Presumably, the earliest known example of the asset price bubble is the tulip-bulb craze (so-called ‘tulipomania’) in Netherlands that started in 1634 and burst in February 1637. “Amid the general fascination with rare species of tulips among the Dutch, prices on rare tulip bulbs rose, attracting the attention of speculators. Since the supply of rare bulbs was severely limited in the short run, and demand sky-rocketed due to the in- flux of speculators, prices rose rapidly amid heavy trading” (Scherbina 2013). At the peak of the bubble, in early 1637, a single rare bulb was sold for an amount equivalent to the price of a nobleman’s castle. One day, as happens in all speculative crazes, prices got so high that some people decided they would be prudent and sell their bulbs. Shortly afterwards other people followed suit. „The process continued in a negative feedback loop; bulb deflation grew at an increasingly rapid pace, and in no time at all, panic reigned. Most bulbs became almost worthless, selling for no more than the price of a common onion (Malkiel 2010).” According to Mackay, the episode was followed by a severe recession from which it took many years to recover.
3.1. What is an asset price bubble?
What exactly are asset bubbles? In general, according to current economic theory, a bubble exists when the market price of an asset is significantly higher than its price determined by fundamental factors for a prolonged period (Evanoff 2012). The efficient market theory asserts that unusual movements in asset prices are a consequence of serious changes in information about fundamentals. Thus, actual and fundamental prices are always the same, and bubbles cannot exist unless they are driven by irrational behavior (which is why bubbles are commonly associated with irrationality).
Either way, it is very difficult to define the existence of speculative asset bubbles. Some even believe that it is not possible to identify a bubble until it bursts. Nevertheless, some economists provide their explanations. In the every-day language the word “bubble” refers to an “object growing steadily unit it finally pops” (Siegel 2003). According to “Financial Times Lexicon”, a bubble is when “the prices of securities or other assets rise so sharply and at such a sustained rate that they exceed valuations justified by fundamentals, making a sudden collapse likely – at which point the bubble bursts.” Another simple definition is that a bubble is a deviation of the market price from the asset’s fundamental value. Charles Kindleberger, economic historian and professor emeritus at the MIT in the “New Palgrave: a Dictionary of Economics defined a bubble as “a sharp rise in the price of an asset or a range of assets in a continuous process, with the initial rise generating expectations of further rises and attracting new buyers – generally speculators interested in profits from trading in the asset rather than its use or earnings capacity (Eatwell et al. 1987). As reasonably pointed out by Siegel (2003), this definition highlights that a high and rising price is “unjustified”, i.e. not related to “earnings capacity”) and is driven by investors who speculate.
Scheinkam and Xiong argue that there are two main factors that lead to speculation. “The first is investors’ overconfidence, which makes them believe that they are able to sell the assets to other people who are more optimistic and will accept a higher price in the future” (Chen 2011, p. 2). Second, because of heterogeneous expectations concerning future prices, as well as heterogeneous interpretations of information, generates deals among investors. What follows, they define a bubble as “the difference between the market price of an asset and its fundamental valuation” (Scheinkam & Xiong 2003). Some economists have given additional substance to the definition of a bubble by relating asset price movements to “fundamentals”. Fundamentals pertain to economic factors like cash flows and discount rates that determine the price of any asset. For instance, Peter Garber, in his book “Famous First Bubbles” states that “the definition of bubble most often used in economic research is that part of asset price movement that is unexplainable based on what we call fundamentals (Garber 2000, p. 4).” Prof. J. Barley Rosser in turn indicates that “a speculative bubble exists when the price of something does not equal its market fundamentals for some period of time for reasons other than random shocks. [Fundamental] is usually argued to be a long-run equilibrium consistent with a general equilibrium (Rosser 2000, p. 107).” What follows, an asset-price bubble can be also perceived as a mispricing of asset values relative to prices that would be consistent with the existence of efficient markets. Hence, bubbles are often described as substantial and long-lasting divergences of asset prices from valuations that would be determined from the rational expectation of the present value of the cash flows from the asset (Malkiel 2010).
