Just how risky are China’s housing markets?

Joseph Gyourko, Yongheng Deng, Jing Wu

Reinhart and Rogoff’s recent influential study of financial crises finds a recurring root – the country’s property markets. This column argues that a similar housing bubble may be developing in China. Urgent research is needed to determine the risk of a full blown crisis.

China is experiencing spectacularly fast growth – so fast that many fear it is driven by a bubble – a property bubble to be precise. Recent memories of what happened when the US housing market bubble burst make the possibility of a Chinese housing bubble a critical concern for the world economy. So, is there a bubble or is it simply hot air?

Financial bubbles are governed by something like the economic equivalent of physics Heisenberg's uncertainty principle. It is impossible to observe a bubble with certainty without actually altering the bubble itself. If people knew it was a bubble, it wouldn't be a bubble – it would have already collapsed. It would not, however, be impossible to envision “diagnostic tests” that would provide a probabilistic identification of a bubble. Unfortunately the state of economics does not provide such a procedure (see Flood and Hodrick 1990 for an early analysis of what would be required to determine convincingly whether or not a speculative bubble exists).

The problem is particularly acute in the case of Chinese housing. Data limitations arise from the fact that there was no real private market in land or housing units in China until the late 1990s, so it is only possible to compare current conditions to little more than a decade of previous data. It is not hard to find highly respected professional investors with opinions on both sides of the question over China’s bubble (see the article by Barboza 2010 in The New York Times for a discussion).

New evidence on a Chinese housing bubble

Our look at the available data strongly suggests that prices are quite risky at current levels, and that it would take little more than a modest decline in expected appreciation to engender sharp drops in prices. The first foundation of this conclusion is that home prices in China are at their all time highs, and have been appreciating at especially high rates recently. This is documented in Figure 1 which plots real and nominal price indexes developed at the Tsinghua University for newly constructed homes in 35 major cities.

Real prices more than doubled over the past decade, with appreciation rates escalating at the beginning of 2007 and then again in early 2009. The most recent data show a record 41% (annualized) growth rate for the first quarter of 2010.

Figure 1. Constant quality price index for newly-built private housing in 35 major Chinese cities, 2000-2010



Source: Wu, Gyourko and Deng (2010). The underlying data source is the Institute of Real Estate Studies, Tsinghua University. See the discussion in Wu, Gyourko and Deng (2010) for more on how these indexes are created.

But it was not high price levels alone that convinced Case and Shiller (2003) and Shiller (2005) that US house prices had become unsustainable – it was the all-time high price-to-rent and price-to-income ratios.

Information on price-to-rent ratios is less widely available for Chinese markets. Figure 2 plots them since early 2007 for eight major Chinese cities. Price-to-income ratios are then plotted in Figure 3 for these same markets, using data back to 1999. For those unfamiliar with these markets, they are listed on the map in Figure 4. Each is among the largest markets in China, with none having a population below 8 million.

Price-to-rent ratios have increased by at least 30% over the past 3 or so years in each of these cities.

The jump was very large in Beijing, rising by almost three-quarters from 26.4 in 2007 to 45.9 in the first quarter of 2010.

Hangzhou, Shanghai and Shenzhen also have seen their price-to-rent ratios rise sharply to over 40.

Even though income growth has been strong in urban China, price-to-income ratios also have been increasing in these same markets.

Income growth did keep pace with house price appreciation in the other large markets, so housing has not become less affordable everywhere, according to this metric.

Figure 2. Price-to-rent ratio in eight major Chinese cities, 2007-2010



Source: Wu, Gyourko and Deng (2010). The underlying data were collected by the Institute of Real Estate Studies, Tsinghua University. See the discussion Wu, Gyourko and Deng (2010) for more on the creation of these ratios.

Figure 3. Price-to-income ratios in eight major Chinese markets, 1999-2010



From Wu, Gyourko and Deng (2010). See that article for more on the creation of these ratios.

