In December of last year I made a statement that startled the students enrolled in my Chinese economic development course: that prices overall in China were high relative to prices of goods in the United States. They were surprised because the consumption choices of American college students studying abroad in China often do not go far beyond that of an inexpensive bowl of noodles, a few Qingdao beers on a Friday night, and a bagful of knock-off brand name clothing from the Silk Market. But the rising Chinese consumer, whose consumption habits require much more than food and clothing, faces a very different basket of consumer goods, and most of those goods are sold at high prices.
To illustrate, here’s a quick look at the prices of housing, airfare, medicine, and cars in China.
The cozy 100 square foot classroom in which I made the above statement is located 15 kilometers from Beijing’s central business district, and if sold on the real estate market today it would list at 80,000 USD. By extension, the modest American 1000 square foot detached home with a yard would sell in Beijing for more than 800,000 USD. What’s more, the property bought in China comes only with a 70 year lease and limited to zero rights to the ground the property lies on. China’s high housing prices are far from a new story, but the outside observer and the Chinese home buyer is consistently befuddled at the persistence of these high prices.
Last month I looked into purchasing a roundtrip flight to Chiang Mai, Thailand from Kunming. The pre-tax cost of the discounted ticket was a surprising 1200 RMB ($190) but the tax burden of the international flight was an additional 2000 RMB taking the total cost of the two hour flight to over $500. The Chinese economy has the fastest growing demand for flights worldwide and an ever-expanding fleet but the consumer continues to face high prices in part due to a few state owned airlines being able to control prices through a regulatory framework that eliminates competition.
In most parts of the world, when the patent for a prescription or OTC drug expires, the price the patent holding pharmaceutical can charge drops drastically given the entry of generic competitors who have the opportunity to legally produce and market the drug under its generic name. In China, however, according to a colleague in the sales department of Johnson & Johnson’s pharmaceutical arm, the retail price of off patent, non-essential drugs does not experience a drop after the patent expires and generic producers rush in. In fact, where the US producer usually immediately drops the product line due to the inability to reap large profits from the drug, the former patent holder in China will tend to raise the price! Why? The Chinese consumer by and large doesn’t trust generics given the reputation for substandard drug producers to use shoddy, carcinogenic inputs.
To give a fourth example, last month I was talking to a friend about purchasing a Volkswagen Tiguan, the inexpensive sister to the high-end Volkswagen Touareg SUV – both models are seen in ubiquity on the streets of any major Chinese city. That friend quickly discouraged me from pursuing the Tiguan SUV (which sells at around $25,000 in the US but retails at around $35,000 in China) because on top of the high cost, car dealers, who collude across a city market to control prices, will charge an extra premium of up to $10,000 for cars that are in high demand! He said I’m better off buying a cheaper KIA or Nissan SUV (which are also seen in ubiquity on the streets). In an environment of perfect competition, the automobile consumer can bargain down the price of a car sale with a dealer, but in China the consumer is held hostage.
These high prices persist for a variety of factors, but the golden thread tying these four examples together and keeping prices high is simply that the Chinese consumer is willing to pay the exorbitant price offered for these goods.
Despite recent regulatory efforts, local governments in China and officials employed therein continue to take advantage of public funds to purchase things like cars, airline tickets, and houses. I posit that the aggregate purchasing power of this cohort, who cares little about the high cost of the transaction by facing a soft budget constraint, is able to prop up prices high above a fair market level. Thus the car dealer when faced with two customers, the average Chinese household and the government official, will consistently sell to the government official at the high price unless the Chinese household chooses the pay arbitrary premium. Last year an audit was performed at a government unit that a close friend works for, and he revealed to me that his employer had in its fixed assets inventory a fleet of 72 cars, but only 35 could be accounted for. The rest were in the personal unchecked use of government employees and their relatives. Extend this example across the tens of thousands of government units in China and a powerful and elite buying force with nearly unlimited funds at their backing emerges. No wonder car dealers continue to collude and charge premiums on sales.
Generally speaking, every Chinese male is required by social norms to own a home and hopefully an automobile before getting married. Said simply, the demands of society can create a high demand for high priced items of which consumers have little choice but to purchase if they want to gain upward mobility. So with such high demand, are new goods flooding the market to meet this demand?
Observers, especially foreign ones, can, given the scale of new (and often empty) housing developments and the massive traffic jams, can easily be confused that markets are at equilibrium or perhaps even saturated. To provide analogy, my American students often make the erroneous generalization that all Chinese people eat out at restaurants all the time because the thousands of restaurants in Beijing are usually packed at dinner time. But a city with nearly 20 million of people would require more than 100,000 restaurants to feed more than half of the population. Beijing has a lot of places to eat, but not that many.
Extending this to the real estate sector, let’s assume that, by and large, households are only buying newly built high-rise homes and that these developments are exclusively built in the cities. Assuming half of China’s households are settled in urban areas and making another liberal assumption that newly built luxury housing complexes make up 50% of urban housing. These assumptions come together say that despite the feeling by urbanites that new housing is going up everywhere only 25% of the population can be supplied with new housing despite the high demand for new housing. High demand and low supply means high prices and that’s certainly what we observe. Indeed, Steven McCord, a real estate researcher at Jones Lang LaSalle has calculated that commodity housing built 1995 to date has only accommodated 20% of China’s urban population, a more accurate discovery that loosely fits my back of the envelope analysis above.
It’s simple economics: high aggregate demand and low aggregate supply drives high prices. So what this means is we’ll continue to see more new housing go up in cities especially as the pace of urbanization and rural to urban migration picks up in the next decade. Extending the example above to cars suggests that traffic jams will never be alleviated. In other words, what we are seeing now in terms of housing provision and cars on the roads is just the tip of a massive iceberg comparing to what the future may bring assuming the economy chugs along without a major bump or crisis.
So with supply growing to meet demand, won’t the high prices fall? With soft budgets in government units, a quality control gap, and a dearth of viable investment options outside of buying an apartment prices are likely to remain high.
If determining factors of the four examples above persist, producers will continue to reap high profits, and the government regulator will continue to bring in high tax gains. Sustainable economic development into the future requires China to make a transition to a robust consumer-based economy and a strong welfare state that wisely allocates tax revenues and redistributes income. High incomes to producers and officials who take advantage of taxes to line their pockets (and garages) prove as obstructions to this necessary transition and create an unlevel playing field.
Moving forward, government regulation must increase quality monitoring in all sectors and to drop demand in luxury housing, reformers must increase the provision of low and middle income housing AND widen channels for household saving so that savers look outside of the housing market for investment opportunities. I’ve never been one to advocate excessive liberalization, but without a reform package that expands private markets, curbs corruption, hardens budgets, and delivers meaningful tax reform, high prices will persist and the Chinese consumer will continue to pay a lot more for less.