The Impacts of Land and Real Estate Price Fluctuations on Financial Stability: Evidence from China

• Published date: 01 March 2023
• Author: Jinsong Wang,Wenhui Wu,Yueqiao Li,Qiyuan Yang
• Date: 01 March 2023
• DOI: http://doi.org/10.1111/1467-8462.12496

The Australian Economic Review, vol. 56, no. 1, pp. 42–60 DOI: 10.1111/1467-8462.12496

The Impacts of Land and Real Estate Price Fluctuations

on Financial Stability: Evidence from China

Jinsong Wang, Wenhui Wu , Yueqiao Li and Qiyuan Yang*

Abstract

We construct a provincial financial stability

index, and use panel vector autoregression to

construct a model for empirical testing. We

find that local governments' reliance on land

grant premiums amplifies the impact on

financial stability. In addition, the relation-

ship between the real estate market and the

financial system allows real estate price

fluctuations to significantly affect market

participants, further impacting financial

system stability. Finally, in the eastern region,

land price fluctuations have a less adverse

impact on financial stability, while in other

regions, rising commodity real estate prices

are the biggest threat to financial stability.

1. Introduction

Following the 1994 tax sharing reform, local

Chinese governments solved the problem of

financing local economic development by

using land leverage as a tool to attract

investment, and by promoting industrialisa-

tion and urban development. However, as

revealed by the 1997 Asian financial crisis and

the 2008 US subprime real estate crisis,

irrationally rising asset prices, especially

commodity real estate prices, are important

factors in triggering financial crises. Since

China's economic development entered the

‘new normal’

1

in 2014, the supply and

demand of land and property markets experi-

enced China's inter‐regional imbalances, with

some regions experiencing wasted land re-

sources or housing inventory backlogs.

Overall, the performance of asset prices,

typified by land and commodity real estate

prices, poses a huge risk to the financial

system. The two major issues originating from

finance, local government debt and com-

modity real estate price bubbles, are currently

important sources of financial risk.

Additionally, the rapid increase in land and

commodity real estate prices and local

fluctuations is highly likely to accumulate

and trigger risks, which in turn will impact

financial stability.

The 2008 global financial crisis ushered in

a rising financial stability risk, and China's

financial system experienced global decline

and local fluctuations. However, while wea-

kened, the growth rate of urbanisation

* Wang, Wu, Li and Yang: School of Economics,

Hangzhou Normal University, Hangzhou, China.

Corresponding author: Wu,

Email: 709693803@qq.com

© 2022 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business

and Economics.

Published by John Wiley & Sons Australia, Ltd

remained at 1.24 per cent per year, while the

permanent resident urbanisation rate increased

from 47.0 per cent in 2008 to 60.6 per cent in

2019.

2

Lu, Ou and Chen (2014) and Wang,

Guan and Zhao (2015) argue that, as the

population continues to be concentrated in

large and medium‐sized cities and new

industries grow, higher living standards and

upgrades in consumption generate greater

demand for urban land and real estate.

Furthermore, Han and Ming (2018), Ni

(2019), Lv (2010) and Zhang (2016) propose

that the 4 trillion fiscal stimulus, together with

the ramping‐up of real estate investment, is

partly responsible for growing land and

commodity real estate prices, price fluctua-

tions, regional diversions, bubbles in the

housing sector and housing pressure.

Since the Chinese economy entered a ‘new

normal’in 2014, macroeconomic growth has

slowed, and the country is targeting high‐

quality development (Li and Zhang 2015).

However, the speed of economic growth in

the southeastern coastal regions significantly

differed from that in the northeastern and

northwestern regions (Yang, Liu and Chen

2020).

3

Tangible assets, such as land and real

estate, witnessed steady price growth, high-

lighting the problem of resource allocation

away from the real economy. This phenom-

enon wasted significant funds, and posed a

substantial threat to the financial system

(Peng, Huang and Shen 2018; Peng, Ni and

Shen 2018). While domestic and foreign

demands are weakening, land and housing

markets seem prosperous in some regions.

The extent of the threat to the financial

system's stability remains unclear. However,

the available research still lacks theoretical

and empirical analysis combining land prices,

commodity real estate prices and financial

stability. This study aims to fill this gap in the

literature.

The financial crises of 1997 and 2008

demonstrated the danger of irrational in-

creases in asset prices, especially commodity

real estate prices. As land and property market

supply and demand become unbalanced

across regions, housing inventory builds up,

making commodity real estate prices unlikely

to be sustainable due to weak economic

fundamentals. These phenomena may burst

the commodity real estate price bubble, hitting

commodity real estate prices, and generating

incalculable losses to housing enterprises, the

banking system, and individual or institutional

investors, ultimately impacting the financial

system. In recent years, the risk of real estate

bubbles has been a significant threat to China's

financial stability.

There has been much research on the

relationship between commodity real estate

price volatility and financial systems. For

example, Kiyotaki and Moore (1997) found

that the real estate market mainly affects the

banking system through the collateral effect,

as evidenced by banking institutions con-

tracting credit during periods of low com-

modity real estate prices, thereby accelerating

risky investments' liquidation in real estate

assets. These phenomena accelerate real estate

deterioration. With the advent of financial

accelerator theory, researchers gradually in-

troduced credit market frictions and credit

constraints into macroeconomic models,

and dynamic stochastic general equilibrium

(DSGE) models with financial accelerator

theory are now the primary framework for

addressing the relationship between asset

price fluctuations, financial stability and

macroeconomic fluctuations (Bernanke,

Gertler and Gilchrist 1996; Bernanke, Gertler

and Gilchrist 1999; Iacoviello 2005).

In both developed and developing coun-

tries, the real estate sector occupies a crucial

position in the national economy. Therefore, it

is often included in macroeconomic models to

examine the synergy between the real estate

sector and investment, gross domestic product

(GDP) and the correlation with macroeco-

nomic fluctuations (Davis and Heathcote

2005; Yang 2012; He, Qian and Guo 2015).

Given the great danger of commodity real

estate price volatility, which may trigger

macroeconomic volatility and financial crises,

effective regulation and prevention measures

are a longstanding concern in academia. The

effectiveness of monetary policy in regulating

house price volatility, and whether the pre-

vention and control of asset price volatility,

43Wang et al.: Real Estate Price Fluctuations in China

© 2022 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business

and Economics.