Excess leverage in China’s housing sector poses potential systemic risk, but the nature of China’s financial architecture makes a broader crisis unlikely. Chinese policymakers, for instance, have a wide array of tools to distribute financial pain across balance sheets. In addition, the government is rolling out policies to support housing demand and affordability. However, these measures may not mitigate the loss of housing as a major growth engine for China.
This piece is the first of a series on China that will explore the country’s property sector, GDP growth conundrum and geopolitical constraints going forward.
In August 2020, the government of China released regulatory guidelines, colloquially referred to as the ‘Three Red Lines’, for housing developers. These guidelines set out three different limits on developers’ leverage and aimed to curtail systemic risk. The regulations have been highly successful, but the success came at the cost of throttling the housing sector and kindling a potential financial crisis. After the principles were introduced, several highly indebted developers (notably Evergrande) began to struggle to service debt and the sector witnessed a severe slowdown.
In most economies, the risk would be that developers would default on loans, with non-performing assets rising rapidly on bank balance sheets, possibly collapsing over-concentrated loan portfolios and the contagion spreading via other creditors in the system.
This is less of a concern in China, where the government has extensive direct and indirect control over lenders as well as lenders’ creditors. Policymakers can therefore step in and impose debt restructuring terms through several different channels and manage to distribute losses without sparking systemic contagion. This applies to developers, banks as well as local governments and their financing vehicles – the net effect resulting in containment of any escalation in financial crisis.
The same cannot be said of the economic effects though, where the loss of housing as a growth motor will continue to weigh on the Chinese economy. Real estate constitutes roughly a quarter of China’s GDP, with about two-thirds of that directly tied to construction activity. Furthermore, Chinese households also hold majority of their personal wealth in domestic real estate.
The combination of the slowdown and lower prices should mean a direct drop in construction activity and a negative wealth effect for Chinese households. This contributed to the weak economic growth in 2023, despite the post-pandemic reopening dynamic. Looking ahead, we expect the property sector to stabilize, with the contraction in residential investment to end over the course of 2024 (Figure 1).
The government has also lowered borrowing costs for new mortgage holders and eased conditions for property purchases in major cities. While these measures should help revive some of the lost demand, housing may still remain as a zero-growth industry in the foreseeable future.
As far as the pace of urbanization is concerned, China has followed its East Asian neighbors closely. The country’s urbanization process has yet to peak, so the current supply overhang should probably still service unmet demand in coming years. However, the peak is also not far away, which means the rapid pace of urban construction should settle down at much lower rates – the growth curve should start to flatten a lot at this point (Figure 2).
China’s real estate has the potential to precipitate a financial crisis, but the specific nature of the economy’s financial structure should mean a contagion will likely be avoided. However, real estate constitutes a quarter of China’s GDP, so the crisis will still have a far-reaching effect on China’s economy. Most importantly, the crisis in general highlights the profound challenge of China’s overreliance on investment as a GDP driver, a problem we will examine in our accompanying piece on China. In the final part of the series, we will also explore China’s geopolitical constraints – dwindling external demand and obstacles to moving up the value chain.