China real-estate: A bubble bursting

CNBC
China real-estate: A bubble bursting
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For 31-year old Beijing resident Wang Yuanzhi, talk about a bubble in Chinese property is not something to be too concerned about.

"If you look at the real estate market in China, it has already seen a golden decade of extreme fast growth. There will still be room for growth in this market, even in the next ten to twenty years," said Wang, who bought a home under construction last December. "The whole housing bubble is a fear; it is a concentration on the risks that the real estate market faces."

Underlying confidence expressed by residents such as Wang may be what China's authorities hope will aid a recovery in a market that has seen prices fall for three straight months.

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For other observers a downturn in China's once red-hot property market poses one of the greatest threats to the economy, the world's second biggest.

"The risks and exposure to property don't look the same as in the U.S. sub-prime [mortgage crisis], but new bubbles never look exactly like the last bubble (otherwise they'd be easy to recognize)," said Patrick Chovanec, chief strategist at Silvercrest Asset Management (SAMG).

"The exposure of China's banks (and now shadow banks) to real estate may look different than it did in the U.S., but it's very real. The main exposure is the reliance on property as collateral to support virtually all forms of lending throughout the economy, a situation that is very similar to Japan in the 1980s," he added, referring to a collapse in Japan's property market after a boom.

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The importance of China's property market cannot be underestimated - it accounts for roughly 15 percent of gross domestic product (GDP) and directly affects other sectors such as banking and construction.

Systemic risk?

To contain a boom in China's housing market and keep prices affordable, Beijing imposed restrictions over the past five years. Those measures together with a slowing economy now appear to be having an impact.

Average new home prices in 70 major Chinese cities fell 0.9 percent in July on month, following a 0.5 percent decline in June, and the question now is just how protracted the slowdown will be.

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"The real-estate market has been the downfall of many major economies in the past - the U.S., Japan," said Dariusz Kowalczyk, a senior economist at Credit Agricole (Euronext Paris: ACA-FR). "So the worst case scenario for China's housing market is an economic crisis."

In China's case, credit expansion drives the housing market and when that slows it has a direct impact on real estate, say economists.

They point out that since 2008, China's money supply expanded by more than threefold and a lot of that money had gone into real estate. Latest data shows that the amount of money flowing into China's economy slowed to its lowest level in six years in July.

Here's how it could play out, according to Silvercrest's Chovanec.

"When property developers can't get more credit, they have to slash prices to unload their unsold inventories (and pay back their debts), which gives investors second thoughts about whether to continue plowing their money into property," he said.

"Sales dry up, prices fall, new [housing] starts dry up, construction dries up, sales of construction equipment, concrete, and steel dry up, land sales dry up, local government revenues disappear and they can't pay their debts ... in other words, falling asset prices undercut the basis for both past and future lending, and you've got a real system-wide problem," Chovanec added.

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Dong Tao, chief regional economist for non-Japan Asia at Credit Suisse (Swiss Exchange: CSGN-CH) in Hong Kong, describes developers as the "weakest link."

"If one property developer gets into trouble that could have a domino effect on the rest of the market," he said. "Without the central government taking action there will be a serious slowdown. Something has to be done and liquidity may have to be eased to help property developers."

In recent weeks, mid-sized developers such as Hong-Kong listed Greentown China Holdings (Hong Kong Stock Exchange: 3900-HK) and Shui On Land (Hong Kong Stock Exchange: 272-HK) issued profit warnings amid a downturn in the housing market.

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A sharp slide in house prices that hurts consumer confidence could see economic growth in China drop below 5 percent, said Credit Agricole's Kowalczyk. To put that number into context, Beijing targets full-year GDP growth at 7.5 percent.

Support at hand?

In a bid to shore up the property market, a number of local governments have eased restrictions on home purchases in recent weeks and state-backed banks have upped lending to the sector.

"I decided to own a place because in Chinese culture and our tradition, it is important. I wanted to get my own place as I am going to start a family and why pay rent when you can have your own space?" said Wang, who expects construction on his new home to be completed next year.

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Analysts add that the fact that Chinese households have relatively low levels of household debt is another reason why not to be too pessimistic about the housing market. An International Monetary Fund (IMF) report published in April ranked China the fourth lowest in terms of household debt levels among 11 Asian countries at around 12 percent of GDP.

"We believe the downturn [in China's property market] is unlike the situation in the U.S. that led to the Great Financial Crisis, and is unlikely to cause a crash in Chinese or international financial markets," said Clem Miller, investment strategist at Wilmington Trust Investment Advisors.

"For one thing, given requirements for large down payments, Chinese mortgage debt is low as a percentage of house value. Additionally, Chinese state banks typically hold these mortgages on their balance sheets rather than sell them into the market as collateralized mortgage obligations," he said.

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Analysts say there is no easy fix to China's property market woes - the sector needs to go through a period of adjustment that helps put the economy on a more secure long-term footing.

"The good news for China is that it has produced more than it consumed for years. As a result, if its own output falls, it can afford to consume more than it produces," said Silvercrest's Chovanec.

"If the economy falters, consumption and living standards do not have to falter too. China can run a trade deficit (assuming its forex reserves aren't depleted by mass capital flight). This can provide a cushion while it undertakes what would otherwise be a wrenching adjustment to its economy."

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