China's Slow Real-Estate Recovery
"Estimating an excess Chinese housing inventory of some 20 percent, it determines that China’s adjustment still has a long way to go, perhaps another three or more years. But it also dismisses the likelihood of a financial crash..."
Since concerns over China’s real-estate bubble manifested themselves in recent stock-market panics, it might help to take a sober look at the matter. On the bad-news front, there is no denying that China suffers from a significant and dangerous real-estate bubble. The adjustment to it will take years to complete and will inevitably have adverse economic and financial implications. On the good-news front, the adjustment has already begun and is proceeding in an orderly fashion that promises to avoid the kind of financial collapse that many fear.
Signs of excess and all that goes with it are clear. Between 2012 and 2014, China significantly overbuilt residential real estate. At times, the country was increasing national floor space at a rate approaching 50 percent a year. Spending on residential construction reached an unsustainable 10.4 percent of the country’s gross domestic product (GDP). That is the second-highest figure on record for any country. Only Spain’s 2006 bubble, which took such spending to 12.5 percent of GDP, surpassed it. China’s rate tops Japan’s 1973 bubble peak at 8.7 percent of GDP and certainly this country’s 2005 peak at 6.5 percent of GDP. The Chinese building surge has managed to raise per capita floor space 20 percent in a remarkably short time. At some 30 square meters, it stands far above any other emerging economy and even some developed economies. Japan, for instance, has only some 22 square meters of living space per capita. Significantly and dangerously, China’s construction boom has so far exceeded sales that unsold inventories at last measure exceeded two years of sales.
Debt problems have inevitably accompanied this kind of overbuilding. Though government debt in China is still a relatively low 25 percent of GDP, real estate–related debt in recent years has exploded to more than twice that figure. At last measure, almost half of all outstanding credit in China was somehow real estate–related. A significant portion of this total seems likely to default, with some estimating that a fifth of all the real-estate debt will fail in one way or another. Since that figure amounts to nearly one-tenth of the country’s GDP, the legacy of this overbuilding cannot help but strain Chinese financial institutions, investors, financial markets generally and, consequently, overall economic-growth prospects. The need for construction cutbacks will further impair the country’s growth potential, not least because residential building has until recently accounted for so much of China’s economic activity.
But as strained as all this looks, and is, much suggests that China can avoid the implosion many frequently fear. Primary in this regard is the clear evidence that adjustments have already begun and, far from a crash, are proceeding in an orderly way. Cutbacks in residential construction had started in 2014, and by December, new construction was reported 26 percent below year-ago levels. No doubt these cutbacks contributed to the slowing of China’s overall pace of growth, but the fact that overall growth continued despite them argues against popular fears of how the adjustment will inevitably lead to recession. What is more encouraging is that even in this relatively short time, the cutbacks have begun to address the overhang of unsold space. Inventories remain high, to be sure, but by the middle of 2014, they had already stabilized and had begun to ease by the turn to the new year. Little data exists so far for 2015, but all signs suggest that inventories fell at least modestly during the last few months.
Meanwhile, declines in real-estate prices will help relieve the inventory overhang further by bringing new buyers to the market. The price picture certainly has changed radically from the 2013 peak. Back then, home prices in China’s 100-city average were rising at annual rates approaching 15 percent, squeezing many buyers out of the market. By late 2014, that pace of advance had slowed to 5 percent and has held steady so far this year. Since household income in China has continued to grow, this price slowdown has made Chinese real estate considerably more affordable. The percent of average annual income needed to purchase 100 square meters of living space stands today almost 20 percent below where it stood in 2010 before the bubble even began to inflate. There are already signs that this affordability improvement has moderated the pace of sales declines. In contrast to early 2014, when purchases were dropping at a 10-percent annual rate, official sources recorded only a 3-percent rate of decline in early 2015. And recently, the Shanghai Daily reported an almost 17-percent jump in purchases during the first seven months of 2015. That figure may exaggerate reality, but its direction certainly points to another source of relief for China’s huge unsold inventory.
There is another aspect of this problem that deserves attention. Americans understandably respond to real-estate problems anywhere by drawing parallels to this country’s 2007-09 debacle. That would be a mistake in this case. Aside from the fact that China has, if anything, overbuilt more than the United States did, its problems in other aspects are not nearly as dangerous as America’s were eight years ago.
The difference lies in where the vulnerable debt resides. In the United States, the questionable subprime loans were widespread throughout the financial system. No one knew who had exposure or how vulnerable they were. Financial institutions, fearing the ability of any counterparty to fulfill its obligations, became wary of transactions generally. U.S. financial markets froze in response, the main cause of the extensive economic harm that all still too vividly remember. China has no such problems. It has no subprime debt. Indeed, Chinese individuals are not especially leveraged, understandably so since until recently, Chinese buyers, by law, had to put down 20 percent on their first home and 50 on their second. According to the People’s Bank of China (PBOC), individual obligations constitute only a fifth of all real estate–related debt. The excesses lie with local governments and developers, hardly a welcome or harmless condition, but much more easily managed by Beijing than was the subprime debt in the United States.
Given such considerations and the path of China’s adjustment so far, it is easy to see how a recent major International Monetary Fund (IMF) study arrived at relatively benign conclusions. Estimating an excess Chinese housing inventory of some 20 percent, it determines that China’s adjustment still has a long way to go, perhaps another three or more years. But it also dismisses the likelihood of a financial crash, such as the United States suffered in 2008, much less the economic implosion of popular fears. Instead, it looks for China’s needed adjustments to proceed along a gradual, orderly glide path that will permit the overall economy to continue its expansion, if at a less rapid pace than in the past.
Milton Ezrati, a contributing editor to The National Interest, is senior economist and market strategist for Lord, Abbett & Co. and an affiliate of the Center for the Study of Human Capital at the University of Buffalo (SUNY). His most recent book, Thirty Tomorrows, on the challenges of aging demographics and how the economy can cope, was recently released by Thomas Dunne Books of Saint Martin’s Press.
Image: Wikimedia Commons/Mystaslav Chernov