China housing: confidence and supply are the concern, not underlying demand
We expect residential construction to strengthen from Q4 as policy support takes effect.
China’s residential construction sector has come under significant pressure in recent years, not because of a lack of underlying demand from consumers, but rather due to regulatory reform and the poor financial health of many developers.
The reduction in developer leverage required by 2020’s “three red lines” policy, including that created by fully funded pre-sales, was the primary catalyst. But the flow-on consequences for developers in poor health such as Evergrande has accentuated market concerns, so too the recent protests by off-the-plan purchasers, with their refusal to pay mortgages on unfinished apartments constraining developer liquidity at a particularly inopportune time.
As of July 2022: real estate fixed asset investment was down more than 6% year-to-date against total fixed asset investment’s near 6% gain; meanwhile, sales and starts are respectively 31% and 37% lower year-to-date.
It is unsurprising then that the market consensus is so downbeat on prospects for the sector and, given its historical significance, for the economy more broadly. In our view however, there is good reason to believe that the sector will soon return to being a positive contributor to the economy, and sustainably so.
It is notable that, after all the sectoral developments of the past two years and with employment under pressure from COVID-zero restrictions, the cumulative decline in new home prices since August 2021 has been less than 2% following gains of over 40% since the last period of price declines back in 2014/2015. This suggests the prime concern for construction is supply not demand.
This assertion is backed up by the stage of construction data. Relative to the surge in starts seen from 2020 to mid-2021, growth in work under construction and completions has been modest. For completions, this follows a prolonged period of underperformance from 2016, limiting the available stock of new habitable dwellings in the economy. Looking ahead, the current weakness in starts and the financial concerns of the sector point to the supply of newly finished apartments remaining constrained for some time.
This reality highlights that a successful resolution to the current situation requires authorities to provide capital and liquidity to developers and, where there are solvency concerns, to arrange for another developer to step in. Doing so will provide confidence to both buyers and developers and allow the industry to slowly work through projects under construction while planning and funding the next round of developments.
While slower than we had hoped, progress towards a resolution is being made. In late-July, detail on a proposed rescue fund for distressed developers was released to the market. More recently, according to Bloomberg, authorities have reportedly also told some developers that state-owned China Bond Insurance Co will provide guarantees for their new bond issuance and that state-owned lenders will purchase the bonds. There have also been anecdotes of some local governments investigating the seizure of undeveloped land from troubled developers, with the proceeds of land sales to be used to fund the completion of current projects. Along with the other initiatives surely in the pipeline, these actions have the capacity to return liquidity and proper functioning to the construction sector and to rebuild confidence.
It is also important to recognise that China’s property investment outlook is not dependent on speculative investment by the wealthy. A key tenet of the reforms of recent years has been to make housing more affordable by building smaller, utilitarian apartments across the city tiers. An increase in Government constructed and owned rentals has also been proposed. Achieving these ambitions will allow investment in the sector to grow robustly and prices to rise on a comparable basis while affordability and social welfare improve overall.
Looking to the long-term, it is worth mentioning that authorities intend residential investment to grow in line with the nominal economy – on average. However, they aspire to grow national and household incomes at a quicker pace. The net effect will be a structural improvement in housing affordability as well as capacity for consumers to invest in property and/or financial instruments for a return. Assuming developer leverage is constrained, China’s financial stability and growth capacity will continue to improve as a result.
Clearly there are risks for the sector, but our baseline expectation is for residential investment to begin to improve in Q4 2022 and to build momentum through 2023. Given the scale of 2022’s weakness and the need for quality new housing across the economy, an above-trend year for investment in 2023 seems likely after which investment momentum should normalise to a rate in line with nominal GDP growth. In part, this is why we expect a 7.0% year-average gain for real GDP in 2023 after a disappointing 3.0% result in 2022.
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