The impact of local government spending pattern on real estate investment and housing prices in China

Abstract

After the fiscal reform in 1994, local governments have to rely more on revenue from land sales, which depends on the performance of the real estate market. However, the performance of real estate market is also affected by how the local government utilizes the land sales revenue to fund local government expenditure. This study investigates the relationship between the pattern of local government expenditure and two aspects of the real estate market, namely housing prices and investment in the real estate market. The former aspect represents the buyer's current valuation of the real estate asset and the latter represents the real estate investor's expectation about the future performance of the real estate prices. We categorize local government expenditures into effectual and ineffectual expenditures. The former consists of expenditures that can improve the investment environment such as expenditure on infrastructure and human capital investment and the latter consists of expenditures on the day-to-day operations of the government and expenditure on stability maintenance (weiwen). We conjecture that only effectual expenditure would have a positive impact on housing prices and real estate investment ceteris paribus. Our empirical results based on provincial panel data over the period 2000-2014 are consistent with our conjecture. Moreover, the impact is stronger as the China's economy became more open after the 2005 exchange rate reform.

Previous studies suggest that expropriation of rural land for urban development at low compensation to farmer often resulted in social unrest, which is suppressed by an increase in weiwen expenditure. Since weiwen expenditure is usually a lot lower than compensation that can satisfy the farmers, local governments are tempted to substitute compensation to farmers by expenditure on weiwen. We hypothesized that the apparent low cost of weiwen compared to compensation has not taken into account the longer-term negative impacts of higher weiwen on housing prices and real estate investment. The negative impacts of weiwen are confirmed by our empirical results. In addition, the 2005 exchange rate reform has strengthened the impact.

The results are robust across different estimation procedures including ordinary least squares (OLS), generalized least squares (GLS) and generalized method of moments (GMM). This is the first empirical study on the impact of different categories of local government spending on housing prices and the real estate market and also how the impacts have been affected by the exchange reform in 2005. One major policy implication is that it may not pay the local government to substitute the land expropriation compensation to farmer by weiwen expenditure although the latter is often a lot lower than the former. Furthermore, since weiwen expenditure is a form of rent dissipation, the central government should implement policies that discourage the local government from suppressing disputes in the land expropriation process by weiwen and encourage a fair compensation to farmers, which is beneficial to the farmers, the local government and the society in the long-run.

I gratefully acknowledge the financial support provided by the GRF of the Research Grant Council of the Hong Kong Special Administrative Region (Project Reference Number: 17239016) (503 words)