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CAIXIN ONLINE
Aug. 3, 2010, 8:30 p.m. EDT
Fear empty flats in China's property bubble
Commentary: Even worse than price bubble is quantity bubble of vacant flats
By Andy Xie
BEIJING (Caixin Online) -- How many flats in China are sitting empty? The media recently floated a story -- denied by power companies -- that 64.5 million urban electricity meters registered zero consumption over a recent, six-month period. That led to a theory that China has enough empty apartments to house 200 million people.
Statistical transparency is lacking in this area, so the truth about empty apartments remains under wraps. Publishing accurate data should be of the highest priority, since the size of the nation's unused apartment stock is perhaps the most important measure of the extent and seriousness of China's property-market bubble. Indeed, it's a grave concern for policy making, since unpublished data may indicate not only a price bubble but a quantity bubble burdening the market.
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Real estate is prone to price bubbles because unique factors restrict its supply response. Inflated prices have been the mark of most modern-day property bubbles. Price bubbles occur frequently and can last a long time.
In the 1980s, Tokyo saw a tremendous rise in property prices not in tandem with supply. The Hong Kong property market experienced a similar phenomenon in the 1990s.
One reason for limited supply is that property development is subject to government regulations, especially local rules. Established communities usually restrict building heights and density, for example, making it virtually impossible for mature communities to increase supply quickly. London, which is now experiencing a price bubble, and Tokyo in the past are cities that tightly control building heights.
Second, infrastructure development takes time and is always relative to land availability. Even in an island-city such as Singapore, land can be reclaimed from the sea at low costs, pointing to the correlation between land and infrastructure. But when property prices are high, and even when money is available for infrastructure development, one should be cautious about plunging in for fear that property prices could later fall. Thus, even over extended periods of time, property supplies may not respond to price increases.
Hong Kong doesn't have height restrictions like London or Tokyo. Nor does it have infrastructure or land shortages. But a government policy limiting land supply created scarcity before 1997, setting the stage for a bubble. The subsequent catalysts for higher prices were loose monetary conditions imported from the United States through Hong Kong's currency peg to the dollar. Even though prices were rising, the government chose not to increase supply, leading to a price bubble.
Thus, demand for property also rises under eased monetary conditions, and climbing price momentum attracts speculative demand. If monetary conditions remain loose for a while, credit access can sustain this kind of speculative demand. This points to a need for the Chinese government to adjust its property-market policies as well as interest rates to reduce speculation and steer the market out of a looming bubble crisis.
It's been said many times that China is experiencing a nationwide urban property price bubble. High prices in major cities where most of the country's property value is concentrated cannot be explained rationally.
Rising rents are a little easier to explain, however, even in the face of empty flats everywhere. Some blame intermediaries for ramping up the market, but this explanation is hard to stick in China's fragmented intermediary real-estate industry. Instead, inflation expectation is probably driving current rent increases: Property owners anticipate spending more in the future remodeling flats to compensate for renter wear-and-tear, so they charge higher rents now to plan for higher costs.
Quantity pump
What especially distinguishes China's property bubble, however, is an unprecedented amount of living space. This huge stock of empty flats equals the nation's quantity bubble.
Quantity bubbles are less common than price bubbles, and they don't last as long. Rising supply usually exerts downward pressure on prices, although an influx of money can hold up prices even when supply is rising.
A price bubble can damage an economy in three ways. First, it usually leads to a banking crisis. As the market trades at ever-higher prices, buyers borrow more against the same property. Banks that maintain the same lending cushion with, say, a 30% down-payment rule suffer losses when prices fall below that level. A banking system in crisis cannot lend normally, and the economy suffers collateral damage due to dysfunctional banking.
Second, the wealth effect leads to excessive consumption during a bubble. The payback weakens an economy for several years.
And third, bubble-induced demand distorts the supply side. When inflated industries go down with a bubble burst, it takes time for other industries to rise in an economy in their place.
A quantity bubble is sometimes a construction bubble, and it fizzles out when a building cycle turns over, crashing prices as soon as new supply becomes available. This is what happened to a commercial property bubble in the United States in the late 1980s, triggering a bank crisis when it burst and prompting the Federal Reserve to maintain a loose monetary policy that helped the banking system heal.
