J Hous and the Built Environ (2017) 32:133–155

DOI 10.1007/s10901-016-9505-6

ARTICLE

Price bubbles and policy interventions in the Chinese

housing market

Dayong Zhang1 • Ziyin Liu1 • Gang-Zhi Fan2 •

Nicholas Horsewood3

Received: 20 April 2015 / Accepted: 22 January 2016 / Published online: 19 March 2016
 Springer Science+Business Media Dordrecht 2016

Abstract The recent dramatic increases in house prices have led to considerable attention
being focused on housing markets in China. Using a unique dataset of city-level house
prices and rents, this paper investigates the presence of price bubbles in major Chinese city
housing markets. Our findings show evidence of price bubbles in most housing markets,
even though the bubbles might be, to a large extent, mitigated by strong government
intervention. In order to distinguish rational bubbles from irrational bubbles, we extend the
existing work to allow a deterministic time trend and break points in the unit root test of
house price–rent ratios. As a consequence, our results demonstrate that the price–rent ratios
in most of the sample cities are no longer non-stationary, implying the non-existence of
rational bubbles in the housing markets.

Keywords Housing bubble  Price–rent ratio  House price  Policy intervention  Club
convergence

JEL Classification R31  R38  E31

& Gang-Zhi Fan

fan10@konkuk.ac.kr
Dayong Zhang
dzhang@swufe.edu.cn
Ziyin Liu
lzyjg2011@gmail.com
Nicholas Horsewood
n.j.horsewood@bham.ac.uk
1
Research Institute of Economics and Management, Southwestern University of Finance and
Economics, Chengdu, China
2
Department of Real Estate Studies, Konkuk University, 120 Neungdong-ro, Gwangjin-gu,
Seoul 143-701, Korea
3
Department of Economics, University of Birmingham, Edgbaston, Birmingham, UK

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134 D. Zhang et al.

1 Introduction

Since the collapse of the U.S. sub-prime mortgage market in 2008, much attention has been
paid to the conditions of housing markets across the world. House prices in most countries
displayed a rapid increase during the early 2000s, followed by a sharp drop after the
financial crisis (Wachter 2015). Such time series patterns suggest the presence of house
price bubbles which can have major implications for the stability of economies. For most
homeowners, housing assets comprise the largest share of household wealth and changes in
the value of the family residence may have a major impact on economic activity, partic-
ularly on consumers’ expenditure. Moreover, decreases in property prices may influence
the solvency of housing finance intermediaries. Consequently, how to detect bubbles in
housing markets and, if observed, how to slowly cool them down is a challenge for
policymakers.
In China, the housing market has experienced remarkable reforms in recent years,
starting with privatization programme introduced in 1998.1 Concomitant with the rapid
expansion of home ownership, house prices grew sharply over the last decade (Wu et al.
2012). In major Chinese cities, such as Beijing, Shanghai, and Shenzhen, house prices have
approached Western levels. The astonishing development of the Chinese housing market
has not only been characterized by high house price inflation but, from the supply side,
there has been ever-increasing investment in the real estate industry. According to the
China Statistical Yearbooks, total residential investment has accounted for more than 10 %
of GDP since 2008. During the recent global economic recession the Chinese central
government introduced a stimulus package of four trillion RMB to promote economic
growth, with a significant proportion of the package being directed toward sectors relating
to the real estate.2 China’s National Bureau of Statistics model calculates that for every 100
RMB investment in the real estate industry, there will be an increase in output in the wider
economy equivalent to 286 RMB. Given the huge importance of the real estate industry to
the general economy, a healthy, stable housing market is crucial to local governments as
well as the Chinese central government. Excessive intervention, which unnecessarily
hinders house price developments, could have detrimental impacts on the economy.
Whether there existed house price bubbles in major Chinese cities and the effectiveness
of the recent housing policy for the different regions are important questions given the role
of China in the world economy. This paper extends the asset bubble literature to address
these research issues using a unique city-level real estate dataset, containing information
on the average housing price and rental price of each of the major cities. The time series
behavior of city-level housing markets can be analysed from 2008. In particular, since the
recent global finance crisis has important implication for many housing markets (e.g., Duca
et al. 2010), it is interesting to look at what happened to the Chinese housing market after
the crisis. In responding to the finance crisis, the Chinese central government ever pushed
out the four trillion RMB stimulus package, which is usually believed to have further
driven up house prices and possibly created a bubble. Although a hot topic, relatively little
research has been undertaken on bubbles in the Chinese housing market. Two recent
exceptions are Ren et al. (2012) and Dreger and Zhang (2013), while these two studies do
not come to a single conclusion regarding major Chinese cities.

1
See Wu et al. (2012) for a detailed description of the history of Chinese housing market.
2
Shanghai Security News, reprinted in Sohu News (http://news.sohu.com/20090317/n262835241.shtml).

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Price bubbles and policy interventions 135

Housing bubbles are usually understood as the systematic deviation of house prices
from market fundamentals (Muellbauer and Murphy 2008). Numerous previous studies
have detected housing bubbles by testing for cointegration relations between house prices
and rental prices or the presence of unit roots of house price–rent ratios (e.g., Mikhed and
Zemcı́k 2009; Clark and Coggin 2011; Ren et al. 2012). However, there is a remarkable
shortcoming with the analysis of housing bubbles in the existing literature as little attempt
is made to consider the difference between housing market and stock market (Kivedal
2013). We allow for a deterministic time trend in the formation of the bubble process, and
changes in housing policy may change the structure of the market.
Furthermore, the similarity of city-level house price bubbles in China is explored.
Housing markets can usually be characterized by regional heterogeneity, and housing
prices therefore are, to a large extent, affected by regional and idiosyncratic factors (e.g.,
Hwang and Quigley 2006; Fratantoni and Schuh 2003). Clark and Coggin (2009), among
the first, demonstrate that regional economic factors are likely to drive housing prices to
converge regionally, while little research has explored the important implication of
regional housing price convergence for potential housing bubbles. Using a recently
developed methodology by Phillips and Sul (2007), although a countrywide convergence
does not exist, the major Chinese cities in our sample can be grouped into convergent
clubs. By searching the patterns of city-level housing price dynamics in this country, our
results attempt to provide policy suggestions to the policymakers.
The remaining of this paper is organized as follows. Section 2 provides discussion of
the Chinese housing market, followed by a section reviewing the literature on bubbles and
studies about Chinese housing market. Section 4 introduces the theoretical background of
housing bubbles. Section 5 explains the empirical design of our paper, and the description
of data is given in Sect. 6. Section 7 reports the results and analyses the findings. The last
section summarizes the major findings and concludes this paper.