Figure 4. Map of the eight major Chinese cities

Chinese government data indicate that these price rises are underpinned by rapidly escalating land values. Because the Chinese government still owns all the land in urban areas and leases its use for long periods of time, we can observe land prices independently from home sales (which include the land plus the structure). We collected data on all the residential land parcel auctions in Beijing dating back to Q1 2003, and created a constant quality price index for Beijing residential land, controlling for a number of location and site quality variables that are described in Wu et al. (2010).

Figure 5 shows that real, constant quality land values increased by over 750% since 2003 in the Chinese capital, with more than half of that rise occurring over the past two years. Additional regression analysis showed that state-owned enterprises controlled by the central government played a meaningful role in this increase, as prices were 27% higher on the parcels they won at auction compared to otherwise equivalent land sites purchased by other investors.

Figure 5. Real constant quality residential land price index for Beijing, 2003-2010.

From Wu, Gyourko and Deng (2010). See that article for more on the creation of the index.

Suspicions if not proof

While it is impossible to conduct a formal test of whether there is any fundamental mispricing in Chinese land and housing markets with these limited data, there certainly is much to make one more than a little suspicious that prices are unsustainable.

The magnitude of the increase in land values over the past 2-3 years in Beijing is, to our knowledge, unprecedented.

These increases post-date the Summer Olympics and the recent price surge in early 2010 suggests a relationship to the Chinese stimulus package which itself is temporary.

The role of state-owned enterprises also is potentially worrisome. It could be that these entities are superior investors and are purchasing sites that are of especially high quality in ways that we cannot control for in our empirical analysis. However, it also could be that moral hazard is at work here, as these entities are thought to have access to low cost capital from state-owned banks and may believe they are too big to fail. If this is the driving force, then prices are being bid up as one arm of the government buys from another.

More broadly, the sharp rises in price-to-rent ratios in Beijing and the other large markets look to be very difficult to explain fundamentally.

Most true fundamentals just do not change so discretely or in such magnitudes as to be able to explain these changes.

The standard economic model of home valuation indicates that owners must be expecting very high rates of price appreciation for these price-to-rent ratios to be sustainable.

That people might believe in such high appreciation is not incredible given the recent history of Chinese house prices. However, this sort of backward looking expectation formation is a classic element of bubble psychology. Moreover that history is quite limited and tells us that prices never go up forever – much less at the extremely high rates experienced over the past few years.

What happens if the bubble bursts?

To provide some insight into just how risky prices and price-to-rent ratios are at these levels, we calculated what would happen if people began to expect that their homes would grow in value by only 4% per year. For Beijing, prices would fall by over 40%, absent offsetting rent increases or other countervailing factors. While a 4% rate of appreciation is lower than what has been experienced in the capital city over the past few quarters, house prices did grow by less than that for five consecutive years from 1999-2003. Indeed, 4% is not an especially low rate of appreciation in the broad scheme of things. If it were to continue for a decade, prices would be 48% higher; over 20 years, prices would more than double (+119%).

Reinhart and Rogoff’s recent study of financial crises often finds the genesis in the country’s property markets (see Reinhart 2008 on this site). Recent data indicate there is reason to suspect a similar predicament in China’s housing sector. Whether it leads to a full blown crisis is another matter, of course, that depends upon the amount of leverage in the system and the safety and soundness of the regulatory environment, among other factors. Those clearly are matters in need of urgent research if we are to fully understand the potential fallout from a meaningful drop in Chinese house prices.

References

Barboza, David (2010), “Contrarian Investor Sees Economic Crash in China”, The New York Times.

Case, Karl and Robert Shiller. "Is there a Bubble in the Housing Market?" Brookings Papers on Economic Activity, No. 2 (2003): 299-362.

Flood, Robert and Robert Hodrick (1990), "On Testing for Speculative Bubbles", Journal of Economic Perspectives, 4(2):85-101.

Reinhart, Carmen and Kenneth Rogoff (2009), This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press.

Reinhart, Carmen (2008), “Eight hundred years of financial folly”, VoxEU.org, 19 April.

Shiller, Robert. Irrational Exuberance (2nd edition), Princeton: Princeton University Press, 2005.

Wu, Jing, Joseph Gyourko and Yongheng Deng. “Evaluating Conditions in Major Chinese Housing Markets”, NBER Working Paper 16189, July 2010.