Five phases of China hard-landing denial

February 20, 2012

By Wayne Arnold

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

China watchers are in denial over the likelihood of a property crash. While politicians openly worry about China’s too-expensive houses, economists polled by Reuters in January still think 2012’s GDP will grow by 8.3 percent. That’s too optimistic. Here are the frequently heard examples of wishful thinking.

“It’ll never happen”

Many investors believe China is protected from a property crash because Chinese buyers don’t rely on mortgage lending, and because there’s plenty of pent-up demand to keep property buoyant. Both assumptions are wrong.

It’s true mortgages haven’t fully caught on. Banks lend as little as 30 percent of the value of a property. But that was true in Dubai before its 2008 crash. Buyers there paid with cash, but it was often borrowed, sometimes from informal sources. Many had other debts, too. And being overleveraged isn’t the only reason to sell. Fear of losing money is another.

Pent-up demand, meanwhile, isn’t evenly spread. Restrictions on buying second or third homes vary from city to city, so lifting them in one place could reduce demand in another. Buyers may also fail to bite: if falling prices make property look cheap now, imagine how much cheaper it’ll look in a year.

“It won’t be that bad for GDP”

Building accounts for over 10 percent of China’s GDP. Include things like furnishings and electronic appliances and it’s much more. If property prices crash, the hole in GDP would be huge. Patrick Chovanec, a Beijing-based professor, calculates that a ten percent drop in real property investment would cut GDP growth to 5.3 percent.

Economists hope two forces can counteract this. One is that China’s ample household savings will enable consumers to keep spending. But the household savings rate of 30 percent of disposable income is skewed toward the wealthy. And investment accounts for more than half of China’s growth, so consumers would have boost buying at more than double the usual pace to produce the same rate of growth.

Affordable housing is the other great hope. Plans to build 36 million units of cheap accommodation by 2017 could support the building trade. But the funding is supposed to come from local governments, who are highly indebted themselves, and depend on selling land and property for their income.

“The banks can absorb the blow”

China’s banking system is right in the line of fire. Yet the IMF estimates that a 26 percent fall in property prices would create nonperforming loans of roughly eight percent of total lending. China’s bank regulator says the $1.63 trillion in property loans are backed by property worth almost twice that.

These numbers are misleading: they understate the amount of property lending and overstate the value of collateral. Most commercial loans use property as collateral, even if they’re not technically real estate loans. And much lending to developers has come from non-banks like trusts, wealth-management vehicles and companies.

The property backing loans, moreover, is valued at current prices. That’s fine if one borrower defaults. But as Japanese banks discovered in the early 1990s, when the entire market falls and defaults spread, the value of collateral also plunges. Non-performing loans could feasibly rise close to 20 percent.

“Beijing will just bail out the banks”

It has happened before – when China carved out bad loans from its lenders in the late 1990s. Now the country has $3.2 trillion in foreign reserves and virtually no foreign debt. But things aren’t so simple. Reserves are technically future claims against the central bank. And while buying bad loans from banks makes the problem disappear from view, it still means a loss gets taken somewhere else in the system.

There’s also Beijing’s debt pile to think of. The government’s official debt is only 15 percent of GDP, but it adds up quickly. Ratings agency Fitch estimates a bailout could cost 20 percent of GDP. Add the unpaid cost of the last bailout, debts at state-owned entities, local governments and pension liabilities, and a Breakingviews calculation suggests Beijing’s debt rises to roughly 130 percent of GDP.

The last option – just print money and stuff it into banks – could worsen China’s inflation problems, and dangerously reduce depositors’ faith in the system.

“Beijing will make everything ok”

The trump card of the China bull case: Politicians in Beijing control the banking system, so they can order banks to lend. When the financial crisis hit, banks doubled lending in 2009.

But that’s what got China into its present property pickle. Lending into a weak economy raises the risk that the money funds unprofitable projects and is lost. Banks funnelled loans to big state-owned companies who didn’t need the cash. Many built property, or lent to those that did.

Moreover, the trick can’t work much longer. Banks would now need to offset not just the drop in their own lending, but lending by non-banks and trusts wiped out by the property crash. Barclays estimates this shadow financing accounts for a fifth of all new funding.

Beijing is aware of the problem. For now, the property market is effectively on lockdown – transactions levels have ground almost to a halt. But spotting a problem is different from fixing it. The denialists are in for a shock.

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