China looks to put the brakes on housing bubble

The Chinese property market is back in the spotlight, following the central government’s decision to harden its three-year effort to put house prices in an affordable range for ordinary citizens. The latest measures include higher down-payments and interest rates for buyers of second homes in cities with excessive price gains. Perhaps more importantly, there will be a 20 per cent capital gains tax on homeowner profits on sale, as against 1 to 2 per cent on sales price previously.

The impact of the latest clampdown on property speculation was immediate, as publicly-quoted real estate developers endured a decline of more than 9 per cent, the largest one-day decline since the summer of 2008.

The rest of the world barely paused for breath, as the major stock market averages in the US continued their assault on the all-time highs registered more than half a decade ago. Is the complacency justified, or could the Middle Kingdom’s housing market be the elephant in the room that interrupts investors’ latest bout of exuberance?

It is important to note that household ownership is a relatively new phenomenon in modern China. It did not exist until 1998, when the government gave birth to a market-oriented housing market through the privatisation of the existing urban housing stock to current occupants at heavily discounted prices.

Previously, housing allocation in urban areas was determined by employers, primarily government institutions and state-owned enterprises.

The fledgling housing market was virtually certain to be vulnerable to excessive price rises given the peculiarities of the Middle Kingdom’s chosen growth path.

These include low real interest rates in the presence of high growth, a closed capital account, and an underdeveloped financial system that offers few investment options to a nation of high-savers.

State interventions
It's hardly surprising therefore, that central authorities have felt compelled, from time to time, to step in and temper outsized increases in house prices. For example, the rapid ascent in urban house prices that began in 2003 and continued through 2007 prompted a serious of administrative measures and financial policies, designed to curb speculative demand.

Efforts to cool the property market proved successful, but renewed – and perhaps even dangerous stimulus – followed the outbreak of the “global financial crisis”. The moderation in prices ended, as property development and consumer mortgage loans surge by roughly 40 and 50 per cent respectively in 2009, and year-on-year gains in house prices reached record levels during the first half of 2010.

Talk of a Chinese housing bubble filled the pages of the respected print media in the West, but Chinafelt compelled to act for domestic reasons, as it became increasingly clear that speculative buying had driven asking prices well beyond the reach of ordinary citizens.

The measures that followed contributed to moderate price declines of about 15 per cent across major urban areas, before the most recent ascent in values began following the easing of monetary policy – in the face of economic slowdown - last summer.

Most commentators believe that the authorities have averted a housing bust and, in their defence, the month-on- month increases in prices over the last nine months do not seem excessive. Indeed, the year-on-year gain in the country’s largest cities turned positive only recently, and was still less than 3 per cent in February.

Furthermore, a top-down perspective paints a similar picture. It is beyond dispute that house prices look expensive relative to household incomes at roughly seven times, but China’s notorious cash economy could be far lower. Additionally, rapid income gains have outpaced annual house price appreciation over the past 10 years, which would appear to discount bubble concerns.

The final bullish point is leverage. The average down-payment that Chinese banks require is roughly 30 per cent on a first home, and as much as 60 per cent on a second property. Also, home equity loans are virtually non-existent.

Unfortunately, a bottom-up view leads to entirely different conclusions. The substantial number of unused apartments in the major cities is plain for all to see. The amount of unsold apartments, as measured by floor space, jumped 40 per cent over the past 18 months.

Pockets of overvaluation
Herein is the true problem in the housing market. Property developers are focussed primarily on the construction of luxury apartments that are purchased by the wealthy for potential capital appreciation with little consideration afforded to possible rental income.

Meanwhile, the stores of value for the highest-income brackets remain beyond the reach of the ordinary Chinese, who struggle to find appropriate accommodation, given the developers reluctance to build affordable housing.

Is there a bubble in China's housing market? The aggregate figures suggest not, but a micro-perspective suggests there are dangerous pockets of overvaluation in high-income segments. Should the world be worried? Time will tell.

charliefell.com