China's Property Market Set for Correction, Not Collapse

Published in the Nikkei Asian Review

October 30, 2014

The real estate sector in China has been called the most important in the world. It accounts for over 16 percent of China's GDP and is the largest source of marginal global demand for commodities. To put it in context, investment in Chinese residential real estate in 2013 was nearly equal to the combined total economic output of Hong Kong, Singapore, and Taiwan.

The concern that demand for housing is no longer deep enough to respond to a fall in prices does not take into consideration the peculiarities of the Chinese real estate market.

Given that it is such an important driver of global demand, many analysts and investors are concerned about the Chinese property market's recent downturn. Housing sales are down 10 percent for the year, investment growth has halved, and headline GDP growth slowed to 7.3 percent in the third quarter. Further complicating the outlook is that the urban housing market appears to be saturated, with nearly nine out of 10 households already owning their homes.

However, there are several reasons to believe we are seeing a correction, not a collapse, in China's real estate market.

From a short-term perspective, it cannot be denied that most indicators are pointing toward a slowdown in the property market. Indeed, it is unclear whether aggregate home prices will begin to stabilize by year-end. Many commentators have looked at the recent data and drawn the conclusion that China is heading for a Japanese-style housing crisis.

Yet authorities still retain substantial latitude to loosen restraints on the housing market, which have been consistently tightened since 2010. The recent easing of restrictions on the purchase of secondary properties is a welcome step, as first-time homebuyers represent only one-fifth of overall purchases. China still maintains relatively stringent controls, such as a maximum 30 percent loan-to-value ratio for purchases and a minimum mortgage interest rate. Certain markets, such as Beijing and Shenzhen, have additional restrictions. This leaves considerable room for loosening should conditions continue to deteriorate.

Hidden Strengths

In the medium to long term, the outlook is even more sanguine. The concern that, as opposed to previous property market downturns, demand for housing is no longer deep enough to respond to a fall in prices does not take into consideration the peculiarities of the Chinese market. While some data shows that home ownership in urban areas is already very high, those indicators take into account only households who legally reside in urban areas under the vagaries of China's household registration, or hukou, system. These measures do not take into account the large number of migrant workers and other unofficial residents who work and live in urban areas but are unable to purchase homes there.

Furthermore, although China's rate of urbanization over the past few decades has been remarkable, it still stands at a relatively low level. The Chinese government estimates that more than 200 million additional people will have moved into cities by 2023. This, combined with continued reforms to the hukou system that allow for more people to obtain urban registration or to purchase homes and access social services, will unlock a large potential stock of fresh demand for housing.

From a financial stability standpoint, downside risks are limited. First, as opposed to markets, which have experienced large housing crises, the financial position of Chinese households is comparatively strong. Only around 20 percent of Chinese households finance their home purchases with mortgages, and the average household has only 5 percent of the value of their home financed with a loan. In fact, only 30 percent of households have any debt at all, according to data gathered in the China Household Finance Survey by the Southwestern University of Finance and Economics in Chengdu. Furthermore, until China undertakes substantial capital market reforms—raising the deposit rate or allowing retail investors to diversify their investments into foreign securities—real estate will remain a significant source of wealth generation and conservation.

The risks to financial institutions and other real estate–related sectors are potentially higher yet still manageable. Developers face possibly the greatest risk of a material downturn in the housing market, as they are relatively highly leveraged and could face funding shortages. However, property developers have been slowing their land purchases and reducing inventories since the first quarter of this year. Should the slowdown in the housing market prove protracted, the fragmented property sector could see a period of consolidation as smaller, less well-capitalized firms are liquidated or absorbed by larger, healthier ones.

To be sure, after years of overinvestment in property, short-term risks from overcapacity are significant, and it remains unclear how long it will take for demand to match the existing supply. But in the medium to long term, there remain significant structural tailwinds to further investment in property.

China's leaders have made it a priority to rebalance the economy away from the old model of investment-led growth, so the structural downshift in real estate investment as a share of economic growth is likely here to stay. This is a reality that Chinese investors, Australian coal firms, and Chilean copper miners alike must adjust to. However, they can take heart in knowing that we are unlikely to see a collapse in the world's most important sector.