HSBC is hopeful that China has the cure for its property woes:
China’s housing market continues to reel. The latest challenge is the refusal of a small group of homebuyers in recent weeks to make mortgage payments for unfinished homes.
Not only could this hurt sentiment among homebuyers more broadly, but it could also add financial stress in the wider construction sector, with some suppliers of affected developers also at risk of stopping debt payments. Given the importance of the sector for the wider financial system, the risks are evident. Here we address the key questions from clients about how to assess the situation and what happens next.
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1) Is this the start of China’s mortgage crisis? We don’t think so. Unlike the US subprime mortgage crisis back in 2008, which stemmed from loose underwriting standards and over-securitisation, China’s housing market, especially on the consumer finance side, is on safer ground. China’s mortgages are largely plain vanilla products, with much higher down-payment requirements, and most mortgages are kept on banks’ balance sheets. The mortgage non-performing loan (NPL) ratio is quite low, at 0.3%, compared with more than 1.5% for other types of commercial loans. Unless there is a significant correction in prices, it’s not rational for homebuyers to walk away from mortgages – after all, without a nationwide personal bankruptcy framework, the personal consequences of a mortgage default are likely to be quite severe.
2) What drives mortgage boycotts, an unwillingness or an inability to pay? It’s more about the unwillingness to pay. The risk is concentrated in projects from distressed developers, as homeowners are concerned about when, or even whether, they will ultimately receive their homes. That said, slower economic growth and incomes have likely contributed to the frustrations of many.
3) Are banks and financial regulators concerned? Yes, given concerns around asset quality and whether banks can keep expanding credit to bolster the economy. If the situation continues to deteriorate, this could mean a broader slowdown in home lending and rising NPLs, further complicating China’s economic recovery.
4) What are the solutions to end the housing market saga, and 5) how can the moral hazard be avoided? One solution could be a comprehensive bailout plan to restore market confidence. This would be aimed at distressed developers, allowing them to complete projects, albeit without exacerbating issues of moral hazard. A public housing, or rental component may well be part of such a bailout strategy.
Except, why would it restore market confidence when “houses are for living in, not speculation”. The problem is the marginal investment buyer’s faith in the system is broken and rightly so. Beijing has broken it on purpose.
Nor do I see moral hazard as a problem for the supply side. So long as the three red lines policy remains in place then the development sector is on notice and there will be releveraging.
The bailout may work to restart some projects but sales and starts will not be rescued. Pantheon agrees:
China’s Property Rescue Fund will not be a Cure-All
China has reportedly signed off on a plan to set up a real estate fund to provide financial support to property developers. The fund currently sits at RMB 80B, with RMB 50B from China Construction Bank, and RMB 30B in relending from the PBoC, and could be scaled up to RMB 300B with further bank contributions. This money could be used to revive stalled projects, buy developer bonds, or take equity stakes; details are sketchy at this stage. Projects completed using the funds would then be turned into rental properties, supporting the government’s goal of boosting affordable rental housing, a possibility we highlighted earlier this year.
Is RMB 300B enough to fix the property sector’s balance sheet? So far, around thirty companies have defaulted, with total liabilities of around $1T, or RMB 6.7T. This arguably overstates the problem, as the fund seeks only to restart stalled projects, not repay the sectors’ total debts. We can find a measure of stalled projects on developer balance sheets in the form of inventory, though data is often available only until 2020.
Even so, the funds seem inadequate for a sector bailout. Consider just those high profile, early default developers: Evergrande, Sunac, and Shimao. Between them, inventories stood at RMB 2.3T in 2020. Given the fund aims to support at least twelve developers, the total inventory stock is certain to be far higher. Inventory valuations are doubtless inflated, but even allowing for some hefty discounting, RMB 300B is surely not enough to mop up all of this stock. For example, development profit margins reportedly stood at around 20% in 2020, so buying at cost might allow the fund to acquire RMB 375B of inventory. It is also a mere fraction of annual real estate investment, which in 2021 stood at RMB 18.2T.
We think the aim of the fund is to head off social unrest, rather than rescue property developers. A recent mortage boycott has spread rapidly across China, the kind of social movement guaranteed to give central government officials palpitations. The boycott stemmed from the stalled completion process, with many homebuyers servicing mortgages on properties which risked never materialising. The fund will likely target the most delayed projects, and those with the largest share of boycotting mortgagors. In addition to cooling hot tempers, speeding up completions should also boost consumer confidence, given the centrality of property to household wealth.
Homebuyers are the clear winner from this policy. The construction sector should also benefit, again helping to tamp down social unrest; property developer suppliers had themselves started to complain about unpaid bills and stopped repaying debts, in some cases. Restarting stalled projects will ease their cashflow problems, and give them a lower risk counterparty in the form of the central government. This will also improve the employment situation, which needs all the help it can get.
Not a property panacea
Whether the property fund will benefit the rest of the sector is less clear. To maximise the policy impact, Beijing is likely to insist on sizeable discounts when taking over stalled projects, which crystallises losses for developers and their financial backers alike. An increase in the supply of rental property should also reduce the rental yield. So while homebuyers may be more confident that properties will now be built, they will also have to factor in a lower financial return if buying as an investment. We would like to see more details, but we are unconvinced for now that this is as positive for developers as the market seems to think.
As with other batches of stimulus this year, the impact on commodities is also likely to be muted, relative to expectations. The support from major banks will prop up the credit impulse, but the funds are being channelled into existing projects, rather than new developments. We assume that at least part of the required raw materials have already been ordered, so the commodity multiplier will be lower than normal.
Plans to issue special bonds to support shantytown redevelopment have also been reported, but details here are even sparser. It does, however, suggest a recognition that the existing focus on infrastructure is insufficient to support growth, thanks to the conditionality imposed, and the straitened circumstances of most local governments. A 2018 shantytown development project ran to RMB 1.8T, over 10% of that year’s total property investment, so the scope for support is significant. This would also be materially supportive for commodities, as it would represent entirely new construction. Again, we need to see details of the planned project size before getting too excited.
What is encouraging, however, is that the central government is gradually taking on more balance sheet risk—China Construction Bank is ultimately backed by the central government—and more of the fiscal burden of supporting growth, rather than piling more obligations onto overburdened local governments. The rumoured policy support follows a similar sized package for infrastructure from policy banks earlier this month. The numbers are small as a share of total investment, let alone GDP, but policy is at least headed in the right direction. The key downside risk to our forecast—that central government would fail to recognise the scale of the macroeconomic challenge—is receding.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
