The Housing Crisis that's Collapsing an Economy

If you've seen China in the news lately, you're probably familiar with photos like these: lots of construction seemingly going on until you look closer, and you realize that there's actually nobody working on these buildings. This is because China's property sector is currently in a bit of a crisis, and it's having a really big flow and effect on their entire economy.

Just how bad is it? Well, according to the IMF, housing starts have fallen by more than 60% relative to pre-pandemic levels. House prices are falling fast, with new home sales falling for 12 straight months. This is bad news for Chinese citizens, as so much of their wealth and savings are tied up in real estate. In America, roughly 65% of households own their own homes, whereas in China that percentage rises to 90%. So, with all this wealth tied up in real estate and house prices falling pretty sharply, Chinese citizens are feeling the pinch. They've stopped spending, which means that businesses generate less income, and as you can see by the CSI 300 index, businesses across the board are doing really poorly.

So, what's going on in China right now, and will their economy turn around anytime soon? Well, to get an understanding of their economy now, you have to understand what's been happening in China over the past few decades. One of the major trends we've seen take place is urbanization. Since the mid-1990s, those living rurally have really been moving more and more to the cities, and this has sparked a monumental rise in urban property development.

Being able to own your own home became a huge social goal for people in China, and that drove huge demand for residential homes—not only to live in, but also as investment products. In fact, in China, approximately 70% of household wealth is tied up in property. People will save for decades and even team up with other families just to put down a deposit on some Chinese residential real estate. Due to this insatiable appetite for residential property, it didn't take long before the developers started testing the waters of just what was possible. Honestly, it turned into a bit of a Ponzi scheme.

We've all heard of the Ponzi scheme, right? This is a scheme where you promise investors a very handsome return, and as you find new investors, you simply use their money to pay the investors who came before them. Then, as people see the returns being made in this scheme, they too sign up as investors, and their investment gives the investor before them the very impressive payout that they were expecting. The cycle continues. Now, these sorts of schemes are a disaster waiting to happen, but although being horribly illegal, they do actually work in a world where you can always find new investors, and this is kind of how Chinese property development works—especially when you talk about pre-sale homes.

In China, developers will sell a pre-sale round where buyers will put down a deposit and start paying back a mortgage before their home is even built. You might say that's insane, but in China, that's just how it goes. In fact, in 2020, 34.5% of developers' funding came from deposits and pre-sales. Now, the problem is revenue collected from pre-sale rounds would not actually be used to fund the project's development; it would, in fact, be shoveled up the chain and used alongside copious amounts of borrowed money to fund the completion of last year's development.

Then they draw up some new apartment buildings and complete the pre-sale round on those, sign up the excited buyers with a fat mortgage, and then that fresh money can be shoveled up the chain again to help fund the completion of the last wave of apartments. A Chinese economist was recently quoted saying, "When the economy is good, with the continuous expansion, most of the properties can be delivered. But when the economy is not good, it becomes a little bit like a Ponzi scheme; if there is no follow-up funding, they will not be able to complete construction."

So, just like a Ponzi scheme, it does actually work as long as there's always fresh demand and nothing gets in the way of these projects being completed. Now, here's the problem that started to trigger this whole property crisis in 2020. Seeing that the Chinese property developers were getting way over-leveraged, the CCP announced a new rule called the "three red lines." What this meant was that for Chinese real estate developers to be eligible to take on more debt, they must first show that their liabilities did not exceed 70% of their assets, their net debt should not be greater than 100% of equity, and their cash reserves must be at least 100% of short-term debt.

While this is all quite smart, the problem was that in 2021, almost half of China's property developers were in breach of at least one of the three red lines, causing a sector-wide crisis in finding new funds as old debts came due. This caused a huge strain on the property development space, and it was obviously very well documented in the media through the eventual bankruptcy of the Evergrande Group. This debt crisis shook investor confidence, and it led to a significant slowdown in China's real estate market, with declining property sales and prices.

But that's the real problem, because so much wealth of Chinese citizens is tied up in property. Remember, roughly 70%—any slowdown in this one sector can quickly lead to a much broader economic issue. Alongside other issues, like the sluggish economy coming out of COVID, having uncertainty in the property sector and falling house prices leads the citizenry to really tighten the belt, and reduced spending has a flowing effect into businesses. Businesses don't generate as much profit; stock prices fall, employees may need to be laid off in cost-cutting efforts, which lowers the spending appetite even more, and you have a bit of a negative spiral. To an extent, that's what we've seen in China over the past year.

So, with that said, what is going on in China right now? How bad are their economic woes, and are there any signs of life? Well, starting with property, there's no doubt that things aren't really that great. Bloomberg recently noted that new home prices fell for the 12th straight month on a month-over-month basis, and the month-over-month measure was the worst in almost a decade.

