The consensus is that China has a real estate bubble. The only argument is whether it will burst in some crash that will take down China’s economy or come in for a relatively soft landing that slows China’s economic growth but in no measure extinguishes it.
It’s tough for me to come down on one side of that debate or the other because most of the time the protagonists don’t bother to set out what the bursting of a real estate bubble would look like in China. There’s a kind of unspoken vague agreement that a Chinese bust wouldn’t look like a U.S.-style bust, but no real effort to put real flesh on the bones of a China-style bust.
And without fleshing out what a real estate bust in China would be like, it’s just about impossible to decide the seriousness of that bust or the extent of its consequences.
Let me take a run at that and see if the effort helps settle the crash vs. soft landing debate. Or at least moves it along a bit.
I don’t think there’s any real argument about this: China is in the midst of a speculative rise in real estate prices that can’t be sustained.
Housing prices rose at an 11.4% annual rate in June. And that was down from a 12.4% annual rate of growth in May and a 12.8% annual rate of growth in April. New home prices rose even faster—at an annual rate of at an annual rate of 14.1% in June.
With prices rising at that pace developers and speculators have rushed to build. In the first five months of 2010 investment in the property market grew by 38.2% from the same period in 2009. And that rate was two percentage points higher than in the first four months of the year.
With supply soaring only cheap money kept the game going. Banks flooded the market with mortgage money in 2009 and into 2010. Loans for second homes. And third homes. Loans to buyers with inadequate incomes. Loans to buyers without credit checks.
Up to this point, the scenario sounds incredibly similar to the run up to the housing bust in the United States.
But there are crucial differences.
First, Chinese buyers never got nearly as leveraged as those in the United States. Down payments in China were a high 30%.; in the U.S. at the height of the frenzy lenders were bundling two mortgages together so that a buyer could borrow the required (and much smaller) down payment as well. Effectively home buyers were putting nothing down. And Chinese home buyers started off with a much larger base of savings. In 2009 the Chinese savings rate was around 40%. In the years just before the end of the boom in the United States the savings rate had actually turned negative.
As a result of those differences I don’t think a real estate bust in China would set off the huge contraction of family balance sheets and consequent steep drop in consumer spending that has resulted from the bust in the United States.
Second, the U.S. boom was a top to bottom boom: rich people in California and Florida and poor people in rural North Carolina and Detroit all got sucked into the whirlpool either through mortgages that let high income families buy more house than even they could afford or through 0% rate teaser refinancing for low income families that couldn’t pay the freight once the real interest rate kicked in. In China the boom has been concentrated at the upper end of the income scale. Speculators have built more and more luxurious apartments and houses at higher and higher prices for China’s population of newly well-to-do. At the same time the country is facing am extreme shortage of affordable housing even the average middle-class Chinese family.
Which has created a strangely bifurcated market. At the upper end huge building programs and the Beijing government’s recent moves to slow lending have created a large supply of empty luxury apartments. Prices in this part of the market have just started a drop that could easily extend to 20% or 30%. In Shanghai the price of the average new luxury home dropped by 13% from April to July, according to China Real Estate Information. (That took the average price for a luxury home down to a still very elevated $9,212 per square meter.)
At the other end rapidly growing cities such as Chongqing are launching crash programs to build housing for anticipated millions of new inhabitants who have been priced out of the private real estate market. In the case of Chongqing projections called for 1.5 million new inhabitants over the next there years and the city is planning to build 30 million square meters of public housing to meet the demand.
This bifurcation means that China is unlikely to see the collapse in housing construction after a bust that has characterized the U.S. experience. If the high-end collapses, as seems quite possible, taking many developers into inactivity if not actual bankruptcy, the public sector is already gearing up to take up the construction slack. And in a command-style economy such as China’s revving up a public housing construction program is actually an easy task. (For more on some of the advantages and disadvantages of China’s command-style economy see my post So remind me–why are we so worried that China’s economy will slow big time? ) A housing market bust in China would have less effect on national economic activity after the initial shock than the bust in the United States has had.
