China’s real estate sector has long been too big and too risky, and that’s no coincidence. It was at the heart of the Chinese leadership’s plan to revive the economy from the global financial crisis in 2008. Since then, the way forward for the sector has been to go into debt in order to increase the supply of housing, given of the infinite demand of Chinese households. for them.
In fact, housing has long been the most important asset for the Chinese as an investment of their savings, in light of the still draconian controls on capital outflows. Investing in housing has been an eldorado for Chinese households, as prices have been rising steadily until recently.
Reasons for lower prices
Prices suddenly slowed down in 2021 for several reasons. First, there was a sudden regulatory push to control the overburdened balance sheets of real estate developers, which resulted in the restructuring of some large real estate companies, such as China Fortune Land, before Evergrande even got into trouble. .
In other words, Chinese households – even though they are inundated by a still rosy image of the Chinese real estate sector and economy in local media – are increasingly reluctant to invest in real estate.
If Evergrande didn’t deliver on its promises, pre-sales for homes would dry up in China, pushing most real estate developers to the brink.
The second reason is that the stricter controls do not only affect developers but also buyers of real estate who face huge down payments as well as the fear of a nationwide property tax, which is widespread for some time.
Finally, Chinese households are bearing the brunt of an economy that has been slowing rapidly for several years, driven by its own overcapacity but also by the trade and technology war led by the United States and, more recently, the pandemic.
Housing is a major source of inequality in China
The Chinese government’s crackdown on the real estate industry comes against the backdrop of China’s rapidly evolving long-term economic goal of “über Alles” growth to common prosperity. The crackdown involved the introduction of the so-called “three red lines” to limit their debt leverage, dependence on pre-sales and short-term funding that was too short.
Common prosperity is President Xi-Jinping’s new economic mantra, after dual circulation, to stress the importance of better income distribution and greater equality of opportunity. Excessively high – and rising – house prices are arguably the most important source of income inequality in China. Access to housing – or lack of it – is a key factor in explaining the income disparity.
Evergrande could not but be the target of government crackdown for a number of reasons. First, it is the biggest real estate developer. Second, it is the most exploited and does not fill any of the aforementioned three red lines.
Third, Evergrande is heavily exposed to foreign investors, whether through the Hong Kong Stock Exchange or bonds issued in the Hong Kong offshore market. These, which represent nearly $ 20 billion, mostly denominated in USD, were mainly bought by foreign private banks and asset managers for their high net worth clients.
It seems clear, after the failure to pay a bond coupon in USD last Thursday, that Evergrande’s offshore debt will undergo restructuring. Following the example of China Fortune Land, which is completing its own restructuring, it will not necessarily be a nominal discount but an extension of the maturity and a reduction in the interest due.
Foreign investors are likely to be relieved if such a restructuring is announced as they now lack clarity on the future of their investment in Evergrande. Still, the bulk of Evergrande’s debt is domestic and will need to be repaid, especially the amount Evergrande received in pre-sales from Chinese households.
1.5 million are waiting for their apartments
Almost 1.5 million Chinese households are waiting for Evergrande to finish their homes, and it sure will happen. The main reason is the massive reliance of other real estate developers on pre-sales, so if Evergrande failed to deliver on its promises, pre-sales for homes would dry up in China, pushing most real estate developers to the brink.
Moreover, President Xi-Jinping’s common prosperity is not really about putting losses on households. As such, the Chinese government has already given clear signs that local governments will deal with unfinished projects.
Two important points to remember follow. First, the Chinese real estate sector is not doomed to collapse after the demise of Evergrande, because public money will be used to resolve its systemic consequences in China. This does not mean, however, that everyone, especially foreign investors, will be fully bailed out. Evergrande should serve as a warning signal of the cost of excessive leverage.
The second point to remember is that China’s growth will suffer. Not only will the real estate sector – which is a key contributor to investment, jobs and growth in China – slow down after the demise of Evergrande, but investors in general will increasingly be wary of the radical change in China’s priorities.
Economic success is no longer the goal, and financial excesses will be penalized. Contributing to common prosperity is now the key objective, even at the cost of disgruntled private investors and hence potential stagnation of the economy.