Real Estate Market Adjustment, Bank Balance Sheets, and Monetary Policy Response
GAO Songyao, WANG Jiaxin, CUI Baisheng
Postdoctoral Research Workstation, Foreign Exchange Research Center, State Administration of Foreign Exchange; Postdoctoral Research Mobile Station, Financial Research Institute, People's Bank of China; HSBC Business School, Peking University; School of Finance and Business, Shanghai Normal University
Summary:
In August 2020, the People's Bank of China, along with the China Banking and Insurance Regulatory Commission and other institutions, introduced the “Three Red Lines” policy targeting the real estate sector. Subsequently, China's real estate market entered a downward trajectory, leading to a contraction in bank credit. Why did this happen？ This paper analyzes the transmission mechanisms and pathways through which the real estate market adjustment since 2021 has contributed to an overall decline in social investment. Furthermore, it examines the effectiveness of different monetary policy measures and the combined effects of policy interventions. Empirical evidence reveals that, on one hand, the real estate sector in China is highly intertwined with bank credit. A decline in housing prices leads to a reduction in real estate loans, which, in turn, results in the contraction of commercial banks' balance sheets and a decrease in the scale of credit. On the other hand, falling housing prices lead to a decline in land prices, reducing local government fiscal revenue and subsequently diminishing capital demand from non-real estate sectors. Based on these facts and logical connections, this paper develops a multi-sector dynamic stochastic general equilibrium (DSGE) model that incorporates both real estate and non-real estate sectors. The model introduces local governments to depict land financing behavior and incorporates the banking sector to capture financial frictions. This framework is used to analyze the impact of declining real estate demand on commercial banks' balance sheets, as well as the effectiveness of various policies in improving commercial banks' balance sheets and the broader macroeconomy. Theoretical model results indicate that, on one hand, a decline in real estate demand leads to a decrease in investment in the real estate sector and a drop in asset prices. On the other hand, falling housing prices result in lower land prices, reducing local government land revenues, which in turn decreases capital demand and asset prices in the non-real estate sector. The decline in asset prices across both sectors leads to a reduction in commercial banks' net worth, thereby constraining their credit supply. If the central bank lowers the reserve requirement ratio (RRR), it can improve commercial banks' balance sheets and enhance credit supply. If the central bank reduces the interest rates on existing housing loans, this could help boost household consumption but may also reduce banks' net worth, further constraining credit supply. In this case, it would be necessary to inject additional capital into commercial banks. This paper offers the following policy recommendations. First, in the short term, targeted policies should be implemented to improve the balance sheets of commercial banks, while in the long term, efforts should be made to reduce the dependence of commercial banks on the real estate sector. Second, when reducing interest rates on existing housing loans, it is essential to simultaneously inject capital into commercial banks. Third, fiscal and taxation system reforms should be advanced in a coordinated manner to expand local tax sources. The contributions of this paper are primarily reflected in three aspects. First, although existing literature has explored the connections between the real estate market and commercial banks, the analysis of banks' balance sheets remains insufficient. This paper collects and organizes relevant data to analyze the relationship among the real estate market, commercial banks' balance sheets, and the macroeconomy. It provides a new perspective for understanding the interactions between the real estate market and the financial system, as well as empirical evidence for building theoretical models. Second, previous studies have mostly focused on the crowding-out effect of rising housing prices on the non-real estate sector. However, in the current context of declining housing prices, not only has investment in the non-real estate sector failed to improve, but the overall scale of social credit has also declined. Following Gertler and Karadi (2011), this paper incorporates the banking sector into a DSGE model to analyze the impact of declining housing prices on land financing, while also considering the dual negative effects of banking financial frictions on credit supply. The findings differ from the transmission mechanisms studied during periods of rising housing prices and offer theoretical and practical significance for understanding the impact of declining housing prices on the overall credit scale and macroeconomic fluctuations. Third, there is a relative lack of literature within a general equilibrium framework that examines the effects of reducing the RRR and lowering interest rates on existing housing loans. Given the close ties among China's real estate market, commercial banks, and land financing, this paper introduces three policy tools: reducing the RRR, lowering interest rates on existing housing loans, and injecting capital into commercial banks. It analyzes the transmission pathways and effects of these policy tools on housing price regulation.
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