THE draconian property curbs announced by the Chinese government on March 1 prompted a rush by some home owners in Shanghai to offload their residential properties before the local government announces details on how the tightening measures would be implemented.

To recap: a 20 percent tax will be "strictly" levied on the capital gains of home sellers; cities with overly rapid increases in home prices will be required to raise the down payments and mortgage rates of second home purchases; the scope of property purchase limitations will be expanded; local governments will be held accountable if home prices continue to surge; the central government will step up inspections of local governments' property controls, and those which fail to meet their targets will be penalized.

To put things in perspective, home sellers were previously taxed at up to two percent of the sale price, the down payment requirement for second home purchases is already 60 percent, while the mortgage rate for buyers of second homes is 1.1 times the benchmark rates. Existing regulations were not always strictly enforced.

The magnitude of the property curbs certainly took the market by surprise, and led to industry leaders China Vanke and Poly Real Estate Group falling by their daily limits of 10 percent on Monday.

Did the market plunge overshoot, or is it a harbinger of lean times for Chinese real estate developers? The market will certainly need time to digest the impact of the new tightening measures. How the curbs will be implemented will be key in determining the responses of potential home buyers, home sellers, and property developers.

Speculative demand

The property curbs do seem to target speculative demand for real estate, and it is likely that demand by speculators for real estate will be virtually eliminated as the bar for making huge profits from speculation has been raised significantly higher.

As part of the collateral damage, transactions of existing homes may significantly drop as the transaction costs of such homes will most probably increase. Home sellers typically factor in such taxes into their asking prices, and attempt to pass on the costs to potential home buyers. In the event that enough home buyers balk at the significantly higher asking prices, and a majority of the home sellers decide to hold on to their properties, existing home prices will remain at elevated levels while transaction volume will plunge.

Potential home buyers with inelastic demand priced out of the existing home market may decide to rent apartments to stay in, thereby stimulating the home rental market. This will provide landlords with a recurring source of regular income, rather than one big lump sum of capital gains which will be taxed at 20 percent.

Alternatively, the potential buyers may turn to the new home market. This could well be the intention of the central government as such a scenario would not only encourage property developers to continue to buy land, thus boosting revenue for local governments. It would also lead to continued investments in real estate construction, a major contributor of domestic demand.

However, the flip side would be that the stronger demand for new homes may lead to higher prices if the supply of such homes is not increased. Thus, it is vital that previously announced government moves to get local governments to increase land supply will help to mitigate any shortages in the supply of new homes.

Perhaps the most significant impact of the latest round of property curbs would be to change the expectations of Chinese citizens in regards to home prices. The government has clearly driven home the message that this time, it will be different; it will step in to proactively manage the property market in order to prevent home prices from irrationally surging any further.

Effective or not

The jury is still out on whether the new curbs, which certainly are the toughest by the Chinese government to date, will help to effectively rein in runaway Chinese home prices.

The previous round of tightening which started in 2010 initially led to a cooling-off period for the real estate industry in China. However, this proved to be only a temporary respite from the long-term trend of rising Chinese home prices after the Chinese central bank, The People's Bank of China (PBOC), on concerns over faltering economic growth, lowered benchmark rates twice within the space of a month in the middle of last year, leading to the bottoming out of the property market.

Looser credit conditions and the surge in liquidity, alongside a steadily recovering Chinese economy, were the main reasons for the failure of the previous round of tightening policies. Liquidity was further fuelled by strong credit growth in January. Total social financing, an indicator of overall liquidity which includes funds raised through bank loans, corporate bonds, equity financing, foreign direct investment, bankers' acceptances, direct company lending and external debt, surged more than 50 percent month-on-month and more than doubled from a year ago to 2.54 trillion yuan (US$403 billion).

In addition, broad money supply, M2, was up 15.9 percent year-on-year in January to 99.21 trillion yuan, with the growth rate rising 2.1 percentage points from December, according to the PBOC.

As long as the earth exists, seedtime and harvest will never cease. The seeds of further home prices increases have been sown. This was borne out by National Bureau of Statistics data. Fifty-three out of 70 cities saw home prices increase month-on-month by up to 2.2 percent in January, while on an annual basis, 53 cities saw home prices increase by an average of less than 4.7 percent, up from the 2.4 percent recorded in December.

February data from China Index Academy, a Soufun affiliate, corroborated the trend of home price increases of greater magnitude. China Index Academy said home prices in 100 major Chinese cities rose 2.48 percent year-on-year to 9,893 yuan per square meter last month, after gains of 1.2 percent in January and 0.03 percent in December. On a month-on-month basis, prices rose 0.83 percent, the ninth consecutive month of increase.

Thus, surging home prices, an issue that has vexed Chinese policymakers and citizens alike for more than a decade, cannot be dealt with in isolation. Property curbs which mainly target speculative demand will be ineffective in an environment where liquidity is abundant. Steps must be taken by the government to mop up excessive liquidity so that expectations of surging home prices can be deflated.

Hope deferred makes the heart sick, but when desires come true, there is life and joy. In a society where stability is prized above all else, surging home prices and a sense of hopelessness regarding home ownership are a sure recipe for disaster. The Chinese government has done well to take decisive action to ensure that a sure foundation is laid for the sustainable development of the Chinese real estate industry.

CapitalVue provides China capital market, fundamental and time-series databases. Read more on www.capitalvue.com.