China monthly: How to fix China’s real estate problem

No less than 22% of housing in China is standing empty, thanks to the real estate bubble. Converting those properties into low-cost housing is one solution

The nature of an investment bubble is such that unless you keep on pumping more and more air into that bubble, it will become unstable and then burst.

Government action could ease China’s bust in building Copyright: Rex Features

This is exactly what seems to be happening in China’s property market at the moment as the pace of construction continues to decelerate.

“While housing sales will likely improve this year, construction and all the industrial activity that depends on it will not. So an upturn in housing sales will not deliver much of a boost to growth,” wrote Rosealea Yao of Gavekal Dragonomics in a February 2015 report, which was quoted in a 2 March Bloomberg article .

Property starts, measured by area of floor space, declined by 26% year-on-year last December following a 35% drop in November, she added. This compared with a 5.5%fall in starts between January and October 2014.

Parcels of land allocated for new projects also fell by 25% last year over 2013, said Yao. This is a big problem for local governments in China, as they are heavily dependent on land sales to balance their budgets.

“The traditional correlation between housing sales and indicators like steel use and construction starts will break down,” she warned.

It seems therefore logical there will also be a breakdown of the correlation between housing sales and demand for the chemicals and polymers that go into construction.

Arguably, the level of real estate oversupply is also truly shocking, even by the standards of China where data usually has the capacity to take your breath away.

For example, a 16 February report by investment analysts, Motley Fool Australia, said that as of 2013, 49m apartments in China were sitting empty – 22% of the total. That is enough vacant real estate to absorb six years’ worth of further urbanisation in China, added the same report.

In other words, all this vacant real estate could add up to six years of “lost demand”, during which the chemicals and polymers that would have gone into building new homes might not be needed.

With this oversupply has come a fall in prices and a rise in unpaid debts. China’s total debt quadrupled from $7trillion in 2007 to $28tr by the middle of last year with half of these loans linked to the property sector, said a February 2014 McKinsey study.

PVC, PHENOL OVERSUPPLY
Specifically, for some chemicals and polymers in China, this would compound already severe oversupply issues.

For example, in the case of polyvinyl chloride (PVC), capacity has grown well in excess of local demand over the last seven years – on the assumption, of course, that China’s construction boom would eventually absorb this oversupply. PVC is used to make water pipes, window frames and other end-use products that go into the real estate sector.

In 2007, PVC capacity totalled 12.4m tonne/year against real consumption of 10.4m tonnes, according to ICIS Consulting. But by 2014, capacity stood at 30m tonnes/year versus real consumption of just 15.9m tonnes (real consumption is consumption adjusted for inventories).

The same applies to phenol, one of the main applications of which are phenolic resins that go into construction. In 2007, China’s capacity was 574,000 tonnes/year compared with real consumption of 10.2m tonnes. Last year, though, capacity had surged to 24m tonnes/year over real consumption of 18.5m tonnes.

And just in case you are not already sufficiently worried, here is something else: The size of China’s main property buying population, those aged between 25 and 49, will peak this year, according to a December 2014 study by Ai Jingwei – a China real estate expert. This is the result of China’s one-child policy, which has left the country with a rapidly ageing population.

The difficulties for China are further compounded by the big role that real estate has played in driving its GDP growth. No less than 23% of the country’s GDP in 2013 was down to the building, sales and fitting-out of homes, said Moody’s Investors’ Service.

A POTENTIAL SOLUTION
Financial calamity and ruin? A real estate crisis so big that it will make the US sub-prime calamity seem like a very light financial rain shower? This need not necessarily be the case because this is China and not the West.

“On the real estate sector in China, one of the big questions you need to ask is, ‘Who owns the land?’,” said a senior executive with a global polyolefins producer.

“The answer is the government – there are no freeholds, only leaseholds – and so they can take the land back any time they like.”

His solution is that empty apartments, which have been bought for investment purposes are acquired by Beijing and then converted into low-cost social housing. The boost to consumer spending, thanks to low-income earners being given access to cheap accommodation would be huge, he added.

This boost to consumer spending would also fit with the government’s objective of rebalancing the economy away from investment and towards consumption.

In the West, such an approach seems almost impossible, given the likely resistance from investors.

“But China has no bankruptcy laws. So all that would happen would be that Beijing would take over the land and the property owners and real estate developers would walk away, free from all their obligations,” the source added.

Surely, though, even the absence of bankruptcy laws would not be enough to prevent huge resistance from investors. Why would any of them be prepared to accept seeing the value of their assets wiped out overnight?

“I don’t think this would be a big problem as you have people in their mid-30s who have already made and lost tens of millions of dollars,” he added.

“As a result, they think that because they made and lost their fortunes so quickly, they can do so again,” said this source.

China not only has no bankruptcy, but also no social stigma attached to losing all your money, he continued.

“Ex-millionaires have, as a result, very quickly found directorships with new businesses. What matters to these new businesses is not the fact that these people have lost a lot of money, but instead that they have lots of experience,” he added.

The polyolefin industry executive’s views were shared by a 23 February editorial in the South China Morning Post, the Hong Kong-based newspaper. It suggested that China could set up a “bad bank”, in which non-performing real estate assets could be placed and turned into low-cost homes that would be bought or rented.

“It is not an altogether unreasonable idea and it’s the kind of measure that can only really work in a country like China,” said a Hong Kong-based banker.

“I can see two advantages. Firstly, you would help fill up all the ‘Ghost Cities’, empty towns and cities in China’s inland provinces. This would boost inland economic growth – one of Beijing’s big objectives,” he added.

As for China’s “Tier 1” cities – its huge very developed cities such as Shanghai and Beijing – turning luxury condos over to low-income workers would solve accommodation shortages faced by migrant workers, he said.

Again, do the math on the boost this could provide to consumer spending: Another 200m people are expected to migrate to China’s more-developed regions over the next decade.

Whether or not such a radical proposal ever gets off the ground is impossible to say. But what seems clear is China has to devise some very radical solutions if it is going deal with all the damage left over from its investment-focused growth model.