Contributing Writer: Novak He | May, 2022
In fall 2021, the world’s most indebted company——Chinese real estate company Evergrande missed its debt repayment deadline. This incident worsened the debt crisis of this debt giant, who had already accumulated a total liability of over $300 billion US dollars. The Evergrande debt crisis caused a stir in the global financial market and its impact on the Chinese economy is profound. It not only revealed the unhealthy expansion of the real estate sector in the past 20 years but also provided the government and the public a great chance to see through the fancy boom of the housing industry. Here I will analyze the history of the Chinese real estate “upsurge”, how the current crisis occurred, and the similarities and differences between the Chinese crisis and the 2007-08 U.S. housing market crash. I will also discuss the social impacts such expansion brings.
The 2007-08 financial crisis in the U.S. originated also in the real estate sector where the “American Dream” featuring big houses was seen as a political goal, often used in partisan propaganda to attract votes. Political pressure pushed Congress to allow for deregulation of home taxes, which resulted in reduced taxes and loan screening. Interest rate was also kept low to allow for more production, construction, and market activities (home purchases and credit expansion). Banks then chose to sell their mortgages for liquidity. Financial intermediaries deliberately designed financial instruments like mortgage-back securities (MBS) and collateralized debt obligations (CDO) and poured countless money into the pool with the help of the shadow banking system. MBS and CDOs were re-wrapped mortgage IOUs. The risk of the mortgage market was transferred to investors and savers (Chinn & Frieden, 2011).
However, under a completely different political system, the Chinese crisis was a different story. It must be analyzed from the very beginning of the Chinese economic reform, which changed the economic route from a planned economy to a market economy.
In the first 30 years of the republic, there were no private houses in the country. All houses are property of the state, and the state was responsible for constructing, maintaining, and distributing houses. However, the state soon felt that the housing maintenance for the whole country was too heavy a burden to take on. Therefore, the state decided to commercialize the housing market by increasing the rent and allowing real estate sales to individuals. This policy encouraged firms to build houses for sale and individuals to own their own homes. Increased construction meant increased economic activities in tens of related industries including construction, raw materials, intermediaries,and more modernized cities. After tasting the benefits of real estate commercialization, the central government allowed for land renting and selling in 1990 and ended the planned distribution of houses in 1998, which was unimaginable even 10 years earlier. Private capital entered the housing market and soon pushed the housing price up to an unprecedented level. In some cities like Hainan, a coastal city in east China, the price of 670 square-meter land even reached 1.2 million yuan (about 200,000 dollars). In comparison, an average worker in Shanghai only earned 32 dollars each month in 1990.
In the early 21st century, land and housing prices in China never ceased rising. Like in the United States, the Chinese government also encouraged people to buy houses by putting forward policies such as tax refunds, loosening loan requirements, subsidizing the real estate industries, etc. The reason behind this was the fast-growing virtual sector of the economy and the unhealthy investment environment in the entire country: the real sector of the economy was experiencing the impact of mass money issuing, which was reflected in both a high growth rate and a high inflation rate. Imagine this juxtaposition: investing in the real sector gives a profit of about 7% while investing in the virtual sector, which includes real estate trading, results in almost 30% profit. Many industries found it difficult to focus on their own field because the real estate industry is so lucrative. As a result, many manufacturers began to invest in real estate. Consequently, in the first two decades of the 21st century, manufacturers of furniture, electronics, industrial raw materials, clothing, medicine, and many other fields all began investing in the real estate market. Even state-owned banks and infrastructure companies bought and sold properties and real estate companies for profit. The fast booming of the virtual economy greatly reduces the motivation of the real sector.
