By Julian Herbst
London, United Kingdom
In August 2021, the second largest property developer in China, Evergrande, warned its shareholders that it was running out of cash, and with over $300 billion in liabilities, it later defaulted on bond payments. The company faced slowing sales and high arrears, but these problems were not unique to Evergrande and a slew of defaults by other developers followed. Valuations have plunged accordingly with the MSCI China Real Estate index dropping over 30% in 2021.
The turmoil was sparked by the “three red lines” policies implemented by the Chinese government in August 2020. The government was worried that the property sector, which accounts for 29% of economic activity in China, was over-leveraged. The three red lines mandated that developers maintain a number of standards: a debt-to-asset ratio of 70%, a 100% cap on net debt-to-equity and sufficient cash to satisfy short-term debts, borrowing and liabilities. These rules meant developers with already high leverage, like Kaisa and Evergrande, could no longer borrow capital, creating a cash crunch. Zero-COVID policies also led to a decrease in housing demand as well as difficulties in finishing planned development, leaving buyers stranded. In turn, this led to a fall in trust—Chinese buyers tend to buy apartments before they are built—and further decline in demand. These problems clearly entrenched themselves, as a lack of market demand decreased sales and decreased cash-flow, further stressing the ability of developers to finish their projects. Overall, sales in 100 major Chinese cities have decreased over 20% year on year, and this combined with the high liabilities of developers, meaning they “cannot” borrow more, has led to the liquidity crisis that the Chinese real estate market currently stands in.
Real estate development in China boomed in the 2000s, urbanising rural provinces and has resulted in almost three quarters of household wealth being tied up to property. However, as large developers grew, they needed credit to buy new land and expand (excessively) into other businesses including sports, entertainment and electric vehicles. The property boom is tied into China’s economic growth model, which has led to an average of over 9% annual GDP growth since 1989; however, it also meant relying on high borrowing. Local governments, which financed their infrastructure investments by selling land to developers, now have no demand from cash-poor developers and are finding it hard to pay their own debts, which Goldman Sachs estimates to amount to $8.2 trillion, or 52% of China’s GDP. Beijing has therefore urged local governments to “clean up” their debts, liabilities and borrowing, resulting in a decrease in FAI, fixed asset investment (infrastructure like bridges, ports, etc.), which is the key driver of China’s economic growth. From January to July 2022, FAI grew only 5.7%, compared to the average of 17.9% from 1996 to 2022. This means that the property slowdown can have knock-on effects on China's overall economic growth.
Economists who have long criticised the highly-leveraged property based growth model China has employed are now at the forefront of attention. A solution many have proposed is the change to a more consumer-based economy in China. Savings are high, at 44% of GDP, almost double the OECD average of 22.5%, while private consumption accounts for only 38.5% of China’s GDP compared with 68.1% in the US. Arguably, Beijing’s lack of a pension system and social security net discourage consumers from going out and buying things. However, many experts also see this shift to a consumer-based economy as unlikely, since the focus on individual actions to influence growth seems to run counter to Xi’s ideology in returning more control over the economy to the state.
What is certain is that the ongoing property crisis will act as a significant headwind to China in the near to mid-term, influencing the global economy of which China is a fundamental part.