abc UBS Investment Research Macro Keys Measuring Property Bubble in China Global Investment Strategy Global Strategy Hong Kong 22 March 2011 www.ubssecurities.com China has had a construction boom for much of the past two decades. Rapid income growth and growth of urban population were key factors behind the property boom, with the help of the housing reform in the late 1990s which resulted in a large one-off asset transfer from the state to the urban population and unleashed huge pent-up demand for modern commodity (private) housing. Tao Wang Economist S1460208080042 wang.tao@ubssecurities.com +8610-5832 8922 Global Macro Team Has China built a big nationwide property bubble and is it about to burst? A year ago, we tried to answer this question in 10 big questions on China s Property, but we think the continued attention and confusion, as well as new developments and understanding about the issue warrants an update. Our short answer is: we are a short-term bull and medium-term bear. The main points are summarized below but look out for a more comprehensive report in the next day or two. Identifying a property bubble before it bursts is always difficult. At the moment, looking at some usual indicators such as housing prices (and derivative indicators such as affordability ratios), construction activity and household leverage, we do not think China has built a big nation-wide bubble. The sharp rise in housing prices in 2009-2010 led the government to restrict commodity housing purchase in large cities, but the push for large-scale social housing construction is likely to give support to overall property construction in the next couple of years. However, we think the risk of a property bubble in the coming years is very high. The poor data quality makes us less comfortable with the general benign picture and recent property sector developments show some alarming signs. Most importantly, various rounds of property sector policy have not addressed many of the fundamental issues, and these factors provide fertile ground for a property bubble in China. Predicting the timing and trigger of a bubble is difficult. We will continue to closely monitor construction activity across the country, along with developments in housing prices and bank credit. Does China have a property bubble? Housing prices Usually, an extended period of rapid housing price increases could be an alarming signal of a housing bubble. In the case of China, the average price for new residential housing in urban areas grew by an average of 9% a year in the past decade, and at double digit in 2009. In an economy where urban household disposable income growth averaged 10% a year, such a pace of housing price growth does not look out of place (Chart 1). This report has been prepared by UBS Securities Co. Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 8.
However, the official housing price data is not adjusted for location or quality. Since the majority of sales are new properties that tend to be built further and further away from city centres, the official price data does not capture well how house prices rise over time. Centaline, the largest real estate intermediary in the secondary market, also publishes average prices for secondary home sales for large cities. Their data show that average prices in large cities have grown much faster than indicated by official housing price data for these cities. However, Centaline data have only limited coverage. A popular indicator used to assess a property bubble is the affordability ratio calculated by dividing average home prices over average household disposable income. Chart 2 below shows the ratio of average prices of a 100 square meter apartment in cities over the average urban household disposable income, which is basically a different way of presenting data in Chart 1. One frequent remark on China s property market is how high average home price is compared to average income on average, it will take 9-10 years of income to buy an apartment and in large cities the ratio has recently deteriorated to 20. In developed economies, this ratio is typically 4-6. Chart 1: Household income has outpaced official housing prices 1999=100 320 300 280 260 240 220 200 180 160 140 120 Urban household disposable income Price of a 100 sqm house 100 1999 2001 2003 2005 2007 2009 Chart 2: Implied affordability index looks alarmingly high Average price of a 100 sq m property over urban household disposable income 12 11 10 9 8 7 6 5 1997 2000 2003 2006 2009 However, the affordability index for China is highly flawed both the numerator and denominator have serious data issues. On the numerator, we already know that the average prices are based on sales of mostly new commodity housing, and not adjusted for quality and location. The issues with the denominator are arguably even bigger. Basically, the average household that buys a home is not a household with an average income. Given that private housing market only got started in the mid 1990s, the penetration of such housing is still low. Commodity housing is still mainly targeting the middle and upper income urban population. The cumulative completion of commodity housing between 1997 and 2010 is about 54 million units, compared to a total of 215 million urban households. According to official statistics, the average income of the top 20 percentile of the urban population is 2.2 times of the average urban income, and that of the top 40 percentile is 1.7 times of the average, which is almost certainly an underestimate. Therefore, for people who so far bought commodity housing, the affordability index would measure 4-5, very much the international norm. UBS 2
