What 'houses are for living' means economically

The sentiment of Xi Jin Ping that 'Houses are for living, not for speculation' is a positive sign. What would the market look like if speculation could be curbed, and housing could be affordable?

How we got here

The housing market in China is in serious distress, and prices are dropping. To some analysts, this is vaguely painted as a negative, but it is a natural economic process. Currently, there are far too many houses (apartments) in China, although many of them are unfinished, while demand for housing has reduced sharply. In addition to the massive number of unfinished apartments, there are also certainly a very large number of finished houses that were bought by investors. The era of increasing price is over, and these investors are left holding the apartment they hoped to sell at a profit. To the extent that they can, they will be looking to sell, even at a steep discount.

The government tends to blame speculators, but the rise in house price was dictated by government policy, fanned by the media, and supported by the interests of local governments. There is much blame to share here.

Local governments had every incentive to attract housing projects, and every incentive to maximize the price they were paid for the parcel of land by the developers. More land sales at higher prices were very much in the interest of every local leader, the government leaders and the party leaders. They certainly benefited personally, at least to some extent, because rising prices meant that their personal housing and that of their friends and relatives increased in value. The local government controls most of the land and buildings in their areas, excepting only lands held by the army and the Central government. Local officials have a lot of power in determining who gets the ownership and control over every development in their area, with only other political forces limiting their physical and practical scope of control.

Rising land prices also benefited local leaders professionally. Increased sales at higher valuations contributed to GDP growth, and local contributions to GDP growth are a major way that local officials bolster their images and get promotions. More local land sales brought in more cash, and more cash also obviously helps local officials.

Ironically, local officials were probably in the best position to see the overgrowth of unfinished apartment buildings, but their interests did not align with reporting the problem. In China, as a general rule, reporting problems is unwise; rather than gaining praise for identifying serious problems, the result is much more likely to be criticism or even punishment. Local officials are expected to be responsible for their areas, but they are not in fact so all-powerful. This problem is a national problem, and while officials were a part of the puzzle, they were not the major driver of the problem.

For example, would a local official be able to do an in-depth appraisal of the solvency of an entity like Country Garden prior to agreeing to a deal? I think the answer is obviously no, and therefore the local officials can't be blamed for Country Garden's failure.

That blame should rest on the regulators of Evergrande and Country Garden.

So national problems will not be reported by local officials. They will ignore small projects that have stopped, and hide big ones, afraid of punishment for things far beyond their control. Their behavior in this regard has been wise: The local official is much safer in the situation we are now in, because his error is also the error of a huge number of other local officials. The Central government doesn't oversee local officials properly, and they can only follow the incentives they are given. The Central government also should regulate large entities like Evergrande, and they have not.

The rise in housing prices was also driven by Central government policy. The constant government requirement of mandated growth means that the banks have to lend. Their managers will be evaluated based on the amount of the loans they issue. Much is made (correctly) about the inability of private firms to get financing, and this is because of the position of the bank managers. They have to extend loans, they will lose their bonus and even their job if they do not, but loans to private firms contain more risk, economically and professionally. Economically there is less certainty of repayment from a private firm compared to the alternative, like an SOE or a big property developer.

China's policy can shift in a heartbeat, and private firms are always on the margin in some way or another. The space for profit of a private firm can disappear very quickly. Professionally, a bad loan to a private firm will lead to serious questions and consequences for the bank manager. Questions will be raised about the possibility that the manager conspired with the lender in some way. Supervisors will question the data that led to the decision to lend. A big loan to a private firm can end a bank manager's career if it is not repaid.

So what is our intrepid manager going to do? The answer, very obviously, is extend loans to 'safe' borrowers, not necessarily solvent or profitable, but rather politically safe. SOE's are always good borrowers, government-backed investment funds are considered safe.

The bank manager has little choice, as the options for lending are quite limited. Based on the requirement of lending, (the demand from the government to lend), the bank manager likely has little power with regard to the borrowers. There are large numbers of such 'safe' borrowers, but there are also a lot of bank managers with the same requirement to lend.

The requirement to lend excessively may have come from the bank itself, but underlying all of this story is the Central government's belief that it can force economic growth to happen through the yearly growth target policy. By setting this target, a strong signal is sent to market participants, like the big banks, the property developers and the local officials. Sell, borrow, buy, or else. Real growth is a secondary consideration.

Although the property developers are private entities, due to their size they are still impacted by the growth target. Evergrande is or was headquartered in Shenzhen, and Shenzhen officials have the burden of mandated growth. That pressure to grow was certainly put on Evergrande by local officials.

Finally, the media. The media picks up on anything they can sell as 'proof' of China's power. Rising house prices were painted as a good thing, when if fact they were a problem in the making. The media helped sell the theory that prices will always rise, a belief that was prevalent for many years. 'The government will never let prices fall' was a statement that was just ubiquitous, and this belief was re-enforced, again and again. The media would report on the higher prices of land in Beijing, but not report that transactions fell to extreme levels. Are prices really higher when only a few entities are buying?

Where we can go

If houses are to be for living, not speculation, the first requirement is that houses are relatively cheap. Not free, but not excessively expensive. Of course, to curb speculation some limits on house ownership will be needed. Still, house buyers must be able to sell and transfer their ownership, when they move or when they decide to buy another place. Loans should be available to those that need them, so that young people can start a family.

This requires land prices to drop; this is a necessity. The Central government must allow local prices to decline to natural levels, and likely to even lower levels at first. The price level is far, far too high now, and prices will drop anyway. That isn't a negative thing, it's a positive.

This means losses for many people and families, but that is offset by a new normal where housing does not weigh on their minds so heavily. Even after a family has a apartment, they often still have housing needs, for their parents or their children. Having an apartment that is valued at a high price is nice, but other housing is equally expensive, and so the problem of housing is not abated. This is why families save such an enormous percentage of their income.

The Central government of course will have to take on a great deal of debt; this will be absolutely necessary. Banks are too deep into real estate, and will need to declare a lot of losses.

This is why it will be so important to identify which developments must be completely abandoned and which must go on to completion. Taking on all the losses of this economic process would cripple the Central government and government banks for years, if not decades.

Still, we've got an interesting situation here, with way too much housing. That's a problem, but also an opportunity.