1. Introduction
Financial risk is a potential threat to the healthy development of the economy, which can possibly devolve into financial crisis and economic recession. The destructive impact of a financial crisis has been evidenced in economic history, for instance, the Asian financial crisis in 1997 and the global financial crisis in 2008. Thus, it is necessary to study financial risk in order to avoid its possible potential damage to the economy, and thus to maintain the sustainability of social development. China now faces a severe situation of financial risk caused by the real estate market. High housing prices have extended from first-tier cities to second and third-tier cities. Local governments are heavily indebted to the development of industrial parks; real estate developers borrow heavily for real estate development; buyers (individuals or families) buy multiple or even dozens of houses for speculation; and banks offer large amounts of real estate-related loans in an effort to obtain benefits from soaring house prices. All of these are encouraged by the short-term benefits, which may cause serious financial problems that impede the sustainable development of the economy and thus society. Two questions arise. (1) How do urban housing price fluctuations relate to these participants’ financial risks? (2) How do the risks derived from urban housing price fluctuation diffuse to various participants and adjacent cities, thereby causing the regional systemic financial risks? It is important to study these issues, because the mechanism of formation of regional systemic financial risk led by housing price fluctuations must be clarified before we can control regional financial risks and avoid a subsequent shock to the economy and society that could be as destructive as the global crisis in 2008. Accordingly, this paper will use empirical evidence from Jiangsu Province to analyze the mechanisms behind the contagion of housing price risks among participants and cities. Jiangsu is one of the most developed of China’s provinces from the perspectives of finance and the housing market, although the economic development between the northern and southern parts of the province differs. The gross domestic product (GDP) per capita in North Jiangsu was 55,127 RMB in 2015, whereas that in South Jiangsu was 125,002 RMB, which is nearly 2.27 times that in North Jiangsu (data source: Statistic Bureau of Jiangsu Province). Thus, Jiangsu is considered as an ideal region for studying regional contagion and differences in real estate financial risks. Due to China’s particular political environment, legal system, and culture [
1], interesting results that differ from those in either the United States (US) or the United Kingdom (UK) markets will be revealed.
There are typical theoretical studies for systemic financial risks, such as Kaufman [
2,
3], Allen and Gale [
4], and Fouque and Langsam [
5]. Kaufman [
3] defined systemic financial risk from the perspective of risk contagion as follows: a single event affects various parts of the system, and then, in a domino effect, the effects extend to a series of institutions and markets, finally resulting in the possibility of collapse or the loss of functionality of the entire financial system. Reinhart and Rogoff [
6,
7] pointed out that asset price fluctuation is the most important trigger event for systemic risk, as is evidenced by historical financial crises caused by the bursting of asset price bubbles. A collapse in asset prices is particularly unwelcome news, especially a collapse in housing prices and commercial real estate prices [
6,
7]. A decrease in asset prices could result in direct book losses for the asset-held financial institutions and investors. Moreover, it could have adverse effects on investors’ market expectations, which could trigger a run on these financial institutions, further reducing their assets and the prices of other financial assets, and leading to a series of losses [
8].
After the subprime mortgage crisis in the United States in 2007, scholars started to pay attention to housing price fluctuation for the study of systemic risks. Pezzuto [
9] pointed out that low interest rates, high leverage, credit euphoria, and the pursuit of short-term interests caused the housing bubble before the subprime crisis. Acharya et al. [
10] asserted that the housing bubble burst resulted in a series of losses in the subprime crisis—including a bank credit default loss, associated losses caused by lack of liquidity, the collapse of the stock market, economic recession—and that all of these losses are derived from personal (family) housing loan default problems following the bursting of the housing bubble. Puliga et al. [
11] found that a stress test on the network of correlations among credit default swaps in the US could not detect the systemic risk before 2008 until the potential losses of financial assets caused by decreases in the housing prices were introduced. Meng et al. [
12] pointed out that real estate bubble bursts generally bring financial system collapses and economic recessions. Liu [
13] introduced the housing market price to forecast the systemic risk. Although the existing literature has recognized the important impact of housing price on the systemic financial risk, the mechanism of formation of the systemic financial risks derived from housing price fluctuations has not been clarified yet. Therefore, this paper studies the issue through both theoretical and empirical analyses, which is one of the paper’s innovative aspects.
