China’s Residential Property Hangover

China bounce in residential property sales is fading looking at recent data. What does this mean for the residential property sector?

Figure 1: China Residential Floor Space Sold (Mln sqm 12-month average)

Source: Datastream/Continuum Economics

A pick-up in residential sales after the post COVID reopening has faded looking at national and developer data, despite government help to support property purchasers and some easing of the property developers financing squeeze. China residential property buyers have always been structurally optimistic and this has helped previous recoveries. However, demand for property could differ in the coming years, as the property crisis could have eroded the willingness of China households to buy a home, given the high price/income ratio in tier 1 and the excess of supply in lower tier 2 and most tier 3 cities. China population has also peaked, which will be a structural headwind to demand. Finally, recent tightening of capital standards also increase the amount of capital that banks need to hold against investor property purchases with loan to value at 60% or above, though this has been lowered for single home owners.

The stalling of the buyer’s recovery now leaves the residential property market in a difficult place. Firstly, the decline in new floor space sold in the last couple of years (Figure 1) would likely mean adverse 2^nd round effects on the economy, if sales do not rebound. This can include property developer’s viability including some further failures; layoffs from the construction industry and adjustment of steel and cement output to a lower trajectory for the residential property market. Given the importance of residential property to China economy, this can be viewed as a hangover from the property boom of the last 30 years. Official figures suggest about 14% of the economy is linked to construction, but other estimates have been double this percentage. Secondly, the lack of recovery in real estate investment (Figure 2) can spill out on a wider basis to impact local government financing vehicles (LGFV’s) financial health and the banking system.

Figure 2: China Real Estate Investment (Yr/Yr %)

Source: Datastream/Continuum Economics

We remain of the view that the strength of the major banks means that the banking system problem is manageable and centered on weaker rural banks that can be taken over. However, the cascade of rising non-performing loans among property developers and further potential failures (KWG failed on loans April 28) can restrain lending growth from part of the banking system. Meanwhile, though LGFV’s will be supported and the worst case taken over by central government (here), this still risks less investment growth for the economy as a whole.

Figure 3: China New and Existing Residential Prices for 70 cities (Yr/Yr %) 

Source: Datastream/Continuum Economics

So far the feedthrough to residential property prices has been modestly negative (Figure 3) and not beyond the previous experience seen in China and certainly not as bad as the U.S./Spain during the GFC. We have previous forecast a national drop in residential property prices of 10-15% peak to trough and this remains likely in the coming years (more tier 2/3 than tier 1 cities), which will be the deepest in modern times. Restrictions on price reductions by developers; inertia and government intervention argue for a slow decline in house prices over a number of years. The DM and EM experience normally see house prices falling more quickly to clear the market, especially where excess inventory exists as in China tier 2 and 3 cities. If house prices in China did fall more quickly then that could mean a harder landing into 2024 for the economy, as wealth effects could then be further adverse feedback loop that hurt consumption.

China authorities will also likely put in place additional policy easing measures. While the PBOC has been reluctant to cut interest rates, a further RRR cut could be seen to help the banking system. Additionally, a cut in the 5yr loan prime rate is feasible, as it would help lower mortgage rates still further. The PBOC will also likely encourage ongoing low double digit M2 growth, which supports the economy but is not too fast for monetary excess to build up. The property sector hangover, plus the low trajectory of CPI, also suggests that interest rate policy normalisation will not now start in 2024 and we now forecast the 7 day policy rate remaining at 1.90% for the remainder of the period. Further modest fiscal policy stimulation could also be evident for the economy more widely, if growth falters.

Under the slow house price decline, the hangover is spread out over a longer period of time and residential property investment weakness will likely remain a drag on China’s economy for years. This is one of the reasons behind our forecast of a slowing to 3-4% growth later this decade (here).