Third, while the commercial real estate bust followed after the housing bust in the United States—and remained largely a problem for regional U.S. banks, in China commercial real estate could actually lead the crisis and create bigger problems for property development companies that their lenders. It’s hard to get national statistics on vacancy rates for commercial buildings in China, but from anecdotal evidence the problem is huge in hot cities such as Beijing and Shanghai.
Beijing had an office vacancy rate of 22.4% in the third quarter of 2009, according to CB Richard Ellis. In the eastern part of the city the vacancy rate at the huge Central Business Development is 35% but plans call for doubling the size of the project. In all 13 million feet of new office space are scheduled to enter the market in 2010.
Fourth, the list of who’s on the hook in the two busts is radically different. In the United States the damage started with the banks who had made the initial mortgages—such mortgage lenders as Household, Countrywide, and Washington Mutual are no longer with us—but it quickly spread through the markets for mortgage-backed securities and derivatives based on those securities to financial institutions such as insurance companies (American International Group), investment banks (Lehman Bros. and Bear Stearns), and then overseas to financial institutions that had bought some of the paper backed, ultimately, by the power of U.S. homeowners to pay their mortgages. That meant the U.S. housing bust took down institutions such as Dutch insurer ING (ING).
In China, first on the hook at the property development companies such as China Vanke, China’s largest developer by market value, Poly Real Estate, China’s second-largest developer, and Gemdale, the fourth largest.
Second are China’s local governments, which are among the biggest lenders and the biggest investors in many real estate projects. Local governments in China are constantly strapped for revenue since they have little ability to raise funds. The real estate boom must have seemed like a perfect solution. Local governments would organize land sales to developers, often using the coercive powers of government to get the land at a low price, and then collect fees from the sale. Often the local government would become a partner in the project. And if financing was a problem, local officials would either lean on a bank for a loan or arrange a loan through an investment company set up by the local government for the purpose of funneling loans to developers. (So what that local governments couldn’t legally set up such businesses?)
Now the local governments are facing two big problems. First, with the slowdown in property development, they’ve lost a major source of revenue. A city such as Tianjin, located east of Beijing, got 41% of its revenue from selling land in 2009. Second, local governments are faced with bad loans and failing projects. Estimates say investment companies run by local governments had extended $1.7 trillion in loans as of the end of 2009. (For more on how deeply in hock local governments are see my post Despite those huge reserves, China could be, gasp, broke.)
Third, of course, are China’s banks. Beijing is sufficiently worried about the amount of bad loans that these banks have made to real estate developers that the People’s Bank has told banks to increase the reserves they keep with the central bank and also to raise new capital in Hong Kong and Shanghai to the tune of more than $40 billion. (For more on this scheme to raise reserve requirements and at the same time to raise capital, see my post Move over Charles Ponzi and Bernie Madoff–China is running history’s largest financial scam.)
Fourth, and finally, as in the United States, there’s the national government. But even here China follows its own solutions. Instead of putting tax payer capital at risk by direction investments or guarantees to troubled financial institutions, China’s government prefers to rearrange the players and redistribute the liabilities. Its solution to the bad bank loans that followed from the 1997 Asian currency crisis was to set up new off-balance sheet investment companies that took bad loans off bank books and effectively buried them. I suspect that if push came to shove and the People’s Bank plan to recapitalize China’s big banks didn’t work, Beijing would work a similar plan in this crisis.
And fifth, as a result of the first four differences, I think a real estate bust in China would inflict more limited damage. Although a real estate bust in China would knock the Shanghai and Hong Kong stock markets for a loop—since both exchanges have heavy exposure to property development companies—I don’t see it creating the kind of multi-year, lingering economic downturn that the real estate bust has created in the United States. The leverage of the financial system and consumers to the boom and bust isn’t as great as it was in the United States, the bust won’t send the entire construction sector into a near depression, and the government has unique tools that let it bury bad debt in the financial sector very efficiently.
A real estate bust in China would be very bad news for China’s stock markets but the damage to China’s economy—and global economy—would be far more limited than the effects of the U.S. housing bust has been.
Of course, the above doesn’t decide between the bust and soft-landing arguments. But at least it fills in some of the details of what we’re arguing about.