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China real estate’s risky diminishing returns
Gone are the days when China could point to soaring real estate prices and rising incomes to justify endless new construction. China’s economic slowdown suggests that housing and office prices are headed for a steep fall that could take down banks and local governments, leading to prolonged stagnation
Kenneth Rogoff 1 Nov 2022

The Communist Party of China’s 20th national congress, which gave President Xi Jinping an unprecedented third term as general secretary, also featured a leadership shakeup that replaced market-oriented technocrats with Xi loyalists, raising questions about China’s plans for its faltering economy. Excessive state control, after all, is a tried-and-true recipe for becoming mired in the middle-income trap that Chinese leaders have long vowed to avoid.

The breakneck pace of state-guided investment in real estate and infrastructure – China’s go-to stimulus strategy – has generated diminishing returns, with slowing economic growth implying an inevitable fall in housing and office prices. This is especially true in the smaller, poorer and less-developed cities that collectively account for more than 60% of China’s GDP. Housing prices in so-called third- and fourth-tier Chinese cities have fallen by roughly 15% to 20% over the past two years. Some form of sustained financial stasis will most likely ensue. But even if it does not look quite like a Western-style banking crisis, the concomitant fall in lending will still inhibit growth.

Real estate constitutes such a large share of China’s economy that a sustained slowdown could cause years-long stagnation akin to Japan’s lost decades since 1990. Counting direct and indirect demand, real estate accounts for roughly 23% of production and 26% of final demand (the latter figure includes net imported content).

Prior to the last couple of years, the spectacular rise in Chinese housing prices was underpinned by ultra-fast growth in incomes, with expectations of future growth pushing prices ever higher. If income growth stalls, China’s residential and commercial real estate prices could collapse like a house of cards, taking down the banks and the local governments that have been furiously lending to the sector.

Many – particularly in the media – seem to believe that China’s recent real estate meltdown, including the spectacular default of property developer Evergrande, can be attributed to government efforts to crack down on excessive credit. But it would be more accurate to say that, by and large, government policies have propped up housing prices – for example, by limiting citizens’ ability to invest in other assets. Real estate prices are falling simply because decades of overbuilding have left supply outstripping demand in many areas.

China’s economic growth has been slowing for years, but recently the decline has accelerated. Given the external and internal headwinds China is facing, the International Monetary Fund’s forecast that the economy would grow by 4.4% in 2023, after 3.2% expected growth this year, seems optimistic. The government’s strategy of cracking down on tech companies and education entrepreneurs while supporting state-sponsored investment projects looks more like an instrument of control than a sensible economic strategy that could move China closer to becoming a high-income economy.

Moreover, the fact that China’s growth strategy is proving less effective means that it needs to invest greater amounts to achieve the same rate of GDP growth per capita. Decreasing returns on real estate and infrastructure investments are among the main drivers of the collapse in Chinese productivity, especially since 2014.

China’s current problems recall the Soviet Union’s diminishing returns on its investments in steel plants and railroads, and Japan’s construction of “bridges to nowhere” in the late 1980s and 1990s. After decades of building real estate at breakneck speed, soaking up raw materials from all over the world, China now finds itself with a housing and commercial real estate stock similar to those of much wealthier countries such as Germany and France.

Alas, gone are the days when China could rationalize soaring housing prices and endless new construction by pointing to rising incomes. True, China can avoid some of the protracted problems that defaults in the West often trigger (and which can take years to resolve), owing to the government’s tight control over the legal system. The government controls key information and seems to treat data on home and apartment vacancy rates – which could shed light on the extent of overbuilding – as a state secret. But the scale of the problem is such that not even the Chinese government can hide its effects, even though it will undoubtedly try.

China and the global economy appear to be at a turning point. Heightened political tensions, together with deglobalization, look set to slow productivity and raise long-run inflation worldwide. Forward-looking indicators of long-term real interest rates have shot up, while the stunning rise of the US dollar continues to expose financial fragilities. Given that Europe is headed for a deep recession, and that the United States seems to be headed for a slump as well, China cannot count on exporting its way out of its real estate-driven slowdown.

It is very much in the world’s interest that China finds a solution to its real estate sector’s overbuilding problems and avoids prolonged economic instability. More than two years ago, at a time when the overwhelming consensus in academic and policy circles was that China could easily overcome the adverse legacy of overbuilding, I suggested that the country had likely hit “peak housing”. Today, with the Chinese government even less inclined to adopt market-oriented reforms, a smooth landing seems less likely than ever.

Kenneth Rogoff is a professor of economics and public policy at Harvard University, a recipient of the 2011 Deutsche Bank Prize in Financial Economics, and the former chief economist of the International Monetary Fund from 2001 to 2003.

Copyright: Project Syndicate

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