Is Chinese Real Estate the Next Great Fall?
Lord Abbett
By Milton Ezrati
January 18, 2011
With the American economy still suffering from its real estate collapse, and with fears growing about Spain’s real estate debt problems, stories of a Chinese real estate bubble take on an ominous tone. It is easy to draw stark parallels between China’s circumstances and those that existed a few years ago in the United States, and even easier to extend those parallels, as many commentators have, to forecast another global financial collapse and recession. Though the possibility of such a disaster exists, China’s real estate bubble differs enough from the American experience so that even in a worst-case outcome, the world will likely avoid the kind of financial and economic carnage it suffered in 2008–09.
There is little question, however, that China is suffering a real estate bubble. Property prices have risen rapidly, encouraging more speculation in residential development, which in turn has propelled prices up farther. To be sure, the pace of price appreciation has slowed in recent months. At last measure, home prices in China rose at an annual rate of about 8%, down from rates of 12–14% last spring and 24% in 2009, supported by an 82% surge in home buying. The boom has already brought Chinese land prices to 60% above their pre-2008 peaks. In Shanghai, prices are 87% above previous peaks. Prices have so far outstripped the population’s ability to buy that nationally the price of a home is some 10 times the median household income. In Beijing, housing prices on average are 22 times the average annual income of city residents. In contrast, America’s home prices at the peak of its bubble stood at 6.4 times median household income.
Against this background, some future price correction seems inevitable, even with incomes rising and a seemingly endless stream of migrants into Chinese cities. Already, concern about the situation has prompted the authorities in Beijing to make efforts to stop the housing bubble from inflating any further. The People’s Bank of China (PBC) has raised its benchmark interest rate twice in just the past few months, for a total of 50 basis points. The PBC has tried to restrict credit further by raising the reserves that banks must hold against deposits. With the finance ministry in Beijing, the PBC has begun to pressure lenders to stiffen their standards for advancing credit and has imposed restraints on land developers. The recent moderation in the pace of land price increases may reflect these efforts, though it is clear the bubble continues to inflate. Bracing for a correction, the PBC has asked companies to estimate their level of write-offs should real estate prices fall 60%. Previously, such stress testing only considered a 30% price drop.
But even in a worst-case scenario, China will face more manageable financial repercussions than America did in its real estate bust. Certainly, homeowners in China are not nearly as leveraged as they are in the United States. In China, a 20% down payment is considered ridiculously low to get a mortgage. The norm has long been closer to 30%, and last September, as part of its efforts at restraint, the government made that a requirement. Second homes now require at least a 50% down payment. As it is, a far greater proportion in China than in the United States purchase for cash, hardly surprising, since the Chinese save some 40% of their aftertax income compared with a negative American savings rate just prior to its real estate bust. In addition to China’s relative lack of leverage, that country’s absence of real estate taxes should also make it easier for Chinese households to hang on as prices decline.
Because of heavy government involvement, what real estate leverage does exist in China also seems more manageable. Most of the debt, in fact, lies with local government, extended by state-own banks. A look at the pattern of financing and development shows, as it turns out, that local government is largely responsible for the Chinese bubble. Because all land in China legally belongs to the state, real estate development leases rather than owns the land on which it sits. Since those leases are made by local government, they have become a critical source of provincial and city revenue, as are the fees associated with transfers of property once it is developed. Fully half of the Shanghai City government’s revenues, for instance, now comes from property transfers and leases. Little wonder, then, that city and provincial governments encouraged development, particularly of the larger and more luxurious sort.
Indeed, government dependence on real estate development has become so great that cities have actually used their access to credit at government-run banks to finance projects. In their drive for development, they have actually cut out private developers and set up their own real estate development firms, either de novo or in cooperation with other state-owned companies, Anhui Salt Mining Company, for instance, or the China Railway Group or the China Ordinance Group, a remarkable branching for a military supply firm. In this environment, it is hardly surprising, then, that the central authorities in Beijing have had such difficulty cooling the boom. Local governments have simply had too much incentive to keep it going. And they have, even in the absence of final buyers. At last count, Beijing can claim 50 empty high rises.
These Chinese finances are so different from American arrangements that there is every reason to look for a very different outcome there when prices drop. For one, the lack of leverage among final buyers means that fewer Chinese than Americans will face a situation in which they owe more on their property than it is worth. That, combined with the lack of a real estate tax, will mean fewer foreclosures and certainly fewer people walking away from their properties. In the meantime, the developers, because they are so closely aligned with government and, in many cases, are the government, will continue to have access to credit from the state-owned banks, even in extremes. Since so many developers are government entities borrowing from government banks, borrowers and lenders are in fact the same people. The government is effectively indebted to itself. China’s real estate debt is already socialized, and in a price collapse it will have less need for the bailouts, uncertainties, and injections of central bank liquidity that were so much a part of the American experience.
None of this is to suggest that the situation is without risk. On the contrary, a real estate collapse in China could turn the recent inflationary concerns into deflationary issues, neither of which would be good for the economy or Chinese financial markets. Even if the PBC can manage the monetary and inflationary complexities of a real estate collapse, the destruction of wealth it would bring would also slow the flow of investment spending that is such a part of the Chinese growth story. It is doubtful, given the demographics and the export advantages that China still possesses, that the interruption would turn that economy’s double-digit real growth negative. Still, a substantial slowdown would certainly hurt Chinese and global growth prospects and China’s markets. But for all these significant problems, the nature of China’s situation raises serious doubt about the easy parallels so many have drawn between Chinese real estate and the pains America’s real estate collapse brought its economy.
(c) Lord Abbett
