China’s reopening optimism has faded just as quickly as it emerged. A raft of data releases over the last several months have pointed to a sharp slowdown in growth following a buoyant first quarter. The emerging weakness has pulled the handbrake on the enthusiasm that surrounded the abolishment of the country’s zero-COVID policy at the end of last year.
Broadly, the outlook for the country is inextricably linked to the residential housing market. The reliance is a function of the structural composition of the country’s economy, whereby investment accounts for 40% to 45% of GDP – the highest of any country in history. Around two-thirds of the investment component comprises infrastructure and property investment. Including related industries, residential real estate is estimated to account for nearly a quarter of China’s GDP.
For the last two decades, China’s growth algorithm has been underpinned by a virtuous cycle of private real estate developers acquiring land at ever higher prices from local governments, pre-selling housing developments and using the cash to repeat the process. Land sales became a huge source of income for local governments, particularly in lower tier cities, enabling them to advance infrastructure development goals. A surging urban population and the insatiable demand for housing kept the country’s growth algorithm humming.
Fast-forward to the present and the growth model that has yielded enviable GDP growth rates over the 21st century is stuttering. Years of unchecked growth in residential projects and developer debt raised the alarm in Beijing. The more unscrupulous developers became more concerned with moving onto the next project rather than finishing the ones for which they had already pre-sold. A combination of debt raised from domestic banks and foreign financial markets, together with the liabilities associated with the pre-sales, pushed leverage ratios to dangerous levels.
In response, Chinese authorities implemented the “Three Red Lines” policy in 2020, which placed ceilings on real estate developers’ leverage ratios. The restrictions have severely impacted developers’ liquidity – hampering their ability to fund new projects. The old model relied on their ability to buy land and pre-sell developments to fund the completion of those in construction. Furthermore, the high debt loads require servicing, sapping already strained liquidity from the companies.
Recognising the spiraling impact of the Three Red Lines policy, six of the “16 Measures” announced by the Politburo in November to revive economic growth, focused on financing real estate development. While the measures show greater support to developers, they don’t address a fundamental loss of confidence by citizens in the companies’ ability to deliver the projects.
The build-up of uncompleted projects culminated in rarely seen protests in parts of the country last year as those who had bought apartments in the developments have been left paying mortgages on properties that are years behind schedule. An indicator of the loss of confidence is evident in sales figures. Total (pre-sold & completed) homes sold declined by 5% in the first half of the year, driven by a 9% decline in pre-sold homes. This compares to a 10% increase in the sales of completed homes – an indication of the deepening mistrust in developers rather than an inability of consumers to purchase real estate.
The ongoing deterioration in the residential housing sector and its impact on the country’s growth rate and household prosperity pushed Xi Jinping and the Politburo to adopt a softer tone when delivering the July communique. Notably, Xi’s oft-repeated phrase that “housing is for living, not speculating” was removed and replaced by a vow to “optimize policies” in the face of “the significant shift in housing supply and demand balance.” It was also acknowledged that the “16 Measures” had not been as effective as hoped, particularly the funding of private developers.
The importance of the housing market in any country plays a significant role in the broader confidence of its populace via the wealth effect. In China, its importance is magnified by the very high home ownership rate (estimated to be close to 70%) and the fact that around 70% of total household wealth is held within the asset class.
After a buoyant first quarter of the year as the country exited the lockdown and COVID infections reduced, the troubles in the housing market are having a growing impact on consumption. Despite a restriction-impacted base, retail sales have lost steam over the last several months, registering just 2% annual growth in July.
We have seen less impact on the higher end Chinese consumer, which speaks to the concentration of the pressure in the housing market among the middle-income population. Second quarter results reported by the large luxury companies showed strong growth from the Chinese customer cohort. Moreover, the demand for domestic flight and hotel bookings surpassed 2019 levels for the first time and outbound travel has reached c.60% of 2019 levels.
Exiting the restrictions, the “average” Chinese consumer should be in a strong position to accelerate spending. Estimates that we have seen indicate that consumers have built up RMB 6.5 trillion (~$900 billion) of excess savings since the start of 2020, which equates to around 15% of total retail sales in 2022. The key to unleashing these excess savings will be a stabilization of the housing market and the related restoration of consumer confidence.
Much like the about turn in the zero-COVID policy late last year, Xi Jinping and the broader CCP are not immune to the political risks that sub-optimal growth can bring. We expect this bout of weakness to be unpalatable to the Chinese authorities, particularly following on from the zero-COVID era. The measures that have been implemented this year have been too broad and vague. Recognising the risks of doing too little, we expect far more significant and targeted support to be rolled out in the second half of the year, laying the foundation for a stronger recovery exiting the year. We anticipate that the measures will be supportive of commodities demand and help boost currently depressed consumer spending.