China's property industry is too big to fail

Andrew Papageorgiou

Realm Investment House

It is no accident that Chinese mega property developer Evergrande is struggling to stay ahead of its creditors and nor is it alone — it is all part of the central government's plan to cool down the speculators and rebalance the economy.

President Xi Jinping's crackdown on reckless borrowing in real estate has triggered a liquidity crisis for developers in a deliberate signal that the era of rampant profiteering in the housing market is over.

It is clear that the Chinese property market is the target of broader state reforms.

Weakness in this sector was set off by deliberate market intervention targeting speculation and the inefficient allocation of capital resources.

When trying to understand the events of 2021, we need to understand the Chinese Communist Party's "common prosperity" platform.



Income inequality in China is a growing problem. The concentration of wealth in the top 20% is greater than in the US and other large European economies.

Common prosperity aims to share the bounty of Chinese modernisation more broadly and address the perceived ills that developed during the nation's rise.

Other government interventions in the education, healthcare and gambling sectors are meant to protect the aspirations of lower and middle classes, and refocus society on the CCP’s original egalitarian vision.

'Houses are for living in'

In relation to property markets, the view is clearly that housing is in a class of its own. As President Xi told the 19th party congress in 2017, “Houses are for living in, not for speculation.”

The party is signalling its intent to substantially slow growth in the sector to deal with a pressing social issue. The problem is, a significant part of the Chinese economy has been set up around property speculation.

For example, selling land has become a significant source of funding for the state. Government land sales totalled more than US$1.3 trillion last year, almost as much as collections from income and sales taxes.

Before the CCP clampdown on leverage, the majority of this land was banked by developers.

They would secure a development pipeline while simultaneously ramping the valuations on land, creating a virtuous cycle that allowed them to increase their leverage even further.

Meanwhile, developer market share concentration has progressively risen. The ramping of leverage and land prices have created a concentration of risk within fewer names in the sector.

For these reasons, it is perhaps reasonable that the CCP has sought to reduce the concentration of systemic risk to developers.

More to the point, the party aims to dilute the centrality of developers as allocators of capital in the sector.

Leaders know to tread carefully

That said, property in China is too big to fail. The Chinese property market is over US$60 trillion in size, making it the largest single investment asset class. It comprises more than 60% of household wealth.

As you would expect, the property sector and real-estate investors are heavily indebted to the Chinese banking system. In turn, the Chinese banking system is the largest in the world, maintaining an asset base of more than US$50 trillion. By comparison, US banking assets total a paltry US$23 trillion.

Clearly, a disorderly collapse of the Chinese property market is not in anyone's interests, least of all the CCP's, given that 70% of households own property and many hold additional apartments as stores of wealth. That said, the status quo could not continue.

Ultimately the state will look to re-assert its control over housing and reduce the importance of developers and the concentration of systemic risk.

How the state is stepping in

We are starting to see signs of how the credit markets are being deflated. The Chinese are allowing state-owned firms to increase their leverage and purchase large projects from highly indebted developers.

The aim is to ensure citizens do not suffer the loss of deposits or apartments. This is important, given developers were using pre-sales to get around credit curbs even before the clampdown this year.

In essence, developers have used ordinary citizens to drive up leverage through pre-sales, which in turn forces the developers into more development, and so on and so forth. This is obviously unsustainable.

These state-owned enterprises will be funded by the bloated Chinese banking sector, meaning the problem can stretch over the horizon and be dealt with over time.

We have also seen “high-quality” state-owned developers authorised to issue asset-backed securities to fund development.

This loosening of financial conditions to facilitate the orderly transfer of assets and projects will protect people while facilitating a significant shift in market share away from private developers and towards state-owned firms.

Sales of new developments plummeted 20 to 30% in September and October, historically a peak period for sales. This coincided with a small drop in property prices. This is completely reasonable in the context of 10 years worth of vacant stock.

Nonetheless, the decline is the worst since 2015, when investors were worried about the Chinese economy making a hard landing. The reversal then was 0.2%, a minuscule number in the context of today's data.

Absorbing an oversupply

The reality is, gauging Chinese property prices is difficult. What we do know is there seems to be a split: prices are still rising in China’s bigger cities due to land scarcity and often a shortage of housing, while the rest of the country suffers from excess supply.

Rhodium Group research suggests household formation rates in China have fallen from a peak in 2015 to between 5 and 7 million people a year. Compare that with a stock of uninhabited apartments of 60 to 70 million units.

It is important to understand these empty houses and apartments are not abandoned. The prevailing cultural practice in China is to keep apartments uninhabited so they maintain their value as a hedge against inflation.

However, given the unoccupied stock equates to more than a decade of household formation demand, it is doubtful construction can maintain its current cadence.

If houses are for living and there are more than enough to live in, what does that mean for the construction sector?

It is important to note that housing and construction make up 20% of the Chinese economy. However, adjustments to Chinese GDP estimates have been modest.

