Beijing Must Avoid Giant Pop in House Prices

Everyone knows that when you start getting stock tips from your shoeshine boy it’s time to short the market. But what about when your Beijing taxi driver tells you which apartment complexes to sink your life savings into?

Deciding whether or not the Chinese real estate market — referred to by hedge fund investor Jim Chanos as “Dubai times 1,000 or worse” — is a giant bubble or not is probably one of the most important questions in the world today.

Apartments in China
Apartments in China

Not only does Chinese growth depend on house building: the fates of many other economies, particularly commodity exporters such as Brazil and Australia, also depend on demand from the world’s second largest economy.

It is also important from a geopolitical perspective.

Housing construction is such a driver of the Chinese economy that if a real estate bubble were to burst the resulting shock could see economic growth fall to the low single digits. By the Communist party’s reckoning, the economy must grow more than 7-8 per cent a year if social unrest and demands for real political representation are to be kept under control.

China’s newly minted middle class might not be so willing to accept authoritarian, one party rule if they saw the value of their shiny new apartments and villas collapse as a result of the party mismanaging the economy into a giant property bubble.

So is there a bubble in the Chinese property market or not?

Forests of empty or half built apartment complexes across the country would suggest there is. But, unfortunately, the smartest people I talk to do not agree. Some say there is a huge bubble, some say there is no bubble and some say even if there is a bubble it will never pop.

For those who define a bubble as a rapid increase in leverage to support speculation in rising asset prices, China’s real estate market does not fit the mould.

The ratio of household debt to disposable income in China was only about 45 per cent in 2010, less than the U.S. in 1960 when the ratio was 55 percent and nowhere near the 130 percent level reached at the height of the U.S. property bubble in 2007, according to figures from brokerage firm CLSA.

But if you define a bubble as a fundamental mismatch between prices and the underlying value of an asset, then Chinese real estate has to be a prime candidate.

On the outskirts of Beijing, near the airport, there are dozens of gated villa communities with names like Palm Beach, Cathay View, Le Leman Lake and Maison De Bourbon.

Despite their grandiose names, even the nicest of these developments resembles a nondescript outer suburb of Houston or Las Vegas. Many are shoddily built and poorly insulated, with a tiny strip of dirt for a backyard and the side of a neighbor's house for a view.

But the going rate for a decent Beijing villa is about Rmb40 million ($6 million), enough to buy a nice London mansion or a luxury apartment in Manhattan.

With about 30 similar new developments under construction in the vicinity and empty farmland for miles around, it is hard to argue that these prices are sustainable.

Beijing luxury villas are an extreme example and don’t represent the entire market but in many cities across the country average house prices are more than 10 times average annual household incomes. Prices of about three times average annual incomes are considered normal in developed economies and prices of five to seven times are more common in other Asian economies.

China property bulls argue that official figures significantly understate real incomes by not including so-called “grey income” — bribes, kickbacks and tax evasion scams that do not show up in official data and could equate to a quarter of reported incomes by some estimates.

The optimists also argue that crazy high prices are supported by government compensation given to households living in the countless inner-city buildings that are being demolished for redevelopment across the country. These handouts allow relocated households to afford far higher prices for their new apartments than their income would suggest.

That is why Beijing and other large cities are full of drivers and blue collar workers on salaries of Rmb2,500 per month who are millionaires on paper because of the rise in the value of apartments they received as compensation for their demolished homes.

But even the most bullish bubble deniers admit that housing prices are too high in China and are unsustainable at current levels over the long term.

The question is, given what’s at stake for China, the Communist party and the global economy, will Beijing be able to bring prices down gradually without provoking a giant pop?