The Chinese Real Estate Bubble – National Accounts, Balance Sheet and (some) Evidence

I know that this is completely outside of the purview of this website. The only argument I can offer is that if and when China cools down it matters to everyone and thus, assuming that there’s no fallacy of division, if China matters to all, it matters to Europe as well.

Sometime ago a friend sent me this video about eerie ghost Chinese cities. If you are an economist this should be tickling your brain. The video visually describes how governments can manipulate economic figures with concrete. After thinking about it a little, I think I understood how it works. Here’s what I’ve been able to puzzle together in my head.

China’s political system is an autocracy of an elite, whose only claim to power is its ability to claim output legitimacy, i.e.: the ability to deliver positive and buoyant growth. However, historical data on growth universally shows that it follows a business cycle of boom and bust, peaks and troughs, incompatible with permanent and buoyant positive growth. Therefore the model of output legitimacy creates an unstable political equilibrium based on a “bubbly” perception that growth is permanent. The empty cities are a symptom of this malaise, a sign of the long term unsustainable nature of any such political system.  While what I describe will provide an example of how command economies are prone to collective action problems, capture and conflicts of interest, the irony of this problem is that the nature of the business cycle and its socio-political dangers were first and best identified by Karl Marx.

The following lines describe how the computation of GDP and the intricacies of the variable measuring Investment allow a large, closed, centrally planned economy to be manipulated by its leaders into giving the impression that growth is proceeding apace. I go on to briefly show how this might look in a very superficial and stylized balance sheet analysis.  My conclusion is that it would appear that Chinese authorities might have used their broad reach into the construction sector supported by their legislative powers to allow it to distort the price mechanism in the real estate market in order to provide an illusion of growth that would be completely false. If this is the case, and it is a big if, then the popping of this bubble would be one of the most dramatic events in the years to come. I conclude with a brief reference to academic studies, which while not confirming this entire speculation, show that the Chinese housing is experiencing a substantial bubble.

GDP Computation – National Accounts:

The expenditure approach to calculating GDP describes it in the following identity:


GDP =  C + I + G + NX, where:


C = Private Consumption

I = Investment in Physical Capital

G = Government Spending

NX = Net Exports


This means that if you increase I, you automatically increase GDP. So ignore the other GDP components and focus on GDP. Investment can be decomposed in the following manner:


I = NRI +  RI + Inv, where:


NRI = “Non Residential Investment”

RI = “Residential Investment”

Inv = “Inventory investment”


or alternatively, according to the European Standards Accounting (ESA 1995):


I = GCF = GFCF + Change in Inventories – Disposals of Valuables, where


GCF = “Gross Capital Formation”

GFCF = “Gross Fixed Capital Formation”

GFCF is a flow variable which measures the value of physical assets acquired (by production or purchase), net of those that were disposed of by sales at a given time. These assets include all machines, real estate( land and buildings), furniture, means of transportation (cars, vans boats airplanes), means of communication (phones) used for productive activity.

So once you build something an apartment block, shopping center or any other type of building, that is registered as a contribution to GFCF, adding to investment accounting, and to GDP.

Moreover, once the year ends, whatever was not sold goes into Inventories, thus adding to Investment accounting as well. Everytime a building company sells a flat or an apartment block, there is a fall in the “Change in Inventories” category of  GCF (and thus in GDP) that is then compensated by a rise in the Consumption item of GDP.  However, if this sale does not occur and nothing is produced next year, because “Investment”/”GCF” is a flow measure, this variable will fall and thus bring down GDP. As a result if a real estate boom is to be exploited to engender economic growth, it is not enough to build during one year. If that is the only source of growth and the market cannot clear so that building companies end up stuck with the stock of real estate capital rather than selling it to consumers, then this it creates a vicious circle dependent on construction.

Does this mean that you can build your way into Growth?

