Will China’s Housing Boom Lead to a Bust?

Despite being the biggest contributor to world growth, China’s economy has been causing worries at home and abroad for the past few years. First, China’s maturing economy experienced decelerated growth. Then, tumbling stock markets sent ripples throughout international markets. Now, China’s housing market is unnerving economists and analysts.

Housing prices skyrocketed between 2015 and 2016 in essentially all cities. In metropolitan areas like Beijing and Shanghai, there was a 25 percent increase in housing prices, and in Shenzhen, some property prices rose as much as 50 percent.

High prices made housing unaffordable for many. In highly developed cities, expensive housing has also resulted in a loss of talent, as many young skilled professionals sought employment in less-expensive cities and foreign countries. In fact, in 2013, the government of Shenzhen reported that Shenzhen companies, which include large technology companies like Tencent, lost 20 percent of their workforce due to expensive housing.

Urbanization has been one of China’s long-term strategies for economic development. Yet, the high living costs of cities have been prohibitive for many, especially low-income workers. Businesses have responded to the shrinking labor pool by raising wages, which has consequently increased labor costs. Higher labor costs have been one of the recent factors that reduced China’s competitiveness in labor-intensive industries.

Additionally, the ballooning housing market will likely have a damaging effect on China’s consumption. Between 2015 and 2016, loose financial regulations enabled people to easily obtain housing loans. As a result, many buyers incurred large amounts of debt. According to China’s central bank, housing loans increased by 2.3 trillion RMB ($335 billion) during the first two quarters of 2016, representing a 109 percent increase over that from the same period in 2015. Additionally, according to the Federal Reserve Bank of St. Louis, housing prices in China have been rising nearly twice as fast as disposable incomes.

Without remarkable wage increases, people must cut the consumption of other goods in order to pay off housing costs. The dramatic increase in housing prices would likely reduce future consumption and obstruct the government’s long-term strategy of making the Chinese economy more consumption-based.

Moreover, the rapid increase in housing prices has enabled many speculators to make significant profits, thus making real estate investment extremely lucrative. This has caused many firms, both private and public, to divert attention from their main business operations to engage in speculation. For example, Hirisun Technology originally expected a net loss of 20 million RMB for the 2016 fiscal year, but after selling an office in central Beijing, made a profit of 1 million RMB. Putian Telecommunication, Tianhe Defense Technology and Guangdong Daily Media are all expecting to become more financially stable by selling some of their real estate holdings.

The increase in housing prices has raised the opportunity cost of operating a business, resulting in a shift towards speculative activities. Although it is still too early to tell, a sustained shift from entrepreneurial and R&D activities towards speculation could reduce innovation and therefore stunt long-run economic growth.

Finally, rising housing prices have spurred widespread concern of a housing bubble for the past couple years. Many households in China save large portions of their wealth in housing and land, more so than any other asset class. Additionally, China’s real estate and construction sectors constituted approximately a fifth of GDP growth last year. Given that housing and land tend to be highly leveraged, a debt bubble can endanger China’s financial system and economy.

Yet, there are conflicting opinions on whether China’s real estate market is actually in a bubble. Researchers at the National Bureau of Economic Research (NBER) found that, in most cities, rising prices are being driven by rising incomes rather than irrational expectations.

“Mortgage loans were protected by down payments commonly in excess of 35 percent,” the NBER authors said. “The housing market is unlikely to trigger an imminent financial crisis in China, even though it may crash with a sudden stop in the Chinese economy.”

However, according to researchers at the Federal Reserve Bank of St. Louis, a bubble is emerging due to high capital returns that are “not sustainable in the long run.”

“Our theory suggests that China’s unprecedented income growth is not the full story behind the housing boom,” Federal Reserve Bank researchers Kaiji Chen and Yi Wen said.

The real and potential consequences of expensive housing naturally lead one to ask: Why are housing prices in China so much higher and what can be done?

Although a handful of factors contributed to rising housing prices, it is ultimately the product of a shortage in supply coupled with a boom in demand.

Weiying Zhang, a prominent Chinese economist, points out that Chinese local governments have a vested interest in raising real estate prices. According to the Shanghai Real Estate Research Institute, revenue from transferring and selling land use rights to private real estate developers accounted for 36.4 percent of the total 2014 revenue of local governments, not including government taxes on real estate development and transaction. Since all natural resources, including land, belong to the national government, local governments stand to earn a substantial profit when they turn the land over to real estate developers.

Thus, local governments experience an increase in their “wealth” when the real estate market is strong, and to that end, they have a strong interest in maintaining high housing prices. Local governments control the real estate market by directing the rate at which undeveloped land is handed over to private real estate developers. At present, this rate is relatively slow, so we observe that the supply of land and hence availability of new houses are very limited when compared to the demand exerted by China’s huge population.

While the supply of houses has grown only modestly, demand has expanded significantly. The high demand for houses is a result of both structural and short-term problems.

While the size of the Chinese middle class and its savings have increased, investment options in mainland China remain rather limited due to the restrictions the Chinese government has imposed on capital flow. The underdeveloped financial services market has thus caused real estate to become a particularly attractive investment to counter domestic inflation, particularly after the stock crashes in 2007 and again in June 2015.

Another short-run source of heightened demand was expansionary monetary policy. In 2015, with the aim of stimulating the real estate market and economy, the government eased restrictions for people applying for housing loans, which has encouraged many people to purchase homes, furthering the rapid rise in housing prices.

It is possible that this unexpected explosion in housing prices resulted in a frenzy among the Chinese middle class, who fear that future housing prices might reach an even more unaffordable level. As evidenced by the chart below, which is based on quarterly surveys from 2014 to 2016 conducted by the Statistics and Analysis Department at the People’s Bank of China, the percentage of respondents planning to purchase real estate hovered around 15 percent, and increased steadily to 20 percent by the end of 2016 Q4. This graph suggests that people’s desire to purchase housing has increased substantially, especially since this was a national survey covering 50 cities of varying sizes across the country.

In order to combat real estate speculation more effectively, the Chinese government should introduce higher taxes on homes that are bought and sold quickly. This would reduce people’s interest in short-run speculation since short-term profit would be substantially reduced. Such a measure would allow real estate profit to return to normal levels, and enable excess capital to flow to other industries. This tax was previously implemented in Hong Kong and was highly effective in curbing speculation.

Already, in an attempt to regulate and stabilize the real estate market, many local governments have introduced administrative eligibility regulations that would permit only local citizens to purchase local real estate. This measure prevents people from other provinces from investing and speculating in a region, and would thus reduce the demand for houses in so-called “first-tier” cities such as Beijing, Shanghai and Shenzhen. However, the regulation has only been effective in terms of temporarily freezing demand, and has not fundamentally reduced the underlying demand for houses.

In the long run, the Chinese government should seek to structurally correct this supply and demand imbalance. The government should further develop the domestic financial services industries to provide citizens with alternative investment options. Additionally, the government should improve transportation between large cities and nearby “satellite cities” in order to reduce the housing demand in large cities. The gradual increase in available housing in satellite cities and the reduction in demand for real estate as an investment would enable the Chinese housing market to restore stability in the long run. Otherwise, high prices may critically damage the development of the Chinese economy in terms of urbanization, consumption and innovation.