China's economy in the doldrums: The ghosts of Chinese real estate sector

Although the IMF has revised its growth forecast for China recently, the future of the Chinese economy is in doldrums owing to massive uncertainties related to real estate slump, increased default and an all-time high unemployment rate. Hong-Kong’s Hang Seng Index has shown a drop of over 25% since January 2023, and Bank of China is repeatedly intervening to maintain the value of its Yuan. Although the IMF is predicting a 5.4% growth forecast, this figure is difficult to achieve owing to the turbulence in the Chinese real estate sector. The real estate sector is the single biggest contributor to Chinese GDP and anything affecting it will invariably affect the Chinese economy.

In 2005 the Chinese property bubble started with a boom and today, nearly 30% of the entire GDP of China comes from the real estate sector which is highest in the world in terms of financial volumes. Even when the Chinese economy is stabilising and the significance of the Chinese Yuan is growing worldwide (thanks to the Russia-Ukraine War), the fall in the real estate sector has still not stopped. Every drop in the Chinese real estate market is pulling its GDP down in a similar ratio.

As per an estimate by Reuters, the return on real estate investments in China are likely to fall below -7.7% this year as against the government projection of -4.2% in May 2023 and the home sales are likely to decline by -5% as against the projected figures of -2.7%. Not only this, the overall sales of real estate projects in China have fallen by a remarkable -35% in August 2023. This is the same real estate sector of China where property prices used to get tripled in a short span of 3-4 years between 2005-2009.

Let us decode the Chinese real estate market and its effect on the Chinese economy in four easy points 

1. Rat race to construct projects against low demand: Due to an artificial bubble in the real estate sector between 2005-2009, the returns in the real estate market were significantly higher and the investors worldwide were looking to secure their investments. This was the time when the Chinese real estate market proved to be lucrative for not only Chinese domestic investors but the global players too. Further, during the economic crisis of 2007-09 when markets were crashing globally, the only opportunity visible was in the Chinese real estate sector. Major property giants like Evergrande, Country Garden, Greenland Holdings, Fantasia holdings, Guangzhou R&F, Aoyuan, Modern Land, Sunac, Zongzhi enterprises, Zhongrong International, Sinic Holdings and Kaisa Group took advantage of this situation and started launching real estate projects despite of the fact that there was much lesser domestic demand. 

2. Easy bank financing and local government financing vehicles (LGFV): In order to support the booming real estate sector, the Chinese government started working on two fronts. First was that in order to promote the sale of these projects, they made individual as well as corporate financing easy and second was that to get the government benefited, the local governments started to float some Local Government Financing Vehicles (LGFVs) to invest in infrastructure bonds in China. 

Common Chinese people found these schemes to be lucrative and bought these projects with external financing or loans. For them, it was a golden opportunity as few banks were even offering 100% financing on residential projects. As per a report from the Washington Post, nearly 80% residents of China invested in this property boom in some or the other way. They took loans and invested in real estate anticipating that they would get good returns. The projects created were much more than the actual demand and as a result, the commercial feasibility of these projects started declining.

As far as LGFVs are concerned, these bonds were simple. Local governments mortgaged their lands to banks and the money obtained through this is invested by means of bonds in the real estate market. It had a direct risk associated with the land prices but no one was bothered. Although these LGFVs offered low returns but since there was direct accountability of local governments, they were considered secure.

This issuance of these LGFVs reached its zenith in 2023 when the total debt on local governments was found to be close to $10 trillion. One of the IMF reports mentioned that these LGFVs contribute nearly 40% of China’s annual non financing corporate bond market. This situation did put the entire economy at huge risk. 

As the investments in real estate were growing, market liquidity became higher than any other country. As a result, property developers like Evergrande started creating cities, shopping malls, housing colonies, commercial districts and other residential options with this easy money. Not only this, with the free flowing money, they also started investing into non real estate markets like theme parks, energy and wealth management products. 

3. Three red line rules of Chinese government and default of real estate giants: As the demand of the projects was declining and real estate companies were working uncontrolled, the lending by the financial institutions started increasing too and reached a critical state. The Chinese government realised that this is going to be a threat to their economy as the real estate companies were working uncontrolled. So they launched the three red line rules in August 2020 to secure their economy and lendings by the financial institutions. 

The first of the three rules says that “Liabilities should not exceed 70% of the total Assets”. Second one says that the “Net debt of any organisation should not be more than 100% of its total equity” and the third one said that “Cash reserves with any company should be at least equal to its total short term debt”.

This rule not only created ripples in the market but also compelled many of the real estate developers to default. Nearly 50% of the top 25 real estate developers defaulted on at least one rule prescribed under the three red line rules policy. They defaulted not only on their payments but also on delivery of projects and as a result, the property prices started falling down. The fall which was in double digit till a year back has been contained to be -7.7% negatively today. As per a data from ‘CreditSights’, the overall overseas default of all the real estate giants is pegged more than $175 billion and out of this Evergrande alone has over $20 billion overseas liabilities as on date. If we take the statement of Hang Seng Bank Chief Economist Mr Wang Dan, more than 5,000 real estate developers in China have already filed for bankruptcy. 

Retail investors also contributed to the default to a large extent. Most of them even walked out of deals after paying instalments for 3-4 years. As a result, we can see several ghost cities in China where projects are ready but there is no one to buy, no one to stay and no one to pay for them. Mike Seccombe says in “The Saturday Paper” that there are about 80 million empty apartments in China currently, a number which is alarming and indicates the fall of the Chinese economy. 

4. Indicators for future (with respect to real estate sector): With the real estate sector contributing nearly 30% to the GDP of China, there is a direct connection between the two. It is estimated that despite all out efforts by the Chinese government to revive the real estate sector, it will be extremely difficult for Beijing to achieve its target of 5.4% GDP growth in fiscal 2023. Although the Chinese government and top notch sources in the Communist Party of China claimed to have a stabilised real estate market this year, the fallout of the previous years is certainly going to haunt not only the Chinese economy but also the global financial aspects. 

The very first reason is the increase in household debt of China which is primarily attributable to the real estate market. We must understand that at a time when China is boasting of achieving 5.4% GDP growth, the avenues of its growth will be directly dependent upon the purchase capacity of its residents and the liquidity in the market. With an average household debt of 128% of annual gross income, purchase capacity of the residents will automatically decline and this will have a cascading effect on its GDP growth. 

At the same time, Chinese exports have plummeted due to various sanctions and trade barriers with the west. Manufacturing industry is also moving out rapidly to countries like India, Philippines, Myanmar and Africa, and at the same time there is no visibility of the return of its investments on Belt and Road Initiative or string of pearls. Investments in Pakistani CPEC alone are more than $50 billion, which are on the verge of a default. 

In view of the above, it is widely perceived that in the current fiscal year, the overall GDP growth of China (if not forged) will remain well below 4% and its dream of achieving 5.4% will be in doldrums. Stabilisation of the economy may not happen immediately or in the next 3-5 years. Although it will achieve some growth but in a holistic view, the same will remain well below the overall average in south Asia. 

The author is a veteran of the Armed Forces. He is a known Defence Strategist with keen interests in international affairs, maritime security, terrorism and internal security.

(Disclaimer: The views expressed above are the author's own and do not reflect those of DNA.)