2 The Chinese housing market

Until 1998, housing units were assigned to households by the government, via the workplace
at state-owned enterprises, and were heavily subsidised. The reforms of the housing market
introduced private sector policies and home ownership began to be the dominant tenure,
although the ownership was limited to only 70 years. The encouragement of home ownership
was successful with owner-occupation of urban households increasing to 87.8 % in 2008,
according to figures from China’s National Bureau of Statistics. Over the same time period,
the new dwellings increased in both size and quality (Yi and Huang 2014).
The initial surge in housing demand was due to the desire to provide better quality
accommodation for the family. However, it had the inadvertent impact of leading to
spectacular increases in house prices over the last decade. Between 2004 and 2009 property
prices doubled in the 35 major Chinese cities, creating large capital gains for households
who were fortunate enough to have become home owners in the early post-reform years.
Consequently, housing started to be demanded as an asset as in Western markets, with
investors owning more than one dwelling in the hope of making capital gains due to
increasing property prices. According to the China Household Finance Survey (CHFS),
about 19 % of urban households owned more than one housing unit in 2013. The major
difference with Western markets is that the houses were not necessarily rented out but left
vacant, with the aim of being sold off at a later date.

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136 D. Zhang et al.

The build-up of asset demand speculative pressure led to the view that there was a
speculative bubble in the Chinese housing market, where house prices might persistently
deviate from the fundamental levels for a significant period of time. That is, the house
prices cannot be justified by those fundamental factors such as personal incomes, popu-
lation, or housing rents.3 Two recent articles, published in the Wall Street Journal and the
New York Times, expressed concerns that a house price bubble might be developing in
China.4
Over the last couple of years the Chinese central government has implemented a series
of strict policies designed to cool down speculative activities in the over-heating housing
market. While the central government relaxed its macroeconomic regulation and control
policy in 2008 and 2009 as a result of global financial crisis, the most stringent government
intervention was seen in 2010 due to dramatic increases in house prices across major cities
in China. The rising risk of a housing market bubble, coupled with growth of GDP
equaling 11 % in the first quarter of 2010, forced the central government to impose tight
regulations on home purchases. Table 1 summarizes the major policies in 2009 and 2010
implemented by the central government. The most stringent housing policies in China were
introduced in the first four months of 2010, including restrictions on the terms of housing
loans and on the interest rate.5
The list of policy changes illustrates how the government still had an influence on the
private housing market by impacting on developers, via the supply of land, and on
households, by affecting the ease of obtaining housing finance.6 The large number of major
interventions suggest that the home ownership market in China was overheating during
2009 and 2010 and the government was attempting to reduce the pressure and avoid a
house price bubble.
One approach to examine the possible existence of house price bubbles concerns the
time series properties of the housing market, and considers the house price index and the
rental price in each city. Figure 1 plots monthly data of house prices and rental prices for
33 major Chines cities between August 2008 and August 2013. A clear deviation of a city’s
house price from its rental price can be seen between 2010 and 2012, with the gap being

3
The key to detect a housing bubble is dependent on where there exists a stable relationship between
housing prices and fundamental factors such as personal incomes, population, or housing rents. Case and
Shiller (2003) provide a detailed discussion on the relationship between housing prices and the fundamental
factors. When these fundamental factors cannot interpret the variations in housing prices, this implies a large
likelihood of the presence of housing bubbles.
4
See Davis (2014) and Bradsher (2014).
5
It is noteworthy that China is a large country with a huge population and land area. It has a complicated
administrative system, and its cabinet, namely the highest administrative organization, is the State Council,
which is composed of various ministries, commissions and the central bank. The State Council, and its
ministries, commissions, or administrative offices are authorized to make managerial rules and policies,
while the ministries or commissions have responsibility to perform their administrative functions in their
respective fields. This helps understand why there might be several regulatory bodies that make housing
policies shown in Table 1.
6
To suppress speculative housing demand, on Apr. 17, 2010 the State Council issued the rules imposing
limitations on housing purchase and loan eligibility by adopting legal, administrative and tax measures, and
China’s major city governments correspondingly localized these rules subsequently. For example, on
February 16, 2011 the Beijing municipal government released its stringent home-purchase limitation rules.
According to the policy, a Beijing-Hukou family who has owned more than one housing unit was directly
forbidden from purchasing one additional housing unit in this city. A non-Beijing-Hukou family who has
owned one housing unit or more was also banned from buying an extra housing unit in this city, if its
members had no temporary residence permits or did not pay society insurance or personal income taxes over
past five consecutive years.

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Price bubbles and policy interventions 137

Table 1 Major housing market policies in 2009 and 2010

Time Regulatory body Key intervention policies

Oct. 9, The State Council From Jan. 2010, qualified exemption of operation tax for private
2009 meeting house transaction changes from 2-year holding period to 5-year
Dec. 14, The State Council ‘‘Four clauses’’
2009 1. Increase residential house supply
2. Support the consumption of improvement and self-use house,
and suppress speculative house investment
3. Reinforce housing market supervision
4. Promote public housing construction
Jan. 10, General Office of the ‘‘Eleven clauses’’
2010 State Council Regarding to consumption and investment demand for housing,
reinforce the differential policy in terms of
1. Credit and loans
2. Taxation
Mar. 10, Ministry of Land and Strengthen the supply and supervision of land use for real estate
2010 Resources development by
1. Setting minimum deposit to 20 % of land base price for
developers
2. Requiring paying off 50 % of land price within one month of
land purchasing
March 22, Ministry of Land and Improve land auction system, and increase land supply; for cities
2010 Resources meeting with higher price level and growth rate, strictly control land
supply to the construction of big size housing
Apr. 2, Ministry of Finance For a person who has a house purchasing history, the tax benefit
2010 for first-time home buyer is no longer applied to this person or
others who have bought another home together with the
aforementioned person
Apr. 15, The State Council Down payment for buying a second home is no less than 50 % of
2010 meeting house price, interest rate raises 10 % above the base rate; Down
payment for a first home buyer with the purchased home area
above 90 square meters is no less than 30 %
Apr. 17, The State Council ‘‘New Ten Clauses’’
2010 Stabilize house prices by introducing accountability mechanism
for local governments
Increase public housing supply and construction
Suppress speculative housing demand

reversed in more recent years. The different time series patterns may just indicate the
different speeds of adjustments in the renting and owner-occupation markets for each city.
Efficient market hypothesis suggests that asset prices can reflect new information fully
and immediately and therefore should follow a random walk path. Many financial studies
have presented empirical evidence on the random walk behavior of stock prices (e.g.,
Borges 2010). However, housing markets are usually considered as less efficient than stock
markets, partly as they may be dominated by unprofessional investors with irrational
behavior. Previous studies, such as Clayton (1997, 1998), have demonstrated that the house
price booms might be largely caused by irrational expectations. Malpezzi and Wachter
(2005) also highlight the remarkable role of backward-looking expectation rather than
rational expectation in driving up housing prices. Kivedal (2013) stressed that the detected
U.S. housing bubbles were more likely to be irrational rather than rational, while the

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138 D. Zhang et al.

