A question of time

It isn’t a question of whether China’s property market is a bubble, but when it will burst.

Xiao Wan bought a 65-square-metre apartment near the North fourth ring road in Beijing last year. He couldn’t even recall clearly the room layout but remembered it was the first decent enough apartment that he found fairly affordable. He hastily signed the purchasing documents, but has never lived there and does not plan to.

The 27-year-old lives with his friend near the third ring road in China’s capital city. He bought the apartment as an investment, which so far is panning out. “I bought it for Rmb15,000 ($2,214) per-square-metre; it now can be sold at Rmb25,000,” he said. “It’s good just having it.”

Wan is not alone. Many homebuyers nowadays in China consider their property assets as part of their long-term savings plan, as well as a hedge against inflation.

Why property? China’s tightly run financial system leaves only three places for its zealous savers to put their money. Bank deposits are one option. But they yield 2.25%, less than the 3.1% rise in May’s consumer price inflation. The equity markets are a second choice. But stocks have been performing poorly; Shanghai’s benchmark index was one of the world’s worst performers in the first half of 2010. (And the bond market is underdeveloped.) Even with its high transaction costs and manic price moves, property has become the preferred investment choice for everyone from young married couples to middle-aged factory workers trying to ensure their retirement.

Recent statistics show that there are about 64 million apartments and houses that have remained empty during the past six months, according to Chinese media reports. On the assumption that each flat serves as a home to a typical Chinese family of three (parents and one child), the vacant properties could accommodate 200 million people, which account for more than 15% of the country’s 1.3 billion population. But instead, they remain empty. This is in part because many Chinese believe that a home is not a real home unless you own the flat.
And so people prefer buying to renting, and as a result, the rental yield is relatively low.

This has fuelled worries that China’s property market is bubbling. Yi Xianrong, a prominent economist, said the numbers are “shocking” and the country’s property market is dangerously overheated. “Many of them are bought by property speculators betting on a constantly rising property market,” he wrote in a commentary to the official newspaper, the People’s Daily. “This is a serious threat to the sustainability of China’s economy.”

In property we trust

Crowds of eager customers carrying several bags of cash (cheque books are not commonly used on the mainland) and folding chairs can frequently be seen waiting at the sales offices in major cities in China. Not surprisingly, home prices in tier-one cities surged around 50% last year, statistics show.

“Some of the apartment prices in tier-one cities match those in Manhattan, but China is still a developing country,” said Frank Yao, senior portfolio manager at Neuberger Berman, a wealth management firm. “When the properties become less affordable, developers will eventually collapse,” he said, noting the recent trend in real estate prices indicate signs of a potential bubble.

But is China’s property bubble about to burst? That’s the million dollar question. “The data about the property market in China is not complete; it’s very difficult to say how big the bubble is. And we don’t have sufficient evidence to precisely illustrate the prospect,” said Shen Minggao, chief economist for Greater China at Citi.

“However, we have two indications showing the property bubble is growing. There are increasingly more people turning to banks to fund their home purchasing and investment in real estate is growing fast,” he said.

Last year, around 50% of the Rmb4 trillion sales in residential properties were from bank lending, compared with 2007, when only 20% of home buying was funded by bank loans.

This is despite the fact that borrowing from a bank is typically the last choice for mainlanders. Most turn to families and friends first. Thanks to China’s one-child policy, a newly married 20-something couple can count on the undivided support of their parents to buy a new flat. Borrowing from parents doesn’t leave a non-performing loan (NPL) trail.

Another sign that the market is gurgling to a boil is that property investment accounted for 10% of total GDP in 2009, compared with 8% in 2007, according to Citi. By contrast, when Japan reached its peak of property investment, it didn’t exceed 9% of GDP, while in the US, investment in real estate never exceed 6%.

“In the first half this year, the growth of property investment exceeded 30%. The market is over-invested,” Shen said.

Battle against the bubble

The problem is severe enough to test the nerves of China’s policymakers. Not only could the dramatically climbing house prices cause social discontent, they could also dampen consumption, which Beijing desperately needs to increase. If families need to allocate more and more of their income to fund their home purchases, that drains away the cash that’s available to buy other consumer goods.

Since mid-April, Chinese authorities have tightened credit conditions for buyers. First-home buyers are now required to make a down payment of 30% for units with a gross floor area of more than 90-square-metres; if it’s a second home, the down payment must be 50% of the actual price (it previously was 40%); mortgage interest rates must exceed the market lending rate by at least 10% (for second-homebuyers); and at the local government’s discretion, applicants for third mortgages can face even more stringent down-payment requirements and higher interest rates.

The government is clamping down on property developers. It tightened developers’ access to bank credit and restricted their access to the capital markets; it can penalise or confiscate land from developers found to be hoarding land.

As a result, transactions have fallen by roughly 60% across the 14 major cities since the introduction of anti-speculative policies announced in mid-April through July, according to Standard Chartered Bank.

“The third quarter will see a significant price correction in the residential property market. We expect the downward price adjustments in the second half will be 20% to 30% in tier-one cities, 10% to 20% in the tier-two cities,” wrote Standard Chartered economists Stephen Green and Jinny Yan in a report.

Economists say that policymakers will tolerate a property price decline of 30%, anything more than that might lead to too many loan defaults.

Still, analysts expect NPLs will gradually increase in the coming years. Watch out for the country’s less creditworthy local government financing vehicles, whose debts are usually repaid through the sale of land. They are expected to suffer the most damage. Defaults among property developers are also very likely since the government introduced tightening measures to cool property prices, Pricewaterhouse Cooper analysts have said.

But there’s the circular problem that if property prices decline too much, that could hurt GDP growth. Property and its related sectors contributed up to 25% of GDP last year. It’s a delicate balancing act: the government needs to cool the market and maintain growth.

To this end, officials are trying to steer developers toward building more affordable housing. Beijing has set provincial and municipal governments a target of 5.8 million new homes this year. But some question if construction of these cheap houses will take place at all. “I don’t see the motivation for local government officials to build these houses,” said Neuberger Berman’s Yao. “It will neither benefit their political career nor help support the local area’s GDP growth.”

The bubble will inevitably burst. It’s just a question of when.

This article was first published in the August 2010 issue of FinanceAsia magazine.

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