The fact is Chinese are among the best savers in the world and they do not have enough places to invest their money. This situation contributes to the formation of asset bubbles. And the bubble on the real estate market – that was the first investment choice in People’s Republic of China for years – became one of them. At given point this made sense – there was plenty of demand for housing in the world’s most populous country. But as investors piled into property and government launched (in 2008) a massive 586 billion dollars economic stimulus program that was mainly invested in public infrastructure projects and housing, the market became saturated – as consumer demand in advanced economies got weaker, the government accelerated investment to offset the decrease in exports and keep the economy growing at a speedy pace (Barth et al. 2012). Then, signs of a great bubble phenomenon in the China’s real estate market and all that goes with it became clear.
According to the Chinese National Bureau of Statistics, the real estate sector accounts for between 25 percent and 30 percent of China’s GDP (if upstream and downstream industries such as steel, cement, glass, and appliances are included). Simultaneously, spending on residential construction reached an unsustainable 10.4 percent of the country’s GDP in 2014. That is the second-highest figure on record for any country. Only Spain’s 2006 bubble, that took such spending to 12.5 percent of GDP, surpassed it. Even with 4.5 percent drop in housing prices the same year, the first in two decades, the unraveling of the overbuilt real estate sector has hardly begun. According to the calculations made by experts from the Shanghai-based E-house company, which deals with the analysis of the real estate market, the ratio of average house prices to average earnings per capita in 35 major Chinese cities was 8.5 in 2013 (by contrast, the price-to-income ratio was around 4 in the U.S., 5 in the UK and 6 in Australia right before the financial crisis of 2008), while the result above 6 is considered as a sign of a bubble.
Taking it all into account, it cannot be shocking that more than 50 million empty apartments await buyers. “As of 2009, the average housing price in 35 of China’s largest cities has increased more than three-fold compared to the average housing price in 1998. In some large cities, the price of real estate even grew by 30 percent per year. If we look at the recent time-series data on housing price and several economic indicators, the trends in these variables show many similarities to the trends of U.S. pre-bubble data” (Chen 2011, p. 2).
However, the housing bubble in the United States has started from sub-prime lending and its derivatives market, whereas investment banks were trading junk mortgages like they were stocks. The Chinese does not have a large mortgage backed securities market that could take down large investment houses, nor does it have a sub-prime lending market. Moreover, it is very hard to find news of home owners from China being foreclosed upon by lenders. Consequently, the alleged bubble in China is nothing like the bubble in the United States and Europe. China’s housing market, unlike the bubble market in the US, depends on a growing urban migrant community, rising incomes, and cash-rich investors.
In present master thesis we will try to provide a theoretical explanation of the paradoxical features of the unprecedented real estate boom in China: housing price growth that is faster than that of GDP and excessive vacancy rates.
This paper is structured as follows. In first chapter, we take a closer look at determinants of unprecedented growth of China’s economy that helped lift millions of Chinese people out of poverty and its main side effects: credit expansion and following excessive debt in both private and public sector. In second chapter, we provide readers with a deep insight into history of Chinese housing system and try to show its up-to-date implications. In the next (III) chapter, we focus on the definition of our subject issue, i.e. the asset price bubble, and try to assess the role of Chinese government in its formation on China’s real estate market. In the last section, in turn (chapter IV), we take a look at divergent views on existence of the ‘bubble’ in China’s real estate market and wonder if it can fragile its banking system.
HIGH GROWTH, OVERINVESTMENT AND FOLLOWING IMBALANCES
The People’s Republic of China (PRC) has been growing at around 10 percent per year over the last three decades. There is a loud debate which center is whether China’s growth over the reform period is significantly attributed to productivity growth or mainly driven by factor accumulation. Regardless of the outcome of this debate that is beyond the scope of our interest in present dissertation, the result of that unprecedented growth is that PRC has overtaken Japan as the world’s second-largest economy. And what is even more, according to recent estimates by the IMF, it may even overtake the United States in purchasing power parity terms. This high growth helped lift millions of Chinese people out of poverty, with the poverty rate sharply down from 84 percent in 1981 to 11.2 percent in 2010 (World Bank Development Indicators).
