The stock market weakness of recent months has been widely attributed to the ongoing drama in the euro-zone, but the setback owes as much to concerns that China’s runaway property market is set to reverse direction, and precipitate a sharp slowdown in economic growth.

The bears argue that the Middle Kingdom’s inflated property prices are reminiscent of Japan’s real estate bubble during the latter half of the 1980s, and believe that the Chinese authorities via accommodative monetary policy and a quasi-fixed exchange rate, are in danger of repeating the same mistakes made by their Japanese neighbours two decades ago.  A similar outcome would undoubtedly prove disastrous for the global economy, given that the developed world already stands on the edge of a deflationary abyss, but are the bears’ worst fears truly justified?

The private residential property market is a relatively new phenomenon in urban China.  Indeed, until housing policy was reformed in the late-1990s, the allocation of apartment units to most urban households was determined by employers, primarily government institutions and state-owned enterprises.  The government gave birth to a market-oriented housing market in 1998 through the privatisation of the existing urban housing stock to current occupants at heavily discounted prices.  The development of a commercial housing industry was encouraged by the state, and the resulting boom in residential construction was supported by the emergence of mortgage finance, as the commercial banks began to offer loans to individual buyers.  The commercial housing industry developed quickly, supported by rapid growth in mortgage lending, and private home ownership had become the norm by 2003. 

Structural factors including favourable demographics, increased urbanisation, rapid income growth and high household savings rates underpinned the buoyant demand.  However, urban house prices began a rapid ascent in 2003 that continued through 2007; price gains in the major cities between 2002 and 2006 averaged 30 per cent a year, and the continued upward momentum in 2007 forced the authorities to implement various administrative measures and financial policies in an effort to depress speculative investment demand.

The actions taken included an increase in the down payment requirements on second home purchases from 30 to 40 per cent, a hike in the mortgage rate on second home purchases to 1.1 times the standard rate, an order to the commercial banks to control their lending to property developers, and the introduction of new rules that made it harder for foreigners to invest in Chinese property.  The restrictive measures introduced proved successful, as the pace of price increases slowed from its peak in late-2007, and house prices eventually turned south, as the global financial crisis inevitably undermined demand.

House price weakness proved short-lived and the decline relatively modest, as a sharp economic slowdown demanded a shift toward more accommodative policies.  Fiscal stimulus equivalent to 13 per cent of GDP, massive credit expansion, and a reversal of the restrictive measures that were implemented in 2007 contributed to a turnaround in the housing market’s fortunes.  The credit expansion saw property development and consumer mortgage loans surge by roughly 40 and 50 per cent respectively in 2009.

Negative real interest rates, high savings rates and controls on capital outflows increased the relative appeal of private housing as an investment vehicle.  The volume of transactions increased substantially in the major cities, and the surge in demand saw house prices resume their upward trajectory and surpass their previous peak by the autumn.  The positive momentum continued during the early months of this year, and prices registered a record year-on-year gain of almost 13 per cent in April.

The Chinese authorities were forced to take measures to curb speculative investment once again, as the elevated prices in the major cities, at roughly 10 to 15 times average household incomes, kept rural migrants out of the market and contributed to heightened social tension.  Down payment requirements on second home purchases have been raised to 50 per cent, the mortgage rate on second home purchases has been increased to 1.1 times the standard rate, and loans for third home purchases have been forbidden.  Meanwhile, the land available for public housing development has been substantially increased; the objective is to address the shortage of affordable housing that has proved socially divisive.

The deliberate attempt to check the advance in urban house prices is beginning to have an effect, as house values dipped month-on-month in June for the first time since the spring of last year.  Concern is now mounting that prices could slip by some 30 per cent before the end of the year, and there are fears that the resulting increase in mortgage delinquencies could lead to financial instability.

Though house prices may well drop sharply in certain pockets of the market, but the fears seem overblown given that loan-to-value ratios averaged just 34 per cent from 2003 to 2009, and still relatively low 66 per cent by international comparison during this year’s spring.  Thus, a substantial drop in prices is required before homeowners find themselves in negative equity.  Furthermore, property loans account for 25 per cent of the banking sector’s total loans – a fraction of the equivalent number across Ireland’s banks, and mortgage lending is equivalent to just 15 per cent of GDP, as compared with a figure of almost 80 per cent at the US housing market’s peak.

The upward trajectory in Chinese housing prices simply does not look like a dangerous bubble; urban prices have advanced by 75 per cent over the past decade, and 15 per cent since last spring.  Given the structural factors underpinning demand including urbanisation and high income growth, alongside the restrictions on supply arising from limited land availability and high population densities, price advances of this magnitude do not appear outlandish.

House prices are sure to weaken following the government’s deliberate attempt to cool the market.  A property-induced crisis appears unlikely however, as homeowners have considerable scope to absorb significant price losses, and commercial banks do not appear to have dangerous levels of exposure to mortgage and property-development loans.  The Middle Kingdom will muddle-through.