The China Bubble

With over a billion people and an economy poised to surpass Japan’s as the 2nd largest in the world, it seems everything that happens in China has an oversize impact on the rest of the world. So what if China’s economic growth turns out to be as reliant on inflated collateral and unsustainable debt as the Europeans or the Americans? Is there a China bubble?

A recent report on CBS “60 Minutes” provided visceral evidence that formation of a real estate bubble is undoubtedly already well underway in China. The report showed entire cities in China’s northeast that were newly constructed and completely unoccupied. This anecdotal evidence is backed up by other reports, such as noted by fund manager Jim Chanos in an interview on Charlie Rose on April 14th, 2010. In the transcript, “Jim Chanos on China’s Property Bubble: Charlie Rose Interview,” Chanos is quoted as saying “The fact of the matter is the game [real estate speculation] has to keep going…because so much of their GDP growth is in construction…50% to 60% of China’s GDP is in construction.”

The more you dig, the more it appears China is not just starting to inflate their real estate bubble, but that China’s real estate bubble is about to pop. China is doing almost exactly the same thing the Americans did – and the fact China has stricter regulations on mortgage lending, with between 30%-50% down payments required on real estate purchases – has not slowed the growth in real estate asset values, the rate of new construction, or the growth in residential and commercial vacancy rates. Go all the way back to 2007 for these statistics from The China Expat, in the report “China Housing Bubble Late 2007 Update:”

“Apparently, housing prices in Suzhou averaged about 500 RMB per square meter six or so years ago. Now, the average seems to be hovering around 7-8000. A rise of 14-16 times, which is even greater percentage wise than the increase in Shanghai housing prices… At the low point in the late ’90s, much of the prime real estate in Pudong [Shanghai] was selling for 1000-2000 RMB per square meter. Today, decent real estate in Pudong starts at 13,000 RMB per square meter. Residential apartments near the famed Oriental Pearl Tower goes for over 100,000 RMB per square meter.”

If you run the numbers, a 14x appreciation in the six years between 2001 and 2007 equates to a 55% increase every year. Fast forward 2.5 years to the present – how much more appreciation has occurred?

In a USA Today report from April 24th, 2010, entitled “If hot China real estate market stumbles, will USA get bruised?,” here is evidence that China’s real estate asset appreciation hasn’t begun to slow:

“Real estate prices have risen for nine consecutive months in China, making home purchases unaffordable for a growing number of white-collar workers. Among large cities, commercial and residential prices in Shenzhen — known as much for its wealth as its seemingly boundless growth — have gained the fastest, rising nearly 21% in the 12-month period ended in February. Overall, the most dramatic jumps are in Sanya, a resort city in southern China where property prices were nearly 50% higher in February than a year earlier, according to the National Bureau of Statistics. Analysts believe that China’s official data likely understate the price increases.”

The same USA Today report also has some good information on what prices actually are for real estate in China, as well as information on vacancy rates. Consider these nuggets:

“At the Curio — one of the most expensive new buildings in the city [Shenzhen] — buyers can purchase a nearly 2,400-square-foot apartment for $1.9 million. In the USA, that amount would buy a 2,400-square-foot beach house in Santa Cruz, Calif., a 12-acre New England farm in Sharon, Conn., or a four-bedroom pad near New York City’s Central Park.

In Shanghai and Guangzhou, the commercial vacancy rate exceeded 15% at the end of 2009. Meanwhile, in Beijing’s central business district, the commercial vacancy rate was 29.2%, while the citywide vacancy rate was about 20%, according to real estate broker CB Richard Ellis.

A healthy vacancy rate for Beijing would be around 10%, says Jack Rodman, president of Beijing-based Global Distressed Solutions, a property consultant. But he believes the city’s actual commercial vacancy rate is closer to 50%, after taking into account office space that’s been completed but isn’t on the market. To get back to a normal occupancy rate could take 15 years, he estimates.”

In a MoneyLife report entitled “The China real-estate bubble,” dated today, June 8th, 2010, the following data was provided:

“Depending on whose numbers you believe, real estate in 70 Chinese cities has risen between 12.8% to 18% over the past year and 95% in Beijing. To buy an apartment in Beijing would cost the average wage earner 17 years’ income.

To pay for these skyrocketing prices the amount of mortgages as a percentage of GDP has exploded from an average of 10% from 2005 to 2008 to 16%, while the amounts have tripled from 500 billion yuan to 1.75 trillion yuan. But is this a problem?”

This is a huge problem. If 50% or more of your economy is construction oriented, and real estate values have appreciated at 3-5x the rate of GDP growth for a decade, and GDP itself is tied to construction activity, this is indeed a huge problem. The large down payments required in China, 30-50%, are about as useless as minimal down payments or zero down payments, if the property suddenly begins to depreciate for more than a year or two at the same rate it once appreciated. So what if you have put 30% down, if your property has appreciated 50% in the year before you bought it?

