Xu Gao on housing sector's centrality to China's economy and how to save it
Xu Gao on housing sector's centrality to China's economy and how to save it
The Bank of China International chief economist and PKU adjunct professor also maps out three policy directions. The best is to let the people truly own the state-owned enterprises.
I read current commentaries - both domestic and foreign - on China’s economy widely. The observation and advice of Xu Gao, Chief Economist and Assistant President of Bank of China International, a securities firm, and adjunct professor at the National School of Development at Peking University, stands out for a few reasons.
Unlike many domestic especially governmental analyses which increasingly tend to downplay the importance of the housing sector, Xu recognizes its centrality in China’s economy, noting its decline cannot be offset by the rapid growth of emerging industries.
China’s real estate companies, many of which have defaulted on its debt, are running short of money. Financial institutions, including banks, are unwilling to lend them money. On the demand side, because they have been for decades selling apartments before completion, homebuyers are now deterred from paying because they worry the houses won’t be completed now that developers can’t even pay their debt.
A key insight here from Xu is that over the past three-plus years, sales of incomplete/presold properties have more than halved, but sales of completed homes remained stable and even grew in 2023. Xu interprets that to mean homebuyers’ boycotts are mostly out of concern for housing developers’ creditworthiness.
The “coordination failure” means the vicious cycle will go on unless the government intervenes. But the Chinese government’s bailing out so far remains piecemeal and largely ineffective. Xu Gao proposes a government-initiated stabilization and relief fund of 1 to 2 trillion yuan [$138-$277 billion] to provide universal support.
The Peking University-trained economist refuses to toe the often-touted line that China’s population decrease has immediately sealed the fate of its housing industry. Xu notes that there isn’t a consistent relationship between immediate demographic shifts and current real estate demand. His evidence is that in 2022 China sees a 1.5% drop in the age group of 25 to 39, the key homebuying people, but its sales of housing area fell 30%; while in 2004 a year-on-year 2% decrease in the same age group's population coincided with a 20% increase in residential sales area.
There is still huge demand for apartments, Xu believes, and given China’s vast size, government-subsidized housing, while commendable, is simply not sufficient. If the current decline of the housing sector, which includes increasingly fewer new supply, he thinks the housing prices, a decades-long complaint of the people and headache for the Chinese government, will surge again in cities - a view not shared by many these days.
China surely needs new growth engines, but Xu says the housing sector’s drop has dragged down the Chinese economy in ways that EVs and solar panels simply can’t compensate. Keeping the fundamentals of the economy is now key and artificially suppressing traditional growth engines can profoundly hinder innovation, he warns.
Beyond real estate, and aimed at the fundamental imbalance of the Chinese economy - the households having too small a share, Xu has been vocally championing the creation of a politically acceptable mechanism that will put China’s vast State-owned Enterprises (SOEs) in the hands of the people. He is not proposing Margret Thatcher-style privatization, but the creation of some multiple state-owned investment funds that should receive SOE equity and then distribute them evenly to everyone, without changing, perhaps depending on how you define it, the state-owned nature of the companies. On that, let’s just say he is too much of an idealist. - Zichen Wang
Below is a translation Xu’s recent video-taped Q&A with Netease Economic Research Bureau of Netease, a Chinese news portal, first published on Friday, May 10. Xu has reviewed and approved the translation. The emphasis is Netease’s.
What is the main problem in the real estate industry: affordability or reluctance to purchase?
The Chinese general populace is not concerned about purchasing houses but specifically about buying pre-sold properties.
Over the past three-plus years, sales of incomplete/presold properties have more than halved, while sales of completed homes have remained stable, even showing an increase in 2023.
In recent years, China's real estate market has encountered numerous problems due to the developers' high credit risks. These risks have significantly deterred public interest in purchasing properties. At the same time, banks and other financial institutions, concerned about the developers' creditworthiness, have become cautious about providing financing and loans, resulting in a reluctance to lend.
