Tuesday, December 20, 2011

Housing in China: "Biggest Bubble of the Century"?

China has managed to create a situation in which it has produced both a housing deficit and a housing glut.

In the article Is China a "Colossus" or a Giant "House of Cards"?, we discussed China’s long-term plan to place an additional 400 million people in cities over the next 20 years. Clearly with the stroke of a pen that plan creates a massive housing deficit. One would think that that would be sufficient to keep all known builders busy. An article in Foreign Affairs by Patrick Chovanec tells us that the focus of the real estate market has been elsewhere: China’s Real Estate Bubble May Have Just Popped.

China has experienced an enormous housing boom driven not by the demands of people needing a place to live, but by investors speculating on the assumption that housing prices will continue to rise. Does that sound familiar? Investors are buying multiple units at a time with no intention of actually using them. Rather, the plan is hold them and resell at a later time when demand drives the price up. Why would investors fall into this classic trap?

"The craze for vacant real estate is due in large part to a lack of attractive alternatives. Strict controls on capital outflows prevent most Chinese citizens from investing any real money abroad. Chinese bank deposits earn very low interest rates -- lower, for the past year now, than the rate of consumer inflation. The public sees the country's domestic stock exchanges, which have endured volatile ups and downs over the last few years, as little more than high-risk casinos. In contrast, real estate, which has not seen a sustained downturn since China first converted to private homeownership in the 1990s, has long looked like a sure bet."

The national government has been complicit in fueling this bubble.

"To maintain GDP growth of nearly ten percent during a massive downturn in global demand, China's leaders engineered a lending boom that expanded the country's money supply by roughly two-thirds. Real estate was already the preferred place for the Chinese to stash cash; now, investors had that much more cash to stash. Prices rose accordingly: In many locations, the cost of prime new properties doubled in just two years."

Local governments also participated. They had become dependent on the funds gained from selling public land to developers, and the real estate activity showed up as contributing to the GDP growth demanded by their superiors.

The rapidly rising prices were putting these dwellings out of the reach of people who might actually wish to live in them. This concerned the central government and attempts were made to slow down the building by making it harder for speculators to get credit and buy multiple units, but never having lived through a bubble before, the builders kept on building—or rather, they kept on borrowing and building. Eventually sales slowed and inventory built up.

"Estimates of such idle holdings range anywhere from 10 million to 65 million homes; no one really knows the exact number, but the visual impression created by vast ‘ghost’ districts, filled with row upon row of uninhabited villas and apartment complexes, leaves one with a sense of investments with, literally, nothing inside."

These unsold dwellings come at a cost to the builders. Since they borrowed to build, they had a need to keep borrowing to maintain them.

"As 2011 progressed, developers scrambled for new lines of financing to keep their overstocked inventories. They first relied on bank loans (until they were cut off), then high-yield bonds in Hong Kong (until the market soured), then private investment vehicles (sponsored by banks as an end run around lending constraints), and finally, in some cases, loan sharks. By the end of last summer, many Chinese developers had run out of options and were forced to begin liquidating inventory. Hence, the price slashing: 30, 40, and even 50 percent discounts."

Where does this leave the market and the country?

"In a telling scene two months ago, Shanghai property developers started slashing prices on their latest luxury condos by up to one-third. Crowds of owners who had recently bought apartments at full price converged on sales offices throughout the city, demanding refunds. Some angry investors went on a rampage, breaking windows and smashing showrooms."

"Shanghai homeowners are hardly the only ones getting nervous. Sudden, steep price reductions are upending real estate markets across China. According to the property agency Homelink, new home prices in Beijing dropped 35 percent in November alone. And the free fall may continue for some time. Centaline, another leading property agency, estimates that developers have built up 22 months' worth of unsold inventory in Beijing and 21 months' worth in Shanghai. Everyone from local landowners to Chinese speculators and international investors are now worrying that these discounts indicate that ‘the biggest bubble of the century,’ as it was called earlier this year, has just popped, with serious consequences not only for one of the world's most promising economies -- but internationally as well."

"In a few cities, such as coastal Wenzhou and coal-rich Ordos, the collapse in property prices has sparked a full-blown credit crisis, with reports of ruined businessmen leaping off building rooftops; some are fleeing the country."

Most of the speculators seem to have made their acquisitions with cash, and—so far—have been waiting this out. If they decide it is time to cut their losses and put their property on the market it could be disastrous.

Many countries have made money out of this housing bubble by selling China materials and equipment to support it. The Chinese will not be the only ones who will suffer consequences if this situation is not brought under control.

In principle, the government could just provide the cheap loans that the builders need to maintain their inventory, but that only stabilizes the situation. The builders can’t move their product unless investors are convinced that prices are going to keep rising—which brings us back to inflating the bubble some more.

Stay tuned. As always, there are few dull moments for China watchers.


PATRICK CHOVANEC is Associate Professor of Practice at the School of Economics and Management at Tsinghua University.

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