Structural problems of China’s real estate bubble and economic crisis theories

Kim Kisoo 

Senior Research Fellow, 

The Sejong Institute 

(kskim@sejong.org)​

China's real estate problem has been discussed in the media for about a month. One cannot believe China’s real estate statistics. According to CNN and other western media, there are about 100 million vacant houses and 30 million houses still on sale. This is unimaginable, but this is China's economy. Some argue that Chinese owners of several houses do not rent their houses when they want to sell them. Still, these statistics do not make sense. In any case, China's home ownership ratio stands at 93%, the highest in the world, strongly suggesting that Chinese real estate is excessive.

Meanwhile, rumors of bankruptcy of Evergrande, one of China's largest real estate development companies, have surfaced. Evergrande’s debt totals $300 billion. This is an enormous amount, or 2% of China's gross domestic product. Evergrande failed to repay $83.5 million in interest on dollar bonds on October 23, 2021 or $47.5 million in interest six days later. It is not known whether the government paid back the interest during the one-month grace period, but it has yet to be heard that Evergrande has gone bankrupt. In short, companies are facing financial difficulties due to the failure to sell houses built by Evergrande. Is the real estate bubble and crisis really limited to Evergrande?

Although it is not often pointed out, China's real estate problem has a serious structural problem. In other words, it is not just Evergrande’s problem. The term "structural" here means that China's economy has no choice but to function as it is. Surprisingly, China's real estate problem is rooted in the tax reform, namely the tax-sharing system, that took place in 1994. This means that the real estate problem cannot be solved without touching the tax-sharing system. Therefore, the term "structural" must be used.

Deng Xiaoping's reform and open door policy were centered on decentralization of power. In terms of relations between central and local governments, decentralization was actively revitalized. The problem is that the aftermath of excessive decentralization in the 1990s showed up through the tax system. In 1993, local and central governments accounted for 77% to 23% of total tax revenues. The relative poverty of the central government's finances became apparent. The tax-sharing system, which was implemented in 1994, reversed the ratio to 47.8% to 52.2% in 1995, and the central government's tax revenue began to exceed that of local governments. Local income naturally ran short. What was the solution? China came up with a novel way as a communist country, of which all land belongs to the government. The central government subsidized part of the tax revenue, and the rest was filled by local governments by selling land. After the new system was implemented, local land sales revenue was about 50% of total local income, discounting central transfers—although there were regional differences.

From the local government’s perspective, land had to be sold; real estate, which had the highest demand for land, was essential. Therefore, as a result of the real estate boom, excessive investment was made in real estate development, resulting in a large number of vacant houses that are not in demand today. In principle, real estate prices rise due to real estate demand. Then, there will be a difference in real estate prices and an increase in demand. The question is how long this will be possible. This, however, will stop when the utility of real estate relative to price decreases, or when there is no more demand for real estate.

The statistics of unsold houses indicate that such a turning point is approaching. What will happen if the real estate bubble collapses in the future? First of all, there is a high possibility of a serious crisis in local finances. The Chinese authorities probably have no clear countermeasures against this. It is said that all real estate-related industries account for about 30% of China's gross domestic product (GDP). In theory, the real estate recession will inevitably lead to a contraction in GDP, which means a visible weakening of China's growth momentum. The "hot engine" of China's economy will cool down. On December 3, reports that Evergrande announced to the Hong Kong Stock Exchange that it would not be able to repay $260 million in debt heated the media. The reason why the world is paying attention to China's real estate issue is clear again. Unfortunately, there is no clear solution to a structural problem. 

※ This is an unofficial  translation  by Jisoo Kim jk1577@georgetown.edu​ ​of the original paper which was written in Korean. All references should be made to the original paper. 
※ This article is written based on the author’s personal opinions and does not reflect the views of the Sejong Institute.