China’s Real Estate Sector Collapses Rapidly as Debt Deflation Looms – Speculators Anonymous

Last year I write an article highlighting China more and more fragile and risky real estate sector. And the stress it posed for the global economy

And since then, the Chinese real estate sector has grown far more stressed. . .

For example, new home price growth in China has slowed over the past year. And stayed negative since May 2022.

In fact, new home prices in September tear down 1.5% – its fastest decline in seven years – with 54 out of 70 major cities seeing prices drop (down from 50 in August). And property sales by floor area in September fell for the 14th consecutive month.

Today, property developers are faced with various headwinds – such as anemic demand, tight liquidity and declining growth.

But the biggest culprit was the ‘three red lines’ policy adopted by the Chinese authorities at the end of 2020 to curb speculation and leverage.

I wrote in September 2021 that: “. . .Chinese authorities have begun to try to control the growing debt burden. So they created guidelines to try to clean up the heavily indebted real estate sector. Thus, they adopted the agenda of the “three red lines” (aka three rules that put strict limits on a company’s borrowing capacity).

In short – the authorities began to force developers to deleverage (i.e. reduce their debt and raise funds instead). . .”

Thus, debt-ridden promoters saw a tsunami of the surge in bond defaults. Especially in 2022.

For perspective: offshore bond defaults (aka dollar-denominated debt) leaps to more than $26 billion in July. And Chinese property developers are responsible for almost everything of this one.

With higher dollar borrowing costs (thanks to Federal Reserve tightening), these overleveraged developers are stuck in a perpetual struggle.

That’s because they can’t refinance their dollar debt or repay principal and interest as growth slows.

And that’s a problem because – like Bloomberg estimates – Chinese developers have faced another one $31 billion in dollar debt maturing in the second half of 2022.

Thus, the fall in real estate prices and the weak growth in indebtedness have crippled Chinese real estate developers.

But above all, it will have far-reaching ripple effects. . .

Why?

Because the Chinese real estate sector is one of the the biggest engines of growth for the economy.

Estimates show that about 29% of the total annual growth comes from the real estate sector. And worse, accounts for 30-40% of total bank loans.

And in terms of investment – as of 2020 – more than 50% of capital investment in China is fueled by real estate.

But the most disturbing These data show that 70% of total household wealth in China is in the real estate sector (compared to just 35% in the United States).

I believe this is the biggest problem since – in such conditions historically‘debt-deflation’ can aggravate very rapidly.

For context: Debt deflation is a term coined by early 1900s economist Irving Fisher. After witnessing the debt-fueled implosion that sparked the Great Depression, Fisher theorized that depressions are due to the overall level of debt rising in relation to falling asset prices and consumption. Thus feeding a feedback loop in further away assets go down, unemployment goes up, the debt burden goes up, and so on.

So, with so much household wealth and debt tied to real estate values, any decline in prices could trigger a tipping point (remember 2008?).

Now – Chinese authorities have recently unveiled drastic measures to try to help the real estate sector recover. These policies aim to provide liquidity, relieve financial bottlenecks and expand debts and liabilities.

And although this is the biggest pivot since the authorities began to control the real estate sector in 2020. I don’t think that’s enough to reverse the trend.

This is because these policies mainly focus on the supply side. Not the request side.

Meaning: if sales of new goods continue to fall (which they have plunged steadily over the past year), then there will be no recovery in the real estate market.

Chinese appetite for home buying continues to evaporate.

This puts Chinese leaders between a rock and a hard place.

On the one hand, they can try to stimulate demand. But to do that, they need to show buyers that prices stop falling and instead rising indefinitely (as they have done in the past).

But on the other hand, it will only amplify why they have been scrambling to deleverage the bloated real estate sector after years of rampant speculation, skyrocketing debt levels and overbuilding.

And worst of all – China’s economy continues to weaken as growth slows and the debt burden increases.

This is evident when looking at at China incremental capital to output ratio (aka ICOR – or capital efficiency).

Putting this into perspective, it shows that over the past decade, it costs Three time more to get half real growth.

Imagine hiking in a sandstorm that’s three times stronger than it was ten years ago, but can only go half the distance.

So – as always – China cannot escape the laws of diminishing returns.

The old manual of trying to inject credit into the system to force growth will no longer work. And will only spur excessive speculation, increased debt and bad investment (further strengthening their current situation).

Time will tell, but it is clear that there are black swans lurking in the Chinese financial system.

What if China implodes – or continues to slow down – I think everywhere will feel it.