China’s Colossal Housing Bubble

There has been a lot of reports recently that China is in the midst of a colossal housing bubble.

In March this year Edward Chancellor, financial historian and bubble expert from Boston-based global investment management firm GMO, released an article entitled China’s Red Flags (available on the GMO website after registration). In this article, Mr Chancellor offers a checklist for identifying asset bubbles and then applies each factor against China.  He warns that the Chinese economy is experiencing an unsustainable bubble whereby growth is being engineered by the Government, via excessive and wasteful fixed asset investment, in order to achieve high GDP numbers. Interest rates are also being kept artificially low in order to spur growth. But, as a consequence, a nasty bubble is developing in China’s real estate market.

Then in April this year, Jim Chanos, hedge fund manager at New York investment company Kynikos Associates, conducted an interview where he warned that China is experiencing a severe real estate bubble and is headed for a crash; rather than the sustained boom that most mainstream economists predict (video available here).

Now a recently released NBER research paper provides a detailed statistical examination of housing conditions in eight major Chinese cities with more than eight million residents – Beijing, Chengdu, Hangzhou, Shanghai, Shenzhen, Tianjin, Wuhan, and Xian. These cities accounted for over a third of all new housing sold by value in China in 2009.

This study suggests that bubble-like conditions are developing in each of these cities. As shown below, housing prices-to-rents have increased by at least 30% in each market over the past three years. The increase in price-to-rents has been particularly large in Beijing, where it has risen from 26 times in 2007 to 46 times in the first quarter of 2010. Hangzhou, Shanghai and Shenzhen have also seen their price-to-rents ratios rise sharply to over 40.

The increase in home prices has, however, been less than the rise in incomes in Chengdu, Tianjin, Wuhan and Xian. But prices in the coastal cities and in Beijing have outpaced even the high income growth experienced in those places. In fact, price-to-income ratios have reached their highest ever levels in Beijing, Hangzhou, Shanghai, and Shenzhen (see below chart).

The authors also do not find evidence that the sharp rise in home prices is explained by population growth outstripping new construction (see below table). In fact since 1999, in five of the eight major cities – Chengdu, Shanghai, Tianjin, Wuhan and Xian – the number of new housing units was at least as large as the net increase in the number of households. Only in Beijing, Hangzhou and Shenzhen did the number of new households exceed the the net increase in the number of housing units. Even so, while upward pressure on prices is to be expected in these cities, the authors conclude that the demand-supply mismatch cannot account for the dramatic rise in home costs.

The authors conclude that home prices in many of China’s major cities are highly risky at these prices and that owners must be expecting very high rates of price appreciation for these price-to-rent ratios to be sustainable – classic bubble psychology. There is, therefore, a high risk that home prices could collapse if the rate of price appreciation slows or modest price falls are experienced. In the words of the authors:

“To provide some insight into just how risky prices and price-to-rent ratios are at these levels, we calculated what would happen if people began to expect that their homes would grow in value by only 4% per year. For Beijing, prices would fall by over 40%, absent offsetting rent increases or other countervailing factors.”

There is also the likelihood that other cities throughout China are experiencing bubble-like conditions in their housing markets, given the rapid pace of capital appreciation that has been experienced over the past decade in China’s 35 largest cities (see below chart).

Yet another credit explosion?

Like all property bubbles, China’s bubble appears to have been caused, in part, by rapid credit growth. Total loans outstanding increased by over 40% from the end of 2008 to the first quarter of 2010. Similarly, outstanding residential mortgages and loans to real estate developers have grown by 38% and 50% respectively over the same time period (see below chart).

Part of the reason behind this rush into housing is the Chinese Government’s near savings capture of its households and businesses. In order to spur economic growth, the Government sets the maximum interest rate paid by Chinese banks for deposits at 300 basis points below the minimum lending rate (and below the rate of inflation). The Government then funnels these massive deposits via state run banks into state-linked firms at below market rates, which then use these funds to build infrastructure and/or expand productive capacity.

Faced with earning an interest rate on deposits below the rate of inflation, Chinese savers have little option but to invest in real estate or domestic stocks, or to provide high interest rate black market loans through the shadow banking system, in order to earn a positive return.

Financial black hole:

According to a recent article by fellow blogger, Charles Smith, China’s residential property tends to be poorly built and prone to rapid deterioration and depreciation. The after market for apartments in China is also near zero, since few investors are interested in buying second-hand dwellings when there are thousands of brand-new ones available. As such, turnover in Chinese residential real estate is extremely low, in the order of 1% or less annually.

