Exec Summary

In recent years, Chinese gross investment has continued to look quite strong, but more and more of it has merely been to replace wearing-out or obsolescing fixed capital, and net investment — the [aggregate] profit source — has been on a long and gradual and steepening decline [from ~2010]. — Levy Forecasting Center [free registration required]

After China’s export-led investment expansion ended ~2010, the speculative boom in residential real estate may have forestalled a slowdown but it brings with it its own set of negatives, exacerbating the deferred payment China’s society will have to pay. A seriously diminished role of real estate in China’s economy will force significant structural changes on all levels of society.

Contents:

1. Faltering Real Estate Prices

2. The Three Eras of China’s Economic Development

3. Down Memory Lane: US 2007 & Japan 1991

The Setup:

There is currently a lot of commotion about China’s real estate. It’s a big and complex topic. In this two part series (see the first part here) we’ll try to boil it down to its essence and draw out the implications. In this second post, we look at the demand side, take a step back and put it all in context.

1. Faltering Real Estate Prices

Here’s our visualisation of China real estate prices. The black line in the top panel is an average of the 70 cities MoM change in price — as long as the line is above zero, prices are growing.

The coloured stacked bars in the top panel are the component contributions of the various cities, grouped by city tier (e.g. Beijing and Shanghai are Tier 1). When a city tier bar is above the zero line that means this particular component is pulling the average up. The reverse is also true. Visualised this way, one can see the drivers behind the changes in the black line average. For example, in mid-2015, it was mostly Tier 1 (gold bar) pulling the average up. Both the top and bottom panel show the same data but it’s visualised differently. Personally, we love the top panel — it’s nice and clean.

Prices are faltering. Looking at the black line, average prices have already been below zero for each of the last 11 months. Homebuyers’ willingness to take out mortgages is down: personal mortgages as a source of funds for RE developers is down 24.4% year-over-year (YTD figures, NBS). It may be a simple case of a depressed/slowing economy increasing uncertainty for household incomes versus the astronomic real estate valuations that’s failing to keep the ball in the air. Whatever the case, bids are down.

Here’s a chart to illustrate just how big a deal this is. It’s big. (See also our other post about the size of real estate over-expansion in China using satellite data).

What’s more, there’s a lot riding on the price of real estate:

Housing wealth now forms a far larger share of overall Chinese assets (including stocks, securitized loans and bank lending) than it does in the United States, accounting for 78% of all assets compared to 35% for the United States — Rogoff and Yang (2020)

Moreover, real estate related activities (e.g. construction, materials, sales, employment) make up the incomes of many people, and by extension, China’s GDP overall (upwards of 20-30%). A faltering in such a prominent sector will no doubt have ripple effects.

2. The Three Eras of China’s Economic Development

Now, to take a step back and put things in context.

This really is the mother of all charts for China. Without getting into the technical detail (see the Profits Perspective for that), net gross fixed investment (i.e. any new investment beyond capital replacements) is the driver of aggregate profitability and GDP growth in any economy (highly recommended but technical read here [free registration required]).

China’s main (healthy) profit engine (first golden arrow) already stalled ~2010, as can be seen from the break of the uptrend on the chart above. That’s the end of the export led investment boom (1st golden line). China’s auxiliary (speculative) engine is sputtering and cannot keep net fixed investment from falling. That’s the faltering real estate boom (2nd golden arrow).

Era I: Main (healthy) engine — Export-led investment boom 1970s-2010

China’s main profit engine was an export-led investment boom. It’s not so much the mercantilist notion of exports driving growth, but the investment in fixed assets like factories built for exports that brought about the boom. However, while starting from a small base, the massive multi-decade wave of investment in infrastructure and factories in support of these export related activities ultimately just petered out. Once you build all the factories to capture global demand through trade, net fixed investment will inevitably fall. This can be clearly seen in the chart above with the growth in China’s merchandise exports first peaking ~1995 and then full on breaking ~2012, marking the end of Era I. (Read more about the world deglobalising in our previous post).

In China’s case, the sudden opening of its vast economy as a source of cheap labor for foreign firms—and one with few onerous environmental or labor regulations or other obstacles to manufacturing and exporting—led to China’s extraordinarily rapid capture of global market share. The fact that vastly more advanced technology was immediately available made the transition even faster.

[… and yet,] the larger investment becomes relative to GDP, the more rapidly the economy heads toward overcapacity and toward a widespread decrease in the ability of assets to earn enough to meet the financial obligations incurred in creating or obtaining them.

— “Beijing Underestimating Developing Economic Storm” Levy Forecasting Center [free registration required]

Era II: Auxiliary (speculative) engine — The blow-off top in real estate that should have never been

Here is where the whole real estate story comes in. Instead of settling for slower growth at the end of Era I, or at least finding a new healthy growth engine (harder than it sounds), China ended up opting for continued high growth through real estate speculation. While investment in real estate can indeed bring short term benefits, it’s less desirable than industrial capex, not least because of the negatives it brings with it (e.g. unaffordable housing, shorter investment duration). Not accepting slower growth from ~2010 essentially was the equivalent of not only kicking the can down the road but also making it snowball.

A large part of the reason behind the drivers of such an outcome is the self-reinforcing cycle of perverse incentives between local governments, property developers, and households. The infamous land transfer fees are at the centre of this drama. Here is how perverse incentives created a self-reinforcing cycle:

(1) It starts with a 1994 tax reform that incentivised local governments to increase revenue through land transfer fees.

