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Falling home prices and fewer land purchases are leading to increased tensions between the central and local governments in China.
Land sales (aka long-term land lease fees) are a critical source of funds for local governments. Efforts by the central government to burst the property bubble have been viewed warily by local governments, which are worried that a declining market will negatively impact their finances. These fears are not unjustified, given that land sales account for around 40 percent of local government revenues.
The question naturally arises as to whether or not local governments have the capacity to thwart central government policy towards the real estate market.
Noncompliant local officials are the foil to many of the central government’s initiatives. Beijing frequently organizes campaign-like efforts to address pressing problems, be it fighting corruption, protecting the environment, or destroying pirated goods. The dynamic is that while local governments toe the line during the midst of a campaign, as soon as Beijing diverts its attention they often return to their old ways. This is especially common in cases where local governments have direct financial interest in ignoring central government policy.
Many observers of Chinese politics have asserted that this same problem holds true for the property market. Resistant local governments are the key reason Beijing has struggled to get the real estate market under control.
Starting in early 2010, the central government has put out restriction after restriction on housing purchases and mortgages in an attempt to reduce prices and overinvestment. Local governments have complied only reluctantly with these mandates. Some localities have even eased up pressure prematurely and subsequently been forced to re-implement Beijing’s policies.
The record for this style of incremental approach to the housing regulation is mixed. After almost two years of pressure, the central government’s policies have finally resulted in a modest decline in housing prices. Housing may be losing its status as a preferred investment (Chinese language). However, while these restrictions were gradually being put in place the housing bubble continued to grow even larger and high prices became an increasing source of social discontent.
The alternative to these types of small-scale regulatory adjustments would be to address the underlying factors driving speculation and overinvestment in the housing market. Financial repression, made up of negative interest rates on deposits, a closed capital account, and a moribund stock market, all push savers to put their money into property.
Some of these distortions are more difficult to fix than others. Liberalizing the capital account is treacherous for any developing country, particularly one that is subject to massive hot money flows like China. The Chinese stock market may recover eventually, but intangibles like investor confidence take time to repair. The low hanging fruit is abandoning the negative real deposit rate policy (which is under the purview of the People’s Bank of China) of recent years to give savers a higher return.
It is widely understood in China that allowing market forces to play a greater role in the determination of interest rates would give savers more of a reason to keep their money in bank accounts and less incentive to over invest in housing. This type of top-down change would have a dramatic effect on housing demand and could help reduce the unsustainable rise in housing prices.
Equally important, this type of top-down approach leaves local governments little opportunity to resist. As Nick Lardy points out in his new book, unlike a decade ago property developers and construction firms are now primarily privately owned. In 1998, state-owned firms accounted for one-third of property development companies, but by 2009 this number had shrunk to 5 percent. Market incentives will cause both consumers and suppliers of housing to adjust their activities downward, and in the process, reduce the amount of investment in residential housing as a percent of GDP. Local governments will complain loudly as they see their land revenues plummet, but they will be unable to prevent an adjustment from occurring.
The key to fighting the housing bubble may not be endless rounds of new regulations, but instead to attack the root cause of the problem.