Fourth Quarter 2007

Riding the Chinese Juggernaut Rewards and Risks

Holland & Knight Newsletter, republished in ABA's Real Property and Probate Magazine
Dennis M. Horn

With a population of more than 1.3 billion people and an annual growth rate that has topped 10 percent, China is a huge market. Real estate investment also has grown significantly during the past few years. People are moving from the countryside to the cities at an accelerating rate. Tourists have discovered China. Foreign business people travel regularly to China. Foreign companies are investing in Chinese manufacturing capacity. Most importantly, ordinary Chinese citizens are creating wealth, both for the emerging middle class and for the superrich. As a consequence, there is a demand for office space, hotels, factories, and, in particular, housing. It is no wonder that the public is barraged by news articles about China as an emerging economic superpower.

This article examines the desirability of investing in China’s fast-developing real estate market. Although potentially lucrative opportunities abound, the legal structure for the country’s fledgling property rights is still largely unproven, which poses substantial risks for the investor.

The Chinese Economy

The Chinese are prodigious savers, and they are putting a significant portion of their savings into stocks and real estate. The stock market and the real estate market, especially in the major cities, are each experiencing boom times as significant wealth chases relatively few investment assets. The volatile Chinese stock market, for example, has more or less tripled in value in the past two years. Untamed – China’s Leaders Struggle to Restrain a Surging but Unbalanced Economy, Fin. Times, May 22, 2007, at 7. In Shanghai and other coastal cities, 70 percent to 80 percent of housing is privately owned. Farmers Are the Last to Benefit from Chinese Property Reform, Fin. Times, Mar. 9, 2007, at 4. This is remarkable, considering that the concept of private property ownership was first formally recognized in the late 1980s and was only incorporated into China’s constitution in 2004. Until a few years ago, most housing stock was owned by government ministries or state-owned enterprises.

China has an aggressive policy of export-led economic growth, supported by a significantly undervalued currency. By one estimate, the Yuan is 40 percent cheaper than it should be. Robert J. Samuelson, China’s Trade Time Bomb, Wash. Post, May 9, 2007, at A17. The export-led economic expansion is supported by favorable labor costs and an education system that is producing large numbers of skilled workers. For example, labor costs in China, at 67 cents per hour in 2004, were a fraction of the labor costs in the United States, where labor costs averaged $22.87 per hour for that year. Erin Lett & Judith Banister, Labor Costs of Manufacturing Employees in China: An Update to 2003-04, available at China is also “racing ahead” of the United States in the number of doctoral level engineering and technology graduates. Vivek Wadhwa et al., Where the Engineers Are, available at (citing statistics that show China graduated more than five times the number of engineers than the United States graduated in 2005, but suggesting China’s figures may be “a substantial overestimate”).

Is it any wonder that the U.S. media is full of enthusiastic predictions about China’s economic power? China has been very successful in obtaining foreign investment. China’s National Development and Reform Commission estimates that China has attracted $383 billion in overseas investment in the five years ending in 2005 achieved by offering low-cost capital, cheap labor, often subsidized plant facilities, and few controls on exports. Mure Dickie, China Moves to Combat Threat of Foreign-owned Monopolies, Fin. Times,
Nov. 11, 2006, at 9. Can China continue this explosive growth?

More immediately, can a foreigner safely invest in Chinese real estate? Columnist Thomas L. Friedman postulated that for a country to create a healthy emerging market, that country must develop a functioning governing software, judicial system procedures for settling disputes, a social safety net, a rule of law, and economic operating systems. Thomas L. Friedman, The Lexus and the Olive Tree 138 (1999). 

By these standards, China has made a good start in developing an institutional infrastructure, but it has a long way to go.

