Real estate: Property throws a shadow over China

Looking out of the window of a lofty bank building in Shanghai’s central business district, it is difficult to imagine that only 20 years ago this side of the city was agricultural land. China’s economic boom has seen places such as Shanghai develop at lightning speed. Set to be a global financial centre by 2020, Shanghai continues to grow. For every bustling hub, though, there are cities full of gleaming houses, malls and theatres that have been recently built but remain steadfastly empty. Ten years of cheap credit and high economic growth led to a boom in construction, with real estate developers building luxury houses and speculating for high returns.

These properties, however, are out of reach for much of China’s growing urban population.

Chinese government policy is to cool the overheated property market and create more affordable housing. Credit tightening that began in April 2010 has continued. In September and October there was a transition in the property market as inflated prices finally began to fall. Last month, the National Bureau of Statistics of China announced that the sales prices of newly constructed residential buildings declined in 34 out of 70 cities surveyed. The trend will continue into 2012.

Investors watch in horror as the value of their physical assets plummets. Protests have spanned the country, from Beijing to Wenzhou.

Even China’s greatest example of achievement and economic growth is not immune to what is happening in its property market today. Recently in Shanghai, investors attacked a property showroom, after the property developer Greenland Group was forced to bring down its prices to attract more customers.

Shanghai and the ghost towns in some of China’s more remote parts stand as metaphors for the two extremes of current investor attitudes to China – some see unstoppable growth and continued development, while others see the obvious evidence of a classic credit-fuelled property bubble.

And lurking in the shadows are several related problems: underfunded property developers threatening default and a budding underground banking system. How worried should investors be about a dreaded hard landing in China and how will its government solve the ills created as a result of tighter credit after 2008?

The decline in property prices has provoked debate about whether or not China is in for a hard landing, but this oversimplifies the situation. China’s vast size makes generalizations a mistake.

The disparity between personal wealth and house prices is greater in some areas than in others. In Beijing, Shanghai, Hangzhou, Shenzhen and Guangzhou, for instance, the affordability ratio of price to income has stretched to 113.5%. These are the cities where prices have been dropping. They are also the cities where protesters have hit back at property developers.

Meanwhile, incomes have risen faster than property prices. Analysts at the University of California Davis suggest that disposable incomes might even be higher than suggested by official data. In an academic study by Xiaolu Wang and Wing Thye Woo, per capita urban disposable incomes were as much as 90% higher than official data in 2008. Hidden household disposable income was estimated at Rmb9.3 trillion ($1.5 trillion). Across the economy as a whole, "price trends look consistent with income trends," says Viktor Hjort, head of Asia fixed-income research and head of global corporate credit strategy at Morgan Stanley. The fact remains that cities such as Beijing and Shanghai are filled with unaffordable luxury apartments and most likely property prices will continue to slide in an effort to make sales. However, as Charles Chen, associate director of equities research at UBS, states: "We haven’t seen the large-scale price drop of property as yet."

How will this pan out? Vincent Chan, head of China research at Credit Suisse, says: "The most likely outcome is that property prices will continue to drop, but no one really knows how that will play out in the wider economy, as China has not had any prolonged property market correction in the past decade."

The equivocal conclusion is that, as Hjort says, "there is no broad-based property bubble in China but we can’t rule out that there aren’t bubbles in certain areas".

The national trend has been for prices to fall, but some analysts see a full-scale bust as inevitable. The credit boom in China between 2009 and 2010 has parallels with what has happened in other countries, they argue. Inevitably, there will be financial stress. The pattern of increased lending in China during the past couple of years has led some to compare it with Japan in the 1980s.

James Chanos, hedge fund manager, and founder and president of investment company Kynikos Associates, makes this comparison to argue that China is due a hard landing. However, the property market in Japan at that time was saturated as well as overinflated. In China, demand still exists. As Arthur Kroeber, non-resident fellow of foreign policy at the Brookings-Tsinghua Centre in Beijing, explains, although there is a demand for housing, "the people need the right property at the right price".

In fact, there is a great housing shortage in China: there are only two houses to every three urban households. Analysts at Brookings Institution estimate that the country needs around 10 million affordable houses every year for the next 20 years.

Price cuts mean more affordable housing, but a large-scale fall in property prices might hurt the central government. Beijing is the greatest beneficiary of the real-estate market. Profits come from two main sources: land sales and taxes, including business tax and corporate income tax. As a result, the central government directly takes around as much as 60% of total revenues.

"We agree the government has the right to make sure land resources are sold at reasonable prices, but the heavy tax burden is arguable," says Oscar Choi, director of China property research at Citi. Moreover, he says: "In the prevailing market situation, the cost of taxes is usually transferred to home-buyers, which indirectly pushes property price higher."

China’s property sector is critical to its economy. During the past five years, construction has accounted for up to 8% of GDP, while indirect factors such as cement production and furniture contributed as much as 18%, creating a total sector worth 25% of GDP. "Without strong real estate investment, it would be hard to achieve even an 8% GDP growth target this year," says Choi.