Not exactly. Under normal circumstances, in most developed countries, these assets which belong to the inventories of building societies are valued at their market price. A real estate bubble takes place when these prices do not reflect the trend value of the underlying building or when the trend value is not an equilibrium one, in which case the prices will continue to rise until they reach a critical mass of some sort and crash. Building societies and real estate companies must then adjust the value of assets in their balance sheet which often leads to bankruptcy as they are not able to shed their liabilities fast enough. This is the popping of real estate bubbles with which Americans, Irish and Spaniards are all too familiar.

Having watched the above video on Chinese ghost towns and aware of China’s famous economic growth, the question must then be how come that the bubble has not yet popped? Clearly there’s no demand at the high supply prices.

The reason I suspect has to do with the role of the Chinese Government in the economy. If I am not mistaken all companies with more than 2000 workers must automatically be 50% owned by the Chinese state. In that case the Chinese government must be a major player in the construction/real estate sector. That means that there’s an intrinsic conflict of interest between the regulator who ought to ensure that tha market clears, the constructor, who wants to make a profit, and the incumbent ruler who wants to remain in power.

In this particular case my suspicion is that prices must be set by the state in some way that on the one hand allows building companies to continue to build or at least to remain solvent with all that stuff in inventories, at the same time as pushing potential purchasers away. As the figure below shows, if the Chinese state were to allow the market to price the real estate market and the building companies to “mark-to-market” assets would fall short of liabilities and equity, leading to insolvencies, liquidation and widespread recession. So while not allowing the market to price these items in the first place might have been wrong, doing so now is probably a good way to avoid financial chaos.

Is there a Chinese real estate bubble? 

There seems to be some evidence that there is indeed a housing bubble in China. However, the evidence focuses on more mainstream metropoles rather than on these ghost towns. In  that case a more orthodox bubble might be in place, although the same manipulative mechanism could  be used to stretch the bubble further than normal market conditions would allow it.

Using records from 35 major cities, Dreger and Zhang 2011 finds evidence of a housing bubble. According to the authors,

“In Figure 1 it can be seen that increasing imbalances have emerged over the past two years. For example, real house prices in Shanghai have been 28% above the long run equilibrium in 2008, and 35% in 2009. While the evidence is similar for Beijing, the increase is more spectacular in Shenzhen. Compared to the cointegrating relation, real house prices are overvalued by 66% in 2009, after 23% in 2008. In general, the bubble is more pronounced in the special economic zones and the south-eastern coastal regions. Overall, the size of the bubble is 20% in 2008 and 25% in 2009, regardless of whether GDP or population weights are applied.

Further analysis indicates that changes in real house prices cause inflation, but not vice versa. In contrast, there is no causality from house prices to GDP growth. Therefore, a decline in house prices may contribute to a lower inflationary environment without huge negative effects on real economic development.”

Similarly, Deng, Gyourko and Wu 2010 provide a wealth of indicators and “rule-of-thumb” pointing in this direction. Here I highlight developments in Price-to-income ratios in eight major Chinese markets, between 1999 and 2010.

Of course not everyone agrees. However, the anecdotal evidence provided in that video testimony and the credibility of the previously mentioned studies has convinced me of the reality of the real estate bubble in China.  Certainly, metropoles such asn Shangai, Shen-Zhen and Beijin do not fit into the previous explanation. Here, a more conventional bubble is likely to take place.

Whether the national accounts channel that I described above exists is arguable. However it is not implausible. The pity is that if China were indeed a rich country, it could create a great big housing programme where it would relocate all the people living in extremely precarious conditions and house them in these ghost towns.

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1 Response to The Chinese Real Estate Bubble – National Accounts, Balance Sheet and (some) Evidence

  1. Dhruv Sharma says:

    Intriguing analysis. I would imagine the fundamental value of real estate in China to be linked to the expected permanent life incomes of the working population. In that the value is the present discounted summation of china’s current and future real growth. Sustaining such a bubble would require a high summation of economic growth in China.

    If that were so, it re-confirms the requirement of legitimacy of the CCP; namely its single-minded commitment towards further growth sustenance at the ‘Chinese level’.

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