A Credit Creation Theory Perspective on China’s Real Estate Bubble & Local Government Debt, Part 3A: A Place to Live vs A Place to Save (Investment)

“Is China’s real estate bubble going to finally burst? Will it drag down the banks and sink China’s economy?”

Last year, since its 2nd largest real estate developer, Evergrande, finally bellied up, China’s real estate market and local debt crisis were talked about a lot. While no one seriously believes that the world’s second largest economy will collapse, some prognosticate that this may finally be the beginning of the end of China’s economic growth.

In my opinion, “whether China will continue to grow or not, and by how much” are secondary. The real questions are “what do the policy makers there really want? Is it really growth? If so, for whom?” In this series, I will share my thoughts, from a credit creation perspective (credit creation theory is the idea that money is created by commercial banks through borrowing & lending.)

This is the first half of the 3rd part of the blog series.

Links to the Rest of the Blog Series (Outline of the Blog Series)

This blog series is organized as following:

• Part 1: Housing Bubble, Debt, & Bailouts - A Summary View: Introduces the central themes of this blog series.
• Part 2: A brief history of China’s commodity housing market: Walks through China’s housing market history.
• Part 3: A place to live vs a place to save: how out of whack is China’s real estate market? Puts China’s real estate bubble in perspective: housing as a commodity and housing as an asset class. 3A compares different major asset classes (stocks, bonds, and real estate) of China, the EU, and the US. 3B discusses how this duality leads to the policy dilemma and conflicting social-political and economic goals.
• Part 4: Lords vs the king: land financing in economic development and public finance: 4A (The Center Must Hold) provides a historical context of the fiscal relationship between the central/national and local/provincial governments, including the 1994 central/local government tax split scheme and its implications for fiscal finance in China. 4B (Debt & Taxes) discusses how land finance works at the local level and regional disparities. 4C (All That Glitters Are Not Gold) talks about why debt and land financing have worked in China and whether it will CONTINUE to work (less about the numbers, more about larger frameworks) (This part Includes selected central and local government public finance data.)
• Part 5: The way out of a debt crisis is through more debt: a perspective from the credit creation theory Introduces key concepts of the credit creation theory of banks, such as “what is money” and “who creates money.” Then lays out the argument for “bailing out the real estate market” through “quantitative easing.”

Outline

“Housing is for living, not speculating” is a popular tagline in China, in response to the rising housing price. However, real estate has aways been an investment vehicle. But is the country over reliant on real estate assets?

According to professor Keyu Jin from The London School of Economics and Political Science?(LSE), property accounts for 60% of Chinese household assets, as opposed to 37% in Japan and 25% in the US. (Jin, Keyu. The New China Playbook: Beyond Socialism and Capitalism (p. 161). Penguin Publishing Group.)

In this article, let’s look at China’s asset class allocation by comparing:

• Total real estate market size of China, the EU, and the US
• Equity and debt (public debt) market sizes of China, the EU, and the US
• Summary & conclusion

Note 1: I picked the EU and US to compare with China for two reasons:

• First, the three economies are somewhat similar in size.
• Secondly, it was easier for me to gather the data, because I am more familiar with BLS (Bureau of Labor Statistics), BEA (Bureau of Economic Analysis), NBSC (National Bureau of Statistics of China), and Eurostat websites.

Note 2: I only included equity, debt, and real estate asset classes because:

• They are the biggest three classes.
• They can store value long-term.
• They are more accessible to most households and retail investors.

For example:

• Europeans have a larger antique/arts market, but the arts market is much smaller compared to stocks & bonds. It’s also exclusive for the wealthy only.
• Commodities are also a huge asset class, but they largely exclude retail investors.
• The money market (repos, T-bills, CDs, etc. technically are debt, but are not considered part of the so-called debt market - really means public debt. They belong to the money market, which is considered a separate market) is sizable, but they are short-term, and, in China, it is not really for small retail investors (70% to 80% of money market transaction value are directly between the banks; the rest go through the exchanges, but mostly for institutional investors.)
• Real Estate Market Size Comparison: EU, PRC, and USA

Real Estate Market Size Comparison: EU, PRC, USA

China’s Residential Real Estate Market

First, let’s put things in perspective: how big is the China’s real estate market?

