing sector directly represents approximately 10% of GDP (approximately 50% more than the US pre-GFC). The bursting of the property bubble would cause fiscal balances to deteriorate, especially for local governments which rely on land sales for around 35% of revenues. A large contraction in China’s property sector would cause a major slowdown in the economy and perhaps even a recession.

Implications for global markets

China is a key driver of global growth. Since 2010, the country is estimated to have directly contributed around a quarter of global economic growth, despite its economy only representing around 12% of global GDP. China accounts for around half of the world’s consumption of iron ore, cement, coal and steel. Should China’s economy continue to slow the global repercussions are likely to be significant, including:

  • Trade links: countries such as Brazil, Russia, Australia and Canada are vulnerable to a China slowdown and have already experienced material depreciations in their currencies against the US dollar as commodity prices have fallen. These economies may also be exposed to the unwinding of commodities-linked domestic credit booms. Other economies with major trade linkages to China, particularly in Asia and Japan, would also be adversely affected.

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  • Financial links: Although relatively nascent, links between Chinese banks and Hong Kong or Singapore could provide channels for the international transmission of a Chinese financial shock. Foreign lending to Chinese corporates has grown at a rapid pace and is focused on the property sector. Chinese property developers currently represent approximately one-third of Asian high yield non-financial corporate bond issuance and could trigger a reassessment of risk premia in the event of large scale defaults. If China experiences a recession and defaults spread across borders, an emerging markets credit crunch is not out of the question.

    .

  • Capital repatriation: Property markets in Canada, Australia, the UK and Hong Kong could be hit if investors pull out of international assets. China also has massive foreign exchange reserves and is one of the world’s largest holders of US Treasury securities.

Fortunately, the Chinese authorities appear to be taking steps to manage the housing market correction and slow credit growth. Furthermore, almost all of China’s debt is held domestically, which makes it easier for the government to manage large-scale defaults as it did in the late 1990s. With government debt at 56% of GDP, China has room for additional fiscal stimulus and debt nationalisation. The country’s huge foreign exchange reserves and current account surplus also make it highly resilient. However, if the returns on incremental spending and investment are sufficiently low the government may not be able to prevent a sharp slowdown or a recession.

While there are a number of reasons to be optimistic about China’s long-term economic future, the short-to-medium term challenges are considerable. China’s property bubble is set to burst and the economic ramifications will be widespread, warranting a cautious approach by investors.

 

Sam Churchill is the Head of Macro Research at Magellan Asset Management. This material has been prepared by Magellan Asset Management Limited for general information purposes only and must not be construed as investment advice. It does not take into account your investment objectives, financial situation or particular needs.

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2 Comments

Adam Furlonger

August 11, 2015

It is important to remember that while China’s leadership is getting comfortable bedding in expectations of a “new normal” of slower growth for the economy, they still hope it is business as usual for the pivotal real estate market.

But as expectations of subdued or declining property prices also become part of the new economic reality, Chinese households have been spurning real estate as an investment asset.

This has left developers with a problem — mounting piles of unsold property inventory and rising debt loads.

Policy makers face a challenge to ensure China is not heading into a new period of sliding prices and a spiral of debt deflation.

According to recently released figures from the National Bureau of Statistics, the ratio of unsold property to annual sales reached 51.5% in 2014, up from 24.7% in 2011.

In the first two months of this year home sales by area fell 17.8% year-on-year and 16.7% in value terms, meaning the oversupply situation is getting worse....not better.

This backlog of supply is expected to remain an overhang at least into 2017-2018 & possibly beyond.

This situation is likely to renew investors’ edginess on China’s outlook given the critical importance of property to the overall economy.

The property sector directly accounts for 25% of growth in GDP and significantly more if raw materials and related refurbishment demand is included.

Even more worryingly Property is estimated to be collateral for around half of all Chinese banks’ lending, according to many experts.

In other words it looks like everyone from Chinese Investors to Chinese Banks are currently learning what the rest of the world discovered during the GFC.....anything that goes up most certainly can come down.

Adam Furlonger

Paul Meleng

June 25, 2015

Very useful article. I find it worth remembering that the key practical difference between a private land system and "communist" is that part of the revolution is reverting ownership of all land to "the people" via the state. When that state then decides to embrace western capital enterprise it has a big asset at its disposal , being the land itself, along with every State enterprise and monopoly. The power then sits with whatever authority is responsible for that land or that service asset or resource.. A huge amount of the private wealth generated in such a change is at heart driven by whoever manages to pick up the fruits of the largesse of privatisation. (witness the overnight creation of the oligarchs of the old USSR) . The graft incentive is even greater and the unearned profits even greater than in our own land development rezoning backscratching game.
Given that our own economy is grossly distorted by that process and yet we have been free enterprise for many generations and that our economists and punters and legislators still get caught and surprised by the bursting of bubbles I wonder why people assume that the players in China would be any better at managing the forces at work. Especially when it has never happened this way before in history in such a framework and certainly never on this scale . Lets face it. Anything is possible.


 

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