China’s banks are trapped between a property crisis and a sluggish economy
- With mortgage boycotts signalling a loss of confidence in China’s property sector, banks are under pressure to help developers deliver on promised homes
- However, the quality of the collateral that secures loans to developers is a broader concern, even as the economy struggles to reboot under strict zero-Covid measures
Fears about China Evergrande Group, the world’s most indebted property developer, spiralling into default now seem a distant memory.
In a report published on August 18, S&P Global Ratings said the mortgage boycotts are “not only a social stability risk. Should the strikes become widespread, they could undermine financial stability, particularly if they cause a sharp decline in home prices.”
The property crisis is escalating just as Beijing doggedly pursues its uncompromising zero-tolerance approach to the Covid-19 virus, imposing citywide lockdowns that undermine the effectiveness of measures to stimulate the economy.
In early 2019, lending to housebuilders was growing 20 per cent year on year. This dropped to less than 5 per cent by December 2020, data from Moody’s Investors Service shows. What is more, corporate loans to the property sector were the main source of new non-performing loans last year, with smaller regional banks facing much higher credit risks than their nationwide peers.
Poor corporate governance and risk controls, coupled with less diversified loan books, make regional banks more prone to lending to vulnerable developers, particularly in smaller cities where most of the unfinished developments are located.
However, the broader concern for the financial sector as a whole is the quality of the collateral that secures loans to developers. Although the stock of mortgage lending affected by the boycotts can be absorbed by banks – a manageable 6.4 per cent of mortgage loan books would be at risk in a worst-case scenario, S&P estimates – a steeper decline in home values would eat into collateral buffers against potential credit losses.
Indeed, part of the reason the government hurriedly mobilised capital to complete the stalled projects is because of the growing threat to land values, the critical underpinning for the collateral. “When there’s a real threat to the valuation of land and housing, the government steps in”, said Nicholas Zhu, senior credit officer at Moody’s in Beijing.
Mounting tension between the government’s efforts to curb leverage and speculation in the real estate industry, and the more forceful measures over the past few months to avert a protracted crisis, is reflected in the share prices of Chinese banks. Since mid-July, they have been moving sideways, lacking direction in a highly uncertain economic environment.
The problem is that Beijing’s policy response is not addressing the root cause of the property sector’s woes. In a blog post published on August 24, Michael Pettis, a senior fellow at the Carnegie Endowment, said the support measures wrongly treated problems in the industry as a liquidity issue, instead of addressing underlying solvency problems. By shifting liabilities onto the balance sheets of local governments and larger banks, China’s financial system continued to be “underpinned by moral hazard”.
Property-related risks in the banking sector are exacerbated by increasing pressure on lenders’ net interest margins, signs of a “liquidity trap” as households and businesses are reluctant to borrow and, crucially, the economic damage and uncertainty wrought by the government’s “dynamic zero-Covid” policy.
The longer China’s policy-induced economic downturn persists, the bigger the risk that long-standing vulnerabilities in the banking sector come under much sharper scrutiny.
Nicholas Spiro is a partner at Lauressa Advisory