Will the Bubble Burst in China?--From Historical Evidence Perspective

    In the previous posts, I talked about the housing bubble in Japan in 1980s, the present housing bubble in China, and we compared the two bubbles and found some similarities and differences between them. A distinct difference is that bubble in Japan burst at last whereas bubble in China still exists although it has remained for a long time. After stating the reasons that the bubble still maintains in China, there is still one thing we are curious, when will the bubble burst? In this post, I will find some historical evidences about the prerequisites that may cause a bubble burst, and plug in these conditions into current Chinese housing market and banking system to see if these conditions may burst the bubble in China. If they cannot, what else conditions may be needed to burst the Chines housing bubble.

    From the flow chart above, we can observe the relationship between the banking system and the housing market. All the arrows in the graph actually connected the whole process and they are also the key points containing the potential risks of the process. Either one of them having a problem may cause the bubble in China burst.

 

• Assumption of Problem Hapening in the Housing Market System

 

    From the historical evidences of bursting house bubble, we first consider the problems happening in the middle two and the bottom two arrows. Actually, these arrows are largely connected. Let us start from the left middle arrow. If the individual borrowers cannot afford their mortgage, the bank will recall the house and auction it to other people. If only a few individual borrowers default, this could not be a problem as other buyers will bid the houses and bank will get their bills paid by others. But if a lot of individual borrowers default, auction may not be successful as everyone in the market is lack of funds. The house price will fall dramatically as bank only care if they can get their cost back. This is what exactly happened in the USA 2007. Therefore, massive individual borrowers default may cause the bubble burst in China.

 

    Turn to the right middle arrow. When the housing price is extremely high and almost no buyers for the houses, then some real estate companies may fail to pay the loans within the specified time because they are lack of liquidity. At this point the bank may cut the successive loans to these firms and may even force them into bankruptcy and sell their houses at the auction in order not to lose. In this case, the supply of the houses will increase and the price will fall to a certain point, at which the bank can get their cost back and there are bidders for the houses. This means that the house price may fall in some certain extent but not lead to the burst of the bubble. But if there are a lot of bankrupt real property companies and not sufficient bidders or some of the bidders of the auction do not have enough cash. Then these buyers may bid by using individual debt, then the potential problem may happen similarly to the first individual borrowers' default case. So, the problems happening in the middle two arrows which may cause the burst of bubble are: massive individual borrowers default and a lot of real property firms’ default. The above situations would only happen when the credit of the banking system is too easy. As long as the central bank controls the credit standard, these two scenarios tend not to happen.

 

• Assumption of Problem Happening in the Banking System

    So what cause the easy credit? We turn into the top two arrows to find the answer. When central bank decides to low the discount rate and down-regulate the legal reserve ratio, the commercial banks will tend to lend more money out to the public and the credit will become easy. When the credit becomes easy, latent defaulting dangers may emerge. As the bubble has formed, it means that easy credit has already dominated in China. Actually from some data, we can get some results. The residential mortgage rate in commercial banks is 6.55% for long-term loan. This number seems reasonable. But if we take account of the recent inflation rate in China, the real loan interest rate is only approximately 3.5%. This figure may indicate that the credit has become easy in the banking system. If the central bank of China suddenly tights the monetary policy, takes aggressive behaviors such as, enhance the reserve ratio or up-regulated the discount rate to a very high level within a short time period, the tragedy will happen. This is what exactly happened in Japanese crisis. So the Chinese central bank may act to let the housing market ‘soft land’, meaning that constrain the credit standards gradually within a long time horizon rather than behaved radically.

 

• Assumption of Problem Happening in Land Price

    So far I considered about the factors that may burst the bubble by plugging in historical evidences and found some factors, but I still omitted a crucial reason that may prick the bubble---the land price. As we mentioned before, Chinese government has the monopoly control on providing land. If it considerably and suddenly dropped the land price, the housing bubble would burst automatically, because major cost of the real property enterprises come from high land price. However, this behavior may be very dangerous and may cause an economic catastrophe in China. It is good for the government also to take the ‘soft land’ strategy in this case---gradually decrease the land price.

 

    In conclusion, housing bubble bursting conditions I get from the historical evidences and personal views are: easy credit, massive individual loans default, real estate property loans default as well as the dramatic fall in land price. There are a lot of other conditions that may burst the bubble I omit. Whether the bubble burst in China depends really on how the government and the people act. There are too many uncertainties in the housing market. What we could do is try our best to prevent the tragedy from happening by both previous bad experiences and every possible reason we could figure out.

