The ugly upshot of a China property fix

China's noble aim to stabilise the property market in the interests of ordinary homebuyers must weigh the economic fallout, and response, among indebted investors.

Stratfor.com

China is attempting to curb rising housing prices that have far exceeded what ordinary homebuyers can afford, but its methods for doing so could expose it to short-term risks from the country's burgeoning informal lending sector. Many wealthy Chinese investors and, even more important, local and regional governments and enterprises have used property markets to earn returns on investments at rates unavailable elsewhere. Reining in such markets could force those investors to turn to semi-officially sanctioned financial products that are being purchased at an alarming pace, even though they are not fully understood and could seriously threaten the entire Chinese economy if they default.

During a session of the National People's Congress on March 1, the State Council announced it would implement a range of new controls on real estate markets in an effort to check recent housing price spikes in 66 of the 70 major Chinese cities. The controls include a 20 per cent tax on sales of second homes, new restrictions on mortgage lending and a host of general exhortations to local governments to better manage local housing prices.

The announcement triggered temporary price hikes in property markets in some cities as fearful developers and speculators quickly moved to trade properties before local governments could implement the new measures. But even when they take effect, the new measures will not likely have a significant impact on China's real estate markets, let alone the economy as a whole – and certainly nothing like the nationwide economic slowdown that followed Beijing's 2011-2012 efforts to rein in the massively inflated speculative property markets.

In part, this is because property markets are not, on the whole, particularly inflated or unstable right now compared to previous peaks in real estate-related activity. While major cities such as Shanghai, Beijing and Guangzhou had significant spikes in home prices and sales in January and February, many small- and medium-sized provincial cities have seen smaller and less consistent price hikes. Overall, inflation of housing prices in the first two months of 2013 stood at 5.9 per cent year-on-year, far below the inflation above 20 per cent seen during property bubbles in 2004, 2007 and 2010. Likewise, while sales are up significantly from the same time in 2012 amid the lending clampdown, they are still a fraction of the volume seen during the 2009-2010 stimulus drive.

This suggests that Beijing's steady efforts to curb runaway speculation in property markets – not only in first-tier cities but also in second- and third-tier cities where land transfer fees make up a much higher proportion of local government revenues – are largely achieving their intended effect of stabilising and gradually lowering expectations for the real estate sector. In fact, the announcement of new restrictions may be intended as much to remind local governments, developers and speculators of Beijing's commitment to long-term rationalisation of real estate markets as it is to impede those markets in the near term.

The central government's intentions

Beijing's underlying goal is to shift property markets away from being havens for speculative investment – often from state-affiliated enterprises and wealthy investors looking for higher returns than the minimal returns promised by bank deposits – and toward becoming genuine housing markets that cater to ordinary homebuyers. It has pursued this aim through a combination of methods. First, Beijing has used a management strategy of pumping credit into the property market when it is weak or, alternately, restricting credit when a speculative bubble begins to form. This keeps the market just active enough to keep it from collapsing but not too active to seriously risk bursting. Meanwhile, the government has pushed through the new round of regulations, which, combined with the ongoing measures to nudge unrelated state-owned enterprises out of real estate markets and compel local developers to build more affordable housing, are intended to provide longer-term property market reform.

But in implementing this long-term strategy, Beijing has exposed itself to new and potentially destabilising short-term risks. China's property markets are driven ultimately by expectations of those involved – from local governments to developers to speculators to ordinary homebuyers – that values will rise significantly in the end. In China in recent years, with virtually no legal investment avenues aside from real estate that offered decent rates of return, investment poured into property markets at extraordinary rates.

Of course, much of the investment into property markets came from wealthy individuals simply looking to maximise their earnings. But a great deal also came directly and indirectly from regional governments and state-owned enterprises driven not only by a desire for high profits but also the need to repay their own mounting debts. This compulsion, in turn, complemented and fueled the needs of local governments and developers to keep selling land and building – again, not only to raise capital, but also to maintain the high expectations necessary to sustain high land values and home prices and keep the system going. At the heart of this system was local governments' dependency on land sales as a source of revenue and high-value land as collateral for loans from state-owned banks – loans used to fund local infrastructure development.

Where property and shadow lending meet

As the central government looks to stabilise property markets, it faces a complex problem. While Beijing knows it must bring housing prices down to levels that ordinary homebuyers can afford, it also knows that doing so would run directly counter to the interests of regional governments and state-owned banks, which must keep land values high, credit flowing and economic activity robust. Therefore, when Beijing clamped down on both the developer and speculator sides of housing markets by limiting access to credit and imposing controls on home purchases starting in late 2011, it understood that local-level actors would inevitably seek alternative avenues of investment and sources of credit. This in large part explains the astronomical growth of informal or "shadow" lending markets since late 2011.

Beijing tolerated informal lending up to a point. In fact, it tacitly supported the absorption of informal lending markets by the state, in the form of "wealth management products" that are managed in large part by local state-owned bank branches but not recorded on bank balance sheets. For developers and speculators, wealth management products – and, to a lesser extent, other informal lending tools – appeared to be the ideal solution. They provided local developers (along with other small private enterprises) much-needed access to supplemental credit while giving investors and speculators a state-managed and theoretically state-backed place to store money that even promised double-digit rates of return.

Though the credit provided through unofficial channels could not match the amount that the government had cut off in late 2011, it nonetheless provided a crucial buffer for a range of local-level actors who suddenly found themselves cut off from official lending. The problem is that informal lending markets are growing faster than the central government anticipated. In the first two months of 2013, informal lending accounted for more than half of total new credit creation. It is not clear what portion of that credit is tied to wealth management products, but given that in 2012, wealth management products were by far the fastest growing form of informal lending, the number is likely large.

Two years ago, wealth management products were minor contributors to informal credit creation and negligible when compared to formal and non-formal credit combined. Now, total outstanding credit linked to wealth management products is estimated at 13 trillion yuan ($2.1 trillion) and could be much higher. Moreover, wealth management products are notoriously opaque, a quality that partially explains their ability to promise unusually high returns at a time when other economic sectors are slowing, stagnant or constricted by central government policies. This also makes them risky. To a surprising degree, it is still unclear to what or whom funds put into wealth management products go.

The majority of these wealth management products are pooled and then reinvested, eventually becoming sources of informal credit for local governments and land developers pursuing risky but potentially lucrative real estate projects or other small-scale enterprises. Anecdotal reports even suggest that many wealth management products are simply reinvested into other wealth management products. What upholds the value of these opaque investment vehicles may ultimately be their affiliations with local branches of state-owned banks and local governments – as well as the implicit guarantee that in the event a product defaults, banks will repay investors. But that assumption was called into question in December 2012, when state-owned Hua Xia Bank and a trust subsidiary of China Citic Group refused to do so after two products defaulted.

Against this backdrop, it is not surprising that Xiao Gang, the new head of the China Securities Regulatory Commission, recently called for a crackdown on shadow lending markets and, in particular, wealth management products. With China's leadership transition now complete, the new leaders will likely implement some form of controls in the coming months in an effort to contain shadow lending before the relatively small-scale defaults of 2012 escalate into something much larger. In this task, however, China's new leaders face the same constraints as their predecessors. In addressing the real estate problem, they inevitably open other issues. They are working within an economic structure that is both dependent on continuous credit creation and increasingly less capable of absorbing and processing the credit and capital it creates.

Stratfor Reprinted with permission of STRATFOR.

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