Property crunch will be followed by lasting decline

  • The root of Evergrande’s troubles – and those of other highly-leveraged developers – is that residential property demand in China is entering an era of sustained decline. Relaxation of regulatory controls on the sector wouldn’t change this fundamental constraint. Construction, a key engine of China’s growth and commodity demand, will slow substantially over the next few years, whether or not the economy escapes the current crunch unscathed.
  • Evergrande’s ongoing collapse has focused attention on the impact a wave of property developer defaults would have on China’s growth. Activity on building sites across the country would be disrupted. Sharp price falls would make it harder for developers to finance construction – even those with healthier balance sheets. Indirectly, developer defaults could trigger a tightening of credit conditions that would slow investment across the corporate sector.
  • While concerns are running high in some quarters, there is a good chance that none of these threats materialises to a significant degree. The scale of pre-sales (90% of new properties are sold before being completed) gives the authorities a strong incentive to ensure that ongoing projects continue as failing developers are restructured. That’s implicit in our view that the claims of homebuyers will be prioritized over those of other creditors. The introduction of controls on other forms of financing has pushed developers to rely even more heavily on pre-sales over the past year. (See Chart 1.)
  • We think the authorities would loosen controls on property purchases if prices fell sharply. And the PBOC would intervene with liquidity injections if financial conditions tightened: the “Three Red Lines” were intended to impose discipline on property developers, not on all borrowers.
  • But even if developers’ current financial strains don’t lead to a sharp slowdown in property construction, the outlook is poor. Developers are at the tail-end of a 25-year boom that has expanded property construction and related activities to 16% of China’s GDP, far higher than in other major economies.
  • The tailwinds that lifted the sector have now gone into reverse. Household formation has slowed. Many families see home ownership as a pre-requisite to getting married. But the number of young adults is declining: there were 31% fewer marriages in 2019 than in 2013.
  • Urban population growth has dropped by a similar amount. And “urbanisation” is anyway increasingly being driven by the reclassification of residential areas on city peripheries as urban, rather than by people moving in from the countryside and needing new homes. We expect demand for new urban housing to halve over the next 10 years. (See Chart 2.)

Chart 1: Developer Financing (RMB trn, seas. adj.)

Chart 2: Urban Housing Demand (million sq. metres)

Sources: Wind Financial, CEIC, Capital Economics

  • COVID provided something of a respite for developers: there was a surge in sales when the country emerged from lockdown – perhaps because many people had additional savings to deploy. But the fundamentals hadn’t changed.
  • Property sales have been declining again since early this year with today’s data showing that sales have now fully reversed the post-COVID boom. (See Chart 3.) Property starts have dropped off: starts were 15% lower last month than they were a year earlier when the Red Lines were announced. Developers have cut back on land purchases too.
  • It will take a while for the pull-back in starts to be reflected in overall construction activity. But stressed developers like Evergrande are also having to halt work on some ongoing projects as pre-sale revenues have dried up.
  • The decline in pre-sales has been exacerbated by current worries about Evergrande. But sales would have fallen anyway this year as the post-COVID boom faded. We highlighted this at the end of last year as a key headwind for the property sector and wider economy in 2021. Our forecasts assume that a property slowdown will lead to a slight contraction in the economy in the second half of the year.
  • In other words, while the Three Red Lines have precipitated the current crisis, they are not its underlying cause. If policymakers relax their stance, developers would have a respite, but not a solution to their fundamental problem. Their trajectory before the Red Lines were introduced was not sustainable: developer borrowing from banks, bond markets and shadow banks doubled between 2012 and 2020 from 9% to 18% of GDP.
  • In any case, we don’t expect policymakers to back down by relaxing the Red Lines. It is true that, in the past, property sector policies were used part of the cyclical demand management toolkit. Controls on purchases would be relaxed and lending to homebuyers and developers would be encouraged when the economy slowed. But there have been signs of a shift in thinking for a while.
  • In 2018/19, for example, the regulatory stance towards property was not loosened as monetary policy was eased. (See Chart 4.) We wrote at the time that “hopes for a wholesale relaxation of property controls in response to economic weakness are likely to be disappointed. If anything, policymakers appear intent on tightening their grip [due to] concerns about debt risks among developers.”
  • The impression of a new approach was reinforced when property controls were not relaxed as part of the stimulus response to COVID. And in August 2020, when many still had doubts about the strength of the post-lockdown rebound, the Red Lines were introduced. The central concerns of property policy now appear to be the level of housing costs and developer leverage. An economic slowdown is no longer a good reason for limits on developer borrowing to be relaxed.

Chart 3: Residential Real Estate Activity
(million sq. metres, seas. adj.)

Chart 4: Spread of Average Mortgage
over Average Bank Loan Interest Rate (bp)

Sources: Wind Financial, CEIC, Capital Economics

Mark Williams, Chief Asia Economist,

Mark Williams Chief Asia Economist
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