What goes up must come down. China’s mighty economy is facing serious challenges. The culprit is its ailing property sector. The property crisis has caused hundreds of real estate companies to default on their loans. Banks have had to write-offs debts in the vicinity of half a trillion US dollars. Thousands of construction-related suppliers face insolvency and millions of investors are stuck with unfinished properties which they cannot sell.
The story of China’s property bubble started in the early 1990s. On the back of the country’s manufacturing revolution, millions of families migrated from the countryside to urban areas, lured by jobs and better incomes. In 1995, only 29.04% of China’s population lived in urban areas. That number has ballooned to 63.89% today. Skyrocketing demand for new homes in urban areas prompted property developers to build at a dizzying pace.
In China, land cannot be owned but is instead leased from the state. Property developers took on massive loans to pay these leases and build their residential blocks. Banks were liberal in granting loans as high demand and healthy profit margins meant low risk.
The state supported the property boom, too. As far as the government was concerned, a thriving real estate market translated to a domino effect of economic benefits. Demand for construction supplies like steel, glass, and cement exploded. Millions of jobs were created. Wealth was generated, fueled by property appreciation. Spending power increased. Everyone was happy. The property sector became so large that it grew to constitute 30% of China’s gross domestic product.
The heady property boom caused property prices to soar to such an extent that it now takes 56 years for an average Chinese worker to pay for an average apartment in Beijing. It will take him 50 years in Shanghai and 46 years in Shenzhen. For context, it only takes 17.3 years to pay for an equivalent apartment in London.
Cultural nuances played a part in the property explosion. In China, it is widely believed that property is the most stable investment one can make. Also, one can only be a respected professional if one owns his own home. These ideas compelled the Chinese to purchase property, even at scandalous prices.
Chinese developers, fueled by easy loans, built to a point that their inventories were out of sync with real demand. At its worst, homes for 90 million people remained unoccupied. They are known today as “ghost cities.”
The prevalence of ghost cities caused the Chinese government to take heed and temper the building boom. The government declared that fresh loans can only be obtained if property developers passed three red-line financial ratios. First, their liability to asset ratio had to be less than 70%. Second, their net gearing ratio had to be less than 100%. Third, their cash to short term liability ratio had to be less than one.
Corresponding levels of loans were granted to companies depending on how many ratios they hurdled. Those that failed all three were denied access to bank financing altogether.
Among the thousands of property developers that raised red flags was the Evergrand Group. Evergrand is China’s second largest property developer and, to the horror of the state, it failed to hurdle all three red-line ratios. Evergrand’s debts amounted to an eye watering $305 billion, equivalent to 2% of Chinese GDP. Its cash reserves amounted to only $15 billion. It owed money to 171 domestic banks, 121 foreign banks, and to the Chinese people who bought their bonds.
Evergrand’s downfall can be attributed to over-expansion. It used whatever money it raised to start new projects instead of finishing existing ones. As of October last year, Evergrand had 1,200 projects under development, with only 200 finished and 700 pre-sold but unfinished. With so many unfinished projects that it could not fully monetize and even more new projects needing financing, it was only a matter of time before the company ran out of cash.
Evergrand is only one example of thousands of Chinese property firms that are in dire financial straits. Two-thirds of all Chinese developers have failed at least one red line ratio.
What has been the effect on the Chinese economy?
The property sector accounts for 20% of banks’ loan portfolios. Banks can’t get paid until existing inventories are sold. The problem is, most inventories remain unfinished and funds have run out to finish them. Buyers rightfully stay away from unfinished projects. Banks are caught in the middle and must absorb an avalanche of bad debts.
With thousands of property firms falling into insolvency, suppliers of construction materials can’t get paid. Evergrand alone owes its suppliers more than $100 billion. Suppliers and subcontractors are defaulting on their debts too.
Knowing that their developers don’t have the funds to finish their units, investors who purchased at pre-development using bank financing have stopped paying their mortgage. Banks are again caught in the middle and must write-off some $220 billion on unpaid housing mortgages.
Those who bought bonds from distressed property developers are unable to redeem them. Thousands have lost their life savings.
The Chinese government recently announced that it plans to relax the three red-line ratios to give more property developers access to cash. With a financial lifeline, it is hoped that they can finish their projects and monetize them. While this will bring relief, it does not negate the severe damage already inflicted to the banking system, suppliers, and private investors.
There are valuable lessons to be learned for Filipino property developers. First, build in sync with demand. Second, in the use of funds, priority should be given to finishing existing projects rather than starting new ones. Third, debt should not be abused no matter how easy it is to come by. Prudent financial stewardship must be supreme.
On the part of buyers, they must look into the financial stability of the developer before purchasing properties from them. The three red-line ratios are good parameters to assess their financial stability.
It is not true that real estate is the soundest investment since they never depreciate. As we have seen in the Chinese experience, property values can drop when the bubble bursts.
Source: BusinessWorld