Why China Can't Cool Its Overheated Real Estate Boom


Even among Western analysts who live and work in China, the major role played by municipal governments in fueling China's increasingly speculative real estate boom is underappreciated. The actions of those local authorities are at the heart of China's property bubble, and they explain why the central government's attempts to cool lending and construction are failing.

China's central government has attempted to douse the speculative flames of its real estate bubble -- prices rose 9.5% in January alone -- by calling on banks to curb real estate lending and by increasing the level of reserves banks must maintain. But those moves are offset by the incentives local governments have to put money into real estate speculation.

The key difference between China's current real estate bubble and the U.S. bubble that popped in 2007 is this: In the U.S., it was individuals and lenders who made overleveraged, speculative bets via subprime mortgages. In China, explained Northwestern University researcher Victor Shih to NPR, the leveraged debt fueling the speculation comes from local governments, which have borrowed trillions of dollars worth of funds from China's banking system to develop real estate projects in their jurisdictions.

Shih has found that almost 50% of the Shanghai government's revenues come from land sales, and local governments have come to rely on this income.

"Local governments now are forming their own real estate developers and would actually buy land from themselves. As this becomes more common -- and it is becoming very, very common -- then local governments have a high stake in maintaining and increasing the value of real estate in their own jurisdiction," Shih observed.

Unsurprisingly, these incentives to boost land values have led to sky-high prices. The right to develop a plot of land in downtown Shanghai was recently purchased for a record $1.35 billion.

Beijing's Own Policies Undermine Its Fiscal Goals

The incentives to local governments start with targets set by the central government. Respected analyst Andy Xie, formerly of Morgan Stanley, observes that local government performance in China is measured by GDP and fiscal revenue -- and both of those numbers can be quickly boosted by real estate development. This makes pouring municipal funds into development a "win-win" for local leaders, even if there's no consumer or business demand for the new buildings.

Xie says this has led to a politically driven bubble, supported by local governments' need to meet the central government's growth targets.

The dependence of local governments on development fees and skyrocketing land values is also fueling a "moral hazard" dilemma. Speculators sense that the government will never let values fall, which encourages further reckless speculation.

In Terms of Real Growth, the "Boom" Is a Bust

Paradoxically, this channeling of China's capital into real estate development is hurting the country's long-term prospects by diverting the capital from other more productive uses. Ultimately, Xie says, this decreases capital efficiency and thus lowers domestic consumption. Though China has been trying to promote domestic consumption for a decade, private consumption as a percentage of GDP has declined every year.

This overreliance on real estate development also threatens the nation's financial stability by increasing debt levels and by relying on overvalued land as collateral. And it creates another systemic risk: Because property prices have increased faster than middle-class income, many otherwise-prosperous households have been priced out of the housing market. This fosters resentment as hard-working people see a handful of local officials and developers becoming wealthy from a bubble that has left housing unaffordable for the vast majority of wage earners.

Moreover, as the white-hot property market creates winners and losers based solely on speculation and political influence, other determinants of income such as education and experience have been marginalized: Ordinary people feel their own efforts won't bear fruit because the system appears to reward only speculators and insiders.

A Feedback Loop of Ever-Inflating Values

All land in China remains government-owned; developers get only leases. But while ownership is clearly in the hands of the state, which level of government is authorized to grant a lease on a given parcel can be unclear. As a result, leases may be negotiated at the local level and essentially rubber-stamped without much oversight by higher-level agencies.

This ambiguity gives local authorities leeway to negotiate leases with companies they partly own and lets them transfer the land at inflated valuations.

Since local governments generate revenues from transfer fees when they lease land to developers, this feeds two bubbles: First, local governments inflate the land prices in order to increase the transfer fees they collect. Then, those ever-inflating values encourage individuals to try to get rich quick by speculating on ever-rising housing prices.

Local governments don't just sell land leases to developers, they also invest directly in developers. That creates additional "one hand washes the other" incentives to play fast and loose with loans and land valuations.

If You Build It, Nobody Will Come

According to Charlene Chu, an analyst with Fitch Ratings in Beijing, industrial loans made to state-owned companies have been funneled into speculative real estate. The net result is nobody knows exactly how much "hot money" from state-owned companies has flowed into real estate development projects.

What is known is that dozens of skyscrapers sit completely empty: By at least one count, well over 60 such towers dot Beijing alone, while some 13 million more square feet of commercial space will enter the Beijing market this year.

But as long as the incentives to drive land prices higher and to build empty skyscrapers remain in place, it's difficult to see how Beijing's tweaking of bank reserves can do much to deflate the rampant borrowing and speculation. The widespread belief that "the government will never let prices fall" will continue to create a moral hazard and add fuel to the speculative fires.

Given China's growing role in the world's economy, this structural imbalance in its property and development markets will have global consequences. If Beijing doesn't establish better control of land deals and create new, healthier incentives for local governments, then the inevitable popping of the Chinese real estate bubble will simply set up another cycle of unproductive investment and indebtedness.