Source: World Bank
“From a supply-side perspective, such remarkable outcomes in terms of growth have been achieved mainly through strong productivity gains and, most importantly, rapid capital accumulation. The former – productivity gains – followed sweeping reforms, starting with the development of private sector initiative under Deng Xiaoping in the 1980s; reforms of public sector enterprises in the 1990s; and China’s integration into global markets since its accession to the World Trade Organization in December 2001” (Albert et al. 2015, p. 5). Capital accumulation may, of course, be related to catch-up process that has been highlighted by a low capital stock and important needs providing strong incentives for foreign entrepreneurs to invest in China (Knight & Ding 2010). However, the catch-up effect cannot rather explain such high growth rates over such a long period of time. “After all, greater trade openness has been a general trend among emerging economies, and relatively low capital stocks are a common characteristic for all developing nations; yet China’s performance is rather unique” (Albert et al. 2015, p. 5).
Nonetheless, there is a widespread consensus that Chinese economy past growth has reached its limits, and that it needs to be rebalanced. The most important cause of this need is the overinvestment that has been propelled by a self-reinforcing cycle of higher growth and higher spending on infrastructure, i.e. so-called ‘accelerator’ (a higher investment rate seems justified when higher growth rates materialize). Very few countries in history have ever recorded such a high investment-to-GDP ratio as China. It rose there from about 41 percent of GDP in 2007 to 49 percent in 2015, only 1 percentage point lower than in 2009 (Gros 2015; Albert et al. 2015). This clearly raises concerns about the overinvestment.
1.1. Credit expansion
Moreover, many of other vulnerabilities are on the rise (IMF 2014a), with rapid credit growth – part of which due to the rapid expansion of shadow banking – and what interests us the most, the real estate bubble in the first place. In this part, we focus on the implications of domestic imbalances that have such a strong global impact due to the fact China as an economy accounts for 28 percent of global savings and investment (close to the US and the euro area combined) (Gros 2015).
First and foremost, from a demand-side perspective, high growth accompanied by a surge in exports and strong international market share has caused big current account surplus (It has widened to 10 percent of GDP in 2007). Other countries in Asia like Japan, Korea or Taiwan had otherwise adopted very similar investment- and export-led growth economic models. Withal in none of these countries imbalances have been as sharp as in China.
According to Albert et al. (2015), growth and following imbalances in Chinese economy shall be seen as partly coming from three main factor price distortions, regarding the exchange rate, wages, and interest rates. First, an undervalued exchange rate has allowed China to significantly benefit from its accession to WTO in late 2001 onwards (Rodrik 2008) and has attracted, as stated by Xing (2006) FDI inflows which, in turn, have helped boost domestic productivity by transfers of foreign technology (Yao & Wei 2007). Second, low wages have been the main reason for China to become a “world’s factory” and an indisputable leader in exports. Third, it has to be clearly emphasized that overinvestment in China has been financed by extraordinary credit expansion. Very low interest rates (the higher one being, until recently, a floor for lending rates, and the lower one being a ceiling for the compensation of deposits) have facilitated strong investment growth (cheap funding available while households’ earnings compressed). Lardy (2008) has assessed the transfer from household sector to the banking sector to have amounted to 4.1 points of GDP in the first quarter of 2008 alone.
Due to the artificially low interest rates China had to rely on quantitative control of credit (Feyzioglu et al. 2009). It was especially evident when aftermaths of the 2008-2009 Great Recession, including the fact that exports were no longer able to support Chinese growth, forced the Communist Party of China shift Chinese economic model into increasingly credit-fueled and investment-led one. ”[A] massive stimulus package, amounting to around 13 percent of GDP according to official figures, focused on infrastructure investment in 2009-10 while a loosening of credit controls (previously set up at the end of 2007 to prevent overheating) enabled a rebound in the real estate market. Later, from 2012 onwards, periodic >>mini-stimulus<< packages aiming at speeding up infrastructure projects have been used to prevent growth from falling below the official growth target” (Albert et al. 2015).
