This Blog Post talks about the infamous and ongoing real estate crisis in China, which has had a rippling effect on the global economy. The Authors begin by elucidating the origin and causes of the real estate crisis, followed by explaining the local and global impact of the same. Further, the Authors throw special light on the Indian and Pakistani economies. The Authors conclude by observing that the real estate sector shall recuperate on the grounds that the regulators of the Chinese economy shall be able to control the real estate crisis.
A. What is the China Real Estate Crisis?
China iscurrently the world’s second-largest economy. A quarter of the Chinese economycomprises the real estate sector, a significant contributor to China’s GDP. However, China’s once-booming real estate sector is currently in a dire crisis. It was blown out of proportion when hundreds of thousands of disgruntled Chinese homebuyers participated in mortgage boycotts. Simply put, these protests resulted from massively indebted real estate developers and stalled construction projects across China. However, this issue is deep-seated, has been simmering for years, and has escalated over the past two years, causing a spiraling effect on China’s economy. It is forecastedthat a 1.4% decline will likely happen in new house prices in China in 2022. According to themost recent data, China’s housing market declined significantly in August 2022, marking the 12th consecutive month of losses. This emphasizes that despite the stimulus packages offered by the Chinese Government, a revival in China’s real estate sector may take considerably longer than anticipated.
B. Origin and Causes
This is a very complex issue as the origins are multi-faceted. Real estate-related activities’ share of the GDP of China is29%, whereas, for other countries such as the United States (US) and the United Kingdom (UK), the ratiowould fall below 20%. The reason for this is the migration of people from the countryside to the urban cities of China. China’s urban populationincreased from around 111 million in 1998, when the housing reform started, to more than 600 million today. It is predicted that it may rise to 900 million by the end of2030. For many Chinese citizens, real estate is their primary form of investment. Unlike other parts of the world, Chinese citizens do not usually invest in stocks and bonds. As a result, the Chinese Government traditionally encouraged businesses to incur massive debt. Real estate prices surged due to increasing demand and lending activity supported by the Chinese local governments that received the leasing revenue. However, the liquidity problem came to the forefront when the Chinese Government unveiled the“three red line policy” in August 2020, which became a nightmare for developers. This policy aimed to constrain property developers’ debtto three specific developer’s balance sheet conditions: cash to short-term borrowings ratio to be less than 1; the ratio of assets to liabilities to be greater than 70%; and a 100% cap on net debt to equity ratio. This set a series of missed payments, stalled projects, and bond defaults in motion. It led to violations of at least one of these red-line criteria by almosttwo-thirds of the top 30 developers in China.
As a result, the Evergrande Group, one of China’s largest real-estate conglomerates and the most indebted property company, took the biggest hit. Evergrande has made the headlines for a couple of reasons – one being the default on its interest payments and the other being its unsustainable business model.Analysts argue that Evergrande was classifying properties — that it could not sell — as inventory on its financial sheet to prevent losses. Further, Evergrandewas accused of running a pyramid scheme where it took money in advance from its buyers for unfinished construction to simultaneously finance new projects at an inflated value, thereby triggering an upward spiral. Evergrandeoverestimated the value of its assets to get large amounts of debt from banks and investors and short-term loans to fund its business. It is uncannily reminiscent of Bernard Madoff’s infamous2008 scheme to use funds raised from new investors to pay back previous investors or eventually support further initiatives.
China’s real estate sector crisis has been exacerbated by its infamous “zero-COVID” strategy, which led to repeated, longer durations of lockdowns, worsening financial conditions, and extended job losses for people in China, thereby affecting their incomes and savings. In addition, China’s Sichuan provincewitnessed an extreme drought and heatwave, affecting the food and power supply. The already starved population of Sichuan province and other nearby provinces could not pay their debts to combat the real estate crisis, and thus, China’s central bankstepped in by infusing cash. However, oddly enough, a heavy burden was placed on the local governments as they weretasked with providing financial subsidies and tax breaks to homebuyers and relief money to developers. However, local governments could not cope with the crippling financial conditions as they heavily relied on selling usage rights over State-owned lands to developers, whichplummeted by 32% in 2022.
