In Shenzhen, one of the most prosperous cities in China, Reuters reported that a large group of people formed a row on a street in July 2022, banging pans and pots. They were not begging for money; they were protesting against unfinished construction of their homes. Many of them had spent their life savings on new properties, but might never see them finished.

These unfinished construction projects are the epitome of a larger crisis – the real estate crisis that started when the trillion-RMB real estate developer Evergrande announced cash flow difficulties. A series of bond defaults from other developers followed. Under the close ties between real estate companies, the banks, and the local governments, the contagion of the real estate crisis is spreading into the whole economy, and the nation is standing at the crossroads of its future.

Over the past two decades, the unparalleled growth of the Chinese economy is fuelled by a powerful model known as “equity finance.” The model works in the following steps:

1. The local government sells land for industrial purposes to enterprises at a very low price. The government simultaneously sets up local government financing vehicles (LGHVs) to issue bonds and borrow from banks, using other land as collateral, and uses the borrowed money for construction projects, notably for facilities such as roads and railway.
2. Companies, attracted by the low land costs and excellent facilities, move into the area. This increases tax revenue for the government and also the region’s population through migration for work.
3. Demand for housing increases due to the higher population. As a result, housing prices rise.
4. The local government sells land for commercial and residential use to developers at high prices, made possible by the high housing prices, further raising revenue. The government also uses new land as collateral and can borrow even more using this land with higher value. The government then embarks on more construction projects and tax subsidization for enterprises, attracting even more companies to the region.
5. More companies mean even higher population and housing prices, and the government can sell land at an even higher price, making more revenue and borrowing more money. Thus, a virtuous cycle is formed.

It is through this model that prosperous cities can be built from scratch, and it is through this method that China’s GDP increased eighteen-fold in the past two decades.

However, like all development models, this model of using land as financing tools has multiple drawbacks. A serious consequence is high housing prices, because ever-increasing housing prices are the basis of the virtuous cycle in the model. For instance, the rental yield (annual rental income of property/current value of property) of commercial office buildings in Beijing is around 3%, while that of residential houses is less than 1%. The percentages in smaller cities are slightly higher, but not by much. According to real estate tycoon Pan Shiyi, a healthy percentage that yields reasonable returns should be 6-7%, and a low percentage means that Chinese housing is severely overvalued. Moreover, 2021 data from the National Bureau of Statistics shows that for individuals who had bought a house on mortgage, they had to spend on average 40-50% of their monthly income paying the mortgage. As an example of the high housing price, the average house price in 2021 Shanghai is Rmb50,141 (£6,017) per square meter, while the average annual income is Rmb78,027 (£9,323). As the saying in China goes, “buy a house, and work for it for the rest of your life.”

A second problem brought about by the land finance model is the high debt level of both the local government and the developers. The local government (or LGFVs that are run by the government) borrows large sums to finance construction projects and often use new borrowing to cover old debt, so that the rate of growth can be as high as possible. Estimates by the Financial Times suggest that from 2013 to 2020, total debt of LGFVs more than tripled from $2.5tn (£2.2tr) to $ 7.8tn (£6.7tr). Similar logic applies to developers, only that they use their projects instead of land as collaterals. The result is high leverage, debt, and turnover, which can be a potential risk for the economy.

The government saw that risk in 2020, and it was quick to take action. The famous ‘Three Red Lines’ policy was implemented in August in the same year to reduce the leverage facing the property sector. The three ‘red lines’ are as follows:

• Liability-to-asset ratio of less than 70%, excepting advances from contracted projects
• Net gearing ratio (net debt/equity) of less than 100%
• Cash to short term debt ratio greater than 1

Companies crossing none of these lines are permitted to increase the size of its debt by only 15% per annum, and for each additional line crossed the permitted annual percentage growth of debt further decreases by 5%. Evergrande, along with multiple other trillion RMB real estate firms, crossed all three lines, which means they cannot increase their debt size.

The ‘Three Red Lines’ policy reduced leverage by controlling the size of debt, but the policy brought significant damage to the firms’ cash flows. When the developers were expanding, they borrowed increasing amounts to generate high growth, often financing old debt with new borrowing. Under the ‘Three Red Lines’ policy, though, the firms found themselves unable to borrow new money to pay back old debts, while the money they borrowed had already been invested in projects.

