‘Pop’ goes the Chinese property bubble

China’s ongoing efforts to deflate a frothy property bubble could accelerate the risk of default by local investment companies that went on an orgy of debt-driven infrastructure spending — and prove a serious drag on economic growth, warn economists.
Just this week, Chinese authorities took a slew of policy actions
to curb excessive speculation in the property market that has sent prices soaring even beyond the big cities. They raised the downpayment requirement for home buyers to check leverage, raised interest rates on second mortg-ages, tightened lending norms to disincentivise speculation by “non-residents” and are reportedly planning a property tax in four cities — Beijing, Shanghai, Shenzhen and Chongqing.

To observers, this multi-pronged crackdown, which targets vendors, buyers, banks and local governments, means only one thing. Chinese authorities are moving “aggressively to deflate a number of housing bubbles around China,” says Standard Chartered economist Stephen Green.

“Beijing has decided that China’s property market needs a short, sharp correction,” adds Societe Generale economist Glenn Maguire. “Or to put it less delicately, an inflating bubble needs to be pricked.”

China’s property bubble has, of course, not been driven by leveraged debt. Nevertheless, says Maguire, “there has been a dramatic surge in the amount of mortgages taken out over the past year — with mortgages equivalent to almost 50% of the value of property sold at the end of 2009.” And just as mortgage debt turned up rapidly in the past year, consumers too have taken on more debt.

In response to the recent policy crackdown, demand for apartments has reportedly fallen nationwide in the past week, and there is anecdotal evidence that some developers have cut prices by 5-10% in Beijing, says Green. “Housing demand is likely to slow for at least a few months” and developers will very likely pull back from land auctions in the coming months.

But the calibrated cooling down of the property market is bad news for local governments, which benefit from land sales revenue, and which, adds Green, were “making out like bandits as their local bubbles continued to inflate.”

In particular, investment companies floated by local governments, which carry a heavy burden of debt, have emerged “as a potentially large drag on growth prospects,” reasons RBS economist Ben Simpfendorfer.

The risk, he points out, is that some local investment companies have used land as collateral to borrow money to fund uneconomic projects. “And if land prices were to fall, in the event of the property market correction, the risks of default would grow.” This linkage, adds Simpfendorfer, “further complicates the central government’s efforts to cool an overheating property market.”

China has experienced a similar problem with non-performing loans (NPLs) in the past as well. In 1999, China bailed out its banks buying 1.4 trillion yuan ($200 billion) worth of NPLs, which equated to 16% of GDP, similar to today’s estimates of likely NPLs. And that bailout did not stop China’s economy from growing. In fact, Simpfendorfer says, “nominal GDP growth was an effective way of absorbing the stock of NPLs.”

But, he says, it seems unlikely China can repeat that performance — of “growing its way out of its NPL problem”. For one, it may be difficult to turn off the credit tap — with risk of higher NPLs — if the risk of a correction in the property market requires a fiscal response to stabilise economic growth.

For another, China is yet to solve the problem of the fiscal relationship between the central and local governments; in particular, it hasn’t found a sustainable way to fund local governments.

“Policy action taken this year is crucial,” cautions Simpfendorfer. “The government must prevent a destabilising property bubble from curbing GDP growth.” Although consumer inflation has so far remained benign, medium-term inflation pressures suggest that the central bank may eventually have to tighten more aggressively than it might like to.