The Achilles’ heel of China’s economy

The real estate market was China’s golden goose for years, but has since become the Achilles’ heel of the Middle Kingdom’s economy. In light of demographic and geopolitical challenges, and given concerns about financial stability, the government of China no longer views the real estate sector as an all-purpose automatic growth engine. That’s why in spite of a mediocre economic outlook, a renewed round of heave-ho real estate sector stimulus is unlikely to occur in the near future. On the contrary, the formerly booming Chinese real estate market faces a pronounced L-shaped trajectory going forward.

Chinese policymakers behind the growth curve

For many economists, it was a foregone conclusion that there would be a vigorous upturn in spring after the lifting of pandemic containment restrictions and the turbulent reopening of China’s economy in the middle of winter. And in fact, the growth data for the first quarter did surprise on the upside, as did the government’s quite ambitious new growth target of +5% for 2023. Lately, however, the Chinese growth locomotive has already started to sputter again and some macroeconomic data points have recently disappointed. We are sticking with our assertion made back in spring 2022 that China will drop out as the main driver of global economic activity in the future (see “Will China come to the world’s aid?”). In fact, a lot more air looks set to escape from the world economy’s former life preserver ring over the coming quarters or, more likely, years. Instead of serving up stimulus with a giant ladle once more as it has done so often in the past, the government of China will likely try “merely” to stabilize the country’s future growth path and to limit the downside risks by implementing narrowly targeted support measures here and there. The People’s Bank of China’s interest-rate cuts in mid-June fall into this category of “homeopathic dosing”.

Homeopathic dosing | Stimulating the economy with a foot on the brake

People’s Bank of China’s interest rates

Sources: Bloomberg, Kaiser Partner Privatbank

Golden goose on shaky ground

The real estate market, which has transformed in recent years from a proverbial golden goose to the Achilles’ heel of Chinese economic activity, is one of the main reasons why China’s policymakers are keeping a foot on the growth brake. The role that the real estate sector played in China’s growth and prosperity model over the past two decades was indeed extraordinary – and unusual:

• Economic growth and employment: Ever since the great financial crisis of 2008/2009, if not before, China’s economic growth has become less and less driven by exports and increasingly fueled by investment spending. In the course of this shift, the real estate industry was the most important sector by far. For more than two decades, it made a disproportionally large contribution to economic growth – depending on the way it is calculated (or including upstream and downstream sectors as well), the real estate sector recently accounted for one-quarter to one-third of China’s total economic output. It not only built housing for millions of Chinese, but also created millions upon millions of jobs.
• Land sales and tax revenue: Prices for land in China have exploded by a factor of 64 since 2005. Local governments in China generate a substantial part of their revenue by selling building plots. The real estate market thus indirectly contributes to the funding of infrastructure projects and public services.
• Wealth formation and social mobility: For many Chinese, owning real estate is one of the few ways available to build and invest wealth. Moreover, owning property is considered a status symbol and a pathway to social mobility. Families often invest their entire life savings to acquire real estate in the hopes of boosting their social status.
• Soft power and geopolitical influence: China’s experience and expertise in the real estate sector have been exported around the world through initiatives like the New Silk Road. This has enabled China to strengthen its geopolitical clout, particularly in developing countries.

For a long time, the interaction of all of these factors created a partially self-reinforcing virtuous cycle of more growth, rising property prices and mounting confidence, more consumption, and greater prosperity. Last but not least, the government used the real estate market as a veritable automatic growth machine whenever the need arose. More than once, the real estate sector was the tool that re-kickstarted China’s economic growth just at the right moment, because rising property prices boost consumer confidence and business sentiment, which leads to greater consumption and increased investment. The government particularly cranked up this economic activity lever in the year 2015, when the People’s Bank of China unleashed a flood of liquidity totaling CNY 3.4 trillion to promote home ownership among low-income families and to reduce the oversupply of housing. This sparked a spike in demand for housing, which in turn stimulated supply and caused real estate prices in many Tier 2 (medium-sized) and Tier 3 (small) cities to more than double since then at their peak.

