Zhao Yanjing on China's Real Estate Crisis  

Zhao Yanjing, “China’s Real Estate at a Crossroads”[1]
 
Introduction and Translation by David Ownby
 
Introduction
 
Zhao Yanjing is a professor of urban planning at Xiamen University in Fujian, and a frequent commentator on national and international affairs (see his Aisixiang profile here).  I don’t think he is particularly famous, but he writes interesting articles on timely topics in a very feisty style, adopting a “truth-telling tone” similar to that of Sun Liping in Sun’s blog posts (see here for an example of Sun in truth-telling mode).  I first noticed Zhao right after the beginning of the pandemic , because he wrote an interesting piece that I translated on how China should “get its narrative” right on the virus.
 
The piece translated here, on China’s real estate crisis, is much closer to Zhao’s specialty as an urban planner than the coronavirus pandemic, and I chose it because the topic does not seem to come up that much in the mainstream press I read (there are surely think-tank pieces galore).  My impression is that Zhao published it first on the Aisixiang website on May 18, 2022, after which it was picked up by financial publications and websites (see here and here).
 
China’s real estate market is enormous, plays a huge role in China’s (and thus to some extent, the world’s) prosperity, and—according to many analysts—is on the brink of a collapse that would burst China’s economic bubble and spark a global economic downturn.  The market has been booming for decades, as residential property serves as the major investment vehicle for most Chinese, and the boom has of course fueled speculation, which naturally encouragers developers to borrow ever more money to build ever more houses to keep up with demand.  

In Zhao’s telling, the cause of the current crisis is the central government’s clumsy, populist efforts to control housing costs through price controls and other measures, all of which mean that developers cannot make their money and pay their debts.  If companies like Evergrande, the one that makes the most headlines, fail or declare bankruptcy, banks and lenders throughout the world will start to call in their debts sector-wide, and the economy will crash, affecting developers, lenders, homeowners, the construction industry, the home renovation industry, the home furnishing industry…A version of this happened in Japan in the early 1990s, and Japan’s economy has never quite recovered.  For good, concise overviews of the property market situation in China in English, see here and here.
 
I do not read a lot about real estate, so am perhaps an easy “sell,” but I find Zhao Yanjing’s arguments sensible and persuasive.  He correctly points out the oversized role that land and land sales have played in China’s economic development—local governments in particular have leveraged land sales to underwrite economic growth—and points out that when the central government intervenes to slow speculation through price and other controls, this kills the goose that has laid hundreds of golden eggs.  Superficially, of course, this puts Zhao on the side of the greedy capitalist developers and against the poor suffering consumers, but as he puts its, China’s capital market is essentially the property market, and if real estate values do not continue to rise, the logic of the system quickly turns unhealthy and systemic growth slows. 
 
Zhao’s ultimate proposal is two-fold:  central and local governments should act quickly—immediately, in fact—to reverse last year’s policies that sought to cool the market down by ending speculation, because without speculation, asset prices go down and certain healthy incentives go away.  At the same time, Zhao insists—citing Singapore as his model—that governments should invest massively in affordable housing to balance out the speculation.  

To him, this is the best way to keep ever more Chinese moving into the middle class—and ultimately the upper class.  Those who were priced out of last year’s overheated residential property market can spend a few years in subsidized houses, saving their money and building up assets to enter the speculative housing market at some future point should they so desire.  Zhao argues that a huge state investment in affordable housing would be much smarter than building more roads and airports, which is where China usually focuses its “infrastructure spending” when times are hard.
 
Zhao offers any number of technical arguments and proposals on which I am unqualified to comment, nor can I really assess the likelihood that state-built affordable housing could readily complement developer-built speculative housing in a market as large as China’s (Singapore can keep its house in order in part because the house is so small).  But Zhao’s argument certainly conveys the complexity of the situation, as well as the challenges faced by China’s government, by which I mean both the real estate market and commentators as astute as Zhao Yanjing. 
 
Translation 
　　 
One, An Evaluation of the Current Situation
 
The real estate data for April is out, and while it looks like housing prices have gone down, we are a very long way from a situation that is “stable, healthy, and sustainable." The latest economic data shows that whether the real estate collapse will have a broad impact on the economy is no longer a matter for discussion. The fact of the matter is that the fall in housing prices has neither boosted the real economy nor solved the housing problem. In the midst of a “once in a century major change in the world,”[2] recent real estate policy has put China's economy at risk.
 
