Deception and Manipulation inside China’s Growing Economy – Part 3/3

CHINA WATCH: Making Sense of China’s Housing Bubble

Author: Prince 小王子


“The market can stay irrational longer than you can stay solvent.”― John Maynard Keynes

Much of China’s economic growth in the past 20 years have been driven by what is termed “land economy”. Indeed, residential fixed investment grew from 498.4 billion yuan or 4.97% of GDP in 2000 to 8.7 trillion yuan or 13.3% of GDP in 2017. If we account for related industries that are pro-cyclical with the real estate market, the share of GDP affected by a sharp downturn in the property market could be as much as 25% by some estimates. Therefore, a proper analysis of the Chinese property market is crucial not only for the health of the Chinese economy but also the world economy, as a crippled Chinese economy would surely spell trouble for the rest of the world.

Housing prices in China grew nearly twice as much as real income during the past decade. Data for thirty-five major Chinese cities show that average real housing prices have grown at an annual rate of around 17 percent over the past decade, much higher than the average income growth rate of 11 percent across the thirty-five cities and the nation’s 10 percent average gross domestic product (GDP) growth in the same period. At the same time, the housing boom has seen vacancy rate rising across all cities, which reached an alarming level of 22.4 percent in 2013. The combination of these features of the Chinese real estate market is an economic puzzle not easily understood: faster pace of housing price growth indicates strong demand for housing, yet the high vacancy rate fails to justify the strong demand. In this paper, I propose a possible explanation to the Chinse housing paradox by identifying the main drivers of housing prices. On the supply side, I examine the land and fiscal policies of China to explain how these policies affect housing prices. On the demand side, I focus on speculative buying by non-real estate firms and individuals to explain how they affect housing prices.

Overall, my research indicates that the excessive growth of housing prices in China is a result of the government’s policy favoring land economy, which pushes land as well as housing prices up. Speculators such as non-real estate firms and individuals are willing to bet on the continuing rise of the housing price, possibly as a result of their understanding of the government’s policy, which led to the high vacancy rate. In such a way, I explain the paradoxical nature of the Chinese housing market.

Fiscal and Land Policy

On the supply side, the Chinese land policy has some unique, albeit opaque characteristics that differentiates it from its Western peers:

  • Ownership rights: under the current system of collective ownership of rural land and state ownership of urban land, China eliminated completely private land ownership. Moreover, transfer of ownership of land is only possible between the government and the collective owners of rural land in a one-way fashion, meaning that the government can buy land ownership from collective owners of rural land, but no one can buy land from the government because it is illegal for the state to sell the land it owns.
  • Land-use rights: Land-use rights are separated from land-ownership rights in China, and are transferable between different entities. The separation of land-use right from land ownership made it possible for the government to lease its land to non-public actors for a fee. The price of which the government chooses to lease its land is not market-determined. The local government has full discretion in leasing the land for as much or as little as it wishes. Land-use rights in China are sold for 40, 50, or 70 years for industrial, commercial, or residential use, respectively.

Altogether, these defining features of the Chinese property market turn the government into the sole supplier of land in China, as well as the ultimate owner of all land. When one buys a house in China, he/she is actually leasing the house for 70 years from the government. Moreover, because local governments can sell land-use rights for a fee, there are economic incentives for the government to develop real estate vs. the other industries, leading to excessive building and huge distortion in the overall economy. This can be illustrated by studying the fiscal account and policy.

Table 1

Table 1 shows a breakdown of the relationship between land leasing revenue and fiscal account of China from 1999 to 2012. We can clearly see from the table that the local government not only engages in, but actively relies on land-leasing revenue to fund its fiscal spending. This is the result of the macroeconomic and fiscal policy adopted by Beijing where the local governments are given a specific GDP growth target every year that they have to meet, yet have to share about 50% of its revenue with the government. Local bureaucrats are hard-pressed to meet the GDP growth target, and their performance in meeting that growth target is the most important criteria for promotion. Thus, by funding the necessary fiscal expansion and spending with money from land leasing, local bureaucrats can meet the GDP growth target simply by leasing more land at higher prices, which would cause fixed-assets to increase in price nominally across the board because land is a necessary input.

Figure 1

As shown in Figure 1, land value has risen consistently at the same if not higher rate than housing prices. And because the cost of acquiring land accounts for a significant portion of real estate development, it is no surprise that when land prices rise, housing prices follow. Moreover, land price constitutes an increasingly greater share of housing price. In the city of Beijing, for example, land values averaged 37 percent of housing prices before 2008 and rose above 60 percent after 2010.

Speculative Buying

Rapidly rising housing prices and land values are not harmful to the general economy if it is driven by healthy market demand. However, in the case of China, although demand has been robust, it is built on false premise. As mentioned before, the high vacancy rate that exists within the Chinese housing market stands in conflict with the high-flying housing prices. We explain this apparent conflict by identifying the buyers of vacant houses using the marginal investor theory. Economically speaking, a marginal buyer of an asset has the greatest effect on asset pricing. Therefore, identifying and analyzing these marginal buyers can help us better understand the rapid growth of housing prices in China.

A study from the Federal Reserve Bank of St. Louis suggests that entrepreneurs and non-real estate firms might be the marginal buyers of vacant home. The study found that a homeowner’s entrepreneurial status is highly correlated with the vacancy status of the housing unit. In other words, entrepreneurs are more likely than other groups of consumers to own vacant housing units. In fact, the study suggests that as much as 25% of vacant homes in China are owned by entrepreneurs. Moreover, a whopping 45% of the non-real estate firms researched by the study have participated in the housing market. And on average, investment in real estate accounts for 15% of these firm’s physical asset over time.

Why do these entrepreneurs and firms choose to participate in the housing market, and what effects do their participation have on the housing price? A rational investor chooses to participate in residential real estate if and only if at least one of the following is true: he has a real demand for housing, he invests in housing for rent, or he speculates in housing for capital appreciation. Because a vacant home is defined as a property resided by neither the owner nor the renter, it suffices to say that our marginal buyers of vacant homes – entrepreneur and non-real estate firms – are participating in real estate because of capital appreciation. In other words, the excessive growth of the housing price in China, as explained using the marginal investor theory, is at least partially caused by the speculative buying on the part of non-traditional real estate investors – entrepreneur and non-real estate firms.

But why do these firms and individuals speculate, of all markets, the Chinese housing market? I propose that this could potentially be as a result of their understanding of the government’s policy, as explained in the last section of this paper. The policy set forth by Beijing requires local governments to constantly being challenged with specific GDP growth targets. But such a way of promoting economic growth often are too short-sighted. To meet the target, local bureaucrats often resort to selling land-use rights and encourage real estate development. Our marginal investors here could have foresaw the implications of such a policy, which would explain why as much as 15% of their physical assets are invested in residential real estate – leading to the high vacancy rate.

Concluding Remarks

An asset bubble occurs when the nominal price of the asset far exceeds the reasonable price as determined by the underlying demand for the asset. In the case of China, I argue that because much demand for housing arises from greedy speculation – and much of the excessive price growth comes from governmental policy favoring land economy – the housing market in China is therefore an asset bubble. This way, we can explain the seemingly paradoxical nature of the Chinese housing market – fast price growth and high vacancy rate. With that being said, the future of the Chinese economy hangs in peril as a result of such asset bubble. Housing assets accounts for over 70% of Chinese household wealth, and a sudden burst of the housing bubble could have catastrophic effects on the Chinese economy as well as the world economy.

Author: Prince 小王子

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Dec. 04, 2019