What a difference a month makes. China’s central government has popped its own real estate bubble, trading the nameplate wealth of its middle class and local government revenues in the short-term for more sustainable urbanization and job creation in the mid-term. While this will not evolve into a financial crisis for China, there is a 25% probability that local governments will receive a bailout before 2015 to maintain solvency.
Stoking the Fire
A massive real estate bubble has been looming ominous in China. The bubble has been most apparent in the cities of Ordos and Wenzhou where speculation is most extreme. In these areas, private lending networks have given investors quick and quiet access to loans to invest in speculative real estate projects. In the beginning, many residents became overnight millionaires, stoking local appetites for risky bets. A survey conducted in October showed that in Wenzhou, 60% of local businesses and 89% of households were tied together with outstanding private loans totaling RMB 120 billion, most of which has been invested in local real estate development projects.
Easy access to unofficial loans caused the hyperinflation of a real estate bubble, boosting the price of commercial real estate in Ordos by more than 1,600% since 2005. According to a survey done in October, the average household in Ordos owns three condos – an investment phenomenon that has produced 168 empty high-rises in this city, alone. Ordos only has one-tenth the population of Beijing, but still managed to sell two-thirds the square footage of real estate in 2010, 98% of which was previously unoccupied.
Although less extreme, a similar real estate bubble has been growing in the first-tier cities of Shanghai, Beijing, Shenzhen and Guangzhou. In Shanghai, real estate prices have risen more than 150% since 2003, and the average apartment is now more than 40 times the annual income of the average citizen. In Beijing, growth in real estate prices have outpaced increases in income by more than 80 percentage points per year since 2005. The middle class fueled much of this growth, viewing investment in real estate as a much safer bet than bank deposits or playing the stock market.
“I Love Government Assisted Housing… I Have Three of Them!”
The proportion of migrant workers to residents in the first-tier cities of Beijing, Shanghai and Guangzhou is more than 3:10. In Shenzhen, it is more than 7:10. Sky-high real estate prices have created a massive barrier to entry for impoverished newcomers looking to settle down. The Chinese government has stated in its 12th Five-Year Plan that level of urbanization will increase from the current 47.5% to 51.5% by 2015. China’s real estate bubble is not only a threat to its banks, but also threatens the country’s rate of urbanization. Less migration into China’s cities will mean less job creation, and for every million jobs lost, China forfeits one percentage point from its GDP growth.
In order to reach 51.5% urbanization, an additional 53.6 million people will have to move into urban areas by 2015. The average Chinese household has 3.3 members, meaning that new urban residents will generate a demand for 16 million additional housing during this period. Not only will China have to construct 16 million housing units in its cities, but it will also have to guarantee that the vast majority of these units are within the price range of a migrant laborer. The government has decided to inject 36 million units of government-assisted housing into the system over the next five years. This is more housing than the US has constructed since 1986. But how to keep these units safe from investors and market speculation?
The End of the Party
In the interest of urbanization and job creation, China popped its own bubble. In 2010, China intensified a series of restrictive purchasing policies in first tier cities, making it nearly impossible to buy non-owner occupied investment housing. Loans to first-time and second-time buyers of commercial housing now required deposits of 30% and 50%, respectively with base interest rates of no less than 10%. Households wishing to purchase a third unit of real estate are now ineligible for a bank loan. The policy also ended loans to non-residents unable to provide certification of paying one year of the city’s taxes and social security dues.
Inflationary pressures finished what restrictive policies started. Chinese citizens are currently squeezed in the triple vice of domestic inflation, an appreciating RMB and waning demand from a collapsing Eurozone. Indeed, China’s PMI for November was 52.5, down from 54.1 in October. Global PMI for the month was down to 49.6 showing a worldwide contraction in manufacturing – not a good sign for China.