There are no official figures available. The National Bureau of Statistics of China (NBSC) reports how much are sold each year (around $2B+ worth of new homes a year before 2022 - residential only,) but the market size is the total asset value - cumulative of all the properties based on their current market values. National accounts (statistical offices responsible for economic data) usually do not report these. Eurostat will give annual transaction data but not the cumulative, and neither does the Bureau of Economic Analysis (BEA) here in the US.

Collecting this data is complex and nuanced than most people think for the following reasons:

1. The total housing (or dwelling) stock is not easy to aggregate. Different types of housing, geo differences, new vs secondhand, total constructed vs usable areas, what to include and exclude (you should only consider properties that can be sold in an open market, and are truly “residential”), etc. all add to the complexity.
2. How to value real estate properties depends on the purpose of the calculation. Is it for insurance, taxes, for buyers/seller, mortgage underwriting, or collaterals to secure loans? For insurers, replacement values are often used. Banks and government agencies use fair market values. You need to keep in mind where you source your data.
3. Fair market value can be arbitrary: it is calculated using assumed market prices of hypothetical sales. So, you start with comparable sales and adjust with assumptions, which is more an art than science. For example, because there is an incentive for local governments to collect more taxes, they are likely to pick more expensive "comparables" to inflate real estate value.
4. Fair market value is hard to determine with newly developed markets because historical sales are few or none.
5. In a fast-growing or volatile market, fair market value is a moving target.

It took a little digging around. The most quoted number for China’s total housing market is around RMB 450 trillion (2021/2022.) It is based on reports by the former top economists from Evergrande’s research arm, Zeping Ren and his team (Mr. Ren left Evergrande in March 2021.) After going over his 2019 and 2021 reports (China Housing Market Value Report), which did a good job explaining the methodology, I believe this is the most sensible figure out there. He and his team relied on data from NBSC, OECD (The Organization for Economic Cooperation and Development), and local statistics bureaus. They followed these steps:

• Treated urban and rural housing as two separate markets.
• For rural homes, they assumed very low valuation, using just build cost (replacement value) to be the fair market value (these homes are mostly self-built homes near/on farmlands; they are mainly for living and are rarely bought and sold.) This significantly “shrank” the overall housing market value.
• For urban homes, they used both national and local data and adjusted for things like the type of homes, such as group homes (i.e., dormitories are considered group homes), subsidized homes, secondhand home sales, etc. (The NBSC’s has new housing sales data, but the Housing Bureau has more comprehensive data, including the secondhand market.)
• Aggregated all the local data to calculate the total market size.

Although there was incentive for Evergrande Research to “over-estimate” the market, the RMB 450 trillion (or $67 trillion using 2022’s FX rate) should be in the right ballpark. This is for housing (or residential real estate) only.

EU and US Residential Real Estate Market

US Residential Real Estate Market

For the US market, I used couple sources to narrow down to a rough size.

A 2022 report from Zillow, U.S. Housing Market has Doubled in Value since the Great Recession, Gaining $6.9 Trillion in 2022, stated that the US private residential market value reached 43.4 trillion in 2022.

Another report by ATTOM, Total Property Taxes on Single-Family Homes Up 4 Percent Across U.S. In 2022, To $340 Billion, aggregated local property taxes and reported that the total taxes for all single-family homes was $340B in 2022, with an effective tax rate of0.87%. $340B divided by 0.87% is around $41 trillion.

Then I made two assumptions:

• Local gov’t usually over-estimate housing value a bit. I assume that on average they overestimate by 5%-7%
• Because about 75% of housing sales are single-family (by unit), but single-family homes are usually more expensive, I assumed that at least 85% to 90% of value is from single-family homes.

Total works out to be between $40 trillion to $50 trillion, on the conservative side.

Because the two sources are very close to each other, I used $45 trillion, and am comfortable with this figure.

EU Residential Real Estate Market

The EU’s aggregate housing total asset value is much more difficult to corner.

Bing suggests that “one way to estimate the total asset value of residential real estate is to multiply the average value of housing per capita by the total population of the EU. According to Statista, the average value of housing per capita as non-financial assets of households in the EU was 103,900 US dollars in 2022.” By doing so, we arrive at around $45 trillion. Although this suggests that it should be a big number, in the tens of trillions, it is a very crude method and doesn’t account for the differences between the 26 EU countries.