The tax reform introduced in 1994 had a large spillover effect on land finance in the years that followed. The reforms specified that the central government would allocate all land-related taxes to local governments…

This new system gave local governments a strong incentive to increase revenue from land transfers. - China’s Real Estate Problem Series 4, Liu Jing, 2022

Land transfer fees became the major funding source for local governments (see chart above).

(2) Local officials look good because construction activity brings jobs, GDP growth, and the revenue funds spending on social services and other obligations.

(3) Lenders are happy as the loans made to developers are backed by the collateral of the land, whose price was determined by market processes (i.e. auction and comparable real estate sales) and property developers were highly profitable.

(4) Developers make a bundle by intermediating between the wholesale (land purchase, construction) and retail property (standardised units in ever taller high-rises) markets. In fact, developers were further incentivised to lever up and acquire more land earlier (read: cheaper) to increase their land bank.

(5) Households wanted to upgrade their homes from government provided shelter, providing a tailwind of real estate demand. Homebuyers gained wealth through property value increases. A wealth effect helped drive consumption, optimism in the future and even more real estate investment.

(6) Back to (1): “Price rises for residential property subsequently increased the profits local governments made from land sales and associated taxes.” (Liu Jing, 2022)

It really is George Soros' reflexivity at work here. Obtaining revenues in perpetuity from the sale of finite land can’t go on forever. Two things stand in its way: local government funding requirements and unaffordable housing.

Anecdotally, even as they have increased over the years, land prices in general, as a percentage of the final residential property price passed on to homebuyers went from a reasonable ~30% to massively higher (indeterminate percentage), squeezing even developers, according to industry participants. The self-reinforcing loop hits a wall.

• See our housing affordability chart in our previous post “Why is China pursuing common prosperity”

• Read more about the end of China’s demographic dividend

And here’s the heart of today’s post. 2022 isn’t the first time when property prices have been falling — they have done so ~2012 and ~2015 as well (see very first chart). So why wouldn’t they simply continue on higher after a brief wobble as before? They might. But in the period for which we have data, it’s the first time when property prices have been falling while net fixed investment has been so low (~10% using data point from 2021). The closer to zero, the less aggregate profits available in the economy, and the more it all becomes a zero-sum game as the pie ceases to grow. From our understanding of the fundamentals, the downtrend in net fixed investment (second golden arrow) will continue, and at some point along this downtrend pain in the real estate sector will trigger a domino effect. Given all the headwinds, it may just happen in this round of faltering prices.

Era III: Japan? 2022 and onwards

This really merits a whole separate post in itself. But the short version is that, given Beijing’s historical stance, it’s more likely to replicate the post-1980s stasis of Japan rather than the post-1970s slower growth of the US.

One of the reasons to doubt the soundness of Beijing’s stimulus and crisis-management programs is that they pass much of the responsibility on to local governments and even to private firms. This is troubling because, as Hyman Minsky argues, stabilizing a financially unstable economy — one experiencing a macro-bubble deflation — requires a lender of last resort and a government with effectively unlimited borrowing capacity, which can only be the monetary authority and the central government or entity that explicitly has the full faith and credit of the central government backing it. Passing the responsibility to local governments, real estate development companies, and others with their own financial problems and, in fact, pressuring them to clean up their own financial positions is not realistic. This passing-the-buck tendency of the central government would appear to reflect the authoritarianism of China’s leadership and its lack of understanding the difference between forcing entities to make sacrifices and providing financial stability when facing the threat of a vicious cycle of financial collapse. [emphasis added] — “Beijing Underestimating Developing Economic Storm” Levy Forecasting Center [free registration required]

Here’s another point that merits a whole separate post by itself. (The entirety of the following argument is opinion).

China is arguably the greatest socio-economic experiment of our generation. It’s a culture with a storied history, which in its fundamental values hasn’t really changed since its defining Warring States Period (475–221 BCE) when many of its philosophical underpinnings were set. The concept of 士农工商 (gradated social status: government official > peasant > worker > merchants or businessmen) and the normative social hierarchy it thus prescribes can be seen even today, though it is often hidden by the glamour of the economic boom of the last 40 years.

China adopted capitalism in the 1970s partly out of desperation (socialist alternatives weren’t working to say the least) and partly as a way of maintaining social control (it’s easier to govern a country full of incentivised citizens willing to play an economic game which they feel they can win). But at the end of the day, the Chinese state only sees capitalism as a business model (no pun intended), a method, a tool, a means to an end, a way of doing things that should still be subordinate to its values and management. Capitalism, however, is an entire value system in its own right — it possesses its own underlying logic that drives its own dynamics and outcomes. It structures social hierarchies in its own way, one that is different to the one expected by the Chinese state. Neither is right nor wrong per se, it’s a value judgement (see previous post Does culture explain covid infections?).

There is an inherent clash coming between these two operating systems. As long as the economy was growing, things were working, and everyone was happy. A marriage of convenience. But now things are starting to be different and Beijing may be totally blind to the nature of the problems it faces. Hence the misunderstanding Levy writes about in the quote (interpretation).

3. Down Memory Lane: US 2007 & Japan 1991

As a reminder, it took 1 year and 9 months between property prices crossing zero growth and an official recession in the US in 2008 (see FRED chart). Whether or not China is similar in this respect is a topic for a different post.

Here’s a chart of how the mortgage crisis worked itself out in the US. In hindsight, holding on to property through the choppy period wouldn’t have been a bad call.

However, as a counterpoint from the universe of potential outcomes, here’s a chart for Japan. House prices never really recovered since the break of the bubble in 1991. Neither really did Japan, hence its infamous “Lost Decades”.

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