No Room to Relax

Andy Xie is a former Morgan Stanley analyst now living in China

The central government has unleashed another round of property tightening measures. This time it is focusing on mortgage lending terms: the mortgage interest discount for first-time homebuyers has been reduced; the discount for second-time homebuyers has been abolished and the down payment requirement raised to 40%; and the rate for third-time buyers is being left to the banks’ discretion with down payments raised to 60%.

Predictably, sales volumes in both 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 of the government’s crackdown?

It seems we have seen this movie before. China has launched property-tightening measures several times but it relaxed them just when they began to bite. The bottom line is that local governments, and the central government through them, depend very much on property for revenue. The market doesn’t believe the government will cut off the hand that feeds it.

Local governments and developers are sitting on massive liquidity that they raised last year through land and property sales and borrowings, taking advantage of the “anything goes” window during the stimulus period. They seem to believe that the central government will change its mind before they run out of liquidity. So they are comfortable waiting and not cutting prices.

Cutting prices doesn’t make sense if the government is expected to loosen policy again soon. The current lending terms effectively keep second- and third-time homebuyers out of the market. To sell, developers must cut prices to levels affordable to the buyers of first homes, who have low incomes and little wealth. All the players will play by the new rules only if the central government proves its credibility by maintaining the tightening policy until local governments and developers run out of money.

Contrary to the policies’ 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 to do.

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 money for a down payment. Resettlement compensation is the biggest transfer of wealth from the government to the household sector since the privatization of public housing at low prices 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 is using a form of leverage to support demand. Local governments borrow to pay the compensation packages, using the land as collateral. The resettled residents use the compensation as down payment for mortgage borrowing; so government debt becomes equity for mortgage debt. There is no real equity in the financing chain.

Second, the high compensation costs, though beneficial to the resettled residents, make local governments a player in further inflating property prices. China’s economic policies have been favorable to the low-income class in the past few years through rural subsidies, agricultural land reform, and price controls for necessities. The resettlement policy is another element in the push to help them, but the costs are being borne by the middle class, whose 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 only get worse.

China’s property market is a massive bubble. The stock of residential properties, developers’ inventories, and land that local governments have pledged to banks may exceed by three times the gross domestic product. Rental yields in most cities are too low to cover depreciation costs. In major cities, the price-to-income ratio, a measure of housing affordability, is routinely above 20, which means that it would take an average mainlander 20 years to buy the average property using their total income. The bubble can still continue because China’s banking system has plenty of liquidity – thanks partly to hot money and because local 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.

The stability of a modern society depends on its middle class being in the majority and content with its situation. The high land-price policy is a form of tax on the middle class, which will slow its growth. China may become a country with a small group of the super-rich, a vast lower class with no property, and a small middle class. Such a social structure would not be good for long-term stability.

The key to a sensible property policy is to reform the fiscal structure. First, government spending, mostly in fixed investment, should be curtailed. China doesn’t need to build everything at once. Last year, the sum of government fiscal revenues, central and local government borrowings, and expenditures by state-owned enterprises probably exceeded half of the GDP. Could the government sector spend so much efficiently? Shrinking the government sector should be a top priority for the nation’s future.

Second, the government sector still owns assets worth more than the entire GDP. The government should give it to the people to expand the middle class – a move that would support consumption, incomes and tax revenue. Shrinking the government and giving wealth to the people are the policies necessary to make growth balanced and sustainable. 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,
China International Business, April 12, 2010

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