As far as, however, factors giving rise to a bubble are concerned, economists and researchers concentrate generally on specific aspects of this general concept: sharp growth in the prices of assets, unrealistic expectations of future price rises and departure of prices from fundamental valuation (Chen 2011). Based on this list, we may conclude that bubbles do exist in China — especially in first-tier cities such as Beijing, Shanghai, Guangzhou or Shenzhen. Nationwide home prices have grown over the past decade, before abruptly declining in 2008. Then, in 2009, the growth in housing prices reached a new peak at 23.8 percent, before declining to 6.7 percent in 2010. This situation has attracted wide worldwide media attention regarding the sustainability of real estate boom in China.
Nevertheless, the past growth in the housing market has been partly explained by decent economic fundamentals. In this regard, there are forecasts that the population in urban areas is expected to increase by another 20-25 percent in the next decade, creating strong demand for residential housing. Moreover, per-person disposable income and the population of the middle class are expected to continue to increase as the economy grows quite sharply, albeit at a slower rate than in the recent past. These factors provide strong support for expectations of an expanding housing market. Already, about 500 million people have moved from rural to urban areas over the past thirty years (Barth et al. 2012). According to National Statistical Bureau, the share of the urban population has increased from less than 20 percent to about 50 percent as of 2010. In effect, the population in China’s megacities represents one-fifth of its population now (and there are about 0.7 billion Chinese people living in the urban area). At the same time, due to high economic growth, millions of Chinese join the middle class each year, thereby contributing to high housing demand (because of high saving rates, many households are able to buy a house with cash and are rather independent on mortgage loans).
For these reasons, there is no doubt that the China’s real estate market is different than any other market in the world. It gives us unique environment to test for a bubble. First of all, the Chinese economy used to grow at much faster rate than developed countries for years. Second, China was alone in world’s economy with GDP growth rate of 12 percent in the first quarter of 2010 despite financial turmoil around the world (Paskelin & Vishwakarma 2011). Third, as stated in the UNCTAD’s report, PRC is the favorite destination for foreign direct investment – incoming Foreign Direct Investment (FDI) rose to 105.74 billion in 2010 from approximately 37 billion in year 2000. Finally, China’s massive population, with over 1.33 billion people, and mass immigration to the city area causes unprecedented demand side in housing sector.
3.2. Bubble’s determinants
According to vast majority of economists, regardless of some above mentioned fundamentals, there are enough reasons to believe that there is a huge bubble in the Chinese real estate market – even bigger than the U.S. sub-prime mortgage problem that led to the burst of the U.S. real estate bubble.
In the past decade, China experienced a surge of house prices at an unprecedented rate. In the 35 major Chinese cities (representing all municipalities, provincial capital cities and quasi-provincial capital cities) residential house prices (on average) have steadily increased from 2426 yuan per square meter in 2003 to 7718 yuan per square meter in 2012. This means more than tripled property value in 9 years, or a 13.7 percent nominal compound annual growth rate (Feng & Wu 2015). Over this period of time, the average CPI of these cities rose only by 30 percent.
Chart 13: Average nominal residential house prices and CPI in 35 major Chinese cities
Source: Feng & Wu 2015
Furthermore, China’s average residential house price-to-income ratio at the national level (a common measure of housing affordability) has sharply increased from 6.6 in 2003 to 8.1 in 2009, and gradually declined to 7.3 in 2013 after a series of house price regulations. As pointed out by Feng & Wu (2015), the 35 major Chinese cities witness an even higher price-to-income ratio, which reached 8.5 in 2013 (E-house China 2014). By contrast, the price-to-income ratio was about 4 in the US, 5 in the UK and 6 in Australia right before the recent financial crisis (Reserve Bank of Australia, 2008).
