Long road to recovery for China’s economy

On 18 September, the US Federal Reserve (Fed) announced its first interest rate cut in four years, reducing the benchmark rate by 50 basis points. The decision was welcomed by the market and led to significant gains in US stock indices. 

The Fed’s pivot in monetary policy was meant to facilitate a soft landing for the US economy and manage market risks, but it also signalled a major change in global monetary policy. 

For emerging markets as well as China’s economy, this is akin to a much needed rain in times of drought. The pressing issue now is, can the Chinese economy, which has been sluggish for nearly three years, overcome its current challenges by leveraging the shift towards monetary easing by central banks globally? 

The answer to this lies in understanding the core reasons that led to the Chinese economy’s prolonged stagnation and continued downturn.

China’s ongoing economic slowdown is characterised by insufficient domestic demand, falling housing and stock prices, as well as intensifying deflationary pressures, among other factors. Many analysts believe that this situation is primarily the result of a vicious downward spiral triggered by the decline in housing prices, and that as long as the government can stabilise the real estate market and restore confidence, China’s economy can return to a path of sustained economic growth. 

Indeed, the root of the current economic issues in China lies in the persistent decline of housing prices, which completely eroded public confidence in the real estate market. This is because from 2003 to 2021, China’s rapid economic growth was entirely reliant on the real estate market, and housing was the primary driver of the economy.

In 2005, my lectures to students would highlight that China was able to maintain rapid economic growth due to housing mortgage loans, which became a driving force as a form of credit consumption. Not only did these loans alleviate the substantial pressure of purchasing big-ticket consumer goods, it also allowed people to leverage their future income over the next 30 years for current consumption. This effectively multiplied their purchasing power by 30 times. 

To address the sudden and rapid expansion of demand for housing, China implemented unique presale housing, land supply and bank credit systems. The housing market along with its related industries and businesses — which also grew rapidly — became the largest driver of economic growth, accounting for over 25% of China’s total GDP.

However, as a form of credit consumption, housing mortgages differ greatly from that of other big-ticket consumer goods, such as cars and white goods. Other types of big-ticket consumer goods are purchased purely for consumption based on real consumption needs — over-buying would lead to depreciation of these products, and credit consumption demand has strict demarcations. 

Meanwhile, housing is a high-cost credit product that can be used for both consumption and investment. If housing was solely a credit consumption good, its demand would be limited, and the growth in demand and its effect in spurring economic growth would eventually taper off. Yet, as an investment good, the nature of housing is more aligned with the nature of financial products. 

In this manner, housing prices would not be based on the laws of supply and demand in accordance with the nature of housing, but are influenced by buyer expectations in the real estate market as well as financial market conditions (such as loan interest rates and leverage ratios). 

With prices in China’s real estate market constantly on the rise for the past 20 years, people believe that housing purchases will always be profitable and are the best form of investment. 

This not only rapidly drove up housing prices, the investment demand for housing would also be infinitely magnified. The result is a sustained and rapid increase in China’s GDP in monetary terms and a speedy inflation of the real estate bubble. Those who cannot afford homes are pushed out of the market, while others purchase by shouldering excessive debt and overspending on their future housing needs.

However, as an investment or financial product, housing prices would switch from a state of constant rise to a state of constant decline once there is a reversal in market expectations. Not only is profit impossible, homebuyers are also exposed to substantial investment risks. 

Investment demand for housing can vanish instantaneously, while consumption demand for housing can only surface gradually as prices decline. This is the current reality of the Chinese real estate market. 

From the second half of 2021, housing prices across China have been declining. Prices in first-tier cities have generally dropped by more than 30%, with some cities experiencing price cuts of 50%.　

Such a nationwide decline in housing prices has become a trend, and it is uncertain when it will bottom out. This is because the current decline only reflects the drop in prices of housing as a credit investment. As for when these prices will drop to the level of housing as a consumption good, there exists a sizeable gap. 

This is because, in the housing market, if credit and tax systems do not effectively limit housing investment and consumption, investors will consistently pay more than consumers. As a result, most homebuyers are effectively pushed out of the market.

As for how low prices need to drop for housing consumption demand to surface, the price-to-income ratio for housing should be between 3 and 6, according to the United Nations. This means that people should spend only three to six years worth of income to purchase a home that meets basic living needs. 

The price-to-income ratios currently exceed 30 in first-tier Chinese cities, with cities such as Nanjing and Hangzhou above 27, and even Chengdu and Wuhan exceeding 18. If we take the ratios for these cities as a baseline, it remains a long road ahead to return to levels and prices of consumption demand for housing — the situation is not over even after three years of continuous decline. 

This scenario could be even more severe than the real estate bubbles that burst in Japan and Taiwan.　　

The present decline in housing prices and the bursting of the real estate bubble in China would also spark several issues. 

Firstly, there is the guaranteed housing delivery crisis that erupted in 2022. From 2015 to the first half of 2024, the number of unfinished pre-sold homes reached 48 million units. Despite recent central government documents ensuring that these constructions would be completed, the progress remains worrisome even after two years. 

Those who purchased homes through presales not only face the substantial risk of continued decline of housing prices, but also the risk that the homes they purchased may never be delivered. If the guaranteed housing delivery issue is not properly resolved, confidence in China’s real estate market will not likely be restored. 

Secondly, as of the end of August 2024, the area of unsold commercial housing in China reached 737.8 million square metres, an increase of 13.9% year-on-year. Within this, the area of unsold residential housing rose by 21.5%. This meant that with the real estate market still sluggish, the volume of unsold homes would increase, and the real estate’s current challenge is tackling excess inventory. 

The central government has introduced policies to encourage local governments to buy unsold homes and convert them into affordable housing through providing low-interest loans. However, local government efforts remain lacklustre, resulting in a glacial pace in progress. It would likewise take a long time to tackle this problem.

That is to say, be it the trend of declining housing prices, the guaranteed housing delivery issue and dealing with excess inventory in the real estate market, short-term policies would not be able to resolve these problems. These are long-term issues that would only be resolved over the long run. 

With the real estate market historically accounting for a significant portion of China’s economic growth, this crisis is indeed one that would take substantial time and effort to resolve.

Many analysts believe that the government should implement strong measures to prop up and stabilise the real estate market, and set China back on the path of sustained economic growth. However, this runs counter to the conditions on the ground; attempting a quick fix would not result in the intended outcome.

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