Some media reports claiming that real estate trading was “saving” the real sector were misleading because depending on selling houses instead of producing goods to profit could only prove that the company and the industry were weak, and the whole process of paying company debt with capital from the virtual sector was ironic. But however ironic it was, relying on the virtual sector indeed injected a huge amount of capital and kept the real sector apparently “thriving”. The fake thriving did not consolidate the industrial foundation but instead destroyed the companies’ confidence and will to produce. It also resulted in an extremely unstable stock market from which companies drew their money to invest. When the tide of the 2007-08 financial crisis was about to overwhelm China, the government had no choice but to further print 500 trillion dollars into the stock market to hold the economy together. Also, at one of the government meetings during the crisis, the financial governors confirmed that the country must take the real estate industry as the pillar industry——they were once again taking the heart-saving pill of the financial sector.
The consequence of the real estate boom was millions of vacant houses and skyrocketing housing prices. Local governments welcomed the companies by subsidizing them for the prosperity they could bring to the local community. Officials are promoted on the scale of urbanization expansion under their administration. Construction companies borrowed from the bank to build new houses but had difficulty selling them due to the high price and low demand. Hundreds of construction sites ended up being “ghost towns”, and hundreds of companies accumulated massive amounts of debt, including tycoons like Evergrande, which accumulated more than 300 trillion in debts, almost as much as the GDP of the state of Wisconsin. Companies like Evergrande have been selling houses at an extremely low price to keep their capital flowing;they have to build and sell to pay for debts and borrow debts to build more. When people’s demand could digest the inventory of houses, the system worked very well and could bring prosperity, but as soon as the economy showed signs of fatigue, excessive borrowing and building created millions of vacant houses. Evergrande had previously entered many other fields (e.g. soccer teams) hoping to get a share of their gold mines, but such expeditions have seen little progress but huge capital loss deteriorating the company’s financial situation.
Fortunately, the government has realized the systemic risk behind the real estate boom. It started to reduce risky loaning activities and closely inspect the vacancy rate. Evergrande’s weakness was exposed and accurately targeted. The Evergrande crisis that the world sees is the result of such policy change.
Comparing the Chinese housing market to the US counterpart in 2007, we can find a series of interesting similarities and contrasts which might be helpful for understanding the crises.
The Evergrande crisis is similar to the U.S. credit crisis in 2007 in that they both involved the real estate industry under loose government regulation and investors both took houses as an investment instrument instead of living places. The high unit price and frequent price change of houses make it a highly lucrative tool for irrational investment. Besides, house investors usually hide their intention to speculate behind the true demand for housing to avoid regulation. The US government-sponsored Freddie Mac and Fannie Mae thus unintentionally helped housing speculation by reinforcing speculators’ confidence. Similarly, the Chinese government also served such a role by making real estate the pillar industry and encouraging over-expansion.
However, compared to the U.S. crisis which was a national credit expansion, the Chinese housing boom was diverse on a local scale: Chen and Wang (2017) claimed that monetary policies accounted for most of the US boom, whereas in China the impact of monetary policies only accounted for 45% of the price rise. Lai & Van Order (2020) also pointed out that the US housing prices were following the steadily rising rent——the price was chasing price. However, in China the price was more like chasing the rent. Therefore, Lai & Van Order concluded that price in China was more stable and steadily growing compared to the United States. Lai & Van Order claimed that the Chinese housing price rise in 2009-2016 was more related to scarcity than to irrational exuberance. Fang et al. (2016) confirmed the low bubble theory of the Lai & Van Order and claimed that unlike the US credit expansion period, Chinese banks require an over 30% percent down payment, greatly reducing the danger of massive default. On the other hand, Fang et al. also mentioned that Chinese have a very high saving rate, ranging from 20% to 50% in the beginning of the 21st century. The Chinese stock market dwarves before the bank deposit pool of Chinese people. Interestingly, data also showed that investing in real estate is in the long run more profitable than the stock market due to the incredible stability of the former.
The role of the government is also subtle in the Chinese housing market: unlike the state governments in the US, Chinese local governments have little rights to collect taxes, making them relying on selling land to maintain the financial balance and pay for debts. Therefore, lowering housing prices is actually contradictory to the goal of local governments. Combined with the special system of official evaluating systems emphasizing local prosperity, the real-estate industry soon became government-backed and grew“too big to fail”. Well-informed of this, Chinese people invest more and more on houses, and speculating became a common phenomenon.