Rental Price (12 months, RMB per Square Meter)

12,000 30
PRICE
RENT
House price (RMB per Squre Meter)

11,000 28

10,000 26

9,000 24

8,000 22

7,000 20

6,000 18
08M08 09M01 10M01 11M01 12M01 13M01

Fig. 1 House price and rental price (average across 33 cities)

former may be defined as a fixed increase in house prices driven by backward-looking

expectation. The expected constant increase in property values is consistent with the
perspective of inefficient housing markets, implying that housing prices cannot incorporate
new information fully and immediately. This indicates that housing price movements do
not appear to follow a random walk pattern and their past trends therefore might be
continuable as we can often find, implying that the trend of housing price growth may be
deterministic rather than random.
Statistical tests for stock market bubbles need to be modified for housing markets by
allowing for house prices or price–rent ratios to follow a deterministic trend (e.g., Chen
et al. 2004). The inclusion of a trend makes house prices deviate from fundamentals,
creating the occurrence of a housing bubble. However, the existing literature only con-
siders a housing bubble to be present if there is a stochastic trend or unit root in the house
price–rent ratio, with the deterministic time trend controlled for in the standard unit root
tests. We adopt a different approach to analyzing a housing bubble by decomposing the
trend of house price growth into two parts: a deterministic time component and a stochastic
component.
When there exists a deterministic time trend, real estate investors form their expecta-
tions following a backward-looking tendency, implying that not all available information is
immediately incorporated into the expectations formation process. In contrast, investors
with rational expectations form their expectations of the value of an asset using all relevant
information, which is also the proposed basis of the efficient market hypothesis (Mishkin
2004, Chapter 7). Consequently, the price expectations of an asset varies due to new
information, with news being random and following a stochastic process. A rational asset
bubble is the one driven by the kind of expectation and is therefore detected usually using
the unit root test for the existence of the stochastic trend.
Attention is also paid to the possibility of structural breaks when detecting housing
bubbles. Failure to do so might result in the incorrect conclusion about the null hypothesis
of a unit root or of no cointegration relationship (Westerlund 2006). Structural breaks in
time series data are likely to distort the results of standard unit root tests (Perron 1989; Im

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Price bubbles and policy interventions 139

et al. 2005). Housing markets are, to a large extent, subject to government policy inter-
ventions, which are likely to lead to structural breaks or changes in these markets (e.g.,
Phang and Wong 1997). The Chinese housing market, in economic transition to a market-
based economy, can be characterized as frequent government interventions as discussed
above. These interventions have been identified to probably exert lasting effects upon the
economic fundamentals in China (e.g., Smyth and Inder 2004). It is important to take
structural changes into consideration in housing bubble detection. As a consequence, our
study also attempts to examine the impact of structural breaks in trend on housing bubbles,
an approach ignored in the extant literature on housing markets.

3 Bubbles: literature and the analytical framework

3.1 Literature review

Since Blanchard (1979), where a theoretical rational expectations model explained the
long-term deviations of asset prices from their fundamental values, bubbles in asset
markets have persistently been a hot topic. Blanchard and Watson (1982) extended the
theoretical model to consider rational asset bubbles and market efficiency. However, the
predictions from the model were inconsistent with empirical findings. Other studies, for
example Evans (1989), and Evans and Honkapohja (1995), examined theoretically the
presence of rational bubbles based on rational expectations, while they also address the
fragility of occurrence of the bubbles.
An asset bubble occurs on account of asset investors’ optimistic expectations of future
asset prices, although the expected price might not be justified by its fundamentals (Stiglitz
1990). Campbell and Shiller (1987, 1988) developed an empirical framework for testing
rational bubbles in financial markets. As a result, we can decompose asset prices into two
components: a fundamental part and a bubble part. Tests for rational bubbles in previous
studies examine whether there are persistent deviations of prices from their fundamental
values based on standard unit root or cointegration tests. While the econometric approach
has evolved markedly over recent decades, the basic logic built on Campbell and Shiller
(1987, 1988) for testing rational bubbles remains. Koustas and Serletis (2005) and Cunado
et al. (2005) provide two good reviews of the literature but do not reach consistent con-
clusions on the presence of rational bubbles in financial markets.
Other studies have attempted to investigate asset bubbles from the angle of irrationality,
for example, Shiller (1988), Lux (1995), Topol (1991). In the wake of the burgeoning
development of behavioral finance research, irrational behavior, such as noise trading,
herding behavior, fads, or mimetic contagion, has attracted much attention when
accounting for asset bubbles. In financial markets, many investors might be inexperienced
or have imperfect information, so they often tend to follow or mimic the investment
strategies of those with information or reputation advantages. The financial literature has
demonstrated evidence on the presence of the irrational behaviors (e.g., Grinblatt et al.
1995).
A growing number of studies have adapted the work in financial markets to explore the
issue of bubbles in housing markets. For example, McCarthy and Peach (2004) investigate
whether there existed a country-wide price bubble in the US housing market and their
findings were inconclusive. They decided that the volatility of housing prices was driven
by market fundamentals. In sharp contrast, Mikhed and Zemčı́k (2009) provide evidence

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140 D. Zhang et al.

supporting the existence of house price bubbles in the U.S. Metropolitan Statistical Areas.
The recent collapse of the U.S. housing market has triggered another series of studies
associated with housing bubbles, for example, Lai and Van Order (2010), Clark and
Coggin (2011), McDonald and Stokes (2013), and Kivedal (2013). These studies followed
the present-value model framework of Campbell and Shiller (1987, 1988) to test the
cointegrating relation between house prices and rental prices, in that housing rental prices
can usually be thought of as the fundamental values in determining housing prices.
Alternatively, it is also equivalent to testing the presence of unit roots in the time series of
house price-to-rent ratios. In an earlier research, Clark (1995) highlighted the potential of
this category of approaches in the valuation of house prices.
Compared to the empirical literature on the US housing market, studies detecting house
price bubbles in China’s housing market are rather limited owing to the dearth of real
estate data. A relative short history of a market-based housing market, coupled with
frequent government interventions, also make such empirical studies difficult. Neverthe-
less, similar to the previous studies, Hui and Yue (2006) investigate whether housing
bubbles exist in Hong Kong, Beijing and Shanghai based on the cointegration test
approach. They found a house price bubble in Shanghai in 2003 but in Beijing. Dreger and
Zhang (2013) employed a panel data set comprising property-related variables for 35 major
cities in China and found that house price bubbles existed in these cities, arguing that they
were probably due to the fiscal stimulus package and substantial credit expansion. How-
ever, housing rents were not incorporated as a fundamental factor in driving the fluctuation
of housing prices. Similar, Ren et al. (2012) investigated the existence of bubbles in the
Chinese housing market using annual real estate data of the major Chinese cities up to 2009
but could not provide any evidence of them. No adjustment was made for the implications
of the recent government policies for the housing market. The current Chinese housing
market can be characterized as frequent policy interventions, which are likely to result in
structural breaks in economic time series and therefore distort the results of unit root tests
(e.g., Smyth and Inder 2004).