Credit loosening is inevitable, he adds. "When property overheating increases and affects social stability, tougher tightening is inevitably introduced. But when a slowdown in the property market results in significant impacts on economic growth, especially local governments’ balance sheets, the policy would swing back to another direction."

Property prices also have a wider political dimension. The Chinese government considers the market as a "tool to adjust economic growth and balance public opinion, and even social stability", says Choi.

Kroeber adds: "China is the latest in a line of Asian countries that have put a premium on high economic growth and social stability. The government aims to make people richer, but it needs to aim for a balance to avoid social instability. It would be socially destructive to continue with high-end property development that normal people in China cannot afford."

If the government reins in credit, corporates will look elsewhere for capital. An informal system for lending or shadow banking is created around trust company investments, inter-company entrustment loans and commodities-related speculation as an alternative to traditional bank loans.

According to the People’s Bank of China, new bank lending to property developers in the second quarter of the year plunged to Rmb42 billion from Rmb169 billion in the first quarter. The gap was filled by the shadow system. Jinsong Du, a research analyst at Credit Suisse in Hong Kong, says: "Trust companies that aren’t subject to the same constraints as banks made up for much of the shortfall, nearly doubling their new financing to the property sector in the second quarter of 2011 to Rmb137 billion from Rmb71 billion."

That might sound alarming, but analysts are more phlegmatic. Hjort at Morgan Stanley says: "[Even though] the official estimate of shadow banking amounts to less than 10% of GDP, to a certain extent, [the onset of shadow banking] is a positive development because risk is dispersed."

That strength is also a hindrance. "Shadow banking is more difficult to control and it is harder to determine how fast it is growing," says Hjort, and Choi agrees: "We cannot quantify the size of shadow banking."

Yet, some analysts argue that shadow banking is containable. Kroeber says: "When it comes to unregulated, informal lending, the central government is very aware of the channels whereby this happens. In effect, the government can send messages top down to companies who take part in these informal channels. Often, these businesses listen when the government suggests they should stop certain channels of lending.

"The government can control informal lending in China. They have the tools to do so, although the tools are clumsy."

However, the fact that shadow banking has a dark side is hard to deny. The city of Wenzhou in Zhejiang Province has illustrated the destructive power of the informal lending market.

Many companies there, especially small and medium-sized ones, have been driven to the edge after being unable to repay various types of loans. During the past six months, more than 90 debtors – mostly in real estate – have fled the city after finding themselves unable to meet repayments on debt. At least two have committed suicide.

"In places where there is a high dependency on manufacturing and a tendency for restructuring, there has been an increase in shadow banking," says Chan.

Total credit in China, including formal and shadow lending, is up from 120% of GDP at the end of 2008 to about 160% now. Kroeber says: "By comparing this to other countries that have had similar increases in credit-to-GDP ratios, we could say that this will lead to the creation of bad credit."

Tightening credit has made it difficult for some businesses to pay back loans. Property developers in China are threatening to default. "There are indications that smaller, more peripheral companies have already failed, but these companies are difficult to assess because they are below the radar," says Hjort.

Smaller property developers do not have any public equity or debt and therefore do not have to report their accounts. Scarce accessible data makes it near impossible to collect information on such developers.

Analysts at Credit Suisse believe that the sector’s risk of default has increased, given further credit tightening in the second half of the year. However, a large-scale default seems unlikely, as the Chinese government would not allow it. "In 2008, the whole world was on the ropes so the government ordered banks to lend money," says Hjort. "In this respect, you could argue that all companies were bailed out."

There is little precedent for government action to help small, private companies.

"The vast majority of property developers today are ultimately private-sector companies," says Hjort. "Purely private companies don’t have the same protection as SOEs," says Hjort. "It is wrong to think that government policy is implicitly offering a safety net for all companies."

Kroeber, at the Brookings-Tsinghua Centre, agrees: "One thing we can be clear about is that there will be no wholesale bailout by the government for property developers." Choi adds: "The central government is losing patience with property developers, borrowers and lenders in general." Kroeber believes the nominally communist authorities will allow the market to regulate itself through default: "The government wants to see default in the property sector. This is government policy." Hjort agrees: "If one or two property developers fail, this will act as a message to other companies that they cannot expect a bailout."

But are some developers considered too big to fail? "People believe that the Chinese central government is strong financially and will bail out strategically important institutions if necessary," says Chan.

Choi adds: "If a big property developer in China was to default, this could lead to political instability. The Chinese government could not allow this to happen. Social instability is one of the greatest fears of the Chinese government."

Prudence and planning are second nature to China’s central government. Slow, careful steps will ensure that the country avoids a crash in its property sector. "China is used to working slowly," says Philip Poole, global head of macro and investment strategy at HSBC in Hong Kong. "Changes we see happening in China will occur over a long period of time."

A slower pace relates to the fact that China is still developing. "This is the angle that needs to be ascribed to the whole story," says a senior banker at an international bank based in Hong Kong. "Without looking at the bigger picture, people focus on the darker sides of the story and a negative outlook is adopted. We need to remind people to be prudent."

And China is almost a dictionary definition of prudence when it comes to steering an economy.

see also: 

China's stimuli package: The consequences of cheap credit
Corporate debt: Questionable investment