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China’s Real-Estate Wrongs

YAO YANG

Yao Yang is Dean of the National School of Development and Director of the China Center for Economic Research at Peking University.

JUN 20, 2014

China’s Real-Estate Wrongs

BEIJING – China’s real-estate sector has been a source of serious concern for several years, with soaring property prices raising fears of overheating in the housing market. But, with price growth easing, it seems that the government’s campaign to rein in property risk is finally taking hold. The danger now is that the housing market will collapse – bringing China’s economic prospects down with it.

In its effort to control rising housing prices, China’s government has pursued nine distinct policies, not all of which have served their purpose. Though policies like limits on mortgages for first-time buyers and minimum residency requirements for purchasing property in a first-tier city like Beijing or Shanghai helped to ease demand, supply-side tactics, such as limiting credit to real-estate developers and imposing new taxes on property sales, have proved to be counter-productive.

This flawed approach allowed China’s housing prices to continue to rise steadily, fueling major housing bubbles, especially in first-tier cities. The average Beijing resident would have to save all of his or her income for 34 years before to be able to purchase an apartment outright. In Shanghai and Guangzhou, the equivalent is 29 and 27 years, respectively – much higher than in other major international cities.

The expectation that this trend will continue has driven homeowners to retain possession of their properties, even though rental rates amount to less than 2% of a property’s market value. But, with the real-estate sector finally facing a downturn, the time to rethink this investment strategy has arrived.

In the first four months of 2014, housing sales dropped by nearly 7% year on year, with construction of new floor area falling by more than 22%. As a result, downward pressure on property prices is mounting.

In normal times, citizens and officials alike would welcome this trend. But, at a time of weakening economic performance, China cannot afford an implosion of the real-estate sector, which accounts for at least 30% of overall growth. Indeed, though China’s government has expressed its willingness to sacrifice some growth in its pursuit of structural reform and rebalancing, the impact of a housing-market collapse on the financial sector would cause growth to slow beyond the acceptable limit.

That impact partly reflects the highly problematic nature of the Chinese government’s long-awaited move to liberalize interest rates. Instead of taking a direct approach – lifting the interest-rate cap imposed on banks – liberalization has been achieved by allowing shadow banking to flourish. As a result, a large number of nonbank financial institutions – such as wealth-management companies and online financial-services providers – are now using promises of high returns to attract small investors. Making matters worse, the monetary authorities have tightened the credit supply, in an effort to deleverage the Chinese economy.

While both interest-rate liberalization and deleveraging are critical to the long-term health of China’s economy, the skyrocketing cost of borrowing is forcing many low-risk companies, which are unable to offer sufficiently high rates of return, out of the market. At the same time, real-estate developers who have borrowed heavily from shadow-banking institutions, based on the assumption that property prices would continue to rise steadily, may struggle to repay their debts, with a sharp decline in prices inevitably leading to defaults. Given that the formal banking sector provides a large share of shadow-banking finance, this could initiate a chain reaction affecting the entire financial sector.

Many remain convinced that China’s government – which wields with the world’s largest foreign-exchange reserves and virtually unchecked authority – would be able to prevent a major financial crisis. But the financial crisis in the fast-growing city of Wenzhou, triggered by bad loans, suggests otherwise – not least because the economy has yet to recover fully. There is no reason to believe that a similar crisis could not occur on a national scale.

To avoid such an outcome, China’s leaders must urgently adopt counter-cyclical measures. They should begin by eliminating non-market-based restrictions on the real-estate sector, which have generated serious distortions not only to the economy, but also to people’s lives, with couples divorcing temporarily to gain the right to purchase an additional apartment.

When it comes to the real-estate sector, China’s government has consistently had the right objective and the wrong strategy. It is time to align intention with action. Otherwise, China’s financial sector – indeed, its entire economy – will suffer.

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About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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