What is the current state of China's real estate?  To my mind it is in crisis. The diagnosis we make at this moment is extremely important, as it will decide whether careful adjustments to the situation will suffice, or if instead it is time to rush to the ICU because if we don’t get on the ventilator at the absolutely right moment, China's economy can go south in a heartbeat. Real estate problems are already having ripple effects on the financial system, and China’s economy’s rapid slide since last year is mostly the result of the downturn in real estate.  Despite the central government's repeated emphasis on preventing systemic risk, the latest economic data show that the possibility of systemic risk has increased, with the trigger point being real estate. 
 
The rapid spread of the epidemic and changes in the international situation undoubtedly had an impact on China's economy in the second quarter. But these are scratches and bruises, not "underlying pathologies" of the Chinese economy, and while they may look bad, in fact their effects are superficial and fleeting. As long as there are no problems with the financial system, the economy will immediately spring back to life once these crises pass. China's economic development, which has repeatedly recovered from crises, illustrates that the ability to resist uncertain external shocks depends critically on one’s own resistance. And how much resistance China can muster is decided by China’s capital market, the heart of which is real estate. 
 
There is a danger that external shocks such as the epidemic or deteriorating international relations will be used to explain the recent economic downturn. Overstating the impact of the epidemic and focusing too much on unexpected events such as the Russian-Ukrainian war can lead to a fatal misdiagnosis of China's economic situation. While the impact of these factors on China's economy cannot be ignored, it is only impacts that are delivered through the financial system that they can trigger economy-wide chaos. Such chaos can in turn amplify the consequences of external shocks and even bring about external shocks that could originally have been avoided. And the root cause of the chaos in the financial system is China's main source of capital—real estate. If real estate crisis is not solved, then neither monetary nor fiscal policy will do any good, and the disaster that did not happen in 2008 may indeed come to pass.
 
Two, Why I Think We’re in a Crisis 
 
China's response to today’s crisis will depend on our understanding of how China weathered past crises.  The reason I see real estate as the source of the present crisis is because real estate was closely linked to China’s emergence from past crises.  
 
The first crisis was 1989.  The current explanation for the end of this crisis was Deng Xiaoping’s “Southern Tour” in 1992, which allowed China to emerge from the 1989 crisis and finally break through the U.S. embargo.  From a political perspective this is correct. But China’s economy had already started to rebound in 1991, when the growth rate leapt from 3.9% in 1990 to 9.3%,  and by the time it reached 14.2% after Deng’s Southern Tour, it was arguably overheated. So what was the real reason the crisis ended in 1991? It was the State Council's issuance, on May 19, 1989, of the "Provisional Regulations of the People's Republic of China on the Grant and Transfer of State-owned Land Use Rights in Urban Areas," which was implemented in 1990. It was precisely this regulation that transformed huge amounts of urban land into valuable assets and made it possible for local governments to use the land as collateral to carry out large-scale investment. In the absence of this measure, the economic effect of Deng’s Southern Tour would have been greatly reduced. 
 
The second crisis was 1997. The accepted explanation for how China survived the "Asian financial crisis" is that "the Chinese government implemented a proactive fiscal policy and a prudent monetary policy, worked to expand domestic demand and stimulate economic growth, deepened the reform of state-owned enterprises, and launched the reform of the social security system, focusing on pensions and medical insurance for employees.”  In fact, these policies had been there all along, and what that really made the difference was the 1998 housing reform.[3] It was this policy that allowed a huge number of urban families to acquire the assets necessary to become a propertied class. At the same time, it also breathed life into the unfinished buildings left by the previously overheated economy, and real estate began to become the pillar industry of China's economy that it is today. 
 
