Urbanization and housing markets in China

July 2011

Two views of a housing boom

Pessimist: China’s housing market is a playground for nouveau riche who buy multiple fancy homes they don’t need. Prices are too high and speculation is rampant.

Clearly, the trend is unsustainable.

Optimist: China is transitioning from a rural to an urban society. New construction is driven by rising incomes and urbanization, and reflects genuine demand for better housing.

Clearly, the boom has a long way to run.

Dragonomics: Both views are correct.In this presentation, we will show how to integrate them.

2

Contents

The rise of an urban China 4– Urbanization is a visible sign of China’s rapid catch-up growth. Migration has accelerated as a private market replaced state-provided housing.

The birth of a housing market 11– The privatization of urban housing from 1998-2003 is crucial to understanding how today’s markets function, but remains little studied and poorly understood.

– Privatization’s transfer of wealth to households helped kick-start the commercial housing market by effectively subsidizing the purchase of new homes.

High prices and bubbles 19– The boost from privatization is starting to fade away, but without subsidies housing is unaffordable for many urban households.

– Housing is increasingly purchased by households who already own a home. Construction drives much economic growth, so the effect of a correction or policy mistake could be large.

The future of migrants 33– Housing is even more unaffordable for rural migrants, almost none of whom participate in the commercial housing market.

– There is tremendous unmet demand for modern urban housing, but the structure of supply currently does not match up with it. The role of public housing is growing from a low base.

A new model of urbanization? 43– Migration is shifting from temporary to permanent as rural workers’ aspirations rise. Policies that better integrate migrants could reap new benefits for growth. City planning also needs to evolve to address urban sprawl and strains on resources.

3

The rise of an urban China

5

Urbanization and growthWhat is the relationship between cities and growth?

• Urbanization does not necessarily cause growth: if people move from rural poverty to urban poverty the economy will not expand very much.

• But urbanization is often a physical sign of development, and most wealthy countries are primarily urban.

• The shift of the labor force out of lower productivity agriculture and into higher productivity industry and services is the main driver of economic development.

• This transfer usually happens via a physical movement from rural areas to urban areas.

5

Source: UN World Urbanization Prospects, Penn World Table 7.0

0

10

20

30

40

50

60

0% 20% 40% 60% 80% 100%

Per-

capi

ta G

DP,

000

US$

PPP

Share of population in urban areas

World urbanization and development179 countries, 2005 data

6

Town and countryChina’s urbanization drive likely still has at least 20 years to run.

• In 1980, fewer than 200m Chinese lived in towns and cities – a paltry 20% of the population.

• Today, that figure has risen to more than 666m, half the current population of 1.3 bn.

• Urbanization has generally happened faster than expected. While UN projections don’t foresee China reaching 70% urbanization until 2050, if recent trends continue the landmark could be hit in 2030.

• In either case, the urbanization process is still far from over.

6

0%

10%

20%

30%

40%

50%

60%

70%

80%

1950 1960 1970 1980 1990 2000 2010 2020 2030

Urban share of China's population

NBS historical

UN projection

Recent trends

Note: NBS historical data on urbanization have not yet been revised to account for the faster rate of urbanization revealed by the 2010 census.

7

How cities growThree ways to get more “urbanization”:

• Natural increase: new household formation by the children of people who already live in cities (here, holders of urban hukou).

• Administrative increase: reclassification of rural residents as urban residents as city boundaries expand.

• Migration: rural hukouholders who live and work in cities for more than six months of the year (the threshold to be counted as resident by the census).

• The latest census indicates actual migration was probably larger than these initial estimates.

7

85

43

97

Source of increase in urban population1998-2009 total: 225m people

Migration from rural areas

Expansion of urban boundaries

Natural increase in urban population

Note: not adjusted for results of 2010 census.

8

Urbanization in AsiaMiddle of the pack.

• In 1950, China was more rural than any other big Asian nation: less than 20% of the population lived in cities.

• Relative to the level of development, China is urbanizing less rapidly than Korea (which is smaller) and more rapidly than India (which is growing slower).

• The hukou system and the associated restrictions on freedom of movement probably mean that China’s urbanization could have been even faster.

• Restrictions may have been beneficial, as China obviously lacks the large slums seen in some cities of other developing nations.

