China’s widening mortgage boycott has raised fears of a further downward spiral of the property sector – a potential threat to financial stability in a country already under pressure from stalled economic growth, sluggish consumer demand, and COVID-19 outbreaks.
Since late June, hundreds of thousands of homebuyers in dozens of Chinese cities have threatened to stop payment on mortgages for pre-sold yet stalled property projects. At least 300 developments are reportedly affected, most in central and western regions, including some 20% in Henan Province.
The threats add pressure in a slowing economy. Second quarter data from the National Bureau of Statistics indicated the nation’s GDP grew just 0.4% year-over-year – the second-lowest ever recorded.
Could China’s property sector problems prompt a systemic financial crisis? It’s unlikely, in our view. Our stress tests indicate that China’s banking system as a whole has sufficient buffer to absorb the shock of a fairly severe downside scenario.
We estimate that delayed projects at the moment account for around 4%-8% of all under-construction projects. In our downside scenario, we assume that eventually 10% of all under-construction projects will be unfinished and all their related mortgages would turn into non-performing loans (NPL). This would translate to around 0.5% NPL formation for the system overall.
Coupled with three other sources of potential downside risk – additional NPL formation from developers, NPLs from construction loans, and banks’ potential shadow exposures to developers – we estimate additional NPL pressure of about 2.6% of total loans. In context, we estimate the annual net NPL formation rate for the whole banking sector is currently at 0.7%-0.8% and the normalised range through 2017-2020 was around 1.0%-1.3%.Footnote[i]
With the size of the potential stress in mind, we examined the three main buffers the banking system has: excess Common Equity Tier One (CET1) capital above the regulatory minimum, general provision reserves, and pre-provision operating profits. We estimate that these add up to about 9.3 trillion yuan, equivalent to 5.7% of total loans in the system – a sufficient buffer to absorb shocks from our downside scenario.
However, the buffer would look noticeably thinner if we exclude the few larger banks with stronger balance sheets.
For small and mid-sized banks, we estimate the potential NPL pressure to be 3.4% of total loans vs. 4.4% of available buffers. However, the impact from isolated cases of small regional bank stress on the banking system should be manageable, due to their small size and limited reliance on interbank funding.
Instead, we believe the key focus in terms of systemic risk should be on mid-sized banks. Not only are these banks relatively large with nationwide operations, they are also much more interconnected within the banking system – 37% of the mid-size banks’ balance sheet is funded by interbank borrowings and bonds, compared with 17% at large banks and 15% at small banks.Footnote[ii]
In addition, mid-sized banks are also relatively more exposed to shadow banking activities, suggesting that they may be more vulnerable if non-bank lenders’ financing to property developers becomes problematic before bank loans.
Considering how the government is handling the financial side of property risk, we think an imminent banking crisis still looks remote. Banks are delaying NPL recognition in their developer loans with forbearance granted by the regulators. Local governments have been issuing special bonds to recapitalise small banks, thus strengthening the loss-absorbing capacity in the system.
High-frequency data from residential mortgage-backed securities (RMBS) asset pools shows that delinquency among outstanding mortgages remains very low, with sequential improvements seen in June, despite some modest upward pressure in 1H 2022.
From a macro perspective, Chinese households’ overall leverage (as measured by household credit divided by GDP) increased quite sharply from 44% in 2016 to 62% in 2021.Footnote[iii] However, this appears manageable compared to developed market economies, and China’s overall household credit growth has slowed in recent years. Data from RMBS asset pools also indicates relatively healthy levels of leverage and debt-servicing burdens for mortgagors. Mortgage defaults should therefore remain low as the household balance sheet on average is well-cushioned. Moreover, the legal consequences of default can result in great social cost for homebuyers.
However, a key concern stemming from the mortgage boycott and the weakening property market is whether negative sentiment could spread to existing homeowners and lead to wider defaults in existing mortgages. If this were to happen, we believe it could potentially lead to a higher chance of systemic risk in the banking system.
[i] PIMCO estimates based on data from the People’s Bank of China and the China Banking and Insurance Regulatory Commission.
[ii] Source: PBOC.
[iii] Source: Bank for International Settlements.
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