The third crisis was 2008.  There is still debate over whether China’s response was successful or not.  But the fact remains that China's economy began to catch up and surpass those of the developed world at this point, and the pre-2008 and post-2008 economies are two completely different things. The explanation for this result is not much in dispute:  it was the central government's expansionary, counter-cyclical investment of four trillion RMB that got China out of the crisis. So why didn’t the other major players pull out their own “four trillion” at the time? Because they didn’t have it.  So where did China's "four trillion" come from? From local governments. Of the four trillion, the central government kicked in one, while local governments were responsible for three, and some scholars estimate that the four trillion eventually leveraged some 30 trillion RMB in knock-on investments. So the bulk of this came from local governments and social capital, which was definitely not the case in other countries. 
 
So the question is, why did the Chinese local governments and Chinese society have so much money at that time? The key answer is that after 2004, local government land revenue skyrocketed, because the mandatory implementation of the "831" policy[4] of public bidding for land sold by local governments allowed these governments to obtain huge amounts of financing from land sales. The soaring value of urban real estate provided a huge amount of credit for society as a whole. People often point to China’s entry into the WTO as the explanation for this growth. This is true enough, but it is predicated on the premise that the 2004 land policy unexpectedly turned China into a capital powerhouse. In an open economy, trade only benefits countries with capital to invest. This explains why other countries that joined the WTO earlier than China, and on more favorable terms, have not achieved the same results as China. 
 
Since real estate was the rocket that powered China’s past growth, the consequences of real estate’s current flameout could be comprehensive as well.
 
Three, Why Policy Has Failed
  
Where did real estate policy go wrong? First, by pitting "housing" and "speculation" against one another; and second, by mistaking increased capacity for real estate as a whole. 
 
For some time now, economic theory has failed to truly understand the financial nature of real estate. The term "land finance" itself reflects a poor understanding of the nature of real estate, mistakenly thinking that selling land and buying houses is all there is to real estate. The primary function of real estate is not direct financing but credit creation. Any business model can be financed as long as it has cash flow, and the ability to finance depends on the availability of collateral. The role of real estate is to act as collateral. Therefore, assigning value to real estate through market transactions and giving it liquidity is the primary function of the real estate market. The transactional aspect of real estate is simply to set prices and create liquidity for the non-traded real estate. 
 
Chinese real estate has been about finance from the beginning:  selling land and houses is finance, and buying land and houses is investment. Although policymakers have attempted to solve the "housing" problem through the real estate market, this goal has never been achieved. Financing and consumption are inherently incompatible, and attempts to achieve the consumption ends through financial means are the main source of the dilemma in real estate policy design, in the sense that if the goal is “housing” you have to have "speculation.”  Once you spurn "speculation," economic growth will be undercapitalized, leading to an economic downturn if the situation is not serious, or to a crisis if it is.
 
In this particular case, real estate is financing mainly local governments, and the central government receives very little profit.  This has long made the various ministries and departments of the central government, who take Western management policies as gospel, suspicious of this “off plan” income. In order to "correct" local governments' land dependence and make them take seriously their responsibility to “house” their citizens, the central government has introduced a series of policies aimed at controlling housing prices. A core aspect of these policies has been to "increase volume and decrease prices,"  meaning to suppress the "excessive increase" in housing prices by increasing the supply of land in the market. 
 
It was precisely this policy, together with the later tearing down of shantytowns and urban villages, urban renewal, and the "transformation of the three olds"[5] that ultimately pushed the real estate market into a state of over-supply, meaning that the sell-through period for commercial housing got longer and longer.  Then came price restrictions, purchase restrictions, loan restrictions, the whole package.  It added up to a series of interventions that, over the course of last year, finally broke the world's largest capital market, one that had refused to go under for twenty years. Beginning in the last half of 2021, real estate has fallen across the boards, which alone was enough squander whatever gains we might have realized through superior management of the epidemic. In the face of China's economic crisis, saving real estate has become the top priority. 
 
Only assets whose prices are rising are worthy of investment. In a cycle of producer competition, simply removing various restrictions on purchases is not enough to create the expectation of rising asset prices. Repeated crackdowns on housing prices tell the market that once prices start to rise again, government efforts to keep prices down will return as well. In addition, the huge pressure to sell the stock of land remaining on the market will force developers to clear it at a lower price. But the law of capital markets is precisely that as prices fall, so does demand. 
 
