International | May 26 2014
By Rosealea Yao and Thomas Gatley of GavekalDragonomics
With this year’s correction in the Chinese housing market spreading, the search for the villain of the piece is on. Most market analysts were primed to expect problems in the numerous small, isolated cities that have overbuilt housing and are swimming in excess inventories. Both our own research and much other analysis has shown that smaller cities have serious problems, thanks to an unhappy combination of weak population growth and government-led building booms. Yet the recent correction got its start not in out-of-the-way ghost towns like Yingkou and Tieling, but in large, prosperous coastal cities like Hangzhou. So does this mean that the problems in China’s housing market are different and more severe than many thought? It does not, but to understand why requires a closer look.
We haven’t changed our view that the long-term fundamentals for large coastal cities are solid: these cities are where China’s people are concentrating to take advantage of the economic gains from urbanization. But the structural divide in the housing market—between this small group of large cities with good fundamentals, and a large group of small cities with bad fundamentals—does not necessarily mean that cyclical corrections will be led by small cities. Property developers themselves saw this division very clearly: indeed, as they realized smaller cities were oversupplied, they refocused their efforts on new projects in the big cities on the coast. But by splurging on expensive land in these cities, developers left their finances stretched. And when sales growth slowed in late 2013, developers’ access to informal financing was also drying up. So developers starting cutting prices in some cities to boost sales and cash flow. The price cuts were focused in cities with high prices, because that’s where they had the best chance of boosting sales. Unfortunately, those large, high-profile cities serve as bellwethers for the national market, and as word of falling prices spread, sales and sentiment were hurt across the country. As a result, China is now experiencing a full-fledged housing downturn, one that will likely continue for at least a couple of quarters.
Ironically, the real villains of the property market—the heavily oversupplied small cities—could manage relatively better. While we shouldn’t expect them to avoid the national cycle, they are unlikely to have a deeper correction than the big cities. First, affordability is much less of a problem in smaller cities, and developers’ margins are much thinner. So the potential for price cuts to stimulate sales is more limited, and developers are more reluctant to start cutting. Second, the cycle in bigger cities is always more volatile, because a greater share of property sales are speculative, there is greater reliance on mortgage debt, and developers’ wide margins give them much more price flexibility. So just as in previous housing cycles, the large cities where prices are highest should see the sharpest downturn. We do think this is a cyclical correction rather than a structural collapse, since the fundamental demand for housing in China remains quite large. But since on our estimates China has been at or near peak housing supply for two years now, its future will hold more of these volatile swings around a trend, and will not repeat the steady upward climb of the past decade.
Where are China’s hottest markets?
To dissect the trends in the big cities responsible for this correction, we dig into the detailed monthly housing data that is available for 40 major cities, which together account for about 40% of nationwide sales volume and include many of the so-called Tier 1 and Tier 2 cities. Though these large cities are all better off structurally than more isolated and slower-growing small cities, they are hardly a uniform group. We divide them into three groups based on historic levels of affordability: the most dynamic but also most expensive coastal cities, some less high-profile but also expensive cities, and the remainder of relatively affordable cities (see table below for the members of each group).
Once this breakdown is done it is easy to see which group has been developers’ darling recently: the most expensive coastal cities. The volume of land sales in this group of cities rose 70% in 2013, well above the 8.8% growth for nationwide land sales. This extreme surge was the result of many developers simultaneously coming to the same conclusion: while smaller cities may once have been attractive because there were fewer government restrictions on housing sales, their prospects were rapidly dimming as excess supply became increasingly obvious. Where better to focus new development than those cities that are clearly the economic hubs of an increasingly urban China—not just the big two of Beijing and Shanghai, but attractive and fast-growing cities like Suzhou, Xiamen and Hangzhou.
It was this surge of investment into very expensive land that laid the seeds for the woes that would later befall developers. Property developers have faced tight credit conditions for many years now, with the government limiting their access to bank credit in an attempt to tame boom-bust cycles in housing. During the good times this discrimination was not actually a tight constraint: most houses in China are purchased well in advance of their completion, so developers are able to fund their expenses with new customers’ down-payments. This strategy does however leave developers highly vulnerable to a sales slowdown, of the sort which began to unfold in the most expensive cities over the second half of 2013.
The cooling of sales was not so much because housing in those cities was becoming less attractive but more because a lot of purchases had simply been front-loaded into the early part of the year, as buyers scrambled to finalize transactions in advance of a feared change in tax rules. But whatever the cause of the cooling sales in hot markets, the effect on the finances of developers in those cities was the same: new cash was not coming in fast enough, and their reserves had been depleted by lots of expensive land purchases. Normally developers would meet this kind of shortfall by turning to various “shadow” financing channels, like trust loans or short-term debt (or, for the biggest firms, selling offshore bonds to global investors). But in late 2013 the central bank was pushing up funding costs for this kind of finance, and ordering banks to reduce their exposure. As a result, developers’ need for additional finance was greatest just when their access to it was weakest.
The only way to get more cash, unpalatable as it might be, was to try to juice sales by slashing prices. Price cuts at some developments in Hangzhou were widely reported in the Chinese press, and in January the city’s official housing price index suddenly went into negative territory after months of steady gains. At the same time, developers scaled sharply back on new construction, a response both to rising inventories and weaker growth prospects, and a measure to reduce expenses. But price cuts spread—the number of cities with falling prices jumped to six in January 2014 from two in December 2013— the problem did not stay contained in the expensive, overheated markets where it started. The big high-profile cities have always led the nationwide property cycle, and this relationship is still holding true. Price cuts in the short term dampen sales, by encouraging fundamental buyers to wait for a better price and signaling to speculative buyers that short-term gains are less likely. April’s data provided clear signs that the slowdown in sales has spread more widely, and that prices are weakening outside the cities where the trouble started. Notably, new housing prices in cities of very different sizes are all softening at roughly the same rate.
So like most of China’s previous property corrections, the latest one had its origins in big cities. The correction will, like previous ones, be most severe in the big cities, because that’s where prices have the most room to move, and that’s where sentiment and sales are most sensitive. Given some easing in developers’ access to credit, and some supportive government policies— both of which have already begun—it’s not hard to see this correction exhausting itself eventually and buyers returning to the market.
The big question mark is over the small cities and their structural oversupply: will this latest correction prove the trigger for big problems here? There are definitely some reasons to think not: housing is not wildly overpriced in small cities, and developers’ finances could be hurt more than helped by major price cuts. Their incentive is to unload the inventories gradually over time rather than to do a crash sale. But if developers’ finances worsen significantly and smaller ones start to go bankrupt, they could be forced into liquidating inventories. The biggest impact is likely to be not on the price of housing in small cities, but on the pace at which new housing is built: the structural oversupply is already a big incentive for developers to cut back, one that will only be amplified by the correction.
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