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EMERGING MARKETS RESEARCH 7 June 2010

CHINA
Managing a property bubble
„ High housing prices have raised concerns about a property bubble and have Wensheng Peng
become a socially divisive issue in China. In a way, investment demand has +852 2903 2651
crowded out consumer demand by driving up prices, and the problem is wensheng.peng@barcap.com
exacerbated by a lack of public housing supply.
Jian Chang
„ In our view, a combination of structural forces and distortions make China prone to +852 2903 2654
a housing bubble, if policy is not carefully managed. Factors that have boosted jian.chang@barcap.com
housing demand – including demographics, urbanisation, income disparity and
high savings – are likely to reverse or decline in intensity over the next 10 years. www.barcap.com

„ The government’s recent measures to cool the housing market focus on limiting
investment demand and increasing the supply of public and low-cost housing. In
our view, this represents a regime shift in housing policy, and more measures –
related to taxes, regulations and the public housing framework – will likely be
rolled out.

„ We expect significant price declines in the next few quarters as investment demand
is curtailed and public housing supply increases. We do not believe this will lead to
a hard landing for the economy, and we maintain our growth forecasts at 10.1% in
2010 and 9% in 2011. Any slowdown in private housing construction is likely to be
offset, to a significant extent, by public housing construction.

„ The impact on the banking sector also is likely to be limited, as banks’ exposure to
the housing sector is not large. In our view, even a sharp fall in property prices will
not cause a financial crisis at this point. China is not vulnerable to a sudden stop in
either external financing or bank lending to the non-bank sector.

„ However, distortions caused by a housing bubble and its eventual bursting,


combined with an aging population – a possible scenario for China in the next 10
years – would be very damaging to the country’s long-term growth potential.
Hence, we take the view that the risk to the economy is much greater if policy is
not strong enough to check the bubble at this point than it would be if the
measures result in over-tightening.

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 12
Barclays Capital | China

What are the main concerns?


Housing prices have risen to After a short-lived correction in 2008, residential property prices saw a sharp turnaround in
record high levels 2009-10, with house prices in major cities surging to levels that significantly exceeded the
previous peak in 2007. Official data show that property prices across the 70 largest cities
rose at a rapid pace in the first few months of 2010 (Figure 1). The rapid increase in prices
was not limited to just a handful of major, wealthy coastal cities; inland cities like Kunming
and Chongqing experienced significant price inflation as well.

Housing affordability has High housing prices have raised increasing concerns about a property bubble, as well as
become a socially divisive issue social division. House prices have risen much faster than average incomes in major cities
over the past 10 years, with prices in Shanghai reaching 16-times average household
income, by our estimate (Figure 2). Partly also reflecting a lack of public housing provision,
the high housing prices have become socially divisive. In general, high-income groups and
the older generation, who are more likely to have bought housing units earlier, have
benefited from the housing boom, while the low-income people and the younger
generation have been left out. Indeed, at today’s high prices, a large number of average
income earners are priced out of the market in the major cities.

Investment demand crowds out From an investment point of view, rental yields have declined sharply in the past few years,
consumer demand as housing prices have increased at a much faster pace than rentals. In major cities, the
rental yield has come down to as low as 1-2% from over 5% in early 2000s. This suggests
that investors now seek a return on property holdings mainly from expected price
appreciation. We see a conflict between the demand for housing as a consumer good and
as an investment instrument. In our view, investment demand has become so large that it
crowds out consumer demand by boosting prices.

Short-term versus longer-term The authorities have recently taken steps to deal with rapid housing price inflation. As a
pain result, there are early signs of a cooling down, with a sharp fall in transaction volumes, but
prices have not declined significantly. At this point, investors seem to have two, potentially
opposing, concerns about the outlook for the property market in China and the associated
impact on the economy. One concern is that a sharp decline in property prices leads to a
hard landing for the economy. Another concern is that prices do not adjust materially and
the bubble continues to build until it eventually bursts, leading to a major financial crisis in

Figure 1: Price inflation accelerated in 2010 Figure 2: Average house price to income ratio is high

% m/m, 3mma, ar 20 Shang hai Beijing Guang zhou


30

16
20

12
10

0 8

-10 4
Apr-06 Apr-07 Apr-08 Apr-09 Apr-10

0
Shanghai National Beijing Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10
Source: CEIC, Barclays Capital Source: CEIC, Barclays Capital

7 June 2010 2
Barclays Capital | China

China. How significant are these concerns? To address this issue, we analyse forces driving
movements in housing prices and the significance of the recent policy measures, and offer a
view on the housing market outlook and its impact on the economy.

