China real estate: a balancing act

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The Chinese real estate market is a perennial concern to investors. Amid still-rising prices, policy measures have grown increasingly restrictive and are likely to remain so for the near term. Overall, the government continues to fine-tune its policy measures to ensure a sustainable evolution of the sector. Ongoing urbanization and strong household balance sheets will also continue to support the sector

Cash and the Goldilocks principle 2 of 8 Compass May 2013

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Please read this important information before proceeding.

Chinese property prices are once again under the spotlight. As expected, the government has announced another round of measures aimed at curbing the seemingly inexorable rise in prices. Concerns of oversupply have been resurrected by reports of ghost towns, such as the Inner Mongolian mining village of Erdos. Is the combination of rising prices and extreme oversupply symptomatic of a property bubble? Will the Chinese government change its stance on the sector in view of policy-implementation challenges?

Alarm bells are sounding across China (again)

The beginning of 2013 saw Chinese property prices start to climb again, after a brief pause in 2H 2012. In the first quarter of this year, the total value of new homes sold in China surged 69% on a year-on-year (YoY) basis, accompanied by both rising volume (+41%) and prices (+20%). Since 2008, average property prices have risen by more than 50%. This is justifiable given the rapid rate of income growth across the country, favourable demographic changes and steady urbanization (see Figure 1). Arguably, the limited investment options in China coupled with the cultural preference for real estate also contributed to the strong investment demand.

Figure 1: China property price trend

Notwithstanding the fundamental drivers, housing affordability has deteriorated significantly over recent years. Our economists estimate that average house prices have increased to around eight times disposable household income (this is markedly higher than the typical price/income ratio of 3 to 5 times in developed economies). The situation is even more severe in tier-1 Chinese cities where strong real- and-investment demand have driven prices higher. Tellingly, prices in Shanghai increased to more than 20 times that of household income in 2011.

There are inevitable implications for the rest of the economy of a surging real estate sector. With a larger proportion of one’s disposable income taken up by mortgage payments, there is less money available to spend elsewhere. As a result, general consumer spending, a key area that Chinese policymakers are looking to promote, may be adversely impacted. Higher property prices could also become an emerging source of social tension as average/low-income households get priced out of the market. Government efforts to maintain a “harmonious society” may, therefore, come under threat.

Over time, with the easing of fundamental drivers, the pace of Chinese growth will invariably moderate, which is all part and parcel of the government’s measures to rebalance the economy. Moreover, as the proportion of the working-age population gradually declines, it would further ameliorate housing demand. Finally, further liberalization of the financial sector may present new investment alternatives. In spite of the above, Chinese policymakers still need to proactively manage the current situation as the risk of a property collapse has increased.

Urbanization continues to drive demand

Has the boom in China’s property sector become a bubble, and is that bubble about to burst? We do not think so. Chinese households have strong balance sheets, which will help to avert potential foreclosures when property prices decline. Based on recent estimates, consumer loans constitute approximately 40% of aggregate household disposable income. This is still far from the US household debt-to-personal disposable income high of 133% seen in 2007. Besides, Chinese households typically use less debt to finance their property purchase due to regulatory and cultural reasons. Therefore, even if property prices were to fall by 30-40%, any negative impact on equity would likely be manageable.

Figure 2: Further urbanization driving new housing demand

More significantly, despite the rise in urbanization (from 20% in the early 1980s to more than 50% in 2012 (see Figure 2)) – which saw 150 million people move from rural to urban areas – the rate is still low compared to Japan and the US. Thus, a rising urbanization trend is still in place to drive long-term Chinese housing demand. For China to achieve an urbanization rate of >70% - in line with the developed markets – it will require an additional 300 million people to move to the cities. A reform of the household registration system is in the pipeline, and this would provide a better social safety net for migrant workers and their families. It will also accelerate the urbanization process and thereby create more demand for housing.

Arguably, the limited investment options in China coupled with the cultural preference for real estate also contributed to the strong investment demand

Admittedly, while there has been some over-investment in the lower-tier cities over the past three years, we believe many of the perceived “ghost towns” today will turn into buzzing cities some years down the road. A classic case is that of the Pudong district in Shanghai – the city was also labelled as a “ghost town” of newly built buildings with low-occupancy rates in the late 1990s. By the mid 2000s, Pudong had become a vibrant city, boasting well-occupied office towers, hotels and sought-after residential homes. We believe the Chinese success formula of “buzzing-up” ghost towns is fairly well-documented and replicable – many more “Pudongs” will emerge in different parts of the country over time. Suffice to argue that the oft-cited case of Erdos in north-western China is not representative of national oversupply, it is more of an exception and, with <10% of China’s population in that region, it is also a less-than-relevant example.

A balancing act

Given the delicacy of the real estate sector, we believe the Chinese government may need to adopt a fine balancing act as part of policy. For example, the policy stance turned from being supportive in December 2008 to restrictive by December 2009. By February 2012, the stance was obviously supportive again (see Figure 3). The frequent changes can be explained by the catch-22 situation that Chinese policy-makers are in: they have to be seen to rein in any excesses and, yet, can not afford a free fall of property prices. Real estate investment and construction account for about a quarter of China’s fixed asset investments, and directly contribute more than 10% of the country’s GDP. The gross impact is likely to be larger if we include the various related industries. Hence, the government’s explicit policy objective is one of maintaining price stability in the sector.

With rising property prices over the past few months the Chinese government, unsurprisingly, announced a fresh round of measures to curb speculative demand in an effort to stabilize prices. In addition to the reinforcement of price controls, home purchase restrictions and further tightening on home mortgages, the regulator is also planning to levy a 20% capital gains tax on sales. The most restrictive measures will likely be applied to tier-1 cities, which have witnessed higher price increases in contrast to the lower-tier cities.

However, the implementation of the latest restrictive measures has been criticised by the public for being ineffective. For example, married couples have reportedly gone through rushed divorces to split property ownership in order to avoid the capital tax – only to remarry after the completion of their property sales. Local governments, especially those in smaller cities, have also been reluctant to enforce the tough measures for fear of crashing the market as land sales revenue is still an important source of financing. It remains to be seen if the government can enforce the measures, and we do not rule out a step-up in enforcement, where necessary.

Moving forward, the Chinese government has been toying with the idea of introducing a nation-wide property tax. Already, Shanghai and Chongqing are running a trial scheme, and we expect more cities to follow suit. While we are cognizant of the challenges of implementing a property tax – largely due to expected resistance from influential stakeholders – such a measure is, in our opinion, likely to be far more effective in curbing speculative demand. In addition, an introduction of property tax becomes more palatable if local governments can retain most of the property tax collected, which can serve as an alternative source of funding, in addition to land sale.

Meanwhile, the government will continue to pursue the social-housing programme to ensure sufficient supply of affordable housing for the growing urban population. With the eventual deceleration of private property investments and activities, the public housing programme could also be ramped up to mitigate marginal slowdowns. Longer term, we believe China’s growth dependence on property investment will gradually decline, and be replaced by consumption in terms of share of GDP as the ongoing economic re-balancing process gathers pace.

Figure 3: China’s property policy measures


While there is cause for concern on China’s surging property prices, we believe the sector is far from collapse. The government will manage the delicate real estate sector by, not only imposing measures to curb speculative demand in the near term, but also by ensuring a sustainable evolution of the sector. Fundamental factors such as increased urbanization and a strong household balance sheet will also continue to support to housing market demand and prices. As China becomes a more consumption-driven economy, the country will become less reliant on property investment growth. For now, the government must remain committed to this fine balancing act.