Some social factors also contributed to the high demand of real estate investment: Housing has always been taken as a status product in China, especially in the marriage market, where males with houses gain high competitiveness (the fact that single males outnumber single females undoubtedly added to that competition).
The Evergrande Crisis brought about various social and economic problems. Not to mention the scandal of Evergrande officials cashing the company’s property soon after the crisis was revealed, the Chinese housing crisis reveals several social problems of the country: 1) motivation for the real sector is reduced due to the lucrativeness of the virtual sector, imposing potential danger for real sector productivity. 2)Accelerated social stratification caused by the rise of housing prices; rich homeowners get constantly richer, while the poor never get any chance to climb up the social ladder. This is evidenced by the article by Fang, Gu, & Zhou (2019) stating that government officials can often buy houses at a much cheaper price than non-bureaucratic buyers on average. More importantly, They also showed that the “discounts” for officials are positively related to their power and ranks, depicting a corrupted system. 3) Rising housing prices also impact the satisfaction of Chinese people: Wu et al. (2020) found that social satisfaction level is generally a U-shaped function of family income and number of houses owned: the “middle class” feel the most pressure from their peers and have the lowest satisfaction level than lower and higher classes. This shows that increasing housing prices create social tension between classes and may therefore undermine social stability of the country. 4) Housing price increases may further suppress consumption in the economy and reduce domestic demand: Liu, Wang, & Zhang (2019) suggested that a rising housing price has both crowding-out effect (suppressing) and wealth effect (stimulating) on consumption: in a highly speculative setting, crowding out effect dominates and consumption is suppressed by the housing price rise. On the other hand, when the average housing area increases, the trend shows that as the housing price grows, a sense of asset appreciation may increase total consumption. However, the wealth effect is relatively scarce in China and the crowding-out effect dominates in the country, meaning housing price rises generally suppress the domestic demand, which is harmful for the economy.
To some extent, the recent Evergrande crisis is a revelation of various problems in the Chinese housing market and could be an opportunity for the Chinese government to, in their own words, “take a bath and seek remedies”. Currently, the government must contain the loss and dissolve the crisis gradually to prevent another financial tsunami. Hopefully, through a thorough, systemic revolution in the industry and regulation, the Chinese housing market can finally develop healthily and orderly.
REFERENCE
Chen, P., & Wang, F. (2017). A national or local phenomenon? A comparison of the US and the Chinese housing markets. Applied Economics Letters, 24(12), 841-845.
Chinn, M. D., & Frieden, J. A. (2011). Lost Decades: The Making of America’s Debt Crisis and the Long Recovery. WW Norton & Company.
Fang, H., Gu, Q., & Zhou, L. A. (2019). The gradients of power: Evidence from the Chinese housing market. Journal of Public Economics, 176, 32-52.
Fang, H., Gu, Q., Xiong, W., & Zhou, L.-A. (2016, 1 1). Demystifying the Chinese Housing Boom. NBER macroeconomics annual, 30(1), pp. 105-166. doi:10.1086/685953
Lai, R. N., & Van Order, R. A. (2020). A Tale of Two Countries: Comparing the US and Chinese Housing Markets. The Journal of Real Estate Finance and Economics, 61(3), 505-547.
Liu, L., Wang, Q., & Zhang, A. (2019). The impact of housing price on non-housing consumption of the Chinese households: A general equilibrium analysis. The North American Journal of Economics and Finance, 49, 152-164.
Wu, Y., Chen, J., Bian, Z., Wang, H., & Wang, Z. (2020). Housing, housing stratification, and Chinese urban residents’ social satisfaction: Evidence from a national household survey. Social Indicators Research, 152(2), 653-671.
Read the full article at: https://issuu.com/uwequilibrium.com/docs/eq_final_2022/22