Since 2009, property prices stubbornly climbed upwards, despite government attempts to cool the market. But not any longer. Average house prices fell by 0.3 percent in November–their third consecutive monthly decline on the China Real Estate Index System.

The size and effect of the price drops are still unclear, but it doesn’t look like property deleveraging in China will squeeze household finances like they did during the U.S. subprime mortgage crisis. A research note published earlier this year by Deutsche Bank pointed out that by international standards, China has very low levels of residential mortgage debt, comprising 19 percent of GDP in 2009. In other words, falling real estate prices won’t have too much of an effect on private consumption.

Instead, the most vulnerable point in the system may be China’s banks, the report said, since “the direct negative impact on the construction industry … could translate into stress for bank books.”

The notion that banks hold much of the risk in a cooling market is supported by the International Monetary Fund’s (IMF) most recent Financial System Stability Assessment of China published in November, which claims that “high real estate-related bank lending exposures (20 percent of GDP), and indirect exposures via property collateral, make banks vulnerable to real estate corrections.”

Bad loans are not the only concern. Falling land prices are squeezing local government revenues, just as pressures are increasing for them to shore up funding for an expansive public housing policy in China’s 12th Five Year Plan. In anticipation of these new stresses on the system, Beijing is working to engineer a “soft landing” and move the country away from a reliance on excessive real estate investment.

Exposures in Local Government Financing Platforms

Aside from their exposures in loans to property developers and industries “vertically integrated” with real estate such as construction, cement, and steel, China’s banks hold a large amount of risk in local government financing platforms (LGFPs), which the People’s Bank of China says comprise 30 percent of total outstanding bank loans. In its stability assessment, the IMF says that overall bank exposures to real estate and LGFPs are “significant at upward of RMB 20 trillion, equivalent to more than 40 percent of the total loans at end-2010.”

Li Wei, a Professor of Economics at the Cheung Kong Graduate School of Business (CKGSB), explains that in their rush to compete on GDP growth figures, local governments have created the LGFP corporate entities (over 10,000 of them, according to the People’s Bank of China) to take out loans and finance large-scale infrastructure investments.
“This financial leverage has helped expand the scale of urban development,” Li wrote in a recent survey study of China’s real estate market. “Not only have local governments gained a significant portion of their income directly from land sales, but they have also been able to use land as collateral for bank financing.”

The value of this collateral will fall with any decrease in property prices, thereby further limiting local governments’ ability to repay LGFP loans. Local governments– who rely on land sales for over 40 percent of their revenues, according to China Real Estate Information Corp.–have in recent months reported that they are facing increasing difficulties in auctioning off land at previous prices. This is why, according to Deutsche Bank, reform of China’s property market must also address local governments’ financing constraints.

Grand Plans for Social Housing

In the meantime, Beijing is tackling another corner of the real estate market: social housing. As part of China’s 12th Five Year Plan, the government is seeking to build 36 million affordable urban housing units by 2015. If the project is successful, 20 percent of the urban population will live in social housing by 2020.

The social housing plan looks great for the central government. For local governments, which bear the brunt of the costs, it’s less appealing. A report published jointly in July by Banco Bilbao Vizcaya Argentaria (BBVA) and China CITIC Bank estimates that the enormous project will require 5.1 trillion yuan in financing over the next five years. The central government has only pledged to fund 7 to 8 percent of this amount in 2011, with local governments and the private sector providing the remainder.

Not only are local governments expected to partially fund the project themselves, but they must also give up a portion of one of their key sources of future revenue: their urban land stock. This is a significant disincentive, as the BBVA report notes: “[L]and provision for low- and public-rent housing appears to be problematic given the lack of incentives of local governments.”

Despite this, officials say they are well on their way to achieving the initial target of building 10 million units in 2011. According to the Ministry of Housing and Urban-Rural Development, 9.86 million of these had already broken ground by the end of September 2011. But construction on these units won’t wrap up until 2013, and with a further 10 million units slated to kick off in 2012, the project still risks running into financing problems in the future.

“The chief problem will be the task of finishing them, given that the target was simply to start them,” wrote Miranda Carr, head of China policy research at North Square Blue Oak (NSBO), in a November 2011 report on affordable housing.

Banks and developers are also coming under increasing financial strain. As the NSBO report goes on to note, “given the uncertain returns on affordable housing, it will only be by strong coercion that investment will be made.” Despite such concerns, most analysts are optimistic that Beijing will step in where necessary to ensure the social housing targets are met.

Beijing Stepping In

The central government is already exploring municipal bond issuances as an indirect way to support local government finances. Guaranteed by Beijing, the trial bonds have so far been successful in allowing governments in places like Shanghai, Guangdong and Zhejiang to borrow at low rates.

The Bank of China’s December 5 cutin the reserve requirement ratio–the first in three years–is also a sign that looser monetary policy may be coming soon. Easier access to credit will help developers and local governments weather the changing housing market.

Beyond social housing, the central government’s most widely-anticipated action in the real estate sector is property tax reform. At a meeting of the National People’s Congress in October, Assistant Minister of Finance Wang Baoan called on officials to “step up efforts to establish a national property-tax policy” and “expand the role it has in controlling housing prices and regulating the market.” Shanghai and Chongqing introduced property tax schemes earlier this year.

While social housing seeks to address the problem of supply for China’s low- income families, the property tax aims to resolve other imbalances caused by the changing housing market. According to a recent Nomura research note, the “property tax will likely become an important and stable source of revenue for local governments, and increased holding costs could well deter speculators.”

These so-called “speculators” have become an important driver of the sky-high prices China has seen in recent years. China’s household savings rate of 40 percent is among the highest in the G20. Much of this excess savings has gone into property, since capital controls still limit overseas investment, and citizens otherwise face low or negative real interest rates in their banks. It has become common for wealthy Chinese to own numerous properties without any debt, leaving the empty buildings there to appreciate in value. This helps explain the low mortgage debt- to-GDP ratio and the high average price- to-rent ratios and vacancy rates in first tier cities, where many of these wealthy investors reside.

A property tax is expected to discourage the use of property as an investment vehicle, and to serve as a penalty for leaving apartments vacant. The Hong Kong Monetary Authority claims that in China’s case, “the impact on the price-to- rent multiple of a 1 percent property tax is equal to that of a 1 percent increase in the real interest rate.” Without wider credit tightening or restrictions on mortgages and purchases, a property tax would effectively change the market’s incentive structure to discourage “speculators” while helping citizens who legitimately need to enter the housing market.

One reason the central government has so far favored purchase and mortgage restrictions is that most municipal governments lack the comprehensive property records that would allow them to effectively enforce a property tax. Last October, Housing and Urban-Rural Development Minister Jiang Weixin revealed that a housing information system has been in the works for the past two years. “Once the platform is built, the house purchase restriction method will be dropped,” he said.

For now, Beijing has signaled that it will continue to tightly control the housing market until socially acceptable prices emerge. Cooling the property boom will not be painless, as it has already grown to extremes in recent years. Yet the measures being introduced are already starting to rebalance the industry, clearing the way for a better housing policy and a more sustainable market in the long run.