China’s road to recovery: how heavily will real estate weigh on growth?

We last took a closer look at the Chinese economy back in September – at the time, a post-Covid rebound many had hoped for failed to materialise, and a dour outlook for the real estate market weighed heavily on both sentiment and the economy. In the intervening months, we’ve seen little change in the real estate market. Subdued demand, weak prices, and continuing concerns around long-term management of property developers’ balance sheets continue to plague the sector. However, we have also seen some positive signs, with Q1 24 performance in particular surprising to the upside. The Lunar New Year holidays were also encouraging, with solid retail sales growth, and dining and domestic travel rising above pre-Covid levels.

The real estate sector and its peripherals have historically contributed between 25 to 30% of Chinese GDP. This proportion was skewed even higher in the earlier periods of the past three decades, making the sector one of the most important growth drivers for the country. This historical precedent raises some concerns about the future trajectory of the Chinese economy as conventional wisdom would dictate a Chinese recovery will require a corresponding improvement in the property market.

We argue two key points in this report:

1. There are few expected tailwinds for the real estate market in the short/medium term. While there have been improvements to the structural issues we previously highlighted (and while we believe the Chinese government ultimately has the tools to tackle these), it will take years before a full resolution. Correspondingly, we see a recovery in terms of prices and demand as being “L-shaped”, with a relatively low probability of a rapid bullish turnaround, precisely because of the ongoing structural risks.
2. Despite the historical precedent, there is a path ahead for a strong Chinese recovery in the face of a laggard real estate sector. Critically, this trajectory depends on a domestic-led recovery, hinged on Chinese consumers re-allocating the (sizeable) assets previously earmarked for property into other sectors. Given the global macroeconomic landscape, and a relatively weak RMB against the dollar, we see limited scope for an externally led recovery of the Chinese economy.

Economic Conditions

As the property market downturn enters its fourth year, the outlook remains dour: the latest data indicates new home sales were down 37% (year-on-year), while secondary transactions fell 23%. There appear to be few signs of reproach, with both homeowners and property agents expecting further price declines. Demand in property markets also remains heavily subdued, with February mortgage issuances actually weakening for the first time in 10 months, despite the single largest cut to the Loan Prime Rate (LPR) that month.

The PBoC cut the LPR by 25bps from 4.20% to 3.95%, as part of stimulus measures to buoy demand in the property markets. On that topic, Chinese authorities have responded to the weak economy with both monetary and fiscal easing. In addition to cuts to the LPR, the PboC also cut the RRR (reserve requirement ratio) rate by 50bps in January. While not strictly an interest rate, the RRR is important as it significantly affects both interbank liquidity and the amount of cash available to domestic banks for lending.

On the fiscal front, markets are expecting a significant special RMB 1tn CGB (Chinese government bond) issuance. While full details of the issuance schedule are not available, their primary use will be to fund re-development of areas hit by floods in 2023, and to improve urban infrastructure. Finance minister Zhu Zhongming also stated the issuance will “help drive domestic demand and further consolidate the recovery of the economy”. Despite being a primarily fiscal mechanism, the bond sale will likely see further easing in monetary policy. The PBoC have been focused on ensuring banking stability, and it is expected that they will likely cut the RRR further to ensure sufficient interbank liquidity following the issuances.

The policy response to the relatively weak economy and real estate market may well be having a positive effect: the first quarter of 2024 displayed a robust performance, particularly during the Lunar New Year holidays. Jan and Feb saw industrial output rise +7.0% (vs +6.8% in December), the highest print since 2022. Services output also climbed +5.8%, with the two-year average improving to +5.6% from +3.7%, marking the best print in a year. In March, PMIs also surprised to the upside, with manufacturing PMI rising by 1.8 points to 50.9, indicating expansionary territory for the first time in seven months, while reaching the highest level in a year. Services PMI was also strong, improving for the sixth consecutive month to 52.4, the highest in half a year.

Importantly, domestic demand appears to be trending in the right direction. During the Lunar New Year period, services consumption outperformed, while goods consumption was solid. Tourist visitation data suggested a 34% (YoY) growth, and was notably 119% of pre-Covid levels. Correspondingly, tourist sales spending was strong, growing 47% and reaching 107.7% of pre-Covid levels. It’s worth noting that the rise above pre-Covid levels is significant, given that up to this point, domestic consumption was lagging behind the pre-Covid growth trendline.

Real Estate – Improving but More to Go

In September, we discussed the interconnected nature of Chinese real estate, and LGFVs (Local Government Financing Vehicles). One of the key points of progress in the intervening months has been a significant degree of risk containment in the LGFV markets. The principal tool to achieve this was the issuance of RMB1.4tn of refinancing bonds. In essence, these bonds are akin to a restructuring of debt at the local government level: these new issuances are longer dated with lower rates, allowing the local governments to utilise the proceeds to pay off the relatively expensive and shorter term LGFV debt. These refinancing bonds and support from Beijing have meant that there have been no defaults on any LGFV debts (including both CNY and USD denominated debt).

