The Great Housing Boom in China∗

China’s decade-long housing boom looks nothing short of a gigantic bubble familiar to many countries: In big cities the price-to-income ratio reached 30 to 1 and the vacancy rate stood at 30% or above. This paper provides a theoretical framework to shed light on the causes and consequences of the great housing boom in China. We argue that the boom could be a rational bubble rooted in China’s unprecedented economic transition– which features persistent high returns to capital. We argue that the very expectation that China’s high capital returns driven by cheap labor and resource relocations are not sustainable in the long run can induce investors to seek alternative store of value for their growing wealth, thus triggering a self-fulfilling housing bubble in a financially underdeveloped economy with limited supply of financial assets. The bubble would exhibit a rapidly rising housing price-to-disposable income ratio during the transition path regardless of whether housing provides rents or utilities. This prediction is consistent with China’s “ghost town”phenomenon and decade-long faster-thanincome-growth housing bubble, which cannot be explained by standard neoclassical growth theory. We show the bubble could prolong China’s economic transition and severely reduce social welfare. Our model also sheds considerable light on similar housing bubbles existed in other emerging economies during their rapid economic growth and transition periods.