When properties stopped selling, some of China’s more fragile real estate networks simply collapsed. In September and October, Wenzhou and Ordos were found to be two canaries in a toxic coalmine. When the Wenzhou Public Security Bureau reported that more than 40 indebted local business owners had gone into hiding as of September 27, central authorities moved in to investigate. It was soon revealed that a network of bank tellers and low-ranking government officials with access to low-interest loans had been borrowing money and then re-lending it with usurious annual interest rates as high as 80%.
Sensing an impending market correction, China’s central authorities moved to make sure that workers got away unscathed. The government started pressing developers in mid-November to sell off properties at discount prices to settle land payments and return bank loans. Deyang Liu, chairman of the board at Savills, said in a recent interview that the central government has been “keeping a very close eye on the construction accounts of developers. They have been pressuring developers to lower prices and sell more units in order to settle these accounts at the end of the year.”
China’s leading developer Vanke responded to the call by lowering the prices of new units in Shanghai, Beijing, Shenzhen and Nanjing by 20%-30% on average. Developers across the country quickly parroted the move, causing a decrease in prices for over 80% of properties on the Shanghai market, alone. Many new homeowners were caught in the middle and lost most of their nameplate wealth overnight. They responded with a series of protests in the offices of real estate developers. Offices were destroyed, but the cries of the middle class fell on deaf ears in the central government.
Reason to Panic?
Thankfully, it appears unlikely that the burst of China’s real estate bubble will trigger a nationwide financial crisis. Tighter purchasing policies have resulted in a 30%-50% cushion for each housing loan issued by banks. Former chairman of the China Banking Regulatory Commission has stated that banks can withstand a 40% decline in housing prices while still maintaining a debt service coverage ratio (DSCR) of 110%. Should prices fall 50% or more, however, banks may become insolvent.
The market is likely to correct downwards between 20% and 30% over the next twelve months, but this will still leave banks with enough liquidity to weather the storm. In fact, Standard & Poor’s upgraded its ratings for Bank of China and China Construction Bank while dropping ratings for Bank of America, Goldman Sachs and Citigroup. On several occasions, S&P has cited the strong liquidity of the Chinese government and the high likelihood of government support in times of distress as reasoning for its high ratings. Clearly, S&P is on to something; the firm realizes that even if China’s banks take a hit from a bursting real estate bubble, the government will surely use its piles of foreign reserves to soften the landing.
Governing the Debt
The real losers will be local governments. Currently, local governments obtain approximately 1/3 of their revenues from land transfer fees obtained by selling development rights to real estate firms. The central government has mandated that 36 million housing units be built over the next five years, and local officials know that their contribution to this sum will have a substantial impact on their careers. Political gain will not come without a price, however, as government-assisted housing yields much lower returns than contracts for developing premium condos.
Local governments are already buried in debt from the 2008 stimulus package. As of 2010, local government debt totaled RMB 10.7 trillion, or 80% of total bank lending, according to statements made by Liu Mingkang of the CBRC. These institutions already stood to loose big with large portions of land being allocated to building homes for the poor. Now, with the market in a downturn, it seems unlikely that local governments will be able to auction off what little land they have left.
Indeed, a report from Centaline China Property Research has shown that in November, 117 plots of land failed to sell in land auctions, up more than 530% from the previous month. There has been a 14% decrease in land sales from the previous year’s totals of RMB 92.1. Plummeting land sales will mean a significant dip in local government revenue, threatening liquidity. If leading indices continue to fall, signaling a contraction of gross economic activity, China may again have to bail out its local governments to help them maintain solvency. I believe that there is a 25% probability that local governments will receive a bailout before 2015 to maintain solvency.
"If I have seen a little further it is by standing on the shoulders of Giants."
- Isaac Newton
Chris Lowder is the Director of Marketing Services at China Monitor. For more insights from China Monitor and the China Economic Information Network (中国经济信息网), please visit our website at www.chinamonitorisg.com
Very interesting reading, Chris! I'm a fan. / Lukas
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