Chart 14: The evolution of China’s national level residential house price-to-income ratio
Source: Feng & Wu 2015
Moreover, the inventory of unsold homes has increased dramatically (by 35.8 percent in 2011). Unsold inventory was up 11.2 per cent for the year to 452.5 million square meters, increasing 11.6 million square meters in December 2015, according to National Bureau of Statistics. Figuratively speaking, in China there is now around 13 million empty homes – enough to house the families of several small countries – and whittling down the excess is among Chinese policy-makers top priorities for 2016. According to Wang Jianlin, China’s richest man and chairman of property and entertainment conglomerate Dalian Wanda Group, it could take four to five years for the market to digest the inventory in tier three and four cities. And this forecast does not seem unreasonably considering the fact that already 21 percent of urban households in China own more than one residence, compared with around 7 percent in U.S. The national home ownership rate stands around 90 percent, compared 64.7 percent in the U.S. These conditions really suggest that there is not a big scope for additional demand.
On the other hand, we have to note that, according to Merrill Lynch, in 12 of 50 major Chinese cities there is currently a deficiency of available housing, and the housing supply in economically vital places like Suzhou, Zhuhai, and Nanjing is right on target. “As land supply and construction starts have dropped for two years in a row, we expect the inventory in 2016 to stabilize at the 450 million square meters level. (…) There is no inventory problem in first-tier cities, prices will still go up,” said Raymond Ngai, Head of China Property Research at Merrill Lynch (Asia Pacific). And he is supposed to be right – the bigger problem exists in smaller cities (see the chart below).
Chart 15: Number of vacant units in China 2000-2012
Source: CLSA Investment Group
3.3. The investment-driven model
Such rampant house supply, price growth, and unusually high price-to-income ratio are driven by few interchanging factors, especially the fiscal stimulus package, massive credit expansion and following overinvestment that we briefly presented in the first section. Namely, the government has urged banks to increase lending to ease the economic slowdown since 2008 crisis. Most recently, The People’s Bank of China cut its benchmark one-year lending rate by 25bps to 4.35 percent on October 23rd, 2015. Policy-makers also decided to lower reserve requirements for banks. Interest Rate in China averaged 6.35 percent from 1996 until 2015, reaching a historic height of 10.98 percent in June of 1996 and a record low of 4.60 percent in August of 2015. What follows, Chinese banks have provided easy credit for housing development, presumably without decent evaluation of risks.
The very important role in this development is played by home mortgage, since most home loans in China are variable-rate mortgages. They accounted for one third of the total lending activities in the second part of the first decade of the 21st century (Dreger & Zhang 2010). And now this ratio is any lower. Chinese homebuyers borrowed more than ever as 2016 got under way, aiding a housing recovery. Medium- and long-term bank loans to households, mostly residential mortgage loans, surged 478.3 billion yuan (73.5 billion dollars) in January 2016, according to the latest data from the People’s Bank of China. In a bid to spur demand in smaller cities and reduce a surplus of homes, the government in January cut the minimum required mortgage down payment in some cities to the lowest level ever. Chinese central bank cut the minimum required mortgage down payment to 20 percent from 25 percent for first-home purchases to the lowest level ever as it steps up support for the property market.
Chart 16: China debt as percentage of GDP by sectors 2002-2015
Source: CLSA Investment Group
Chart 17: China interest rates 2008-2016
The eased requirements are for buyers in areas without the purchase restrictions that are applied in some of the biggest metropolitan areas such as Beijing, Shanghai or Shenzhen. The minimum down payment for second-home purchases was in turn cut to 30 percent from 40 percent. A rising stockpile of unsold new dwellings is hampering government efforts to spur investment expanding at the slowest pace in more than five years. China’s politburo in early December 2015 vowed to reduce home inventory as one of its key tasks in 2016, the official Xinhua News Agency reported.