The reluctance to purchase, coupled with the reluctance to lend, has in turn exacerbated the financial pressure on developers and heightened their credit risks, creating a vicious cycle.
Given that pre-sold homes constitute a significant segment of the housing market, the sharp decline in their sales has triggered a plunge in the broader sales of the market.
Indeed, in China, there is a substantial market for resale homes and homes that are previously owned but not inhabited. Nonetheless, this market is defined by a phenomenon I describe as "the margin leading the stock," where the sale of new homes drives the market for resale homes. Thus, new homes play a pivotal role in shaping the overall market dynamics.
From this perspective, the primary issue in the real estate industry currently stems from developers' constrained liquidity and elevated credit risk.
The economic downturn resulting from the real estate sector slump also significantly contributes to the decline in income expectations on the demand side. Since real estate is a key driver of demand within China's economy, the primary concern in the real estate market continues to be the credit risk of developers.
To expedite the recovery of the real estate industry, supportive policies must focus on this primary concern.
However, since last year, numerous policies targeting the real estate sector have failed to address the core issue, focusing instead on boosting demand by easing purchasing restrictions and reducing mortgage rates. As these measures do not tackle the root problem, their impact on revitalizing the industry has been limited.
Furthermore, the real estate market is currently undergoing a severe contraction in supply with no clear end in sight. The supply of real estate has significantly diminished over the past few years; since the beginning of 2021, the area under construction has decreased by more than two-thirds.
This is why I am concerned about a potential surge in urban real estate prices in the coming years. Despite the current downward pressure on prices, the existing oversupply could soon shift to an undersupply, potentially leading to substantial increases in urban housing prices within the next few years. The logic is straightforward: supply has significantly contracted, and on the demand side, people are not refraining from buying homes; they are just hesitant to purchase pre-sold homes. Therefore, demand for home purchases is merely suppressed—not eliminated—by the high credit risks of real estate developers.
What is the key to overcoming the real estate slump?
The immediate priority for the Chinese government should be to restore market confidence in developers, which, I'm afraid, will likely require the use of public funds to provide direct support to developers. The market is currently suffering from a significant coordination failure due to developers' high credit risks.
To address this, it is essential to rebuild confidence and correct the market's coordination failure. It is recommended that the government establish a real estate stabilization and relief fund with 1 to 2 trillion yuan [$138-&277 billion] to provide universal support.
As long as state-backed funds are injected into the market, financing from other commercial institutions will likely follow, breaking the market's coordination failure and transforming the industry. This approach is essential for resolving the current situation.
To date, no similar policies have been introduced. A policy initiative aimed at ensuring the delivery of pre-sold projects was proposed in 2022, but it has been primarily project-based. So is the project whitelist mechanism introduced this year that allows banks to lend with confidence to companies on the list. While these policies have been helpful, they fall short of breaking the industry's current vicious cycle.
Projects are managed by developers; so if these developers are financially unstable, more projects may face complications. Additionally, there is a significant risk that policies intended to safeguard projects could inadvertently increase financial pressure on real estate developers.
In a scenario where a nationwide real estate developer with projects across multiple regions. Local governments, keen to ensure the completion of projects within their jurisdictions, would have a strong incentive to freeze project funds locally to guarantee that investments are channeled into local developments. This action could prompt other local governments, which might not have initially planned to freeze funds, to do the same, potentially leading to a "bank run effect."
In such scenarios, the pressure on real estate developers can escalate dramatically, as reallocating funds between projects becomes challenging. What is now required is comprehensive financial aid to help developers quickly normalize their cash flows. This approach is crucial to addressing the ongoing challenges in the real estate industry. Ensuring the stability of developers is essential for the successful delivery of projects.
How do you understand the business logic of the real estate market?
The leverage ratio in the real estate industry is indeed notably high and has been increasing over the past decade. This phenomenon is in fact directly linked to the lack of price elasticity in land supply.
