China's number 1 macroeconomic policy challenge: The property market

（中文摘要：羅念慈在今期文章扮演「魔鬼」，嘗試評估若北京不出手救市，任由地產市場爆破，中國經濟將受怎樣的影響。初步結果顥示，GDP 增長將很可能減慢至低於7%，而銀行體系內的第一級資本亦有可能被一掃而空。這解釋了為何北京一直致力防止地產市場跌進「世紀末日」。因此，為免對整個經濟體系造成震盪，北京將傾向繼續維持其寬鬆政策，A 股將因而受惠。）

 

The property market’s correction remains the biggest policy challenge for Beijing in the coming year. But the immature nature of the Chinese financial system suggests that a US-style price collapse would be unlikely. Direct risks to the household and banking sectors will be manageable. Transaction volume will continue to bear the brunt of the correction, leading to a chain effect on the economy and bank balance sheets that cannot be accurately assessed. Due to this uncertainty, Beijing needs to keep a policy-easing bias to avoid a market meltdown wreaking havoc on the broader economy.

 

We play devil’s advocate here and ask “what if Beijing does not come to the rescue?” Our assessment shows that GDP growth could easily fall below 7% and Tier 1 capital in the banking system could be wiped out. This supports Beijing’s determination to prevent a property “Armageddon”. Note that these assessments can only give a rough idea of the possible outcomes but not a concrete conclusion due to the lack of reliable data.

 

Beijing has so far refrained from massive economic bailout. Some argue that Beijing should not intervene and should allow a thorough adjustment in the property market and related industries alongside financial liberalisation; this should be part of structural reform. However, the risk of an all-out property collapse wreaking havoc on the economy is not negligible, leaving Beijing determined to keep any property woes from getting out of hand and maintain a policy-easing bias until the dust has settled.

 

The key concern is not property price collapse but transaction volume contraction. This is because China’s property market is not highly leveraged. Mortgage loans account for only about 18% of total bank loans. So property owners have long-staying power and are not under pressure to fire-sale their asset for cash during a market correction. This is a fundamental difference between China’s property market and most of the other markets, which are highly leveraged.

 

Rather, the bulk of the market correction comes from contraction in transaction volume, which has a domino impact on developers’ cash flow (and, hence, their repayment ability), banking lending and investment spending. To see this, consider total property investment, which accounts for 15% of GDP, with housing alone accounting for 10%. If related sectors, such as materials, cement, steel, etc., are added, total property investment accounts for more than 20% of GDP.

 

Property has a pervasive impact on the economy via its links with:

 

Table 1 presents a benign (1) and a risky scenario (2). The market’s forecast for property investment in 2014 ranges from 14.8% in scenario 1 to 9.8% in risky scenario 2 (i.e. a 5 and 10 percentage point contraction, respectively). Its estimates for property investment as a percentage of GDP range from 16% to 25%. 

 

Under scenario 1, where property investment accounts for 16% of GDP, a 5 percentage point fall in investment growth would subtract 0.8 percentage points from 2014’s GDP growth (5 x 16%), while under scenario 2, where property investment accounts for 25% of GDP, a 10 percentage point fall in investment growth would subtract 2.5 percentage points from growth (10 x 25%).

 

In other words, if there is no policy easing to offset the contraction in property investment, GDP growth could fall below 7.0% this year, a level that is believed to be below Beijing’s tolerance limit. So the government has a strong incentive to prevent property investment from collapsing.

 

In 2014, China’s banking system had an average Tier 1 capital of RMB8.1 trillion, or 10.9% of risk-weighted assets. Table 2 breaks down the banks’ exposure to the property sector. Direct exposure via mortgage and developers’ loans was RMB15.2 trillion. The market’s estimate for banks’ on-balance-sheet property investment ranges from RMB2.7 trillion in scenario 1 to RMB5.4 trillion in scenario 2. Indirect exposure, via trust and entrusted loans and wealth management products, is estimated at between RMB3.8 trillion and RMB7.3 trillion. 

 

According to listed banks’ data, half the loans are collateralised, with 90% of those by property. This means 45% of bank loans are collateralised by property (item D in table 2), with estimates ranging from RMB10.4 trillion to RMB15.2 trillion. There is also exposure via local government debt (LGD), 72.5% of this is funded by banks, according to our estimate, amounting to RMB13 trillion.

 

Total bank exposure to the property sector is estimated at RMB45.1 trillion under scenario 1 and RMB56.1 trillion under scenario 2. Meanwhile, we estimate conservatively that non-performing loans (NPLs) amounted to 37.6% of total loans, or RMB17.0 trillion and RMB21.1 trillion under scenarios 1 and 2, respectively. According to the government, the bad debt recovery rate has remained at 25% in recent years. But NPL provisions amounted only RMB1.8 trillion in 1Q 2014. So theoretically, banks could lose between RMB11 trillion and RMB14.1 trillion. Given that Tier 1 capital was only RMB8.1 trillion, a sharp property market correction causing NPLs to soar (towards our conservative assumption, for example) would more than wipe out all Tier 1 capital.

 

 

This is not to say the banking system would crash. A closed capital account and Beijing’s “selective implicit guarantee” policy would prevent a systemic shock from getting out of hand. But the potential impact on the banking system means Beijing cannot afford not to intervene; it will have to ease policy further to avert a property market collapse.

 

Thanks to the property market’s threat to the broader system, China’s policy cycle has entered another easing phase, despite policy normalisation by the US Federal Reserve. The liquidity-driven A-share market will continue to benefit from this moderate growth and disinflation macro backdrop. Correction in the real estate market has lowered significantly the returns on property, and related wealth management products, investment. This has prompted more and more local Chinese investors to return to stocks, giving the A-share market sustained power to ascend further. Welcome to the A-share bull market.