Is the Global Economy About to Collapse? Inside China’s Real Estate Crisis

China is caught in a self-perpetuating housing market downturn. The only way out may be to relieve property developers, whose nefarious practices contributed to distrust in real estate in the first place. 

China’s central bank cut interest rates in August to encourage borrowing, but Covid lockdowns and declining confidence in the market mean the move will have little effect. The Chinese banking system is becoming increasingly fragile, with about 4% of outstanding mortgages already affected by growing payment boycotts across the country. And slow growth in July shows the crisis is already impacting the nation’s overall economy. 

Besides the obvious implication of financial hardship for the Chinese people, why does this matter? China is the world’s second-largest economy. 18.6% of U.S. imports came from China in 2020, while exports to China totaled $124.5 billion. China is already reducing its holdings of U.S. treasuries, effectively pushing up consumer interest rates in the U.S. If China’s economy collapses, it will have devastating effects on the global economy.

The Ingredients in China’s Real Estate Meltdown

A Housing Bubble Created by Government Policy and Cultural Pressures

The Chinese property market has been in freefall for nearly a year. In the spring, desperate property firms began accepting garlic, watermelons, and other farm produce as funds for a downpayment. But things weren’t always this dire. For six years before the decline, property values grew rapidly. China’s citizens believed real estate was the best way to increase their wealth and spent huge portions of their income on primary homes and investment properties. Government policy and societal pressures supported this behavior. 

Most of the problem was created because local governments are incentivized to artificially drive up demand for housing and keep prices high. City governments get 46% of their revenue from land transfer fees. To collect more money, these local governments increased property subsidies, encouraging more home buying. They even manufactured demand by forcing people to sell rural residences and buy more expensive units in urban housing complexes. 

But relying on land sales for local revenue isn’t sustainable, especially with the slew of other factors impacting the market. One solution would be raising property taxes to cool the housing market while maintaining funding for local governments, but the idea hasn’t taken hold so far. 

Meanwhile, there has been a lot of cultural pressure for citizens to become homeowners, particularly men looking to start a family. About 78% of household wealth in China is tied up in real estate, which has long been considered a stable investment. Generally, people save their income for years for the chance to buy a home. For this reason, damping demand may have been challenging, even if local governments were willing to take the loss.

Real Estate Developer Ponzi Schemes

In China, real estate developers have adopted the pre-sales model to fund their projects—essentially a Ponzi scheme. Chinese home buyers were willing to buy properties that were not yet built, and some property developers used that money to finish projects they had already sold, allowing them to collect more money from pre-sales. About 90% of real estate was pre-sold. That strategy would be sustainable with continued demand, but once the housing market slumped, the jig was up. 

Ironically, it was in part government policy reacting to the potential risks of the situation that caused companies like Evergrande to default, leaving Chinese note holders to pay mortgages on unfinished properties. This cast doubt on real estate as a secure investment, causing a steep decline in demand. Now property developers have trouble raising funds to complete those projects—it’s a vicious cycle. 

Government Attempts to Control Excess Debt

In an attempt to keep the housing bubble from bursting, China implemented the “Three Red Lines Policy,” which established three requirements for property developers:

• Liabilities must account for no more than 70% of assets
• Net debt can’t make up more than 100% of equity
• Must have at least 100% of short-term debt in money reserves

Almost half of all property developers in China didn’t meet the requirements. That caused land acquisition to slow down and development projects to go unfinished as developers could neither sell the properties under construction nor access financing. By 2020, for example, Evergrande had nearly $200 billion in projects under construction, but the company only managed to sell a fraction of the amount that year. 

A Zero Covid Policy That Crippled the Economy

President Xi Jinping’s “zero Covid policy” prioritizes limiting the spread of Covid over maintaining a stable economy. Strict isolation measures have hurt consumer spending and led to higher unemployment. As an example of the dramatic response, just a few infections in Beijing last month meant that 21 million people were required to get tested every three days to be allowed in corner stores.

As a result of the policy, migrant workers and young people are unemployed in large numbers. Economists view China’s separation from the rest of the world picking up pace as investors, tourists, international students, and ex-pats lose interest in the country. 

Widespread Boycotts of Mortgage Payments for Unfinished Projects

For Chinese homeowners, enough is enough. They’re tired of lockdowns and sick of waiting for developers to finish the homes they’re already paying the mortgage on. For many, affordability is also a concern due to the weakening economy. What started with a small group of homeowners boycotting their mortgage payments in 2021 has blossomed into a movement impacting hundreds of billions of dollars in loans. Hundreds of thousands of middle-class Chinese homeowners are refusing to make monthly payments until their homes are built. 

A protest of this magnitude is rare in China. We all know the famous image of the Tiananmen Square “Tank Man,” who stood in front of a row of Chinese tanks in 1989. But usually, the government is swift in squashing dissent. This time, however, they’ve so far failed to control the spread of the protest on social media. Meanwhile, property developers can’t respond to homeowners’ demands because they don’t have access to financing.

How the Chinese Government is Responding

Economists say these signs indicate a need for China to pivot away from a growth model that is too reliant on property. Economic policy should be focused on raising wages. But instead, the People’s Bank of China slashed interest rates to encourage even more people to buy more property. Most experts agree it won’t do any good. 

One thing that may help, at least temporarily, is the $30 billion loan fund established to bail out struggling property developers. But that’s only a drop in the bucket compared to the total outstanding debt owed by property developers. And, of course, fixing the problem with more debt has its own harmful economic effects.

The Ripple Effect on the U.S. Economy

While some experts are less concerned than others, there’s no question that an economic collapse in China will negatively impact the United States. Real estate loans are already weighing on the Chinese economy by limiting resources for production. Lockdowns alongside the housing slowdown have driven up unemployment. Inflation rates are declining. Without successful intervention, global trade will be impacted as China would cut back on purchasing goods like cars and aircraft from the U.S. 

And as exports to the U.S. also decline, China is likely to spend even less on U.S. Treasuries, which would cause a rise in interest rates to account for less demand. Mortgage rates for fixed-rate 15 and 30-year loans, which are based on the 10-year Treasury yield, would also rise, impacting housing affordability. 

A decrease in spending on U.S. Treasuries could also impact the value of the dollar, which rises and falls with demand for Treasuries. If the dollar declines against the Chinese yuan, that will affect import prices—especially gas prices, which are denominated in the dollar. Foreigners would get cheaper gas, as their currencies would be stronger against the dollar, while Americans would pay more at the pump. And, as we know from recent experience, gas prices impact the entire U.S. economy. 

How U.S. Property Investors Should React

During any economic downturn, diversification of investments provides the best protection against losses. Experts also recommend investing gradually so that you can make decisions as economic changes unfold. That’s possible if you’re exploring passive investment opportunities. 

For those looking to actively invest in property, make sure you’re being cautious with all of the latest news coming out. The housing market appears to be rebalancing, but most experts agree a housing crash isn’t likely. 

In any event, maintaining a strong cash position is key to financial stability during a recession. If waiting to buy allows you to bolster your emergency fund, you’ll be better insulated financially. That said, if the right property comes along, the numbers check out, and you’re not stretching yourself with the purchase, fears about the economy shouldn’t stand in your way. While all investments involve risk, real estate is a relatively safe option—in the United States.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.