At the heart of the financial crisis which started in September 2008 was the real estate bubble in the United States and large parts of Europe. The impact of these multiple bubbles bursting is still being felt in the Western economies, more than six and a half years later.
The impact of these bubbles bursting was felt in other parts of the world as well, including China and India. China has managed to limit the damage of these real estate bubbles bursting by creating a real estate bubble of its own, over the last six and a half years.
China has gone on a huge borrowing binge in the aftermath of the financial crisis. The country has borrowed close to $20.8 trillion between 2007 and mid 2014. This is more than one-third of the money that has been borrowed globally during the period. To give readers a sense of how massive this borrowing is, the Chinese have borrowed more than 11 times India’s most recent gross domestic product of $1.87 trillion.
The McKinsey Global Institute recently released a very interesting report titled Debt and (not much) deleveraging. This report points out: “From 2000 to 2007, total debt grew only slightly faster than GDP, reaching 158 percent of GDP, a level in line with that of other developing economies. Since then, debt has risen rapidly.” By mid 2014, China’s total debt had touched 282% of its gross domestic product (GDP). This is greater than the debt to GDP ratio of some of the most developed countries in the world like Australia, the United States, Germany, and Canada.
The biggest driver of this growth in debt was borrowing by non-financial companies, primarily property developers. “At 125 percent of GDP, China now has one of the highest levels of corporate debt in the world,” the McKinsey report points out.
Nearly 45% of the borrowing or around $9 trillion is related to real estate in one way or another. Between 2008 and August 2014, property prices in China rose by 60% as per an index of 40 Chinese cities. Prices rose by 76% in Shenzen and by 86% in Shanghai. In fact, residential property prices at the premier locations in Shanghai are only around 10% lower than similar properties in cities like New York and Paris.
“Property prices have increased as well, as households have bought homes and invested in real estate to find better returns than bank deposits offer,” the McKinsey report points out. Nevertheless, property prices in China have been falling over the last one year.
As often happens in such cases when “easy money” is available the Chinese developers ended up building more homes than there was a demand for and are now finding it difficult to service their debt. In fact, on Monday (April 20, 2015) Kaisa, one of the largest integrated property developers in China, defaulted on interest that it had to pay on its debt.
In a statement to the Hong Kong Stock Exchange the company said that it had not made interest payments on its bonds due to mature in 2017 and 2018. Business Insider points out that the company “didn’t pay $16.1 million in interest on its 2017 notes, or $35.5 million in interest on its 2018 notes.” Experts who follow the real estate sector in China closely feel that other large Chinese real estate sector companies will also default in the time to come.
Given this, it is not surprising that the activity in the real estate sector is slowing down. As Wei Yao of Societe Generale points out in a recent research note: “The contraction in property starts deepened further, from -17.7% year on year in Jan-Feb to -19.5% year on year in March, making the past quarter (-18.4% yoy) the second worst in history. Land sales, in volume terms, revealed a similar deterioration and were one-third less compared to a year ago in March.”
The Chinese government understands that a major portion of Chinese growth in the aftermath of the financial crisis has come in from the real estate sector. Given this, it has started to step in to ensure that the real estate sector continues to drive growth. “The combination of the policy-easing measures announced in late March, mortgage rules relaxation and bigger tax break, should support a housing sales recovery in the coming months,” writes Yao.
Over and above this, the People’s Bank of China on Sunday (April 19, 2015) cut its reserve ratio by 100 basis points at one go. One basis point is one hundredth of a percentage and reserve ratio is the portion of deposits that banks need to maintain with the central bank. This massive cut will add nearly 1.3 trillion yuan into the Chinese financial system, giving an incentive to banks to cut interest rates particularly to real estate companies as well as on home loans.
The problem is that the Chinese banks are not in a mood to pass on the lower interest rates to borrowers. As a recent Reuters newsreport points out: “Beijing has tried to revive a flagging housing market as it looks to arrest an economic slowdown, but banks are increasingly worried about bad debts and are not passing on policy steps like interest rate cuts and lower downpayment requirements to home buyers…But the banks’ stance means policy is not feeding through to the real economy. And as the housing market accounts for about 15 percent of China’s economy, it is crucial to stopping the loss of economic momentum.”
To that extent the situation is a tad similar to that in India, where the Reserve Bank of India (RBI) has cut interest rates twice since the beginning of this year, but the banks are in no mood to pass on that cut, given that they are sitting on a huge amount of bad loans.
Getting back to China, one thing that makes the Chinese government different from that of India is that it has much greater control over the economy than the Indian government has. It has recognized this slowdown in the real estate sector and at the National People’s Congress(NPC) in March 2015 (a good time to remember that in China, the party and the government are one and the same) revised the GDP growth target to 7%. As Yao of Societe Generale wrote in a research note released in March 2015: “The Government Work Report, released at the opening session of the NPC meeting, carried few surprises. A number of economic targets have been set lower than last year (see table 1). The much hyped growth target is now “around” 7%, but the urban job creation target was unchanged at “more than” 10m, compared with the actual result of a 13m increase in 2014.”
And if the situation becomes worse than it currently is where more Chinese real estate companies start to default on their debt, the government is in a position to rescue the financial sector, like it has done before. As the McKinsey report points out: “China’s government has the capacity—if it chooses to use it—to bail out the financial sector even if default rates were to reach crisis levels. This would most likely prevent a full-blown financial crisis. Because China’s capital account has not been fully liberalized, spillovers to the global economy would most likely be indirect, via a further slowdown in China’s GDP growth, not through financial contagion.”
The column originally appeared on The Daily Reckoning on Apr 23, 2015