The pundits are prophesying doom. With good reason, we think: Chinese house prices are higher than ever before. Rents and yields are falling. The Chinese regulators are alarmed, and are imposing new controls on house purchases.

It doesn’t sound good:

  • BNP Paribas says that China's home prices could fall by as much as 20% in the second half.
  • Citigroup says that “a turning point' is “unavoidable'.
  • Morgan Stanley’s former economist Andy Xie says this is “the biggest bubble in history'.
  • Hedge fund manager James Chanos says that China is “on a treadmill to hell,' with growth

    driven by the “heroin of property development.'

The Chinese government agrees that the music has to stop.

The Chinese authorities have:

  • Ordered developers not to take deposits for sales of uncompleted flats without proper approval
  • Curbed loans for third-home purchases
  • Increased down-payment requirements
  • Increased the land supply
  • Pushed up mortgage rates
  • Considered taxing owners of three or more homes
  • Started a real-estate tax trial in Beijing, Chongqing, Shenzhen and then Shanghai

China’s worrying property fundamentals

What a difference five years makes! When the Global Property Guide first began gathering data in 2005, Beijing condominiums earned 9%, and Beijing villas earned yields 9.5% to 13%.

Imagine – 13% yields! Bliss it was that dawn to be alive.

Let's compare the Global Property Guide’s research for 2005 and 2010.

Beijing – in 2005:

Last Updated: Oct. 15, 2005
BEIJING - Luxurious
COST (US$) YIELD (p.a.)
60 sq. m. 150,000 1,200 9.60%
100 sq. m. 240,000 1,800 9.00%
150 sq. m. 340,000 2,800 9.88%
200 sq. m. 440,000 3,600 9.82%
250 sq. m. 640,000 5,000 9.38%
300 sq. m. 820,000 7,000 10.24%
350 sq. m. 1,100,000 8,500 9.27%
BEIJING - Villas      
200 sq. m. 460,000 5,000 13.04%
250 sq. m. 600,000 6,500 13.00%
350 sq. m. 850,000 7,800 11.01%
450 sq. m. 1,200,000 10,000 10.00%
600 sq. m. 1,650,000 13,000 9.45%

Our research for Beijing today:

Last Updated: Feb. 18, 2010
BEIJING- Apartments COST (US$) YIELD (p.a.)
55 sq. m. 232,320 603 3.12%
85 sq. m. 365,585 887 2.91%
120 sq. m. 568,320 1,184 2.50%
155 sq. m. 719,665 1,548 2.58%
185 sq. m. 860,250 1,928 2.69%
250 sq. m. 1,231,250 2,865 2,79%
350 sq. m. 2,149,000 4,669 2.61%

What is striking is not so much that prices have risen (they have) but that rents have fallen. So of course have yields. Obviously there has been oversupply in the intervening years.

In Shanghai, returns were less stellar in 2005 than in Beijing, with rental yields on apartments ranging from 5.4% to 7%.  Today, gross rental yields on almost all sizes of apartments in Beijing are below 3%, and in Shanghai the situation is broadly the same.

Were the official statistics wrong?

The Chinese official data (National Bureau of Statistics of China) says that the average increase (year-on-year) in property prices was 10.7% in February. This kind of number, or less, has been reported year after year for most cities, with occasional outliers like Shenzhen or Hainan.

A possible explanation is the technical weakness of the statistics:

Suppose that prices are rising uniformly at the same rate in downtown and in the suburb. Since more expensive properties are less demanded, more units in the suburb (at lower price levels) will be supplied to the market. Thus, the “average' price increase will be lower than the uniform, true rate of the price increases. More buildings are sold in the second-tier suburbs than the first-tier, and even less in the downtown area, the “average' price may be lower than the location-controlled index. The official statistics most likely underestimates the size of housing bubble.

(Takatoshi Ito, of the University of Tokyo; see China's Property Bubble, Vox, 15 April 2010).

Our data suggests that this is only part of the story. Not only have prices been rising faster than suggested by the official statistics, but rents have been static or falling.  

The Chinese have overbuilt.

Will it be really bad?

China’s economy is now exploding. There was 11.9% GDP growth in the 1st quarter, the strongest growth for 3 years. First-quarter auto sales rose 72% from a year earlier to 4.61 million vehicles, according to the China Association of Automobile Manufacturers. Other sectors of the economy are also white-hot.

A wave of pundits (including Ito and Michael Pettis) has compared the Chinese bubble to Japan in the mid-1980s. They worry that China will repeat the Japanese ‘lost decade’.

China today certainly feels a lot like Japan then. Japan in the mid 1980s had:

  • Deregulation
  • A booming economy
  • Growing foreign interest
  • Low interest rates
  • Surging stock markets
  • A hands-off attitude by the authorities toward the construction boom
  • Obviously overvalued property prices
  • Pressure from foreigners to revalue the currency by pushing up interest rates

China in 2010 has – well, the list is exactly the same.

Yet it doesn’t follow that the outcome will be the same.

Why China will be different

The cause of Japan’s ‘lost decade’ was that, after Japan’s housing crash, Japanese banks were not forced to clean house, both Ito and Pettis agree. Chock-full of bad loans, Japan’s banks were unable to lend to new borrowers, causing 15 years of under-investment.  Ito also points to insufficient fiscal stimulus by the MoF, after the Bank of Japan pushed up interest rates.

Will this happen in China?  We don’t think so. The Chinese economy is so dynamic, its authorities so powerful and so willing to step on the accelerator pedal, that the second cause Ito gives for Japan’s ‘lost decade’ – insufficient fiscal stimulus by the MoF – is unlikely to be repeated.

China’s authorities rarely do things by halves.  If their clampdown causes a crash and they need to stimulate, they will.
So although China’s are surely in just as much of a mess as Japan’s were, we think the outcome will be different.

The role of the surplus and the Yuan

The Chinese Yuan is considerably undervalued.  It appreciated 21% against the dollar after 2005, before its rise was put on hold in July 2008, during the financial crisis.

Recently the Chinese authorities have decided to resume the upward march of the Yuan, following pressure from the US.

Would appreciating the Yuan cool the inflationary bubble? Andy Xie, a well-respected former Morgan Stanley chief China economist, has argued that the Yuan's appreciation is itself an important reason for China's vast property bubble. Massive hot-money inflows, he says, are part of the excess liquidity and speculation. And mild currency appreciation isn’t going to solve anything.

Xie is right in one respect, for sure.  The Chinese authorities will not allow a mega-surge of the Yuan, given the catastrophic effects of such currency surges in Taiwan and Japan in the late 1980s. Whatever happens to the Yuan, it will happen gently. And it will therefore have little effect on the Chinese property bubble.

Nevertheless the tide has turned.

The authorities are cooling things

Earlier this week the Chinese authorities ordered developers not to take deposits for sales of uncompleted flats without proper approval. This came on top of curbs on loans for third-home purchases, and increased down-payment requirements and higher mortgage rates.

China’s bank regulator has also told the nation’s larger banks to conduct quarterly stress tests on property loans and ensure risks are strictly controlled.  The Bank of Communications, China’s fourth-largest publicly-traded lender, has already announced that bank mortgage loan volumes are dropping.

The Chinese authorities’ response does not therefore primarily depend on a currency rise. The key elements will be the fiscal and monetary brakes, and indirect measures, such as administrative guidance.

The authorities are in a very strong position, with extensive formal and informal powers.

The slowdown is starting now.

It will be unpleasant for a couple of years.

But is it likely to turn into a long-term disaster, like Japan in the 1980s? We don’t think so.