Chinese Real Estate Sector: Bubble or Fundamental Value?

by Alberto Forchielli e Alberto Pagliarini*
Many people have written about the risk of a real estate bubble in China and opinions are extremely diverging. To some real estate in China is a bubble of historic proportion while to others real estate prices and construction levels are justified by the expectation of future fast economic growth. As it is very dangerous to call something a bubble (at the end of the day, a bubble is something good that’s gone on for too long) we will simply try to point to some of the interesting issues in the debate.
China’s economic environment is characterized by excess liquidity due mainly to an undervalued currency and a substantial loan growth (especially since the advent of the global financial crisis). The undervalued RMB increases monetary supply indirectly in two ways:
1- With exports higher than imports, there is more demand for yuan than for other currencies. In a market environment this would push up the value of the yuan but in a system of fixed exchange rates, the People’s Bank of China (PBOC) has to buy foreign currencies and sell yuan, therefore increasing the amount of yuan in circulation. The PBOC then tries to cancel out this additional amount of money in circulation by increasing reserve requirements for banks and issuing “sterilization bonds”
2- The expectation of eventual yuan appreciation has driven unrecorded foreign capital flows (hot money) into China
Substantial loan growth directly increases money supply. The current wave of lending has 2 main causes:
1- Government encouraging banks to lend in the aftermath of Lehman Brothers’ bankruptcy (just as an example, most of the 4 trillion yuan stimulus program itself was to be funded by bank loans and not by direct government’s spending)
2- Negative real interest rates (as at April 2010, China’s bank deposit rates were extremely low: 0.36% for demand deposits and 2.25% for one-year deposits) creates demand for borrowings not only from corporations but also consumers (China’s household debt rose by 43.3% to 8.2 trillion yuan in 2009)
This environment of excess liquidity which is driving asset prices in China is desirable for powerful interest groups:
1- State-owned enterprises don’t want interest rates to rise: low interest rates amount to wealth transfer from Chinese families (who have approximately 30 trillion yuan in savings) to SOEs and local governments (which are the largest borrowers from Chinese banks, since studies have found that more than half of private businesses had no access to bank credit)
2- Exporters are vehemently against currency appreciation: wage growth together with increases in land and rental costs have reduced Chinese exporters’ competitiveness and pushed them to relocate from Eastern China to Central/Western China
3- Local governments consider high land prices their lifeline: they have become dependent on the property sector for revenue as profits from manufacturing decline and spending needs for social programs rise (China’s current social spending is around 6% of GDP vs. more than 24% for OECD countries)
China’s current policy mix is a form of subsidy to the supply side. Low wages and resource prices were the subsidies before. Now that resource prices are high and wages are rising, low yuan, low interest rates and high land prices have become the drivers of SOEs (a large number of which has recently diversified into real estate), exporters and local governments. All those factors are hidden taxes on households.
The excess liquidity environment seems to have driven valuations to a “bubble-like” level from an affordability perspective: as at November 2009, the number of years necessary to pay off an apartment was 33.9 in Beijing, 20.8 in Shanghai and 16.3 in Chongqing but only 11.3 in New York and 8.4 in London.
Other clues of a bubble are large projects that have become a symbol of China’s waste: New South China Mall (2nd largest mall in the world, 99% vacant), Now Ordos (city for 1m people in Inner Mongolia, completely empty) and Huaxi Village (the world’s tallest village).
What’s interesting about the real estate situation in China is that the price bubble has been accompanied by a quantity bubble as developers have brought a substantial numbers of apartments to the market in the last few years. A recent media report stated that 65m urban electricity meters registered zero consumption over a 6-months period suggesting that there is a huge quantity of empty flats held purely for speculation (since there are no costs related to holding a flat, the government charges a tax on the mission real estate transaction but no periodic tax on real estate ownership).
