China, unlike other major economies, has recently cut interest rates to stem the economic impact of its zero-COVID policy and to address a growing housing crisis. The country’s traditionally strong housing market was hit by a funding crisis, causing development to stall and buyers refusing to pay their mortgages.
The recent spate of mortgage strikes by homebuyers across China has exposed the risk that has accumulated in the market as it has evolved over the past two decades. The mortgage strikes began earlier this year among a group of people who had bought houses in an Evergrande development in Jingdezhen city, Jiangxi province, but the protests have since spread to buyers of other developments across China.
More than 300 groups of homeowners are believed to be refusing to pay between $150 billion (£127 billion) and $370 billion in home loans to date, according to informal polls published online.
These protesters all have one thing in common: they are paying mortgages, often at a rate of 5% to 6%, on houses they have never lived in. These properties were sold before they were built, under the so-called presale system, which is a common way of buying property in China.
The buyers’ strikes are prompted by a widespread belief among these protesters that the funds homeowners have paid in advance to the builders of these property developments have been misused.
With the pre-sale system, buyers deposit money into an account before the property is built. Chinese banks and local authorities are required to monitor developers’ use of these funds. Developers are not supposed to be able to access all of the money until they reach certain pre-agreed milestones during the build process.
But buyers have recently complained that, whether local authorities are aware of it or not, many banks have been lending to developers before the required stage of work has been reached.
Buyers have also complained that while these funds should have been held in designated escrow accounts that regulators can monitor, sometimes they aren’t, allowing developers to circumvent regulations. Overall, these buyers believe that the loose regulation of funds has given some developers both the temptation and the opportunity to keep investing in new projects by borrowing more before current projects are completed.
In fact, a common pattern in China’s real estate development industry is that developers buy land, pledge it to banks to obtain credit, start projects, begin the pre-sale process with buyers, and then use those funds to purchase land for other projects to use.
In such situations, only a portion of a buyer’s funds may go towards building their own property. As a result, a recent liquidity crisis in the industry has stalled many projects because the developers involved can’t afford to keep building.
The Rise and Fall of China’s Real Estate Market
Today’s situation follows a boom in the Chinese real estate market. The housing market has enjoyed a long surge since the early 2000s, peaking in 2018 before embarking on a gradual slowdown that ended in a sharp drop in sales in early 2022.
The chart below (Figure 1) shows the change in the China Real Estate Climate Index, which measures all business activity in land sales and real estate. New home sales have fallen significantly this year, with values down 22% compared to the same time last year.
The weak market has significantly reduced the funds available to developers as shown in Figure 2 below. This is the main cause of the current situation where developers have halted construction causing homeowners to go on strike by refusing to pay their mortgages.
The tightening of credit conditions also plays an important role. One major policy change is the government’s “three red lines” regulation introduced in August 2020. It categorizes developers by their debt level, which then determines how much more they can borrow annually.
More than 60% of developers have met at least one of the debt thresholds set by regulators in 2021, as shown in Figure 3 below. Around 10% – including crisis-stricken Evergrande – have injured all three. In this case, the developers are not allowed to take out new loans for this year. The resulting credit crunch has left many developers in a stressed position, with some even defaulting.
The further effects
The potential for a developer bankruptcy wave is currently the biggest risk facing the Chinese housing market and could lead to a large number of unfinished properties.
This is not alarmism: Chinese developers generally borrow heavily to fund ongoing construction. While the industry average debt-to-asset ratio is around 65%, some of the leading companies are even more leveraged (see Figure 4 below).
The industry has also seen a gradual decline in developers’ current ratios (their ability to repay short-term debt, see Figure 5 below), indicating lower overall liquidity and making the industry vulnerable to financial shocks.
Risk from the real estate sector could also spill over into the broader economy via banks and local governments, which are the two largest entities supporting China’s growth.
Banks lend to both buyers and developers and could therefore face a rise in bad debts if the housing market collapses. The good news is that these loans make up a relatively small portion of total bank lending. By my own calculations, based on government figures, mortgage lending accounted for just under 20% of total bank lending by the end of 2021, while according to the big banks only around 0.01% of this lending is affected by the current strikes.
On the other hand, real estate developments account for only 6.2% of the total loan portfolio of Chinese banks. Still, larger defaults could prompt banks to tighten lending conditions, further reducing market liquidity.
Local governments are a different story. They often rely heavily on land sales for income and failure to secure a stable flow of proceeds from land sales could affect their investment and urbanization projects. This would further strain China’s recovery from the pandemic at a time when it is already struggling due to the government’s ongoing zero-COVID policy.
When it comes to global implications, it should be remembered that China’s “closed” capital account policy restricts money movement in and out of the country. This largely isolates China’s financial market from the international market.
So, unlike during the 2007-2008 global financial crisis, these outages would likely not affect the global economy directly, although countries that trade with China may see a slight drop in demand from their Chinese consumers.