Fear Empty Flats in China's Property Bubble

Even worse than a price bubble burdening China's property market is a speculationfueled quantity bubble of vacant flats
How many flats in China are sitting empty? The media recently floated a story denied by power companies that 64.5 million urban electricity meters registered zero consumption o er a recent! si"#month period. That led to a theory that China has enough empty apartments to house $%% million people. &tatistical transparency is lac'ing in this area! so the truth about empty apartments remains under wraps. (ublishing accurate data should be of the highest priority! since the size of the nation)s unused apartment stoc' is perhaps the most important measure of the e"tent and seriousness of China)s property mar'et bubble. *ndeed! it)s a gra e concern for policyma'ing! since unpublished data may indicate not only a price bubble but a +uantity bubble burdening the mar'et. ,eal estate is prone to price bubbles because uni+ue factors restrict its supply response. *nflated prices ha e been the mar' of most modern#day property bubbles. (rice bubbles occur fre+uently and can last a long time. *n the -./%s! To'yo saw a tremendous rise in property prices not in tandem with supply. The Hong 0ong property mar'et e"perienced a similar phenomenon in the -..%s. 1ne reason for limited supply is that property de elopment is sub2ect to go ernment regulations! especially local rules. 3stablished communities usually restrict building heights and density! for e"ample! ma'ing it irtually impossible for mature communities to increase supply +uic'ly. 4ondon! which is now e"periencing a price bubble! and To'yo in the past are cities that tightly control building heights. &econd! infrastructure de elopment ta'es time and is always relati e to land a ailability. 3 en in an island#city such as &ingapore! land can be reclaimed from the sea at low costs! pointing to the correlation between land and infrastructure. 5ut when property prices are high! and e en when money is a ailable for infrastructure de elopment! one should be cautious about plunging in for fear that property prices could later fall. Thus! e en o er e"tended periods of time! property supplies may not respond to price increases. Hong 0ong doesn)t ha e height restrictions li'e 4ondon or To'yo. 6or does it ha e infrastructure or land shortages. 5ut a go ernment policy limiting land supply created scarcity before -..7! setting the stage for a bubble. The subse+uent catalysts for higher prices were loose monetary conditions imported from the 8nited &tates through Hong 0ong)s currency peg to the dollar. 3 en though prices were rising! the go ernment chose not to increase supply! leading to a price bubble. Thus! demand for property also rises under eased monetary conditions! and climbing price momentum attracts speculati e demand. *f monetary conditions remain loose for awhile! credit access can sustain this 'ind of speculati e demand. This points to a need for the Chinese go ernment to ad2ust its property mar'et policies as well as interest rates to reduce speculation and steer the mar'et out of a looming bubble crisis. *t)s been said many times that China is e"periencing a nationwide urban property price bubble. High prices in ma2or cities where most of the country)s property alue is concentrated

cannot be e"plained rationally. ,ising rents are a little easier to e"plain! howe er! e en in the face of empty flats e erywhere. &ome blame intermediaries for ramping up the mar'et! but this e"planation is hard to stic' in China)s fragmented intermediary real estate industry. *nstead! inflation e"pectation is probably dri ing current rent increases9 (roperty owners anticipate spending more in the future remodeling flats to compensate for renter wear#and#tear! so they charge higher rents now to plan for higher costs. Quantity Pump :hat especially distinguishes China)s property bubble! howe er! is an unprecedented amount of li ing space. This huge stoc' of empty flats e+uals the nation)s +uantity bubble. ;uantity bubbles are less common than price bubbles! and they don)t last as long. ,ising supply usually e"erts downward pressure on prices! although an influ" of money can hold up prices e en when supply is rising. < price bubble can damage an economy in three ways. =irst! it usually leads to a ban'ing crisis. <s the mar'et trades at e er#higher prices! buyers borrow more against the same property. 5an's that maintain the same lending cushion with! say! a >% percent down payment rule suffer losses when prices fall below that le el. < ban'ing system in crisis cannot lend normally! and the economy suffers collateral damage due to dysfunctional ban'ing. &econd! the wealth effect leads to e"cessi e consumption during a bubble. The paybac' wea'ens an economy for se eral years. <nd third! bubble#induced demand distorts the supply side. :hen inflated industries go down with a bubble burst! it ta'es time for other industries to rise in an economy in their place. < +uantity bubble is sometimes a construction bubble! and it fizzles out when a building cycle turns o er! crashing prices as soon as new supply becomes a ailable. This is what happened to a commercial property bubble in the 8nited &tates in the late -./%s! triggering a ban' crisis when it burst and prompting the =ederal reser e to maintain a loose monetary policy that helped the ban'ing system heal. ;uantity and price bubbles may grow together. &outheast <sia! for e"ample! e"perienced a +uantity#cum#price bubble that lasted se eral years in the -..%s. <s regional currencies were pegged to the dollar! loose monetary conditions were imported from the 8nited &tates! fueling a property bubble. ?ue to few restrictions on urban de elopment! rising prices led to massi e increases in supply. 4i+uidity inflow fueled speculati e demand. 5ut when 8.&. monetary policy tightened! the mar'et crashed and triggered the <sian =inancial Crisis. The latest e"perience in the 8.&. mar'et was mainly based on a price bubble! although some cities such as 4as @egas and Aiami saw +uantity bubbles as well. The 8.&. go ernment +uic'ly recapitalized its ban'ing system! limiting the direct effect of the ban'ing crisis on the economy. Current wea'ness can be e"plained mainly by the wealth effect and employment losses in bubble#inflated industries. :hen Taiwan e"perienced a price#cum#+uantity bubble in the late -./%s! analysts determined the number of empty flats by obtaining electricity meter data from the power supplier! leading many to conclude that about -5 percent of all flats were empty. Today! some analysts are trying the same tactic in China. 5ut Taiwan)s housing conditions are less comple". Betting to the core of China)s data re+uires more calculating. Housing types! for e"ample! must be considered. China)s urban housing stoc' is mainly split between old! public housing built for company or go ernment employees! and some 6% million units of pri ate housing built o er the past -% years. (roperty de elopers are now

