The Federal Reserve Bank of St Louis recently released an interesting short report on China’s epic housing bubble, which it warns could burst in the event that both household income growth and the savings rate start to decline, and/or capital controls in China begin to relax, removing housing’s preferred status as a store of wealth (h/t Bernard Hickey at Interest.co.nz):
Housing and land prices in China have increased continuously and dramatically for the past two decades. In fact, housing price growth has significantly outstripped income growth. Current housing prices are roughly 11 times annual income; in large cities such as Beijing and Shanghai the price-to-income ratio is as high as 23 to 1.1 By comparison, Tokyo house prices were 15 times income and U.S. house prices 5 to 6 times income when the Japanese and U.S. housing bubbles, respectively, burst in 1990 and 2006. Rapid price growth, large price-to-income ratios, and high vacancy rates (between 25 and 30 percent) suggest the possibility of a bubble.The top chart compares key facts for the Chinese and U.S. housing booms and the bottom chart compares the recent mortgage debt as a share of gross domestic product for both. While in both cases nominal house prices increased by close to 50 percent over a 5-year period, the differences are striking. The U.S. housing boom reflects over-consumption and over-borrowing, whereas the Chinese housing boom reveals large investment in construction and apartment holdings. Most of the “vacant” Chinese homes have been sold to private owners but are being held as investments alongside multiple other homes.
Asset bubbles are typically defined by the relative role of fundamental and speculative demand. Those who argue against a Chinese housing bubble point out that China is currently undergoing “the greatest urbanization story the world has ever seen”…[However] construction growth is well on pace to exceed demand from migration. High vacancy rates may also suggest “speculative” demand. China’s extraordinarily high household savings rate (about 25 to 30 percent) is well documented, and financial repression and highly underdeveloped financial markets severely limit the supply of quality assets for investment. In combination, these forces encourage demand for housing as a store of wealth… Individuals hold housing as they would gold because they wish to save and housing offers the most attractive return of all available financial assets. This explains why most of China’s empty apartments are sold properties. Store-of-value demand is speculative in nature because it hinges on the expectation that housing prices cannot fall or the rate of return to empty apartments can consistently dominate that of cash. But nowhere in the world is this guaranteed—housing prices do fall sometimes, as they did in the United States in 2007. Thus, speculative demand generates bubbles because, more so than fundamental demand, it is fickle and prone to sharp reversals…Housing is not an ideal store of value. Building houses consumes productive resources, and those who need housing as a basic necessity must compete for its acquisition with those who want it to preserve wealth…The Chinese housing boom has generated global attention because of fears that it is not sustainable and its collapse would intensify the current world slump and significantly prolong the worldwide recession. Because of its speculative nature, significant store-of-value demand for housing suggests a bubble that could burst, especially when both the household income growth rate and the savings rate start to decline and capital controls in China start to relax. But how soon and how fast these events will happen—and if, when, and how investors might lose faith in housing as a store of value—are naturally difficult, if not impossible, to predict.
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