Liquidity Constraints, Transition Dynamics, and the Chinese Housing Return Premium

Home price movements received increasing academic and public attention in recent years. In this paper, I propose a novel explanation for large housing booms in emerging markets that highlights the effect of household wealth accumulation on housing prices under liquidity constraints, using the recent Chinese housing boom as an example. In China, housing prices grew 170% during 2003–2012 in real terms. Returns on housing commanded a 12% premium annually over the risk-free rate. Across Chinese cities, increases in the value of housing are closely associated with increases in household wealth, whether measured with or without housing. I argue that the high Chinese housing return premium results from an upward transition in household wealth from a low initial condition interacted with liquidity constraints. Specifically, low initial household wealth, under liquidity constraints, limits housing prices to be low in 2003; but as household wealth quickly rises aided by high household savings, housing prices also quickly increase. I quantitatively assess this explanation using an otherwise standard consumption-housing two-asset dynamic portfolio choice model, augmented with realistic liquidity constraints and low initial wealth, with housing priced in industry equilibrium. The model matches the high housing return premium and explains 92% of the observed increase in housing prices. The model also generates other intriguing predictions, including an investment motive that helps explain the high Chinese household saving rate puzzle. It also predicts that a permanent slowdown in Chinese economic growth might only lead to a temporary dip in Chinese housing prices. The analysis in this paper also provides insights for understanding other episodes in emerging housing markets for which there are both liquidity constraints and low initial household wealth.