China Cannot Offset Its Property Bubble Easily

Commentary No economy has been able to ignore a property bubble and, even less so, offset it and continue to grow, replacing the bust of the real estate sector with other parts of the economy. Heavily regulated economies from Iceland to Spain have failed to contain the negative impact of a real estate sector collapse. It will not be different in China. China has three real estate problems: the massive size of the sector, its excessive leverage, and the amount of developer debt in the hands of average households and retail investors. According to China researcher George Magnus, writing in The Guardian, “China’s real estate market has been called the most important sector in the world economy. Valued at about $55tn, it is now twice the size of its U.S. equivalent, and four times larger than China’s GDP.” Considering construction and other real estate services, the sector accounts for more than 25 percent of China’s GDP. Just to consider other previous examples of property bubbles, the average size of the sector was somewhere between 15 and 20 percent of a country’s GDP. And none of those economies managed the excess of the property sector. Of course, the problem of a real estate bubble is always excessive leverage. Developers take on too much debt, and the smallest decrease in housing prices makes their equity vanish and their solvency ratios collapse. In the case of China, the level of debt is simply staggering. According to the Financial Times, the ratio of net debt of 19 of the largest Chinese developers stands at over 60 percent to equity. Evergrande is not even the most indebted. Two developers stand at more than 120 percent net gearing. The top 10 most indebted Chinese developers amply surpass the level of debt-to-assets that made Spain’s Martinsa-Fadesa collapse. Chinese and foreign retail investors are also heavily exposed to the real estate and construction market. Evergrande was the biggest issuer of commercial paper, and developers’ debt was sold to small investors in different packages. Furthermore, Chinese families have around 78 percent of their wealth tied up in property, more than double the United States, according to a 2018 report by Chengdu’s Southwestern University of Finance and Economics and China Guangfa Bank. China has also launched nine REITs (real estate investment trusts) that raised more than $5 billion in just a week in over-subscribed offerings in a market that could reach $3 trillion, according to Bloomberg. These three factors mean that it will be impossible for China to contain a bubble that’s already bursting. According to the Financial Times, prices of new homes across China’s biggest cities fell in September for the first time since April 2015. New home prices dropped in more than half of the 70 cities relative to August. With high leverage, prices that have risen massively above real GDP and real wages, and a population that’s heavily exposed to the sector, the impact on China’s economy will be much more than just financial. Even if the People’s Bank of China tries to disguise the fiscal impact with liquidity injections and bank direct and indirect bailouts, the real estate bubble is likely to hit consumption, utilities that have built infrastructure around empty buildings, services, and sectors that manufacture parts for construction. The Chinese regime may contain the financial implications, but it can’t offset the real estate sector impact on the real economy. This means weaker growth, higher risk, and lower consumption and investor appetite for China exposure. Furthermore, the central bank can’t solve a problem of solvency with liquidity. Property bubble-driven growth always leads to debt-driven stagnation. Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times. Daniel Lacalle Follow Daniel Lacalle, Ph.D., is chief economist at hedge fund Tressis and author of “Freedom or Equality,” “Escape from the Central Bank Trap,” and “Life in the Financial Markets.”

China Cannot Offset Its Property Bubble Easily

Commentary

No economy has been able to ignore a property bubble and, even less so, offset it and continue to grow, replacing the bust of the real estate sector with other parts of the economy. Heavily regulated economies from Iceland to Spain have failed to contain the negative impact of a real estate sector collapse. It will not be different in China.

China has three real estate problems: the massive size of the sector, its excessive leverage, and the amount of developer debt in the hands of average households and retail investors.

According to China researcher George Magnus, writing in The Guardian, “China’s real estate market has been called the most important sector in the world economy. Valued at about $55tn, it is now twice the size of its U.S. equivalent, and four times larger than China’s GDP.”

Considering construction and other real estate services, the sector accounts for more than 25 percent of China’s GDP. Just to consider other previous examples of property bubbles, the average size of the sector was somewhere between 15 and 20 percent of a country’s GDP. And none of those economies managed the excess of the property sector.

Of course, the problem of a real estate bubble is always excessive leverage. Developers take on too much debt, and the smallest decrease in housing prices makes their equity vanish and their solvency ratios collapse.

In the case of China, the level of debt is simply staggering. According to the Financial Times, the ratio of net debt of 19 of the largest Chinese developers stands at over 60 percent to equity. Evergrande is not even the most indebted. Two developers stand at more than 120 percent net gearing. The top 10 most indebted Chinese developers amply surpass the level of debt-to-assets that made Spain’s Martinsa-Fadesa collapse.

Chinese and foreign retail investors are also heavily exposed to the real estate and construction market. Evergrande was the biggest issuer of commercial paper, and developers’ debt was sold to small investors in different packages. Furthermore, Chinese families have around 78 percent of their wealth tied up in property, more than double the United States, according to a 2018 report by Chengdu’s Southwestern University of Finance and Economics and China Guangfa Bank. China has also launched nine REITs (real estate investment trusts) that raised more than $5 billion in just a week in over-subscribed offerings in a market that could reach $3 trillion, according to Bloomberg.

These three factors mean that it will be impossible for China to contain a bubble that’s already bursting. According to the Financial Times, prices of new homes across China’s biggest cities fell in September for the first time since April 2015. New home prices dropped in more than half of the 70 cities relative to August.

With high leverage, prices that have risen massively above real GDP and real wages, and a population that’s heavily exposed to the sector, the impact on China’s economy will be much more than just financial. Even if the People’s Bank of China tries to disguise the fiscal impact with liquidity injections and bank direct and indirect bailouts, the real estate bubble is likely to hit consumption, utilities that have built infrastructure around empty buildings, services, and sectors that manufacture parts for construction.

The Chinese regime may contain the financial implications, but it can’t offset the real estate sector impact on the real economy. This means weaker growth, higher risk, and lower consumption and investor appetite for China exposure. Furthermore, the central bank can’t solve a problem of solvency with liquidity.

Property bubble-driven growth always leads to debt-driven stagnation.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.


Daniel Lacalle

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Daniel Lacalle, Ph.D., is chief economist at hedge fund Tressis and author of “Freedom or Equality,” “Escape from the Central Bank Trap,” and “Life in the Financial Markets.”