The economic threats from China’s real estate bubble

How serious the threat to China’s economy is to the difficulties of Evergrande The most indebted real estate company in the world, and now Fantasia, Become? The answer is not that China will experience a catastrophic financial crisis. Rather, the economy’s dependence on demand from real estate investment must end. It imposes major adjustments and creates a major headache for authorities: what can replace real estate investment to generate demand?

From a macroeconomic point of view, the most important fact about the Chinese economy is its extraordinary savings. In 2010, it reached 50% of the gross domestic product. Since then, it has fallen a little. However, it was 44% of GDP in 2019. Household savings are very high, averaging 38% of disposable income between 2010 and 2019, accounting for just under half of all these savings. The rest mainly consists of corporate retained earnings.

If the economy does not fall into a slump, investment and net exports must match savings if the economy is operating close to potential output. Since the global financial crisis, net exports have been a small percentage of GDP and the world will not accept any more. The average fixed investment from 2010 to 2019 was about 43% of GDP. Surprisingly, this was 5 percentage points higher than between 2000 and 2010. On the other hand, the growth rate has dropped significantly. This combination of high investment and low growth shows a significant drop in return on investment (directly shown in the rise in “incremental capital productivity”). (See chart.)

Increased investment and lower growth mean lower returns.Graph showing fixed investment as an average of% of GDP, GDP growth rate (%), and incremental capital production ratio over the last three years

However, there is an even bigger problem than this suggests. First, large investments are associated with significant increases in debt, especially in the household and non-financial enterprise sectors. The former jumped from 26% to 61% of GDP in the first quarter of 2010-2021, while the latter jumped from 118% to 159%. Second, a significant portion of this investment is wasted. Xi Jinping himself spoke Regarding the need to shift to “pursuing genuine growth rather than expanding GDP growth”. This must be a big part of what he meant.

This combination of high and unproductive investment and debt spikes is closely linked to the size and rapid growth of the real estate sector. 2020 paper by Kenneth Rogoff and Yuan Chen Yang China’s real estate sector claims to account for 29% of GDP in 2016. In high-income countries Only Spain before 2009 matched this level.. In addition, almost 80% of this impact comes from investment, and about one-third of China’s very high investment is in real estate.

Household savings are high, but less than half of national savings. Graph showing the components of China's national savings as a percentage of GDP

Many strong indicators show that this investment is driven by unsustainable prices and excessive leverage, creating huge surplus capacity. The price-to-income ratio in Beijing, Shanghai and Shenzhen is much higher than in other big cities around the world. Housing wealth accounted for 78% of China’s total wealth in 2017, compared to 35% in the United States. The household debt ratio is equivalent to that of high-income countries. Vacancy and other surplus capacity measurements are high. In 2017, home ownership reached 93%. In addition, family formation is slowing, China’s population is aging, 60% of which is already urbanized. All of these indicate that the real estate boom needs to end.

The government controls China’s financial system, which can prevent a financial crisis. House prices can fall sharply, which can have a significant negative impact on household wealth and spending, but it can be avoided. The most likely threat is the collapse of real estate investment. This has a major negative impact on local government finances. But above all, it will leave a big hole in demand. “A 20% decline in real estate activity could lead to a 5-10% decline in GDP without considering the amplification of the banking crisis and the importance of real estate as collateral,” Rogoff and Yang said. Insist. It may be worse.

Explosive increase in debt following the global financial crisis. A graph showing China's debt as a percentage of GDP by sector.Breakdown by government, non-financial companies, financial companies, and households

Between 2012 and 2019, investment contributed 40% of China’s demand growth. If investment in real estate plummets, it will leave a big shortage. However, tolerating this painful adjustment is ultimately desirable. It should improve the welfare of the population: after all, building unnecessary property is a waste of resources. Slowing down the pace of recent real estate investment is also a natural consequence. “Three red linesFor real estate developers imposed by the state last year. ”: Strict restrictions on a company’s debt-to-asset ratio, debt-to-capital ratio, and cash-to-short-term debt ratio.

The current main policy is to shift spending to consumption and keep it away from the most wasted investment. This will require redistribution of income to households, especially poor households, and increased public consumption. Such changes also fit into recent attacks on the privileges of Otomi. It will also require major reforms, especially in the structure of taxation and public spending. In addition, investment needs to shift from real estate to high carbon emissions. That too will require major policy changes.

Prices in big cities in China are very high. Graph showing the ratio of housing prices to rents in major cities (2018). Shenzhen topped the list with almost 80. It is twice as high as Munich, which is the highest in Europe.

Crisis is also an opportunity. The Chinese government is well aware that the big investment boom in real estate is far beyond its reasonable limits. The economy needs a driving force for various demands. The country is still relatively poor, so a long-term economic slowdown like Japan is not necessary, especially given the room to improve the quality of growth. But a model based on wasted investment is nearing its end. Must be replaced.

Housing is becoming an increasingly speculative asset. Graph showing homes already owned by buyers when buying new homes (percentage of new buyers)

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