The Real Estate Bubble in China's Large Cities

For the last few years, a real estate bubble has been emerging in large cities in China such as Beijing and Shanghai. Housing prices have risen by a factor of five or six in the six years from 2004 to 2010.

Looking at a typical example in Beijing, the price of a 95-square meter condominium located outside the Third Ring Road, equivalent to Loop 7 in Tokyo, hit three million yuan (approximately 40 million yen) in December 2010. This is comparable to 46 years' worth of the estimated average annual income of 65,158 yuan (over $10,000) in Beijing at the time. Also, the rent for such condominium was 5,000 yuan, almost equivalent to the average monthly income. Moreover, within a 2-km radius of the city center, housing prices are twice as much. In other words, housing prices in prime locations are already close to 80% of housing prices in central Tokyo. These prices are already beyond the economic capacity of the average middle class salaried worker and have caused a certain amount of social discontent.

Why have housing prices risen this high? We should not overlook the fact that the real estate bubble in China is caused not only by market speculation but also is largely attributable to institutional mechanisms in China.

In the 1994 reform of its fiscal system, China made a major shift from a fiscal contracting system to a tax-sharing system between the central and local governments. After introducing this tax-sharing system, however, an imbalance arose in the distribution of revenue and workload between the central and local governments, and many local governments ran into fiscal difficulties as a result. There are different levels of local governments under the central government, including provinces, prefectures, counties, and townships, and the lower the local government level, the greater the fiscal hardship it faces. In addition, since the fiscal discipline of local governments is weak, they are prohibited from issuing municipal bonds. Therefore, searching for an autonomous source of revenue after the agricultural tax was abolished on January 1, 2006, local governments switched the main source of their revenue to the land use tax. To collect more revenue, local governments ran full tilt toward land use tax by selling development rights to real estate developers along with use rights for limited periods of 50 to 70 years. As a result, the percentage of local government revenue derived from land use taxes (the dependence of local governments on land use taxes) was as high as 20.4% in 2010.

This is the major contributor to the real estate bubble in China, and local governments' forcing farmers to sell their land has caused a number of other social problems in recent years.

Given these factors, the real estate bubble in China has occurred through a very different mechanism from the experiences of Japan, the United States, and Europe. Is it therefore possible for the Chinese government to slow this down or provide a soft landing for the real estate market, which Japan, the United States, and Europe failed to do?

At the moment, the handling of the real estate bubble by the Chinese government can be categorized according to the following three policy measures.

First, to rein in speculative demand, restrictions in real estate speculation have been gradually adopted since the second quarter of 2010. The most decisive policy to control real estate speculation was a regulation introduced in April 2011 requiring a minimum 60% down payment for second home purchases and suspending bank loans for third home purchases. In addition, other policies such as an additional tax on the sales of existing homes and the introduction of a real estate tax have been implemented in some cities on a trial basis.

One could say that the current real estate market in China is effectively under the strict supervision of the central government, based on its "three restrictions" principle (on purchases, loans, and prices). As a result, the year-over-year increase in the amount of real estate sold fell from 13%-14% at the beginning of 2011 to 4%-5% by the end of the year. In terms of changes in the sales prices of new homes in 70 large- and medium-sized cities under this supervision, 48 saw prices fall while 22 saw prices remain flat in January 2012. No cities had an increase in prices.

Second, the government is building large-scale "subsidized housing" for low- and medium-income households in urban areas, supported by fiscal stimulus. In its 12th Five-Year Plan for National Economic and Social Development (2011-2015), the Chinese government set a target for urban subsidized housing of 36 million units. If this target is reached, more than 20% of low-income housing needs in urban areas will be met. Over the same period, 7.5 million "rural housing" units will also be renovated and remodeled. Nationwide, the construction of 10.43 million new houses has begun, and 4.32 million houses were completed by November 2011. Construction of an additional seven million houses is set to begin this year.

Subsidized housing in China refers to houses supplied by the government to low- and medium-income households, of which the stock, price, and rent are controlled. These consist of low-rent housing (low-rent public housing for low-income households), affordable housing (low-price housing for low- and medium-income households), and public rental housing (low-rent public housing for low- and medium-income households not eligible for the above mentioned low-rent housing and affordable housing, displaced households, invited senior engineers, and migrants from other regions). Subsidized housing serves the role of supporting real estate investment as a whole and mitigating income inequality at the same time.

Third, the year-over-year increase in the acquisition of land development rights by real estate companies has fallen sharply from 57.1% at the beginning of 2011 to just 2.6% by the end of the year. This reflects the rapid increase in the number of unsuccessful bids for land development rights since the middle of 2011, and those local governments that rely on land use tax as a revenue source are now facing a fiscal crisis.

In response to these circumstances, the central government?as part of its aggressive fiscal policy?is offering most local governments "special subsidies" for the construction of subsidized housing.

Meanwhile, to lessen the dependence of local governments on land use tax revenue, which is a major cause of the real estate bubble, in October 2011, the Ministry of Finance finally announced the "2011 Pilot Program for Local Government Bond Issue." The cities of Shanghai and Shenzhen and the provinces of Zhejiang and Guangdong were chosen as test cases for allowing local governments to issue bonds. Also, this year, 10 local governments including the cities of Beijing and Tianjin have applied to issue their own bonds, and the central government will issue municipal bonds of 250 billion yuan (3.3 trillion yen) on their behalf. The proceeds are expected to be used to finance infrastructure investment, which has been driving local economies, and to write off non-performing loans held by local government financing platform companies.

The immediate response of the central government to the inflated real estate market has been to control speculative demand, create effective demand, and, at the same time, take steps to alleviate the fiscal difficulties of local governments and redistribute revenue through increasing public spending to reduce disparities. Now that these vigorous policy measures have been running for two years, home prices have been declining moderately and are stabilizing in most cities.

It could be said that this is because the gradual adjustment of the real estate market through the macro policies of the central government has been successful.