Is China's property market overvalued?

Beijing's recent clampdown on the property market is designed to curb speculation in certain cities only.
Beijing has rolled out a slew of measures in recent months to cool investment growth, in particular the property market. The anti-speculation measures are aimed at the foreign investors and luxury residential market. But foreigners, and their alleged property speculation, account for a very small share of total transaction activity in China. Why target them? Beijing seems to have flushed out the austerity measures hastily. Is there a policy panic, which could end up in policy overkill, crashing the market? Is ChinaÆs property market vulnerable to a collapse?

The bottom lines
ò ChinaÆs property market is going through some short-term pains for long-term gains.
ò The economy may not be as hot as the headline numbers show, but the growth imbalance is serious û excessive investment and heavy reliance on exports
ò Rather than cracking down on the whole economy, Beijing is trying to re-balance the growth drivers to consumption.
ò Hence, administrative measures are used as the primary policy lever to redirect growth momentum away from investment and exports, with monetary policy as a secondary tool.
ò Beijing is serious about rebalancing growth and preempting potential economic overheating. Thus, the current battle is not just against property. More austerity measures are on the way.
ò Policy risk for the asset market has risen sharply in the short-term, leading to an inevitable slowdown of the asset market.
ò There is no evidence for a national property bubble. The authorities are trying to prevent speculation from creating an asset bubble.
ò Due to their role in driving property transaction momentum, the foreign investors/speculators are targeted by the recent austerity measures despite their small share in the Chinese property market.
ò Conditions for a market crash (sharp fall in income growth, housing oversupply and sharp monetary tightening) are not present. Beijing is not in policy panic, thus not risking systemic volatility.
ò The secular up-trend for housing prices remains intact, given limited supply, strong income growth, accelerating urbanisation, financial liberalisation and continued inflow of foreign capital.

The trigger for the new austerity measures
ò 2Q06 GDP growth came in at 11.3% YoY, up from 10.3% in Q1 and was the highest since 1995.
ò Urban fixed-asset investment growth sped up to 35% YoY in June (from 30% in Jan-May)
ò Industrial output jumped 19.5% YoY in June (from 17.9% in May and 3mma 17.4%).

These growth numbers were too strong for BeijingÆs comfort. They also suggested that last 2.5 years' tightening package had not been effective in reining in excessive growth pressures. The key reason for the failure was defiance from the local governments. Some market players estimated that over 90% of the local governments ignored BeijingÆs land quotas and project approval procedures and illegally supplied land to developers and other investors. Corruption was the common link between these various defiance motives.

The measures
Beijing was quick to respond. A few days after the GDP data was released, it came up with a whole bunch of austerity measures. On the macro front, it cut export tax rebates by 2 ppt; hiked banksÆ reserve requirement ratio (RRR) by 0.5 ppt to 8.5%, the 3rd RRR hike in 3 months. Before that, there was also an interest rate hike of 27 bps in April (28th). It has also intensified the anti-corruption campaign.

On the property market front, a slew of measures were rolled out, with the following within the last 2 weeks of July:
ò A 20% capital gains tax on property bought and sold within 5 years
ò Setting up 9 regional bureaus to monitor land sales at local level
ò A cut of the LTV ratio for lending to developers (they are required to pay at least 50% upfront now)
ò A restriction on foreign investment in Chinese residential property
ò A rule restricting developers building large homes

And the following were introduced in May:
ò State Council unveiled a slew of measures, including a 5% business tax on total sale price, raising mortgage down payments, punishing developers who sit on land holdings
ò State Council announced 6 broad measures, including tax, credit and land restrictions to slow the property sector

These series of measures were BeijingÆs most intensive tightening moves in 4 years, reflecting its increasing hawkish policy stance.

Why target the foreigners?
The amount of foreign investment in Chinese properties is small, estimated to have accounted for 4.5% of total property investment (or US$8.7 bn) in 2005 (see chart below). Shanghai and Beijing perhaps accounted for 90% of this.

