The Prophecy Came True: The Ongoing Crisis of the Chinese Housing Market
The crash of the Chinese developer giant Evergrande set off a chain reaction of defaults from China’s top developers, effectively cutting out the steam to the roaring train of the Chinese housing market. Although optimistic beliefs claim that this series of defaults will be just another hiccup in an overall indestructible and risk-free market and that the government has the power to intervene and save the market in the short run, these recent events serve more as a wake-up call for the central government to reevaluate the housing market as a double-edge dagger. Despite the housing market’s crucial contribution to China’s economic growth in the past two decades, its unsustainability is deeply entrenched in the central economic policymaking and local government agendas, which exacerbated the financialization and the subsequent speculations of Chinese housing, threatening the economy in the long run.
Chinese housing market’s initial boom from 1998 to 2003 followed a sustainable free-market approach, filling the demands arising from decades of socialist provision housing model, yet the lack of investment platforms in the early 2000s gradually led to the financialization of housing. Before the policy reform in November 1998, the government operated under a “dual tracks” system where the government controlled the distribution of housing to state-owned enterprises’ employees at a price significantly lower than the market price, and individuals could purchase housing from the government (Qiao, 2). Because individuals could not take out mortgages, provisional housing made up most of the market. However, after abolishing the “dual-tracks” system, the government legitimized the private ownership and trading of real estate and housing and opened access to mortgages for citizens. Compared to provisional government housing, private housing provided homeowners with additional choices for customizations: larger spaces, more rooms, and more locations. As a result, the housing market gradually picked up steam as more consumers sought to purchase their own homes.
However, by 2003, people quickly realized the financial aspects of private housing. Compared to the nascent Shanghai Stock Exchange and Shenzhen Stock Exchange, which despite the high growth opportunity, carried high inherent risks, private housings have a steadily increasing demand and only sparse supplies, as developers’ capacities are limited. Furthermore, from 1998 to 2003, housing prices only increased 3.5% annually, while personal income per capita grew at a much higher 9.5% annually (Qiao, 2). As shown in the top model in Figure I, the accumulated demands and limited supply expanded the housing prices quickly, where the average housing price jumped almost 45% in 2004. And aside from 2011, house prices exhibited sustained growth driven by salary growth, as the median new commodity housing index of CREIS (Chinese Real Estate Index System), which measures housing appreciation, increased from 97.9 points in the first quarter of 1998 to 145.1 points in the second quarter of 2006, around an 8% increase year-on-year (Wu, 12). More notably, the megacities like Shanghai and Beijing saw even more aggressive price increases, wherein in the first quarter of 2006, house prices in Beijing increased by 17.9% (Wu, 12). However, even since its beginning, private housing has proved to be an expensive asset for the average person. The bottom model in Figure I benchmarks the yearly mortgage payment for a comfortable home for three against the average salary in Shanghai. As shown by the graph, the mortgage payment takes up 90% of the average salary. For a family with multiple sources of income or people with enough funds for a larger down payment, this mortgage could be handled; however, for those who were newcomers to the city or those earning below average, they have been priced out from the start and needed to take on larger risks to buy their first home. This planted the seed for severe issues in the future as the increasing housing prices further diminish demands. Nevertheless, the sustained appreciation at this stage solidified private housing as the golden investment class and expanded housing outside of its practical use for Chinese households and investors alike, subsequently leading to an increase in speculations enabled by the banking sector.
Figure I.
It is undeniable that the growing housing market and fixed-asset investments in infrastructure has brought prosperity to the Chinese economy by creating numerous construction jobs, a large amount of liquidity for business as they were allowed to use housing as collateral for business loans, and wealth effect from appreciating housing prices. Spearheaded by these two sectors, China’s GDP averaged a staggering 9.27% growth rate from 2003 to 2018, becoming the world’s second-largest economy in less than two decades (World Bank). However, the housing market’s expansion highlighted unsustainability over the long term, both in terms of the market itself and its ripple effects on China’s SMEs (small- and medium-sized enterprises). Compared with an investment in the housing market with minimal risk, high compounded return, and lower mortgage rates relative to business loans, starting a business was simply the less optimal choice for many Chinese families with adequate funds. As the economic growth became coupled with the prosperity of the housing market, its maintained expansion requires an increasing demand to steadily drive higher revenue through larger volume or higher prices. But once the market becomes saturated or the price becomes too high to justify the purchase, the whole system built on the premise of increasing demand no longer holds, and the Chinese economy will face devastating damage from the housing market’s demise. Due to the Chinese government’s absolute authority in market planning, their control and policymaking could bring the final say.
Chinese central government’s policymaking regarding the heated housing market and the manipulation of the real estate market through state banks to combat financial downturn stripped away the chance of cyclical and healthy self-correction from the market. The fourth quarter of 2008 saw a sharp drop in the Chinese GDP growth rate to 6.3% amid the 2008 Financial Crisis (Schueller, 168). To rejuvenate the economy, the government acted swiftly by injecting a stimulus package of 4 trillion yuan, consisting of significant investment in infrastructure projects (Wu, 14). The package was allocated on a competitive basis, which motivated local governments to push forward with land supply to satisfy the conditions for these projects. To further fuel consumption and investment, the central bank announced a reduction of 1% in the bank deposit requirement, effectively releasing 450 billion yuan for investment, most of which flowed into the housing market to ease capital constraints on developers (Wu, 14). The minimum capital requirement for commodity housing projects was reduced from 30% to 20%, and the down payment for house purchases was reduced to 20% in October 2008 (Wu, 14). After the series of new policies, the Chinese economy was revigorated, growing at 10.7% year-on-year in the fourth quarter of 2009 while the rest of the world was still suffering from the aftermath of the financial crisis (Schueller, 168).
