China Property Problems: Lower Tier Cities
Bottom Line: China residential construction is shrinking, with the epicentre being tier 3 and 4 cities that do not have the economic pull of tier 1 and 2 cities. The overhang of excess housing stock will likely require larger price declines and take more years to resolve, which risks a prolonged economic and financial drag on tier 3 and 4 cities. This is a problem at a national level and is one of the reason we look for China growth to slow to 4% in 2024 and 3% by 2026.
China Tier 3 and 4 Over construction
China has four tier 1 cities (Beijing, Shanghai, Guangzhou, and Shenzhen) and 35 tier 2 cities (3-15mln people and normally province capital cities).Tier 3 cities are between 150k-3mln by population; moderate GDP levels and are prefecture capital cities, while Tier 4 cities are below 150k population and county level cities. These Tier 3 and 4 cities are approximately 560 cities and form the bulk of residential construction in China.
These Tier 3 and 4 cities have grown quickly with the rural to urban shift, but are now growing more slowly with a slowdown in the shift to urban centres. Though registration systems in China restrain internal movement, tier 1 and 2 cities have a bigger pull than tier 3 and 4 cities. In a 2022 IMF paper Rogoff and Yang estimated that new demand for housing in these Tier 3 & 4 cities will actually decrease in the period 2022-35 in contrast to increasing demand in tier 2 cities (Figure 1).
Figure 1: Total New Housing Demand (sqf billions)
Source: IMF Rogoff and Yang (here) Note their Tier 3 captures Tier 3 and 4 cities.
Concerns also exist that excess completed housing will also weigh on tier 3 and 4 cities and part of Country Garden problems (here) relate to its heavy exposure to tier 3 and 4 cities. The scale of the problem is difficult to judge given the gaps in data in China, but anecdotal evidence suggests that tier 3 and 4 cities are the epicentre of the housing crisis. It is fair to now to call this a property construction crisis as the cumulative level of national new residential real estate development is now down over 50% compared to the same 2018-21 YTD period (Figure 2).
Figure 2: Cumulative YTD Million Square Metres Residential Real Estate Development
Source: Datastream
This causes a cascade of economic problems in terms of lower construction within GDP/reduced construction employment/lower steel/cement/copper demand. It also causes a cascade of financial problems in terms of non-performing loans (NPL’s) and defaulting bonds for property developers; knock on investment pay-outs for shadow banks and NPL’s rising for weaker banks. Economists and financial markets worldwide are becoming more aware of these adverse feedback loops, but we want to emphasise that the impact will likely be greater in tier 3 and 4 cities than tier 1 and 2 cities. Tier 1 and 2 cities looking at official house price data appear to be experience a modest decline in prices and they could escape with moderate decline circa 10-15% peak to trough multi-year. Tier 3 and 4 could be more brutal and see large house price falls, which causes a regional economic problems multi year. Rogoff and Yang estimated that tier 3 and 4 cities account for 80% of urban residential construction by value, which means this will have national ramifications. However, with the gaps in data in China, it is difficult to see this in advance of high frequency indicators being released. Our baseline forecast is for 4.9% 2023 GDP growth, 4% in 2024 and slowing to 3% in 2026 (here), but our main alternative scenario is for 1-3% GDP growth multi-year (Figure 3) and we need to highlight this alternative until the data becomes clearer.
Figure 3: Scenario Analysis for China Debt Overhang
| Baseline — 60 to 70% | Alternative — 20 to 30% | Worst Case — 5 to 10% |
| Debt Hangover Slows Long-Term Growth | Debt Crisis Causes a More Dramatic Slowing of Growth | Major Financial Crisis As Well as Debt Crisis for the Economy |
China’s debt overhang is restructured as borrowers are state linked (e.g. SOE/LGFV’s) or directed (e.g. property developers) and creditors are heavily state influenced (e.g. banks). Money supply growth remains low double digit to ensure enough momentum for nominal GDP. Restructuring of debt still causes economic activity to be weaker in certain sectors and causing a slowdown in growth to 3-4% by 2024-27, alongside the effects from population aging and slowing productivity growth. Growth slows to 3 to 4% | Curtailed economic activity from borrowers is larger than the baseline, with consumers and private businesses holding or reducing debt/GDP ratios. Economic growth slows more dramatically than the baseline, though China’s authorities would likely resort to aggressive fiscal and monetary policy expansion.They also become more aggressive in active management of any bank or financial market fallout. | Debt restructuring is not smooth and intermittent defaults causes a major loss of confidence in sections of the banking system and financial markets.M2 and TSF growth slows to 5% or below and China ends up with a full blown recession, as demand collapses. |
Source: Continuum Economics