To Everything There Is a Season: China, Economic Restructuring and the Real Estate Bubble; By Anirud
C3S Paper No. 0123/ 2015
Tales of the Chinese real- estate sector and the housing sector in specific are legion. What can be discerned though, are specific figures (such as the fact that close to 75% of household assets in China are housing assets[i]) and numbers that stand out in this context and tell us of an economy that is structured altogether differently from any the world has seen. Dean Guthrie of the George Washington School of Business, in a talk on the Lessons that can be learnt from the market driven economy of China[ii], speaks of an interesting tale which details Mr. Xiaoping agenda when he was in the United States, to sign the normalization agreement with President Johnson (1979). There were three cities in specific on his list: Atlanta, Seattle and Houston. Specifically, Dean Guthrie alludes to Coca- Cola, Boeing and NASA. In his opinion, this translates to how to build an economy: A consumer base, high- class manufacturing infrastructure and finally an aeronautics program. China has a world- class manufacturing/ industrial sector and have hit their stride when it comes to high- technology too with an active space program and with military modernization being well on its way to catching up with the United States. This is the story of the third element and how it might be achieved in the decade to come, and of China’s meteoric rise and its possible fall, as we know it today, and it began in 1979.
The Chinese economy is built on the pillars of socialism. It is a command economy that is dominated by the free market. While innovation and entrepreneurship are staples of the economy today, it was not always like that. State Owned Banks (SOB’s) and State Owned Enterprises (SOE’s) were the mainstay of the economy for the longest time and in many ways, still are. The People’s Bank of China (PBC) is the equivalent of the Federal Reserves (The United States) and the Reserve Bank of India (India), and has jurisdiction over setting monetary and fiscal policy. Though in actuality, the PBC is more powerful than the RBI and the Fed, with the second largest reserves of assets.[iii] It sets both interest rates on deposits and lending rates for the commercial banks that have been allowed to spring up since liberalization. Deposit rates are higher than the international rates, the reason why many people move their money from the United States to China, even though there are restrictions on the amount of money foreign nationals can bunk in China, while lending rates have infamously been lower than the international norm and this has led to many economists to accuse China of protectionism and of having a destabilizing influence on the state of the world economy. Even though, at 6%, some might argue that it is high. Just not as high as others might like it to be. Low borrowing rates and low return on fixed deposits in Banks are two economic forces that have contributed to the current state of the economy, as we shall see. It is important to understand capital control regulations as they present themselves in the case of China before we can make an analytical assessment.
Interest Rates of the Years 1990 – 2012
The Real Estate Sector
Real estate is the driver of the Chinese economy, with construction projects and project building contributes to an inordinate share of the Gross Domestic Product (GDP). Official Chinese policy until 1988 and in some cases until the early 90’s was that housing could not be owned and that the state would provide individuals with dwelling at an extremely reasonable and subsidized rate.[iv] This meant that those who did go to college and graduate were expected to join one of the SOE’s. The 2011 housing policy also meant that domestic property developers started feeling the pinch, with many going into debt. This also led to scores of sites being abandoned. Some with equipment still within their premises, looking like a dystopian future. These abandoned construction sites dot the landscape. One reason for this is because of the sheer enormity of the situation that property developers have created for themselves. With only a handful of homes being sold at a staggering rate, dropping the price in the future is not an option for many developers because those who have already purchased homes will then demand a discount or rebate of some kind. This is precisely what is holding the prices where they are, and they are proving to be quite sticky, with drops in prices only being marginal at best. Shown below is a chart compiled from data provided by the National Bureau of Statistics (NBS) which details the price increase, stagnation and decreases and as can be seen, prices have tended to increase year upon year, with a reported average growth of a staggering 17% in the year 2010.
