Chinese Real Estate: Decline And Consequence

Includes: FXI, TAO
by: William Gamble


Real estate is probably the most important sector in the Chinese economy. Real estate construction accounted for about 16% of Chinese GDP last year.

Real estate prices are still growing in large cities, but have started to decline in third and fourth tier cities.

This will endanger the large local government debt pile.

Foreign investors are also directly exposed through Chinese developer bonds amounting to $48 billion (US dollar bonds) and $6 billion in renminbi denominated debt.

Real estate is probably the most important sector in the Chinese economy. Real estate construction accounted for about 16% of Chinese GDP last year. This level approaches the levels in Ireland and Spain before their housing bubbles imploded. Not only is it important to the economy, it also represents the main support for local governments. Land sales and property related taxes provide 38% of total government revenue. This is particularly important for heavily indebted local governments. It is relied on not only for the income; because of its high valuation it is used as collateral for their loans. Given its importance, any wobble in China's real estate market will have significant consequences.

But is there any need to worry? According to the latest official data house prices in China's 70 biggest cities rose an average of .3% in February alone. The annual increases in Beijing, Shanghai and Shenzhen region were 10.3%, 13.1% and 12.8%, respectively. According to Wang Jianlin, a developer and China's richest man, "There are only two possibilities to explain why people are predicting a collapse of Chinese real estate. Either they have ulterior motives or they have insufficient intelligence."

Is Wang Jianlin right? With such continued strong growth is there any reason to suspect problems? The growth figures for Chinese cities are actually slower than for the US housing market. The Standard & Poor's/Case-Shiller index, which tracks property values in 20 metropolitan regions across the US, rose 13.4% on an annual basis. Monthly increases in the price of US real estate during the first quarter rose .4%, also faster than China.

The cause for concern is not the growth but the rate of growth. The blistering pace of growth in 2013 has begun to moderate. The number of Chinese cities experiencing growth reached a 13-month low. The problems are not in the large cities. As the size of the market declines, the problems rise. Prices in first tier cities are strong. Prices in second tier cities are shaky. Prices in third and fourth tier cities are starting to decline.

Growth in land prices has also started to slow. They have declined from 2.6% growth in the fourth quarter to 2.1%. This is the first slowdown since 2012. Such a decline would hardly be noticed except for the collateral issue. Many local governments need to refinance. Falling prices of their collateral won't help.

Though prices are generally increasing, sales are not. Property sales gained 26% in 2013, but they have slowed substantially since then. This is true not only in smaller cities but in Beijing and Shanghai as well. Beijing had a 65% fall in sales of pre-owned homes and a 56% fall in sales of new homes in the first quarter. Shanghai had similar numbers: a 56% fall in pre-owed homes and a 40% fall in the new home market. The average fall in sales for the top 10 tier one cities was 20% in the first quarter. The first six days of April saw a decline of 23% in 42 cities.

With all the declines, it is surprising that prices haven't fallen as well. Price cuts are rare in China and only used as a desperate measure. Most developers faced slow sales start with discounts or extras. For example in Qinhuangdao east of Beijing two large developers, Evergrande and Vanke, are in a price war with their smaller competitors. A Chinese price war does not necessarily mean a fall in price. Instead it usually means a rise in discounts or extras. Vanke offers Rmb 50,000 in cash rebates. Evergrande's offer is to pay for two-thirds of the 30% down payment required by law until construction is completed in a year. In other lethargic markets developers are offering free interiors, household appliances or parking spaces.

Another problem is President Xi's fight against corruption. With limited investment options, real estate is a preferred place to put your funds, even if you made the money in ways that weren't exactly honest. The government is presently implementing a property registry system and will probably force government officials to register their assets in an attempt to clamp down on corruption. The possibility of exposure will induce many officials to sell the luxury apartments they own and not buy more.

So far the slowdown is not critical, at least in first tier cities. But many smaller cities are severely overbuilt and a correction is likely. But any air coming out of a Chinese property bubble will have an impact far beyond China.

Thanks to the generosity of central bankers, investors, especially in Asia, have been searching for higher yielding investments. The result is an extensive direct exposure to Chinese property companies through their bonds. Chinese developers have dominated the Asian bond market. A fifth of all non-financial bonds sold by companies across Asia in 2013 came from Chinese real estate companies. They provided more than 40% of new issuance. All of this debt added up to $48 billion of US dollar bonds and $6 billion in renminbi denominated debt. In addition to the bonds, there is probably another $30 billion in syndicated offshore loans outstanding.

The US debt must be a real problem since renminbi fell as low as 6.2509 renminbi against the dollar this week. This is the weakest since Dec. 12, 2012, when it hit 6.2588 yuan. That is a loss of 3.1% for 2014 which more than offsets last year's 2.9% gain. The renminbi is now Asia's worst performing currency.

With the property market softening, the bonds are deeply underwater. Vanke and Evergrande are the largest and second largest real estate developers in China. Country Garden is number eight. Their bonds trade at about 92 cents on the dollar, a fall of 8%. Bonds of smaller developers have fallen further. Developers' shares have fallen along with their bonds. The shares of Evergrande and Agile, the ninth largest developer, have fallen by a quarter.

To their woes, the Chinese government has tightened credit. Data released on April 15th showed that total social financing, the widest official measure of credit, fell by Rmb 560 billion ($90) billion or 9% year on year. In contrast the US taper has been slowing at only $10 billion a month since the beginning of the year.

Worse, much of the credit from the shadow-banking sector has disappeared. Non-performing loans at Chinese banks have been rising. They have already been discouraged from lending to developers. The main alternative was the shadow banking system, but new loans have declined 78% year on year. New loans are also more expensive. Trust loans are extended for interest rates of about 11%.

With all the problems, there is always the possibility that a slowdown could turn into a collapse. This is especially true in China where local debts are so intertwined that the collapse of one company can lead to the collapse of many more. In the past the Chinese government has prevented a hard landing by just issuing more debt. But there is a limit to this policy. It now takes three yuan of debt to produce one of growth. So eventually it has to stop. Whether that time is now will become evident quite soon, but the signs are certainly ominous.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.