The only way for the developers to repay debt is to liquidate some of their assets. But the issue is that the largest section of the developers’ assets is properties under development, which cannot be converted into cash if the vendors and construction crews are not paid, and even if they are paid, the developer cannot guarantee that the houses can be successfully sold. Evergrande’s 2020 financial statement shows that while it has Rmb1.5tr (£180m) of current liabilities and Rmb1.9tr (£228m) of current assets, 1.2 trillion (£144m) of current assets is properties under development. Moreover, developers often issued wealth management products and other items as means of borrowing, and these potentially large figures are not reported on financial statements. Similar asset-debt structures are found in other real estate companies such as Sunac and Fantasia Holdings, showing severe difficulties in repaying debts.

Meanwhile, due to almost unaffordable house prices, the amount of transaction in the house market fell in recent years. President Xi further cooled the property market by saying that “houses are for living, not for speculation.” Therefore, developers faced high debts on one hand and low revenues from housing sells on the other, creating the condition for a crisis.

In August 31, 2020, a letter from Evergrande asking help from the Guangdong government was leaked on social media, sparking fears. In October, real estate giants Fantasia Holdings and Sinic defaulted on the repayment of bonds worth around $500m in total. Meanwhile, credit-rating agencies downgraded the credit level of these companies, raising the cost of raising debt capital in international markets. Due to cash shortfalls, construction projects were left unfinished, and people stopped buying new homes in fear that they would not be handed their house.

The demand for housing was driven even lower by economic downturns brought about by Covid-19 lockdowns in China. Thousands of small and large enterprises in cities under lockdown went bankrupt, while for the remaining ones profit level fell dramatically. This was passed in the form of falling incomes, further reducing housing demand. In the recent Chinese Communist Party’s 20^th Congress, Xi showed no signs of relaxing the zero-Covid policy, which means that the lockdowns can represent a long-run impact on the property sector.

The low demand of housing by consumers then led to the low demand for land by developers. This was very problematic, because on average 40% of the local government’s revenue comes from land sales. It is worth remembering that the local governments also had large debt obligations, and low revenue brings them intense pressure. In June 2022, local government reports claimed that if the central government does not introduce a large bailout, the local governments would not be able to repay their debts by the end of the year. The inability for developers and local governments to repay debt puts significant pressure on banks, as the potential amount of bad loans is huge.

But that does not mean a sudden crash of the Chinese economy. The property sector, contributing to about a quarter of China’s GDP, is indeed too big to fail. An advantage of having a strong central government is that there is a lot of room for market intervention in times of crisis. The Chinese central government can redirect funds local governments to help them repay their debts, while restructuring teams can be sent to real estate companies such as Evergrande to help them survive the crisis. However, a consensus among most Chinese is that the property market will eventually leave the stage. With little speculation and low expectations, the exceptionally high housing prices are detached from fundamentals. As a chief economist at Hang Seng bank says, “the old model of relying on infrastructure and housing has essentially finished.”

If the property market exits – an eye-watering 20-30% of GDP growth in 2019 – what is the next engine for China’s economic growth? This is a question that even experts found difficult to answer. Manufacturing is an option, but low-end manufacturing yields limited growth in returns, while China is facing sanctions on high-profit high-end manufacturing. Strict government control over capital markets restricts the opportunities in this market and adds friction in the effective channelling between savings and investments. Meanwhile, after the 20^th Congress, the prioritization of politics over the economy led to grim expectations of China’s future economic development. The path that China will take after the rise and fall of real estate is still an enigma, but the road to sustained economic growth will surely not be an easy one.

The two decades of fast growth under land finance has made a few rich, but many others spent their life savings on an asset that is almost guaranteed to lose value. One thing for sure is that the real estate mania in China is now over. History moves in cycles, from Netherlands’ tulips to China’s houses, and there have always been winners and losers. As Warren Buffet puts it, “be fearful when others are greedy,” and hear the silence before the music stops.