July 3, 2014 12:00 am JST

Ana Swanson: China's property market past tipping point

China's new home prices in major cities edged down in May, underlining the downward trend in the market. © Reuters

The recent downturn in China's property market has alarmed not only investors but also the government. In May, the People's Bank of China met with the country's biggest lenders to urge them to grant mortgages in a more timely and efficient manner. The central bank's move was part of the government's broader efforts to revive a sagging economy without further inflating asset bubbles in the process.

     But reactions from the banks have been mixed. Tracking by my company, research firm JL Warren Capital, shows that banks have indeed quickened home loan approvals, but they have also raised mortgage rates. Despite the central bank's urging, low profits mean commercial banks are not eager to extend mortgages to consumers.

     This has not helped the accelerating contraction in the Chinese housing market. During the first week of June, the total floor area sold in primary residential housing markets in 48 cities tracked by Centaline Property Agency was down 34% year-on-year. China's "first-tier cities" -- such as Beijing, Shanghai, Guangzhou and Shenzhen -- saw the largest declines, with a 44% decrease in units sold year-on-year. Units sold also fell 36% and 15% year-on-year, respectively, in smaller second- and third-tier cities.

     Many analysts say the falling property prices have been triggered by monetary policy tightening since mid-2013. Cash-starved property developers have responded to tighter liquidity conditions by reducing prices and slowing the supply of new homes to the market.

     But we at JL Warren Capital see a more fundamental driving force behind the downturn.

     According to our estimates, the Chinese property market has reached a tipping point, due mainly to China's demographic trends, as well as an aggressive buildout in new housing in the last few years. We estimate that the housing market has crossed over from a fundamental shortage into a fundamental surplus, with the supply of gross floor area exceeding demand by 1.4 billion square meters.

     These trends suggest that efforts to stimulate the property market by increasing liquidity are unlikely to be effective in the near future. As post-financial crisis monetary easing around the world has so keenly demonstrated, it is impossible to stimulate a demand that isn't there.

A new kind of crisis

The 2008 downturn in China was triggered by the global financial crisis, while the 2011 slowdown in the property market was largely the result of government-imposed restrictions on home purchases aimed at curbing speculative demand in a white-hot housing market. Many of those restrictions are still in place.

     This time, however, we believe it is a massive change in demographics that has cut into fundamental housing demand. Fundamental demand includes both "hard" demand -- demand for housing for owner-occupancy and rental -- and demand for housing as an investment vehicle. Within hard demand, new home purchases are largely the result of newly formed households, that is, people getting married and starting families, and by existing households upgrading to larger homes.

     On average, Chinese marry at around 25 years old, an age that has not fluctuated much over the years. But China's birth rate has changed substantially since the reform and opening up that began in 1979. China's births peaked in 1987 at 23.3 million births per year. It fell to 18.2 million in 1992 and 12.4 million in 2003.

     For many young couples in China, purchasing a house is a precondition for getting married. Hard demand driven by newly formed families, therefore, likely peaked around 2012, 25 years after the peak number of births, and has since fallen along with the drop in new household formation. We estimate new household formation has declined around 7% per year since 2012.

     The Chinese property market appears to have reached an inflection point in 2013 or the first half of 2014, where the fundamental shortage was replaced by fundamental surplus.

     As excess supply increases over the next few years, price cuts will deepen. China's highly leveraged property developers will be forced to slash prices to move inventory and ensure they have enough cash to service their debts. The expectation of future declines in home prices will also lead to a contraction in investment-driven demand, which we estimate is currently around 15% of total commercial home transactions in China, down from a peak of 30% in 2009.

     Based on our recent industry survey, we are now expecting a 5-10% decline in average sales prices in China's housing market in the second half of 2014 and a 30% decline in 2015. Developers are selling an increasing proportion of smaller homes while also discounting larger ones.

     We think part if not most of this negative sentiment is likely to be already priced in the market, and especially into the stock prices of the residential developers. But the slowdown will still send ripples through the construction, commodity and financial sectors, which are heavily dependent on the domestic property market.

Inescapable factors

Some critics will counter that China need not worry about the effects of this demographic decline on the property market, because rapid urbanization will offset the decrease in demand.

     China is certainly urbanizing rapidly: More than 52% of Chinese lived in cities by the end of 2012, and the World Bank predicts the figure could reach 70% by 2030. But the idea that urbanization directly results in rising home demand in China's first- and second-tier cities is largely a myth. Our research shows that high prices and government restrictions prevent most migrant workers from purchasing homes.

     Today, roughly 470 million of the 650 million people living in Chinese cities have urban household registration, meaning they face fewer restrictions when buying property in the city than those registered in rural areas. The remaining 180 million, however, are mostly low-paid migrant workers who work in the city and send money back home to rural areas, where they are still officially registered as residents. Many cannot legally purchase a home in urban areas, nor can they afford to.

     In the near term, the limited range of investment choices available in mainland China will likely continue to artificially boost the fundamental investment demand for residential property.

     In addition, restrictions on the outflow of private capital continue to channel Chinese savings into the property market. This artificial subsidy to the property market will only disappear if and when Chinese authorities deepen the domestic financial system and open the capital account.

     But while no one can predict the timing of its burst, China's speculative property market bubble is clearly unsustainable. The market has passed the tipping point, and the law of supply and demand will win out in the long term.

Junheng Li and Priscilla Zhu of JL Warren Capital LLC contributed research.

Ana Swanson is a Washington-based analyst at JL Warren Capital in New York, a China-focused firm that uses big data to analyze the country's equities and economy.