Over the past year, news agencies alleged that Chinese real estate developers operate as Ponzi schemes and are on the brink of collapse. This assertion demands sufficient evidence as such behavior may harbor financial crimes that, if exposed, could damage global markets. This article outlines the mechanisms by which China has sustained unprecedented real estate growth over the past two decades, paying particular attention to the mechanisms behind China’s current crisis.
In December 2021, China Evergrande Group, China’s second-largest real estate developer, defaulted on its debt. On August 30, 2022, China’s largest property developer, Country Garden Holdings, revealed that yearly profits had plunged 96% from $2B to $88M. In total, 28 property firms in China have defaulted on payments or gone into restructuring. As Beijing grapples with anti-lockdown protests, the potential for future defaults from prominent real estate developers, and the ripple effects this would cause, looms large.
China’s transformation from an agricultural-based economy into an industrial power has been labeled as one of the most important economic and geopolitical phenomena in centuries. In 2013, the CCP launched a 12-year plan to relocate hundreds of millions of Chinese from rural areas into cities. The goal of this modernization plan — termed “China’s Great Uprooting” — was to move 70% of China’s population by 2025. China is on track to meet this figure as the 2021 Seventh National Population Census reported that 63.89% of citizens live in urban areas.
However, China’s unsustainable reliance on debt to finance industrial growth has not come without a price. The annual profits of 136 Chinese real estate companies are down 87% from $19.2B to $2.5B compared to last year. When comparing July 2022 to July 2021 real estate figures, (1) new projects in China fell by 45%, (2) the value of home sales dropped by 29%, and (3) property investments decreased by 12%. Bloomberg reports that this is the worst half-year earnings report for China since 2008.
What are the reasons for this decline? First, there is Xi Jinping’s Three Red Lines policy. To curtail unsustainable borrowing, the CCP has instituted restrictions on developers’ ratio of outstanding liabilities to assets, debt to equity, and cash to short-term debt. Real estate developers, now with reduced capacity, are struggling to complete outstanding projects. Second, China’s “Zero-Covid” policy has resulted in mass lay-offs (youth unemployment is at a record high of 20%), restricted citizens’ ability to view homes, and forced potential homebuyers to reevaluate their future purchases. Changes in China’s housing sales volume are pictured below in Figure 1.
China’s property market is estimated to be worth $60T and makes up ⅕ of China’s GDP. A collapse of China’s housing market would submerge the Chinese economy and have ripple effects throughout the world. Figure 2 illustrates outstanding debts due in 2022-2024.
For Chinese families, owning a home is seen as a safe investment and a symbol of upward mobility — 70% of Chinese household wealth is stored in real estate. There is an important distinction between buying real estate in China and buying real estate in the United States: In China, developers pre-sell units years before their completion, meaning that buyers pay for houses and apartments that aren’t even built.
Is this “pre-sale strategy” nothing more than a Ponzi scheme by a different name? Using the collateral from pre-sold projects, developers finance the next project, thus restarting the cycle. Data from China’s National Bureau of Statistics shows that over ⅓ of Chinese developers’ liquidity (34.5%) comes from the short-term profits made using this pre-sale strategy, as shown below in Figure 3.
According to Foreign Policy, more than 85% of Chinese homes are sold through pre-sale.
The Chinese Communist Party uses Local Government Financing Vehicles (LGFVs) to purchase land. LGFVs are a means to borrow money off the books whereby investment firms sell bonds to finance development projects. For example, Rizhao — a municipality on the East coast of China — held a land auction this year for a property worth $170M. The winning offer came from a state-owned financial institution, meaning that the city essentially sold the land to itself. This Ponzi-scheme like structure moves money around in a circle.
Real estate developers have begun to run out of money to complete projects: Nearly 9% of housing projects under construction in China have become “rotten tail buildings” — or 烂尾楼 (làn wěi lóu) — a term used to describe unfinished homes. The ratings agency S&P estimates that 2,000,000 homes remain unfinished across China. Out of frustration, around 2% of pre-sale homebuyers are boycotting mortgage payments and organizing protests across the country according to an August 2022 report by Goldman Sachs. An open-source document on GitHub titled, “WeNeedHome,” claims that homeowners have boycotted 342 projects in 119 different cities across China. Such public dissent is rare and the Cyberspace Administration of China is censoring any information vis-a-vis citizens’ anger at real estate developers. Figure 4 shows a heatmap of these protests across China as of 21 September 2022.
China’s overleveraged real estate market faces a future obstacle: an aging population as a result of China’s 36-year one-child policy. In the absence of a rapid increase in annual fertility rates, China’s real estate developers will face severe difficulties in filling newly built megacities. More than 50 “ghost cities” across China, once thought to house millions, now stand relatively empty. According to the 2017 China Household Finance Survey, 65,000,000 units, or ⅕ of the homes in China, are purchased but remain vacant. Figure 5 graphs projections of China’s population decline:
With $117B due at the end of this year, serious questions surround China’s ability to keep the real estate bubble from bursting. The CCP is taking active measures to see the real estate industry through this debt crisis.
On August 22, 2022, China’s Housing Ministry announced ¥200B ($29.3B) in special loans to be used for completing sold but unfinished projects. One month later, on September 30, 2022, the CCP announced an additional ¥600B, or $85B, of financing for the property sector. The People’s Bank of China and the China Banking and Insurance Regulatory Commission told the six largest banks that mortgages and loans to developers are desperately needed to address a serious liquidity crisis. In addition, on November 28, 2022, the China Securities Regulatory Commission (CSRC) announced five measures to support equity financing for real estate developers in China.
Since the start of the COVID-19 pandemic, developers’ access to bond and equity markets has been constrained. According to a November 30, 2022 sector report by Moody’s, “the equity funds raised by developers can be used for a wide range of activities, such as mergers and acquisitions, construction of stalled projects and affordable housing, replenishment of working capital and repayment of debt”. Given the sustained pressure facing China’s real estate market amidst high refinancing needs, developers are forbidden from using equity funds for new development projects.
Lastly, according to a Wall Street Journal report from September 30, 2022, China is conducting information campaigns to sway the research of Goldman Sachs and JPMorgan surrounding this debt crisis. Prior to the 20th National Congress of the Chinese Communist Party on October 16, 2022, the CSRC asked multiple banks to avoid publishing politically sensitive information.
Investment in real estate development, foreign and domestic, is one prong of Beijing’s economic strategy. Through its Belt and Road Initiative (BRI) projects, China has formed important political ties with countries receiving loans from state-sponsored Chinese banks. A cursory analysis reveals that China, as the world’s largest bilateral lender, has given out $932B of loans over the past eight years. However, research by the Centre for Economic Policy and Research indicates that 60% of China’s total credit portfolio is held by borrowers in distress. Of particular interest is Evergrande’s $22.7B in offshore debts consisting of private loans and bonds. The World Bank has warned that widespread defaults in such a scenario could result in a series of defaults not seen since the 1980s. With $39B of debt set to mature in the first quarter of 2023, questions remain over Beijing’s ability to keep a cash-strapped property sector afloat.