The risk is that many Chinese are pouring their life savings into an illiquid, deteriorating asset that, in all likelihood, cannot be sold without taking a significant haircut on their investment. According to Mr Smith:

“When the citizenry finally understand that the Central Government cannot stop prices from falling, or provide a deep, liquid market for re-sales, then panic will take hold, just as it does in the collapse of every bubble”.

But loan-to-value-ratios are low, right?

One factor that should work in favour of the Chinese housing market, when compared to its western counterparts, is that higher loan-to-value ratios (LVR) are required when taking out mortgages for property.   In China, first time buyers are now required to provide a 30% deposit (recently increased from 20%), whereas investors are required to provide a 50% deposit (recently increased from 40%).  Further, according to UBS, Chinese household debt as a share of disposable income is only 57%, whilst mortgage debt-to-disposable income is even lower at 33.5%. This compares to the United States where the equivalent ratios are 124% and 94% respectively, and Australia where the household debt-to-income ratio is over 150%.

So, on the face of it, these higher LVRs should reduce price volatility and cushion the Chinese banking system from mass defaults should the Chinese housing market correct.

However, as reported by Mike Shedlock from Sitka Pacific Capital Management, many of the down payments used to purchase properties are borrowed from the black market shadow banking system at high interest rates. As such, actual debt levels are higher than those reported by the official figures, making Chinese households more vulnerable to a correction than would appear by the official statistics:

“Families lend, friends lend, and they all rely on each other for cash reserves. The ties of honor and reputation are all that enforce repayment. It is a great shame if you can’t repay. Face is everything. Many simply repay by “rolling the debt” borrowing more to pay the vig.

Almost no one has the 20% to 30% down to buy a place. The down payment is typically borrowed at terrible interest or comes from a “marriage gift” which had its origin in borrowed funds, not from savings.

It’s like fractional reserve lending on steroids… A collapse of the bubble could cost lots of folks their life savings. This makes the financial aspect of Chinese society much more fragile than it appears on the surface. There is a lot of interconnected personal debt below the radar”.

A highly unstable economy:

If the housing market does correct, it could significantly slow the Chinese economy. According to the NBER research paper discussed at the start of this post, gross capital formation contributed over 90% of China’s GDP growth in 2009, offsetting the negative impacts of the decrease in exports following the onset of the Global Financial Crises (GFC). Private housing investment accounted for around 15% of total investment volume in urban areas in 2008 and about 13% in 2009. Further, output in the home construction industry constitutes around 6% of China’s GDP, employs around 14% of all workers in urban areas, and consumes around 40% of all steel and lumber produced in China. So it is safe to assume that any slowdown in housing production and/or the effect of a significant house price decline on the household sector would have an adverse impact on China’s economic growth.

More broadly, China’s economy is inherently unstable. China has a tiny consumer base – around the size of France’s – and its economy is heavily geared towards exports, not expanding consumption. Put another way, China cannot absorb (consume) its own goods, so it must export them in order to grow. But this strategy only works when there is a never-ending appetite for its products. And with its two main buyers – the European Union and the United States – both deleveraging and experiencing sluggish growth, their is little prospect that exports will return to their pre-GFC levels anytime soon.

So the Chinese Government is, instead, left subsidising production and consumption in order to maintain growth. But such an approach produces vast amounts of waste and is unsustainable. In the words of Jim Chanos, China is “on a treadmill to hell because 50% to 60% of GDP is construction… they’re really hooked on this sort of heroin of real estate development”.

Already, the leading indicators are not looking good for the Chinese economy. First, as reported in Bloomberg yesterday, China’s manufacturing data, as represented by the Purchasing Manager’s Index (PMI), was the weakest in more than a year.

Second, the Baltic Dry Index (BDI), which measures the demand to ship raw materials and is a leading indicator of commodities demand and raw materials production, recently experienced its longest fall in 15 years. This fall in the BDI reflected, in part, a reduction of Chinese steel demand and production and a corresponding slowdown in orders of iron ore.

Third, in June, real estate prices in 70 large Chinese cities declined over the previous month for the first time in almost one-and-a-half years – by 0.4% for new construction and 0.1% for existing structures. Given the extremely high price-to-rents ratios in China’s cities, and that high rates of capital appreciation are required to maintain these levels, China’s home prices are likely to continue correcting in coming months, placing China’s banks and households under pressure.

Finally, it has been reported that China’s banks are already facing losses on nearly one quarter of the 7.7 trillion yuan ($US1.1 trillion) of loans made to local government vehicles. According to this report, 27% of the loans to local government vehicles are being serviced by the cash flow generated by the underlying projects, whereas a further 50% of the loans are covered by a combination of cash flow from the projects and the underlying value of collateral or loan guarantees. But 23% of the loans, worth around 1.6 trillion yuan, are classified as doubtful. These loans are likely to have been made to allow local governments to embark on social projects, such as creating new parks or planting trees, or they could have been made to unqualified borrowers. Many of these loans are likely to have been squandered on bad investments, or on corrupt payments.

