One year ago, investors began to assess the implications of a possible default of China’s largest property developer, Evergrande. The company had $300 billion in debt outstanding, and China’s property market weakened as a result of measures the Chinese government took in 2021 to curb booming property prices.
At that time, Ed Yardeni raised the specter that an Evergrande meltdown could turn into China’s version of a “Lehman Moment.” But most economists downplayed the likelihood of global contagion, and U.S. investors shrugged it off.
Implications of Evergrande Fallout
My assessment then was the fallout from an Evergrande default would take longer to play out than the U.S. housing crisis in 2007-2008. The key consideration was that bank loans to China’s property developers are not marketable instruments, and workouts are subject to complex negotiations and regulatory oversight that can take years to settle. Evergrande, for example, recently missed its own deadline for restructuring its company by July 31.
At the same time, I maintained investors should pay attention to what was happening because China’s property market is a dominant sector and an integral part of China’s remarkable economic transformation. Property represents more than two-thirds of household assets compared with about one-quarter for U.S households. Therefore, an unraveling of this sector could rival what happened in the U.S. during the housing bust.
Last year, the spillover to other sectors was limited, because aggregate demand held up as China weathered the COVID-19 pandemic reasonably well. A Reuters survey of 10 analysts and economists showed they were still upbeat about property values and expected them to rise by 5 percent this year. Instead, prices have fallen for 11 consecutive months, and they appear headed for further declines.
COVID, Complex Approval Processes Weaken Property Prices
One reason for the weakening in property prices is the Chinese government’s zero tolerance policy toward COVID, in which parts of the country have been shuttered in response to outbreaks. Economic activity was barely positive in the second quarter of this year, and investment firms, including Goldman Sachs and Nomura, have cut their forecasts of economic growth this year to 3 percent—well below the government’s target of 5.5 percent that it concedes is no longer feasible.
Meanwhile, problems are spreading because the process for buying apartments in China requires purchasers to make substantial down payments on complexes that are under construction. The slump in the economy has caused developers’ finances to deteriorate such that they are unable to complete many projects. Some buyers, in turn, have responded by withholding payments on their mortgages, and demonstrations against property developers are becoming common.
As a result, Chinese banks are being squeezed on two fronts. The asset side of their balance sheets is under pressure from bad loans to developers and those purchasing apartments. (Note: Loans that are property-related account for about 30 percent of all bank loans.) At the same time, the liability side of some smaller banks has been impacted by runs from their depositors.
To bolster the sector, the Chinese authorities have lowered interest rates to make mortgage payments more affordable. They are also trying to shore up property developers by providing financial relief. The State Council recently passed a plan to establish a fund worth up to 300 billion yuan ($44 billion) to support multiple property groups. But these measures appear insufficient to stem the problem.
The outcome ultimately hinges on how Chinese households respond if property values continue to plummet. The main risk is that China would confront a loss of confidence by households at a time when business confidence is shaky due to the government’s clampdown on technology companies and other private businesses. This combination could result in a growth recession if not outright recession.
Will Property Bubble Usher in the End of an Era?
A version of this article was posted to TheHill.com on August 26, 2022.
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