Most impressively is how effective this was at calming markets despite the relatively small borrowing – the RMB 1.4tn represents just 2% of outstanding LGFV debt, yet spreads on AA rated LGFV bonds tightened by around 225bps in a year. The effectiveness of the refinancing was likely bolstered by the decision to apportion funds to those provincial governments that were the most indebted and facing liquidity problems (mostly in lower tier cities). The central government has also continued to make strides at stemming the systemic and concentrated risk the LGFV vehicles represent. Over the past 6 months, LGFV net issuances were negative, as Beijing cracks down on spending, and rejected LGFV borrowing applications in Jan and Feb worth RMB 75.2bn.

Despite the progress, the sector is a long way off a full recovery. The central government recently introduced a “project whitelist”, which identified developers who would, in essence, be assured funding to complete projects. This funding is provided via domestic banks (as can be seen in the data showing a steady increase in bank lending to developers over the past three years, despite a massive reduction in turnover and revenue in the sector), but is very critically a government mandate. The rationale for the support is to avoid further market turmoil by ensuring that projects the developers already committed to will be completed. While this is positive with regard to avoiding a total collapse of the market, it is not good news in terms of addressing structural risks. The reason developers need credit support is due to their unhealthy balance sheets, with many remaining heavily indebted, having limited liquidity, and remaining below funding level targets.

In the short term, Beijing is both willing and able to ensure sufficient credit flows to developers. However, the central government face a long-term challenge of liquidating over USD 2tn worth of excess stock that currently sits on developers balance sheets. Authorities will likely have the tools needed to tackle this (for example debt swap programmes or profit transfers with SOEs), but the scale of the problem means it will be a years-long process to address the issue of over-supply in the market. Further compounding this is there is the general consensus that we are past peak demand in the sector, as demand in 2030 is expected to fall to just 9mn units, or half that of the 2017 peak.

What comes next?

Given we expect a real estate recovery to be L-shaped, a positive growth trajectory cannot continue to rely on the sector. Instead, we believe strong growth, if it materialises, will be driven by a recovery in domestic demand, particularly as the scope of externally led growth appears limited for the time being. On this latter point, it is worth noting that the outlook for global Chinese exports is actually quite positive for 2024. The Yuan is currently relatively weak, making exports very cost competitive. However this means further weakening provides limited upside for export revenues and volume, and it is likely China will defend the currency from further depreciation. Furthermore, global macroeconomic outlooks remain fairly uncertain, and without improvement in global demand, Chinese exports have limited scope to exceed expectations that are already fairly positive.

Instead, we see growth potential via a substitution effect in domestic consumers. Over the past three years, household net bank deposits have surged to over CNY 30tn, or over 20% of GDP. This has been in large part due to reduced spending on property and property adjacent sectors, freeing up a significant amount of assets that were previously allocated for housing investments. Given the lack of expected recovery in the housing markets, and a naturally waning demand in the sector, these previously earmarked assets might be used by consumers in other sectors. If consumers begin spending as they believe they no longer need to save as much as before to get on the property ladder (and in the case of wealthier investors, who now see property as lacking sufficient returns), there is a real possibility of a revitalisation in domestic demand as investments and spending in other sectors generate growth regardless of the state of the property market.

But given the importance of the property sector and home ownership in China, can we really expect Chinese consumers sentiment to improve, given the previously “core” real estate sector is weak? Well, the answer is “probably”. A recent Deutsche survey indicated that between Q3 23 and Q1 24, there has been a marked improvement in consumer willingness to spend, despite the negative impact from the property market on the economy. Across every category (food and non-food consumption, general household bills, and financially supporting family), the degree of spending cuts due to negative property market outlooks has fallen. Importantly, between Q3 23 and Q1 24, we have actually seen further declines in the market, so the sentiment improvement has not come off the back of a property recovery.

The central government is also focused on tapping into domestic consumers: the catchy “Action Plan for Large-scale Equipment Replacement and Consumer Goods Trade-in” was released in mid-March, and is intended to boost domestic purchases across a variety of industries, along with increasing capital investment in key industries by 25% by 2027. It is worth noting that there are approximately 7.5mn passenger vehicles older than 15 years that are expected to fail Chinese emissions standards. Analysts expect a significant portion of these to be traded in as part of the programme, providing a significant boost to spending.

In fact, the programme touches a market estimated at CNY 11tn worth of domestic demand, roughly the same size as property investment in 2024. Current (and planned) government policies point towards the belief that continued and sustained economic growth will come by driving domestic demand. The days of focusing on real estate as a growth driver appear to be behind us (we previously noted the Chinese government itself was aware of the unsustainability of the property markets).

A key metric to watch going forward will be how those significant household deposits evolve. We expect strong improvements in domestic demand to lead to a slower pace of the deposit growth rate (though not necessarily going negative in the near term). In fact, we have witnessed this play out at the start of the year, as the rolling 1-year average rate has fallen steeply in the past year. Whether growth and recovery can be sustained will depend on how Chinese consumers behave, but if it plays out well, China may be able to meet its 5% growth target for 2024.