Another indicator related to housing prices is rental yield, the return to property asset. Data on rental yield is poor, but according to Centaline, rental yields in tier 1 cities have been low and have dropped recently to below 3% (they are close to 2% in Shanghai). Housing leverage Past experience shows that a credit boom almost always accompanies or predicates a property bubble. In the case of China, mortgage lending grew rapidly in 2009-2010 but has slowed in recent months following restrictions on second and third mortgages and higher interest rates. Lending to property developers has also slowed in recent quarters. Chart 3 shows household mortgage relative to their disposable income. Two things are immediately noticeable: household leverage ratio is still at a moderate level at end 2010; but it did surge in 2009 and 2010 a credit boom was behind the housing market boom in these years. The sudden rise in household leverage suggests that given time and opportunity, Chinese households could rake up debt rapidly. There are two more comforting pieces of data. First, importantly, new mortgage finance value relative to the value of commodity residential sales, our proxy for loan-to-value ratio, has come down in 2010 after surging in 2009 (Chart 4). This is consistent with our belief that affordability is not an issue for most/many of the actual home buyers. Second, overall direct bank exposure to the property sector is still at relatively stable level even after recent increase. However, banks indirect exposure to the property sector could be significantly larger. Loans to many local government investment platforms and to the corporate sector are often backed by land and property collateral, and borrowing by these entities for general fixed investment could be diverted to property development. In addition, given the importance of the property sector as the final destination for many industrial products, investment of and credit to many heavy industrial sectors are indirectly exposed to the property sector as well. Chart 3: Household leverage is still moderate but rose sharply in 2009-10 Share in disposable income (%) 70 Chart 4: Mortgage loan-to-value ratio is relatively low Net new mortgage finance relative to commodity residential sales value (%) 80 60 50 40 30 20 10 Consumer loans Housing mortgage 70 60 50 40 30 20 10 0 1997 1999 2001 2003 2005 2007 2009 0 2004 2005 2006 2007 2008 2009 2010 UBS 3
Construction activity Another sign of property market bubble is a period of a sudden rise in construction activity. Just before the Asian financial crisis, the economies that later saw a property market bubble burst all experienced a surge in construction activity (Chart 5). In the case of China, construction activity as a share of GDP has stayed relatively stable in the past decade, picking up somewhat in the last couple of years. Compared with countries prior to the Asian financial crisis, China s activity level does not look that alarming. However, we have seen a steady rise in the trend, and continued rise in construction activity would bring China in worrisome territory on this metric. Alternatively, we can look at the physical construction rather than value added. Comparing construction per capita, China is building about 1 sqm of housing per capita on average over the past decade compared to a likely figure of around 1.5 sqm per capita in the US and Spain before there bubbles burst, although in the past two years China s housing effort has increased to about 1.3 sqm per person in the urban areas (Chart 6). Of course, given that China is a country that is going through rapid urbanization, the comparison with developed economies may not be all that appropriate. Chart 5: Construction as a share of GDP Construction and real estate value-added share in GDP (%) 20 18 16 14 12 10 Korea 8 Taiw an Malaysia 6 Thailand Hong Kong China 4 1980 1985 1990 1995 2000 2005 Chart 6: Construction per capita Residential housing construction per capita (sqm completed, annualized) US 2.4 Spain China 2.0 Japan 1.6 1.2 0.8 0.4 0.0 2000 2002 2004 2006 2008 2010 Housing stock Earlier this year some investors sounded alarm about China s high housing stock value as a share of GDP, and compared it to that of Japan before its property bubble collapsed. Our own estimates put China s stock of (urban) residential property much lower, at about 75% of GDP (Chart 7). In principle, the valuation of housing is relevant for a risk assessment of a housing bubble, and we would expect the value of the stock of housing in China to be much lower than in developed countries. However, different assumptions about depreciation and housing values can lead to different estimates. Moreover, how housing stock value differs between countries is influenced by many factors, including the depth of the financial sector, the tax regime and other elements in the policy setting. We do not view this is a good indicator for assessing a property market bubble. UBS 4
Chart 7: The value of housing stock Household housing w ealth 600 % of GDP 500 % of disposable income 400 300 200 100 0 China 2010 US 2006 UK 2006 Germany 2006 Japan 2006 Source: CEIC, OECD, UBS estimates How about the physical stock of residential housing? The numbers here makes us somewhat less sanguine. We estimate that China has built a cumulative of 120-140 million units of urban housing since 1990, on top of more than 80 million units that existed before then. This is a large number, compared to a total of 215 million urban households in 2009. Of course, many old units were barely liveable and many have been torn down in the meantime, and more than 10 million people will be urbanized each year in the coming years. Nevertheless, the phase of rapid build up of urban housing to satisfy the pent-up demand may be close to an end. Will China have a property bubble? Short-term bull, medium-term bear To summarize the previous section, although there are some signs of alarm, and there may be ghost towns and localized property bubbles, at the aggregate level, it does not seem that China has already built a big nationwide property bubble. Can China avoid a property bubble in the medium term? We think it will be very difficult. In the short term, we think the risk of a property bubble burst is small. The ongoing property tightening measures are unlikely to bring a sharp drop in property construction the government is balancing restrictions on commodity housing purchase with a push for social housing construction. We think the pick up in social housing construction this year and next will more than offset the likely weakness in commodity housing sector. Home prices are unlikely to fall significantly as the leverage in home purchase is relatively low, income is rising rapidly, and expectations of future price increase remain very strong. However, in the next few years, the risk of China accumulating a large property bubble is quite high. Even as the government attempts to stabilize housing prices with various administrative and supply side measures, we think the following fundamentals provide fertile ground for a property bubble in China: A combination of high saving rate, under-developed capital market and a closed capital account means that a large share of household wealth still exists in the form of bank deposits (Chart 8). As investment or assetdiversification demand for housing rises, the shift from bank deposits to property asset could cause a bubble UBS 5
