Global Economy's Next Threat: China's Real Estate Bubble

We might be tempted to envy China's spectacularly resilient real estate boom: After sagging in the global financial meltdown of 2008, property values in China's urban centers skyrocketed in 2009. Shanghai's Pudong district, for example, experienced a 57% rise in a matter of months.By comparison, residential real estate in the U.S. is up 3.4% on average from its bottom in May, but still almost 30% below its peak in April 2006.

%%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%%However, those admiring China's reflated housing bubble might be careful what they wish for, as the new real estate bubble in China is even more precarious than the one which imploded in 2008.

The popping of China's current housing bubble -- considered inevitable by regional experts such as Andy Xie -- could have widespread consequences. If housing turns down in China, China's growth could slow or even decline. And since the entire world is looking to China to lead global growth, then that could spell major trouble for the "global economy is recovering" story.

China's Stimulus Dwarfs America's

The reflation of China's real estate bubble has a number of causes, and the most obvious one is that nation's stupendous $586 billion stimulus, which was packaged with efforts to promote real estate lending and development to boost growth. According to China's central bank, new home mortgages in the first nine months were quadruple the amount borrowed a year earlier.

In terms of GDP -- China's GDP is $3.3 trillion compared to $13.8 trillion for the U.S .-- China's $586 billion stimulus is three times as large as America's $787 billion stimulus. China's stimulus spending is a heart-pounding 17.8% of their GDP, as opposed to America's comparatively modest 5.7% of GDP.

Even if we use the CIA Factbook's estimate of China's GDP in terms of purchasing power parity (PPP), China's stimulus is still almost triple the U.S. government's stimulus (5.5% U.S. versus 14.4% China).

Real Estate Bubble Worries Central Government

Analysts in China are concerned that this tremendous rise in construction, lending and speculative buying -- housing starts nationwide rose 194% in 2009 -- is blowing a bubble that could burst in 2010, taking down everyone who jumped into the game in 2009: homeowners, banks, developers, stock markets, and local governments.

The central government is also concerned. In late December, China Premier Wen Jiabao made a widely publicized comment that "property prices have risen too quickly." He vowed to impose new limits on speculative borrowing, such as raising the deposit requirements to purchase raw land to 50%.

Central government efforts to stimulate the property market included tax breaks, smaller down-payment requirements, lower loan rates for first-time buyers, and vastly increased bank lending. In an effort to lower the boom on speculative flipping -- buying and selling of properties within a short time span -- China's State Council announced changes to tax breaks for home sales by individuals.

Macro Picture Still Gloomy

Lost in the euphoric frenzy of China's real estate market is the glum macroeconomic backdrop. China's overall economy depends heavily on exports; from January to July 2009, China's exports dropped by 22 percent -- a major hit to the nation's income stream.

Despite the surge in domestic construction and infrastructure projects resulting from the stimulus spending, China's exports are still declining. And too much money has flowed into new and unneeded factories which are now idling at low capacity.

The present housing boom also has some serious macroeconomic headwinds. A typical 1,000-square-foot apartment in Beijing now costs about 80 times the average annual income of the city's residents, wildly out of line with the historic levels of three or four times annual income.

This speculative fever has been fed by a number of factors which will sound eerily familiar to Americans bruised by the U.S. housing bubble's rise and fall: low interest rates, official promotion of bank lending, and tax break galore for new buyers.

Unlike in the U.S., local governments in China are major players in real estate development because they sell land leases to developers for hefty sums. According to Chinese economists, up to half of all local government revenue comes from selling state-owned land to private developers.

Perhaps most dangerous, about 90% of the new construction is aimed at the luxury market, which is unaffordable to the average Chinese household. (This should sound familiar to residents of New York and other major international cities.) As a result, thousands of new homes and condos are sitting empty, purchased as investments not as places to live. The empty new city of Ordos reveals just how far the speculative fever has progressed.

This disconnect between massive overbuilding of luxury homes and what average households can actually afford raises the future risks of public anger and social discord.

China's Housing Market Is Different

To fully understand why China's housing market has ballooned into a new and increasingly risky bubble, we have to understand that it's not just government policies that have created a runaway speculative market; other financial and cultural issues are also at work.

Patrick Chovanec, an associate professor at Tsinghua University's School of Economics and Management in Beijing, China, recently described a number of these key issues. (I can confirm these from first-hand experience in China, and from our friends who have owned condos in China for many years and live there part-time.) The key issues include:

1. There are no property taxes in China, so the costs of carrying speculative (empty) homes is very low in comparison to the U.S.

2. Property values have, with brief interruptions, risen for decades, so the average Chinese household considers real estate a much safer bet against inflation than the stock market.

3. Until recently, households had few investment alternatives to a simple low-yield savings account. The incredible boom and bust in the Chinese stock market in 2006-08 -- akin to the dot-com mania in NASDAQ stocks in 1998-2000 in the U.S. -- left many Chinese investors wary of the stock market. As a result, many view owning investment properties as akin to "money in a savings account," that is, a low-risk, long-term investment.

4. Though the central government is trying to suppress speculation, it is aiming at the wrong target. Flipping property is simply not common in China; the overall number of sales of existing homes is very low by U.S. standards. The speculation arises from the easing of lending by the central government and local government dependency on real estate development for revenues and economic growth. As a result, the planned tax on private re-sale transactions will do little to lower speculation.

Hard Landing Is Likely

From one point of view, China's Central government massive stimulus and easy-credit campaign have spurred a massive malinvestment in unneeded factories, marginal infrastructure projects and speculative luxury-market housing, much of which is sitting empty as "investment properties" held in lieu of other investments by Chinese households.

History does not provide many examples of governments successfully deflating a speculative credit or housing bubble. Speculative excesses tend to run out of steam quickly and end in a bust. Now that China's central government has already gone all-out to boost the economy, the world should wonder what's left in their expansionist tool belt should China's real estate suffer the hard landing in 2010 that many analysts expect.

And if China's real estate sector runs out of steam, so too does the entire China growth story -- and the global leadership many have been counting on.
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