China’s Property Bubble: Can It Be Deflated Safely, or Will It Burst?

The collapse in the property values in the United States and many European countries, which helped lead to so much financial and economic damage, could be repeated in China, according to professors from Wharton and the Guanghua School of Management at Peking University.

In a joint symposium held at the Peking University campus in Bejing on March 10 and organized by both schools, finance professor Xinzhong Xu of Guanghua assessed property values in China and concluded that China may well be inflating a real estate bubble. Wharton real estate professor Susan M. Wachter also said she saw the warning signs of a bubble, but suggested that China may be taking steps to prevent a major disruption.

China's Property Problem

While the United States undergoes the most severe contractions in housing prices since the Great Depression, the housing market in China, with prices soaring up, appears to be the mirror image of the U.S. According to many observers, China may be on a path towards the kind of boom-bust housing market that has plagued the U.S. One measure of the run-up in house prices in China: Between January and August of last year, house prices jumped by 70% in Beijing and 47% in Shanghai.

Prices were climbing swiftly in China's housing market despite a brief slowdown in country's economy over the last year. "Last year, China suffered heavily as in other countries," said Xu. However, "two industries still did very well indeed — one is online gaming, and the other is the property market."

Today, Xu said, house prices in Beijing and Shanghai "are comparable to London and New York. If you compare property prices in Manhattan with those within Beijing's second ring road, they are only about 3% different." Given that GDP per capita in China is far below that of the U.K. and U.S., this makes housing unaffordable for most Chinese. The average household income to average mortgage ratio far exceeds 100% for the country's four big cities — 143 in Beijing, 151 in Shanghai, 111 in Shenzhen and 167 in Hangzhou. Of the top ten biggest cities, "the only place in which people can probably still afford to buy is in Chongqing [of Central China Sichuan Province], where household income to mortgage ratio is 48%," said Xu.

What Is Behind Soaring Prices?

Why — and how — are people still scooping up houses in China? "In the U.S., you have three-year mortgages," said Xu. "In China, you have three-generation mortgages: Yourself, your parents and your grandparents. Because of the one-child policy, you have five families covering one mortgage."

What is more, local governments in China have every incentive to drive property markets and push up prices. This is partly a result of 1994 fiscal reforms to raise local government revenues, which were falling despite overall GDP growth. The reforms sought to replace the old, discretion-based system of revenue sharing between central and local government with a rule-based revenue sharing arrangement.

The overall success of the change is debatable since certain discretionary powers remain with central and provincial governments. Nevertheless, "By most estimates, land sales and taxes account for between 40% and 60% of local government revenues" now, said Xu. In 2009, proceeds from land sales alone amounted to RMB 1.5 trillion, some 40% of local government income, and the property sector contributed 2% of all GDP growth. Local government encouragement of high property prices is underpinned by loose monetary policy. According to Xu, loans to property developers and for mortgages accounted for about 40% of all loans last year.

In order to reduce the upward pressure on house prices, Xu recommended localized urbanization. "China's cities become larger every year and we say we want to create international mega cities." The problem this creates is that people only want to live in the mega cities where quality of life is better, and so there is a rush to purchase housing in places like Beijing and Shanghai. Many people living far from these cities still buy a flat in a mega city if they can afford it. This results in many empty "ghost apartments" that people never use. "This trend has a cascade effect in the property markets in second tier cities," Xu said. "As prices go up in Beijing, prices go up in other cities, too."

That is why China needs to revive its small cities and stop promoting mega cities, Xu said.

Another way to increase housing affordability, according to Xu, is to make property taxes progressive so that middle and lower income homeowners will pay less tax. Finally, housing should be provided to the poorest citizens in society, Xu noted. Here, there is a glimmer of hope. The budget approved at the close of the National People's Congress on March 14 included a 10% boost in spending, including more money for low-cost housing.

"As for the future, I am not optimistic," said Xu. There are too many institutional players with an incentive to keep prices high. And in addition to local governments, there are others with vested interests in holding property values up. Banks provide 40% of their loans for the property market, for example, and they would be hurt if property prices fell. Yet, if a bubble is growing, the consequences for banks could be far worse. "So, here are our lessons: Japan in 1989, Hong Kong in 1997, the U.S. in 2007 and China, 2017?"

Echoes of the U.S. in 2007?

