Housing surpluses in some places and shortages in others reflect China's failed economic strategies

The scenic lakeshore city of Dali in southwestern China, renowned for its ancient pagodas and peaceful vibe, has been a favorite tourist spot for many years. Last January and February, after China abandoned the zero-COVID doctrine and eliminated virtually all domestic travel restrictions, Dali prefecture received nearly 20 million tourists, more than five times the size of its own population, making it one of the most visited destinations across China.

But while tourists are going to Dali, a growing number of people are leaving the city and settling in larger and wealthier cities like Beijing and Shanghai, where housing is in short supply. A new PIIE Working Paper discusses the resulting mismatch—housing surpluses where people don't want to live and shortages where people do want to live—which reflects the failures of China's social engineering and housing policies. At a time when Beijing is moving away from market-driven economics, it needs to rethink that approach when it comes to housing—letting markets determine population flows and where houses are or are not built. There are signs this may be happening, but it needs to happen faster.

Dali is a typical "tier-3 city" facing a housing crisis

In Dali, housing prices, including for new construction, have been declining since mid-2021, though they have recovered modestly in recent months. Investment in real estate development also continues to shrink, dropping by 43 percent through April 2023. The population in Dali prefecture during the 2010-20 decade shrank by 120,000 people, sending demand for housing down while housing surplus has grown because of long-time overinvestment and overbuilding.

Other smaller Chinese cities find themselves in a similar situation, according to 2020 census data, which also record population inflows in the past decade in Beijing, Shanghai, Guangzhou, and Shenzhen and surrounding areas. Most small cities in Northeast China and Midwest China lost population at the same time. People see better economic opportunities in the large cities, despite the many barriers these cities have created trying to turn migrants away.

The Chinese government has sought to discourage these trends, somewhat unsuccessfully. Megacities like Beijing and Shanghai have even set caps on total populations. Land allocation in China also follows the central government's directive toward "balanced" urbanization. Smaller cities in inland provinces usually receive more land quotas for real estate development while larger cities in coastal provinces receive less. But these incentives have largely failed to change the trends.

The results have created huge social and economic problems. The population in top-tier cities is growing, and housing shortages have fed a price bubble and an affordability crisis. Measured in price-to-income ratios, a commonly used metric in measuring housing affordability, the four tier-1 cities in China are now among the least affordable around the world. The runaway housing prices in the megacities are sometimes seen as a cause of some ancillary social problems, such as declining birth. Many young Chinese are deterred from starting families and having kids due to the difficulty in purchasing a home in cities. The high cost of mortgage debt for homeowners, meanwhile, reduces disposable income to help raise kids. Runaway housing costs are also driving away talent and hurting businesses, making cities less competitive.

In lower-tier cities like Dali, homes are more affordable because of excess housing supply and lack of housing demand. Rogoff and Yang (2022) estimate that total housing stock in China (the aggregate in tier-1, tier-2 and tier-3 cities) increased from 39 billion square meters in 2010 to 56 billion square meters in 2021. Tier-3 cities consistently contributed to more than 78 percent of the total housing stock in China during the same period, while hosting only 66 percent of China's urban population at the same time. Real estate developers, chasing elusive profits, have been slow to adapt to this reality.

China should overhaul its urbanization strategy

What should China do? First, land quotas should be allocated based on actual population flows, not some made up population targets. China's top-tier cities need to increase housing supply, whereas cities with population outflows should avoid wasteful housing investment and construction. Despite the already large populations in Beijing and Shanghai, population density in these cities is still lower than other major cities in East Asia like Seoul and Tokyo. There is still room to accommodate more people. Some innovative thinking could help. A nationwide land quota market where localities on the coast with net population inflows swap assigned quotas with inland localities with net population outflows may be a good idea.

The central government has signaled some change in its land policy. A government document in March 2020 called for more flexible land quota setting based on market factors. If implemented with concrete actions, populous cities could exercise greater leeway in increasing land supply for residential housing.

Such a step would have to overcome the hesitation of local officials concerned that increasing land supply would lower land and property prices, which may reduce government revenues and trigger homeowner protests. The tension with local authorities reveals an important political economy reality in China. Local governments are critical players in the country's real estate market, which is discussed in detail in the PIIE Working Paper. Given the roles of local governments, reforming local government finances and finding them more sustainable sources of revenue other than land revenue should be an essential part of any serious reforms in the housing sector.