The Chinese housing market has taken off dramatically in the past decade, capturing the attention of both domestic and foreign investors. Against a background of macro and real estate-specific policy tightening, however, headlines have pronounced doom and gloom in recent months, as property prices have fallen dramatically in cities such as Shenzhen. Real estate developers’ share prices have plummeted, and investor confidence has crumbled. There has even been talk of market collapse.


Amid the presiding pessimism, however, many analysts argue that, despite the existence of bubbles, China’s housing market fundamentals remain strong. The government is now beginning to address the demand for mass market housing, and this underdeveloped segment of China’s housing market could provide a new driver for the real estate market in the years to come, experts say.


Home Grown Troubles


On the face of it, the facts are alarming. “Anther mania in China comes to a juddering halt,” proclaimed The Economist, a publication not known for sensationalism, in April. The average price of apartments in Shenzhen had fallen by 28% since October 2007, the magazine noted. Shanghai property developers have been forced to offer discounts of up to 10% on purchase prices, and prices in Beijing and the surrounding areas have seen a slowdown in the rate of appreciation. Meanwhile, property developers including Guangdong-based Agile Property saw their valuations drop by as much as two-thirds.


What is more, property price increases are decelerating throughout urban China, according to a June report on China’s construction and real estate industry by Dragonomics, a Beijing-based economics consultancy. In the first quarter, year on year sales of residential property declined for the first time since 2002, falling 4%, the report said. (Housing makes up 8% of physical construction.)


What accounts for the real estate sector’s travails? Experts say that, rather than being part of the fallout from the U.S. subprime crisis, they are largely a domestic phenomenon. Joan Wang, senior manager of research and consultancy at Savills Property Services in Beijing, says she has observed little direct influence from the subprime crisis on Chinese real estate markets to date. In Beijing, her area of responsibility, there have not been many companies that have tried to reduce office or housing space due to subprime losses. “I think for the domestic companies there is really[no effect], but for the foreign investors there might be some,” she says, especially amongst U.S. based investment institutions. She has heard reports of some foreign investment companies trying to dispose of their properties in China, she says, but local companies have been insulated from collateral damage from the subprime crisis, with their performance being determined largely by domestic factors.


What are these domestic factors? According to Dragonomics, slowing land and real estate purchases reflect the tight squeeze that the government has put on the real estate market, beginning last November. To rein in speculation, the central bank instructed Chinese lenders to increase the capital cost and cut the availability of loans for housing investors. Interest rates for mortgage seekers with a second property were raised, and larger down payments were requested. These changes triggered the slowdown in property prices.


Placing events in a wider context, Wang explains that Chinese real estate developers have also encountered difficulties. On the one hand, there is the tighter macroeconomic environment, as Beijing tightens monetary policy in an attempt to bring inflation under control: The central bank has been upping banks’ credit requirements, which set a new record on June 10. On the other are specific measures targeting real estate, among which she emphasises the importance of policies targeting foreign investors. Beginning with “Circular 171” in 2006, the Chinese authorities have introduced measures to curb perceived foreign speculation in real estate. More drastic measures were introduced in mid 2007, including severing foreign-invested real estate enterprises’ access to foreign debt. The government’s actions have been partly attributed to fears that such speculation would drive house prices out of the reach of ordinary buyers.


Given both the difficulty of obtaining foreign funding and the current tight macro conditions, Wang says that property developers are suffering a shortage of capital. “They can’t get enough credit from the local banks and also they can’t get foreign financing,” she says. Indeed, such leading lights of the industry as Pan Shiyi, the chairman of SOHO China (the dominant developer in Beijing’s central business district), have complained that the shortage of credit has been the capital-intensive real estate industry’s biggest problem this year. Other industry leaders have added that rising raw material, labor and land costs place further pressure on their margins.


A tale of Two Types of Cities


Nevertheless, Wang remains an optimist on the future of Chinese real estate. A closer look at the statistics suggests that she may have good reason. Despite the clouds of concern gathered over the real estate industry in cities such as Beijing and Shenzhen, throughout China growth in floor space under construction has grown steadily since early 2007, hitting 27% year-on-year growth in March, according to Dragonomics. Investment in housing actually rose to 35% in March, up from 27% in February. And in April, real estate prices were still rising 10% year on year, albeit at a decelerated rate.


How can we explain this apparent paradox? According to UBS economist Jonathan Anderson and others, those cities that have been experiencing difficulties are not representative of the wider situation in China’s property market. In fact, these economists argue that the long-term economic fundamentals of China’s broader property market remain strong.


Anderson argues that in order to understand China’s housing market, it is necessary to grasp the distinction between the real estate market in first-tier and lesser cities. A large component of the market in first-tier cities such as Beijing, Shanghai, Guangdong and Shenzhen, where China’s big-name property developers operate, is made up of high-end developments. (Anderson adds to this list the booming markets of Chengdu and Chongqing in western China; the Dragonomics property and construction report notes that the coastal metropolises of Hangzhou and Ningbo are the hottest second-tier markets.) Cities in this category experience housing bubbles, explains Anderson, who was speaking at a recent seminar for businessmen in Beijing. As liquidity rushes in, making them prone to volatility, “these prices can skyrocket up 100% and down 30-40%,” he says.


A Beijing-based independent analyst, who declined to be named, adds that many of the cities where property prices have fallen have easy access to money form outside China. Speculative inflows tend to be channelled into either the stock market or real estate, given that other outlets such as bonds or futures remain underdeveloped, he explains. The Fujianese diaspora, for instance, has channelled funds back into real estate in their home province, giving rise to instability in the property market there.


