Housing Prices Need to Decline for China to Successfully Deleverage: Everbright Securities

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The global chief economist of Everbright Securities says that China needs to bring down its housing prices if it hopes to effectively deleverage its economy.

In a speech delivered to the China Finance 40 Forum Peng Wensheng (彭文生) said that while the concerted deleveraging campaign launched by Beijing earlier this year had achieved some success in reducing the debt levels of state-owned enterprises, risk in relation to real estate leverage continues to worsen as structural imbalances persist.

“This year China has expanded its deleveraging efforts, and we have seen definite results,” said Peng. “According to calculations by BIS the credit-GDP gap has fallen, indicating that the pace at which leverage ratios are rising has started to ease.

“M2 growth has fallen markedly, indicating that the pace at which the balance sheet for the entire financial system or banking system is growing has slowed, which in turn means that the leverage ratio of the real economy is no longer continuing to expand at an excessive pace.

“Risk has been significantly contained, and this is a good sign.”

According to Peng, however, the real cause of China’s mounting debt levels is structural imbalances which still continue to remain unaddressed.

“The structural problems during the process of deleveraging remain as pronounced as they were before.

“Structural problems does not refer to a high leverage ratio for the overall economy, but high leverage ratios for a given sector. The history of finance tells us that the problems brought about by high leverage are structural in nature.

“The US sub-prime mortgage crisis was caused by high leverage in the household sector, primarily rapid growth in the debt of low-income households.

“When it comes to our current situation, in terms of the ownership system it’s mainly state-owned enterprises, and in terms of sectors it’s mainly real estate.”

While the 2017 deleveraging campaign in tandem with strong growth has achieved some success in containing state-owned enterprise debts, real estate remains the chief problem for Chinese deleveraging efforts.

“This year SOE’s have seen marked improvements in profits, deriving benefit from economic growth, as well as supply-side structural reforms,” said Peng. “While SOE’s may not repay debts following profit improvements…this will still cause net corporate assets to increase, and a reduction in enterprise leverage ratios irrespective of debt repayment.

“For this reason I believe that the biggest problem at present remains real estate. The current real-estate enterprise debt-to-GDP ratio continues to climb…the real-estate enterprise leverage ratio is worse than that for SOE’s, and while SOE’s are already pursuing deleveraging reforms, real-estate companies are still sanguine about their prospects.

“Looking at household leverage ratios, consumer loans and mortgage lending growth is very rapid overall, and while the average leverage ratio of the household sector isn’t high compared to other countries, it’s still rising at a very swift rate.

“This is a problem, but an even bigger problem lies in its structural character…the rich have large amounts of money and do not need to engage in leverage, while those who are engage in leverage are all the middle-class and low-income groups who have comparatively poor repayment capabilities, such as young people buying homes, and are forced to use mortgages.”

According to Peng the key to macro-economic deleveraging will be to contain real estate prices, given that real estate serves as collateral for credit and gains in prices spur expansion of credit across a broad range of areas.

“I believe that if we want macro-deleveraging to achieve genuine results, we need to spur adjustments to real-estate prices…only if real estate pries fall will it be possible for macro-leverage ratios to see sustained declines.”

Peng further points out that analysis of leverage levels amongst households should focus more on disposable income as opposed to assets.

“Macro-economic leverage is the ratio of debt to GDP, and isn’t the debt-asset ratio at the micro-levels. Although the financial reports of real estate enterprises would indicate that their leverage ratios are strong, this is based on the pre-condition that housing prices and land prices constantly increase, which is unsustainable.

“For example if the initial downpayment for a house is 50%, then the leverage ratio is 2, but if the price of the home doubles, then the leverage ratio will markedly decline.

“For this reason analysis of household debt-asset ratios is meaningless for the banks and macro-analysis. To take an example Hong Kong’s current leverage ratio is very high, and a considerable number of households lack the assets to repay their debts, but as long as they have stable work, and can continue to repay the principal and interest, they will not default.

“Consequently I believe that balancing leverage ratios should use debt to disposable income ratios, as opposed to household debt to GDP ratios.”

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