Quantifying the spillover effects of real estate
In their 2024 working paper, Chen, Du and Ma investigate how the effects of China’s Three Red Lines policy had spread beyond the real estate sector.
Wong Wei Chen
31 May 2024
The real estate sector is intricately connected to many other industries, and occupies a central position in any economy. At the upstream, banks and other financial institutions pump in massive amounts of capital for construction projects, which in turn create businesses for a diverse array of subcontractors and professional services such as architectural and engineering firms. On the downstream, completed buildings require the services of renovation and property management companies, utility providers and security firms, to name a few.
The industry, however, has a tendency to be highly leveraged, and the American subprime crisis, which precipitated the Great Recession of 2007-09, is a cautionary tale of over-borrowing. More recently, defaults by Chinese developers such as Evergrande and Country Garden are also a case in point. The spillover effect of a beleaguered real estate sector, and how it impacts adjacent industries and the overall macroeconomy is therefore a cause for much concern. In China, the Three Red Lines policy was thus implemented in August 2020 to rein in the risks of excessive debt by property developers.
Policies, however, seldom hit the mark exactly, often underachieving by being ineffective or overachieving by producing desired outcomes but also generating unintended consequences.
In their 2024 working paper, “The Spillover Effects of Real Estate”, Chen, Du and Ma investigate the unintended negative impact of the Three Red Lines policy on financial markets and the real economy in China. The research explores how the policy's curbs on leverage by real estate developers impacted non-real estate firms with significant exposure to the property sector, and how these effects might influence the wider Chinese economy.
This paper was presented on 20 May 2024 in the Real Estate and Urban Economics track at 11th Annual Conference of the Asian Bureau of Finance and Economic Research (ABBER). ABFER is founded by academics from Asia, North America and Europe, with the objective of strengthening Asia-Pacific oriented research, and connecting globally prominent researchers, practitioners and policymakers. IREUS co-hosts the Real Estate and Urban Economics track and Household Finance track with ABFER.
Background
The Three Red Lines policy was implemented on 20 August 2020 to address concerns about the highly indebted property-development sector in China. Specifically, there were three requirements for the real estate firms, namely:
(i) liabilities should not exceed 70% of assets (excluding advance proceeds from projects sold on contract);
(ii) net debt should not be greater than 100% equity; and
(iii) money reserves must be at least 100% of short-term debt.
Depending on the number of rules violated, real estate firms can be grouped into four categories: red category (three rules are violated); orange category (two rules violated); yellow category (one rule violated), and green category (no rule violated).
Violating these regulations has consequences for firms seeking further leverage. Companies in the best financial position (green category) can increase their liabilities (with interest) by up to 15% annually. The limits are progressively stricter for companies in the yellow and orange categories, capped at 10% and 5% growth, respectively. Those in the most precarious financial condition (red category) are restricted from taking on additional debt.
Empirical strategy and identification
The unexpected and unprecedented announcement of the Three Red Lines policy was treated by Chen et al. as an exogenous shock on the real estate sector, potentially affecting the dynamics between property developers and their suppliers and vendors, including a tightening of trade credit. Since even financially healthy companies in the green category faced limitations on liability growth (capped at 15%), the reach of the policy was industry-wide.
Using data from the stock market, a firm’s exposure to another firm can be estimated through correlations between their stock returns. A high correlation suggests higher exposure and vice versa, so Chen et al. deployed this method to classify non-real estate firms into a treatment group which was significantly exposed to the real estate sector, while the rest formed a low-exposure, control group.
Correlations among company stock returns over the period 2010 to 2019 formed the pre-policy, benchmark period. Given the exogeneity of the Three Red Lines policy, any change relative to the benchmark period following policy implementation could therefore be interpreted as arising from the policy effect.
Findings
Observing a 10-day window centered on 21 August 2020 (one day after policy implementation), the researchers found that post-policy stock returns for significantly exposed non-real estate companies dipped by an average of 0.28% under the Capital Asset Pricing Model (CAPM), a financial model used to estimate the expected return of an investment, typically a stock or a portfolio of stocks. Results returned by other financial models (FF3 and CH4) were likewise negative, and corroborated the spillover effect hypothesis.
As a robustness test, Chen at al. investigated the impact of the policy on bond spreads. In the context of the study, bond spreads are defined as the difference between the yields of corporate bonds, which carry higher risk, and the yield of bonds issued by the state-owned China Development Bank, which are considered low-risk due to government backing.
In a riskier environment, investors seek higher yields to compensate for holding corporate bonds instead of safer government bonds. During the post-policy period, bond spreads are therefore expected to widen.
Findings from the study showed that bond spreads for significantly exposed non-real estate firms increased by an average of 32 basis points following policy announcement.
Effects beyond the financial market
The researchers next examined whether policy effects had extended beyond the financial market to also impact the real economy where production, distribution and consumption take place.
To account for the lead-lag effect between the financial market and the real economy, Chen et al. observed data over a 12-quarter window, and subsequently found that firms more exposed to the real estate sector experienced lower investment, sales growth and profit.
Investment – defined as the ratio of capital expenditure over a period to total assets owned at the end of the period – decreased by an average of 0.42%, while sales growth and corporate profit respectively dipped by 2.20% and 0.23%. The overall investment decline arising from the Three Red Lines policy was estimated to be at least 390 billion RMB over the 12-quarter observation window.
Policy implications
In today's highly interconnected economy, the real estate sector functions as a crucial node, generating significant spillover effects across various industries. Any policy formulated for real estate therefore also needs to consider ripple effects that could percolate upstream and downstream.
Kaiji, Chen is an associate professor of economics at Emory University and a senior research fellow at the Center for Quantitative Economic Research (CQER) of the Federal Reserve Bank of Atlanta.
Huancheng, Du is a former postdoctoral fellow at Chinese University of Hong Kong, Shenzhen, and is currently working at Central University of Finance and Economics.
Chang, Ma is an associate professor of finance at Fudan International School of Finance, Fudan University.