Another focal point in this crisis was the turmoil in the banking sector. The regional banks’ clients in the province of Henan found out that access to their accounts had been frozen. The local government’s hasty decision to stop the access to bank accounts by the clients was to avoid the unexpected depletion of the banks’ currency reserves, which could have contributed to a currency crisis in China. The action undermined the depositors’ faith, and they protested publicly and on social media with legitimate demands to safeguard their hard-earned money. The ChineseGovernment stepped in and ordered the release of some funds back to the depositors, which has helped to calm the citizens to a certain extent by making them place their faith in the financial economy of China once again.
While a complete collapse of China’s financial system or its economy is improbable, the Chinese Government’s attempt to deflate a $7 trillion real estate bubbleneeds a better strategy to pull it out of its current predicament.
This situation also meant that China’s financial system had to be underpinned by implicit moral hazard. This is because while the rise in debt on the banks’ balance sheets was naturally matched by a rise in the book value of their assets, the real economic value of these assets was often far less than the bookvalue. Thus, what looked like healthy balance sheets were often seriously strained and embedded with hidden losses. Banks and bank investors would only accept this condition if they believed that the Chinese Government would make these losses whole. By combining excessively high Gross Domestic Product (GDP) growth targets with an administratively determined credit allocation process (rather than a market-determined one), China consequently ended up with a financial system underpinned by moral hazard. As a result, once China ran out of easy investment opportunities, it was inevitable that there would be rising stress within the banking system and a rising risk of insolvency.
C. Current Position
According to surveys conducted by several companies, the total amount of mortgages that might be indefault could range from $150 billion to $370 billion. Various major Chinese property firmshave defaulted on their overseas debts. Evergrande’s headquarters in Hong Kong wasrecently seized.
Since July 2021, there have been 11 straight months of declining property sales in China, mostly due to mortgageboycotts. Contrary to what most observers had predicted, China’s real estate industry became far more intertwined with and linked to the rest of its economy and financial system. The ensuing commercial property crisis has initiated the dismantling of many steel companies, state-controlled asset managers, and independently-owned banks.
One may find it easy and convenient to blame Evergrande’s collapse for the problems that the Chinese property sector is facing, but the truth is that the dominoes began to tip as a result of the structural issues within financial institutions of China and the tendency for excessive risk-taking in real estate transactions. Furthermore, 50%-70% of pre-sale funds had to beretained in escrow accounts managed by the local government until 2022. However, this system exploited issues as some local governments used the pre-payment funds to promote their state-funded development and otherprograms in exchange for developers’ favors.
Policymakers are faced with boycotts, and to resolve this issue, they haveproposed a grace period for mortgage payments. However, the Chinese Government could not develop a comprehensive plan to stop the boycotts. The mortgage boycott is ongoing as disappointed homebuyers are convinced they are the targets of widespread fraud.
In the past, China’s economy was represented by the speed at which homes were built, but now, confidence in its real estate model is decreasing. In addition to debtors striking over mortgage payments, buyers are pulling out of the market, and developers are having trouble raising money. In other words, China may need to help its struggling real estate developers to save the regular people.
China’s real estate crisis severely worsens its economic problems, which are already made worse by Beijing’s harsh “zero-COVID” regulations and the slowing of global development. The World Economic Forum (WEF)estimates that for every percentage point that China’s GDP shrinks, the global GDP falls by 0.2%. According to2019 research by the US Federal Reserve, an 8.5% decrease in China’s GDP would result in a 3.25% decline for advanced economies and a 6% decline for emerging economies.
According to some estimates, real estate makes up approximately 30% of China’sGDP, which is twice as much as it does in the US. Although an economic collapse of that magnitude is unlikely to occur in China,analysts believe it may be headed for a long decline that slows down global growth in the upcoming years. Chinese real estate developers hold relatively small amounts of foreigndebt. Hence presently, the global economy does not face a high risk of a financial crisis like the one caused by the collapse of Lehman Brothers in the US. However, due to the sheer size of China’s economy and the fact that it contributes around 18.56% of the world’sGDP, a significant slowdown in China’s economy may still significantly affect the global economic recovery in the post-pandemic phase.
