Don’t expect China’s property bubble to shrink as long as Beijing tinkers with rules but neglects credible reform
Beijing has unleashed another round of property market tightening measures, and this time it’s tightening mortgage loan terms considerably: The mortgage interest discount has been reduced for first-time homebuyers; the discount has been abolished and down payment requirement raised to 40 percent for second-time homebuyers; and rates are at banker discretion while the required down payment has been raised to 60 percent for third-time buyers.
Predictably, sales volumes in the primary and secondary markets have collapsed. But no one is panicking, not even those who live off the property bubble. Why? Aren’t they supposed to be terrified when Beijing cracks down?
It seems we have seen this movie before. Beijing launched property tightening measures several times in the past but then relaxed as soon as the market felt the bite. The bottom line is that local governments, and Beijing through them, depend very much on property for fiscal revenues. And now, the market does not believe the government will cut off the hand that feeds it.
Local governments and developers are sitting on massive amounts of liquidity they raised last year through land and property sales and borrowings while taking advantage of an “anything goes” window open during the economic stimulus period. They seem to think Beijing will change its mind before their liquidity runs dry, so they are comfortably waiting without cutting prices.
Current lending terms effectively keep second- and third-time homebuyers out of the market. Thus, to sell now, developers have to cut prices to levels affordable to first-home buyers with low incomes and little wealth. But cutting prices doesn’t make sense if Beijing is expected to loosen again soon.
This game will continue until Beijing proves its credibility. And it can only prove its credibility by maintaining a tight market policy until local governments and developers run out of money. After that, everyone will have to play by new rules.
Contrary to Beijing’s policy intent, local governments are readying for another round of property inflation. Local governments have been using bank loans to resettle residents, and resettlement costs have skyrocketed since those being moved need enough compensation to buy properties at today’s prices. Unless property prices rise considerably, local governments will end up losing money, which they cannot afford.
Such resettlements played an important role in supporting demand for property last year. The overwhelming majority of end-user purchases probably came from resettled residents who used their compensation cash for down payments. Resettlement compensation is the biggest transfer of wealth from the government to the household sector since the privatization of low-cost public housing a decade ago. It is probably the most important government action supporting today’s economy.
The positive elements of resettlement compensation come with two major negatives. First, it uses a form of leverage to support demand. Local governments borrow to pay compensation packages, using land as collateral. Resettled residents use compensation cash as down payments for mortgages. In this way, government debt becomes equity for mortgage debt; there is no real equity in the financing chain.
Second, although high compensation payments benefit resettled residents, they make local governments a player in further inflating property prices. Ultimately, the costs will be borne by China’s nascent middle class.
Beijing’s economic policies have been favorable to people in the low-income bracket over the past few years through rural subsidies, agricultural land reform and price controls for necessities. The resettlement policy is another element designed to help them. But the middle class is paying the price while their most important expenditures – property, cars and education – are highly inflated. Indeed, China’s property and car prices are among the highest in the world in absolute terms, and by far the highest relative to income. Unless policies change dramatically, the middle class squeeze will get worse.
China’s property market is a massive bubble. The stock of residential properties, developer inventories and land pledged to banks by local governments exceed by three times the nation’s gross domestic product. Rental yields in most cities fail to cover depreciation costs. The price-to-income ratio, a measure of housing affordability, is routinely above 20 in major cities, which means an average Chinese citizen would spend his or her entire income for 20 years to buy an average-priced property.
The bubble can continue because China’s banking system has plenty of liquidity, partly thanks to hot money and because governments have many levers to channel bank liquidity into the market. But the longer the bubble lasts, the more damage it will do to the economy.
A modern society’s stability depends on a dominant and content middle class. A policy that supports high land prices is a form of tax on the middle class, slowing its growth. China may become a country with a small number of super-rich, a vast class with no property, and a small middle class. This kind of social structure would be risky for long-term stability.
The key to sensible property policy is fiscal structural reform. First, government spending, mostly in fixed investment, should be curtailed.
China doesn’t need to build everything at once. The sum of all government fiscal revenues, central and local government borrowings, and expenditures by state-owned enterprises probably exceeded half of GDP last year. Can the government sector spend that much money efficiently? You know the answer. Shrinking the government sector should be a top priority.
Second, assets in the government sector still exceed the nation’s entire GDP. The government should give these assets to the people in a way that expands the middle class. Such a move would support consumption, incomes and tax revenue. Policies that shrink the government and give wealth to the people are needed for balanced and sustainable growth.
The rapid expansion of the government sector only increases its need for revenue and the incentive to inflate the property bubble. Without credible government reforms, property tightening is not credible.
Andy Xie is an independent economist. This article first appeared in the South China Morning Post.
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