Early this year, property prices and sales resurged in top-tier Chinese cities — and, to a lesser extent, in second- and third-tier cities. The revival followed the boom (and subsequent collapse) of China's stock market in 2015, which, in turn, reflected Chinese investors' search for sound investments after the prolonged decline in home prices that began in March 2014. This recent history could serve as a cautionary tale for China's macroeconomic managers today, especially if the housing market keeps slowing in the second half of 2016. The Chinese government is running out of sustainable avenues for channeling the investment on which its economy still depends. At the same time, it is also running out of effective ways to maintain the high growth and employment rates that undergird social and political stability in much of the country.
But all parts of China are not created equal, and another housing market slump would hurt some regions more than others. The past few months of relatively robust price growth have disproportionately benefited China's largest and most advanced cities, nearly all of which are clustered on the coast. Conversely, the pangs of another downturn in housing prices will likely focus on the regions least able to bear them. For provinces in central, western or northeastern China — home mostly to second- and third-tier cities that would likely lose investment to their first-tier coastal counterparts in the event of a price drop — the consequences of a protracted decline would be manifold. Not only could these regions expect higher unemployment, but their local and municipal governments would also lose a crucial source of revenue if land sales were to dwindle.
Investment is the main component of China's GDP, contributing 44 percent in 2014. Nationwide, local governments are responsible for the vast majority of investment; in the first five months of 2016, local governments accounted for nearly 96 percent of total completed fixed asset investment across the country, according to the National Bureau of Statistics of China. But localities take in a far smaller share of tax revenue and other budgetary income — often less than 50 percent — a legacy of the central government's push to recentralize fiscal and administrative powers in the early 1990s. As a result, local governments in many parts of China rely heavily on extra-budgetary sources of revenue to fund the investments that keep their economies afloat and their populations employed. For the past two decades, no source of revenue has been as lucrative or as consistent as land sales, which depend on dynamic housing markets and high home prices.
The regions least reliant on extra-budgetary sources of revenue, including land sales, are often also those with the most vibrant and sustainable housing markets. Meanwhile, areas that suffer the greatest imbalances between local spending and revenue intake tend to have the most vulnerable property markets. In 2014, for example, three top-tier coastal cities — Shanghai, Beijing and Tianjin — respectively covered 90, 87 and 81 percent of their total spending with revenue from taxes and other budgetary sources, well above the national average of 57 percent. These cities, along with major southern cities such as Shenzhen and Guangzhou, also boast the country's strongest property markets.
By comparison, only 55 percent of what Chongqing, a municipality in southwest China, spends annually comes from budgetary revenue. And in China's poorer central and western regions, that figure is considerably lower: Some cities spend 10 times the amount of budgetary revenue they take in each year. In addition, these regions have the weakest housing markets in the country. All these factors leave them far more susceptible to construction-related downturns than megacities such as Shanghai and Shenzhen.
Anticipating the Fallout
For provinces such as Sichuan, Shaanxi and Hunan, another housing slump would be especially damaging. Each province receives less than 50 percent of its total expenditures through budgetary revenue, and all encompass countless second- and third-tier cities strapped with high levels of local government and corporate debt. In the event of another sustained price decline in the housing market, investment will likely ebb from these cities and flow into larger ones such as Chengdu or Chongqing, which offer higher and safer returns. The regions lack the wealth and administrative infrastructure to generate enough tax revenue to sustain the high levels of investment that they need. Moreover, their investment needs are too large to manage through transfers from the central government alone. During a downturn, these areas are at the greatest risk of experiencing large budget deficits, a grim prospect given their already high levels of (and reliance on) debt, both formal and informal.
Of course, one month of stagnating home prices does not make a sustained downturn. Nevertheless, given China's precarious economic circumstances, and considering the primacy of housing-related construction in China's GDP and as a source of employment, any hint of a slowdown in the market merits attention. June's home price figures will help clarify whether May was merely a fluke or the start of a troubling trend. If it is a sign of things to come, then rising unemployment, local corporate and government debt defaults, and even unrest in the parts of China most vulnerable to the fallout from a housing slump may soon follow.