China’s letting the market determine the clearing price for new homes.

That’s a new idea for them. Sort of.

As China urbanized, mass migration from the countryside to the nation’s cities pushed up home prices, imperiling affordability. The Party’s solution — or one of them anyway — entailed capping prices on so-called “pre-sale permits.” Long story short, if you were a developer and you wanted to sell units in a new project before they (the units) were finished, you were obliged to keep prices below levels considered exorbitant by local housing authorities.

Pre-sales were a critical source of funding for developers. If you can sell apartments before they’re finished, you can go ahead and use the money to buy more land for future developments. If that sounds risky to you, that’s because it is. At various intervals over the course of China’s property meltdown, market participants — not to mention buyers — questioned some developers’ willingness and financial wherewithal to finish pre-sold homes, triggering a crisis of confidence which in some instances became self-fulfilling.

In boom times, the government’s price “guidance” was a de facto buyer subsidy: The controls kept prices for new apartments artificially low, so if you could get your hands on one, you could turn around and sell it for a tidy profit pretty much immediately to someone who wasn’t lucky enough to get in on the pre-sale. Now, though, with the market in free fall, government controls are keeping prices artificially high, preventing developers from clearing bloated inventories. The price controls, then, are a double-edged sword — a knife “with two sharp edges,” as one Reuters journalist put it last year.

In the linked Reuters piece, opinion columnist Chan Ka Sing described developers’ at times desperate efforts to mitigate the problem. For example, builders have gone as far as offering prospective buyers gold bars to bridge the gap between the sales price and the likely value of apartments in the secondary market. (“I understand your concerns Mr. Li. Would you reconsider if we offered you, say, a duffle bag full of bullion?”)

Why not just scrap the guidance? Well, two reasons. More than two, actually, but two main reasons. First, if the market price ends up being far below the low-end of the guidance range, everybody who bought at the government-mandated price takes a big hit. That could deal a severe psychological blow to already depressed consumer sentiment, further undermining domestic demand. Second, prospective buyers, seeing the big price declines, may assume that additional discounts can be had simply by waiting around. This is deflation dynamics 101.

China may not have a choice. As the above-mentioned Chan wrote for Reuters last year, the fallout from a dramatic price slump would be “enormous” considering China’s 90%+ homeownership rate and there’s no telling, given the country’s ongoing economic malaise, “where an undistorted price will settle.” But without a property market recovery, the economy won’t find its footing. And in order to get a recovery in real estate, the market has to be allowed to clear. As Chan wrote, in the same September 2023 article, “finding the bottom of the market looks crucial.”

Fast forward a year, and the Party’s begrudgingly coming around to this painful reality. On Tuesday, Bloomberg described an abrupt, near-20% price cut by “a mid-sized residential project” on the “outskirts” of Beijing. Nearby developments were compelled “to follow suit.” In other words: Price wars!

This isn’t an entirely new development (no real estate joke intended), but as the linked piece emphasizes, it’s notable that Beijing’s now joining smaller cities in relaxing (or even scrapping) price guidance. If prices for new homes catch down to the resale market… well, suffice to say the potential exists for very large declines.

Since the onset of the property crisis in 2021, the accumulated difference between the price decline for new homes and existing homes is more than half a dozen percentage points.

If given the opportunity to cut prices and clear inventory, developers will take it. Existing home sales now outstrip sales of new homes, a scenario builders are obviously keen to reverse. But, again, additional large price declines could be destabilizing and may perpetuate deflation in the near- to medium-term as more homeowners are pushed underwater and buyers wait for the bottom.

Do note: The property downturn has created a negative equity problem in China. At first, that’s a problem for the homeowner. But depending on the severity of the situation (i.e., how far underwater a given borrower is) it can quickly become the bank’s problem. Apparently, some lenders started warning Chinese regulators about a negative equity spiral earlier this year.

Meanwhile, Xi Jinping’s reportedly mulling a “new” plan to facilitate local government purchases of empty properties. It sounds a lot like all his other plans in that regard: The Party would allow local governments to issue new special bonds, with the proceeds earmarked for buying up unsold homes. In other words, local governments, already laboring beneath unsustainable debt burdens, will go into even more debt to buy assets the price for which is about to fall further, and which may or may not bring in enough rental income as affordable housing to cover the debt servicing costs associated with the bonds issued to finance them.

If you’re curious, China had 382,380,000 square meters of residential housing for sale last month, up nearly 23% from a year ago. As the linked piece above indelicately noted, that’s roughly “the size of Detroit.”