There is another industry report by Savills, The Total Value of Global Real Estate, with the following datapoints:

Total Global Residential Real Estate (2020): $258 Trillion

• US: 11%
• China: 30%
• Europe and North America: 43%

According to this, China’s is $77 trillion and US’ $28 trillion. China’s is a bit higher than the previous estimate but in the same range. The US’ is quite lower than my previous estimate. This suggests that their methodology may be more conservative for developed markets. Also, the figures reflect 2020 numbers, and the US housing market has grown strongly since 2020. I made some assumptions to strip out Canada (a very fraction of the US usually), UK, and other non-EU European countries like Russia, using GDP ratios. The final estimate for the EU is between $60 trillion and $70 trillion.

Also, the earlier mentioned report from China’s Evergrande Research, has compared China’s housing market with few selected European markets using historical OCED data. France’s and Germany’s real estate value to GDP ratios were in the 3X range few years ago (France and Germany are the largest markets in continental Europe.) Because it is sourced from OECD, I feel relatively confident. EU’s GDP is around $18 trillion. Therefore, I feel somewhat comfortable about the $60 trillion to $70 trillion range.

Residential Real Estate Market Size Comparison

My final estimates are:

• EU (the European Union): $65 trillion
• PRC (Peoples’ Republic of China): $67 trillion
• USA: $45 trillion

Notes:

• The estimates reflect market size as of 2022 or early 2023.
• The estimates are residential only.
• China’s market size excludes Hong Kong’s, and the EUs exclude the UK’s.
• I am the least confident of the EU’s real estate market size.
• China’s second-hand real estate sales is trending up, most sales are still new home purchases. US and EU are almost exactly the opposite.

The charts below show the detailed comparison. The three economies are different (China has a lot more people, high home ownership, but much lower GDP per capita). Therefore, I have used GDP, population, and home ownership to create the “adjusted views”:

• GDP: I used 2022 GDP figures for the EU, PRC, and US ($16T, $18T, $25)
• Population: 2022 population estimates provided by Bing (449M, 1,426M, 333M)
• Homeownership: estimates by ChatGPT and Bing (0.69, 0.66, 0.90)

Figure 2a. Total Real Estate Market Comparison: EU, PRC, and US

Figure 2b. Per Capita Real Estate Market Comparison: EU, PRC, and US

Figure 1c. Per Capita Real Estate Market Comparison Adjusted for GDP/Capita: EU, PRC, and USA

Note on “adjusted for” calculation:

To make GDP related adjustments, I used mean scaling to normalize the data: I divided each GDP/capita by the average of the three (i.e., $36K, $13K, and $75K for the EU, PRC, and US) to get three ratios. I then divided each market related figure (here, namely, real estate market/capita) to get a normalized market/capita view.

Essentially, I am estimating what the real estate metrics from the three economies would be had individuals from each economy produce a similar amount of GDP on average - pushed EU’s and PRC’s up and US’ down so to speak.)

Here are some quick takeaways:?

• Total Aggregate (Real Estate Market Size): PRC and EU are similar in size, and both are about 1.5X as large as the US (see Figure 1a.)
• Per Capita: China’s overall market size is still largely attributed to its population. If we look at real estate value per head (for everyone in the country), PRC is much smaller. The EU and US are similar to each other, and each is about 3X of China.
• Per Capita adjusted for different living standards: Because Europeans and Americans have higher average incomes, I adjusted the per capita real estate value for GDP/capita. Now China is slightly smaller than the EU (a bit less than 10%.) The EU and China are 2.3X and 2X of the US.? One way of interpreting this would be “had the Chinese and Europeans have the same level of nominal income (i.e., GDP output per capita increases significantly, or the dollar depreciates against the euro and RMB significantly), their real estate asset values would be more than doubled (theoretically, of course.)
• Per Homeowner adjusted for different living standards: Although I did not chart this, it is worth mentioning that if we also adjust for home ownership, China will shrink further. EU is 1.4X of China, and China is only 1.5X of the US (China is evenly between the EU and US.) This is because China’s reported homeownership is 90% vs 69% and 66% for the EU and US. However, I am still not 100% convinced that the real home ownership in China is really that high - I’d need to better understand the methodology.

