Short Selling the Real Estate Bubble in China Kaiguo Zhou Sun Yat-sen University, Guangzhou, China

Reading Questions What’s the relationship between real estate bubble and financial crisis? Why is there a bubble in the Chinese real estate market currently? How about the development of real estate price index in recent years in China? How about the affordability of urban residents under the current housing price level? What is the Chinese government doing to stop the bubble? When will the bubble burst? How can the domestic investors short sell the real estate bubble in China? How can the overseas investors short sell the real estate bubble in China?

The role of real estate bubble in financial crisis Real estate bubbles may induce financial crisis. An increase in real estate prices will increase the supply of credit to the real estate industry, which in turn, will lead to further increases in real estate prices. A decline in real estate prices may diminish bank capital by decreasing the value of real estate assets owned by the bank. A drop of this type may possibly shrink the value of bank loans collateralized by real estate which in turn can result in additional defaults and thereby reducing the bank’s capital.

Why is there a real estate bubble in China currently? Speculation has caused housing prices to increase rapidly in the past three years. Although the GDP per capita and disposable income per capita are both increasing in China, the growth rate of housing prices is far greater than the GDP and disposable income. Most of urban residents in China cannot afford a house or even a down payment in a city where they live and work, according to the current level of their personal income.

The development of real estate price index in recent years Monthly Price Index of Real Estate Sales, on a Month-to-Month Basis

Affordability of urban residents under the current housing price level Guangzhou, the second largest city in China in terms of GDP per capita, as an example It will cost a couple an equivalent to 19 years of salary (ignoring the time value of money) to buy a house of 90 square meters. Compared with current rental price levels, purchasing a house is not a reasonable choice while renting a house is preferred by urban residents.

The government’s reaction The government has realized that the real estate bubble does exist and has started to implement some measures to suppress the real estate price. it requires the commercial banks to enhance the proportion of down payment of mortgage loan to the borrower who buys the second house, from 30% to 50%. The mortgage loan rate is enhanced by 10% for the purchase of the second house. The required reserve ratio of commercial banks was enhanced for three times within this half year (on January 18, February 25, and May 10, respectively).

When will the bubble burst? The high real estate price can not sustain for a long time in the future. By forecast, during the second half of this year, the real estate price will start to go down. The real estate price will return to the reasonable level during the second quarter of next year. The real estate bubble will burst then.

How do domestic investors short sell real estate bubble? Short sell the stocks related to China’s real estate industry (Short selling stocks in China started on March 31, 2010.) Hold a short position in index futures using the Shanghai and Shenzhen 300 index futures contract Short sell stocks having a high positive correlation with real estate stocks, e.g., steel companies, wood producing companies, cement and brick producing companies, financial companies, etc.

How do overseas investors short sell real estate bubble? Simply short sell stocks on the Hong Kong stock market that are closely related to Chinese real estate firms Short sell Chinese companies listed both in mainland China and in Hong Kong (called “A+H shares”) Short sell ADRs issued by mainland Chinese and Hong Kong firms in the US market

Other strategies for investors The demand for many commodities such as steel, cement and wood will significantly decrease due to the shrink of real estate market. Investors may choose to short sell such kinds of commodities in the international market. The raw materials of such commodities can also be short sold.