With respect to the financial contagion effects, most of the empirical literature focuses on the transnational contagion and the linkage effects of financial markets. Stehle [
14] discussed the relationship of the pricing of risky assets among nations. Sarno and Taylora [
15] studied the relationship of capital flows, stock market bubbles, and financial risks among Asian countries in 1997. Hui et al. [
16] built a Fractionally Integrated Vector Error Correction Model with nine securitized real estate indices, showing that the markets of Asia, Europe, and North America converge in a similar trend, with a peak before the 2008 global crisis and cointegration from North America to Asia and Europe. Accordingly, most of the literature focuses on the international financial risk contagion effects of financial markets, whereas systemic financial risk contagion among cities is rarely studied. Therefore, taking 13 cities in Jiangsu, China as the study area, this paper analyzes the issue of how the systemic financial risks that are derived from housing price fluctuations diffuse from one city to adjacent cities and, thus, to the whole Jiangsu region. This is another innovative aspect of this paper.
In the real estate field, many studies have shown the spatial contagion effects of housing prices. Clapp and Tirtiroglu [
17] introduced spatial contagion effects into their dynamic analysis of the housing market. Moreover, empirical evidence of the spatial diffusion effect of housing prices has been provided by many studies, such as Pollakowski and Ray [
18], and Brady [
19]. Hui et al. [
20] found that the domino effect on the Chinese housing market apparently diffused from the east to the west and from the south to the north. Chen [
21] asserted that it is important to consider the spatial linkages of real estate investment among the provinces in China. Accordingly, numerous articles determine the spatial contagion effects of housing prices from the geographic spatial perspective. This paper extends the geographic spatial perspective and methodology from housing prices to the field of regional systemic financial risks, and studies the spatial contagion effects of financial risk derived from the urban housing price fluctuations between cities. This is another innovative aspect of this paper.
Overall, the existing literature has made some achievements in both theoretical and empirical research on the issue of asset price fluctuation and systemic risks. With respect to housing price volatility and systemic risks, most studies focus on personal (family) loan defaults and the subsequent bank risks. This is consistent with the housing market supply being transformed from newly built housing to stock housing both in the US and in European countries; thus, real estate developers have not been the main participants in the real estate financial market. However, the situation in China is different, because real estate developers and local governments play important roles in both real estate supply and the real estate financing markets. As Su and Tao [
22] and Liu et al. [
23] stated, local governments, real estate developers, banks, and individuals or families are united through financial ties, jointly promoting urban expansion and housing prices. Therefore, urban housing price volatility will create risks for local governments, real estate developers, banks, and other participants, and lead to systemic financial risks that should be studied in future research. Accordingly, this paper analyzes the relationships between urban housing price fluctuation and the financial risks of the main participants (local governments, real estate developers, banks, and individuals or families), and tries to reveal the mechanism of formation of the systemic financial risk that is derived from housing price fluctuations.
Furthermore, while the transnational linkages of financial markets and the spatial contagion of housing prices have been studied by many scholars, the regional contagion of the systemic financial risk that is derived from urban housing price fluctuations has not been studied. Thus, this paper also builds spatial economic models and empirically analyzes the spatial contagion effects of the financial risks that are derived from urban housing price fluctuations among the 13 cities in Jiangsu.
The remainder of the paper is organized as follows.
Section 2 analyzes the theoretical mechanism of formation of the regional systemic financial risk that is led by urban housing price fluctuations.
Section 3 builds panel spatial econometric models to test the relationship between urban housing prices and participants’ excessive investment or speculation and the spatial contagion effects among the 13 cities in Jiangsu, and compares the differences between South and North Jiangsu.
Section 4 is a discussion of real estate developers’ excessive investment.
Section 5 outlines the conclusions.
2. Mechanism of Formation of Regional Systemic Financial Risk Led by Urban Housing Price Fluctuation
In this section, we first discuss the role of the four main participants in the formation of systemic financial risk, and then establish a theoretical model to capture the spatial contagion of the financial risk.
2.1. Systemic Financial Risk
Unlike the case in the real estate financial market in the West, a real estate secondary finance market has not been established in China, and housing mortgage loans and real estate development loans are the main tools in the primary market. The real estate financial chain has four main direct participants: land suppliers (local governments), housing suppliers (real estate developers), capital providers (banks), and the real estate demand side (either individuals or families). Below, we discuss the role of the four players in systemic financial risk.
2.1.1. Local Governments
Since land is owned by the state in urban China, local governments are the monopolists of land supply. On the one hand, local governments employ various land supply strategies and rely on land-use right transaction fees to expand their financial revenue, in addition to gaining economic, and thus political, advantages [
22,
23,
24,
25]. On the other hand, local governments indirectly receive numerous land mortgage loans from banks through their subsidiary institutions, such as local government financing vehicles, to develop industrial zones and infrastructure in order to further promote the local land value, and thus gain economic and political advantages; this is called “land finance” [
23,
26,
27,
28]. Consequently, local governments are encouraged to push up local housing prices, which will create a housing price bubble.
Once the housing price bubble bursts, land prices will decline sharply, and local governments will be trapped by many debts, relying on land revenue for repayment. Since local governments will not be able to repay their debts, banks and other lenders will face massive losses, which will bring systemic financial risks. The “land finance” is unsustainable, and is harmful to the sustainable development of the economy and society.
