Tuesday, April 27, 2010

A game changer in China?

Last week I saw that an announcement of the possible phasing in of an asset based property tax that could be the beginning of a huge game changer in China and its overheated property market.

Too much investment, too little consumption
First, let me explain by stating my interpretation of the macro problem in China. In the wake of the global financial crisis, China’s initial response of massive $586b stimulus program that helped to stabilize the Chinese and world economy, but created a problem by blowing an asset bubble. Chinese stimulus was directed mainly at fixed investment and created excess capacity, which will eventually end up in a bust. A better solution would have been to stimulate consumer demand, which would have better re-balanced its current account and fund flow problems, as well as dampen the trade tensions she has with her biggest customer, the United States.

The tsunami of liquidity in China has resulted in a real estate bubble, but it’s a bubble that you can’t really trade. Patrick Chovanec, longtime China watcher, puzzled about the bubble:

As a Beijing homeowner myself, I’ve experienced this puzzling phenomenon firsthand. We have been told that the value of the condo we bought last year has gone up 30% based on sales of new nearby developments, but it’s impossible to confirm since there is no secondary market.

Real estate as a form of money
The bubble is in the pricing of new units. There are little or no transactions in the secondary market. That’s because of the structure of property taxes in China, according to Chovanec:

The average property tax in the U.S. is 0.95% of assessed value, which for serious real estate investors represents a relatively modest cost of doing business. But for a typical homeowner, such taxes amount to roughly 3% of their income, a not-insignificant cash outlay, especially if they are not getting full use out of the property. This and other aspects of the U.S. tax system—including the home mortgage interest deduction and passive loss rules—create strong incentives for residential property owners to either use it to live in or to generate income by renting it to others to live in, and penalize them for letting it stand idle. The effect is to keep housing prices closely tethered to real end-use demand for livable space, by driving owners to find such uses. Investor sentiment can push those prices too high or too low for a time, but the need to find actual occupants eventually forces a correction.

Chovanec states that property taxes in China are on transactions, i.e. sales, and not on assets. So there is an incentive for investors to hold property and not to sell. In fact, real estate in China can be thought of as a form of money:

In China, there is no cost to holding property indefinitely. In fact, it can be relatively attractive option. Unless they already possess offshore funds, Chinese citizens have limited investment choices: they can gamble on an unstable domestic stock market, buy low-yielding government bonds, or stash their cash in even lower-yielding bank deposits. By contrast, real estate—occupied or not—offers them a visibly reassuring place to park their money, sheltered from inflation. Americans have long been familiar with this advantage to owning a home, but with little or no holding costs, Chinese owners are unconstrained by the need to make the property “pay” in cash or in kind. For them, an empty condo is a store of value, much like gold, another asset that performs no practical function besides retaining its worth.

A modest annual tax may not be the only factor shaping these behaviors, but it’s emblematic of an important difference in outlook. There’s an old story reported by an American journalist in Shanghai after the end of World War II. Ravaged by hyperinflation, locals had turned to using tins of sardines as an alternative currency. One recent arrival opened his “proceeds” from a sale only to find the sardines inside were spoiled. He complained to the other trader, who cried, “You opened them? My God, man! Those sardines aren’t for eating, they’re for buying and selling.” Apartments in China aren’t for living in, they’re for investing. That is the real source of demand.

Consider the theory of money. Money can be anything: gold, currency, cigarettes, sardines, etc. Why not real estate? Yes, condos do deteriorate over time, but do cans of sardines.

If we think about money in that framework, then much of the Chinese’s recent liquidity injections into the economy became a less liquid form of money, i.e. real estate, Let's call that M4 (= M3 + real estate held as money). If the authorities want to control the growth of M4, then they have to create disincentives to the use of real estate as a store of wealth by instituting western style asset-based property tax.

Here is the announcement last week that could turn out to be the game changer:

Under the rules being considered, authorities would classify any purchase of third or additional property by a single family as a commercial investment, making it subject to a 1.2% annual levy on 70% to 90% of its value, according to a report Friday in the Shanghai Securities News.
These are baby steps, but an asset based property tax could be create an enormous paradigm shift about how property is perceived in China. How this plays out and how long this takes to play out is anyone's guess.

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