Chart 18: Mortgage loans in China 2007-2016
Consequently, as pointed out by Paskelin & Vishwakarma (2011), over half of China’s fixed asset investment was in manufacturing and real estate between 2003 and 2014. Over that time, investment in both sectors rose at an average annual rate of 25 percent and 24 percent, respectively. In the first two months of 2016 China’s urban fixed-asset investment grew 10.2 percent year on year 3.8 trillion yuan (586 billion dollars).
Hence, growth picked up slightly from the 10 percent increase recorded in 2015, according to the National Bureau of Statistics. It marked an end to several years of continuous decrease in the growth of China’s fixed asset investment.
Chart 19: China’s urban fixed investment 2015-2016
Source: Market Realist
This massive and fast investment growth has built up serious production capacity in some basic industries, including steel, cement, chemicals, metals, and textiles. This trend continued after the financial crisis and resulted in overinvestment when the market failed to eliminate unproductive capacities. China’s central government has identified overcapacity (that has got much worse since 2009) and the closure of debt-ridden ‘zombie’ firms as one of its key policy priorities for 2016, and it has already published action plans aimed at shutting 100-150 million tonnes of low-end steel capacity and 500 million tonnes of coal production. More precisely, as far as iron is concerned, according to the China Iron and Steel Association (CISA), China now has an annual capacity surplus of around 400 million tonnes, with utilization rates falling to 67 percent in 2015. Despite the fact, that production fell for the first time since 1981 last year, capacity will probably increase further in 2016.
Chart 20: Global crude steel production annually 2008-2015
Source: Word Steel Association
3.4. The role of governments
“The Chinese government, both at the central and local levels, has played a significant role in developing and sustaining China’s investment-driven growth model. The government has formulated and implemented growth-centric policies, including five-year plans and industrial strategies, complemented by fiscal, financial, and trade policies” (Paskelin & Vishwakarma 2011). Such policies have been used to spur investment in certain priority industries with significant impact on economic growth and employment.
The extraordinary growth of home prices in PRC is also partly caused by the behavior of municipal governments. As pointed out by Barth et al. (2014), prior to 2007, the sale and leasing of state-owned land were very significant source of revenue for local authorities. The ratio of land sales to municipal government revenue increased from less than 1 percent in the early 1990s to more than 50 percent by 2007. Moreover, to raise land prices and what follows increase revenues, municipal governments restrained the use of land for residential purposes. This helps to understand the low price elasticity of land supply, which – in turn – boosts home prices as demand increases. Last but not least, they have even set up exit barriers for market-driven bankruptcies, and mergers and acquisitions, in order to retain investment and jobs in their respective jurisdiction (Barth et al. 2014).
All that combined with China’s robust economic growth has fostered strong market confidence and motivated Chinese companies, both state-owned and private, to undertake substantial capital investments as part of their growth strategy. “The size of the Chinese market and the overall transitional nature of the Chinese economy, however, have made market coordination and access to reliable information difficult (Paskelin & Vishwakarma 2011).”
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.
 Consumers buy dwellings for three main reasons: investment, housing value and speculation. Only those buyers who purchase housing for its value are the inelastic consumers in the long run housing market, and for this reason the size of this group will determine the long-run trend of housing price.
 Shiller highlights also the role of “feedback loops” in the propagation of bubbles. According to him, price increases for an asset cause greater investor enthusiasm, which then leads to increased demand for the asset and therefore to further price increases. What is more, Schiller reiterates the news media play a prominent role in increasing the optimism of investors. The media are, in his view, “generators of attention cascades.”
 The inventory is even bigger including homes which haven’t been built, and are estimated to take three-and-a-half years to be cleared, said Zhu Jin, a Shanghai-based analyst at Orient Securities Co.
 Chinese home ownership data is from a June 2014 report by the China Household Finance Survey
 Boosted by a series of easing measures in the past year, housing sales in China rebounded from 2014 and rose 16.6 per cent in 2015 to 7.28 trillion yuan in value.