Financial trends: risky model will spawn new China crises

How much will it cost to fix China’s housing system? Through next year developers will owe debts exceeding $300bn. Assuming local property prices keep falling at the current rate, analysts believe a rescue would cost as much as $1.1tn.

The slide in Chinese property prices and stocks was one of five dominant financial trends that started this year. They will rumble on through 2023 and are the subject of today’s Lex column.

China Evergrande Group led China’s property rout. House prices have fallen every single month since the heavily indebted group first showed signs of trouble at the end of 2020. Local banks and developers will feel the true impact in 2023.

In November, shares of developers rallied when regulators said they would allow developers to access some presale housing funds. That permitted construction to resume on some 2mn unfinished homes pre-sold by developers. Building costs had forced them to default on loans.

Fundamental problems will remain. Government support helps developers access fresh presale funds. But that presumes China’s highly leveraged model, long the foundation of the local construction industry, will continue.

This means local developers often sell houses long before starting construction. Developers use presale funds to acquire more land at steep prices. They start multiple projects while committing little of their own capital. Banks contribute to the speculation with mortgages on unbuilt properties.

The system can resemble a Ponzi scheme. The music only goes on playing when demand for new homes keeps growing. When it falters, and prices fall, the developer is in a bind.

But shifting away from this dangerous model creates problems of its own. Developers would shoulder extra funding costs of about 30 per cent by moving to an after-construction sales model. Funding costs for developers would increase by about 30 per cent. Smaller private developers would risk falling behind. Their state-owned peers have access to much cheaper financing.

Moreover, mainland and Hong Kong developers have diversified into each other’s markets to hedge risk, as the two have historically offered uncorrelated returns.

That strategy may no longer work. In 2023, Hong Kong home prices are expected to fall by as much as 30 per cent, as rising interest rates increase the number of negative equity mortgages.

Beijing has a big fixer-upper on its hands.