8

Sources: UN World Urbanization Prospects, Penn World Table 7.0

0%

20%

40%

60%

80%

100%

0 5 10 15 20 25 30 35

Shar

e of

pop

ulat

ion

in u

rban

are

as

Per-capita GDP , 000 US$ PPP

Asian urbanization and economic development

South Korea

China

Japan

India

9

Urban consumptionUrbanization represents a change in lifestyle not just location, with major economic implications.

• Urban households tend to consume more energy than rural households, so urbanization will also drive increases in China’s energy consumption.

• Efficiency improvements in home appliances offer room to offset some of this impact.

• Also, new adoption of appliances will eventually slow once most households own them.

9

-

50

100

150

200

250

300

350

Urban Rural

Durable goods per 100 households

Air conditioners

Refrigerators

Washing machines

10

Urbanization speeds upThe biggest decade yet.

• Figures from the 2010 census show that urbanization accelerated over the past decade, rather than slowing down as previous official estimates indicated.

• In 2010, four in 10 urban residents did not have a local hukou, up from three in 10 in 2000.

• This finding is more intuitive, and is in line with the obvious and very rapid changes in China’s physical urban environment.

• Housing privatization and faster economic growth combined to support faster urbanization, mostly through more migration.

10

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1980-1990 1990-2000 2000-2010

Increase in urbanization rateAnnual average, pp

Birth of a housing market

12

Housing privatizationChina has had a private housing market for little more than a decade.

• Large-scale housing privatization began in 1998 and was largely complete by 2003.

• Scattershot efforts to privatize work unit (danwei)housing started in the early 1990s, but fizzled out. In July 1998, the State Council ordered work units to stop allocating housing to employees, and give them cash subsidies instead.

• Mortgages and housing provident funds were also encouraged to help households finance the purchase of housing from their employer.

12

0

100

200

300

400

500

600

700

800

1998 1999 2000 2001 2002 2003 2004 2005 2006

Progress of China's housing privatizationmillion sq m

Privatizations

Commercial sales

13

Housing privatization (2)The biggest sale in history?

• We estimate about 4.1 bn sq m of housing was privatized in 1998-2003, sold to households at an average price of Rmb500 per sq m.

• Although the proceeds were supposed to go to housing funds, work units probably pocketed them. The total was about Rmb2 bn.

• But the benefit to households was much greater, as average market prices were about Rmb1,600 per sq m.

• These estimates imply a total wealth transfer to households of around Rmb4.5 trn, or one-third of annual GDP in 2003.

13

0

200

400

600

800

1,000

1,200

1998 1999 2000 2001 2002 2003

Privatization revenues and subsidiesRmb bn

Estimated subsidy

Privatization receipts

14

Mortgage debtChina’s housing boom is not debt-fueled.

• Mortgage borrowing has grown along with the market but remains a relatively small part of the banking system’s total assets.

• Household leverage has increased from zero but remains moderate.

• Down payments are typically a high share of the final price, and a nontrivial fraction of housing purchases are in cash outright.

• Household savings, generational transfers and wealth gains from privatized housing are bigger drivers than debt.

14

0%

2%

4%

6%

8%

10%

12%

14%

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Rmb bn Home mortgage lending

Mortgage lending (lhs) Share of total lending (rhs)

15

Construction and growthA pillar industry.

• Housing reform helped create a vast new industry driven by private consumer demand, which also offered new opportunities to many private entrepreneurs.

• Construction and real estate directly account for about 10% of China’s GDP.

• However the indirectcontribution is much larger, as industries like steel and cement are heavily driven by real estate activity.

• Chinese households’ purchases of major consumer goods tend to be closely tied to the purchase of housing. This is obviously the case for appliances but also tends to be true for cars.

15

0%

2%

4%

6%

8%

10%

12%

Construction and real estateShare of China's GDP

Real estate

Construction

16

Resource consumptionWhy investors care.

• The construction boom is one of the main reasons why China’s economic impact on the rest of the world is so much greater now than it was a decade ago.

• China is now the biggest global consumer of most metals, and has by far the world’s biggest steel industry.

• Much though not all of this metal consumption is driven by the construction cycle.

16

Source: IMF World Economic Outlook, April 2011.

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

2000-05 2006 2007 2008 2009 2010

China's share of global demand for base metals

Copper Aluminum Other base metals

17

Resource consumption (2)Global markets have felt the impact of China’s urbanization.

• China’s development has been much more resource intensive than its predecessors in rapid industrialization, but these precedents suggest metal consumption will still grow.

• The later a country starts development, the lower the level of GDP at which resource intensive growth starts – probably because more catch-up growth is available.

