Andy Xie on China’s Empty Apartments

I recall a presentation on China at the Asia Society on the eve of the financial crisis, in which an economist commented on China’s extremely low interest rate on deposits (less than 1%) versus its markedly higher inflation rate, and commented that that was a recipe for hyperinflation. Well, that hasn’t been and is unlikely to be the result. Instead, we are seeing an even more extreme version of what negative real interest rates in the US produced: leveraged asset speculation, particularly in the biggest asset class, residential real estate.

Recent articles in media have illustrated how out of line prices are with incomes and rental yields. Reader Glenn Stehle highlighted a key factoid in a recent New York Times article on China’s real estate bubble boom:

And as the prices of new apartments soar — in Shanghai, for instance, they often exceed $200,000, while the average disposable income is about $4,000 a year — the trend also threatens to undermine the central government’s goal of affordable housing for the rising middle class.

We noted that the Chinese officialdom is worried about the social implications of overpriced housing. Richard Smith, who provided a series of posts on China’s real estate markets (here and here), tried making sense of the investment math:

The residential RE stuff is completely baffling: the valuation differences between cities are large; but none of them look cheap. Shanghai may be extreme – but even at the more modest (!) house price = 8x salary in other cities, a 30-year mortgage @ 6% or so takes 60% of gross average income (unless my calcs are completely shot) . So I can’t understand who is buying housing at all or how or what they are living on – even if the parents and grandparents are helping out their 1 child, it is quite a stretch. Rental yields 2-4% depending on location so that’s no good if there’s much gearing.

Another piece of the puzzle comes from Andy Xie (Caixin via MarketWatch), that the number of vacant apartments in China, the result of speculative warehousing (purchased as an investment but kept vacant) plus new construction languishing unsold is much greater than commonly realized:

How many flats in China are sitting empty? The media recently floated a story — denied by power companies — that 64.5 million urban electricity meters registered zero consumption over a recent, six-month period. That led to a theory that China has enough empty apartments to house 200 million people….

What especially distinguishes China’s property bubble…is an unprecedented amount of living space. This huge stock of empty flats equals the nation’s quantity bubble.

Quantity bubbles are less common than price bubbles, and they don’t last as long…A quantity bubble is sometimes a construction bubble, and it fizzles out when a building cycle turns over, crashing prices as soon as new supply becomes available….

Quantity and price bubbles may grow together. Southeast Asia, for example, experienced a quantity-cum-price bubble that lasted several years in the 1990s. As regional currencies were pegged to the dollar, loose monetary conditions were imported from the United States, fueling a property bubble. Due to few restrictions on urban development, rising prices led to massive increases in supply. Liquidity inflow fueled speculative demand. But when U.S. monetary policy tightened, the market crashed and triggered the Asian Financial Crisis…

One useful figure for analysts is China’s living space per capita….Based on this limited data, however, we can confidently conclude that China does not have a housing shortage. Moreover, its per-capita living space is higher than in Europe and Japan. Indeed, if we adopt Japan’s standard, China already has sufficient urban housing space for every man, woman and child in the country.

Far more important than general data, however, are the housing figures pointing to a huge quantity of empty flats apparently being held only for speculation.

In a normal market, the vacancy rate should be equal to the number of households relocating, times the average transition period, plus newly formed households times the average purchase period. For example, a vacancy rate of 1.5% could accommodate a market in which 6% of households relocate every year, and the transit time is three months. If new household formation is 3%, and the average period for a property purchase is six months, this factor requires a vacancy rate of another 1.5%. The total normal vacancy rate should be 3%. This figure includes the new properties ready for sale.

Although the government doesn’t publish vacancy data, I think the vacancy rate for the nation’s private, commercial housing stock is between 25% and 30%. That’s at least double what’s required in a normal market. The gap between what’s needed and what’s available can be viewed as speculative inventory. The value of this inventory held by speculators is probably around 15% of GDP. It’s being kept on ice, just as copper and other commodities are hoarded in anticipation of rising prices…

Right now, tight credit is holding back the market, and supply is piling up on the developer side as inventory. The government’s tightening squeezed buyers of second and third homes, and transaction volumes across the country collapsed. What I’ve learned from intermediaries is that most property demand now falls into restricted categories, i.e., speculative.

It’s reasonable to assume, therefore, that the supply would be close to 15% of GDP in value this year and in 2011. That’s because when the policy is relaxed — as most expect — speculation will probably revive and lead to a doubling in the total value of speculative inventory.

Chances are good that policy makers will indeed relax policy. In some cities, banks are already loosening a bit. A key reason is that local governments have a lot of debt — commonly five times more debt than revenue — and could get into financial trouble without a decent level of property transactions.

Local governments in China depend on real-estate deals for revenue and could default if the market falls too far. Thus, the central government may loosen policy to help the locals without making a formal announcement. Such a change of heart would ease short-term government difficulties but double the trouble down the road when the property bubble bursts.

So even if China’s stock of empty flats is only half that recent estimate of 64.5 million, it would still be equivalent to 20% of all urban households. That’s higher than Taiwan’s vacancy rate at the peak of its bubble. Moreover, as credit rules are loosened, the stock could rise to more than 30%.

China’s housing oversupply isn’t surprising. Excess supply reflects the under-pricing of capital, and China’s system is structured to increase supply quickly. But rising prices alongside rising vacancy rates are surprising. Normally, speculators are spooked by high vacancy rates. But China’s phenomenon is unique for at least four reasons:

1) A sustained negative real interest rate has led to a falling demand for money and rising appetite for speculation. Greed and inflation fears are working together to form unprecedented speculative demand for property.

2) A massive amount of gray income is seeking safe haven. China’s gray income of various sorts could be around 10% of GDP. In an environment of rising inflation with a depreciating dollar — the traditional safe haven — China’s rising property market is becoming a preferred place to park this money.

3) Few people in China have experienced a property bubble. The property crash in the 1990s touched a small segment of society, such as foreigners and state-owned enterprises. Geographically, it was restricted to the country’s freewheeling zones in Hainan, Guangdong and Shanghai. Most people didn’t even know there was a property crash. This ignorance has led to a lack of fear that’s now turbo-charging greed.

4) Speculators think the government won’t let property prices fall. They correctly surmise that local governments rely on property deals for money and do all they can to prop up prices. But their faith in government omnipotence is misplaced. At the end of the day, the market is bigger than the government. The government can delay, but not abolish, market forces. Nevertheless, faith in government is replacing fears of a downside, and speculative demand will continue to grow as long as credit is available….keeping interest rates low will only worsen the nation’s bubble problem. Periodic credit tightening and crackdowns on speculation won’t work because they are not taken seriously and never last….

One only needs to glance at modern-day price and quantity property bubbles around the world to understand the stark consequences. What’s happening to the U.S. economy now is a prime example, and it should be lesson for us. Otherwise, China’s economy will look like America’s.

Notice the bind China is in. It has to keep the bubble going to preserve local government finances. They’ve become a classic Minsky Ponzi unit. And efforts to move away from the dollar as reserve currency, something which China desires from a practical and prestige perspective, only makes the domestic bubble worse.

We’ve pointed out repeatedly that creditor nations typically fare the worst in severe financial crises. China appears to be defying that pattern, but the implosion of its real estate bubble may prove it to be no exception.


Originally published at naked capitalism and reproduced here with the author’s permission.