In this guest post, Yuan Tian, a student in my “Monetary and Financial Theory” class, discusses one of the most important dangers the world economy now faces: a possible collapse of housing prices in China, with unknown effects on China’s banking system. Here is what Yuan has to say: 

It’s always a hot topic among Chinese people to talk about real estate prices. The bubble has become bigger and bigger since the 1990s. Of coruse, a bubble is an unsustainable rise in the price of an asset, well above the market price given fundamentals. A bubble is indicated by three signs: a gap between disposable income and home prices, rising inventory, and a rising number of properties per person.

In a way that would be hard to imagine for Americans, in the current real estate situation the majority of Chinese people still can’t afford a house after working hard for a lifetime. China’s real estate prices have been changing in dramatic ways: prices soaring in the past, and now perhaps an environment of declining prices. That is the question: will the real estate bubble really burst in China?

Optimists insist that the prices won’t decrease a lot due to the large population and demand in China. They also mentioned that right now in the bubble, China’s residential mortgage debt is only 15% while in the U.S. borrowing 80% of a house’s value is considered conservative.

Pessimists don’t think so. They are arguing that as China’s financial market matures, people might be less likely to purchase houses because they will have more other investment options.

As for population growth, statistics show that the population will reach the peak in 2018 and labor force will shrink starting in 2015. Thus people predict that the property prices will start to fall between 2017 and 2018 thanks to the “one child policy” and China’s aging population composition. According to this information, pessimists predict a 40% decrease in the next five years since there will be fewer people willing to purchase a house but the supply is still large. Anther great concern, that I take very seriously, is the possibility of falling dominoes. Once the supply is bigger than the demand, real estate companies will face a money chain rupture. They will have to decrease the price to attract more buyers and save the company.

If there is a crash, it could cause a financial crisis like the United States faced in 2008. In the US, housing prices declined steeply after peaking in mid-2006, and it became difficult for many borrowers to refinance their loans. As adjustable-rate mortgages began to reset at higher interest rates (causing higher monthly payments), mortgage delinquencies soared. Securities backed by mortgages, including subprime mortgages, which were widely held by financial firms globally, lost most of their value. Global investors tried to drastically reduce their holdings of mortgage-backed debt and other securities, and there was a decline in the capacity and willingness of the private financial system to support lending. Concerns about the soundness of U.S. credit and financial markets led to tightening credit around the world and slowing economic growth in the U.S. and Europe. 

To save the market, right now Chinese government is trying hard to come up with policy interventions. Let’s have a brief look at China’s housing industry changes and government policy responses in recent years.

Before 2003, as part of fostering economic growth in China’s, the Chinese government regulated and supported the under-developed housing market. From 2000 on, there was no more government housing allocation in China and people had to purchase houses through housing companies. After that, the government enacted a series new rules and regulations such as lower mortgage rates, reduced down payments, and lower transaction fees to further stimulate the housing industry.

Then in 2002, the Public Land Building System was enacted. Following in 2004, all lands started to be put up for auction. It was around that time that housing prices began to rise. From 2004 to 2006, with Chinese government encouraging housing sales and offered many benefits to the housing industry as well as fostering economic growth more generally. Prices of houses rose a lot not only in big cities but also in small inland cities. Construction boomed rapidly during this period.

In 2005, in response to the increasing prices, “Eight Rules,” “New Eight Rules” and “Opinion of Such Departments as the Ministry of Construction on Effectively Stabilizing House Prices” were enacted, marking the central government’s first efforts to rein in home prices. But the trend was hard to stop. For example, over the course of the one year, 2005, average housing prices in Beijing increased by 20%, while the price had increased only 0.78% from 2000 to 2004. The bubble has only gotten worse since then, despite the government’s efforts to stop it. 

Later in 2010, China posted the “Notice of the State Council on Resolutely Curbing the Soaring of Housing Prices in Some Cities”  to require a down payment on second homes from 40% to 50%. In addition, banks must charge a minimum mortgage rate on second homes of 1.1 times the benchmark interest rate, and increased down payments on first home larger than 90 square meters from 20% to 30%. Then in 2011, China had “National Eight” real estate market regulations. On the other hand, Chinese government has started the property tax pilot program–a program I think is pretty useful. The program asks for higher property taxes for those who own more houses in China. It has been in place in Shanghai and Chongqing since 2011. 

Prices might be controllable in the future by government policies. So far, recent policies have not been given deadlines. In the short run, there may be volatility due to uncertainty. 

Though we can’t know when the bubble will burst, the recent situation in China gives some ominous portents. According to the Securities Times newspaper, housing developers in the industrial city of Hangzhou cut prices this week by an average 19% in a scramble to sell about 120,000 newly-built apartments. The current inventory of new, unsold units now exceeds the total number of housing units offered for sale in Beijing and Shanghai combined. A study by Shanghai’s Tongji University said real estate has been especially shaky in the northeastern city of Wenzhou, where new-home prices have fallen every month for the last two years. 

My view is that the housing bubble will burst in near future–or may now be in the process of bursting.