The housing market is the biggest downside risk to China's near-term economic outlook.
In the event of a housing crash, GDP growth would decline sharply with a severe downturn in construction, rail investment and steel production.
Production of food, motor vehicles, and other manufactured goods would be relatively unaffected.
China’s housing market is cooling rapidly and fanning concerns about a potential crash. In May, prices fell in 35 of 70 major cities, the most in 24 months. Prices increased in only 15 cities, while prices were unchanged in 20 cities. Housing starts are around 20% lower than a year ago. Some 9.2% less residential floor space was sold this year than last, even as property developers increase discounts to shift inventory.
This has all been part of a multiyear campaign by the authorities to cool China's property market. As the housing market turned bubbly in 2012 and 2013 the authorities steadily tightened restrictions by raising down payments and interest rates for multiple mortgages, adding a 20% capital gains tax on apartment sales, and levying an annual property tax in some cities.
The housing market is extremely sensitive to credit conditions and monetary policy, and the government's restrictive stance is cooling the market. Since its creation in 1998 China's private housing market has gone through three broad cycles. There was a long boom after the 1997 Asian financial crisis, a 2008 slump and recovery with the post-global financial crisis stimulus, and a 2011 slowdown, which led to further stimulus and the current tightening phase.
When the government began tightening in 2012 it also tried to dampen expectations that it would back down as soon as the market cooled. Then-Premier Wen Jiabao stated that the government would "unswervingly continue to implement all manner of controls in the property market to allow prices to return to reasonable levels. ... We cannot allow prices to rebound, or all our efforts will come to naught."
As housing slows, the possibility of a policy mistake increases. The likelihood of this scenario occurring is remote, but the odds have risen in recent months, as the government remains committed to a clampdown on housing.
Housing within the Chinese economy
Housing plays a growing role in China's economy, and the long-term outlook for the sector remains broadly positive as increased urbanization and greater middle-class wealth drive development. In recent years investment in residential buildings regularly grew at twice the pace of GDP growth, so that by 2013 residential investment accounted for 10.4% of GDP or CNY5.89 trillion (US$949 billion), up from 1.95% of GDP in 1997. This investment was supported by the annual migration of 20 million Chinese into urban areas and the tripling in urban disposable incomes. These trends will continue, albeit at a slower pace.
As of 2012, 712 million Chinese—52.6% of the population—lived in urban areas while 642 million resided in rural areas. The government aims to raise the urban share to 60% by 2020. Using the U.N.'s 2020 population projection for China of 1.387 billion, achieving China's goal would mean 15 million people per year moving into cities. The government also aims to double per capita incomes between 2010 and 2020.
Yet a positive long-term outlook does not preclude the possibility of near-term stress. A housing market crash is still the biggest risk to China’s economic outlook.
Modelling a housing crash
To gauge the effect of a housing crash, we modelled the impact of a 30% peak-to-trough decline in house prices on the wider economy. We used a factor-augmented vector autoregression model to allow us to isolate the impact on investment, industrial production, trade, and other areas of China’s economy. Global growth is incorporated using the OECD composite leading indicator.
We found that a 30% decline in Chinese house prices results in a 5.4-percentage point drop in fixed asset investment when compared with the baseline forecast. As can be expected, this would be driven by a 48% drop in investment in construction assets and a 26% drop in investment in ferrous metal mining. Investment in rail and public utilities would also fall substantially, despite their role in transmitting fiscal stimulus, most likely as the slower growth of cities and fewer land sales would cause local governments to delay infrastructure investments.
The overall impact on total fixed asset investment is relatively small because manufacturing would be largely unaffected by a housing crash. Investment in manufacturing assets—which make up a third of all investment in fixed assets—would fall just 1.7% below the baseline. Manufacturing investment is helped by its predominate export focus and relatively stronger global growth.
Looking at industrial production, we find that steel production would fall 20% below baseline levels under a 30% house price crash. Related to the drop in steel production, production of iron ore, general machinery and electrical machinery would also be badly affected, with 5- to 15-percentage point declines below baseline.
However, industrial production overall would be only 3.6 percentage points lower than our baseline forecast, helped by relatively small declines in food and motor vehicle manufacturing. The declines in investment and production would be in line with a 2- to 3-percentage point decline in GDP growth from our baseline expectations. Hence a 30% drop in house prices could see full-year GDP growth slow to 4%, which would be China's worst performance in 24 years. Industrial production would grow 6% across the year, while fixed asset investment would grow 12%.
A boost from foreign trade would prevent an even worse outcome. In our model, a housing crash would cut China's imports by 16.8 percentage points from baseline forecasts. This in turn would slow global growth and push exports 5.9 percentage points below baseline. But the bigger imports decline means that China's trade surplus would rise under a housing crash. At the depths of the housing crash, the monthly trade surplus could be US$16 billion higher.
Spreading the pain of a housing crash
A housing downturn would clearly affect the direct physical investment and production of housing inputs. Household exposure and related financial accelerator effects are less of an issue in China than in more developed economies. A variety of factors limit household leverage and the potential financial multiplier effects of defaults and forced sales. For instance, more than 80% of households own their homes, and those taking out a new mortgage must pay a 30% down payment on first mortgages and a 50% down payment for second mortgages.
The use of "shadow" forms of financing by property developers and related firms to finance investment, and the reliance of local governments on land sales revenues has created concerns about hidden corporate and local government debt risks. But the potential effects may be overblown. A global comparison by the Financial Stability Board showed that Chinese shadow banking assets equaled just 10% of GDP, versus 174% for the U.S. and 220% for the U.K.
This suggests that the central government has ample room to bail out local governments and banks if necessary. State ownership of key financial assets (including the government's 67% to 83% ownership of China’s Big Four banks) helps to minimize the risk of insolvent banks restricting lending and exacerbating the crisis.
Even if the government were forced to recapitalise banks and put bad loans into asset management firms, essentially converting a banking credit stimulus into a fiscal stimulus, the drag on GDP growth as the government reduced spending to pay for this would be spread over a number of years, similar to its playbook after the 1997 Asian financial crisis stimulus. China would be able to avoid a Japan-style lost decade because its point on the development curve means that there are still significant areas of catch-up growth, and many areas where investments would earn a positive return.