3.2 Analytical framework

Present value models have been applied extensively to areas of economics and finance, for
example the price–dividend ratio (Balke and Wohar 2002), expected stock returns (Van
Binsbergen and Koijen 2010) and the exchange rate (Engel and West 2005). The housing
market version of the model suggests that the house price–rent ratio is based on house-
hold’s expectations of future rental growth and future house price inflation. There is a
burgeoning literature where the price–rent ratio is employed to investigate the degree of
overvaluation in the housing market (see inter alia Kishor and Morley 2015; Engsted and
Pedersen 2015; Hattapoglu and Hoxha 2014).
The present value model of asset prices is based on Campbell and Shiller (1988) and
provides a theoretical framework for analysing bubbles. Based on the model and some time
series techniques (see Appendix 1 for more details), they develop two testing methods for
rational bubbles, namely, a multivariate cointegration test and an univariate version test
based on unit root analysis.
These two frameworks can also be applied to detect rational bubbles in housing markets
in addition to those in stock markets. While there are some noteworthy differences between
housing market and financial market, we can adjust the present-value methodology to the
housing market. For example, we replace the stock dividend–price ratio with the house
price–rent ratio, which may be calculated based on the regionalized housing markets. We

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Price bubbles and policy interventions 141

can also allow for the frequency of housing transactions using monthly housing transaction
data.
Phillips and Yu (2011) conduct a more recent extension for the test strategy by further
developing an explosive process to interpret the existence of financial asset bubbles. If we
use pt to represent the fundamental value of housing determined by the present value
model, the actual house price might deviate from this fundamental value in the below
expression:
pt ¼ pt þ bt ð1Þ
where the additive component bt represents the bubble component. According to Blan-
chard and Watson (1982), if we allow for the continuous growth or bursting of a bubble for
next period, it may be expressed as the following form
(
ð1 þ rt Þ
btþ1 ¼ bt þ utþ1 with probability p ð2Þ
p
etþ1 with probability 1  p
where Et ½utþ1  ¼ Et ½etþ1  ¼ 0. It is noteworthy that Eq. (2) does not take a deterministic
time trend into consideration, while it is important to incorporate such a trend into the
testing of house bubbles as discussed above. To allow for a deterministic time trend,
suppose that it launches at time i, for i \ t, and continuously grow until the bubble bursts.
As a result, we can rewrite Eq. (2) as

ð1 þ rt Þbt p1 þ bi p1 ð1 þ gÞti þutþ1 with probability p
btþ1 ¼ ð3Þ
etþ1 with probability 1  p
where g represents the constant growth rate.
Equation (3) suggests that we can decompose a trend driving a housing bubble into a
deterministic time component and a stochastic component. The stochastic component
usually reflects the unexpected or random deviations of house prices from their funda-
mentals, whereas the deterministic time trend can represent the irrational expectation on
the dynamics of house markets due to only absorbing the historical information. This
suggests that there are four possible outcomes of the price–rent ratio based on the present
value framework. We can make use of the following Augmented Dickey–Fuller (ADF)
regression to allow for these four possible outcomes:
X
k
Dyt ¼ l þ bt þ ayt1 þ cj Dytj þ et : ð4Þ
j¼1

The possibilities are as follows:

1. b ¼ 0 and a\0, the series is stationary without a time trend. Hence, there are no
bubble components
2. b 6¼ 0 and a\0, the series is stationary around a deterministic time trend, and so
contains irrational bubble components but no rational bubble.
3. b ¼ 0 and a ¼ 0, the series is nonstationary without a time trend, and thus contains
only rational bubble components (stochastic part).
4. b 6¼ 0 and a ¼ 0, the series is nonstationary around a deterministic time trend, and
thus contains both rational bubble components (stochastic part) and irrational
components (deterministic part).

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142 D. Zhang et al.

The above analysis can be extended to allow for a structural break in the unit root test,
improving our understanding about the effect of housing policy on housing market and the
explicit role of the deterministic time trend in driving price bubbles.

4 Empirical strategy

4.1 Unit root tests

Using the present value model, the conventional univariate stationarity tests are employed
to detect house price bubbles on the log price–rent ratio of each city, namely, Augmented
Dickey–Fuller (Dickey and Fuller 1979, ADF hereinafter) test and Kwiatkowski–Phillips–
Schmidt–Shin (1992, KPSS hereinafter) test (see also Greene 2003). A stationary log
price–rent ratio process indicates no bubble, while the alternative suggests that house
prices deviate from the levels implied by fundamentals, indicating the existence of a
bubble. Since the panel unit root test usually has higher power than the individual unit root
test, we also apply the panel unit root procedure such as the Im et al. (2003, IPS here-
inafter) test to the data set.
Since the Chinese housing market may have experienced significant policy interven-
tions, it is also necessary to consider the possibility of structural breaks in the time series of
house price–rent ratios. Zivot and Andrews (1992) test (see Appendix 2 for more details)
for detecting unit roots in time series allows for the possibility of one break in the trend.
Furthermore, to check structural breaks in panel unit root tests, we also apply the Im et al.
(2005) Lagrangian multiplier (LM) test to allow for endogenous breaks in time series.
Under the existence of structural breaks, they demonstrated that this approach is more
effective than the others, such as Im et al. (2003).

4.2 Forming convergent clubs

Cities with common features are likely to be affected by policy changes in a similar way,
suggesting that the dynamics of house price–rental ratios are likely to converge among the
cities. Phillips and Sul (2007, PS hereinafter) propose a panel data clustering approach to
enable cities to be classified into convergent clubs (see Appendix 3 for a brief introduction
of this approach).

