How Will China’s New Leaders Handle Housing?

As products of a political system that increasingly operates on the basis of consensus, Xi Jinping, newly installed general secretary of China’s Communist Party, and Li Keqiang, the country’s soon-to-be-installed prime minister, can be expected to continue the policies of the previous leadership for dealing with the overheating of China’s residential market and providing an adequate supply of affordable housing to urban residents. The two linked concerns—among the largest sources of popular discontent in China today—will emerge among the defining issues during their terms, which begin when they fully assume power in March.

However, it is unlikely that Xi and Li will be able to completely get a grip on the fundamental economic problems underlying these issues during their ten-year terms. Dealing with them would mean completing the unfinished task of transforming China’s investment-based economic growth model into one led by domestic consumption. This, in turn, would necessitate bringing forward the difficult task of financial-sector liberalization, including freeing up interest rates; allowing the convertibility of China’s currency, the renminbi; and overhauling the tax system—not all of which can necessarily be accomplished within a decade.

The nearly continuous rise of residential property prices in cities like Shanghai between 1998 and 2010 was interrupted only twice—by the SARS pandemic in 2003 and the global financial crisis in 2008. In response, China’s central government moved to impose home purchase restrictions on 14 first- and second-tier cities in April 2010. The restrictions limit the number of units households can buy, curb purchases by nonresidents, and cap the prices developers in given localities can charge for apartments. The number of cities subject to restrictions was expanded in August and November 2011, and by the middle of last year 48 cities were subject to controls. In addition, in 2010, China’s policy-making People’s Bank of China (PBOC) ordered the tightening of credit, especially for housing loans and for developers, in yet another bid to deflate the real estate bubble.

Now, however, with nearly all Chinese economic indices pointing to a slowdown, the downturn in the residential sales market that resulted from these cooling measures has begun to feed into the larger negative trend in the national economy. The problem has arisen of how both to keep the lid on residential prices and harness genuine occupational housing demand to drive domestic consumption—a conundrum the new national leadership will have to wrestle with.

While the new national leaders may lack the political clout to embark on the difficult, systemic reforms needed to address the underlying causes of the nation’s economic malaise, China has reached a point at which massive credit injections into state-owned enterprises and similar state-affiliated companies are no longer effective in jump-starting the domestic economy. Recognizing this fact, various central government leaders have spoken frequently over the past two years of the need to make domestic consumption the main driver of economic growth.

However, this is easier said than done. Not only would this involve dislodging powerful entrenched interests that benefit directly from the current investment-based economic growth model, but also, if seriously undertaken, it would involve overhauling China’s export-based growth model, which has suppressed domestic consumption by channeling resources away from the household sector to maximize investment in export-oriented manufacturing.

The outgoing central party leadership in the final two years of its term exercised moderation with respect to stepping on the pedal of investment-led growth. Instead, the main stimulus applied during this second round of the global economic slowdown involved cutting the benchmark lending rate, trimming the state banks’ required reserve ratios, and approving 60 infrastructure projects that had been scheduled for launch this year. Still, the collective 1 trillion renminbi price tag of the investment initiatives represents only about 25 percent of the total stimulus applied in 2008 and 2009.

However, what the new leadership faces is a classic case of “damned if you do, damned if you don’t” with respect to leveraging real estate investment and development to pull the economy out of the doldrums. The temptation to take this approach is great: China’s real estate sector accounts for 13 percent of the country’s gross domestic product, and 80 percent of all development activity is concentrated in the residential subsector, which has 40 separate domestic industries clustered around it.

Keeping the home purchase restrictions in place is increasingly arduous for the central government, and their continuation has become a significant point of contention between central and local government authorities.

Part of the rub regarding imposition of restrictions is the effect they have had in undermining urban land values and slowing municipal development land sales. The resulting drop in land sales revenue has unsettled municipal governments because such sales have constituted one of their principal funding sources for construction of public housing, 90 percent of which is funded with local revenues.

Revenues from land sales for 20 Chinese cities for the first half of 2012 were off by nearly 40 percent from a year earlier, according to a report issued by Homelink and published in Caijing magazine. China’s four most populous cities—Beijing, Shanghai, Shenzhen, and Guangzhou—reported a drop in land revenues of nearly 60 percent, the report says.

However, toward the middle of last year the trend in the development land sales market became somewhat less clear. Real estate services firm SouFun-CREIS reported in September that, whereas national-level land sales declined for the second-straight month, average land prices for residential sites had, in fact, been rising since January 2012, except for a dip in May.

Though the land market apparently regained some of its steam in midyear, buoyed by the central government’s modest credit-easing measures, some would argue that this kind of second wind is bound to be short-lived. They would also argue that land banking in the near future will be opportunistic and driven by financially strong players, given such factors as the unlikelihood that the central government will abide by any major short-term relaxation of the home purchase restrictions, the relatively high level of inventory carried by many developers, and the burden of carrying that inventory by highly leveraged developers.

