Last year – I wrote an article highlighting China’s increasingly fragile and risky property sector. And the stress it posed for the global economy

And since then, China’s property sector has grown far more stressed. . .

For instance – newly built home price growth in China’s declined over the last year. And has remained negative since May 2022.

In fact, newly-built home prices in September fell 1.5% – its fastest decline in seven years – as 54-out-of-70 major cities saw prices fall (up from 50 in August). And property sales by floor area in September declined for the 14th straight month.

Now – property developers have faced multiple headwinds – such as anemic demand, tighter liquidity, and declining growth.

But the biggest culprit was the ‘three red lines’ policy enacted by Chinese authorities in late 2020 to rein in speculation and leverage.

I wrote back in September 2021 that: “. . .Chinese authorities began trying to gain control of rising debt burdens. So they created guidelines to try and clean up the highly leveraged property sector. Thus they passed the ‘three-red lines’ agenda (aka three rules that put hard limits on a company’s ability to borrow).

In short – the authorities began forcing developers to deleverage (aka cut back on debt and raise cash instead). . .”

Thus, debt-ridden developers saw a tidal wave of soaring bond defaults. Especially in 2022.

For perspective: offshore bond defaults (aka dollar denominated-debt) surged to over $26 billion as of July. And Chinese property developers are responsible for nearly all of it.

With higher dollar borrowing costs (courtesy of the Federal Reserve’s tightening), these over-leveraged developers are stuck in a perpetual struggle.

That’s because they can’t refinance their dollar debts or repay principal and interest as growth slows.

And that’s a problem since – as Bloomberg estimates – Chinese developers faced another $31 billion in dollar debts maturing over the second half of 2022.

Thus declining home prices and weak leverage growth have crippled Chinese property developers.

But most importantly – this will have wide-reaching ripple effects. . .

Why?

Because China’s real-estate sector is one of the largest growth engines for the economy.

Estimates show that roughly 29% of total annual growth comes from the property sector. And worse, accounts for 30-40% of total bank loans.

And in terms of investment – as of 2020 – over 50% of fixed asset investment in China is fueled by real estate.

But most troubling is data showing 70% of total household wealth in China is in the property sector (compared to just 35% in the U.S.).

I believe this is the biggest issue since – in such conditions historically – ‘debt-deflation’ can compound very quickly.

For context: debt deflation is a term by early-1900’s economist Irving Fisher. After he witnessed the debt-fueled implosion that triggered the Great Depression, Fisher theorized that depressions are due to the overall level of debt rising relative to falling asset prices and consumption. Thus fueling a feedback loop into further asset declines, rising unemployment, higher debt burdens, and on and on.

Thus with so much household wealth and debt tied to real-estate values, any price declines could trigger a tipping point (remember 2008?).

Now – Chinese authorities recently unveiled sweeping measures to try and help the property sector recover. These policies aim at providing liquidity, relieving financial bottlenecks, and extending debts and liabilities.

And although this is the biggest pivot since authorities began reining in the property sector in 2020. I don’t believe this is enough to reverse the trend.

That’s because these policies mostly focus on the supply side. Not the demand side.

Meaning: if new-property sales continue falling (which they’ve plunged steadily over the last year), then there won’t be a property market revival.

The Chinese appetite for buying homes continues to evaporate.

This puts the Chinese leaders in-between a rock and a hard place.

On the one hand – they may try to stimulate demand. But to do so, they must show homebuyers that prices will stop falling and instead rise indefinitely (as they’ve done in the past).

But on the other hand, this will only amplify the reasons they’ve tried so hard to deleverage the bloated property sector after years of rampant speculation, soaring debt levels, and over-building.

And worst of all – China’s economy continues to grow more fragile as growth diminishes and debt-burdens rise.

This is evident when looking at China’s incremental capital-to-output ratio (aka ICOR – or capital efficiency).

Putting this into perspective – this shows that over the last decade, it’s cost three times more to get half the real growth.

Imagine hiking into a sandstorm that’s three times stronger than a decade ago, but only able to gain half the distance.

Thus – as always – China cannot escape the laws of diminishing returns.

The old playbook of trying to pump credit into the system to force growth won’t work anymore. And will instead only stimulate excess speculation, rising debt, and malinvestment (reinforcing their current situation further).

Time will tell, but it’s clear that there’re black swans lurking in China’s financial system.

And if China implodes – or continues slowing down – I reckon everywhere will feel it.