How we got to today’s situation?


Housing reform in 1998 boosted Private housing market in urban areas started in 1998, when the government reformed the
private housing market housing policy. Before 1998, most urban households received apartment units from their
employers (mostly government institutions and state-owned enterprises). The problem with
the old regime was limited space and the low quality of housing. As part of the reform in
1998, physical allocation was changed to monetary allowances, along with a massive
privatisation of the existing housing stock at heavily discounted prices. Subsequently, a
private housing market developed rapidly.

Long-term housing price In the past 12 years, the economy has gone through cyclical ups and downs, and monetary
inflation mainly driven by conditions fluctuated significantly. Naturally the housing market was affected by these
structural forces developments. However, we believe structural factors and government policies have played
a much larger role in determining the long-term trend in housing prices. In brief,
demographics and urbanisation have underpinned housing demand, while a sharp rise in
savings and a widened income gap led to strong investment demand for property. On the
supply side, a lack of public housing exacerbated imbalances in the private housing market.

Rise in working-age population A main driving force for housing demand is the rise in the working-age population, which
boosts household income and has boosted per capita income growth. China’s working-age population, defined as the
housing demand population older than 15 and younger than 65, has increased by 63% since 1980, compared
with growth of 4% in Japan and 38% in the US. In particular, the group of people, aged
between 20 and 59 years old, who most likely buy housing units, increased to 61% of the
total population in 2008, up from 53% in 1990 (Figure 3). In terms of the number of people,
this group rose from 600mn in 1990 to over 800mn in 2008. The working-age population is
projected to reach a peak in 2015 (Figure 4), and thereafter, demographics are likely to be
less favourable to economic growth and housing demand.

Figure 3: Population growth boosts housing demand Figure 4: Working-age population is projected to peak soon

62 Share of Age 20-59 in total population (%) 900 1,200 China (LHS, Person mn) 300
Population, age 20-59 (RHS, Person mn) Japan (Person mn)
60 850 1,000 US (Person mn) 250

58 800 800 200

56 750 600 150

54 700 400 100

52 650 200 50

50 600 0 0
1990 1993 1996 1999 2002 2005 2008 1950 1965 1980 1995 2010 2025 2040

Source: CEIC, Barclays Capital Source: CEIC, Barclays Capital

7 June 2010 3
Barclays Capital | China

Urbanisation increases urban Urbanisation has also been a driving force for housing demand in cities. The urbanisation
housing demand ratio (urban area population as a percentage of the total population) has risen from around
20% in the early 1980s to just below 50% currently. In the past 10 years, about 150mn
people migrated from rural to urban areas. As a result, the urban population increased
rapidly while the rural population shrank, even though the one-child policy is more
stringently implemented in cities (Figure 5). The government has adopted policies in recent
years to facilitate rural migrants’ integration into urban life. The process of urbanisation is
likely to continue for many years, and this should support housing demand (Figure 6).
However, the pace of urbanisation may be constrained by the high cost of housing.

Income disparities also play a Income disparities increased sharply before stabilising in recent years owing to various
role factors, including surplus labour, and an indicator is the widened gap between urban and
rural residents’ per capita income (Figure 7). This has generated a wealthy class that is a
small proportion of the total population, but accounts for a relatively large share in major
cities and in the high-end property market. To some extent, the luxury apartments in Beijing
and Shanghai are still affordable for the wealthy, even though more modest apartments are
barely affordable for the average local household.

Investment demand for housing Investment demand for housing has been boosted by the sharp rise in savings in the past 10
has risen strongly years (Figure 8). A combination of factors, including the rise in the working-age population,
rapid income growth, widened income disparities and an underdeveloped social safety net,
have boosted savings (see China: Declining trade surplus: A structural view, 6 May 2010).
On the other hand, the closed capital account and underdeveloped domestic financial
markets limit investment opportunities for domestic residents. Property, therefore, has
become a favoured instrument for wealth accumulation. This is exacerbated by the strong
upward trend in housing prices (in contrast to the large swings in stock prices in recent
years), which has fostered a belief that housing prices can only go up.

