Average prices of new homes in cities in China continues to climb to astronomical levels but that has not slowed down home buyers. In cities like Hong Kong, Shenzhen, Beijing and Shanghai, home price to income ratio is a staggering 40:1. Yet, home prices continue to rise at an average pace of ~11% from last year. Price appreciation in Beijing and Shanghai is much higher at ~19% and ~16% respectively.
To calm the property market, Chinese authorities announced new and tougher property buying restrictions earlier this year. Restricting how many houses people can buy, higher mortgage rates and requiring bigger down payment for second and third houses were instituted in early 2017. These regulations seems to have slowed down price gains in places like Beijing, Shanghai and Shenzhen. But that hasn’t happened in smaller locations like Suzhou, Gangzhou, Tangshan or Bengbu.
With each new policy intended to restrict home purchases, buyers are piling on. Household debt in China has climbed to 42% of GDP and is well above other emerging market countries. A decade ago, real estate sector accounted for 10% of China’s GDP. It now accounts for almost 30%.
Future Wealth’s View
The buyers in China are under the delusion that the bubble will not burst and that the government will provide a soft landing to the housing market. It is a mistake to think that the government can somehow control China’s housing market forever. In the near term, a deck of levers, which they can move up or down depending on the direction they want their housing market to move, may work. But ultimately, market forces will take over and, you guessed it, the bubble pops.
The root cause of this bubble is the loose monetary policy set by Beijing to achieve growth above its potential. Instead of wealth accruing in the financial markets, growth has been in fixed assets. The real estate bubble and the increasing level of debt provide a perfect parallel to the subprime crisis of 2008 in the US. We all know that the ending of that movie was not pretty.
It is going to be a test of the greater fool theory pretty soon in China. Used frequently in financial markets, the greater fool theory states that the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. The price of an object is justified by a buyer under the belief that another party is willing to pay an even higher price. Speculation based on a belief in the greater fool theory is a great way to make a lot of money, as long as the greatest fool doesn’t turn out to be you.
Needless to say, investing in China looks extremely risky near term. Anytime, the property sector becomes the critical pillar for the economy, consequences could be dire. Even more scary is that fate of the world economy could be in the hands of China’s real estate. Last time we had substantial slowdown in China in late 2014, it sent ripples around the globe.
Be careful out there!