5 Data

The data are collected from Xitai Real Estate Database (http://www.cityre.cn/en/), which
provides the data of average housing transaction prices and rents in major Chinese cities.
Our sample data cover the period between August 2008 and August 2013, the longest
sample available for disaggregated data for China. We consider 33 cities, with 27
belonging to the official 35 major cities whose housing price indices are regularly issued by
the National Bureau of Statistics of China. Out of the 35 major cities, Haikou, Taiyuan,
Yinchuan, Huhehot, Urumqi, Jinan, Changsha and Nanjing are excluded from our sample.
However, our dataset still covers the Chinese major areas and so can detect house price

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Price bubbles and policy interventions 143

bubbles across the country.7 Additionally, there are six relatively smaller cities in our
sample, Wenzhou, Quanzhou, Tangshan, Wuxi, Yangzhou, and Xuzhou, which also pro-
vide more insights into the Chinese housing bubble.
Compared the earlier studies on the Chinese housing market, our dataset has several
advantages. First, the sample period is extended beyond the global financial crisis. Second,
our dataset contains information on the cost of renting in the major cities as well as their
house prices, whereas most of the existing studies were only able to analyze house price
indices constructed by the National Bureau of Statistics. The Xitai Real Estate Database
not only presents the information on the average housing prices and rents in major Chinese
cities but also on the average prices and rents of the municipal districts within cities.8
Our sample data are also comparable to Wu et al. (2012) for eight major cities. Figure 2
displays similar time series patterns of the house price–rent ratios in these cities, with the
highest price–rent ratio being in Hangzhou in 2010. Similar to Wu et al. (2012), the ratios
follow distinctly different paths for Chengdu, Wuhan and Xi’an compared to the other
cities, implying the possibility of two convergent trends for these major cities. Further-
more, we are also able to find a clear slowing down of the upward trend for all the eight
cities after 2011. It coincides with the effects of the stricter policy measures issued by the
Chinese central government.

6 Results and discussion

6.1 Unit root tests

Table 2 reports the results of ADF and KPSS unit root tests with time trends included.
Only three cities, Shijiazhuang, Dalian and Quanzhou, have stationary price–rent ratios.
Once a trend break is considered, the Zivot and Andrews (1992) test suggests that the log
price–rent ratios of 15 out of 33 cities are stationary around a breaking trend. Although the
date of the break differs across cities, it roughly happened around 2010 and 2011. These
results suggest that government intervention in the housing market did work, and at least
partially suppressed the housing bubbles in some major cities. However, other major cities,
such as Beijing, Chengdu, Shenzhen, Chongqing and Wuhan, were not affected by the
measures and the house price–rent ratios were still non-stationary, indicating the presence
of house bubbles in these cities. Smaller cities, such as Tangshan and Wenzhou, are also

7
According to the figures released by China’s Ministry of Civil Affairs, as of 2014 there were 288
prefecture-level cities and 361 county-level cities in mainland China. Our study attempts to detect housing
bubbles in major Chinese cities. We believe that the housing market conditions of these major cities have
significant effects on the whole economic state in this country.
8
We know that since a house can be regarded as a mixture of multiple bundles of housing characteristics
such as structural, proximity, and neighborhood attributes, a hedonic method may be used to regress house
price or rent on these housing attributes in order to build quality-adjusted housing price or rent indexes.
However, the use of the hedonic approach usually requires a great deal of the actual housing transaction
data. Although the database we use is one of the largest real estate databases in mainland China, it does not
offer detailed information on the actual housing transactions in the major cities such that we cannot estimate
hedonic-based housing price and rent indexes. Since there is a relatively short development history in the
Chinese housing market, the quality-adjusted housing price indexes have not yet constructed for the major
Chinese cities. In effect, so far, only in the very limited number of Western countries have this type of
housing price indexes been constructed and released regularly to reflect the variations in the pure housing
prices (Hill 2013).

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144 D. Zhang et al.

4.0
Beijing
Shanghai
Xi'an
3.8
Chengdu
Shenzhen
Tianjin
3.6 Hangzhou
Wuhan

3.4

3.2

3.0
08M8 09M1 10M1 11M1 12M1 13M1

Fig. 2 Log price–rental ratio for eight major cities in China

shown to be inconsistent with the prediction of the present value model, even when trend
breaks are taken into consideration.
The IPS panel unit root test statistic is -1.186 and insignificant at 5 % level, suggesting
that we cannot reject the hypothesis that there is a unit root in each time series in the panel.
Such a conclusion is reinforced with the Im et al. (2005) LM panel unit root statistic being
-1.574 and we are unable to reject the null hypothesis. However, when we allow for one
break in the time trend, the statistic of the Im et al. (2005) test becomes -21.422 and is
significant at 1 % level, suggesting that the panel is stationary around a breaking trend. The
corresponding optimal breaking point for the panel is January 2011. The trend break,
possibly reflecting the policy changes in 2010, provides evidence that the bubble in the
housing market was under control.
Table 3 reports the estimated deterministic time trends in the Zivot and Andrews (1992)
regression when testing for unit roots. In general, there is strong evidence supporting
upward trends for most series apart from Tangshan. The upward trends disappear after the
break, becoming much lower and even negative, and are statistically insignificant. What
we can learn from the trend components is that the irrational bubbles driven by the
deterministic trends exist before the break points, but disappear afterwards. Furthermore,
even if we control for these deterministic parts, there exist still a number of cities showing
the existence of rational house bubbles driven by the stochastic trends as implied by their
nonstationary house price–rent ratios.

6.2 Housing price convergence clubs

Since the Chinese housing market might display regional heterogeneity across the country,
we examine whether some of the major cities behave in a similar way by using the PS
methodology to group the cities into clubs. Although each city has its own specific house
price dynamics, it is possible that they share the common movements with house prices
converging to a certain equilibrium path. Table 4 reports the test results for club
convergence.
Table 4 demonstrates that the log t statistic of the full sample regression rejects the null
hypothesis of convergence for all the cities, while the searching procedures for convergent

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Price bubbles and policy interventions 145

