China’s property boom is shifting from Beijing and Shanghai as government measures to curb the market haven’t kept prices from rising in secondary cities.

New home prices rose in 67 of 70 cities in May led by smaller centers as developers hold off price cuts, even as existing home prices cool following higher interest rates and down-payment requirements. Standard & Poor’s on June 15 cut its outlook on Chinese developers, echoing concerns of a property bubble aired by bears such as hedge fund manager Jim Chanos.

Efforts to rein in property prices have been focused on the nation’s largest urban areas, leaving less affluent cities such as Urumqi in the northwest and northeastern Dandong with surging home values as developers increased building there. That raises challenges for a government that last week escalated its fight against inflation by raising bank reserve requirements for the ninth time since October.

“Purchase restrictions in the major cities drove speculators to second- and third-tier cities,” said Liu Li-Gang, who formerly worked for the World Bank and is chief China economist at Australia & New Zealand Banking Group Ltd. in Hong Kong. “China should raise interest rates and basically use monetary policies to curb demand, otherwise negative interest rates and few appealing options will send more speculation into the property market.”

Debate that’s been raging for more than a year is now intensifying over what the shifting boom signals. To bears, it is a sign one of the world’s most toxic asset bubbles is still inflating, fueled by speculative buying and cheap credit. To economist Stephen Roach and hedge fund manager Chris Ruffle, the bubble fears are overblown as incomes rise and the largest urbanization in history continues.

Deflating Bubbles

“I can’t say a bubble will never happen,” Roach, non- executive chairman of Morgan Stanley Asia Ltd., said in an interview in Shanghai last week. “The important signal Chinese authorities have sent is that unlike their counterparts in the West, they are focused on relieving or deflating bubbles before they become a major problem.”

The stock market seems to agree. A measure of property stocks on the Shanghai Composite Index is the only industry group that is up this year. It has gained 4.5 percent, while the benchmark is down 5.7 percent. China State Construction Engineering Corp. has added 14 percent in 2011, while Poly Real Estate Group Co. has added 7.4 percent.

China’s investment in residential property accounted for 6.1 percent of gross domestic product last year, the same level as the record in the U.S. in 2005 preceding the subprime crisis there, according to Citigroup Inc. The government is prepared to sacrifice 1 percentage point to 1.5 percentage points of GDP growth to curb the property market, Citigroup economists led by Shuang Ding and Minggao Shen wrote in a June 20 research note.

Fighting Inflation

“China’s quest to curb property prices is one of the important parts to its fight against inflation,” said Hong Kong-based Shen, Citigroup’s China research head. “If home transactions slow, property-related consumption and investment might also slow, and take the overall economy with it.”

China’s inflation rose to the highest in almost three years in May to 5.5 percent from last year, data last week showed. The central bank has raised interest rates four times since October, and most bankers in a central bank survey expect more monetary tightening in the third quarter.

The effort to cool home prices is already having some effect, damping the market for existing homes. Prices in May fell from the previous month in 23 of 70 cities measured, the National Bureau of Statistics said on its website June 18. That’s more than the 16 cities that posted declines in April.

Developers Holding On

“We see home price have stabilized, but they are far from dropping,” said Sun Mingchun, the Hong Kong-based Great China economist at Daiwa Securities Capital Markets.

Justin Chiu, executive director at Cheung Kong (Holdings) Ltd., Hong Kong billionaire Li Ka-shing’s property company, said developers are still holding up prices in China, at the expense of softening volumes.

“But it can’t persist forever,” he said in Singapore June 21. “It really depends how long developers can hold on but home prices will come down sooner or later.” Hong Kong’s second- biggest developer by market value has projects in more than 10 Chinese cities.

The government last month said it won’t ease property curbs and ordered local officials to continue to implement measures to control prices.

Since 1998, China’s nationwide home prices have surged at least 140 percent. The capital Beijing, its financial hub Shanghai and the southern manufacturing center of Guangzhou led gains. Prices in Shanghai, home to more than 20 million people, almost quadrupled in the past 10 years, and tripled in Guangzhou.

Accumulating Wealth

The surge in home prices should be “no surprise” given China’s 30 years averaging 10 percent annual economic growth, said Citigroup’s Shen.

“China’s rising home prices is strongly linked with the country’s economy, which is a process of wealth accumulation,” Shen said.

China last year surpassed Japan as the world’s second- biggest economy, and is forecast by PricewaterhouseCoopers LLP to eclipse the U.S. by 2018. Urban household income per capita rose 13.7 percent in 2010 from 2009. China’s economy expanded 10.3 percent in 2010.