Price Indices of 70 Cities in China
A caveat to the story of the real estate sector is that of federalism and the decentralized nature of the Chinese polity. Often seen as a monolith of the communist, centrally controlled state, the Chinese administration actually is more divergent in terms of power than people usually give it credit for. The argument of competition as propounded by any center of right economist applies here in a rather strange way. For example, even though growth rates are decided at the center, the regional administration of districts have a great amount of autonomy when it comes to deciding how exactly to reach those targets, with districts being incentivized to perform. The problem with this system is that district administrators are not incentivized to give due consideration to the longevity of their plans. This means that they rely on the sale of local land to fund their projects. Without recourse to any other form of capital, their reliance on land sales has spurred on the rate at which developers get their hands on property. Hurting for funds and having to finance their own welfare programs, which includes health and education and since there it makes more sense to target high- income luxury apartments, the land rights agreements are sold to higher end developers, this has added to the glut of luxury homes and office spaces, even in tier- 2 and tier- 3 cities. Even though local authorities have rights of re- possession, loopholes in the law ensure that legally, developers can stall for an indefinite amount of time after they purchase the land.[v]
Land Sales Figures
Cultural Concerns: Savings as a Function of Income
In many ways the amount of influence the Communist Party of China (CPC) has over the economy might be both a boon and a curse, with one of the unsaid fears being that if economic and living conditions are not, at the least maintained and at most improved, the CPC could have a really messy situation on their hands. As P. Chidambaram (former Union Finance Minister under the UPA government) famously said when referring to the decimation of his party in the Lok Sabha 2014 elections: “If we’d got the economy on the right track, nothing else would have mattered in 2014. It wasn’t corruption or scams, it was the economy which destroyed us in the general elections.”[vi] Growth in GDP has slowed down from double digit figures and is estimated to be around 7% (in real terms) in 2015. What this means for China is that the year 2014 probably heralded the beginning of growing pains for the world’s fastest growing economy. Another way to examine the debate on the relative health of the Chinese economy is to view it as economic restructuring. From being a major investment based economy, China is trying to alter this trend and rely more on domestic consumption to be the driver of its GDP. The Chinese have always been big- savers, and this might be the one cultural trait that might save them in the years to come. While some feel like the property and real- estate bubble died down in 2011, or thereabouts, the sector accounts for almost 1/5th of GDP, year- to- year, within fixed capital investment in China just above 40% of GDP.[vii] It has all the characteristics of a bubble, and given the nature of both the Chinese society and the economy, it could end a lot worse than the sub- prime mortgage crisis. As it unraveled in the United States, the sub- prime crisis resulted in an enormous number of defaults on loans, upon which banks gobbled up real- estate holding and housing. These houses were then given away at a pittance to individuals who also took loans to buy them, on incredibly low rates and paying almost nothing down for them. China on the other hand does not deal in the same frivolous manner with housing. While low interest rates are a similarity that the two scenarios share, the comparisons end there. The PBC kept lines of credit open for low- interest borrowing and this has resulted in a debt to GDP ratio of 3:1. Most of the debt is household debt and this has added to the fragility of the situation.
Down- payments for houses are anywhere between 30- 40% of the property value. This might be good news for the economy but it is quite terrible news for millions of lower middle- class individuals who more often than not spend up to 20 years of savings, and sometimes reach into the reserves of their parents to afford houses. Owning a house in China has attained a status in China that is tough to comprehend, even though owning a house in most parts of the world is almost like a rite of passage to adult- hood and self- sufficiency.Xiaoping’s economic liberalization and consequently the ability of a Chinese graduate to be able to join a private firm and own his own home, affected this. Curiously enough,this is a curse of sorts to the urban male graduate in China where the marriage market cannot be penetrated without a stable income and more importantly, without a home. China has indeed come a long way from those days of relative confusion and stability.[viii]
Chinese Development by Province
Capital Flow Concerns: A Narrow Portfolio
As mentioned above, there is a cultural explanation for the amount of money that is routed to the real- estate and property market year after year, but there is also an economical explanation for it. Most Chinese cannot make individual forays into external markets, and only the cream of the crop can invest outside the country. With the linking of the Honk Kong stock exchange with the main-land Shanghai stock exchange, this is expected to change. The specific problem is that capital deepening can only be effective at increasing the productivity of Chinese laborers and enriching their financial wealth for a specific amount of time. Eventually, capital deepening will give one diminishing returns, and this is when diversification is necessary. Even at an individual level, with the stock market being seen as too unstable for investment and fixed deposits not being viewed favorably, there is only one direction that the lower and upper middle- classes see as a viable investment and that is in real- estate.