Real Estate Investment in China

Currently, there are three ways for foreigners to invest in Chinese real estate. First, each foreigner can buy one house for personal use. To buy the house, the foreigner must have studied or worked in China for more than a year. The foreigner cannot rent the house to a third party because that would convert the “personal use” house to an investment that is not permitted. Second, the foreigner can invest in a “foreign invested real estate enterprise,” which is a company organized in China that has at least 25 percent foreign ownership, significant capital, and government approval at the local level (and for larger enterprises, at the state level). Local government agencies may be reluctant to approve of these enterprises. For example, last year, when the central government was attempting to clamp down on residential housing speculation by limiting foreign ownership, the government of Shanghai reportedly granted very few licenses for foreign-invested real estate enterprises for investment because of fear that this would undercut central government policy. Third, foreigners can rent space in a building on the same terms as Chinese nationals. The lease term would be limited to the remaining term of the land use right or 20 years, whichever is less.

These vehicles for investment depend on different laws and regulations. To buy a house or to buy real estate through a “foreign invested real estate enterprise,” the foreigner (including nationals from Hong Kong, Macau and Taiwan) would rely on both the Property Law and a series of regulations restricting foreign investment in Chinese real estate. These regulations were promulgated in July 2006 by joint action of various government agencies. The rules were changed in what appears to have been a failed attempt to constrain property speculation. Before that date, foreigners could buy real estate in China directly, without these restrictions. At the moment, foreigners cannot directly acquire investment real estate, except through a “foreign invested enterprise.” It is not clear what restrictions would apply to foreign-owned property purchased before the effective date of these regulations.

The Property Law

The new Property Law of China, enacted in March 2007 and effective in October 2007, regulates all investments in Chinese real estate by foreigners and by Chinese nationals. This law is China’s attempt to enshrine in law the rights and limitations of real and personal property ownership. But China must confront some very real constraints on economic growth, including the paucity of law and precedent in economic matters, local corruption, government control of the courts, unrealized environmental costs, and hidden social costs for labor. Can a centrally controlled government, steeped in Marxist tradition, maintain the innovation of ideas and the agility of market response that have been the hallmark of economic growth in the Western world? Is the Chinese model so robust that China can thrive without confronting any of these issues? The issues raised have direct application to real estate and other sectors of foreign investment in China. The new Property Law embraces concepts that are similar to familiar American concepts. For example, “land use rights” sound a lot like the rights granted under a ground lease. The rights in personal property sound like the rights outlined in the Uniform Commercial Code. Similarly, “partitioned rights in building areas” envisions a scheme for multi-family housing that is similar in concept to a cooperative apartment or condominium ownership. The right of the government to take over private property for public use resembles the condemnation rights enjoyed by governments in this country. See The New Chinese Property Law: A Real Estate Practitioner’s Perspective, by Patrick A. Randolph Jr., on page 14 and The Chinese Land Use Right: Is It Property?, by Gregory M. Stein, on page 22 in Probate & Property, September/October 2007, for discussions of the new Property Law. Indeed Chinese law drafters commented that they have looked around international experiences when drafting and revising the Property Law.

Despite the similarity, however, it would be wrong to assume that these principles will work in China in the same way that they work in the United States. First, China’s basic legal framework, grounded in civil law, is very different from common law. Second, unlike U.S. laws, Chinese laws have not yet been molded by regulations and precedent into principles that will guide courts and administrators in a predictable way.

Some Disturbing Realities

The Property Law is an example of both the strengths and weaknesses of China’s legal system today. Chinese politicians were able to reconcile many different points of view enshrining private property rights into law without abandoning socialist principles while addressing the pragmatic concerns of property investors. The Property Law also balances urban interests with rural interests.

Although the Property Law itself provides a direction, it leaves many unanswered questions. The devil is in the details, and there are very few details in the new Property Law. For example, the Property Law provides for recording title to land use rights.

The current recording system is succinctly described by
Prof. Pat Randolph, as follows:  

Registration of property ownership has been part of the law of China for two decades ... . Registration occurs in the public registration office in the area in which the property is located. The civil law views the land and the buildings on that land as separate items of ownership, so Chinese law has required separate registration … . In many areas, this distinction meant registration for land and buildings in different offices run by separate ministries. Further, there was overlapping jurisdiction for registration of land use rights generally, and it was possible for different public offices to have different registered claims for the same property.