As noted in the post “The Razor’s Edge – Inflation vs. Deflation,” collateral is wealth; collateral is currency; the ability of collateral – asset value – to create purchasing power simply dwarfs the impact of national fiscal and monetary policies – especially in the short run. Think of a nation’s fiscal and monetary policies as the helm and the rudder of a giant ship. Think of collateral as the ship itself. Point the ship at an iceberg for a thousand miles, and try to stop the collision when the ship is on a direct heading and 1,000 feet away. It can’t be done.

The United States experienced low double-digit rates of real estate appreciation for about five years, and is paying an awful price. The Chinese have now experienced mid double-digit rates of real estate appreciation for nearly twice as long. There is no doubt their real estate market will correct – to put it mildly. What does this all mean?

First of all, there will have to be some triggering event. In the U.S., the triggering event was basically when the buying frenzy began to slow down. Once prices stopped getting bid upwards, the searing light of day began to shine onto Potemkin Villages of overpriced and empty buildings from Miami to Las Vegas, and the party ended. Sooner or later, the Chinese are going to experience exactly the same thing.

Once this happens, China’s construction industry is going to shrink dramatically. With commercial and residential real estate nationwide already at 25% vacancy rates, there is no other option. And unlike the United States, where construction barely exceeded 10% of GDP even during the bubble, China’s construction industry is estimated to be at least 50% of their GDP. When construction falters, China is going to experience massive unemployment.

As China’s economy enters its version of the great recession, how the rest of the world adjusts is difficult to predict, but the effect may not be as dire as one might imagine. China has only in the past quarter become a net importer after years of massive trade surpluses, so few countries – certainly not America – are overly reliant on exports to China. And China’s GDP, despite having experienced miraculous (and unsustainable) expansion over the past 10+ years, is still only tied with Japan’s at around $5.0 trillion per year, compared with the U.S. and the European Union who both are about triple that size. China’s GDP only represents about 8% of the global economy. Given the economic turmoil that has already erupted in the U.S. and the EU, it is possible China’s economic slowdown will not catalyze further economic difficulties elsewhere. It will certainly take pressure off energy prices. The biggest risk is a China crash will contribute to global deflation, which remains the most terrifying bogeyman of all.

In America, unfunded liabilities and expanding debt present financial policymakers with a potentially ominous future. But America is watching the Europeans grapple with a debt-fueled meltdown at least as severe as America’s, because it is exacerbated by problems America doesn’t have – a strained integration of previously independent national economies, an entitlement-driven statism that America, at least so far, does not match, and a population aging far more quickly than America’s. And China also faces an inverting age demographic that is going to challenge them economically within the next 10-20 years.

China’s asset bubble going to burst, throwing them into a financial crisis and raising anxieties around the world. The real question is will America adapt and learn from the economic carnage witnessed elsewhere? America’s response in this scenario, where sudden economic downturns in China and the EU underscore America resilience, is an opportunity that cannot be missed.

The biggest risk of America reemerging economically amid relatively worse economic problems in the rest of the world is that their good fortune will be squandered, as structural reforms to America’s economy are deferred or abandoned in the face of a deceptively positive economic performance. America will still be able to print currency at will, borrowing additional trillions because even as a nation dealing with unprecedented debt, she still has the most diverse and secure economy on earth. Most crucially, America may delay reforming her public sector, using her ability to persist in massive federal deficit spending only to indulge in overpaying public sector bureaucrats – a hideous waste of deficit spending, which is properly used on infrastructure projects and technology initiatives that yield long-term strategic returns on investment.

America can use this coming decade of economic reprieve, purchased by more severe economic challenges in China and the EU, to make deficit-fueled but genuine investments that will secure her future economically, or America can use this opportunity to simply spend another decade printing borrowed money to pay excessive compensation to unionized public employees. Such a feckless act will inflate the mother of all bubbles, an American debt bubble of unprecedented and ever burgeoning magnitude that will progressively induce investment to gravitate to chastened, reformed and recovering foreign shores. A bubble fueled by irresponsibility and corruption, and ignored 2nd chances, whose cataclysmic burst will signal the end of the America era.

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2 comments to The China Bubble

  • David Somers

    With the recent curbs enforced by the Chinese government on internet transfers of information, I believe a person could speculate this massive real estate debacle is already occurring and has been since American consumer demand weakened 2 years ago.The Chinese are famous for hiding facts.

  • yujiao

    With the recent curbs enforced by the Chinese government on internet transfers of information, I believe a person could speculate this massive real estate debacle is already occurring and has been.