The contraction of land supply marks 2004 as a crucial turning point. After August 31, 2004, known as the "831 threshold," all land transfers had to be conducted through the "bidding, auction, and listing" method. Following the "831 threshold," there was a significant reduction in the growth rate of land supply, leading to a shortage. This shortage, in turn, has resulted in the continuous rise in land prices.
In this context, developers' taking on more leverage is a normal business arbitrage. On one hand, rising land prices offer the promise of lucrative returns from holding land, enabling entities to profit significantly from price differences. On the other hand, the cost of borrowing funds from financial markets is relatively low compared to the high investment returns fueled by rising land prices. Therefore, by continually increasing their leverage, companies can capitalize on the difference between from low cost of capital and high returns from land, as well as returns on the property. This is, in fact, the market at play. From this perspective, the high leverage behavior of real estate developers is intrinsic to market dynamics.
What is the primary issue in the current real estate market?
The primary issue in China's real estate market over an extended period has been the lack of market adjustment in land supply, i.e., insufficient price elasticity. When housing prices rise rapidly, land supply does not expand sufficiently to moderate these increases. Additionally, in regions with strong appeal for population influx, such as major cities on the eastern coast of China, land supply is relatively scarce, whereas in central and western regions—where housing prices are lower and some areas even experience significant population outflows—land supply is more abundant. This results in a spatial mismatch in land allocation
When land supply fails to adjust in response to price changes, such as by increasing supply where housing prices are high or in areas where prices are rising, housing prices will naturally remain elevated. Local governments, as the sole suppliers of land, need to fully understand and respond to this dynamic.
Of course, this perspective does not negate the role of land finance but rather calls for optimizing its operations to better support economic growth while making housing more affordable for the public.
For the real estate sector in China, it is essential to introduce stronger market mechanisms in land supply, allowing it to respond to the price signals of housing in both time and space dimensions.
Blindly dismissing land finance or the real estate sector is not advisable. Instead, it is advisable to address the bottlenecks hindering industry development, thereby enabling more efficient resource allocation by the market.
What would be an objective and rational assessment of the real estate industry?
The real estate industry is undeniably a cornerstone of the Chinese economy. Its significance is reflected in its contribution to GDP, investment, and employment, as well as its influence on a vast array of upstream and downstream industries. Moreover, the industry plays a crucial role in fulfilling the public's aspirations for improved living standards and conditions.
Yet the industry has its own share of challenges. Often, the focus tends to shift towards the industry’s problems rather than its contributions. It is only when the industry suffers substantial damage and its contributions falter that the importance of real estate is fully realized. This underscores the current predicament of the real estate sector.
The current decline of the real estate industry cannot be offset by the rapid growth of emerging industries.
Therefore, prudence is required in formulating economic policies. The notion that "real estate is problematic and needs a restart" is perilous.
In my opinion, one cannot deem a phenomenon incorrect or propose changes to it without understanding its rationale. Currently, some perceive the real estate sector as purely detrimental, advocating for its overhaul. However, this overhaul itself is a key reason behind its current weakened state, plunging the industry into an unprecedented vicious cycle.
The priority should be to restore normalcy to the real estate sector. The government's introduction of "Three Major Projects," [develop government-subsidized housing, renovate urban villages, and build dual-use public infrastructure that can accommodate emergency needs] including the ambitious construction of government-subsidized housing, is commendable. However, if the current downtrend in the housing market continues, it may prove challenging to stabilize real estate investments through these initiatives alone.
While projects like government-subsidized housing are vital due to their public welfare nature, they should supplement rather than replace market mechanisms. Given China's vast size and the extensive housing needs of its population, relying solely on government-subsidized housing to fulfill these needs is impractical.
Therefore, the initial step should be to adjust real estate policies to rejuvenate the market. Subsequently, explorations can be made regarding new models for real estate that align with high-quality growth principles.
In an era of an aging population and declining birth rates, how much housing demand does China actually have?
