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China’s Diminishing Returns

Gone are the days when China could point to soaring real-estate prices and rising incomes to justify endless new construction. China’s economic slowdown suggests that housing and office prices are headed for a steep fall that could take down banks and local governments, leading to prolonged stagnation.

CAMBRIDGE – The Communist Party of China’s 20th National Congress, which gave President Xi Jinping an unprecedented third term as general secretary, also featured a leadership shakeup that replaced market-oriented technocrats with Xi loyalists, raising questions about China’s plans for its faltering economy. Excessive state control, after all, is a tried-and-true recipe for becoming mired in the middle-income trap that Chinese leaders have long vowed to avoid.

The breakneck pace of state-guided investment in real estate and infrastructure – China’s go-to stimulus strategy – has generated diminishing returns, with slowing economic growth implying an inevitable fall in housing and office prices. This is especially true in the smaller, poorer, and less-developed cities that collectively account for more than 60% of China’s GDP. Housing prices in so-called third- and fourth-tier Chinese cities have fallen by roughly 15-20% over the past two years. Some form of sustained financial stasis will most likely ensue. But even if it does not look quite like a Western-style banking crisis, the concomitant fall in lending will still inhibit growth.

Real estate constitutes such a large share of China’s economy that a sustained slowdown could cause years-long stagnation akin to Japan’s lost decades since 1990. Counting direct and indirect demand, real estate accounts for roughly 23% of production and 26% of final demand (the latter figure includes net imported content).