The Chinese real estate sector is one of the most important assets of the Chinese economy. Over the past few decades, real estate has greatly contributed to China’s transition to a socialist market economy and strong economic growth. Now, however, what once fueled the Chinese economy is threatening to slow it down. Structural economic problems are emerging and real estate is among the first sectors to show signs of problems. Given the importance of the real estate sector to the Chinese growth model, failure to address these issues would likely lead to a collapse that would bankrupt the Chinese economy and devastate the global economic system.
There are many solutions to the crisis on paper, but they run counter to another Beijing priority: reducing economic inequalities. The initiative to combat inequality, known as “shared prosperity,” has been the party’s main focus since last year and is included in the current five-year plan of the Chinese Communist Party. China will have to decide whether to solve its housing crisis or stay on the course of shared prosperity. While it will try both, Beijing will likely ultimately prioritize overall welfare and postpone resolving the real estate problem until later.
China’s concept of growth – challenged by Western standards – derives from a continuing need to sustain an economy that can both support a large population and prevent the wealth gap between wealthy coastal cities and the far interior from further widening. Rapid urbanization in the country, a booming financial sector and, just as importantly, the appetites of domestic and foreign investors fueled the real estate boom in China that began in the 1990s and continues to this day.
Little control over the markets
However, relying on real estate for strong and steady growth came at a price: Beijing’s less control over market forces. From the beginning of 2000, the real estate market began to grow rapidly as investors and developers assumed the government would step in if need be given its importance. China relied on sector expansion to maintain strong economic growth and household net income, so any market downturn could only be short-lived. This optimistic assumption, however, only lasted for a moment. Beijing soon tried to contain the frenzy of speculation and soaring prices, problems that threatened to undermine China’s extraordinary economic growth.
Fearing a bursting of the housing bubble, the People’s Bank of China introduced a “three red lines” policy: an ambitious reform package to improve the financial stability of the sector by reducing developer debt, improving debt coverage and increasing liquidity. In 2020, the first year of reform, most firms saw improvements in their asset-to-liability ratios and debt levels.
However, as would be expected with the new agents, there were also some side effects. For example, some firms make greater use of minority interests and joint ventures, allowing them to increase debt through a subsidiary and offset equity on their balance sheets. This reduced the transparency of the financial statements, but not the debt. As firms could only borrow to a limited extent, their available cash and overall sources of liquidity decreased, which could undermine firms’ ability to weather short-term crises.
The main reason the three red line policy did not work as expected is that it was too low and too late. Since China has always cared to maintain the pace of growth over the past few years, the country risked reform only when it seemed critical. Unfortunately for Beijing, it was the three red lines that triggered the current real estate crisis.
It made headlines in December 2021: China Evergrande Group, one of the country’s largest developers, officially filed for bankruptcy. Despite initial government assurances that Evergrande was isolated and repairable, more cracks soon appeared in the foundation. In early March 2022, trading in shares of Evergrande and two of its entities on the Hong Kong Stock Exchange was abruptly halted. The company said it would not publish its annual results until the end of March due to major restructuring. The results have yet to be released, and although Evergrande said restructuring was underway, it naturally raised further questions and concerns about the true extent of the company’s debt.
The bigger problem for the Chinese government is that the debt crisis is by no means confined to Evergrande. As of late November 2021, several other developers are showing signs of difficulty or, like Evergrande, even failing to meet their commitments. International auditors are withdrawing from heavily indebted Chinese developers as uncertainty about the depth of the crisis grows. The fear of hidden debt has plunged some developers’ bonds, even those previously considered safe.
This represented a serious loss for China: default by Chinese offshore borrowers hit an annual record last year, with the real estate sector accounting for around a third of defaults. Every event that is taking place in the Chinese real estate sector is exacerbating the crisis and making its resolution increasingly difficult.
Despite the sounding alarm bells in the real estate sector, the Chinese government has so far focused on stability and short-term growth and has not implemented further reforms in the real estate sector. The main reason is that solving real estate problems in the short term carries a high risk of destabilizing the economy, which may threaten the authority of the Communist Party. In theory, real estate tax reform would improve market distortions by encouraging real estate speculation and boosting local government revenues.
Indeed, on March 5, the National People’s Congress unveiled a comprehensive land tax plan as one of the main goals of a joint welfare program, crowned with the slogan “Houses are for housing, not for speculation.” However, party elites criticized the plan, arguing that a tax would disproportionately burden many party members who own more than one property and would harm social stability.
The real estate reforms carried out by Chinese President Xi Jinping also did not meet the interests of the highest local authorities, whose priorities are to stimulate economic growth, secure the state budget and prevent social chaos in their regions.
Serious ramifications for the world economy
While Finance Minister Liu Kun called for a reform package to be implemented and deepened earlier this year, China’s Finance Ministry recently announced that trial property tax reforms currently in force in 10 cities will not be extended to other cities. Maintaining high levels of employment and social stability, and limiting the harm to loyal investors, are too important for Beijing to risk.
Construction accounts for about 16 percent of urban employment in China. The collapse of the industry would mean about 5.5 percent of the Chinese population would lose their jobs. Even now, when unemployment has risen from 4.9 percent. in October to 5.5 percent. in February, it is almost certain that social stability will be severely damaged. Nor will it help reduce the wealth gap. In addition, 30 percent of Chinese bank loans are allocated to housing construction, and at least 60 percent of bank loans are secured by real estate as collateral. Therefore, should the real estate market collapse, China will experience a full financial crisis that could undermine the stability of the system and have serious consequences for the global economy.
China still has ways to deal with this problem, even in its current state. Some positive changes are already happening: Chinese banks are finally ready to ease the three red lines policy to allow a safe landing for many troubled or insolvent real estate companies. The government is also encouraging mergers and acquisitions in the real estate development sector, with larger, usually state-owned, developers likely to take over financially weaker companies that have used their local government ties to borrow. But instead of a few small measures here and there, the scale of the problem is likely to require a well-planned, well-coordinated chain of shock reforms – which is currently not visible.
Despite many red flags pointing to a full-scale economic crisis, China is sticking to its Co-Prosperity Initiative and only implementing policies that are in line with the growth goals of the current five-year plan. These goals are to help maintain internal order and political stability. Under the current plan and the China Vision 2035 project, China hopes to become a “moderately advanced economy” by 2035 – defined as GDP per capita rising to $ 30,000. Even if hard reforms would cut growth significantly for a few years, this would still be a reasonable target, while it could take decades to recover from a complete economic crisis.
There is probably no better time than now for China to reconsider its priorities.
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