China can handle its property bubble
SERIOUS MONEY:THE STOCK market weakness of recent months has been widely attributed to the ongoing drama in the euro zone but the setback owes as much to concerns that China’s runaway property market is set to reverse direction and precipitate a sharp slowdown in economic growth.
The bears argue the Middle Kingdom’s inflated property prices are reminiscent of Japan’s real estate bubble during the latter half of the 1980s, and believe the Chinese authorities via accommodative monetary policy and a quasi-fixed exchange rate, are in danger of repeating the mistakes of their Japanese neighbours. Such an outcome would prove disastrous for the global economy, given that the developed world already stands on the edge of a deflationary abyss, but are the bears’ worst fears truly justified?
The private residential property market is a relatively new phenomenon in urban China. Indeed, until housing policy was reformed in the late-1990s, the allocation of apartment units to most urban households was determined by employers, primarily government institutions and state-owned enterprises. The government gave birth to a market-oriented housing market in 1998 through the privatisation of the existing urban housing stock to current occupants at heavily discounted prices. The development of a commercial housing industry was encouraged and the resulting boom in residential construction was supported by the emergence of mortgage finance. By 2003, private home ownership had become the norm.
Structural factors including favourable demographics, increased urbanisation, rapid income growth and high household savings rates underpinned the buoyant demand.
However, urban house prices began a rapid ascent in 2003 that continued through to 2007; price gains in the major cities between 2002 and 2006 averaged 30 per cent a year, and the continued upward momentum in 2007 forced the authorities to implement administrative measures and financial policies to depress speculative investment demand.
The actions taken included an increase in the downpayment requirements on second home purchases from 30 to 40 per cent, a hike in the mortgage rate on second home purchases to 1.1 times the standard rate, an order to the commercial banks to control lending to property developers and the introduction of rules that made it harder for foreigners to invest in Chinese property.
The measures proved successful, as the pace of price increases slowed from its peak in late 2007. Eventually, house prices turned south, as the global financial crisis inevitably undermined demand.
The weakness proved short-lived and the decline relatively modest, as a sharp economic slowdown demanded a shift toward more accommodative policies. Fiscal stimulus equivalent to 13 per cent of gross domestic product, massive credit expansion and a reversal of the restrictive measures of 2007 contributed to a turnaround in the housing market’s fortunes. The credit expansion saw property development and consumer mortgage loans surge by roughly 40 and 50 per cent respectively in 2009.
Negative real interest rates, high savings rates and controls on capital outflows increased the relative appeal of private housing as an investment vehicle. The volume of transactions increased in the major cities and the surge in demand saw house prices resume their upward trajectory. By autumn of last year, they had surpassed their previous peak. The positive momentum continued during the early months of this year, and prices registered a record year-on-year gain of almost 13 per cent in April.
The Chinese authorities were forced to take measures to curb speculative investment once again, as elevated prices in the major cities, at roughly 10 to 15 times average household incomes, kept rural migrants out of the market and contributed to social tension. Downpayment requirements on second home purchases have been raised to 50 per cent, the mortgage rate on second home purchases has again been increased to 1.1 times the standard rate and loans for third home purchases have been forbidden. Meanwhile, the land available for public housing development has been increased. The deliberate attempt to check the advance in urban house prices is beginning to have an effect, as house values dipped month-on-month in June for the first time since the spring of last year.
Concern is mounting that prices could slip by 30 per cent before the end of the year, and there are fears the resulting increase in mortgage delinquencies could lead to financial instability. Though house prices may well drop sharply in certain pockets of the market, the fears seem overblown given that loan-to-value ratios averaged just 34 per cent from 2003 to 2009 and are still relatively low at 66 per cent by international comparison. A substantial drop in prices is required before homeowners enter negative equity.
Furthermore, property loans account for 25 per cent of the banking sector’s total loans – a fraction of the equivalent number across Ireland’s banks. Mortgage lending is equivalent to just 15 per cent of GDP, as compared with a figure of almost 80 per cent at the US housing market’s peak.
The upward trajectory in Chinese housing prices simply does not look like a dangerous bubble; urban prices have advanced by 75 per cent over the past decade, and 15 per cent since last spring. Given urbanisation and high income growth, price advances of this magnitude do not appear outlandish.
House prices are sure to weaken following the government’s attempt to cool the market. However, homeowners have scope to absorb significant price losses and banks do not appear to have dangerous levels of exposure to mortgage and property-development loans. The Middle Kingdom will muddle through.