China's housing market has just gone through a year that had two strong characteristics: either standing still or going back. Just as prices remained largely static, the volume of trade fell sharply. Developers are in difficult financial straits. To understand the predicament the market now finds itself in and to forecast the short- or long-term trend, one needs to look at the supply and demand and at government policies.

First, housing prices are affected by demand. There are essentially four groups of buyers: the middle class, public servants, foreign investors and private entrepreneurs. There are essentially two strong economic sectors, infrastructure and manufacturing, and both are mainly labor intensive. Workers in these industries, many earning very low wages, cannot afford apartments and cannot settle in cities. For years, the middle class has been the main source of real demand in buying apartments to live in. But the number of middle-class people cannot grow that much as long as China's service industry continues to be controlled by State-owned companies.

There are not enough jobs to go around for new university graduates. While the middle class is relatively small, those in it are mainly concentrated on first-tier cities such as Beijing, Shanghai, Guangzhou and Shenzhen. They have always been there to help push prices to a level that might be regarded as reasonable, but their influence on prices that are now well above their purchasing capability is minimal.

The other three groups, mainly investors or speculators, who regard apartments as capital assets and whose investment behavior is driven mainly by their expectations on housing prices, have been pivotal in pushing housing prices in some cities to ludicrous levels.

While foreign investors may use free cash flow to buy some real estate, they use most of the profits from their foreign direct investments to expand production. While the concerns aired about hot money from abroad are reasonable, people do not realize that they may need to worry that foreign companies may turn their profits and working capital into short-term investments by speculating in capital goods in China.

Private entrepreneurs, hobbled by low profits in manufacturing, have for years turned to financial investments, especially real estate.

There is a well-known riddle called "missing money" that goes like this: Since the broad money supply (M2) growth rate is much bigger than the total of the GDP growth rate and the growth rate in consumer prices, where does the excessive money go? It can be reasonably assumed that much of it turns into hidden income for public servants. Since the investment opportunities in industry are extremely limited, for many years buying apartments has been the easiest way to keep money growing.

Many of these investors or speculators, who feel that it is either costly to renovate these apartments or inconvenient to rent them out, leave them empty. It is estimated that as hundreds of millions of ordinary people fight for their dreams of owning their own home, tens of millions of apartments or houses lie unused.

Second, housing prices are affected by supply. As housing prices increase, real estate development becomes rampant. In the new housing market, local governments - the land providers - are rushing to sell land to developers, who rush to build houses.

Though under such high prices the housing market has little connection with most people, supply cannot satisfy the feverish speculation of the rich.

In the second-hand housing market, with the expectation of further price rises, the fear of inflation and few other investment opportunities, most homeowners are reluctant to sell their houses and instead hold on to them.

Though local governments are unwilling to build more apartments to rent to the public, as a political task they are obliged to provide apartments.

Finally, the government holds sway over the housing market. The government has an important role in the trend the market follows. It is not only a rule maker but the most important market player, because it is the only land provider and owns almost all the big real estate companies. However, the local government and central government do not see eye to eye.

Despite spectacular growth in the housing supply, for the majority of Chinese, owning a small apartment has become increasingly out of reach. The central government, seriously concerned about the systemic risk and about social instability, has begun the arduous task of pulling the price of housing back to a reasonable level.

It has made many policies, such as tightening monetary supply, increasing the size of down payments, increasing the cost of mortgages and restricting the purchase of additional apartments.

The central government will need to continue the efforts to pull prices back to reasonable levels, and it has many highly effective tools at its disposal, such as imposing high property taxes, continuing restrictions on additional apartments, providing more apartment rentals, releasing more land, investigating public servants' property holdings, reducing the expectation of inflation, and providing more opportunities by giving up its monopoly in many industries.

Local governments continue to rely on land sales for revenue and they together with real estate and property developers are a powerful lobby. They do not want a sharp drop in prices.

However, there are some new trends. Many wealthy families are considering investing or even migrating abroad, which will reduce demand and increase supply. And the government, with the legitimacy of its authority in mind, will need to ensure a soft landing for house prices.

Two important groups driving high housing prices in China are foreign investors and private entrepreneurs. It seems that they are withdrawing from China.

As capital assets, the prices are mainly decided by the expectation of future prices. Because housing prices have kept rising without fail for many years, a self-fulfilling expectation has been created. But after all these years of speculation in real estate, 2012 may prove to be a turning point.

Since price expectations are at a turning point, a drop in prices is highly likely. China is vast, and different levels of cities will face different situations.

For first-tier cities, a drop of 30 percent this year may be a little too big to contemplate -it would put at risk local government revenues, government debts and bank loans. A more plausible drop in housing prices would be in the order of 15-25 percent in first-tier cities, 5-15 percent in second-tier cities and up to 10 percent in third-tier cities.

Considering changes in competitiveness, aging of the population, urbanization and future inflation, it is possible housing prices in first-tier cities will be halved in the long run. For the first several years the drop will be big, and for the following years the drop will be small.

The author is a lecturer at the Management School of Shanghai University and a research fellow at the China Europe International Business School Lujiazui International Finance Research Center. The views do not necessarily reflect those of China Daily.

(China Daily 01/20/2012 page11)