15 September 2019

No Armageddon in China property market

A downturn in the property sector will have a big potential knock-on effect on domestic investment and demand in China. Total property investment accounts for 15 percent of the nation’s GDP, with housing alone accounting for 10 percent. If related sectors, such as materials, cement, steel, etc., are included, the figure is likely to be more than 20 percent. Crucially, the default risk in the shadow banking market and the rapid rise in local government debt are property-related. Hence, Beijing has a strong tendency to contain any property market shocks.

Average housing price growth has started to slow, while housing starts (a leading indicator for property investment) and sales have begun to contract (see Chart). Average housing inventory (much of it presumably involuntary, given the collapse in housing sales) rose to 12 months of supply in April from seven months a year ago, with the average inventory in tier 3 and 4 cities amounting to almost 24 months. Meanwhile, funding for property developers has tightened due to a combination of policy tightening to control shadow banking activities and to facilitate structural reforms and financial liberalization.

However, the unfolding correction may not lead to price implosion as experienced in the US due to low leverage and the lack of financial innovation. Mortgage loans account for only 17 percent of GDP, compared to 79 percent in the US and 43 percent in Hong Kong. The Chinese government requires a 30 percent down-payment for the first home, 60 percent for the second, and imposes an outright ban on buying third homes in many cities.

Most Chinese homebuyers pay up. So unlike in the US, Chinese buyers have strong staying power and are not under pressure to exit via fire sales when the market falls. There are also few home equity loans, implying that Chinese home buyers have not ‘monetized’ the appreciation of their property. So any negative effect from a property price correction on consumption should be limited.

In late 2013, the People’s Bank of China (PBoC) stress-tested 17 major Chinese banks, which account for 61 percent of all mainland bank assets and concluded that the banking system’s average Tier-1 capital ratio would stand at 10.5 percent of risk-weighted assets even under adverse conditions, including a 400 percent rise in non-performing loans and GDP growth slowing to 4 percent a year.

Research by a major mainland bank also shows that a 50 percent drop in Chinese property prices would push the average NPL ratio to its 2007-high of 6.6 percent from the current 1.0 percent. In 2004, the NPL ratio was more than 12 percent, but China’s economy and banks still operated normally through the years. The point is that even a 50 percent drop in property prices would not render China’s banking system dysfunctional.

All this may be cold comfort, as many non-standard (i.e. illiquid non-tradable) products, such as trust and wealth management products and shadow-bank lending, are tied to property. Further, mortgages form the collateral for about 40 percent of bank loans and another 10 percent of loans are backed by land. The precise ‘hidden’ impact of this property-related lending is impossible to assess due to the lack of data.

From a macroeconomic perspective, one way to approximate such a knock-on effect is to examine the risk of local government debt (LGD) on banks’ capital ratios, as most of local government borrowing and investment are property-related. We recently estimated that the rise in systemic risk stemming from the rapid rise in LGD could erode the average Tier-1 capital ratio to 7.0 percent from the reported 10.6 percent. This is still a sufficient capital ratio. So a property market correction is not yet a fatal problem, given Beijing’s ample financial resources and massive capacity to borrow under a closed capital account and a ‘selective implicit guarantee’ policy.

The broader problem is that a fall in collateral value would force banks to increase provisions, thus reducing their lending capacity, and erode companies’ borrowing capability as property is the key collateral. With China’s corporate debt estimated at 130 percent of GDP, this domino effect on the banking and corporate sectors is a real risk.

Lastly, a big drop in construction activity, even without a sharp price drop, will have a negative impact on industrial sectors, such as steel, cement, chemical, materials, machinery, metals, etc. and imports of commodities, due to their extensive linkages. Hence, commodity prices would also likely be adversely affected.

Due to the potential large knock-on effect on the economy, Beijing will almost certainly strive to avoid a property market collapse. It still has many levers available, including loosening the restrictive property policy, speeding up social housing construction, rolling out further urbanization and industrialization measures, removing the hu kou (or household registration) restrictions in smaller cities, increasing ‘targeted’ infrastructure spending and even loosening monetary policy.

A major collapse in property prices may not result, but transactions would likely contract sharply due to rising financial stress in the system, which would have a knock-on effect on the economy.

Nevertheless, a property ‘Armageddon’ is unlikely; growth will not collapse, in my view. Beijing is poised to ease policy to contain the collateral damage. Its biggest challenge is to strike a balance between injecting sufficient stimulus to prevent a property meltdown and avoiding pumping excessive liquidity that risks the revival of the old bailout model.

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Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”