Letting the air out of the bubbles
Rather than bursting, mainland real estate and credit markets will take decades to unwind
Despite the familiar refrain from analysts these last few years, China's real estate and credit bubbles have not burst.
While I, too, am worried, I have not been brave enough to venture a prediction until now: I think the bubble will gradually deflate over a decade or two, rather than burst dramatically.
I draw my inspiration from the Chinese stock market, which has been deflating gently for 22 years and counting.
Since China's stock market was created in 1992, it has been a bubble. Its price-earnings multiple has fallen from about 100 times to about 20 times. Excluding the 16 banks that trade at single-digit multiples, the ratio is still almost 30 times.
That deflation has destroyed trillions of yuan of valuation and hurt many millions of innocent savers and gamblers alike. In these 22 years, China's money supply has grown 43-fold, but the stock market is still gasping for air. It is truly water torture.
China's stock investors often sell their investments in well-performing stocks and funds while holding on to their losing bets. For example, there are always massive redemptions once a fund outperforms.
Peter Lynch, who used to manage money at Fidelity, ridiculed this behaviour as "pulling the flowers and watering the weeds". It is an irrational human behaviour globally, but much more pronounced in China, where retail investors dominate.
So instead of bailing out of a weakening real estate market, they will most likely hold tightly on to their holdings of housing units if the prices should weaken, provided that they have the holding power.
China's households are very under-geared. Credit card debt is a tiny fraction of banking sector assets. Car loans are negligible. Mortgage loans on housing have grown, but nothing like in the US or Europe.
For most mortgages, property prices would have to fall by a third or even half before hitting equity. Most mortgages older than a few years have built a thick cushion on the back of regular repayments and rising property prices.
Corporate leverage is high in China, but over half of the economy is still in the hands of the state. The government runs a broadly balanced budget.
The central government and the layers of local governments are one and the same thing. Beijing not only dictates local governments' taxes and expenditures but also sets the formula for sharing revenues with them.
In many cases, the central government also issues bonds on behalf of the local governments. This is sure proof that local governments are simply subsidiaries of the centre. We are unlikely to see a Chinese Detroit go bust while the central government stands idly by.
In hindsight, the US crisis in 2008 was triggered by the "free market religion" long adhered to by the US government and the Federal Reserve. If those institutions had poured enough money into Lehman Brothers and other "too big to fail" institutions when the first signs of a panic emerged, a crisis would have been avoided.
In China, there will be no congressional debates in the event of such a challenge. They will just throw money at the problem. After much politicking, the US government and the Fed did pretty much what the Chinese government did straight away.
China doled out a four trillion yuan (HK$5 trillion) stimulus package in late 2008 while US politicians were still locked in debate. The Chinese are far more tolerant of the "moral hazard" a quick rescue may create.
Finally, it is important to consider some cultural and institutional factors related to China's real estate market.
(1) Unlike in the US, Chinese citizens cannot declare bankruptcy or walk away from their mortgages. Their liabilities will be with them forever, until repaid.
(2) There is a stigma attached to housing defaults. In Hong Kong, for example, while a person can declare bankruptcy, households continued to service their mortgages long after the values of their homes had fallen well below their mortgage liabilities after the crisis in 1997.
So, what is going to happen to the millions of vacant flats and the very high housing prices across China? The outcome is most likely a gradual deflation, lasting many years or even decades. The deflation will constitute destruction of household savings and wealth, much like the protracted deflation of the country's stock market.
But as the destruction will be spread out over many years, its drag on the economy will be gradual rather than dramatic.
Joe Zhang is the author of Inside China's Shadow Banking: The Next Subprime crisis?