Abstract: The Chinese economy faces mounting downward pressure in the short run. China must be vigilant against a hard landing of its real estate market, and work to secure the liquidity of the real estate companies. At the same time, to prevent negative impact of the real estate sector from amplifying, it’s imperative to improve the cash position of other sectors, increase the supply elasticity of the upstream sectors, and curb the surge in commodity prices.
China recorded a year-on-year (yoy) GDP growth of 4.9% in Q3, 2021, much lower than the potential rate.
We believe that in the short run, the Chinese economy still faces mounting downward pressure. China must be vigilant against a hard landing of its real estate market, which, while posing limited threat to the financial system, could deal significant blows to the real economy.
I. STRAINED SUPPLY AND SLUGGISH DEMAND
The Chinese economy was under pressure on both the supply and demand ends in Q3, 2021. Strained supply of coal power and industrial production restrictions have stemmed economic recovery. The demand side posed even greater challenges, with sluggish consumption, weak investment, and export which was not doing so well as the data suggested. These combined led to low output and high prices.
The momentum of consumer spending has remained muted since the COVID-19 outbreak. In September 2021, total retail sales of consumer goods grew yoy by 4.4%. The yoy growth in the sales of automobiles, representative of durable goods, has been on a continuous downward ride, sliding to -17.3% in September, due partly to the chip shortage and partly to the drop in final demand. One reason behind the sluggish demand is the stringent COVID control measures in place, which have significantly curbed the recovery of spending on services. In addition, the slow recovery of employment and income of the middle-to-low-income groups has also dragged the consumption growth.
Investment is under mounting downward pressure. The accumulated yoy growth of total fixed asset investment in China was 7.3% for the first three quarters of 2021, much lower that of the first half of the year at 12.6%. Among the three main types of investment, infrastructure investment has remained depressed; the yoy growth of fixed asset investment of the real estate sector has fallen sharply; and while manufacturing investment has performed relatively well due to strong exports earlier in the year, whether the momentum can be sustained still remains to be seen. Infrastructure investment is in the doldrums partly because the major funders of infrastructure projects, local government financing vehicles (LGFVs), have been under strain due to loan disposals and reduced revenue from land sales. Without the support from LGFVs, increase in budgetary expenditures and special bonds alone is hardly enough to stimulate infrastructure investment. Despite the resilience ever since the COVID outbreak until 1H21, real estate investment has plunged since entering the second half of the year.
Export has not been so optimistic as the data suggests, either. In September 2021, yoy growth of export reached 28.1%, mainly driven by the price hike as a result of higher costs. We have decomposed the growth of export into three parts, growth of export volume, yoy growth of export price per unit, and the two multiplied. Our calculation shows that ever since July 2021, the role of export volume in driving export growth has rapidly diminished, while export price hike has been the main force behind the fast increase in export sales. Over 60% of the export growth in July and August, 2021 was caused by the price effect. However, the cost-driven growth in export has failed to make the exporters most profitable. The profit of Chinese manufacturers in August only grew yoy by 6%.
II. BE ALERT TO THE RISK OF A HARD LANDING OF THE REAL ESTATE MARKET
Real estate follows a distinct cyclical pattern. After a boom in the past few years, the market would naturally start to cool off. However, tightened regulation on real estate companies and financial institutions and the blow of the COVID-19 pandemic together added to the down cycle. As a result, the real estate sector has faced unprecedented pressure since the second half of 2021.
In the third quarter of 2021, indicators of the real estate market dropped sharply. Sales of commercial housing saw a yoy growth of -12.5%, and new construction -17.4%. This sudden drop in real estate sales can be attributed to two reasons. One is the reduced support for consumer housing loans. Individual medium and long-term loans in the third quarter of 2021 decreased by 510 billion yuan from the same period last year, the largest continuous contraction since 2018. Interest rates of mortgage loans rose during this period. In September 2021, the national average interest rate of mortgage loans for first-time and second-time home buyers were respectively 5.46% and 5.83%, an increase of 23 basis points and 29 basis points from the end of last year. Second, affected by the Evergrande incident, consumers are worried about other real estate companies as well and wonder whether there will be price discounts and whether the developers will be able to deliver houses on schedule.
Real estate companies have been suffering a periodical liquidity crunch. Under the high-turnover model, real estate companies highly depend on the timely collection of sale receivables, and the sudden decline in sales has brought huge cash flow pressure to them. With the Evergrande incident, domestic financial institutions have become more cautious in lending to real estate enterprises. However, financing in the overseas market has encountered greater problems, such as the panic selling in the dollar bond market. Not only Evergrande’s bond prices plummeted, but the bonds issued by many other Chinese real estate companies also fell after the National Day. Once panic set in, the overseas market treated high-quality and low-quality real estate companies the same. As long as there are bonds that are about to expire, the market would be concerned about solvency of the company regardless of any statement or explanation given.
If the real estate sector experienced a hard landing, it may not, like in the developed countries, cause systemic damage to the financial system and then spread to the real economy. Due to different national conditions, a hard landing of China’s real estate sector may cause limited damage to the financial system. However, considering the huge size of China’s real estate industry and its close relationship with land finance, it may bring about a broader impact on credit growth which can cause more direct harm to the real economy.
The sharp drop in sales has resulted in liquidity crunch at real estate companies, which may be followed by a decline in local government land sales income as well as income of upstream and downstream businesses (from cement, rebar to decoration appliances). As a consequence, China may further see a credit decline in residential, corporate and government sectors, an increase in bankruptcy, a rise of credit risk premiums, and a fall in social credit and total income, which will further aggravate the decline in housing prices and sales revenue.
III. HOW TO PREVENT A HARD LANDING?
To prevent a real estate hard landing is to prevent a liquidity crisis in the real estate sector, and to do that, we need to help the real estate companies secure their cash flow. Real estate companies take in money mostly from sales, which are heavily influenced by mortgage policies. Therefore, the first thing is to allow cities to relax mortgage loan quota based on local conditions, so that homebuyers’ need for mortgage loans can be addressed on a market-led basis. Second, we should support real estate companies in issuance of new bonds to repay the maturing ones. Emergency bailout loans should be made available to those that have unexpectedly run into liquidity problems, in amounts sufficient to help them weather the crisis but not necessarily at favorable rates. Furthermore, we should not hasten to drop anymore “regulatory bombs” in the real estate market in the near term.
There is also a need to boost the growth of total social financing and improve the cash position of companies in other sectors. To prevent the negative impact of the property market from spreading and amplifying across industries, as well as to increase the dynamism of the economy, we should take the following measures: (1) Lower the interest rate. This will cut the cost of borrowing for businesses and households on the one hand, while increasing the value of their asset holdings, improving their balance sheets, and strengthening their ability to cope with shocks on the other. (2) Increase public borrowing to fund infrastructure development. This will bridge the gap for infrastructure investment that emerged due to the drop in local government land revenue. It is also a rare opportunity to reduce dependency on land finance.
Finally, we need to curb the surge in commodity prices and increase the supply elasticity in the upstream sectors as soon as possible. Specifically, unnecessary administrative intervention in commodity supply should be reduced and there should be a return to market-based pricing. Meanwhile, import restrictions on some upstream products could be eased to relieve the increasing upward pressure on commodity prices.
This article, first published on October 26, 2021 in Caijing Magazine, is an abridged edition of a Working Paper of the same title.
