Will the Current Property Market Downturn in China Lead to a Financial Crisis?

Insights for What's Ahead

• There is no end in sight to China’s property downturn. Confidence from prospective home buyers continues to deteriorate against a backdrop of declining home prices and concerns about developers’ ability to finalize projects. The recent mortgage boycott is but a symptom of the confidence problem and serves as a reminder about the seriousness of the liquidity crunch faced by developers. This crunch is likely to continue given that Chinese authorities are not relenting on their drive to deleverage the sector. Even with the ongoing relaxation of property purchase restrictions and reduced mortgage rates, we expect that real estate investment and other core real estate indicators will remain weak.

• While the risks of a financial crisis are real, the likelihood of such a scenario is low. China has the necessary tools – and is using them – to manage and avoid a financial crisis. This is achieved mostly by maintaining liquidity levels in the market and intervening as necessary to prevent systemic risks, including those posed by overleveraged developers. Also, in China mortgages are basically full recourse loans, as borrowers are personally liable beyond the collateral (i.e., the property asset); and the down payment ratio is relatively high. This reduces incentives to stop paying them even in a situation of negative equity – i.e., when the value of the property asset falls below the outstanding mortgage. In fact, the ongoing mortgage boycotts have so far been isolated to unfinished apartments in stalled projects driven by a conscious decision by homebuyers to pressure developers to finish these projects, not because of household financial difficulties.

• But the economic pain is likely to increase. Estimates suggest the property sector contributes up to 25 percent of China’s GDP growth due to its importance as a driver of demand for commodities and industrial activity (e.g., building materials, household goods, etc.). Moreover, housing assets are estimated to account for around 70 percent of Chinese households’ wealth. And, finally, upwards of 30 percent of local government revenues come from land sales to developers. It is therefore not surprising that the ongoing property downturn is one of the key drivers behind China’s current growth slowdown. Looking forward, we expect demand for new houses to remain restrained, leading to continued weakness in housing prices and in property investment, which in turn will affect upstream industrial activity and important consumer spending categories. This could lead to a situation where the decrease of property value relative to households’ liabilities (not only mortgages) could weaken balance sheets to such an extent that it reduces their incentives to borrow and spend in general. This could give rise to a vicious cycle: the slowdown in economic activity negatively impacts job creation and income growth, which in turn weakens consumer confidence and reduces households’ willingness to spend. 

• A period of industry consolidation favoring SOEs is likely to follow. Chinese authorities are likely to continue relaxing property restrictions to try to boost new home sales and property investment. But there is no indication that they will stop focusing on deleveraging and reducing financial risks. This will force developers to rethink their business models and improve their balance sheets. In the meantime, we are likely to see more defaults by overleveraged developers. But there will also be winners: the sector will consolidate further, with opportunistic, well-funded developers taking advantage of the situation to acquire distressed assets at a discounted price. Many (if not most) of these are likely to be state-owned or state-backed companies and investment funds.