MARCO BARBIERI: Are we seeing early signs of Japan-style deflation in China?
The comparison between China’s housing market and Japan’s property bubble of the early 1990s has been much debated, but has taken a new dimension after Evergrande’s recent default and China’s policy response to property market distress.
Though this downturn is unlikely to translate into a debt crisis, as it did for Japan during the 1990s, lower structural property growth coupled with tighter global liquidity conditions will prove to be deflationary and have global spillover effects.
During the 1980s Japan experienced a period of strong growth that saw GDP-per-capita rise five times, the Nikkei four times and real estate prices increase as much as six to seven times.
After the Plaza Accord in 1985 the yen rapidly appreciated against the dollar (from 240 to 120 yen), prompting the Bank of Japan to aggressively cut interest rates in 1987 from 5% to 2.5%. Loose monetary conditions and subsequent tax rate cuts resulted in strong real estate demand, which fuelled an already buoyant property sector.
In an attempt to arrest the growing property bubble various policies were introduced to curb funding and transaction activity. The effect of such policies as well as tighter monetary conditions had a pervasive effect and resulted in a dramatic correction in asset prices, with a spike in bank bad debts. What had started as a property bubble in Japan, by the mid-1990s had transformed into a full-blown debt crisis.
China’s remarkable rise over the past two decades saw property prices increase more than six times since 2002. Strikingly, property prices-to-median income ratios for China’s top five tier-1 cities are two to three times higher than the ratio of global cities such as London and Paris.
Similar to Japan’s policy response of the late 1980s, faced with an overheated property sector Beijing tabled various policies aimed at curbing liquidity and moderating funding. The “three red lines” policy (August 2020), which was introduced to create a more sustainable model and moderate the pace of sector growth, set financial health guidelines for real estate developers that included net-debt-to-equity limits and borrowing constraints.
However, the outcome of this policy proved negative as many developers that had been operating outside policy guidelines found it difficult to borrow under the new rules and faced cash flow constraints. In December 2021 China’s largest property developer, Evergrande, defaulted on interest payments due to its offshore bondholders. The effect of property prices and activity levels has been significant, with real estate prices collapsing 30%-40% over the past year.
While China’s policy response may have been a misjudgement so far, as was Japan’s during the late 1980s, current dynamics are unlikely to escalate into a debt crisis. Unlike Japan, China’s ownership of its banks in effect allows it to control the risk transfer mechanism between householders and banks. The state’s ability to instruct financial institutions to restructure bad loans ensures that it can reduce the immediate effect of property distress on the banking system.
China has also managed to exert administrative influence over property transactions over the years, with measures such as price restrictions and guidance to control for price movements. What is perhaps more concerning from a systemic risk perspective is the structure of China’s real estate developers funding. With banks only accounting for 25% of developers funding, households are exposed to potential distress via different mechanisms.
China’s property distress comes while the country is facing headwinds from geopolitical tensions with the US, the effects of its zero-Covid-19 policy and tighter global liquidity conditions. The country’s ability to support the local property sector and ultimately prevent deflationary pressures is a function of its willingness and global liquidity conditions. While last month’s announcement of ¥300bn in new infrastructure spend and an extension of borrowing to local governments worth ¥500bn has gone a long way in addressing its willingness, international liquidity conditions are a firm headwind.
After the spike in global excess dollar liquidity in 2020 (the sum of world economies money supply, converted into dollars) as a result of the advent of Covid-19, tighter liquidity conditions have persisted as the Fed and other central banks have aggressively raised interest rates in light of rampant inflation. A stronger dollar and tighter global dollar liquidity have weighed on China’s foreign exchange reserves, which have started to decline due to an increase in net outflows.
While China is able to print domestic currency to reflate the system, in a tight dollar environment this process will tend to weaken the currency, lower the dollar value of domestic money supply and accelerate capital outflows, further reducing foreign exchange reserves. As global macro conditions remain challenging, despite China’s willingness its ability to help the local property market and prevent deflationary pressures is not unlimited and will come at a cost.
• Barbieri is SA equities director at Northstar.
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