A lack of public housing A lack of supply, particularly of public housing, exacerbates the social problem. After the
exacerbates the problem housing reforms in 1998, the government pledged that economic, or affordable, housing
should be a significant part of the supply. Over the years, however, its share in the total
housing supply declined sharply to about 6% in 2008 from 28% in 1999. In 2007, the
government outlined new initiatives to increase the supply of public housing, but a lack of
incentives for local governments and developers inhibited implementation.

Figure 5: Urban population has risen rapidly… Figure 6: … and urbanisation has a long way to go

Person mn 100 (urban population in %of total)


1,600 Population: Urban Population: Rural

1,400 80 Japan

1,200 China
60 1985~2010
1,000
800 40
600
400 20

200
0
0 20 30 40 50 60 70 80 90 00
49 53 57 61 65 69 73 77 81 85 89 93 97 01 05 09

Source: CEIC, Barclays Capital Source: CEIC, Barclays Capital

7 June 2010 4
Barclays Capital | China

Housing market in China is In our view, a combination of structural factors – demographics, urbanisation, income
prone to a bubble… disparities and high savings – make China prone to a housing bubble, if policy is not
carefully managed. Some of these factors, which have supported housing demand up to
now, are likely to start to reverse in the next decade. In particular, the working-age
population is expected to peak around 2015. In addition, income disparity is likely to
narrow, and the saving rate to drop (see China: Declining trade surplus: A structural view, 6
May 2010), Hence, in our view at some point in the next 10 years, both consumer demand
and investment demand for housing will likely decelerate.

Monetary conditions are not the So far we have not discussed monetary policy, as we believe fundamental driving forces and
driving force distortions in the housing market go beyond monetary policy. Mortgage loans have grown
strongly along with housing price inflation in the past 10 years. However, in our view the co-
movement stemmed more from strong housing demand and economic optimism, which
are reflected in housing prices and then in bank lending, rather than a credit supply-driven
property price boom. Nevertheless, changes in monetary conditions may have a cyclical
impact on the housing market. In particular, the strong expansion of money and credit in
2009 probably raised inflationary expectations and reinforced investment demand for
property. Hence, in our view, regulatory and structural measures should be the main
instruments to control a property bubble, while monetary policy should guard against
playing an accelerating role.

How significant is the recent policy response?


New housing policy to limit The State Council issued a policy statement on housing on 15 April. Broadly speaking, the
investment demand and raise measures focus on two areas, one is to limit investment demand for housing, and the other
supply of public housing is to increase supply, particularly via public housing construction (Figure 9). An increase in
public housing supply will help to meet housing demand of low-income groups, and by
increasing the total supply of housing units, also will likely dampen private housing prices,
in our view. Excess investment demand is often a driving force in a housing bubble, and the
new limits on this front are of key importance, in our view.

Figure 7: Income disparity rose in the past two decades Figure 8: Savings increased markedly in the past 10 years

18,000 2.7 55 %
Urban (CNY, LHS) S/GDP
16,000
Rural (CNY, LHS) 2.5
14,000 50
Urban-rural ratio (%, RHS)
12,000 2.3
10,000 45
2.1
8,000
40
6,000 1.9
4,000
1.7 35
2,000
0 1.5 30
85 88 91 94 97 00 03 06 1995 1997 1999 2001 2003 2005 2007 2009
S/GDP

Source: CEIC, Barclays Capital Source: CEIC, Barclays Capital

7 June 2010 5
Barclays Capital | China

Down-payments and interest Specifically, to limit investment demand, the State Council policy statement instructed that:
rates are raised for second-home 1) for first-time homebuyers of units over 90sq m, the down payment was raised to 30%
mortgages (from 20%); 2) for second-home mortgages, the down payment raised to 50% from 40%
and the mortgage rate to no less than 1.1x the standard rate; 3) for the third-home (or
above) mortgages, the down payment and mortgage rate should be “substantially higher”;
4) local governments could impose special and temporary policies to curb property price
speculation; and 5) it would speed up the formulation and implementation of a “property
consumption tax” and would adjust taxes on “property-related income”.

