China builds rebalancing on weakness in real estate
Government needs to absorb investment-driven bad debts to avoid a crash in property sector
China's economy is rebalancing. Unfortunately, it is changing a lot like the United States did in 2006 and 2007, with a sudden slowdown in real estate.
That was perhaps inevitable, but it raises some familiar risks - a chain reaction of real estate losses, debt defaults and a sudden slowdown in growth.
The costs for the rest of the world could be high, particularly in places like Brazil and Australia that have prospered by feeding China's formerly insatiable appetite for raw materials.
Growth of China's gross domestic product is expected to slow to 7.3 per cent this year, the smallest expansion in 24 years, according to a poll.
On the surface, that is in line with a government goal of transitioning from an economy dependent on investment to one more like that of more developed countries, with a higher consumption share.
But while consumption is growing as a share of China's economy, it is doing so in significant part because investment, particularly in real estate, is falling in importance.
Property investment fell in the first quarter to 12 per cent of GDP from 15 per cent last year. That compares with about 5 per cent in the US. The value of new homes sold fell 7.7 per cent and new home starts dropped more than 25 per cent.
That in turn very likely was driven by a tightening of financing conditions, with the widest measure of lending down more than 9 per cent from a year ago.
And overall debt in China is very high, with some evidence that absent a continued flow of new borrowing, bad debts will have to be faced.
"Burgeoning debt was not an unlucky accident," said Michael Pettis, a finance professor at Peking University. "It is fundamental to the way the growth model works, and we have arrived at the stage, probably described most imaginatively by Hyman Minsky in his work on balance sheets, in which the system requires an acceleration in credit growth simply to maintain existing levels of economic activity."
Pettis argues that China's debt problems have become so large that they cannot be "managed" by imposing discipline on borrowers or reforming banking.
"Without a massive transfer of wealth from the state sector to the household sector, it will be impossible for growth rates of anything above 3 to 4 per cent - and perhaps even less - to occur without an unsustainable increase in debt, whether that occurs inside or outside the formal banking system and whether or not discipline has been imposed on borrowers," he wrote.
A Minsky moment, the sudden collapse of asset values when debt-fuelled speculation comes to a sudden halt, would be, like everything else, different in China.
China has pulled off an economic miracle, but it has done so by relying heavily on investment, and with an increasing proportion of that investment funded by debt. So far, so Minsky.
While it is true that the quality of investment has fallen, theoretically reducing borrowers' ability to repay debt, the story is not as simple as it would be in the US.
In China, not only is everything a political question, the state's apparatus has far more power to manage how political questions are resolved.
So, while the government has a stake in a transition away from low-quality investment, many bet that it will not allow credit to tighten so badly that real estate crashes.
As individual borrowers tend to be less leveraged than in the US, that makes the job of managing a credit slowdown a bit easier.
It does not make a real estate crash impossible, however. Animal spirits work the same way in China that they do in Orlando, Florida, and with about 10 years of overbuilding to work through, it is not hard to see the possibility of a cascade of weakness through the economy.
Ultimately, bad debts in China will need to be recognised and absorbed by some sector. Pressing them on to households goes against the goal of increasing consumption, while company balance sheets seem unlikely to be able to handle the sheer size.
That leaves the government, which may be China bulls' best hope.
It will not end at China's borders. Managed or out of control, the transition to lower investment is at hand, and for those who have done well out of it - think resource-heavy countries - the most they can hope for is enough time to absorb the blow.