Trouble ahead for Australia?

A key reason why Australia was able to ride-out the GFC of 2008/09 was because of continued strong demand for commodities by China. China is Australia’s number one export destination, accounting for 22% of our exports. As such, Australia benefited directly from the massive building boom that emerged following the Chinese Government’s 4 trillion yuan ($US590 billion) stimulus package, which led to sharp rises in the prices of commodities, including iron ore, aluminium and copper.

However, if a significant slowdown emerges, evident by a fall in China’s infrastructure construction and/or apartment and home building, then demand for Australian commodities will fall sharply, leading to both lower commodity prices and decreased volumes being exported into China. The economic consequences for Australia from a sharp slowdown in China could, therefore, be enormous and would manifest itself through significantly lower economic growth, higher unemployment and falling asset prices.

What deeply concerns me is that while most of Australia’s mainstream commentators are alive to the opportunities that stem from Australia’s heavy exposure to China, they are completely unaware of the significant potential risks to China’s (and by extension Australia’s) economic outlook.

Till next time.

Cheers Leith

Unconventional Economist
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  1. Woohoo, new post from Leith, now to read it an off too bed I am sure it is a goody… Chinese Housing Dragon – will it implode?

    Sorry all I was so excited to read Leith's posts I dashed to the bottom to share my joy!



  2. The_Mainlander

    This is not that unsurprising to me.

    I have been reading about China for months and the very fact they have been building vacant cities – literally and selling the houses/apartments to 'Investors' to park here cash as further perpetuated demand for Australian raw materials.

    (see link:

    I think there could be a case for talking about 'real demand' versus so called underlying demand here!

    This will be huge.

    I think Leith is right to be concerned

    "What deeply concerns me is that while most of Australia's mainstream commentators are alive to the opportunities that stem from Australia's heavy exposure to China, they are completely unaware of the significant potential risks to China's (and by extension Australia's) economic outlook."

    as the emperor has no clothes – the Media are too sh*t scared to say anything as too much of their revenue comes from this.

    Scary time.

  3. Hi Leith
    I'm becoming a fan of your well written and considered blog. I've started to use it to take a more balanced perspective when used in conjunction with the more bullish commentators out there.

    I'm interested to understand if you have participated and profited from the Australian housing or stock markets – with your own funds? I understand that you own a home. Your observations would carry considerable additional weight if you have successfully applied your research to making informed and profitable market decisions, particularly in the context of our housing market.

    Have you contemplated selling your own home to be cashed up to exploit opportunities that will prevail in the event of the downturn that you expect?

    For what its worth I have profited from our markets over the past 10 years, although in the context of adding value rather than relying purely on market movements alone. I am more inclined to see Australia as many, many different housing markets with their own drivers and timings with each providing some sort of opportunity at any given time. Opportunities still exist in the US and UK markets when this micro rather than a macro view is taken.

    Your informed commentary assists in better understanding the macro drivers, the real challenge is in then understanding how this impacts at the micro level.

    A case study for a future post maybe??

  4. Just would like to say thanks to Leith for his time to write these blogs. My brother and I are reading these now with interest. We share his opinion on these issues. Keep up the great work and look forward to future blogs.



  5. Leith van Onselen

    Thanks for the feedback everyone. I'm glad you are enjoying the posts.

    Gary, to answer your questions, I do not currently own any shares or investment properties. My only 'asset' is my family home, which we have (thankfully) mostly paid-off.

    To add some context, I am 32 years old, married, have one child (2 year-old) with another on the way shortly. My wife currently does not work so we are living off one income. Because of our particular circumstances, we are not interested in taking financial risks and are, instead, paying-off our motgage as quickly as possible. This way, if I lose my job (unlikely but possible), we can re-draw from the offset account and survive financially.

    Although I strongly believe that Australia's housing is massively over valued, we are not considering selling-up and renting. The disruption would be too much and we are happy with where we are. Besides, trying to pick when the bubble will burst is problematic.

    We used to own lots of shares and I traded options (with limited success), but we sold up in 2005 prior to buying our house.

    In some ways I am a weird guy. Unlike most home owners, I get angry when prices rise and would be very happy if prices fell. It frankly pisses me off seeing younger people, like my younger brother-in-laws and friends, being screwed over by higher housing costs. The way things are heading, every generation is becoming worse-off than the one before. I honestly believe that housing affordability is the biggest social issue facing Australia.

