Economic Slowdown and Housing Dynamics in China: A Tale of Two Investments by Firms

Abstract

In the past decade, the Chinese economy has witnessed a great housing boom, accompanied by a slowdown in economic growth and an increase in firms financial investment. The waning economic prospects are shown to lead to a surge in housing prices by stimulating firms demand for financial (especially housing) assets. Motivated by these facts, we take an off-the-shelf dynamic New Keynesian model with novel modeling of firms dynamic portfolio choice between physical and financial investment. Housing assets earn a positive return and can be used as collateral for the firm s external finances. A negative productivity shock decreases the relative return of production capital, which translates into a housing boom by increasing the firm s housing demand. A rise in house prices then generates competing effects on real investment: it not only raises the firm s leverage due to the collateral effect but also depresses the firm s demand for physical capital because of the crowding-out effect. After calibrating the model for the Chinese economy, our quantitative exercise suggests the former effect is dominated by the latter, which implies counter-cyclical housing prices. Among the policies used to stabilize the aggregate economy and housing markets, our counterfactual analysis implies that the capital-subsidization policy targeting house prices performs better than monetary and deleveraging policies.