China has implemented monetary easing amid the global economic slowdown since the Lehman Brothers failure, and this has boosted real estate and other asset prices. China’s situation at present resembles Japan’s situation in the late 1980s, when authorities, reacting to the export slump caused by the upward revaluation of the yen after the 1985 Plaza Accord, adopted a low interest rate policy in order to spur an expansion in domestic demand - and thereby created the conditions that led to an economic bubble. The question is whether the Chinese economy, and its real estate market in particular, is at risk for a similar asset bubble.
The upsurge in the yen that began in 1985 triggered a downturn in the Japanese economy, prompting the Bank of Japan (BOJ) to enact monetary easing in hopes of bolstering domestic demand. Monetary easing created a liquidity surplus, and massive amounts of funds flowed into commercial real estate and equities. Bank lending doubled between 1985 and the mid-1990s, most of which (equivalent to 40%-50% of GDP) is thought to have gone into the property market.
China, with its expanding economy, also experienced an accelerated real estate boom beginning in 2005. In the second half of 2007, the government introduced measures to temper the sharp rise in property prices, including restrictions on bank lending and a new tax system. In 2008, just as these measures began to take effect, the market was hit by the Lehman shock, sparking an unexpectedly severe fallout in the fourth quarter. China’s government then switched back to a monetary easing stance, and bank lending has widened at an annualised pace of over 30% since January 2009, according to People’s Bank of China. We believe that a large part of the lending has been for real estate. Specialised real estate developers and the real estate arms of many large state-run firms have added to their property holdings. State-run firms may have accounted for more than 60% of the transaction volume in the initial stage of the market turnaround in the first half of 2009, though this has since subsided to around 30%.
In response to the overheating in real estate, the government has moved to dampen the growth in bank lending. Since July 2009, the pace of lending growth has been reduced to a moderate rate of 15% annualized. The Government has also tightened conditions for the purchase of second homes. Nevertheless, China’s authorities have yet to act in earnest to curb the property price rises, as they did in 2007.
Characteristics of the Japanese Bubble
Japan’s bubble was driven primarily by commercial real estate. Real estate loans to individuals accounted for only 20% of the overall credit growth, according to BOJ statistics, and bad debt after the bubble’s burst was concentrated in commercial property. On the pretext of commercial building construction or golf course development, investors across the nation had made exceedingly speculative purchases of commercial real estate, in hopes of a further rise in land values. In contrast, bad debt on residential real estate was fairly limited.
The post-bubble bad debt problem dragged on for nearly 15 years, a result of several factors specific to Japan. First, the bubble occurred after the end of the nation’s high-growth era. Japan’s potential growth rate at the time was an estimated 3%-4%, and the growth in real demand for real estate had already passed its peak. Also, the property bubble was extremely speculative in nature, with commercial real estate prices quintupling in just six years from 1985 to 1991. Furthermore, there was a distinct increase in leverage even among general businesses, as a result of land acquisition and excessive capital spending. So the bursting of the bubble led to a deterioration in fundamentals across the corporate sector.
From a mid- to long-term perspective, China’s real economy stands in marked contrast to bubble-era Japan. China is likely to continue to enjoy high growth for an extended period, and more importantly, demand in China for residential real estate is qualitatively different from demand in Japan, the U.S. and Europe. We could say that the rapid growth in the Chinese economy and the accompanying changes in the socioeconomic environment are systemic shifts that would span a 100-year cycle, as were the 1911 Revolution (founding of the Republic) and the establishment of the communist state in 1949.
One of the legacies of China’s prolonged stagnant growth prior to economic liberalization, is an overwhelming shortage of residential property that meets its new living standards. It will likely take a considerable period of time for supply to catch up to demand. From 2003-2009, residential property prices in major coastal areas rose an average of 12% annually, according to Centaline Property Research Center, though there remain regional gaps. Given China’s near-double digit economic growth, price trends over the past five to six years seem to be within a tolerable range, when compared with post-bubble Japan or with the U.S. in the wake of the sub-prime crisis.
Overall, the basic economic conditions in present-day China are substantially different from those of late-1980s Japan or the post-bubble U.S. As for the financial system, we note the striking improvement in the health of Chinese banks over the past five years. The share of loans in the real estate sector (loans to real estate firms as well as home mortgages) is relatively low; less than 20% of total lending, according to the PBoC statistics. As such, we see little risk in the foreseeable future that increases in loans to the real estate sector will pose a threat to the financial system. That said, a rapid increase in lending could lead to a rise in bad debt in the future, a risk of which Chinese regulators seem well aware.
Providing quality housing for the public is one of the critical policy goals for the Chinese government. The biggest challenge will likely be supplying vast numbers of reasonably priced middle-class homes. According to PIMCO’s own research and estimates, real estate development at present is directed mainly toward luxury properties, with mass-market housing accounting for only around 10% of total residential sales. Furthermore, luxury developments offer high margins, and regional governments, which in China have land use rights, have a strong incentive to prioritise such projects in order to boost their revenues (an estimated 10% of which stem from land sales).
Funds for real estate investments from abroad, mainly from overseas Chinese, have also been pouring into high-priced housing. If this results in an excessive rise in property prices, it will likely interfere with the government’s strategic aims. Therefore, the government may have to balance its long-term housing policy for the nation as a whole with the short-term goals of regional governments and real estate developers if it hopes to achieve a sustained stable housing market.
An expansion in mass-market housing is vital for China to realise growth powered by domestic demand. A high percentage of home purchases in China are carried out in cash (down payments are generally around half of the purchase value), and the amount of home mortgages remains relatively small. This is related to the nation’s high savings rate, but as middle-class housing becomes more available, the younger generations may rely more on loans. Increased demand for homes and durable goods may help promote a healthy cycle in domestic demand as a reduction in the savings rate may lead to higher personal consumption.
Given China’s potential growth, its real estate market has plenty of room for enlargement over the long term, which stands in clear contrast to Japan’s real estate bubble. That said, the current situation seems to have some characteristics of a future asset bubble. A key theme in the months ahead will likely be whether and how the Chinese government is able to contain the potential overheating in the market and shift the focus of housing supply towards the mass market.