Quantity and price bubbles may grow together. Southeast Asia, for example, experienced a quantity-cum-price bubble that lasted several years in the 1990s. As regional currencies were pegged to the dollar, loose monetary conditions were imported from the United States, fueling a property bubble. Due to few restrictions on urban development, rising prices led to massive increases in supply. Liquidity inflow fueled speculative demand. But when U.S. monetary policy tightened, the market crashed and triggered the Asian Financial Crisis.
The latest experience in the U.S. market was mainly based on a price bubble, although some cities such as Las Vegas and Miami saw quantity bubbles as well. The U.S. government quickly recapitalized its banking system, limiting the direct effect of the banking crisis on the economy. Current weakness can be explained mainly by the wealth effect and employment losses in bubble-inflated industries.
When Taiwan experienced a price-cum-quantity bubble in the late 1980s, analysts determined the number of empty flats by obtaining electricity meter data from the power supplier, leading many to conclude that about 15% of all flats were empty. Today, some analysts are trying the same tactic in China. But Taiwan's housing conditions are less complex. Getting to the core of China's data requires more calculating.
Housing types, for example, must be considered. China's urban housing stock is mainly split between old, public housing built for company or government employees, and some 60 million units of private housing built over the past 10 years. Property developers are now building about 20 million private flats, and local government-owned land banks may be good for another 20 million to 30 million.
About 1 billion square meters worth of public housing (or about 14 million, 70-square-meter units) have been torn down, leaving about 9 billion square meters of this type of living space nationwide.
Moreover, companies and government agencies are still building apartments for employees. This practice has slowed but remains significant in many cities even today. It's hard to tell how many of these newer flats are out there.
There are similar unknowns about dormitories, such as factory dormitories that house workers from rural areas who migrate to manufacturing regions. Most of China's more than 200 million migrant workers may be living in such dormitories.
Not all commercial property is market-driven, since certain people with connections or other advantages may own rental apartments that tend to have high vacancy rates and should be taken into account when calculating market excess.
Another consideration is that massive quantities of housing have been springing up in rural communities near major cities. And when farmland is rezoned for urban development, the region's housing starts falling into the urban category.
Numbers crunching
Although China's new property sales topped 14% of GDP in 2009, the data is confusing. Maybe it's confusing by design, since firm figures on total urban housing stock are hard to find. My guesstimate is that China's total urban stock is around 17 billion square meters, plus or minus 10%.
One useful figure for analysts is China's living space per capita. Surveys in most cities suggest the average living space is between 28 and 30 square meters per person. We don't know which population segment these surveys cover; they certainly don't include migrant workers. And we don't know if empty flats are counted.
Based on this limited data, however, we can confidently conclude that China does not have a housing shortage. Moreover, its per-capita living space is higher than in Europe and Japan. Indeed, if we adopt Japan's standard, China already has sufficient urban housing space for every man, woman and child in the country.
Far more important than general data, however, are the housing figures pointing to a huge quantity of empty flats apparently being held only for speculation.
In a normal market, the vacancy rate should be equal to the number of households relocating, times the average transition period, plus newly formed households times the average purchase period. For example, a vacancy rate of 1.5% could accommodate a market in which 6% of households relocate every year, and the transit time is three months. If new household formation is 3%, and the average period for a property purchase is six months, this factor requires a vacancy rate of another 1.5%. The total normal vacancy rate should be 3%. This figure includes the new properties ready for sale.
Although the government doesn't publish vacancy data, I think the vacancy rate for the nation's private, commercial housing stock is between 25% and 30%. That's at least double what's required in a normal market. The gap between what's needed and what's available can be viewed as speculative inventory. The value of this inventory held by speculators is probably around 15% of GDP. It's being kept on ice, just as copper and other commodities are hoarded in anticipation of rising prices.
Watch out
We should fear China's quantity bubble. And we should be terrified by the potential for a massive amount of new, speculative inventory that could come on line this year and next.
Right now, tight credit is holding back the market, and supply is piling up on the developer side as inventory. The government's tightening squeezed buyers of second and third homes, and transaction volumes across the country collapsed. What I've learned from intermediaries is that most property demand now falls into restricted categories, i.e., speculative.
