The PBoC Props Up China’s Housing Market
A healthy housing market is critical to China’s economic growth and financial stability, but slowing home sales, driven by pandemic restrictions and demographic shifts, has unsettled both real estate developers and home buyers. The People’s Bank of China (PBoC) has responded by lowering mortgage interest rates, which has contributed to the fragmentation of the Chinese housing market across different tiers of cities.
China’s housing market shares similarities with those in other countries, but its unique historical circumstances have resulted in notable distinctions. Housing reform has been a central aspect of China’s reform and opening up, with the PBoC playing a crucial role in guiding the development of the housing market from the outset. During the first decades of the People’s Republic of China, a person’s home was not considered a private asset. That changed in April 1980, when Deng Xiaoping introduced reforms that allowed individuals to purchase homes for the first time with the option of taking out a mortgage loan. The current structure of the Chinese housing market dates back to 1998, when Premier Zhu Rongji declared the commercialization of all housing, putting an end to the socialist welfare housing system in China. That same year, the PBoC encouraged commercial banks to allocate up to 15 percent of new loans to mortgages.
Housing policy is an essential component of the PBoC’s mandate to “implement monetary policy, prevent and resolve financial risks, and maintain financial stability.” Over the last twelve months, the PBoC has introduced new policy tools in response to unprecedented challenges in China’s housing market. This past January, the PBoC effectively abandoned its established policy of managing housing demand by setting a nationwide minimum interest rate floor on mortgages in favor of a city-by-city tailored approach that allows municipal governments to set rate floors in local markets. The PBoC’s goal with this change is to engineer the soft landing of China’s property market in the context of over-leveraged developers and timid buyers. Although these policy tools have been moderately effective, they have also caused unintended consequences.
Maintaining a healthy housing market is crucial for China. For Chinese households, their home represents their most important asset. A PBoC survey of urban households conducted in 2019 revealed that the value of housing composed 59 percent of households’ total assets, while mortgage loans stood at 12 percent of total assets. These figures are similar to the United States in 2008 on the eve of the subprime mortgage crisis and Japan in the 1980s before its real estate bubble burst. In the broad economy, official statistics show that the real estate sector accounts for 6 to 7 percent of China’s GDP, but the entire footprint of real estate activity is much larger. Kenneth Rogoff estimated that the real estate sector and associated activities accounted for 29 percent of China’s GDP, comparable to both Ireland and Spain before the global financial crisis. A CaixiaBank report estimated that the real estate industry accounted for about 30 percent of China’s GDP after considering the whole supply chain and its inputs.
China’s housing sector has been showing signs of distress since the second half of 2021, when home sales started to slow partly due to COVID-19 pandemic restrictions. The slower pace of home sales meant less cash flow for China’s highly leveraged real estate developers, like Evergrande, setting the stage for credit defaults across the real estate and construction sectors. As the surviving developers were forced to deleverage, they halted construction on unfinished projects. In many cases, the residential units of these projects were pre-sold to buyers who had taken out mortgages. Many of these borrowers were left paying a monthly mortgage on unfinished or nonexistent homes. The situation reached a flash point in the summer of 2022 when frustrated borrowers refused to make payments and used social media to advocate for a nationwide mortgage boycott. Since then, the PBoC has increasingly intervened in markets to ensure that property developers have sufficient credit to deliver on unfinished homes and that potential home buyers are incentivized with attractive mortgage rates.
China’s housing market is tiered, with the different tiers distinguished by location, socioeconomic development, and housing quality. Over the last year, China’s housing market has become increasingly fragmented as home price trends have diverged across cities. While the national average home price has remained steady, many individual cities have experienced a persistent over-supply of housing that has caused a steady decline in local home prices. National statistics are skewed by the influence of first-tier cities like Shanghai, which have large housing stocks that are expensive relative to other cities. However, the fundamental demand for housing in second- and third-tier cities across China is being eroded by two demographic trends. First, China’s urbanization rate has peaked and is in terminal decline. The data show that since 2017 the ratio of new city-dwellers relative to the whole population has consistently declined every year. In 2022, the number of new city-dwellers declined to the lowest point in forty-two years. Second, new family formation in China has been declining since 2013 alongside the falling marriage rate, the byproduct of decades of China’s one-child policy. The COVID-19 pandemic and lockdown restrictions have exacerbated these two negative demographic trends.
