As China transitions from an agrarian society to a metropolitan-based consumption economy, Beijing has found itself locked in a constant battle to keep the rising property market in check. Beijing’s strict capital controls regime and strong-handed intervention in capital markets has left few attractive alternatives for Chinese investors outside of the domestic property market, while prevailing cultural expectations encourage young Chinese couples to buy homes and apartments before tying the knot. These two factors have significantly contributed to the market’s exponential growth over the past twenty years, tying up 78% of China’s wealth in real estate.
A Bubble on the Horizon?
A bubble is formed when demand sharply outstrips supply, which increases asset prices. As prices appreciate, speculators join the market and continue to push prices up. Speculators then begin taking riskier and riskier measures to enter the market-by taking out loans at unrealistic premiums, for example-which quickly drive prices to a point at which they no longer reflect the real value of the underlying asset – all while injecting unsustainable risk into the market. Eventually, real demand begins to wane while speculative prices continue to rise, signifying the initial onset of a bubble burst.
Due to the drastic economic impact of the pandemic, housing markets in many of China’s largest cities had relatively cooled off from 2019 figures. Yet, with China’s recovery, the housing market has once again begun to warm. Over recent months, housing prices in major cities from Beijing to Shenzhen have been ablaze with consumers purchasing property at record speeds. With the market approaching a similar bubble-like form as before the pandemic, concern has begun to grip at China’s financial sector.
The economic fallout of a bursting property market bubble would be catastrophic. A burst would lead to a sharp decline in property values, which would then send shockwaves through the financial industry as millions of Chinese investors trigger mass mortgage defaults. Additionally, China’s emerging middle class would be disproportionately affected, dealing a solid blow to a fragile Chinese economy that has relied on the consumer power and economic productivity of one of the most powerful economic classes in the world to emerge from the pandemic.
While some argue that rising prices in the real estate market have coincided with growing household incomes and an overall increase in wealth creation among the Chinese population – and that there is no bubble in the market – these claims have been met with resounding criticism. Household debt has far outpaced income growth, with household debt-to-income ballooning to over 120% in 2019. With the pandemic spurring elevated unemployment figures and slowing income growth, this ratio is anticipated to continue growing more stark and place more pressure on lenders as the risk premium for borrowers grows.
Interestingly, the Chinese real market is unique in that it is defined by higher-than-normal down payments. While in many Western markets, down payments typically come in around 10-20% of the total property value, it is not uncommon to see down payments of 40-50% in Chinese real estate transactions. This has led to the assertion for some that a housing bubble is unlikely to arise given the lower debt-to-transaction price ratio, which acts as a lever of sorts for individuals from lower socio-economic classes to purchase properties at significant multiples of their household incomes and provide price support for high housing prices. However, with declining national savings rates, which clocked in at 44% at the end of 2019 – down 6% from its peak in 2010 – growing property prices are outpacing individuals’ ability to match the corresponding higher down payments. In turn, individuals must rely more on institutional lenders, who are either likely to reduce lending or offer loans at higher interest premiums given the lower overall liquidity of borrowers. The effects of these possibilities are likely to be felt via depressed demand for properties as the pool of potential buyers contracts.
Loans and the Heavy Hand
In an effort to cool the housing market to sustainable levels of growth, beginning in August 2020, the People’s Bank of China (PBOC) began addressing the apparent risks of a property bubble by releasing a policy that limits loans in the sector. The new regulations are targeted towards reducing access to credit for both developers and buyers, and, poignantly, have no expiration date. They are slated to stay in place until significant evidence of cooling is witnessed throughout the country’s property market and mandates that all would-be lenders in China decrease the quantity of loans that they offer to the industry.
In theory, the policy is intended to provide a security blanket for lenders around the country to limit their risk exposure should any sudden spikes or shocks rattle the housing market, while also containing the ability for widespread real estate speculation. Yet, the policy comes with a cost. When the PBOC took similar measures during China’s last housing bubble scare from 2005-11, the policy was successful in its objective, albeit led to a material decline in national economic growth. Many economists now worry that the policy could hamper economic growth at a time of severe fragility for the world’s second largest economy and contribute to another period of economic decline as was witnessed from 2012-13.
The basis for the new policy is formed by two key indicators: a concentration management system (CMS) and the PBOC’s “three red lines.” The CMS limits the capitalization of financial institutions’ property-related lending based upon a five-tier scale and the three red lines – debt-to-equity, debt-to-cash, and debt-to-assets – and functions as a bulwark against high financial risk exposure for lenders within the housing sector.
However, the CMS bears an unintended impact on property developers, and by extension, the broader economy. Property developers often rely heavily on bank loans to finance new projects and investments, which have now been complicated by PBOC aims to cap annual debt growth among developers to no more than 15%. This is likely to lead to heavy ramifications for the broader Chinese economy, as real estate – even excluding housing construction and some residential consumption – accounted for 7% of China’s total GDP in 2019, while other industries directly intersecting with the sector accounted for an additional 17.2%. Equally important, a 2020 report by Harvard and Tsinghua universities estimated that a 20 per cent drop in real-estate activity could lead to a 5-10 per cent fall in China’s GDP, all other things being equal. With real estate as such a prominent sector guiding China’s economy, any cascading effects on the major stakeholders in the market are certain to bear adverse impacts on the Chinese economy at large.
Short-Term Gains or Long-Term Losses?
As cases from around the world have demonstrated time and time again, housing bubbles can act as precursors to systemic collapse that permeate throughout entire economies. Having witnessed the US and Japanese property bubble bursts in the past few decades, the PBOC has adopted some of its most stringent measures yet to cool China’s domestic housing market. However, given the severity of the restrictions and the spillover effects on other related stakeholders and industries, the long-term sustainability of loan limitations has been called into question. To many, the new policy appears as a band-aid approach and ignores the factors driving the bubble itself.
The first and most significant challenge to the real estate industry are the wildly expensive property prices in first- and second-tier cities that have already swelled to multiples out of reach for all but the most privileged citizens. Large areas of Chinese cities are characterized by property values that approach or exceed those found in the world’s most expensive real estate markets, such as London, Sydney, and New York, but are contrasted with residents that earn just fractions of fractions of local property values.
Related to the first challenge are the increasingly risky loans that Chinese citizens must take out to pay for housing in these cities. Tackling inequalities, including education and earnings potential, among various demographics within the Chinese population would serve as a long-term approach that could help bring equilibrium to the housing market without the need for heavy-handed government policies that target short-term cooling measures. By introducing newly qualified segments of China’s population into the housing market, Beijing could ensure that there remains sufficient demand to support property prices while reducing the amount of risky loans required to purchase property.
Is It Sustainable?
Looking forward, the recently administered loan limitations towards the property sector will continue to be monitored by PBOC regulators over the short- to mid-term, or until signs of relative cooling within the property market are observed. However, policymakers must continue to question the long-term feasibility of this approach. The frequent tightening and loosening of restrictions on property loans will add uncertainty into the industry, thereby increasing supply-side risk premiums while driving a wedge between the financial institutions, property developers, and prospective homeowners.
To dilute the risk of a property bubble burst, the government must begin addressing the underlying catalysts driving the sky-high real estate premiums as opposed to applying short-term stop-gap measures that do little to guarantee the possibility of responsible homeownership for a growing middle class, nor guarantee a stable operating environment for one of the most influential segments of the Chinese economy.