Land supply for residential The statement stressed the need to increase housing supply, particularly via construction of
housing is increased sharply public rental and “affordable” housing. The planned land supply for residential property
development increased sharply to 180,000 hectares in 2010, up from the actual supply of
76,500 hectares in 2009 and an average of 54,650 hectares in the previous five years
(Figure 10). In particular, the land designated for public housing construction was raised to
24,000 hectares, more than double the 2009 allotment. Of the land for private housing
development, 80,000 hectares was set for medium- and small-sized housing units. Indeed,
there are specific requirements on fulfilment of land allocation for different types of
residential development by the local governments (Figure 11). The aim is to increase the
use of land for public housing and medium- and small-sized private housing at a minimum
of 70% of the total land allocated for residential purpose.

Public housing construction is On 19 May, the Ministry of Housing and Urban-Rural Development signed letters of
set to increase sharply responsibility with the provincial and municipal governments on 2010 public housing work

Figure 9: The government policies since April 2010


Date Agency Major policy measures or announcements
31-May State Council ƒ Approved the NDRC’s plan for a gradual reform of the property tax
26-May State Tax ƒ To tighten the collection of the land value appreciation tax from developers, including guidelines on the
Administration technical details for calculating the amount due
19-May Ministry of ƒ Signed letters of responsibility with all the provinces and cities on 2010 public housing construction
Housing ƒ Local governments will be responsible for supervision, financing, land supply, and ensure the completion
of the 2010 target
ƒ The nationwide target is 3mn units of public housing supply and 2.8mn units of reconstructed slum-area
housing supply
26-Apr CSRC ƒ Chinese real estate companies planning to raise capital through share issuances will have to be jointly
approved by both the Securities Regulatory Commission and the Ministry of Land and Resources
19-Apr Ministry of ƒ Property developers are ordered not to take deposits for the sale of uncompleted apartments without
Housing proper approval.
ƒ Developers approved to conduct sales of uncompleted apartments must make information about the
price and number of units publicly available
15-Apr Ministry of ƒ Significantly increase land supply for (public) housing construction in 2010. Planned housing supply is
Land 1.4x the actual land supply in 2009. Planned supply for public housing is double the actual supply in 2009
14 and State Council ƒ Issued a notification entitled "to resolutely curb the excessively fast property price rise in some cities”
17-Apr ƒ For first home of size over 90sqm, raise mortgage down payment to 30% from 20%
ƒ For second home purchase, raised mortgage down payment to 50% from 40% , mortgage rate not lower
than 1.1x benchmark lending rate
ƒ For third and above home purchase, down payment and mortgage rate will be substantially higher
ƒ Banks in cities with excessive property price gains are advised to stop mortgage lending to third-home
buyers, and to buyers without residence approval
ƒ To strengthen property market supervision, cracking down illegal acts, such as land hoarding and sales
delays by developers
ƒ To increase the supply of housing, particularly of public and affordable housing
ƒ Demand provincial governments to take overall responsibility in stabilising housing prices and ensuring
housing supply, and municipal governments are responsible for policy implementation
Note: For other key policy responses in 2008-09, see Figure 1 in the “Increase supply to limit property price inflation”, Global Economic Weekly, 18 December 2009.
Source: www.xinhuanet.com, Barclays Capital

7 June 2010 6
Barclays Capital | China

objectives. The government is targeting public housing construction in 2010 at 3mn units, a
substantial increase from 2009. According to this plan, the size of public housing
construction in 2010 will likely be 180mn square metres (assuming an average size of
60 sqm for public housing), equivalent to over 30% of total residential completions in 2009.
It is unlikely that the 3mn units will be completed in 2010, considering that the impetus
increased only recently. But there is no doubt, in our view, that public housing will increase
over time to meet a substantive part of the total housing demand. We have seen specific
follow-up measures from some local governments. In particular, the municipal government
of Chongqing, one of the four largest cities in China, announced a target of an increase in
public housing to meet one-third of the total housing demand. Shanghai has also launched
an initiative on public rental housing.

A regime shift in housing policy We note that in addition to the specific measures, the provincial governments have been
asked to take responsibility for stabilising housing prices and ensuring housing supply.
Some in the market have questioned the sustainability of the housing measures. In our view,
the recent measures represent a regime shift in housing policy, and we believe the
government will not easily change course for three reasons: 1) high housing prices have
become a social and political issue; 2) a significant decline in the housing market will not
cause a hard landing for the economy (see below); and 3) a rise in the volume of land sales
will help to limit the impact of a fall in land prices on local government financing.

