CHINA’S property sales growth reaccelerated this year, growing by 25 percent year on year to date, while property starts grew 12 percent in the same period after two years of decline.

The property recovery has helped to stabilize domestic demand and the overall economy, but the recent price rally, which grew more than 30 percent across a number of big cities, has caused concerns that another property bubble is being reflated, especially with leverage rising so sharply.

Could the rally lead to another construction boom?

In our view, the recent property market frenzy has not yet spread to a great many cities, pushed household debt up to alarming levels, or led to strong construction growth. Construction is where the biggest potential drag on China’s economy would come from, given a still relatively healthy household balance sheet.

There is upside risk to construction and economic growth especially if credit reaccelerates in the absence of government action to contain the frenzy. The construction recovery may be sustained in the next few months but to weaken in 2017 as sales decelerate and policy tightens somewhat, with developers staying cautious given still high existing and potential inventories in most lower tier cities. We maintain our 2016-2017 GDP growth forecasts of 6.6 percent and 6.3 percent, respectively.

But a stronger property rally lasting into 2017 may increase the risk of another major round of downward adjustments thereafter. Investors should closely monitor property sales, new property starts and property investment for near-term upside risk which may increase the medium-term downside risk. Meanwhile, the spreading of surging price momentum to more cities alongside an alarming rise in leverage could trigger more aggressive policy tightening, cooling the property rally.

Understanding the direction of property construction is a key to gauging China’s economic outlook over the next 6-12 months.

After the initial recovery began to fade at the end of 2015, property sales reaccelerated in 2016.

The much-hoped for property recovery came after two years of progressive policy easing, starting with relaxation of home purchase restrictions in mid-2014. This was followed in the past two years by multiple mortgage down payment requirement cuts, interest rate cuts, increased credit access for mortgages and developers, land supply restrictions in many cities, and other measures to speed up urbanization and property destocking.

The most important factor setting off the recent rally may have been the last down payment requirement cut in February this year coupled with a surge in credit expansion in the following months, possibly amplified by local governments’ pushing up of land prices.

The property recovery has certainly helped to support growth this year after deep adjustments in the sector had dragged down the economy the previous two years. Property is arguably the most important sector in China and the correction in property construction not only meant weaker property investment, but also led to reduced demand for construction materials, machinery and transport, dragging down industrial and mining production and investment.

Indeed this year’s property construction rebound, together with the government’s infrastructure investment, helped to underpin demand for (and prices of) commodities and led to improvement in industrial profits and local governments’ land sales revenue.

The recovery has been uneven, with some bubbly developments appearing. While many Tier-3 and Tier-4 cities are struggling to digest over-supply, property prices in other cities have risen by 30-40 percent in the year to date, and in some districts over 50 percent, with the rally spreading to more cities.

Price-affordability ratios in a few big cities have risen to record levels of nearly 20 years of annual income, though nationwide the ratio has been much lower and relatively stable.

Adding to the property price surge is news of land auction prices breaking record after record. In Tier 1 cities, average land prices have increased by over 60 percent since early 2014.

More worrying for policy makers and regulators perhaps is the trend of rising leverage. Mortgage lending has expanded by over 30 percent year on year in recent months, with the net increase in mortgage loans exceeding 3 trillion yuan (US$448 billion) so far this year and accounting for the bulk of new bank lending in recent months.

Shadow credit

In addition to formal lending, there is increasing lending to buyers for down payments often made by real estate intermediaries or other shadow banks. Although banks are not permitted to lend to developers for land purchases, there are increasing anecdotes to suggest that shadow credit for land purchase is widespread and has been increasing.

Does the recent property frenzy in some cities mean that a big property bubble has been reflated and is about to burst soon, leading to devastating economic and financial consequences?

We think it unlikely in the near future as the frenzy has not yet spread to a great many cities, pushed household debt to unsustainable levels, or led to strong construction growth. As we mentioned earlier, although strong property price momentum is spreading, many Tier 2 and most Tier 3 and Tier 4 cities are still coping with excess inventories where prices have been subdued.

Notwithstanding the recent surge in mortgage borrowing, China’s household balance sheet also remains relatively healthy overall. More importantly, property investment and overall construction activity are growing only modestly despite the rally in housing and land prices, and construction is where the biggest potential drag on the economy would come from.

Moreover, while the government may seem increasingly uncomfortable with the frothy developments in China’s property market and has already fired off a few warning shots, the overall weak state of the economy means that monetary policy is unlikely to tighten significantly soon. Given China’s high overall debt burden and little signs of consumer price inflation, we do not expect the central bank to raise interest at least in the next couple of years.

If the government tightens policies suddenly or for some other reason housing sales starts to decline, we would argue that construction will unlikely weaken as much as in 2014-2015. This is because property construction has just started to recover after two years of adjustments, and has yet to return to its previous heights; property inventory levels have come down across the board compared to 2014; and although land kings are been repeatedly created and developers seem to have pushed up new starts notably this year, developer sentiment remains relatively cautious and property investment has not accelerated as sharply as in the typical past cycles.

Does that mean that we can expect property sales and price increases to be sustained, leading to a major re-acceleration of property construction to propel the economy once again in the next couple of years?

One cannot exclude that possibility but we think that it is unlikely for now. So far developers have been reluctant to increase construction significantly — new property starts rebounded strongly in the first few months of this year but the momentum has weakened, and overall property investment has been subdued. Given that so much floor space is “under construction,” which may become potential new supply when sentiment and financing improves, it is reasonable to be cautious.

Also, although inventories in Tier 3 and Tier 4 cities have declined significantly, it may still take longer for destocking to be completed and a new balance reached, given population outflows in some cities. Similarly for some Tier 2 cities, the steep adjustment in their core industries may hinder any property revival for an extended period of time. Tier 3 and lower cities account for over half of overall construction in China.

Property sales remain robust in the coming months and exceed new property starts, leading to continued destocking. We think the government will be reluctant to tighten property and credit policies nationwide but may step up targeted tightening, pressuring some local governments to reintroduce home purchase restrictions and increase land supply. As a result, we expect the recovery in property investment and ongoing construction to be sustained or even strengthen in the coming months. This would then pass through to the upstream supply chain, pushing up demand for commodities and materials, helping to stabilize production and investment in those sectors.