We've now seen year-over-year declines in house prices in 67 out of the 70 major Chinese cities—the most since 2015. The data isn't any better for secondhand housing, i.e., houses being sold that aren't brand new; prices have now dropped 7.5% year-on-year, with a 1% fall in May alone. This is the sharpest decline since at least 2011 when China started using this current data collection method. What's worse is that from January through May, year-over-year property investments fell by the most on record, other than during the earliest days of the COVID pandemic, falling 10.1% year-on-year.

Now, there has been some action taken from the Chinese government recently to try and assist the residential property sector. Reuters notes that China will now allow local government authorities to buy some homes at reasonable prices to provide affordable housing, and that they will cut interest rates on mortgage loans and down payment ratios for home buyers to try and boost this lackluster property demand. But it still seems investors aren't yet responding to those stimulus measures. Bloomberg also notes that funding for developers has stayed weak since the government drew up a whitelist of property firms that are eligible for loans late last year; a broad gauge of financing for developers, including loans, bonds, and proceeds from home sales, continued to shrink heavily—down 24.3% from a year earlier.

So, things still aren't looking great for the Chinese property sector, and as I was mentioning before, this does have a flowing effect into the broader Chinese economy. Because house prices are falling, the average Chinese citizen is seeing their wealth fall before their eyes, and this, coupled with the sluggish response to their economy after the COVID lockdowns, ultimately has people tightening the belt, which isn't good for the economy. We have to remember that while the U.S. printed trillions of dollars of stimulus during the tough lockdown periods of the pandemic, China actually chose not to implement large-scale stimulus; and as you might expect, it caused a totally different outcome from what has been seen in the U.S.

Because the U.S. printed a lot of money and gifted it out, it inflated spending behavior, right? The savings rate skyrocketed, meaning the average citizen had more in their pocket to spend, and as you can see, consumer spending rose steeply coming out of the pandemic and has continued to rise ever since. Now, that's great to keep the economy humming, but it also caused a lot of inflation—at worst, 9.1%. That's what we've been dealing with.

Now, in China, they have not been giving out W's of cash, and instead, they've seen deflation. The price of goods and services has been shrinking, and that's because of citizens tightening the belt. We can see this occurring in the data too; a recent survey of 20,000 households done by the People's Bank of China found that in Q1 of this year, more people were looking to add money to their savings, and there was a lower focus on investment and consumption. All this has had a tremendous impact on share prices of Chinese companies. As I noted at the top of the video, the CSI 300 index has been performing very poorly since mid-2021.

If you look at their biggest stocks in Alibaba, Baidu, Tencent, JD.com, and so on, all of these companies have seen their share prices crunched, particularly those that are directly related to consumer spending, like Alibaba and JD. But is there any light at the end of the tunnel? Is there any sign that there could be a turnaround anytime soon?

While there is a very long way to go, there is actually some bits of data that are improving at the moment. The deflation we saw at the start of this year has ticked back up into very slight inflation, which is good to see, and there are hints that the consumer is starting to spend again. China's retail sales beat expectations in May, climbing 3.7% compared with the year ago, beating the expectations of a 3% rise from Aida's poll of economists.

The country's National Bureau of Statistics elaborated that total retail sales of consumer goods reached 3.92 trillion Yuan, or around $540 billion U.S., with sales in urban areas up 3.7% year-on-year and sales in rural areas climbing by 4.1%. While not related to local consumer spending, another important bright spot for the Chinese economy in this latest batch of data was exports that grew 7.6% year-on-year in May in U.S. dollar terms, beating the Reuters forecast for a 6% increase.

So, there are some positive signs, but the Chinese economy is far from out of the woods, and a lot of this will come down to measures the CCP takes to spur on the economy. They have taken some action, as I said, allowing local governments to buy property as well as lowering rates and a few other bits and pieces here and there. But economists have been critical that the CCP has not done enough to spur on demand in their own economy. They keep talking about the fact that they want to strengthen domestic demand and, quote, "strengthen consumption," but time after time, they fail to take the measures that actually will do that.

We are certainly expecting interest rates to come down. People are expecting a relaxation of regulations in the housing industry, which is staggered and facing a long period of years ahead of shrinkage, and may well be some further borrowing to finance infrastructure, for example. What we really want to see, though, is we want to see government measures to put income into people's pockets, so that they can go out and consume. That, I'm afraid, is something that may not actually be seen.

And I, for one, hope that China is able to reverse these economic trends. As odd as it may sound with all the China-bashing that happens in the media, China obviously plays a major role in the global economy. They are a huge buyer of stuff that our countries sell; they're also a huge producer of stuff that we need. So while it might sound a little bit odd, I'm definitely in the Charlie Munger camp that we shouldn't be looking at fighting China. The world would be a much better place if we all focus on getting along with them.

But, with that said, guys, that is an update on the Chinese economic situation that is stemming from its property crisis. I hope you enjoyed the video; please leave a like on it if you did. And a quick reminder that if you are looking at getting started investing, or if you want to learn how to analyze stocks and also support the channel in the process, you can learn pretty much everything that I have learned over the past 10 years over on New Money Education.

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