China’s Real Estate Ponzi
The dominos begin to fall
China seems to be where all the economic and financial fireworks are lately. While the American economy continues to amaze in its ability to muddle through (honestly I’m a bit shocked at how well the market has been able to shrug off all these interest rate increases so far), the Chinese economy is starting to really sputter.
The big problem as I already pointed out here is China’s property market. For years it ran what in retrospect looked a lot like a Ponzi scheme. Property developers were paid years in advance of when they were obligated to deliver the homes and condos. Instead of using the advance payments to build the homes like they were supposed to, they bet it on land to super charge growth and expansion. This worked as long as demand for property remained high, which made people alright with paying for a home years in advance and also drove land prices up.
As we already know, property prices are no longer going up and this has put developers and their customers in a bind. Developers who were foolishly counting on never-ending demand for both forward condo sales and land suddenly find themselves without money — extremely troublesome when you’re on the hook for billions upon billions of dollars in condos that you have barely started to build. Customers are in an even trickier spot — many of them have taken on mortgages for homes they may never receive (and even if they do get it eventually, it will probably be after a multi-year delay). So unsurprisingly many have decided to just stop paying their mortgage. I would too if I were them.
This puts significant pressure on the government to step in. If they do not, then the risk is that property values could go into free fall as people begin to doubt both the ability of developers to deliver the promised homes as well as the viability of real estate as a store of value. A property price crash would also put further pressure on the economy — the real estate sector is a big employer and the asset class of choice for most citizens (so unemployment would rise and spending would fall as people feel poorer).
It’s important to note that a real estate slowdown in China would probably feel very different than one in America. So much more of China’s economic growth and finances (especially at the local government level) are leveraged to property development, home price appreciation, and land sales. In America, a decline in home prices would be painful sure but the U.S. economy is more diversified than China’s and its banking system, unlike in 2008, is well capitalized (as is the average U.S. consumer).
In China, it’s a different story. Many local and regional governments in cities that aren’t tech, trade, or finance hubs rely on land sales and property development for economic growth. It’s a symbiotic loop where property developers give money to local governments in return for land. This money allows the local government to pay their workers. And the workers turn around and purchase condos (years in advance) from the property developers.
When land prices decline and this loop reverses, local governments lose their ability to raise money and pay their workers. This not only reduces the value of the land previously purchased by the property developers (hurting their balance sheets) but it also hurts the developers’ cashflow due to people losing their jobs (because the government is unable to raise as much money from land sales) and no longer pre-buying homes. Struggling property developers are even less likely to finish building the promised homes, which puts even more financial stress on local citizens who’ve sunk most of their life savings into a home they may never get to live in. Understandably, these citizens become disenchanted with and extremely distrustful of the system.
This is a negative feedback loop that only the government can break. If the Chinese Communist Party decides to leave everyone to their own devices, then China could be approaching its own Lehman moment.