Summary:
Since the second quarter of 2022, the year-on-year growth of new residential property prices across China’s 70 large and medium-sized cities has remained negative. Concurrently, the macroeconomy has been characterized by stable yet slightly declining leverage ratios in the household sector, weak real estate development investments, and credit contractions. Existing theoretical studies mostly characterize housing price fluctuations based on the collateral constraint mechanism that captures the positive feedback loop between housing prices and debt. Nevertheless, from the perspective of household balance sheets, changes in debt exert a limited impact on households’ intertemporal decision-making. Hence, this mechanism is insufficient to explain the recent economic characteristics of China. To address this gap, this paper proposes a household balance sheet constraint mechanism that captures the positive relationship between housing prices and household net worth. By constructing a dynamic stochastic general equilibrium (DSGE) model embedded with this mechanism, this paper successfully replicates the key features of China’s recent macroeconomic data. This paper arrives at three key findings through empirical and theoretical analysis. First, a loss of housing net worth triggers the household balance sheet constraint mechanism, which exerts negative static and dynamic multiplier effects on housing prices and household net worth. This mechanism drives a decline in housing prices and a contraction of household sector balance sheets, and then spills over to other sectors via the inter-sectoral balance sheet channel, leading to a credit contraction and downturn in the real economy. In particular, the completed real estate development investment remains in a state of prolonged weakness. Second, the narrower the space for household sector leverage expansion, the stronger the household balance sheet constraint mechanism, and the larger the magnitude of macroeconomic fluctuations induced by shocks to household housing net worth. Third, countercyclical adjustments to the interest rates on outstanding mortgage loans targeted at housing price fluctuations reduce household debt-servicing costs, which in turn improves household net worth, thereby weakening the household balance sheet constraint mechanism. Consequently, this policy is able to mitigate the macroeconomic fluctuations caused by housing net worth shocks. Taken together, these conclusions carry important policy implications: the key to mitigating housing net worth shocks lies in weakening the intensity of the household balance sheet constraint mechanism that captures the positive feedback loop between housing prices and household net worth. In practice, lowering interest rates on outstanding mortgage loans bolsters household net worth, which in turn weakens the negative feedback loop between falling housing prices and household net worth erosion, thus effectively cushioning macroeconomic fluctuations induced by housing net worth shocks. Building on this, governments may consider three approaches to further improve household net worth: cutting household expenditures, expanding household income, and stabilizing housing prices. The marginal contributions of this paper are embodied in three specific aspects. First, this paper proposes the household balance sheet constraint mechanism and verifies its amplification and transmission effects on household housing net worth shocks by constructing a DSGE model. It provides a concrete and testable DSGE framework for existing theories that emphasize the household balance sheet transmission channel during housing price downturns, thereby enriching the theoretical literature on the macroeconomic implications of household balance sheets. Second, the model constructed in this paper captures the recent economic phenomena in China characterized by declining housing prices, household sector balance sheet contraction, weak real estate development investment, and simultaneous credit tightening. It offers theoretical insights for understanding the persistent downturn of China’s recent real estate market and provides a theoretical framework for relevant policy simulations. Third, this paper simulates the effectiveness of housing regulatory policies in addressing household housing net worth shocks, which provides theoretical support for the formulation and improvement of China’s housing regulatory policies and also offers policy implications for further stabilizing the real estate market.
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