 Once a growth engine, now a problem | China’s real estate sector is (too) huge

Real estate-related economic sectors’ share of gross domestic product

Sources: Rogoff & Yang, Kaiser Partner Privatbank

Once a one-way street, now a dead end | Real estate in China is too expensive

Home ownership prices in China, Renminbi per square metre

Sources: Rogoff & Yang, Kaiser Partner Privatbank

No bubble without trouble

At the end of the 2010s decade, if not before, China’s success model started to show more and more cracks and increasingly revealed its downsides. The speculation-driven construction boom resulted in vacancy rates well above 20% on average. Deserted ghost cities were left behind as colossal monuments to economic inefficiency. Ever-spiraling prices made buying a home practically unaffordable for young families and at the same time widened the divide between property owners and non-owners. Property prices increasingly became detached from the economic fundamentals, and a wide array of statistics (see charts below) made it recognizable to even laymen that China’s real estate miracle was arguably perhaps just a bubble. Environmental pollution and strains on natural resources likewise belonged to the negative side of the coin. But above all, the rapidly mounting debt loads of real estate developers and local governments posed ever-increasing risks to China’s financial stability, which ultimately made the ever more perilous risks more relevant to the central government. These risks were probably one of the prime reasons behind Chinese President Xi Jinping’s drastic U-turn. In August 2020, he announced his “three red lines” for property developers (more equity capital, leverage limit, raised minimum liquidity ratio), triggering an earthquake in the real estate market (including bankruptcies of many real estate companies) that is still causing aftershocks to this day.

Bubble? | Without comment

Real estate price-to-income ratios in major cities

Sources: Numbeo, Kaiser Partner Privatbank

Bubble! | Without comment

Valuation of different asset classes (2017), in CNY trillion

Sources: Rogoff & Yang, Kaiser Partner Privatbank

The government’s (inevitable) policy realignment

The government enacted further measures in addition to the “three red lines”. For example, a cap was placed on the number of properties that a single person can acquire. Moreover, minimum down payment requirements for real estate purchases were raised, and stricter mortgage lending guidelines were implemented. Xi Jinping put the government’s policy realignment with regard to the real estate market in a nutshell three years ago in his mantra “houses are built to be inhabited, not for speculation.” This stance is still valid today because China, at the same time, finds itself confronted with demographic and geopolitical challenges. China’s fertility rate has dropped to 1.3 children per woman (only South Korea, Taiwan, Italy, and Singapore have lower birth rates), and the country’s population is on pace to rapidly (over)age. Multiple studies have found that young adults in China are deciding today against having children due to the high cost of educating them and particularly in view of expensive housing costs. Better housing affordability for the masses thus has a high priority for the senior leadership of the Chinese Communist Party. Greater affordability could be achieved not just through higher wages, but also through stagnant or further mildly declining real estate prices. Meanwhile, in the context of the geopolitical situation and especially the rivalry with the USA, the leadership of China sees itself in an era of “struggle” and is less tolerant than before of excesses and bubbles that could burst at any moment. It instead wants China’s economy and financial system to be “grounded” as much as possible so that it can resist adverse shocks, including external ones (e.g. US sanctions).

An oblong “L”

Averting a downward spiral in the real estate sector is a top priority for the government in the quarters ahead. However, there will be no return to the heave-ho real estate market stimulus of past years in the interest of avoiding renewed excesses in any event. The support measures implemented for the real estate sector thus far (including loans to property developers) should also be read in that light. They aim, first and foremost, to bring initiated construction projects to completion so that the citizens who already paid for their new condominiums in advance (which was the case in 90% of the projects prior to the crisis!) can finally live in them. Business involving entirely new real estate projects continues to lie idle, in contrast. Despite selective liquidity injections, many property developers remain in dire financial straits. Citizens, for instance, are no longer willing to pay in advance for their dreams that exist only on paper. And there is also only meager demand now on the part of local governments – their long-gushing source of revenue from the sale of building plots is increasingly drying up. The central government will probably continue to be able to close only part of the resulting financing gaps in the future. Weaker real estate developers will drop out of the market. Meanwhile, those banks that are still issuing loans at the government’s behest will most likely almost inevitably incur losses and will thus absorb part of the value destruction in the Chinese real estate sector.

There is a lot suggesting that the current real estate market slump is structural and not cyclical.

Altogether, there’s a lot suggesting that the current real estate market slump is structural and not cyclical. If the government doesn’t make another U-turn, which we believe is what’s most likely to happen, the industry risks sinking into a multiyear malaise in the shape of a pronounced “L”, at the end of which looms a China less dependent than before on the real estate sector. Sporadic stimulus and easing measures will likely continue to be forthcoming, but will tend to serve more as a means of managing downside risks than as a catalyst for sparking a new boom. The same goes for potential further interest-rate cuts like the ones in recent weeks because although mortgage rates recently fell to a 14-year low, people in China are hardly buying real estate in the present situation. Quite the contrary, they are actually even paying down their mortgage debt, not just because consumer debt is already high anyway and the economic outlook is uncertain, but particularly also because the carry trade on the Chinese real estate market is definitively over. It worked only as long as the Chinese could count on a continual increase in property prices that outpaced mortgage rates. But that era is history now. The real estate industry’s immense size and importance also dims the prospects for China’s entire economy. From next year onward, even a growth level of +5% could prove to be too high a hurdle for China to clear.

In a liquidity trap | Even low interest rates are unlikely to bring about a turnaround

Weighted average mortgage interest rate for consumers

Sources: PBoC, Kaiser Partner Privatbank