According to data released by China's National Bureau of Statistics early this month, real estate prices in 70 medium- to large-size cities in China surged 8.2% year-to-year in August, and the trend is still upward. This has become a concern, not only for consumers, but also for the government. On August 13, the State Council issued its "Opinions on Solving the Housing Difficulty of Urban Low-income Families," in which it is explicitly stipulated that local governments should speed up the establishment of a low-rent housing system to address the housing needs of this segment of the population.
What are the driving forces behind China's property prices? In our August 29 issue, we interviewed Zhang Yongyue, who analyzed the issue from the supply and demand angle. In this issue, China Knowledge@Wharton interviewed Hua Wei, director of Fudan University's Real Estate Research Center in Shanghai, for his views on China's macro economic environment. An edited version of the conversation follows.
China Knowledge@Wharton: As a researcher in both real estate and finance, what do you think is driving China's soaring real estate market?
Hua Wei: I think China's real estate prices are entering a period [of upward growth]. The fundamental reasons for such change, however, are not found in the real estate industry itself, but outside. To get to the bottom of this, we cannot simply base our analysis on "supply and demand" [but must look instead at] the fundamental cause.
Three things have contributed to the current situation: the macro economy, industry factors and regional factors.
China Knowledge@Wharton: Can you start with the macro economy?
Hua Wei: In 1998, China's economy started to experience a surplus of products. As of this year, it has entered a period of surpluses in both goods and capital.
Since 1998, the Chinese government has relied on expanding domestic investment to boost the economy, but domestic consumption did not grow along with it. In other words, domestic consumption grew more slowly than investment. So since 1998, a surplus of various goods has shown up in [such products as] refrigerators and color TVs. Today, there is a "double surplus" of China's "competitive edge" products -- namely those that have low labor costs -- internationally and internally.
Second, in 1998, China's foreign reserve was small and capital very scarce, so we tried to attract more overseas capital and encouraged civilians to save more. These savings could then be converted into investment. But now we have excess liquidity. On the one hand, China’s foreign reserve has topped US$1.5 trillion; on the other hand, there is abundant yuan in mainland China. The central bank has taken a series of cooling measures but has not shaken off excess liquidity in the market.
During such a massive transformation, my view is that China did experience some changes in its financial and investment systems as well as the economy's growth pattern. But the changes were not great enough to catch up to shifts in the environment at large.
China Knowledge@Wharton: What are some of these shifts?
Hua Wei: Excessive domestic investment each year has bolstered production capacity. Over 10 years, it has evolved into a surplus of consumer goods. Under this scenario, to seek further development, enterprises have had to move their focus to exporting, which has resulted in abundant external demand and inadequate internal demand.
Meanwhile, China faces two challenges: One is the urban/rural dual structure and the other is the lack of an all-round social security system for rural residents. The so-called competitive advantage of the Chinese economy is, to a great extent, reflected in the exploitation of the environment and a cost structure that doesn’t provide social insurance for the lower income, less productive labor force.
In addition, the Chinese government's fiscal and tax reforms were lagging behind. More than 80% of the fiscal revenues of various levels of government is from the turnover tax, 70% of which is made up of the value-added tax. Because this policy encourages enterprises to expand their scale and increase operating income for tax payment, it is a potential hazard for the rapidly-growing large scale Chinese economy. And I think the Chinese government's reluctance to significantly appreciate the yuan can be mostly ascribed to these two factors.
China Knowledge@Wharton: Regarding appreciation of the yuan, what policy do you think the Chinese government will adopt?
Hua Wei: I believe a gradual appreciation of the yuan will be a medium- and long-term process. As I mentioned, China has a dual urban/rural structure. If the yuan appreciates greatly against the U.S. dollar, the market prices of agricultural products in yuan under a WTO agreement will drop dramatically. Furthermore, China's agriculture basically has no subsidies, and it has no scale either. What’s worse, as I have noted, is that China's peasants have no direct social insurance. Therefore, once the old-time model has been displaced by foreign agricultural products, it will eventually evolve into a social conflict. The government will be responsible for any losses.
The money for the government to pay for these losses is again from fiscal revenues, of which the major part (the value-added tax) depends significantly on the output value of the heavy chemical industry. Once the yuan rises, especially against the U.S. dollar, China's national industry, including the heavy chemical sector, will suffer serious impairment.
Therefore, yuan appreciation will result in two things: Fiscal revenues will not necessarily increase; and the self-cyclic model of China's small-scale agriculture will be destroyed, while peasants continue to lack social security. The reforms or transformation needed to solve these two issues cannot be achieved in a short period. This implies that a gradual appreciation of the yuan is the optimal option for China's government.
China Knowledge@Wharton: How does a gradual appreciation of the yuan relate to real estate prices?
Hua Wei: They are very closely related.