without much household leverage, as increased flow of funds to property lead to higher property prices, which in turn attracts more shifts. Low deposits rates (set by the government), together with the lack of a property tax and other carrying costs, makes people tolerant of low rental yields and facilitate the shift of saving from banks to property assets. The lack of adequate rental yields also reduces the supply of rental properties and adds to scarcity of housing resources in the market. Local governments are the monopoly suppliers of land for urban housing construction. As monopolies that rely heavily on land revenue for discretionary investment spending, local governments have strong incentives to push up land and property prices as well as overall property construction (Chart 9). The corporate sector has high saving and retained earnings, helped by distorted factor prices and no need to pay dividends, and is increasingly attracted to invest in land and property, partly because of inadequate corporate governance and entrance barriers in many other sectors. The focus on urbanization as a driver for domestic demand and growth in the coming years is often interpreted by local governments and the general public as urbanizing suburban areas with property construction. This could lead to accelerated build up in the property sector that could not be sustained in a few years. The intentional and mandated segregation of urban and rural land and housing markets constrains supply of urban housing and pushes up urban housing prices. At the same time, discounting rural housing stock and property construction could lead to overbuild in the overall property sector. Against the general background of ample liquidity, low interest rates, and the focus on the urban property construction aspect of urbanization, we think it may be very difficult for China to avoid a property bubble in the coming years, particularly if policies do not address the fundamental issues above. Chart 8: A large share of household wealth exists as bank deposits Chart 9: Land sales made up 30% of local government s finances in 2010 Urban housing stock 39.5% Bank deposits 42.2% Land sales revenue 29% Local govt revenue 39% Insurance policy Bonds 4.2% 1.1% Equity 13.1% Transfer & tax refunds from central govt 32% UBS 6
What to watch and what might be the trigger? How will this end? We do not think that China s property bubble will necessarily manifest itself in sky-rocketing prices and a subsequent sharp price decline, and in any case there is no good price measures to follow. Given that households have strong balance sheet and have usually put down 30-40% of their own cash into home purchase, they are unlikely to walk away from servicing their mortgage debt. Compared with economies where a property bubble was led by a housing credit bubble, the chance of large bad debt resulting from mortgage loans and large foreclosures is small. A more likely scenario is that one day, household sentiment toward additional properties shifts and demand for homes drop sharply. The property sector finds itself with too much supply, and more importantly, all the related construction material and heavy industry sectors that sells to property construction find themselves with excess capacity and extra inventory. Banks lending to these sectors and companies would then run into trouble. This is especially so since Chinese banks tend to rely heavily on collateral value in their general lending. Adding banks exposure to these sectors, the share of banks portfolio that would be affected by a property bust would be quite large. What could be the trigger? The exact trigger is difficult to predict. An aggressive credit tightening, a sharp rise in interest rates, the opening of portfolio outflows, a sustained good performance in equity market or other asset market that draws funds away from property to other assets, are all possible candidates. It is also possible that at some point housing prices stop rising, and the real negative returns on housing asset lead to a drop in demand. At least from the surface, there is not a sustained credit boom and alarmingly high leverage related in the property market. This means that the process of a bubble accumulation and burst in China could be less sudden and more drawn out than in other economies. In addition, if the current plan of social housing construction is carried out faithfully, the increased supply of low cost housing could help to stabilize housing prices and influence market sentiment gradually. What should we watch? We should continue to watch all the indicators we mentioned in the previous section, not necessarily the level, but the trend over time. Most importantly, given the poor quality of the price related data, we should watch closely construction activity and credit expansion. So far our two favourite indicators are our UBS property construction index and monthly bank lending. However, our property construction index uses activity data from urban commodity housing market, which could become less useful in tracking future developments as social housing and construction in rural areas become more important, which are not adequately covered in commodity housing data. Also, office and commercial space are mostly constructed outside of the commodity housing market since companies, local governments and related entities often engage in such development on their own. We will have to watch nationwide completion and construction more closely in the future. UBS 7
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