With so much wealth that is locked into a middle- class that is sizeable enough to count as a surreal country in its own right, the Chinese administration needs to know that it is becoming an increasing liability to have such high- saving, hard- working individuals. The burgeoning middle class is one of the prime targets of real- estate builders and property developers, with individual families owning up to 5- 6 condos. None of which, save for maybe two, they will ever live in. As of July 2014, house prices had fallen about 8%, but the vast majority of homes seem out of the grasp of a significant portion of the lower middle class and the poorer classes. The proliferation of high- rise condos and prime office- property began in Tier- 1 cities and has now spread to both Tier- 2 and Tier- 3 cities. Urban myths abound on how China puts up a new city, literally from nothing, in the span of 2 years. Portfolio diversification which is a sign of financial maturity and health needs to be instituted in a way that will not rock the boat, and given the Chinese record with reform, it seems highly possible that the government will find its way out of this financial hole.
The City of Ordos in Mongolia and its Desolate Streets
The Reform Agenda
The PBC instituted reforms, includes instructing commercial banks to provide liquidity to first- home buyers. This is part of the larger plan of China to have greater mobility from rural to urban areas, which is in turn part of the bigger gamut of the Chinese Dream, as elucidated by Xi. The ambitious urbanization campaign in 2013 has been estimated to have set the government back about $ 6 Trillion. 460 Million People are said to have joined urban centers. This has also led to restrictions on home buying, imposed by the government. Beijing is an example where there are restrictions on buying homes if one is not a resident of the city, and even a cap on the number of houses that one can purchase. This restriction coupled by the outdated hukou system means that there are going to be an increasing number of condo’s that are going to be on the market. The hukou system is akin to an internal passport system, which restricts where one can own real- estate. Individuals are required by this law of documentation to more often than not only purchase either land or real- estate in the district/ prescient that they are registered in. The migration of labor from rural to urban areas is usually a good barometer to measure the economic health of China, in real terms, but the restrictions placed by the hukou system mean that they cannot own property or houses, but can only rent them out, which by itself is a financial far- cry.
During the 2008 crisis, China was said to be the only country that was contributing to growth in world GDP, and there is some truth in the statement that China, with capital control and a rather aggressive monetary easing campaign managed to keep the economy to sink too deep in the morasses of sub- prime mortgage[ix], but anecdotal evidence suggests that all was not rosy. Millions of migrant workers are said to have moved from urban centers back to their home constituencies where they hoped to find alternative employment. This is a reason why economists are still not calling the Chinese real estate problem a bubble that is about to burst, because the consequences of it are not apparent yet. Another reason, because of which many feel that the bubble died in 2011, is because of the slowing down of the Chinese economy. This they say, is because of the fact that the Chinese government deflated the sector, and the slowing down is a consequence of a maturating of the economy and not an indicator of a coming crash.2011 was when China instituted what has been called the “One- House Policy”. Reminiscent of their policy on population, the one- house policy set caps on the number of houses that could be purchased by an individual. This meant that the one avenue of investment that many individuals opted for, even though it was unhealthy, was again cut off. This has led to the flight of capital from mainland China overseas. One destination for this capital is Australia and another is London.[x]
The official policy that was adopted by the Chinese administration as a result of the growingly unstable real- estate market was fiscal easing and dropping rates at which loans could be taken. This, they hoped would result in capital being made available or investment. As mentioned before, this was a short- term fix and resulted in a certain exacerbation of the problem itself. Another policy that has been suggested is the conversion of this glut of expensive houses into what is called ‘social housing’. This would mean that the administration would have to commandeer the development projects so that they might essentially kill two birds with one stone. Though this does seem like the perfect solution, there are layers to it. Even though this might solve the problem of extra inventory and migrant housing, this would cause the burgeoning middle class a significant amount of fiscal pain. As mentioned before, because the down- payment is a significant percentage of the property value, this means that it might be tough to ameliorate this loss across the board, unless the government decides to compensate them in full, which they will find it tough to reconcile themselves with since it is a pretty penny.