The policy of suppressing housing prices is largely based on a misunderstanding of the capital market. These days everyone is describing the capital market with the negative term "bubble," but few people give a precise definition of what a bubble is, and many policymakers take for granted that bubbles are bad, and the bigger they are, the worse they are. In fact, the price of any asset is its future valuation, and any valuation, big or small, is a bubble. Higher valuations mean bigger bubbles; bigger bubbles mean cheaper capital. So is it better for capital to be expensive or cheap?  An entrepreneur has no problem answering that question. The problem is not that a big bubble is bad, but that the bubble cannot be infinitely big. Before the bubble bursts, the higher the asset price actually is, the better [from an entrepreneur’s perspective]! 
 
The real question is how to keep the bubble from bursting. What does it mean for a bubble to burst? Simply put, it is the shift of assets from a situation in which "demand exceeds supply" to one in which "supply exceeds demand". The risk of asset bubbles is determined by both price and scale. It is not that the lower the prices, the safer things are, because once scale is out of control, no matter how low prices are, supply will eventually exceed demand, and the bubble will burst; conversely, as long as there is sufficient demand (or the supply scale is small enough), the bubble will not burst even if prices get very high. There are still people studying how to prevent the real estate bubble from bursting, while the constant stream of auctions without sales 流拍 and people returning homes to developers 退房 shows that the real estate bubble has already burst in many cities! The question now is how to restore liquidity! 
 
Four , Emergency Measures
 
If the above analysis that real estate is already in crisis is correct, the thing to do right now is to get real estate to the ICU, because no matter what complications might result from a hasty operation, the thing to do is to get real estate’s heart beating again!  The current problems in China's property market are the result of the erroneous policy that sought to "increase volume and suppress prices." It was just this strategy that produced the sudden change, in the third quarter of 2021, from expecting that supply could not meet demand, to expecting that supply would exceed demand.  Once any asset enters the "supply exceeds demand" category, it will immediately lose liquidity. In order to stop the fall in prices, we must first adjust our strategy to change expectations. 
 
Only assets whose prices are rising are worthy of investment. In a cycle of producer competition, simply removing various restrictions on purchases is not enough to create the expectation of rising asset prices. In a market where "supply exceeds demand," there is no rapid liquidation, and prices do not increase. The stock of land already in the market is bound to create huge pressure to sell, thus forcing developers to clear it at a lower price. But it is not the price that determines demand in the capital market, but whether prices go up or down. As long as prices fall, even if they are not high, demand will shrink. The only way to restore liquidity is for assets to go from state of "oversupply" to one of "undersupply." To do this, the prerequisite is to sell off the land for commercial housing that is already in the market as soon as possible. If necessary, the government should be in the market for large-scale reverse repurchase. Only when the market realizes that there will soon be no more houses for sale will expectations shift from “excess supply” to “excess demand.” 
 
Many people take it for granted that since it took so much effort to keep housing prices down, they will immediately rebound with a vengeance once the pressure is off. But the reality is that, just as in the case of fertility rates, the fact that it is hard to keep them down does not mean that they will rebound automatically.  Expectations-based capital pricing is like a bubble, which, once burst, cannot be put back together. At the transition point between supply exceeds demand and demand exceeds supply, the "price-volume" relationship is non-linear:  when the market demand is 100 units, an increase in supply from 99 to 101 units will result in a sudden shift from consumer competition to producer competition, and a corresponding discontinuous plunge in market prices from consumer prices to producer prices.
 
Since the situation is an emergency, every moment counts.  If we don’t get it on the “ventilator” right away, there is a risk that the real estate market will go the way of Japan, meaning that even if it does not immediately go into a state of shock, we might see a long term hibernation, in which the market becomes a vegetable.  For this reason, fixing real estate calls for strong medicine, with no hemming and hawing or hesitation.  Concrete emergency relief options include (but are not limited to):
 
(1) Immediately putting an end to the inappropriate policy of suppressing real estate prices, and removing price controls that keep developers from clearing the market, thus giving the market a clear signal that home prices are going up!
 
2) Moving away from price management and toward quantity management.  Take selling off the stock of existing property as the most important short-term goal, which requires taking the sell-through period and not prices as the core indicator for assessing whether real estate policy is functioning properly in various parts of the country. 
 
