Real estate bubble that refuses to burst

In seeking remedies, need to look beyond the symptoms to the causes

The announcement of an interest rate cut on June 7 coincided with claims from several quarters that the number of houses being sold in many cities is rising and that price falls are easing. Given that real estate regulation has failed more than once in the past, there are many who suspect that the present round of regulation will end the same way and that house prices will start rising again.

As long as the real estate bubble continues, such speculation is unlikely to abate. But this real estate bubble seems to be unlike previous ones, and there is no easy way out.

What traditionally happens with such bubbles is that the value of real estate rapidly increases until it reaches unsustainable levels and then rapidly falls. The bubble is thus burst, leaving in its wake a tide of mortgage debt and defaults.

There are at once similarities and differences between the economic circumstances of China today and Japan of the 1990s, when the latter experienced a real estate bubble.

From a monetary policy perspective, it could be concluded that both bubbles were unavoidable. The amount of broad money (M2) China holds is almost twice its GDP, similar to Japan but much different to the US and Europe, whose ratio of M2/GDP is less than 1. This means China uses a great deal of money to support rapid economic growth. It can be assumed that once economic growth slows, money will flow from other industries to real estate and cause a real estate bubble, similar to what happened in Japan in the early 1990s.

But China's situation is not the same as what happened in Japan, where a free market system holds sway and land can be freely traded. In China, almost all land is controlled by the government, and in order to look after all its people there is no less than 120 million hectares of arable land. So land prices in China are not really decided by market demand and supply.

In China there is a widening gap between rich and poor, which means the rich can afford high housing prices while the poor cannot even afford a small apartment. Houses and land are scarce resources and are good investments when there are few investment opportunities and the broad money is much higher than GDP.

The peculiarities of China's market system as it relates to housing, together with the gap between rich and poor, mark out its real estate bubble as decidedly different to a traditional one. The most important characteristics are its size - bigger - and the period over which it bursts - longer. The later feature can be attributed to broad money continuing to increase through many channels, such as government investment and bank loans, the gap between rich and poor not narrowing and land supply remaining tight.

Of course, a prolonged real estate bubble brings with it a plethora of ills, such as unfairness, widespread speculation, the distorted allocation of resources and increased living costs. So the central government has tried everything to rein in prices, including a policy of restricting people buying additional apartments, and prices have at least come to a standstill.

Restricting the purchase of additional apartments, which puts a lid on housing prices and on sales, is little more than a stopgap measure giving the government more time to implement more effective measures. Thus the incessant rumors that the government will ditch buying restrictions policies.

The truth is that although local governments are trying to get around restrictions on buying additional apartments, the central government has stuck to its original policies, any fine-tuning having been structural rather than substantive. So any increases in sales have been mild, and mainly as a result of demand from those buying an apartment for the first time, the kind of purchase that is encouraged.

As for reports that in some cities thousands of people were lining up to buy houses, they can be dismissed as isolated cases or simply as real estate marketing ploys.

As house prices have risen over many years, government regulations have been in place, so it might be concluded that such regulations can never stop price rises, which accounts for the big real estate bubble we are now living through. But a more important and meaningful question is what happens to the bubble from here.

We know it will last for some time, and over the period it will fluctuate in its severity. Short-term factors that will determine that severity include any financial difficulties local governments face, the determination of the central government, the financial pressure on real estate developers and the number of first-apartment buyers.

The number of houses being sold in the past month may coincide with a confluence of factors: in poor macroeconomic circumstances many people are holding out the hope of policies that are not restricted to interest rate cuts; local governments, under the increasing pressure of debt, are trying to get around real estate trading restrictions; running low on funds, real estate developers are pulling out all the stops with their marketing; those who have been sitting tight waiting to buy a house have decided they can wait no longer.

In the short term the bubble is stable and is not ready to burst, but in the long term that burst will finally come. The longer the bubble lasts the more harm it will do, so what can be done to shorten its life?

Unfortunately, there is no easy way out, as long as demand is high and supply is low.

In China, the rich have a weighty say in driving demand. They buy additional houses to guard against depreciation, which is why the old regulations did not work, whereas curbs on buying additional apartments do work. In addition, supply is inextricably linked to land supply, the main source of income for local governments.

It seems that demand from the rich remains strong as long as the gap between them and poor continues to widen. It seems, too, that land cannot be freely traded on the market and the only land provider, the government, will provide little additional land.

The government is now considering imposing high property taxes to deter people from holding multiple sets of apartments, but the fact remains that the rich feel they must find some way of hedging against inflation.

When all is said and done, the real estate bubble may be a symptom of a disease rather than its source. The main sources of that disease are a lack of investment opportunities and the widening income gap.

And what causes those hot beds of disease to flourish? While the entrepreneurship of the private sector is tied and bound, government money-making activities, including those of State-owned enterprises, are allowed free rein.

China needs a small State-owned economy, a marketing system of land, a dynamic private sector and a policy to reduce the gap between the rich and the poor. Until some of these are improved there will be problems, and they will not be limited to a mere real estate bubble.

The author is a lecturer at the Management School of Shanghai University and a research fellow at the China Europe International Business School Lujiazui International Finance Research Center. The views do not necessarily reflect those of China Daily.