By John Richardson
NEARLY three years on from when the Chinese central government first promised to reform local government financing, little progress appears to have been made: Local governments are still addicted to land sales to meet their funding requirements.
At the heart of the problem is this:
- Although China might still need 800m square metres of new housing every year to meet demand – the equivalent of roughly the size of Singapore – restrictions on how much land can be developed has led to very steep inflation in the cost of land in the major cities.
- This has made it easy for local authorities to meet their financing requirements.
Reforming local government financing now seems even more of a challenge thanks to this year’s re-inflation of the property bubble. Local governments have lost tax revenues from the closure of factories as manufacturing capacity in oversupplied sectors such as cement and steel is rationalised. Selling more expensive land has thus helped them to plug this funding gap – and has helped to pay for economic stimulus measures aimed at compensating for lost factory jobs.
This helps to of course explain why Beijing has allowed the real-estate bubble to take off again.
So does the fact that a weak global economy is offering China little support: In August, China’s exports were down by 10%.
Another reason is again connected to this huge oversupply in manufacturing. Because the state-owned enterprises (SOEs) are responsible for most of the excess capacity, they have seen their profits decline more than the private sector. The SOEs are thus increasingly dabbling in real estate speculation.
But by increasing China’s addiction to real estate as source of growth, Beijing has raised the financial risks from withdrawal.
Tulips and Chinese condos
Many thousands more families have lumped together their entire collective savings to go long in real estate. One-fifth of buyers are estimated to be investors rather than owner occupiers. The negative wealth effect would be significant if property prices merely stopped rising at today’s heady pace.
Next come the property developers who are at risk of going bust. Deutsche Bank says that property developers have driven—up land prices by 66% in 2016 in China’s 100 leading cities because they are worried about losing out in land auctions. Two-fifths of winning bidders would lose money if price rises merely level out, never mind decline.
Is this a bubble to end all bubbles? Quite probably, yes. Total home loans are expected to be around 30% of GDP this year versus 20% in 2014. No less than 80% of all bank lending in January-August was to the real estate sector.
In an article called “Keynes and Hayek in China’s Property Markets,” Tsinghua University professor Andrew Sheng writes as follows:
Chris Watling of Longview Economics compares China’s property market today to the Dutch tulip mania that peaked in 1637. He points out that property prices in Shenzhen, in particular, jumped 76% since the start of 2015, bringing a typical home to $800,000, just below the average home price in Silicon Valley. This, he suggests, may be the last hurrah before a market meltdown.
The above slide, from HSBC research, pictures these alarming statistics:
- China’s total value of residential housing to GDP (the red line) is currently 3.27 times GDP, and is forecast to hit 3.72 times by year-end.
- Japan’s great bubble (the black line) peaked in 1990 at 3.7 times GDP. Shortly after, property prices fell through the floor, losing 67%.
- Hong Kong’s 1997 bubble peak (green line) was at 3.04 times.
- The US bubble peak (the blue line) in early 2006 was at 1.75 times.
- Hong Kong’s current bubble has left the value of residential housing at 5 times GDP. This is expected to rise to 5.5m times by the end of this year.
A Continuing Battle for Reform
The problem for the reformers, led by President Xi Jinping, is that this new real-estate bubble runs counter to their attempts to remake the Chinese economy.
Firstly, if you can make a fortune from speculating in property, why bother to pursue risky innovation in manufacturing and services? A further disincentive not to bother with a hi-tech start-up is poor patent protection. The dilemma for China is that if it falls short on innovation, it will fail to escape its middle-income trap.
And secondly, there is the issue of inequality. Relatively few people can afford condos in Beijing, Shanghai and Shenzhen, where the total value of real-estate is reportedly more than that of the whole of the US. The many thousands of additional families that have poured their collective savings into real estate still represent the rich elite. There are far more people with little, or no, real estate equity living on urban incomes that at the high end only averaged $9,000 as recently as 2013.
Thirdly there is the issue of debt. The Bank for International Settlements estimates that China’s debt is already 250% of GDP compared with 150% before the Global Financial Crisis.
History suggests that countries with these kind of debt levels suffer financial crises – never mind the risk created by even further leverage if this latest real estate bubble were allowed to continue.
But what about the fact that China still needs some 800m metres of new housing each year? Doesn’t this create the option of even more real-estate led growth? No, not if, as I said, debt is the issue.
History also suggests that property bubbles that go wrong don’t have to involve nationwide imbalances. For example, the US pre sub-prime bubble was mainly concentrated in Florida, Arizona, Nevada and California
Xi and his anti-reformers have staked their entire political reputations on making their economic reforms work. To back down now would thus jeopardise their political survival. They also know that it would quite simply be the wrong thing to do for China’s long-term good.
There will therefore be a continued struggle between the reformers and the anti-reformers – and this is likely to culminate at the critical Communist Party meeting in November next year. Five of the current seven members of the top Standing Committee are due to retire, leaving only Xi and Prime Minister Li Keqiang eligible for reappointment.
Xi might fail to win the struggle. What then for the Chinese economy? It is hard to see a good outcome because of the scale of today’s imbalances.
Or Xi might win and his reforms simply don’t work as they could prove to be too difficult to implement.
In the best of outcomes, Xi wins and the reforms works. But to suggest that this will inevitably lead to a smooth transition from the old to the new economic growth model is plainly wrong. The transition would be stop/start – at times one step forward and two steps back – and could take many years.
Events in China further underline how we are facing levels of economic, social and political volatility that nearly all of us have never experienced before.