Table 2 Unit root tests for the log price–rent ratios

City ADF Lag length KPSS Z&A Break date

Beijing -1.4194 0 0.1702* -3.2434 2010M01

Tianjin -1.6942 0 0.2389** -5.6671** 2011M02
Shijiazhuang -4.3898** 1 0.1312 -5.1386** 2011M10
Shenyang -1.9128 0 0.1874* -4.0666 2011M11
Dalian -3.7310* 9 0.1114 -4.2647 2011M01
Changchun -1.5325 0 0.2376** -5.3987** 2011M01
Harbin -2.0927 0 0.2224** -5.3804** 2010M03
Shanghai -1.7006 0 0.2166** -4.5349* 2010M05
Hangzhou -1.5951 0 0.2139* -5.3671** 2010M07
Ningbo -2.5895 0 0.2126* -4.2525 2010M05
Hefei -4.4663** 0 0.2535** -5.2446** 2011M01
Fuzhou -2.0369 0 0.2173** -3.9853 2010M11
Xiamen -3.3000 0 0.0901 -3.9524 2012M10
Nanchang -2.4267 0 0.1355 -3.7497 2011M10
Qingdao -2.4945 0 0.2038* -4.0966 2011M09
Zhengzhou -0.7400 0 0.2268** -3.8694 2011M01
Wuhan -1.4306 0 0.2045* -3.5208 2010M12
Guangzhou -3.3084 0 0.2618** -5.2033** 2011M04
Shenzhen -1.9812 0 0.2239** -3.7056 2009M06
Nanning -1.3793 0 0.2223** -3.7886 2010M06
Chongqing -1.3584 0 0.2239** -3.9461 2011M01
Chengdu -1.9048 0 0.1962* -2.8356 2011M01
Guiyang -1.5751 0 0.2052* -5.0709** 2011M11
Kunming -1.4933 0 0.1731* -3.4207 2011M10
Xian -0.8807 0 0.2229** -3.5597 2011M02
Lanzhou -1.0821 0 0.2360** -5.0904** 2011M04
Xining -5.0615** 0 0.2501** -8.1285** 2011M12
Tangshan -3.6962* 0 0.1750* -4.3352 2010M04
Wuxi -3.4192 3 0.1077 -5.8541** 2011M03
Yangzhou -1.1405 0 0.2272** -6.7301** 2011M01
Xuzhou -2.8128 0 0.1881* -4.7003* 2011M10
Wenzhou -1.5416 1 0.2015* -3.9961 2010M06
Quanzhou -4.7518** 0 0.1225 -5.2084** 2011M03
A 5 % significant level is denoted by * and 1 % is denoted by **. BIC is used to select the optimal lag length
given the maximum is set to be 10

clubs can identify two city clubs. For each of them the log t statistic is non-significant,
implying that we cannot reject the convergence hypothesis within each club. Guided by the
categorization of city clubs, we further plot the log house price–rent ratios for the full
sample and each club in Fig. 3.
The general patterns for these ratio plots are analogous. The first club, mainly consisting
of relatively developed or rich regions, shows higher price–rent ratios relative to those of

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146 D. Zhang et al.

Table 3 Trend before and after break

City Break date Trend_bef t-stat Trend_dum t-stat Trend_aft.

Beijing 2010M01 0.0070 3.1769 -0.0069 -3.0870 0.0000

Tianjin 2011M02 0.0130 5.3816 -0.0151 -5.2841 -0.0020
Shijiazhuang 2011M10 0.0019 3.2485 -0.0030 -2.3587 -0.0011
Shenyang 2011M11 0.0050 3.6711 -0.0084 -3.4943 -0.0034
Dalian 2011M01 0.0032 2.0684 -0.0039 -1.8784 -0.0007
Changchun 2011M01 0.0081 5.1490 -0.0098 -5.1006 -0.0017
Harbin 2010M03 0.0106 4.4700 -0.0151 -4.7862 -0.0045
Shanghai 2010M05 0.0122 4.0761 -0.0135 -4.1074 -0.0013
Hangzhou 2010M07 0.0116 5.1873 -0.0146 -5.2509 -0.0030
Ningbo 2010M05 0.0088 3.1627 -0.0108 -3.2645 -0.0020
Hefei 2011M01 0.0033 2.2603 -0.0067 -2.8303 -0.0034
Fuzhou 2010M11 0.0052 3.1967 -0.0079 -3.3199 -0.0026
Xiamen 2012M10 0.0013 2.3796 0.0067 2.0469 0.0080
Nanchang 2011M10 0.0026 3.6209 -0.0041 -2.9163 -0.0015
Qingdao 2011M09 0.0049 3.5505 -0.0069 -3.1427 -0.0020
Zhengzhou 2011M01 0.0039 3.5422 -0.0066 -3.9081 -0.0027
Wuhan 2010M12 0.0026 3.1173 -0.0040 -3.2156 -0.0014
Guangzhou 2011M04 0.0081 4.3394 -0.0078 -3.8303 0.0003
Shenzhen 2009M06 0.0104 3.2701 -0.0094 -3.1329 0.0010
Nanning 2010M06 0.0084 3.6396 -0.0080 -3.6008 0.0005
Chongqing 2011M01 0.0049 3.5641 -0.0071 -3.6773 -0.0022
Chengdu 2011M01 0.0025 2.0853 -0.0037 -2.0678 -0.0012
Guiyang 2011M11 0.0038 4.4275 -0.0109 -4.8361 -0.0071
Kunming 2011M10 0.0016 2.8463 -0.0039 -3.1487 -0.0024
Xian 2011M02 0.0035 3.3609 -0.0049 -3.5912 -0.0014
Lanzhou 2011M04 0.0067 4.5672 -0.0144 -4.9583 -0.0078
Xining 2011M12 0.0036 4.6102 -0.0116 -5.3123 -0.0080
Tangshan 2010M04 -0.0034 -2.0679 0.0045 2.2024 0.0011
Wuxi 2011M03 0.0070 5.2873 -0.0097 -4.7236 -0.0027
Yangzhou 2011M01 0.0100 6.6149 -0.0135 -6.6740 -0.0035
Xuzhou 2011M10 0.0045 3.8075 -0.0086 -3.5512 -0.0041
Wenzhou 2010M06 0.0114 3.8212 -0.0141 -3.8969 -0.0027
Quanzhou 2011M03 0.0018 2.4136 -0.0024 -1.8835 -0.0006
Trend_bef are the coefficients for deterministic trend before breaks and trend_dums are additive parts for the
deterministic trend after breaks. In other words, Trend_aft = trend_bef ? trend_dum

club 2. We also construct the relative transition paths for the two clubs, presented in
Fig. 4.9 The relative transition paths clearly display the deviating behavior of the two
clubs’ average price–rent ratios relative to the average full sample price–rent ratios,
implying that the price–rent ratio of each member city in these clubs can converge to two

9
See Phillips and Sul (2007) for a detailed discussion on the definition of the relative transition measure.

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Price bubbles and policy interventions 147