The Chinese always think long- term. There are a scant number of instances where the Chinese have done anything outrageous and completely out of line and have lost control of the situation. It is the exemplar of the Buddhist middle path. Moderation. Additionally, China has always shown that it has always had both the administrative and intellectual capacity to overcome adversity, there is something to be said for countries which are connected with the Chinese economy, which is essentially every country in the world, to develop contingency plans for the doomsday scenario, which is: a consumption- led meltdown.[xi] Another relevant view on this manner, as implied by a VoxCEPR paper is that the severe expansion and over- supply in the housing sector might not by itself be a crisis but could certainly exacerbate a financial crisis if it did occur.[xii]This is because of the convergence of investment in the real- estate sector and this means that there are strains that are being placed on the Chinese economies. With a number of important sectors of raw materials being linked to it (as mentioned later), the real estate sector is quite central to the Chinese economy and this can be called the ‘potential’ effects of a crisis and not the direct effects of a real- estate led crisis. What this would mean is that import- dominated economies that depend on China might have to shift their focus elsewhere to meet their quotas. Oil and crude demand would drop significantly, which would depress their prices even further. Chinese exports and more importantly, domestic consumption would be fall. According to Ahuja and Myrvoda, who authored an IMF paper, even a 1% fall in real estate investment could mean up to a loss of 0.1% in GDP, and that’s just in the first year. Also according to the paper, the spillover effect from a meltdown could affect the G20 economies for 4-5 quarters.[xiii] Industries, in specific that would be affected are cement, heavy metals and agricultural products, since China is a reason for a large part of production, even if not directly. What this means for India is two- fold. On the one hand a slower China could present India with significant economic opportunities. This would require an aggressive economy that could harness both manpower and intellectual property to ensure that the import needs of countries are met and then when countries are looking to source their needs, that India would be able to step up and claim her share of the global economy. The concern here would be that domestic infrastructure in India is still a worry and quite paradoxically, China is one of the countries that has been identified as a potential investor in infrastructure and industry. The worst- case scenario for India would be if the Chinese meltdown took place and if India remained reactionary, instead of actively creating her own luck. In reality, ceterisparibus, according to the IMF paper, real GDP in the year succeeding the fall could be depressed to the tune of 0.05% and total exports could fall by as much as 1%. A significant problem, which is offloading of goods by Chinese companies in the event of a crash in prices, is not something that India need be very concerned about. As it stands today, a major concern for India could be having to find an alternative trading partner to the tune of 1% of exports and also to ensure that a destabilized China does not put a damper on the effort to improve both infrastructure and industrial production capacity.
A Cautious Future
The belief among economists is that the growth that China has experienced over the past decade and more is not natural and not sustainable. It’s a bit contentious when one begin to describe any kind of economic growth as natural and un- natural, but what needs to be understood is the difference between economic growth that is fuelled by consumption, on the one hand, and investment on the other. The Chinese economy, as must be obvious by now, is fuelled primarily by investment, with consumption accounting for about 35%, which for the record is not altogether low for a developing country.[xiv] Investment is largely supported by the government and SOE’s which have access to easy credit and low rates of interest. It is this that economists refer to when they call it “un- natural” growth. Regardless of that, it must be recognized that given the structural problems that the Chinese economy faces, it might be time for a change. The problem with a forecast in the case of China’s real- estate sector is that the symptoms that either a successful deflation by the government, or the beginning of the melt would display are roughly similar. Prices are falling, but steadily. Homes have not ceased to have some value and this might continue to be the only problem that the real estate sector could face, if both property developers and consumers both can tide over the bad times. On the other hand, a rapid fall could be triggered by a massive dumping of property and homes if investor confidence falls low enough. Though it must be noted here that real- estate prices have risen consistently for a decade in tandem with real wages. Thus, if income can go grow alongside the real- estate sector, this might help buoy the economy from a price crash/ scare. Much is incumbent on how the government will weigh these divergent outcomes. The reasons why the People’s Republic of China (PRC) still exists and has not ceased to exist like the Union are too myriad to explore here, but it must be said that China has been fortuitous in part and has also shown a pragmatic streak that did not exist in the leadership of the Union. Chinese leaders have also shown an openness to the western world in certain contexts. This pragmatism is driven by social stability being of paramount importance to the party leadership. China’s policy of instituting small scale legislative reform and feeling the pulse of the nation has served them well till now.