1.2. Debt growth
Consequently, the investment surge that has been financed by an acute rise in overall debt, in contrast with, as stated by Albert et al. (2015), “the 2003-2007 period where debt remained constant as a share of GDP.” Fueled by real estate and shadow banking, debt nearly quadrupled, rising to 28 trillion dollars by mid-2014, from 7 trillion dollars in 2007 (more precisely: it grew from 140 percent of GDP in 2008, to 282 percent in 2015 and, while manageable, is larger than that of the United States or Germany).
Chart 2: Overall debt level in different countries
Sources: MGI Country Debt database, McKinsey Global Institute
On one hand, many economists argue that, since debt is mainly domestically held and what follows, investment is not financing through external funding, risk of a sudden-stop or reversal of capital is not high. On the other, as argued by Drehmann et al. (2011), the most significant early warning bell heralding a financial crisis seems to be the credit-to-GDP gap. By this metric, as pointed out by Albert et al. (2015), China is well into the danger zone. Officially, credit-to-GDP in China is not huge and accounts for 41 percent (while Japan’s debt to GDP ratio is 230 percent and America’s is 103 percent). In fact, nobody knows the real value because of enormous amount of money borrowed by government owned enterprises from government-owned banks. This unknown is what is the most scary about China’s debt, as credit agencies and financial markets have yet to factor its effect into the price of Chinese financial assets. For example, this is why the cost to insure Chinese government bonds against default for five years climbed about 38 basis points, or 0.38 percentage point, since mid-November 2015 to 134 basis points in March 2016. That exceeds the cost of credit-default swaps on the Philippines, which has a Moody’s rating five levels below that of China.
Chart 3: Credit-to-GDP ratio in China 1994-2012
Sources: Credit Suisse, CEIC
1.3. Overinvestment and excess capacities
All mentioned above not surprisingly have led to the immense overinvestment accompanied by excessive capacity of many sectors, as evidenced by the continuous decrease of the PPI index since early 2012 and a drop in in the capacity utilization rate (from 80 percent before the Great Recession to around 60 percent in 2012) (IMF 2012). Between Q1 2013 and Q1 2014 it stood at 80 percent on average for manufacturing in total – according to the Federal Reserve Board, the total U.S. capacity utilization rate was almost the same from 1972 to 2013, which is generally seen as a normal level (Hu & Zhuang 2015). As far as, however, capacity utilization rates for five manufacturing industries including steel, cement, aluminum, flat glass, and shipbuilding in China is concerned, in 2012 it was at level of 72, 73.7, 71.9, 73.1 and 75 percent, respectively, much lower than the 80 percentage level. In addition, 15 industries were identified by the China’s government to have continued excess capacity in 2014 (Ministry of Industry and Information Technology 2014). The Guiding Opinion of Chinese State Council states a few factors that contribute to that state. The most important ones are: overinvestment, low levels of market concentration and growth-driven investment policy.
Chart 4: PPI in China 2011-2016
Chart 5: Capacity utilization rates in China 2006-2011
As in turn stated by Albert et al. (2015), these excess capacities brought about a lower productivity of capital: the incremental capital-output ratio (ICOR) – a measure that assesses the marginal amount of investment capital needed to generate the next unit of production – climbed significantly after the crisis, from 4 (3 according to official Chinese statistics) on average during 2000-07, to more than 6 (4) in 2013 (but the rate of return on capital is still high).
Chart 6: China’s GDP growth rate & ICOR 1991-2013
Source: CEIC Data
Chart 7: China’s added GDP & ICOR 1997-2013
Sources: National Bureau of Statistics, the Economist
That is, by the way, why Standard & Poor’s  claims that, among a 32-country sample including Australia, Canada, France and most BRICS, China has the highest downside risk of an economic correction due to the low investment productivity over recent years. Based on ICOR, Xu Ce of the National Development and Reform Commission, an economic planning agency, and Wang Yuan of the Academy of Macroeconomic Research, a think-tank under the commission (Ce & Yuan 2014) estimated that China had made around 6.8 trillion dollars on worthless investments between 2009-2013. If true, it would mean that fully 37 percent of Chinese investment since 2009 was wasted on building highways to nowhere and skyscrapers with no one in them. Economists reasonably debate the merits of the methodology, but the fact that infrastructure spending in China has long been woefully wasteful is undisputed (see: the report named „Year of the White Elephant”, in which the Beijing firm J. Capital Research enumerated several of China’s dubious recent infrastructure projects). In consequence, the boom is turning into a bust. Capital stock has been lately recognized as being too high. Slowdown in investment has, in turn, led to lower investment rates.
