Learning the Hard Way: China’s Distorted Real Estate Market

Soaring property prices have effectively priced the average Chinese citizen out of the housing market. Last year, a government official conceded that he could not afford an apartment on his humble salary. Fortunately for him, most government officials are provided with comfortable public housing—he need not worry. The emerging middle class does not have it so easy: for instance, statistics show that it is not at all unusual for an ordinary resident of Beijing to spend 80 percent of his income on monthly mortgage payments. This leaves little room for discretionary spending, thereby crippling the middle class’ purchasing power and standard of living while contributing to a widening wealth gap.

Housing prices have increased dramatically in big urban regions, particularly China’s first tier cities such as Beijing and Shanghai. This places enormous pressure on China’s emerging middle class. Take Beijing again: a Goldman Sachs study concluded that house prices in the capital have risen 80 percent faster than wages in recent years. Even the global recession—the worst in decades—has been unable to slow this steep rise; in fact, the National Bureau of Statistics finds that housing prices in 70 of China’s biggest cities jumped by 11.7 percent year-on-year in March alone, marking the largest increase since figures were first compiled in 2005.

China’s soaring housing prices appear largely disconnected from economic rationality; few understand how Chinese are able to afford similar housing prices to those in the United States with only a seventh of the per capita income. Certainly the drive for home ownership is strong; everyone desires a place to settle down and call their own. Renting is a poor substitute, particularly in China where owning an apartment is often a pre-requisite for males to obtain approval for marriage. It is therefore not uncommon for ordinary Chinese to purchase an apartment with down payments from parents or even grandparents, as few are able to cover the cost on their own.

But the actions of a rising middle class do not alone explain the dramatic rise in property prices. Culpability for the real estate bubble instead lies with three interconnected players: wealthy investors, enabling local governments, and exploiting state-owned enterprises.

  • “Hot money” has garnered most of the blame in the press and government—and continues to flood the market virtually unabated: investment in property development grew to an astronomical 659.4 billion yuan (US$96.7 billion) in the first quarter of this year alone, a rise of 35.1 percent from the same period last year. Real estate continues to be among the more attractive investment vehicles for the rich, particularly given the immaturity of more sophisticated financial instruments, the instability of the stock market, and the constraints on private enterprise. The unbending, gravity-defying rise in property values has only continued to fuel the appeal of real estate investments. Besides pushing prices out of reach of even many professionals, the perverse impact of wealthy investors has also biased the market in favor of high-end rather than affordable housing.
  • Local governments also play a significant contributing role in fanning the real estate frenzy and may well deserve the most blame in begetting the real estate bubble. With the government constitutionally owning all land, local governments—and corrupt officials—are able to generate significant revenue from the sale of “land use rights.” China’s local governments are burdened with a wide range of social obligations but are constrained in their ability to generate and collect revenue. The sale of land use rights to the highest (or best connected) bidder offers a crucial source of funding. The City of Hangzhou, for instance, relies on land-related taxes and other forms of revenue for an estimated 30 percent of its budget. In Shanghai, revenue from land use rights contributes a substantial 100 billion yuan (USD$14.9 billion) on average to the city’s coffers each year. It should surprise few, then, that scholars and the public widely believe that local governments tacitly encourage the ballooning real estate market despite orders from the central government to the contrary. Indeed, the actions of local governments have at times led to the absurd and obscene, as demonstrated by the growing phenomenon of glittering new ghost towns consisting of shiny but virtually unpopulated high-rises.
  • State-owned enterprises (SOEs) have also garnered widespread blame from the public for driving up the price of land. Enjoying easy access to state resources—including much of China’s massive stimulus spending—state owned enterprises have barged into the highly profitable property market. Indeed, SOEs have been prominently involved in many of the most notorious “land kings,” i.e. properties with record high prices per square meter. Recognizing the detrimental influence of SOEs, the central government has commanded its primary centrally controlled SOEs to exit the real estate market. Yet local SOEs, in collusion with lower levels of government, will almost certainly continue to distort the real estate market to exploit their advantageous access to capital for vast profit.

Asset bubbles come and go; they are an unfortunate but common trait of virtually every economy, particularly those experiencing China’s explosive levels of growth. But what makes China’s real estate case so perplexing is the largely unspoken but very real fact that land in China is not “owned” in perpetuity, as is typical of a market economy, but rather “leased” from the government for a period capped at seventy years—every inch of land is ultimately owned by the government (and, by extension, the Communist Party). Given this, one would anticipate the value of land to fall over time as the lease approaches its expiration date. Yet prices have exploded in the opposite direction.

What can explain such seemingly irrational activity? In fact, the public and the government have reached an implicit agreement that land use rights will be protected, either through wholesale reform of China’s land rights or—more likely—through extensions of land use rights for a fee. Actions to the contrary would risk collapsing of the real estate market, which impacts virtually every citizen (particularly the well-connected). The government’s hands, therefore, are largely tied for fear of inciting public opposition on a scale sufficient to risk its grip on power.

Given the absence of formal policies and rights—and local government’s insatiable need for funding—disputes and confusion will inevitably arise that will have a destabilizing effect on the real estate market if not political power. Informal arrangements, promises, and assumptions are a poor substitute for genuine property rights that are the hallmark of a genuine market-based economy. China’s overeager real-estate investors are bound to find this out the hard way.

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