Unfortunately, the property crisis in China is a highly complicated situation that has the potential to cause chaos on a worldwide scale. Pre-sales undoubtedly benefit buyers because China is one of the world’s fastest-expanding real estate markets. Since 2000, China’s home prices have more thantripled.According to the income-to-price ratio for buildings in China, which is 1:34:9, it would take 34.9 years for someone making the average salary to pay for a house. In contrast, the notoriously pricey New York region has anincome-to-price ratio of 5:4. The pre-sale model has failed due to a lack of faith in the developers. Thus, the Chinese authorities must amp up oversight on the entire pre-sale mechanism instead of abolishing the practice altogether, at least in the short term.
The current crisis will also have a ripple effect elsewhere, such as on China’s currency. The US and European Union (EU) aretightening financial and policy conditions to combat inflation, while China is lowering rates to boost the real estate market and stabilize itseconomy. The US Treasury bond rates are now higher than those of Chinese Governmentbonds, and this yield differential will continue to widen over time, weakening the Chinese yuan. No country wants to be outcompeted by China; thus, a weaker Chinese Yuan will pressure other emerging market (EM)currencies. Such a depreciation might have been artificially designed to strengthen the attractiveness of China’s exports and lead to better growth and trade as against other developing economies and their currencies.
Impact of the Cut in Interest Rates by China
China is currently cutting interest rates at a time when other major central banksare hiking them to combat skyrocketing inflation. The People’s Bank of China has changed its strategy; it has alreadydecreased interest rates twice in 2022 to support economic growth amid a real estate crisis and a rise in COVID-19 infections.
The Chinese real estate sector, which is seeing a decline in sales due to developers being overwhelmed by debt, is anticipated to benefit from an easing of interest rates. The unexpected move by the world’s second-largest economy comes at a time when investors are already worried about a worldwide downturn as a result oftwo consecutive quarters of GDP decline in the US, often known as a “technical recession.”
Following a crackdown on debt (that resulted in a real estate recession in China) due to lockdowns related to the COVID-19 pandemic, China’s central bankdecreased its prime lending rate, a benchmark for market rates. China has ahigh credit-to-GDP ratio, which indicates greater involvement of the banking industry in the Chinese economy.
The real estate markets in China and Indiarepresent two opposing spectrum extremes. An expertcommented regarding the China Real Estate Crisis as follows: “The share of GDP from real estate and ancillary industries — this is work done academically — is 25 percent in China, a huge part of the economy. In India, depending on estimates, it’s anywhere between 7-9 percent. The starting point in terms of the real estate contribution to both the absolute GDP and GDP growth is much more favorable.” In addition, China’s actions have caused commodity prices to fall aftermonths of erratic oscillations in anticipation that the Chinese economy will require additional stimulus to regain momentum.
Another expertcommented on the China Real Estate Crisis: “The fall in commodity prices may aid India’s property market which has been battling with a rise in input costs, with these increases being eventually passed on to the buyers.” It wasfurther added: “With China’s interest rates on a decline and with India increasing the same, higher investments may flow into our country, which may also benefit the property market.”
According tomany experts, India’s real estate sector is in a lot better shape than China’s real estate sector. Over the past ten years, India’s real estate values have remained unchanged. An expertopined that: “In terms of the consumer, the affordability, and the developer, Chinese developers are completely clogged. There’s a lot of debt. It’s sloshing around all over unseen.”
Special Light on India and Pakistan
In the first nine months of 2021, India and China’s bilateral tradeincreased by about 50%. Additionally, China is a crucial source of imports for India, including chemicals, telecom equipment, active medicinal ingredients, and components for smartphones and automobiles. Thus, a weakening of the Indian economy will further affect the infrastructure and consumer markets inIndia due to depleted imports of electronics and FMCG from China. However, this opportunity can be very well availed by domestic Indian suppliers in these sectors to create their position in the market to establish a brand name.
If the economic crisis in China leads to a protracted downturn in the Chinese real estate sector, it might also affect India’s booming iron ore exports, as a large portion of it is bound for China. However, the crisis in China could be aglimmer of hope for steel producers in India. The reason behind this is thatone-third of the steel mills in China may be on the verge of bankruptcy because they rely on the real estate market. Hence, this might provide an opportunity for Indian businesses to replace Chinese steel firms and assert their position globally. The collapse in the Chinese real estate sector wouldlower commodity prices, which should benefit India shortly. It is in the best interest of Indian developers to evaluate their financial risks critically and reconsider their business strategy to make it more robust in the current economic setup. The slowing Chinese economy can trigger an investment outflow from India. However, on the flip side, if India can expedite the economic reforms, it can become the next global manufacturing hub.