3) Using the sell-through rate to determine the supply of commercial property in the cities.  In cities that have not reached the desired sell-through rate, we must stop adding new supply to the markets.  At present, many cities are using the real estate slowdown to accelerate the injection of even more property into the market, to the point that even state-owned industries that belong to the municipalities are joining in to support the market, which is like drinking poison to quench your thirst. 
 
4) To maintain high share prices in the capital market, companies should engage in reverse repurchases. On the land market, the government should do the same, and in cities where the sell-through period is particularly long, governments should consider land buybacks, to return real estate to a situation where demand exceeds supply as soon as possible.  Rather than investing in useless infrastructure projects, the central government's special bonds 专项债 should be invested in local government land, because once liquidity is restored to the housing market,  these investments can immediately become high-value assets. 
 
(5) All projects that directly or indirectly lead to a significant increase in the supply of commercial housing, such as urban village improvement, urban renewal, residential conversion of industrial/commercial/office/hotel properties, and large-scale shantytown renovation must be stopped immediately.[6]  Urban renewal must rely on independent financing and not on land sales. 
 
(6) After selling off the land that has entered the market and the existing stock of houses,  we must continue the practice of "starvation sales," so that new land supply and population growth display the same curve.  Top priority should be given to the management of transaction prices in the secondary housing market, and the primary goal in the management of the commercial housing market should be to ensure the liquidity of the housing stock and land. 
 
Five, Curing the Disease
 
The contraction of land supply for commercial housing will inevitably lead to a decline in fixed investment and an increase in the cost of living for residents. This gap has to be taken up by the large-scale construction of affordable housing 保障房.  In the face of the current crisis, we should build as much affordable housing as possible, as quickly as possible. If in a year we add 50 million units, of 50 square meters each, at an average cost of 5,000 RMB per square meter (including the benchmark land price), this amounts to a fixed investment of 12.5 trillion. Due to the stable rents this will produce, the quality of this investment is much better than that in old or new infrastructure,[7] with their diminishing marginal returns. In 2020, although only some 13.56 units of commercial housing were sold, this represents the savings of one hundred million new urban residents.  As we enter the next phase of dwindling supply, the policy choice is simply between providing affordable housing in eight years or in two years. 
 
Beyond the investment itself, the huge consumption represented by the purchase of home appliances, furniture, and renovations would be enough to make up for the gap in the demand for declining commercial housing. If half of China's households could reach the level of wealth found in developed countries, the “war” would be over, because the sheer size of the huge consumer market itself would overwhelm all competitors, including the U.S. The construction of affordable housing will directly boost consumer spending and quickly inject new momentum into the market.  When we say “housing is not about speculation,” we don’t want to get rid of speculation, but rather to increase housing.  Without affordable housing, even if the real estate market returns to its previous level, it still will not be "stable, healthy, and sustainable." In order to be sustainable, we must distinguish between two markets. 
 
Singapore's model of  "a small amount of high-priced commercial housing + a large number of low-priced rental units" proves that only when commercial housing and affordable housing support one another, one fulfilling the function of “speculation” and the other that of ”housing,” is it possible to make targeted policies (prices for affordable housing, scale/volume for commercial properties).  And only then can we arrive at a real estate market that is "stable, healthy, and sustainable." The world's urban development experience shows that cities with high housing prices are good for economies in capital-intensive stages such as industrial start-ups and research and development, but not for those in labor-intensive situations involving operations and manufacturing; cities with low housing prices are good for labor-intensive economies such as manufacturing and operations, but they are poor in capital-intensive economies engaged in innovation and entrepreneurship. Only cities with a dual housing systems (such as Singapore and Shenzhen) can meet the conflicting needs of both capital and labor. 
 
Implementing this "dual-track" strategy is easier said than done. As with all dual-track systems, the biggest difficulty with the housing system lies in the difficulty of separating the commodity and affordability markets. Since commercial housing is difficult to securitize and trade, investment in commercial housing requires the purchase of physical housing. The housing system reform in 1998 started with a dual-track system in which "affordable housing was primary and commercial housing was secondary.” The reason we wound up with a market that is heavy on speculation and low on housing is that the price difference between commercial housing and affordable housing has led to huge arbitrage activities. 
 
