• Tue
  • Dec 23, 2014
  • Updated: 7:07am

Letting the air out of the bubbles

Rather than bursting, mainland real estate and credit markets will take decades to unwind

PUBLISHED : Wednesday, 02 April, 2014, 11:28am
UPDATED : Thursday, 03 April, 2014, 1:00am

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.

China's money supply has grown 43-fold, but the stock market is still gasping for air

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?


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Given the austerity effort in the western governments, deleveraging of their people, trade barriers, cropping-up of mini-world-factories all over the world, manufacturing jobs flowing back to the US, QE tapering hence rise in US interest rate hence renewed US dollar strength, recent massive EM currency depreciation (in addition to those since 2011), more-than-30% revaluation of the yuan/US$ exchange rate since 2005, and massive increase in China's real-wage-rate/worker-productivity ratio,
China’s continued yuan appreciation against the US dollar (in the name of yuan internationalization) is a dumb policy, because now she needs a relatively strong external demand to supplement the drop in the (growth rate of ) domestic investment, so as to maintain her future GDP growth.
China's consumption expenditure takes a long time to grow further, and some of it is disguised as government expenditiure and business investment.
There are other ways, other than yuan revaluation, to encourage the Chinese enterprises to upgrade their manufacturing productivities (like tax reduction and government subsidies).
Like the world’s DRAM market, there is no way to eliminate the excess capacity, and the market can’t return to equilibrium, if those inefficient enterprises don’t withdraw from the market.
China’s growing service sector should be able to absorb those released surplus workers.
Of course, China’s GDP growth rate has to come down if the economy is to be rebalanced from less investment to more domestic consumption.
But there are other considerations as well.
Too-low GDP growth rate will lead to the problem of growing unemployment, thereby affecting the systemic stability of the whole country.
So, not only must the growth-rate floor be maintained, the minimum wage rate has to be further increased, and the inflation rate must be subdued, to appease the Chinese people and to prevent any Arab-Spring-like revolution from happening in China.
If China further opens up her capital account, then the international loan market is also opened to the country.
Suppose the Chinese government wants to deflate the property market and asks the policy banks to stop lending to the property developers.
The developers will start to borrow from the international market.
(Indeed this has already been the case even before the capital account is fully opened.)
This will frustrate the govenment's attempt in subduing the overheated property market,
and the bubble will get bigger and bigger (especially if the Chinese investors remain invested in the local property market and don't diversify their investment in other countries).
There's also the problem of maturity mismatch.
The Chinese developers tend to obtain short-term (1-year) loans from the foreigners.
If, because of government intervention, they can't sell their accumulated stock on time and turn them into cash flows, then they can't repay their foreign debts,
unless those debts are evergreen debts (can be rolled over).
Or they have to reduce greatly the price they have been charging, encouraging the potential buyers to wait longer, opening the stage for the deflation of the bubble.
Also, because of the opening up of the capital account, there will be short-term capital inflow into the country.
The fund will most probably not enter into the real economy.
Instead, they may further prop up China's property market, creating a fake prosperity.
Property sector bubble is a symptom of the failure of an economy’s economic development, because when the economy is in deep trouble ( for one reason or another), the government (democratic or not) finds it necessary to do something about it.
Usually expansionary monetary policy is used to try to stimulate the economy.
But the average rate of return of the real economy has already become relatively low (due to the law of diminishing marginal returns, especially when there is no breakthrough in technology advancement which greatly increases productivity growth),
so the profit-seeking capital ultimately flows into the property sector, thereby creating a housing bubble.
Like throwing more sand into a pile of mountain-like sand, eventually it will crumble down under its own weight.
(From ‘Good Bye, World Factory’)
So, to maintain China’s GDP and employment growth this year,
using one-size-fits-all expansionary monetary policy will only cause further wasteful investment and excess capacity,
thereby maintaining the life of those should-have-gone-extinct zombie enterprises.
Instead, pin-pointing expansionary fiscal policies (and a weaker yuan) is the better policy choice.
The package indirectly caused China’s present real estate and credit bubbles.
Profit-seeking capital always flows to the sectors with the highest possible returns.
In China, one part of those capital flowed to the property sector, hence the current real estate bubble.
The other part flowed to the shadow banking market, whose funds were mainly obtained by the local governments and the SOEs (almost at all costs), causing wasteful investments and excess capacities, and also the present credit bubble --- fast-rising government and now-too-high enterprise debts.
It can be said that a real estate bubble means a sign of failure of the country’s economic development --- it means that very few real economic investments can produce as high a return as that of the bubbling property sector.
After the 2008 crash in the west, external demand for China’s exports fell tremendously, adversely affecting the country’s GDP and employment growth.
In principle, at that time those inefficient enterprises (SOEs or whatever) should have gone extinct, leaving resources for those efficient ones to better compete in the next cycle.
In practice, this kind of painful adjustment is almost always never done, everywhere in the world.
Instead, the government always comes to the rescue.
The 4-trillion-yuan stimulative package was enacted in 2008 in China.
As was said by UBS’s Tao Dong, ‘without US’s disease, China nevertheless took the same medicine.’
Once again, the road to hell is paved with sincerity --- a majority of them are the government’s well-intentioned but misguided policies.
To know a bit more about China's housing bubble, you can also read the following:
'Does China have a housing bubble? Here’s why nobody knows for sure'


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