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Friday, April 16, 2010

Solving China's Property Bubble

China’s property market is getting too hot. Inflation is rampant at 11.7% and finally the Chinese government is taking steps to cool it down. The government said they would increase mandatory down-payments on second and third homes as well as on first homes larger than 90 square meters. They also plan to increase the supply in the property market through the construction of affordable small and medium sized houses. Though some of these actions are laudable, I feel that they are not the most effective set of reforms to deal with this problem.

The Chinese government has announced an increase in down payment on first homes of more than 90 square meters from 20% to 30% and an increase from 40% to 50% on second homes. The increase in mandatory down-payments, especially for the purchase of second or third homes, was intended to deter speculators. However, this reform isn’t going to be very effective as a quarter of Chinese home-buyers pay cash for their houses and the average mortgage only covers about half of the value of the property because home-buyers want to avoid paying interest. Hence, while this reform will not deter that many deep-pocketed speculators because they are paying similar down-payments anyway, it will adversely affect those people who aren’t wealthy, can’t afford large down-payments and are buying a house for their own use.

This said, the other reform adopted by the Chinese government to cool the property market -increasing the supply of houses will, in theory, reduce the equilibrium price of houses. Also, the fact that the houses are small and medium sized means that the increase in supply is aimed directly at those who are worst hit by the inflation. However, the large flaw with this plan is that building houses and apartment blocks takes a great deal of time and, by the time construction is completed, the housing bubble may already have burst.

So if increasing down-payments is actually missing the point and increasing supply will take too long to have an effect, what should the government do? Well, they have got to look at the root of the problem which is why people are putting money in the property market in the first place. In my opinion, the main reason for this is the fact that Chinese deposit rates are capped at a paltry 2.25% - not even enough to compensate for inflation which ran at 2.7% this February. If deposit rates are so low, why would anyone put money in a bank? What China needs to do to cool off the property market is raise its deposit rates so people make deposits rather than spend money inflating the property bubble.

Raising the deposit rates will have the added advantage of mitigating the effects of the imminent rise in inflation. I hear you say that China’s inflation rate is at a ‘perfect’ level of 2.7% according to the Consumer Price Index. Indeed, this rate of inflation is near-perfect but is likely to rise later in the year. We can see this from the Producer Price Index which rose at a rate of 5.2% in March as a result of an increase in commodity prices – foreshadowing inflation.

However, though raising deposit rates seems to be the ideal solution, it cannot be put into practice as the central bank cannot raise the deposit rate because of the peg on the USD. Clearly, in order to cool down the property market, the Chinese government must allow some flexibility in the price of the yuan – in turn allowing for upward adjustments in the deposit rate. The increased deposit rates will increase speculative inflows - hence the yuan will appreciate. This will rebalance the skewed trade balance with the US by reducing the competitiveness of Chinese exports. It will also bring about a structural change in the Chinese economy, making it less dependent on exports and more driven by domestic demand.

Deep Vaze

16/4/2010

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