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

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 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 housing 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 other macroeconomic policies.