The guest commentary below was written by written by Daniel Lacalle. This piece does not necessarily reflect the opinions of Hedgeye.
A few months ago, I wrote that the Chinese slowdown was much more than covid related and pointed to the challenges coming from the excessive weight of the real estate sector in the economy.
A research paper by Rogoff and Yang estimated that the real estate sector constitutes 29 percent of China’s GDP.
The problems coming from the slow-motion deterioration of the property sector have extended to the financial challenges of Chinese local governments and may create a relevant fiscal problem for the nation’s public accounts.
Sales at China’s largest housing developers fell 43% in June from a year earlier, according to China Real Estate Information, creating an alarming funding gap for local governments, where finances are heavily dependent on land sale revenues, and a significant problem for the financial sector and the government.
China’s central bank has promised to mobilize a $148bn bailout to complete unfinished real estate projects as anger rises among property buyers that have not received their homes after advancing significant payments.
The size of the real estate sector in the economy is enormous and the impact on gross domestic product of a slump in sales may be impossible to offset with other sectors. According to S&P Global, China’s property sales will probably drop by about 30% this year due to the increasing figure of homebuyers’ mortgage payment suspension.
This could be worse than in 2008 when sales fell by roughly 20%, according to Esther Liu at S&P Global Ratings. There is no sector in China that can mitigate the impact of such a drop in tax revenues and output.
JP Morgan explains the extent of the problem in a recent report (“China’s housing market alarm bell rings again”). Since June 30, mortgage suspension requests due to delayed home delivery have expanded to more than 300 projects in different parts of China.
JP Morgan’s equity research team estimates that these requests represent a total value of RMB330 billion (or a mortgage value of RMB132 billion assuming 40% Loan to Value).
Local governments have seen their fiscal revenue decline by 7.9% in the first half of 2022 and land sales collapsed by 31.4%. “Meanwhile, fiscal expenses by local governments rose 6.4% due to stickiness in fiscal spending and increasing costs associated with the zero-COVID policy” and JP Morgan estimates that a 5%pt deceleration in real estate investment would reduce GDP growth by 0.6-0.7%pt.
There are relevant implications for many sectors and for families. Real estate developers were the largest issuers of commercial paper in China and millions of savers invested in bonds and debt instruments of property developers to generate stable and safe returns.
Many of those are defaulting. According to ANZ bank, China bond defaults have reached US$20 billion in 2022, more than double last year’s total. Out of nineteen defaults recorded, eighteen come from property developers.
Real estate is also a relevant driver of economic activity in services and other manufacturing sectors. The collapse of many developers is generating ripple effects throughout the sectors that thrive from construction and the activity that real estate incentivizes.
For investors globally this is largely a domestic issue, and many expect the government to contain it through a series of bailouts and liquidity injections to the financial sector to prevent a credit crunch.
From a financial perspective this may be correct, but there is no way for the Chinese government to prevent the macroeconomic implications coming from the burst of a bubble of such enormous magnitude. Chinese GDP (gross domestic product) growth slowed to only 0.4% in the second quarter, and youth unemployment is rising to new highs.
The Chinese government may contain the financial implications of the real estate crisis, but to do so it will have to abandon the target of 5.5% GDP growth for 2022 and probably reduce the 2023 objective to a much smaller figure.
For years, the government has been concerned about the rising level of debt in the Chinese economy and the elevated weight of the housing sector, but it seemed it expected growth and the improvement in the so-called “new economy” to disguise the problem.
Many international analysts expected China to be the first economy to prove that it could navigate a real estate bubble by deflating it through central planification. There was too much hope laced on central planning and too little attention to the extent of the problem.
Now it is evident that there is no sector that can dilute the effect of a real estate bubble burst. Even if the financial challenge is addressed through bailouts and liquidity injections, the impact will have to manifest itself in the currency, inflation, unemployment, growth, or all at the same time.
Many believe that the easiest solution is to depreciate the yuan but the central bank knows it is not that easy, as inflation would deteriorate the standards of living of an already discontent population, and devaluation would destroy the purchasing power of real wages and the value of savings.
If we can learn anything from this property slump is that inflating growth with a central -planned housing bubble never leads to an easy and manageable solution.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor note by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the most recent Escape from the Central Bank Trap. This piece does not necessarily reflect the opinions of Hedgeye.
