According to data released by China’s National Bureau of Statistics early this month, real estate prices in 70 medium- to large-size cities in China surged 8.2% year-to-year in August, and the trend is still upward. This has become a concern, not only for consumers, but also for the government. On August 13, the State Council issued its “Opinions on Solving the Housing Difficulty of Urban Low-income Families,” in which it is explicitly stipulated that local governments should speed up the establishment of a low-rent housing system to address the housing needs of this segment of the population.


What are the driving forces behind China’s property prices? In our August 29 issue, we interviewed Zhang Yongyue, who analyzed the issue from the supply and demand angle. In this issue, China Knowledge at Wharton interviewed Hua Wei, director of Fudan University’s Real Estate Research Center in Shanghai, for his views on China’s macro economic environment. An edited version of the conversation follows.

China Knowledge at Wharton: As a researcher in both real estate and finance, what do you think is driving China’s soaring real estate market?


Hua Wei: I think China’s real estate prices are entering a period [of upward growth]. The fundamental reasons for such change, however, are not found in the real estate industry itself, but outside. To get to the bottom of this, we cannot simply base our analysis on “supply and demand” [but must look instead at] the fundamental cause.


Three things have contributed to the current situation: the macro economy, industry factors and regional factors.


China Knowledge at Wharton: Can you start with the macro economy?


Hua Wei: In 1998, China’s economy started to experience a surplus of products. As of this year, it has entered a period of surpluses in both goods and capital.


Since 1998, the Chinese government has relied on expanding domestic investment to boost the economy, but domestic consumption did not grow along with it. In other words, domestic consumption grew more slowly than investment. So since 1998, a surplus of various goods has shown up in [such products as] refrigerators and color TVs. Today, there is a “double surplus” of China’s “competitive edge” products — namely those that have low labor costs — internationally and internally.


Second, in 1998, China’s foreign reserve was small and capital very scarce, so we tried to attract more overseas capital and encouraged civilians to save more. These savings could then be converted into investment. But now we have excess liquidity. On the one hand, China’s foreign reserve has topped US$1.5 trillion; on the other hand, there is abundant yuan in mainland China. The central bank has taken a series of cooling measures but has not shaken off excess liquidity in the market.


During such a massive transformation, my view is that China did experience some changes in its financial and investment systems as well as the economy’s growth pattern. But the changes were not great enough to catch up to shifts in the environment at large.


China Knowledge at Wharton: What are some of these shifts?


Hua Wei: Excessive domestic investment each year has bolstered production capacity. Over 10 years, it has evolved into a surplus of consumer goods. Under this scenario, to seek further development, enterprises have had to move their focus to exporting, which has resulted in abundant external demand and inadequate internal demand.


Meanwhile, China faces two challenges: One is the urban/rural dual structure and the other is the lack of an all-round social security system for rural residents. The so-called competitive advantage of the Chinese economy is, to a great extent, reflected in the exploitation of the environment and a cost structure that doesn’t provide social insurance for the lower income, less productive labor force.


In addition, the Chinese government’s fiscal and tax reforms were lagging behind. More than 80% of the fiscal revenues of various levels of government is from the turnover tax, 70% of which is made up of the value-added tax. Because this policy encourages enterprises to expand their scale and increase operating income for tax payment, it is a potential hazard for the rapidly-growing large scale Chinese economy. And I think the Chinese government’s reluctance to significantly appreciate the yuan can be mostly ascribed to these two factors.


China Knowledge at Wharton: Regarding appreciation of the yuan, what policy do you think the Chinese government will adopt?


Hua Wei: I believe a gradual appreciation of the yuan will be a medium- and long-term process. As I mentioned, China has a dual urban/rural structure. If the yuan appreciates greatly against the U.S. dollar, the market prices of agricultural products in yuan under a WTO agreement will drop dramatically. Furthermore, China’s agriculture basically has no subsidies, and it has no scale either. What’s worse, as I have noted, is that China’s peasants have no direct social insurance. Therefore, once the old-time model has been displaced by foreign agricultural products, it will eventually evolve into a social conflict. The government will be responsible for any losses.


The money for the government to pay for these losses is again from fiscal revenues, of which the major part (the value-added tax) depends significantly on the output value of the heavy chemical industry. Once the yuan rises, especially against the U.S. dollar, China’s national industry, including the heavy chemical sector, will suffer serious impairment.


Therefore, yuan appreciation will result in two things: Fiscal revenues will not necessarily increase; and the self-cyclic model of China’s small-scale agriculture will be destroyed, while peasants continue to lack social security. The reforms or transformation needed to solve these two issues cannot be achieved in a short period. This implies that a gradual appreciation of the yuan is the optimal option for China’s government.


China Knowledge at Wharton: How does a gradual appreciation of the yuan relate to real estate prices?


Hua Wei: They are very closely related.


Our fiscal tax policy, the urban/rural dual structure and the government have determined that the yuan will appreciate in a gradual manner. The steadily growing Chinese economy and the fast swelling GDP, if calculated in dollars, will attract international capital, represented by the liquidity of the U.S. dollar, ready to make long-term strategic investments in China.


To keep the yuan exchange rate from increasing too much, the central bank has to issue a lot of RMB. So you can see in the past 10 years that the M2 currency on average has basically outpaced GDP growth of 10%. Currency supplied to the whole country by the central bank is becoming increasingly abundant compared with goods and services.


In such a context, the central bank is continuously creating excess liquidity. On the other hand, China’s banks have mainly lived on the interest spread between deposits and loans. The government’s macro policies mainly control loan credit. Therefore, liquidity growth each year has surpassed bank deposit growth, and the gap is expected to expand.


China Knowledge at Wharton: So your conclusion is…

Hua Wei: Capital surplus is an aggregate surplus, but it’s not allocated evenly to all industries. We can divide industries into production and assets. Within China’s production industry, the defense and military sectors are not open, while petrochemical and energy are monopolies. The remaining sectors are fully competitive markets with shrinking ROIs. On the other hand, capital aims to seek returns and control risk, so investors are not willing to enter the production field. Many owners of small and medium enterprises have withdrawn from the over-competitive businesses which they used to be engaged in.


The key targets of investment are in the assets category, namely bonds, stocks and real estate. Consequently, we have seen a surge of real estate prices in Chinese cities over the past five years. Despite the various austerity measures adopted by the government, the relatively insufficient supplies and over abundant capital in the assets category have remained unchanged.


The large amount of capital in the hands of the people that cannot be put into the production industry or saved in the banks has boosted the demand for assets. For example, the Zhejiang property speculator group (mainly made of Wenzhou people), the Guangzhou property speculator group and Shanxi coal mine owners are all rushing to buy real estate. The surplus capital at home and abroad is swarming into China’s asset markets to share the gains from China’s high growth, both now and in the future.


China Knowledge at Wharton: Why is international capital going after Chinese real estate?


Hua Wei: Because the American economy grows very slowly and the yuan has a good outlook for appreciation against the U.S. dollar. The Chinese economy is growing fast each year. From investments in profitable real estate properties in China, such as office buildings, commercial shops and hotels, investors automatically get earnings every year. Profitable properties in the non-residential category attract a large number of overseas institutional investors. Their exit does not require a transfer of title. Instead, they could exit in the secondary market in Hong Kong, Singapore, London or New York in the form of packaged equities. No title transfer is involved at all. In fact, given the appreciation of the yuan against the U.S. dollar and its internal depreciation, the real appreciation of the yuan is much greater than the nominal and it has magnified the attraction of the Chinese market to the U.S. dollar.


China Knowledge at Wharton: What is your opinion of China’s internal demand for real estate?


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