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Is the Chinese property bubble bursting rather than deflating?

Despite restructuring initiatives, anxieties over the health of China's real estate sector are intensifying
Is the Chinese property bubble bursting rather than deflating?

The Evergrande (HK:3333) saga rumbles on. Singapore-based REDD Intelligence has reported that Chinese authorities plan to exclude debt accrued by property developers in relation to distressed assets when assessing their adherence to the 'three red lines' policy.

The latter initiative was introduced in August 2020 to constrain debt ratios within China’s massively indebted property-development sector, specifically liability-to-assets, net gearing and cash-to-short-term debt.

You never feel quite confident when quoting state-sanctioned economic data from China, but there were signs that the effective forced deleveraging had taken some of the steam out of the local property market. It even initially resulted in several rating upgrades of real estate developers.

You would be justified in asking whether said upgrades were overly optimistic. For, if Beijing is intent on fudging the basis on which the debt ratios are calculated, it could signal that prices and volumes within the sector remain under severe pressure.

It begs the question whether China’s housing bubble has already popped and we have failed to either notice or acknowledge it due to wider pandemic-linked distractions? That may seem a somewhat fanciful notion, but few identified the systemic fault lines in the US property market which undermined the global financial system in 2008.

China’s exposure to the sector is well noted. With a dearth of alternate paper assets there have been few places for investors to park their cash. So around 90 per cent of the nation’s households own an apartment, yet around a quarter of apartments in China are sitting empty. This partly reflects the constant 'flipping' of properties, which has driven churn-rates and prices dramatically.

Although buyers in the country generally come to the market with significantly higher deposit levels than the UK, they have a greater proportion of their net worth tied up in speculative real estate assets, a real problem when prices click into reverse for any length of time. In December, transaction volumes were down 38 per cent year on year.

Bubbles develop on the back of assumptions on future prices which are unsustainable. Consider pre-pandemic analysis from the US-based Urban Reform Institute, which deemed China’s property market to be “severely unaffordable” based on a price-to-income ratio of the median house price. Admittedly, housing affordability has deteriorated across many geographies, but China remains an outlier in this respect.

China’s property developers need to repay double the amount in in dollar-denominated offshore debt in the first quarter 2022 compared with the fourth quarter of last year, a period in which they struggled to meet financing obligations. Institutional investors are clearly getting edgy due to gathering offshore debt defaults. Reuters reports that an ongoing bond sell-off impacting China's biggest homebuilder, Country Garden (HK:2007), has left most of its international market debt trading below face value.

It is possible that China’s economy will find sufficient support due to increased liquidity brought about by the actions of the People's Bank of China, specifically a cut in the reserve requirement ratio for banks. But the potential magnitude of the problem for Beijing policymakers is clear enough given that the real estate industry accounts for around 30 per cent of China’s economic output. That also means its health is entwined with prospects for the global economy.

Closer to home, investors would not emerge unscathed if a managed (structured) decline in China’s property market gave way to an uncontrolled collapse amid a cascade of debt defaults. Shareholders in the mining sector are already feeling the ripple effects of the former. Iron ore spot prices have contracted by 42.6 per cent over the past six months, as a growing number of property development projects in China have been put on ice or cancelled altogether.

The knock-on impact will not be confined to the commodities complex. If the ill-effects of China’s property crisis continue to leech out into the wider economy, prospects for foreign-listed companies with significant business interests in China will also deteriorate, while purveyors of luxury goods will take a significant hit, too. The reality is that real estate investment supports a range of industrial sectors, including construction, building materials and consumer electronics.

Some pundits have drawn parallels between China’s current woes and the asset price bubble which prefigured Japan’s so-called 'lost decade'. That might be a stretch, given that the problem in Japan was largely down to inadequate oversight in the company auditing process, enabling companies to conceal the accurate level of their indebtedness through subsidiaries. Nonetheless, there is a certain irony in that Japan then, like China now, was widely assumed to set to eclipse the US as the world’s preeminent economy before things turned sour.