China’s current mortgage crisis will end up being much bigger than Evergrande’s simple default a year ago. This is largely due to the scale of the problem and the fact that the solution requires Beijing to spend considerable political capital rather than just financial capital.
While Beijing’s “hit a mole” approach to bailing out the worst-hit property developers will allow it to fend for itself and avoid contagion in the banking system, it comes at the expense of government credibility and undermines the confidence in the “pre-sale” business model. which accounts for more than 80% of all real estate developer revenue.
Hundreds of billions of Chinese homebuyers’ money is at risk, tied up in pre-sale accounts they may not be able to recover. This figure will likely increase as more property developers default in the coming months. Nearly half of all listed property developers now trade at a P/E ratio below 0.5, matching Evergrande’s situation four months before it defaulted. In addition, nearly 100 cities, including large municipalities like Chongqing, are said to experience incomplete project issues.
The growing scale of stalled property projects means the more than 300 mortgage boycotts, based on a rough social media count, are likely just the tip of the iceberg. As more defaults ensue, these boycotts will grow accordingly.
On the face of it, the solution is obvious: bail out struggling developers because it’s mostly a cash flow problem of not being able to pay construction companies to complete projects. Once construction restarts, units will be completed, buyers will get their homes, and mortgage payments will start flowing again.
But what is obvious is not simple politically. In fact, Beijing has been quite timid to step in because it is concerned about a huge moral hazard problem that would shift all the cost onto the central government.
As of now, containing the problem has been left to the local governments’ own apparatuses. But they are increasingly overwhelmed as the problem worsens, as unfinished projects are heavily concentrated in cities with weak property markets and anemic growth. This means that the size of the necessary bailouts is disproportionate to the fiscal capacities of these local governments.
If local government guarantees on pre-sale units are no longer credible, then the blame should stop in Beijing. Essentially, Beijing needs the equivalent of a “deposit insurance” guarantee on pre-sale units: a promise to buyers that they will get their units regardless of what happens to the developer.
But such an open-ended commitment will come at an exorbitant cost. Since 2020, approximately $5 trillion in residential property has been sold through the presale model. Assuming that only 10% of projects require bailouts equal to half the value of the property, the total bailout cost is $250 billion.
This cost could quickly increase when local governments realize they will be off the hook and relinquish all outstanding rescue responsibilities. That’s quite a pickle for Beijing, which is probably why it appears to be paralyzed by inaction, as securing full bailouts is a tough pill to swallow.
As a result, Beijing will likely lag behind in taking a wait-and-see approach, focusing most of its energies on bailing out projects from already failing developers. But Chinese households are impatient and increasingly pessimistic, and this uncertainty about the bailout of their stalled projects is not boosting their confidence in the Chinese economy.
And trust is precisely what Chinese consumers need. There are already signs that homebuyers are voting with their feet and abandoning pre-sales. When mortgage boycotts began making headlines in mid-July, pre-sale units plummeted even in major cities where unfinished projects are rare.
Chinese households also seem to have a very pessimistic view of employment and income, according to a survey by China’s central bank. Even before the COVID-related lockdowns, urban wage growth was more than three percentage points lower than pre-COVID.
In short, the real estate sector is now flanked by both supply and demand constraints. It cannot deliver units to people who want them and it risks losing future buyers due to loss of trust.
In the short term, this practically does not ensure fairly weak real estate sales. If nothing is done, this vicious circle will certainly get worse. But with an improving economy and the upcoming political transition, Beijing has a strong incentive to wait a bit longer before taking more drastic measures.
But the longer Beijing waits, the bigger the bailout bill, as more defaults and disappointing property sales figures emerge in the meantime. This will likely force Beijing to bite the bullet on a blanket guarantee, increasing the likelihood of a meaningful bailout by the end of the year.
Houze Song is a member of MacroPolo, the think tank of the Paulson Institute of Chicago. Follow him on Twitter @hzsong.This was first published by MacroPolo—“The Chinese mortgage fiasco: To bail or not to bail?“