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What to Make of China’s Real Estate Crash

Image via VOX EU CEPR

The world’s second largest economy is in deep trouble. In China, where economic growth has exceeded the expectations of Western economists for decades, financial indicators are now showing signs of a serious slowdown. Hong Kong’s Hang Seng Index, a historic gauge of the country’s economic performance, has slid more than 20 percent from a recent peak in January. Global investors are also expressing doubts, with the Chinese yuan reaching its lowest level in 16 years. Consumer spending is hurting, economy-wide investment has slowed dramatically, growth forecasts have been downgraded, and the Chinese government has even announced it will stop measuring youth unemployment in the country after it reached a record 21.3 percent in June. Though forecasts are mixed, it is clear that something is very wrong in the Chinese economy, and the signs are alarmingly similar to other major economic crises of the past three decades. Such a crisis could have lasting impacts not only on the country’s financial health, but also on the very underpinnings of Chinese political order.

China’s current situation is a unique combination of bad economic circumstances, the foremost of which is its massive debt crisis. The Chinese economy has grown at an astounding pace in recent years as other major economies have slowed or stalled, and it is the country’s white-hot real estate market that has driven much of that growth. As China’s population grew, demand for housing became a key economic force that, combined with significant infrastructure spending from the government, made real estate development the biggest sector in the Chinese economy at around 30 percent of total GDP.

The construction boom drove a lucrative but ultimately unsustainable cycle. At the encouragement of the state, developers overproduced housing, and banks offered favorable mortgage terms to entice homebuyers. Cranes rose above cities across the country as land values seemed like they would climb forever. Local governments also fueled the fire by involving themselves in the real estate speculation and amassing a collective debt assessed to be somewhere around $9 trillion to fund the development of new municipal infrastructure.

The result was a real estate bubble of unprecedented size—and it just popped. Property sales are set to fall by 30 percent in China this year. For context, that figure was 20 percent in the United States at the height of the 2008 financial crisis. The impetus for the collapse was China’s strict lockdowns during the Covid-19 pandemic. Demand faltered as the economy was shuttered, and investment quickly followed suit, putting an abrupt stop to the speculative real estate cycle. Debts began to pile up as payments were missed, causing a freeze on construction. Asset prices collapsed as a result, leaving Chinese firms, local governments, and individuals on the hook for unprecedented levels of debt.

The lack of transparency in Chinese economic reporting has made it difficult to gauge exactly how bad things are right now. However, most experts agree that the outlook is not positive. The crisis in China risks turning into what’s known as a “balance sheet recession”—when a country is faced with massive amounts of debt and must spend money to pay it off instead of consuming. This depresses demand and, in turn, a country’s output. Though it is unclear whether this phase of the crisis has yet begun, it looks increasingly likely that it is on its way.

China’s impending recession is not without precedent: Today’s crisis is a near-perfect reflection of the Japanese debt crisis of the 1990s that led to the first serious research on balance sheet recessions. Unfortunately, history shows that responding to this type of depression is uniquely difficult. Fiscal stimulus traditionally employed to deal with downturns, like cutting taxes, is unlikely to have a large impact in China because the extra income will likely go toward paying down debt instead of accomplishing the intended effect of increased consumption. Similarly, monetary approaches like interest rate cuts or structural reform policies are unlikely to work due to a shortage of borrowers.

Richard Koo, a Japanese economist who has spent his career studying balance sheet recessions, has a simple solution to the problem, though it is unlikely to be implemented. In place of traditional fiscal stimulus, he believes the Chinese government should provide direct relief to the hurting development companies, allowing them to complete construction projects that are currently at a standstill. This would help public and private balance sheets, providing assets to stand against the country’s immense debt. Most of all, direct relief would improve economic sentiments in China, possibly encouraging consumers to spend more and get the economy moving again. However, the Chinese government looks unlikely to implement such a solution, deriding similar fixes as “welfarism.”

Possibly the most interesting story of all is not strictly economic, but rather has to do with the societal implications of the collapse. One of the worst-performing indicators in China today is consumer confidence, evidenced both in surveys and by the economy-wide slowdown in investment. This is typical for financial crises, but it is exacerbated in China by the last few years of Chinese politics: Covid-19 lockdowns, pervasive corruption in state-owned enterprises, and the Chinese Communist Party’s (CCP) attempts to stifle the country’s nascent private sector have all led to a decline in trust in the state. As a result, consumer sentiment may ultimately take longer to recover than it should.

This specific problem is a result of a fundamental tension that underlies many of China’s economic woes. Chinese political leaders’ desire to centralize power under the Communist party often contradicts the best economic direction for the country. In pursuit of their political goals, Chinese leaders have suppressed market forces, expanded the state’s role in the economy, and stifled innovation and entrepreneurship. Now, as the Chinese economic legacy of consistent yearly growth unravels in a collapse of the CCP’s own making, questions may well be raised about what, if not providing a strong economy, the ruling party is there for. This should particularly scare party leaders because the country’s citizens are now wealthier and more educated than ever before. It is not unimaginable that a population accustomed to stable economic growth and a rapidly increasing standard of living may now start to question the efficiency of China’s “state capitalist” system.

So what are the country’s prospects for the future? Koo imagines it takes anywhere from five to 10 years to repair balance sheets countrywide, and that timeline for recovery is supported by historical examples. The 2008 financial crisis in the United States, which some have called a balance sheet recession, took a decade and a pandemic to fully recover from. The Japanese economy is, by most accounts, still recovering from its 1990s shock. In China, the crisis could last even longer—real estate makes up more of China’s economy today than it did Japan’s at the end of the 20th century, meaning balance sheets reeling from the collapse may take even longer to recover. Additionally, China faces an aging population and cooler relations with its trading partners than Japan did. But China does have one advantage that Japan did not: the gift of experience. When Japan was rocked by its crisis, policymakers had no reliable tools to navigate their way out of it. Now, China has observed a handful of examples and knows roughly what works and what does not.

Still, experts are mostly pessimistic about the country’s recovery because Beijing does not look poised to provide the fiscal help the country needs. The government has cut interest rates some; however, this solution is not only less effective but also limited—rates can only go down so far. And though limited fiscal stimulus has been applied on the supply side, the state looks unlikely to offer any meaningful relief to households. Similarly, Chinese President Xi Jinping has signaled that efforts to bail out the construction sector are off the table because of his government’s goal to transition to an economy built around consumer spending.

So, while economic forecasters differ slightly on China’s direction, the consensus largely seems to be that the golden era of Chinese economic growth has come to an end. Public opinion is notoriously hard to measure in China, but it seems increasingly likely that this economic failure will have dire implications for the future of the ruling Communist party as well. Unless the party quickly rights the ship and goes back to delivering consistent economic outperformance, the coming decades could prove to be turbulent ones for the CCP.