Blog

China’s Mortgage Boycott: Could Property Sector Cracks Lead to Systemic Risk?

Our stress tests show the Chinese banking sector as a whole can absorb shocks from a severe downside scenario, but mid-sized banks and contagion pose potential risks.

China’s widening mortgage boycott has raised fears of a further downward spiral of the property sector – a potential threat to financial stability in a country already under pressure from stalled economic growth, sluggish consumer demand, and COVID-19 outbreaks.

Since late June, hundreds of thousands of homebuyers in dozens of Chinese cities have threatened to stop payment on mortgages for pre-sold yet stalled property projects. At least 300 developments are reportedly affected, most in central and western regions, including some 20% in Henan Province.

The threats add pressure in a slowing economy. Second quarter data from the National Bureau of Statistics indicated the nation’s GDP grew just 0.4% year-over-year – the second-lowest ever recorded.

Could China’s property sector problems prompt a systemic financial crisis? It’s unlikely, in our view. Our stress tests indicate that China’s banking system as a whole has sufficient buffer to absorb the shock of a fairly severe downside scenario.

Pitting property sector risks against banking system buffers

We estimate that delayed projects at the moment account for around 4%-8% of all under-construction projects. In our downside scenario, we assume that eventually 10% of all under-construction projects will be unfinished and all their related mortgages would turn into non-performing loans (NPL). This would translate to around 0.5% NPL formation for the system overall.

Coupled with three other sources of potential downside risk – additional NPL formation from developers, NPLs from construction loans, and banks’ potential shadow exposures to developers – we estimate additional NPL pressure of about 2.6% of total loans. In context, we estimate the annual net NPL formation rate for the whole banking sector is currently at 0.7%-0.8% and the normalised range through 2017-2020 was around 1.0%-1.3%.

With the size of the potential stress in mind, we examined the three main buffers the banking system has: excess Common Equity Tier One (CET1) capital above the regulatory minimum, general provision reserves, and pre-provision operating profits. We estimate that these add up to about 9.3 trillion yuan, equivalent to 5.7% of total loans in the system – a sufficient buffer to absorb shocks from our downside scenario.

However, the buffer would look noticeably thinner if we exclude the few larger banks with stronger balance sheets.

Key focus for systemic risk: Mid-sized banks

For small and mid-sized banks, we estimate the potential NPL pressure to be 3.4% of total loans vs. 4.4% of available buffers. However, the impact from isolated cases of small regional bank stress on the banking system should be manageable, due to their small size and limited reliance on interbank funding.

Instead, we believe the key focus in terms of systemic risk should be on mid-sized banks. Not only are these banks relatively large with nationwide operations, they are also much more interconnected within the banking system – 37% of the mid-size banks’ balance sheet is funded by interbank borrowings and bonds, compared with 17% at large banks and 15% at small banks.

In addition, mid-sized banks are also relatively more exposed to shadow banking activities, suggesting that they may be more vulnerable if non-bank lenders’ financing to property developers becomes problematic before bank loans.

Imminent banking crisis unlikely, but watch for contagion

Considering how the government is handling the financial side of property risk, we think an imminent banking crisis still looks remote. Banks are delaying NPL recognition in their developer loans with forbearance granted by the regulators. Local governments have been issuing special bonds to recapitalise small banks, thus strengthening the loss-absorbing capacity in the system.

High-frequency data from residential mortgage-backed securities (RMBS) asset pools shows that delinquency among outstanding mortgages remains very low, with sequential improvements seen in June, despite some modest upward pressure in 1H 2022.

From a macro perspective, Chinese households’ overall leverage (as measured by household credit divided by GDP) increased quite sharply from 44% in 2016 to 62% in 2021. However, this appears manageable compared to developed market economies, and China’s overall household credit growth has slowed in recent years. Data from RMBS asset pools also indicates relatively healthy levels of leverage and debt-servicing burdens for mortgagors. Mortgage defaults should therefore remain low as the household balance sheet on average is well cushioned. Moreover, the legal consequences of default can result in great social cost for homebuyers.

However, a key concern stemming from the mortgage boycott and the weakening property market is whether negative sentiment could spread to existing homeowners and lead to wider defaults in existing mortgages. If this were to happen, we believe it could potentially lead to a higher chance of systemic risk in the banking system.

For more insights on China, read our recent blog, ‘What China’s Recovering Supply Chain Means for Global Inflation’.



The Author

Alex Zhou

Credit Research Analyst

Annisa Lee

Head of Asia-Pacific Credit Research

Related

Disclosures

Singapore
PIMCO Asia Pte Ltd
8 Marina View, #30-01 Asia Square Tower 1 Singapore 018960
65-6491-8000
Registration No. 199804652K

PIMCO Asia Pte Ltd is regulated by the Monetary Authority of Singapore as a holder of a capital markets services license and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised.

All investments contain risk and may lose value. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2022, PIMCO.