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Bubble, Bubble…China's Trouble
07/23/2010 9:33 am EST
Many aspects of China's real estate bubble mirror the run-up to the housing bust in the US. But there are important differences as well.
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 either side of that debate, 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 US-style one, but no real effort to put 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-versus-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 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 38.2% from the corresponding period of 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. Let me describe a few.
1) Chinese Buyers Aren't Nearly as Leveraged as US Buyers Were
Down payments in China were a high 30%; in the US, 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. Homebuyers effectively were putting nothing down.
And Chinese homebuyers started off with a much larger base of savings. In 2009, the Chinese savings rate was about 40%. In the years just before the end of the US boom, Americans' 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 have resulted from the bust in the United States.
MORE: Commercial Real Estate May Be Worst of China's Woes|pagebreak|
2) The US Boom Was Top to Bottom
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 they could afford or through 0% teaser financing for low-income families that couldn't pay once the real interest rates 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 the newly well to do. At the same time, the country is facing an extreme shortage of affordable housing for middle-class Chinese families.
That 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 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 $856 a square foot.)
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 call for 1.5 million new inhabitants over the next three years, and the city plans to build about 323 million square feet of public housing to meet the demand.
This bifurcation means China is unlikely to see the collapse in housing construction after a bust that has characterized the US experience. If the high end collapses, as seems 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 easy. (For more on some of the advantages and disadvantages of China's command-style economy, see my July 13 column.) 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.
3) Commercial Real Estate May Lead China's Woes
The commercial real estate bust followed the housing bust in the United States—and remained largely a problem for regional US banks—but in China, commercial real estate is leading the way. It's hard to get national statistics on vacancy rates for commercial buildings in China, but anecdotal evidence suggests 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 square feet of new office space is scheduled to enter the market in 2010.
NEXT: Who's to Blame for China's Bubble?|pagebreak|
4) Different Folks Are on the Hook
In the United States, the damage started with the banks that 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 (NYSE: AIG)) and investment banks (Lehman Brothers and Bear Stearns) and then overseas to financial institutions that had bought some of the paper backed, ultimately, by the power of US homeowners to pay their mortgages. That meant the US housing bust devastated institutions such as Dutch insurer ING (NYSE: ING).
In China, first on the hook are the property development companies such as China Vanke, China's largest developer by market value, and Poly Real Estate, China's second 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 because they have little ability to raise money. The real estate boom must have seemed like a perfect solution. Local governments organize land sales to developers, often using the coercive powers of government to get land at low prices, and then collect fees from the sales. Often the local government becomes a partner in a project. And if financing is a problem, local officials can 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 if local governments can't legally set up such businesses.)
Now the local governments face two big problems:
- With the slowdown in property development, they've lost a major chunk of revenue. A city such as Tianjin, southeast of Beijing, got 41% of its revenue from selling land in 2009.
- 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 this blog post.)
Third on the hook: China's banks. Beijing is sufficiently worried about the amount of bad loans made to real estate developers that bankers have been ordered to increase the reserves they keep with the People's Bank of China, the country's central bank, and 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 June 2 column, "China's Ponzi-Like Banking Policy.")
Fourth—and finally, as in the United States—there's the national government. But even here China follows its own solutions. Instead of putting taxpayer capital at risk, 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 those 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.
Although a real estate bust in China would knock the Shanghai and Hong Kong stock markets for a loop—because 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 allow it to 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 the global economy—would be far more limited than the effects of the US housing bust have 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.
At the time of publication, Jim Jubak's personal portfolio did not include shares of any company mentioned in this column.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.
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