Discussions about real estate often utilize population data, which can lead to biased perspectives. For instance, the assumption that the current demographic trends indicate a declining demand for real estate is premature and lacks a robust data-driven foundation.
Observing the demographic shifts among 25 to 39-year-olds, who are primary homebuyers, relative to changes in the real estate sales area, shows that population changes are significantly smaller than those in the real estate market.
This is because population metrics change gradually, and population shifts might be hard to recognize on a year-to-year basis. Thus, using population to gauge real estate demand means using a long-term, slowly changing variable to explain the economic cycles and industry fluctuations that occur on monthly, quarterly, or yearly scales. Consequently, the two do not align well.
According to data from the United Nations, the population in China aged 25 to 39 decreased by approximately 1.5% in 2022, while the residential sales area fell by nearly 30% that year. Despite the large disparity in these rates, both metrics show a decline. However, contrasting data in 2004 reveals a different scenario: a year-on-year 2% decrease in the same age group's population coincided with a 20% increase in the residential sales area. This historical comparison suggests that there isn't a consistent relationship between demographic shifts and real estate demand.
In fact, using population to discuss real estate demand is an overly simplistic concept of "counting heads," that is, more people means more housing demand, and fewer people means less housing demand. But demand is not just a number but a function influenced by various factors. When we talk about demand, we are talking about a demand function. The current low demand for home purchases is primarily due to high housing prices which suppress potential demand. If prices were reduced, demand would likely rise, highlighting the need for a nuanced understanding to inform policy effectively.
What is the relationship between real estate and new productive forces?
Undeniably, it is essential for the Chinese economy today to cultivate new productive forces and promote innovation. However, the most important thing to do now is to stabilize the macroeconomy, and the key to stabilizing the macroeconomy is to cover the base.
From 2022 to 2023, real estate investment experienced an average annual decline of over 10%, making it the most significant drag on the Chinese economy. Meanwhile, in 2023, the total sales of retail goods, an indicator of consumer consumption, showed positive growth, albeit at a modest pace. Although exports notably weakened in the latter half of 2023, entering a phase of decline, China's ability to influence these trends is limited due to heavy reliance on external demand. Moreover, data from January and February 2024 indicate a significant rebound in exports. Regarding investment, China's investment is primarily divided into three sectors: infrastructure, real estate, and manufacturing. In 2023, both manufacturing and infrastructure investments showed robust growth rates, pinpointing real estate as the principal area of risk.
Real estate, often considered an "old" industry, continues to play a pivotal role in the economy and is far from obsolete, as the public's aspirations for a better life are fundamentally tied to basic needs such as housing, food, clothing, and transportation.
Therefore, the current priority should be to keep the fundamentals of the economy stable, stabilize economic growth, and provide businesses with a normal operating environment. When businesses achieve comfortable profits, the entrepreneurial spirit will thrive, fostering extensive experimentation and trial and error, which are essential for genuine innovation. Conversely, artificially suppressing traditional growth engines can profoundly hinder innovation.
What are the optimal, suboptimal, and worst solutions for China’s economic challenges?
Over the past several decades, consumption has accounted for a relatively low proportion of China's overall economy. This situation has led to a lack of a sense of gain among the general populace, with many feeling a disconnect between GDP growth and their personal financial situations.
At the core of this disconnect is the need for a structural adjustment in income distribution, which is crucial for addressing the challenges within China's economy.
It is important to clarify that the proposed income distribution adjustment extends beyond the household sector to include the relationship between the corporate and household sectors. Typically, households function primarily as consumers, while businesses act primarily as investors. Therefore, the distribution of income between these two sectors plays a crucial role in determining how income is allocated between consumption and investment.
As is widely recognized, China's economy is characterized by excessive investment, which can result in low returns on investment (ROI). Under such circumstances, an effective strategy could be to withhold further investment and transfer income to the public, thereby enabling consumers to increase their spending. Achieving this shift necessitates a significant transfer of income from the corporate sector to the household sector.