Pakistan’s 2021-22 Economic Surveyprovides an overview of the extent of its debt to China. It currentlyowes $87.7 billion in debt. Pakistan’s protracted economic catastrophe resulted from careless borrowing that China encouraged. The military hasreceived an 11% boost in budgetary funding, while other departments like education, housing, and health have reduced budgets. All this is taking place while Pakistan is on the verge of a financial collapse. Due to this, there has been an unusualreaction against Pakistan’s military.
Uncertain and undisclosed conditions between the countries were used to fund the ambitious China-Pakistan Economic Corridor (CPEC), presumably where a sizable portion of the Chinese loan has gone. It is a known fact that Chinese lenders require strict confidentiality from their debtors and do not release a granular breakdown of their lending. In 2015, the Governor of the Central Bank in Pakistandisclosed that: “I don’t know out of the $46 billion how much is debt, how much is equity and how much is in kind.” He alsodeclared that even he did not know what the debt implications of CPEC were.
The International Monetary Fund (IMF) reportedly demands that Pakistan renegotiate the energy contracts for the CPEC before granting assistance. A studyrevealed that the cost of the CPEC power projects was much higher than equivalent projects overseas and that certain loans were granted for CPEC power projects at Libor + 4-4.5%. Hence, with such large economic dependence on China, Pakistan will likely take the most drastic hit due to the Chinese economic slowdown.
At least 70property-relaxing measures have been enacted by various local governments since President Xi Jinping’s Politburo encouraged them to take action to defuse the property crisis. These measures include decreasing the minimum down payment requirements and requiring parents to utilize their housing benefit funds to help their children buy homes. While the national Government has refrained from the directstimulus, it has given local governments implicit clearance to roll back property austerity restrictions. The State Council, chaired by Li Keqiang, Premier of the Chinese Government,recommended that local governments support necessary housing demand with city-specific financing regulations in late August 2022. Similar hints were given inApril 2022 in response to statements made by President Xi Jinping’s Politburo of the Communist Party, which suggested that local governments may “refine” their housing regulations to ensure market stability. Shanghaieased acquisition restrictions in the Lingang neighborhood, home to cutting-edge companies like Tesla. Non-local employees of those companies can now acquire one house after a year. Certain municipalities, most notably Taizhou in eastern Jiangsu province, changed the necessary down payment amount for homebuyers subsidized by the Provident Fund. Further, the minimum required down payment for second houses isreduced by as much as 20% points in several tier 2 cities, which are sometimes referred to as regional centers. These cities include Nanjing, Suzhou, and Wuxi. It has beenpredicted that Chinese cities will continue to optimize their real estate laws in light of their particular circumstances, notably by improving the financing choices available to local real estate developers.
The Chinese real estate sector is too large to fail. Thus, it is highly probable that the regulators will bring the present situation under control. It has beenreported that the Chinese Government has given the Ministry of Housing and Urban-Rural Development authority to push State-owned banks and developers to reach a compromise. The difficulty is that this strategy relies on spending additional State resources to address the problem, which is not viable in the long term. It will take a miracle to entice foreign creditors back to China’s real estate market because they have already lost billions of pounds investing in Chinese real estate bonds. The longer it takes to develop a comprehensive strategy to deal with the rapidly growing real estate issue, the more likely it is that China will experience a hard landing in its economy.
About the Authors
Ms. Pallavi Parmar is the Founding Partner of Vidhigya, The Advocates. She extends her heartfelt thanks to Ms. Somya Singh, Advocate for assisting her in doing research and structuring this article while giving her valuable contribution.
Ms. Charvi Devprakash is a 4th-year Law Student from PES University, Bengaluru.
Managing Editor: Naman Anand
Editors-in-Chief: Muskaan Singh and Hamna Viriyam
Senior Editor: Pushpit Singh
Associate Editor: Charvi Devprakash
Junior Editor: Intisar Aslam
Preferred Method of Citation
Pallavi Parmar and Charvi Devprakash, “The China Real Estate Crisis: Falling Blocks to the Chinese and Global Economy?” (IJPIEL, 28 November 2022).