Foreign Affairs: China’s Real Estate Crash

I had an article published today in the online version of Foreign Affairs, about the unfolding drop in China’s real estate market, why it is happening, and what it means for the Chinese economy.  You can access the original version here.  Those who are interested in the background to this story should check out my first article on this subject back in June 2009, which appeared in the Far Eastern Economic Review.

China’s Real Estate Bubble May Just Have Popped
A Host of Factors Are Set to Undermine the Country’s Economic Growth

by Patrick Chovanec

For years analysts have warned of a looming real estate bubble in China, but the predicted downturn, the bursting of that bubble, never occurred — that is, until now. In a telling scene two months ago, Shanghai property developers started slashing prices on their latest luxury condos by up to one-third. Crowds of owners who had recently bought apartments at full price converged on sales offices throughout the city, demanding refunds. Some angry investors went on a rampage, breaking windows and smashing showrooms.

Shanghai homeowners are hardly the only ones getting nervous. Sudden, steep price reductions are upending real estate markets across China. According to the property agency Homelink, new home prices in Beijing dropped 35 percent in November alone. And the free fall may continue for some time. Centaline, another leading property agency, estimates that developers have built up 22 months’ worth of unsold inventory in Beijing and 21 months’ worth in Shanghai. Everyone from local landowners to Chinese speculators and international investors are now worrying that these discounts indicate that “the biggest bubble of the century,” as it was called earlier this year, has just popped, with serious consequences not only for one of the world’s most promising economies — but internationally as well.

What makes the future look particularly bleak is the lack of escape routes. If Chinese investors panic and rush for the exits, they will discover that in a market awash with developer discounts, buyers are very hard to find. The next three months will be a watershed moment for a Chinese investor class that has been flush with cash for years but lacking a place to put it. Instead of developing a more balanced, consumer-based economy, an entire regime of Beijing technocrats — drunk on investment-led growth — let the real estate market run red hot for too long and, when forced to act, lacked the credibility to cool the sector down. That failure threatens to undermine the country’s continued economic rise.

Real estate woes are already sending shockwaves through China’s broader economy. Chinese steel production — driven in large part by construction — is down 15 percent from June, and nearly one-third of Chinese steelmakers are now losing money. Chinese radio reports that half of all real estate agents in the southern city of Shenzhen have closed up shop. According to Centaline, more than 100 local government land auctions failed last month, and land sale revenues in Beijing are down 15 percent this year. Without them, local governments have no way to repay the heavy loans they have taken out to fund ambitious infrastructure projects, or the additional loans they will need to keep driving GDP growth next year.

In a few cities, such as coastal Wenzhou and coal-rich Ordos, the collapse in property prices has sparked a full-blown credit crisis, with reports of ruined businessmen leaping off building rooftops; some are fleeing the country. The central bank’s decision on December 5 to lower the reserve requirement ratio for the first time in three years signaled a broader move to pump money into the economy. Beijing has directed banks in Wenzhou to extend emergency loans to troubled borrowers. Of course, officials could halt the sell-off simply by handing developers enough cheap loans to allow them to carry their inventory. But such a strategy risks re-inflating the bubble.

The impact of a housing downturn would have a significant impact globally. International suppliers who have been fueling China’s construction boom — iron-ore miners in Australia and Brazil, copper miners in Chile, lumber mills in Canada and Russia, and multinational equipment makers such as Caterpillar and Komatsu — could be hard hit. Heavy losses on real estate and related lending could damage investment and consumer confidence, undermining the rising tide of Chinese demand that has been a much-needed growth engine for everything from Boeing airplanes to Volkswagen and GM automobiles to KFC and McDonald’s fast food.

Understanding how this came to pass means parsing the host of distortions and mind games that characterize China’s real estate market. Residential real estate construction now accounts for nearly ten percent of the country’s total GDP — four percentage points higher than it did at the peak of the U.S. housing bubble in 2005. Bullish analysts have long argued that large-scale urbanization and rapidly rising incomes warrant such an extraordinary boom.

But new urban residents are not the immediate drivers of China’s recent run-up in real estate. Chinese investors, large and small, are the ones creating the market. For more than a decade, they have bet on longer-term demand trends by buying up multiple units — often dozens at a time — which they then leave empty with the belief that prices will rise. Estimates of such idle holdings range anywhere from 10 million to 65 million homes; no one really knows the exact number, but the visual impression created by vast “ghost” districts, filled with row upon row of uninhabited villas and apartment complexes, leaves one with a sense of investments with, literally, nothing inside.

The craze for vacant real estate is due in large part to a lack of attractive alternatives. Strict controls on capital outflows prevent most Chinese citizens from investing any real money abroad. Chinese bank deposits earn very low interest rates — lower, for the past year now, than the rate of consumer inflation. The public sees the country’s domestic stock exchanges, which have endured volatile ups and downs over the last few years, as little more than high-risk casinos. In contrast, real estate, which has not seen a sustained downturn since China first converted to private homeownership in the 1990s, has long looked like a sure bet.

