The Myth of the Chinese Real Estate Bubble
Jason Hsu, Ph.D.
Chairman & CIO
The West is fond of pointing out China’s astronomical real estate prices. When measured as a multiple of annual household income, China is head-and-shoulders above other countries. Many of China’s cities are now less affordable to its inhabitants than Hong Kong, London, New York or San Francisco.
Low affordability is often used to define a real estate bubble. After all, if no one can afford to buy, there is no one to sell to. Prices must eventually fall, or so the saying goes. But even if a crash isn’t in the near future—a topic I’ll explore below—low affordability is still a reasonable measure of social pain. Unaffordable housing is often cited as the number 1 reason for adult unhappiness.
Beijing is aware of the western “bubble” narrative. But in this article, I will explore Beijing’s different take on its own high real estate prices. I hope to provide context for those investors who are seeking to understand Beijing’s current real estate policy.
Investors should start by recognizing that Beijing has learned from the past. It saw Japan’s real estate crash derail the country’s long-term growth, and it continues to observe Hong Kong’s ever-escalating housing crisis. To claim Beijing is paranoid about avoiding these two outcomes in Chinese cities is an understatement. In fact, many of China’s top economists have devoted their entire careers to researching these two topics alone. Let me address them in order.
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Avoiding Housing Crashes: Deleveraging the Real Estate Sector
The 90’s Japanese housing crash and the 2007 Global Financial Crisis were both driven by real estate speculation and skyrocketing leverage. The collapse of unproductive real estate investments financed by margin ended with disorderly de-leveraging, unraveling the financial institutions who extended too much credit to unqualified speculators. Beijing’s fixation on leverage in the real estate sector is driven by its desire to avoid a comparable crash that could ravage its own financial institutions, debilitating the entire economy for years or, as in the case of Japan, decades.
For better or worse, Beijing has significantly more policy tools available than either Japan or the United States. To discourage real estate credit, most governments are limited to raising interest rates and bank reserve requirements. The effectiveness of these tools is suspect for several reasons. Primary among these is that higher interest rates and reduced credit impact everyone, not just real estate investors. Draconian tightening to deleverage the real estate sector is difficult to implement when it impacts the entire economy.
But in China, the regulator can pursue a simpler and more targeted approach: it can simply forbid financial institutions from lending to real estate developers with high leverage, and it can impose higher mortgage rates and lower loan-to-values on second homes. Beijing’s willingness to intervene directly in markets provides for precision policy-making.
For trained economists, the issue has never been the effectiveness of Beijing’s targeted real estate policy. The issue has and always will be Beijing’s willingness to enact targeted policy at all—it smells too much like central planning. But as a practical matter, China’s targeted interventions are effective. The current trajectory suggests an orderly deleveraging of the real estate sector in China is underway. China Evergrande is a public demonstration of Beijing’s policy-making and crisis containment deftness.
Preserving Housing Affordability: The Real Elephant in the Room
For Beijing, the issue of housing affordability strikes much closer to home – and it is a much more difficult problem to address. While housing affordability, such as the issues facing Hong Kong, is of little concern to global investors, it is of grave concern to Beijing.
Housing affordability is among the most visible social problems plaguing Asia. It consistently ranks as the number 1 factor in Asia’s abysmal misery index score. The Chinese government can solve affordability by either driving up income or reducing home prices. Although the first is a more desirable path, it is unfortunately impossible to engineer on short order – even for Beijing. Which means the only other viable path is to reduce homes prices.
But for obvious reasons, reducing home prices is exceedingly unpopular with existing home-owners and lenders. A workable approach, which could take a decade to bear fruit, requires Beijing to work actively to contain property prices while inflation and economic growth raise household income. But a more promising and immediately impactful alternative is a Singapore-like government housing program, where low-cost rentals are built and operated by the state for lower income earners.
When a Bubble is Not a Bubble: Homes and Collectibles
It is useful here to take a slight detour to understand China’s high real estate prices. Why do home buyers insist on buying when renting is more rational? Readers should be reminded that despite multiple liquidity-induced property crashes in Asia, home prices in Japan, Hong Kong, Korea and Taiwan have mostly rebounded quickly to new highs. Even immediately after these crashes, prices remained largely out-of-reach for many buyers in these markets.
In much of Asia, risk-free bank deposits yield significantly more than rental yield. But almost any measure, buying is a poor investment and reflects irrational consumption. Unless, of course, you assume long-run real estate prices in China won’t be tied to its underlying cash flow fundamentals. That is, home prices will keep rising even as rent stagnates. This is indeed the prevailing expectation in China.