2.1.2. Real Estate Developers
With the housing price increase, real estate developers will seek to increase their financing scale to expand production and obtain more profits. From the perspective of collateral, a housing price increase will raise the mortgage value, and thus developers’ financing capacity. With respect to liquidity, housing price growth is indicative of a market boom and the favorable performance of developer enterprises, although the liquidity of assets may be overestimated. With regard to capital, the growth of housing prices increases the net assets of developers’ enterprises, and thus their long-term solvency and expected return, which will attract more investors [
29]. In China, real estate developers’ real self-owned capitals only account for a low part of the total, and they mainly rely on bank loans for the rapid expansion of real estate investment [
23]. With increasing housing prices, real estate developers tend toward overleveraging and overinvestment, which could create a housing price bubble.
A decline in housing prices decreases the value of inventory and fixed assets, creating liquidity risks for real estate developers. Besides, a decline decreases real estate developers’ capital and increases the book capital liability ratio, which will result in equity loss for investors and claim loss for banks, spreading the systemic financial risks.
2.1.3. Banks
The growth in housing prices promotes banks’ credit ability, lowers their expectation of risks, and leads to banking credit expansion, particularly for mortgage loans and real estate development loans. There were 32.2 trillion in real estate bank loans by the end of 2017, accounting for 26.8% of the total amount of bank loans [
30]. With the expansion of banking credit, economic participants can obtain more funds to either invest in or speculate on real estate, which brings housing price upswings, and can even cause a housing price bubble. Guerrieri and Uhlig [
31] stated that the boom or busting of credit causes the boom or busting of housing prices. Shen et al. [
32] found that there is a bidirectional lead-and-lag relationship between credit and the housing prices in China.
If the housing prices decline, banks will face the following three problems: (1) credit defaults from real estate developers, local governments, and individuals or families (buyers); (2) the need to dispose of collaterals to achieve liquidity, in addition to the negative consequences from the markdown value loss and the market loss of further housing price decreases; (3) panic due to undesirable expectations arising from the decline in housing prices, even triggering a run on banks. Banks then are faced with huge loss or even bankruptcy, leading to systemic financial risk.
2.1.4. Individuals or Families
Soaring housing prices attract more and more individuals or families to either invest in or speculate on the housing market in the following two ways: (1) as creditors or shareholders, to expand their investment in real estate financial markets; and (2) as real estate buyers, to purchase more real estate and sell it when the prices increase. Such investment or speculation could further increase the housing prices in the short term, creating a positive feedback loop between price and speculation, and thus producing a price bubble. In China, many studies use the high housing vacancy rate to illustrate the heavy degree of speculation [
23].
When the housing price bubble bursts, investors and speculators face big losses, and cannot repay the loans from banks, causing systemic financial risks and the possibility of social instability.
2.1.5. Mechanism of Formation of Systemic Financial Risk
In summary, the mechanism of formation of systemic financial risk is as shown in
Figure 1.
2.2. Spatial Contagion
After having clarified the financial risk led by housing fluctuation to the four participants, this section explains how the risk diffuses between cities. According to Zhang [
33], adding price expectations to the demand equation, the dual expectation models of supply and demand are as follows:
where
a, b, c, d, e, f, and
g are non-negative.
,
and . are housing supply, demand, and price, respectively, at the
t period.
is the expected value of
. Here,
and
are the expected values of the supply side and the demand side, respectively.
The supply volume of the current housing market is determined by the price expectation in the previous period—that is, the current supply is a function of the price expectation in the previous period—and the current housing market demand depends on both the current price and the expectation of the price in the next period. The expected value expresses the expectation of price. Real estate developers’ expectation of the current price in the previous period is . When the market price is expected to rise, then ; when the market price is expected to decline, then . Similarly, real estate demanders’ expectation of the price in the next period in the current period is . When the market price is expected to rise, then ; when the market price is expected to decline, then . is the ratio of demand derived from either investment or speculation to the total demand; when only real demand exists in the market, .
Solving the Equation set (1), we obtain:
Introducing
into Equation (2), then:
Assuming that the housing price of City A rises continuously and attracts the attention of investors in City B, who will expect the rise of housing price in City B, thereby increasing the housing demand by
in City B, the demand equation will be as follows:
Fixing
St, and solving Equation set (1), then:
Comparing Equation (5) with Equation (2), the demand shock brought about by the expectation of change causes the housing price to fluctuate by .
Assuming that the housing price in City B is in equilibrium, which is determined by the market fundamentals, then
. If
, the housing price in City B changes from Equation (5) into:
If , then , .
