Chinese Real estate industry at a critical moment with mortgage boycotts

Developers historically presold units to recoup funding earlier from project, and then obtain financing for new project from the unearned revenue. From a cashflow perspective, developers already obtained most of revenue long before units are delivered, their profit maximizing practice would be to invest the projects in new projects and obtain new financing, as much as they can. Balance sheet increased exponentially, solvency ratio deteriorated, but banks look away and continue to lend, for profits and for relationship. Local governments continue to support their expansion for tax income on land sales and for political track records. Suddenly we have no control over the real estate market, and we have a moral hazard problem on all parties involved.

The situation right now is dire. We have multiple gigantic developers such as Evergrande already in default, and not only in foreign bonds, but also local currency bonds. If they fail, the development loans combined with the mortgages from homeowners not performing would put so much stress on the banking system that the most likely outcome is insolvency even at the big 4 Chinese banks. Protests and coordinated mortgage payment halts have been happening country wide, with the most recent one in Wuhan. The growing mortgage boycott for now remains contained affecting about 1%-2% of China’s $5.8 trillion in mortgages but spreading rapidly. Policy makers should realize that these social unrests are very dangerous to political stability as well and require a swift and effective solution.

Simply asking the banks to collect only the interest portion of the mortgage (what they did in Henan) is obviously not enough. Costs would be minimized if the government and the central bank step in as early as possible, directly intervening the corporate restructuring and coordinate the build out of remaining development projects with related parties at the ground level. They must step in immediately, inject enough liquidity directly to these developers either through M&A or direct control, and thus inject trust and confidence back to the homeowners that their home will be delivered in time. I cannot imagine any other way they can solve this problem without incurring unbearable costs, because these developers are now too big to fail. It may be very contradicting but at the same time, this is also an opportunity of the lifetime for policy makers introduce reform on the existing growth model, as China have been too reliant on real estate industry, and the existing beneficiaries of the system are now the most vulnerable. Needless to say this is a very delicate situation. Policy makers can achieve an ambitious redesign of the Chinese economic model, but anything less than a perfect execution and timing could mean a financial crisis.