The bubble has done much harm to society but government efforts to curb the hike in house prices appear to be working

There may have been doubts there was a real estate bubble in China a few years ago, but it is obvious now. The average house price has tripled between 2005 and 2009. In some cities like Shanghai and Beijing, house prices increased by more than 40 percent in 2009 alone, and an additional 30 percent in 2010. The prices in both cities are now ridiculously high, while the rent to price ratio is much less than the deposit rate and the average family needs to work decades to afford a small apartment.

A real estate bubble is not only an economic problem, it is also a social disease that can do a great deal of harm and a ticking economic time bomb.

First, it causes unfairness. A rapid increase in house prices means the wealthy and those who were fortunate enough to buy apartments early can accumulate a fortune, while others cannot afford a property any more.

Second, it causes a prevalence of speculation and decline in entrepreneurship. Investing in real estate becomes so profitable that people indulge in speculation rather than manufacturing.

Third, the distorted house prices send the wrong signals, which cause the real estate industry to be inefficient and concentrate too many resources in the industry.

Finally, a real estate bubble increases living and production costs, which decrease consumption and cut cities' competitive advantages.

So what are the risks if a bubble bursts? Traditionally, when a real estate bubble bursts, the value of property decreases but not the level of debt, which may cause families and banks to go bankrupt and then cause financial crises. But what happened during real estate crises in other countries, such as the 2007 subprime crisis in the United States, is not likely to happen in China. Compared with US home owners, Chinese owners will not go bankrupt since they have higher down payment rates and do not consume more along with the increased value of their property. And banks will be safer too, since house prices have increased so fast that most loans were offered when the prices were still low.

Will the bursting of China's bubble affect local governments? Not really, in 2009 and 2010, in order to tackle the financial crisis, local governments had a heavy deficit, but according to data from the National Audit Office, at the end of 2010, the debts of local government financing platforms were 10.7 trillion yuan ($1.68 trillion) and the loans are basically guaranteed by the expected returns from land sales. The fiscal deficit and debt balance are reasonable and controllable proportions of the GDP.

In fact, the government can help burst the bubble slowly and control some of the risks.

After two years of regulations aimed at trying to cool the property market, some cities in China finally seem to be experiencing a slowdown. While some speculators and developers still expect efforts to curb the bubble to fail, many are seriously preparing to fight for their survival, as demand for apartments has been falling across the country following the government's ban on the purchases of a second property, increased minimum down payments, increased mortgage rates, and trial property taxes. At the same time, due to the tight monetary policy, developers are finding it difficult to access additional loans at a time when a sharp drop in real estate transactions means they have less working capital. Some realty brokerages across China have closed hundreds of offices, and some developers are starting to show signs of being bankrupt.

Premier Wen Jiabao said in Moscow recently that the tightened real estate regulations will not waver and the government aims to lead housing prices back to a reasonable level. While it is the third time in a month that Wen has expressed the government's determination to continue with its efforts to cool the market, it is noticeable that this is the first time in years that the government has shifted from "curbing excessive growth in property prices" to "bringing prices down to a reasonable level".

This change seems sudden but is actually not surprising, considering that there will be a transition of leadership in the State Council in 2013 and the current government needs to pave the way for the next government. Among three highly anticipated reforms, reform of the political system, reform of State-own firms and reform of the real estate industry, the latter may be the easiest.

In the short run, the government should stick to the current policies. It seems that the current tight monetary policies are resulting in continued expectations for lower prices. Purchase limits in some cities are only temporary measures and will phase out after a national database on individual property ownership is established, which will pave the way for introducing property tax in more cities. China is also aiming to construct 10 million affordable housing units this year, of which 98 percent had commenced construction by the end of September, according to the Ministry of Housing and Urban-Rural Development.

In the long run, there are three factors that will prevent the real estate bubble from expanding. First, monetary policy should go back to neutral, which means the central bank could loosen the interest rate policy. Second, the land exchange system should be more market-driven. Third, the government should continue to discourage speculation and increase construction of social housing.

Although the real estate bubble in China has caused much harm to society, there is still a chance to deal with it before it does even more damage. Considering the records of failure of past policies, the government should remain firm and not loosen its current policies.

The author is a lecturer at the Management School of the Shanghai University and a research fellow at the China Europe International Business School Lujiazui International Finance Research Center.