We have seen a reduction in 2022 and 2023 consensus numbers of about 0.2%, and 2022 estimates have fallen from a July peak of 5.6% to 5.4%, according to Bloomberg consensus numbers.

That said, there is a reasonable dispersion. Bank of America has reduced its GDP estimate by 2.2% in recent months, while J.P. Morgan forecasts a 1% reduction. These forecasts seem consistent with a view that construction will slow meaningfully from here.

Implications for Australia

In terms of global impact, China’s share of GDP might be less than 20%, but in recent years it has made up almost 30% of the world's GDP growth.

When you consider multipliers via China's influence in the ASEAN region and "belt and road" global infrastructure development strategy, the number is likely much higher still.

China has been the world's growth locomotive for decades and Australia has been a primary beneficiary. Raw materials, agricultural products, tourism and education have all benefited directly from the Chinese phenomena.

The Reserve Bank of Australia has used its macroeconomic modelling tools to simulate a range of scenarios around a Chinese slowdown.

As recently as 2019, a comprehensive report was written on the spillover impact to Australia from a severe Chinese slowdown.

The report noted that weak financial linkages would reduce the risk of borrower non-performance being directly transmitted to Australia. However, it noted that economic spillover effects could be substantial, especially after considering the flow-on impact of a slowdown on China's trading partners.

The report estimated that a 5% reduction in Chinese growth could reduce Australian GDP by a meaningful amount over a three-year period — about 2.5% if direct and indirect channels are included.

Shock absorbers such as interest rates and currency offsets would reduce this number.

Where a slowdown would be felt

The most affected would be exporters of commodities, particularly inputs into the construction process — most notably iron ore and coking coal for steel production, and thermal coal and natural gas for cement production and general manufacturing.

Such a slowdown would also be expected to meaningfully impact Australia’s education and tourism sectors, or at least impair the post-COVID recovery.

From a credit investor's perspective, the volatility in US dollar bonds issued by Chinese real estate developers is big news. The market these bonds exceeds US$170 billion across over 340 securities. Evergrande is the most notable issuer, carrying US$14 billion of that market.

While our financial institutions and domestic Australian investors might have limited direct exposure to the Chinese real estate sector, notable secondary effects flow through indirectly.

The volatility has been disruptive for Asian private bank clients and institutional managers, and could increase their risk aversion.

Given that Asian investors have increasingly become involved in Australian issuance in both Australian and US currencies, such risk aversion tends to soften overall demand, making issuers more reliant on domestic and US investors.

Expect caution, not drama

That said, the Chinese government is unlikely to allow events to become disorderly. While investors can expect some burden-sharing to involve certain names, it is hard to see China throwing away a decade of hard work building confidence in its debt capital markets.

At the time of writing, the more prominent Chinese real estate names in US dollars have bounced strongly off their intra-month November lows.

The Chinese authorities have started to relax their leverage limits with a view to allowing an orderly transition of assets and projects to higher quality firms. This is seen as being credit-positive overall.

Meanwhile, there is a great deal of debate about how big the debt problem actually is. Many point to the Chinese commercial paper market as a significant source of concern.

This debt market suffers from poor disclosure and is used informally as a form of non-bank funding. In 2020 alone, US$550 billion in Chinese commercial paper was issued.

Chinese regulators estimate the shadow banking market had almost US$13 trillion outstanding in 2019, almost 90% of GDP at the time.

In this market, various issuers attract capital through wealth management and fund products, attracting the savings of ordinary Chinese people with generous rates that often finance highly leveraged and speculative activity.

This market is significant in a global context, but the transmission channels outside China are limited, given it is based on the savings of ordinary citizens.

It is difficult for authorities to force burden-sharing in this market, as ordinary people would be affected.

On the dawn of an historic third term for President Xi, it is unlikely such a drastic step would be taken, given the impact on the middle class.

The big players will do the lifting

All of this points to the need for Chinese state-owned enterprises and banks to swallow the poison and digest it slowly over the decades to come.

In some ways, the action of Chinese central command is reminiscent of the approach Japanese regulators took in the 1980s when faced with a problem of similar gravity.

As such, the most plausible impact on us here in the Antipodes would be via a significant slowdown in Chinese real-estate development.

We should expect that weakness to flow through the direct channels of commodities and energy, and possibly also affect the post-COVID recovery of our services sector. The most notable effect might be on short-term interest rates.

These events may support the view that rate rises are unlikely in 2022 and if Chinese property weakness spreads, we could see a change in forward assumptions for 2023 and 2024 that would further impact the current rate path projected by domestic bond markets.

If this materialises, Australian investors might find the current very low rate environment becomes entrenched, and the challenge for yield will continue for retirees and savers.

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Andrew Papageorgiou
Founder, Investment Manager
Realm Investment House

Over the last 20 years Andrew has gained considerable direct investment experience in dealing in domestic and international equity markets, derivatives, direct infrastructure (equity, debt & structuring), real estate (equity & debt) and private...

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