Pinpointing the Bubble in China's Real-Estate Market

The big risk comes from developers who took on too much debt, not homebuyers.

Ghost town.

Photographer: Qilai Shen/pictures ltd/corbis/getty images

Americans enjoy an unusual kind of security -- their big, domestically focused economy isn’t very vulnerable to external shocks. But most people around the world don’t have that luxury: Their jobs, businesses and livelihoods are very sensitive to events in far-off lands, and the choices of leaders they don’t elect. Right now, much of the world is in danger from a potential recession in China.

China, which still is the biggest contributor to global growth, has been looking shaky for a couple of years now. Growth is down from insanely fast to moderately fast. The stock market rose and crashed. Liquidity problems have been common in the banking sector, and a lot of money has flowed out of the country. So far, through all of this turbulence, growth has managed to hold up -- or at least it has, according to the official statistics.
QuickTake China's Pain Points

But it’s the housing sector that will really make or break the country’s economic destiny. Prices fell in 2014 and early 2015, and it looked as if the long-promised Chinese housing crash had finally arrived. But then prices recovered, as they did after another smaller fall in 2011 and 2012. Now they’re on the rise again:

On a Tear

Average residential property prices year over year in 70 top Chinese cities

Source: Bloomberg Intelligence

If a true crash ever does come, it may well be catastrophic. China doesn’t have well-developed stock markets, so households save a lot of their money, directly or indirectly, in housing and land. Much of the economy itself is based on real-estate development. Land also tends to be highly leveraged, and asset-prices crashes that involve lots of debt tend to be devastating for growth. So Chinese housing prices are hanging like an economic Sword of Damocles over the head of the global economy. Will the sword fall soon?

Everyone in the finance industry no doubt has an opinion on this very big question. Academic economists have looked at it too. It no surprise that different researchers have come to different answers.

Some economists -- like many industry professionals -- interpret the housing boom as a bubble. Kaiji Chen and Yi Wen of the Federal Reserve Bank of St. Louis have a model in which demand for housing as a savings vehicle kicks off expectations of rising prices that then become a self-fulfilling prophecy. They write:

In our model, current generations of entrepreneurs seek alternative stores of value for their rapidly growing wealth. In a financially underdeveloped economy with a limited supply of financial assets, housing becomes a natural investment option…This sustains a self-fulfilling growing housing bubble…Our theory also predicts that such a fast-growing housing bubble will lose steam…as surplus labor is exhausted in rural areas.

This is an interesting theory, because it draws together most of the ideas that people have been tossing around regarding China’s economy over the last decade, and puts them all together in one unified model. And it reaches the same conclusion many industry people have arrived at -- Chinese housing is in a bubble that will crash when the country’s rapid catch-up growth flames out.

But the strength of this model -- its plausibility -- is also its weakness. It’s built from conventional wisdom. That’s a valuable exercise, because it shows that all the various pieces of conventional wisdom fit together into one logically coherent story. But the theory hasn’t undergone a trial by fire yet -- it hasn’t been tested against data. So if conventional wisdom is wrong, the theory’s prediction of a crash won’t come true.

Some other recent papers take a more agnostic view. Jing Wu, Joseph Gyourko and Yongheng Deng, for example, note that price-to-rent ratios are very high, meaning that small downward revisions in growth expectations could cause prices to fall a lot. But unlike Chen and Wen, they don’t have a model that predicts doom.

A more sanguine view is put forth by the prestigious team of Hanming Fang, Quanlin Gu, Wei Xiong and Li-An Zhou, in a paper called “Demystifying the Chinese Housing Boom.” These authors construct house price indices for Chinese cities, and they find that in most cities, price appreciation is being driven not by unrealistic expectations but by rapid income growth. Chinese people, they contend, are making more money, so they’re spending it on housing.

Yes, Chinese homebuyers are paying huge percentages of their income to buy property. But Fang et al. note that there’s no obvious reason to believe this behavior will stop any time soon. The authors are not very worried about a bubble or a financial crisis. They also note that Chinese homebuyers make large down payments, which means they’re less reliant on debt than their American and Japanese counterparts. “The Chinese boom,” they write, “is different in nature from the housing bubbles in the U.S. and Japan.”

So which academic team is right? Is Chinese housing a bubble, or isn’t it? In fact, all three teams of authors make important points. But I think all three ignore the highly leveraged corporate sector. Homebuyers may not be borrowing like crazy, but real-estate developers and many other companies have. If slowing economic growth causes households to pull back on their housing purchases, it could be companies, and the banks that lend to them, that are on the hook. Even if Chen and Wen are wrong, and the housing market isn’t a true bubble, a downturn could still wreak a lot of damage on the Chinese economy -- and on all the economies around the world that are dependent on China.

So I think it does make sense to be concerned.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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