Beijing’s response to the global financial crisis added jet fuel to the fire. To maintain GDP growth of nearly ten percent during a massive downturn in global demand, China’s leaders engineered a lending boom that expanded the country’s money supply by roughly two-thirds. Real estate was already the preferred place for the Chinese to stash cash; now, investors had that much more cash to stash. Prices rose accordingly: In many locations, the cost of prime new properties doubled in just two years.

But this run of speculation has bid up the price of housing and left people who actually need a place to live in the lurch. Given the prices prevailing earlier this spring, the average wage earner in Beijing would have had to work 36 years to pay for an average home, compared to 18 years in Singapore, 12 in New York, and five in Frankfurt. The bidding war has further pushed developers to build ever more costly luxury properties that investors crave but few ordinary people can afford.

By the spring of 2010, China’s leaders were growing increasingly worried that skyrocketing prices were sowing the seeds of social unrest. In response, Beijing imposed a series of cooling measures to rein in speculative demand. These included a stipulation for larger down payments, tougher qualifications for mortgages, residency requirements for home purchasers, and limits on the number of units a family could buy. Although these restrictions were mainly confined to Beijing and Shanghai, where central authorities hold the greatest sway, they were meant to send a clear signal that China’s leaders wanted property prices to level off.

Real estate developers, however, believed they had seen this movie before. They had witnessed earlier cooling campaigns, as recently as early 2008. Each lasted a few months before reverting back to business as usual. Local governments depend on a healthy real estate market to generate revenue from land sales (as the state owns the land), and property development has long been a key driver of the GDP growth that the central government both demanded and prized. Let them see the effects of a slowdown, developers figured, and China’s leaders would rush back in to support the sector. They always had before.

So the property developers bet against cooling. They continued borrowing and building, even in the face of a relatively soft and uncertain market. Until that point, Chinese developers had been able to move everything they built, usually pre-selling it before it was finished. But starting in the late spring of 2010, they began piling up substantial stocks of unsold inventory, for the day when the government would, so they thought, relent and demand would come surging back.

Because the industry kept on building, there has been no negative impact on GDP. Real estate investment has continued growing at nearly 30 percent annually. But inflation began to rise from 1.5 percent in January 2010 to a peak of 6.5 percent in July 2011, and authorities began to sweat. They broadened their cooling efforts. The central bank tightened credit expansion, and China’s economy began to slow. As 2011 progressed, developers scrambled for new lines of financing to keep their overstocked inventories. They first relied on bank loans (until they were cut off), then high-yield bonds in Hong Kong (until the market soured), then private investment vehicles (sponsored by banks as an end run around lending constraints), and finally, in some cases, loan sharks. By the end of last summer, many Chinese developers had run out of options and were forced to begin liquidating inventory. Hence, the price slashing: 30, 40, and even 50 percent discounts.

The biggest unanswered question is whether existing investors — the people holding all those sold but empty “ghost” condos and villas — will join in the sell-off, which could turn the market’s retreat into a rout. So far, that has not materialized. Unlike highly leveraged developers, most multi-home buyers invested their own money and do not face the same immediate pressures to sell. However, their willingness to hold idle properties depends on real estate’s reliability as a store of value — a rationale that seems to be disintegrating before home buyers’ eyes. While pre-owned home prices in Beijing fell only three percent last month, transaction volumes there and in other cities have plummeted (down 50 percent year on year in Shenzhen, 57 percent in Tianjin, and 79 percent in Changsha), suggesting that many owners would like to sell — so long as it is not at a loss — but are having trouble finding buyers. Would-be residents, who once felt pressured to buy before prices rose even further, now prefer to wait and look around for a better deal.

In recent weeks, a growing chorus has called on the government to lift restrictions on multiple home purchases — revealing, when push comes to shove, just how much the market has come to depend on investor, rather than end-user, demand. But both types of demand depend, in their own way, on the assumption of ever-rising prices. Unless that assumption can somehow be restored, neither looser regulation nor looser lending will persuade the Chinese to pile back into property. Just as elsewhere, China’s monetary authorities may find themselves, as it’s said, pushing on a string of unwilling demand.

Ironically, as Chinese investors start pulling their money out of property, many are putting it into bank- and trust-sponsored “private wealth management” vehicles that promise high fixed rates of return but channel the proceeds into investments — like real estate developers and local government bonds — whose returns are themselves predicated on ever rising property prices. Many fear this repackaging of real estate risk is laying the foundation for a follow-on crisis that some are labeling the Chinese equivalent of Wall Street’s collateralized-debt-obligation mess.

While frightening, the popping of China’s real estate bubble is not all bad news. Cheaper, more affordable housing could also unlock the savings of China’s working-class families, unleashing greater consumer demand and helping to rebalance the global economy. Investment long bottled up in idle real estate could flow to more productive pursuits. These adjustments have been put off too long. This is why at least some of China’s leaders appear determined to force a correction despite the risks. But they know they are walking a razor’s edge.