Growing concern that a property bubble is bursting in China is leading to increasingly dire predictions for the country’s steel industry.

In the latest edition of its China Steel Insight report, steel consultancy MEPS International argues that these fears are misplaced and that demand for steel in China remains sufficient to support 8% growth in domestic apparent consumption this year.

There is little denying that a property crisis is currently unfolding in China. The cost of homes has fallen for five months in a row, according to SouFun, a company which tracks property prices. In larger cities such as Shanghai, developers have been slashing prices by as much as one-third.

This is concerning because a downward trend in prices will reverse the logic that has underpinned growth in this industry over the past decade. This has the potential to bring to a halt the break-neck pace of construction from which the steel sector has reaped such benefits.

This property boom, which has seen sustained double-digit growth in floor space under construction, has been fuelled by speculation. Negative real bank deposit rates and a volatile equity market have meant that investors have piled into real estate, investing heavily in high-end property.

This speculation driven demand has enabled construction of prime developments to far outpace real demand. The result is millions of empty houses and entire ghost towns - purchased as a bet that China’s urbanisation process will eventually generate buyers, willing to pay a higher price for these units.

A large part of China’s construction boom has therefore rested on property being an attractive investment for cash rich speculators. But as house prices fall, speculation driven demand has inevitably disappeared. The momentum driving construction of these units, and the logic which underpinned real estate’s golden years, has collapsed.

In a positive sense this will encourage developers to sell off their stock and halt new construction activity, enabling real demand to catch up with supply. In the worst case scenario, however, the existing owners of these properties will join in this sell-off. The fact that most home owners are not highly leveraged may avert this more serious outcome, but some sort of collapse is clearly on the cards.

These scenarios have played out before, as real estate bubbles in countries such as Japan and Ireland have burst. But there is one important difference here. China is a developing country where a vast swathe of the population still needs basic housing. Even in modern Shanghai whole families are still living in single rooms in colonial-era houses. It is often forgotten that until 1999 most of urban China lived in state allocated homes.

A pertinent question is, if the property boom of recent years has been driven by speculative real estate, how has this need for ordinary housing stock been satisfied? Quite simply it has not. In other countries a real estate bubble was burst to reveal the absence of any real demand to sustain construction activity. In the case of China, a deflating bubble has revealed the extent to which this speculative boom has suppressed real demand.

As a result of a real estate sector chasing higher returns from luxury developments, the government estimates that a staggering 36 million economic housing units needs to be built between 2011 and 2015. This is only the tip of the iceberg – the bare minimum which must be done to prevent a social crisis. The market for affordable housing is far bigger and at the moment does not even include most migrant workers, who until they are granted residency rights are unlikely to make their family home in the city.

Sustaining growth in the construction sector will require real estate developers to engage with this demand. Private sector construction of residential units collapsed to less than 5% growth, year-on-year, at the end of 2011, but the figure for government sponsored affordable housing surged above 40%.

Focusing on this lower priced market requires a fundamental shift in the business models of many real estate developers. It will involve accepting substantially lower returns. Developers need to recognise that the good times of seemingly endless demand for luxury developments are over. The more astute companies are already making this transition, from a focus on speculative real estate to construction of affordable housing. Others will simply choose to, or be forced to exit the property market.

This shift in strategy will not only sustain output growth in the steel industry but will substantially increase consumption of this material. Affordable housing units are generally more steel intensive than top-end housing. Moreover, unlike empty properties purchased for speculation, these units will be furnished, generating further demand for steel from the white goods sector. Rafael Halpin, MEPS’ China analyst comments, “China has witnessed a phenomenal boom in demand for steel from the real estate sector over the past few years. But this has been achieved by leapfrogging over real demand, straight into a speculation fuelled property bubble. As this bubble bursts, the Chinese steel industry can look forward to several more years of record output, as developers step back and begin supplying the country with the affordable homes it desperately needs”.

Source: MEPS China Steel Insight