Our fiscal tax policy, the urban/rural dual structure and the government have determined that the yuan will appreciate in a gradual manner. The steadily growing Chinese economy and the fast swelling GDP, if calculated in dollars, will attract international capital, represented by the liquidity of the U.S. dollar, ready to make long-term strategic investments in China.
To keep the yuan exchange rate from increasing too much, the central bank has to issue a lot of RMB. So you can see in the past 10 years that the M2 currency on average has basically outpaced GDP growth of 10%. Currency supplied to the whole country by the central bank is becoming increasingly abundant compared with goods and services.
In such a context, the central bank is continuously creating excess liquidity. On the other hand, China's banks have mainly lived on the interest spread between deposits and loans. The government's macro policies mainly control loan credit. Therefore, liquidity growth each year has surpassed bank deposit growth, and the gap is expected to expand.
China Knowledge@Wharton: So your conclusion is…
Hua Wei: Capital surplus is an aggregate surplus, but it's not allocated evenly to all industries. We can divide industries into production and assets. Within China's production industry, the defense and military sectors are not open, while petrochemical and energy are monopolies. The remaining sectors are fully competitive markets with shrinking ROIs. On the other hand, capital aims to seek returns and control risk, so investors are not willing to enter the production field. Many owners of small and medium enterprises have withdrawn from the over-competitive businesses which they used to be engaged in.
The key targets of investment are in the assets category, namely bonds, stocks and real estate. Consequently, we have seen a surge of real estate prices in Chinese cities over the past five years. Despite the various austerity measures adopted by the government, the relatively insufficient supplies and over abundant capital in the assets category have remained unchanged.
The large amount of capital in the hands of the people that cannot be put into the production industry or saved in the banks has boosted the demand for assets. For example, the Zhejiang property speculator group (mainly made of Wenzhou people), the Guangzhou property speculator group and Shanxi coal mine owners are all rushing to buy real estate. The surplus capital at home and abroad is swarming into China's asset markets to share the gains from China's high growth, both now and in the future.
China Knowledge@Wharton: Why is international capital going after Chinese real estate?
Hua Wei: Because the American economy grows very slowly and the yuan has a good outlook for appreciation against the U.S. dollar. The Chinese economy is growing fast each year. From investments in profitable real estate properties in China, such as office buildings, commercial shops and hotels, investors automatically get earnings every year. Profitable properties in the non-residential category attract a large number of overseas institutional investors. Their exit does not require a transfer of title. Instead, they could exit in the secondary market in Hong Kong, Singapore, London or New York in the form of packaged equities. No title transfer is involved at all. In fact, given the appreciation of the yuan against the U.S. dollar and its internal depreciation, the real appreciation of the yuan is much greater than the nominal and it has magnified the attraction of the Chinese market to the U.S. dollar.
China Knowledge@Wharton: What is your opinion of China's internal demand for real estate?
Hua Wei: The demand of China's population for housing will far exceed the capacity of the existing market. The current supply shortage in China, especially in big cities, has become a very serious problem. So is the limited supply of stocks. The real circulated shares add up to only 60-plus trillion. A small amount of capital may [inspire] a large capital expansion in the real estate market. Making it worse is that this trend will not change in the short term.
China Knowledge@Wharton: What do you think of China's economy overall?
Hua Wei: A surplus in foreign trade and the capital account, coupled with the excessive currency issued by the central bank, has resulted in excessive liquidity, which is far surpassing the growth of products and capacity.
Consequently, the double surplus in China's production area is not eased but is aggravated. Enterprises are trying their best to export more goods. Meanwhile, in the capital markets of securities, bonds, equity and real estate, the capacity and, production cycles are not in line with the demand, so the supply cannot be increased quickly in the short run. That's why China's asset markets are booming.
In the context of a capital surplus and short supply, some capital fled to the consumer market, which led to inflation. The central bank cannot raise the interest rate too much because of concerns about foreign exchange stability. If the central bank greatly increases the interest rate or the U.S. cuts the interest rate [too much], the larger exchange difference and the wider interest spread will increase the attraction of the yuan against the U.S. dollar. There will be flourishing demand for the yuan and greater pressure on China's central bank to maintain a steady exchange rate.
On the other hand, the negative real interest rate makes people reluctant to deposit money because they don't make a profit.
Therefore, excessive capital and the limited asset markets are the root causes of the currently soaring property prices, the swelling equity market and rising inflation in China.
On the surface, the culprit is the foreign trade surplus and foreign investment; looking more deeply, however, they are the inevitable outcomes of the low technological content and low-competitiveness of the heavy chemical industry, the dual urban/ rural structure and the undeveloped rural social security system.
China Knowledge@Wharton: Will this structural imbalance take a turn for the better?
Hua Wei: Currently, the imbalance is not improving but getting worse.