Why are the Housing Price Bubble Still Existing in China?

    After the financial crisis, the housing price rallied to another peak in history. Why does the housing price bubble still exist recently? There are several hot reasons that were discussed among the society. I categorize them into three perspectives:

Macroeconomic perspective:

Supporting industry for the whole economy:

    As China is a developing country, many industries are not mature. Therefore, real property industry has become one of the most important supporting industries, which fuel the economic growth since 2003. It has been driving the whole economy development during the last decade. If this industry failed, Chinese economy may fall into great depression. Consequently, the government actually tends to protect the property industry from failing deliberately. This may be a very important reason for supporting the high housing price.

   

Supply perspective:

l  High land price: as I mentioned in the last post, the unbearably high land price is due to mainly two reasons:

§  The Chinese government has monopoly power of pricing the land

§  Local government increased the land price in order to hit the GDP target. In other words, land sales income takes the dominant position of local government income.

    Under such a high land price, the cost of real estate firms, therefore, increased dramatically and this does underlie a high housing price.

l  Cost of the construction materials increased

    The expense of these construction materials increased because of two reasons. One is the severe inflation. When there is inflation, the price of goods goes up. The other is the massive increase in demand of these materials. Since 2008, Chinese government invested 4 trillion Yuan into fundamental construction. This decision increased the demand of construction materials like steel, cement, and concrete sharply, which are also necessary materials for building houses. High price of these fundamental building materials definitely increased the cost of real estate companies and thereby leading to a high house price.

l  Corruption

    In China, a very interesting reason backed up the high house price is the official corruption. Some real estate dealers usually bribe some government employees and officials, giving them some perquisite or providing them with inside trading price of houses, to let them sell the land at a low price. These officials buy the house at a low price and can sell it at the market price which is much higher to earn massive profits. This official corruption phenomenon is so common that some of the officials or their relatives (dealers may also bribe the relatives of an officials) even own about ten houses individually. These people just hold these houses and wait for even higher housing price. This behavior definitely lacks the supply of houses in some extent, which helps pull up the housing price. 

Demand perspective:

 

l  Urbanization

    The urbanization process in China is growing very fast in recent years. More and more people during this period migrate from rural areas to megacities like Guangzhou, Shanghai and so forth. Migration of these people enhanced the demand of houses in big cities violently.
This rigid demand helps a lot in maintaining or even propelling the high housing price.  

l  Cultural pressures:

      

In China, there is a very weird but common thought among Chinese residents. That is if one does not own a house when he/she is about to marry, he/she will feel very mentally unstable. This cultural pressure imposes a strong mental pressure to people and let them feel that they must purchase a house in order to marry. This pressure pulls up the demand of house and thereby boosting the housing price indirectly.

What are the Similarities and Differences Between These Two Bubbles?

    After going through the two housing price bubbles, I wonder if there are some similarities and differences between these two. In this post, Iprimarily talk about some similar and different results of the two bubbles, which were due to different policies, and try to dig out the stories behind these results.

    In the two bubbles, I found that the causes of  the two bubbles were similar, but the stories behind them were quite different. Why was that?

Similar causes:

• High Inflation

    In the medium period of the two bubbles, high inflation rate emerged in both cases. However, the reasons were different. In Japan, high inflation was due to the extreme low discount rate, which dramatically brought the money supply up, whereas, in China, the first period's inflation (2005-2007) was because of the explosion of the economy, and the second period's inflation (2008-2012) was mainly caused by the 4 trillion RMB government injections, which also substantially increased the currency in circulation. After the appearance of high inflation, the reactions of the citizens in both countries were surprisingly similar. They both had an expectation of continuous inflation next period, and invested more in the real property industry, which indulged the housing price bubble.

• Land Price

    When the bubbles in both countries formed formally, the land prices in either country were unbearably high. However, the reasons were pretty different. Chinese government has monopoly control on the land trading. Local government misused the power of pricing the land to enhance income, because they were assigned missions to hit some GDP targets. Consequently, the land of price reached at a very high level, which still remained high recently, while in Japan, the land trading is controlled by the ‘invisible hand’- the land market. The high land price during the bubble was totally results of severe speculations. The different reasons for pricing land may be a crucial factor that bubble in Japan burst whilst bubble in China still exists.

Differences of two bubbles

    Although many similarities appeared among these two bubbles, there were a few differences of them.

