China's Growing Mortgage Revolt Is Driving Increasingly Drastic Measures

Beijing Has Not Been Able To Get Ahead Of The Crisis

Despite Beijing’s ongoing efforts to quell the growing mortgage boycott movement, it is continuing to gain momentum and spread more and more across China. When a number of suppliers and contractors for embattled and indebted developer Evergrande last week joined Chinese homeowners refusing to make payments on their mortgages so long as their homes were unfinished, there were roughly 300 projects at risk across 91 cities.

Real Estate Crisis, Banking Crisis...Political Crisis?

As of two days ago, the boycott had spread to at least 320 housing projects in more than 100 cities. At the same time, a regional bank scandal in Henan and Anhui Provinces remains unresolved, and is sparking a crisis of confidence in China’s small “village” banks.

The Henan bank scandal highlights growing concerns over China’s more than 300 high-risk local banks, and it isn’t the only sign of waning trust in a key sector of China’s economy. Recent weeks have also seen a national wave of mortgage boycotts, as people stop or threaten to halt payments on homes purchased in advance as part of now-delayed housing construction. 

What was merely a real estate developer scandal has now become metastasizing banking and economic crisis, which makes it a political crisis as well.

Local Governments Unable To Quell Rising Protests

Beijing’s preferred solution set to these twin crises is for the local governments in each city and province to take matters in hand to resolve the situation. Direct intervention by Beijing is seen as creating an unacceptable moral hazard. However, it is unlikely the local governments have the resources to fully address either crisis, let alone both.

Provincial authorities in Henan and neighboring Anhui province last week started repaying smaller victims of the recent banking scandal – those with deposits of $7,400 or less – and also reportedly pledged to refund deposits of up to $14,800 starting this week. They have also punished five local officials over the scandal.

But China’s highly indebted local governments are in a tight spot. They have been hit particularly hard by the real estate crisis because they depend on revenue from land sales. Meanwhile, the zero-COVID-19 policy has imposed new burdens on local leaders.

Moreover, local governments have been as reckless in accumulating debt as property developers, which limits their options for direct intervention with either developers or banks. The local governments simply don’t have the money.

However, the bigger news is that local governments are broke. They have a borrowing of $7 trillion by way of outstanding bonds and borrowings, in addition to a funding gap of $1 trillion. The governments have run out of funds as real estate, i.e. the selling of land use rights, was their main source of earnings.

The situation is being compounded by Beijing’s saddling local governments with the costs of sustaining the country’s “Zero COVID” policies. With virtually all major cities under permanent threat of quarantine and lockdown, continuing to provide testing and other heatlhcare resources through local bureaucracies and governments leaves almost no budget left over for resolving any other large-scale crisis.

“Localities are having to bear the cost of all the COVID testing and other COVID-related policies. That is a big chunk,” says Jean Oi, a professor of Chinese politics at Stanford University. “Their revenues have suffered severely.”

Consequently, while Beijing would like local governments to resolve the real estate and banking crises, local governments by themselves lack the means to even begin doing so. Beijing’s involvement has become a matter not of “if” but “how”.

Beijing Considers Seizing Land From Indebted Developers

One alternative that is gaining traction in Beijing is allowing local governments to seize undeveloped land owned by distressed developers then transferring those properties to healthier developers in exchange for the funding necessary to complete stalled housing projects.

The proposal, which is still under discussion and could change, would take advantage of Chinese laws allowing local governments to wrest back control of land sold to real estate companies if it remains undeveloped after two years, without compensation. That would give authorities more leeway to direct funds toward uncompleted homes, potentially to the detriment of creditors who would lose claims on some of developers’ most valuable assets.

While this maneuver might allow unfinished projects to be completed, stripping insolvent developers of their assets would further complicate already complicated bankruptcy and debt restructuring proposals, leaving both onshore and offshore creditors with little recourse to recoup even a portion of what is owed—which would greatly magnify the fallout from developer debt defaults and increase contagion fears.

Completing housing projects has become the main priority for Beijing, as that has become the only means to halt the mortgage boycott. Without completed homes delivered to homebuyers, there is no real incentive for homebuyers to continue paying on mortgages for homes they may never see.

Now, as property developments stall across the country and house prices fall, many Chinese homeowners are slashing spending, postponing marriage and other life decisions, and, in a growing number of cases, withholding mortgage payments on unfinished homes.

Peter, for one, has given up on starting his own business and buying a BMW 5 series after construction on his 2 million-yuan ($300,000) home in Zhengzhou, the capital of Henan province, was halted by China Aoyuan Group. He is now saddled with a mortgage that’s eating up 90% of his disposable income on a home he may never see.

With China’s banks holding some 38 trillion yuan in mortgages, plus an additional 13 trillion yuan in loans to distressed developers, a wave of mortgage defaults could very quickly become a larger crisis than even China’s state-run banks could address.

Builder Bailout Fund

In addition to the land seizure proposal, Beijing is also reported to be working on a bailout fund to deliver additional financing to developers to allow work on unfinished housing projects to resume and be completed.

The People’s Bank of China will initially issue some 200 billion yuan (US$30 billion) of low-interest loans to commercial banks who can leverage that by up to five times to raise a total of 1 trillion yuan to fulfil the needs of the mainland’s property sector, the Financial Times reported on Thursday, citing sources.

