House of pain
China is rare in many ways, but its housing market is just as dependent on psychology as everywhere else. After years of gains, prices are now falling in most Chinese major cities. When negative thinking sets in, it’s hard to escape the pessimism spiral.
House prices can be notoriously volatile. In OECD countries between 1970 and 1995, a 40 percent price gain over six years was typically followed by at 25 percent decline over the subsequent five. Later studies show a bank crisis makes the correction deeper and longer. China looks due a correction. Average house prices in 40 big cities, according to data from the China Index Academy, have now risen 49 percent in 5 years.
The good news is that the boom has not been fuelled by leverage. The 5.1 trillion yuan ($838 billion) of new housing loans extended since 2010 is just 20 percent of the value of houses bought during that time, government data shows. That reduces the risk of households being forced to sell, or getting trapped in negative equity.
Nevertheless, falling prices undermine people’s perception of their wealth, and therefore their propensity to consume. Less housebuilding hits demand for materials and labour. Contentment, consumption and activity are crucial to China’s mission of keeping society stable, so can-do politicians and developers are now mooting ideas to coax buyers back to the market.
There are three tactics. One is to cut the red tape that makes it difficult for buyers to snap up houses. Wuhan and Fuzhou last week joined the cities removing restrictions on purchases, such as quotas for certain kinds of buyers. But that’s not necessarily a big bang. Many buyers have already bought elsewhere. If prices are falling, they may still decide to wait.
The second strategy is to cut mortgage rates, or allow borrowers to take out bigger loans. New rules from the People’s Bank of China on Sept. 30 would allow banks to lend 30 percent below the benchmark rate, and let buyers who have paid off their first home loan buy a second property with as little as 30 percent downpayment. But all that may create only a small adjustment in behaviour.
Imagine a buyer who sees a house as a purely financial investment, as many do. With the interest rate on bank savings capped at around 3 percent, speculating on property has been an attractive alternative.
But the economics are getting more unattractive. Typical investors can already get 6 percent a year from buying deposit-like wealth management products. The stock market, in a good year, could return even more. That increases the opportunity cost of investing in housing.
If a homebuyer expected the return on their home equity to match what they can get from wealth products over five years, they would need to believe their house could rise in value by 34 percent in nominal terms, after factoring in compound interest. Beyond Beijing and Shanghai, few cities have that potential.
Making mortgages more freely available, or increasing the permitted loan-to-value, doesn’t make the investment any more attractive. A house would still have to increase in value enough to justify the cost of mortgage payments, which are currently around 6.6 percent a year. For a house that is 30 percent mortgaged, halving the borrowing cost only reduces the required valuation gain from 34 percent to 29 percent.
Buyers may not always be that analytical, but the unattractive reality is dawning on them already, which is why sales volumes have collapsed. Some sellers will eventually cut their losses as prices slide, causing others to follow. Developers will fail, reinforcing the sector’s bad aura. Even those who don’t sell face the psychological effect of buying a lemon.
That leaves the third tactic: giving away free stuff. Some developments now dangle access to a hukou, the precious registration that grants access to local government services. More mundane freebies include language classes, wedding car rental and extra balconies.
Next could be direct government subsidies to buyers, to increase affordability without apparently lowering prices. It may be a drop in the bucket though – the average 70 square metre house in one of China’s biggest cities already costs 20 years of disposable income.
Meanwhile the government can paper over the most visible signs that might spook buyers, as it is doing now. That includes bailing out developers, especially when there is a risk that they might abscond with investors’ funds, as has happened in the small city of Handan.
What politicians can’t hide is visible overbuilding – a problem almost everywhere, and something that can quickly weigh on buyers’ psychology. Some cities are building over a decade’s worth of supply. Taking a wrecking ball to all that unwanted housing may be too much to ask, but that makes a demolition of prices all the more likely.
This article was updated on Oct. 1 to include new central bank rules.