·        Aggressive bank behaviors in Japan but conserved banks acts in China

   

    At the end of the bubble in Japan, commercial banks faced the high costs due to the high discount rates, have to loan to risky firms in order to obtain high returns to survive, while in China, most of the commercial banks are state-owned or at least have state as an influential shareholder, so they do not concern too much about the returns but consider the risk as the first place. Therefore, commercial banks in China behaved relatively conserved to Japanese banks. In other words, Japanese banks took too much risk, whereas Chinese banks had little risk because they had strict investigations before making a loan and involved state as a strong back-up.

·        Different results so far

    When the bubble occurred, both governments took measures to restricted money supply and cut loans to real estate companies. In specific, when the bubble appeared, Japanese government attempted to control the money supply, so it up-regulated the discount rate to commercial banks. Additionally, some commercial banks cut loans to real estate companies However, these actions lead directly to the miserable tragedy. In China, Bank of China enhanced the reserve ratio of commercial banks several times to reduce the money supply, and recently, commercial banks stopped loaning to some real estate companies. But the bubble still remains.

An explanation for the different results: Speculation dominated the bubble in Japan but both real demand and speculation donminated the bubble in China

    One of the most important reasons that caused the Japanese bubble was the overheated speculation. During the bubble time, almost everyone engaged in the property industry to seek speculative opportunities which enhanced the housing price dramatically. In China, speculation was also serious when the bubble occurred. However, there is another dominant factor behind the bubble: high real demand of house. Cultural attitudes determine that having a house means having a home. Therefore, when young people marry, they need to purchase a house. Another factor that drives the high demand is due to the urbanization process. As urbanization process is accelerating in China in recent years, megacities require a lot of labors. Therefore, more and more people swarmed into these cities. Their needs of houses drive the demand even further. This may be another reason why the housing bubble still exists in China. In the next post I will explain the reasons of existing property bubble in detail.

Myths behind the Chinese Property Bubble

    In the previous post, I talked about the housing price bubble in Japan during 1990s and made some statements about the potential reasons behind the housing bubble. In this post, I am very curious about the existence of housing price bubble in China from 2005 to 2012. Firstly, I start with formation and expansion of the property bubble. After that I will talk about the turning point—development of the property industry during 2008 financial crisis, and finally, end up with reflation after the crisis.

• Formation of the property bubble

    At the beginning of 2003, Chinese government listed the real estate property industry as one of the most important industries that drive the development of economics and implemented a lot of policies to encourage investing in the real estate industry. Meantime, the Bank of China (BOC) implemented some monetary policies, (such as low the rate of loans and discount the down payment of purchasing a house) to attract residents’ investment in this industry. The housing bubble emerged initially at that time. However, the housing price during this period of time rose within a reasonable interval until 2005, because the Chinese government realized the rapid increase in housing price and adjusted some policies to limit this increase, they included:

1. Up-regulated the loan rate of purchasing houses (even higher than the original unadjusted one)
2. Canceled some preferential loan policies (e.g. increased the proportion of down payment of a house loan by 10%) 
3. Taxed for second-hand house transactions
4. Enhanced the credit standard investigation of the real estate companies.

    Nevertheless, these polices did not prevent the final expansion of the bubble.

• Expansion of the property bubble

    As many capitals flowed into real property industry in 2006, the housing price started to expand dramatically. The house price tripled from 2006 to 2007, although the Bank of China increased the loan rate 5 times from 5.0% to 7.29% and raised the reserve ratio of commercial banks. Why the housing bubble stubbornly expanded with no regard of any monetary policies? There are few reasons for this substantial expansion:

  

    1. Local government increased land prices dramatically during this period for local government income and a vanity for GDP growth ----> rise the costs of real estate companies ----> raise the price of houses

          2. It is Limited for Chinese investors to get access to foreign investments. Therefore, they invested mainly on domestic properties---->increased the demand of real estate properties.

          3. High inflation rate

     From the China inflation rate chart above, we can observe that from January 2006 to January 2008, the inflation rate in China boomed to a very high level (approximately 9% per year). During this period of time, almost every citizen in China expected that the inflation would maintain next period and this anticipation drove them to invest in the real property to retain the value of their fiat money and, thereby increasing the demand of house even further. 

