The Collapse of China’s Real Estate Bubble: Causes and Consequences

A Bubble Caused by Beijing’s Failures

There are no economic bubbles in the world that do not eventually collapse. While some similarities exist between the difficulties China is currently experiencing and Japan’s situation following the bursting of its asset bubble in the early 1990s, they are exceeded by the number of substantial differences. The primary cause of Japan’s bubble economy was market failure, while China’s real estate bubble is the consequence of government failure.

During the last 20 years, the Chinese government has positioned real estate investments as the engine of economic growth. In particular, under the Hu Jintao administration (2003–12), former premier Wen Jiabao decided to use the sale of land usage rights (fixed-term leases) by local governments as a way of funding their budgets. This resulted in local governments raising the price of land usage rights, which property developers accommodated by raising land prices as well. Developers that did not accommodate the demands of local governments found it difficult to win bids for government contracts. This is the history that led to a bubble in China’s real estate market.

Forty years ago, at the start of Deng Xiaoping’s reform and opening up policies, the per person residential area of Chinese living in urban areas was around 3 square meters. Since the standard size of families in urban areas was three to four persons at that time, the average residential area of families was around 10 square meters. For a long time, Chinese strongly desired to live in larger homes.

Since land is publicly owned in China, its sale is forbidden in land policies, and urban redevelopment was not possible. In the mid-1990s, learning from Japan’s fixed-term land leaseholds, the Chinese government separated ownership rights and usage rights and made it possible to sell the latter. Through this reform, urban redevelopment took off, and the construction of condominiums for individuals accelerated.

While demand from individuals hoping to own a home did exist, few had the means to do so. For a long time, home ownership was beyond the reach of Chinese people. With the change in the rules making ownership possible, though, for young people wanting to marry, owning a home has become a prerequisite. Such deep-seated demand has augmented the aggressive development plans of property developers.

Xi Questions Real Estate Investments

The Xi Jinping administration, however, began to question real estate investments. In October 2017, President Xi declared that homes are for living in, not for speculation. This comment slowed the demand for real estate in China, and the real estate market turned downward.

Based on their optimistic economic outlooks, China’s property developers borrowed funds from state-owned banks and issued bonds, burdening them with debt beyond their financial capacity. Owing to the downward trend of the real estate market and the stalled sales of condominiums and residential housing, many developers are unable to repay their debts. Major property developers including Country Garden and the Evergrande Group have defaulted, and many other developers are at risk of doing so. There is growing concern that a wave of bankruptcies is about to sweep the real estate industry.

The chain reaction of defaults in China has spread wider than the defaults that followed the collapse of Japan’s asset bubble. The management difficulties of property developers have propagated to local governments, which are no longer able to finance their budgets through the sale of land usage rights. Pensions and social security funds controlled at the local level now risk running out of funds.

A Mountain of Bad Debts

The Evergrande Group has filed for bankruptcy with a New York court. While this is a measure to extend the life of the company, Evergrande is thought to be effectively insolvent, with hardly any prospect of restructuring its business. On September 28, the company confirmed that founder and chairman Hui Ka Yan was in police custody.

As noted above, China’s real estate bubble is largely the result of government failure. The government, however, cannot rescue individual companies that have failed. On the other hand, creditors and real estate owners will not be able to protect their assets if the real estate bubble is left unaddressed, which will risk the emergence of massive protest movements.

Another concern is the mountain of bad debts held by the state-owned banks that lent funds to the Evergrande Group. Following the collapse of Japan’s asset bubble, the crisis spread to financial institutions, and major players like the Long-Term Credit Bank of Japan and the Nippon Credit Bank went under. China’s state-owned banks currently face a similar risk.

In Japan, the Deposit Insurance Corporation was used to rescue banks at that time. While China established a deposit insurance system in May 2015, its guarantee capacity is still insufficient. As a result, the Chinese government will be compelled to inject treasury funds.

Ways to Avoid Contagion

Could the collapse of China’s real estate bubble cause a financial crisis? While a crisis will be unavoidable at the local level, a nationwide systemic crisis is unlikely. This is because the mechanism of financial crises is the transmission of crisis-related information. In democracies, information about the management situation of financial institutions is transmitted in real time, and systemic crises readily occur.

In contrast, since the Chinese government is able to control information, if the branch of a state-owned bank in a certain locality is unable to fulfill the withdrawal of deposits, while this information might be shared locally, it will not easily spread nationwide. State-run media would not report it, and comments in Internet-based social media would be immediately deleted.

While local financial crises would not readily spread nationwide, though, the problem will remain unsolved. Unless the government actively undertakes reforms and works to solve it, isolated crises will merge together and develop into a nationwide systemic crisis. This will mean not just a financial crisis but a revolution.

Foreign Companies Will Pull Out of China

Finally, how will the collapse of a real estate bubble in China affect the global economy? With the winding down of the COVID-19 pandemic, China’s economy was expected to make a powerful V-shaped recovery. In fact, the recovery turned out to be L-shaped.

Should the real estate bubble burst and China’s economy slow further, this will risk a further relapse of the economy. It is reported that Premier Li Qiang has ordered the formulation of bold stimulus measures for the remaining fourth quarter of the year, but not much can be expected from these, due to the weakening of the fundamentals of the Chinese economy.

Given this situation, there is concern about the impact the collapse of China’s real estate bubble would have on the world economy. While foreign institutional investors with stakes in China’s property developers may suffer losses, though, the effect on the world economy will likely be limited.

Should the real estate bubble burst and should China’s economy slow further, foreign companies that have set up local operations will rush to pull their factories out of China. This is precisely the derisking mentioned by US President Joe Biden. Going forward, it will be important to manage the China risk and to reduce its potential effects.

(Originally published in Japanese. Banner photo: A building of China’s Evergrande Group under construction in Nanning, Guangxi Zhuang Autonomous Region, China. © Jiji.)