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August 25, 2023

News in Charts: Chinese real estate market falters

by Fathom Consulting.

Fathom has been warning for years that things have gone badly wrong in China’s real estate market, a fact which is now becoming widely appreciated as some of China’s biggest property developers default on their debts. The country is in the grip of a house price bubble which has put home ownership out of the reach of many ordinary people, while at the same time suffering from a monumental over-supply of partially completed and unoccupied housing stock which is being held back from the market. With strong vested interests on both sides, policymakers walk an increasingly narrow path to prevent the bubble from either inflating further or bursting abruptly.

It’s against this backdrop that China’s new home prices have fallen by 0.2% on a monthly basis in July after five consecutive months of rises, dashing the high hopes of financial market participants that the housing market would make a strong recovery after the reopening of the economy. The downturn in prices was not difficult to foresee after several months of weak economic data, as China’s recovery ran out of steam. In a speculative and highly overvalued market such as Chinese real estate, the only way for housing demand to rise is through continuous expectations of price appreciations. But market momentum has slowed and now reversed, and in Fathom’s view it is likely to prove very difficult to turn things around.

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One of the reasons for the weakness of the property market is that housing in China is still extremely unaffordable, despite some easing since 2020 as a result of regulatory policy. Fathom estimates that Chinese house prices range between 5 and 18 times the average household disposable income, depending on the province. Prices are therefore already stretched, and despite the best efforts of Chinese policymakers, with mortgage rates at historic lows and measures in place to encourage buyers, demand remains subdued. Going forward, weak sentiment among buyers will continue to weigh on housing demand, and recent policy-rate cuts will not be enough to arrest the downward momentum of prices.

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Thanks in large part to the Chinese government’s long-standing policy of stimulating the economy through debt-fuelled investment, the housing market has been in a bubble for years — a bubble that it has recently been trying to restrain by limiting the amount of debt that real estate developers can take. The result has been a dramatic fall in housing starts, which are down by more than 60% since their peak in December 2020 — a pace of decline which is ominously comparable to the US and Spanish housing markets immediately before the GFC. Despite this, there remains a substantial oversupply of construction projects in China: indeed, Fathom’s proprietary indicators suggest there is enough uncompleted housing stock to accommodate 200 million people, roughly equivalent to the population of Brazil. These houses are not reaching the market, as property developers have delayed releasing properties onto the market in a bid to avoid a collapse in prices.

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The structural problems of the housing market have made investors more sceptical about the ability of highly indebted property developers to repay their debts, resulting in a sharp fall in the value of real estate bonds. Coupled with the more challenging financing environment, and also with weaker balance sheets, this has put further pressure on property developers’ repayment capacities. Cracks in the system have already started to emerge. First Evergrande, and more recently Country Garden, two of the largest property developers in China, have defaulted on their debts and will have to go through a debt restructuring process. Country Garden’s shares have plummeted 45% over the past month, while those of Evergrande have been suspended since last year.

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In Fathom’s Global Outlook, Winter 2022, we attached a 15% weight to a scenario where the trouble in China’s real estate spilled over into the financial sector, risking a banking crisis in China. Fathom has been warning of this possibility for several years, pointing to several factors that make it more likely. In particular, non-performing loans reached 50% of Chinese GDP in 2022 according to Fathom analysis, well above official estimates of 2.5%. A chain of defaults by property developers could cause this figure to skyrocket, shaking the foundations of China’s financial system. In this scenario, house prices would fall dramatically, sending the economy into outright recession, with GDP falling by almost 10% by 2025 relative to Fathom’s baseline scenario. The consequences of such a housing market slump in China would be long-lasting — house prices remain below their pre-GFC peaks in both the USA and Spain, while Japanese house prices continued to fall for more than 20 years after its own bubble burst in the early 1990s.

Whether this scenario materialises will depend on many factors, but a key thing to watch will be how shocks in systemically important property developers feed through to the banking sector. Fathom captures the likely route through which such shocks would be transmitted in a Minimum Spanning Tree (MST) diagram, based on correlations in equity prices, which implicitly shows investors’ perceptions about the interrelationship between Chinese property developers and banks. According to the MST, investors do not perceive Country Garden as one of the most systemically central institutions; but it is only one node away from Longfor Group Holdings, which is such a central node and whose shocks could propagate quickly.

The timing and nature of the policy response to such a crisis would also be key to the outcome. Fathom believes that the Chinese financial authorities would intervene and manage to avoid a full-blown banking crisis, but not before it is too late to avoid a Japanification of the economy.[1]

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

[1] The prospects for China’s economy will feature in Fathom’s upcoming Global Outlook, Autumn 2023; charts and analysis will also be made available to Refinitiv users via Chartbook.

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