The second problem is the huge amount of financing. Housing and related public services (schools, hospitals, cities) require a great deal of capital. The commercial housing market finances these public services through land sales and home purchases.  If ever the supply of commercial housing gets out of control, revenue from land sales will naturally decrease and investment in affordable housing will dry up. No city's budget is adequate to comprehensively cover affordable housing, which requires alternative sources of financing to supplement land sales. Singapore's provident fund system uses stable employment as a cash flow to solve this problem. But it also makes it difficult for units in this system to become a highly liquid household asset. It is hence difficult for Singaporean households to share in the growth of social wealth through real estate. 
 
The real solution to this problem was China's "1998 housing reform". This was a great innovation in China that was grossly underestimated. Many people now see the "housing reform" as simply "public to private" and ignore the first 30 years of affordable housing. China's housing reform was not a matter of "changing a wrong system into a right one," but instead one of "completing an unfinished system." Without the former public housing, no “transformation” would have been possible. In China's two-track system, the tracks are not parallel, but sequential, in which public housing was followed by the market.  This is the biggest difference between China and Singapore, and explains the greater efficiency of China's housing reform. The 1998 housing reform opened the door to direct financing by local governments and created the first generation of China's middle class. The rapid growth in wealth of this middle-class family supported China's position as the largest single domestic market outside of the United States, providing the greatest leverage for China to compete globally. By repeating the "housing reform," China could turn its entire urban population into a propertied middle class with commercial housing assets.
 
The trick to successfully solving the two major problems of "arbitrage" and "financing" in the 1998 housing reform was, simply put, "rent first, buy later.” When wages were low it was like renting from the work unit, and after the 1998 reform, rents were reduced in consideration of work seniority, and then families bought out the rent with a lump sum payment.   If the new affordable housing follows the same path, by limiting eligibility (to people who currently do not have a home but do have stable employment), limiting the price (based on costs), limiting standards (unit size), in addition to discouraging secondary sales of these units for a longer period, it can achieve an effective separation between affordable housing and commercial housing.  Stable rents and maturity can sustain the commercial housing market, so that the affordable housing itself can serve as mortgage financing, thus completely solving the problem of affordable housing financing.  Following housing reform, affordable housing, together with limitations on secondary sales, will share the premium of urban public service enhancement through the rise of housing prices, and all families may get rich rapidly. 
 
Six, Conclusion 
 
A good policy is not a flawless policy, but a policy that can balance short-term crises with long-term benefits, a policy that can identify strategic priorities. The current Chinese economy must stop the bleeding before it operates on the patient. Without the recovery of the main capital market, real estate, the economy’s heartbeat will not recover, and other successful surgeries will not change the general situation of economic recession, and the economic crisis will evolve into social unrest. We must be able to quickly identify the real problems in this "crisis of survival," otherwise we will only incur greater danger if we try to drive the car while pushing on the brakes and the gas at the same time. 
 
Notes

[1]赵燕菁, “在十字路口的房地产,” published on the Aisixiang website on May 18, 2022.
 
[2]Translator’s note:  The idea of a “once in a century major change in the world” is used frequently in China as a shortcut for the notion that China’s rise marks a fundamental change in world history.  See for example Yuan Peng, “The Coronavirus Pandemic and a Once-in-Century Change.”

[3]Translator’s note:  The 1998 reform put an end to the long-standing practice of work units’ or companies’ supplying houses to employees, and switched to a market mechanism.

[4]Translator’s note:  In March of 2004, the Ministry of Land and Resources and the Ministry of Supervision jointly issued Order No. 71, requiring that beginning from August 31, 2004, all land for commercial projects should be sold through public bidding, and local governments should no longer make agreements on the basis of historical factors or personal relations. At the same time, developers were required to pay the land transfer fee in a timely manner, and the government could retake the land if it remained undeveloped for two years.

[5]Translator’s note :  the “transformation of the three olds” appears to refer to a Guangdong policy to rebuild "old towns, old factories and old villages." Most of what Zhao appears to be talking about in this passage would fall under the general heading of what we call “urban renewal.”

[6]Translator’s note:  Zhao adds a technical detail concerning the “volume ratio 容积率,” which is a means of calculating how much above-ground floor space is added by a specific project.

[7]Translator’s note:  The word Zhao uses for “old infracture” is tiegongji 铁公基, which refers to investments in railroads, highways, airports, utilities, etc.