The real estate market appears to be undergoing a correction. While a slowing of investment and construction would have a significant impact on growth, an orderly adjustment is factored into the staff’s baseline scenario [7% growth in 2015].
Real estate has been a key engine of growth in China.
Together with construction, it directly accounted for 15 percent of 2012 GDP, a quarter of fixed-asset investment, 14 percent of total urban employment, and round 20 percent of bank loans. In addition, the sector has close links to several upstream and downstream industries. Local governments rely on land sales—closely linked to activity in the sector—as an important source of funding (see Box 3), and real estate is extensively used as collateral for corporate sector borrowing. As a result, a decline in real estate investment could significantly disrupt financial and real activity in China. Ahuja and Myrvoda (2012) estimate that a reduction in real estate investment by 10 percent could reduce GDP growth by about 1 percentage point.
Recent data suggest that several regions are in oversupply.
Residential real estate inventories have increased sharply in Tier III and IV cities, as well as in the industrial Northeast (including Shenyang and Changchun) and parts of the Coast (including Hangzhou, Dalian, Fuzhou and Wenzhou). Commercial real estate, meanwhile, appears to be in oversupply across most regions. In terms of residential price dynamics, Tier II and Tier III/IV cities have performed the weakest, with prices in the latter group falling on month-on-month basis recently. The hardest-hit geographical areas include the industrial Northeast and the Coast. However, developers seem reluctant to cut prices because it may lead new buyers to stay on the sidelines and cause problems with those that bought earlier at higher prices.
Distortions weigh heavily on the property market.
On the supply-side, the market is distorted by local governments’ reliance on land sales to finance spending. This helps explain the over-supply in many Tier III/IV cities. On the demand side, the market is prone to speculation since housing is an attractive investment given low deposit rates, a lack of alternative financial assets, capital account restrictions, and a history of robust capital gains. This helps explains why, especially in top-tier cities, prices appear to be overvalued and price-to-income ratios remain high—even though, thanks to rapid income growth, affordability indicators have generally been improving.
Real estate appears to have entered a downturn.
As of May, average residential price growth started to turn slightly negative, and there were declines in transactions (10 percent) and new starts (12 percent). Real growth in investment has fallen from almost 20 percent in 2012 and 2013 to around 10 percent by May. While the previous downturns, such as 2008 and 2012, were driven by policies to cool the market, the current one has come without a direct tightening of real estate policies and appears driven by overcapacity and concerns about future capital gains.
An orderly correction in real estate should be manageable.
The staff baseline assumes that real estate investment slows to around 5 percent in 2014, stalls in 2015, and gradually recovers thereafter. It takes into consideration low leverage of homeowners, underlying housing demand fundamentals, and government ability to support developers if needed and take other measures (such as removing purchase and lending restrictions, and accelerate infrastructure and social housing construction). On the other hand, risk of large drop in final (investor) demand has increased even if underlying, medium-term home ownership demand is sound. If the market were to undergo a sharper correction—with new starts declining by, say, 30 percent for the year (compared to 20 percent year-to-date), which implies a -3½ percent year-on-year growth in residential investment—then GDP growth would likely be around ¾ percentage point lower than in the baseline (in the absence of offsetting measures).
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