building about $% million pri ate flats! and local go ernment#owned land ban's may be good for another $% to >% million. <bout - billion s+uare meters worth of public housing Cor about -4 million! 7%#s+uare#meter unitsD ha e been torn down! lea ing about . billion s+uare meters of this type of li ing space nationwide. Aoreo er! companies and go ernment agencies are still building apartments for employees. This practice has slowed but remains significant in many cities e en today. *t)s hard to tell how many of these newer flats are out there. There are similar un'nowns about dormitories! such as factory dormitories that house wor'ers from rural areas who migrate to manufacturing regions. Aost of China)s more than $%% million migrant wor'ers may be li ing in such dormitories. 6ot all commercial property is mar'et#dri en! since certain people with connections or other ad antages may own rental apartments that tend to ha e high acancy rates and should be ta'en into account when calculating mar'et e"cess. <nother consideration is that massi e +uantities of housing ha e been springing up in rural communities near ma2or cities. <nd when farmland is rezoned for urban de elopment! the region)s housing starts falling into the urban category. Numbers Crunching <lthough China)s new property sales topped -4 percent of B?( in $%%.! the data is confusing. Aaybe it)s confusing by design! since firm figures on total urban housing stoc' are hard to find. Ay guesstimate is that China)s total urban stoc' is around -7 billion s+uare meters! plus or minus -% percent. 1ne useful figure for analysts is China)s li ing space per capita. &ur eys in most cities suggest the a erage li ing space is between $/ and >% s+uare meters per person. :e don)t 'now which population segment these sur eys co erE they certainly don)t include migrant wor'ers. <nd we don)t 'now if empty flats are counted. 5ased on this limited data! howe er! we can confidently conclude that China does not ha e a housing shortage. Aoreo er! its per#capita li ing space is higher than in 3urope and Fapan. *ndeed! if we adopt Fapan)s standard! China already has sufficient urban housing space for e ery man! woman and child in the country. =ar more important than general data! howe er! are the housing figures pointing to a huge +uantity of empty flats apparently being held only for speculation. *n a normal mar'et! the acancy rate should be e+ual to the number of households relocating! times the a erage transition period! plus newly formed households times the a erage purchase period. =or e"ample! a acancy rate of -.5 percent could accommodate a mar'et in which 6 percent of households relocate e ery year! and the transit time is three months. *f new household formation is > percent and the a erage period for a property purchase is si" months! this factor re+uires a acancy rate of another -.5 percent. The total normal acancy rate should be > percent. This figure includes the new properties ready for sale. <lthough the go ernment doesn)t publish acancy data! * thin' the acancy rate for the nation)s pri ate! commercial housing stoc' is between $5 and >% percent. That)s at least double what)s re+uired in a normal mar'et. The gap between what)s needed and what)s a ailable can be iewed as speculati e in entory. The alue of this in entory held by speculators is probably around -5 percent of B?(. *t)s being 'ept on ice 2ust as copper and other commodities are hoarded in anticipation of rising prices. Watch Out :e should fear China)s +uantity bubble. <nd we should be terrified by the potential for a massi e amount of new! speculati e in entory that could come on line this year and ne"t.