    Anyway, that's my story.

    Cheers Leith

  6. AustralianTexan

    Perth, the most reliant on the Australian mining boom, has dropped 2% in May and 1.5% in June. Can't wait to see the July drop. A sustained 10% drop will cause a major problem, Perth is already a third of the way there

    I sold my Perth investments 4 years ago when it started to get crazy. I sold some land for $100 per sq ft and bought it in a better suburb in Texas for $1 per sq ft and it came with a house! My best friend just finished selling all 20 of his Australian investment properties, just in time.

    Leith, come join us (with your brothers) in the best suburb in the World, The Woodlands in Texas. High incomes, big homes, forest, lakes, great schools and low taxes.

    There are places where 500k buys you a great house and enough rental properties to retire!

    What kind of a house and how many rental properties does 500k get you in Australia.

  7. "Investors" are culprits for jacking up housing prices fast. Why they can? There is a market formed by influx of riches in major cities, with Beijing and Shanghai being the worst. So, even without the investor-effect, housing prices should still be around these levels today. A friend of mine owns a flat right next to Peking University. He paid 10,000 RMB a sq meter back in mid 1990s. It sells for 45,000/sq meter now easy if he wants to sell it. In my opinion, there's no bubble, and actually, the housing market is just starting. What you see is only the upper middle class and there up trying to jump in. The lower-middle class is yet waiting. Although, I must say that government buildings are a waste of pure corruption nature.

  8. Yes,very true and the situation hasn't escaped some of the more aware but you wouldn't guess that from the degree of complacency in Australia.We are in a bubble and not just real estate.Like all bubbles it will burst.

    To mix metaphors,when the tide goes out we will see who has been swimming naked.

  9. It always seemed odd to me that an economy growing above 10% for over 20 years could have inflation under 3%.Normally inflation is at least equal to growth. I suspect much of the growth that the Chinese statisticians report is in fact inflation.

    I also doubt that the Chinese count the negative growth in resources, such as the pollution of waterways, depletion of agricultural land, the costs of bad loans, the protection of government owned enterprises and the destruction of cities, the cost of homelessness.

    Another significant impact is through the one child policy, resulting in a rapidly ageing population without a supportive family network, or an aged pension system. There are also 40 million males in the current population more than females which is bound to lead to high levels of social dysfunction, including high rates of prostitution.

    Further, it seems any Chinese who have the wherewithal whether in skills or money are emigrating, depriving their inputs to the Chinese economy.

    Overall it looks to me like the China miracle is one big lie that the West is happy to believe rather than generate real, sustainable economic growth.

    Greg Deane

  10. One story really sums up the China story.

    There had been a Chinese tv show called Snail House. It serves as a microcosm of Chinese society today. The main actors were two sisters who become “fangnu,” or mortgage slaves, with the episodes centering around their quest to meet their monthly payments. Officials brought the show to an abrupt end when one sister slept with a corrupt Communist Party official to in order to make payment ( 1). Skyrocketing home prices, corrupt party officials, censorship, and an increasingly confrontational and disgruntled society are all under-reported facets of the China story.

    Shell buildings, luxury apartments with no appliances, or even walls are being sold. One official bought 24 units. Chinese students are buying 500k homes in Australia.

    The implications of their housing bubble are immense. The perception of the China story is woefully inaccurate. The wealth concentrated to a very small slice of society, and built on guaxani -or connections. For example, 600 million people still make less than $3 day, and 300 million make between $3-6 a day. Many of whom have seen their land confiscated for below market rates. The military is made up of mostly poor, and their families the ones being left out of the China "miracle." A 2 star general recently said that they risk a collapse unless they adopt western democracy. A book by a chinese disident recently said the PM is all talk. The ADRs that trade on the NYSE are called the "politurbo" due to their close connections.

    This will likely be more than your garden variety housing collapse, and the probability of a Soviet style collapse is greater than the zero that is currently priced into the market.

    latest :

    much of the above is similar to the above, but might be another insight or two :

  11. Hi there,
    Thanks for the blog. An important read. I can confirm this as factual. I have lived and traveled extensively in eastern China.
    There are massive apartment complexes where no one lives.. they are just stores of wealth because the rich don't want to leave their money in the bank (interest savings rates are lower than inflation).

  12. so does anyone one know how we can get 1% loans too ? I don't want to compete with those that can.

    i have a degree in finance, but i am studying to be a doctor in Australia and i have had training in cardiology.

  13. Wow Leith
    Great information

    I’m desperately looking for the HOME PRICE index for Beijing and other Chinese cities with real data that I can graph against the US Cities.
    Bill Cuughlin