•The intensity of the construction build out may help explain why China consumes so much metal; rapid industrial upgrading and heavy industry growth also likely a factor.

17

Source: IMF World Economic Outlook, April 2011.Metals include aluminum, copper, lead, nickel, tin and zinc.

02468

101214161820

0 5 10 15 20 25 30 35 40

Per c

apit

a m

etal

con

sum

ptio

n (k

g)

Per-capita GDP, 000 US$ PPP

Metal consumption and economic development, 1960-2009

South Korea

Japan

Europe

China

18

Construction boomA huge increase in the supply of new housing.

• China’s annual volume of residential construction and sales is now roughly six times large as it was before housing privatization.

• The broad objective of housing reform was to mobilize private capital in order to supply a higher quantity and quality of housing. In these terms, housing privatization was clearly a success.

• So why are so many people unhappy with the housing market as it exists today?

18

0

100

200

300

400

500

600

700

800

900

1,000

Residential floor space completed and soldmillion sq m

Sales

Completions

The unresolved problems:high prices and bubbles

20

Property pricesUrban property prices have at least doubled over the past five years.

• There are multiple and confusing measures of urban property prices in China, and a great deal of local variation.

• But it is undeniable that property prices have risen significantly since the completion of housing privatization.

• High property prices remain the chief complaint of white-collar urbanites and a potent social/political issue the government has repeatedly tried to address.

20

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

2004 2005 2006 2007 2008 2009 2010

Urban property prices Rmb per sq m

36 city average, NDRC Price Monitoring Center

21

Land revenueLocal governments make money from land.

• Fiscal dependence on the sale of land-use rights is significant, but sometimes overstated.

• Land revenues typically account for about 20% of total local revenues, not 70% as is sometimes claimed. Much is spent preparing the land for development; the remainder helps finance infrastructure projects.

• The concern is that localities have an incentive to keep property prices high to maximize revenue.

• Shanghai and Chongqing are experimenting with property taxes that could provide a more sustainable source of revenue.

21

2,864 3,258 4,061 4,386

2,295 2,862 3,235

3,731

1,038 1,396 2,911

1,975

274 186 350 324

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2008

2009

2010

2011

f

Sources of local government revenueRmb bn

Other off-budget funds

Land revenue

Transfers from center

Local-level revenue

22

Housing affordability

22

Overall affordability looks stretched, but this obscures market drivers.

• The overall price/income ratio has not been a good guide to how the housing market actually performs.

• Sales are robust at current prices without significant mortgage debt.

• The majority of people in the housing market either benefit from the implicit subsidy of privatization, benefit from other subsidies or transfers, or have higher than average incomes.

• Government policy seems to be keep housing price growth at or below rate of income growth, implying stable or declining affordability index in future.

8

9

10

11

12

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Housing affordability indexRatio of average cost of 100 sq m unit to

average annual household income

23

Housing ownershipThe first wave of housing subsidies is over.

• A large proportion of urban households live in units purchased at below-market prices, or in units financed by the sale of one purchased at a subsidized price.

• But the effect of these subsidies and wealth transfers is fading, and an increasing number of young, first-time homebuyers confront the commercial housing market without these advantages.

• This generational shift helps explain why high housing prices are now a much more salient political issue for the urban population.

23

0%

10%

20%

30%

40%

50%

60%

Purchased from work

unit

Purchased from

market

Private housing

Rented public

housing

Rented private housing

Other

Housing stock by type of ownershipShare of total

2005 2009

24

Supply and demandMigration is not the main driver of housing demand.

• On our estimates, only about half of new housing supply over the past decade has gone to serve fundamental demand from new household formation.

• PBC surveys show first home buyers account for only half of mortgages.

• The rest of the new housing supply has gone to meet demand for new, bigger or better housing from households who already own a home.

• Upgrading and investment demand has accounted for even more of total housing demand in the last couple of years, which is worrisome.

24

0

1

2

3

4

5

6

7

8

New housing supply and urban population growth Units and households, millions

Social housing

Off-market housing

Commercial housing

New urban households

25

Why invest in housing?Best of a bad lot.

• Housing is one of the only reliable stores of value in China’s repressed financial system. It is also one of the only assets to which ordinary households can gain clean title.

• Bank deposits have provided a negative real return for most of the past few years, and stock market volatility has scared off many retail investors.