Table 4 Test for club convergence

Classification Number of members Test for convergence

Log t coefficient t-statistics

Full convergence 33 -0.501** -2.877

Sub-convergence
Club 1 20 0.120 0.552
Members Beijing, Tianjin, Shijiazhuang, Shenyang, Shanghai, Hangzhou,
Ningbo, Fuzhou, Xiamen, Nanchang, Qingdao, Guangzhou,
Shenzhen, Nanning Kunming, Tangshan, Wuxi, Yangzhou,
Xuzhou, Wenzhou
Convergence in the remaining group
Club 2 13 -0.152 -1.070
Members Dalian, Changchun, Harbin, Hefei, Zhengzhou, Wuhan,
Chongqing, Chengdu, Guiyang, Xi’an, Lanzhou, Xining,
Quanzhou

Superscript ** represents 1 % level of significance. t-statistics are HAC consistent

3.8
Log Price-Rental Ratio (Full Sample)
Log Price-Rental Ratio (Club 1) 2011M2
3.7 Log Price-Rental Ratio (Club 2)

3.6

3.5

3.4

3.3

3.2

3.1
08M08 09M01 10M01 11M01 12M01 13M01

Fig. 3 Log price–rental ratio for full sample and clubs

different equilibrium paths. This also suggests that a countrywide convergence of price–
rent ratios does not exist. The graphic results are also consistent with the estimated ‘log t’
coefficients for each club. For club 1, Table 4 displays that the coefficient is positive 0.120,
thus we have observed a slightly upward transition path but for club 2, this coefficient is
-0.152, corresponding to a slightly downward transition path. Combining the information
together, we can comfortably say that the housing market in China has been separated now,
which has clear policy implication that the major city housing markets should be treated
differently.

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148 D. Zhang et al.

1.06

Club 1
1.04

1.02

1.00

0.98

0.96 Club 2

0.94
08M08 09M01 10M01 11M01 12M01 13M01

Fig. 4 Relative transition paths for two clubs

Table 5 Panel unit root test for

Statistics
clubs
Panel IPS test
Club 1 -0.813
Club 2 -0.880
All statistics follow No break One break
asymptotically standard normal
distribution Panel LM test
** is to represent 1 % Club 1 -1.030 -18.611 ** 2010M10
significance and * for 5 %
Club 2 0.471 -18.992** 2010M09
significance

Table 5 reports the panel unit root test results for each club. Consistent with the graphs,
both the IPS test and Im et al. LM test suggest the existence of unit roots in the panel.
However, when a trend break is included in the test, both clubs are found to be stationary
around a breaking trend in the third quarter of 2010; similar results are found with the Zivot
and Andrews test. A clear upward trend exists before the break point and then disappears
afterwards. Although the stricter policies were implemented in first quarter 2010, it took
several months for the effects to be felt in the housing markets.
To analyse major housing markets in China, Ren et al. (2012) suggest grouping major
Chinese cities into two categories by their GDP levels: high GDP cities and low GDP
cities. Our findings are consistent with such a view and the convergence of our cities to two
clubs could reflect common levels of economic development. For example, Table 6 shows
that apart from Dalian and Wuhan, 10 out of 12 members in Club 2 are low GDP cities by
the Ren et al. classification. Besides, among them, 7 cities have stationary log house price–
rent ratios around breaking trends, implying that the housing markets of these cities are
more vulnerable to the stringent policy intervention.

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Price bubbles and policy interventions 149

Table 6 Clubs and income

City Second club First club High GDP Low GDP
categories
Beijing Club 1 H
Tianjin Club 1 H
Shijiazhuang Club 1 L
Shenyang Club 1 H
Dalian Club 2 H
Changchun Club 2 L
Harbin Club 2 L
Shanghai Club 1 H
Hangzhou Club 1 H
Ningbo Club 1 H
Hefei Club 2 L
Fuzhou Club 1 H
Xiamen Club 1 H
Nanchang Club 1 L
Qingdao Club 1 H
Zhengzhou Club 2 L
Wuhan Club 2 H
Guangzhou Club 1 H
Shenzhen Club 1 H
Nanning Club 1 L
Chongqing Club 2 L
Chengdu Club 2 L
Guiyang Club 2 L
Kunming Club 1 L
Xian Club 2 L
For definition of low and high Lanzhou Club 2 L
GDP groups, please refer to Ren Xining Club 2 L
et al. (2012)

6.3 Summary of findings and policy suggestions

The empirical findings can be summarised as follows:

First, although there is evidence of house price bubbles in most of the major Chinese
markets, these bubbles appear to be suppressed by the severe government policy inter-
ventions. An upward trend in the average house price–rent ratio existed before 2010,
implying an irrational bubble was developing. Individual Zivot-Andrews unit root tests
show that when a trend break is taken into consideration, most of the city-level series are
stationary around a trend break. Although our panel unit root tests suggest non-stationarity
in the full sample, the unit root hypothesis is rejected when a trend break is permitted, with
the date being 2011M2. The timing of the break points differs for each city but is roughly
found to be around 2010 to 2011. Due to their backward-looking tendency, real estate
investors could have followed a deterministic time trend to form their expectation, giving
rise to irrational bubbles during the sample period. The recent government interventions
have, to a large extent, achieved their goal of suppressing the irrational house price bubble.

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150 D. Zhang et al.

Second, there is clear evidence of regional differences in the Chinese housing market.
Dreger and Zhang (2013) suggest regional differences of house price bubbles in Chinese
cities. Our results support the view that the major cities which are located in coastal and
developed regions are more likely to form bubbles in their housing markets. These cities
are mainly grouped into club 1 using the PS procedure. However, when a structural break
is taken into account, the LM-panel unit root test rejects house price bubbles for both clubs,
indicating that the central government responds with appropriate policy measures to
suppress the over-heating housing markets. However, the PS results suggest the regional
heterogeneity of housing markets means that the local governments still need to tailor their
policy instruments to different regions or clubs.
Third, while our sample cities can be classified into two city clubs, there is still evidence
of the differences of housing market conditions across the cities. For example, the time of
the break points differs between each city. These differences might be partially
attributable to various lags for the central government’s housing policies to have an impact
in a region, while possible housing bubbles in some major cities might be triggered by the
country-wide expansionary policy after the recent financial crisis. The central government
and each local municipal government might have different policy targets for and under-
standing of the conditions of housing markets. While the central government pays more
attention to a sustainable, healthy development of real estate industry, a municipal gov-
ernment might be more concerned with local investors and require a different housing
policy. Consequently, there has been less effective implementation of the central gov-
ernment’s regulative policies in many cities. Some major cities, such as Beijing, Shenyang,
Chengdu, Wuhan, Xi’an, Shenzhen and Chongqing, are found to have had a housing
bubble even when a trend break is allowed for in unit root tests. In this sense, the central
government set clear policy goals and provided detailed instructions regarding future
interventions of major housing markets, with accountability mechanisms introduced for
local government officials.

