Unveiling China's Real Estate Crisis: A Paradigm Shift for the Economy

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The property market, which has represented up to 30% of the economy, entered a crisis over two years ago due to government restrictions on developer borrowing. Real estate investment decreased last year for the first time in ten years, and without a potential rescue from Beijing, the downturn is expected to continue, posing a significant risk to China's growth prospects in the next three to five years.

China can only overcome this property crisis through a gradual and difficult adjustment," stated Alicia Garcia-Herrero, the chief economist for Asia Pacific at Natixis. "This adjustment has only just begun and will require several years to complete."

Furthermore, she mentioned that the country must align the supply of housing with significantly reduced demand, as the aging population is causing a decrease in demand.

It is a challenging task. According to state media, a former deputy head of the national statistics bureau recently stated that China's population of 1.4 billion is insufficient to occupy all the vacant apartments scattered throughout the country.

To address the issue of oversupply, the government has implemented a nationwide "de-stocking" policy. This includes reducing the rate of land sales in urban areas and urging developers to lower housing prices in order to stimulate demand.

According to Garcia-Herrero, absorbing this surplus capacity in the property sector will inevitably negatively impact China's economic growth. She predicts that China will experience a reduction of approximately 1.5 percentage points of growth annually until at least 2026.

An Evergrande housing complex in Wuhan, in China's central Hubei province, on September 28, 2023

The World Bank has revised China's gross domestic product (GDP) forecast for 2024, lowering it from 4.8% to 4.4%. This adjustment is attributed to ongoing domestic challenges, including high levels of debt, a weakened property market, and an aging population.

The International Monetary Fund (IMF) predicted that China's growth will likely decrease to approximately 3.5% in the coming years, down from this year's 5%, due to demographic challenges and a slowdown in productivity growth. The last time China experienced consistent growth at this level was in 1989 and 1990, when the economy expanded by only 4.2% and 3.9% respectively, following the significant decline from the 11.3% growth observed in 1988, which was caused by international sanctions triggered by the Tiananmen Square crackdown.

The IMF said future growth could exceed 3.5% if Beijing comes up with more stimulus and economic reforms.

A worker operates machines at a texile factory in Nantong, in eastern China's Jiangsu province on September 14, 2023.

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How did we get here?

For years, Chinese developers adopted a straightforward strategy for their business - selling apartments before their completion. This business model was introduced by regulators in 1994 to match the growing demand as China underwent rapid urbanization following market-oriented reforms.

By selling apartments in advance, these developers were able to finance their rapid expansion, resulting in real estate moguls emerging as some of the wealthiest individuals in the country.

The strategy was successful until approximately three years ago, when the Chinese government took action against the real estate industry's excessive borrowing. The government's concern was the potential risk of financial instability, as well as the need to control escalating property prices and the associated dangers of mounting debt.

As a result, this decision further intensified the financial difficulties faced by developers such as Evergrande. Ultimately, Evergrande defaulted on its debt obligations in December 2021, triggering a broader crisis within the industry.

Hui Ka Yan, chairman of property developer China Evergrande, attends a news conference on annual results in Hong Kong, China March 29, 2016.

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Evergrande's intended restructuring and recovery plans have proven to be unsuccessful as the company's difficulties have exacerbated. The recent disclosure that its founder and chairman Xu Jiayin has been apprehended by authorities on suspicion of criminal activities has sparked concerns among investors who were optimistic about the company's reconciliation with its creditors by the end of this month.

Apprehensions have intensified regarding the future of Evergrande, given its substantial outstanding debts of over $300 billion and the countless incomplete housing units scattered throughout the nation.

The potential liquidation of the firm could negatively impact households and erode confidence in the struggling real estate market, undermining Beijing's efforts to revive the sector and prevent larger economic issues.

In a sign of potential progress, Sunac China, another prominent developer, received approval from a Hong Kong court on Thursday for its multibillion-dollar offshore debt restructuring plan.

But overall, the property sector has experienced a significant decline as it grapples with a sharp decrease in demand. Official data reveals that new construction starts, measured by floor area, have witnessed a decrease of 2% in 2020, 11% in 2021, and a staggering 39% in 2022 when compared to the previous year.

