The economic rise of China can be compared to a fable. It has enabled one of the largest transformations of living standards in humanity’s history. Before 1980, most Chinese people lived in the countryside and primarily worked in the peasantry. The massive economic development initiated by Dan Xiaoping resulted in the largest rural-to-urban migration in history. Ordinary Chinese, who mostly maintained a similar living standard for thousands of years, suddenly moved to the city in droves for better opportunities. This massive migration of people, coupled with better economic conditions and a disposable income, raised the need for houses. Ordinary people considered owning a home a status symbol. People’s reluctance to invest in other places like the stock market or bond market made real estate a very attractive investment destination. Real Estate companies capitalising on this demand started taking up various projects nationwide. For over two decades, the growth story seemed too good to be true. There was a widespread belief that property prices would always go up as there were plenty of customers and investors. Large international foreign lenders also invested heavily to cash in on this modern-day Chinese gold rush. They predicted the Chinese government would always let its real estate sector succeed. The principal argument behind this assumption was that this sector plays a vital role in the overall Chinese economy. It employs many people and has multiple industries dependent on it, like steel, cement, and tiles. Over half of total steel production in China is used in the real estate sector. A slump in this sector leads to a slump in the entire economy. So why did it come to this?
In China, most of the property is owned by the government, and in the past, it was the state’s responsibility to provide people with housing. But most of the housing was dilapidated. The largest rural-to-urban migration in history in the world’s most populated country created a massive housing shortage. To ease this, the government allowed private development and ownership of property. The local governments leased properties by providing subsidies to develop them. This was also an important revenue source for the local government to collect funds for other projects and their everyday operation. The massive demand for real estate led to the creation of large real estate developers who started developing projects by taking on high amounts of liability. The Chinese real estate market works differently than in most places. In the United States or Europe, one can pay the downpayment and then pay the rest in instalments or other payment plans at the buyer’s convenience. In China, on the other hand, buyers must pay the property price in full before the project is ready. The real estate company then uses this money to invest in different projects and complete the running projects. This was a game of high risk, high return, which ultimately bet on specific market conditions like the continuous rise of property prices, never-ending demand, and the faith that the Chinese government will always have their back. This started a construction frenzy; in 2020, Evergrande, the largest realtor in the world, reportedly generated revenue of over 70 billion dollars. The transaction of these large volumes of money widely led to the creation of the belief that this company was too big to fail. A company deemed too big to fail and has a history of giving extremely high returns on investment will never run out of credit to fund its projects; at least, that is what most people thought.
Then came the pandemic. It had a far-reaching social and economic impact on the Chinese consumer’s mindset. People were stuck in lockdowns and faced financial difficulties. Households started taking up austerity measures to cut costs. It was also found that 80 to 90 per cent of the Chinese population owned homes, and 20 percent owned more than one home, which they bought as a form of investment to park their money. But this unsustainable growth of the real estate market was taken as an alarming sign by the Chinese government, and past events like the Japanese housing bubble crash in the 1990s and the global financial crisis of 2008 triggered by a housing bubble in the US market forced them to roll out a new policy called the three red lines policy.
- Liability to asset ratio (excl. advance receipts) of less than 70%
- The net gearing ratio of less than 100%
- Cash to short-term debt ratio of more than 1x.
If the developers fail to meet one, two, or all of the ‘three red lines,’ regulators would limit how much they can grow the debt. Large companies like Evergrande and Country Garden started to feel the cash crunch. It became tough for them to manage funds to complete existing projects and undertake newer ones. They failed to pay their loans and defaulted. This created a very negative reputation of the Chinese real estate market internationally. Evergrande was liquidated after it constantly failed to pay back its creditors. Country Garden is on the verge of bankruptcy.
To counter the three red lines, Beijing may allow some property firms to add more leverage by easing borrowing caps and pushing back the grace period for meeting debt targets set by the policy. Regulators could extend the deadline by at least six months, initially June 30, the report cited people familiar with the matter. Under the new proposal, China will ease restrictions on debt growth for developers depending on how many red lines they meet, easing borrowing caps for companies that meet all three thresholds. The Chinese economy relies heavily on real estate, so they must reestablish confidence in this sector. The city government of Suzhou in eastern Jiangsu province plans to buy about 10,000 new units, the newspaper reported, citing market information. Jinan City in Shandong province proposes purchasing 3,000 units to rent out. This shows the trend of local governments taking over some of the burden from the heavily leveraged real estate sector.
More recently, the authorities have appropriately focused on containing risks and helping the sector transition to a more appropriate and sustainable size. They took resolute action to rein in excessive developer borrowing and other property sector risks after the start of the pandemic. Real estate activity has since contracted sharply, and most recently, the authorities have aimed to boost rental housing, expand affordable housing, and upgrade under-developed urban neighbourhoods. Due to structural factors, particularly demographic change, China’s housing market faces additional pressures in the coming years. The need for additional new housing will diminish in coming years as the population declines and urbanisation slows. Large public subsidies in the previous decade helped millions move to newer housing from older buildings lacking modern amenities. Such demand will likely be more limited as depressed land sale revenues have tightened local government fiscal constraints and fewer residents live in older housing.
Facing these cyclical and structural adjustment pressures, housing investment is poised to fall further and likely remain subdued. The IMF recently projected new real estate investment into the medium term based on several scenarios for the evolution of fundamental demand and the impact of the overhang of inventories and other supply-side pressures. In these scenarios, IMF analysis shows that real estate investment would likely fall 30 per cent to 60 per cent below its 2022 level, rebounding only very gradually. This would be comparable to significant housing downturns in other countries with similarly sizable slowdowns in starts.
Increases in spending on affordable housing and urban redevelopment that are planned this year could help offset some of the investment declines. However, this spending is not likely to sufficiently reduce the large overhang of housing inventories held by troubled developers. However, a shorter and smoother transition for the real estate sector is achievable. Allowing more market-based adjustments in home prices and quickly restructuring insolvent developers will help clear the overhang of inventories and ease fears that prices will gradually decline. Rules allowing banks to avoid recognising bad loans to developers should be phased out. The authorities should also support viable developers and tighten regulations to prevent future build-ups of risk. Insuring homebuyers against the risk that developers fail to complete purchased homes could help restore confidence and ease sales pressures for developers. Stricter escrow rules for presale financing would also help improve legal protections for homebuyers. A nationwide property tax and improved pension or other saving options would help reduce households’ need to invest in housing. Fiscal reforms that close local governments’ structural mismatch between revenues and spending obligations will also be needed to reduce their reliance on land sales and property activity.