We expect a significant price Following the recent policy announcement, transaction volumes in the private housing
decline market have declined sharply in major cities. We expect a significant decline in housing
prices, possibly 20-30% in the next few quarters. If the policy objective of returning housing
to an affordable commodity for most people is to be achieved, there must be a significant
retreat. This will likely happen as investment demand is curtailed and supply, particularly of
public housing, is increased over time.

What are implications for the economy?


Housing correction is not going How will the economy be affected by a correction in the housing market? For any sector of
to cause a hard landing or the economy, a downturn must affect some stakeholders. In this case, some property
double dip in the economy developers may face cash flow problems as sales drop, and the quality of banks’ property-

Figure 10: Land supply planned for residential development Figure 11: … with specific requirements on its allocation for
rises sharply in 2010 different segments of the market

Hectares, th low-rental housing


Land supply for housing (4%)
200

Land supply for public housing economic housing


160
(9%)

120 slum area


reconstruction
80 (20%)
small & medium
size housing (44%)
40

Large & deluxe size


0
housing (23%)
2010 (planned) 2009 (actual)

Source: CEIC, Barclays Capital Source: CEIC, Barclays Capital

7 June 2010 7
Barclays Capital | China

related loans may be affected. However, from a business cycle perspective, the economy is
also at a strong point, and some slowdown in overall growth may be desirable to control
inflationary pressures. We do not believe that a significant decline in housing prices will
cause a hard landing or double dip in the economy. Moreover, in our view, even a collapse
in the housing market, at this point, will not cause a financial crisis in China. On the other
hand, we believe that the damage caused by a property bubble to the long-term growth
potential of the economy is often understated, and that public policy should guard against
being unduly influenced by exaggerated short-term concerns.

Near-term impact on the economy is often overstated


Impact on household We take a sanguine view on the impact of a housing price fall on consumption. Any wealth
consumption is likely to be effects associated with changes in housing prices are likely to be limited, in aggregate terms.
limited First, about half of the population lives in rural areas, where the property market is not active
and changes in housing prices in urban areas do not have a significant impact. Second,
while a fall in prices likely has a negative wealth effect for existing homeowners, potential
buyers would benefit from it. Low-income people, the younger generation and new urban
residents migrating from rural areas would be able to save less for down-payments and
hence have more money for consumption, and these people tend to have a higher
propensity to consume than high-income people. Figure 12 shows that household
consumption growth historically has show little correlation with the index measuring
property market conditions. This is supported by an earlier empirical study (see “Property
Market and the Macroeconomy of Mainland China”, Pacific Economic Review, April 2008).

Impact on private housing The impact on private investment could be more significant, but should not be large on
construction can be significant overall growth, in our view. Housing construction and investment has accounted for about a
… quarter of fixed asset investment in recent years, and historically it has been positively
correlated with housing market conditions (Figure 13). As total investment has accounted
for about 44% of GDP in recent years, property construction and investment made up
about 11% of GDP.

...but public housing construction We provide broad estimates of the implications for the growth outlook. For 2010, our
is a partial offset current projection of real GDP growth at 10.1% already includes a reduction in investment
contribution to growth from 8pp in 2009 to 5pp this year (Figure 14), reflecting credit

Figure 12: Consumption shows little correlated with property Figure 13: … but real estate investment is significantly
market conditions affected by changes in housing market conditions

25 110 50 110

20 40
105 105

15 30
100 100
`
10 20

95 95
5 Household consumption (% y/y) 10 FAI (% y/y)
Real estate investment (% y/y)
Real estate climate index Real estate climate index
0 90 0 90
Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10

Source: CEIC, Barclays Capital Source: CEIC, Barclays Capital

7 June 2010 8
Barclays Capital | China

tightening and restrictions on new projects as well as a high base. Out of the 3pp decline,
0.75pp is attributable to property investment. Considering the latest developments, we
assume now a sharp fall in private housing construction growth to a low single-digit rate by
Q4. On the other hand, we assume the 3mn public housing target for 2010 will consist
roughly of one-third each for newly started, ongoing, and completed units, implying more
than 100% growth in public housing investment in 2010. These give rise to overall real
property investment growth of around 16% in for 2010 as a whole (compared with 30%
y/y in Q1). We then derive an estimate of the change in property investment contribution to
GDP growth in 2010 from 2009 at -0.91pp, compared with -0.75pp already factored in. This
suggests a downside risk of around 0.2pp to our overall growth forecast of 10.1% for 2010.

