Basic Problems – The Diplomat

China’s real estate market is in a slump triggered by Evergrande’s default last year. Overleveraged developers have been curbed by the three red lines policy, which has tightened leverage requirements. Other real estate developers, including Shimao and Sunac China Holdings, have also missed debt repayment deadlines. This sudden drop in the real estate sector is in stark contrast to the exciting times of the past few years, when officials constantly warned consumers not to speculate in the market. Now, over-indebtedness due to mixed development incentives threatens to bring down large real estate companies.

One of the few destinations for household savings, China’s real estate market has grown since the late 1990s and has seen few corrections. Property prices have risen, particularly in large Tier 1 cities like Beijing and Shanghai. The presence of collateral has allowed both developers and home buyers to secure loans to support investments in the sector. As a result, about 27 percent of bank loans in China relate to real estate. Real estate developers kept building to meet the seemingly endless demand, but in order to do so they had to take on debt to bridge the gap between build and sell.

In addition to bank loans, developers borrowed in the form of onshore and offshore bonds, escrow loans and asset management products. Lenders thus range from institutions to the public at home and abroad. Developers also engaged in joint ventures to invest in projects while hiding their debt. Joint ventures have allowed real estate companies to keep debt off the balance sheet.

To prop up the sector, regulators recently lowered the quoted interest rate on loans (LPR). In addition, local governments have been advised to implement their own real estate policies according to their needs. For example, some local governments like Shanghai have reduced buying restrictions for homebuyers. Both Tier 1 cities like Beijing and Shanghai and Tier 2 cities like Suzhou and Zhengzhou have lowered mortgage rates. Such actions by local government have often been used to boost or dampen real estate activity.

While these measures will ease some key indicators like home sales and prices, the rules don’t necessarily solve the problems faced by heavily indebted developers. Many are struggling to pay off their debt amid COVID-19 lockdowns and dwindling demand. The measures also fail to address the underlying issues behind the excessive property development. Local governments and the public depend on the real estate sector to provide a source of income and/or investment, which drives real estate construction. For years the government has allowed price increases and prevented major corrections to prevent social unrest. In fact, construction has contributed to national GDP while other sources of production have struggled to keep up.

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China’s crackdown on property debt can be seen in the context of the country’s struggle to curb corporate debt. In 2016 and 2017, officials cracked down on corporate debt, much of which was held by state-owned enterprises (SOEs). These companies had taken on large debts to support government policies to stimulate the economy in the wake of the global financial crisis and slowing global growth. SOE margins have been pushed up while the source of over-indebtedness, implicit government guarantees on SOE debt, has not been addressed.

The real estate debt crackdown is similar, attacking developers’ leverage indicators rather than the underlying issue of over-reliance on construction as a failsafe in economic downturns and as a primary investment opportunity. Preventing downturns early helped support excessive investment in the sector and contributed to the massive asset price bubble plaguing the industry.

Authorities need to address the causes of excessive debt accumulation in the real estate sector, not just the symptoms. Allowing housing prices to fall, reducing reliance on housing construction as a source of GDP, and creating other investment opportunities can help. In addition, a much-anticipated property tax may help better control speculative behavior in the housing market in the long term. While this alone may not solve all problems, it can help provide local governments with a steady stream of revenue (instead of relying on new-build-related land sales) and reduce zeal in overheated areas.

China has sought new sources of GDP, particularly in the new technology sectors, but also requires continuous reforms in many industries to increase competition and strengthen the private sector. This could help spur growth without over-reliance on the real estate industry.

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