In a pure market economy, the transfer of income between corporations and households can typically be achieved through dividends. This mechanism of income transfer, coupled with the guiding price signals of ROI, plays a crucial role in regulating income distribution to prevent long-term underconsumption and overinvestment.
However, this model does not fully apply to China. Here, corporate dividends to households presuppose substantial direct shareholdings by individuals. While state-owned enterprises (SOEs) in China are owned collectively by the populace, the general public lacks influence over SOEs' operations. When the ROI is low, it is challenging for residents to demand a share of corporate earnings for consumption. As a result, China faces persistent issues of underconsumption and overinvestment.
The optimal solution involves directly addressing the root causes. By effectively linking SOEs with the household sector and fostering a competitive market for state ownership, it becomes feasible to align the preferences of households with the investment behaviors of SOEs. This strategy, without altering the ownership structure of SOEs, would establish a market-based mechanism for the distribution of income between the corporate and household sectors, thereby balancing investment and consumption.
Implementing this optimal solution, however, takes time. Before a market mechanism for income distribution is fully established, economic policies must focus on constrained optimization.
Given the current limitations on substantial income redistribution to consumers, persistent deficient consumption is anticipated. Consequently, it is essential to leverage investment to stimulate demand and stabilize growth, or the economy risks sliding into recession or even crisis.
China's investments predominantly focus on three areas: infrastructure, real estate, and manufacturing, which together account for about 80% of total investment. The "suboptimal solution" relies on investment in infrastructure and real estate to stimulate demand. Exclusive reliance on manufacturing investment might exacerbate overcapacity, as these investments transform into supply once projects are completed.
Investments in infrastructure and real estate can be considered "quasi-consumptive" investments. They do not lead to a direct expansion of production capacity but enhance residents' welfare and living standards. Hence, in the absence of reforms to the social distribution structure, demand should be driven by infrastructure and real estate investments—this approach represents as suboptimal solution for China’s economic challenges.
Some may oppose infrastructure and real estate investments citing potential side effects. Some even advocate for "de-investing" in these sectors. However, pursuing this path could place China in a situation where income distribution limitations continue to suppress consumption. With investment intensity being inadequate, this may lead to an economic slowdown stemming from insufficient demand. Such a downturn would not inherently rectify income distribution imbalances, so it won't spontaneously reconfigure economic structures to stimulate growth, thus potentially leading to prolonged economic stagnation. In my view, this represents the worst solution.
China has had similar experiences. From 1998 to 2002, China experienced five years of deflation, during which the main policy approach was to reduce excess capacity.
Following the Asian Financial Crisis in 1997, China set an 8% economic growth target in 1998. Despite measures such as expanding domestic demand and issuing special government bonds, the country failed to meet this target. Subsequently, the country embarked on a large-scale restructuring of SOEs, which led to significant layoffs of workers. The economy did not rebound until 2003, not due to efforts to reduce excess capacity but rather due to increased external demand following China's accession to the World Trade Organization in 2001.
Currently, without effective policy stimulation in real estate and infrastructure, the challenges might be more severe than those faced in 1998.
Under the current income distribution structure, China has an excess supply that can either be utilized domestically in infrastructure and housing construction or exported overseas. However, exporting this supply risks provoking protectionism in other countries, making it unrealistic to expect a surge in external demand like that experienced in 2001 following China's WTO accession.
In summary, the strategic choices are clear: either develop consumption through income distribution reforms, which is the optimal strategy or stimulate investment, particularly in real estate and infrastructure, which represents the suboptimal strategy. These approaches are essential for achieving internal economic balance.
Given a comprehensive understanding of macroeconomics and the recognition that the macro economy functions as an interconnected system of balances, making strategic choices between optimal, suboptimal, and worst options should be straightforward.
More details into his arguments above can be found in The East is Read, a sister newsletter
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