• Low holding costs (no annual property tax) and limited capital gains taxes also favor property investment. Local property taxes may gradually change this.

25

-5

-4

-3

-2

-1

0

1

2

3

4

5

Jan-

07

Apr

-07

Jul-

07

Oct

-07

Jan-

08

Apr

-08

Jul-

08

Oct

-08

Jan-

09

Apr

-09

Jul-

09

Oct

-09

Jan-

10

Apr

-10

Jul-

10

Oct

-10

Jan -

11

Apr

-11

Real and nominal interest rates on deposits

nominal 1-yr deposit rate 1-yr deposit rate minus CPI

26

Multiple home owners

26

The number of multiple home owners surged in recent years.

• The increase in new housing supply since 1998 implies about 24m households now own more than one home.

• A study by the China Real Estate Chamber of Commerce showed the number increased by 6.7m in 09, against an annual increase of 1.1m in 05-08.

• Housing supply is increasingly going to meet demand from multiple home owners, who are mostly in the upper income brackets. It is not only rural migrants who are excluded from the commercial housing market, but a growing part of the urban native population.

0%

10%

20%

30%

40%

50%

Lowest 20% Lower middle Middle 20% Upper middle Highest 20%

Households owning more than one home By income quintile, share of total

2008 2009

Policy response

Restrictive policies aim to restrain investment demand and cut prices.• Successive waves of property market restrictions have been rolled out since April 2010.

• In Jan, the minimum down payment on second home purchases was hiked to 60% from 50%. Mortgage interest rates rose to 6.6% in Feb; mortgages for second homes are 7.3%. Mortgage loans for third-home purchases were suspended.

• In 16 major cities, each family may purchase only one unit of housing. Many major cities also restrict purchases by non-residents. Enforcement of these policies should be better than in 2009. Local governments were required to announce targets for containing housing prices.

• Trials of the long-awaited property holding tax were launched in Shanghai and Chongqing. Initial coverage is narrow and rates are low, but both could become more significant over time.

• The government is now promoting reverse bidding in land auctions: it fixes the final house price and developers compete to supply at the lowest cost. This could reduce upward pressure on land prices.

27

28

Construction cycleToo much of a good thing?

• On a 30-year average, real estate and construction account for about 10% of annual nominal GDP growth, though cycles make this volatile.

• The stimulus to counteract the 2008 global financial crisis unleashed a housing boom that was bigger in relative terms than anything that had come before.

• The centrality of the construction-urbanization boom to China’s growth process makes careful management of the property cycle essential.

28

0%

5%

10%

15%

20%

25%

30%

Construction and real estateShare of China's nominal GDP growth

29

New constructionReasons for a housing correction.

• The volume of new construction has surged far above historical levels, and looks excessive relative to the level of sales.

• Housing completions have lagged, despite all the new construction, suggesting a combination of longer building times and withholding of properties from the market to push up prices.

• A lot of new housing supply will be coming on to the market this year, when demand is being artificially constrained. So we expect prices and sales to drop, and both have showed some weakness already.

29

0

200

400

600

800

1,000

1,200

1,400

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Residential floor area started, completed and soldmillion sq m

Starts

Sales

Completions

30

The 2008 housing crunch

30

Q3 08

Industrial production and electricity plummet

Q2 08

Construction activitynose-dives

Q1 08

Property transactions drop

-400

-200

0

200

400

600

800

(20)

(10)

0

10

20

30

40

Jan-

05

Jul-0

5

Jan-

06

Jul-0

6

Jan-

07

Jul-0

7

Jan-

08

Jul-0

8

Residential floor space sold

Total floor space, annual (rhs)

Yoy % change, ytd (lhs)

yoy % change sq m mn

2011

How to avoid a repeat?

Policy response

Public housing is both a counter-cyclical investment push and a social policy. • The combination of investor-driven demand at the top end and insufficient supply at the low end of the market led to a worsening of housing affordability for ordinary families in 10.

• Current government policy aims to restructure the market by constraining investment demand at the top end while massively increasing supply at the low end. This supply expansion will mostly come through the “social” housing program.

• The target market is potentially quite large. We estimate that the urban homeownership rate is no more than 45%, much lower than the often-reported 85%, primarily because of the large population of migrant workers that cannot afford housing at commercial prices.

• But 40% of urban hukou holders also do not own a home. This group of primarily young, low- to middle- income families need assistance to get a leg up into the commercial housing market.

