The Fate of China's Economic Bubble

What Are the Reasons behind China's Bubble Economy?

Why did a real estate bubble pop up overnight? The actual reason for the real estate bubble lies in the national savings rate of over 40% and the high investment rate that spawned it. During the past 10 years the high economic growth rate was supported, but as a result of the undeveloped social security system, consumption is now dropping. People carry fears of an insecure post-retirement lifestyle and so they restrain current consumption. Over the past 10 years the propensity to consume has dropped by 10 points. One problem lies in the fact that most household savings is concentrated in state-owned banks, which in turn are mediated by state-owned companies. Under the government's policy of soft budget constraints, state-owned companies ignore capital costs (interest) and tend instead to inflate investment. As the propensity to consume decreased, however, state-owned banks and companies consorted to attempt to earn ever-greater expected returns and entered into real-estate investment.

When looking at current Chinese society it is clear that there is a great demand for real estate. Originally, urban residents lived in old apartments distributed by state-owned companies, but as the fast-rising wealthy class craved more comfortable residences there is now a strong trend toward buying new apartments. In order to help residents purchase homes the government also approved state-owned banks to provide housing loans.

Real-estate developers, however, have little interest in developing small, “economy” apartments, but rather they are fervently working to develop luxury condominiums and resort villas. This is because companies can earn higher expected returns on luxury condominiums and resort villas than they can on simple economy apartments. It is, quite simply, a get-rich-quick, high risk, high return business. This is the mechanism that has spurred the current real-estate bubble in China.

Promotion of the Real-Estate Bubble through Private Financing

At the same time, if the primary source of funding for the real estate bubble is only financial intermediation by state-owned banks, it should be possible to quickly deflate the bubble through sober financial policies by administrative authorities. The problem is not that easily solved, however. That is to say, the advent of the current real estate bubble is deeply connected to private financing. Vast private funds are cycling outside of the legal financial system, thus creating an environment where the impact of administrative authorities' policies is unable to spread.

Interestingly, the areas where the real estate bubble has grown the most are not cities like Beijing or Shanghai, but rather places famous as tourist sites like the city of Hangzhou in Zhejiang. For Chinese, this is rather unexpected. In reality, Zhejiang is a region where private financing has been exceptionally well developed. In Hangzhou, real-estate investment is primarily conducted by investors from Wenzhou in Zhejiang. Wenzhou's economy got its start primarily in manufacturing items such as shoes and buttons but has already progressed past the beginning phase of capital accumulation, and Wenzhou entrepreneurs are now looking for new opportunities through international investment.

Over the past 10 years, Wenzhou investors and entrepreneurs-armed with vast funding throughout China-have quickly expanded through speculative business practices, in particular by stockpiling electricity and coal and selling it off at high prices. They are now pursuing real estate speculation in the same manner. Specifically, Wenzhou investors buy up all of the real estate property under construction in an area and sell it off at monopolistic prices. As a result, their prices have become the real estate market's benchmark and real estate prices are skyrocketing accordingly. In Hangzhou, where in the mid-1990s residential buildings went for 2,000 yuan/sq m, prices have now reached as high as 9,000 yuan/sq m for both new and old buildings. Luxury apartments in the city overlooking West Lake can go for as high as 40,000 yuan/sq m (about 600,000 yen).

The real problem with the real estate inflation in Hangzhou is that as real estate prices have risen, income has not. The average monthly salary in Hangzhou is roughly 2000 yuan; the average resident can't even afford a normal apartment, let alone a mansion. According to local surveys, the end users of Hangzhou's high-end real estate are not people from Hangzhou at all, but rather capitalists and foreigners from the big cities like Shanghai and Beijing.

For a Chinese, a one-unit 10-20 million yen luxury condominium is most likely just an unattainable dream, but compared to other countries such a condominium seems like a steal. In particular, when one considers the future growth of the Chinese economy, for foreigners it seems that buying such a place would not be a bad investment at all.

This speculative real estate investment, which has inflated the market and caused an asset bubble, cannot last long, however. First, getting a scent of policy changes in the government, it is not clear when Wenzhou investors will sell their property at bargain prices. Second, if there is a round of real estate buying by foreigners, the underlying support of the market will weaken. Third, most domestic demand is for “economy apartments”, not for resort villas and luxury apartments. The weakness of true demand for extravagant villas and apartments in the market may very well become the greatest cause for the collapse of the bubble. The real question is, how much of a soft landing can be prepared for the current real estate bubble?

On 21 July the Central Bank of China revaluated the yuan in order to curb the spread of “hot money”, and also decided to pursue reforms of its exchange regime such as expanding the flexibility of its yuan market. At the same time, the Central Bank and the Bank Oversight Board strengthened regulations on discount windows for state-owned banks and other commercial banks, and purposeful measures are being put in place in order to prevent the expansion of the real estate bubble beyond present levels.

In the midst of these economic policies by the Chinese government, the real estate markets of major cities appear to be cooling to a degree. This does not mean that real estate prices are dropping, however, but merely that the rate of increase for real estate is declining. There is fear in the market that the government's bad loans will be exposed, and thus no one is taking drastic measures to clamp down on the market. While Prime Minister Wen Jiabao has sent strong warnings to local governments through announcements such as “Local governments should cooperate with the central government”, the investment boom in local regions does not seem to be over yet.