The central government has taken a lot of measures. It requires the local government to establish minimum insurance for rural areas jointly with the central government, to take the initiative to raise capital and set up a special fund to provide disadvantaged communities and low-income families with low-rent apartments, to rigorously improve the social security system for migrant workers and to improve the cost of using environmental resources.
In addition, given the large amount of foreign reserves, China's shift to overseas investment and the establishment of the China National Foreign Exchange Investment Company shows the top leaders' identification of, and deep concern for, this trend.
However, given that the traditional investment mechanism is not changed, our foreign reserves will continue to increase. It is therefore imperative for China to fully and quickly transform the foreign exchange investment system and the country's development pattern, and adopt a diversification strategy for the national foreign reserve. If the transformation is slow, it will be difficult to ease the conflict. China’s level of liquidity is [so high] that even complete openness in the property and equity markets could hardly contain it.
China Knowledge@Wharton: Let's come back to the real estate industry itself.
Hua Wei: China's real estate industry has double restrictions. One is the unsophisticated financial market, which favors bank loans but devalues direct finance. Apart from a few listed companies, no sound financing channels have been developed for real estate companies. The other is the disparity in different regions because regulations implemented by local governments are so inconsistent. Moreover, the main economic groups are various local governments with no unified code in the country. The real barrier for investors is not in capital but in administration.
But the demand in real life is huge and it can be created every minute, while it takes several years to have houses become available. The production cycle is long partly due to opaque governmental procedures.
In the meantime, large numbers of people are swarming into cities. These urban citizens' income needs to be spent on improvement of their living conditions. The closer to the city center, the scarcer the land is.
China Knowledge@Wharton: What's your opinion of the government's cooling measures for the real estate market?
Hua Wei: From the central government perspective, we all agree that macro regulation is very essential. The key is that some tactical principles were not aligned with the macro requirements because we have overlooked the fact that what brings real change in the market is not one single policy but a policy portfolio.
We do have good policies. For example, the 90/70 policy was intended to reduce apartment sizes and to increase supplies, but was executed in a one-size-fits-all manner. Projects not in line with the planning need to be reworked across the board, which will take at least one or two years. We have enacted many good policies, such as recalling land that has been idle for two years, but we forgot that a precondition of land transfer is that household relocation will occur. Therefore, although the policy has good intentions, it is not practical. To sum up, our macro regulations have clearly defined objectives, but the approach is too idealistic and over-simplified to be a cure for the fundamental problem.
Besides, there are some unjustified policies. There were many property speculators at the beginning, but the number has dwindled, so why are we so stringent about the 5-year limit for second-hand property trading? Now it is the ordinary people who are being held down. The drop-off in second-hand property transactions creates more demand for newly-built properties.
China Knowledge@Wharton: But second-hand property prices are still rising?
Hua Wei: Yes they are high but the transactions are not as active as they were a few years ago. On the one hand, money is amassing, but the trading volume is declining, which is distributing the money to the new houses. What do new properties require? They require the relocation of households. As the supply in the downtown areas is more and more restricted and no one wants to move to the outskirts, property prices in the downtown shoot up too quickly, as we find in Beijing, Shanghai, Guangzhou and Shenzhen.
China Knowledge@Wharton: There is a phenomenon in big cities that young couples are unwilling to share a spacious apartment with their parents, but prefer to buy a high-price unit by taking out heavy loans.
Hua Wei: Their expectation is understandable. The life pace nowadays has changed and there is a generation gap, but we should act according to our capabilities. Also, there is something wrong with our consumption habits.
According to the current trend, those people who rented houses four years ago have experienced a big loss; those who bought the houses have made a huge profit. But have you noticed that if everyone thinks this way -- buying is better than renting -- then who will be willing to rent? Based on this logic, the earlier one buys, the better. Now there is a younger-age trend emerging in house buying -- parents buying apartments for their teen-age children for the purpose of fixing their future costs. A lot of irrational behaviors are not derived from a concept but from real events.
It is not because Chinese people like to keep up with the Joneses, but if you act early you can get a larger house; if you buy later, a smaller one. Under this system, one has to buy an apartment either by using money he has, borrowing the money or finding some other means to make the purchase.
China Knowledge@Wharton: What's your suggestion for the government?
Hua Wei: People are rational. They know they don't make money by depositing it in the bank, so they take out the money to buy stocks and apartments. It is not that they are unwilling to choose but the choices are limited. Too many people have invested their money in the same direction and so the limited choices require huge amounts of capital.. It is not as simple as just telling people not to buy houses. China is at a crossroads of social conflict and transformation. We need to reconstruct a social order, set a framework of wealth distribution and form a stable society.
One last thing to stress: We need to correctly understand the property market. In no case will housing prices remain flat in a fast-growing economy with inflation. In a fast growing economy, housing prices will go up steadily.
We need to find a permanent cure rather than take a painkiller. Housing prices are not an issue only for the real estate industry; this is a social and economic issue, which intertwines China's history and future.