• Social housing is intended to give these people a leg up into the commercial housing market, allowing them to eventually upgrade to a second home. Migrant workers are unlikely to benefit substantially from the social housing program as currently designed.

31

32

Social housingThe second wave of subsidies is beginning.

• In March, the government announced plans to build 36m units of “social” housing over the next five years. By 2015, 20% of the urban population is supposed to live in some form of subsidized housing.

• We think the actual increase in housing supply will be smaller, about 20m units. In 2011, 40% of the target is slum renovation.

• New social housing projects will help keep construction growing while the market corrects.

• But some of the target will be met by repurposing existing “off-market” construction projects.

32

0

2

4

6

8

10

12

14

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

f20

12f

2013

f20

14f

2015

f

New housing supply by typemillion units

Social housing

Reclassification

Off-market housing

Commercial housing

The unresolved problems:the future of migrants

34

Housing stock

34

There is still a relative shortage of housing.

• We estimate the housing stock rose to 140-150m units by 2010, still about 80m less than the urban population. The expansion of public housing in coming years will reduce, not eliminate the shortage.

• The under-housed are primarily rural migrants, who live in dormitories, slum villages or shared accommodation.

• There is still plenty of room to build more housing in China, but the future supply of housing needs to be better oriented toward demand from first-time homebuyers.

0

50

100

150

200

250

1998 2005 2008 2009 2015f

Urban housing stock and urban householdsmillions

Urban households: migrants

Urban households: natives

Units of independent housing

35

Economic housingThe initial push for low income housing failed.

• One of the original goals of housing reform was to provide a large quantity of subsidized housing to low income urban residents.

• While construction of such “economic” housing (jingji shiyong fang) surged in the early years of housing reform, it faded in later years as developers switched to pursuing more profitable commercial housing projects.

• Subsidized housing was again enshrined as a national priority in 2007, to no noticeable effect.

35

0%

5%

10%

15%

20%

25%

30%

0

10

20

30

40

50

60

70

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Completions of "economic" housing

Volume (m sq m, lhs) Share of total (%, rhs)

36

Migrant housingNo room of one’s own.

• A recent NBS survey shows only 1% of migrant workers report owning their own home in a city.

• Most rural migrant workers live in extremely dense collective housing, and almost none own their own home.

• This makes the often-cited 85% homeownership rate impossible, as migrants are around 30% of the urban population. We estimate the actual homeownership rate is about 45%.

• Urban natives by contrast have benefited massively from the privatization of housing in the late 1990s, which helped them afford to buy new housing on the commercial market.

36

57%

19%

19%

4%

1%

Migrant worker accommodation by typeShare of total

Employer-supplied housing

Shared rental

Self rental

Other

Own home

37

Barriers to migrantsHigh cost of living.

• The high cost of housing relative to income is one of the main things preventing rural migrants from truly settling down in cities.

• Current hukou policy also plays a major role: the lack of urban social insurance makes life more expensive and exacerbates the problem of social integration.

• Notably, education policy makes it difficult for children to live with their parents and go to school.

• Extending social welfare rights is needed to help integrate migrants into urban society so that they can become economically significant consumers.

37

-

10

20

30

40

50

60

70

80

Income too low

Cost of housing

Children's education

Unable to look after parents

Inadequate social

welfare

Unequal social status

Cannot integrate socially

Obstacles to settling in cities cited by new-generation migrants

38

Social housing by typeMigrants may not benefit much from social housing.

• A transparent mechanism to allocate social housing is lacking, and much of it may end up going to government officials and SOE workers.

• Public rental housing would be most accessible to rural migrants, but there is not yet a coherent long-term funding plan.

• Chongqing plans 800,000 units of public rental housing open to households without an urban hukou. But standards are still high enough to keep out many migrants. And developers are counting on eventual sales to cover their costs.

38

1.7

2.1

1.0

0.8

2.3

1.6

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Social housing targets for 2011million units

Slum upgrading into commercial housing

Slum upgrading into social housing

Price-capped housing

Economic housing

Public rental

Low-price rental

39

New generation migrantsYounger migrants are changing the dynamics of urbanization.

• In 2009, there were 145m inter-county migrant workers living in urban areas.

• 85m migrant workers are the “new generation” born after 1980.

• Half of all rural people aged under 30 have left to work in towns and cities.

• The average new generation migrant left home aged 20, falling to 17 for migrants born in the 1990s.

• New generation is the first rural generation to be “non-agricultural”: 90% did not spend a single day doing agricultural work in 2009.