Figure 14: Implication for our growth forecast


2009 2010F 2011F

Current growth forecast


Real GDP (% ) 8.7 10.1 9.0
Contribution to GDP growth
Consumption (pp) 4.6 5.4 4.6
Gross Capital Investment (pp) 8.0 5.0 4.4
Change in contribution to GDP growth (pp) 3.9 -3.0 -0.6
of which property investment (pp) 1.1 -0.8 -0.2
Net Exports (pp) -3.9 -0.3 0.0
Downside risk due to the latest property tightening policy
Real property investment (%y/y) 24.0 15.7 7.0
Private (%y/y) 10.5 0.0
Public-related housing (%y/y) 100.0 70.0
Change in property investment contribution to GDP growth (pp) -0.9 -0.9
Decline in growth compared with the current forecast (pp)
Real GDP (%) -0.2 -0.7
Note: Contribution to GDP growth = % growth rate * share in GDP in the previous year
Source: CEIC, Barclays Capital

We see small downside risk to For 2011, we assume investment in one-third of the 3mn public housing units targeted in
our growth projection 2010 will fall mainly in 2011, with a further 2-2.5mn new units to be started in the year
(according to the plan announced in late 2008). This translates into a moderation in public
housing investment growth from the high base in 2010. We also assume a slowdown in
private property investment to zero growth for the year as a whole. Putting these together,
we estimate a downside risk of 0.7pp to our forecast of 9% GDP growth in 2011. However,
we believe the overall case is not strong enough to change our forecast. First, the
government is pushing for increases in small and medium-sized private housing
construction, and more generally in overall housing supply. This is in contrast to the
housing market tightening in 2007, when the policy focused on slowing property
investment via controlling land supply. Even in that episode, property investment growth
dropped to single-digit growth in 2008 only for a few months (Figure 15). In other words,
our assumption of zero growth in private housing is a rather extreme case. Secondly, policy
could be relaxed in other areas in 2011 if needed, such as boosting investment
infrastructure and public utilities. Overall, we believe our scenario serves to supports our
view of no hard landing in the Chinese economy.

7 June 2010 9
Barclays Capital | China

A property collapse at this point will not cause a financial crisis


A significant drop in housing prices and slowdown in property transactions will likely
worsen banks’ asset quality via the impact on mortgage delinquencies and loans to
developers. However, we believe a banking crisis is unlikely even in the event of a collapse in
property prices.

Banks’ exposure to the property First, while banking sector’s exposure to the property sector has increased over time,
sector is not large especially in 2009, it is from a low base. The direct exposure, measured by the share of
mortgage loans and loans to developers in total loans, stood at about 20% in Q1 10 (Figure
16). Their indirect exposure, eg, lending using land and commercial properties as collateral,
however, is likely to be significant. Nevertheless, the repayment capacity of borrowers
depends more upon on their cash flow than changes in values of the collateral. Hence, as
long as the economy is not trapped in a prolonged period of low growth, the concern is
unlikely to be of systematic importance.

China is not vulnerable to a Second, China does not rely on external financing and, therefore, is not vulnerable to a
sudden stop in either external sudden stop in external financing flows. A common feature of the financial crises in other
financing… countries in recent years is that in most cases, external financing was involved to a
significant degree in the boom period, and a sudden stop in this financing often triggered a
crisis. China has been a significant net exporter of capital, and capital inflows are mostly in
the form of foreign direct investment. Furthermore, its external investments are mostly in
liquid instruments such as foreign government bonds.

… or in bank lending to the Domestically, the banking system has a large pool of liquidity locked up in required reserves,
nonbank sector which can be released in times of need. Moreover, Chinese banks are majority owned by the
state, and in our view, it is hard to imagine that a wiping out of banks’ capital position due
to loan losses would lead to a sudden stop in bank lending to the non-bank sector, which is
often an important accelerator of a financial crisis.

Households ultimately bear the This does not mean that there is no price to be paid in association with loan losses. The
cost of bad loans government policy favours the banking system via interest rate regulation, which gives
banks’ an unusually large lending spread. However, this comes at a cost to households,
which receive a low, regulated deposit interest rate. Moreover, in the event the government
needs to recapitalise banks, households will be the ultimately bearer of the costs.