The fact that prices have risen so much even as empty apartments accumulated is surprising, but China’s phenomenon is unique for at least 4 reasons:
1- A sustained negative real interest rate has led to rising appetite for inflation-protection (which the average Chinese investor can only find in stocks and real estate because of government restrictions on foreign investments)
2- A massive amount of gray income is seeking safe heaven (according to some, shadow income could amount to up to 15% of GDP)
3- Few people in China have experienced a property bubble (the property crash in the 1990s touched a small segment of society): this has led to recklessness by real estate speculators
4- Speculators think the government won’t let property prices fall (the so called “Wen Jiabao put”) because local governments rely on property deals for income and will do all they can to prop up prices
Without holding costs, property for Chinese investors is a store of value, much like gold. The problem is that using luxury condos, instead of gold or other assets, as currency is immensely wasteful. Construction of all these useless high-end units consumes huge quantities of resources that could go into creating useable wealth. And without adequate maintenance, any utility these apartments might have will deteriorate rapidly.
Additionally, many in China have been accumulating deposits to buy their first house only to see price rise faster than their savings. This has generated a sense of anxiety that they may never catch up socially, a sense captured very well in the primetime TV soap opera “Dwelling Narrowness”. High real estate prices therefore help explain why consumption is so low (and has been decreasing as a % of GDP since 2001, exactly when real estate prices started rising again after the bursting of China’s 1998 property bubble): Chinese households save to afford purchasing a house.
Bubbles are harmful also because they divert resources to bubble making activities: in the same way that Americans got carried away by the real estate bubble, Chinese businessmen are reluctant to focus on real economic activities and are devoting more and more time and energy to market speculation.
A few months ago the State Council issued policy measures with the goal of limiting property market speculation (including restricting financing options for third homes, increasing mandatory down payments to 50% from 40%, and abolishing interest rate benefits for second-property purchases). More recently, additional tightening measures have been announced (down payment requirement for 1st home buyers revised up from 20% to 30%+; for second-home buyers, down payment requirement is 50% or above and mortgage rate is 10% premium to PBOC base rate; mortgages to 3rd home buyers and non-local residents have been prohibited).
Although these measures may cool off the market temporarily, we think a more long-term solution would require structural adjustments:
1- Raising interest rates
a. It would reduce incentive to over-invest (otherwise called “under-pricing” of capital, low interest rates incentivize investment but after a decade in which investment averaged 45% of GDP decreasing marginal returns should be expected)
b. It would improve standard of living of Chinese household (increasing returns from savings while decreasing the cost of housing)
2- Revaluing yuan would reduce inflation and accelerate the transformation of the Chinese economy from low-value added to higher-value added activities
3- Taxes creating a regular stream of revenues for local governments (which would decrease local governments’ reliance on a bullish real estate market)
Of course, increasing interest rate would create problems for SOEs (a study by researchers at the Hong Kong Monetary Authority found that aggregate profits of the SOE sector would have been zero if these businesses had borrowed at the rates paid by the private sector). In the first half of the 1990s, loans to SOEs in Eastern China turned into NPLs as the money was used to finance overcapacity in a series of sectors. The downsizing the state sector that followed was a painful (48m jobs were lost in the following decade) but necessary step in the path towards economic growth in China.
A revaluation of the RMB would force exporters to relocate to Central/Western China or abroad (Vietnam, Africa, etc.). The good news here is that a forward-looking government has realized that inflationary trends in Eastern China would eventually drive away exporters and has devoted most of the infrastructure spending from the 2008 stimulus (US$586Bn or 14% of China’s GDP) to Central and Western China (much like the round of infrastructure investing in 1998 prepared the Coastal provinces to the arrival of Western manufacturers at the time of the WTO entrance). Following in the path of Japan and South Korea, China should eventually transition to higher value-added activities. Prerequisites, though, for this transformation are strong intellectual property rights.
Local governments should have regular revenue streams (in the form of periodic property ownership taxes, income taxes, consumption taxes) so that they would not have incentives in fuelling a property bubble.
To finish on a positive note, the “reversion to the mean” is a very powerful rule and it tells us that the growth of China and India towards the role that they held for most of the 20 centuries after the birth of Christ will continue. The US as we know it has a very short history so it’s tough to tell while for Japan we can probably prognosticate a decline (economically, it has had a small role for most of the last 2,000 years) which can also be explained by their demographics (Japan has now 3 workers for every retiree and the ratio will decline to 1.5 by 2050); China might suffer some bumps in road but has definitively a bright future ahead.
*Alberto Forchielli is President of Osservatorio Asia while Alberto Pagliarini lives and works in Hong Kong since May, 2007.

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