The debt-fueled property & construction bubble that drove its growth turned into a huge explosive mess with an enormous amount of debt.
By Wolf Richter. This is the transcript of my podcast of last Sunday, THE WOLF STREET REPORT.
It’s mind-boggling just how important the residential property sector is to the Chinese economy, to what extent government-dictated economic growth was achieved by building more apartment towers, and it’s even more mind-boggling how much debt residential property developers have racked up, and how much household wealth is tied up in the property sector at multiple levels.
Then there are the demographic headwinds the property sector has been facing for years, that are coming to the forefront.
So now there is a property crisis in China that is making the US mortgage crisis of 2008 look like child’s play in terms of magnitude.
The central government has been trying to deal with rampant real estate speculation and prevent it from going even more haywire and take down the financial system and the economy.
In August last year, the government introduced limits on corporate borrowing, known as the “three red lines,” which forced some overleveraged property developers to begin to deleverage. The government also put into effect other policy tools, such as curbs on mortgage lending.
Now we’re a year down the road. Numerous property developers are in the process of defaulting on their debts. The most indebted one of them, Evergrande, has turned into a total fiasco. It has over $300 billion in known liabilities, plus, according to Goldman Sachs, $156 billion in off-balance sheet debt and contingent liabilities.
Authorities are busy trying to prevent financial contagion and a financial crisis. And they have some unique controls to prevent a classic financial crisis:
The state owns the largest four banks, and it can tell them to lend, and it can tell them not to hound borrowers, and it can tell them to convert defaulted debt to equity, and move on, and it can clean up their balance sheets later.
The People’s Bank of China is part of the government, and it will do whatever it takes.
The government can also lean on large asset managers and brokers to buy shares and bonds, and why not, apartments.
The government owns much of the media and can lean on other media outlets, and it is already stifling financial commentary, and it thereby controls the message.
These are powerful controls to have. Not much is left up to the markets.
But the property sector is such a huge part of the overall economy and has been so important to economic growth, that financial contagion is the lesser problem.
China’s residential property market could be the largest in the world with a total asset value of $62 trillion, with a T, compared to $34 trillion for the US property market, according to Goldman Sachs Investment Research.
Apartments are what Chinese households invest in – not just one apartment to live in, but apartments as investment properties that remain empty, with households owning multiple apartments like American households own mutual funds or stocks, betting on continued rise in prices.
In the broadest sense, including the support industries, construction, real estate services, and supporting financial services, the property sector accounts for about 28% to 30% of GDP, according to numerous reports.
For years, when a province needed 6.5% economic growth because the central government said so, it cranked up the property sector. Building apartment towers just to increase GDP, whether anyone needs more apartments or not, and finance the whole thing with huge amounts of debt, is problematic, it turns out.
Chinese property developers, such as Evergrande, all together have $5.2 trillion with a T in debt, according to estimates by Nomura, cited by the Wall Street Journal. Of that $5.2 trillion in debt:
46% are bank loans – so that’s about $2.4 trillion in bank loans to just property developers.
10% are bonds, so that’s about $520 billion in bonds. They include $271 billion in the infamous dollar bonds that are now defaulting, and whose prices have collapsed, and whose yields have spiked to record highs. But these dollar bonds are only 5% of the total debt that the property developers owe.
One of the Evergrande dollar-bonds that stopped paying interest in September will hit the end of the 30-day grace period on October 23, and barring a miracle, will then be officially in default [update Oct 23: state-owned media reported that this bond payment will be made].
The prices of dollar bonds of many property developers have collapsed to 20 or 25 cents on the dollar. And the overall market of junk-rated dollar bonds in China has taken a massive hit, with yield spiking over the past few days to the peak levels during the financial crisis.
For years, there was the assumption among foreign investors when they bought dollar junk-bonds that the government would bail them out when the big S hits the fan. That had been figured into the risk calculus and price.
But that assumption is now out the window, and prices plunged and yields spiked to adjust to the new perception that there might not be a government bailout of the dollar-bonds.
And 26% of that $5.2 trillion that property developers owe, or about $1.4 trillion, are owed to apartment buyers that have bought unfinished apartments in presales. This $1.4 trillion are essentially interest-free loans by tens of millions of households to developers. If the developer collapses, those households end up with a fragment of a construction site, and their investment may be gone.
In addition, developers have borrowed from suppliers and contractors by extending the time they take to pay them.