Figure 15: Property lending relative to total loans and NGDP Figure 16: Banks’ exposure to the housing sector is not large

Real estate investment (% y/y) 22


45
Real estate investment,deflated by PPI (% y/y)
40
35 18
30
25
14
20
15
10
10
5 Mar-05 Dec-05 Sep-06 Jun-07 Mar-08 Dec-08 Sep-09
0 Real estate loan /total outstanding loan (%)
Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Real estate loan /GDP (%)

Source: CEIC, Barclays Capital Source: CEIC, Barclays Capital

7 June 2010 10
Barclays Capital | China

Longer-term damage of a housing bubble is often understated


A housing bubble, if unchecked, would increase distortions and inhibit structural
adjustments in the economy, and its eventual bursting, particularly if associated with a
change in demographic trends, would be very damaging to the long-term growth potential
of the economy. In our view, this is a bigger risk than a financial crisis.

Housing bubble increases social First and foremost, rapid housing price inflation has created a social problem, as investment
discord demand crowds out consumer demand for housing. Also, the wealth gap between low-
income and high-income groups is exacerbated by housing price increase, as the latter
group is more likely to have bought and invested in properties. If price inflation continues,
social discord will only rise.

Inter-generational gap Second, there is also an intertemporal element. In general, the older generation tends to
compounds the problem of benefit from housing price inflation while the younger generation tends to suffer. As assets
population aging are claims against future goods and services, the inter-generation wealth gap will only
exacerbate the burden of the younger generation, which will increase as the population
ages. In other words, the older generation (people in their 40s and 50s) will take too big a
share of resources at the expense of the younger generation. This would distort incentives
and reduce the innovative capacity of the economy, which will be very important as a
source of economic growth after working-age population peaks in 2015.

Low housing affordability hurts Third, high housing prices in cities are not conducive to urbanisation, which has been an
urbanisation important driver of economic growth in China. The importance of urbanisation as a source
of growth will only increase as population ages and surplus labour disappears.

Excess investment in housing Fourth, strong investment demand means a lot of savings are put into property holdings
causes inefficient allocation of with questionable long-term returns for individual investors and, even more so, for the
resources economy as a whole. As demographics change and savings decline, both consumer and
investment demand for housing will decelerate, and any bubble will eventually burst. For the
economy as whole, a housing bubble leads to inefficient resource allocation and damages
the longer-term growth potential.

7 June 2010 11
Barclays Capital | China

EMERGING MARKETS RESEARCH

Piero Ghezzi
Head of Economic and Emerging Markets Research
+44 (0)20 3134 2190
piero.ghezzi@barcap.com

EM Global
Michael Gavin Andrea Kiguel
Head of Emerging Markets Strategy EM Strategist
+1 212 412 5915 +1 212 412 5965
michael.gavin@barcap.com andrea.kiguel@barcap.com

Asia
Jon Scoffin Peter Redward Wensheng Peng Jian Chang
Head of Research, Asia-Pacific Head of Emerging Asia Research Head of China Research Regional Economist – China, Hong
+65 6308 3217 +65 6308 3528 +852 2903 2651 Kong
jon.scoffin@barcap.com peter.redward@barcap.com wensheng.peng@barcap.com +852 2903 2654
jian.chang@barcap.com
Wai Ho Leong Prakriti Sofat Rahul Bajoria
Senior Regional Economist – Korea, Regional Economist – Indonesia, Regional Economist – India, Malaysia,
Malaysia, Singapore, Taiwan Philippines, Sri Lanka, Vietnam Thailand
+65 6308 3292 +65 6308 3201 +65 6308 3511
waiho.leong@barcap.com prakriti.sofat@barcap.com rahul.bajoria@barcap.com
Matthew Huang Kumar Rachapudi Krishna Hegde Avanti Save
Strategist – North Asia Strategist – South Asia Credit Strategist Credit Strategy
+65 6308 3093 +65 6308 3383 +65 6308 2979 +65 6308 3116
matthew.huang@barcap.com kumar.rachapudi@barcap.com krishna.hegde@barcap.com avanti.save@barcap.com

7 June 2010 12
Analyst Certification(s)
We, Wensheng Peng and Jian Chang, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or
all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to
the specific recommendations or views expressed in this research report.

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