China Acts to Calm Its Overheated Real Estate Sector - and Misdiagnoses the Problem

Dec.20.09 | About: iShares China (FXI)

China’s leaders are becoming increasingly alarmed that a bubble may be forming in the country’s booming real estate sector. That’s why, late last week, they announced the reimposition of a nationwide property sales tax in an effort to rein in speculative buying. But while their intentions are sound, the new tax takes China in entirely the wrong direction, and is more likely to make the problem worse rather than better.

To understand why, it’s important to realize what the new tax is and is not. It is not a “property tax” as understood in most Western countries, i.e., an annual tax on the value of property holdings. China’s government has often announced its intention to impose such a tax, but each time the move has been postponed due to the panicked opposition of real estate developers.

The policy announced last week is a transaction tax. According to the Financial Times, it “requires anyone selling a secondhand apartment or house within five years of its purchase to pay a sales tax of 5.5 per cent.” Previously, the same tax had been imposed only on owners selling within two years. The idea, in both cases, is to discourage speculators from buying residences with the sole intention of selling (or “flipping”) them for a quick profit, rather than to live in. Such practices were highly prevalent in the U.S. in the past couple of years and played a key role in contributing to the formation of the real estate bubble and sub-prime mortgage crisis there.

In China, however, “flipping” is not the problem. Some people may be engaged in short-term ”flipping,” but as I’ve described in my FEER article “China’s Real Estate Riddle,” a lot more are buying residences — in many cases multiple units — and holding them vacant indefinitely as an unproductive ”store of value,” like gold. As I mentioned in my article, the Financial Times estimates that there are 587 million meters of apartment space that buyers have purchased over the past five years only to leave lying empty (for a concrete notion of what this statistic means, take a look at Al Jazeera’s report on Ordos). This puzzling phenomemon is due to the fact that Chinese citizens have relatively few investment options, and China’s real estate sector (unlike its stock market) has never experienced a sustained downturn since the country converted to private home ownership in the mid-1990s. The fact that China has no annual holding tax on property means there is little penalty for letting property lie idle, in the hope that it will appreciate or at least retain its value. The result is an inflated market where the demand for property as a pure investment vehicle far outstrips the demand for affordable, usable space.

If people were trying to “flip” their properties, that might actually be a good thing. At the very least, it would mean those residences would have to be brought onto the secondary market and priced. What we see in China, though, is an extremely weak secondary market. In the U.S., the ratio of secondary to primary residential property transactions for the first half of 2009 was 13.45; in Hong Kong it was 7.25. In China as a whole, that ratio was 0.26 (four times as many new home purchases as secondary sales). Even in China’s most developed markets the ratios were just 1.30 for Beijing, 1.56 for Shanghai, and 1.35 for Shenzhen. [Keep in mind that an immense quantity of existing housing stock was privatized in the 1990s, at nominal prices, so the explanation cannot be simply that China is a "new" market -- China actually has a higher rate of established home ownership (80%) than the U.S. (70%)].

The way I read these figures is that an immense amount of new housing is being purchased and accumulated (in a vacant condition) off-market. Nobody has any idea what it is actually worth because there is little urgency to offer it to end users on the secondary market and actually see it priced based on their demand. If investors were at least trying to “flip,” we might find out, but they’re not, and so prices for new residences (especially on the high-priced luxury end) continue to rise without anything to bring them back down to earth.

What China desperately needs is an annual property holding tax, like in the West, that imposes a hurdle rate of return — effectively, a penalty for allowing property to remain idle. What it is getting is a sales tax that gives buyers an incentive to let their property lie idle even longer, and withhold it from being priced on the secondary market. The fact that this tax is being adopted as a temporary measure — a bid to calm a momentarily overheated real estate sector — rather than a permanent change only gives investors a further incentive to hold onto their vacant properties longer to try to wait out the government’s mood.

If China’s real estate sector were experiencing a typical bubble, where assets are being rapidly flipped higher and higher until the music suddenly stops, China’s new property sales tax would make eminent sense. But this new policy misdiagnoses the problem, which is that property is being accumulated and left idle, indefinitely, as a store of value. As long as that property remains off-market, and is not compelled to be priced based on actual demand for affordable usable space, the asset price illusion will continue and the bubble will grow. If China wants to bring it real estate market back to earth — and that’s a big “if” — it should be offering investors a reason to use, rent, or sell. An annual property holding tax does this. A higher property sales tax, while well intentioned, only makes things worse.

[For your information, for those who might be wondering if I've suddenly converted to advocating tax increases, I have not. In my view, the imposition of an annual property holding tax should be revenue-neutral, i.e., should be offset by trimming or abolishing other taxes. China's top personal income tax rate of 45%, for instance, is sorely at odds with its desire to develop Shanghai as a financial center, compared to Hong Kong with its tax rate of 16%. And its 3% revenue tax on service firms (in addition to corporate taxes on profits) imposes yet another burden on a sector whose development China desperately needs to encourage. What I advocate is not raising taxes, but revising the tax structure to reward productivity and discourage the wasteful accumulation of idle assets.]