39

0

10

20

30

40

50

60

70

16-29 30-39 40-49 50-59

Rural labor force by employment and age% of total

Migrant

Local non-agricultural work

Local agricultural work

40

Migrant educationNew generation of migrants is significantly better educated.

• One-quarter of the new generation have a high-school education or above –twice as many as the old generation.

• Better educated workers will demand better pay and conditions. They are also more likely to seek job training and try to improve their position.

• They are also culturally more linked to the urban world, and have aspirations not fundamentally different from young urbanites.

40

0

10

20

30

40

50

60

70

Rural labor force by level of education% of total

Old migrants

New migrants

Total rural labor force

41

Off-farm work“Do I look like a farmer?”

• Younger migrants increasingly have little experience or interest in agricultural labor.

• They are less likely to view working in urban areas as a temporary way to build savings before returning to the rural homestead.

• They are more likely to see migrant work as the first step in a series of urban jobs with gradually higher incomes.

• Central policymakers recognize that this shift is occurring, but hukou and other policies are still based on the assumption that rural migration is temporary rather than permanent.

41

Age cohorts 1990 2004 2007

16-20 23.7 78.6 93.1

21-25 33.6 82.8 91.5

26-30 28.8 71.0 89.4

31-35 26.9 65.1 87.2

36-40 20.5 54.0 72.7

41-50 20.8 44.0 54.1

Source: Scott Rozelle

Share of age group engaged in off-farm work

42

Migrant hopesMigrant workers are isolated from the urban economy on which they have pinned their hopes.

• New generation of migrants are far more reluctant to return home than the older generation.

• Two-thirds of migrant workers live self-contained lives on their work site, and are not active participants in either the housing market or the broader urban social and economic.

• Migrant workers live in the city but they are not of the city. This may change as a) wages rise, b) more public rental units become available, and c) the new generation make their permanent homes in the city.

42

8%

37%

22%

11%

22%

Future plans of new-generation migrant workers

Definitely stay in city

Try to stay in the city

Return home after earning enough cash

Definitely return home

Unsure

A new model of urbanization?

Quality not quantity

How to benefit from future urbanization? • China’s unusual pattern of urbanization means it has not reaped all of the potential benefits from the growth of cities. The social, legal and economic restrictions on the rural migrants that make up 30% of the urban population limit how much their incomes can grow.

• Dismantling barriers to permanent migration could both boost productivity and provide new sources of consumer demand. Future urbanization in China needs to be as much about integrating migrants already present in cities as it is about additional migration.

• This will require significant changes to how both cities and villages are managed – and funded. Bigger mandates for urban governments to provide the social services and infrastructure needed to facilitate urbanization will put further strain on local finances.

• Local governments will need sustainable funding sources to replace current reliance on land sales. Likely to be a combination of resource taxes in western provinces and property taxes in more developed areas.

• Agriculture and rural communities will also have to reorganize to cope with much reduced rural population. Larger farms and increasing commercialization of land seem inevitable.

44

Five Year Plan: principlesA new view on urbanization.

• The target is actually the same as in 11th Plan: a conservative 4 pp increase in the urbanization rate over 5 years, or 0.8 pp a year. But thinking on urbanization has changed significantly. Key points:

• Allow permanent migration: “Gradually transforming the rural migrant population that meets the requirements into urban residents is an important task in the promotion of urbanization.” (General principle: rural migrants with stable work who have lived in a city for more than a year can become urban residents.)

• No forced urbanization: “The right of rural residents to independently choose whether to enter cities or remain in the countryside must be fully respected.”

• Improved public services for temporary migrants: “For rural migrants who temporarily do not meet the requirements to settle down in cities, the provision of public services must be improved and the protection of their rights and interests strengthened.”

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Pilot projects

How to implement urbanization principles is up to individual localities. Sichuan and Chongqing are leading.

• In 2007, Chengdu and Chongqing were chosen to pilot reforms designed to integrate rural residents into urban communities (chengxiang tongchou) and speed up the process of urbanization.

• These reforms could become a template for promoting rural-urban migration nationwide, thereby boosting urbanization and transforming China’s rural economy.

• Both cities have ambitious urbanization targets:

– Chengdu plans to turn at least 1m of the city’s 5m local rural residents into urban citizens by 2017– Chongqing plans to turn 10m of the municipality’s 23m local rural residents into urban citizens by 2020

• Both cities’ plans rely on a mechanism by which farmers can trade their rural land use rights for an urban apartment and hukou. This helps finance urbanization by adding to the urban land supply.

