I want to write a little follow up to my piece in Bloomberg Views about real estate prices in China. As usual start there and come here for the follow up and explanation.
It is not just the value of real estate prices that I think is concerning but the framework for what is driving the increase in prices and the theory behind it. Before I focus on the Chinese situation, let me back up to before the 2008 global financial crisis and what economists were arguing about before the collapse in US housing prices.
Prior to the collapse in real estate asset prices in the United States in 2008 that precipitated the global financial crisis a key, albeit somewhat wonky debate, was whether monetary policy should worry about asset price inflation or just aggregate price inflation. Then Governor Fredric Mishkin argued in a May 2008 speech that “monetary policy should not respond to asset prices per se, but rather changes in the outlook for inflation…impl(ying) that actions, such as attempting to ‘price’ an asset price bubble, should be avoided.” It is questionable in light of the 2008 financial crisis, whether this argument would hold sway today.
On a brief side note, I would love to see a vigorous debate on this topic but there has been little debate on this topic. I think it is generally accepted that loosened monetary conditions have helped push up asset prices in developed markets, but I have not seen much debate about whether monetary policy should be used to try and restrain asset prices or even drive them down. Alan Greenspan actually argued before 2008 that monetary policy was better placed to help stimulate after a bubble has popped rather than trying to determine the correct level of asset prices.
Chinese authorities, more for political reasons that from an adherence to economic modelling, have implicitly targeted what they believe to be an acceptable growth rate in real estate prices. Using a combination of monetary stimulus and regulatory measures, Chinese officials implicitly target real estate asset price growth that they believe represents an acceptable rate of price growth.
This has resulted in a couple of conclusions or outcomes. First, Beijing appears to have an implicit real estate asset price target. I say implicit because they have not announced a specific price target as part of the monetary policy framework, but it is clearly near the top of the list of prices they watch and there is a clear monetary and broader regulatory real estate asset price target. They do not want prices sinking nor do they want prices rising too rapidly. Given what we know about how Beijing manages the prices of all other prices and asset prices, I don’t think it is a stretch at all to believe or watch how they behave and see an implicit asset price growth target framework at play here. Second, Beijing does not appear that good at price targeting. Just like the Fed, BOJ, or ECB with their broader inflation targets, the PBOC does not seem that good at asset price targeting though they continually miss on the high side rather than the low side. Third, there is a clear behavioral response to the implicit real estate asset price target. There is a reason about 70% of Chinese household wealth is in housing and people buy second and third apartments. There is an expectation that the real estate price target framework of Beijing will be carried out resulting in safe appreciation.
I have become incredibly skeptical of the implicit asset price targeting because you see how clearly investors behave in response to the unofficial asset price growth target. Asset price growth targeting by central banks inevitably leads to gaming of the system by investors. Though it may be difficult for investors to profit from generalized 2% price increase, it is much simpler when the government is targeting price increases in such a fundamental asset as housing in China.
I also wonder if there is a difference between asset price targets and specifically about the amount of leverage attached to the asset purchase or amount of wealth it represents as a portion of the national portfolio. Given the 70% portfolio slice of household wealth, should we differentiate between that major portion and the portfolio holding that represents say 10%. I would think based just on the wealth effect, there is good reason to treat real estate differently than other assets. This would seem to imply targeting a lower real estate asset price growth target.
It may also be necessary to think about asset prices differently based upon the debt tied to them. Use a simple example, you can buy a stock with a 10% return or you can use that same money to buy a house that you also take mortgage to buy that will grow in value 10%. Now Chinese households are not as leveraged as US households, but I have heard way too many stories of how Chinese skirt the financial system rules to believe it isn’t a lot more widespread than people believe, but given the leverage attached to mortgages, there is higher risk. Assets attached to rising leverage ratios, as is the case with China, might signal the need for a lower asset price target if one at all.
Finally, it should not be overlooked at housing prices started rising so dramatically as real economic output was really slowing so dramatically. Previously when real estate prices were rising so dramatically, it was argued it was not a bubble but tied to expectations about future economic growth. However, with economic growth slowing, and household incomes slowing even more, what is the fundamental rationale now for home price increases? The real estate asset price target is clearly out of sync with the broader economic reality.
I return to two simple questions: how appropriate is an asset price growth target for China, what are the risks they are running, and how good are they at producing desired results? I would say: not very, high, and not very good.