Alternative growth engines

Amid the slowdown in the property sector, Beijing is actively seeking alternative drivers of economic growth.

President Xi Jinping recently emphasized the importance of promoting a "new form of industrialization," wherein sectors such as green technology could assume the role previously held by the property sector.

According to analysts from Capital Economics, achieving that goal in the near future may be impossible. In a recent research note, Mark Williams, Sheana Yue, and Zichuan Huang stated that although these sectors have been experiencing substantial growth, they are still too insignificant to compensate for the overwhelming importance of the property sector.

The sectors designated as "strategic emerging industries," such as advanced materials, tools, and green energy products like electric vehicles, accounted for just over 13% of the GDP in 2022.

"They expressed doubt that these nascent manufacturing sectors would attain the scale or foster the same level of growth or employment as the property sector did."

On September 6, 2023, at the IAA Mobility 2023 international motor show in Munich, Germany, visitors were captivated by the Cyberster electric car, a creation of the Chinese car brand MG. The event, which takes place from September 5 to September 10, is being hosted at the Munich trade fair grounds and various other locations throughout the city. (Photo by Leonhard Simon/Getty Images)

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Housing assets make up the largest portion of household wealth in the Chinese economy, amounting to approximately 70%, according to the latest figures from the central bank in 2020.

For years prior to 2021, land sales to developers accounted for over 40% of local government income. However, this percentage decreased to 37% in 2022.

According to analysts from Capital Economics, X's new industrialization plan appears to primarily aim at contextualizing China's policy objectives, aimed at achieving tech self-sufficiency and competing with Western nations, rather than solely boosting GDP growth. The analysts further opined that by reallocating resources towards technological advancement, the plan may potentially lead to a decline in overall economic growth.

Negative wealth effect

Consumption doesnt look like a viable immediate option to fill the hole left by the property sector, either.

The spending habits of China's middle class, which had been driven by the property boom for many years, have now been affected by the decline in home prices. As a result, people are now holding onto cash instead of actively spending.

Household bank deposits reached a record high of $18 trillion yuan ($132 trillion) by June, surpassing China's GDP for the previous year, according to the People's Bank of China. In 2022, household savings increased by $2.6 trillion yuan ($17.84 trillion), representing an 80% growth compared to 2021. This amounted to more than one third of their total income, whereas prior to the pandemic, individuals typically saved around a fifth of their income.

Shoppers in the Guanqian Street shopping area in Suzhou, Jiangsu province, China, on Wednesday, Jan. 25, 2023.

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In 2022, China experienced a 4.3% decrease in net household wealth, primarily driven by declines in home prices and the stock market. This marked the first decline of its kind in over twenty years. Analysts from Oxford Economics recently observed a resemblance to Japan's situation in the 1990s, where a broader erosion of confidence among Chinese consumers and investors in the post-bubble growth model is becoming apparent. To foster growth in this environment, significant structural policy adjustments are required, with consumer spending being a crucial area to focus on.

Challenges to rebalance

Chinese policymakers face multiple challenges in making those changes.

According to analysts from Stanford University and the Asia Society Policy Institute (ASPI), households are already heavily indebted for housing and have limited borrowing capacity for consumption. They emphasize the need for the government to quickly establish additional sources of income growth, apart from housing, to stimulate household consumption.

Shoppers at a market in Dali, Yunnan on January 14.

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Demographics pose another significant challenge and contribute to the motivation of numerous Chinese individuals to save a substantial amount. Oxford Economics analysts revealed that China's social security system continues to progress at a slow pace, and its primary component, the pension system, has been facing a deficit since 2014.

They highlighted the fact that precautionary savings, which account for approximately 32% of personal disposable income, have remained significantly high and resistant due to the absence of a sufficient pension system. In light of this, both research firms propose that Chinese authorities explore methods to enhance disposable incomes and increase productivity.

According to analysts from Stanford University and the ASPI, a crucial overhaul of China's economy will require prioritizing the development of new industries, enhancing productivity, and reinforcing rental markets. Reporting by Michelle Toh.