A “grace-period” idea has been floated of late to stop the weeks-long mortgage boycott on stalled properties. While it may grant temporary reprieve to homebuyers, such measure could lead to problems of moral hazard that impact credit culture. Loan waivers could also backfire if it encourages broader collective action. Already there are reports of suppliers to property developers willfully defaulting on loans in the hope of waivers. 

The adequacy of the measure has also been brought into question. It might have erroneously assumed that a deterioration in household debt serviceability was the main culprit. Household debt stood at 62% of GDP in 2021, which was modest by international standard. Henan, which records the most boycott notices, has the fifth-largest GDP in the country. It grew 3.1% in 1H, well above the country average of 2.5%. Meanwhile GDP per capita of Hubei and Hunan reached RMB86,416 and RMB69,440 respectively in 2021, ranked 9^th and 14^th among 31 provincial regions. Hence, households’ financial hardship doesn’t seem to be the driving factor in the mortgage strikes.

Rather, a large part of the turmoil stems from the debt-ridden developers. They have been grappling with intensifying financial stress over the past two years owing to the deleveraging campaign. Offshore market remained largely closed off, with the yield on property bonds staying prohibitively expensive. Our China Property Offshore Bond Price Index (Sep 2019 = 100) slid to 31.8 in July. Control over presales escrow account continued to be tight, compounding builders’ financial strains. For the 35 listed developers we track, 14 of them have either entered into bond default or extension. These names represented c.39% of China's total presales value in 2020-2021.

Funding relaxation introduced since 1Q has had little impact. Developer funding sources declined 25.3% YOY in 1H as banks dithering over property financing. And measures aimed at stimulating demand, such as mortgage rate cuts and loosening home-buying rules, have not yet taken hold as rising defaults and rating downgrades kept sapping confidence. Unlike previous cycles, a continued drop in values failed to entice prospective buyers. Property sales by floor area plunged 22.2% YOY in 1H, while new home prices in 70 cities dropped for a tenth straight month in June.

Long-term household loans to households, a proxy for mortgages, halved to RMB1.56tn in January-June. Presale proceeds account for about half of developers’ cash inflows. Subdued sales worsened the financial position of many debt-saddled builders, exacerbating a downward spiral.

Ensuring housing project delivery is the priority. Already more than 200 projects have been affected by the mortgage boycott across the country. Assuming 30% of the projects sold by distressed developers in 2020-21 is subject to delivery risk, mortgages at risk is estimated to be RMB1.1tn, or 2.9% of the total outstanding mortgage loans (see here). Regulators may shore up confidence through credit support. Urging banks to step up developer loans could also help ring-fence the problem. Setting up a joint fund between asset management corporations and local municipalities to purchase unfinished projects is another viable option.

With huge capital buffers built up over the years, lenders can absorb the potential loss with limited earning impact. Our calculation shows that there would be about 4-5% net profit impact in FY22-24F in our base case on unchanged provision coverage ratio. Meanwhile, we do not expect non-performing loans to be significantly affected given house delivery is largely guaranteed in this case (see here).

Still, a lack of timely policy response could weaken lenders’ asset quality and complicate the economic outlook. Our 2022 GDP projection of 4.2% assumes that residential sales will stabilize in 2H (a 10%-20% sales decline in FY22). A stagnant sales recovery coupled with an increase in NPLs would dampen banks' lending appetite, adding to headwinds facing the already-troubled property market. Real estate investment was down 5.4% YOY in 1H and would be strained further should the boycott and defaults escalate. Compounding the problem, housing and affiliate industries that are contingent on property holdings, ownership, and distribution altogether account for 25-30% of China's GDP. Falling sales and construction as a result of a growing boycott will hamper the real economy by weakening upstream and downstream activities.

That would also pressure the already-stretched fiscal position of local governments, given land sales proceeds contributed more than 40% of their total revenue. Budget deficits for localities in 1H ballooned 27% YOY to RMB5.6tn, the highest ever for the first half of any year. Apart from land sales revenue, which plunged 31.4% YOY to RMB2.4tn, a countrywide tax relief program has also bitten into revenue. Tax refund amounted to RMB1.85tn in 1H, about three times the size of FY2021. The resultant surge in debt loads precipitates the need for fiscal consolidation. Outstanding local government bonds rose 15%YOY to RMB76.4tn as of March. Among 31 provinces, 26 had debt to fiscal income ratios over 100%. A prolonged drop in land revenues means local governments may have to scale back spending, making the recovery even more challenging and protracted.

Against this backdrop, a timely and appropriate government action is warranted to curb mortgage defaults from spreading further to less-developed regions that have higher exposure to distressed developers. Failure to do so may trigger detrimental economic disruption even in the absence of systemic risk in the banking sector.

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