In 2012, the government embarked on numerous financial reforms. They included liberalizing interest rates, clamping down on property price increases, limiting government agency spending, and imposing new rules on lending. These narrowed bank lending margins, so money flowed instead into retail trusts and wealth management products (i.e., shadow banking) through which banks could continue to invest in real estate and chase yield.
Nevertheless, a large portion of official lending in China is still aimed at the real estate sector. By some measures, housing absorbed up to one-third of total lending in 2013. Furthermore, maturity peaks are coming, with more than 60 percent of all loans due in Q2 2014, and almost 45 percent of those in Q1 2015, being in the real estate sector. The impact is felt even beyond official loan channels because property is often used as collateral to support billions of dollars in corporate borrowing.
Chart 1 & 2: China's real estate is a crucial part of its economy
Sources: Bloomberg, Nomura, Milken Institute.
Notes: Loans from large and middle-market banks, including ICBC, Bank of China, BoAg, BoCom, China Construction Bank, China Merchants, Minsheng, Everbright, and Citic. "Gov’t" refers to regional and local government, while "M&M" stands for metals and mining.
Now, housing inventory is overflowing, and it's not limited to first-tier cities like Beijing, Shanghai, Guangzhou, and Shenzhen. In fact, second-, third,- and fourth-tier cities account for 95 percent of housing under construction. In the same way that infrastructure development (e.g., subway projects) in many small cities has overshot their actual needs, the supply of real estate has far outstripped demand in recent years.
Because of this structural overbuilding, the market has displayed cracks. For example, Zhejiang Xingrun Real Estate, a major property developer, defaulted this year on $567 million in debt owed to more than 15 banks. Li Ka-shing, a real estate investor and the richest man in Asia, sold nearly $3 billion in Chinese property in the past year.
As these fissures appear more frequently, the government has two policy choices: Embrace reform by letting companies default and trusts fail, or continue to bail them out. The more likely route, in our view, is continuing bailouts because so much of investors’ wealth depends on growth targets remaining high, which in turn relies on the continual expansion of real estate. There’s just too much at stake for the leadership to do otherwise.
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