China’s private residential property market has only existed for 13 years. In 1998, then Premier Zhu Rongji and his government introduced private home ownership as part of its plan to shield the economy from the Asian financial crisis, allowing the trading of homes and banks to offer mortgages. Prior to that, most of China’s urban population lived in government or factory distributed homes.

‘Underlying Demand’

Chinese investors have flocked to property in part due to a lack of other options. Capital controls prevent citizens from investing overseas, while putting money in banks yields interest rates of 3.25 percent a year, less than inflation.

“Underlying demand from the end users is still very much here,” said Michael Klibaner, Shanghai-based head of China research at Jones Lang LaSalle Inc. “There’s no bubble from that perspective.”

Chinese families also are not saddled with big mortgages, said Klibaner. Chinese buyers have to pay at least a 30 percent down payment for the first home they buy, and 60 percent for second homes, compared with as low as zero down payment in the U.S. ahead of its financial crisis.

“The western concept of bubble with tremendous level of leverage on home buyers clearly is not the case in China,” he said.

Urbanization

Too much is being made of the so-called Chinese property bubble as China’s urbanization fuels demand for housing, according to Morgan Stanley’s Roach.

“China often puts new office and residential supply online before demand,” Roach said. “Over the next 20 years, some 360 million people will move from the countryside to cities in China and that provides a powerful source of demand to absorb the supply that’s now being put in place.”

About 170 million people moved to cities in the last 10 years, the biggest urbanization in history, according to the Chinese Academy of Social Sciences. China, with 1.3 billion people, aims to increase its proportion of those living in cities from 47.5 percent to 51.5 percent by 2015, it said in its latest five-year plan. That would be the first time in its history that urban residents outnumber those in the countryside.

Tourism Hub

China implemented a two-year stimulus package totaling 4 trillion yuan after credit markets froze when Lehman Brothers Holdings Inc. collapsed in September 2008. A record $2.7 trillion of loans were extended in the past two years, fueling a surge in home prices and construction.

While prices have moderated in Beijing and Shanghai, new home prices in less affluent cities including Mudanjiang, Lanzhou and Qinhuangdao, posted increases of at least 7.7 percent last month, according to the latest data.

In the southern city of Sanya, in Hainan province, home prices surged almost 50 percent in October, their peak, from a year earlier after the government rolled out a plan to build it as an international tourism island. Prices in the central city of Wuhan, the transportation hub of the country’s new-high speed train, rose 17 percent last year from 2009, according to SouFun Holdings Ltd., as the government plans to spend 2.8 trillion yuan on railways in the next five years.

To cool the market, the government this year has raised the minimum down payment for second-home purchases and authorities introduced residential property taxes in cities including Shanghai and Chongqing.

“The Chinese government knows very well that there’s a bubble in some Chinese cities and not in others, so they didn’t impose a nationwide flat tax,” said Hong Kong-based Luca Silipo, chief economist for the Asia-Pacific region at Paris-based investment bank Natixis SA.

Chanos Versus Ruffle

Chanos, the hedge fund manager known for predicting Enron Corp.’s collapse, told Bloomberg Television in New York on May 24 that Chinese developers have too much land on their balance sheets, similar to the U.S. before its housing market tumbled. He has been forecasting a Chinese housing crash since last year.

China is in a “bit of bubble” as its formula for steering its economy is “running out of steam,” billionaire investor George Soros said at a conference in Oslo on June 14.

Chris Ruffle, who helps manage $19 billion for Edinburgh- based Martin Currie Inc. from Shanghai, said China critics focus too much on so-called “ghost towns” such as Kangbashi in northern Inner Mongolia province to support their arguments that the nation’s property market is in a bubble.

Ghost Towns

Designed for 300,000 people, Kangbashi, the new urban center of Ordos prefecture west of Beijing, may have only 28,000 residents, Bank of America Merrill Lynch said in May 2010. To Ruffle, that’s not necessarily a problem: “It’s all sold, mostly for cash,” said Ruffle. Ruffle has started to buy “heavily discounted” property companies with their assets in Central China, he said, declining to name the stocks.

The Chinese government is facing a dilemma on the one hand to control inflation while on the other hand not wanting the property market to crash, said Patrick Chovanec, an associate professor at Tsinghua University’s School of Economics and Management in Beijing.

“I can’t say when you are going to see a turn in the market, but I can tell you dynamics in the market are not healthy or sustainable,” he said.