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How land swaps work

An ingenious solution or invitation to abuse?• The rural property exchange is also a platform for land swaps, which allow local governments to exploit their power to turn collectively-owned rural land into much more valuable state-owned urban construction land.

• Farmers vacate their homesteads and move into modern housing that takes up less space. Their former homes are demolished, and the land returned to agricultural use, producing a net gain in agricultural land.

• The government converts this into a “land credit”. This is sold to real estate developers at auction, who buy the right to develop a similar amount of agricultural land on the outskirts of the city.

• The mechanism remains controversial, in part because of worries that farmers could be coerced into selling their land use rights. Advocates say land-use changes and exchanges are happening anyway, so there needs to be a formal structure to regulate them.

• Forced demolitions of rural housing, and forced takings of rural land by village authorities, are already on the rise because of the rising value of land for property development.

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Five Year Plan: urban planning

A new pattern of urban growth. • The built-up area occupied by Chinese cities has tripled over the past 20 years to 37,000 sq km. Managing future urbanization requires a pattern of urban growth that uses resources more efficiently and avoids endless urban sprawl.

• Promotion of urbanization is constrained by the policy “red line”: preventing further loss of farmland to maintain grain security.

• The sheer size of China’s rural population means that smaller cities, not just megacities, will be needed to accommodate future migrants. McKinsey’s report on urbanization argued for a less distributed pattern of urbanization with more megacities, but not clear how much influence it had.

• Five Year Plan calls for controlling the rapid expansion in the land occupied by megacities, and varying rules on migration by size of city.

– Megacities: control population growth

– Large cities: continue to attract new migrants

– Small and medium cities: relax entry requirements

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Five Year Plan: regions Designated centers for future urbanization. • Bohai Rim (Beijing/Tianjin/Dalian/ Qingdao)

• Pearl River Delta

• Yangtze River Delta

• Harbin-Changchun

• Shijiazhuang

• Taiyuan

• Zhengzhou

• Hohhot

• Yinchuan

• Xi’an-Lanzhou

• Urumqi

• Lhasa

• Kunming

• Guiyang

• Chengdu-Chongqing

• Nanning-Haikou

• Fuzhou-Xiamen

• Changsha-Wuhan-Nanchang

• Lianyungang-Xuzhou

• Hefei

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Cities by sizeLots more small cities.

• China is already well down a path of a relatively dispersed pattern of urbanization, albeit one with several significant megacities.

• Spreading urban development more widely is also a way to spread development inland from the wealthy and highly urban coast.

• In coming decades, China will have hundreds more “small” cities with around 1m population.

• These UN forecasts are conservative. McKinsey projects China will have 8 megacities of 10m+ people by 2025 (vs UN’s 5), and 15 large cities of 5m-10m (vs UN’s 9).

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0

50

100

150

200

250

300

350

400

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020

2025

Number of cities by population size

10m or more

5m to 10m

1m to 5m

500k to 1m

Source: UN World Urbanization Prospects 2009

Liu He’s theoryUrbanization is key to future consumption. • “At China’s current development stage, gradually promoting urbanization and guiding surplus rural labor to move to cities is the main source of expanding domestic demand.”

• Estimates that a 1 pp increase in the urbanization rate directly drives 0.4 pp of GDP growth.

• The small group of megacities (e.g., Beijing, Shanghai) are hitting constraints on resources and transport infrastructure after rapid population growth. But they also have economies of scale and clustering benefits that are difficult for other cities to replicate.

• Solution is “city networking” that uses improved transportation networks to link the small, medium and large cities in a given region into a single economic unit. Large cities provide a domestic market, while small cities serve as production zones and bedroom communities for migrant workers.

• Rural migrant workers are increasingly educated and skilled, and have a strong demand to join the urban middle class. Providing affordable housing (mainly public rental housing) is the key public policy for accommodating this social transformation.

Source: Liu He, “Three Key Questions on Expanding Domestic Demand,” May 2011. (Liu He is economic advisor to President Hu Jintao)

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This presentation was prepared by GK Dragonomics research staffAndrew Batson, Tom Miller and Rosealea Yao

abatson@gavekal.com

Dragonomics is an independent research and advisory firm specializing in China’s economy and its influence on Asia and the world.

For more information:

www.gavekal.com