Chart 8: China’s GDP annual growth rate
This trend will probably continue, because the temporary nature of investment boom was not taken in consideration and, as pointed out by D. Gros, growth rates at 10 percent were treated as a sign that Chinese economy would be able to maintain double-digit growth rates even when global growth fell because of recession. This illusion convinced people that a permanently higher investment rates were proper for China. “The observed growth rates in China from 2008 to 2014 might have been well above the longer-term sustainable rate, and the markets are reacting so strongly because they fear that Chinese growth might now undershoot the equilibrium rate for a time until the excess capital spending of the last five years has been absorbed” (Gros 2015).
1.4. Redirection to the consumption
As highlighted by Albert et al. (2015), achieving such tremendous capital accumulation and investment rates would not have been possible without very high national savings, which increased from 36.4 percent of GDP in 1992 to 51.8 percent in 2013. That is, by the way, why many economists and observers define character of the Chinese economy as a combination of exceptionally high national savings and investment rates.
The leading Communist Party of China (CPC) has been committed to redirecting the growth model away from investments (and exports) and towards consumption since the 18th congress of the Chinese Communist Party in 2013.
Chart 9: Elements of China’s GDP growth 2004-2014
Source: Federal Reserve Bank St. Louis
That change has been possible due to the fact China do not need to rely on external financing to fund investment thanks to high national savings that have exceeded investment in last ten years (Albert et al. 2015).
Many economists have tried to explain what has caused so huge household savings in China. Few reasons have been offered. Chamon & Prasad (2010) point out that one of the drivers of household savings may have been raising housing prices. Ma & Wang (2010) argue that households had to save more to self-insurance against risks related to health and pensions, since end-1990s when large-scale restructuring and downsizing of SOEs led to decrease of so-called “iron rice bowl”. Modigliani &a Cao (2004), in turn, mention the role of the one-child policy, which caused a radical decline in the ratio of people under the age of fifteen (who consume but do not safe) and, what follows, undermine the traditional role of family.
“[Nonetheless], as argued by Ma & Wang (2010), household savings as a percentage of GDP are not exceptionally high in China [and they are lower than in India – M.W.], and only account for about half of national saving; what really makes China an exception compared to other countries, even in Asia, is the combination of high savings in each of the three institutional sectors (corporates, households, government)” (Albert et al. 2015). The fact, however, is that: China is now displaying the same three symptoms that Japan, the US and parts of Europe all showed before suffering financial crises: a rapid build-up of leverage, elevated property prices and a decline in potential growth.
Michał Wołangiewicz, prawnik, ekonomista. Absolwent studiów licencjackich ekonomii oraz studiów magisterskich prawa oraz ekonomii menedżerskiej Uniwersytetu Wrocławskiego. Student studiów LL.M. na specjalizacji Corporate and Commercial Law na the London School of Economics and Political Science (LSE). Alumn Akademii Liderów Rynku Kapitałowego (ALRK) i stypendysta Fundacji im. Lesława A. Pagi. Interesuje się rynkiem kapitałowym, chińską gospodarką, CSR oraz młodą sztuką. Fan piłki nożnej oraz kolarstwa górskiego (MTB), które od wielu lat czynnie uprawia.
Poverty headcount stated at 1.90 dollars a day (2011, PPP).
 Metric used to measure the rate at which potential output levels are being met or used. By the United Nations capacity utilization is defined as the ratio of an industry’s actual output to its estimated potential output.
 So, the higher a country’s ICOR, the less efficient it is – that is, it takes more investment to produce a smaller amount of economic output.
 Their analysis was published last week as an opinion piece in the Shanghai Securities Journal, a government-run newspaper.
 Over that time, when U.S. Treasury Secretary Timothy Geithner’s recent visited to Beijing, Xi Jinping, who is now a General Secretary of Communist Party, in privately reiterated China’s desire to shift its economy to rely more on domestic consumption and less on exports and foreign trade.
 On 29 October 2015, the existing law was changed to a two-child policy allowing Chinese couples to have two children (in order to help address the aging issue in China).