Randolph, supra, at 17 (citations omitted).

Prof. Randolph goes on to describe how information about ownership is often closely guarded by the registrars and is therefore not universally available to the public. Although the Property Law contemplates a universal recording system, such a system will require new regulations and much work on the ground to put it into effect. In the meantime, except in large cities where the registration process has been more standardized, it will be very difficult for an investor (or a title insurer, if a title insurance industry were to emerge) to ascertain quickly and with certainty that the investor has good title to the land use rights.

The Property Law, translated into English, covers 28 pages. By contrast, personal property law and real property law are covered in volumes of regulations and years of interpretations of various U.S. courts to help practitioners understand the statutory law. The new Property Law provides a direction. It will only be implemented by regulations that must be promulgated by the State Council and its agencies. These agencies will sort out the existing regulations and amend those inconsistent with the Property Law. They will promulgate new regulations to implement certain provisions, such as the recording requirements. In addition, the People’s Supreme Court will address issues arising in lower courts. These interpretations will be legally binding in nature. In the meantime, a foreign investor will have to factor legal uncertainty into its decisions. This uncertainty is not limited to the paucity of statutory law. It also extends to the lack of predictability in enforcement of existing laws and

Consider the case of Feng Bingxian, a businessman who was indicted in 2006 for “assembling to disturb social order.” Western news sources report that Feng’s real crime was to sue the government in a massive class action involving 60,000 investors who dug and developed oil wells around Yanan in Shaanxi, a northern province whose local officials allegedly approved the exploration, then confiscated the wells after they had begun to show profits. The police also arrested 13 of 15 businessmen serving as lead plaintiffs in the case and the lawyer representing Feng. Procurate Indicts Feng Bingxian and Three Other Shaanxi Oil Investors, Apr. 23, 2007, available at Mr. Feng’s case is one of the troubling realities in China today. Local officials often subordinate individual property rights either to what they view as the public interest or to their own economic interests. In some cases, the officials may believe that individuals are holding up progress that will benefit their jurisdictions. In other cases, the officials may be corrupted by local developers who stand to make a profit on the project. As one commentator put it: “Without the establishment of an administrative and legal system which can act independently of officials and the Communist party, laws can be next to useless.” McGregor, supra, at 7.

China maintains a unitary government structure. Departments at the provincial, city, and county levels theoretically take direction from Beijing. In practice, the central government has limited control over local government decisions. Similarly, the courts are ostensibly directed from the central government but, in practice, are often controlled by the local government. Because the local governments may be motivated by their own fiscal and planning needs rather than by central policy and because local officials may be motivated by their personal financial interests rather than even local interests, local governments and their officials sometimes make decisions that are at odds with central law and policy. The courts, which are under local government control, often find a way to enforce these local government decisions. Local control also means that local favorites have access to information and access to decision makers that is denied to outsiders. This makes it difficult for foreign investors to enjoy a level playing field in property acquisition and development and means that it is critical for a foreigner to choose a trustworthy local partner and to retain as much control over the enterprise as possible before investing in China.

Economic and Political Constraints

The uncertainties are not limited to China’s emerging legal system and regulatory structure. China also is laboring under a number of economic constraints. Although China’s leaders have done a good job of spurring economic growth, China is starting from way back in the economic pack. China’s per capita GDP in 2006 was $1,947.69 versus $7,593.53 for Mexico and $44,314.78 for the United States. IMF World Economic Outlook Database, available at . China’s economic growth has been very uneven, with much of the wealth creation concentrated along China’s waterways and in China’s largest cities. China’s growth relies on a dangerously high level of output from energy-intense, polluting industries. As a consequence, China is set to be-come the world’s largest producer of greenhouse gases in the coming years. China’s air and waterways are heavily polluted to the point where some of China’s major river systems are not fit to sustain aquatic life. China’s social safety net is poorly developed. There is no equivalent to the U.S. Social Security system and only 17 percent of workers have pensions; a mere 14 percent of workers are covered by unemployment insurance. Samuelson, supra, at A17.