Though the foreign share is small, it is highly visible and important in the luxury residential market in the big cities. Foreign investors are often the key players driving transaction momentum. Their activities in the luxury residential and top-tier commercial markets in the big cities are mostly where speculation is found. The authorities want to stop speculation from spreading to an asset bubble by targeting the small but volatile foreign slot of the market.

Why is Beijing worried?
Rapid rise in housing prices is normal in developing economies with strong growth, like China. This is because demand for both tradable and non-tradable goods rise as income grows. Generally, non-tradable goods prices, like housing asset, will likely rise faster than tradable goods prices as tradable goods supply is more elastic. In response to rising demand, imports and local goods supply will rise to dampen tradable goods price hikes. But non-tradable goods supply, including housing, is inelastic. Hence, their prices rise faster.

In big cities, like Shanghai and Beijing, property prices have risen rapidly, resulting in sharp yield compression (see chart below). The government is concerned about that, as expectation of asset price inflation attracts excessive investment and speculation. These, in turn, would risk financial instability. Though ChinaÆs mortgage loans account for only 10% of all bank assets, banksÆ exposure to property, including loans to developers and investors and loans with property collaterals, would be many times more than that. Any major market shake-out could boost NPLs sharply.

Is the market going to collapse?
If experience in other Asian economies is any guide, the conditions for a market crash are not here. They include sharp fall in income growth, significant oversupply of housing and sharp monetary tightening.

Income growth
It is true that housing affordability has worsened, especially in Shanghai (see chart below). The rapid rise in housing prices in recent years has made it increasingly difficult for ordinary households to buy houses. This has, in turn, raised social and political tension.

However, rising housing prices should not be seen in isolation. Strong income growth tends to raise affordability. Indeed, ShanghaiÆs robust income growth last year (12.8% YoY) helped improved housing affordability (see chart above) on the back of a mild residential price correction (-0.1% YoY).

ChinaÆs overall income growth has remained robust. The risk of a sharp drop in income growth is quite low. An improved fiscal position and ample liquidity in the banking system mean that Beijing is in a good position to counter any economic slowdown. Hence, income growth is not a risk threatening the market.

Land supply is a hard constraint. Despite its large size, ChinaÆs population is concentrated in certain regions, esp. the coastal provinces. Strong income growth in the past 3 decades has led to a rapid fall in arable land areas. Protection of arable land is now a top policy priority. This means that land supply near the urban centres will only become more limited going forward.

On the other hand, housing demand will keep rising, due to strong and steady income growth, financial liberalisation, housing reform and urbanisation. Hence, supply is also not a factor risking a market crash.

Even in the luxury residential market in Shanghai, the supply and demand gap is expected to fall in the next few years (see chart below). With the latest policy actions limiting luxury residential development, the risk of future supply lies in the downside. Excess demand for high quality housing should help underpin prices over the longer-term, despite an expected mild correction in the short-term.

Monetary tightening
While the PBoC has tightened up credit conditions recently, any major monetary crackdown is not likely. As the authorities want to rebalance the growth drivers from exports and investment to consumption, they will need to keep liquidity reasonably loose to facilitate the growth transition.

On balance, administrative measures are carrying a heavier weight in redirecting growth momentum than monetary policy, which is taking a secondary role. Finally, a lack of inflationary pressures argues against the need for any large scale monetary tightening.

Is there a policy panic?
Flushing out a large number of measures in a short period of time looks like policy panic. This is not the case. The overall policy tone is hawkish indeed, but the measures are highly selective to target excessive investment growth, including the property market, and speculation. None of the measures affect end-usersÆ fundamental housing demand. They are focused on anti-speculation in the luxury residential market.

There are no imminent economic problems and no evidence for a national housing bubble that would create policy panic. Housing demand is supported by robust fundamentals. Overall, property price growth has not outpaced income growth so that property prices cannot be blamed for growing excessively (see chart below). There are overheated pockets in certain cities, notably Shanghai and more recently Beijing and Shenzhen. These are what Beijing is trying to tackle via the administrative lever.

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