The first indication that the central government’s discomfort with this situation has led it to prepare to change tactics for calming the overheated market emerged last June, when the State Information Centre (SIF), a central government think tank, published this statement: “China should unify its present array of property taxes by cutting transaction taxes while raising taxes on those with multiple homes to penalize speculators without hurting genuine homebuyers.” It went on to state that effective property taxes could replace home purchase restrictions as China’s main tool for controlling home prices.

This was echoed in late August by comments on the PBOC website that the home purchase restrictions should be lifted “at the right time” because they tend to curb genuine housing demand and dampen economic growth. Adopting a position similar to the SIF, the PBOC suggested that an enhanced tax plan be put in place to cool the property market as a substitute for the kind of direct administrative interference with the market represented by the purchase restrictions.

A tax targeting property ownership, if well designed and effectively implemented on the national level, could indeed help wean municipal governments off their long-term dependence on revenues from land sales. An effective tax system that made holding vacant residential units less attractive to investors would obviate the need to impose administrative restrictions on home purchases.

At the same time, while there is a growing sense that purchase restrictions are having a number of unintended negative effects, there is also a feeling that establishing a genuinely effective national real estate tax would require a substantial amount of time.

Local officials are the biggest opponents of a new tax plan: they believe its adoption would lower housing values, thereby substantially reducing the premiums they can collect from sales of development sites. Other obstacles include slow progress on launching a property value assessment system; achieving consensus concerning the specification of the tax base, exclusions, and exemptions; assignment of responsibility for administration of the system, rate setting, and assessment; and allocation of tax revenues.

Despite these problems, it appears inevitable that some form of the tax will be rolled out. The Ministry of Housing and Urban-Rural Development (MOHURD) noted that this new fiscal regime would increase the holding cost of real estate and give owners an incentive to lease out vacant units. But a real estate tax, if imposed nationally, would affect third- and fourth-tier cities more than first- and second-tier cities, where the existence of a more robust leasing market will enable some property owners to pass the new tax burden on to new tenants.

An additional signal that the central government is taking a new tactical approach of advocating desirable kinds of residential sales activity emerged last July when the Ministry of Land Resources (MoLR) announced the launch of a campaign to boost land supply for development of “ordinary” housing—that is, housing for middle-class workers. This represents a profound philosophical shift in that it seeks not to curb sales, but to step up sales of residential property—and specifically to boost the sale of those properties designed and specified to accommodate occupiers of ordinary urban homes.

The MoLR also moved to more closely monitor local land supply, requesting that local governments issue reports on their land supply activities every 30 days and keep land supply for ordinary housing pumped up. It also mandated that municipal authorities continue to keep land prices flat, a directive that brings to mind Persian Emperor Xerxes’s command that his troops lash the sea into being obedient.

At some level, the central government must be aware that the overheated residential market is not simply a function of a supply/demand imbalance. Even if it is only a stopgap measure, creating a supply surge in ordinary housing is not without risks. It is unclear whether the state can effectively “command” commercial activity. Hence, this new directive is not apt to be rolled out with the rigidity of a production order in a state-run factory, but rather will be implemented by municipal governments working in conjunction with developers, who are unlikely to acquire sites blindly but rather will carefully consider their commercial potential.

And increasing the supply of ordinary housing is not easy. Assembling viable development sites is not a minor problem, and it will only grow more difficult because municipal governments are unlikely to willingly give up prime residential sites for ordinary housing development. The consequence likely will be that few major cities will experience oversupply of ordinary housing in the near future.

The long-term overheating of China’s residential market is a phenomenon that is systemic and ultimately related to lack of liberalization of the country’s financial system. The prolonged run-up in housing prices is the result of exaggerated demand caused by a large amount of investment capital being bottled up in the country with no suitable investment alternatives to provide an effective store of value. As a consequence, over the past decade China has been turned into a nation obsessed with real estate, and specifically homeownership, with possession of an apartment being the chief sign of financial security. Although it appears in some cities and in certain market subsegments that as much as 30 percent of the units sold are held by investors rather than end users, it is difficult to distinguish between end-user demand and investment demand because property by nature is both an investment asset class and part of the infrastructure that supports everyday life.

However, it is uncontestable that the weight of investor purchasing interest has been a key factor driving the rapid escalation in residential prices over the past decade. This price run-up has been socially destabilizing because so much of the wealth generated in China during this period has been related to flipping real estate.

At the same time that home purchase restrictions have run into problems due to their market-deflating effect when the central government needs to keep the economy pumped up, the new party secretary and premier will inherit a plan to spend $800 billion to build 36 million public housing units between 2011 and 2015. This ambitious plan has been dogged by funding shortages and accusations that some municipal governments have misallocated funding toward pet infrastructure projects, as well as by questions concerning the fairness of allocation of public housing units. This situation has been exacerbated by the flagging will of the municipal governments to invest in housing low-income families at a time when the cooling economy and declining market in development land have sizably dented their annual revenues.

