China’s property market is beset by crises. Many of the country’s largest property developers have either defaulted on their debts or are on the verge of doing so. Property and land sales — the lifeblood of local government finances — are declining by double digits. COVID-19 lockdowns, weak business confidence, and tighter financial conditions all present headwinds for the sector. 

When property developer Evergrande tumbled into financial distress last year, many analysts immediately drew parallels to the United States on the eve of the 2008 global financial crisis. Evergrande was destined to be China’s Lehman moment, a tipping point for a wider economic turmoil. 

These comparisons overlooked the fact that China’s household balance sheet looks very different from America’s before the financial crisis. Weak U.S. household balance sheets were a key factor in igniting a wave of mortgage defaults. Chinese households have less personal debt, more home equity, and a higher savings rate. As a result China’s real estate crisis is likely to play out differently from the U.S.’s, with the key challenge for policy makers being to ensure that pain for property companies doesn’t spread to the rest of the economy.

Understanding China’s household balance sheet is critically important to evaluating the health of the Chinese economy. Economic reforms over the past several decades have led to immense wealth creation for Chinese households. This new wealth has bolstered demand and raised living standards. Despite the state’s heavy involvement in the economy, household assets and net worth are significantly larger than those of the government. 

At the center of the household balance sheet is real estate. Residential real estate in China is worth about $60 trillion (including inventories), Goldman Sachs estimates, making it the largest asset class in the world. The share of household wealth tied up in housing in China is almost twice that of the United States. 

In the span of a few decades, Chinese households have gone from having almost no borrowings to having a large and growing stock of debt, largely to fund home purchases. In the third quarter of 2021, Chinese households owed banks nearly $11 trillion. What outside observers focused on household debt levels often overlook, however, is that asset values have grown more quickly than borrowing, leading to a 16-fold increase in household net worth between 2000 and 2019.

There are significant downsides to holding a large share of total wealth in real estate. First, real estate exposure is usually undiversified and heavily exposed to local property market risks. Second, it is a relatively illiquid asset class. Real estate sales have long lead times and high transaction costs relative to most financial assets. Additionally, there are worrisome signs that Chinese home prices have grown at an unsustainable rate, having increased by 411 percent between 2000 and 2020, almost four times as quickly as in the United States. A series of indicators, including the price-to-income and price-to-rent ratios, all point to the market being highly inflated. 

A correction in Chinese home prices — particularly a severe one that brought them back to more affordable levels — would ripple through household balance sheets. The most immediate impact would be a decline in net worth as a result of falling real estate and equity values. Total household net worth can shift dramatically during periods of economic distress: in the first quarter of 2020 alone, U.S. household net worth dropped by more than $6 trillion, due to the pandemic. After a reduction in their wealth, Chinese households would likely lower their consumption levels, exacerbating the negative economic impact. 

The effect on household incomes would be less severe than the drop in asset prices, but it would still be significant. Wages would decline, particularly for people employed in the real estate and construction industries. Transfer payments might be cut, as local governments struggle to finance their budgets with lower land sale tax revenues. Property income would fall, as companies in the sector cut dividends and fail to make interest payments amid a decline in rental earnings. Business income would weaken, thanks to a fall in overall economic growth. If the financial sector is in distress, households would be able to borrow less from banks to finance investment and consumption.

For all this, Chinese households as a whole are less vulnerable to the immediate financial effects of a downturn in housing prices than American households were in the run-up to the global financial crisis. Prudential controls for mortgage borrowing have ensured that loan-to-value ratios in China remain moderate. First-time buyers are required to make significant down payments, typically 30 percent. Second homes require even higher down payments, sometimes as high as 70 percent. These down payments, combined with home price appreciation, mean that most Chinese households have a significant equity buffer in their homes. 

Even after a large housing price correction, many Chinese homes would not be underwater (the situation in which a property is worth less than the amount owed on the loan). Their continued solvency may reduce the risk of widespread strategic defaults by homeowners and reduce bank losses during foreclosures. 

Although it has significant buffers in the short run, the household balance sheet cannot permanently escape the effects of a depressed housing market. The Chinese government needs to carefully wind down troubled developers without shaking homebuyer confidence.

The high rate of savings in China increases the ability of households to weather shocks to their incomes. Chinese households save an amount equal to about 23 percent of gross domestic product (GDP) each year — more than three times the global average of 7 percent. This amount far exceeds total annual household debt payments, implying that households may be able to continue to service their debts even in the face of large declines in household income. 

Mortgage securitization is also less of a risk. The scale and complexity of securitization in the U.S. turned a spike in mortgage defaults into a full-blown financial crisis. Losses on mortgage-backed securities led U.S. financial markets to seize up and pushed over-leveraged financial institutions into default. Mortgage securitization in China is significantly less developed than in the U.S. At the end of 2020, China had about $184 billion in residential mortgage-backed securities outstanding – a fraction of the $8.6 trillion in the U.S at the end of 2008. As a result, Chinese banks are much less vulnerable to the threat of a securitization-driven financial meltdown.

Of course, a real estate correction would play out very differently across individual household balance sheets. Wealthier households in China are twice as likely as lower-income groups to have debt, but this debt represents a smaller share of their income. Given evidence that income is underreported for high earners, the debt-to-income ratio may be even more favorable for wealthy households than official statistics indicate. Lower-income households in China are less likely to hold debt, but those that do have very high debt burdens that are difficult to sustain. Moreover, much of this debt is from the shadow banking system, which typically charges higher interest rates. 

Highly indebted low-income households would undoubtedly struggle during a property market–driven economic slowdown. However, in the aggregate, Chinese households have significant equity in their homes, a high savings rate, and reasonable levels of indebtedness. As a result, unlike the United States in 2008, China is not facing a real estate crisis driven by a household balance sheet recession. In the face of short-term price volatility and an economic slowdown, the household balance sheet remains amply solvent. 

The strength of household finances gives Chinese policymakers some room to maneuver as they try to fix the significant underlying problems in the real estate sector. The current distress is concentrated in property developers and the local governments that sell land to them. The unsustainable land–finance nexus has reached its breaking point, pushed along by central government policies like the Three Red Lines, which cut off financing for developers.

Although it has significant buffers in the short run, the household balance sheet cannot permanently escape the effects of a depressed housing market. The Chinese government needs to carefully wind down troubled developers without shaking homebuyer confidence. To do so, policymakers are leaning heavily on lenders, suppliers, and contractors to continue working with bankrupt developers to complete pre-purchased homes under construction and deliver them to buyers. State-owned property developers are gobbling up land and projects from troubled private developers, a bailout that will leave the entire industry under greater state control. 

China’s real estate crisis is a profound economic challenge that will weigh heavily on future growth. The one bright spot is that Chinese household balance sheets are a source of strength and resiliency that may help China avoid some of the worst-case outcomes.

As of March 31, 2022 Seafarer’s client accounts did not own shares in the entities referenced in this commentary.

The views and information discussed in this commentary are as of the date of publication, subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only, and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

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