Equity and Debt Market Size Comparison: EU, PRC, and US

Equity Market (Stocks)

Figure 2. EU, PRC, and US Equity Market Comparison (as of 2023)

China’s stock market is both overregulated and highly volatile. Historically, most of internationally known Chinese logos (like Alibaba and Tencent) are listed either in the US or Hong Kong or chose to remain private (like DJI or Huawei). Recently, even some have chosen to delist from the NASDAQ, they usually return to Hong Kong, not the mainland. Although the total volume has been growing fast, most average Chinese households trust their life savings there.

Debt Market (Public Debt)

Figure 3. Global Bond Market Comparison

China’s debt market commenced in 1978. Real development started in the 1980s. The Shanghai Stock Exchange and the Shenzhen Stock Exchange were established in Dec 1990, marking the beginning of a more formal and organized domestic bond market in China.

The domestic debt market thrived better than the equity market. It had just surpassed Japan just few years ago and is now at more than $20 trillion. The domestic bond market is the flip side of the US debt market: the US has more corporate bonds and China’s are mostly government or government backed bonds. It is more attractive to investors because the yield spread is big enough to speculate (plenty of safe bonds and dangerously risky junk bonds with lucrative interest rates) but the actual risk is a lot lower than the equity market. The overall default rate is not high. There are more manufacturing firms in China, especially state-owned (SOE) manufacturing companies, who have hard assets for collaterals (factories, plants, and equipment.) For bond investors, even if a borrower defaults, one can strip the parts and sell them. Sometimes one can even make a nice chunk of profit when an undervalued SOE goes bust.

However, it takes a lot of money to play in the bond market directly. It’s more for institution investors or wealthy individuals. Bond mutual funds are available and growing in China, but I don’t think they are as large and mature enough to help many average households access the domestic debt market yet.

Data sources include:

https://asianbondsonline.adb.org/documents/abmg/abmf-hkg-bmg2020-overview.pdf

https://www.visualcapitalist.com/ranked-the-largest-bond-markets-in-the-world/

Summary

Let’s put everything together. Here is how they compare.

Table 1a. EU, PRC, and US Debt, Equity, and Real Estate Markets

Table 1b. EU, PRC, and US Debt, Equity, and Real Estate Market Allocation

The key takeaways:

China’s real estate market, in aggregate, is on par with the EU’s and larger than the US’. But this is largely because of its population. Per capita, it’s still a fraction of the EU and US.

Both the EU and China clearly prefer real estate over other assets: both have around 70% of equity + debt + real estate investments in real estate. Adjusted for population and living standards, both invest twice as much in real estate as the US does.

EU is slightly more on the equity side, while China favors debt a bit more. Given the recent years’ policy liberalization in the bond market, China is likely to be even heavier on debt and lighter on equity and real estate.

The US economy is still much more financialized and diversified than China and the EU. Its debt + equity + real estate asset size outsizes the other two by 40% to 60%. It has an almost perfect 1:1:1 debt/equity/real estate ratio, giving it profitability, liquidity, and stability.

From this comparison, we can predict that, as an asset class, as long as China’s per capita GDP continues to rise, there is still plenty of room to grow for its real estate market.

Real estate value per capita is still low compared to the west. While China’s debt market has a good chance of narrowing the gap with the US in the next 10-15 years, I can’t image both the debt and equity markets grow that fast. Therefore, the real estate market remains the only place to absorb China’s excess capital.

Because China’s population decline officially started in 2022 and homeownership is already high, it won’t be business as usually. I predict that:

• Growth will come more from rising housing prices bolstered more second-home sales instead of new housing units.
• Higher prices and higher secondhand home values will lead to price/product differentiation, which leads to more exclusivity for the wealthy (think of Hamptons Beach). This will have more social and political implications.
• Growth will benefit different industries: we will see a large shift from “steel & cement” to “accountants & lawyers” and from construction to services. Also expect more financialization of the real estate industry and beyond. The biggest low-hanging fruits for US and European multi-nationals in China will be the financial sector.