China's property bust holds lessons for India

India and China are on the opposite end of the economic cycle in real estate

China’s property market is in its worst slump since private property markets were created in the country in the mid-1990s. Sales are stuck at 80 per cent of the pre-pandemic levels and, while they may have hit bottom, show no signs of picking up. The bust began in mid-2021, as the government clamped down on property developers in an attempt to rein in leverage and protect the financial system. There were fears of systemic risk if the unbridled borrowing of the property developers was not brought under control.

Already weakened by their restricted access to credit, the Covid shutdowns further decimated the developers’ balance sheets as buyers stayed away. Sales volumes this year are on track to decline to 1.5 billion square metres, the lowest level since 2015. The problem now seems to be a lack of confidence among buyers. Evergrande is the biggest in a long list of developers with severe financial stress. In the offshore bond markets, bonds worth 150 billion renminbi (RMB) are in default, with another 80 billion RMB of bonds having their maturity extended. This is more than 15 per cent of all developer bonds issued overseas. In the onshore bond markets, developers have defaulted or extended the maturity of another 70 billion RMB worth of bonds.

Individual buyers have seemingly lost faith in the capacity of the developers to complete projects or deliver apartments that they have already pre-sold. Slowing income growth in China and the uncertainties around the lockdowns have further dented buyer confidence. The majority of apartments in China are pre-sold by developers, with the latest data showing that almost 90 per cent of all residential property was sold in advance of completion. As the authorities clamped down on builder leverage and access to credit, the property developers increased their focus on pre-sales as a source of cash. The ratio of property pre-sold increased from 80 per cent in 2017 to 90 per cent today.

As sales cratered in 2021, this critical source of funding disappeared. The pre-sales model works well when demand is growing and developers can sell more apartments every year. It is a real millstone around their neck when sales are falling and the cycle reverses. As more and more developers came under stress, buyers became increasingly worried as to whether they would actually get the property that they had paid for. Groups of buyers have publicly spoken about suspending mortgage payments until they receive the completed property. As risk aversion sets in, even willing buyers are not ready to commit to projects still under construction. This is now becoming a vicious cycle. If the developers cannot pre-sell property, they cannot complete projects, thus creating completion risk, and the cycle continues.

The financial troubles of developers have forced them to suspend construction activity and stop new projects. The ongoing construction activity is down by 40 per cent and new construction starts is down by 30 per cent, back to 2010 levels. Land sales are down by 50 per cent. Clearly, the sector is in crisis mode.

This slowdown is forcing a crunching adjustment in a sector that has been one of the major growth drivers for the Chinese economy over the last decade. Construction and real estate account for about 14 per cent of Chinese gross domestic product (GDP) directly and by many estimates about 30 per cent of GDP if we account for the indirect effects. Activity in the property sector has declined in real terms for four quarters now, the longest and deepest decline seen in over 30 years. Despite the weak property data, the economy has continued to grow, largely due to exports and the stimulus for infrastructure expenditure. However, there is no chance of China hitting the 5.5 per cent growth target set for 2022.

The weak outlook has forced local officials to relax property ownership restrictions and mortgage rates have declined by over 100 basis points this year (reaching 2016 levels). However, while arresting the decline, these measures do not attack the core issue of a lack of buyer confidence. The government needs to address its stimulus measures to ensure that property projects get completed and apartments already paid for are delivered. The central government has taken some steps in this direction, asking the state policy banks to fund projects stuck midway. However, not enough has been done. Chinese policymakers seem reluctant to directly help over-leveraged property developers, continuing to target the bulk of all stimulus measures towards infrastructure spending.

China seems poised to go through an extended economic slowdown unless more concrete measures are taken to shore up the property markets and buyer confidence. Exports, given the global slowdown, and infrastructure spending on their own are unlikely to bring the Chinese economy back towards 5 per cent growth anytime soon.

Illustration: Binay Sinha

The weakness in China’s property market will have inevitable consequences for global commodities. Till now the impact has been limited as the surge in infrastructure spending seems to be offsetting the property slowdown. However, if construction continues to decline, commodity prices will be impacted. The other impact of the property slowdown is in the divergence of monetary policy between China and most of the developed world. The US and EU are tightening policy and financial conditions to arrest inflation, while China is actually cutting rates to offset the property bust and stabilise its economy. The US treasury bond yields are now higher than Chinese government bonds, and the yield gap will only grow. This has inevitable consequences for the Chinese currency. The RMB has weakened and is now moving towards a critical level of 7 (USD/RMB), having started the year near 6.35. The last time the Chinese currency had crossed 7 was during the depths of the Covid-19 panic in April-May 2020. A weakening Chinese currency will inevitably put pressure on other emerging market (EM) currencies as well. No country wants to lose competitiveness to China.

The property bust in China holds some lessons for India. It shows how large a driver of growth the real estate and construction industry can be for us as well. It also highlights the drag on growth that we also went through following the IL&FS crisis. The real estate sector in India was suddenly deprived of liquidity, as non-banking financial companies could not grow their balance sheets due to funding constraints. We saw a wave of defaults by builders and a surge in real estate-related non-performing assets. As construction activity and the broader real estate sector are now poised for robust growth, they will be a strong growth multiplier for the Indian economy.

The property sector is a microcosm of the differences between India and China and where each country is placed on its respective growth cycle. In India, construction and real estate is booming, credit is growing and property reforms have already been put into place. Construction, therefore, will drive growth. China is in almost exactly the opposite position.

The writer is with Amansa Capital