China's Financial Risks are Really About Land Prices
The recent sixth plenum of China's top party leadership concluded that "China will focus on combating asset bubbles and preventing economic and financial risk." This statement reflects widespread worries about two possible bubbles — a debt bubble and a property market bubble. Actually, the two are related, and the common factor is the surge in land prices over the past decade.
Concerns about China's debt problem typically point to two key debt indicators: the debt-to-gross-domestic-product (GDP) ratio, and the increase in the debt-to-GDP ratio. Globally, China's debt-to-GDP ratio of around 250% puts it right in the middle — higher than most developing countries but lower than most developed. This is what one might have expected. Thus the debt-to-GDP ratio by itself does not necessarily signal a financial problem.
What matters more is the exceptionally rapid growth in the debt ratio. Most countries that have experienced such a huge surge have crashed. Thus, why not China?
Normally, rapid credit growth shows up as either GDP growth or inflation. But this was not the case for China. GDP growth has been declining steadily, and growth in producer and consumer prices has been minimal or even negative. Solving this puzzle requires understanding the links between where the credit went and its impact on GDP growth and asset prices.
China is unique in that most of the debt surge since the global financial crisis in 2009 is accounted for by the corporate sector. Most of the firms involved are state-owned. And most of the lending has gone into property development and infrastructure rather than industrial expansion.
The result is that the flow of credit facilitated a huge increase in fixed asset investments (FAI), which as a share of GDP went from around 45% a decade ago to 80% today. But a surge in FAI is not the same as GDP growth. In the national accounts, FAI includes land transfers and related price increases, but what counts as investment for GDP purposes is gross fixed capital formation (GFCF), which excludes the value of land and transfers of existing property. What happened during this period was that the credit surge fed directly or indirectly into a nearly fivefold increase in the price of land in the major cities and threefold in the smaller ones.
In most countries, even a doubling of property prices would be seen as a bubble. Surely, then, a three- to fivefold increase must be a bubble?
Yet China is unique in that a private housing market only came into existence in the late 1990s, when households were allowed to buy their homes. And only in 2004, after the first land auctions were launched, did the value of land, which underpins the value of property, become subject to market forces. It was around that year that the FAI and GFCF ratios began to diverge. In essence, China's land or property prices went essentially from nothing in the former socialist system to a valuable and tradable asset in today's more-market-driven economy.
Thus, whether China has a financial problem depends on whether the current price of land (property) is sustainable. If it is, then much of the increase in the debt-to-GDP ratio over the past decade is what economists would call "financial deepening" — a positive development — as financial markets are establishing the value of real assets, which were largely hidden before.
The answer might come from looking at comparators.
Many have focused on property prices in Tokyo, New York or Hong Kong. But per capita incomes are much higher in those places. Consider India – another developing country with a huge population relative to available arable land. Few realize that property prices in Delhi and Mumbai are twice as high as in Beijing and Shanghai. Alternatively, consider Russia, which underwent a similar privatization of its housing in the late 1990s with the result that property prices in Moscow rose tenfold in the subsequent decade.
Both India and China's property prices are distorted by land management, tax policies and zoning regulations. In China's case, hukou residency restrictions and the absence of rural land markets also matter. Currently, nationwide there is considerable excess inventory that will restrain near-term price increases, although bouts of speculative purchases will periodically drive up prices in China's mega-cities such as Shenzhen where supply is much tighter.
Overall, affordability as measured by the ratio of incomes to housing prices has been improving even as prices have surged and excess inventories have been declining. But ultimately, only the passage of time will tell us whether property prices in China are too high or too low.
The author is a senior associate at the Carnegie Endowment and a former World Bank Country Director for China.
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