7 Conclusion

Time series data of house prices and rents in 33 Chinese cities have been used to inves-
tigate the conditions of municipality housing market. The research contributes to the
current literature by allowing for a deterministic time trend, with a break point, when
testing for housing bubbles. Such an approach enables rational bubbles to be distinguished
from irrational bubbles. Based on the present value model framework, our results
demonstrate that there exist significant price bubbles in most of the housing markets, when
deterministic time trends are considered, implying that irrational expectations might play
important roles in generating these bubbles. In 2010 and 2011, these trends are found to
disappear after a series of restrictive policies were introduced into the markets, with the
majority of the housing markets in China returning their fundamental levels. When trend
breaks are allowed, the unit root tests indicate that bubbles are not present in the house
price–rent ratios for most cities, suggesting the authorities were effective in cooling down
the over-heating house markets. There is evidence of differences in housing market con-
ditions between the major regions and cities, requiring local governments to tailor policies
to specific locations.
Since the crash of the U.S. sub-prime mortgage market in 2008, the possibility of
bubbles in major housing markets has been a great worry to the Chinese public. A healthy

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Price bubbles and policy interventions 151

real estate industry will help improve the economic development and the country’s growth
rate. However, rapid urbanization and the fast development in the real estate industry have
created huge challenges for regulators and policy makers of the Chinese housing market.
Understanding the city-level conditions of the housing market in China, and its dynamics,
is crucial for implementing better housing policies. It will help the government balance
between the dangers of intervening too much and too little in the Chines housing market.
Our research has shed light on the housing market bubble and shown that the intervention
policies during 2010 and 2011 suppressed the bubbles in most cities. However, the policies
were not entirely effective in some cities, such as Beijing, Shenyang, Chengdu, Wuhan,
Xi’an, Shenzhen and Chongqing, implying that further improvements in the localization of
central government’s housing policies are required.

Acknowledgments The authors would like to thank conference participants at the 2014 Global Chinese
Real Estate Congress (GCREC) for helpful comments.

Appendix 1: Present value model

Assuming a two-period model, the house price–rental relation can be written as:
Et ½Ptþ1 þ Dtþ1 
Pt ¼ ð5Þ
1þr
where Pt denotes the asset price at time t, Dt the housing rental income at time t, and r the
constant discount rate. A rational investor may evaluate the price of an asset as the present
value of its next period price plus rental income. Recursively solving this equation, we obtain
X
1
Pt ¼ hð1  aÞ ai Et ðDtþi Þ ð6Þ
i¼0

1
where a ¼ 1þr a
; h ¼ ð1aÞ ¼ r 1 . Campbell and Shiller (1987) rearrange this equation as an
empirically testable form:
X1
Pt  Dt h ¼ h ai Et ðDDtþi Þ ð7Þ
i¼1

Since both asset prices and rental incomes usually evolve as nonstationary I(1) pro-
cesses, a long-run cointegrating vector (1; h) exists if the present value model holds.
Alternatively, by Campbell and Shiller (1988), because
rtþ1  logðPtþ1 þ Dtþ1 Þ  logðPt Þ
a logarithm transformation for this equation can generate

pt  dt ¼ rtþ1 þ Ddtþ1 þ lnð1 þ eptþ1 dtþ1 Þ ð8Þ

where the lower case letters represent the logarithms of the upper case variables. By means
of a first-order Taylor expansion, we can linearize model (8) as the following expression:
pt  dt  rtþ1 þ Ddtþ1 þ k þ qðptþ1  dtþ1 Þ ð9Þ
 d
ep  d
where q ¼ 1þe  d and k ¼ lnð1 þ e
p
p
Þ þ q½p  d, p and d are unconditional mean of each
variable. Under this log-linear form, a stationary log price-to-rent ratio process implies the

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152 D. Zhang et al.

nonexistence of a rational bubble in housing prices, while failing to reject a unit root
hypothesis indicates the presence of such a bubble.

Appendix 2: Zivot and Andrews (1992) test

The null hypothesis for the test is:

H0 : yt ¼ l þ bt þ yt1 þ et ð10Þ

The following augmented regression is considered when testing for unit roots:
X
k
yt ¼ l þ hDUt ðkÞ þ bt þ cDTt ðkÞ þ ayt1 þ cj Dytj þ et ð11Þ
j¼1

where for k 2 ð0; 1Þ; DUt ðkÞ ¼ 1 if t [ Tk; 0 otherwise, and DTt ðkÞ ¼ t  Tk if t [
Tk; 0 otherwise:
Zivot and Andrews (1992) calculate sequentially one-side t-statistics for testing ai ¼ 1
and select the minimum value as the test statistic. The break point is selected as the point
 
generating a minimum t-statistic: ta^i kiinf ¼ inf ta^i ðkÞ.
k2K

Appendix 3: Club convergence

Panel data, Yit, we can decompose it into a systematic component (git) and a transitory
component (ait) as,

Yit ¼ git þ ait ð12Þ

which can in turn be transformed into a time-varying factor representation:
 
git þ ait
Yit ¼ lt ¼ dit lt ð13Þ
lt
where dit is an idiosyncratic component and lt is a common component. The idiosyncratic
component measures the distance between Yit and the common component. If the factor dit
converges to a constant d, then there will be convergence clubs. Scaling the common factor
lt , the PS method introduces a relative loading or transition coefficient:
Yit dit
hit ¼ 1 PN ¼ 1 PN ð14Þ
N i¼1 Yit N i¼1 dit

This relative transition parameter has a cross-sectional mean of unity; and when dit
converges to a constant, hit converges to unity. The variance of this transition parameter
P
Ht ¼ N1 Ni¼1 ðhit  1Þ2 converges to zero in the long run (t ? ?).
The PS method also allows for a test of convergence starting from the following
regression
 
log H1 =H A  2 log LðtÞ ¼ c^ þ b^ logðtÞ þ ut ð15Þ

123
Price bubbles and policy interventions 153

In (15) LðtÞ is a slowly varying function, defined as logðtÞ for t ¼ ½rT ,…, T, where ½rT 
denotes the integer part of rT, and r is a positive number. PS also show that the parameter b
equals twice the convergence rate a. The one-sided t-statistics for b^ using HAC standard
errors can be constructed, and the (one-sided) null hypothesis of convergence is rejected at
the 5 % level if tb \  1:65.
To accommodate any possibility of sub-group convergence, PS introduce a systematic
way of clustering based on repeated log-t regressions. It is a four-step process, namely,
ordering, forming core group, seizing membership and stopping rule (see Phillips and Sul
2007 for more details).

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