The dangers of the Chinese property bubble

April 19, 2016

As the Chinese growth model reaches the end of the road and the economy starts the process of what will probably be a wrenching and painful adjustment all eyes are on the banks and the finanacial sector as fears grow that the country could suffer a major financial crisis. But an even more pressing and threatening danger is a collapse in property prices which would lead to massive loss of household wealth, a collapse in consumer spending, and the decimation of local government budgets and the construction sector.

The price of Chinese property to income ratios in the top Chinese cities are off the charts. Beijing is 33.5 times income, Shanghai is 30.2 and Shenzhen is 30.0. The average apartment in such tier I cities is only 650 square feet and would go for $460 per square foot, or $300,000, in a tier II city, we’re talking $100,000. That may not sound like a lot, but the average Chinese are only making about $10,000 per year!

According to the IMF ’s house price-to-wage ratio, China has seven of the world’s top ten most expensive cities for residential property. All through the country’s tier-one, tier-two, and even some tier-three cities, housing prices are severely out of proportion with the incomes of the people who live there.

In Xiamen, a coastal city with a perpetually hot property market, $300,000 for an apartment is normal — even though the minimum wage there is hardly $200 per month and the average wage is around $1,000. Even for the city’s middle class residents, who make between $1,200 and $5,000 per month, the price seemed prohibitively high.

Nevertheless 90% of Chinese families in the country own their home, giving China one of the highest home ownership rates in the world. What’s more is that 80% of these homes are owned outright, without mortgages or any other leans. On top of this, over 20% of urban households own more than one home. So with wages so out of whack with property prices, how can so many people afford to buy so many houses?

The current property market in China must be understood in the context of where this market came from. Hardly 20 years ago China’s property market didn’t exist. It wasn’t until the mid-90s that a series of reforms allowed urban residents to own and sell property. People were then given the option to purchase their previously government-owned homes at extremely favourable rates, and most of them made the transition to being property owners. Now with a population provisioned with houses that they could sell at their discretion and the ability to buy homes of their choice, China’s property market was set to boom. By 2010, a little over a decade later, it would be the largest such market in the world.

In China individuals are not, as is the general modus operandi in the West, going out and buying property on their own, instead property is bought using finance raised via entire familial and friend networks who financially assist each other in the pursuit of housing.

At the inner-circle of this social network is often the home buyer’s parents. When a young individual strikes out on their own, lands a decent job, and begins looking to pursue marriage, buying a house is often an essential part of the process. Owning a home is virtually a social necessity for an adult in China, and is often a major part of the criteria for evaluating a potential spouse. As parents tend to move into their children’s homes in old age, this truly is a multi-generational affair. So parents will often fork over a large portion of their savings to provision their children with an adequate house, often buying it years in advance. If parents are not financially able to buy their kids a house outright, they will generally help with the down payment, or at the very least provide access to their social network to borrow the required funds.

There are also very strict rules as to how much money people can borrow from the banks for purchasing property. Although this slightly varies by city and wavers in response to current economic conditions, for their first home a buyer must lay down a 30% down payment, for the second it’s 60%, and for any property beyond this financing isn’t available. So for people to buy homes in this country they need to step up to the table with a large amount of cash in hand. In fact, 15% of all residential property in China is paid for in full upfront.

Why there is so much liquid cash available for these relatively large down payments is straight forward: the Chinese are some of the best personal savers in the world, and saving on average roughly 30% of their income, which is often called into use for such things as making a down payment on a home. This propensity to save in large amounts is partly cultural (reflecting a culture that values prudence and the still vivid memories of great insecurity during the Cultural Revolution) but is also the result of the system of financial repression that exists in China and which underpins the Chinese growth model (see this article). Financial repression involves holding down interest rates for savers so savers respond by saving more.

Another way that Chinese home buyers are able to afford their down payments is via the country’s Housing Provident Fund. This fund began when the country started privatising urban housing as way to help residents afford to buy their homes. Part of this fund included a government initiated savings plan where employees are given the option to invest a portion of their monthly earnings and have it matched by their employer to assist them with buying a house.

Once the down payment is accounted for, getting mortgages in China is a relatively straight forward affair, and the standards for qualifying are relatively low. For the most part, a borrower’s monthly salary must be at least twice the monthly repayment rate of the loan. Interest rates hover around 6%. On average, those who have these loans will devote between 30% and 50% of their monthly income towards paying them back.

A far smaller proportion of Chinese households have mortgages compared to,say, the USA. Just 18% of Chinese households have mortgages, compared with half of all home owners in the USA. China’s home mortgage-to-GDP ratio was just 15% in 2012, whereas in the USA it was a staggering 81.4%. Although monthly wages in China tend to be relative low, non-performance on mortgages is virtually unheard of — in 2013 the default rate was a mere 0.17%.

The problem in China is not the danger of a cascading mortgage default crisis but, given that the ordinary Chinese have a huge proportion of their personal wealth tied up in property, a sudden reversal in the property market (and given the recent huge rises in prices a major correction does seem very likely) could wipe that wealth out. It is estimated that as much as 75% of personal wealth in China is in property as they have overinvested in one illiquid and bubbly asset that they wrongly believe can only go higher. The Chinese now often buy empty properties for the future, or even for pure investment, they don’t actually use these properties. An independent firm monitored homes that were using no electricity and found a 27% vacancy rate.

In urban areas, property has bubbled up between five and seven times just since 2000. It’s even greater than the unprecedented housing bubble in Japan in the 1980s, which suffered a 60% collapse that it’s never recovered from, even 25 years later. A 60% collapse is the minimum the Chinese should expect. But it would actually take 80% to get back to the pre-bubble values of early 2000. This would be devastating to the Chinese. It is estimated that household wealth in China is $27.2 trillion, or about three times GDP. With 75% of that in property, that comes out to $20.4 trillion. If property values falls 60% as it did in Japan, that would mean $12.2 trillion in wealth would just disappear. And if it falls 80%-plus due to the larger size of China’s bubble, we’re talking $16 trillion or more evaporating! If the Chinese property market crashes hard it could be the largest relative evaporation of household wealth in modern history.

If the Chinese property market does suffer a major correction it will have profound effects. For a start it will drastically undermine the attempt to shift from the old, and increasingly unsustainable, growth model based on low consumption to a new model based on greatly enhanced personal consumption rates. If property crashes and wealth is wiped out the Chinese consumer will reduce consumption, the exactly opposite of what is needed. The insecure Chinese consumers (after past poverty and with weak social safety nets) will respond to disappearing wealth by spending less.

Local government in China depends on land development sales for roughly 2/3 of their revenues. These are not fee simple sales of land, but the sale of leasehold rights, as all land in China is owned by the state. There is no substitute source of local government revenue waiting in the wings should land sales and housing development grind to a halt. Local governments will lose 2/3 of their operating revenues, and there is no other source they can tap to replace this lost revenue.

If China does suffer a property wealth implosion (and all property bubbles eventually crash sometime) given its scale it will make Japan’s look benign. Cities like Vancouver, Sydney, Melbourne, Singapore, San Francisco, L.A., New York, and London, anywhere that thrives on affluent Chinese laundering their money out of their country, will feel feel the knock on effects.

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