Markets Insight
July 7, 2014 6:04 am
End to China’s property boom has barely begun
Financial markets are having trouble pricing the implications
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The Chinese property sector is in a recession. Market optimists insist it is going through an “adjustment” similar to previous property downturns.
A more sober view, however, is that because of unprecedented overbuilding, and leverage nurtured by the eruption of shadow banking, this downturn is both more serious and systemic. China is probably in the first stage of a denouement of the property- and construction investment-led growth model of the past 15 years. Financial markets are having trouble pricing the implications.
If this leading edge of China’s growth model saw a fall in investment growth from 20 per cent to 10 per cent, economic growth would slide by roughly 2 per cent, taking into account secondary effects. The stream of downward revisions to economic growth is not over yet.
Despite structural oversupply, the decline in property starts, sales and prices has not yet been extraordinary. Property and land prices have been declining since the end of 2013, and have further to go, but they may not collapse as a result of forced sales by households. Household leverage and mortgage loan-to-value ratios are low, and homeowners are subject to large downpayments on first and second homes.
Chronic oversupply
While weaker trends have permeated the largest cities, they are most acute in so-called Tier 3 and 4 cities, which account for almost 70 per cent of homes under construction and home sales, and almost 60 per cent of housing investment. Inventories have risen to about 15-30 months of sales in many of these cities.
Further, the intricate connections between residential and commercial property, shadow banking and vigorous credit creation raise financial instability risks. Direct commercial bank property loans form about a fifth of bank assets, but perhaps half of all bank loans are collateralised by property and land.
Banks are protected from sudden liquidity shocks by captive household deposits, but they will face problems over asset quality. Debt service risks loom large for construction-related companies, indebted state-owned enterprises with significant property financing and local governments.
Banks are also the principal sponsors of and agents in shadow banking, which has been encouraged by traditional bank lending restrictions, and grown in a few years into a near Rmb40tn ($6tn) industry, or half of GDP. The property and heavy industry sectors, such as coal and steel, have been leading borrowers, and consumers have gained from wealth management products, which pay much higher interest rates than controlled deposit rates.
Stealth stimulus
In spite of rhetoric that market forces should be allowed a greater role, the authorities have resorted to administrative stimulus by stealth as the property downturn has gathered pace.
Announced initiatives include two rounds of lower targeted reserve requirement ratios, actions to hold down interbank interest rates and ease property purchase and development conditions, and accelerated fiscal spending, and shantytown and railway investment. While these measures are helping to stabilise the economy at midyear, the harder the property downturn is resisted now, the bigger the economic and financial risks will become.
Financial markets have not yet priced for the end of China’s long-running property boom. With or without short-term palliatives, construction will support but no longer lead GDP growth, and the sector will have to work off oversupply and leverage, while adjusting to new legal restrictions affecting land clearance, resettlement of people, and agricultural land preservation.
At the very least, this downturn will not be over until we have had several quarters of declines in the ratio of credit to GDP and in property sales and transactions, non-financial sector deleveraging, and more defaults. You can see why the process has barely begun.
George Magnus is an independent economic adviser to UBS
Copyright The Financial Times Limited 2014
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