“The main problem here is that liquidity for the entire sector is affected,” said Kenny Ng, a strategist at Everbright Securities International. “Developers need cash to finish their projects, pay workers and suppliers.”

Without fresh capital, more and more developers are facing defaults, placing more and more housing projects at risk of non-completion. So far, 20 developers have defaulted on offshore bonds.

This month, Junfa Property in Kunming, in southern China’s Yunnan province, became the 20th developer to default, when it failed to pay interest on an offshore bond. Seven other property firms have applied for maturity extensions.

The bailout fund is viewed as a way not only to get real estate developers the money needed to finish housing proejcts, but also to restore confidence in the broader real estate sector.

Reuters describes the promised rescue fund as the first step in creating a "war chest" of as much as $44 billion (300 billion yuan). The state hopes the effort, announced Sunday, will not only help property developers resolve a debt crisis but also restore confidence in the real estate sector.

However, the bailout fund faces a major hurdle: loaning distressed developers more money puts those developers even deeper in debt, thereby increasing the likelihood that more of them will default on some of their debt obligations—which would in turn add to the growing stress being felt by China’s banks.

The government hopes the banks will be able to leverage its initial fund by up to five times to raise a total of about Rmb1tn and partially fill the funding gap needed to complete unfinished projects, the people said. But bank executives and analysts have warned that the PBoC may struggle to raise its targeted amount given the difficulties banks will face in making a return on distressed real estate projects.

A key problem: most of the housing units in stalled projects have already been sold—hence the growing mortgage boycott—which limits the amount of additional revenue the developers can achieve even if the projects are completed. Diminishing home sales and falling housing prices only amplify the revenue shortfall.

“A lot of unfinished residential projects have already been sold out or are located in under-developed cities where home purchase and housing rentals are weak,” said Dan Wang, chief economist at Hang Seng Bank China. “That limits the number of developments the bailout fund can invest in without suffering a loss.”

Housing transactions in smaller “third-tier” cities, where most unfinished developments are located, fell more than a third this month from a year ago even after local authorities rolled out numerous support measures to boost buyer demand, ranging from interest rate cuts to subsidies on purchases.

Contagion Spreading Abroad

As the mortgage boycott and real estate crisis spreads, the pressure being placed on China’s banking sector is complicating financial challenges coming from abroad, as Chinese-funded development projects within Xi Jinping’s cherished “Belt and Road Initiative” run aground on funding crises of their own. Most notably, China and Pakistan are actively seeking a third nation to join the multi-billion dollar China-Pakistan Economic Corridor, as Pakistan’s ongoing financial woes have only been made worse by efforts to complete development projects under the CPEC banner.

Seven years later, Pakistan has slipped into a financial crisis partly caused by what was meant to be a solution to the chronic ailment. CPEC contributed to a rise in Pakistan’s debts. Islamabad had to import billions of dollars of materials for the project that widened its current account deficit. As the economic situation spiralled out of control after the pandemic broke, Pakistan sought an International Monetary Fund (IMF) bailout. The $6 billion package was also stalled as the country tried to meet IMF conditions for release of payments.

The real estate crisis in China and attendant banking stresses are reportedly leaving China unable to continue funding investment in the CPEC projects without at least some debt repayment. The extent to which this threatens the CPEC project itself, and, by extension, much of the ongoing BRI development work, is not fully known at this time.

Losing Control Over Events

At the heart of the real estate crisis is an economic and political landmine Beijing wants very much to avoid setting off: with over 70% of household wealth among Chinese tied up in real estate, a complete collapse of the real estate sector would almost completely wipe out the wealth of China’s nascent middle class, potentially stranding China in a “middle income trap”.

The “middle-income trap” is a theory of economic development in which wages in a country rise to the point that growth potential in export-driven low-skill manufacturing is exhausted before it attains the innovative capability needed to boost productivity and compete with developed countries in higher value-chain industries. Thus, there are few avenues for further growth — and wages stagnate.

China’s manufacturing base has already expanded well into the “Lewis Turning Point”, where worker wages rise faster than overall inflation as the surplus labor pool is exhausted and the country reaches full employment. Rising worker wages diminish the global competitiveness of Chinese manufacturing, reducing the prospects for further significant growth within that sector.

For some time, China’s solution to the middle income trap has been real estate development, using homebuilding and construction to power internal wealth creation independent of exports. However, that focus on real estate has generated a tremendous property bubble that is now very much in the process of deflating, destroying the very wealth China sought to obtain.

This leaves Beijing no room to maneuver. It has to prop up the real estate sector, and it has to somehow preserve housing prices. Failure to do so will send millions of average Chinese workers careening back into poverty, and very likely touching off an even greater wave of social unrest than a mere mortgage boycott. However, propping up the real estate sector entails injecting into the market the very forms of moral hazard President Xi Jinping sought to overcome with his “Three Red Lines” program in 2020.

If the mortgage boycott continues to expand, Beijing will have lost all control over the Chinese economy and, by extension, China’s future. That the mortgage boycott has grown as far as it has suggests that Beijing may have already lost control, and is powerless to prevent the real estate sector’s eventual collapse.

How (or if) Xi Jinping and the CCP maintain political legitimacy and credibility in the wake of such a collapse—what the Chinese call “The Mandate Of Heaven”—is a question to which we may very soon get the answer.