A translation of the original blog written at the Central Bank of Chile
The real estate sector represents a significant portion of China’s economy. Rogoff and Yang (2021) estimate that, prior to the sector’s crisis, its contribution to the economy—including related industries—accounted for approximately 30% of GDP. This figure is well above the median of 16% of GDP for developed countries analyzed in their study. The sector’s boom was driven by increasing demand for urbanization, economic growth, and government policies favoring investment over the past decade.
In China, properties account for more than 50% of household wealth (Li and Zhang, 2021)
China’s real estate market has been undergoing a severe contraction since 2021. Over the past two years, housing sales and new housing starts have plummeted by 30% and 60%, respectively (Figure 1). At the same time, housing prices have fallen by around 10% in some cities. This deterioration is attributed to two structural problems:
Several factors explain the oversupply in China’s housing market. On one hand, for many years, there was a high pace of construction, encouraged by government policies as part of its growth strategy. On the other hand, structural factors have weakened demand and are expected to continue doing so in the future. Specifically, population aging and slowing migration flows have reduced demand and are likely to persist in the coming years (Rogoff and Yang, 2022). Additionally, demographic growth is expected to turn negative, homeownership rates are high (90%), and the average age of housing stock is relatively low.
In recent years, demand has also been impacted by the pandemic and the real estate market crisis, which has further dampened demand due to doubts about the financial health of developers and declining housing prices.
The second structural problem is the financial fragility accumulated by real estate developers. Over the past 20 years, developers accrued debt (from households, banks, and others) at a faster rate than the growth of their assets, leading to an increase in the liabilities-to-assets ratio from about 70% to 80% (Figure 2). This debt increase was driven by government policies favoring the sector and by the developers’ business model.
This model relies on rapid project turnover, heavy dependence on pre-sales, and significant leverage. A typical cycle involves a developer obtaining pre-sale funds for a housing unit and securing loans from various financial intermediaries to purchase land from local governments. The developer then begins construction, selling unfinished homes years before completion to buyers who start paying mortgages before the houses are fully built. One key vulnerability of this business model is the potential for severe liquidity pressures if any steps in this cycle fail (Huang, 2023).
These issues significantly affected the sector’s activity after the introduction of various government policies aimed at controlling the debt levels of real estate developers. In particular, the “three red lines” policy introduced by the Chinese government in August 2020 set limits on three financial ratios that developers must meet in order to access new credit. Following this policy, only three developers met all the criteria, while the rest failed to meet at least one. Notably, Evergrande, Sunac, and Greenland failed to meet all three. With the contraction of the sector and accumulated vulnerabilities, many companies have experienced significant liquidity and/or solvency problems in recent years, including Evergrande and Country Garden
Since then, the authorities have implemented various measures to support the sector, though these have had limited effects. Among these measures, packages to restore financing channels for developers and relaxations of restrictions on home purchases for families stand out. As of September this year, the effects have been modest, in a context where consumer confidence remains at historically low levels, housing prices continue to fall, and doubts persist about the financial health of developers. Recently, an expansion of the fiscal deficit by 0.8% of GDP was announced to address the slowdown. This stimulus, to be implemented immediately, could provide some relief (likely temporary) to the sector.
The sector’s and China’s economic outlook will depend on how the government’s response evolves. If the current situation persists, with relatively limited stimulus efforts, the sector is likely to face a prolonged adjustment, resulting in slow economic growth compared to historical trends. However, if more fiscal stimulus is implemented to reactivate activity and boost confidence, as recently announced, economic activity will likely recover more strongly in the short term but will increase the risk associated with the country’s elevated sovereign debt levels. A bailout for struggling companies also carries the risk of increasing sovereign debt and potential moral hazard. Lastly, a restructuring of developers’ debt will affect the financial situation of households and banks.
Despite the challenges, China’s situation has two key mitigating factors compared to past crises in other economies. On one hand, the country has accumulated current account surpluses over the last few decades, which limits the possibility of a sudden stop due to a loss of confidence in the country. Additionally, despite the high exposure of the banking sector to the real estate market, the greater prevalence of state ownership in banks reduces the likelihood of a banking crisis in this context.