China’s new party leadership has considerably less room to maneuver than in 2008, when its predecessor applied a massive fiscal stimulus to shield the economy from the global financial crisis. While China has sufficient financial reserves to apply a much more robust stimulus, it could do so only at the risk of making another major round of bad investments and possibly sparking another major boom bust/cycle in the real estate market—something that could be even more destructive than the downside of the current cycle and which the government wishes to avoid at all cost.

The fact that in the fiscal blueprint for the 12th Five-Year Plan, released in late September by the PBOC, the Central Bank was sufficiently confident to set a clear inflation target for 2013 suggests that no major blowout of inflation will occur within the year because of an unexpectedly large spike in credit. The plan also remained vague about timing for movement to full convertibility of the renminbi, an event that would have a profound impact on the domestic real estate market.

Abruptly abandoning home purchase restrictions and making a massive injection of credit may be tempting, but likely would lead to a strong price rebound, which is precisely what the central government wishes to avoid. What tools does the central government still have to keep the lid on housing prices? It would appear there are not many, so the new leadership is left to carry on where the former leadership left off. However, the new leadership at the same time will have to contend with persisting dissatisfaction about home purchase restrictions on the part of municipal authorities, who can be expected to continue pushing their leeway in relaxing implementation of the policy.

Although the new central government leadership undoubtedly wishes to start its term on a positive note, without the enormous clout of former party strongmen such as Mao Zedong and Deng Xiaoping, it is unlikely to take the big state-run monopolies head-on. Instead, it likely will continue pursuing structural reforms, such as phasing in a new national real estate tax system to replace the use of administrative orders to interfere in the market.

Although economic growth in China showed signs of stabilizing slightly in the fourth quarter of 2012 and is likely to hold steady this year, it is unlikely to return to the pistol-hot double-digit pace witnessed earlier. China is now in the early stages of a gradual but inevitable structural shift from fast-paced, investment-led growth to slower—but more sustainable—domestically focused expansion.

While the new leadership will want to keep the public housing construction campaign launched by the previous administration pumped up, some cities will find that revenues from land sales remain below normal, making it difficult for them to meet their development targets this year. Faced with a potential funding shortfall, over the coming year the new central government leadership is likely to increase support for policies intended to attract more private investment capital to the public housing sector, something with which it has enjoyed relatively little success to date. Most of the new public housing–related investment vehicles, such as the proposed Chinese public-housing real estate investment trusts, if they eventually achieve liftoff, will probably mostly capture investment from domestic financial institutions.

The central government is unlikely to publicly change its line about the necessity of strictly curbing speculative investment and rising housing prices, and will certainly not retreat from advocating continued imposition of home purchase restrictions. But if the Chinese economy remains weak, over the coming year the central government will be apt to interfere less in local fine-tuning of purchase restrictions, and affected cities will continue to extend greater flexibility to encourage certain categories of buyers to acquire housing to live in.

In 2013, land sales to developers and residential sales to the public are both expected to rise off the generally depressed levels witnessed in 2012, triggered by a more optimistic mood on the part of the homebuying public following the emergence of a more relaxed credit environment.

Land sales in some cities are expected to return to more positive levels this year, especially in first- and second-tier cities such as Beijing, Shanghai, Nanjing, and Suzhou, where a combination of rising demand and declining construction has resulted in a low level of residential stock in the pipeline. Also, in a geographically diverse group of second- and third-tier cities, spanning southern, southwestern, eastern, northeastern, and northern China, developers recently have stepped up acquisition of sites for residential or composite development at attractive prices—a trend that is expected to continue.

However, the presence of developers that have accumulated substantial inventories of unsold stock will remain a negative force in the market. Many have assumed substantial leveraging in order to bear the cost of carrying these inventories, and those whose portfolios are concentrated in cities with weaker fundamentals will remain under pressure to continue discounting prices.

More specifically, localities where developers have an exceptionally large supply of unsold properties in the pipeline, or where there was excessive speculation during the pre-2011 residential property boom, are expected to continue to experience broad declines in residential prices in 2013. The continued presence of these financially burdened developers and their unsold stock, combined with the drag exerted by the persisting home purchase restrictions, is expected to prevent a strong rebound in the residential sales market in 2013.

However, China’s better-financed developers, which have also been somewhat encouraged by the recent steps toward easing credit, are entering 2013 with an appetite to replenish their diminished land banks and take advantage of still-viable localities where land prices have dropped well below their 2010 peak. These stronger players will be seeking situations where they can find opportunities for distress plays and viable locations or project types not subject to home purchase restrictions or, when selecting sites in larger cities where purchases remain restricted, they will show a greater preference for politically correct but commercially viable parcels zoned for subdivisions of ordinary housing.