,ight now! tight credit is holding bac' the mar'et! and supply is piling up on the de eloper side as in entory. The go ernment)s tightening s+ueezed buyers of second and third homes! and transaction olumes across the country collapsed. :hat *) e learned from intermediaries is that most property demand now falls into restricted categories! i.e.! speculati e. *t)s reasonable to assume! therefore! that the supply would be close to -5 percent of B?( in alue this year and in $%--. That)s because when the policy is rela"ed as most e"pect speculation will probably re i e and lead to a doubling in the total alue of speculati e in entory. Chances are good that policyma'ers will indeed rela" policy. *n some cities! ban's are already loosening a bit. < 'ey reason is that local go ernments ha e a lot of debt commonly fi e times more debt than re enue and could get into financial trouble without a decent le el of property transactions. 4ocal go ernments in China depend on real estate deals for re enue and could default if the mar'et falls too far. Thus! the central go ernment may loosen policy to help the locals without ma'ing a formal announcement. &uch a change of heart would ease short#term go ernment difficulties but double the trouble down the road when the property bubble bursts. &o e en if China)s stoc' of empty flats is only half that recent estimate of 64.5 million! it would still be e+ui alent to $% percent of all urban households. That)s higher than Taiwan)s acancy rate at the pea' of its bubble. Aoreo er! credit rules are loosened! the stoc' could rise to more than >% percent. China)s housing o ersupply isn)t surprising. 3"cess supply reflects the under#pricing of capital! and China)s system is structured to increase supply +uic'ly. 5ut rising prices alongside rising acancy rates are surprising. 6ormally! speculators are spoo'ed by high acancy rates. 5ut China)s phenomenon is uni+ue for at least four reasons9 -D < sustained negati e real interest rate has led to a falling demand for money and rising appetite for speculation. Breed and inflation fears are wor'ing together to form unprecedented speculati e demand for property. $D < massi e amount of gray income is see'ing safe ha en. China)s gray income of arious sorts could be around -% percent of B?(. *n an en ironment of rising inflation with a depreciating dollar the traditional safe ha en China)s rising property mar'et is becoming a preferred place to par' this money. >D =ew people in China ha e e"perienced a property bubble. The property crash in the -..%s touched a small segment of society! such as foreigners and state#owned enterprises. Beographically! it was restricted to the country)s freewheeling zones in Hainan! Buangdong and &hanghai. Aost people didn)t e en 'now there was a property crash. This ignorance has led to a lac' of fear that)s now turbo#charging greed. 4D &peculators thin' the go ernment won)t let property prices fall. They correctly surmise that local go ernments rely on property deals for money and do all they can to prop up prices. 5ut their faith in go ernment omnipotence is misplaced. <t the end of the day! the mar'et is bigger than the go ernment. The go ernment can delay! but not abolish! mar'et forces. 6e ertheless! faith in go ernment is replacing fears of a downside! and speculati e demand will continue to grow as long as credit is a ailable. *n other parts of the world! central ban' attitudes toward real estate speculation are changing. *srael)s central ban' 2ust raised its interest rate! specifically citing a need to fight a property bubble. (roperty prices in *srael ha e risen $% percent in the past -$ months. *ndia! 0orea and Taiwan are raising interest rates out of concern for inflation and speculation as well.

China)s problems are much bigger than what)s found in these economies. 5ut 'eeping interest rates low will only worsen the nation)s bubble problem. (eriodic credit tightening and crac'downs on speculation won)t wor' because they are not ta'en seriously and ne er last. China)s latest property mar'et tightening appears to ha e been impro ised. 1f course! any buyer discrimination policy is comple"! hard to implement and creates e"cessi e mar'et olatility. 6ow! if special interest pressure leads to a change in policy! speculators would be further emboldened! and the e"cess would multiply! ma'ing the e entual ad2ustment so much more painful. ,aising interest rates! howe er! would cool speculati e demand gradually! a oiding mar'et disruptions. <t this point! a rate hi'e would be the best policy option. 5ut a delay in raising interest rates would only cause a surge for the stoc' of empty flats and ine itably lead to collapse. 4ong range! a policy of sustainability would re+uire resol ing local go ernment financial problems by increasing non#property re enue sources or limiting e"penditures. Currently! the in estment#led growth strategy that)s been adopted by all local go ernments ine itably leads to ma"imizing re enues from land sales. &o unless limits are put on this strategy! the property mar'et will function abnormally. (roperty ta"es could play a significant role in re enue streams. *n many countries! property ta"es support local go ernments and public ser ices. China should adopt the same model! while also restricting fiscal spending. The bottom line is that China urgently needs a coherent property strategy. The massi e o erhang of empty flats should goad policyma'ers to act now. *f the go ernment eases rules for the property mar'et before adopting a coherent policy! though! a crash could bring down the economy for an e"tended period. 1ne only needs to glance at modern#day price and +uantity property bubbles around the world to understand the star' conse+uences. :hat)s happening to the 8.&. economy now is a prime e"ample! and it should be lesson for us. 1therwise! China)s economy will loo' li'e <merica)s. Andy Xie is a board member of Rosetta tone Advisors !imited