China has embraced a policy of limiting interest paid on savings as a means of subsidizing low-interest capital loans to industry. By using cheap labor, land, energy and water resources and cheap capital to jump start its export economy, China has spurred enormous industrial growth. These policies have little regard for the consequences and costs to the Chinese people. This trade-off is typical of many developing countries and in fact happened in the United States in the early stages of its own industrialization in the late 19th and early 20th centuries. Will China be able to avoid the debilitating economic collapses that the United States and other countries have suffered on its path to economic prosperity? And in an increasingly interdependent world, if China suffers these setbacks, how will its problems affect the rest of the world? The possibility that China will suffer a sharp reversal of fortune because of these hidden costs must count as a risk factor in investment decisions.

Finally, serious questions remain about whether a centrally controlled economy is nimble enough to react to market challenges. Certainly, China’s policy to restrict foreign investment in real estate, adopted in late 2006, has done little to arrest the dramatic rise in property values in the major cities. Although China has been very successful in launching its export-based economy, it has been notably unsuccessful at controlling its unintended consequences, including rampant speculation and an increasing gap between the rich and the poor. Efforts to restrict the flow of information, for example, by restricting the sites that Google can provide to Chinese nationals, also may have the unintended side effect of limiting entrepreneurial innovation. Indeed, some commentators have questioned whether Marxism as an ideology is consistent with the demands of today’s interdependent world. Columnist Martin Wolf notes: “As the ideology of a mighty state in the modern world, Marxism is another dead end. But a party-state whose ideology is the justification for its hold on power cannot abandon Marxism lightly. Nor does it have anything compelling to put in its place.” Martin Wolf, China’s Great Walls Cannot Keep Out the World Forever, Fin. Times, May 16, 2007, at 11.

Leaving ideology aside, there is some evidence that dictating economic policy from Beijing can be disastrous. A senior executive for a U.S. company based in Hong Kong commented to the author that her biggest concern about investment in China is the lack of economic predictability rather than the threat of government expropriation. The Chinese government has been known to pass laws or issue regulations with little advance notice to address perceived problems that have significant and often unintended economic effects. For example, last year when the government decreed that foreigners who were resident elsewhere could not own residential property in China, it had a crippling effect on some high-end housing developments that targeted second-home buyers resident in Hong Kong. This executive speculated that insiders may have had notice that this decree was coming but that many Hong Kong investors were blind-sided and were hurt economically. She also mentioned a recent tax change that imposed uniform tax rates on profits from domestic and foreign investment. The tax change was designed to quell speculation, but it had the perhaps unintended side effect of dramatically changing the exit strategy for some foreign investors who had bought and developed property under the old tax laws and were faced with a much higher tax on sale. She concluded that investment in China was more difficult because it is hard to predict future investment returns within a constantly changing legal landscape. More recently, in order to stop hyperinflation in housing prices, China has severely restricted its banks nationwide from making real estate loans. The short term effect has been predictably negative for housing. The long term effect is not clear.


Despite the substantial economic achievements that it can claim, China has an emerging economy. Its leaders are slowly creating a legal framework and a judicial system that balances the principles of a socialist government with the necessity of providing for private ownership as an engine for economic growth. Applying Thomas Friedman’s test of judging a country’s investment climate by its governing software, China is not there yet. A foreigner who is contemplating an investment in China should factor into its investment decision the substantial risk inherent in any investment in a developing country that has a largely untried legal infrastructure and a government with limited experience in directing or even channeling a market economy.

Reprinted with permission of the American Bar Association.
Originally published in Probate & Property,
September/October 2007.
Copyright © 2007 American Bar Association.
Updated since publication.

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