China’s mortgage market differs significantly from Western countries in that almost all of China’s $5.6 trillion in residential mortgages are adjustable-rate mortgages. The effective interest rate on these mortgages resets once a year, usually in January, and is calculated as the benchmark loan prime rate (LPR) [PDF] plus a fixed spread. The LPR is the average of lending rates submitted by a panel of eighteen banks that is supposed to reflect the rates they offer to their best clients. The LPR closely tracks the medium-term lending facility (MLF) rate, which is the rate at which banks can borrow from the PBoC to fund new mortgages. The spread between the MLF rate and the average effective mortgage interest rate is a gauge of how profitable mortgage lending is for Chinese banks. In December 2021, this spread peaked at 2.68 percent but since then it has fallen to 1.51 percent as of January 2023. This dramatic spread compression has squeezed the net interest margin of Chinese banks, which is at its lowest level since at least 2010.
Over the last year, the PBoC has taken a series of policy actions aimed at lowering mortgage interest rates in a bid to spur buyer demand and shore up home prices. Chinese banks are allowed to offer adjustable-rate mortgages subject to a nationwide minimum interest rate floor. Under normal circumstances, the mortgage interest rate floor is equal to LPR for first-time homebuyers and LPR plus sixty basis points for all other borrowers. In May 2022 the PBOC broke this convention by lowering the nationwide floor on new mortgages to twenty basis points below LPR for first-time buyers. Later in September, the PBoC announced it was “relaxing” [PDF] the nationwide interest rate floor in some cities where housing prices had been trending down for the previous three months.
In January 2023, the PBoC largely abandoned the nationwide interest floor by establishing the city-by-city dynamic adjustment mechanism on mortgage rates. Under this new policy, local governments are empowered to reduce or completely remove the interest rate floor on new mortgages offered by local banks if new home prices in the locality fall month-over-month and year-over-year for three consecutive months during a quarterly assessment period covering the last month of the prior quarter to the second month of the current quarter. If the same home price metrics later show that prices rose for the assessment period, then the nationwide interest rate floor would be reinstated on all new mortgages. Of the seventy largest cities in China, forty-six are eligible for the local rate floor setting.
The PBoC’s city-by-city approach to housing policy has created an uneven landscape across China in terms of borrowing costs. Generally, mortgage interest rates remain highest in the tier one cities where housing prices remain relatively high and there are few unsold homes. Policy implementation is more varied in weaker housing markets. For example, in Zhengzhou, the epicenter of last year’s mortgage strike, the local government has been authorized to reduce or remove the interest rate floor since December 2022. The following month, the city recorded its first monthly rise in home prices in half a year. The housing inventory absorption period, a measure of how long it would take to clear the supply of unsold new homes, has decreased from eighty-one months in December 2022 to thirty-eight months in February 2023. Generally, six months is considered indicative of a balanced market. In the inland city of Lanzhou, the new policy has caused the housing absorption period to fall from a peak of over ten years in December 2022 to four years in February 2023.
The PBoC’s fine-tuned approach to housing policy has had some unintended consequences. Many homeowners who took out mortgages before interest rate floors were scrapped have locked in higher borrowing costs compared to newer borrowers. This has led to grumbling that they are being effectively punished for having bought their homes too soon. Unlike in Western countries, mortgage refinancing is rare in China, in part because of regulations and also because historically stable spreads have meant the cost-savings from refinancing were mostly negligible in the past.
Many borrowers have responded to the situation by paying down the balance on their relatively high-cost existing mortgages. In 2022, a wave of mortgage prepayments totaled an estimated $827 billion, roughly 14 percent of all mortgage balances. Overall, mortgage balances have flatlined, growing only 6.6 percent year over year in December 2022 compared to more than 40 percent the year prior.
While this trend is definitely negative for Chinese banks’ profitability, its broader impact on the Chinese economy is unclear. The extent to which households are using cash on hand to deleverage is beneficial in terms of financial stability but negative in terms of shifting the economy toward more sustainable consumption-led growth. Some households have paid down mortgage balances by taking out cheaper personal loans, a risky practice that could lead to further household indebtedness, which has increased rapidly over the past five years. China’s household debt to GDP ratio was 61.4 percent at the end of September 2022, slightly higher than the Group of Twenty average. While this level does not yet cause concern, the slower pace of income growth and higher interest rates may lead to a deterioration in the ability of households to service this debt, adding another obstacle to China’s shift to a consumption-based economy.