Although you might label home prices in China a bubble because they deviate from cash flow fundamentals, you could also see Chinese apartments as luxury collectibles—like vintage Ferraris or a Jackson Pollock. Home ownership in China, like art ownership in the West, is a powerful display of social status precisely because of the high cost of acquisition. And in practice, both luxury collectibles, in the West, and real property, in Asia, have provided phenomenal storage of value for their owners despite having de minimus cash yield. Indeed, luxury collectibles are often seen as a more desirable storage of value than legal tender, despite the utter lack of cash flow fundamentals.
It’s said that in China, a person’s ability to find a life partner is predicated largely, if not entirely, on their ownership of an apartment in a prime district—not only is it an indication of income and wealth, but also an indication of “delayed gratification,” which is regarded as one of the highest virtues. While Renminbi can be spent to buy your date a fancy dinner, owning an apartment in Shanghai gets that someone to go to dinner with you in the first place. Thus, Chinese young people borrowing paper currency to finance the ultimate storage of value—one that validates your worth and character—isn’t necessarily irrational speculation as the West would like to view it.
Of course, the million-dollar question is, “How do we deflate unaffordable home prices in China?” Once you understand what is driving much of the inflated home prices, it feels like the solution could be as hard as deflating the price for gold, art, vintage cars, sports memorabilia, and dare we say—Bitcoin! If it were easy, most Asian governments would have already fixed their runaway home prices.
The Bigger and Deeper Issue
Housing supply has increased meaningfully in China in the past five years, but new supply has done little to contain prices. While new home prices are capped by the government, second-hand apartments begin trading at record highs and at a meaningful premium to new apartments. Consumers’ willingness to pay any price really does suggest a pricing framework that is unlike consumption goods and more like collectibles. Although Chinese homes present owners with little downside risk, they do tie up wealth and income. Given current housing affordability in China, a young person must literally forgo consumption for decades to own the ultimate Chinese hard asset—an apartment. What this creates is excessive saving (held in properties) and insufficient consumption.
Today, young adults in China are consigned to a life of long hours in service of becoming a homeowner. The dark shadow of a down payment and mortgage crowds out personal time and leisure spending and are a primary cause for adults in Asia to feel that they are unable to build a family. The high misery index in China isn’t an artificial construct; it measures pain very accurately.
Beijing is rightly concerned with the social pain caused by this issue. However, there is also an economic problem to be addressed: although Chinese workers have worked and saved excessively, much of their capital has been mis-directed. A significant percentage of the country’s investments have been sunk into the real estate sector. Households must save to purchase property; their bank savings become loans to real estate developers; and their down payments on new homes become operating capital for new construction. In China, too little of a household’s cash flow is being directed toward consumption or investment in other industries.
Beijing understands that the excessive Chinese investment in real estate would be more productive if directed elsewhere. Why? Because in industries other than real estate, greater investment leads to productivity gain. Take for example, a computer manufacturer produces 1-million laptops today and sell them for $1,000 apiece; next year, with investment in better technology, they will be able to produce 1.5-million higher performance laptops and sell them for the same price. The increase in the total value of the goods produced is driven by increased outputs and improvement in quality-to-price ratio. Consumers receive substantial benefit as a result as they are able to buy more and often for less.
This does not happen in the real estate sector. In any given Chinese city, the increase in production value for property year-over-year comes predominantly from escalating prices rather than increase in new units built. As a result, much of the value of a real estate investment accrues to the producer and little is shared with the consumer. Year after year, consumers are getting less for what they pay – not more.
Again, Beijing understands all this. It knows disproportionate investment in real estate creates value for local bureaucracies and developers while starving other industries of much-needed capital and consumers. It recognizes the heavy investment in real estate is untenable in the long-run. And it is working sensibly to diversify household wealth from property and bank deposits (the latter of which is often invested back into real estate projects).
Beijing’s recent policies are precisely geared toward this goal. Yes, it is indeed a very complex social engineering experiment. It is also the kind of government planning and market intervention that gives the West anxiety. However, it is also clear – given decades of data from across Asia – that the problem is one that the free market is more likely to worsen rather than fix.
Having spent the past several months in China, I see the pain that housing affordability has caused people across the country. I have also seen the economic potential that will be unlocked as this problem is solved. So I say, “Good luck, Beijing!” I hope you have the right solution, even if I don’t know for sure that you do. But I do feel confident you’re at least solving for the right problem.
This article was first published to LinkedIn:
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