Crazy for Real Estate
By moving too slowly on capital market reforms and the implementation of laws to protect the interests of household investors, central authorities may have diverted an unnecessarily large proportion of household savings into real estate.
In recent years trust companies and commercial banks have attracted a lot of retail investor interest with so-called “wealth management products,” many of which are ultimately linked to loans to real estate developers in exchange for a relatively high return. Recent events have shown, however, that the risks associated with these securities can be quite high, especially when the legal mechanisms for resolving defaults and disputes are underdeveloped.
All in all, these trends have shown that regulatory and administrative power in the financial sector can be better used to help improve faith in more conventional stock and bond investments, and in doing so reduce the fanatical demand for urban property that has been observed in recent months.
With all of this in mind and in the broader macroeconomic context we find today, one has to ask, is the current fixation on real estate in urban China rational? In many ways it would seem that the answer to this question is “yes”: it is rational for many to expect that strong cultural and investment demand for real estate will overwhelm administrative control measures. Furthermore, the impact of these factors is amplified by a lack of adequate investment alternatives for households who save a large proportion of their incomes. An additional reality not described above is local governments’ dependence on land and property sales to make up for annual revenue shortfalls. Adding to this combination of factors is the fact that households in China have comparatively low levels of mortgage and other forms of consumer debt, and it looks like the probability that prices will fall significantly any time soon appears relatively low.
The momentum behind urban property prices in China is, however, becoming harder to sustain. Current trends require constant additional inputs of energy in the form of credit to property developers, and information to drive household investment behavior. The former is a positive force where it comes to investment in property development, which drives increases in the supply of new real estate. The information (in the form of actions, coming from central regulators) indicates to households that real estate investment is probably their best choice, with few alternatives. Together these forces are part of what is driving a feedback loop that continues to send first-tier property prices ever higher.
Returning to ideas from systems theory, when the state of a system depends on a set of variables, a significant change to one factor beyond a certain point can cause what is called a “phase shift,” when a new set of relationships between the individual factors comes in to govern the system. As indicated above this is about managing opposing forces to maintain a certain equilibrium. In this case, a necessary step to preserve systemic stability is the rapid development of capital markets and reliable new investment opportunities for households. This would help deflate the demand bubble that currently exists.
A second necessary step is to better manage the supply of new credit to property development, improving transparency and formalizing informal channels for raising capital. This would help to deflate the supply bubble, a phenomenon that increasingly holds the financial system and much of the rest of the real economy hostage to the property sector as it gets larger.
Looking ahead, the successful management of the economy will depend more on the government’s ability to balance opposing forces rather than strict adherence to ideological economic policy agendas. The property sector is perhaps the biggest and best case in point. With this in mind and when it comes to divining future price trends in the property sector, it will be important to think through how policy reforms elsewhere will feed back into and balance with the systemic characteristics of the property sector in China. So will these most recent measures targeting high home prices have their desired effect? Probably not. Prices are a product of systemic relationships, not an autonomous phenomenon.
WILLIAM HILTON is director of PRC Macro Advisors, an independent analysis firm headquartered in Hong Kong.