It's reasonable to assume, therefore, that the supply would be close to 15% of GDP in value this year and in 2011. That's because when the policy is relaxed -- as most expect -- speculation will probably revive and lead to a doubling in the total value of speculative inventory.
Chances are good that policy makers will indeed relax policy. In some cities, banks are already loosening a bit. A key reason is that local governments have a lot of debt -- commonly five times more debt than revenue -- and could get into financial trouble without a decent level of property transactions.
Local governments in China depend on real-estate deals for revenue and could default if the market falls too far. Thus, the central government may loosen policy to help the locals without making a formal announcement. Such a change of heart would ease short-term government difficulties but double the trouble down the road when the property bubble bursts.
So even if China's stock of empty flats is only half that recent estimate of 64.5 million, it would still be equivalent to 20% of all urban households. That's higher than Taiwan's vacancy rate at the peak of its bubble. Moreover, as credit rules are loosened, the stock could rise to more than 30%.
China's housing oversupply isn't surprising. Excess supply reflects the under-pricing of capital, and China's system is structured to increase supply quickly. But rising prices alongside rising vacancy rates are surprising. Normally, speculators are spooked by high vacancy rates. But China's phenomenon is unique for at least four reasons:
1) A sustained negative real interest rate has led to a falling demand for money and rising appetite for speculation. Greed and inflation fears are working together to form unprecedented speculative demand for property.
2) A massive amount of gray income is seeking safe haven. China's gray income of various sorts could be around 10% of GDP. In an environment of rising inflation with a depreciating dollar -- the traditional safe haven -- China's rising property market is becoming a preferred place to park this money.
3) Few people in China have experienced a property bubble. The property crash in the 1990s touched a small segment of society, such as foreigners and state-owned enterprises. Geographically, it was restricted to the country's freewheeling zones in Hainan, Guangdong and Shanghai. Most people didn't even know there was a property crash. This ignorance has led to a lack of fear that's now turbo-charging greed.
4) Speculators think the government won't let property prices fall. They correctly surmise that local governments rely on property deals for money and do all they can to prop up prices. But their faith in government omnipotence is misplaced. At the end of the day, the market is bigger than the government. The government can delay, but not abolish, market forces. Nevertheless, faith in government is replacing fears of a downside, and speculative demand will continue to grow as long as credit is available.
In other parts of the world, central bank attitudes toward real-estate speculation are changing. Israel's central bank just raised its interest rate, specifically citing a need to fight a property bubble. Property prices in Israel have risen 20% in the past 12 months. India, Korea and Taiwan are raising interest rates out of concern for inflation and speculation as well.
China's problems are much bigger than what's found in these economies. But keeping interest rates low will only worsen the nation's bubble problem. Periodic credit tightening and crackdowns on speculation won't work because they are not taken seriously and never last.
China's latest property-market tightening appears to have been improvised. Of course, any buyer discrimination policy is complex, hard to implement and creates excessive market volatility. Now, if special-interest pressure leads to a change in policy, speculators would be further emboldened, and the excess would multiply, making the eventual adjustment so much more painful.
Raising interest rates, however, would cool speculative demand gradually, avoiding market disruptions. At this point, a rate hike would be the best policy option. But a delay in raising interest rates would only cause a surge for the stock of empty flats and inevitably lead to collapse.
Long range, a policy of sustainability would require resolving local government financial problems by increasing non-property revenue sources or limiting expenditures. Currently, the investment-led growth strategy that's been adopted by all local governments inevitably leads to maximizing revenues from land sales. So unless limits are put on this strategy, the property market will function abnormally.
Property taxes could play a significant role in revenue streams. In many countries, property taxes support local governments and public services. China should adopt the same model, while also restricting fiscal spending.
The bottom line is that China urgently needs a coherent property strategy. The massive overhang of empty flats should goad policy makers to act now. If the government eases rules for the property market before adopting a coherent policy, though, a crash could bring down the economy for an extended period.
One only needs to glance at modern-day price and quantity property bubbles around the world to understand the stark consequences. What's happening to the U.S. economy now is a prime example, and it should be lesson for us. Otherwise, China's economy will look like America's. See this commentary on Caixin Online.
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