China real estate bubble

I have been engaged in a friendly debate with a number of economists about when China’s real estate “bubble” will finally burst. The opinions of the economists vary. Some believe the bubble will never burst. Some project the bubble will burst “sometime” in the future. The future date is usually something vague like 2013. The argument being that the Chinese government will not allow the bubble to burst until after its 2012 power transition.

For the last year, I have been arguing that all these projections are too optimistic and since June I have been contending that the bubble has already burst.

Recent events here in Qingdao (where I live) illustrate my point. Since June of this year, officially advertised prices for new residential real estate projects in Qingdao have fallen an average of 30%. In a market that has seen nothing but price increases for many years, this has been a shock to local real estate purchasers. As is typical in China, most new real estate projects have not been completed. In a typical project, buyers purchased in June for a project that will not be completed until sometime at the end of next year. Now they are seeing units in that same complex being sold at 30% or more less than what they paid in June. Since prices are still in free-fall, they have no idea how bad it will be.

Owners in these projects have formed groups on QQ and Weibo to discuss their fate and to share rumors. On many projects, these unfortunate buyers have demanded the developer reduced their prices to match the recent discounts. In the alternative, they have demanded their purchase contracts be cancelled. Most of these buyers have paid substantial down payments, so the reduction in price or the cancellation would require the developer to pay refunds to the buyers. Of course, none of these remedies were contemplated in the real estate purchase agreements and for this reason, most Chinese real estate developers have refused to cancel purchase contracts. As a result, many buyer groups have organized formal protests, picketing at the sales offices of distressed projects. These protests have had some impact and there are reports some of the larger real estate developers are starting to offer at least partial price discounts. No developers have offered refunds.

The impact of the price decline has been considerable. Since the prices are widely advertised in the local newspapers and other media, the decline and the amount of the decline is well known in the local community. Most local residents have real estate fever, and they will freely tell you that prices have declined a minimum of 30%. This has had an immediate impact in three important ways. First, the sale of existing units has fallen dramatically. The only sales occurring are for drastically discounted units, with 30% to 50% discounts becoming normal. Second, work on uncompleted projects has slowed or stopped. Thus, all those buyers who paid deposits risk being trapped in permanently uncompleted projects. Third, the purchasing of undeveloped land has virtually stopped. Even though the local government has offered substantial discounts on land, with so many dead or dying projects littering the local landscape, developers are in no mood to take on new land at any price. This is particularly true in since Chinese law prohibits requires land be developed within two years after its purchase. The lack of land sales then means the primary source of income for the local government has dried up.

In response to this, the Qingdao government has announced a number of new measures intended to loosen many of the restrictions on purchasing residential real estate that have been imposed over the past several years. This includes a reduction in interest rates, a reduction in the amount of down payment required, and a relaxation on restrictions on purchases of residential real estate for purely investment purchases. The government is confident these changes will bring the real estate market back to a “normal” level, with normal being defined as approximately the price level of June of this year with no major increase or decrease. The local newspapers carry articles virtually every day explaining how 2012 will mark a return to the formerly strong real estate market of the recent past.

However, these policies appear to conflict with the most recent decision of the central government to leave the recent restrictions in place. Beijing apparently believes that the bubble has not burst but rather that the real estate market is returning to a normal, healthy condition. Whether any of the locals believe the above is “healthy” and “normal” is not known to me because I do not care. To put it bluntly, I am certain the Chinese real estate market cannot be guided be back to a healthy, vibrant state in 2012.

Once a real estate bubble bursts there is no government powerful enough to stop the resulting collapse in prices and subsequent effects. The real estate bubble has burst in China and the government must now work to contain its impact. Though governments cannot stop a real estate bubble from bursting, they can play a role in dealing with the impact. Some governments push the economy to recover quickly. Others take counteractive measures that make matters worse. We will have to wait and see which approach China takes. So far, the signs are not encouraging.

What are you seeing out there?

Update: A number of readers have written to point out a very good article by Patrick Chovanec in Foreign Policy Magazine, entitled China’s Real Estate Bubble May Have Just Popped. To put it mildly, Chovanec too seems very worried by what he is seeing with China’s real estate market.