Background to China’s property bubble
In 2007, China was constructing around 1.5 billion square metres of gross residential floor space per year (or approximately 15 million housing units). This was to support urbanisation, replace old housing stock and to meet the investment needs of Chinese households. During the GFC, the economy received a huge credit stimulus and property market restrictions were loosened considerably, generating a boom in construction activity. Despite a recent slowdown in urbanisation, China maintained its high construction rate, resulting in massive excess supply of housing.
A serious geographic mismatch also developed between housing supply and demand. Although urbanisation generated strong housing demand in Tier 1 and 2 cities, a disproportionate share of property development was concentrated in smaller cities. Subsequently, Tier 1 cities such as Beijing and Shanghai generally suffer from housing shortages, while Tier 3 and 4 cities hold most of the excess supply.
Moreover, unfavourable demographics are putting downward pressure on property demand. China’s working age population (aged 15-59) peaked in 2012 and is currently declining by several million people each year, while the main property buying demographic, the population aged 25-49, is expected to peak in 2015 and decline thereafter.
According to the China Household Finance Survey, 22 per cent of urban housing in China is vacant. Meanwhile, vacant floor space on developers’ books has increased by over five time since 2007.
What does this mean for China?
A build-up of unoccupied properties held by investors and developers will ultimately lead to a major contraction of construction activity and linked sectors in the economy. Indeed this process is already underway. National house prices have fallen 5 per cent in the past year and urban housing completions are down 15 per cent so far in 2015. Electricity consumption, steel and cement production and rail freight traffic have also all slowed significantly (or are contracting).
A property fire sale could result, leaving many developers insolvent. In addition, China’s property industry is highly leveraged and closely linked to the shadow banking system, creating potential financial system risks.
With real estate accounting for more than half of household wealth in China, if prices fall dramatically, household consumption would likely follow suit. Household debt, around half of which is mortgage-related, has risen considerably from around 8 per cent of GDP in 2000 to around 38 per cent in 2014 but remains low by international standards. Interest rate liberalisation, capital account opening, and the availability of alternative investments (eg wealth management products) could also undermine property market fundamentals.
China’s residential property sector may need to contract by as much as 50 per cent to work off the excess supply. With real estate and related industries accounting for 20-25 per cent of GDP, the bursting of the property bubble would cause a major slowdown in the economy and perhaps even a recession.
Implications for global markets
China is a key driver of global growth having contributed one quarter of global economic growth since 2010, despite only representing around 12 per cent of global GDP. China is by far the largest consumer of commodities and accounts for around half of the world’s consumption of iron ore, cement, coal and steel. Should China’s economy continue to slow or face a hard landing, the global repercussions are likely to be significant.
Commodity export countries such as Brazil, Russia, Australia and Canada are vulnerable to a slowdown in China and have already experienced material depreciations in their currencies against the US dollar. In some cases these economies may also be exposed to the unwinding of commodities-linked domestic credit booms. Other economies with major trade linkages to China, particularly the emerging markets in Asia and Japan, would also be adversely affected.
Although relatively nascent, financial linkages between Chinese banks and Hong Kong or Singapore could provide channels for the international transmission of a Chinese financial shock. Foreign currency lending to Chinese corporates has grown at a rapid pace, and has been focused on the property sector. If China experiences a recession and defaults spread across borders, an emerging markets credit crunch is not out of the question. Meanwhile, property markets in Canada, Australia, the UK and Hong Kong could be hit as investors pull out of international assets.
Fortunately, the Chinese authorities appear to be taking steps to manage the housing market correction and slow credit growth. China has room for additional fiscal and monetary stimulus and could nationalise a portion of its domestic debt. The country’s huge foreign exchange reserves and current account surplus make China highly resilient to external financial shocks. However, if the returns on incremental spending and investment are sufficiently low, or if the private sector cuts expenditure, the government may not be able to prevent a sharp slowdown or a recession.
While there are a number of reasons to be optimistic about China’s long-term economic future, there are short-to-medium term challenges if China’s property bubble is set to burst and the economic ramifications will be widespread, warranting a cautious approach by investors.