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China has yet to stop its runaway property bubble

Capital controls and easy money keep investors tied to domestic real estate

Price caps on new condos have led to a supply squeeze in the southern Chinese city of Nanjing, pushing up the cost of existing units. (Photo by Issaku Harada)

BEIJING -- Wu Jianying, a company employee in Beijing, visited her father's hometown in Hebei Province, in mid-March. In Wen'an County, a one-and-a-half-hour drive south from the capital, she heard a strange rumor: The government might soon place restrictions on property purchases. In such a rural town, she wondered.

On April 1, China Central Television, the state TV broadcaster, reported in its evening news that the Communist Party and the State Council had decided to build a large city in Hebei Province. The new city, Xiongan New Area, would be created in an area adjacent to Wen'an.

Real estate transactions have since been forbidden in Xiongan. It is rumored, however, that condominium prices rose from 6,000 yuan ($871) per sq. meter around noon on April 1 to 24,000 yuan later that evening after the news.

"A group of speculators from Beijing had collected cash and had been actively looking for and buying properties for half a year," read an internet post. Although definite plans for the new city were unknown, just who had bought Xiongan real estate and how they did it became hot topics online.

Speculative money has also poured into real estate around Xiongan, prompting Wen'an County to restrict property purchases since April 5 in order to halt another asset bubble from forming like the ones in Beijing and Shanghai, where prices have continued to rise.

An important real estate indicator compares the price of a new "standard" condo to average annual income. Five to six times a person's annual income is thought to be appropriate. But according to the Nomura Institute of Capital Markets Research, the estimated indicator in 2016 stood at 20.5 for Beijing, 25.4 for Shanghai and 36.7 for Shenzhen. By comparison, the figure from Tokyo Kantei for Tokyo was 18.1 at the height of Japan's bubble economy in 1990.

During a March speech in Beijing, Chinese Vice Premier Zhang Gaoli emphasized that China would deal with the real estate bubble to prevent financial instability -- an unusual statement coming from a member of China's top leadership.

In Shenzhen, dubbed China's Silicon Valley owing to its many entrepreneurs, new condominium prices have risen 50% from 2015, according to the National Bureau of Statistics of China. Residents appear to be resigned to the soaring prices. "I started a business 10 years ago by selling a condominium in Shenzhen's Nanshan District," lamented an online poster recently. "I've spent the entire 8 million yuan I earned over the decade to buy back the condo."

The government is also worried that the bubble could prove detrimental to business development, as the lure of easy money from speculating in the real estate market diverts funds away from business startups. Jokes about the situation abound: "The worst loser sells real estate to start a business," goes one joke.

Easy money, few options

The Chinese financial market is awash with easy money as a result of monetary easing policies implemented in the wake of the financial crisis that hit the U.S. in 2008. This pushes large amounts of money into real estate and investment products rather than business, creating a serious financial structural problem.

Cash and deposits as M2 -- a measure of the money supply -- totaled 155 trillion yuan in China at the end of 2016, or about $22 trillion. This is larger than the combined total of the U.S. at about $13 trillion and Japan at $8 trillion. China's M2 expanded from 150% as a percentage of gross domestic product at the end of 2008 to 210% in 2016. Given that China's GDP is only 60% that of the U.S., it is easy to see how large the country's cash and deposits are.

"China's M2 as a percentage of GDP is the highest in the world. It is natural that real estate prices rise, to say nothing of the downward pressure on the yuan," said Wu Xiaoqiu, vice president of Renmin University of China.

Real estate is said to account for more than 60% of personal assets in China. "There are too few financial products in China," Wu said. He feels that the number of financial products should be increased through reform in order to alter asset management that currently depends too heavily on real estate. However, investors who suffered losses in the 2015 Shanghai stock market plunge say trading stocks is dangerous compared to buying condos.

Another reason for rising real estate prices is that overseas investment has become difficult due to China's capital controls, which have been incrementally strengthened since 2015. "Domestic funds unable to flow out of the country have ended up in domestic real estate," remarked Zhiwu Chen, professor of finance at Yale University.

Temporary fix

Will China's real estate prices continue to rise? They "will fall around 2020," predicts Li Xunlei, chief economist at Zhongtai Securities. He said that property prices will drop in many cities, but that prices of higher-yield properties will later rise again in large cities such as Beijing and Shanghai.

One reason for Li's predictions is declining population mobility. The number of people living away from where their family is registered, or the "floating population," recently began decreasing. This demographic increased during the era of high economic growth, from 67 million in 1981 to more than 250 million in 2014. However, it fell by a combined total of 7.7 million in 2015 and 2016, the first drop since China began compiling statistics. The reason is that the number of people who migrate from farming villages in order to find work in cities has stopped growing.

Fewer migrant workers from rural communities buying homes in cities will lead to weaker property demand. According to Li, property prices in 2016 rose the highest in Hefei, Anhui Province, and second highest in Xiamen, Fujian Province. These two cities also had the largest and second-largest population growth. Meanwhile, a sagging population caused 2016 real estate prices to fall in Dalian, Liaoning Province, Li pointed out.

Another reason for Li's outlook is that M2 growth will slow in China as economic growth slackens. The country's M2 growth target for 2017 is 12%, down 1 percentage point from 2016 as the government reins in its monetary policy, adopting a more neutral stance for fear of stoking the property bubble. M2 grew 10.6% on the year in March 2017.

Local governments have been trying to curb soaring real estate prices. Purchase restrictions, beefed up in spring 2016, included stricter housing loan regulations. This was followed by other efforts to deflate the bubble last fall and this spring. At present, at least 60 cities, including Beijing, Shanghai and Nanjing, have introduced similar restrictions.

But these regulations will only temporarily keep prices from rising. "The more numerous and detailed the regulations, the more often emerge problems that did not originally exist," remarked Yale University's Chen.

The Nanjing municipal government introduced a price ceiling for new condos in April 2016, and in October made it difficult for people without Nanjing family registers to buy new condos. As a result, new condo supply decreased and funds flowed into existing condos, causing their prices to jump.

Conflict of interest

Local governments lack stable revenue sources and depend on real estate sales for income. To facilitate this, they expropriate land in farming villages then sell it to developers at high prices. Sale of government land accounted for 43% of local governments' revenues from their own fiscal resources in 2016. "If real estate prices actually fall, the city government will soon stop purchase restrictions," said Zhu Dehao, a real estate broker in Nanjing.

China does not impose taxes on real estate ownership. This is very unusual for a major country and promotes speculation: People buy and hold properties, waiting for prices to rise before unloading them. Before the National People's Congress this past March, expectations rose that a tax on real estate ownership would be introduced. However, the congress did nothing.

The reason may be obvious: Many high-ranking Communist Party members, or their relatives, own real estate. Adopting such a politically loaded policy -- especially just months ahead of the party's key meeting this fall -- could have caused problems. "China should actively study the tax systems of the U.S., Europe and Japan. It is very regrettable that the enactment of a real estate tax has been put off this year," said Jia Kang, chief economist at the China Academy of New Supply-side Economics.

Xi Jinping's government has preferred shortsighted purchase restrictions and is hesitant about fundamental reforms such as real estate taxation. Japan's real estate bubble burst in the 1990s, mainly because of introduction of the land value tax and controls on real estate financing. The Chinese leadership seems to be afraid that such drastic reforms could burst the bubble. Li of Zhongtai Securities compares the government's current real estate policy to "dancing on a piano wire." He added, "It's a really difficult act, and the longer one dances, the more difficult it becomes."

How to gently deflate the real estate bubble will remain an important task for Xi's administration, which is expected to start its second term.

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