The volatility seen in Shenzhen’s property market, meanwhile, is partly explained by the city’s proximity to Hong Kong, the analyst says. Since the Hong Kong dollar is pegged to a weakening U.S. dollar, and the Chinese yuan has been appreciating against the greenback, moneyed Hong Kongese have sought to convert their dollars into yuan assets. In response, Shenzhen’s banks have taken strict measures, refusing to grant second mortgages. Furthermore, since the city has a large migrant population and a corresponding lack of middle class property buyers, when property prices collapsed, panic selling spread among heavily leveraged investors. However, as Shenzhen’s prices had been growing faster than the national average, the analyst views the price fall there as a correction.


Built on Solid Foundations


It is a very different story outside of these hot, mainly first-tier cities, says UBS’s Anderson. He posits out that roughly 90% of housing activity occurs in mass-market developments in second-, third-, and fourth-tier cities. In contrast to the speculative high-end markets, this mid-to-low range housing features “no mortgage exposure, no leverage and very little speculation.” While prices may be volatile, they fluctuate within single-digit growth rates. “This is fundamentally demand-driven stuff,” he says. The big turnaround in Guangzhou and Shenzhen last November, for instance, was not mirrored substantially in indicators for the mass market and lesser cities, he points out. National price averages can be misleading, Anderson cautions, as they are heavily skewed by massive price fluctuations in the extremely speculative high-end markets.


Furthermore, economists argue that China’s real estate industry is not threatened by the kind of systemic problems that have recently emerged in the United States. “This is not the U.S., where you have a ten-year, huge housing issue [and] enormous rising leverage,” Anderson comments. While as recently as in 2002-3 construction in China was premised on a “massive speculative wave of short-term money,” he says, in recent years “things look decently well behaved.”


In contrast to the U.S., Chinese banks do not own derivatives from mortgages and developers’ loans, limiting the potential for difficulties in the real estate industry to spread to the rest of the financial system, other experts note.


Arthur Kroeber, managing director of Dragonomics, adds that a comparison of the amount of new mortgage issuances and the total value of housing sales in China over the past seven years yields a figure of 35%. In other words, almost two-thirds of housing sales have been paid for in cash. This, he says, is consistent with anecdotal reports from developers. “So in terms of systemic risk, I’m not terribly concerned because at the household level there’s not much leverage,” he argues.


Housing the People


“There is no unified property market in China and as a result there is no macro issue,” Anderson argues. “There is no macro housing bubble in China, and it doesn’t look as if the authorities are going to be taking enormous macro decisions to try and influence the aggregate property market.” In contrast, whilst Kroeber agrees that China does not have a macro housing problem, he believes that the government has diagnosed one. This, he says, lies behind its efforts to reduce the liquidity available to developers and property owners.


Analysts are more enthusiastic about another recent trend in government policy regarding the real estate industry: stronger support for the development of affordable housing. In 2007, the government stated that the proportion of small apartments below 90 square metres, a mere 25% of the housing supply in 2006, must grow to make up at least 70%. Beijing municipality has announced plans to build 10 million square metres of affordable housing by 2010.


“The structural demand driver of ordinary housing is very, very powerful, and that’s not going away,” Kroeber says. So far, the number of new apartments created has failed to keep pace with the amount of new households, he adds. According to some estimates, meanwhile, the bottom 60% of society by income can only afford to buy apartments smaller than 90 square metres, while around three-quarters of housing space built in developments is larger than this. Based on mid-priced housing’s strong fundamentals, as demand is spurred on by the rapid pace of urbanization, this slice of the market will reward investors, Dragonomics advises.


Based on conversations with government officials, the Beijing analyst believes that small apartments will be a new driver for China’s real estate industry in the coming years. Investment in smaller apartments grew 90% last year, he notes – though this was from a small base — and fell short of the government’s own target. Should demand for smaller properties stall, he believes it will be possible for the government to kick-start it with measures such as extending credit to poorer households. “Demand can be easily generated if the government is willing to do so,” he says. Besides providing housing for its people, he notes, shifting the balance of housing supply in the direction of smaller apartments also serves the Chinese government’s purpose of stemming the flow of hot money into real estate.


Some economists have played down the significance of existing low-cost housing schemes, however. Prominent independent Chinese economist Andy Xie has argued in a public seminar several months ago that this is “mostly propaganda,” though he nonetheless believes that providing cheap housing for all will be crucial to social stability. “It’s a matter of time,” he predicts. Why hasn’t the government already made bigger strides in doing so? “There’s no money problem,” he says, since government coffers are flush with cash. “It’s an incentive issue, because the Chinese government behaves like a businessman: they want to make money.” Local governments receive greater profits from selling land for bigger apartments than for mass-market accommodation, discouraging the construction of mass market housing, experts say.


In developing a coherent mass-market housing policy, the central government faces further practical problems. “On the demand side, specific credit policies are yet to be developed to cater to the lower and middle income households and to the urban migrants,” the World Bank pointed out in its February Quarterly Update on China. The report identifies a number of obstacles to developing debt products for lower and middle income groups. One difficulty, particularly acute among this population, is the lack of an effective credit information system allowing lenders to track borrowers’ credit histories. Checking the housing status of borrowers is also problematic, the report says, since China’s property registration system is not integrated at the national level. The absence of effective mortgage insurers is a further systemic weakness: If mortgage lenders are not able to share risks, down payments will tend to be higher, and barriers to borrowing higher.

Nevertheless, the World Bank and others point to signs of progress: An intra-governmental task force has been formed to look at policy issues relating to urban housing, including examining central government subsidies to low income households and local government subsidies programs for low income housing. “China’s government has stepped up its efforts to meet the demand for affordable housing from lower and middle income households in cities,” the report acknowledges.