Earlier this May, China’s central government issued new regulations to impose heavy taxes on real estate deals in an attempt to restrain China’s overheated real estate market. Another document was issued earlier this July to stem the flood of foreign money buying up Chinese real estate. The runaway market in recent years has attracted the attention of the media, business world, and scholars as well. What are the factors behind the continuous rise in prices? How will the overheated market impact China’s financial system?
In a paper published this March titled, “China’s Real Estate Cycle and Financial Stability,” Zhang Xiaojing, research fellow at the Economics Institute, Chinese Academy of Social Sciences, and Sun Tao, research fellow at the Financial Stability Bureau, People’s Bank of China, discuss the reasons behind the market’s explosion and the potential impact on China’s economy.
What Makes Prices So High?
For their paper, the two scholars worked out a complicated metric model to analyze different factors driving up housing prices in China.
The first factor, they note, is the acceleration of urbanization. The historical data shows that from 1988 to 1997, the average annual growth rate of urbanization had been 0.61%, while from 1998 to 2004, the growth rate nearly doubled to 1.2%. “[The data] clearly illustrates that since 1998, the acceleration of urbanization and the rapid growth of urban populations have resulted in huge demands on housing, which in turn facilitated the development of the real estate industry,” says Zhang Xiaojing. “The rising income of Chinese people is certainly another important factor. As more people can afford property, the demand has become real and effective.”
A large amount of foreign investment flowing into China’s real estate industry has added fuel to the flames. According to a survey done by the Financial Market Division of People’s Bank of China in Shanghai, foreign funds accounted for 23.2% of all the money purchasing houses in 2004, compared with 8.3% in 2003. The percentage is still climbing. The authors believe that the flood of foreign investment into China’s real estate business is based on the expectation of further RMB appreciation. “This expectation has driven global idle funds to China’s real estate market and pushed up house prices in an abnormal way, which has had a tremendous adverse impact on the market,” they write.
Limited investment and financing resources as well as the over-enthusiasm of local government authorities for the real estate market also contribute to high prices. Zhang and Sun note that China’s financial market is not well developed, which means the public doesn’t have enough investment resources. “At present, bank deposits account for over 70% of the people’s financial assets,” says Sun. “Therefore, under circumstances where the interest rate is falling, the securities market has gone bust, the foreign exchange market is controlled and the bond market is under-developed, it is simply natural to choose real estate as the way to invest.”
In addition, they say, the local authorities have played a critical role in housing price increases, because they happily embrace the real estate industry. The current criteria used by the central government to evaluate the achievements of local authorities are GDP and annual fiscal income. As long as the provincial GDP achieved rapid growth and annual fiscal income ranked high during his or her three-year term, a local official’s achievements would be recognized by the central government.
Furthermore, local authorities solely own the right to land requisition and leasehold. According to the Rural Land Requisition Law in China, if a piece of land contracted by a farmer is under requisition as urban land, compensation is based on the original annual income derived from the land. Since agricultural products are priced extremely low, a farmer would receive very mean compensation. Once the local authorities own the land, they may sell it to the highest bidder. Because of this loophole in the system, a large-scale “land enclosure movement” was launched in various provinces and cities in China.
“The compensation to the farmers only costs tens of thousands of RMB, while developers would pay tens of millions for the land,” the authors write. “The difference becomes the fiscal income of the local authorities. Moreover, once construction starts, every stage contributes to GDP growth. Consequently, low cost requisition and high price transfer has become a shortcut for many local authorities to improve achievements and to increase fiscal income. They also deliberately push up the land price in order to gain more fiscal income; therefore, the house price rises in proportion.”
Risks to the Banking System
Zhang and Sun also analyzed the impact of rising house prices on China’s financial system. In their view, the financial system is dominated by the banks, which would be the main channel for real estate financing. “At present, commercial banks carry almost all the burden of real estate financing. Funds that are needed at different stages — e.g., development loans, operation loans and mortgage loans — are mainly provided by the banks. The increased market risk will be easily transformed into credit risk, which will affect the stability of the financial system.”
It is the large quantity of Chinese home buyers who are bearing the brunt of skyrocketing prices. More consumers are obliged to purchase excessively priced houses on loans. Risks increase when the amount of mortgage loans keeps growing. The authors indicate that the risk is reflected by how much of consumers’ disposable income can be used to make their monthly home payment. “Once a home buyer’s income status changes, and he or she can no longer pay off the loan, there will be bad debt.”
However, in the case of personal mortgage loans, if bad debt happens, the bank can sell the mortgaged house by auction to control the risk. The bigger risk, the authors note, lies in real estate loans provided to developers.
Because local authorities deliberately raise land prices, real estate developers can find themselves in serious shortage of funds. According to the researchers, in recent years the average assets-to-debt ratio of Beijing real estate development companies has been 81.2%, while the figure for the 20 largest developers nation-wide is even higher. As a result, developers have to borrow heavily from banks. Ironically, these loans are all guaranteed by the local governments. It is estimated that over 80% of long-term development loans are related to government guarantees. “Some of these guarantees are tangible, e.g., a guarantee letter issued by the general office of the local government. Others are intangible, e.g., some local officials give a verbal guarantee saying they would be responsible,” they write. “But in reality, one office term lasts just three years. When the construction is over, the officials may have already left office. If the buildings are unmarketable due to overpricing or other reasons, no one will take the responsibility. The false government guarantees are very likely to result in bad debt and further undermine the whole financial system.”
They also emphasize that because all real-estate-related loans are mid- to long-term loans, while the deposits are mostly short-term, the banking system will face more severe risk and could have a financial crisis if bad debt occurs.
Suggestions for the Government
At the end of their paper, the scholars conclude, “The potential risk of the rising house prices will first and foremost be seen as bank credit risk.” In order to effectively minimize the risk and maintain financial stability, the scholars make a few suggestions for policy makers. First, the banking industry must be more cautious when granting loans; second, the governance structure within the banks should be more complete.
They also suggest that it is critical to control the investment impulse of local authorities, which are a major driving force of the overheated market. This would require the central government to alter their focus on local GDP growth and official achievements, as well as to reform the unreasonable land leasehold system.
The Chinese government also needs to effectively control foreign investment into the real estate market from speculation by capital control and regulation, they say. “In order to discourage speculation, 137 IMF member states out of 187 regulate and control foreign investment in real estate,” explain the authors. “China should take stronger measures to dampen speculation.”
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