Due to the rise in housing prices in City A, the demand in City B increases by
, and then:
The growth of the housing price in City B will raise both investment demand
e and real estate developers’ expected price
f. When
e and
f rise to a certain point, if
, then the housing price will tend to diverge, that is:
The housing price in City B will increase continuously along the path of Equation (3): and finally deviate from the initial equilibrium price , accompanying the growth in investment demand e and real estate developers’ expected price f. Accordingly, the housing price bubble in City A diffuses to City B by changing the investment demand and the expected housing price in City B.
Based on the above analysis, the increase in the housing price will stimulate heavy investment or speculation from participants, causing a sharp increase in the housing price, and thus financial systemic risk due to the financial loss or bankruptcy of all of the participants when the housing price decreases. Furthermore, the housing price bubble could diffuse to adjacent cities, thereby spreading the risk to the whole region, resulting in regional systemic financial risk.
5. Conclusions
This paper finds that various participants benefit from the soaring housing prices, and thus they are encouraged to expand investment to promote the increase of housing prices and ignore the subsequent risks and sustainability of economic and social development. Once housing prices decrease, these participants will face a series of financial problems and systemic financial risk. The spatial conduction of the risk of the housing price bubble between cities has also been found in theoretical models. Based on the theoretical analysis—the mechanism of formation of regional systemic financial risk derived from housing price fluctuation—this paper builds a spatial lag model (SLM) and a spatial Durbin model (SDM) to empirically study the effects of investment from participants on housing prices and spatial contagion effects among cities in South and North Jiangsu. Employing panel data from 2003–2014, this paper finds that participants’ investment expansion stimulates the sharp increase in housing prices. They ignore the subsequent financial problems once housing prices declines to pursue more profits, which will trap various sectors in either loss or bankruptcy, thereby leading to systemic financial risk. At the same time, the increases in housing prices and local governments’ land supply prices in local cities elevate housing prices in adjacent cities, diffusing the risk derived from housing price fluctuation among cities, and thus generating regional systemic financial risk. The main findings in detail are as follows:
(1) Local governments’ land supply price, banks’ credit expansion, real estate developers’ investment expansion, and individuals’ or families’ demand have strong positive influences on housing price. Real estate developers’ expansion of real estate development investment (RDI) elevates housing price, showing that the excessive investment from participants stimulates the sharp growth of housing prices. The movement of RDI and the vacant space of houses show a similar tendency in the typical cities in Jiangsu, rather than the opposite tendency, as is the case in theory, suggesting excessive investment from real estate developers. These heavy investments or speculation from participants drive a dramatic increase in housing prices, creating financial systemic risk in Jiangsu, because the participants will face great financial loss or even bankruptcy if the housing prices decrease. Furthermore, there is a significant positive interaction of housing prices among cities, and local governments’ land supply strategies in adjacent cities have significant positive effects on the housing prices in local cities due to “imitative behavior” among local governments, suggesting a spatial contagion of the housing price bubble risk among cities, and thus the formation of regional systemic financial risk in Jiangsu.
(2) In South Jiangsu, local governments’ land supply price has the largest influence on housing prices, followed by real estate developers’ investment expansion, and then bank credit expansion. The real estate developers’ investment expansion contributes even more than bank credit expansion to the increase in housing prices, suggesting heavy investment from real estate developers in South Jiangsu, which is consistent with the reality. However, demand from individuals or families has no significant influence on housing prices, because the “substitution effects” of central cities offset their “driving effects” in South Jiangsu. Housing prices in the central cities, such as Suzhou and Nanjing, are much higher than in adjacent cities, which attracts individuals or families from the adjacent cities to the central cities, thereby reducing the housing demand and housing prices in adjacent cities.
(3) In North Jiangsu, bank credit expansion has the greatest effect on housing price, followed by local governments’ land supply price, and then demand from individuals or families. This shows that housing market participants rely on direct finance—heavily so on bank credit due to the undeveloped financial market in North Jiangsu—and that banks’ credit expansion to the housing market is also considerable. The expansion of demand from individuals or families has a significant positive effect on housing prices. Since there is no big difference in housing prices between central cities and other cities, individuals or families will raise their price expectation, and thus increase their housing demand in adjacent cities when housing prices in central cities rise.
(4) Compared with North Jiangsu, the spatial contagion effect on housing prices in South Jiangsu is stronger, and the expansion of real estate developers’ investment is more serious, which makes the regional systemic financial risk more severe. Due to the great difference in housing prices between central cities and adjacent cities, there is slightly less “imitative behavior” among local governments in South Jiangsu, and there are substantial “substitution effects” between the housing demand in central cities and the housing demand in adjacent cities. Participants rely more heavily on bank credit in North Jiangsu due to the less developed financial market compared to South Jiangsu.