Why China's Housing Bubble Will End Badly

Imagine that your local city and county controlled all land rights, and the only ownership a private builder or developer could secure was a long-term lease. Now imagine that 40% of the city and county's revenues come from the lease fees paid by developers. Next, imagine a giant real estate bubble has priced most residents out of the market, and that the local governments are reaping huge gains as the development rights and leases they sell are skyrocketing.

Can you say conflict of interest?

That's the Chinese real estate dynamic in a nutshell. Local governments have every incentive to push lease prices higher, further fueling China's real estate bubble, and zero incentive to build low-cost housing for the average citizen.

Who Benefits

Minxin Pei, professor of government at Claremont McKenna College and a senior associate at the Carnegie Endowment for International Peace, recently described who benefits from what he termed China's "irrationally exuberant" property market: Local government and its officials, and state-owned enterprises (SEOs), which have exploited their ties to government-controlled banks to enter the speculative real estate market with a vengeance.

"With access to almost unlimited no-cost credit from the state-controlled banking system," he wrote, "these behemoths have abused their financial clout and plunged headlong into the real estate market, snapping up high-priced land and investing in high-end residential housing units that now sit empty across the country."

Once you understand this dynamic, it's not difficult to see why China's housing bubble will end badly. Local governments are so heavily dependent on development fees and taxes for their revenues that any fallback in new development will spell catastrophe for city and regional government budgets.

Who Pays for the Bailout

Who will lose when the bubble inevitably deflates?

Residents will suffer because government services will have to be slashed as revenues from development fees collapse.

The Chinese investors who overpaid for grossly inflated luxury condos will suffer massive losses, developers dependent on a fast-rising bubble market will go bust, and somebody will end up covering the losses as bankrupt developers renege on their loans.

Since most of the loans came from government-owned banks, then that "somebody" will be the Chinese taxpayer. Sound familiar?

"China's taxpayers will twice be made the victims by the housing bubble," Professor Pei noted. "In the bubble years, they're priced out of the market for affordable housing. When the bubble bursts, they'll pay for the cleanup. When Chinese state-owned banks write off their bad loans, they don't do so with money growing on trees. Instead, the Ministry of Finance will issue bonds to recapitalize the banks -- and fund the bailout with future tax receipts."

How Big a Bubble?

Recent reports estimate there are 64.5 million vacant "investment" flats in China. Analyst Andy Xie recently laid out the risks this giant speculative bubble poses to China's local governments and banks.

"Local governments in China depend on real-estate deals for revenue and could default if the market falls too far," he wrote. "Notice the bind China is in. It has to keep the bubble going to preserve local government finances. They've become a classic Minsky Ponzi unit."

If the Chinese central government keeps the bubble inflated with easy money, Xie concluded, the resulting crash and bailout will only be that much more painful.

Local Officials Benefit Personally from Bubble

While contributions from property developers tend to have outsized political influence in much of the world, local government officials in China are brazenly pocketing the proceeds from development. For example, the majority of homes in a newly launched subsidized housing project in Shaanxi Province have been handed to local government officials.

Add up these factors -- widespread corruption, a real estate bubble that's priced average citizens out of the market, local governments dependent on new development for their revenues and a government-run banking sector that will turn to taxpayers to fund the inevitable bailout -- and there's plenty of fuel for taxpayer resentment and anger once the bubble pops.

Sound familiar?

Based on the accounts of these analysts, Chinese taxpayers will soon have common ground with their American counterparts: They, too, will be stuck paying for the bailout of private developers and government-controlled banks (which in the U.S. are called Fannie Mae and Freddie Mac).