• Temporary deflation of the property bubble and following recover

We all know that there was a serious financial crisis in 2008 all around world. China did not escape from this crisis, as a result, the bubble in stock market burst in 2008. However, a strange thing happened, the property industry just experienced a short-term deflation, after that, it reflated and formed another more severe bubble from 2008 to 2012. Why was that happening? The key reason behind that was during the depression of the stock market in 2008, Chinese government realized the crisis coming, so it decided to save the whole economy by injecting 4 trillion Yuan into the economy, mainly invested in fundamental constructions. This action directly increased the supply of money in the whole banking system, which lead to another high inflation period. Except this significant monetary measure, Chinese government also low the loan rate and the reserve ratio of the commercial banks to protect the real property industry from failing. Consequently, over-investment in the real property industry helped China get through the ‘ice period’ but also recovered the housing price bubble. 

What Happened to the Real Estate Market in Japan in early 1990s?

Introduction: Housing price bubbles appeared in many countries around the world in recent years. It is very important to know what were the reasons that behind these bubbles. In this whole posts, I start with the housing price bubble in Japan from 1980s to 1990s, and then turn into the current occurring housing price bubble in China. In post three, a comparison of similarities and differences between these two bubbles will be introduced. Lastly, I will state some reasons about why the housing bubble still exist in China and some factors that may burst the bubble in post four and five respectively.

Part one: Housing price bubble in Japan during 1980s and its monetary policy

It is widely known that the price of real estate and stocks inflated greatly in Japan in the early 1990s. Although it  has become history, knowing the reasons behind the formation, expansion, and the burst of the housing price bubble are extremely significant to remind us avoiding making similar mistakes. First, we begin with the formation housing price bubble in Japan from 1986 to 1989.

Formation of the housing price bubble (1985-1987)

Things started with the Plaza Agreement in September, 1985. In this agreement, five countries (USA, Japan, UK, France, and West Germany) announced simultaneously that they would get involved in the foreign exchange market because of the high USD exchange rate relative to other currencies. After this event, JPY began to appreciate relatively to USD. In the early 1987, Bank of Japan (BOJ) eased some monetary policies in order to counter this appreciation of Yen. However, these policies to some extent backed up the housing price bubble later.

Expansion of the housing price bubble (1987-1989)

There are mainly two reasons that may account for the expansion of the housing price bubble:

1. Monetary policy

The BOJ adopted monetary easing policy in 1987, and this monetary easing really reduced the cost of funding of investors, and the capital costs of issuance of new shares and bonds with warrants. Meantime, the BOJ down-regulated the official discount rate of the central bank from 5% to 2.5% and this decision aroused a dramatic increase in assets price, especially for real estates and stocks. There were two explanations for why down-regulation of discount rate lead to booming in assets price.

·    The first one is when the BOJ down-regulated the official discount rate, it actually encourages the commercial banks to make a loan from the BOJ and let them lend money to firms or individual investors. Firms and investors use these borrowing funds to invest in real estate and stock market, which definitely arouse a huge increase in demand of assets.

·   The second way is that as commercial banks loan more from the BOJ, more money were actually generated by the banking system, thereby increasing the supply of money. When government prints too much money, inflation emerges. During that particular time, inflation was very severe, so everyone wanted to invest in real assets to stop their fiat money from lossing value. This raised the demand of real estate even further.

The BOJ retained the low discount rate until May, 1989, which set a potential for the disaster later.

2. Taxation and regulations

During the expanding period, Japanese government imposed high tax on transacting land, but low tax on holding land. This tax policy leaded to a low land supply, and consequently, a high land price, which increased both price of houses and the collateral value of the land.

In this period, the housing bubble expanded rapidly due to these inadequate actions and reached its peak at the end of 1989. After that, the housing bubble formally started to burst dramatically.

Burst of the housing price bubble

 In 1989, Japanese government felt the pressure of the abnormal economy, so it increased the official discount rate 5 times from 2.5% to 6% within only few months. Meanwhile, the BOJ required all commercial banks cut their loans to the real estate companies. These two monetary policies significantly grew the costs of these real estate firms and also imposed great pressure for commercial banks to make profit by borrowing from the BOJ. At this time, the costs of both commercial banks and real estate firms were pretty high. Besides the cost factor above, another factor drove the burst of the bubble was that when bubbles formed, although the price in housing market remained at a very high level, the return on it was actually very small. At this point, it is not far away from the bubble bursting.


     At the end of 1989, the price of the asset market was too high to earn extra profits. Therefore, as the leaving of speculators and investors from these asset markets, the bubble of stock market firstly burst, followed by a large decline in land price. Finally, facing high costs on the one hand and depressed market on the other hand, many real estate firms bankrupt and the housing price bubble exploded.