The enormous size of the housing market made it an ideal vessel for the central government to manipulate the economy. On the other hand, stimulating the economy through the housing market created a vicious cycle that inflates the market and snowballs to severe long-term effects. The housing market is usually the first sector to be impacted by a financial crisis due to decreasing demand. But because of China’s aforementioned dependence on the housing market for GDP growth, a halt in the market could cause a chain reaction across all industries; therefore, by stimulating both the supply and demand through similar policies as the 2008 crisis, the government was able to boost consumption significantly in the transaction of properties and thereby averting the downturn. In hindsight, this decision seemed atypical and short-sighted for a government known for its long-term economic planning, but China’s homeownership rate was only around 74% in 2008, which did allow the government to pre-expense some future demand to save the current economy. However, as the housing market became increasingly saturated, the continuous government intervention during the pandemic left no room for it to correct itself, creating a system where the housing price is forced to grow without regard for the economic climate.
The increasing housing prices also corrupted social mobility for the younger generation. As those born in the 90s come to the megacities like Shanghai and Shenzhen to work, they find it hopeless to own a home or start a family. In Shanghai, the average wage is just over 170,000 yuan (USD 24,409). In comparison, a comfortable home for a family of three in a convenient location can easily cost 10 million yuan (USD 1.4 million), almost 60 times the yearly wage (World Bank). This means that affording a home solely by earning a paycheck is nearly impossible. Homebuyers would need to currently own and sell a home in that city to afford the down payment, let alone the mortgages. Even though the central government realized that an oversized housing market and rising housing prices would pose significant risks to the economy and social mobility, their attempt to cool off the market proved futile.
The conflict of financial interest between the central government and local government led to poor implementation of the state’s effort to cool off the market and gave rise to highly leveraged business practices of private developers. In China, each local government needs to submit budgets to the central government at the beginning of the year for the central planning of public expenses (Qiao, 14). For less developed inland regions, the annual budget could be limited due to low tax revenue from local businesses. Because local governments could not issue their own debt, they set their eyes on the real estate market to boost revenue. By leasing out the land for private construction, the local governments could generate high additional revenue each year. Given the rising housing prices, the developers flocked to lease lands from the local governments, driving up the land prices. This creates a vicious cycle where the increasing prices of the land lead to higher housing prices, which in turn lead to higher land values, benefitting the local government as they can earn even higher revenue but vastly inflating the housing prices. The central government had made efforts to artificially decrease high-end demand and supply to stabilize the housing prices, primarily through adjusting mortgage rates for owners with more than two homes or outright restricting them from purchasing more properties. But because rising house prices are in the interests of the local government, the implementation of those policies is usually loosely enforced. For example, after the home purchase restriction announcement, many multi-property owners, who own housing in older units that are not recorded in the housing database, were not affected at all. Some families who sought to keep investing in housing would get a divorce and allocate the current homes to one party, so the other could buy more properties. As a result, though the central government’s attempt to cool off the market had short-term effects, the housing market would nevertheless pick up steam after each artificial setback and return to its high growth stage.
Driven by the profitability of the housing projects and limited land sales, developers’ competition created an extremely unsustainable business model — “preselling homes,” where developers sell houses to consumers before the units are built and collect payment from homebuyers to use as financing for previous projects. After a period of consistently rising housing prices, developers formed a higher risk appetite and started to anticipate their future land supply needs. These developers speculated on the rising housing price and purchased more lands than their operational needs and capabilities from the local government each year and packaged those lands to market to homebuyers as future projects that are available for purchase right now. Though this practice allowed developers to expand quickly, it also put a redline on the cash flow requirement, where if multiple projects failed to reach the sales target, the constructions for previous projects would be out of funds, causing more than just financial catastrophes, but also social unrest, where homebuyers are usually left with unhabitable homes. However, when price steadily increases, successful businesses are often not the ones that are most successful at producing and marketing products but rather the most aggressive in speculating on real estate (Pettis). Developers willing to take excessive property risk consistently outperform their more prudent rivals, and over time the former begin to displace the latter (Pettis).
At this stage, all the players in the market — the banks, the developers, the local governments, and the central government — shared a common interest in increasing housing prices. In this process, homebuyers and developers have formed a greater fool game, where homebuyers and developers invest in the housing market without concerns for the fundamentals due to the belief that there will always be a “greater fool” to buy the properties at a higher price. The vicious cycle that the players collectively created pumped up the pricing to an unreasonably unaffordable level, and the younger generation no longer feels compelled or even capable to purchase housing for themselves. As mentioned in the beginning, some optimists are still bullish for the housing market, claiming that the government will ultimately intervene with another injection and balance supply and demand. However, this system built on a flawed basis has already reached a breaking point, as the high prices combined with the devastating effect of the pandemic and lockdowns on the economy effectively killed the demand for private housing, the most crucial premise for the greater fool game. Subsequently, the diminishing demand crashed the cash flows of many prominent developers, whose cash flows were spread thin in multiple projects. The Chinese government acted swiftly again, trying to boost demand by decreasing mortgage rates, easing down payment requirements, and lifting the home purchase restriction, but this time, their effort has been to little avail. Sales at the country’s top 100 property developers fell 39.7% in July from the same period last year and decreased 28.6% from June (Li). Even if the Chinese government managed to drag the housing market out of the mud this time, it must push decoupling from the housing market for growth to the top of its agenda. However, the government has to do so with surgical prudence — one wrong move, and we may witness the fall from grace of the second-largest economy in the world.
Work Cited
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