Features | Economy | East Asia

If China’s Property Bubble Bursts

The cooling of China’s real estate sector is good for the economy. But the government is right to be worried about the social consequences of the bubble bursting.

By Eve Cary for

In October, Beijing announced that four city and provincial governments – Shanghai, Shenzhen, Zhejiang and Guangdong – would be allowed to start issuing bonds for the first time in China’s history.  Zhejiang is expected to issue $8 billion yuan in bonds, including half three-year bonds and half five-year bonds. The proceeds are intended to fund infrastructure projects already under construction.  

But why now?  What was the impetus for this unusual step? 

Quite simply, it’s a financial pacifier – recent central government policies aimed at cooling down real estate have hurt local governments, who rely on land sales and development fees as their most important sources of revenue.  As these revenues fall, local governments will become increasingly desperate to find other means to finance infrastructure projects and social services.

Real estate has certainly been a boon for local governments.  Land revenue, garnered from a variety of fees and taxes, is particularly attractive because it’s considered extra budgetary income, which isn’t counted in the central government’s accounting of local government budgets and thus can be kept and used with no strings attached by local governments.  As a result, the revenues coming from commercial and residential land leasing and sales have become the most important source of local revenue, accounting for 30 percent to 50 percent of rural government revenues, and 50 percent to 60 percent of city government revenues. 

Real estate has also made a difference to local officials politically: local officials are evaluated for promotion based heavily on the rates of growth in their jurisdictions, as well as the amount of revenue they collect and their revenue contributions made to higher levels of government.

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Land transfer fees form another crucial piece of the pie: in 2007, land transfer fees were 67 percent of Sichuan Province’s local revenue, and 40 percent of Chongqing’s. In 2010, land transfer revenues totaled 3,000 billion RMB ($464 billion), which was more than 70 percent of local government revenues. This year, HSBC estimates that land transfer revenues will be less than 2,000 billion RMB. 

Clearly, local governments depend heavily on revenue from land sales, transfer fees, and other real estate-related fees and taxes. Now, after years of gangbuster growth, central government policies aimed at avoiding a bubble burst have dampened the real estate market. 

Property prices have finally begun to slow this autumn, with average property prices in a 70-city index seeing their first monthly decline in several years.  In addition to the impact of the current slowing, there also remains the possibility that the real estate bubble could burst.

Unlike the U.S. bubble, a bubble burst in China wouldn’t spell doom for the homeowner – in China, real estate investment is a vehicle for saving, not borrowing, and required down payments are 30 percent to 40 percent, limiting debt levels.  Instead, local governments will take the brunt of the slowdown or bubble burst as result of their heavy reliance on real estate revenues.  

As mentioned, local governments will experience a significant loss of revenue, and not just from a decline in land sales: local governments also rely on income from construction and the production of raw materials that goes into construction.  

In 1994, fiscal decentralization reformed China’s revenue sharing system, effectively reducing local governments’ share of the central revenue stream while increasing their responsibility for providing social goods.

For example, local governments’ share of revenue fell from 85 percent in 1978 to just 45 percent in 2002, while their share of total expenditures increased to 70 percent from 53 percent in the same period.  Subnational governments account for 79 percent of government budgetary expenditures and are responsible for providing the vast majority of social services. As a result, a decline in local government revenue could have significant consequences for schools, hospitals, and social welfare programs. 

Local governments may also find themselves dealing with more social foment. Fewer construction projects and reductions in the demand for raw materials and equipment would lead to a significant uptick in unemployment – a major cause of social unrest. Protests arising from unemployment are particularly difficult to deal with as it’s a legitimate issue that other Chinese citizens are often sympathetic to, and local governments have trouble framing the protestors as rabble-rousers or troublemakers.  

Though mortgage defaults would be rare, social discontent would likely blossom over lost equity. Social instability would also have political consequences for local governments. As important as growth rates are in promotion calculations, levels of social unrest may play an even bigger role – large and visible protests are a sure way to get demoted in the Chinese political system.  

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Loan defaults are another likely – and dangerous – consequence. Local governments rely on unconventional means of financing, including local government financing vehicles, which have grown dramatically since 2008, and are estimated to number 10,000. Land value is often used as collateral, meaning that a fall in land prices could lead to underwater loans and defaults. For examples, local financial institution surveys in China reveal that 90 percent of land developers expect to repay loans from increased value of land. In Liaoning in 2010, 85 percent of local government financial vehicle loans missed debt service payments (according to the Liaoning Daily website), and local government debt as of the end of 2010 was estimated to be 10.7 trillion yuan.  While the central government expects that 2.5-3 trillion will be defaulted on, Standard and Chartered estimates that that number will be closer to 8 to 9 trillion yuan. In fact, Cheng Siwei, deputy head of China’s 9th National People’s Congress, noted that China’s “version of the U.S. subprime crisis is the lending to local governments, which is causing defaults.” Defaults will certainly impact smaller financing vehicles, though state banks are relatively safe.  China Bank Regulatory Commission (CBRC) Chairman Liu Mingkang has stated that based on a stress test conducted in April, Chinese banks can withstand a 50 percent drop in property prices. 

Personally, local officials will suffer from a real estate downturn – many of these taxes and fees are a source of personal enrichment, and local officials often receive kickbacks from local developers. And as local governments benefited when real estate flourished, so they will suffer as real estate cools. For a number of structural reasons, local governments will be hit hard by the real estate slowdown, and would be deeply affected by a bubble burst. 

While revamping the system entirely (i.e. changing the revenue/expenditure division system) is out of the question, the Chinese government has taken some positive steps, including allowing the issuance of bonds. 

Additionally, officials launched a pilot property tax in January 2011, starting with the cities of Chongqing and Shanghai. The property tax originally targeted a small sub-section of large, expensive homes, though the project has been expanded in Chongqing to include other properties, such as second homes.   A property tax will provide an additional revenue stream that may help shift local government reliance away from development taxes and fees.

In the long run, cooling the real estate sector is positive for the economy and local governments. Rampant real estate development has led to rapid economic degradation, has had the potential to lead to a devastating bubble, and has sparked social unrest through government land grabs. Still, one thing is clear – the adjustment for local governments will be far from easy.

Eve Cary is a researcher at the Brookings Institution in Washington.