China’s housing prices rose rapidly last year. New homes sold at price more than 50% higher in some big metros according to Knight Frank. As always, rising market attracts speculators, betting on the price appreciation. Investment demand crowds out real demand, pushing the price higher than anyone can imagine a year ago during the crisis time.

The outcome is not that surprising as Chinese banking system injected over RMB 9 trillion into the economy together with RMB 4 trillion fiscal stimulus. The abundant credit inflated the housing market in two folds: Cheaper financing inflated the purchasing power of buyers and speculators; the hyper money printing raised household’s inflation expectation. Property as a good asset class to provide inflation protection became the shelter of household investors.

Leave unattended, the housing bubble would severely damage Chinese economy. In a bubble period, the price would not indicate a real situation of demand and supply. Hence the manipulated price would send false signals to the investors, banks and governments. Many profitable projects justified in the bubble period would finally find no way out but bankruptcy. Non performing loans will skyrocket in banking system then spread to other industries. The economy would have to experience a tough hard landing as what happened to SEA countries in last Asian financial crisis.

Chinese government is veteran of bubble fighting with years of track record. The government stipulated restrictive measures on housing market in 2005 and 2007 respectively to mitigate risk of housing bubble. The measures were effective in the short term. But soon the government will be tempted to loosen the restriction as Real Estate is so important to the economy that it account for 30% of the local government’s funding, 20% of the total investment and a big part of housing related consumptions. Hence the government will have to release those restriction measures when the economy faces sluggish outlook. The stimulated market will inflate the economy back to high growth with a consequence of sharp rising housing price.

We believe the on going development will follow the same pattern. The government will continue to issue restrictive measures to curb the housing price. But the solid growth of the economy will finally justify the price and support another round of further appreciation.

The central government noted the risk of housing bubble and issued a round of restriction measures early in January including raising RRR and down payment ratio for land acquisition. Housing transactions dropped 1/3 in the following month but the price stay high and even rise further in March. The market did not believe in the commitment of the government’s cool down measures. Indeed, a rising property market induces a buoyant land acquisition market where local governments will enjoy high premium to fund their expense and big infrastructure projects. There is limited motivation for the local governors to restrict housing prices. But the central government is more salient under the pressure from the general public and media complaining on housing affordability and a potential systematic risk of bubble bursting. Hence the central government put out more restrictive measures targeting on residential market to crackdown speculative investors.

The tightening believed to be effective this time. The ban on mortgage issued to multi-house owners will significantly lower the buying power of speculators. Most important, it will shake up public’s conviction of always rising housing price. Transactions in tier 1 cities dropped 70% the week it announced and stayed in low level. Major developers are reluctant to lower selling price but most analysts believe the price will correct 10% to 20% from current level. As minimum down payment ratio is 20% and most buyers pay more than 40% capital on their purchase, commercial banks will not experience severe trouble on foreclosures as US banks did last year.

The risk of bubble burst is largely mitigated. The economy has been cooled down due to the restriction on housing market and credit growth, together with the saga of European’s sovereign debt issues. The easing commodity price will also help on the inflation pressure, which has been edging up to 2.8% last month. In general the economy has slowed to a sustainable growth rate. Overheating should not be a key concern.

Looking forward, there is still compelling long term growth story in China. As much as it grew so fast in last decades, China is still a poor country with GDP per capita of only US$ 4000 per annul which is the same as US in 1934 and Japan in 1960. There is still great growth potential during its catch up period. The government initiated trillion-dollar infrastructure projects last year as part of massive stimulus plan. Not all of them will be wise investment. Waste is unavoidable. But it’s not like Japan, building roads to no where just to provide jobs. Those infrastructures will become the enabler for China’s further growth. For example, the high speed railways joining undeveloped inner cities to more developed coast cities will be crucial to the economic development of the inner provinces. Hundreds of emerging cities will have a chance to compete with their coastal counterparties to grow their own economy. Investments in power stations, refinery factories, telecoms look excessive for now. But the growing demand of China consumers will soon outpace current supply. After all China is a populous country with 1.3 billion people. The demand for infrastructure is far from enough.

Commercial real estate market did not show any sign of bubble. Most of the investors in the market are more rational institutional investors. The government also restrict SOE and insurance funds to directly invest in property market. The cap rate compressed 100bps which is in line with most Asian commercial property market. We believe Chinese commercial real estate will actually benefit from the cool down of housing market. On one hand the mitigated risk of bubble burst protects a healthy banking system and capital market. On the other hand, stable housing price will free up part of household’s savings and investments to consumption, which will benefit the income of the commercial properties.