A man and a woman ride on an electric scooter past new apartment buildings in Jining, China. (Photographer: Qilai Shen/Bloomberg)

Why China Can’t Fix Its Housing Bubble

(Bloomberg Opinion) -- Real estate is the driver of the Chinese economy. By some estimates, it accounts (directly and indirectly) for as much as 30 percent of gross domestic product. Keeping housing prices buoyant and development robust is thus an overriding imperative for China — one that is distorting policymaking and worsening its other economic imbalances.

Despite reforms in recent years, there's little question that Chinese real estate is in bubble territory. From June 2015 through the end of last year, the 100 City Price Index, published by SouFun Holdings Ltd., rose 31 percent to nearly $202 per square foot. That's 38 percent higher than the median price per square foot in the U.S., where per-capita income is more than 700 percent higher than in China. Not surprisingly, this has put homeownership out of reach for most Chinese.

Worried about these prices, and about growing indebtedness among developers, China's State Council has hatched a plan to encourage rentals. It will offer tax breaks to developers that rent out some of the housing they planned on selling, and will prod financial institutions to "provide support for companies in the residential rental sectors."

This is a thoroughly misguided way to address the problem.

For one thing, rental yields in China are extremely low. In big cities, such as Beijing and Shanghai, yields are hovering around 1.5 percent (compared to an average of about 3 percent in the U.S. and 4 percent in Canada). Wages in China simply aren't high enough to keep up with the credit-fueled rise in asset prices, and thus developers can't earn a reasonable rate of return by renting out units. A tax break won't fix that.

Worse, developers are heavily weighted down with debt, much of it short-term. Many are paying out 7 to 8 percent bond yields, with debt-to-equity ratios of around 380 percent. Encouraging them to rent out their housing surplus thus drives a money-losing trade: Developers rent to consumers to make a 1.5 percent yield, while paying a combined debt-and-equity cost of capital of almost 10 percent. That 8.5 percent negative yield multiplied by millions of units amounts to an enormous subsidy for renters, but it significantly worsens developers' debt problems. Actively encouraging this is not exactly standard economics.

These problems are compounded by the way rental agreements are structured in China. Typically, renters borrow from banks to make an upfront, one-time payment to developers that covers, say, five years. But they can repay that loan over as many as 10 years. The upfront payment from the bank to the developer provides some short-term cash-flow relief. But otherwise, all it does is delay debt repayments attached to the unit and shrink the loss on unsold inventory.

Underlying all this is the simple fact that China can't allow real-estate prices to decline significantly. Politically, homeowners have come to expect their property values to rise continually in a one-way bet; reforms that threaten this dynamic have even led to rare protests. Given that household lending now makes up 22 percent of financial-institution assets, a reset in housing prices would also carry serious financial risks.  

Rather than run those risks, China is simply ramping up development. New starts and land purchases have grown strongly through the first five months of 2018. Investment in residential real estate is up 14 percent and development loans are up 21 percent. Far from reducing leverage, banks are jumping back into the speculative bubble: Mortgage growth is now at 20 percent.

The most direct way to deflate this bubble is to slow lending. That could mean increasing required down payments even further, raising the capital risk weighting on real-estate assets for banks, or simply setting a hard cap on new loans. But without a significant slowdown in the growth of credit flowing into real estate, no amount of tinkering by regulators will make much difference.

In fact, by accelerating real-estate lending while encouraging banks and developers to subsidize renters, the government is making things worse by delaying a restructuring. Developers will worsen their debt load. Consumers will be burdened with longer rent-repayment terms. And new homes will remain as unaffordable as ever, even as added inventory comes on the market.

At best, this latest plan will buy time. But this raises the all-important question: For what?

©2018 Bloomberg L.P.

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