China’s real estate market on the brink: not a Lehman moment but an economic threat


Just weeks after investors faced a crackdown on major tech companies in China, they are now reading a possible default from the country’s largest real estate developer, Evergrande. The company is $ 300 billion in assets and the Chinese real estate market has weakened due to measures taken a year ago by the Chinese government to curb soaring house prices. These measures contributed to a 21% drop in home sales by developers in August over a year ago.

According to a TBEN Business report, Ed Yardeni raised the specter that a collapse of Evergrande could have “systemic risks comparable to the impact of the demise of Lehman Brothers on the US stock market.” However, other economists have played down the likelihood of global contagion, and U.S. investors seem to agree as the fallout outside of China has been limited so far.

My own opinion is that a liquidation of the Chinese real estate market would not play out in the same way as the collapse of the US real estate market in 2007-2009. However, this would have major repercussions on the Chinese economy. The reason: real estate accounted for two-thirds of Chinese household assets in 2019, compared to about a quarter for US households (see Figure 1). Additionally, the latest estimate for China is higher today at 78% due to rapid price appreciation over the past two years.

Figure 1. Household wealth by asset type, China vs United States

Source: JPMorgan Asset Management: Guide to China, July 31, 2021

An Evergrande default would differ from the Lehman Brothers collapse in two key ways. First, China’s financial system is under extensive government control, and the government has a habit of acting to calm the boom in real estate markets, and then relax policies when economic growth is threatened. Although the government has so far refrained from saving Evergrande, it has the capacity to prevent a total collapse. By comparison, the US government had no prior experience with bailouting the housing market before the 2008 crisis and was reluctant to bail out Lehman.

Second, the fallout from an Evergrande default would take much longer to resolve. With US markets heavily securitized, asset values ​​fell as US money market funds experienced large cash outflows. By comparison, bank loans to Chinese real estate developers are not negotiable instruments, and arbitrations are subject to complex negotiations and regulatory oversight that can take years to resolve.

This does not mean that China is off the hook over a housing bubble. When Chinese authorities began cracking down on real estate developers a year ago, Goldman Sachs estimated that the total value of Chinese developers’ homes and inventories reached $ 52 trillion, far exceeding that of the United States. In addition, around 20% of apartments in circulation are estimated to be unoccupied, which indicates the degree of real estate speculation.

One of the big unknowns today is how many real estate developers and lenders in China will need to be rescued. As the Wall Street Journal editorial board argues, Evergrande could become the biggest victim of the Chinese real estate bubble, but will not be the last. In addition, some areas are poorly regulated such as wealth management products which are backed by Evergrande and other developers.

A report by Xie Yu of the Wall Street Journal indicates how widespread the problems have become. Measures taken by regulators last year included capping banks’ exposures to real estate in both developer loans and mortgages, as well as overhauling land auctions and in some cities introducing controls. prices on home sales. Meanwhile, developer profit margins have started to squeeze, and by mid-August developers defaulted on $ 6.2 billion in high-yield debt this year, more than the decade before. In response, Moody’s Investors Service recently downgraded its outlook for the sector to negative.

spillover effects on other sectors were limited. One reason is that China resisted the Covid-19 pandemic reasonably well initially, although economic activity has recently slowed due to epidemics in parts of the country. A recent Reuters survey of 10 analysts and economists showed they were still bullish on property values: while their house price appreciation projections for this year were lowered to 3.5% from 5 % previously, they still expect a 5% recovery next year. But that assumes that the government will act in a timely manner to prevent a collapse in the housing market.

The outcome ultimately depends on the reaction of Chinese households if property values ​​begin to fall. The main risk is that China faces a loss of household confidence at a time when business confidence is shaken due to the government’s crackdown on tech companies and other private companies. This combination could lead to a growth recession of 3-4% next year, or even an outright recession.

Finally, it raises the question of whether a collapse in the Chinese real estate market could spill over to other parts of the world. The main reason to believe that it will not spread is that the involvement of foreign investors in the Chinese real estate market and financial system is low. By comparison, foreign investors were heavily involved in mortgage-backed securities issued by US institutions.

That said, given the importance of the Chinese economy to the global economy and international trade, a slowdown would have ripple effects on China’s major trading partners in Asia, Europe and North America. For this reason, US investors should closely monitor developments in China.