Real Estate Dependency: Is China Relapsing As The Economy Falters?

China has been dependent on its real estate sector to drive its growth plans. The country’s focus on growth, combined with perverse incentives for local governments, banks, real estate companies, officials and citizens ensured that its real estate sector grew unabated.

By the time the government realised the problems and introduced the “three red lines” guidelines to stabilise the sector, it was already too late. Evergrande and other troubled developers had depended on a continual flow of funds from banks in order to fund land purchases and operations. The guidelines prevented them from taking on more debt, creating a cash flow crunch during a period of low demand.

Multiple large developers have defaulted on their payments since the new guidelines were issued. The issues have been exacerbated by the strict lockdowns implemented in several cities of the country to prevent the spread of Covid.

With the economy stagnating, the Chinese government is looking for ways to prevent a decline in growth and restore the economy back to health. With real estate forming around 15 per cent of the economy, Chinese vice-premier Liu He has advocated easing rules for real estate companies again. Indirectly, real estate contributes to 25 per cent of the economy.

To understand the country’s dependence on real estate, it is important to understand the incentives at play here. Local governments have various tax and growth targets set for them to meet. Despite the liberalisation of the economy, the land isn’t privatised but taken on lease from the government for a certain long-term period.

The land became a major source of revenue in 1985 under the premier Zhao Ziyang, on the suggestion of Henry Fok, a Hong Kong-based businessman. The local governments give out long term land-use rights, in exchange for capital. Apart from generating upfront revenues, it allows local bodies to tax the people and companies shifting in, all while creating employment for the local citizens.

These sales are financed by Chinese banks that had been pushed to lend at easy terms in order to help the economy grow. For banks, lending would mean size as well, and size would mean greater proximity to the ruling party and more power. Propelling the real estate boom was the growing mass of migrants who had shifted from villages to cities in search of better opportunities in China.

“If you build, they will come” became the mantra of land developers who seized up thousands of acres to build megaprojects in China. As a result, land has become a major revenue driver for provinces and indirectly drives the rest of the economy. Some provinces have even blasted through mountains to create more land to sell. Others have resorted to moving schools, and older buildings to the outskirts of the cities in order to sell the valuable land in the city centre. However, provinces seem to have gone overboard with land sales and building new cities.

Unfortunately, the projects were unviable as the cities hardly needed more buildings. Though migrants continue moving away from villages, the pace has slowed down significantly — lowering the need for new real estate. Consequently, China is now lined up with a huge real estate inventory that nobody wishes to buy. Given the leverage used to build these huge ghost cities, it was only a matter of time before loans went bad.

However, for years, Chinese banks have claimed that bad loans are a minute portion of their loan book. The evidence and the numbers do not add up, leading money to suspect that the numbers are being dressed up by the government.

Previously, Beijing had issued directives to prevent debacles in the banking and real estate sector, but the economy’s dependence on the sector prevented it from taking any strong steps. But after the Evergrande crisis, the regulators have turned quite cautious. The Chinese public has always believed that the government will bail them out no matter whether a private company defaults or a wealth management product sold by Chinese banks.

A debacle the size of Evergrande could lead to social unrest if people do not receive their hard-earned money, and unrest is anathema to the authoritarian Chinese government. As a result, Evergrande’s pre-sales revenues have been ring-fenced and real estate companies are being watched closely by the government.

The effects of the lockdowns are visible in the numbers in the month of April — retail sales were down 11 per cent, industrial production fell by 2.9 per cent, while the new real estate sector constructions fell 44 per cent. New property sales have significantly decelerated as well, placing further pressure on an already declining economy. Local government financing vehicles that sell bonds to fund real estate development have raised just 75 per cent of the amount they raised in the first quarter of the last calendar year.

For Liu He, reviving the economy is of utmost importance and the vice-premier has been asking officials to ease the pressure on Chinese companies. If reports are to be believed, Hu Chunhua and Han Zeng, both of whom are vice-premiers have taken a stance opposed to Liu He. They believe, just like the Housing Ministry, that the real estate sector must be controlled and the problems must be solved before easing the rules again.

Simply put, Liu He appears to believe that China is in a grave economic crisis, while the other premiers believe that the economic issues aren’t as grave. In addition, it appears that Liu and his supporters believe that the room for stimulus such as lowering interest rates is limited as other countries continue to increase rates.

If investors are offered lower rates with higher risk, foreign money is likely to move out of China. Apart from real estate, Liu has already assured investors that the technology crackdown is nearing an end, as investors have sold technology stocks relentlessly over the last year.

China’s situation remains sombre, and the policies it uses now could have long term ramifications. Easing the real estate market could relieve the pain for now, but could potentially lead companies to borrow unsustainably or misuse funds again. In contrast, keeping the sector under strict control could cause a significant impact on the economy immediately as visible from lacklustre sales over the last few months. At indirectly 25 per cent of the economy, the impact of a collapse in the real estate sector is huge, not just in China, but in the rest of the world as well.

This article was first published here.