Then there is the undisclosed off-balance sheet debt. Goldman Sachs estimated that Evergrande alone had about $156 billion in off-balance-sheet debt and contingent liabilities, such as mortgage guarantees to help people buy its apartments.
Property developers also borrowed from shadow-banks, known as trust companies, and they borrowed from individuals who bought so-called wealth-management products. Investors in Evergrande’s wealth-management products now are at risk of not getting their money back unless there are bailout arrangements from the government.
And then there are the demographic trends that started playing out years ago. They’re slow moving.
China is an immensely crowded country, and one of the cornerstones of its success in elevating hundreds of millions of people out of poverty over the course of a few decades was the one-child policy – which has now been rescinded. The side effect of this one-child policy is that the working age population began to shrink in 2012, and has continued to shrink. This means that household formation is shrinking, which means that demand for apartments to actually live in is shrinking.
But when housing becomes a financialized highly leveraged asset class, there can be nearly unlimited demand, well, until something breaks. And then what do you do with all these vacant investment properties?
In 2019, sales of new homes accounted for over three-quarters of total home sales in China, compared to just about 12% in the US, according to data cited by the Wall Street Journal.
Homeownership is already over 90% for urban households in China, among the highest in the world.
And by late 2018, 87% of home purchases were by people who already owned at least one home. They were buying to speculate in real estate.
The numbers are just gigantic. There were about 1.6 million acres of residential floor space under construction at the end of 2020, according to government data, cited by the Wall Street Journal. That would equate to tens of thousands of apartment towers.
I did a little math. The average apartment size in China is said to be 60 square meters, according to the internet. That’s 646 square feet. New construction may be larger on average, but we’ll run with that number.
So 1.6 million acres of floor space under construction, at 646 square feet per apartment on average, would mean that there are 108 million apartments under construction.
Let that sink in for a moment: 108 million apartments under construction, when urban homeownership is already 90% and when the working-age population has been declining for nearly a decade.
So this has been the business model: Build it and they will buy because apartments have become financialized investment products purchased for capital gains, and not yield, since relatively few of these apartments were rented out.
But there are carrying costs for apartments. If they’re not rented out, and if they’re dropping in prices, investors get into a very sour mood very quickly, and they’ll go demonstrating in the streets, at which point the government starts thinking about bailouts to avoid a social explosion.
But even bailouts cannot revive the old business model that led to all this. It doesn’t come at a surprise. The warnings have been sounded for years. What’s surprising is that it took so long.
Total sales among China’s 100 largest property developers plunged by 36% in September from a year earlier, according the Wall Street Journal. Sales by the 10 biggest developers, including Evergrande, collapsed by 44%.
Developers resorted to discounts to dump apartments, and those discounts hit prices in the overall market.
Home prices dropped in 16 out of 31 divisions – that’s the 23 provinces and the cities that are administered by the central government. This was the first time since March 2015 that home prices dropped in a majority of the 31 divisions, according to official data.
The situation may be even worse than the official data shows. There was online chatter, according to the Nikkei Asia, that property developers, such as Evergrande, are dumping apartments at half the original price.
Given how crucial property is to household wealth, a widespread decline in property prices is going to be a gigantic mess. Once apartment prices start declining, they’re no longer perceived as an attractive investment property, and buyers vanish, and prices drop further and sales stall.
The government can likely use its powerful controls of the system to prevent a classic financial crisis.
But it also controlled economic growth by specifying how much growth it wanted, and provinces and cities complied by producing this growth through property investments, construction projects, and the like. But it is this growth model that has led to the current debt-fueled fiasco.
Whatever the government will do with Evergrande and other developers, it will likely try to avoid a messy collapse of them. Some creditors, especially foreign creditors, may be taking big losses. Other creditors, such as households that invested in pre-sale apartments and wealth management products, may get bailed out. The biggest property developers may get unwound methodically, as the government has been doing with its big conglomerates starting a few years ago.
But that growth model of debt-fueled property speculation is finished. The model created the biggest real estate bubble ever, bogged down by an enormous amount of debt. That bubble is now deflating. The government is trying to make sure that it doesn’t implode uncontrollably.
They have their hands full defusing the risks, and some things they’ll be able to defuse, and other things will blow up. But the debt-fueled real estate speculation that was the biggest driver of economic growth is out the window. What’s left is a huge China-size mess for years to come.
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