This article was first published in Nikkei Asia on December 1, 2023.


Stronger policy framework would reduce risk of further real estate bubbles

China has recognized the need to stabilize its property sector to keep developers’ severe financial problems from spilling over further into banking and other key sectors of the economy or even affecting other nations.

The real estate sector accounts for nearly 30% of China’s gross domestic product. About 40% of outstanding bank loans were issued to developers and homebuyers. Land sales to developers have also long been a key source of revenue for local governments.

The risk of spillover from property market distress is especially high because many of China’s large developers have expanded well beyond the real estate sector, venturing into areas including agriculture, automobiles, health care, entertainment and tourism.

Last year, Chinese nonfinancial companies defaulted on a record $52 billion of offshore debt. Developers accounted for most of this sum.

A further $84 billion of developers’ dollar bonds are due for repayment over the next two years and creditors have reason to be worried about whether they will get back their money.

Around 45% of Chinese property companies are at risk of debt distress based on two common financial metrics: the debt-service coverage ratio, which measures net operating income against scheduled principal and interest payments, and the interest coverage ratio, which measures earnings before interest and tax against interest expenses. Those seen as at risk have a debt service ratio of less than 1 or an interest coverage ratio below 1.25.

Since September 2022, the government has adopted a calibrated approach, implementing a range of policies to stabilize the property sector while mindful of the risk of tilting the market into overconfidence. Measures have included extending outstanding loans to developers, relaxing requirements that developers keep revenues from apartment presales in escrow accounts and reducing interest rates for first-time homebuyers.

Although a broad-based collapse of the property market has been averted for now, more developers continue to run into trouble. Worries have most recently centered on China Vanke, which though one of the country’s largest property companies, had previously appeared comparatively unscathed.

At this point, it would make sense for the government to look at restructuring the debt of troubled large developers through steps such as lengthening borrowing terms and trimming interest rates. These initiatives should be executed through the coordinated effort of regulators, creditors and local governments.

For property companies that really prove nonviable, assets and business lines should be gradually pared down through sales. Where there is little prospect of sale, operations can be wound down and liquidated to bring the company back to a manageable size.

Developers who are getting help in the form of lowered interest rates should undergo means testing to ensure their ability to service their debts would survive future higher rates. Controls on escrow accounts should ensure funds are used for construction of specific related projects to prevent misuse.

The authorities’ longer-term prudential policy stance should be strengthened to stamp out speculative demand and avoid a recurrence of destabilizing distress. Preventive measures, like the imposition of taxes on property investors, are always better than crisis management.

Robust macroprudential policies should be consistently in place to ensure that loans are prudent right from inception. Conducting stress tests on the ability of mortgage borrowers to pay back their debts is essential. Only those that meet prudential policy standards should be granted loans to minimize potential risk to bank balance sheets. Moreover, larger property developers should build up cash reserves sufficient to cover several months of expenses to ensure adequate liquidity even when cash flow runs short.

The integrity of the banking sector should be strengthened through better transparency and improvements in corporate governance. Clearer ownership limits on banks can help to reduce potential conflicts of interest, heading off the possibility of a repeat of China Evergrande Group’s heavy borrowing from Shengjing Bank.

Taxes on capital gains from the sale of property within a few years of purchase could be introduced to discourage speculative real estate activity. This would align with President Xi Jinping’s principle that housing is for living, not for speculation, while also generating additional fiscal revenue.

The good news is the property market itself is showing some resilience and according to National Bureau of Statistics data, property prices remain above pre-COVID levels.

The country’s largest cities appear better poised for a rebound than secondary cities. This divergence could accelerate with further rural migration to the biggest cities while smaller ones could see population falls. Such population changes would likely affect property demand and eventually impact price trends.

By employing comprehensive measures, China’s financial landscape can be fortified. This would help to safeguard systemic stability and resilience against shocks in the property sector. A stronger policy framework in turn will reduce the risk of any reflation of the country’s real estate bubble.