The game- plan for China, going forward from their 2015 position is uncertain. While it is true that the Chinese economy is backed strongly by the government, it is not certain whether a crisis can be completely averted. If the crisis does come to pass, it could mean domestic unrest. Weaning a country off easy, low- interest money will not be easy. There will have to be reforms that further open up the market, in addition to SOE’s becoming more efficient. The middle- class is one of dreamers. Aspiration plays an important part in the cohesion of said class, and this reiterates the previously mentioned point, that the flow of capital and equity needs to be directed. The view of certain financial experts, such as Anne Stevenson Yang (Co- Founder of JCapital), is that 2015 China is a doomsday scenario.[xv] What seems to be missing from these estimates is the fact that China might not be a monolith in the political sense, but it is a monolith in an ideological sense, which makes expendability an issue. The survivability of China depends on the parts and people that it can leave behind in its pursuit of the Chinese Dream. Xi Jinping might have got overtly attached to the idea of the “Chinese Dream” but he would do well to remember that the term is a reference to the American Dream, and we all know how that ended.
[i] Harry Dent. “Look Out! Is China’s Real Estate Bubble Ready To Burst?” Economy & Markets Daily, February 20th, 2015. http://economyandmarkets.com/markets/foreign-markets/chinas-real-estate-bubble-ready-to-burst-urbanization-domino-effect/
[iii] The People’s Bank of China. http://www.pbc.gov.cn/publish/english/952/index.html accessed on 18th May, 2015
[iv] Zhou Yu. “China’s Urban Housing Reform- With Special Emphasis on Property Ownership. “The Virginia Polytechnic and State University, August 1999. http://scholar.lib.vt.edu/theses/available/etd-072799-023940/unrestricted/major.pdf
[v]Mylène Gaulard. “The Real-Estate Bubble in China” Universidad Nacional Autónoma de México (UNAM), Jun 14th, 2013. http://www.probdes.iiec.unam.mx/en/revistas/v45n178/body/v45n178a3_1.php
[vi] Rajdeep Sardesai. 2014: The Election that Changed the World. Penguin Publishers: New Delhi, 2015
[viii] Johan Nylander. “How The Search For Love Fuels China’s Housing Bubble” Forbes. http://www.forbes.com/sites/jnylander/2015/05/04/how-the-search-for-love-fuels-chinas-housing-bubble/
[ix] Linda Yueh. “China’s Strategy towards the Financial Crisis and Economic Reform” The London School of Economics, 2012. http://www.lse.ac.uk/IDEAS/publications/reports/pdf/SR012/yueh.pdf
[x] Kenneth Rapoza. “China Real Estate Is Unstoppable” Forbes. http://www.forbes.com/sites/kenrapoza/2015/05/04/china-real-estate-is-unstoppable/
[xi] Peter Navarro. “The Chinese Real Estate Market’s ‘Butterfly Effect’” HuffingtonPost, March 13th, 2013. http://www.huffingtonpost.com/peter-navarro-and-greg-autry/china-real-estate_b_2806103.html?ir=India&adsSiteOverride=in
[xiii]Ashvin Ahuja; Alla Myrvoda. “The Spillover Effects of a Downturn in China’s Real Estate Investment” The International Monetary Fund, 2012. http://www.imf.org/external/pubs/ft/wp/2012/wp12266.pdf
[xv] Anne Stevenson- Yang. China: The Emergence Form and Potential Return to Isolation. (Mexico: Cátedra Extraordinaria México-China, 2013). http://dusselpeters.com/CECHIMEX/libroChinaAlone.pdf
(Anirudh Rangarajan is an intern with Chennai Centre for China Studies. As a statutory requirement of his academic course in The Foundation for Liberal and Management Education (Pune), he is required to carry out research in a think tank on identified issues in China under the guidance of the members of C3S. The views expressed in this article however are of the author. He can be reached at firstname.lastname@example.org)