The Evergrande wobbly: Examining a housing bubble in China

Centre For Risk Analysis’ John Endres and Simpe Jonas put pen to paper on the possible risks of a housing bubble in China. China’s second largest property developer, Evergrande, is on the brink of financial collapse with the real estate giant struggling to contain its almost $300bn debt burden. Many analysts, including Endres and Jonas, are concerned about the potential knock-on effects of Evergrande’s demise. The housing market in China has been a key driver to economic growth and given its importance to GDP in the world’s second largest economy, a decline in prices could have extremely negative consequences. Broader macroeconomic issues and supply chain disruptions are fuelling the possibility of an economic slowdown in China. – Justin Rowe-Roberts

By John Endres and Simpe Jonas*

China Evergrande wobbles

John Endres

The world’s most indebted property developer, China Evergrande, missed a Thursday deadline to pay $83.5m on its dollar-denominated debt. It has a 30-day grace period before bondholders can call a default which, if it occurred, could be Asia’s biggest-ever dollar-bond default. Evergrande owed around $88bn at the end of June, with 42% of that coming due in under a year. In addition, it has sold a staggering 1.4 million apartments, worth $200bn, that it hasn’t completed yet, implying total liabilities of around $300bn.

A vulnerable behemoth

This matters because China’s real estate sector — under a broad definition including both the production of property and the rendering of property-related services — makes up a quarter or more of that country’s GDP. By way of comparison, China’s GDP is more dependent on housing construction than Ireland and Spain were prior to the financial crisis, and far more dependent than the United States. This means that if growth in the sector slows down, it will affect the country’s overall growth rate, with some models estimating that a 20% decline in real estate activity could lead to a fall of 5%-10% in GDP — and that is without considering second-order effects such as the impact of declining real estate prices on collateralised debt or a subsequent banking crisis.

Signs of a bubble

Experience from other countries has shown that warning signs of housing bubbles include a hypertrophied real estate sector, rapid price inflation, and high debt accumulation, all features currently present in the Chinese property market. Housing prices in China have risen rapidly since 2015, driven by loose monetary policy and expansionary fiscal policy. Currently, the home price to income ratio is above 40:1 in China’s major cities, compared to 22:1 in London and 12:1 in New York. The market value of China’s housing stock is now more than double that of the United States and more than triple that of Europe — figures reminiscent of the Japanese housing bubble of the late 1980s and early 1990s. Outstanding mortgage debt makes up over 70% of total household debt, while the ratio of household debt to GDP has risen rapidly to above 60%.

Price correction overdue

Simpe Jonas

At the same time, both housing supply and demand are not supportive of continued elevated price levels. Assuming no new construction, it would take two to three years of housing sales to clear the current stock of vacant residential floor space — an indication of an oversupplied market. On the other side of the equation, slowing population growth and the decline in the 20-50 age group (the primary home-buying group), combined with an expected slow-down in household income growth, show that there is little prospect of a continued growth in demand into the future. Combined, this signifies structural downward pressure on prices.

Chinese government’s response

In response to the overheating of the housing sector, the Chinese government introduced measures including its “three red lines” deleveraging campaign for the property sector, with the aim of both shrinking the debt bubble and dampening demand. But its efforts to engineer a soft landing bear the risk of causing unintended side effects — such as the trouble highly leveraged companies like Evergrande find themselves in now.

Given the size and importance of Evergrande for the Chinese property market, and the prominence of the property market in the Chinese economy, the government will probably be left with no choice but to intervene to save Evergrande — which will introduce further market distortions and volatility. Even if it succeeds in averting the current crisis, the underlying risks remain. Both the housing bubble and increasing government intervention pose significant threats to the Chinese economy, and, by extension, the global economy.

Loadshedding in China

The energy sector is also feeling the effects of Chinese state intervention, with several provinces in China experiencing power rationing and factories being forced to cut production. In part, this is because of a push to enforce environmental regulations: local governments are ordering the power cuts as they try to avoid missing targets for reducing energy and emissions intensity. Secondly, China is experiencing a coal shortage after imposing sanctions on Australian coal imports for political reasons. Alternative sources of supply have been more expensive. In the context of a global energy shortage that has seen the price of coal increase more than threefold since the beginning of the year, many power plants are finding it unprofitable to operate, creating supply gaps and posing a further risk to China’s economic growth.

Europe running out of gas

In Europe, buying enough natural gas to heat an average home for a year cost $140 a year ago. With the northern hemisphere winter approaching, that cost has now increased six-fold, to $860. Partly this is because gas is increasingly being used as a stop-gap for electricity generation as other primary energy sources have stumbled: renewables turned out to be unreliable, coal is becoming increasingly expensive as the price of EU carbon trading permits rises, and there is not enough nuclear power available as a reliable, low emission alternative. Consumers are now beginning to feel the cost of the green energy transition in their own pockets, which could turn climate goals into own goals if public support for drastic interventions ebbs on the back of dramatically rising energy costs.

Global energy shortage

The energy crunches in China and Europe are reflective of tight markets worldwide, marked by record-high gas and electricity prices in Europe, record coal prices in China and global oil prices well above their longterm averages. This is a response to cyclical drivers: the energy sector received low investment in 2019 and 2020. When demand in the world economy rebounded in 2021, boosted by low interest rates and high government spending, and with an emphasis on the manufacturing sector, energy production was not able to expand at the same pace. As a result, inventories of gas, coal and oil are running low — a counter-intuitive outcome, given that fossil fuels have supposedly fallen out of favour. We flag for you the risk that the limited availability of energy, although temporary, may put a brake on the global economy recovery.

  • John Endres, director, Centre for Risk Analysis and Simpe Jonas, analyst, Centre for Risk Analysis.

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