Following an epic collapse in property prices in the U.S. since 2007, the U.S. real estate market remains gloomy. Some 2.8 million U.S. homes were repossessed in 2009 and there is a surfeit of bank-owned foreclosed houses going for rock-bottom prices.

Wachter noted that household debt had been growing in the U.S. since 1975. Starting in 2000, the growth in that debt, which far outpaced the range of growth in government or corporate debt, accelerated as a percentage of GDP. At the same time, the house price index was rising and people continued to accumulate more mortgage debt while home ownership rates continued to increase.

So why has this situation gone beyond a rational reversal point and been allowed to become a bubble? Wachter said household debt consisted "not just of mortgage debt, but mortgage debt of specific types. Mortgage debt became far riskier to households than had ever been produced before." Non-prime, unregulated mortgage debt rose quickly, for example. "At the height of the bubble in 2006, non-prime had gone from almost zero to nearly 50% of mortgage originations," Wachter noted. As the bubble emerged in 2004 to 2006, new toxic types of mortgages came onto the market, such as interest-only and pay-option mortgages.

Meanwhile, over the same period the price of risk was dropping, which was a sign of trouble ahead, according to Wachter. "We can now see that over time the risk premium for non-prime mortgage debt securities declined. While we did not know this at the time, we can retrace these numbers after the fact." So, people could more easily get mortgages — lending terms eroded while house prices accelerated. Later, they plummeted by 30% nationally on average, said Wachter.

Compounding these difficulties was what Wachter termed the "pro-cyclical creation of risk" – where regulatory agencies were racing to deregulate both the mortgage market and the mortgage-backed securities market in the recent years. Since many of these securities traded in a way that allowed them to avoid strict market discipline, the process created risky mortgage-backed securities that weren't accurately valued.

U.S. Market Remains in Danger

When the housing market collapse came, it took three forms: "a collapse in housing prices; a collapse in balance sheets of borrowers whose mortgage payments accelerated two or three times beyond their incomes, and a collapse in the banking sector as a whole," Wachter said. That led to "the credit conditions which undermined the entire economy." According to Wachter, there had been a "break in the normal pricing connection between an investment product and a borrower's product.

Today, "foreclosures and under-water mortgages abound, despite the rescue effort." And, according to Wachter, the "unprecedented massive intervention" by the U.S. government saved the world from "the potential great cataclysm of a second great depression."

But a catastrophe avoided doesn't mean trouble averted altogether. Though critical, the stimulus spending has led to U.S. debt — as share of GDP — to soar from 57% in 2001 to 70% in 2008. The mortgage system has been federalized so that nearly all mortgages are provided through Fannie Mae and Freddie Mac, and the banking sector remains challenged. Ultimately, Fannie Mae and Freddie Mac will have to be reformed and the massive federal deficit will have to be tackled.

"It is a waiting game," said Wachter. "We need to restructure, rebuild and rethink our financial architecture."

Will China Follow in the Footprints of the U.S.?

Going forward, the first job is to identify and evaluate an asset bubble before governments can decide how to act. "These are hotly debated issues," said Wachter. In the U.S. a few years ago, [Fed] Chairman Ben Bernanke said that it is not the role of the Federal Reserve to monitor asset bubbles. Things are changing and "there is an evolving consensus that we should attempt to identify bubbles," said Wachter. "Especially as it becomes more clear that taking care of them afterwards involves overwhelming costs to the economy."

The U.S. bubble was not unique and many banking crashes have been triggered by real estate bubbles before, Wachter pointed out. She believes the key cautionary signal is when asset price increases are not correlated with economic fundamentals, but are correlated instead with a decrease in the cost of debt. As the debt premium charge decreases, the asset bubble increases.

"Clearly in China, there are cautionary signs," she warned. "We have lessons to learn from the U.S. Firstly, regulation has a role to play and undermining regulation in a way that allows risk to spread unchecked is unhelpful." She added that when it appears a crisis is brewing, leverage should not be increased. "What we did in the U.S. was allowing loan-to-value ratios to increase as house prices increased. My understanding is that China is going in the opposite direction and that is certainly to be recommended."

Xu agreed that the signs of a bubble are there, even though there is no simple yes or no indicator. He added: "The more difficult question that nobody can answer is: When is this bubble [in China] going to burst?"

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